The first quarter of 2018 saw prime brokerage revenues jump 20 per cent to USD4.9 billion for the largest investment banks according to a report from Coalition, which monitors the industry.
As the Financial Times wrote on 23 May 2018, this revenue boost was the highest in almost three years among the world’s 12 largest investment banks but signs of a sustained period of growth appear short lived. Volatility earlier in the year has not continued.
This is the fuel that hedge funds use to increase their trading activity – in so doing, increasing the revenues earned by prime brokers for giving up balance sheet. On the one hand, investment banks might be forgiven for thinking that prime brokerage is a fickle business, dependent on the whims of how much leverage and securities lending activity they wish to engage with.
On the other hand, during the longest equity bull market in history, US investment banks have strengthened their balance sheets and built a strong capital buffer. This has enabled them to reinvigorate their own trading desk activities and generate revenues independent from prime brokerage activities.
As Forbes revealed in June this year, the five largest US investment banks had a combined securities trading portfolio of USD1.53 trillion as of Q1 2018, up 15 per cent from USD1.34 trillion at the end of 2015.
This shows that proprietary trading is on the rise. But while prime brokerage will likely always remain a key part of investment banking, it remains to be seen whether US banks will choose to use more balance sheet, or resources, to support hedge funds.
One prominent global prime broker, who asks to remain anonymous, tells Hedgeweek that there is a limit to how much science can be applied to assessing the economics of hedge fund clients and the relative merits of their wallet size. “Relative to the size of our book, it’s not a material balance sheet investment, rather it is a resource in which we invest,” they say.
Technology is, nevertheless, being used by primes both large and small to help better understand their hedge fund clients and to try to better recognise where the value and the returns are coming from.
At the same time, technology is allowing the buy-side to compare the rates they are getting with their PBs versus the market and potentially discover new PB relationships that might better fit their business.
Some solutions look specifically at how PBs are ‘axed’ and whether they can find complimentary trades in the market. ENSO (acquired by ICAP in April 2016), for example, has become a matching engine and is used as another sales channel for primes, as well as a way for hedge funds to discover which primes might add value to their portfolios.
ENSO provides powerful portfolio analytics to the hedge fund and asset management industry. ENSO’s team of prime brokerage, asset management, technology and data specialists deliver identifiable and measurable operational insight on counterparty credit risk, collateral management, and portfolio financing and treasury functions.
The tier one broker quoted above believes that the single largest change to the PB model, which is still yet to be completed, is the focus on the use of balance sheet.
“There is an inward and an outward dynamic; to know what the returns are and to make sure clients understand those returns. That is strengthening the relationship and it is very important that they understand how you offer the balance sheet.
“The vast majority of clients make fine returns. A relatively small number run complex business models and returns are an issue, with dedicated finance teams focusing on that issue. Most clients would like to know their returns are fine,” he says.
Small independent primes like Wedbush play a vital role in the overall PB ecosystem where their capabilities tend to be more closely aligned to supporting emerging managers, and those running smaller, niche fund strategies.
“If I asked someone to send me a sample portfolio and I told them we could source all of their shorts without issue, they are probably going to be more confident about developing a relationship with us,” suggests Sean Trager, head of Wedbush Prime Brokerage. “Oftentimes, when a prospect sends you a potential portfolio he is very much reaching for the stars i.e. it is an ideal portfolio where he would like to be short X number of obscure names. And typically we are able to source that liquidity whereas a lot of our competitors would struggle to do so.”
Proficient market access, wedded to good market research, can lead to fruitful relationships with emerging managers who are more likely to trade obscure names to generate alpha because their size allows them to, without fear of the market moving against them. Over the long term, this gives prime brokers like Wedbush the chance to develop relationships with managers who might not be hugely profitable at the outset but could be at a future point in time, when their AUM has grown.
In that regard, prime brokerage requires patience and resource commitment.
To ease the burden of this, it is not uncommon for larger hedge funds to enter in multi-prime arrangements. This is important, from a diversification perspective.
Stuart Bloomfield is Managing Director, Head of Prime Services Sales, Scotiabank. In his view, hedge fund managers need to think about the geography of different prime brokers, and to try to select relationships that are less likely to be at the mercy of a changing strategy or commitment to the prime brokerage business-line.
As balance sheet is much more important a commodity for banks, it is necessary for managers to strike the right balance and ensure that each PB in a multi-prime relationship gets a sufficient slice of their wallet.
“The challenge managers have to solve is how diversification amongst their Prime Brokers might look – that is, how each of the Prime Brokers complements rather than competes against each other. Managers used to think in two dimensions, price and margin when allocating business but increasingly they have to consider a third dimension, whether the allocation fits with a Prime Broker and is therefore a sustainable arrangement. The addition of the third dimension means managers may need to compromise on price or margin efficiency to address a sustainability issue with a particular bank.
“Managers should get into the details with each Prime Broker to understand what business is a best fit and what their thresholds and metrics are around assessing clients,” adds Bloomfield.
Since the financial crisis, the old model of ‘divide and conquer’, where PBs onboarded all and sundry without necessarily worrying about how much value hedge funds added, has ended. US banks have worked well to bolster their liquidity ratios in response to regulation but European banks have lagged behind and are still working through issues.
Overall, the last decade has been a period of consolidation, causing smaller hedge funds to be jettisoned. Mini primes and small independent self-clearing primes have stepped in to fill the vacuum, taking on clients who would otherwise have nowhere to go.
This concerns some people who feel it should be hard to win any new business.
“The fact is, for many of our clients, if they didn’t work with us they wouldn’t have anywhere else to go,” states Trager. “That’s not ideal. Some online retail brokers have segued into the institutional community and do a good job but they aren’t a traditional PB; they moved into this space because they had the capital and the technology to do so.
“We are a full service prime broker: we do research, securities lending, we offer clients the chance to participate in syndicated deals and so on. Regulation has made it more difficult to be an independent prime and in my view, we can’t afford to have much more consolidation if we want to retain a free market.”
Some prime brokers pride themselves on offering stronger value-added services than others as a way to appeal to hedge fund managers availing of a multi-prime relationship. Winning new business is hard but retaining that business, and growing, is harder. When it comes to hedge funds, prime brokers don’t only look at monthly trade revenue activity and financing levels, they look at AUM growth. How is the manager doing? Are they attracting new investors? And if not, could this be a short-term relationship that offers little real value to the bank?
Capital introduction teams play a key role in this respect. It is in their interests to get their clients in front of the right investors. This requires understanding what investors are looking for in the first place.
Brett Yarkon is Head of Capital Introduction at Cowen Inc. Yarkon and his team spend a great deal of time speaking to allocators and getting a sense of investor sentiment, at a minimum on a quarterly basis, to support Cowen’s prime brokerage and outsourced trading clients. It is a highly tailored approach that one would expect at Tier One firms such as Morgan Stanley.
Looking at the last quarter, Yarkon says that continued allocator interest in private markets is making it harder for hedge funds to raise new assets. There is, he says, no urgency investing in hedge funds, unlike private equity funds, which might have a hard close.
“Everything is cyclical but with the inundation of hedge fund products, it has become a lot more difficult to raise capital,” says Yarkon. “From a pure seeding perspective, it seems the traditional sources of that capital have dried up to a certain extent. Speaking to an allocator recently, he said it is almost the luck of the draw; you need to have the right product put in front of the right investor at the right time. Also, there have been a few unusually large new launches this year, which took capital away from others who have been trying to launch a new hedge fund firm.
“If you’re speaking with an institutional allocator, like a FoHF, and they have a fully invested portfolio, even if they love a hedge fund manager’s product, that manager is not going to get money from them until they redeem from someone else.”
It often can be one in, one out, and that frustrates many firms trying to raise capital to get up to scale.
This reinforces the earlier point that prime brokers need patience when committing resources to hedge fund clients, especially newer and emerging managers. Not all primes will see the value in this and decide to focus on more established managers. It depends on the internal strategy and the level of support across the investment bank.
At Scotiabank, part of its growth strategy is to roll out Direct Electronic Access (DEA) in Europe to unlock partnerships with systematic equity managers trading Europe, whether they’re located locally or from other regions. This is a Prime Broker taking an organic approach to grow its market share, with a clear plan around the size of manager and type of trading strategies it is willing to take on.
“Historically our equity execution capability in Europe has been limited to care orders and this has somewhat restricted the hedge fund strategies we can service for our clients. By offering DEA, our clients will be able to send us a much higher volume of trades and choose from a suite of algorithms, depending on how they wish those trades to be executed.
“The off balance sheet revenue this rollout will generate will complement the traditional Prime Brokerage revenue and generate more compelling returns – an important trend for every Prime Broker,” explains Bloomfield.
Trager believes that new managers are likely to be more open to partnering with smaller primes who have a longer-term outlook and are willing to support them early on in their AUM growth cycle.
“Twenty years ago when I started in the business you couldn’t go to market without having a brand name prime broker on your offering document. Your marketing deck needed one to give it credibility, whereas now people are looking for a competitive edge.”
The larger primes must therefore remain aware of the changing mindset and priority set among millennial start-up managers who aren’t necessarily swayed by the kudos of a name as in times past. Bulge bracket primes will always remain focused on their top 10 or 15 per cent highest revenue clients, but continuing to tweak the business offering and commit resources to new talent should still remain part of their business strategy.
On the capital introduction side, teams like the one headed up by Yarkon understand that investors want to stay up to speed on the next best manager, as they look to adjust their portfolio holdings. In many ways, finding these new managers/ideas is of far greater importance than a cap intro team bringing them a roster of high profile managers they’ve already heard of and are familiar with.
“Our aim is to continually have conversations with investors on a quarterly basis in order to stay on top of investor trends,” says Yarkon.
“We always make sure to ask them if they’ve allocated in the prior 12 months, and if they have, we follow up with what strategies and types of firms they invested with. We also inquire about what strategies they’ve redeemed from, and what are they looking for now? Getting answers to these questions allows us to quickly draw a summary of what the allocator’s views are on managers, and if we start to see patterns of responses across different investors, we can start drawing conclusions about what’s driving investment decisions.
“We listen to what allocators are saying, figure out why they are saying it, and then take that back to our client base as a source of new guidance.”
As technology improves and the PB/manager relationship model evolves, it is not too much of a quantum leap to suggest that greater transparency – and a clearer understanding by both parties as to the economic value of the relationship – could help prime brokerage to become more profitable than ever before. Specialist primes could well trump the generalists, focusing on a lower number of key clients (regardless of AUM size) with a good Return on Capital, than using up balance sheet to support a wide number of clients; and potentially reducing the quality of returns.
“Our story is one of transparency, it’s what clients expect,” says Bloomfield. “We’re honest in our views with prospective and existing clients. Ten years ago, the Prime Brokerage financing markets were almost entirely opaque but increased competition and technology has enabled managers to become more attuned and ensure they are not overspending.
“It’s an important part of doing business today. The more you can be transparent the more it should lead to better, more sustainable business relationships based on trust.”
Yarkon offers the following advice to those managers evaluating their current PB relationship(s): “When you’re speaking to your prime broker and capital introduction team, you really need to be sure they understand what you do, and as importantly, have the ability to articulate that back to the right allocator audience. Also, get a good sense of who that allocator audience is.
“Manuy times, I see managers who have allocator idea lists from other cap intro teams that we know have no interest in their strategy or firm profile. Pick a prime broker whose cap intro team can put you on the path to getting in front of the right allocators at the right time.” n