European Hedge Funds and their Prime Brokers

European Hedge Funds and their Prime Brokers

A recent article by three Deloitte risk advisory executives looked at what European hedge fund managers value most in their prime brokers. The short answer: counterparty strength; good working relationships; competitiveness of fees; and the performance of core PB roles at a high level.

Let’s drill down a bit into the survey, reported on by Deloitte Partner Mark Ward, director Chris Farkas, and Assistant Manager Will Hindley.

There are five different segments of the European PB market. Listed from high-end downward, these are: the incumbent global players; enhanced custody businesses; specialists; introducing broker mini-primes; and a polyglot final segment that includes trading arcades, incubators, and enhanced brokerage accounts. The typical clients of a specialist PB will include asset managers looking for bespoke stock loans; market access or margining solutions; and some capital introductions. The typical clients of an IB mini-prime might include asset managers who have been forced off larger platforms, or who are unwilling to pay the larger PB fees. Those in the trading arcades, etc., are generally off the radar of hedge fund investors, so they do their capital raising via family, friends and word of mouth.

The incumbent global prime brokers represent 71% of the hedge fund firm/PB relationships the surveyors encountered, “which demonstrates their ability to provide services for hedge funds of all sizes.”

Ranking the Headline Factors

Deloitte developed a list of six “headline” factors that could influence a hedge fund manager to use one prime broker rather than another. These factors included the above-mentioned four, (counterparty strength etc.) as well as technology and franchise. Here, the reference to technology points to the ability to report sensibly and in a timely and customized fashion, as well as the ease of use of the systems involved. The reference to a PB’s franchise points to brand, the range of products and services it offers, its trade execution, etc.

Deloitte asked the survey participants which three of these six they regarded as of the most importance. Counterparty strength, core services, and fees were each ranked in the top three by 20% of the respondents or more. Relationship was ranked in the top three by 15%. The other two headline factors, tech and franchise, showed up on that elite list much less often.

If one asks: which is the single most important factor, rather than allowing a list, one gets a somewhat different ranking: counterparty strength and core services still come in first and second, but relationship comes in third (and “fees” comes in last).

To understand the importance of a good relationship between the asset manager on the one hand and the prime broker on the other, we need to keep in mind, write Ward, Farkas, and Hindley, that many managers see the PB operation as their “portal to the rest of the firm.” So outside of the core services, hedge fund managers may expect other services, such as sales coverage, block deals, research (analysis and company meetings), IPO access, etc.

How Many Prime Brokers?

Some managers (18%) have only one prime broker. Half that many (9%) have two. Nearly a third of those surveyed (32%) have three PBs. This leaves 41% saying they have four or more. The number of PBs possessed by participants in this survey goes up to seven.

There are lots of reasons for using multiple PBs—from the value of some of them as “niche” players, and the firm’s involvement in more than just that niche, to the expectation that the use of multiple PBs lessens counterparty risk, or credit risk, to the satisfaction of investor requirements.

There is inertia involved in a manager’s relationship with any service provider, especially a PB. Once adopted, such a relationship is not easily abandoned. Nor is it easy for a firm to adopt a new PB even if it is keeping all its existing PBs in the process. The survey respondents almost unanimously said that adding/dropping a PB is “a difficult process with potentially limited upside,” but one that they must be willing to undertake in the right circumstances.

Demographics of the Respondents

The respondents to the survey represented the full range of hedge fund strategies. The best represented strategy of the bunch was global equity long/short (23%), followed by Euro equity long/short (19%) and Euro event-driven (12%).

In terms of trading styles, the full range of possibilities was again represented. There was one high-frequency trading firm, and there were others with very slow turnover.

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