Get a Linear Perspective

With risk-averse banks unwilling to support anyone but the larger funds, Linear Investments has
become a lifeline for smaller, start-up clients. SAFI THIND meets the men who help the ‘little guy’

HEDGE Article August 2015

By Safi Thind – Published in HEDGE Magazine – August 2015

EVEN NAVINDER SARAO, the so-called Hound of Hounslow, needed capital. But when he approached Linear Investments for a potential cash raising service, Sarao, a day trader based in West London who is accused by the US authorities of helping crash one of the biggest financial markets in the world, was dismissed.

“He came to see us to raise capital,” says Paul Kelly, CEO of Linear Investments. “He seemed to have an attention-deficit problem; there was something not quite there. It made us uncomfortable because he operated from his own house, was highly leveraged and was doing large volumes, models which trended towards doing the same thing. So we refused.”

Admittedly, dealing with James Bondesque villains who operate out of their parents’ home isn’t an everyday occurrence for the hedge fund service company, one of the new breed of organisations taking up the slack from the fallout of the financial crisis, which has seen the guts ripped out of the banking sector’s ability to help smaller hedge funds do business.

Linear was set up in May 2010 by chairman Jerry Lees, former global head of alternative execution at Credit Agricole Cheuvreux (CAC), to provide a full-wrap service – from execution, to capital raising to prime brokerage services – effectively to allow a hedge fund to outsource everything. The idea itself was conceived as far back as 2008, with the advent of the financial crisis, which made it clear that a new dynamic was about to shape itself.

“I was looking to start Linear in 2008,” Lees says. “With the 2009 crash I saw the writing on the wall for a lot of traditional bank prime brokerages. It was obvious to us that the financial crisis and the advent of Basel III would have a massive impact on reducing the credit profile of banks and their ability to service hedge funds.”

Lees’ previous work focused on synthetic prime brokerage and electronic trading at CAC, ideas that he drew on when formulating the new company. Since setting up, Linear has grown to reach 45 hedge fund clients, and there are expectations to reach 100 in the next couple of years. The size of clients it deals with has grown from the $5m-20m (£3m-13m) mark up to $100m (£65m) currently.

Because the company doesn’t have big-bank overheads, it is able to deal with smaller clients generating combined revenue in the hundreds of thousands rather than millions, as required by banks. The majority of these are ex-prop traders looking to set up a hedge fund, though Linear has also been approached by established hedge funds wanting to outsource a fund or desk, as well as those with no ex-bank experience.

It certainly seems to be an apposite time to be in this business. Since 2010, there has been a progressive withdrawal of banks from prime brokerage. Those left are increasingly restricting this to larger funds.

“The risk appetite is not there,” says Kelly. “If you have less than $100m in assets, banks generally won’t deal with you. Given their own expenses, banks don’t see value in providing services for smaller guys. They are all shedding smaller funds. People are running out of places to go.”

Lees says that it has been a steady process getting the various components in order, building up the balance sheet and developing a track record for Linear. The company started off doing execution only in 2010. In 2012, Lees approached Kelly, who had been working as head of wholesale execution services, Europe, Middle East and Africa (EMEA), at Citigroup, to build the prime brokerage business. “We needed to put into place the infrastructure for the prime brokerage,” Lees says. “The focus has been on building broker relationships.

” The prime brokerage service was launched early last year. Linear acts in an intermediary role, bridging the gap between its hedge fund clients and bank prime brokers. For example, a hedge fund in need of leverage finance will approach Linear and open a prime brokerage account, investing funds held by Linear in its underlying accounts with global prime brokers. Through this Linear can provide leverage financing, stock loans and fully hedges the position with its prime broker.

Having a go-between is more expensive for a hedge fund than going to the prime broker directly, as it would have been able to in the past. But given that traditional routes have been closed off, it is now a necessary tack for most. Lees says the company currently has about $300m (£194m) in prime brokerage leveraged positions and is aiming for $1bn (£645m) of positions in the next 18 months.

Linear has other strings to its bow. Apart from prime brokerage and trade execution, the company also does capital introduction, connecting new and growing hedge funds with investors. It has raised £10m to £15m so far – which is modest by some standards, but the management is confident on increasing this as the company grows.

“Capital introductions can be expensive,” Lees says. “We are constantly talking to people, family offices, funds of hedge funds, going to hedge fund conferences to make connections. A capital introduction team won’t find you unless you have £500k. Whereas we start from zero.”

Linear entered into partnership with Bainbridge Partners last year to form the B&L fund, a joint venture raising capital to seed early-stage funds, which should help it raise more capital in the future.

The company also offers regulatory and compliance services. Linear has created a Cayman Islands-registered superstructure with “protected cells” that allow new hedge funds to obtain a Cayman licence for £20,000 per year, a fraction of the cost of registering directly. There are currently 20 Markets in Financial Instruments Directive (MiFID)-appointed managers held under the company’s FCA licence.

Being a regulated entity, Linear is able to provide a regulatory umbrella and passport funds across Europe. This can mean more time and cost saving for clients. For example, costs for a new hedge fund looking to register with the FCA can run up to £100,000, with a year spent registering. Doing it through the Linear licence will cost considerably less, and avoid the need to put up £150,000 regulatory capital, which is already funded by Linear.

The company is replicating its Cayman segregated portfolio fund structure in Malta, which should be ready in the next few months, allowing interested hedge funds to register in the ex-British colony.

“People like this because it gives you the option of Ucits or Alternative Investment Fund Manager (AIFM) licences and a full passport to market funds across Europe,” says Kelly. “Malta is an independent European country, not an offshore tax haven and has full double taxation international treaties. But if the fund’s investments are held outside Malta the fund pays 0% tax.”

As competition increases, getting every bit of performance is vital. In these straitened times, where small funds are finding it ever harder to meet the costs of setting up and running a hedge fund, the trick is to keep overheads down as much as possible. And it isn’t just new hedge funds that are more focused on saving money. Kelly says that more established hedge funds that have suffered under the crisis have also approached the company, with the explicit aim of reducing costs. “

A lot of the smaller funds in the £100m- £200m range have suffered the most,” Kelly says. “All their infrastructure costs have become way too high. As investors have become much fussier, there’s increased pressure on hedge funds to react to get costs down. A lot are looking to downscale.”

Yet another service offered by the company is outsourced trading, which is designed to allow funds to reduce internal operational, IT and staff costs.

“A typical fund with two traders would have costs in the region of $1m (£646,000) a year to run its desk, taking into account two salaries and bonuses, IT, Bloomberg, Voice and all the technology backup,” Lees says. “We charge the client competitively in basis points, allowing them to remove a layer of high fixed cost coming out of the bottom line. The impact is an immediate and significant contribution to the fund manager’s bottom line.”

It has already attracted a fund from the €10bn (£7bn) German Aquila Group to use its trading desk. Both Lees and Kelly are confident the company will attract more big funds who want to outsource their trading both in Europe and the US. But, just because the company deals with costcutting investors, Kelly is at pains to point out that it isn’t a free-for-all. Linear does have some strict selection criteria.

“We won’t take on CDS – there is a lack of interest from our providers to support these,” he says. “We are quite vanilla, in that we work with managers in equities, fixed income and listed derivatives.”

If you are a stay-at-home trader with tendencies to crash entire global systems, it’s probably best you don’t apply.