Tag Archives: hedge fund prime broker

Prime Brokers, Margin Lock-ups & Hedge Funds

Today we have another guest post from Karl Cole-Frieman who specializes in providing legal advice to hedge funds and other alternative asset managers.  Mr. Cole-Frieman specializes in Loan Trading and Distressed Debt Transactions, ISDAs, Soft Dollars and Commission Management arrangements, and Wage and Hour Law Matters among other legal matters which hedge fund managers face on a day to day basis.
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The Margin Lock-up Returns to Prime Brokerage
By Karl Cole-Frieman, www.colefrieman.com

In 2009, the problems affecting major banks have also impacted their prime brokerage units, and accordingly there is less appetite to extend credit to hedge funds.   As the banking industry recovers, however, credit terms are beginning to loosen up again.  As a result, we are beginning to see the return of the margin lock-up for larger prime brokerage clients, who may in fact be in a stronger bargaining position for such agreements than they were a year ago.

What is a Margin Lock-up or Term Commitment?

In the most basic terms, a “margin lock-up” or a “term commitment” is a credit facility extended by a prime broker to a hedge fund or other institutional client.  The terms are used interchangeably in the industry.  Margin lock-ups prevent the prime broker from changing margin rates, collateral requirements, and often from declining to clear the hedge fund’s trades during the term of the lock-up.  For large managers, they are often 90 days, but can range from 30 days to 120 days, and perhaps even longer for the largest hedge fund managers.  Practically speaking, the way the arrangement works is that if a prime broker wants to make a change covered by the margin lock-up, they will provide the manager with the requisite notice before doing so.

Margin Lock-ups and Prime Brokerage Agreements

A margin lock-up is negotiated separately from a prime brokerage agreement, but ideally the two agreements are negotiated at the same time.  Our experience has been that it is significantly more difficult to negotiate a margin lock-up after the prime brokerage relationship has been established, and that a fund’s greatest negotiating leverage is before signing the prime brokerage agreement.

Negotiating a Margin Lock-up

There are two significant points to negotiate in a margin lock-up: (1) the scope of the commitment (and exclusions), and (2) the termination events.  For the scope of the commitment, it is essential that the commitment includes clearing trades.  Remember that a prime brokerage arrangement is a demand facility, and the prime broker can normally decide to stop clearing a hedge fund’s trades at any time and for any reason.  This is potentially highly disruptive, and could result in significant losses for a fund.  If clearing trades are covered by the margin lock-up, the prime broker will have to provide the requisite notice, which will allow time to make alternative arrangements with other counterparties.

Termination Events and Margin Lock-ups

Termination events can be very contentious in a margin lock-up negotiation.  The termination events in a margin lock-up give the prime broker the right to terminate the margin lock-up if a certain event occurs.  The prime brokers will want to negotiate off of their templates, which will initially have so many termination events it would make the margin lock-up worthless.  Managers should be wary of a completely subjective termination event, and such provisions should be negotiated out of the agreement.  For example, some prime brokers will try to insist on including a provision that it will be a termination event if the prime broker determines that it would cause the prime broker reputational risk to continue to do business with the fund.   More typical termination events include NAV triggers and key person provisions.

Bilateral Termination Events are a Secondary Consideration

Some hedge fund lawyers advocate that the termination events in a margin lock-up should not be completely unilateral, meaning, for example, that the credit rating of the prime broker should be a termination event.  We view this as a secondary consideration, and not a point to get bogged down on in the negotiation.  If a manager is concerned about the credit rating of the prime broker, they can simply move their balances.  They don’t need to terminate the lock-up – leave it in place in case the fund restores balances with that prime broker.

To find out more about margin lock-ups and other topics relating to prime brokerage or custody, please contact Karl Cole-Frieman of Cole-Frieman & Mallon LLP (www.colefrieman.com) at 415-352-2300 or [email protected]

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If you are thinking of starting a hedge fund, please contact Mr. Bart Mallon, Esq. at 415-296-8510.  Other related hedge fund law and start up articles include:

Hedge Funds and Rehypothication

Ongoing Legal Issues For Hedge Fund Managers

While many of the posts on this blog deal with start-up and regulatory issues that hedge fund managers face, we also are aware that there are many ongoing legal issues which affect the business of the fund.  Below is a guest post from Karl Cole-Frieman on hedge fund rehypothication and the prime brokerage relationship.

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What is Rehypothication?
By Karl Cole-Frieman, www.colefrieman.com

One of the most frequent questions that I am asked these days is to explain the term “rehypothication” in the context of a prime brokerage agreement.  The concept of rehypothication has been imbedded in the credit arrangements of prime brokerage agreements for years, but until 2008 and the collapse of Bear Sterns and Lehman Brothers, it was rarely discussed (except by certain lawyers who negotiate these agreements).  In the simplest terms, hypothication is the posting of securities or other collateral to a prime broker in exchange for credit or margin.  Rehypothication is the further pledging or lending by the prime broker of the already hypothecated securities or other collateral by the customer for its own purposes.

Prime Brokerage and Rehypothication

In modern prime brokerage, rehypothication is deeply ingrained in the business model of the major prime brokers.  Typically, hedge fund customer assets are rehypothicated to other banks to raise cash for the prime brokers.  Allowing the prime brokers to rehypothicate assets has historically kept down the cost of borrowing money for hedge fund managers.  In recent years, hedge funds have benefited from this arrangement by obtaining very cheap margin pricing.

Bankruptcy of a Prime Broker

The problem for hedge fund managers is that if there is a bankruptcy filing of their prime broker, hedge funds may have difficulty getting their rehypothicated assets back, particularly if these assets are held by the prime broker’s London affiliate, as the UK has more relaxed rules regarding rehypothication.  A number of highly successful managers had to literally shut their doors in September 2008 because their assets were tied up in Lehman Brothers’ London affiliate.  Lehman filed for bankruptcy in September 2008, and Pricewaterhouse Coopers, Lehman’s European administrator, currently estimates that assets may be returned to clients in the first quarter of 2010 – a year and a half later.

Hedge Fund Managers and Rehypothication

It is important for hedge fund managers to understand this concept of rehypothication for several reasons.  First, managers need to take ownership of their prime brokerage arrangements and understand them in general.  It has been my experience that many managers that take extreme care in making portfolio decisions pay absolutely no attention to their prime brokerage or custody arrangements.  As the events of 2008 demonstrated, they do so at their peril.  Imagine being up for the year, and then losing everything because the manager neglected to monitor their prime brokerage and custody arrangements.

Second, investors are asking about it.  The concept of rehypothication entered the hedge fund vernacular in 2008 and is here to stay.  Investors now frequently ask about rehypothication, and other prime brokerage concepts/arrangements, in due diligence, and there are a lot of misconceptions about the term.  Nevertheless, especially in the current environment, a lack of understanding about prime brokerage, custody, etc . . . can make the difference in receiving an allocation from an investor or cause a manager to fail operational due diligence.  Managers need to be prepared to discuss these concepts and be aware of the terms in their own prime brokerage agreements.

To find out more about rehypothication and other topics relating to prime brokerage or custody, please contact Karl Cole-Frieman of Cole-Frieman & Mallon LLP (www.colefrieman.com) at 415-352-2300 or [email protected]

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Other related hedge fund law and start up articles include:

New Model For Hedge Fund Prime Brokerage?

Nirvana Solutions’ White Paper Predicts the Emergence of a New Model of Prime Brokerage – The Multi-Prime Service Platform

San Francisco – June 15, 2009 – The financial crisis of 2008 has upset the relatively stable equilibrium previously maintained between hedge fund managers and their traditional service providers, according to a white paper released today by Nirvana Solutions, provider of Nirvana (TM), a real-time portfolio management system for multi-prime hedge funds, prime brokers, and fund administrators.

The white paper, entitled “The New Model of Prime Brokerage – The Multi-Prime Service Platform,” documents the dynamic changes to the hedge fund industry and its service providers in the aftermath of the 2008 market crash. Peter Curley, managing partner at Nirvana Solutions, examines how the roles of traditional service providers have changed, leading to the emergence of a new service model providing the full range of hedge fund services through a single, real-time multi-prime infrastructure built on a common, outsourced technology platform.

“The profound impact the crisis has had on hedge funds has already been well- documented,” Curley said. “Another significant outcome of the crisis, we feel, will be the aggregation and convergence of services provided to hedge funds through a single service provider. This new service provider cannot be adequately described as a mini-prime or a fund administrator but rather a hybrid of both, a model we are calling The Multi-Prime Service Platform.”

New requirements, such as multi-prime technology that can provide real-time views of critical data such as exposures and risk, and impending hedge fund regulation, are now converging to significantly increase the barriers to entry for new hedge fund managers. The operational efficiencies achieved through The Multi-Prime Service Platform promises to provide the critical sub-$500 million segment of the hedge fund industry–where the tension between the new requirements and the hedge funds’ ability to pay is at its most intense–a cost effective, fully integrated solution providing real-time transparency in a multi-prime environment.

To download the white paper please visit: www.nirvanasolutions.com.

New Model For Prime Brokerage Whitepaper

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About Nirvana Solutions (www.nirvanasolutions.com):

Founded in 2006, Nirvana Solutions is a San Francisco based software company that provides real-time portfolio management systems to multi-prime hedge funds, prime brokers, and fund administrators. Nirvana™ is the hedge fund industry’s first portfolio management system built around the Financial Information Exchange (FIX) protocol. The ability to dynamically accept FIX messages, combined with the aggregation of multi-prime data, ensures true real-time views of critical measures such as P&L and Risk. Nirvana’s ability to offer real-time transparency is complemented by a full suite of on-demand and historical reporting. The Nirvana solution is made available in an easy-to-deploy Software as a Service (SaaS) model and can be implemented in a modular or complete fashion.

For Further Information, please contact:

Peter Curley
for Nirvana Solutions
(415) 513-8950
[email protected]

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Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include:

Operational Issues for Hedge Fund Managers Using Multiple Prime Brokers

The hedge fund and investment management industry has seen many radical changes during the last year, including the consolidation (or elimination) of the large prime brokerage firms.  Because of these events many funds have moved to a multi-prime broker model instead of the more traditional single prime broker model.  There are obviously many advantages to going to a multi-prime broker model (including the reduction of prime broker bankruptcy risks), but there are also many logistical issues which need to be considered.

Start up hedge funds which wish to use a multi-prime broker approach should discuss this option with their hedge fund attorney as well as their hedge fund administrator which will be able to help with the back end aggregation of the prime brokerage fees.  Additionally, managers may want to seek a software solution like the one from Advent described in the press release below.  Continue reading