New York (HedgeCo.net) – A new independent study by Pershing LLC, “Lending and Leverage: The New Securities Finance Model for Hedge Funds,” examines the changing business model of securities financing for hedge funds in 2010.

“The major challenge for hedge funds of all sizes continues to be access to hard-to-borrow securities. A prime broker with access to inventory, whether through electronic markets, retail pools or relationships with institutional lenders, is critical,” Craig Messinger, managing director of Pershing Prime Services said. “Forging a strong operational relationship with a prime broker is critical to a hedge fund’s success, regardless of where securities loans are sourced.”

The study draws on proprietary investor surveys, as well as primary and secondary research, to provide insights into changing investor attitudes and an evolving regulatory environment. It also offers guidance on how hedge funds can execute successful lending programs for the future.

Highlights from the study include:

• Hedge funds face a mixed climate. Institutional investors are reasonably comfortable with leveraged investing today, though investor opinion about hedge funds and leveraged investing remains mixed. In a recent Finadium study of 92 U.S. public pension plans, including 25 focused interviews, 56% of pension funds reported having at least some investments in hedge funds or 130/30 vehicles. This does not represent, however, a wholehearted acceptance of leveraged investing. Many pension fund managers cited their personal dislike of leveraged investing, even though their institutions were invested in hedge funds.
• Investor and regulatory changes forced the evolution. The market turmoil of 2008 served as a catalyst for changes to the prime brokerage industry, and the decision by many global regulators to suspend short selling in 2008 created major disruptions in the prime brokerage business model. This resulted in the curtailing of client short selling in less liquid issues–the most profitable segment of the business for both hedge funds and prime brokers. As the ruling to avoid naked short sales has been made permanent, hedge funds and prime brokers have made the appropriate adjustments in their practices, and they are aware of greater possible changes in market structure.
• Securities lending remains the key differentiator. While the number of prime brokers has increased, access to securities lending inventors through retail and institutional programs remains a key differentiator for hedge funds in the current competitive marketplace. Securities loans may not be as important to hedge funds today as they were in 2008, however, it is expected that securities lending will return to center stage over the next several years.
• Investors are demanding greater transparency. Leveraged investing continues to be seen as a murky area full of risk and unintended consequences. Transparency in securities lending pricing creates a more productive relationship between hedge funds and their prime brokers, and it offers hedge funds new opportunities to attract investors.
• Prime brokers remain critical service providers for hedge funds. A hedge fund’s best ally in obtaining fairly priced securities loans or synthetics will be its prime broker. The critical point in choosing a prime broker is ensuring that the fund’s and prime broker’s interests are aligned; if one party looks for transparency while the other does not, regular conflicts will arise. If both parties look to capitalize on the best-priced, most accessible means of completing a trade, then both parties will benefit by creating a lasting relationship.

Josh Galper, managing partner of Finadium, one of the study developers, concluded, “Going forward, hedge funds will need to spend more time focusing on the costs and means by which they obtain securities loans. As more transparency enters the securities lending market, investors are looking for hedge funds to demonstrate an ability to secure the best financing for their trades. This in turn places a greater emphasis on how funds source securities lending inventory and how they manage their prime brokerage relationships.”

Pershing LLC. is a BNY Mellon company.

Editing by Alex Akesson
For HedgeCo.net
alex@hedgeco.net
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