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Portfolio > Asset Managers

Hedge Fund Operations at Risk with Capital Structure Arb Strategies

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NEW YORK (–Nine out of 10 managers who have launched capital structure arbitrage strategy businesses have failed to build an adequate infrastructure beforehand, according to new research from Carbon360.

The firm will be releasing a full study on the topic of capital arbitrage operations shortly, and so far researchers have found that running such a strategy is costly in terms of personnel, service provider relationships and systems.

According to an executive summary of its upcoming study, Carbon360 has found instances where fund administrators have terminated relationships with managers due to the pressure of handling the settlement and payment processing associated with the strategy.

The increased pressure arises from the instruments managers use. Capital structure arbitrage is a hedge fund strategy that takes advantage of pricing inefficiencies between the debt and equity structure within a specific company. The financial instruments cap arb players use often carry settlement risk because there are long settlement cycles on almost all over-the-counter and loan products.

Besides longer settlement cycles, the use of swaptions creates a more complex collateral arrangement that makes risk monitoring more difficult, since swaptions are contracts on more-illiquid securities. The inability of a manager and a counterparty to communicate the details of trades has prompted several regulatory warnings, Carbon360 officials said.

According to the study, cash and margin management also are a challenge because managers may fail to have systems in place to reconcile capital requirement commitments with cash on hand. Also, as a result of increased layers of complexity, the hedge fund manager can expect to be responsible for 85% to 95% of the clearance and settlement process themselves, officials said.

Most managers are not prepared for such intensive chores and must suffer several quarters of “undue operational pain” before they can maneuver with agility, the study concludes.

Contact Bob Keane with questions or comments at: [email protected].


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