06/04/2011 Author: Tony Griffiths

Credit where credit's due

 When credit lines dried up in the aftermath of the financial crisis, funds of hedge funds (FoHF) felt the pinch more than most. Seeking not only leverage like their single manager brethren, the majority of FoHF managers had, and have, several short-term concerns for which additional relationships are required. These short-term concerns are soothed by what the industry calls bridge loans, or bridge liquidity. And in late 2008, FoHFs would find that the providers and terms of bridge loans were to change dramatically.    

Unlike single managers, whose liquidity issues are dealt with by their primes, FoHFs have no automatic calling point for short-term financing. Bridging the liquidity gap between redemption and subscription requests, FX hedging for relevant share classes, as well as additional leverage, all require a steady flow of capital. Short of implementing an inefficient, not to mention inconvenient, cash buffer, FoHFs will source said capital in the form of a bridge loan; a committed or uncommitted line of credit provided, at a cost, by a third party.

Prior to the financial crisis, providers of bridge loans were in plentiful supply. A significant proportion of investment and custody banks offered such facilities, as did a number of administrators. Estimates for the size of the pool vary, but, during interviews conducted by HFMWeek, suggestions of anything from 20 to 50 have been forthcoming.   

“The landscape has changed dramatically,” says Cameron Hedger, managing director at Credit Suisse. “Primarily, the number of participants in the space as lenders has decreased significantly. Pre-crisis the number exceeded 15. During the crisis there were literally one or two banks still extending credit to FoHFs. In 2009 it grew to three or four, now there are probably about five players who are truly active.” 

While no-one argues with a dramatic drop in lender numbers, the true current total also divides opinion. The half-dozen figure received a lot of backing from those HFMWeek interviewed, although Michael Romanek, principal of Rise Partners, an independent consultancy which sources and arranges credit and bridge facilities, notes that he now primarily works with about 12 entities.

Trickier still is ascertaining who exactly it is that’s active. Everyone agreed that the large European investment banks, predominantly Credit Suisse and Deutsche Bank, were the big players. Administrators were also touted as a growing sect, with Citco and Northern Trust names that gained traction. HSBC and JP Morgan topped the list of those making an increasing amount of noise – since verified by HFMWeek. Historical player Prime Fund Solutions (PFS) – the fund admin arm of Fortis – continues to offer a visible service, but is expected to be restructured when the firm is finally purchased by Credit Suisse.

In terms of absentees, a few obvious examples include Bear Sterns, Lehman Brothers and AIG. Confirming whether some desks, such as Swiss Re, are closed or merely inactive proved more difficult. “Right after the crisis it wasn’t that the majority absolutely closed their desks,” Romanek says. “They went into a dormant mode and some of them are still in it.”

Other names received a more mixed response. Royal Bank of Scotland (RBS), State Street, Bank of New York Mellon and Citigroup were name-checked by some interviewees. KBC, SocGen, BNP Paribas and BarCap were given as examples of bridge lenders that made more noise pre-crisis. “Goldman Sachs and Morgan Stanley always did a bit of it,” says one source. “They could be still, but we wouldn’t see them either way.” 

Herein lies the problem. “The bridge loan space was never like prime brokerage – ‘here’s our website, this is what we do’,” explains Romanek. “It was always a little murky, opaque world.” Even now, much of the activity remains below the radar and the identities of the serious players are disputed. As HFMWeek found, in certain cases a name could evoke extreme reactions, depending on who you spoke to. As a result, while most agreed that there were about six with sizable offerings, each person’s list varied to some degree. Romanek, whose business thrives on matching funds with lenders, says his list of 12 includes many entities that operate without noise. “And I would like it to stay that way,” he adds.

There are two main variants of bridge facility providers, one being the custody banks and the second being distinct fund-linked financing desks, often through derivatives. “The former can generally compete best purely on price, but comes with many limitations which may not be suitable for a given manager,” Romanek explains. “The latter can provide more flexibility, better service and include the added benefit of providing this via a tri-party pledge agreement with a funds present custodian. At present, pricing is becoming more homogenous however the practices among the banking groups, in this sector, have become more diverse.”

A key differential currently appears to be the extent to which the service is a part of a firm’s fund administration package. The likes of Credit Suisse will offer bridge financing as a core service (via a fund-linked products desk situated within the equities division of the investment bank) while HSBC, among others, bundles it in with admin, offering it only as part of a full package.

Asset custody also makes a difference: Citco, who, as an administrator, doesn’t have the balance sheet of an investment bank, syndicates its loans to the financial community; JP Morgan seeks to obtain a security interest in the fund’s assets, typically holding them in a custody account; and HSBC requires full custody as a minimum.

Citco’s offering is perhaps the most distinct, offering bridge liquidity via its Amathea platform. An integrated offering linked to both custody and administration, Amathea maintained its AA1 credit rating through the entire crisis, Gilbert Grosjean, Citco’s head of financial products, reveals.

If the terms of the offerings vary, the source, through the fund-linked desk, is more standardised for the investment bank model. A bridge loan can be offered as a simple bank revolver, appearing on the bank’s balance sheet not unlike a credit card limit. More often though, the loan would be granted as a structured product and appear on a bank’s trading book – a far more favourable option. Typical trade variants include: a VFN (Variable Funded Note); a financing swap (created as swap transaction); and an ASCO (accreting strike call option).

While the size of the requested loans remains similar – typically 10% to 25% of a fund’s Nav – the price has, unsurprisingly, skyrocketed. “Bridge facilities were extended at lower spreads pre-crisis than they are today,” says Credit Suisse’s Hedger. “The banks have increased costs of funds post-crisis, and it has caused them to reassess the risks associated with all lending activities.”

Fees typically have two components: a commitment fee, to ensure that a service is paid for even if the loan is untouched; and the borrow rate, for once the loan is used. The two are usually combined.

In broad terms, the pre-crisis spread over Libor for a combined fee would be below 100bps, depending on the particular portfolio that’s being lent against and the nature of the FoHF. “During the crisis, spreads blew out to north of 250bps,” an un-named source says, “if facilities were being extended at all. We’re now somewhere in between that now, probably closer to the 200bps-mark again, depending on the nature and the quality of the assets.”

According to Romanek, commitment fees didn’t really come into play pre-crisis. “Though prior commitment fees ranged from 3bps to 25bps, managers could nearly always negotiate them to zero,” he says. “However, now 25bps would be the starting point and would be regarded as an extremely low commitment fee, with the norm being around 80bps and possibly as high as 50% of the drawdown rate.”

 “Pricing spiked post-crisis and recently has been coming down, but given capital requirements and funding costs at banks I don’t think we’ll see pre-crisis level pricing in the near future,” Michael Gordon, a managing director for JP Morgan’s equity derivatives division, says.

“Before 2008, we saw a lot of uncommitted lines,” says John Sergides, Head of EMEA business development, global transaction banking at Deutsche Bank. “People were happy to agree to uncommitted lines to reduce performance drag, as their use was concentrated around month-ends with an implicit guarantee the line would be there.” An uncommitted line works much like an overdraft – there is no guarantee it will be there.

“Recently, the demand has been for committed lines versus uncommitted lines from the funds,” Sergides adds. “The higher cost reflects that commitment, but it is a secure facility which gives investors comfort when they want to know about their liquidity position. A committed loan equates to security for investors.”

The demand for bridge loans is not at pre-crisis levels. But, as Gordon says, echoing the wider sentiment, “there has been a clear pick-up in demand that started in 2010.”

In many ways, appetite is not the issue. As long as there are FoHFs there will be a need for bridge financing. The battle taking place is as a result of a gradual re-emergence of competition. HSBC and JP Morgan are the latest providers of bridge loans to increase their visibility in the past 12 months. With balance sheets growing stronger by the day and the supposed demise of the FoHF sector now consigned to post-crisis hysteria, expect more to follow suit.