By James Williams – Given that around 90% of the hedge fund industry is dominated by smaller managers running between USD100milllion and USD1.5billion in AuM it is perhaps little surprise that smaller, boutique prime brokerage firms are holding their own against bulge bracket prime brokerages owned by European and US banks.
Banks are now under enormous pressure to strengthen their balance sheets under Basel III. As a result, their prime brokerage divisions are becoming ever more ruthless in terms of the size and quality of hedge fund managers they are willing to support. This is opening up a huge opportunity for younger non-bank owned primes like London-based Global Prime Partners whose modus operandi is serve the start-up and emerging manager market.
“In terms of total industry assets, 80 per cent are probably with the top 10 per cent of managers. That leaves 90 per cent of managers in the marketplace for us. From what I’m seeing, some of the bigger primes are moving even higher upstream and requiring higher minimum revenues and higher minimum sizes (in terms of AuM).
“I’ve heard of two large primes who have recently raised their minimums and that’s good news because it means potentially more business for firms like us,” explains Kevin LoPrimo, Global Head of Hedge Fund Services at Global Prime Partners.
Prime brokerage is a massively expensive undertaking. Firms need to have significant skin in the game to ensure that they have the full suite of trade execution, margining, securities lending, clearing and custodial services in place, as well as non-commoditised services ranging from capital introduction to market research, regulatory consultancy etc. In effect, this requires a significant IT spend.
One trend that seems to be emerging in the US, in parallel with the rise of boutique primes in Europe, is that of technology solutions groups moving into the prime brokerage space. One such firm is recently established Liquid Holdings Group. The Liquid technology platform has been developed to support start-up and emerging managers not only from an execution standpoint via its EMS/OMS solution, but also to provide pre-trade compliance controls, real-time risk monitoring and even shadow accounting; all of which is delivered on a cloud-based platform.
What technology firms like Liquid are doing is effectively pushing forward the evolution of the ‘mini-prime’ model, which has proved hugely popular in the US but has, in the view of Robert O’Boyle, EVP of Sales & Solutions, been a limited model.
This is because until now mini-primes have focused almost exclusively on providing execution support to clients by acting as the introducing broker to more established primes like Credit Suisse, Goldman Sachs etc. What Liquid is doing with its technology platform is expanding the level of support; trade execution is just one element. Providing best-of-breed technology solutions is the real value-add.
“We offer clients the standard prime brokerage services such as custody, margining, securities lending,” says Julia Bronson, who heads up Liquid Prime Services, “but in addition we will be able to offer clients LiquidMetrics. This is our real-time risk management system and will enable us to provide enhanced risk, performance and P&L monitoring. Our intention is to become the top service provider in the start-up and emerging manager space.”
O’Boyle adds: “The advantage is we were born in the cloud so we are able to offer our solution from a technology standpoint at an extremely competitive price. Liquid Prime Services was born out of our belief that there needs to be a full-service offering from front to back across managed services, technology and excellent trade execution: offering all of those services on a cloud-based platform is effectively what the next generation of hedge funds need.”
For any new manager, the costs of setting up a hedge fund keep rising. Having the ability to keep the IT spend to a minimum yet still receive high-touch support and, at the same time, know that the fund’s assets are being cleared and kept in custody by tier-one institutions is a significant advantage.
For smaller primes like Liquid and Global Prime Partners, developing relationships is the name of the game. Indeed, the two firms themselves have joined forces, with GPP now using the Liquid platform to extend the suite of services – both during and after trade execution – to its clients in Europe.
LoPrimo confirms that GPP has broadened out its business by establishing clearing and custody relationships with BNY Mellon as well as Deutsche Bank, on top of existing relationships with Nomura and Kas Bank.
“Working with other service providers opens more doors for us and gives us more ammunition when we are targeting new managers or looking to open up other lines of business. A big way for us to get introductions to clients is via other service providers, including some of the primes themselves. We’re talking to a number of bigger primes right now who are doing their annual or bi-annual cull of the smaller end of their market and they’re saying to us ‘Here’s a handful of clients you should talk to because we’re offloading them’,” comments LoPrimo.
That aside, the firm has experienced extraordinary growth since it launched its prime services division three years ago. In year one GPP took on 10 clients only; this was intentional as the firm got up and running. In the last two years, LoPrimo confirms that they’ve added a further 70 clients.
“Currently, we have between 35 and 45 clients in the pipeline; we have literally priced 18 clients in the last few weeks and there are still another 12 yet to be priced. It is busier than I’ve ever seen it with respect to start-ups.”
What these boutique primes are doing is helping start-up managers achieve a degree of “investor and operational alpha” they would have no chance of achieving by going to a more established prime broker. And as O’Boyle says, it is not just about enabling execution for smaller hedge funds, it’s about offering a cost-effective one-stop-shop solution.
“If you look back at the mini-prime market it was all about enabling execution for smaller hedge funds and hopefully providing capital introduction. Today, with the evolution of the hedge fund marketplace, execution is no longer the endgame. It is about providing institutional-quality tools a hedge fund needs to grow their business in a scalable and reliable way.
“You can’t do that without changing the mini-prime model. We believe that being born in the cloud, providing best practices from a back-office standpoint in conjunction with prime services, is necessarily the new model because that allows us to fully support the rising demands of hedge funds in a cost-efficient way.”
Another US prime broker that is looking to leverage its existing capabilities and showcase them to a wider hedge fund manager audience, as opposed to only being associated with the start-up market as an introducing broker, is Concept Capital.
“We aren’t changing our capabilities but what we are doing is communicating that the capabilities we have are applicable to a much broader audience than the one that has historically been attracted to us,” emphasises Jack Seibald, managing member at Concept Capital.
These capabilities exist through its relationship with sister firm ConceptONE. Whereas Concept Capital Markets provides the standard prime brokerage services by connecting managers to tier-one institutions including JP Morgan, BNY Mellon and Merrill Lynch for clearing and custody, the focus of ConceptONE is on middle and back office work: portfolio and risk analytics, risk reporting on a T+1 basis and, increasingly, regulatory reporting solutions under Dodd-Frank and AIFMD.
As part of Concept’s evolution, therefore, the aim is to raise awareness among emerging and established managers that actually they can provide effective support for manager using multiple primes. Seibald explains: “If a manager is looking for a second or third prime, we’re probably an ideal solution for them. When they use different prime brokers they necessarily have to work with different systems unique to each prime. The issue becomes how to aggregate the portfolios and all of the trading activity into a single view from an intraday management standpoint, from a risk assessment standpoint, and from an aggregated reporting standpoint at end of day or on a T+1 basis.
“We can do two things for managers; firstly we can introduce them to one of our clearing partners as an introducing broker; secondly, and perhaps more importantly, we can do aggregation using our portfolio and risk monitoring systems. Let’s say you’ve already got a trading account with Goldman Sachs and you choose us as your second prime and we connect you to JP Morgan as the custodian.
“Every day we upload from those different accounts all the position activity and reconcile it in one system. All of the trade activity that the manager engages in during the day automatically feeds into the system and updates the portfolio in real time. This means the manager can view their portfolio from a risk and exposure standpoint in an aggregated fashion and, moreover, drill down to see exactly which assets are held with which custodian.”
Having a consolidated view, particularly when it comes to cross-margining, is something that other more established primes like Newedge are increasingly focusing on. This is particularly important given that Newedge is looking to diversify its expertise within the prime brokerage space – it has a long-standing reputation as the leading broker to CTAs – and support more equity, fixed income and FX managers.
“We have the ability to give them an aggregated view of their margining requirements both within the fixed income or futures part of the portfolio and beyond if they are trading other asset classes. Consolidated reporting is something managers are paying closer attention to,” comments Duncan Crawford, Global Co-Head of Alternative Investment Solutions, Prime Clearing Services at Newedge.
One of the keys to Newedge’s success, thus far, in Crawford’s opinion, has been the singular focus on each client. This might sound trivial but at the heart of every successful prime brokerage model is the commitment to relationship building.
“Managers have strong relationships with the team here at Newedge, we’re not a revolving door. From my perspective that’s a key strength of Newedge; when a client calls us they know we will bend over backwards to support them.
“Without that approach we wouldn’t have got to where we are today.”
Crawford says he is surprised that larger primes are culling their hedge fund clients, noting that “we can make money on smaller managers, even if they’ve only got USD20-30million in AuM.
“We built our prime brokerage platform on start-up managers and our consultative approach to those managers hopefully helped put them in the right direction to build a successful hedge fund. We speak to appropriately sized investors to help managers build their assets and reach critical mass to then take on institutional money.
“We’re not looking to make a quick buck from any of clients. We look to build a symbiotic relationship over the long-term.”
That’s not to say that Newedge is immune from regulatory pressures. Under Basel III, some strategies will need to be more closely assessed says Crawford, in particular certain fixed income, global macro and asset-backed security strategies “that are using a significant amount of OTC non-cleared trades”.
Trading. Reporting. Risk management: technology is helping smaller primes, who perhaps don’t have the same legacy issues as older and more established prime brokerages, connect more meaningfully and comprehensively to hedge fund managers. It is, perhaps, a sign of where the prime brokerage model is headed. But that’s not to say that people-driven solutions such as capital introduction will be overlooked.
As LoPrimo concludes: “We have family offices and FoHFs as well as some endowments coming to us saying, ‘We’re seeing some talent out there but we’re looking for more, what can you show us?’ and we’re providing the necessary introductions. We have, for example, established an agreement with a MAP provider where they are going to allocate to some of our managers and that will serve as an even greater incentive for new managers to come and join us.”