INSIGHTS

Hedge Funds, Leverage and

Counterparty Negotiations
JPMorgan Alternative Asset Management

This paper will outline:

Executive Summary

The importance of
monitoring hedge fund
leverage and asset liquidity

It is critical that hedge fund managers focus on

negotiating financing and counterparty agreements that allow them to manage their assets
with as much flexibility as possible. The importance of this has become more apparent recently,
following the decline in available credit extended throughout the financial system, including
credit available to hedge funds.

The reasons why managers

use leverage, and which
strategies tend to use the
most
How hedge funds borrow
and take leverage
Important factors that hedge
funds and their investors
should consider when negotiating financing agreements
Select industry observations

Contributors:
Douglas Smith, CFA
212-648-2622
douglas.x.smith@jpmorgan.com
Andreas Deutschmann
212-648-2338
andreas.deutschmann@
jpmorgan.com
Additional contacts:
Sara Dan
(Hong Kong)
852 28 00 2060
sara.dan@jpmorgan.com
Pascal Bougiatiotis
(London)
44 0-207 742 22 74
pascal.bougiatiotis@jpmorgan.com
For further information,
please contact your JPMorgan
representative.

The importance of monitoring hedge fund

leverage vis--vis the liquidity of the assets
under management is an area that is often overlooked by investors. While it is important to
consider the asset liquidity relative to the
liquidity of investors (i.e. redemption terms), it
is equally important to monitor asset liquidity
relative to any debt that a manager uses. This is
important since debt holders often have rights to
force the liquidation of collateral under certain
circumstances.
There are several reasons why a manager may
use leverage, including:
1. Return enhancement (directional)
2. Risk reduction
3. Magnification of low-risk returns
(arbitrage)
4. Enhanced liquidity or lower transaction
costs from employing leveraged
instruments
There are also several ways that hedge fund
managers can obtain leverage, some include:
1. Embedded leverage in options, futures,
and other securities
2. Repurchase agreements
3. Swaps
4. Prime brokerage borrowing facilities
5. Traditional term financing

Better insight + Better process = Better results

When taking leverage, there are a number of

terms that must to be addressed in each financing agreement. Managers need to ensure that
their capital base is relatively stable, and also
that the terms in their agreements are commercially attractive. Several of the terms/items
mentioned in this paper include:
Financing costs vs.
counterparty risk
Margin requirements
Termination events
Valuation of
collateral
Special clauses
Legal entity and
capitalization

Collateral and
haircuts
Triggers
Cure periods
Duration and
Maturity
Trading limits and
trade cancellations
Cash management

Hedge fund managers that are proactive in

negotiating for the best terms will often have an
advantage, and/or be better positioned for difficult market environments. They will have more
time to unwind certain positions if necessary, or
equally as important to take advantage of mispricings that surface in the capital markets by
leveraging their liquidity.

Introduction
In December of 2007 the Wall Street Journal reported
that Investment banks are cutting back on loans to
hedge funds, eliminating some clients and raising
borrowing fees for others. The lenders are slimming
their balance sheets after heavy losses in the debt
markets in recent months. And, after taking multibillion-dollar write-downs, they also are becoming
more cautious as the economy slows. The article mentioned that banks are often turning away new hedge
funds clients, and charging financing spreads that are as
much as 5x 10x higher than they were at the beginning of 2007 for existing clients.1
With the continued market volatility and dampening
liquidity, it is critical that hedge fund investors understand the financing arrangements of the managers with
whom they invest. While negotiating with counterparties for the most favorable financing rates can help
reduce financing costs, there are many other aspects
that managers need to address. As we have written
about previously, if hedge fund managers receive margin or capital calls from their prime brokers or capital
providers, it can have a detrimental (sometimes spiraling ) effect, since they may be forced to liquidate positions at inopportune times. This is particularly important today, since capital markets are witnessing a period
where liquidity is much lower than over the past few
years, which can make it difficult for hedge fund managers to sell their positions quickly at reasonable valuations when capital is needed.
While there were several significant hedge fund implosions prior to the Wall Street Journal article, the frequency of such implosions increased significantly during the first quarter of 2008. Understanding how managers obtain financing and negotiate counterparty
agreements has always been part of J.P. Morgan
Alternative Asset Managements (JPMAAM) due diligence process, but it took on an extra level of importance in the summer of 2007 as the credit environment
began to significantly deteriorate. After conducting a
focused review of each of our underlying managers at
that time, we were able to help underlying managers
who we determined were the most vulnerable, and to
redeem from those who did not take action.

Fortunately, JPMAAMs efforts to partner with our

underlying managers in such a capacity has allowed us
to avoid many of the recent hedge fund implosions that
have occurred due to unsecured financing and forced
liquidations.

Leverage, Financial
Intermediaries, and Hedge
Funds
As hedge funds continue to become more dominant
capital market participants, as well as important customers of financial intermediaries such as broker/dealers and investment banks, their impact on the capital
markets has become much more amplified. In turn, the
impact of an increase or decrease in risk appetite
among financial intermediaries is also having a more
pronounced impact on the capital markets, since these
same intermediaries lend capital to hedge funds for use
in managing their portfolios.
In a recent paper by the Federal Reserve Bank of New
York2, the authors outline the growth of securities broker/dealers and investment banks assets and leverage,
and point to the fact that the relationship between the
two is positive and pro-cyclical (see exhibit 1 on the following page). Essentially, as the value of their assets
increase, investment banks take on more leverage by
borrowing more (i.e. increasing their liabilities) and
investing in additional assets, including making loans
to hedge funds. The key is that the amount borrowed
by financial intermediaries in a positive environment
tends to be greater than what is necessary to simply
scale their leverage ratios back to where they started; in
other words the financial intermediaries borrow even
more and increase their leverage ratios to higher levels
as assets increase. The same works in reverse, whereby
broker/dealers and investment banks tend to reduce the
value of their liabilities by selling or calling in assets in
negative environments. The reduction in assets is
amplified in times when asset values are declining, as
these financial intermediaries seek to reduce leverage
ratios to levels that are lower than where they started.
The overall result can be an amplification of volatility
and the overall cycle, where price changes and leverage
adjustments reinforce each other.
2

Exhibit 1. Total asset growth and leverage growth of U.S.

investment banks
Quarterly leverage growth (percent)
20
15
10
5

2007:Q3

0
-5
-10
1998:Q4

-15
-20
-20

-15

-5
0
10
5
-10
Quarterly asset growth (percent)

15

20

Sources: Federal Reserve Bank of New York; U.S. Flow of Funds Accounts2

The authors of the paper describe this circular or spiraling effect as feedback. In the charts in exhibit 2
below, one can optically see the spiraling nature of
leverage, or this feedback effect.
Given the pro-cyclical nature of asset and leverage
growth for broker/dealers and investment banks, and
the fact that hedge funds continue to play a more
active role as their customers, hedge fund managers
need to ensure that their financing agreements are structured to mitigate the impact that any cyclical reductions
in risk by financial institutions have on their ability to
manage assets.

Liquidity
It is important to monitor the redemption liquidity
that managers offer their investors vis--vis the
Exhibit 2.
Leverage management during an asset price boom

liquidity of the assets in their hedge fund portfolios.

This is important since a manager should have sufficient liquidity to meet redemptions. While important,
investor redemptions have been a smaller factor leading
to many of the recent hedge fund failures, especially
since many hedge fund managers have provisions that
allow them to limit cumulative redemptions in times
of stress (e.g. gates). However, one of the primary factors contributing to recent hedge fund failures has been
the demand by counterparties to return capital or to
meet margin calls, which forces managers to liquidate
their assets in short order.
Consider it from the perspective of a simple hedge fund
balance sheet. Hedge funds balance sheets, just like any
corporation, have three broad components:
Assets represented by the securities owned and
traded by the fund manager
Equity a funds assets under management, or the
investors capital
Liabilities the amount owed to lenders and counterparties for providing financing, which the manager
employs to amplify or leverage returns to equity
holders
It is important that the liquidity of each stakeholder
(lenders and equity holders) is appropriately matched
with the liquidity of the assets managed by the fund.
Consider the case of a hedge fund with no leverage. In
this case the only stakeholders are investors, or equity
holders, and the primary consideration is whether there
is sufficient liquidity to satisfy any investor

Leverage management during an asset price decline

Banks increase leverage

Banks reduce leverage

Balance sheets
contract

Balance sheets
expand
Balance sheets
weaken

Balance sheets
strenghthen

Asset prices decline

Asset prices rise

Sources: Federal Reserve Bank of New York2

Exhibit 3. Hedge Fund balance sheet unlevered portfolio,

quarterly liquidity with 45 days notice
$160
$140
$120
$100
$80
$60
$40
$20
$0
Value of assets (securities)

Value of equity (AUM)

Hedge fund balance sheet

Value of Assets (securities)

Value of Equity (AUM)

150

150

Days to Liquidate

Days to Liquidate
(i.e. notice period)

15

45
Coverage Multiple
3.00x

redemptions. As an example, take a manager with $150

million in AUM. If the weighted average days to liquidate the assets of the portfolio (without selling the
assets at a significant discount) is equal to 15 days, and
the notice period required for investors to redeem is 45
days, it provides the manager with a sufficient coverage
multiple of 3.00x (see exhibit 3 above). This does not
take into account gates or other tools available to the
manager, which he can utilize to buy more time to satisfy redemptions during stress periods.
Now consider the same manager with 3x leverage.
There are now two stakeholders, equity and debt holders, with two distinct liquidity considerations. Assume
that equity holders have the same liquidity as before,
with a notice period of 45 days. Also assume that the
liquidity profile of the assets in the fund is the same,
with an average of 15 days to liquidate. With lenders
now representing 67% of the assets, the way in which
investors are positioned, as well as the liquidity risks
for the manager are dramatically different. First, just
like a corporation, lenders are senior in the capital
structure and have a first claim on the assets (again,

the securities held in the fund), and must be made

whole before a single dollar of capital is paid to equity
holders. This right further extends to debt holders,
since they also have the right to seize and liquidate the
collateral under certain conditions. Second, unlike
redemptions placed by equity holders, which are subject to a lengthy notice period and perhaps other
restrictions, if the manager is in a situation where the
lender is calling capital, the notice period before a lender can force the liquidation of the assets is often two
business days. In the case of the 3x leveraged fund,
this means that 67% of the assets are subject to a two
day liquidation call, and have a coverage multiple of
only 0.13x (see exhibit 4 on the following page). Worse,
in practice the percentage may be higher, since a lender
will usually not call in loans and force a manager to
sell assets until the assets decline by some trigger
amount; in such a situation, although the value of the
managers assets has declined, the face value of the loan
remained the same, and therefore the percentage of
assets which need to be liquidated can quickly reach
100% of the asset value in stress scenarios. In such a
situation, little may remain for the equity holders/
investors in the fund.
A number of hedge funds including larger firms such
as Sowood, Bear Stearns and Peloton, encountered this
firsthand and were subsequently forced to shut down.
While these are extreme cases, nevertheless, managers
need to focus on negotiating the best available terms
with their counterparties, so as to reduce their costs and
just as importantly their risks. Further, investors (or
equity holders) in hedge funds who focus solely on the
liquidity of the hedge fund assets versus investor
redemption rights are overlooking what may be a far
more significant liquidity risk.

Why use leverage

Loosely defined, leverage is simply the act of capturing
a greater amount of exposure to an investment than
what one otherwise would be able to capture by solely
using cash on hand (or an investors equity). Leverage
is a term that is often maligned, particularly when
mentioned in conjunction with hedge funds. However,
most individuals use financial leverage in their own
lives in one form or another. For instance, the purchase

Exhibit 4. Hedge Fund balance sheet 3x levered portfolio, quarterly liquidity with 45 days notice
$500
$400
$300
$200
$100
$0
Value of Assets (securities)

Value of Equity (AUM)

Value of Liabilities (Loans)

Hedge fund balance sheet 3x levered portfolio, quarterly liquidity with 45 days notice
Value of Assets (securities)

Value of Equity (AUM)

Value of Liabilities (Loans)

$450

$150

$300

Days to Liquidate (time necessary for

manager to sell aassets)
15

Days to Liquidate (i.e. notice period)

Days to Liquidate (counterparty/

lender payment due)

45

2
Coverage Multiples

3.00x

of a home with a mortgage is a leveraged investment.

Although it can certainly amplify the risks, the prudent use of leverage in portfolio management can also
provide significant benefits for investors by reducing
risk and/or enhancing risk-adjusted returns.
While they are not necessarily mutually exclusive, there
are several reasons why a hedge fund manager will use
leverage in their portfolios:
1) General return enhancement managers with
high conviction in certain ideas can take more directional exposure to these positions. Assuming the positions outperform the cost of borrowing, the returns on
the positions will be enhanced.
2) Risk reduction while intuitively most persons
would not associate leverage with a reduction in risk, if a
manager shorts positions against his or her long positions, the result is a levered portfolio which typically will
be less volatile. This is due to the fact that the directional exposure to volatile markets, sectors, or other systematic returns is negated, even though the portfolio is leveraged. Consider the following example: Assume that a

0.13x

hedge fund manager has $150mm in assets under management. If the manager were to short $100mm of stock
alongside the $150mm of long positions, the manager
would have levered up the portfolio, but at the same time
reduced his or her systematic exposure to equity markets.
Gross leverage would be 167% (250/150 = 1.67), but the
net exposure or leverage would be 33% ((150-100)/150)
(see exhibits 5a and 5b on the following page).
Although equity long/short managers are leveraged,
the lower net exposure to equities generates a more
consistent return profile and a lower level of volatility
than the broader markets. Through the application of
leverage, and by being long and short the markets,
their returns are often smoother and less volatile.
3) Magnification of low-risk returns for strategies
that seek to capture spreads or returns that are thought
to be lower in risk, managers often will lever up the
exposure to magnify returns that otherwise would not
be compelling. Although similar in concept to above
point #1, the level of leverage used and the motive is
slightly different, often because such low risk returns
are typically completely hedged and far less directional.

Exhibit 5b: Net portfolio exposure

Exhibit 5a: Gross portfolio exposure

$300

$160
$140

$250

$120
$200

$100
$80

$150

$60

$100

$40
$50

$20
$0

$0

Hedge Fund Assets

$150

Value of Long Positions

Unlevered
portfolio

Leveraged
portfolio

150

150

Value of Long Positions

100

Value of Short Positions

150

250

100%

167%

Net Dollar Exposure

Net Leverage %

Absolute Value of Short Positions

Gross Dollar Exposure
Gross Leverage %

As an example, consider a merger arbitrage hedge fund.

A merger arbitrage manager will invest in companies
due to be acquired, and typically short the stock of the
acquirer as a hedge (assuming it is a stock for stock
deal). The price of the target company following the
announcement will usually not trade up to the anticipated closing price, since there is often uncertainty
related to whether the acquisition will close. There are
many reasons why a merger may not close, including
other bidders, antitrust regulations, management disagreements, poor earnings of the target company in the
interim, etc. If the manager is correct though and the
deal closes, then the target companys stock will trade
up to the closing price and the manager will profit.
The difference between a target companys price just
after the deal is announced, and the actual closing price
of the deal is what is commonly referred to as a spread.
The more uncertainty associated with a deal closing,
the wider the spread; if the market believes the deal is
highly likely to close then the spread will be narrow.
Managers can lever up low risk spreads in order to generate annualized returns that are more attractive. Please
see exhibit 6 on the following page.
4) Liquidity and/or transaction costs while derivative securities are leveraged investments (see the section

Leveraged Portfolio

Net Dollar Exposure

Absolute Value of Short Positions

Value of Long Positions

Hedge Fund Assets

Unlevered portfolio

Leveraged Portfolio

Unlevered portfolio

$150
Unlevered
portfolio
150

Leveraged
portfolio
150
-100

150

50

100%

33%

that follows), often they are more liquid, or carry lower

transaction costs than investing in the referenced assets.
An example may be futures contracts for commodities.
If a manager seeks exposure to corn, soybeans, cattle,
copper, etc., he or she is more likely to buy the futures
contracts versus the actual hard assets. Futures contracts are leveraged, since the margin required (i.e. the
percentage of the overall amount that an investor must
deposit to get exposure) is a small relative to the overall value of the referenced commodities. Another example may be credit default swaps (CDS). CDS contracts reference bonds or other fixed income securities,
and allow managers to pay a premium or spread based
on the par value of the debt to receive protection
against default. By paying a premium, a manager can
quickly hedge their long fixed income positions, or
take directional downside exposure to select fixed
income assets without borrowing the securities and selling them short, which can result in transaction costs.

Leverage by Strategy
While any hedge fund strategy can employ leverage,
certain strategies tend to employ higher levels of leverage than others. Generally, strategies that are more directional in nature, or in other words exhibit some net

Exhibit 6: Merger arbitrage position example

Upon Deal Closing, Stock of
Short Acquirer

Acquirer Delivered to Target

Long Target

Company Shareholders
One for One share exchange. Assume $100 of capital. Assume deal closes in four months. Aside from short sale, no additional
leverage employed. Purchase one share of target, short one share of acquirer.
Acquirer Stock Price After
Deal Announcement
$100

Target Stock Price After Deal

Announcement

Difference / Spread

$98

$2

Return From Spread

Approximate Annual Return from Spread *

2.00%
6.00%

One for One share exchange. Assume $100 of capital, with leverage of 3x. Assume deal closes in four months. Purchase three
shares of target, short three shares of acquirer. Assume annual financing cost of capital borrowed is 5%.
Acquirer Stock Price After
Deal Announcement
$100

Target Stock Price After Deal

Announcement
$98

Difference / Spread
$2

Leveraged Spread

$6
6.00%

Return From Leveraged Spread

Approximate Annual Return from Leveraged Spread *
less: cost of financing ((5% * 120/360)*$200)/$100

18.00%
-3.33%

Net Annual Return from Spread

14.67%

* This is a simple example. Merger arbitrage manager would also receive a short interest rebate on short sale proceeds, incure a cost for stock
borrowed, and owe any dividends paid on the short stock position to the lender.

exposure to a market factor, are less leveraged than

arbitrage strategies which attempt to capture pricing
discrepancies (spreads) between assets. Directional
strategies may include long/short equity, macro, distressed, emerging markets, to name a few. Arbitrage
strategies include convertible arbitrage, event driven,
merger arbitrage, fixed income arbitrage, etc.

Directional Strategies
Long/Short Equities:

0.0x to 2.0x

Distressed Securities:

0.0x to 1.3x

Opportunistic/Macro:

1.0x to 2.5x

Below is a summary of the leverage levels typically utilized for several of the strategies mentioned above. The
figures represent gross leverage.

Arbitrage Strategies
Merger Arbitrage:

0.8x to 2.5x

Relative Value:

1.0x to 20.0x

Event Driven:

0.8x to 2.5x

Relative Value Sub-strategies

Convertible Bond Arbitrage:

3.0x to 7.0x

Fixed Income Arbitrage:

5.0x to 20.0x

Statistical Arbitrage:

2.0x to 4.0x

Fundamental Equity Pairs:

1.0x to 2.0x

Source: JPMorgan Alternative Asset Management

How do Hedge Funds Obtain

Leverage?
While this is not an exhaustive list, there are several
common ways that a hedge fund manager can obtain a
greater exposure to an asset class or security than the
amount of capital they manage, or in other words take
leverage. The means to achieve this can be broken
down into two general categories, short-term leverage
and long-term financing:
Short Term Leverage:
1. Perhaps the most readily available and easiest way to
lever returns is through purchasing securities that have
leverage already embedded in them. Securities such as
futures, exchange-traded options, and components of
structured products can be purchased on an exchange
or directly from a broker.
Bank
or
Broker/Dealer

Futures, ExchangeTraded Options,

Structure Products

Repurchase
Agreements
(Repos)

OTC Derivatives
and
Swaps

a. Futures an investor can easily obtain exposure to

commodities or financial assets by purchasing a
futures contract. The investor will realize the profit
or loss on a set value (contract size) of the asset, but
is only required to deposit a margin equal to 5% 15% of this value. For instance, investors purchasing
soybeans via futures contracts on the Chicago Board
of Trade (CBOT) would need to deposit approximately $3,000 for approximately $60,000 soybeans
for future delivery. This assumes that the price is
$12 per bushel, and that a futures contract is for
5,000 bushels. As the price moves prior to delivery
date, the investor receives cash if the price increases,
and must deposit cash when the price declines.
Basically the investor has deposited 5% of the value
and captures 100% or the price movement, translating into 20x leverage on the investment.

b. Options similar to futures contracts, an investor

captures exposure to the value of an asset by only
investing a fraction of the cash price for that asset.
Unlike a futures contract though, investors who purchase a call or a put are only liable for the amount
they invest, and are not required to post margin as
the price of the underlying asset moves. However,
investors who sell unhedged options (or naked
options) may be required to deposit cash or collateral
as the price moves against them. One can dissect the
price of an option into its components, which scholars such as Fischer Black, Myron Scholes and Robert
Merton did when they created the Black Scholes
options pricing model. There are several components
which factor into the pricing of an option, including
the value of the referenced asset vs. the strike price,
the implied volatility of the referenced asset, the
time to expiration, and the time value of money (i.e.
the risk free rate). We mentioned the last component
since an option is an indirect way to capture exposure to a referenced asset without a significant capital outlay, or in other words a means of leverage. For
instance, investors purchasing call options pay a
time premium, and that time premium (which is
the value of the option price less any in the money or
intrinsic value), has a financing rate component to
compensate for the embedded leverage in the
instrument.
c. Structured products although not necessarily
short-term, depending on the structure, there may be
leverage embedded in certain structured products, or
components of structured products. Consider the case
of a collateralized debt obligation (CDO). CDOs
invest in a portfolio of debt instruments, often high
yield debt or asset backed securities. The CDO will
be structured as a holding company or special purpose vehicle (SPV), which then invests in a portfolio
of underlying securities. The sponsor of the CDO will
sell securities backed by segments, or tranches, of the
CDO to investors. The number of tranches will vary
depending on the CDO, but importantly the tranches
have varying levels of subordination. In a plain vanilla CDO, there may be a senior tranche, a mezzanine
tranche, and an equity tranche. Lets assume a simple

occur, again reflecting the fact that the equity tranche

is a leveraged investment.

CDO structure with an 85% senior tranche, a 10%

mezzanine tranche, and a 5% equity tranche. (see
exhibit 7)
Should any defaults occur in the underlying ABS
securities, the equity tranche would absorb them
first, in this case up to 5% of the value. Should
defaults exceed this amount, the mezzanine tranche
would absorb any defaults up to 15% of the value.
Only after 15% of the underlying securities have
defaulted would the senior tranche begin to absorb
losses. Naturally, the ratings of the senior tranche
would be the highest, and are typically structured as
investment grade. Mezzanine and equity tranches
would have lower ratings since they are first to
absorb defaults, with the equity tranche often carrying a non-rated qualifier. The returns pledged to
each tranche would also reflect the risks. Should
defaults be minimal, the equity tranche would deliver returns that may be double or more of what senior
tranche holders may receive.
The key point is that the equity tranche is a leveraged investment in a portfolio of bonds or ABS. This
is possible since the underlying ABS securities, on
average, yield more than the senior and mezzanine
tranches of the CDO. Although the difference in
yields between the underlying ABS securities and
the yield on the senior and mezzanine tranches (8%
versus 6% or 6.5%) is much less than the difference
in the yields between the underlying ABS securities
and the yield on the equity tranche (8% versus
15%), since 95% of the capital is invested in the
senior and mezzanine securities, and only 5% of the
capital is invested in the equity tranche, the equity
tranche returns (and risk) are amplified. On an attribution basis, the cumulative attribution of the senior
and mezzanine securities is equal to 5.75%, which
when subtracted from the 8% yield on the collateral,
leaves a residual yield of 2.25% (based on the entire
collateral value) available for the equity tranche and
any servicing fees or dealer commissions. Assuming
fees and commissions equal 1.5%, the remaining
0.75% of the collaterals return can be paid to the 5%
equity holders. Therefore, the return for equity holders
is equal to 0.75% / 5% = 15%. With this magnified
return comes a magnification of losses should defaults

Exhibit 7: Simple Example CDO Structure

Tranche

Rating

Yield

Senior Tranche

85%

AAA

6%

Mezzanine Tranche

10%

BBB

6.50%

Equity Tranche

5%

NR

15%

Weighted Average Yield of Collateral

8%

Tranche Yield Attribution: Senior

(0.85*6%) =
Mezz
(0.10*6.5%) =
Equity
(0.05*15%) =
Weighted Average

5.10%
0.65%
0.75%
6.50%

Servicing/Management Fees, Dealer Commissions, etc.

1.50%

2. Repurchase agreements (REPOs) effectively a

REPO is a securitized loan. Although sometimes structured as long-term agreements, typically the loans are
short-term, often overnight, and entail the purchase of
a security or securities by a bank from a hedge fund (or
any entity in need of cash), with the simultaneous
pledge by the seller to repurchase the security at a
higher price. The difference in price is the borrowing
cost that the hedge fund pays, for the privilege of
accessing the banks cash between the sale and repurchase dates. Lenders will often haircut the collateral,
and apply this haircut to the amount of cash they disperse in through the agreement. Haircuts vary based
primarily on the volatility and liquidity of the securities being sold and then repurchased. REPOs often reference a Master Repurchase Agreement (MRA) or a Global
Master Repo Agreement (GMRA), which serves as a
starting point for negotiations between lender and
borrower.
3. International Swaps and Derivatives Association
(ISDA) agreements between counterparties. Hedge
funds often will contract with an investment bank to

either receive or provide the returns of specific securities, indices, currencies, commodities, etc., in exchange
for the returns of other securities or a financing rate
(typically LIBOR + a spread). The manager can gain
exposure to the returns of a large dollar value of securities, and typically only must deposit an initial margin
of 5%-15% in the form of cash or equivalent securities.
If the return of the reference asset is positive then the
manager receives a payment from the counterparty, but
if the return of the reference asset is negative then the
manager will owe the counterparty a payment. ISDAs
cover swap transactions and other derivative transactions (e.g. options) that are executed in the over-thecounter (OTC) market directly between parties, versus
on an exchange. Following is a diagram outlining the
exchange of returns from a simple total return swap
agreement.
Return of S&P 500
Counterparty

Hedge Fund
Financing charge
(e.g. LIBOR + Dealer Spread)
Margin Posted*

* Margin is typically posted using cash, in an amount equal to

5% 15% of the notional value of the swap initially. As the index
fluctuates, additional margin may be required.

While counterparties can negotiate swap terms directly,

most often a swap agreement will reference what is
referred to as the ISDA Master Agreement, which was
developed by the Association to serve as a basis of
understanding between two counterparties. It contains
definitions, basic representations and warranties, events
of default or termination events, and other common
elements of most swap transactions. The agreement is
often accompanied by a Credit Support Annex, which
specifies the terms related to the collateral posted by
the hedge fund, including eligible collateral and the
banks right to liquidate collateral under certain events.
Finally, there are usually schedules or amendments to
the ISDA Master Agreement which allow for changes
to, or the inclusion of specific terms which the counterparties negotiate. In summary, each trade is governed

by a trade confirmation, which is governed by the

ISDA Master Agreement, Credit Support Annex, and
any applicable schedules/amendments. It is important
to note that the ISDA Master Agreement was constructed by the member firms of the Association, and
therefore may be biased to protect the member firms
executing with a hedge fund which is the reason that
managers may need to negotiate for terms that are less
one sided (see the sections that follow).
Swap transactions can take many forms, and can
involve a wide variety of referenced assets. One important point for investors to realize is that a counterparty
investment bank will usually not take risk when providing the returns of a referenced asset to a hedge fund.
The bank will replicate the returns of the referenced
securities by purchasing the actual cash instruments, or
by purchasing derivatives (such as futures contracts).
The dealer spread that is paid above the financing rate
(typically LIBOR) represents the profit that the bank
receives for the transaction. The financing rate represents the cost of balance sheet capital that the bank
otherwise could deploy (e.g. by making loans to other
customers), were it not to invest its capital so as to
hedge its risk to the hedge fund. In the case when the
bank uses futures contracts to hedge the exposure, the
contract itself would have an embedded financing rate,
and the financing rate paid by the hedge fund would
be used to satisfy this cost.
Medium to Long-Term Financing:
Bank
or
Broker/Dealer

Investors

Prime Brokerage
Borrowing Facility

Term Financing
Bonds

4. Prime brokerage borrowing facilities A bank

or broker/dealer performing the services of a prime
broker will perform a multitude of services in addition
to trade execution. These services may include

10

providing financing for leverage, providing stock loans

(for shorting), portfolio accounting and performance
calculations, and introducing managers to potential
investors (Capital Introduction). While managers will
usually trade with many brokers, who are often referred
to as executing brokers, the prime broker will hold the
funds securities and execute the transactions on their
behalf. Since securities are held in the prime brokers
account, they can also be pledged as collateral in the
Prime Brokerage Margin Account Agreement. Effectively
this is the same type of agreement that an individual
investor can receive from his or her broker when they
open a margin account, although hedge funds typically
have access to more financing than an individual would
under Regulation T, since they can borrow from offshore financing affiliates of the prime broker. Prime
brokerage is really more accurately classified as a service
versus a type of entity, since both banks and broker/
dealers are in the business of prime brokerage.
A prime brokerage margin account agreement will
usually contain the rights that the prime broker has
with regards to a hedge fund managers dealings with
executing brokers, and importantly the rights that the
prime broker has related to the collateral held in the
account. Typically the prime broker will have the right
to liquidate the collateral, accelerate any contracts, and/
or buy in securities which the fund has sold short if
certain triggers or covenants are breached. In addition,
the agreement will specify the fees the broker can
charge, the right the broker has to lend securities held
in the account to others, representations and warranties
of the manager, and other terms. Outside of margin
account financing, prime brokers may also offer specific
loan facilities to their hedge fund clients, often longer
term in nature than the standard margin account
financing.
5. Traditional term financing (e.g. notes, bonds,
etc.) funds, or vehicles set up by funds, will issue debt
that can be used as a more permanent source of capital
for managers. Although similar to financing provided by
prime brokers, term financing arrangements are not subject to discretionary margin requirements or foreclosures
by counterparties. Instead, they are subject to certain
covenants that exist until the debt matures. For instance,

Citadel, a large hedge fund based in Chicago, was able to

issue five year notes recently. The notes were issued by
two of Citadels hedge funds, and the proceeds were used
to make investments and to reduce exposure to shortterm financing. The debt was guaranteed by the funds,
and the funds were each assigned a rating by a rating
agency in order to complete the deal. While
several hedge funds and hedge fund management companies have gone public via an initial public offering, the
bonds issued by Citadel were significant since it was one
of the first true debt offerings of its type.
Important factors that hedge funds and their
investors should consider when negotiating
financing agreements
Each source of capital comes with various considerations that are important for fund managers to address,
and for investors in their funds to understand. While
the amount of leverage employed by managers, and the
types of agreements they structure will vary (often
depending on the investment strategy), below are several examples of items that are important to consider.
1. Financing Costs vs. Counterparty Risk: While
striving to reduce financing costs is a simple concept, it
is slightly more complicated when one considers that
prudent managers must balance a pure cost reduction
approach to negotiating against counterparty concentration risk. For instance, a prime broker or investment
bank will charge a lower fee for funds that borrow significant amounts or that execute a high volume of
trades. However, managers do not want to be too
dependent on any counterparty. Rather, it is prudent to
deal with several in case one has a sudden risk aversion,
which can lead to that counterparty refusing to renew
their agreements; or in a more extreme case, should the
counterparty be unable to renew agreements because of
a lack of liquidity. The transparency of financial conditions at counterparties, or market participants perception of counterpartys financial viability, can have an
immediate impact on their capital and their ability to
extend financing. The importance of this was recently
demonstrated, as Bear Stearns was forced to sell itself
to JPMorgan Chase & Co. following massive withdrawals by clients.

11

2. Margin Requirements: Managers may be required

to post some initial amount of cash or cash equivalent
when they enter into a swap or other transaction. The
less cash that they have to post, the more that can be
kept in the fund and used to generate returns. In
todays environment, the amount of margin required
for new financing agreements or swap transactions has
increased substantially. Managers should negotiate for
margin requirements that are minimal, if possible, so
they can keep as much of their cash unencumbered.
Moreover, managers should also request credit for margin posted with for trades placed on other desks of the
same bank (i.e. the margin collateral should all be netted). Finally, managers should seek high minimum
values to post when it is necessary to post addition
margin, and request that the counterparty bank also
post collateral (two way) if the trade moves in the
managers favor.

or sell their positions and post cash. Managers should

negotiate for triggers that allow for sufficient movement in the value of their collateral before triggering a
termination or default, which again may force a liquidation of the collateral securities. This is particularly
important at times when markets are less liquid (such
as today), since a forced sale in such a market can
quickly lead to substantial losses. Further, triggers
associated with a decline in assets should be predominately performance based; if investors withdraw capital
from the fund, the agreement should account for this
separately and the AUM threshold triggers should be
adjusted accordingly. In other words, managers should
not be overly punished should their fund assets decline
due to investor withdrawals, assuming that the collateral securitizing the agreement has not been tainted or
otherwise declined in value due to negative
performance.

3. Collateral and Haircuts: Before an investment

bank or prime broker will loan a hedge fund money,
the manager has to pledge collateral to secure the loan,
swap, etc. For hedge funds, this collateral is represented
by the securities/investments in their fund, or a specific
subset of their investments. Credit providers will
require a certain value of collateral to be pledged vis-vis the amount of the loan (i.e. Loan-to-Value Ratio).
Managers should negotiate for terms that require a
minimal amount of collateral to be posted, flexibility
regarding the type of collateral, and minimal haircuts
to the collateral required. For instance, as risk-aversion
has spread through the financial system following subprime and credit declines, investment banks are
increasing the haircuts they apply to the collateral posted. Effectively, this reduces the leverage that managers
can take. Importantly, managers should ensure that any
changes to collateral requirements, including haircuts,
are understood in advance of the changes being implemented since if counterparties can adjust such
requirements with minimal notice, it can put the
hedge fund at risk.

5. Termination Events: In addition to performance

based triggers, counterparties may terminate an agreement for a variety of reasons. It is important that the
reasons are justified and restricted, since a sudden termination can curtail the profits that a hedge fund
manager otherwise would capture, or again lead to a
forced liquidation of securities. It is critical to lay out
in detail any covenants that would allow a counterparty
to terminate an agreement, and to address these covenants outright. Examples of such covenants may
include: a) key man provisions often an agreement
states that the counterparty has the right to terminate
should any partner of the hedge fund organization
cease to be engaged in his or her current role, but managers may want to negotiate for a group of partners
ceasing to be engaged before the counterparty has the
right to terminate; b) Material Adverse Change clauses
are often noted in agreements, whereby a counterparty
can terminate an agreement for a variety of reasons;
these clauses are quite vague and managers may want
to ask for more specific details of what constitutes a
material adverse change before agreeing to such a
clause.

4. Triggers: There are a number of events that may

trigger either a termination of a loan agreement or
swap, and/or an event of default. Typically, if the collateral falls in value by a certain amount, the manager
must post additional collateral in the form of securities,

6. Cure periods: A cure period is the amount of time

that a manager has to cure or remedy a cash shortfall,
a breach of select covenants, or to otherwise satisfy obligations to which they are bound by the agreement. For

12

instance, a manager may have represented that no more

than a certain percentage of the assets in their fund
would be invested in a specific asset class, or that the
fund cannot be overly concentrated in certain securities
or sectors. If the manager is in breach due to assets
appreciating or depreciating, ideally he will have sufficient time to cure the breach through selling or purchasing securities to get back into compliance.
Typically cure periods are expressed in a number of
business days, but sometimes the period is as short as
the same business day. Managers should negotiate for
sufficient cure periods so they can avoid having their
facilities cancelled.
7. Valuation of Collateral: Typically there is a valuation or calculation agent specified in financing agreements or swap contracts, who is responsible for determining the value of the swap mark-to-market and/or
the collateral securitizing a loan or swap. If the collateral is frequently traded on an exchange there is little
room for disagreement about how it should be valued.
Often though, hedge funds will invest in less liquid
securities that are not frequently traded, such as assetbacked securities, collateralized debt obligations, private
loans, etc. These same investments are frequently
pledged as collateral or referenced in financing agreements. Should the value of these securities be marked
down by the valuation/calculation agent, it may again
force the manager to liquidate these illiquid investments. In the case where such securities are referenced,
managers should ensure that their provider does not
have the ability to value the collateral independently, or
if they do, that either the process, model, or other
means to arrive at a value is determined and agreed to
in advance by both parties (some managers require an
independent valuation agent to calculate collateral
value). Otherwise, it can be a quick and easy way for a
counterparty wishing to cancel their financing agreement to mark down the value of the collateral, force a
sale of the collateral, and cancel their agreements, again
putting the fund at risk. Finally, depending upon the
collateral pledged, the manager should ensure that the
counterparty values all components of a security to recognize full value. For example, an agreement where a
fixed income arbitrage manager who is posting debt
securities should account for the market value of the

bonds plus the accrued interest associated with such

bonds which may not necessarily be included in the
value unless explicitly stated in the agreement. Another
example may be loans (perhaps private) which have
rights or options for equity linked to them if the
counterparty simply values the debt component independently it may understate cumulative collateral value.
8. Duration or Maturity: The ideal situation for a
manager is to contract to receive financing or swaps for
the longest period possible, with the right to cancel the
agreements at the option of the manager. While there
may be break-up fees or other charges should the manager terminate an agreement, having their financing
locked up for longer periods will reduce a managers
rollover risk. In addition, if a manager has the option to
terminate an agreement, he or she can negotiate with
other counterparties, or renegotiate with his or her current counterparty, for more favorable terms
continuously.
9. Special Clauses: Each swap, repo, debt issuance or
financing agreement is different, and managers should
be on the lookout for unique clauses that will need to
be addressed. As one example, some agreements have a
cross default clause, where if a fund defaults or is in
breach of any other financing or swap agreement, the
current agreement will automatically be in default and
be subject to termination. The inter-relationship of
financing agreements under such a clause, if broadly
included in a managers various contracts, can put the
fund at significant risk. Suppose that due to an operational error, a fund is a day late in sending payment to
one of its counterparties, technically placing the fund in
default. With such a cross default clause in place, the
manager is now in default on each of his contracts, even
if the matter was quickly settled and addressed with
the initial counterparty, and even though that particular agreement may have entirely different terms, collateral, etc. A minor operational error puts the entire fund
at risk of having to be unwound, since counterparties
can seize the collateral and begin to liquidate. While in
actuality this is unlikely to happen, it is important for
managers to constantly consider the what if scenarios
that may play out as they negotiate with their counterparties. If banks suddenly decide to reduce the risk on

13

their balance sheets, obscure occurrences such as these

may provide an opportunity to cancel their agreement
with a manager.
10. Trading limits and trade cancellations often
prime brokerage agreements will have clauses that
allow the prime broker to limit the type or size of a
transaction with an executing broker. While prime
brokers certainly need to protect themselves (and their
capital), managers may want to consider asking the
prime broker to provide the circumstances in which
such limits would be implemented. In addition, if the
net equity in an account falls below a minimum
amount specified in the prime brokerage agreement, the
broker may be able to disaffirm trades that a manager
placed with an executing broker(s). Ideally there should
be a cure period and/or advance notice required before
such actions are actually taken by the prime broker.
11. Counterparty/prime broker approval process
and ongoing review hedge funds ideally will have a
formal approval process with designated professionals
who are responsible for approving counterparties, as
well as monitoring counterparty credit exposure.
Documenting this process, and assigning responsibility
to professionals is an important component of running
a successful hedge fund management company.
12. Legal entity and capitalization when entering
into a transaction, the counterparty is often a subsidiary of a major investment bank. The subsidiary may or
may not be well capitalized, and may or may not be
guaranteed by its controlling entity which also may
or may not be capitalized. Just because the parent company name is attached to the counterparty entitys
name does not mean that the parent company guarantees any transactions of the subsidiary. Fund managers
must understand where each of their counterparties
stand in the overall capital structure, and their recourse
should a counterparty fail to satisfy its obligations
under an agreement. The starting point for hedge fund
managers may be to inquire about whether the entity
they are trading with is rated by a rating agency, and/
or whether there is another entity guaranteeing the
obligation such as the parent company. Finally, a
manager should also understand whether their counterparty has the ability to assign trades to another entity

under the parent company umbrella, under what circumstances this would occur, and the status of these
alternate entities with regard to capital structure, ratings, guarantees, etc.
13. Cash managers will often have unencumbered
cash that has not been posted as margin or invested in
securities. If this cash is held at the same prime broker
that the manager trades with, and the prime broker
defaults on its obligations, there is the risk that access
to the cash may become restricted. Managers may benefit by instructing their prime broker to transfer any
unencumbered cash to other subsidiaries of the same
bank such as the asset management division, so that it
is not commingled with the assets held at the prime
brokerage entity, or even to have the cash managed by
a completely different bank.
Larger Funds vs. Smaller Funds
As the hedge fund industry has grown rapidly, it has
also evolved. Generally hedge funds are far more
sophisticated in how they structure their agreements
with counterparties compared to a decade ago.
However, larger firms have a distinct advantage due to
their scale. There is a disproportionate amount of capital being managed by the largest hedge fund firms,
with some studies suggesting that more than half of
hedge fund AUM is being managed by less than 5% of
hedge fund organizations these organizations are
much better postioned to negotiate for the best commercial terms. Smaller firms may lack the scale and
resources to do as thorough a job at negotiating, and
may also be at a bit of a disadvantage since they generate lower trading volumes. Therefore, the initial agreements they strike, typically with fewer counterparties
or perhaps just one, must be as tight as possible given
the higher counterparty concentration risk. We at
JPMAAM recognize that smaller managers are often
the most able to effectively exploit opportunities in
niche strategies. We attempt to partner with our underlying manager when possible in order to facilitate the
advancement of their businesses. As an example, if we
believe that a manager needs to devote more time to
negotiating with counterparties, we will often recommend a consultant that specializes in reviewing and
negotiating such agreements for hedge fund managers.

14

Negotiating vs. Renegotiating

While every attempt should be made to renegotiate
contracts with counterparties for more favorable terms
whenever practical, negotiating the best terms is paramount at the outset. Intuitively this makes sense, since
once an agreement is in place and capital has been
deployed, the negotiating leverage that a manager has
declines. Therefore, the initial agreement sets the stage
for further negotiations.
The relationship of basis risk, liquidity,
and leverage, and a recent example of the
importance of monitoring manager financing
arrangements
Basis risk is the risk that positions in a hedging strategy that are designed to offset each other will not realize
price changes or cash flows in the same manner. Many
of the most highly leveraged hedge fund strategies are
relative value strategies such as fixed income arbitrage,
convertible arbitrage, etc., where the manager attempts
to capture a spread between different securities, whether the spread is a difference in price or a difference in
cash flow or yield. As previously mentioned, managers
will usually apply leverage, sometimes significantly, to
amplify the spread to an annualized return that is
attractive. The primary risk for managers employing
these spread-based strategies is an event where spreads
widen instead of narrow (i.e. basis risk). While no manager is perfect and will lose money in positions that go
against him or her, when this happens the manager
should be able to cut losses by selling their long positions and covering their short positions quickly. While
leveraged positions involving basis risk can often generate significant losses, it is when the third risk factor, a
lack of liquidity, is combined with leverage and basis
risk, that adverse market fluctuations can occasionally
lead a hedge fund to collapse.
Sowood Capital Management: This fund imploded
in the summer of the 2007. The fund was a multistrategy fund, with a heavy emphasis on fixed income
trading. Following a sharp increase in credit spreads in
June and July, the creditors of the fund effectively
forced the manager to liquidate assets, at a time when
liquidity in the marketplace was minimal. Ultimately,
the fund sold virtually all of its assets at a deep

discount to Citadel, which had sufficient capital and

liquidity to purchase the entire portfolio (recall that
Citadel had issued long term debt backed by their
funds, providing a stable base of capital for a portion of
its capital structure).
Many of the points mentioned throughout this paper
are directly related to items mentioned in the letter
that Sowood sent to investors upon the funds collapse,
and serve to justify how important it is to structure
sound financing and counterparty agreements.
Below are several excerpts:
During the month of June [and July], our portfolio
experienced losses mostly as a result of sharply wider
corporate credit spreadsand exacerbated by a marked
decline in liquidity.
Until the end of last weekour counterparties had
not severely marked down the value of the collateral
that the funds had posted nor changed our margin
terms, and immediate liquidity needs could be met
howevergiven the extreme market volatility, our
counterparties began to severely mark down the value
of the collateral that had been posted by the funds.
In addition, liquidity became extremely limited for
the credit portion of our portfolio, making it difficult
to exit positions.
Given what we were facing and our uncertain ability
to meet margin callsCitadel offered the only immediate and comprehensive solution.
The transaction enabled us to avoid anticipated forced
sales at extreme prices that would have been made to
satisfy obligations under our counterparty agreements.
Is this a new phenomenon: While the current credit environment is unique in terms of its magnitude and
the underlying catalysts that caused it (e.g. declines in
real estate values, coupled with subprime mortgage
issuance driven by the massive issuance of structured
products, etc.), the premise behind many of the recent
hedge fund failures is very consistent with historical
patterns. The concept of significant basis risk, illiquidity
and leverage as a potentially lethal cocktail has existed
for many years. The means by which the combination
manifests itself may be different, but essentially the

15

same principles apply. For example, lets rewind by a

full decade. In 1998 the hedge fund Long-Term Capital
Management (LTCM) succumbed to the perils of managing a highly leveraged portfolio, where the price
action of related securities went completely against
expectations (i.e. basis risk). LTCM was betting that
the value and yields of government bonds would converge, but after Russia defaulted on its debt obligations
the opposite happened. Further, there was not sufficient
liquidity in the markets to exit positions, since much of
the price action in the bonds that caused losses for
LTCM was liquidity driven as investors fled to quality,
selling debt backed by Russia and other countries and
purchasing U.S. Treasuries; therefore this left no bid for
LTCMs long holdings and an increasing asking price to
cover their short positions. While the catalysts that drove
LTCMs decline were different than those related to the
recent hedge fund failures, the positioning of the funds
and the results were the same. Unfortunately, investors
should continue to expect the same problems to surface
again. Therefore, having a dialogue with managers about
their financing agreements and their philosophy related
to the use of leverage will always be an important ingredient of a thorough due diligence process.

Conclusion
In todays environment of declining liquidity and significant bank subprime losses, it is particularly important for hedge fund managers to obtain financing from
the strongest counterparties. In addition, their agreements with these counterparties should offer competitive economic terms, should provide sufficient time and
flexibility to manage through difficult periods, and
should not place the fund and fund investors at undue
risk. Managers who are proactive in negotiating for the
best terms will often have an advantage, especially during the tougher times. They will have time to unwind
certain positions if necessary, or equally as important,
to take advantage of mispricings that surface in the
capital markets by leveraging liquidity they have available that others may not.

References
1) The Wall Street Journal. December 28, 2007. Page
C1. Hedge Funds Feeling the Pinch on Credit, Too.
By Gregory Zuckerman and Alistair MacDonald.
2) Liquidity, Monetary Policy, and Financial
Cycles. Federal Reserve Bank of New York research
publication. Authors: Tobias Adrian and Hyun Song
Shin. January/February 2008 Volume 14, Number 1.
Website: http://www.ny.frb.org/research/current_
issues/ci14-1/ci14-1.html

Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends,
which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. References to specific securities,
asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations.
These materials have been provided to you for information purposes only and may not be relied upon by you in evaluating the merits of investing in
any securities referred to herein. Past performance is not indicative of future results. Indices do not include fees or operating expenses and are not
available for actual investment. Indices presented, if any, are representative of various broad base asset classes. They are unmanaged and shown
for illustrative purposes only.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal
or tax advice. You should consult your tax or legal advisor regarding such matters.
JPMorgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. and its affiliates worldwide
which includes but is not limited to J.P. Morgan Investment Management Inc., JPMorgan Investment Advisors, Inc., Security Capital Research & Management Incorporated, J.P. Morgan Alternative Asset Management, Inc.
www.jpmorgan.com/insight

JPMorgan Chase & Co. 2008

IM_HFLEV_NEG_0508

16