Hedge Funds Stopping the Bleeding: Hedge Fund Closures and Scandals Rocked the Industry in 2008. Financial Institutions with Hedge Fund Credit Relationships Need to Protect Themselves

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AFTER A YEAR in which the global financial crisis and the Madoff scandal led to hundreds of hedge funds closing their doors, members of the RMA New York Chapter met to assess whether the bleeding has stopped and what the future might look like for the hedge fund industry.

"What we're seeing now is not the demise of hedge funds, but a very large cyclical correction," said Barbara Tsarnas, senior vice president and head of Hedge Fund Credit for the Americas, HSBC Securities (USA) Inc. "If hedge funds continue to perform well, as many did in the first quarter of 2009, many investors will stay and new investors will come in."

Tsarnas said redemptions are slowing at many funds and some investors have rescinded their requests for redemptions.

"If there is not some new fright, it seems like the bloodletting has ended. Still, we'll probably see more capital leaving hedge funds through the rest of this year. For the next few years, we'll probably see very slow growth or maybe a plateau."

Tsarnas described best practices for hedge fund credit based on many years of experience working in the area.

Focus on Legal Documentation

Legal documents are the key to credit protection, Tsarnas said. "Never delegate the word crafting or negotiation of credit terms to your legal department. Negotiators really don't know credit that well and they won't always interpret your covenants correctly. In heavy negotiations, they may not defend them as well as credit can."

Credit staff must fully understand all the terms in legal documents to be able to evaluate them correctly. "Then they can think through the implications of the credit terms in worst-case, what-if scenarios. Do not let documents go out to a client until you or your trained staff have vetted them, and stay involved in the negotiation process."

Credit officers should review original documentation annually and whenever they take over a hedge fund relationship to be sure recent credit approvals are consistent with the terms of the agreement, Tsarnas said. If a document has a mistake or if changing circumstances require different terms, the credit officer should try to negotiate the change

with the hedge fund counterparties.

"If you don't ask, you won't get. If you ask your counterparties to correct a mistake in the document or improve terms that they know aren't market standard because so much time has passed, very often you will get improved terms from the counterparty," she said.

Consider Collateral

Initial margin should be taken with hedge funds on every trade, Tsarnas said. "About 95% of the time, funds pay initial margin on trades after the fact. The credit analyst should examine each funds portfolio annually for trades that didn't get the initial margin and go back through sales to remediate the margin. Initial margins collected this way in 2006 and 2007 were an enormous comfort in 2008.

"In 2008, when many funds breached their covenants, many hedge fund credit people asked for higher initial margin on old trades in exchange for waiving their option to terminate. With enhanced collateral, financial institutions can stay the course with poorly performing hedge funds with great comfort and flexibility. …