Hedge funds unsure over Basel III impact

While full implementation of capital requirement regulations could have a major effect on hedge fund financing, one in three are unaware of the potential impact, finds a new survey.
Hedge funds unsure over Basel III impact

At least a quarter of hedge fund managers globally have no idea whether incoming capital requirements emanating out of Europe will have a major impact on their business.

The Basel III regulations, not due to be fully implemented until 2019, require banks to have risk-based capital and leverage ratios of at least 10.5% and 5% respectively. It would likely mean that banks would be less willing to lend money to hedge funds seeking to buy illiquid securities that they may hold on their books for an indefinite period.

But State Street survey, released yesterday, revealed a sizeable proportion of hedge fund managers did not know whether the rules would significantly increase their cost of financing (29% didn’t know), change their business model (25%), or change the way they manage service providers (26%).

Dan McNicholas, State Street’s Asia head of sector solutions for alternatives based in Hong Kong, said there would be a “fundamental change in how hedge funds finance themselves” once the Basel III rules were implemented in full.

Ignorance over the impact of regulatory changes was the most interesting revelation of the poll. “The burdens placed by regulators are going to have a dramatic impact,” suggested McNicholas. “What it takes to run a hedge fund both in terms of cost and people is expected to increase significantly.”

Almost all survey respondents said they expected regulatory scrutiny of the hedge fund industry and operational complexity to increase, with nearly a third expecting both to rise significantly.

As a result, McNicholas suggested the industry would face rising expenses, with infrastructure requirements alone costing $6-20 million depending on the size of the fund. Conducting due diligence on potential investors was taking longer than before and the focus on operational and other non-investment activity had "increased significantly post-2008”, he added. “That trend is unlikely to diminish.”

There are, however, likely to be differing impacts on firms depending on their strategies. Investment banks’ allocation of resources to their prime broking arms is likely to make some clients more attractive than others, and hedge funds could suffer, noted McNicholas.

Hedge funds running a niche strategy with high leverage demands would have a greater impact on prime brokers' capital requirements, while clients with more straightforward strategies that pay higher equity commissions would be looked upon more favourably.

The impact of Basel III on Asia-focused hedge fund managers has also been increasing, and could limit funds’ diversification into strategies pursued by hedge funds in the West, which often require higher leverage and levels of risk.  

Relatively low-cost equity hedge strategies account for 71.3% of assets managed by Asia-focused hedge funds, compared with a global average of 27.7%. More capital-intensive hedge fund strategies account for only 25.8% of assets managed by Asia-focused hedge funds, compared with 53.2% of global hedge fund assets.

More constrained financing may inhibit a more diverse range of Asia-focused hedge fund strategies developing, but McNicholas is confident the region can avoid this. “The general trend of Asia being a home for, and having the capacity for, more complex strategies continues. From 2006 onwards it’s always been on an uptick,” he said.

The survey showed 91% of hedge fund managers agreed that funds in the future would be required to demonstrate their value to prospective investors more clearly to attract capital.

Increasingly that capital is coming from ultra-high-net-worth investors. Of those polled, 65% expected allocations from UHNW investors to increase, compared with 63% who expected a rise in allocations from institutional investors.

McNicholas said Asia would see growth of HNW investors share of hedge fund AUM. This is partly due to the rising importance of liquid alternatives. Half of the survey respondents agreed that liquid alternative funds, such as those under the Ucits umbrella, would seize share from traditional hedge fund strategies over the next five years.

*A survey of 235 hedge fund executives was conducted by Citigate Dewe Rogerson in October 2014. Asia-Pacific-based respondents made up 11% of the total, with 57% in North America and 32% in Europe.

¬ Haymarket Media Limited. All rights reserved.