Key Takeaways
- • David Belmont, Chief Risk Officer at Commonfund and former head of prime brokerage risk management at UBS Investment Bank, frames hedge fund failure as arising from many distinct risks, including market crashes, investor redemptions, fraud, counterparty collapse, and key-person departures.
- • Prime brokers face limited upside (interest and fees) against potentially unlimited downside, since they can lose all capital extended to hedge funds.
- • Belmont cites 2008 as a year in which a record 1,471 hedge funds went out of business.
- • Belmont argues that assessing hedge fund risk requires examining the perspectives of investors, hedge fund management, and prime brokers together.
Summary
David Belmont, Chief Risk Officer at Commonfund and a lecturer in the practice of management at Yale SOM, outlined the many ways a hedge fund can fail in a Yale Insights piece drawn from his guest lecture in the course Hedge Fund Strategies. His list ranges from concentrated market bets, such as a large position on natural gas prices that a mild winter undermines, to investor flight after a single down year, earnings overstatement and excess fee extraction by managers, prosecution of a prominent founder for insider trading, counterparty collapse, rogue trading, trading system failures, and defection of key employees to rivals. He also cited broad market crashes, noting that in 2008 a record 1,471 hedge funds went out of business.
Prime brokers, the investment banks that provide hedge funds with market access, margin financing and matchmaking services, bear significant exposure to these risks because their own capital is at stake if a fund fails. Belmont, who previously led risk management for the prime brokerage business at UBS Investment Bank, said prime brokers have limited upside, mainly interest payments and fees, against potentially massive downside, since they can lose every dollar they extend. A prime broker must therefore assess a fund's operations, strategy and personnel carefully. In his words, "We had to take risks, but we had to do it intelligently."
Belmont's book, Managing Hedge Fund Risk and Financing: Adapting to a New Era, underpins this framework. He argued that a complete view of risk requires considering investors, hedge fund management and prime brokers together. He characterized the industry as a prisoner's dilemma: "as long as everybody cooperates, everybody gets something. But every individual has the ability to take down the house of cards."
Prime brokers, the investment banks that provide hedge funds with market access, margin financing and matchmaking services, bear significant exposure to these risks because their own capital is at stake if a fund fails. Belmont, who previously led risk management for the prime brokerage business at UBS Investment Bank, said prime brokers have limited upside, mainly interest payments and fees, against potentially massive downside, since they can lose every dollar they extend. A prime broker must therefore assess a fund's operations, strategy and personnel carefully. In his words, "We had to take risks, but we had to do it intelligently."
Belmont's book, Managing Hedge Fund Risk and Financing: Adapting to a New Era, underpins this framework. He argued that a complete view of risk requires considering investors, hedge fund management and prime brokers together. He characterized the industry as a prisoner's dilemma: "as long as everybody cooperates, everybody gets something. But every individual has the ability to take down the house of cards."
Go deeper than the headline
Research every firm in this story, track the ones that matter and get the daily briefing — free for 7 days.