Delegate biographies: Learn more about the panelists
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Executive summary
• The credit crisis has prompted more emphasis from prime brokers on transparency from hedge funds, and vice-versa
• Financing costs have in some cases gone up but there is a growing recognition of symbiosis between prime brokers and their clients that limits tightening of terms
• Use of multiple prime brokers adds complexity but the diversification it offers is an advantage. It also encourages competition between prime brokers to provide comprehensive services
• A prime broker’s ability to source hard-to-borrow stocks is a good measure of its competence
• Collateral management and control of rehypothecation are crucial aspects of the relationship between prime brokers and hedge funds
• Margin lock-up agreements are a useful safeguard that are more readily negotiable than some hedge funds realize
• There is increasing scope for new entrants to the prime brokerage industry, with some emerging markets candidates on the horizon |
IC, Simmons & Simmons Let's start with an overview of the sector in the light of the continuing problems in the structured credit and securitization markets.
TC, Fortis The landscape has changed dramatically. I don't think that today you can walk into a boardroom of any major bank and not see post-traumatic stress in terms of a shell-shocked management team. People are evaluating their entire approach, and that starts with credit provision and knowing your counterparty as well as the price of credit to funds. Those who do not want to share all their information will see rises in price.
TL, Man Investments That's true, although because prime brokerage is very profitable, you can see the opposite, which is that for the best funds, banks are competing even more aggressively for that prime brokerage business. And on the fund side, their ultimate investors are putting pressure on them to deal only with banks with balance sheet. But the funds have to be careful. Balance sheet is clearly just one part of the prime brokerage service and has to be married with excellent service, speed of service, attention to detail and prompt turnaround time. Larger organizations with massive balance sheets tend to be slower and clumsier, and that can hurt you significantly.
AB, Simmons & Simmons Prime brokers are much more concerned about hedge fund data; they have tightened their criteria for lending to hedge funds; they want to know much more about funds' positions and dealings with their other prime brokers. Conversely, the hedge funds have begun to worry about the creditworthiness of the investment banks that are their counterparts.
RC, Sabre Fund Management From a hedge fund point of view, counterparty risk has been a high priority over the past year. Equally, we need to have secure and efficient execution and financing, so we have not approached current counterparty concerns as a credit decision so much as by ring-fencing client assets to obviate the credit decision. Through our use, almost wholly, of synthetic prime brokerage, we effectively had 100% cash exposure to our counterparties, and at the same time an opportunity to ring-fence assets almost entirely. We reduced counterparty exposure as far as practicable, by putting non-collateral assets into separate custody and by limiting collateral to risk-free securities that are in our clients' names and custodied as far as possible. Our prime brokers now operate largely on hearsay collateral. There is a cost in this, but we can offset it by better management of our cash.
AH, Gartmore Did your prime brokers react to this?
RC, Sabre Fund Management Yes. First of all, they said: "You should be telling your investors that we've got a great balance sheet", and, of course, pricing became a factor in the discussion. However, we are not credit analysts, and we are not going to be well regarded for the attempt, or for pitching the Street's self-views, worse if we get that wrong. We said: "The solution is for you to do the financing and we'll sort out how and where the collateral's held". There was a meeting of minds and it went very smoothly after that.
AH, Gartmore Yes, the situation was very simple with us. We actively managed our cash away from the prime brokers and it became even more so over the past 12 months, and we saw a similar type of response from prime brokers as well.
TL, Man Investments Did you find that their service level changed at all? Lately, prime broker efforts are generally directed to get as much of the long/short equity business as possible, since this is very profitable. Prime brokers have been forced to re-examine what is profitable and what is not. Service levels generally flow from that.
AH, Gartmore We didn't see a significant shift away from any kind of service levels that we would have continued to expect and the support that you expect to get from your prime broker
Financing costs up
RC, Sabre Fund Management Financing costs have gone up?
AH, Gartmore Yes.
RC, Sabre Fund Management And they depend a lot on the type of securities you hold and how they're rated by the counterparty?
AH, Gartmore And how levered you are, how big your synthetic side of your business is, and so on.
LP Do you think prime brokers are taking advantage of this alleged credit crunch issue to just jack their charges up?
TL, Man Investments I don't think the prime brokers can easily do that. First, they still make a lot of money in this business. Second, given the calls for diversification, they have to compete harder to keep business. So raising rates is not that straightforward and some people have dropped rates to get business.
TC, Fortis Also, most of the larger fund clients of a prime broker will be touching a number of different parts of the bank that provides the prime brokerage service. So the prime broker funding rate is just one component of a wider service set and so will be governed by that totality. There's a lot more to that discussion than just the prime brokers raising rates.