Fresh challenges for prime brokers in era of low leverage
By James Williams - For the prime brokers on whom hedge fund managers rely so much on, there’s not been a huge amount to shout about in 2011. Trading volumes are down and leverage is stuck at modest levels of 2.1x to 2.4x (compared to 4x leverage prior to 2008), despite record-low financing costs. It’s fair to say that 2011 hasn’t exactly been a halcyon year for prime brokers.
“Less leverage means lower balances, which drive prime brokerage revenues,” says Glen Dailey, Managing Director and Head of Prime Brokerage at Jefferies.
This is a business where margin levels are tested at the best of times, let alone those when political inertia in the eurozone conspires to push fund managers to the sidelines. “None of the managers that we speak to have been asked by their brokers to reduce risk,” explains Patric de Gentile-Williams (pictured), COO of FRM Capital Advisors.
Sovereign debt problems, and a ban on financial stock short selling by the likes of France and Italy in August led managers to begin shifting assets to other regions. Within this bearish climate, however, securities lending levels have increased. Two big trends have emerged this year. One has been the shorting of European government bonds and corporate bonds, the other has been a marked increase in shorting China stocks listed in Hong Kong.
Tim Wannenmacher, Head of Prime Services, APAC, UBS Hong Kong, estimates that there’s been approximately “a 20 per cent increase year-on-year in the bank’s Asian securities lending business”, noting that demand mainly has come from global equity l/s managers and, to a lesser extent, multi-strategy managers.
Although market volatility has been tough on money managers, Jefferies, the New York-based prime brokerage, has seen trading volumes spike at times this year. “As a broker, volatility increases trading volume so certainly months like August were record months for us from a transaction standpoint. Our business continues to grow and a lot of that comes from the transaction side, the commission side,” explains Dailey.
For China, there are a couple of reasons why shorting volumes have increased. First is the questionable accounting standards which led to stocks like Sino Forest getting hammered. Second is the risk of a China hard landing if the global economy slows down - bears like Jim Chanos have long criticised China’s burgeoning real estate market.
“Short sellers looking at China themes have to take into consideration where government spending policy is going. Sectors like industrial, technology, shipping, basically all the big macro-themed sectors that are affected by growth in the US and Europe – these are all potential targets for short sellers,” explains Dan Sofianos, Equity Finance Sales Trader, UBS Hong Kong.
Sofianos said that in some cases there’s been a fivefold increase in shorting volumes. “Within China’s H share market there’s been a concentration of interest from managers in financial firms due to tightening capital requirements and non-performing loans. We would say that interest in shorting financials is up 50 per cent on last year. The H share market is quite liquid so it’s popular with managers as a macro play,” he said.
Ben Sofoluwe, Head of Securities Lending, Deutsche Bank says the sector that’s come under the most pressure has arguably been the alternative energy sector, citing global macro concerns but adding that government subsidies, which commenced several years ago, are starting to expire. “It’s by far the heaviest shorted sector and we expect that to continue into 2012,” says Sofoluwe. By contrast, managers have been going long healthcare and utilities sectors.
Capital introduction has become an important value-add service to prime brokerages. Raising funds has been tough this year, and as with 2010, the trend continues to be one of assets flowing to the biggest and best managers. Recent figures by Hedge Fund Research show that net inflows this year are USD70.7billion. Nine funds alone have attracted 38 per cent of that money, with London CTA Winton Capital enjoying a 10 per cent slice of the pie. As Emma Sugarman, global head of capital introduction at BNP Paribas, New York, told Bloomberg succinctly: “It’s been a tough slog.”
Mairead Kenny, head of European capital introduction at Bank of America Merrill Lynch, takes a cautionary stance on these figures: “If you look at AUM numbers in the industry they vary from USD1.9trillion up to USD2.5trillion so it’s hard to ascertain precisely what percentage of inflows a hedge fund or hedge fund strategy is capturing.”
Certainly the industry is getting more polarised. There’s less career risk for institutional investors choosing established managers, it’s easier to get such investments approved by the board of trustees.
However, Kenny observes that there has been renewed appetite for start-up managers amongst FoFs and family offices, as well as a resurgence in seeding vehicles over the last 12 months.
“Mathematically, many allocators limit the maximium percentage they wish to be of a fund’s assets, so those that write big tickets need to allocate to larger funds. However, there’s also now a considerable number of tickets being written to smaller funds,” says Kenny, with Charlotte Burkeman, head of EMEA prime brokerage at Bank of America Merrill Lynch, adding: “They might write a ticket for USD300million so it’s hard for a small fund where you can only allocate perhaps USD20million. However, the number of tickets being written to small funds overall seems to have grown.”
The more a prime brokerage can leverage off existing institutional relationships, for example in private banking, asset management, and match them up to managers the greater is the potential for them to grow their assets. It’s a symbiotic relationship. Both the manager and broker have vested interests.
Although the start-up market has not traditionally been an area of focus, Burkeman says it is something that they are increasingly more focused on: “It’s definitely something we’re focusing on more because we believe it’s important to be there to support managers early on. This is increasingly true as many managers are now starting with a full compliment of prime brokers so the opportunity to be added later has diminished. We’ve won a good number of start-up mandates this year. The pipeline for next year is very strong and we’re working with several that we expect to start with USD500million+ next year.”
One of its newer clients is London-based Skyline Capital Management, a global equity l/s specialist with a specific focus on emerging markets established by Geoff Bamber and Vernon West last year. As the firm’s COO, Andrew Brown, comments: “Some prime brokers are better set up to deal with smaller funds and start-ups. We want to work with people that understand what it is to be a small but fast-growing fund management business. They’ve been excellent with us at every stage.”
As for where the smart money has flowed this year, Kenny notes that assets have been going to managers who can play volatility effectively. Those running global macro and CTA strategies have, like 2008, seen an upsurge in interest. “Quantitative strategies such as statistical arbitrage have also been doing very well and interest in them is at levels we haven’t seen for a while,” observes Burkeman.
Generating alpha is the key priority for hedge fund managers. To that end, they expect their brokers to provide market access solutions in order to gain exposure to hard-to-access securities, particularly in emerging markets. Consequently, synthetic prime brokerage (Delta One desks) is gaining in popularity. UBS’s Wannenmacher notes that the use of synthetic equities solutions continues to grow in Asia: “We’ve seen trading volumes growing for us as a firm but also for the market at large.”
Swap counterparties like hedge funds favour synthetic equities because not only do they enjoy the benefits of ownership, without actually having them sit on their balance sheet, but also because of the lower costs involved e.g. no transaction costs. Wannenmacher comments that if you want to be a full-service prime brokerage “you have to offer a seamless solution across synthetic and cash prime brokerage. Pre- and post-trade execution, securities lending and value-add services have to be exactly the same. They’re an integral part of our offering and there should be no obvious difference in terms of cost and availability.”
The only caveat to that is if the prime broker is unable to source the securities and needs to go to another bank, in which case trades are executed at slightly different prices.
Hedge funds push the envelope when it comes to finding the next best trading idea. As they look towards less transparent markets, the reliance on synthetic equities is likely to see more prime brokers ramp us these services.
HSBC Prime Services is doing precisely that. “We’re launching our synthetic prime offering in the US in January 2012 called Prime Swap. We’re conscious that 70 per cent of the world’s hedge fund assets are managed out of the US and a lot want to trade in Asia and Emerging Markets. With Prime Swap we can give them access to those markets,” says Chris Barrow, HSBC Prime Services’ global head of sales.
Wannenmacher observes, however, that market dislocations in 2011 have kept hedge fund managers in liquid markets where equity swaps are less necessary. “One of the lessons of 2008 is that hedge funds have become more rigorous with respect to liquidity management. Asset-liability management is critical and you only want to be exposed to less liquid assets if you have sufficient long-term capital and funding secured.”
Margins are a constant concern for prime brokers. Some, like Mark Harrison, EMEA Prime Finance head at Citigroup, believe the business, which was originated and run by broker/dealers, is, in reality, much more of an investment banking business. Long-term, that’s where he sees it ending up. And with strong balance sheets such a critical factor today, it seems a valid argument.
“There won’t be any dramatic change in terms of the eight or nine ‘major’ players, they will always continue to be in the business in some form or other. It’s a business that suits a bank more than a broker/dealer and that migration has started and will continue over time,” says Harrison.
JP Morgan acquired Bear Stearns’ prime brokerage business in 2008 and this year rolled out its operations in Europe. Teresa Heitsenrether, head of EMEA prime brokerage, is very much taking a long-term view and isn’t too concerned at launching the business in a year when leverage is down and balances are off.
She’s confident that conviction will return. When managers start putting money back to work “we’ll be part of the equation”. Consequently, there’s been no kneejerk reaction to get managers onboard quickly to scale up the business.
“We’re not worried. We have the strength of balance sheet that affords us to take a long-term view, we’re not under any urgency or pressure in that respect, we only want to bring on business that makes sense to us,” explains Heitsenrether.
HSBC’s Barrow adds that key revenue drivers this year have derived from custody, financing, stock borrowing and market access products.
As to what is the current challenge facing prime brokerages, Wannenmacher opines: “We believe counterparty strength and the ability to fund hedge funds in a stable and reliable way and access to the entire capital markets business are the most important considerations for choosing a prime broker today.”
He adds: “The demands on our services continually change in response to client needs, market regulation, Basel III capital requirements etc. It’s important as a prime broker to partner up with hedge funds you think can be important to you, and that you can be equally important to them. The prime broker is your access point to the entire firm – that’s the real value proposition to fund managers and one that UBS can offer.”
Heitsenrether echoes Wannenmacher’s point on funding: “I think capital and a strong balance sheet are going to be paramount because it’s those brokers who are going to be able to support activity and be there consistently on the financing side. The ability for managers to have access to balance sheet is going to be key.”
HSBC sees OTC clearing in line with Dodd-Frank next year (and MiFID II the year after) as becoming an important growth space for prime brokers. “We’ve taken the step towards anticipating future regulation,” says Barrow, confirming that an OTC clearing system was built in parallel with its Prime Services infrastructure to accommodate clients moving forward.
“Centralised clearing is going to be on interest rate swaps initially. I think we’re two, three years’ away from equity swaps being centrally cleared so long term I think we’ll benefit,” says Dailey.
Please click here to download a copy of the Hedgeweek special report: The Evolution of the prime brokerage model - Challenges & opportunities 2011
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