The Limits of Leverage
When hedge fund investors responded to the credit crisis by rushing to cash out their holdings, they got a shock: the agreements they’d signed with the funds contained terms that prevented immediate redemption. Investors had to wait months to redeem their hedge fund holdings for cash, leaving many confronting big losses.
So-called gates, soft-locks and other restrictions are all standard contingencies hedge funds commonly write into investor contracts, designed to prevent large-scale redemption in the face of the very event investors were reacting to.
“It’s quite shocking in some ways, because these are professional investors and wealthy, sophisticated individuals who should have known better,” says Professor Suresh Sundaresan. “But easy money was coming in, and people signed the contracts without reading the fine print.”
Just as investors were content to sign agreements without giving close attention to the finer details, prime brokers were happy to lend to hedge funds in a flush market. “But when times were bad, some prime brokers were quite ruthless in turning off the flow of credit, shutting down these funds,” Sundaresan says.
Wedged between its investors and prime brokers in this way hedge funds are short two options: the funding option of the prime broker and the redemption option of their investors. Thus, the funds are at the mercy of both should the market turn down. This is in stark contrast to mutual fund managers or others at large institutional funds, who don’t short their investments and can issue equity or bonds to raise money and survive rough patches.
Sundaresan, working with John Dai of Capula Investment Management, a London-based hedge fund, was charged with developing a risk allocation framework for hedge fund capital to determine the maximum amount of leverage a fund can take on and still remain able to fulfill large-scale redemptions from investors and withdrawal of balance sheets by prime brokers.
Individual investors periodically choose to take their money out of a fund, and the funds can easily accommodate such redemptions. Likewise, since prudent funds typically work with many prime brokers, the departure of one doesn’t exert much pressure on the fund. “If one prime broker decides it doesn’t like your style and stops funding you, the fund can still borrow from a half dozen other prime brokers,” Sundaresan says. “That’s OK. But we argue that if there’s a repeat of 2008 credit crisis, investors and prime brokers are going to move to redeem and cut off funding at the same time.”
High leverage and short bets using borrowed money are essential aspects of hedge fund strategy, crucial to funds’ ability to generate the high returns that attract investors. “If a fund depends on leverage, its managers must recognize that there is a small probability that everyone will exercise their options at once,” he says. “Even if a portfolio manager is comfortable taking leverage at 10 times, the hedge fund might be better off just taking five times, reflecting the potential for prime brokers and investors exercising their options. The fund may make only 100 basis points a month instead of 200. But it survives.”
Each hedge fund has many portfolio managers; some managers pursue strategies that require a great deal of prime broker funding, while others don’t. The researchers’ paper outlines how to allocate risk capital between the various portfolio managers. For example, if 10 times leverage is optimal then how does a fund divide that leverage among portfolio managers, that is, do some managers use higher or lower levels of leverage than their colleagues?
Sundaresan recommends a risk allocation strategy in which no trader can lose more than 5 percent of allocated capital in a given month and argues that portfolio managers who produce large returns but require large amounts of prime broker funding should be penalized because withdrawal of prime brokers in a recession will drive the fund down. (This strategy also protects the fund in the event that a prime broker collapses, another danger; Bear Stearns and Lehman Brothers were both prime brokers.)
The researchers also recommend buying some insurance against aggregate shocks, which not all funds do as a matter of course. Sundaresan likens this to term life insurance — the likelihood you will need it is very low, but it’s a good investment should a catastrophe come along. A hedge fund can and should safely spend 1 to 2 percent of its assets each year to buy insurance such as credit default swaps (CDS), he says, with the idea that with a crisis the spread goes up and the fund would make money. “The hedge funds that were prudent survived 2008 with good returns, in part because every year they bought CDS protection.”
Hedge funds already employ a common method for measuring and managing risk — value at risk, or VAR. Sundaresan argues that VAR is too imperfect a measure for the funds to depend on. “Value at risk depends on how volatile the markets are and that is anybody’s guess. Before the credit crisis volatility was very low. After the credit crisis, it quadrupled. If you set your risk limit at 15 based on VAR, it was not a very helpful measure for you.”
Instead, Sundaresan recommends that unencumbered cash is a more accurate and more transparent signal of a hedge fund’s overall risk position, better reflecting market volatility, investor redemption behavior and prime broker behavior.
Unencumbered cash is cash that hedge funds keep on hand and is not used as leveraged collateral. Hedge funds are marked to market on a daily basis — they tally their gains and losses every day, paying out and taking in cash accordingly, using unencumbered cash to do so. A hedge fund with $4 billion in assets, for example, might hold $3 billion of that as unencumbered cash, and put $1 billion with a prime broker as collateral, borrowing enough against the $1 billion to carry out its investing activities.
Investors and policy makers, he says, should look to unencumbered cash rather than VAR to get a realistic grasp of where a hedge fund’s leverage is. A high ratio of unencumbered cash allows a fund to meet redemption calls from investors without touching its portfolio and to meet unexpected big losses. The less leverage, the higher the percentage of unencumbered cash and the less cost the fund will incur. “Eighty percent is in good shape. Forty percent is trouble,” Sundaresan cautions. “Any number between those two notches calls for corrective action.
“Thus, the combination of buying insurance and then really sweating the details on a daily basis — as reflected through unencumbered cash — on the risk of the positions are some of the other things to do after you’ve set some risk capital limits.”
Suresh Sundaresan is the Chase Manhattan Bank Foundation Professor of Financial Institutions in the Finance and Economics Division at Columbia Business School.