3
I
Prime Custody: Achieving Asset Protection & Operational Simplicity
Institutional Investors Give Up Direct
Ownership of Assets with Alpha-Seeking
Strategies
Over the past decade, institutional investors have become
the dominant source of capital for the hedge fund industry.
In our June 2011 report,
Pension and Sovereign Wealth Fund
Investment in Hedge Funds; The Growth and Impact of Direct
Investing
, Citi Prime Finance notes that allocations from the
institutional segments (pension funds, sovereign wealth funds,
endowments and foundations) reached $1.1 trillion or 52% of
the hedge fund industry’s total assets under management by
the end of 2010. This compares to allocations of $125 billion
(20% of total industry AUM) in 2002.
1
Historically, institutional investors tended to allocate funds
exclusively to long-only asset managers as their need to
ensure the stability of their assets caused them to shy away
from the hedge fund industry. For many years, high net
worth individuals, qualifed investment participants, and a
small number of pioneering endowments looking for more
diversifed returns were the only audience that focused on the
hedge fund sector.
These endowments signifcantly outperformed their peers
in the aftermath of the Internet bubble losses (2000–2001).
Using the success of these endowments as a model, many
institutional investors began to allocate a portion of their
portfolio to absolute return strategies pursued by hedge
funds. Splitting a portion of their portfolio off and allocating
that money to these new breed of managers focused on
absolute—as opposed to relative—return strategies was seen
as diversifying the institutional investor’s portfolio risks and
smoothing their long-term return profle.
However, taking on exposure to these hedge fund managers
resulted in institutional investors having to accept a vastly
different model on how the mechanics of their investments
would work.
Traditionally, in their long-only portfolios, institutional investors
would hire an investment manager to select securities and
purchase those securities on the investor’s behalf. The
manager would allocate to each investor in their fund that
investor’s share of the fund’s purchases. These securities
were placed into a segregated account with the investor’s
designated custodian and held in the investor’s name.
In contrast, institutional investors placing funds with alternative
managers would typically become a limited partner in a hedge
fund’s co-mingled vehicle. Securities would be purchased
and held in the fund’s name, not the investor’s name. The
fund manager would have full control over the designation of
these assets. To obtain the leverage many of these alternative
managers relied on in these strategies, the fund manager
would “hypothecate” or place such securities with their prime
broker to cover their fnancing obligations. The prime broker
would in turn have the rights to “re-hypothecate” or use those
assets in their fnancing pool.
Institutions with Hedge Fund Investments
Have Indirect Exposure to Broker-Dealers
The differing mechanics of these two models are illustrated in
Chart 1. As shown, securities purchased with capital supplied
to long-only managers are allocated back to the investor and
held in the investor’s name in a custody account. Securities
purchased with capital allocated to a hedge fund manager are
owned by the fund, not the investor. To secure their fnancing
arrangements, the hedge fund manager posts these assets to
their prime broker in exchange for a cash loan. This is known
as margin fnancing.
When this margin loan takes place, the hedge fund has a direct
exposure to the prime broker and its broker-dealer entity.
Because the investor is a limited partner in the co-mingled
hedge fund vehicle, they end up also having an indirect
exposure to these counterparties.
The downside of having exposure to prime brokers and
their associated broker-dealer entities became abundantly
clear in the fall of 2008 as turmoil rocked the broker-dealer
community in the wake of the Lehman Brothers bankruptcy.
In some instances, hedge funds (and thus indirectly the
investors in those hedge funds) were unable to recoup assets
that subsequently got caught up in the Lehman Brothers
bankruptcy proceedings.
Since that time, there has been much more sensitivity about
potential counterparty concerns. Both hedge fund managers
and the investors that allocate capital to these managers want
to be able to minimize their exposure to these broker-dealer
entities, particularly during periods of market turmoil such as
those noted in the summers of 2010 and 2011.
The introduction of a “prime custody” solution can provide
the desired level of protection by giving hedge fund managers
a mechanism to transfer away any “excess” securities not
being directly used to secure a margin loan to a segregated
account where the hedge fund manager maintains
ownership of those securities.
1. Citi Prime Finance estimates based on HFR, Greenwich Associates, Prequin and McKinsey & Company data.