Hedge Funds to Prime Brokers: Getting to Yes

Once in the catbird’s seat when picking prime brokers, hedge fund managers are now faced with doing their own sales jobs.

They have to persuade prime brokers to accept them as clients with expectations that align. With prime brokers becoming far more selective, hedge fund managers might not get their first choice of prime brokers or all the services they want. Only the largest and most lucrative hedge fund managers are guaranteed to win the most coveted tier-one prime brokers.

Even if a hedge fund manager does get its first pick of prime brokers, it will be ill-served if the term sheet is too expensive and service is poor. Settling for second best might not be a bad idea, if managing the ideal prime broker’s expectations is too burdensome and detracts from managing investors’ interests.

“Securing a quality prime broker requires the hedge fund manager to effectively communicate what the fund can bring to the relationship,”  says Mark McGoldrick, director of prime brokerage Cowen Prime Services in New York.  “Prime brokers will analyze existing and new clients based on their current investment strategies and try to evaluate the likelihood the hedge fund can attract investors and grow its assets. It is an exercise in handicapping the hedge fund manager.”

The culprit for the change in the historically cozy relationship between hedge fund managers and prime brokers is the Basel III Accord, which is making it more expensive for prime brokers to stay in business. To meet the required liquidity coverage ratio, the net stable funding ratio and the leverage ratio, banks must set aside incremental capital. The LCR is designed to ensure that banks have sufficient assets to cope with a short-term liquidity disruption. Banks must hold sufficient high-quality assets (HQLA) to cover a worse-case scenario for 30 days. The NSFR requires banks to hold a minimum amount of stable funding over a one-year period based on liquidity risk factors related to assets, off-balance sheet liquidity exposures and contingent funding. The LR aims to restrict the build up of leverage, so banks must hold sufficient Tier 1 capital relative to their exposure to ensure that the ratio never falls below three percent.

So what do prime brokers want from hedge fund managers? “Prove that the revenues they will earn from their hedge fund client will offset the cost of doing business,” says Victoria Hart, portfolio manager with Pinnacle View Capital Management in New York. Prime brokers earn their keep through three basic services: trade execution, back-office clearance, and securities lending and financing. A hedge fund won’t be of much use to a prime broker unless it can generate substantial revenues. The more trades, leverage and short-balance a hedge fund manager handles through a prime broker the more revenues it will generate for the prime broker.

The big bucks for the prime brokerage is in the securities lending and financing business — providing hedge funds with the ability to borrow stocks and bonds to short-sell and the ability to borrow money to buy stocks and bonds. The amount of securities borrowing, short-selling and financing the prime-brokerage provides the hedge fund manager will ultimately have an impact on how much of the prime broker’s balance sheet is used. “The prime broker has to balance out the amount of fees earned from trading, custody, securities borrowing and financing with the amount of the balance sheet used,” explains Christopher Caruso, president of Pangaea Business Solutions, a River Edge, NJ-based counterparty risk advisory firm for hedge fund managers. As a rule of thumb, the higher the amount of balance sheet used, the more capital the prime-broker must set aside and the higher the fees the prime broker will charge. That is if it wants the hedge fund manager’s business in the first place. It might decide that the hedge fund manager is too expensive.

Negotiating Tactics

What does the hedge fund manager have to do? First and foremost, convince the prime broker that it is the right fit — that means it has the right investment strategy. The prime broker might just be able to make money using the collateral posted by one hedge fund manager for the financing needs of another. Or the prime broker might specialize in the types of assets the hedge fund manager owns. “Hedge fund managers which have similar investment strategies and assets to the existing clients of the prime broker stand an easier chance of being balance sheet efficient and maintaining a good relationship with the prime broker or being accepted as a new client,” says Caruso, formerly head of North American relationship management for Deutsche Bank’s prime brokerage business. “Prime brokers are always trying to optimize a client’s portfolio.”

The ideal prime brokerage client is a moderately leveraged market-neutral hedge fund manager, says McGoldrick, who is also a board member of the trade group Hedge Fund Association. The reason: it generates securities lending fees without using too much of the prime broker’s balance sheet. Short balances can offset debit balances carried.

It would be ideal for the hedge fund manager to understand the methodology the prime brokerage uses to make its decision. There is a “hurdle” or ranking each hedge fund manager must pass. Until recently, the methods of the ranking was a closely-held secret. All the hedge fund manager would know is whether or not it made the cut. These days, its not unusual for a hedge fund manager to get some hint of the how the metrics work, if the prime is willing to answer the question. “A hedge fund manager needs to understand just what the return on assets hurdles are and how they are derived so that it can either remain a client in good standing or be signed up ” says Caruso. That knowledge will provide the power to make the necessary changes if the manager falls below the mark.

The hedge fund manager can always decide to reduce the number of prime brokers with which it does financing business business. so its contribution to the remaining prime brokers’ bottom line is more profitable.  Or it might decide to increase the number of trades it executes with a prime broker. Existing clients do have a competitive edge over potential new ones for one reason. They might be judged on the same standards, but the prime broker might cut it a break and actually explain just what it needed to remain a client.

Even if the hedge fund manager is able to surpass the hurdle rate, that doesn’t mean it will win everything it wants. It may have to rely on the minimum: a trading platform and limited financing. Prime brokers might also limit the type of risk management and reporting services offered. Most edge fund managers can forget about the two value-added functions — corporate access and capital introduction. Hedge fund managers ideally want to meet with the C-level executives of the firms they trade in and win referrals to new institutional clients. However, in the same spirit they are limiting their client base to only the most profitable, they are limiting these special services to only their top clients.

“Hedge fund managers need to ask their prime brokers for more details about exactly what services they will receive,” cautions Hart. “Service levels can vary dramatically. Checking out the prime broker’s credibility with fund administrators and legal counsel isn’t a bad idea, she adds. Neither is asking the prime broker for referrals from other clients and why some may have left.

Other Options

For hedge fund managers which either get tossed out or turned down by the bulge-bracket players, there is a growing category of mid-tier players that could be just as good. The new middle rung of the prime-brokerage ladder can offer-24 hour international trading desks, risk analytics and financing, explains McGoldrick whose firm is a mid-tier prime broker. Mid-tier prime brokers often used an “introduced model” in which they place or “introduce” hedge fund assets to another custodian on a fully-disclosed basis. The mid-tier players still handle all of the servicing and back-office work at their firms making the distinction between them and bulge-bracket prime brokers rather operationally blurry. The difference might just come down to corporate access and capital introduction services. “Emerging hedge fund managers need to be nimble and accept resources that are adequate,” says Hart. “In many cases, mid-tier prime brokers fit the bill.”

Although most of the hedge fund clients turned away by the bulge bracket firms will likely find a new home with mid-tier brokers, some will make their way to mini-primes. As their name implies, mini-primes often handle the smallest hedge fund clients and simply serve to introduce them to other larger prime brokers, which actually clear the trades. Ultimately, the hedge fund manager will still gain access to the larger players, albeit indirectly. One downside: the mini-prime must ensure it can keep track of all the securities and cash movements between the hedge fund and multiple larger prime-brokers. Yet another: the introducing brokers must still prove their worth to the larger bulge bracket firms so they too stand a good chance of being dumped. Case in point: last year JP Morgan said it would shut down its mini-prime business.

Bottom line: given the new dynamics between hedge fund managers and prime brokers, honesty might well-be the best policy. Prime brokers have to be up front about what they need from the hedge fund manager while hedge fund managers need to explain just what they want. If each player can’t be satisfied with the other offers, the relationship won’t work. “It has become a two-way street,” says Caruso. “The relationship needs to work for both sides to be successful.”