For investment banks, providing prime brokerage to hedge funds is big business. But the expanding industry comes with expanding risks, and corresponding regulator concern.
According to new research from Greenwich Associates, which interviewed 72 respondents in Europe, some 60 per cent of hedge funds use a prime broker. And, as Jesper Bang, head of prime brokerage at Dresdner Kleinwort, puts it: “When hedge funds account for up to half of the trading volume on the major exchanges, it comes naturally that investment banks are following that increased activity.”
According to Steven Cowcher, Dresdner Kleinwort’s head of hedge fund sales, there is a need for specialist advice as hedge fund strategies start to blur, and a chance for prime brokerage to move “up the value chain” from traditional cash financing. “For example,” he says, “increasingly, long-short managers are making allocations to private equity or adding an active equity element to their strategy.”
Broader relationship
Prime brokerage can also be a starting point for a broader relationship, as Michael Brian, head of equity prime services, Europe, at Barclays Capital, explains. “As a client type, hedge funds are interesting as they require lots of the services we provide and trade a broad range of products, and are often active traders,” he says. “They may also use investment banks to distribute their funds and more recently some of the large groups have required investment banking services.”
But does all this come at a price? Regulators have previously expressed concern about the systematic risk of broker loans to hedge funds. And, says Greenwich Associates, the banks themselves have been concerned about the concentration of counterparty and credit default risk, as well as overall levels of hedge fund exposure. According to the report, several large banks actually reduced the amount of liquidity extended to hedge funds for short periods over 2006.
The prime brokers insist that they are well on top of the problem. According to Mr Bang, a prime broker panel meets regularly to discuss concerns and regulatory developments with the UK regulator, the FSA, via the London Investment Banking Association. Moreover, he says, regulators from different countries have made the “extremely positive” move of talking to each other, “with a view to possibly harmonising some of the regulation and getting a more global view on hedge fund exposures”.
Of course, Mr Bang concedes, regulators are still afraid “that another LTCM could disrupt the global financial market”. But, he stresses: “They should find comfort in the fact that leverage levels are not nearly as high as in 1998, when LTCM collapsed.” The much-publicised blow up of Amaranth last Autumn is unlikely to have eased concerns. But, Mr Cowcher points out, “to the best of our knowledge no prime broker suffered a loss”.
Mr Brian argues that liquidity is better managed in the hedge fund industry than it was five years ago. “Systematic risk,” he explains, “appears where there is a disconnect between the liquidity offered by different parties in the industry. For example, if a hedge fund makes a large allocation in percentage terms to illiquid assets, but offers investors monthly liquidity, that’s a dangerous disconnect.”
The investment bank is concerned to make sure the term of financing is in alignment. “As a firm,” says Mr Brian, “we want to get as much information as we can about the assets being traded and the relationships our clients have with investors in terms of liquidity, to allow us to set the optimal margin and financing terms.”
Although Greenwich Associates reports a dramatic increase in the proportion of hedge funds who see willingness to offer so-called “haircuts” as key in choosing prime brokers, Mr Brian stresses that Barclays Capital, at least, does not try to differentiate itself by the amount of leverage it will extend.
As the market becomes increasingly complex, what can prime brokers do to differentiate themselves? According to Greenwich Associates, client service is still the most important selection criterion, closely followed by the financial/repo desk.
According to Neill Ebers, chief operating officer of Lionhart, hedge funds look for a prime broker with “good risk management control, good sound operational support and the technology, coupled with the right tools, to capture corporate activities.” Compliance will, he thinks, remain key.
Seeking a bargain
“Margin financing is important to us as well,” he says. “It is not because we are margin or leverage hungry, but because, if we have large margin excess across a portfolio, we can move into markets and opportunities when we see them becoming undervalued or cheap.”
Increased hedge fund use of derivatives has prompted another potential differentiator for prime brokers. Says Mr Cowcher: “Of course the hedge fund goes for breadth of execution capability across cash as well as derivative asset classes. An increasingly important buying criteria, however, is the ability of the prime broker to be able to administer their derivative positions.”
As prime brokers gear up to fight for a changing market, they have their eye on one set of clients in particular: the big players. Mr Brian explains: “At the end of last year, although there were around 10,000 hedge funds globally, the top 300 groups controlled 70 per cent of the money. The growth rate of the biggest hedge funds last year was on average 40 per cent a year in terms of assets. The battle ground for prime brokers is focusing on those larger group and they require very different services to five years ago.”
