Prime brokers: Managers lament shortcomings of capital intro

“Ask any manager what they want from a prime broker and, if they are being honest, it will be as simple as capital introduction,” says the manager of a small seven-year-old hedge fund. “If you are small, you need assets. If you are a middle-size firm, you need assets. And if you are a large hedge fund manager, you still need assets. It’s the lifeblood of hedge funds.”

According to a survey by Tabb, managers view capital introduction as the main reason for adding or switching a prime broker relationship, such is its importance. Yet a straw poll of small and medium-size hedge fund managers in Europe, the US and Asia last month by Euromoney reveals a shared opinion that prime brokers place far less importance on the service. Thirty managers were asked whether they thought prime brokers’ capital introductory services were helpful, while some of the leading prime brokers were asked how they approached the service. A disconnect in what managers want and what prime brokers can feasibly offer reveals a gap in the market that could be filled by third parties.

One hedge fund manager says: “After being in business for a while most hedge funds, if not all, will admit that the prime brokers’ cap intro efforts are really just a marketing ploy to get your financing business, and in reality add very little to the raising of capital.” One niche fund manager laments: “Prime brokers are only going to introduce strategies that are already popular to prospective investors or that have had a recent run of good returns. They don’t want to look stupid. It’s too selective.”

Similar opinions were echoed by almost all the hedge fund managers Euromoney spoke to for this article. It should be noted, though, that Goldman Sachs, UBS and, in Europe, Credit Suisse, were praised for their approach to capital introduction.

But are hedge fund managers expecting too much from their capital introduction providers? Capital introduction does not produce profits for prime brokers, and is also hard to boast as a differentiator to attract clients. And cost pressures are mounting for prime brokers as the market becomes more crowded and as hedge fund managers seek to use a smaller number. The Tabb survey finds that 13% of hedge funds used six or more prime brokers in 2005 but only 6% are using that many this year. Eighty percent of hedge funds use just one or two brokers, and 13% use between three and five.

Prime brokers complain that hedge fund managers don’t understand capital introduction and often wrongly assume that it equates to capital-raising. “Cap intro is often misunderstood. It is a dating game,” says Ali Hackett, co-head of global equity finance (prime brokerage) at Citigroup. “A prime broker will have a database of investors with requirements of the hedge funds that may interest them in terms of track records, strategies, and size. They are then matched by a database of funds that match that criteria.”

A senior executive at a prime broker says that some hedge funds are irrational when it comes to capital introduction. “I’ve had managers come to me that have had returns of minus 20% and want to know why we aren’t introducing them to investors, as they desperately need more money. Some don’t have track records at all. Capital introduction doesn’t work like that.”

Prime brokers also have to be careful with capital introductory services for regulatory reasons. They cannot do more than act as middlemen, since they cannot be seen to be advising investors where to put their money. It can be frustrating for managers but Hackett says the service is still of value, especially if the cap intro team has access to many and varied investors, and understands fully what each investor is looking for, and what, in turn, each hedge fund is offering.

And how do capital introductory services differ among prime brokerage competitors? Barclays Capital, for example, decided not to offer capital introduction precisely because it didn’t view it as a differentiating service.

Credit Suisse, however, disagrees and says its capital introduction service is different from that of its peers. Philip Vasan, head of prime services at Credit Suisse, says: “We offer a highly filtered approach to capital introduction. There are some well-known conferences that some providers offer to draw in a large number of clients but we prefer to introduce our hedge funds and investors in a small setting where we’ve already screened both.”

That might be the case, but the problem with capital introduction is that it is largely reliant on the skills of an individual, and that individual’s ability to introduce funds to investors without overstepping the regulatory mark. It’s also an area of high staff turnover, says one consultant, so it is understandable that prime brokers find it hard to maintain an edge in the service.

Hedge fund respondents questioned for this article claim to have had greater success using third-party capital introductory services, or employing their own sales forces. It is questionable how much longer, therefore, prime brokers will be able to compete on capital introduction. “At some prime brokers, the London office might not know what the New York office is doing and vice-versa,” says one industry participant. “I have seen a London-based manager come to the US for a roadshow [organized by its prime broker] to raise capital and the New York-based cap intro people did not know even know who the fund was. It’s a mess and I only see it getting worse, with the cap intro role being phased out altogether [and left to third parties].”