What Is Synthetic Prime Brokerage and How Can Hedge Fund Managers Use It to Obtain Leverage?
Hedge Fund Law Report
One of the services traditionally provided by prime brokers to hedge funds is the provision of leverage, that is, loans extended to hedge funds to pursue their investing activities and enhance returns. Such leverage takes various forms. The most common form is a margin loan in which the hedge fund posts a certain amount of equity with the prime broker – for example, 50 percent of the initial purchase price of a security – and the prime broker lends the hedge fund the remainder of the purchase price. Other methods of providing leverage include repos and stock loans. Another strategy by which hedge funds obtain leverage is through the use of over-the-counter (OTC) derivatives, notably including total return swaps (TRSs). Generally in such arrangements, the prime broker pays the hedge fund the “total return” on a reference asset (e.g., in the case of equities, capital gains and dividends) and the hedge fund pays the prime broker fees, capital losses and interest on any embedded leverage. The prime broker often hedges its position by purchasing the reference asset. So-called “synthetic prime brokerage” is a means of institutionalizing the TRS-based delivery of leverage to hedge funds from prime brokers. Generally in a synthetic prime brokerage arrangement, a prime broker establishes an account that is “advised” by a hedge fund manager. The manager has discretion to trade the assets in the account in accordance with the strategy stated in a management agreement or a PPM incorporated by reference into such an agreement. However, the prime broker – not the manager – owns the assets in the account. The account and a hedge fund advised by the manager enter into a global TRS whereby the account pays the hedge fund the total return on the assets in the account and the hedge fund pays the account any losses on those assets, fees and interest on embedded leverage. Notably, whereas prime brokers that enter TRSs usually must purchase assets to hedge their short TRS positions, in synthetic prime brokerage arrangements, the hedge assets are built into the arrangement: by directing the account to purchase those assets, the hedge fund effectively does the prime broker’s hedging for it. This article details the mechanics of the typical synthetic prime brokerage arrangement; the level of control retained by a hedge fund manager over the account; how prime brokers ensure reliable hedging; the benefits and pitfalls of synthetic prime brokerage arrangements for hedge fund managers; whether recent U.S. legislative and regulatory action will diminish the utility and availability of synthetic prime brokerage in the U.S.; the global implications of U.S. legislative and regulatory action; and other leverage alternatives beyond synthetic prime brokerage.