The Impact of Basel III and AIFMD on Emerging Funds

Liquidity, Capital and Investment are squeezed whilst costs and procedures expand exponentially.

Jerry Lees – Hedge Forum

Is there a way around the dilemma faced by all Hedge funds; rising costs, a tough environment in which to raise funds and the disinterest of most Global Prime Brokers in start-ups?  How can you build a track record without busting your budget in the meantime, and is there a faster and more cost effective way of fighting through the regulatory jungle? Global Prime brokers are not taking on emerging funds and even unceremoniously dumping smaller funds.  How does a start-up find a suitable PB who understands their needs and will nurture the fund in it’s early days?

The 2008 banking crisis and the knee jerk reaction of European regulators to implement far reaching and complex new regulatory structures, on top of an already demanding requirement rolling out under Basel III has put increasing pressure on banks to strengthen their balance sheets and reduce risk exposure. These changes are now rapidly filtering through to the hedge fund space, the pace forced by the impending impact of Basel III in 2015, and many hedge funds are finding themselves without a home.  At the same time, costs and operational/regulatory burdens are escalating following the implementation of the AIFMD directive. Hedge funds are being squeezed from all sides.

There is growing demand for boutique prime brokers to consolidate smaller and mid-sized hedge fund businesses and deliver a more palatable product back to the global prime brokers (PB) in terms of both size and structure.  Boutique Prime Brokers spread cost and services across a number of smaller funds within a group solution.

Global prime brokers are shedding smaller unwanted clients.   A white paper published by JP Morgan at the end of 2014 confirmed that; “Structural challenges to the prime brokerage financing model are, in effect, structural challenges to the hedge fund financing model.”  Accordingly, the report goes on to say, hedge funds should expect significant changes in their relationships with prime brokers.

How and why are boutique players, such as Linear, able to fill this gap and take the place of the global players for smaller and medium sized funds?  The answer, as you might expect, is not single threaded.  It is a combination of the lower cost base of the boutique and their ability to consolidate the business of many smaller clients and block up the outcome to  presenting the larger PB one high value counterparty.   The specialist boutique prime broker is able to invest in IT and systems unavailable to the smaller hedge fund due to cost and scale.   And, by consolidating services such as regulatory oversight, offshore structures, compliance, risk, IT, portfolio management systems, middle and back office and marketing and capital raising across multiple clients – the boutique prime broker delivers serious economies of scale.  This allows the smaller fund to focus on their investment strategy, reduces costs, simplifies their model and structure.  An additional advantage, from the point of view of any potential investor, the fund has a third-party ensuring adherence to regulatory and operational standards.  This can resolve many issues of proof of process for smaller funds.

Raising Capital for the Emerging Fund. 

Finally, raising capital for the smaller fund is a very difficult, costly and time consuming task , they are too small to be considered by the big investors for the global PB roadshows etc.  At the same time, investors are massively risk averse and track record is fundamental, due diligence is extremely time consuming and finding an investor prepared to risk funds in early stage and smaller funds is increasingly difficult. Once again Linear steps in to provide a marketing support team to provide a common service across multiple fund clients looking for similar investors.

In summary, the pressures of Basel III and AIFMD combined are forcing prime brokers to shed smaller hedge funds whilst those funds operational and regulatory cost burdens are increasing greatly; a squeeze at both ends. The solution has to be through specialist firms such as Linear who can bring together effective operational solutions for hedge funds and deliver a client product to the global prime brokers that meets their needs for return on capital deployed. The specialist PB client, by grouping multiple funds into one, is effectively large enough and produces sufficient income to warrant the support cost, capital deployed to justify the business to the global prime brokers.