A Special Relationship

A special relationship

Originally published in the February 2005 issue

Would you invest in a fund that a. does not know whether or not they are paying competitive market rates; b. trades on a relationship that is simply due to the fact that members used to work at the bank in question, and feel some illogical, even misplaced, loyalty to that firm; c. dismisses costs with the immortal phrase "it's only basis points", rarely converting these basis points in to economic reality; d. is unlikely to have re-evaluated the terms of their original documentation and agreements; or e. is often unable to itemise and/or identify one of the largest costs they incur. If you can't measure it you can't manage it.

Intellectually, you would say no. Actually, you probably already are. The relationship that we are talking about is the one that all too often is described by hedge fund managers as "special" or "unique" – that of the hedge fund and their prime broker.

Investors frequently take comfort from hedge funds having one of the major prime brokers as their provider. Why? Having one of the established names as a prime broker does not safeguard investors. In fact, the legal documentation of some of the oldest providers of services actually protects the prime broker at the hedge fund's expense. In addition, it does not guarantee operational efficiency, it does not guarantee best execution, it does not even guarantee positions are correct and up-to-date – it is merely a business relationship between the hedge fund and the prime broker. The issues that should concern investors are the management, or lack thereof, of this relationship, and the operational processes in place within the hedge fund's back-office, which is especially important as the fund grows.

All too often the hedge fund world, a world that prides itself on having the sharpest brains in the finance universe, seemingly places enormous reliance on this relationship, whilst having virtually no knowledge or understanding of the largely operational functions of the prime broking arms of major investment banks. Maybe this should come as no surprise as fund managers typically had the operational backup before, as a proprietary trader within an investment bank, and just take that area for granted.

How do the Prime Brokers Do It?

The prime broking business hinges upon the belief of hedge fund managers that they are treated as "special" by their prime brokers and hence do not want to upset them. But how do the hedge funds know that they are "special"? The simple answer is that they do not; prime brokers have the luxury of operating within an opaque marketh with secretive participants and no on-screen pricing for the majority of services on offer.

Prime Broker Revenues

Over the past few years most investment banks have been scrambling to either get into the prime broking market or to further bolster their existing activities. A study by AndrewMcCaffrey, the Chief Executive Officer of Attica LJH Investment Management, estimated that investment banks derive as much as 20% of their revenues from prime broking with hedge funds. This is an average across a large number of banks and at one big prime brokerage player contributed at least 70% of the revenue generated by their global clearing unit in 2003.

It is difficult to identify prime broker fees as a percentage of assets under management because of all the different cash streams inherent within the business. This again aids the prime broker in their quest for profits as hedge funds would find it impossible to compare like with like. If one was forced to put a number upon it, depending upon hedge fund size, strategy, longevity and number of prime brokers, fees vary between 15 and 100 basis points of assets under management – quite a range!

Another attraction for investment banks is that this is not a cyclical business; prime brokers can generate a relatively constant revenue stream in any market conditions. Indeed it is estimated that there is a share in some $10bn in prime broker revenues up for grabs every year.

Who is to Blame?

Ultimately no one is completely to blame, nor is anyone completely blameless. We are not attempting to vilify prime brokers. They are businesses and have every right, and indeed need, to generate revenues. They provide a range of services without which hedge funds would find it difficult to survive. There is, however, a degree of opportunism given their counterparts do not have access to the necessary information in order to fully evaluate their services.

Nor can hedge fund managers be taken to task. Their problem relates back to the opaqueness of the prime broking world and quite often the internal structure of hedge funds that allows individual traders to determine certain transactions. Hence, even those hedge funds with multiple prime broker relationships often do not leverage off this and can be committed to the same transaction with different prime brokers at hugely different rates and levels. There is, however, a degree of contributory negligence whereby they do not strive to furnish themselves with as much information as possible.

How should the relationship be managed?

To ascertain the best approach it is useful to look at the services provided by the prime brokers. Among the basics are custody, clearing, reporting, securities lending, cash lending, execution and leverage. There are a plethora of other services on offer but the key profit generating areas for the prime brokers are lending stocks, lending cash, execution and swaps.

Stock Borrowing and Lending

This market has been prime broking paradise – unquoted, no widely accepted screen prices, and no industry standard spreads – in other words a licence to print money. Whilst it is true that borrowing fees have been significantly reduced over the past 10 years (reducing from an average of around 300bps down to below 40bps per annum) there is still significant money to be made. Lenders of the stock funds have seen fees reduce by an even greater degree, thus spreads have been maintained on much larger volumes.

"Stock Loan" is an area where the "special" relationship is particularly emphasised by hedge fund traders, as they believe that this gives them access to tough (aka "hot") stocks that they may not be able to borrow elsewhere. This may sometimes be true but don't kid yourself. All relationships are special but some are more special than others…

All too often it is left to individual traders to cover shorts. It is very common to see the same stock borrowed from different prime brokers at different rates. In fact it is not uncommon to see the same stock borrowed from the same prime broker at different rates.

The best solution for this has already been adopted by some hedge funds – a centralised borrowing unit. Some managers believe that the cost of this outweighs the potential benefit. This may be the case at smaller funds, but all hedge funds could introduce an element of control over this area. It is not difficult for any fund of any size to review all borrows within their portfolio as opposed to by individual trader. It is critical that this is done in an effective manner, it is not the rate that is all-important but also the size and duration of the borrow. It is also worth noting that at least two of the commonly used off-the-shelf inventory management and trading systems used by European hedge funds does not have the necessary functionality to calculate monthly stock-loan fees. Therefore, unless the funds using these systems have purchased or developed another way of calculating these fees, they can go largely unchecked.

Lending Cash

Both rates and margin requirements vary enormously between hedge funds. These variations quite often have no rhyme or reason but are purely driven by what the prime brokers feel they can achieve. Again, the fact that the hedge fund manager probably never had to worry about this before, and their reluctance to discuss their business with peers allows such disparities to thrive. All too often, the hedge fund manager only cares about the margin requirement if the fund is already highly leveraged, little realising that there is an opportunity cost to any such excessive margin requirements.

Swaps & CFDs

Once more the opacity of the market lends itself to these types of transaction, and the maximisation of prime broker profits. Spreads are often determined by how much the prime broker wants to deal with that hedge fund and the significance of his relationship with them, or whether they have more than one prime broker and are therefore kept competitive by a straightforward comparison. It should be mentioned that these products are easier to compare broker by broker than might at first be thought.

Is there a solution?

There is, but someone at the hedge fund in question must take ownership and be in a position to influence the hedge fund traders, who are usually personally invested in the fund and therefore wield considerable powerwithin the organisation.

Hedge fund managers must have an appetite for change and be prepared to challenge the rates being charged by prime brokers. All traders, including those at hedge funds, should always pursue best execution – whether pricing a basket of securities to purchase, or managing the fees they pay to their other service providers including prime brokers. Prime brokers know who and where they are overcharging and the vast majority are just waiting for the call to re-negotiate rates. The relationship is only normally damaged when a hedge fund makes unreasonable and/or frequent demands for re-rating. Even the biggest of hedge funds cannot afford to employ these bullyboy tactics

When a hedge fund is paying too much, this should be a willing decision. In return they should be demanding a better level of service from their prime broker. This is obviously very difficult to quantify because of client confidentiality clauses and the managers' innate secretive natures. Funds should be able to justify their decision to investors and be able to specifically highlight how they are receiving a better service.

Finally, is there any such thing as a "special" relationship?

Nine times out of ten, we would say no. The only real way to find out if the hedge funds that you would like to deal with are truly special is for an independent review of their prime broker relationship…but then we would say that, wouldn't we?

HedgeMasters LLP work with hedge fund managers to save money, using an innovative no-win, no-fee charging structure. We analyse operations and utilise our extensive prime broking knowledge to look after the costs, leaving hedge fund managers to concentrate on what they do best – trading. Quick savings are made in all areas; front, middle and back office. For further information contact – leemasters@hedgemasters.com sarahwilliamson@hedgemasters.com 020 7834 2794