Capital Crunch Catches Up with Hedge Funds

It is no secret that the subprime crisis has cut the amount of capital available to hedge funds. While industry players procure funding from many sources including wealthy individuals, many hedge funds rely on capital introductions and margin lending provided by their prime brokers. But the latest FINalternatives Prime Brokerage Survey conducted in May indicates that prime brokers’ capital introductions and margin lending services come up short in fulfilling client expectations.

One in three hedge fund managers considers the capital introduction services they receive from their prime brokers to be “poor”, the survey shows. In fact, only one in four rate such services as “fair”, and just one in six say they are “good”. A miniscule one in nine considers their prime broker’s capital introduction services “excellent”. A further look into the hedge funds’ fundraising dynamic helps to better illustrate the phenomenon.

As hedge funds grow in size, so do their capital-raising needs. Over 80% of the hedge funds in the early stages of capitalisation are already planning moderate to aggressive growth; and the percentage of funds planning to grow at a moderate rate expands as funds grow in size; while the percentage of funds planning to conservative growth declines to nil as funds grow in size.

Self-reported fund manager satisfaction with their prime broker’s capital introduction services offers an intriguing picture. While at least 50% of the funds with under US$100 million in assets under management find their prime broker’s capital introduction services satisfactory, funds with US$100 million to US$500 million report a dire need to improve servicing of this particular segment. Those funds in the US$500 million to US$1 billion category that are pursuing aggressive expansion are equally disappointed in the capital introduction offerings of their prime brokers, as are large funds (over US$500 million) desiring to grow more conservatively.

What is so disappointing about the level of capital introductions offered by prime brokers? The major reasons reported are prime brokers’ insufficient activity in the capital introduction space, inferiority of investors the funds are being introduced to, and the tough financial environment makes it difficult to conduct fundraising. As one anonymous survey respondent with over US$1 billion in assets puts it, “cap intro has gotten worse and worse. (The prime broker) used to have events for us to present our products to investors, but these are getting fewer and fewer, and investors are less impressive.” Another anonymous survey respondent managing US$10 million or less adds, “My only complaint (with my prime broker) is with cap intro, but I do understand the fund is small right now and the environment is difficult.”

The observed dissatisfaction with capital introduction services comes at a time when 28% of hedge fund managers report that their prime broker has tightened margin requirements in response to the crisis. Since capital introduction is a natural substitute for margin lending in that it increases the overall pool of assets available to a hedge fund manager to invest, one might expect the funds to be more dissatisfied with the capital introduction of prime brokers who tighten margin lending requirements. An in-depth analysis reveals that this is not the case: instead, it appears that the prime brokers that have succeeded at arranging meaningful capital introductions for their clients have subsequently tightened their margin requirements.

This is not to say that fund managers are thrilled with tighter margin requirements. Says one respondent managing US$10 million or less, “(the prime broker provides) inadequate systems to account for portfolio margining... (The system) capped my knees on more than one occasion and more recently placed cement on my feet and threw me into the East River.”

In fact, of funds facing tightening margins over the past year (28% of all funds), a whopping 50% are considering changing their prime broker. By comparison, of funds that report no change or loosening in their margin requirements (70% of all funds), only 7% say they are considering switching. Similarly, of funds that rate their prime broker’s capital introduction services as “poor” (34% of all funds), 39% are considering replacing their main prime broker. And of funds that rate their prime broker’s capital introduction services as “excellent” (12% of all funds), only 7% are thinking about switching their prime broker. Among the prime brokers with the highest client satisfaction in capital introductions, managers pointed to Lehman Brothers, Merlin Securities, Calyon and Morgan Stanley.

The FINalternatives 2008 Prime Brokerage survey shows fundraising to be an important and valuable function of prime brokers. But, the survey also shows that there is definite room for improvement in this space. Whether the capital can be gained through a capital introduction or via a margin loan, the end result appears to be the same: fund managers rely on their prime brokers to arrange some type of fundraising activity. Hedge funds are looking for high-paced capital introduction activity, opportunities to pitch their projects to investors, as well as reliable and transparent systems for margin lending. The gaps in capital introduction services identified by the survey can cost prime brokers clients, and at the same time can create a bonanza for third-party marketers and other hedge fund service providers who can deliver the critical fundraising services in today’s tight financial conditions.

This article first appeared in the June 2008 edition of FINalternatives Prime Brokerage. Please visit for more information.