Hedge Funds and Prime Brokers: The Role of Funding Risk

Abstract

Using a unique data set with information on individual hedge funds and prime brokers this paper analyses three potential determinants of hedge funds' funding risk: financial distress of prime brokers, reliance on multiple prime brokers and large investor redemptions. The paper thereby contributes to our understanding of the embeddedness of hedge funds in the financial system. Our findings show that an increase in prime brokers’ distress is associated with a significant decline in fund performance. Hedge funds benefit from relying on multiple prime brokers in having significantly higher returns. Depending on the length of the restriction period, requests for large investor redemptions affect fund returns over consecutive months, indicating the investment into more illiquid assets.

Keywords: Hedge Funds, Prime Brokers, Funding Liquidity Risk, Investor Redemptions, Multiple Prime Brokers

JEL Classification: G00, G11, G12, G23