Comment: AlphaSwiss: Credit Risk - Use Hedge Fund Investments as Collateral

As hedge funds are becoming more and more part of the extended asset allocation, banks and lenders have started to look for solutions to evaluate credit risk connected to these investments.

The recent single digit performance of hedge funds indices started a new trend: external leverage. "It's definitely a trend. People are leveraging up to try for that 15% to 20% return," says Michael Araiz, chief executive of Further Lane Asset Management.

Citigroup managing director Kent Lucken agrees, saying more of his private-banking clients are leveraging hedge funds to expand their portfolios. In some cases, he says, partnerships are even putting up their shares to collateralize loans for private planes.

Since many single and multi strategy funds trade in hard to value or illiquid securities, banks find themselves in a difficult spot to use these funds as collateral. Borrowing against hedge funds has grown in popularity among investors and an increasing number of banks are embracing such loans.

Large banks often have analysts, as part of their investment teams, to help solve the valuation problem. Research analysts usually cover due diligence and allocate hedge fund lending ratios.

Other institutions use companies like AlphaSwiss in Switzerland, to calculate appropriate lending ratios. 'We have started to offer the service to external parties, after being assigned to structure a risk management platform by one of our asset management clients. Our model uses a qualitative and quantitative score framework, as well as proprietary style and risk premium analysis.' said Edmund Wandeler, client relationship manager. 'Especially since a recent blow-up has caused many banks to reconsider the state of their risk management systems. We have been approached from entities, mainly in Switzerland but also from other countries across Europe, to help evaluate and monitor their credit risk exposure in alternative investments'.

It's becoming clear that external hedge fund lending is a profitable and growing business, but requires lenders to have the know-how in-house or use the service of experienced third party providers.

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