Rough Seas? Prime Brokerages Change Tack To Navigate Choppy Markets

Jun 16 2008 | 2:00am ET

Wall Street and reality TV don’t usually go hand in hand. But as the collapse of Bear Stearns, the sub-prime mortgage meltdown and a handful of high-profile hedge fund blowups force major changes in the way hedge funds borrow and employ leverage, the prime brokerage industry is in the middle of what can only be called an extreme makeover. And as the industry works to recreate itself, institutional investors are proving one of the biggest factors in how it is changing.

FINalternatives Prime Brokerage 2008FINalternatives Prime Brokerage 2008“Hedge fund investors have said ‘we want change,’” says John Quartararo, a partner with San Francisco-based prime brokerage firm Merlin Securities. “They haven’t done it overtly, but they’ve become far more sophisticated and are now telling hedge funds, ‘If I’m going to allocate $500 million to your fund, this is how I expect you to run your business,’” he says, pointing to institutional investors’ demands for greater transparency in hedge funds’ risk exposure and leverage—information prime brokers are often pushed to provide in real-time.

Though Bear Stearns has become the poster child for hedge fund risk, the firm was not alone in its heavy exposure to the sub-prime mortgage industry. Over the last year, sub-prime related losses have taken their toll on the performance of some of the industry’s highest profile hedge funds, including those of Goldman Sachs and Merrill Lynch. Not surprisingly, it has resulted in an industry-wide focus on risk control—one that has elicited significant changes in the ways both hedge funds and prime brokers are operating.

Large hedge fund firms have taken to using multiple prime brokers and are becoming more and more demanding about the services they require. They want prime brokerages that can not only provide them with state-of-the-art trade execution platforms, but real-time data on risk exposure and clearing information, as well as phone access to industry specialists.

As concerns over counterparty risk have moved to the forefront, a handful of hedge funds have begun reducing their exposure to prime brokers’ balance sheets by creating third party relationships with major banks and moving fully paid-for assets away from their prime brokers. It is a completely different story, however, for small and mid-size hedge funds, which are having a hard time securing lending and finding prime brokers willing to take their business. And as prime brokers take their own steps toward reducing risk, many have begun catering to multistrategy hedge funds—a shift that will likely make it even harder for smaller single-strategy hedge funds to find prime brokers willing to take their business.

Jeremy Todd, director of Jersey City, N.J.-based Pershing’s prime brokerage sales efforts, says there has been a noticeable shift in hedge funds’ priorities over the last year.

“When it comes to diversifying counterparty risk, the first trend that has emerged is the use of multiple primes,” he says. “The second is that we’re seeing a lot of funds moving fully paid-for assets into banking institutions. They’re setting up tri-party relationships with firms that have prime brokerage arms and are then using those agreements to do their shorting and financing with the prime brokerage subsidiaries of the banks.”

Since Pershing is a wholly-owned subsidiary of the Bank of New York Mellon, Todd has seen the trend first-hand. He says several of the hedge fund industry’s largest firms have moved their fully paid-for assets to BoNY-Mellon over the last year. Through such arrangements, hedge funds are now financing all their long positions through the bank, while continuing to get backing for their shorting activities through Pershing.

“Prime brokers are seeing these trends and are trying to position themselves to be as tightly linked in with the banks as they can because it’s good marketing,” says Todd, who believes the trend will continue, particularly among funds with $1 billion or more in assets under management.

The shift is an appealing one for banks, as investor interest and the money piling into hedge funds continues to soar. Westborough, Mass.-based TABB Group estimates that prime brokerage units will earn more than $11 billion in revenue from hedge funds in 2008 alone. In fact, by 2010, TABB expects that the revenues generated by prime brokerage services for hedge funds, such as financing, stock loan and custody, will surpass traditional institutional business lines such as the cash equity business.

The potential for such profits has spurred bulge-bracket firms to build up their prime brokerage operations or to add prime brokerage units if they are not yet in the business. There has been strong merger and acquisition activity among prime brokers, and industry observers predict that consolidation will continue. When a liquidity crisis struck Bear Stearns in early March, the opportunity to acquire the firm’s prime brokerage operation was one of the most attractive prospects for JPMorgan Chase when it bought the struggling bank. And Bank of America had no shortage of interest in prime brokerage business before striking a deal this month with BNP Paribas.

As the prime brokerage industry has matured, there has been an evolution in the areas of specialization at individual firms. The explosion of electronic trading in the last decade led to a wave of technological advancements that the largest prime brokerage firms were quick to adopt.

Now, with little difference between the execution and data capabilities they offer, prime brokers are beginning to differentiate themselves through pricing plans and the level of expertise they provide.

“Where the original approach of the prime brokerage community was to service any and all types of hedge funds, we’re now seeing more of a trend where people are trying to hone in on what they really think is their specialty,” says Matt Simon, an analyst with TABB.

Simon says there has been an increase in the number of prime brokerages that have bolstered their operations in order to accommodate large, multi-strategy hedge funds. Such funds have become the most desirable clients because the volume of trades they execute tends to be higher than their more narrowly-focused competitors, and because of the greater likelihood that funds with a more diverse investment approach will survive market downturns.

Large hedge funds are also significantly more profitable than their small and mid-size competitors. According to TABB, large funds generate six times as much revenue for brokers as medium-sized funds, and 333 times as much as small funds, a fact that has clearly not been missed by the industry’s major prime brokers, who are more or less unwilling to take on the business of hedge funds with anything less than $100 million in assets under management.

Prime brokers’ appetites for the largest hedge funds is making it extremely hard for smaller hedge fund firms to secure lending, creating opportunities for smaller prime brokers. In fact, smaller primes say that their bulge-bracket counterparts frequently refer business to them. But while there is seemingly no limit to the number of hedge funds seeking capital, risk control has become more important than ever.

“Smaller hedge funds are capital-starved,” says Justin Press, co-head of BTIG’s prime brokerage group. With the majority of smaller hedge funds likely to struggle and ultimately go out of business, he says initial due diligence on prospective hedge fund clients has become more important than ever.

“There’s a reason that there are only 300 hedge funds in the world with north of $1 billion in assets under management who control 75% of the assets,” says Press. “You really have to make your bets on people that you think can grow and raise money.”

It is that very thinking among investors that has been the driver of many of the current trends among hedge funds and prime brokers. In the wake of major blowups, such as Amaranth Advisors’ 2006 collapse after losing $6 billion on bad natural gas bets, and the scandal that led to the demise of the Bayou Group in 2005, institutional investors have heightened demands for transparency from hedge funds, requirements that have trickled down to the prime brokers they rely on for financing and trade execution.

“One of the key driving forces behind change in the prime brokerage industry is the proliferation of the sophisticated institutional investor. Not only do these investors require greater transparency into funds, they insist that the funds step up their operations and infrastructure,” says Merlin’s Quartararo. “Fund managers, in turn, look to their prime brokers to provide advanced attribution and risk analytics, as well as a suite of investment products and administrative services. The prime brokers that evolve on behalf of their client’s client will define and lead the industry.”

by Britt Erica Tunick

This article appeared in the June 2008 edition of
FINalternatives Prime Brokerage

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