The brokers’ sword of Damocles over hedge funds’ heads

A very interesting article published by Hedgefund.net from Devi Koya, a partner at the law firm of Baker & McKenzie.

A decline in asset under management at a hedge fund has multiple consequences not only on the manager's revenue but also on its creditworthiness. Since hedge funds are using leverage extensively in their investment strategies, through cash borrowing or derivatives, their capacity to meet their liabilities is of the highest importance for their trading counterparties. The first mechanism of protection for brokers is their ability to call for additional margin or collateral to reduce their credit exposure to a fund. The other protecting clauses in the brokerage contracts are the Additional Termination Events clauses or "ATE". For example, if the funds breaches some predefine threshold is terms of assets under management, key man departure … the broker has the right to call for additional margin or collateral. The next step after an ATE occurrence will be the termination of the relationship by the broker and the liquidation of the fund's positions usually at fire sale prices.

Hedge fund's CFO should be very careful in negotiating their prime brokerage and ISDA agreements especially in regards to ATE. Furthermore, they need to obtained waivers from their brokers, after the occurrence of an ATE, to avoid being at the mercy of their counterparties during the next adverse market event (which will no doubt occurs sometimes in the future).

Competent legal, compliance and operations teams are no longer a luxury for hedge fund but a requirement in an environment where everyone try to pass the "hot potato" to its neighbor.

Devi's Corner: When the Banks Won't Call You Back - NAV Triggers' Effects on Hedge Funds
Between 2007 and 2009, many hedge funds declined in size due to investor redemptions and/or performance declines. These same hedge funds trade derivative agreements under an ISDA Master Agreement that typically contain provisions defined as Additional Terminations Events ("ATE") which can be triggered by the decline of a fund's net asset value...
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