Investors seeking a large amount of cash in a hurry—whether to take advantage of
an investment or entrepreneurial opportunity, or meet a capital call, for
example—rarely view the hedge funds in their portfolios as candidates for
liquidation. Because these funds almost always have lockup periods, they are not
considered particularly liquid. However, investment banks have recently devised
ways to use these assets to back borrowing. These loans allow investors to use
their hedge funds or other illiquid assets (such as restricted stock holdings)
to free up cash to meet unexpected needs. “People rarely realize that their
hedge fund portfolio is one of their liquid assets as well, because you can draw
cash from there quite quickly,” says Stanislas Debreu, a Los Angeles–based
managing director with SG Americas Securities, one of the few firms that
structures these transactions.
 These loans are typically nonrecourse, meaning that if a borrower
defaults on the loan, the only assets the lender can claim are those funds
pledged as collateral. “The beauty of this is that the loan is granted not
because of credit reasons, but because it is an asset-based loan, so we only
look at the assets and not at the individual,” Debreu says. “It means that deals
can get done without having to go through a thorough review of the credit
history of the individual.” For individuals who value privacy or wish to avoid
the hassle of credit checks, nonrecourse funding is ideal.
These transactions usually require a diversified portfolio of hedge funds for
collateral. Yet, because growing numbers of affluent investors access the market
via fund-of-funds vehicles anyway, this requirement rarely proves to be
problematic.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.
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