One of the most important relationships for any new hedge fund manager is with their chosen prime broker. This is who the manager relies upon for financing positions through margining, providing leverage, lending securities for shorting selling activity, clearing and settling trades. For prime brokerages within universal banks, such as UBS, JP Morgan, Citigroup, the level of support might also extend to fund administration and custodial services.
In essence, any prime brokerage relationship will be multifaceted and unique to each individual manager. In addition to “core” or commoditised services – such as those outlined above – prime brokers are increasingly focusing on value-added services. This could be to support managers by providing detailed research – something that firms like Newedge, who have a strong history in the CTA/managed futures space excel in - cross-margining solutions to support trading across multi-asset classes, not to mention the most popular service: capital introduction.
For today’s start-up manager, then, a prime brokerage relationship should not be viewed lightly. Increasingly positioning themselves as the “gateway” into a bank’s full range of services, prime brokers are a vital cog in the wheel of most hedge funds and can be integral to their long-term success.
Back towards the end of November 2012, Bloomberg hosted its annual Hedge Fund Start-up Conference in London. One of the panel discussions was entitled: Prime Brokerage: Core Services vs Value Adds. The panellists included: John Hindley, Director, Credit Suisse; Chrisk Farkas, Head of Hedge Fund Consulting-Europe, Deutsche Bank, and Jaeyung Kwon, Vice President at J.P. Morgan.
Some of the key points that start-up managers need to be aware of when selecting their prime broker will now be detailed.
Do you really need a Prime Broker?
Okay, this may seem an odd question but one of the biggest issues for start-ups is actually determining whether or not it is necessary to have a prime broker. Most assume that they do. Everybody has one, so surely I need one too? But it absolutely depends on the strategy and how that manager intends to trade. Will the mandate be European-focused, or global? Will it trade equities, futures, or OTC derivatives? What kind of investors will be targeted, and what will be the growth expectations of the fund? If a manager plans to trade plain vanilla government bonds and has no intentions of attracting institutional money, or overly rely on leverage to magnify returns, they probably won’t need a prime broker.
“The point is that for some people it could just be a custodial relationship where the bank is essentially warehousing positions and providing clearing and settlement services. Prime brokerage is like a V12 engine, but if you’re never going to take it out of second gear, then why even bother?” says Chris Dennis, Director, Prime Finance Team, Deutsche Bank.
Another key element that quickly becomes apparent at the initial discussion stage is culture: does that manager fit in to the culture of a particular prime brokerage, is there a good fit with the strategy? Not only is it vital that the manager feels comfortable, the prime broker itself has to be 100 per cent confident that it can deliver exactly what that manager needs. Understanding what’s under the hood, from both parties’ perspectives, is vital.
Now, assuming that the first discussion goes well and the manager chooses their respective prime broker, typically the start-up timeline in terms of getting the Prime Brokerage Agreement in place, will take anywhere between 15 and 20 weeks.
Within that process there are a number of components that the prime broker will help with.
The most important of these include: helping the fund select their service providers; establishing the Prime Brokerage Agreement; capital raising and marketing (which can stretch from day one to full launch and beyond), consultancy experts to get the right trading systems in place (this is separate from service providers and is focused on making sure systems work efficiently).
Running through every step of this process is the ability for the prime broker to understand exactly what the market is going to accept, from an investor’s perspective, with respect to the organisational set-up. It’s this on-going consultancy-driven approach that can add real value, and ensure that a new manager has got the requisite infrastructure (and people) in place.
Choosing Service Providers
One of the first things the prime broker will do is hand hold the manager and act as their trusted adviser in choosing the most suitable service providers. This might involve setting up meetings with tax advisers, lawyers, property administrators, insurance brokers, as well as fund administrators and custodians.
No manager wants to re-invent the wheel as they grow and bring on new trading strategies. Getting the selection of service providers right from day one can save a lot of trouble and expense further down the line. It is, in essence, a function of the strategy, and of the manager’s long-term aspirations. With this clearly defined, a prime broker can assist with navigating the odyssey of selecting all the right service partnerships.
“I think there’s an element where the prime broker can become the repository of best practices. In effect it becomes a benchmarking exercise. For strategy, “X”, typically these three options are the right options to be considering versus options 4, 5 and 6. No two managers are the same so there’s no cookie cutter approach,” says Dennis.
Establishing the Prime Brokerage Agreement
The exercise of drafting legal documents and in particular the Offering Memorandum is the remit of a law firm, but most prime brokers will have a teams of consultants to help understand the nuances of setting up a fund management company and relevant fund structure. An extension of the service provider support, a prime broker will help steer the manager towards the right tax adviser and law firm and can even help managers in the appointment of external independent directors to the fund’s board.
Aside from this, one of the most important documents that a manager needs to get in place, in addition to the Offering Memorandum, is the Prime Brokerage Agreement.
This details everything from margin agreements to leverage agreements, depending on the instruments that the manager will be trading, and is essentially a series of legal documents that encompass the relationship with the prime broker.
Market-wide acceptable limits are generally followed when it comes to setting out the parameters for margining and leverage, but again it depends on each individual client and ensuring that an open dialogue is put in train.
“Understanding the leverage requirements for the strategy, knowing what has been detailed in the OM in terms of the leverage to be applied, net and gross exposure limits: those will all help arrive at an agreed upon arrangement between the prime broker and manager on acceptable leverage, margining, liquidity,” says Dennis.
Crucially, then, any start-up manager has to be 100 per cent clear on the fund’s strategy and its expected execution process before engaging with the prime broker. Strategy type will play a huge role in determining acceptable trading parameters. For example, an equity statistical arbitrage manager trading thousands of small positions in large cap European equities will typically have higher leverage arrangements with their prime broker than someone who trades distressed debt assets.
Ultimately, the PBA is designed to protect the interests of both parties.
“The prime brokerage relationship should be a long-term relationship so there’s a degree of trust that has to be there from the outset. So it’s key for the manager to be as open as possible for the relationship to prosper. Internal risk teams that work at prime brokerages can, in effect, be an extension of the manager’s team.” adds Dennis.
Today, in addition to providing cutting edge research and supporting managers in other areas such as synthetic equities – not all prime brokers have what are referred to as Delta One trading desks which support this activity in markets where physical shorting is not possible – one of the most important “value-added” services is capital introduction.
This is where the prime broker introduces the manager to its global investor base (which typically involves cross-over with a bank’s wealth management/asset management divisions), the aim being to help a manager grow its AUM. Some investors will happily invest in early stage managers and won’t insist on a track record but, generally speaking, most managers need to earn their stripes first.
Over the years, however, the whole concept of capital introduction has become a lot more discriminatory.
“I would say that capital introduction has become a more limited resource on the Street,” proposes Dennis.
“The old school thinking where prime brokers would work with 30 managers, knowing full well that half of those probably wouldn’t survive beyond 12 months – their logic being that at least of the 15 remaining maybe five would likely become big fish – has changed. Resources are more constrained and prime brokers have to be more specific and pick their winners more carefully.”
There is no hard or fast rule on when or whether a prime broker will entertain the idea of introducing a new manager to potential investors. Whereas some primes will expect a manager to reach a minimum AUM threshold, more generally speaking capital introduction is a function of perceived growth trajectory. This ties back in to the idea that every prime brokerage relationship is long-term, not transient.
“A manager that starts at X and doesn’t grow to 2X is potentially less interesting than one who starts at 0.2X and grows to 5X, for example. A prime broker can be thought of almost as like a founding partner, which is why there has to be a close alignment in terms of culture and strategy from the beginning,” adds Dennis.
Those who fit the profile have the opportunity to benefit from client introductions, and potential tickets being written, thus accelerating the strategy’s assets and with it, provided performance is good, a manager’s reputation.
Systems and Technology
This is a complex area and one that often gets underestimated by most new managers. Regardless of how brilliant a strategy might be, if the systems aren’t in place to execute it the manager will fail. The Street has seen too many examples where a top-class stock picker has been hamstrung by the infrastructure.
Managers then, must ensure that due consideration is given to setting up the technology and operational infrastructure, from front- through back-office. The prime brokerage team can help by bringing what is essentially a project management service to the table, working with the manager to understand exactly what systems are needed, and then implement them. After all, these are people that have done it many times over for all different types of managers. It’s a service that perhaps doesn’t get the recognition it deserves. Especially because of the way investors’ expectations have changed.
“Post-Madoff, the investor is looking with a fine tooth comb at what’s in place. In this environment, the machines and systems used by a start-up really have to be tuned to an institutional-quality scale. You have to build that scalability on day one,” says Dennis.
A lot of start-ups think very short-term when in fact they should be thinking two, three, five years ahead and how they envisage the business growing. It is harder – and more costly - to readjust the trading infrastructure further down the line.
Partnership equal success
The most fruitful prime brokerage relationships are those where the manager is open-minded and willing to work as partners. Just like managers have to demonstrate that their interests are fully aligned with their investors – and the more skin in the game they have the better – so the same process applies to the prime brokerage relationship. Managers have to understand that to benefit fully from such a relationship a long-term mindset is applied. That’s what really separates “wannabe” hedge fund managers from the real deal. And with primes becoming pickier in terms of who they work with as the industry becomes ever more crowded, there’s little room for error.
“People have to think through their commitment to the business. Anecdotally, for every 10 meetings we have with potential managers, when we go through the list of things they need to be thinking about seven or eight of them reconsider,” concludes Dennis.
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