After all, prime broking is one of the most important service provider slots that need to be filled when setting up a hedge fund, and it is hardly less important five years down the road. But in between, much can be achieved by the hedge fund which can manage its prime broker relationships effectively.
For starters, there is already a firmly entrenched view within the hedge fund community that if a firm is using a prime broker for the bulk, if not all its trades, it remains a very complicated process to appoint another. This is a myth that is encouraged by many prime brokers, who might argue that this would make stock loan more complicated, or that the fund would lose the benefits of cross-margining.
“There’s a simple way around that,” says Sarah Williamson, Managing Director of HedgeMasters, a West End consultancy serving the hedge fund community, “you could appoint a second prime broker, and put certain countries with one prime broker, depending on their strengths – e.g. your European trades with a European prime broker because they have better settlement systems in place or are more familiar with the currencies.”
The process of appointing a new prime broker is actually made extremely easy by the service provider. Tactically speaking, it can be as simple as crossing the positions at market close prices at the end of the day. “It is a straightforward thing to do,” says Williamson. “We’ve done it several times for our clients.”
When a hedge fund first starts, it probably only needs one prime broker, because the new manager wants to be relatively important to one service provider at this critical stage in their development. Indeed, it can be detrimental to have too many prime broking relationships, as some more established hedge funds found to their cost in the 1990s. Managing 10-12 different relationships might sound good from the point of view of being able to negotiate fees down, but the fund manager also becomes too small a source of business to each broker to really matter that much.
“You want to make sure your prime broker relationship is significant,” says Charles Stopford Sackville, Managing Partner of Securities Finance International, a specialist in operational and personnel consulting within the hedge fund industry.
A fund with between $500 million and $5 billion under management should not be considering more than five or six broker relationships in order to remain a client worth dealing with.
It is logistically easier to have one prime broker per fund, especially if funds have different geographical foci. Ultimately, it makes life easier for the administrator trying to calculate the NAVs, although technology advances in the financial sphere have improved the ability of hedge funds to manage multi-broker relations, thanks to electronic matching of positions, and should make it easy for administrators to check the prices of overnight positions, regardless of whether a fund is being served by one broker or three.
There is a commonly held belief amongst fund managers that they are only paying a fairly small percentage of their total cost to their prime broker, but if they are managing over $500 million, the impact on the NAV is starting to become appreciable.
“Basis points represent the same thing many times,” says Stopford Sackville. “A few basis points for lending, borrowing stock, borrowing money. Where we work with hedge funds, and bearing in mind they are in the $500 million to $5 billion range, we can save them the equivalent of between three and 30 basis points on their performance.”
A lot of investment banks have demonstrated how profitable their prime brokerage divisions are, and it boils down to these basis points – they go a long way. Leverage compounds this too – a fund that is twice leveraged will see three basis points turn into six.
And prime brokers are often ready to negotiate fees with funds that they suspect are shopping around in the market for a new broker. Hedge funds are highly valued customers of investment banks, and a canny manager will often find that the prices he has been quoted are not necessarily carved in stone.
It helps in such situations to retain an independent party, like HedgeMasters, which has an in-depth knowledge base covering the prices being paid in the market for different broking services, and can advise accordingly.
“You can only negotiate so often,” says Williamson. “Don’t accept their first offer. They’re making a good spread – and if you’re a significant client of theirs, they will want to keep you. Hedge funds are scared of moving away from their prime broker, whereas in actual fact the relationship is reversed, the prime broker is terrified of losing headline clients.”
The marginal cost of servicing one extra hedge fund is tiny: losing a customer will mean little to the prime broker in terms of costs, but will make a substantial impact in terms of profits. Ergo, there is a considerable incentive for the prime broker to keep hedge funds on board whenever possible. It begs the question, is it worth maintaining a relationship with a smaller name in the prime broking space, given that they will work harder to keep your business – especially if you are a smaller and less well-established manager yourself? It really depends on what kind of fund you have, says Stopford Sackville.
If you are constantly putting on difficult trades, big brokers won’t be interested, as they prefer managers that fit smoothly into their existing suite of services. Complex strategies covering multiple securities types and markets, seeking cross-margining facilities across different products, might be better served by a smaller, more nimble prime broker like Barclays. A small hedge fund with a specific niche might well be better off finding a broker that bests fits its specific needs, and taking the extra time to shop around in the market for that relationship.
For example, a fund launched to specialise in shipping stocks would need a prime broker with access to the large reserve of privately-held shipping shares in order to be able to run short positions, perhaps one with a big private banking operation, rather than a conventional top tier investment bank.
For example, a fund launched to specialise in shipping stocks would need a prime broker with access to the large reserve of privately-held shipping shares in order to be able to run short positions, perhaps one with a big private banking operation, rather than a conventional top tier investment bank.
As funds get further down the road, it is less of an issue – fund performance speaks for itself. This can be slightly unfair: Williamson sees many ‘new generation’ prime brokers that she thinks could add significant value for starting hedge funds, but the bias some investors – including funds of funds – have towards the likes of Goldman Sachs or Morgan Stanley hampers the smaller prime brokers’ ability to win business in the emerging manager community.
Without the prime broker, the hedge fund can’t exist, but once a fund has multiple broker relationships, it becomes easier to transfer without a break in day-to-day trading if a manager – or indeed a broker – decides they want to terminate the relationship. It also keeps the brokers more honest, as the manager can compare the different rates he is receiving for various services.
Prime brokers are limited in the degree of assistance they can provide managers with when it comes time to raise money. “The amount of assistance in money-raising that prime brokers give their customers beyond inviting them to seminars where there are investors is quite minimal,” says Stopford Sackville.
By inviting both existing and potential clients of the bank to the same seminar, the prime broker is not technically favouring just its own client base, and can therefore comply with regulatory requirements.
Says Williamson: “Most people, when you ask them a few years down the line, ‘How much capital did your prime broker directly introduce you to?’, will say ‘Nothing.’ When you’re starting out, [cap intro] will seem like a really good deal, because trailing round for capital is one of the hardest parts of starting up.”
Ultimately, when a prime broker is offering a manager cap intro as part of its service, it really means helping the manager to get into a room where there are potential investors. After that, it is down to the manager. This is still one of the biggest reasons why a start-up should consider one of the leading players initially, of course. A more established manager, with a good track record, has less need to be attending such sessions.
Leverage can be an important added extra in this relationship, but again, this will depend on the strategy the manager is running.
A warrant arbitrage fund might consider this a crucial component, but not necessarily a long/short equity fund. The latter are funds managed by professionals used to operating in the long only environment, for whom leverage is a dirty word. Whether two times or five times leverage is on offer is thus frequently not an issue.
“I think prime brokers have sold hedge funds the idea that they’re prepared to lend the hedge fund money,” says Stopford Sackville. “They’re not actually doing that. They’re lending money against securities and strategies they (the prime broker) effectively own.”
“I think prime brokers have sold hedge funds the idea that they’re prepared to lend the hedge fund money,” says Stopford Sackville. “They’re not actually doing that. They’re lending money against securities and strategies they (the prime broker) effectively own.”
“For example, if your short side is going up in value, then you’re paying more in stock loan fees,” says Williamson. “I think the perception of the relationship is arguably very skewed in these sorts of situations.”
Auto-borrow programs are schemes set up by prime brokers that have very transparent fee rates for stock lending: the portfolio manager thus has a very good idea of what a short position will cost him. “They have a rate built into the program for what they call GC – general collateral borrowers,” says Stopford Sackville.
This kind of service is of interest to funds like stat arb players, with a high volume of transactions being carried out on a daily basis, which want to factor in the cost of borrowing so that they know a trade will be profitable. A typical program would offer major European index stocks at 40bps, while the bank would be paying 10bps to obtain them. On average, the bank will almost always make money on such deals, and those where their profit margin is going to be squeezed can always be transferred to a list of more expensive select stocks that is updated on a daily basis.
Borrowing rates can be looked at in two ways by banks: fees over 50bps, and borrowing in excess of $500,000. That will help to isolate the large size or large fee loan: a typical example would be a stock that is part of a rumoured merger, for which more would be charged. Roughly 80% of the lending volume of a bank will fall outside the 50bps/$500,000 parameters, and will generally be part of the auto-borrow facility.
Williamson reckons that fees charged on the auto-borrowing program could be tabled for negotiations as well. “The argument here is that it costs the same to settle a stock loan trade, no matter how big it is, so if the prime broker is making daily interest on a stock loan, and it’s only open for a week, they may not make their cost of borrowing back, whereas if the same stock is open for six months, after a couple of weeks they’re accruing profit all the time. The size and the terms of the borrowing are the key facts for the prime broker.”
Stock lending has become a much more sophisticated process in the last decade or so. Institutions which lend to the banks have woken up to the fact that additional fees can be earned from this.
There is a greater degree of knowledge about the marketplace on the part of the original lenders too. The big advantage the prime brokers still enjoy, of course, is the lack of any open pricing on what a given stock is costing for them to borrow. This gives them plenty of control over the rates they’ll then lend to hedge funds.
Despite the fact that the European prime broking stage is dominated by two or three big names, Stopford Sackville and Williamson agree that the industry remains relatively immature and has some way to travel, especially on fees. “It must be, otherwise we wouldn’t be able to do what we do,” says Williamson.
The actual broking product is fairly commoditised, but pricing has yet to be homogenised, and consequently hedge funds still represent one of the biggest sources of income for the investment banks. It is not surprising that additional services have emerged on top of the core trading support functions, and have mushroomed over the last few years. As a business model for an investment bank, prime broking is hard to beat, and it comes as no surprise that many smaller banks in both the US and Europe are now running their own operations.
Ultimately, the relationship between a hedge fund and its prime broker remains critical. Even though some third party agencies have emerged that can collect the trade orders from a number of small funds, and collate these into a bigger trade to place with the broker, the prime broking is still a critical credit wrapper for a hedge fund manager.
Big stock lenders will not lend directly to a hedge fund, but the credit risk management department within a prime broker has access to the hedge fund’s positions, and can make a more informed lending decision. In the event of a default, it is easier for the prime broker to liquidate the portfolio assets.
Is it still a relationship business? Yes, particularly that which exists between those sitting on the trading desks at the hedge fund, and who they’re placing their trades with. If that is the prime broker, then it can be very important.
But from the perspective of the nuts and bolts side of the hedge fund operation, there is still plenty of scope to review fees and relationships on a regular basis, and have a positive impact on the fund’s P&L at the end of the quarter.
Commentary
Issue 28
Prime Broking: Myths and Reality
What is your prime broker doing for you?
STUART FIELDHOUSE
Originally published in the June 2007 issue