Prime brokerage debate: How to profit by keeping hedge funds happy

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IC, Simmons & Simmons Let's start with an overview of the sector in the light of the continuing problems in the structured credit and securitization markets.

TC, Fortis The landscape has changed dramatically. I don't think that today you can walk into a boardroom of any major bank and not see post-traumatic stress in terms of a shell-shocked management team. People are evaluating their entire approach, and that starts with credit provision and knowing your counterparty as well as the price of credit to funds. Those who do not want to share all their information will see rises in price.

TL, Man Investments That's true, although because prime brokerage is very profitable, you can see the opposite, which is that for the best funds, banks are competing even more aggressively for that prime brokerage business. And on the fund side, their ultimate investors are putting pressure on them to deal only with banks with balance sheet. But the funds have to be careful. Balance sheet is clearly just one part of the prime brokerage service and has to be married with excellent service, speed of service, attention to detail and prompt turnaround time. Larger organizations with massive balance sheets tend to be slower and clumsier, and that can hurt you significantly.

AB, Simmons & Simmons Prime brokers are much more concerned about hedge fund data; they have tightened their criteria for lending to hedge funds; they want to know much more about funds' positions and dealings with their other prime brokers. Conversely, the hedge funds have begun to worry about the creditworthiness of the investment banks that are their counterparts.

RC, Sabre Fund Management From a hedge fund point of view, counterparty risk has been a high priority over the past year. Equally, we need to have secure and efficient execution and financing, so we have not approached current counterparty concerns as a credit decision so much as by ring-fencing client assets to obviate the credit decision. Through our use, almost wholly, of synthetic prime brokerage, we effectively had 100% cash exposure to our counterparties, and at the same time an opportunity to ring-fence assets almost entirely. We reduced counterparty exposure as far as practicable, by putting non-collateral assets into separate custody and by limiting collateral to risk-free securities that are in our clients' names and custodied as far as possible. Our prime brokers now operate largely on hearsay collateral. There is a cost in this, but we can offset it by better management of our cash.

AH, Gartmore Did your prime brokers react to this?

RC, Sabre Fund Management Yes. First of all, they said: "You should be telling your investors that we've got a great balance sheet", and, of course, pricing became a factor in the discussion. However, we are not credit analysts, and we are not going to be well regarded for the attempt, or for pitching the Street's self-views, worse if we get that wrong. We said: "The solution is for you to do the financing and we'll sort out how and where the collateral's held". There was a meeting of minds and it went very smoothly after that.

AH, Gartmore Yes, the situation was very simple with us. We actively managed our cash away from the prime brokers and it became even more so over the past 12 months, and we saw a similar type of response from prime brokers as well.

TL, Man Investments Did you find that their service level changed at all? Lately, prime broker efforts are generally directed to get as much of the long/short equity business as possible, since this is very profitable. Prime brokers have been forced to re-examine what is profitable and what is not. Service levels generally flow from that.

AH, Gartmore We didn't see a significant shift away from any kind of service levels that we would have continued to expect and the support that you expect to get from your prime broker

Financing costs up

RC, Sabre Fund Management Financing costs have gone up?

AH, Gartmore Yes.

RC, Sabre Fund Management And they depend a lot on the type of securities you hold and how they're rated by the counterparty?

AH, Gartmore And how levered you are, how big your synthetic side of your business is, and so on.

LP Do you think prime brokers are taking advantage of this alleged credit crunch issue to just jack their charges up?

TL, Man Investments I don't think the prime brokers can easily do that. First, they still make a lot of money in this business. Second, given the calls for diversification, they have to compete harder to keep business. So raising rates is not that straightforward and some people have dropped rates to get business.

TC, Fortis Also, most of the larger fund clients of a prime broker will be touching a number of different parts of the bank that provides the prime brokerage service. So the prime broker funding rate is just one component of a wider service set and so will be governed by that totality. There's a lot more to that discussion than just the prime brokers raising rates.

TL, Man Investments Some marquee customers don't care about rates as a priority in light of more pressing issues. Many are interested in their risk being managed, getting a lock-up agreement in place, day-to-day operations - there's a myriad of issues that for many hedge funds are more important than 10 basis points.

IC, Simmons & Simmons The bigger, more successful clients actually feel that they have more bargaining power now rather than less. They feel that because their business is sufficiently important, they've got more chance, for example, of obtaining better rates or margin lock-up agreements than in the past.

RC, Sabre Fund Management Yes. It's a two-way street. And there is some notable stability compared with 1998, perhaps because the banking community is as concerned today as its own members as much as clients. There has not been the destabilizing tightening of terms to funds seen in some cases 10 years ago, even if the money market has been problematic.

AB, Simmons & Simmons Each side needs the other.

Investor pressure

IC, Simmons & Simmons Are you seeing pressure from investors in relation to your prime brokerage arrangements?

LP Exactly - in the run-up to the Bear Stearns debacle and all the subsequent rumours, are your investors asking you where you're doing your swaps and what your counterparty risks are? And to the legal experts, were end investors threatening hedge funds to move the balances and so creating those runs on the prime brokers?

RC, Sabre Fund Management We've certainly dealt with investor concerns over counterparty risk and segregation. A lot of people felt that we should have our cash segregated under FSA rules but that does not represent the protection we required. In a synthetic portfolio, we've repositioned in custody the collateral excess, we sweep the cash away generated by our transactions, and our counterparty risk is then limited to the settlement for the next reset date, typically less than one monthâ€s P&L of the investment strategy. Investors seem comfortable with that. Other funds more active in cash equities can be more nonchalant. I have heard some say: "Well, if we have the risk of this or that leading investment bank… if that's going to go pear-shaped, then the basis of global finance is in question and there's not a lot we can do about it". I cannot say that we have noticed wholesale switching of counterparties. The emphasis, certainly our emphasis, has been to stay put and do it better.

Multiple brokers/diversification

AH, Gartmore One result, has been the move towards multiple prime brokers. It's a good idea in principle but you have to look at the strategy of the fund and whether or not you need to add that operational complexity.

RC, Sabre Fund Management You have to have back-up via a mix of providers. You cannot afford to be hostage to one counterparty. This brings extra complexity but is necessary. Also, the idea that the prime broker is a short cut to having a custodian - a package deal - is changing. We're separating out the custody and other functions, focusing on the prime broker as a financing and settlement organization. This has implications for custody business models, which are based on lien and can preclude collateralizing of third parties, and for listing regulations for funds to move with the times.

TC, Fortis The diversification issue is real and I think that when you make that decision you won't be talking to a prime broker unless they meet your operational requirements. But then the choice is based on the profile of the bank behind the prime broker, and funds will try and diversify on that basis. That is why you are seeing more entrants into the prime broker market now, because many entrants' balance sheets are under siege by materially different circumstances.

IC, Simmons & Simmons Is this coming out of due diligence? Are investors beginning to raise more detailed questions?

AH, Gartmore I think it's an extension of things that have already come up at board meetings. Investors are more interested in who we do business with and who we appointed as prime broker and what our back-up is if something goes wrong.

IC, Simmons & Simmons And they don't go into the detail of what sort of rehypothecation arrangements you have agreed?

AH, Gartmore Some have asked that. We have very low rehypothecation levels. Yes, the questions are being asked.

TL, Man Investments People want to see your methodology. Do you have a plan? Do you have a diversification policy? Do you have a credit policy? Do you have an OTC policy?

But just going back to multiple prime brokers: they understand that we want and need diversification but they also want to get as much of our business as they can and they have invested heavily in what one of my contacts refers to as "the technology arms race" to make themselves attractive one-stop-shops. So they want to keep as much of business as possible and pump it through these platforms. And some of the technology - for example, cross-product margining - is pretty good.

IC, Simmons & Simmons Though of course it gets hard to do cross-product margining across multiple brokers.

TL, Man Investments Yes, so you could see it as an effort to keep all of a fund's business - but it does reduce funding costs too.

Hard-to-borrow expertise

IC, Simmons & Simmons What value do you put on the hard-to-borrow expertise of prime brokers?

AH, Gartmore With hard-to-borrow generally, if you're not utilizing your own portfolio of stocks and you're going to a big global custodian or institutional lender to borrow stock, the way you get hard-to-borrow is you're a good client and you run a good balance of, say, GC business, or easy-borrow business, to get allocation to the juicy stuff. We already have arrangements with a number of our custodians that they're able to borrow securities, and you rely on their honesty and the relationship that you have. You have to police it properly and make sure that you are getting full benefit of what you actually have. And that goes back to the earlier points about rehypothecation. In the past, people have been sufficiently clever to make good profit from rehypothecation using assets that are hard to borrow. There are probably still hedge funds out there that don't know what's being done behind the scenes, and we're lucky enough that we do, and we benefit from them.

And I guess now there's less need for the big prime brokers to borrow easy names away from their own inventory, because a lot of them have exclusive portfolios - they use their own in-house stock. So in a lot of cases where, say, five, 10 years ago a lot of the prime brokers would have had big easy-borrow balances outside with an institutional lender or global custodian, now they don't; now they might not have such a large percentage of their easy-borrow book outside of their own inventory.

TC, Fortis Yes. I've always thought you could measure a stock loan desk by how successful they are in obtaining hard-to-borrows.

AH, Gartmore I think that comes back to my earlier point about how we choose prime brokers for things like emerging market funds and funds that want to get access into synthetic markets: you go with the people you know can get you access. You're not going to go with a prime broker who isn't very good at finding stock because you're never going to be able to trade. I think the business has predominantly always measured a house in terms of its ability to do hard-to-borrow.

IC, Simmons & Simmons So is that a true barrier to entry?

TC, Fortis Most definitely.

AH, Gartmore Certainly in certain areas of growth, yes.

TC, Fortis I would say that that's the lifeblood of prime brokerage.

Collateral management

IC, Simmons & Simmons Collateral management is absolutely crucial.

TC, Fortis Absolutely. It is probably the most under-appreciated key role within any firm, buy side or sell side. Efficient collateral management can mean life or death.

TL, Man Investments I definitely agree. It's highly necessary and definitely under-appreciated.

AH, Gartmore Yes, and I think that perhaps in previous times you might have negotiated a rather broad collateral remit to clients and now might be perhaps rethinking that.

RC, Sabre Fund Management I reiterate what was said before. Collateral and managing it has been top of our operational agenda. Prime brokers have collateral to protect themselves, principally - the prime brokers here can address that. But possessing it also creates extra economic possibilities for the prime broker, use of cash and re-use of assets. The package deal that was prime brokerage, and the trading focus of their hedge fund clients, has afforded prime brokers a lot of scope. In unpicking different functions of prime brokerage, which we have done for ring-fencing purposes, the economics change for both provider and fund. If funds were not accustomed to scrutinizing the components, one issue might have been the returns on their cash deposits. We have found that using regulated money market funds (strictly those of the stable NAV variety) is a good way to employ collateral excess, and in certain cases it is also acceptable collateral to the broker.

IC, Simmons & Simmons Do you have any concerns about rehypothecation at the moment, bearing in mind how that works technically?

RC, Sabre Fund Management Exactly our point, and we have two collateral formats. One uses only money market funds, which, by their nature, are not rehypothecated I am not aware that this customarily occurs. The other employs short-term government securities, where the counterparty will not take money market funds as collateral, and in that case we set limits on the level of rehypothecation. Within those parameters we have no concerns.

IC, Simmons & Simmons Alan, I know you said earlier that you have very strict limits on rehypothecation, presumably seeking to balance your exposure to the prime broker who's rehypothecated against your liabilities to it?

AH, Gartmore Yes. We're an equities house, so depending on the type of assets being invested in, we had varying degrees of rehypothecation and we were very successful in negotiating that to a very consistent level most of the prime brokers and across different asset classes within the hedge funds. The aim is to limit the rehypothecation rights as much as you can.

AB, Simmons & Simmons So over-rehypothecation is a risk. How do you control it?

AH, Gartmore It's obviously a concern and you can have rehypothecation levels but you need to know that they're actually being adhered to, which comes back to trust in your PB, and their reporting and monitoring procedures.

AB, Simmons & Simmons We are seeing a shift towards greater transparency, including a willingness on the part of PBs to provide information as to which securities are being rehypothecated.

IC, Simmons & Simmons Rehypothecation is normally calculated as a percentage of liabilities but there seems to be some divergence in the marketplace as to how liabilities are calculated by the prime brokers, which then impacts, inevitably, on the extent to which they are able to rehypothecate assets. Do any of you look closely at how liabilities for that purpose are calculated?

AB, Simmons & Simmons The key is the calculation of the indebtedness amount and defining what constitutes indebtedness, because this determines what portion of a client's securities a prime broker is entitled to rehypothecate. And there are other issues here to do with how a prime broker's systems are set up to deal with the various elements of the indebtedness formula - for example, are short market sale proceeds included to offset market value of short-positions, and do you refer to net cash indebtedness or to the gross value of cash advances?

TC, Fortis This is definitely an issue that we are keenly aware of, and I think the conventional differences that you've alluded to are definitely a matter of discussion.

Margin lock-ups

AB, Simmons & Simmons How valuable do you think having a margin lock-up agreement is, in the sense of having a legal agreement in place as opposed to relying simply upon trust or the business relationship? How important is it to actually have a relatively robust legal agreement in place to agree that a specific margining methodology is applied?

RC, Sabre Fund Management We looked at margining terms this year. We were on a grid arrangement, which meant there was a blanket rate that covered everything. It was not parametric and so was unlikely to change. Originally there were no particular formulas about how terms could be changed, except an assurance that it would be discussed before it happened. But, subsequently, we have got three days' notice before the current margin rate changes, provided we operate within a stated universe of transactions. If we have the right returns from our collateral, then our margin amount is not an opportunity cost so much as a factor in portfolio construction and leveraging decisions.

AH, Gartmore This kind of agreement is usually very bespoke, because, depending on who you're speaking to and what funds they have, you're comparing apples to orange. There's a desire to have that assurance that you won't have your margin or finance terms changed overnight but the costs of that agreement have to be looked at as do the constraints and other covenants embedded. We've heard terms of 30, 60, 90 days bandied about and obviously the further up the term you go the more exclusions there are.

RC, Sabre Fund Management In committing to a schedule of transactions - the most liquid equities traded - if we were to go outside that list then the rules wouldn't be the same.

AB, Simmons & Simmons So you would see lock-up agreements as good to have, but not necessarily essential?

RC, Sabre Fund Management Any fund needs a level of assurance for its financing terms. For funds using less liquid instruments this gets much more critical.

AH, Gartmore Also you look for an element of trust between the fund and the prime broker. As well as wanting the comfort that you have something in writing that says certain things can't be done within a certain parameter, equally you would hope to be in a position to know that it's not going to all turn on a sixpence within 24 hours.

AB, Simmons & Simmons Are these lock-up agreements easier or more difficult to obtain and negotiate these days?

AH, Gartmore Something that I discovered in talking to the prime brokers about this was that the claim that they've always been on offer. It's just I don't know that many people really thought they needed to take them up. I was surprised when I first asked the question, it was like. "Yes, sure. How long do you want it for?" And you think: "Oh". And then you find out what it's going to cost you. So again it's a balancing act, depending on, I guess, the fund strategy. Do you think it's worth having it? And we're going through that process at the moment.

IC, Simmons & Simmons And of course there is no standardization. Now, in time you might get a domestic standard margin lock-up agreement, in the same way as there's a standard give-up agreement. But you won't get a standard agreement between Europe and the US.

Capital introduction

IC, Simmons & Simmons No one has mentioned the hot topic of previous prime broker discussions - capital introduction. Do people still value this service?

TC, Fortis I think it's one of a number of services that prime brokers have to look at but I think the differentiating factor for any organization that maintains this function is to differentiate themselves by the quality of the end investor and/or be able to marshal their own resources. I find that there are very good people who focus solely on capital-raising outside the prime broker space.

TL, Man Investments It's valuable but it is difficult for the banks to provide. For example, the hedge fund manager going to the bank for potential cap intro wants it to be as exclusive as possible, they want the individual attention, and I don't know how many banks there are out there who can really do that given an active client base of many hedge fund managers asking for this service.

LP What's interesting is that if we'd had this debate two years ago people would have been talking a lot about capital intro and money-raising, rather than risk management. How times have changed.

The future

RC, Sabre Fund Management What do you all predict that prime brokers are going to have to do to defend their patch from new entrants? Is it financing, is it balance sheet, is it new ways of helping funds report risk to their clients? What are the new ways of doing prime brokerage to hold on to business?

TL, Man Investments I'd say financing and derivatives are two big issues, as is market saturation. A key thing that we have already mentioned too is access to liquidity in new areas or asset classes.

RC, Sabre Fund Management What about less glamorous areas such as offering better reporting platforms to clients and their investors in search of transparency?

TC, Fortis I think as Tony alluded to earlier, once the investment has taken place in the technology platform, you have to maintain and update that investment. That investment means people; it means modules that are updated for regulatory changes; it means modules that are updated for structural changes within the market. So I think, yes, prime brokers will look to use technology as a differentiator and continue to invest in new technologies.

New entrants

RC, Sabre Fund Management One possible development could be more new entrants to the market. It used to be said that the investment in systems, risk management and staff was a significant entry barrier to prime brokerage. Have the barriers to entry gone down sufficiently to allow significant new entrants into the market?

TL, Man Investments I think that is true to an extent. Banks are realizing that they do have the component parts of the business even if they are not joined up, and they also have made great strides in the development of technology internally that enables them to provide these services. And they've got the advantage of other people's trial and error that they don't have to go through.

AH, Gartmore True, but from a hedge fund perspective, would you want to put your business with somebody who had no track record?

TL, Man Investments That depends. But if you're dealing with people who are experienced that you know from elsewhere and they have a team of people that you have felt comfortable with before, then yes.

TC, Fortis People are willing to entertain newcomers, and they're willing to say yes to diversification and over time come to a full yes, but the entire process takes a bit of time.

RC, Sabre Fund Management Are you really seeing a new competitive landscape in prime brokerage?

TC, Fortis Most definitely, yes.

RC, Sabre Fund Management With the increase in interest in emerging market assets, there's a lot more room for small specialists to come in and serve hedge funds. While it is not always operationally easy to work with such specialist local execution or lending firms, often because the local regulatory environment wants to channel foreign investor behaviour, the big prime brokers are not dominant or complete providers in emerging markets.

TC, Fortis That's a very good point. There is definitely room at the table for additional service providers who can provide that. And I say this as someone who sources a lot of supply for traditional intermediaries that have been fulfilling their own prime brokerage mandates, and now we've got our own prime broker.

AH, Gartmore Emerging markets is a significant part of our business. Here the rate is not the issue, the issue is getting liquidity. A lot of these positions are long-term trades and you need comfort that the prime broker knows the market well, whether they're borrowing from locals or offshore lenders, and to communicate to those suppliers that they can't just pull lines of stock, for example. As a hedge fund borrowing in those markets, you want to have the comfort that you'll be able to keep the positions as long as you want them and on the flip side you have to understand that you cannot just come out of positions at a moment's notice in large volumes.

TC, Fortis In other words, the prime broker needs to know the rules of engagement and make sure that you do too.

AH, Gartmore We consider that quite highly when we're looking at a prime broker in the context of a new fund or market.

IC, Simmons & Simmons And that's where you think that there's scope for new players?

TC, Fortis It's one area of many. The constraints in the current environment are such that the big traditional player cannot provide all the services funds need. It's opening the field of competition.

But, given the stress management and the shell shock that's going on - absolutely. I think it's a safe bet that expansion into some of the more exotic markets is on hold for a bit until market practitioners can better navigate through the global volatility.

AB, Simmons & Simmons And who do you see as potential entrants? HSBC? Fortis?

TC, Fortis I can only speak on behalf of Fortis and say that we have a commitment from the top of the institution to not only build a prime brokerage platform but to make a real difference with the clients we serve. In addition, I think that you'll have to look across the spectrum of money centre banks. I think it would be logical to look at new entrants and the unique expertise that can be brought to bear.

LP In five years' time, one of the big Middle Eastern banks will be a significant player in prime brokerage. They will model their business on the old CTA-style, where they will invest, own a piece, do the execution, do the clearing. And I think that's a growing trend that you'll see across the hedge fund universe, of vertical integration, from raising the money, owning a piece of the management, doing the execution, doing the clearing, doing the risk management. And it's going to come from the area that has the big bucks.

AB, Simmons & Simmons The banks from the emerging markets.

LP Exactly. Maybe it's Chinese. Maybe it's Middle Eastern. And you will see the emergence of a very significant player from that region within the next five years. We're already seeing this CTA-style, silo integration coming, with banks buying stakes in hedge fund management. But that's what I think's going to be the big out-of-left-field trade in the next few years.

IC, Simmons & Simmons Do you see the domestic US prime brokerage business in a different way?

TL, Man Investments The US business has some catching up to do.

IC, Simmons & Simmons In what sort of areas?

TL, Man Investments Being able to offer the same leverage as outside the US. There has been considerable effort but we're still not there.

LP I think a lot of how the prime brokerage industry is going to develop in the US is going to depend how those securities exchanges strategies play out. But the issue of dark pools of liquidity and so on has been going on in the US for 15 years.

TC, Fortis We are finding more and more global players in the US. I think we all know there's been some recent acquisitions that have created some very exciting propositions for some, at one point, non-US players. This landscape will continue to change but within the US it's going to be incumbent upon the banks themselves to go abroad, to create those alliances, and to create those paths of business that may have not been there to the degree that is required by the managers that practise on a global stage. The banks that are not able to fully service the needs of a manager on a global basis should realize that their offerings may be greatly impaired.

Fixed income versus equities

AB, Simmons & Simmons Do we expect to see a greater evolution in the equities area or the fixed-income area? And how much activity in each of these areas do you think we're going to see?

TC, Fortis Fixed income can only grow. It's absolutely an area that should not be neglected. If anything, it's an area where institutions can build relationships by expanding the discussion beyond long/short equity.

LP I think you have to separate the different ends of the food chain in debt. Debt people by nature are happy when there's global misery, and so this is their time, no doubt about it. And that isn't even taking the distressed side into account. I would have thought this was going to be a huge growth area over the next year or two for the prime brokerage industry.

RC, Sabre Fund Management It is easy to imagine that the fixed-income arena is going to be a once-in-two-generation opportunity for some investors, although time and method are not obvious. There might be a wider and developing offer of fixed-income PB going forward. The big difference between fixed income and equity prime brokerage is that fixed income didn't start out being traded on exchanges. That colours actors and techniques as it stands. Liquidity and price discovery is different. It is a market segment where certain dominant firms can establish their franchise quite powerfully as the market works out and regulation evolves. Mifid [Markets in Financial Instruments Directive] hasn't managed to get to grips with debt markets yet.

LP The reason prime brokers don't really like distressed debt and other types of structured debt products is that they are often part of a buy-and-hold strategy. How are you ever, as a prime broker, going to make money out of that?