Hedge funds and Private Equity - PES

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the hedge funds themselves would benefit from comparatively better financing conditions,
increasing leverage and the possibility to attain better financial returns.
Such a virtuous circle would be completely reversed in a justifiably higher interest rate scenario.
Assuming the above hypothesis one could see a boom and bust cycle among hedge funds
following major movements of the interest rate structure.
The recent increase of investors’ appetite for hedge funds can be at least in part explained by the
present extremely positive positioning of the interest rate structure. So, despite the boom and
bust hypothesis to be verified, one has to consider the possible threat to the financial stability
provided by the hedge funds in the case of a major, global increase of interest rates.
As we will see from the evaluation of the trend in hedge fund industry returns, there is evidence
that it is downward. This is in itself creating further pressure on the leverage of the industry.
Together with the continued growth of hedge funds, leverage will be increasingly important to
continue squeezing high double-digit growth ROE (= Return On AUM) out of low-ROA investment
strategies. An increasing dependency on leverage could pose serious challenges for
absolute return investment and the risk of the vicious circle.
It is not easy to get an idea on the state of leveraged hedge funds owing to lack of disclosure.
But estimates from different studies shed some light on the issue. Looking at the most used
types of leverage relevant for hedge funds: margin loans, securities lending, reverse repos and
derivatives, there seems to be basis for an estimate of the following magnitude:
Margin loans: In 2005 – with all the necessary, reasonable assumptions given lack of disclosure
– it is estimated that global margin debt of hedge funds could be roughly $300 b.
Securities lending: Assuming that hedge funds are probably the only customer group that
has a structural demand for securities borrowing and taking a 40 % ratio as the representative
for the industry, securities lending to hedge funds could amount to roughly $500 b.
Reverse repos: This leverage activity is not only used by hedge funds, but by many other
customer groups as well. A reasonable guess would be that 20 % of all reverse repos are
with hedge funds; this creates a volume of hedge funds at 120 b US dollars.
Derivatives: This is, based on all accessible studies, the most important source of leverage.
Leverage in a derivative comes from entering into a contract with a relatively large notional
value – in that context there is only a need to have sufficient cash available to meet the initial
collateral margin. The notional value of the derivatives book is likely to overstate its economic
risk.
All in all, it could be estimated that total hedge fund industry debt including the derivatives is
between 150 and 250 % of AUM, i.e. 2.0 – 3.3 trn US dollars.
Within this estimate extreme cases like LTCM are well known. According to the Financial Times
(1.12.06) the balance sheet of Citadel’s two main funds show that the leverage
(=liabilities/shareholders funds) amounted to 11.5 times. This is an example of ground breaking
ability to access capital markets for unsecured debt and thereby putting rising pressure on the
collateralised lending of investment banks.
A majority of hedge funds have limited choices for boosting returns – and extensive leverage is
one of those. Think LTCM!