11/08/2010 Author: Tony Griffiths

The return of leverage

The gradual rise in hedge fund borrowing through 2010 was confirmed last week by FSA figures noting a marked increase in leverage. But with May and June's rocky performance yet to be factored in, it remains to be seen whether this mark of confidence is here to stay

The speed at which wounded financial confidence heals is easy to measure. It’s all a matter of leverage. Last week, the Financial Services Authority (FSA) released its second biannual survey of the UK hedge fund industry, showing an increase in lending. The country’s 50 biggest hedge funds increased the total value of their positions as a multiple of net capital to 399% in April, from 328% in October 2009. After months of hushed conjecture, the trend was finally given the regulatory stamp of approval. Leverage, said the FSA, was returning to the sector.

According to Anthony Byrne, Deutsche Bank’s European co-head of prime finance and global head of securities lending, “leverage has increased by circa 70% from the nadir during the crisis, but is still only at 75% of the high-water mark pre-credit crunch.” Leverage has increased around 30% from the final quarter of 2009, he adds. “There was a marked upward swing that occurred around Q2 2009. Since then there has been a slow upward trend which has flattened out in Q1 2010.”

Among other things, the FSA’s April calculations came too early to capture the May/June dip, during which industry confidence was given another shaking down and leverage with it. Figures from the client base at Credit Suisse Prime Services showed leverage to have fallen from a peak in March – though June numbers are still higher than those in December 2009. According to the Swiss bank, the gross leverage of their clients at the end of June averaged 2.55, down from 2.68 in March, but up from 2.53 in December.      

The picture is mixed. While one industry source suggested to HFMWeek that clients at Citigroup and Barclays’ prime brokerage arms have deleveraged en masse, other primes appear to be profiting. Merlin Securities, a US-based mid-sized prime brokerage, acquired an $800m mandate in Q2 – one of its largest – and is poised to secure its first $1bn client by September. The former has been utilising leverage and the latter is expected to follow suit.

“We’ve seen a dramatic increase in shorts and a significant increase on the margin side,” said Ron Suber, Merlin’s head of global sales and marketing. “Around late May/June we saw funds step on the gas a bit and find merger arbitrage deals or convertible deals where leverage made sense. The custodians were now willing to do it on some of the more illiquid assets like convert high-yield and distressed or illiquid, hard-to-price global equities.”

With balance sheets freeing up, the willingness of custodians to lend to more illiquid strategies is a new feature of the landscape, says Suber. Unsurprisingly, it comes at a price. “For those securities that use more capital – the illiquid, harder-to-price – primes are charging more for leverage.”

At Deutsche Bank, overall costs have risen for clients requesting term facilities, while illiquidity still demands a premium. “We are generally offering more leverage than funds are deploying,” reveals Byrne. “Funding costs have normalised but not returned to pre-crisis levels for the less-liquid classes, while equity costs have not changed significantly.”

If leverage levels are tied to the industry’s inherent uncertainty, fluctuations at least appear to have achieved a generalised upward trajectory. Managers may have deleveraged post-May, but signs for July are promising. “Looking at the long/short space, it seems as if the average has been going up again in July,” says Joe Shaw, portfolio manager at 3A Alternative Asset Advisors, a fund of hedge funds that directly manages around $3bn in assets. “It depends on the manager, but, in general, leverage is slowly rising again.”