In today's post-Lehman climate, hedge funds are seeking to use multiple prime brokers in order to reduce the risk of locking up assets with insolvent banks, writes Nicholas Pratt...
The relationship between hedge funds and their prime brokers underwent an almost absurd reversal in the wake of the demise of Bear Stearns and then the default of Lehman Brothers. It was prime brokers that used to worry about the solvency of their hedge fund clients; now hedge fund managers worry about the solvency of their prime brokers.
This has changed the prime broking business model and the relationships between brokers and managers. During the height of the hedge fund boom, the popular model was to use one or two prime brokers as a service ‘superstore’ that could provide start-up cash, office space, access to clients, and various financing options. There was little consideration of counterparty risk or the need for diversification. If a hedge fund did have two prime brokers, they would both be broker-dealers.
This has changed and hedge funds now seek to use multiple prime brokers. This already happened at the more mature hedge funds, which were aware of the need to diversify for both commercial and governance reasons, but in the post-Lehmans world the trend has spread to all hedge fund managers.
Giles Drury, senior manager, investment services, at KPMG, says: “What we are seeing is essentially an unbundling of services as hedge funds look to segregate the custody of their assets from the normal range of prime broking services.”
This has implications for both funds and brokers. On the funds side, due diligence of potential providers has become more prominent, particularly with regards to the contractual status of various relationships, says Drury. For example, hedge funds want to know which international branches of their broker they are exposed to.
Similarly, Jon Anderson, global head of OTC derivatives at GlobeOp, a fund administrator, says: “Previous due diligence may have concentrated on portfolio margining and operational efficiency and hedge funds would have seen these features as reasons to centralise their prime broker relationship with one provider, meaning one place to do reconciliations, valuations, trade capture and other processes.
“Now, in a multiple prime broker context, due diligence has to cover business risk, credit quality, commitment to the industry from both sides and the actual services that prime brokers provide. Hedge funds will now have more relationships to manage which could impact on the reporting requirements, the number of interfaces, the storage of data and a consistent management of all this information.”
At a time when hedge funds are under financial pressure due to the declining value of their assets and a drop in performance, cost has become a bigger issue. An unbundled, multi-prime broker model is more expensive, excluding as it does the various discounts and complimentary services that were on offer in the old one-stop-shop approach.
Luckily for any cash-strapped hedge funds, a change to the business model brings with it various offers of assistance from service providers. For technology-focused firms like GlobeOp, the back-office burden of maintaining multiple relationships and interfaces is likely to lead to more outsourcing of back-office processes. And for those hedge funds that continue to manage their own back offices, particularly the larger, more mature funds, there will be more willingness to embrace technology standards, electronic links and automation.
Good news for custodians
But the biggest beneficiaries of these changes could well be custodians.
“The first change is that there are fewer prime brokers,” says Blair McPherson, a sales head at RBC Dexia Investor Services. “The second change is that even those prime brokers that have done a good job are finding that hedge funds want a prime broker with a strong balance sheet that can offer new services. This has opened the way for custodians.”
There has always been a convergence between custodians and prime brokers in terms of servicing hedge funds, says McPherson. But it is now more explicit as hedge funds review their trust arrangements and the rehypothecation (basically, the lending out of clients’ cash to other investors) and ownership of their assets, as well as administration and custody.
“This is a healthy development for the industry and also good news for custodians,” says McPherson.
It is not just custody that custodians can offer, he says. Hedge funds are looking for more credit in terms of overdraft facilities, repos and collateral management and this raises the possibility of custodians extending their offerings to include financing.
It has also brought new entrants to the prime broker market, one being BNP Paribas, which acquired the Bank of America’s (BoA) equities prime brokerage unit in October 2008.
“The changes have been fortuitous for us because we are coming somewhat new into the market,” says Talbot Stark, global hedge fund relationship manager at BNP Paribas. “Historically we have had niche status in terms of derivatives and esoteric instruments on our international platform so this [acquisition] has helped in terms of delivering this on a global basis.”
Stark says that the acquisition has given BNP Paribas a head start in its efforts to break into the international prime broker market. “It is very difficult coming into the prime broking business from a ‘greenfield’ status,” Stark says.
Stark also claims that as “the only double A-rated prime broker out there”, hedge funds are “keen to explore what we provide”.
As with any recent acquisitions in the prime brokerage sector – including JPMorgan’s acquisition of Bear Stearns – the market is waiting to see how integration will proceed in terms of migrating customers and establishing global platforms. Given increased due diligence, hedge funds will no doubt look to see the potential for long-term stability from any newcomers to the market.
Aside from more intensive due diligence and the growing role for custodians, the biggest implication of the changing prime brokerage model is the extra expense involved for hedge funds, particularly at a time when resources are scarce. While the industry is currently focused on security and governance, are we merely seeing a temporary change in focus or is this a genuine and permanent paradigm shift?
“I think it is a trend that will last forever,” says GlobeOp’s Anderson on the basis that a painful lesson has been learned about the need to diversify risk and that it is very difficult to regress from a position of greater transparency, segregation and operational resilience. This sentiment is echoed by KPMG’s Drury. “The hedge fund industry has had a kick in the teeth and the pain is being felt on both sides in that the prime brokers are losing revenue. But I cannot see this trend reversing.”
A new era
Staffan Ahlner, a managing director at BNY Mellon, likens the development in the hedge fund industry to what took place in the pensions fund market 20 years ago. Assets that were previously held by brokers were moved to the relatively safer environs of the custodians and although the two markets have very different investment strategies and philosophies, Ahlner feels that the current trend will remain.
“We are seeing a new area of competition in the prime broking market. It used to be about financing and now it is about stability and sustainability. The new risk is administration and having your assets locked up. The key is setting up a structure that allows the fund to access its assets in the event of a default of a prime broker and that is what people are looking for.”
RBC Dexia’s McPherson adds: “The new model of multiple providers rather than a single prime broker will be more expensive for hedge funds but I think this is just a cost of doing business in today’s environment. If you are asking a counterparty to take a risk, then there has to be some reward and with the changes to the rehypothecation process, prices will have to go up. But I think the market has changed for the better and changed for good.”
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