Sophisticated investors know to keep an eye on the often lightly disclosed topic of leverage usage for some time.  A new report from the Pacific Alternative Asset Management Company (PAAMCO) takes the concept deeper by discussing two types of leverage: implicit and explicit leverage.

Risk Leverage

“It is essential to be aware of the existence of both types of leverage before an investor can fully monitor and assess the risk associated with their investments,” the report stated.

Explicit Leverage

Explicit leverage is money or assets contractually borrowed for a fee, often borrowed from Prime Brokers. A common example can be found when a hedge fund shorts a stock or engages in a repurchase (REPO) agreement.

This is not a statistic one normally sees clearly disclosed in bold print. “One way to figure this out is by reviewing the often overlooked audited financial statements,” the report said, spotlighting a key fact in disclosure documents: often the most significant details are in the small print. “Many investors glance through these reports at lightning fast speed with little interest in the details.”  Explicit leverage details, for instance, can be found by comparing total fund assets to the net assets, with the difference being approximately the amount of fund level explicit leverage, for instance.

The report then moves into a key risk management point often overlooked even in light of the MF Global Holdings Ltd (OTCMKTS:MFGLQ) debacle.  “From a counterparty risk perspective, however, hedge funds could better protect their assets by holding them in a custodian bank account rather than a prime brokerage account,” the report noted. “Nevertheless, the majority of hedge funds keep their assets in prime brokerage accounts to obtain explicit leverage, while also benefiting from larger PB relationships.”

It matters not if money is held in a smaller derivatives / equity brokerage such as MF Global Holdings Ltd (OTCMKTS:MFGLQ) or a larger bank brokerage account that has exposure to $600 trillion in derivatives risk, a hedge fund manager who blindly places their excess cash in a brokerage account could be exposing fund investors to unnecessary risk.  Sophisticated money management services offered sweep money out of a brokerage account on a daily basis to protect against such risk.

Implicit Leverage

Perhaps the trickier type of leverage to recognize is implicit leverage because, unlike explicit leverage, implicit leverage does not show up on a hedge fund’s balance sheet. “Implicit leverage is commonly referred to as off-balance sheet financing,” the report noted, taking different forms and representing different levels of risk.  “This type of leverage includes options, futures, forwards and swaps. From a leverage perspective, these products allow investors to receive the economics of a security without having to put up the money to purchase it.”

The report was now heading down a slippery slope.  If the investor is aware, certain options and derivatives account types require transparent disclosure of leverage, most commonly measured by “margin to equity.”  Margin is the technical term the report is describing when it says leverage can “allow investors to receive the economics of a security without having to put up the money to purchase it.” While margin to equity levels are a detail that highly sophisticated managers watch, this is not visible in all investment products.  This is particularly true in fund products regulated by the Securities and Exchange Commission which does not require alternative investment funds to make transparent their leverage usage.

When discussing transparent leverage usage, the report mentions SWAP derivatives transactions as it hovers just above a hole.  Since the late 1990s when derivatives laws were unwound, SWAPs were not required to provide transparency into their leverage usage.  Commodity Futures Trading Commission Chairwoman Brooksley Born fought a losing battle to study the leverage in these SWAPs derivatives just before she was unceremoniously removed from her position at the CFTC for doing so in 1998.  These opaque SWAP derivatives transactions were at the center of the 2008 market crash.  The PAAMCO report did not go down this path, as one might expect.

The report noted that at times the footnotes in a financial report can provide insight into leverage usage and thus risk.  “It may seem counterintuitive to review financial statements for off-balance sheet leverage. But, if an investor knows where to look, the audited financial statements can also be used to determine exactly how much exposure the fund has to implicit leverage products. Even though you won’t find this information in the balance sheet, the footnotes to the financial statements typically aid in identifying these risks.”  It is here that PAAMCO demonstrates how a good alternative asset brokerage firm adds value to the process.