Hedge fund-linked derivative desks in the U.S. are looking at ways around a hedge fund liquidity crunch caused by rising lockup periods. The desks, which finance and provide capital protection for funds, hedge this by investing and trading in the funds. "One of the main things we look for is liquidity," explained one structurer. The issue is a big concern for traders because risk managers might start capping business with certain counterparties if the exposure can't be hedged.
Firms including BNP Paribas and Credit Suisse are consulting lawyers to find ways of hedging exposure to funds, which have increased lock-up periods to land exemptions from the Securities and Exchange Commission hedge fund advisor registration rules. The rules came into play in February, but funds that lock investors in for at least two years don't have to register.
The full effect of the registration requirements on lockup periods has yet to be felt, but already dealers are looking at alternative ways of hedging. Firms providing leverage to hedge funds of funds may ramp up the cost of loans to pay for the extra risk. Fund derivative desks could also drill deeper into the fund's strategy, and hedge through derivatives of the fund's underlying investments. This is already done to some extent, but with hedge funds unwilling to reveal details of their holdings, this may not be effective enough to satisfy the risk managers.
While firms may have to cut down on financing and writing protection on hedge funds, the SEC requirements could provide new business for fund derivative desks. Several desks are reportedly working on ways of acting as swap counterparties between hedge funds and investors, with the dealer taking the liquidity risk. This way investors would have synthetic exposure to liquid share classes from the hedge fund, while the fund itself would still comply with the minimum two-year lockup to be exempt from advisor registration. A fund-linked structurer at a U.S. firm said he has not yet seen this done, however, and there are likely to be concerns the SEC would see this as a run-around.
A funds lawyer noted the SEC would certainly be capable of outlawing this type of structure by amending the registration rules. Firms considering these structures, he added, should focus on institutional clients. "Those are not the investors that the SEC is going to go out there trying to protect," he explained.