Prime brokerage debate: The race to keep up with the clients
The hedge fund industry is now institutional. In the US, 5% of the groups run 65% of the money, while in Europe concentration is even greater. To keep up, prime brokers need multi-asset skills, cross-margining and the IT to match. Dog walking may not be available any longer.
CB, Clifford Chance The nature of prime brokerage has changed, as has its profitability and relevance to the institutions. What are the core services prime brokers must offer today to stay competitive?
MB, Barcap A prime broker acts as a centralized clearer and custodian to a hedge fund’s assets. The prime broker uses the assets as collateral to make loans of money, equities and/or bonds to the fund. The size of the loan extended depends upon the quality of the collateral and the risk associated with the entirety of the fund’s portfolio. The more sophisticated investment banks are increasingly able to incorporate derivatives and other products into the risk calculation. That is the core service. Prime Services at Barclays Capital is a multi-asset financing business with customers able to choose to finance via prime brokerage, CFDs, swaps or repo.
JB, Dresdner Kleinwort The prime broker is a facilitator who assists increasingly sophisticated clients in fulfilling their investment strategy. Clients are turning to complex strategies and structures in order to generate higher returns and thus differentiate themselves. Dresdner Kleinwort will finance most asset classes via bespoke financing solutions and offers true cross-margining.
DP, Merrill Lynch There are certain core functions prime brokers have to perform well to ensure the operational efficiency of a hedge fund, but to us it’s also about helping the client across all their activities, including alpha generation. It’s about giving colour on the stock loan market to help portfolio timing decisions, giving transparency on what the free float is, for example. Equally importantly, we provide access to the research capabilities and resources of the rest of the bank. Our consulting side of prime brokerage helps clients run and develop their business, with capital introduction as a key function in planning business development in terms of asset growth.
AL, Man We see prime brokers as solutions providers. We have a huge managed account platform and we rely on prime brokers for clearing solutions, for the right technology, for global presence and so on. When we can step out of traditional prime brokerage, we start looking at ways to cross-sell one another’s firms, to people we look to partner with long- term, whether it’s dealing a structured finance platform, FX or distribution.
CB, Clifford Chance As the market institutionalizes, though, will those commoditized clearing services become less important and the more value-added services more important?
MB, Barcap The industry is certainly becoming much more institutional. In the US now, there are around 210 groups running $850 billion, so that’s less than 5% of the fund management groups running around 65% of the assets. In Europe about 12% of the groups run two-thirds of the assets. That relatively small number of increasingly institutional asset management organizations is the battleground for prime brokers. The challenge for some of the prime brokers is that they built their business models for a less mature industry, where everyone was a start-up, and there was far less information available about who the investors were. Today the industry looks very different.
DP, Merrill Lynch Four or five years ago, the traditional prime brokers would not want to service, say, an emerging markets credit fund because they had enough money coming from the plain vanilla equity long/short business. Now more innovative prime brokers will do the more complex business as a way to get their foot in the door. That has been a very positive thing for hedge fund investors. Whereas seven or eight years ago only two prime brokers in Europe could deliver effectively, now there are at least six.
CT, New Star We should point out that the three clients of prime brokerage here have particular requirements. We are the bigger players, but many people in the hedge fund industry have one fund which is specialist in one area. Their requirements from the prime broker are narrow and the interactions and cross-selling are not material for them. It’s a very basic, commoditized, clearing service for many people.
CB, Clifford Chance So is there still room for the smaller start-up and will that start-up get the services they need from the prime brokerage community?
MB, Barcap The talented boutique fund manager starting with a small amount of capital is statistically less likely to succeed than he would have been in 1999 and less likely to succeed by himself rather than, say, being under Gartmore’s platform. So focusing on the bigger hedge fund organizations with multiple funds may be a better use of a prime broker’s resources.
CT, New Star There’s nothing new in this. In the 1990s if you were the biggest fund manager you would always get the first telephone call and the best service from the equity sales person. The prime brokerage business is exactly the same. The bigger you are, the more money you can pay and therefore the better the service. An add-on service is not commoditized because, by definition, you can’t offer it to everybody, and the prime broker provides the big guys with different services from the small guys.
DP, Merrill Lynch I think there is still a place for the new, entrepreneurial start-up, but they’re more savvy. When a hedge fund awards their PB mandate, they’ll have questions like, “What do I get from your capital introduction team? Will I go to your big annual conference? Will I get a roadshow in Geneva? Who’s going to be my dedicated capital introduction person? Will I get help from your start-up services team? What coverage am I going to get from the research sales team?” A big institution will get all that attention by definition – the alpha generation ideas and so on – but it’s even more critically important that the boutique start-up gets the support that will allow it to build a sustainable business model.
JB, Dresdner Kleinwort The more institutionalized hedge funds have started to internalize many functions, and to obtain financing away from the traditional service providers. Why should they pay for the extra services they don’t need? It’s becoming very competitive, but a large portion of the hedge fund industry still needs the prime broker services.
Barriers to entry
CB, Clifford Chance Is the entry level now too high in terms of capital allocation, staffing and client base, for someone wanting to start up a prime brokerage service within an existing financial institution?
DP, Merrill Lynch Yes, and in five years’ time there’ll be fewer prime brokers than there are at present. It’s an incredibly expensive business. All the prime brokerage firms have devoted hundreds of millions of dollars to providing these basic services – but the basic commoditized service is not easy and it’s expensive.
AO’R, Gartmore The prime brokerage business requires constant reinvestment to keep up with market developments and client demands. But there are different ways to break into the market – synthetic prime brokerage is a cheaper option for example. Many new brokers are capturing prime brokerage flow using what is essentially a swaps platform originally built by their derivatives business.
CT, New Star You can enter if you’re willing to take a long-term view. Today’s model of prime brokerage has huge up-front costs and the barriers to entry are high, but people are attempting to enter because of its strategic importance to the banks. There are still people you’d expect to be in who are not. The two largest global banks are not big in this business, and they are allegedly the experts at lending and finance.
CB, Clifford Chance Earlier we briefly mentioned the new types of assets that were being accepted as collateral. How far down this road have we gone?
JB, Dresdner Kleinwort A few years ago, no-one wanted to touch emerging markets. Now we’re talking loan notes and other esoteric asset classes, all included within Dresdner Kleinwort’s prime brokerage platform. The prime brokers are constantly trying to keep up with the hedge funds as they’re moving into new asset classes.
DP, Merrill Lynch And these more complex assets are where prime brokerage is not commoditized. (Incidentally, that’s where some of the newer entrants are gaining market share at the expense of the more traditional prime brokers who aren’t as nimble.) That’s ultimately a good thing for investors. A good prime broker enables the hedge fund to invest in these classes. If they haven’t got someone who can provide the financing to allow leverage or the access to methods of obtaining short exposure, then obviously it excludes that asset class or sub-class from the portfolio. So prime brokers are fulfilling an important role.
CB, Clifford Chance Since prime brokerage is asset financing, can’t clients get better pricing by going to the fixed-income desk for repo, to the equities desk for securities lending, to the derivatives desk for margin lending?
DP, Merrill Lynch We are going to give better margin when we see the whole portfolio, because there are bound to be uncorrelated assets and negatively correlated hedges in the portfolio that reduce the overall portfolio risk. Therefore the net margin that we’re charging the hedge fund will be lower. That’s where it makes it harder for hedge funds to start disintermediating the prime broker. I think hedge funds have got to the stage where, having brought down fees from 3X to X, getting them down to 0.85X isn’t really the principal objective now. It’s now about how we can help with the hedge fund’s operating efficiency and alpha generation.
MB, Barcap Exactly. It’s very important for us that we look at the risk holistically, across product, across asset class. It allows us to set optimal margin levels and makes it as easy as possible for the fund to interface with us from a collateral management perspective.
We don’t see much pressure to reduce fees, but a lot of clients want to talk about transparency. Hedge funds don’t always understand how they pay their prime broker, or how the cash management works. They want to understand how they are being charged and to ensure they are receiving value for money.
CT, New Star Also, from the funds’ point of view, if your business is concentrated in one area, you have more influence. If you ring up with a problem, because the profit and loss centre is in one area of the bank, one phone call gets a problem sorted. That’s invaluable from the buy side.
AL, Man And conversely, the bank is in a position to react much more proactively.
DP, Merrill Lynch Silos are definitely being broken down. Some banks have achieved more than others, but certainly in Merrill Lynch, trading, derivatives trading, sales, prime brokerage, all have the same reporting line, and that was different three years ago.
AO’R, Gartmore Firms that have such profit-sharing arrangements, and a lack of silos, can definitely be more aggressive in terms of price and services they offer.
Transparency and pricing
CB, Clifford Chance Transparency will drive down the price the banks can charge, right?
DP, Merrill Lynch Absolutely. Hedge funds are incredibly detailed in their calculations. They allocate their $7 million pot of commission brokerage very carefully but they’re not counting prime “brokerage” as part of the total brokerage book. They’re now beginning to realize that their prime broker may be getting way too much money compared with the overall services across the investment or commercial bank they’re getting back from that entity. That’s the reason we’ve seen the drive towards transparency.
AO’R, Gartmore We’ve definitely consolidated our prime brokerage list, in order to leverage the relationships with brokers we feel we are getting the most from.
DP, Merrill Lynch The buy side wants to know how much they’re paying. If you’re paying X prime broker X million dollars, you want to make sure you’re getting value for money, not just the commoditized services, but in terms of what other services you could get from that bank. You can’t do that if you don’t know how much you’re paying in the first place.
AO’R, Gartmore On the other hand, are banks looking at the revenue they make from clients in prime brokerage compared with the other trading areas?
DP, Merrill Lynch Definitely, because as we examine the full range of services and access we provide to clients; it won’t just be the commissions. It’ll also be how much money the bank has earned in prime brokerage that determines how high or low in the rankings a client is.
JB, Dresdner Kleinwort Prime brokerage is all about building long-term relationships. You don’t see hedge funds switching prime brokers that frequently because it may be a resource-intensive process for everyone. Just as the buy side needs to understand exactly who and how much they pay for the services, the prime broker will know where they make the money and where they are adding value for the hedge fund.
Spreading the risk
CB, Clifford Chance Aisling touched on the consolidation of her prime broker panel, yet my impression is that there is a trend towards multiple prime brokers.
MB, Barcap There are times when it will make sense to have multiple prime brokers because each one brings different skills or resources. People will look at new prime brokers if they bring something attractive and can demonstrate that it is tangibly different. But otherwise consolidation to reduce your operational overheads when there may be a tougher returns environment than previously is a strong motivation. So consolidation towards prime brokers that can service you across multiple asset classes is a trend that we see.
DP, Merrill Lynch Some large hedge funds with 10 prime brokers have realized that that takes a lot of time, potentially increases operational risk, and also is inefficient, because you’ve got margin in so many different places. I see them bringing that number down to something more like four or five prime brokers for a $5 billion-plus hedge fund. At the same time, those funds with only one prime broker are looking to add one or two prime brokers for price and service competitiveness reasons, and also to get more return for themselves and shareholders in terms of their access to more than one investment banking/commercial banking entity. Going back to alpha generation, if you believe that a company is going down and you’d like to put on a certain size short sale trade, if you only have one prime broker, you have to take what stock loan you’re given. If you’ve got three prime brokers you’ll get an allocation from each of those. That’s good for the investor because you’re able to put on more of that trade, you generate more alpha, the investor gets more return and, coincidentally, the hedge fund manager who’s earning the 20% performance fee also earns more too.
AO’R, Gartmore If you only want one prime broker, you’d better make sure that they have the best availability across the whole street, because not everyone has all the stock.
MB, Barcap If you go to three prime brokers to borrow the same stock and they all contact the same lenders, then that can move the market. You need to be sensitive to that.
AO’R, Gartmore Ideally your relationship is so good that your prime broker knows the other two or three brokers on your call list, so they know if it’s the same pool of stock. Under this relationship, the prime broker understands they need to give you their best availability and price on the first call, so you don’t have to make 10 calls to get the lowest stock borrow rate. The prime broker accepts there is a core group of brokers that you deal with and value to ensure you maximize supply and minimize price.
DP, Merrill Lynch Different prime brokers will have different unique sources of stock. Prime brokers have different “exclusives” they can provide a client access to. Also, the big custodial lenders will give allocations if there’s a hard-to-borrow stock. They may say to a prime broker: ‘‘based on the level of your ‘easy-to-borrow’-balances, I’m going to give you 10% of my total amount available.’’ So if you have access to two prime brokers that’s two lots of 10% you have access to.
CB, Clifford Chance We’ve touched on some of the product and services available now. What are the trends?
DP, Merrill Lynch A key trend is the increase in multi-asset class funds. Funds want the freedom to invest in relative value, wherever they identify it, and have the ability to move more quickly out of strategies that are having difficulties generating returns. This pushes banks to service them on a single platform, give them uniform reporting, having one margin call across the different asset classes, and making sure there’s comprehensive cross-margining. It costs a lot to develop the systems to margin clients optimally, so a prime broker that has been willing to spend this money will be in a very good position to win market share. But the ultimate beneficiaries are the hedge fund managers and the investors themselves.
MB, Barcap This is a big shift over the last couple of years and it is a trend that challenges the established industry model. The fact that more groups now operate discretionary multi-strategy funds with a mandate to dynamically allocate funds across multiple asset classes or to trade the entirety of a company’s capital structure from loans to equities, and on a global basis, poses many questions for the industry. How do these groups best interface with funds of funds? How is the value proposition of the funds of funds affected? How do investors ensure they get diversification benefits from investing with several of these multi-strategy groups? As for us, how do prime brokers need to evolve their businesses and platforms to service these groups? It raises issues for everyone.
JB, Dresdner Kleinwort The performance of some hedge funds has recently been relatively weak, which is encouraging them to use their capital most optimally by having offsetting trades in one account. We also see clients becoming much more opportunistic. They see the benefit of allocating capital efficiently on one prime brokerage platform between products, keeping the margin low.
You need to have a robust but flexible technology-driven prime brokerage solution with the necessary interfaces within your organization to recognize the client’s trading activity. You need to have the right technology from the outset. It has become expensive to keep up but it’s a necessity.
Choosing a prime broker
CB, Clifford Chance Does it show from the outside? Can you tell who has got their act together and who hasn’t?
AO’R, Gartmore A lot of lip service is paid to cross-margining. From my experience every prime broker on the street promises cross-margining across most asset classes but only one or two can deliver.
JB, Dresdner Kleinwort True cross-margining is becoming a buzzword in the industry, but it doesn’t make sense to use it in every single fund. There has to be a natural correlation between the various asset classes for there to be a benefit.
AO’R, Gartmore Some brokers understand the product really well and will at least acknowledge that there should be smaller haircuts. But in so many instances, you’re told you will get the benefit and you don’t.
AL, Man I definitely agree that there are so many out there that say: ‘‘We’re very good at this. We can do this,’’ and it comes down to the difference between having it automated and having to deal with one-off operational exceptions. And if you have someone who can do this for you, someone in their risk department who’s very knowledgeable and sees the whole picture, if they leave, what are you left with?
MB, Barcap You should ask your brokers to document how they will margin you. When there’s a signed contract they have an obligation to deliver.
AO’R, Gartmore Yes, Barclays has the advantage of a global netting agreement for margining, but it still comes down to how automated everything is behind the scenes. You’re relying on brokers’ internal systems interfacing smoothly, but they don’t in a lot of cases. For instance, derivatives clearing has suddenly become part of prime brokerage, but it operates on a completely different system, so it is very difficult to avail of cross-margining, especially with exchange margins in place.
AO’R, Gartmore Some of the really big prime brokers have only recently put CFDs on the same platform as all the rest of the equity prime brokerage. That’s so basic it’s unbelievable.
DP, Merrill Lynch In the banks’ defence, some of the developments have not been foreseeable. Five years ago no one would’ve thought of trading CDS in an equity long/short fund, and so prime brokers weren’t set up to anticipate the cross-margining of equities and CDS. It takes the client to decide this is an effective way of investing, and then we have to respond. There’s bound to be a lag but it’s important that we’re transparent and that we only sell what we have as opposed to what we’d like to have.
The rise of credit derivatives
CB, Clifford Chance Will credit derivatives be used by more and more clients, not just the multi-strategy funds, but also in other less diverse products?
DP, Merrill Lynch Yes. With CDS liquidity being so much deeper than the underlying, it’s just going to grow and grow. The ability of prime brokers to service that credit and interest-rate derivatives intermediation, has been a massive development that will help hedge fund investors and managers.
MB, Barcap Hedge funds are increasingly using derivatives, whether in foreign exchange, fixed income or equity. That’s why the investment banks are investing in technology, to allow them to intermediate and step into and clear the trades. The technological challenge is key, because it has to be automated.
CB, Clifford Chance By diversifying risk in its portfolio, isn’t the multi-strategy asset class fund concentrating risk in operations and counterparty by focusing on a single prime broker? You’ve got a broad range of assets, but you’re routing them all through one person.
MB, Barcap If you’re going to house all of your derivative business in one place, then you need to be very comfortable with the credit rating of that organization, and be very sure that the relationship will work well for a long time. But there are lots of benefits.
CT, New Star As far as the concentration of credit is concerned, some people have one entity as custodian of 100% of their fund. They have the most fantastic risk management systems and stress testing, so that they can’t lose more than 1%. Yet they could lose 100% if the counterparty goes bust.
CB, Clifford Chance What is the nature of the capital introduction service? I think it may mean different things to different people.
DP, Merrill Lynch It is one of the consulting roles a prime broker can perform. We’ll research what the market appetite is for a particular strategy. Even the smartest manager can be in the wrong strategy at the wrong time. So we give people advice based on our understanding of what investors want. The critical mass issue is very important in Europe now. If you don’t have $50 million when you start, or soon after starting, it’s highly likely you’ll close within 18 months. If you don’t have a really solid infrastructure, if you don’t have a high-quality COO or CFO at your fund, you will not attract investors. So we’re giving advice on what is more likely to make the fund successful. And then in addition to that, when we know that there are investors looking for a particular strategy and we believe this is a high-quality manager, it’s about setting up targeted meetings, with the emphasis on ‘targeted’. And then it’s also providing advice, as markets change, as regulations change and investors become demanding on certain aspects. It’s about communicating on an ongoing basis.
JB, Dresdner Kleinwort There’s also the quality of the investors you can bring to the table. Hedge funds want a tailor-made cap intro solution that brings them in front of the right investors who have an interest in the hedge fund’s strategy and who match the hedge funds investor mix. It’s the targeted approach that makes the value difference.
MB, Barcap The whole capital introduction business, as we know it, may just go away. Five or six years ago, no one knew who the investors were. There’s a lot more transparency now. There are a lot more assets concentrated with big fund of funds groups. So it’s going to be harder for a capital introduction group to differentiate itself, unless it’s bringing you into a new market or subset of investors.
CB, Clifford Chance So apart from cap intro, what else special do you have to offer ?
AL, Man I think you’d be surprised at some of the services the banks have had to provide, because of the leverage some of the hedge funds can have over them.
CB, Clifford Chance I hear that some prime brokers even offer a dog walking service?
MB, Barcap Well, we’re going to focus on operational efficiency, cross-margining, great financing and excellence in client service across asset classes.
DP, Merrill Lynch I wouldn’t underestimate how valuable it is to clients to have prime brokers as their sponsors, to help them navigate through the complexity of an investment bank, and help them get the attention and resources that they need. It can be a very important benefit to them.
JB, Dresdner Kleinwort When you start a hedge fund you want to keep it as lean and mean as possible. Then there are benefits to outsourcing, asking service providers to provide the additional services when needed.
AO’R, Gartmore Also, as hedge funds become more institutionalized, they will rely less on risk management at the prime broker, capital introductions, and other “add on” services like FX prime brokerage. Institutions have their own systems and solutions in place, for example, Continuous Linked Settlement reduces settlement risk when executing foreign exchange with multiple brokers.
MB, Barcap For a small organization to pay for a foreign exchange prime broker makes sense, to avoid negotiating lots of contracts and reduce operational and collateral management overheads. Larger groups may feel it’s not worth paying that fee for someone to clear their FX trades, when they’ve got existing legal contracts and established infrastructure, or they may want to outsource.
CB, Clifford Chance Is this an area where you’re seeing an increasing demand?
MB, Barcap FX prime brokerage has been around for a long time and demand remains high. Some equity quantitative groups are applying their models and research teams to other asset classes including FX, fixed income and commodities which will lead to an increased demand for derivative prime brokerage.
JB, Dresdner Kleinwort FX prime brokerage is definitely a growth area with more hedge funds starting to trade FX as an asset class. But there is also more demand from traditional money managers and the private banks who see benefits in FX prime brokerage: intermediation – wider deeper pool of liquidity, single credit relationship, centralized collateral pot, anonymity when trading and the use of the technology.
CB, Clifford Chance How do you see the market evolving over the next two years? What are your predictions for the future, Jesper?
JB, Dresdner Kleinwort The market will turn more and more towards derivatives and bespoke financing solutions. Maybe we’ll end up using cash instruments to hedge out derivatives. We will see a constant flow of new products brought to the market by the prime brokers and prime brokers will become more efficient in their use of technology. Going forward it will become very technology-driven.
AO’R, Gartmore Yes, given the heavy IT spend that will be needed, I can see fewer full-service prime broker providers and more specialized providers.
DP, Merrill Lynch Hedge funds that currently restrict themselves to one prime broker will diversify to enjoy the benefits of two or three. There will also be an increase in the number of asset classes that we are asked to look after for clients. Derivatives intermediation will continue to increase significantly.
AL, Man We will see integrated platforms across more and more products. And many prime brokers will establish a greater global presence, in order to hold positions in some of these markets and to expose themselves to a larger and more diverse clientele.
MB, Barcap I think the hedge fund industry will see more consolidation and institutionalization. There will continue to be successful start-ups but these will often be large and institutional from day one. The prime brokers will be pushed to operate efficiently across more instruments and markets. As the hedge funds continue to grow, there will be increased emphasis on liquidity management which will favour the commercial banks.
CB, Clifford Chance I think there will also be an increase in the geographic scope of prime brokerage, not just in the regions that the investments are coming from, but also in the diversity of the prime brokerage client base. We are already getting questions about Shariah-compliant prime brokerage services and an increasing interest in prime brokerage generally from the Middle East. I can just see that spreading further and further afield.
CT, New Star Volumes will continue to grow. Margins will continue to fall. The power will continue to move to the institutions, which include large hedge fund groups. In the evolution from being an operational to a service culture, the service culture is going to have to grow in order for people to keep hold of their margins.
CB, Clifford Chance Finally, can you see any threats to the growth of prime brokerage?
CT, New Star Prime brokerage will evolve and it may break into its constituent parts. Stock borrowing and lending may go electronic. In the old days, who would have thought about derivative exchanges going electronic and cutting the banks out? It could happen in some of those commoditized areas, whereas some things like risk management or taking specific trades which are a funding complex are less likely to go electronic. But I don’t see why stock borrowing and lending can’t go electronic today.
AO’R, Gartmore Agreed. It is also arguable that some financing arrangements can be arranged more efficiently, through the fixed income division, for example. Structured financing has moved into the prime brokerage space to facilitate operational ease, not competitive pricing. Potentially clients are willing to pay that little bit extra to have everything in one place. But that could change.
DP, Merrill Lynch If a hedge fund tries to take away from the prime brokers all the easy-to-finance business, for example financing all their bonds with non-prime brokers via the repo market, eventually it won’t be worth the prime brokers’ while to finance the difficult assets (and provide the rest of the prime brokerage service). There has to be a happy medium.
CB, Clifford Chance So price compression is a possible threat?
DP, Merrill Lynch It is an important topic for the industry. Rates have compressed significantly. Some profit margins have gone down to a fifth of what they were five years ago. There’s a hurdle rate at which the bank has to fund itself, has to pay to borrow the stock in the first place. The super-normal profits have been driven out of the market as it’s moved from being an oligopoly in Europe six or seven years ago to a fully competitive market. Price has definitely been one of the factors that has led to hedge funds sharing that business around. That’s ultimately good for the end investor. We believe a dramatic increase in volume will compensate for the dramatic decline in margins.
CB, Clifford Chance Thank you all very much. UCITs III and regulation we’ll have to leave for another day.
You can have your questions answered by prominent market players.