Since cash was crowned king during the credit crisis that erupted in 2007, its dominion has steadily grown. Painful memories of the Lehman Brothers Holdings bankruptcy, coupled with more-recent worries about European sovereign debt, have hedge fund investors closely watching their managers’ cash holdings. “We want to make sure managers have access to their cash when they need it most, especially in worst-case scenarios,” says Thomas Woodbury, absolute-return director at the University of Pennsylvania’s $6.5 billion endowment, referring to prime brokerage distress and market meltdowns. “We don’t see much upside in taking risk on cash,” agrees CIO Kristin Gilbertson, who points out that cash oversight is just one part of the endowment’s hedge fund due diligence process.
Until Lehman went bust in 2008, hedge fund managers routinely kept heaps of excess cash with their prime brokerages. “Precrisis, hedge funds were not overly concerned where they held their cash,” explains Alfredo D’Onofrio, head of sales at the New York branch of Toronto-based Bank of Nova Scotia’s prime brokerage division.
That quickly changed. “Post-2008 everyone became a bankruptcy and cash expert,” quips Jonathan Yalmokas, head of U.S. prime brokerage at Bank of America Merrill Lynch. “People no longer feel comfortable leaving cash with just a prime broker.” For hedge funds that did hold some cash away from their primes, postcrisis withdrawals were brisk. “We were the liquidity provider through all of that,” recalls Jill King, senior portfolio manager and partner at Chicago-based Horizon Cash Management, which invests $2.5 billion of alternative-investment managers’ cash.
Hedge fund managers get mixed messages, Penn’s Woodbury admits. Prime brokerages want their cash, and managers must keep a buffer for margin accounts. But endowments and other investors encourage them to sweep any excess into the safest of places, including Treasury bills held in custodial accounts, Treasury money market funds and direct deposit accounts at banks.
Prime brokerages have had to adjust to the reduction in cash holdings. Even if interest rates were still in the 3 to 5 percent range, prime brokerages don’t pay hedge fund clients to take counterparty risk, Yalmokas notes. Today many hedge funds move excess cash out to a third party for safekeeping and separation in the event of a default, leaving prime brokerages with fewer assets. The cash management industry has grown more creative in response to hedge fund and investor needs. Besides Treasury bill investments, another way to secure cash is the Federal Deposit Insurance Corp. package strategy: New York–based Stone Castle Partners, for example, spreads a hedge fund’s cash, up to the $250,000 limit guaranteed by the FDIC, among 350 regional banks.
That’s just one option. “I don’t think there’s a silver bullet,” says Brian Chu, co-founder of $3.7 billion endowment asset manager HighVista Strategies, in Boston.
At $8.4 billion, Irvine, California–based fund-of-hedge-funds firm Pacific Alternative Asset Management Co., new managers are herded onto a separate-account platform where staff monitor and control their activities; Northern Trust Corp. holds a portion of their surplus cash. Paamco investment operations director James Rankin points to the safety of the Transaction Account Guarantee program, through which the FDIC guarantees without limit any bank account balance that doesn’t pay interest. The firm uses TAG for its U.S. funds of hedge funds.
Despite the flight of hedge fund cash to safe havens, many small and midsize managers still stick with their prime brokerages for cash management. That’s because they lack the resources of the biggest shops, says BofA Merrill’s Yalmokas. Here’s betting those funds won’t make it into the University of Pennsylvania’s hedge fund portfolio. • •
