SG Americas Securities offers a number of ways to arrange these transactions, from a very simple credit facility structured as an asset-based loan collateralized with the hedge fund assets, to more complex synthetic solutions that involve replicating a loan using derivatives. Loan-to-value ratios range from 10 to 80 percent of the deals. “If we lend 80 percent, so the client only puts in 20 percent, then he has five times the leverage,” Debreu says.

TOP VIEW Some investment banks now offer loans against the hedge fund assets in investors’ portfolios, not unlike the credit facilities they have offered to those with illiquid stock positions in the past. These nonrecourse loans allow investors to obtain cash for unexpected expenditures or simply to execute a wider range of asset allocation strategies. Because the loans are asset-based, they only put the collateral—not other assets held by the borrower—at risk, lowering their overall exposure.

To illustrate how such an arrangement works, Debreu starts with a hedge fund portfolio valued at $50 million. “Instead of having $50 million invested and $50 million at risk, we tell investors, ‘Why don’t you place only $15 million at risk and have $35 million in debt?’” In this case, the investor would be leveraging a little over three times while freeing the $35 million to be used elsewhere. This means such a facility need not only be used to fill a sudden and unexpected liquidity gap. It can also be used as part of the overall asset allocation. “The question then, is what to do with that $35 million we extract from the portfolio, and the answer we often get from people is that they invest it in a conservative manner; they put it in bonds, municipal bonds and so on,” Debreu says. “You then have a $50 million hedge fund exposure, $15 million at risk and $35 million in a safe place.”

The simplest way to monetize the hedge fund holding is with an asset-based credit facility. Investors pledge hedge fund shares to secure the loan while maintaining ownership of them. They then pay a base rate plus a spread to the bank. In return, they receive cash, while still remaining free to allocate the underlying investments as they please. The facility can be structured with a fixed term or as a revolving credit.

An alternative is to use an over-the-counter derivative con­tract called a “prepaid forward.” “You achieve exactly the same purpose as before, except you use a derivative,” Debreu says. “Here, the client remains the owner of the portfolio of hedge funds, but he sells the portfolio forward at a low price. He therefore sells it at a high premium, and the premium that we pay is equivalent to a loan.” At maturity, the client repurchases the hedge fund portfolio from SG to repay the loan.

A third option is to replicate the structure using derivatives. “Instead of investing in a hedge fund and selling it forward to SG, the client buys an option from SG, and then we go out and invest in the hedge fund portfolio,” Debreu says. In this case, investors do not explicitly own the hedge fund portfolio. Just as with any other over-the-counter derivative, the contract the bank writes gives synthetic and leveraged exposure to the underlying asset. Most investors will choose between the different methods based on how much leverage they want, Debreu says. If they only need a small amount of leverage, say 10 to 25 percent, then the simple loan is probably best. The derivatives structures are better suited to those seeking higher amounts of leverage.

Ideal Assets
Debreu says a hedge fund portfolio is an ideal asset to use as the basis on which to offer nonrecourse funding because a truly diversified hedge fund portfolio typically has a low standard deviation (a measure of risk). “If you look at a portfolio of hedge funds that is truly diversified in terms of strategy and in terms of number of managers, you get down to an asset that has a standard deviation in the range of 4 to 6 percent. So in terms of risk, a hedge fund portfolio is a great thing to lend against,” he says.

Other assets, of course, can be used as loan collateral. Real estate is popular, but with prices falling in the United States, banks today may not be as willing to make those loans at attractive terms. Raising capital on the back of concentrated equity positions is also common. A simple way to do this is to use a derivatives-based structure known as a collar. “The collar usually contains about 15 percent equity risk,” says Eric Leve, senior vice president of international equities at investment company Bailard, based in Foster City, Calif. “By selling a call option and buying a put option, out of the money, you’re able to create a fairly narrow range in which you have equity exposure, and, outside of that, you are capped. Institutions will then lend you money against that, so you can monetize the collar,” he says.

Boutique outfits, such as New York–based New Millennium Financial, offer simple nonrecourse loans against stock holdings. “We make loans at below market rates,” says Austin Bleich, the company’s president. “They pay somewhere in the 4 to 5 percent fixed range basis, so if they feel that they can put that money to use and earn more than 5 percent somewhere else, then of course it makes sense in terms of diversification,” he says.

Such liquidity solutions are also popular with executives or business owners who for various reasons need to retain ownership of a large amount of single company stock. Although the underlying stock is listed and is therefore liquid, an investor’s particular circumstances (a delay in selling stock for tax reasons, for example) effectively makes it illiquid. This type of equity-backed financing has been around for years and has proven useful for many wealthy investors. Now, new products from sophisticated firms allow them to extend the same principle and benefits to loans backed by the alternative investments in their portfolios.

John Ferry is an Edinburgh, UK-based financial journalist and a senior correspondent for Worth.

Additional Information
 Going Liquid: The Santa Fe Diversified Fund