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Business Consulting Industry Report: July 2017

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Industry Trends

Updates in Cash Management

Wendy Beer interviews: April Frazer, Managing Director and Global Head of Regulatory Advisory and Capital Structuring, Wells Fargo Securities; Geneviève Piché, Managing Director and Relationship Manager, Financial Institutions Group, Wells Fargo Securities; Katie McGuire, Director and Relationship Manager, Financial Institutions Group, Wells Fargo Securities

Can you please set the table for us on U.S. banks and their appetite for deposit exposures post Basel III?

With the implementation of U.S. versions of the Basel III liquidity coverage ratio, U.S. banks began paring back their appetite for deposit exposure to certain counterparties.

As the estimated cost of providing deposits to these counterparties rose in 2015, activity in deposit substitutes climbed, and plans for alternative approaches to short-term investing accelerated. The shift in bank deposit behavior is exhibiting itself in 3 ways:

  1. The term structure of short-term CD offerings has been truncated and switched into floating-rate product.
  2. The availability of favorably priced deposit products for financial companies has diminished
  3. Investment approaches of financial companies have changed

Around the time of implementation for the Liquidity Coverage Ratio (“LCR”) in the U.S., issuance in the bank CD market began to shift from short-dated fixed-rate to longer-dated floating-rate products. This has allowed banks to access the same large money market fund buyer base without tripping the 30-day LCR threshold. The move to more floating-rate structures allowed money market funds to buy longer-dated CDs without extending their weightedaverage maturity profiles. The percentage of floating-rate vs. fixed-rate CDs in money market funds has changed significantly over the past two years.

Percentage of Floating-Rate CDs in Prime Portfolios


January 2015
May 2017
Fixed
69.3%
42.6%
Floating
30.7%
57.4%

Do CDs pose an alternative investment option for short- term cash management?

CDs represent the same counterparty credit risk as other deposit products, but in negotiable form. Nevertheless, while CDs are considered to be “negotiable” instruments, meaning they have a CUSIP and can be bought and sold in the secondary market, they are not typically traded with the frequency of corporate bonds.

How has Money Market reform affected the CD market?

The market for CDs has grown exponentially in the past 25 years in the U.S. as foreign institutions have gained access to the U.S. market and grown their desire for dollar funding. Money market funds still represent the major buyer base for large CDs, but with the advent of money market fund reform, banks have lost a significant amount of direct short-term wholesale funding. Prime money market funds have lost over $1 trillion in assets, and bank CDs have been affected more than any other investment class. A decrease in short-term funding availability has forced banks to reprice their money market offerings and steepen the LIBOR curve.

Basel III is ultimately the regulatory standard for bank capital adequacy, stress testing and LCR. What do we need to understand about LCR and its impact on how banks are managing cash holdings (i.e., how they are classified toward the bank’s capital reserves)?

AF: A brief review of LCR is a good place to start: The Federal Reserve adopted the LCR in 2014. The LCR standard applies in full to U.S. depository institutions and U.S. depository institution holding companies with greater than $250bn in assets or $10bn in international exposure. A modified LCR applies to bank holding companies and savings and loan holding companies that maintain between $50 billion and $250 billion in assets and are not significantly engaged in insurance or commercial activities.

The LCR requires that these institutions hold enough High Quality Liquid Assets (“HQLA”) to withstand severe deposit outflows over a 30-day period. LCR, which focuses on the short end of a bank’s funding liability side (less than 30 days), aims to improve the banking sector’s ability to absorb shocks arising from financial and economic stress.

Net outflow assumptions take into account the deposit’s purpose and depositor type (wholesale or retail). Wholesale deposits are divided into operational and non-operational sub-categories. Regulators now require that all deposits from non-regulated institutions including investment advisors, investment companies and non-regulated funds are considered non-operational in nature. Operational deposits are subject to a 25% runoff factor (or 5% if entirely covered by deposit insurance). Non-operational deposits placed by financial entities or affiliated entities are subject to a 100% runoff factor, therefore U.S. LCR rules assume a 100% run off for all AAM and PE= deposits.

Liquidity Coverage Ratio 100% < Total HQLA Net Cash Outflows over Stress Horizon

What has changed in the Landscape from 2015 when LCR was first implemented to now?

AF: A number of post-crisis regulations have been proposed or finalized since the LCR was first implemented, including Total Loss Absorbing Capacity (“TLAC”) requirements, Net Stable Funding Ratio (“NSFR;” note: NSFR requirements have not been finalized in the U.S.) requirements, and the Method 2 G-SIB surcharge. These regulatory requirements, among others, discourage reliance on short-term wholesale funding and incentivize banks to depend on reliable short-term and long-term funding sources. Nominal changes have been made to the existing LCR rule, notably the ability for certain investment-grade, U.S. general obligation state and municipal securities to be counted as HQLA up to certain levels if they meet the same liquidity criteria that currently apply to corporate debt securities

The new U.S. Administration and Congress have made financial de-regulation a focus of their agenda, which includes revisions to the LCR, other liquidity requirements, and the applicability of these requirements. Various Administration reports and legislation exist that points to reform on this front, but U.S. bank regulators, the U.S. Administration, and the U.S. Congress have not implemented any final and binding changes to the LCR and other liquidity requirements.

Has Basel III and/or the changing interest rate environment made it easier for smaller and/or non-bank entrants to the space to capture market share?

AF: It can be argued that community banks are better positioned to capture market share or gain certain types of deposits, such as non-operational deposits, since the applicability of most post-crisis liquidity regulations do not apply to these institutions. But because most large banks view relationships with counterparts on a holistic basis, large banks are able to “absorb” the negative impact of certain unfavorable exposures and deposits from an LCR perspective through other services and revenue provided to / from the client.

GP/KM: A few years ago, when rates were near zero and larger banks were determining their LCR requirements; several banks pulled back from the cash management space for hedge funds or significantly increased pricing. As rates have recently increased and banks have largely determined LCR requirements, we are beginning to see more competition in the cash management and depository business amongst banks of all sizes.

The primary goal of cash management at hedge funds is safety and preservation of capital. Over the last 10 years the concept of “cash management” has expanded the Treasury function to “active cash management.” What are the alternative products competing for client cash and how are funds using these products to obtain incremental yield for their cash portfolio?

GP/KM: Purchasing highly liquid securities as a cash alternative (treasuries, money markets, etc.) Where funds and managers hold their cash is typically dictated by the company’s investment policy. Most policies require cash to be available on an overnight basis. Some companies have investment policies prohibiting leaving cash in bank accounts over the FDIC insured amount ($250,000).

Other managers are prohibited from investing in nontreasury money market funds (MMFs) due to potential investment risk. The majority of managers we speak with explore purchasing 100% treasury MMFs, prime MMFs, and directly buying treasuries as an alternative to bank deposits as rates on treasuries and MMFs have recently increased. As rates have recently increased, managers are focusing more on yield coupled with counterparty risk when determining the best cash management solution.

What impact does the prevalence of these products/rates have on cash management?

GP/KM: As rates have risen over the past few months, deposits have become more attractive for banks as they are able to earn higher net interest income. However, this is partially offset by increased compliance requirements to open and maintain bank accounts. Pricing on accounts has come down slightly over the last two years; however, more recently banks are offering higher earnings credit rates (ECR) to offset bank fees.

What should hedge funds be thinking about in terms of risk management when selecting a counterparty for cash management?

AF: Hedge funds should consider the overall financial condition in addition to risk management when selecting a counterparty for cash management. From a financial condition perspective, a hedge fund should consider the level and volatility of pre- and post-crisis profitability of the firm. Other leading indicators of financial health, such as asset quality (non-performing assets as a percentage of assets, net charge-offs as a percentage of average loans, etc.) should also be considered and monitored.

From a risk management perspective, the hedge fund should evaluate the counterparty’s current capital levels in relation to its required minimums and compliance with other applicable post-crisis regulations (LCR, TLAC, etc.). Hedge funds should also evaluate and monitor consent orders and other regulatory measures that indicate non-compliance with other regulatory and supervisory requirements that, while not necessarily directly related with liquidity, speak to the quality of the bank’s overall risk management framework.

What new products have been developing as a liquidity alternative?

AF/GS: In the financial institutions space, with the reduction in liquidity available through large money center banks, one liquidity alternative may be developing in the bi-lateral repo market. With the DTCC receiving regulatory approval to expand the number of counterparties able to directly access the repo market via the DTCC’s Centrally Cleared Institutional Tri-Party Service, a new alternative source of liquidity and investment has been created. On June 29, the first trade in the CCIT was cleared, involving Morgan Stanley and Citadel. The platform is allowing nontraditional repo counterparties to be cash lenders into the FICC repo service. As a place to hold cash, CCIT repo is interesting in that all securities eligible for the CCIT service must be Fedwire eligible, which only includes Treasuries, Agencies and Agency MBS. The credit risk profile, then, of this short-term investment alternative would be similar to the credit risk of the securities underlying the transaction, i.e. U.S. Treasury and related securities. This may be viewed similar to having a deposit account at a financial institution over-collateralized by government securities. Not only does this take away the counterparty credit risk of the unsecured deposit, but it diversifies the risk of the investment across multiple counterparties on the central-clearing platform.

Money Market Reform: Investors on the Move

Contributing Author: Sean McCormack, Director, Funding Capital and Liquidity, Wells Fargo Securities

The flow of money into US prime money market funds has begun to accelerate in the last 3 months.

As detailed in our last quarterly update, the question was not if but when investors would return en masse to the short-term funds hammered with over $1.0 trillion in redemptions as new regulations took effect last October. The most recent data from the Investment Company Institute indicates that time might be rapidly approaching. Institutional and Retail prime funds have seen inflows of roughly $45bn since AUMs bottomed out in the 4th quarter of 2016, with approximately half of that move coming since the start of 2nd quarter of 2017. In a recent article on the Wall Street Journal, Peter Crane, president and publisher of Crane Data, predicted that a historical trend of net inflows in the second half of the year is likely to return in 2017, giving the funds’ AUM a further boost. As for the gains already logged, portfolio managers note investors’ increasing comfort with the floating NAVs, with the “volatility” often rooted four places to the right of the decimal point, as a factor. In addition, two rate hikes so far this year have helped generate increasingly attractive returns.

Market professionals and investors (existing and potential) will now focus on the Fed and the year’s remaining meetings to determine if the prime funds can continue to deliver a noticeably superior yield relative to their competitors in the government bond fund space without having to extend duration beyond comfort levels. The behavior of short term rates post the June 14th hike indicate this may be difficult and last week’s release of the minutes from that meeting did little to change popular opinion that another hike was not likely before December.

Since the Fed began raising rates back in December of 2015, the average spread between 3 month Libor and the Fed Funds Effective Rate has averaged approximately 33 basis points, with the widest gaps coming in the run up to meetings with the potential for another hike. Since the June meeting however, the spread has dropped to just 14 basis points. In addition, the September Eurodollar contract has settled into a fairly tight price range predicting a 3m Libor fixing of @ 1.34% on September on September 18th, < 4 basis points higher than this week’s high.

So if the Fed, as indicated, starts to trim its balance sheet towards the end of this quarter, the question will become whether or not the contraction in money supply can put sufficient pressure on short term rates to ensure prime funds can further extend spreads over government bond funds’ returns and lure more investors back into the fold.

The Top 10 Mistakes of New Managers

Contributing Author: Steve Nadel, Partner, Investment Management Group, Seward & Kissel

#10: Not dealing with past employment restrictive covenants.
Unfortunately, we often see instances where a manager has either neglected or misinterpreted an existing restrictive covenant from a prior employer that may impact the manager’s new business. This typically comes up in the context of either use of a prior track record or bringing on prior employees or clients from the old employer firm. Sometimes, the results of this can be quite devastating, as we have seen instances where managers have been enjoined from using information or from poaching personnel. This is especially difficult when the dispute rises to the level of a litigation, in which case it becomes a public matter, and can stall the efforts of the new manager before they even really start.

#9: Not knowing your audience.
Before a manager begins to structure investment vehicles and devise the terms of investment therein, it really needs to have a firm understanding of its audience. For a variety of reasons ranging from tax to economics, different investors will be drawn to different products. Beyond the basic issues relating to taxable, tax-exempt and foreign investors, there needs to be an understanding also of the more subtle business points that often arise. For example, certain investors may be more insistent on lower fees, while others may be more concerned with better liquidity terms. Similarly, for risk control reasons, some allocators prefer a separately managed account over investing in a collective investment vehicle.

#8: Hiring a CFO/COO without people skills.
Since most managers starting a new fund try to begin with a leanly staffed enterprise, the CFO/COO becomes a vital hire as a jack of all trades. Unfortunately, we have seen numerous instances over the years where managers have become enamored with candidates who have off the chart technical skills, yet are severely lacking in people skills. Not surprisingly, this often comes back to bite the manager, either because the manager has alienated investors with whom the CFO/COO has been interacting or has caused other staff at the firm to leave due to a hostile work environment. Managers are therefore advised to check references not just for technical skills but also the softer social skills.

#7: Not thinking creatively.
The current state of the capital raising market has been particularly challenging. With this in mind, managers need to think outside the box in terms of creative ways to attract investors. Among the novel approaches that managers have undertaken are bespoke fee structures, customized managed accounts and specialized reporting. The best received ideas are typically those where the manager speaks with its investors, understands their needs and concerns, and develops a viable proactive solution.

#6: Not practicing your pitch in front of others.
Managers are typically a very confident lot when it comes to investing money. However not all of them are created equally when it comes to pitching their product. Accordingly, it is vital that managers practice their pitch with a varied group of people ranging from their friends to their advisers to their brokers. Presentation styles and weaknesses generally can be addressed, if caught early enough, however we have seen instances of managers who went into a pitch and were not able to answer important questions that they hadn’t expected or cursed or did something else to turn off an investor.

#5: Trying to build the perfect mousetrap.
In a market where investors do not like surprises, we repeatedly see managers who choose to disobey this mantra, and often come to regret it. The most common scenario where we have seen this arise involves coming up with a highly complex liquidity or fee provision that may have never been seen before, and that typically creates a fair amount of discomfort with the investors. While a slight deviation resulting in a familiar surprise will often be OK, trying to reinvent the wheel, usually will not.

#4: Not caring about the firm name.
There are usually two issues that the manager should be cognizant of when selecting a potential name for the firm. The first issue involves whether the name violates any preexisting trademark rights, while the second issue relates to whether the name may be confused with others. If the name is very unique, the primary concern will be whether there is any other name out there like it that could assert priority trademark rights. On the other hand, where the name is so commonly used that it cannot be trademarked, the startup manager needs to be sensitive to the possible confusion that could arise if one of the other people using that same name gets into trouble.

#3: Misstating facts about the PM.
In the year 2017, there are many ways for investors to check key information about the PM before making an investment. Yet despite this, there are often instances where managers misstate their roles at prior shops or some other vital point such as a prior honor or title. Managers should carefully fact check any information they provide to investors to ensure 100% accuracy. Failure to do so may be something that is difficult to overcome once detected, as oftentimes investors will talk to each other.

#2: Failure to do thorough background checks on personnel.
In addition to the points raised in the preceding entry, if a proper background check is not done, and an employee fails to disclose certain issues, not only could it be embarrassing, but there could be legal issues raised, if for example the employee had disciplinary history in its background.

#1: Being a kid in a candy store.
Managers need to be particularly sensitive in the early days to the costs they may incur. Time and time again, however, we continue to hear stories of managers who have entered into personal guarantees for leases of fancy office space, or given out large guaranteed bonus compensation. It is imperative that the manager minimize its liabilities at startup, and there are numerous ways to structurally do so through good guy guarantees, vesting schedules and other similar devices

Investor Trends

Trends in Hybrid Structures

Wendy Beer and Jasmaer Sandhu speak with Blayne Grady, Partner, Akin Gump Strauss Hauer & Feld LLP; Joshua Williams, Partner, Akin Gump Strauss Hauer & Feld LLP

Hybrid products have been on the rise since 2008. More recently, we have seen investors showing increased acceptance and interest of these more complex structures. To what do you attribute the increasing popularity of hybrid structures?

BG/JW: There are a couple trends coming together that might explain part of the increasing popularity. Asset classes like credit and infrastructure that tend to lend themselves to hybrid funds have seen a lot of interest in recent years. Hybrid funds are often well-suited to address the needs of credit funds, and there has been an explosion in credit fund strategies since 2008 as traditional bank lending has pulled back significantly due to regulatory pressure. Alternative investments funds have rushed into the void to fill that lending shortfall. Much of the “shadow banking” lending that has emerged via credit funds is in illiquid medium-term structured credit instruments, which aren’t always well-suited as the main investment program for a hedge fund that needs to provide LPs with periodic liquidity.

What are the most common investment structures and what assets are most conducive to these vehicles?

BG/JW: We’re still seeing the traditional partnerships serve as the fund vehicles for hybrid funds, with appropriate feeders and blockers as needed for the specific investor base and fund strategy. But it’s more a function of those closed-end/PE fund partnerships beginning to incorporate elements of hedge funds, and vice versa.

Is the master feeder structure a natural fit for hybrid strategies and if not, why not?

BG/JW: I’m not sure it would be a natural fit any more so than other structures, but master-feeders could certainly work for a fund with hybrid terms.

What are some of the tax implications of the use of multiyear performance allocations

BG/JW: Depending on the annual performance of the fund, there may be risk that a multiyear performance allocation could be recharacterized as a fee for US tax purposes. For example, assume that a performance allocation is measured over a three-year period and, although the fund has significant income and gains over the entire period, there is no gain in year three. Thus, technically, the fund has no income to allocate to the sponsor in year three, even though the sponsor is economically entitled to a performance allocation. It may be difficult in such circumstances to avoid having the allocation treated as a fee for U.S. tax purposes, which means that the character of the fee could be entirely ordinary (as opposed to a mix of capital and ordinary, depending on the fund’s underlying income). This also could lead to potential adverse consequences under sections 409A and/or 457A of the Internal Revenue Code, and could give rise to deductibility issues for U.S. taxable investors.

While private credit seems to be the predominant asset class for these vehicles (real estate would be another), what are some of the other most common assets and some of the pros and cons that lend or another asset class to these structures? Are there differences in the trends between the different illiquid asset classes?

BG/JW: Private credit, infrastructure and core real estate are frequent asset classes for hybrid vehicles. The characteristics that these classes share include underlying assets that are generally illiquid but that generate a decent amount of periodic current income/yield distributions during the ownership of the assets. Additionally, there is often not a great deal of increase in asset value over the hold period – whether as a result of the private credit being paid back in full at maturity, or whether due to the stability of the markets for infra or core office properties.

Are there differences in trends you are seeing from a structuring and/or fee perspective, for the different classes?

BG/JW: Sometimes different strategies will have different hurdle rates in their yield waterfalls, depending on return profile of the asset class. A higher yield strategy might have a higher hurdle rate, for example.

Why would an investor choose a hybrid structure over just investing in a PE firm?

BG/JW: I’m not sure investors are necessarily choosing funds based on structure – investor commitment decisions are still very much focused on the manager and its track record and investment approach, regardless of whether the fund is structured as “pure” closed-end private equity or whether it incorporates some hybrid element. However, all other things being equal, hybrid elements (for example, LP liquidity features in a closed-end fund or multi-year performance periods in a hedge fund) are often viewed positively by the investor community as responsive to LP needs, and can facilitate fundraising success. ]]>