Hedge funds and prime brokers: the party’s not over, but the venue changed

Once upon a time, before the world economy and financial markets turned upside down and leverage became a dirty word, prime brokers truly loved hedge funds. The capital introduction party was the place to see and be seen and the prime brokers couldn’t spend enough money. If private jets, Veuve Clicquot and five-star venues weren’t involved, something was wrong, as in you were in the wrong place.

And then came the sequence of events involving prime brokers that most in the industry know inside out, and the revelation that a word many were aware of but few had seen in action – re-hypothecation – reared its nasty, ugly head and changed the industry for good.

Almost three years on, the prime brokerage-hedge fund relationship is still very much intact, though changed for good. Indeed, according to a recent report by research and analysis firm Celent, the entire risk-tolerance paradigm has shifted to be more transparent and tolerant of multiple prime broker relationships – something investors now demand of hedge funds before handing them a penny.

The report, which was compiled with technology services company Broadridge Financial Solutions, focuses on the information technology aspects of the relationship, specifically operational processes and what prime brokerages are doing to expand and adapt their offering and IT infrastructure.

In other words, less cap-intro parties and more technology and systems that allow hedge funds to work across multiple asset classes and multiple platforms.

More specifically, the report focuses on what prime brokers are doing to retain and expand their roster of hedge fund clients, and what hedge fund clients expect of them in a new world where they are expected to deliver alpha at a lower cost and with less smoke and mirrors – and across more prime brokerage platforms, as the chart below shows.

Among the broader trends, hedge funds are expecting their prime brokers to provide an extended product and geographic breadth through one platform. “This is putting some significant pressure on the prime broker platforms that need to process asset classes and manage credit, risk and expo- sure, collateral, and margin across products and entities,” according to the report.

Prime broker clients are also expecting them to carry real-time processing and statuses, intraday business controls, and real time settlement and position status. On the flip side, prime brokers expect a high level of operational transparency and are now particularly sensitive to re-hypothecation risk.

Really.

What’s more, funds are requesting a clear segregation between the execution and the prime business of its provider, to avoid any information leakage and ensure that each of them earn business on their own merits – i.e. a stronger, more visible Chinese wall. The graphic below shows how hedge funds are moving from multiple primes to multiple asset prime brokerage platforms, according to Celent.

There is also a new focus on operational efficiency – something that makes sense given hedge fund investors now all but require a multiple prime-broker platform before even considering writing a check. Lost in the concept, however, is an increased reliance on workflow, reconciliations, reference data and exception management that can flow in between various prime brokerage houses.

And where prime brokers aren’t on the hook quite as much anymore for lavish parties that bring investors and hedge funds together in opulent splendour, they are certainly expected to continue creating “value-added” services – like providing consulting expertise on beyond-the-checklist things like HR, real estate and strategy.

In addition to capital introduction, of course.

The report focuses on the increased demands that all of the above are placing on prime brokers’ IT infrastructure – such as being able to accommodate hedge funds’ expectations of trade allocation, data aggregation and, as noted, multi-strategy and multi-market productivity.

And there’s more work to be done. While the report notes that 33% of hedge funds have been able to meet investors’ demands for more transparency post-2008, more than 40% of investors still note that real-time monitoring of re-hypothecated assets, segregation of assets and integrated reporting across all asset classes in a multi-prime and multi-asset trading environment is key – and still not entirely being done with the hedge funds they are either already invested with or kicking the tires.

What is clear from the report and certainly from broader anecdotal evidence is that the multi-prime model is considered by many institutional investors to be a “best practices” consideration for investing. The chart below confirms that hedge funds continue to expand their prime broker relationships to the multi-prime format.

The drawback is the cost and the time constraints that multi-primes can have on managers who need to find ways to gather data across multiple platforms.

Given the ongoing growth of the hedge fund industry as well as rebounding interest from institutions and family offices for alternative strategies, we highly expect the economics will convince prime brokers to beef up the IT and offer all the things that hedge funds need and want to satisfy their hedge fund clients, and more.

Because it’s pretty clear what will happen if they can’t or don’t.

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