If you’re an advisor or manager, it might be worth your time to check out a new whitepaper out from CalALTs (formerly California Hedge Fund Association) titled, “Best Practices. Hedge Fund and Private Equity Operations” in conjunction with their AltsLA conference. The research dives into the complexity of the Prime Broker relationship for hedge funds. For futures firms, it’s simple enough to sub in FCM’s or clearing firms for futures firms.
If you ignore the redundancy of the word “continue,” the takeaway line that stuck with us, is:
“Continued management of these relationships…. will continue to be imperative.”
This is a full time job. We know. We do it full time for dozens of hedge funds, mutual funds, and family office clients (see here to learn how funds can ‘outsource’ this type of management). Indeed, the best practices paper has a few pages on outsourcing on just this sort of work.
The full text on broker relationships from CalAlts =
Prime Broker and Hedge Fund Relationships
Over the past several years, bank regulations under Basel III have been implemented with the goal of ensuring banks are better situated to absorb financial and economic stress, have improved risk management and governance and have improved transparency. The focus of these regulations has been to increase the amount and quality of capital required, decrease leverage and improve the liquidity profiles of the banks. These regulations have required the banks to take a sharp look at their balance sheet usage resulting in a focus on their prime brokerage units. Consequently prime brokers have been caused to evaluate their portfolio of clients in the context of various metrics, including but not limited to, return on assets and risk weighted assets. This has caused prime brokers to be less inclined to grow balances and take on new business but rather to run their businesses strategically to meet clearly defined long-term targets. This pressure on the prime broker units has directly impacted the hedge funds that utilize their balance sheets.
Each prime broker has their own unique client portfolio mix and risk and return profile and thus their own metrics of what makes an optimal hedge fund client. They also have their own unique suite of service offerings and operational capabilities. Likewise, each hedge fund manager has their own unique strategy, operational infrastructure, client portfolio mix and unique opportunities and challenges in managing their business.
The relationship of the hedge fund business and the prime broker is of mutual benefit. The hedge fund manager looks to the prime broker for certain services specific to their profile such as financing, securities lending, access to balance sheet, capital introduction, research, etc. The prime brokers now look to the hedge fund client not to use all of their services to the max, but rather to manage their use of balance sheet, financing and service offerings in the most efficient and profitable manner. Both parties spend a great deal of time working to understand how to optimize the relationship using the levers at their disposal to increase profitability while minimizing additional risk to their portfolios and their organizations.
Not to be lost in this analysis, both parties need to continue to keep counterparty risk in mind. It remains critical that hedge funds understand where their assets are held and continue to diligently monitor the financial health and stability of their counterparties.
In order to maintain a successful relationship, the hedge fund and the prime broker need to have transparent communication on what the primary drivers are for each side. These conversations need to be frequent and need to look at the holistic client relationship tracking all resource consumption and revenue generation.
As the prime broker and hedge fund businesses as well as the market and regulatory environments evolve, this will be an area of continual change. Continued management of these relationships and transparent communication will continue to be imperative.