Choosing Your Prime Broker

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(reprinted with permission from HFMWeek)

When setting up as a new hedge fund manager, one of the most important relationships to establish is that of the prime broker. With banks facing regulatory pressures in the form of Basel 3, many are re-appraising their client book to ensure that they are getting a suitable return on investment for the balance sheet they provide. Consequently, the first point for start-ups to focus on is to articulate what they will be doing with the fund they are planning to launch.

“They should have a well developed outline of the investment strategy, investment process and the type of portfolio they intend to run,” explains Jack Seibald, Global Co-Head of Prime Brokerage, Cowen’s prime services unit. “Will the fund employ a long/short strategy, or will it be a long-only, concentrated portfolio strategy that perhaps uses indexes or ETFs on the short side for hedging purposes? Many new fund launches of late are managed by long-only stock pickers. There’s nothing wrong with that, but the prime broker needs to know this from the outset in order to provide appropriate guidance on pricing.”

Having a clear plan can therefore make a significant difference to those service providers one is talking to as to whether they will want to do business having defined what potential revenue opportunities are on offer. Will the fund be using leverage? Will active shorting be employed? What will the fund’s gross and net exposures likely be? What might the expected portfolio turnover be? Will it be a fund that buys 12 names and trades them once a year, or one that trades 100 names and turns over the portfolio every month?

“Self-analysis is critical to defining what the service provider relationships will likely be. My advice to managers is that they talk with multiple service providers in each category, but only to do that once they’ve done the self-analysis part,” says Seibald.

What’s in a name?
Oftentimes, start-ups will blindly assume that they have to appoint Goldman Sachs to the fund because of the kudos that come with doing so. But as alluded to above, today is a completely different environment to a decade ago. Many of the bulge bracket firms have become far more discerning in who they do business with and have materially higher requirements (in terms of revenue threshold) when onboarding and engaging with new managers. The start-up has to weigh what his true options are in the marketplace, rather than just assuming that by going to the biggest names they will a) get an account open and b) even if they do, that they will receive the same level of service as a billion dollar client.

Best of both worlds
Which is where the introducing broker model has its advantages. Cowen runs a multi-clearing IB model and has clearing agreements in place with names including Goldman Sachs, Pershing (Bank of New York), Merrill Lynch (Bank of America). From a reputational and custody standpoint, this goes a long way to comforting institutional investors as it relates to asset protection and counterparty risk. “Legally and technically, they are your prime broker and custodian. It’s an alternative way of getting a relationship in place with one of the bulge bracket names without having to deal with them directly as a standalone client,” says Seibald.

Cowen’s prime services unit, on the other hand, provides all the client-facing services as it assists with trade execution, trade break resolution and settlement, corporate action resolution, facilitating information flow to the manager’s other service providers (fund administrators, auditors), and more. Not only does it provide a route to working with bulge-bracket counterparties, it also means that the client benefits from a high-touch level of service and the types of solutions that only a large client might expect to receive from a bulge bracket firm.Last fall, Cowen Prime Services extended its offering to London. Like in the US, Cowen Prime’s London platform offers European hedge fund managers securities lending and margin financing facilities, custody and trade execution services (both cash and synthetic), an outsourced trading solution, as well as aggregate portfolio reporting services.

Multi-prime model…?
When asked whether start-up managers should adopt a multi-prime model, Seibald suggests that it depends largely on the fund’s AUM. Some primes do not think too highly of the concept unless the manager is running a multi-hundred million dollar fund and is able to provide each appointed PB with a substantial level of business. “Splitting potential revenues across more than one PB is a risk diversifier, but it becomes difficult for smaller and mid-sized managers to do this as they lose the benefit of cross margining the portfolio.

They have to meet a certain level of business for two, three, four prime brokers, whereas holding the portfolio at one prime broker means the prime can be better rewarded while the fund’s cross-margining capability becomes more efficient. “We have the ability to open funds on the books of any one of our clearing firms, or all of them, in a seamless manner because we keep a set of investment books and records on each of our clients’ funds in Advent Geneva. If a client started with Pershing, for example, and their assets grew substantially, to the point where they wanted to add Goldman Sachs, they wouldn’t have to go and strike up that conversation. We could offer them that solution directly,” explains Seibald.

Aggregate reporting
Another benefit to using Cowen as a multi-clearing introducing broker is that, even if the manager is already established and wishes to appoint Cowen as their second prime brokerage relationship, Cowen will provide aggregate portfolio reporting; something that few, if any, primes will offer.”We will take electronic data overnight from a variety of prime brokers and custody banks and aggregate that data for each of our clients. We will report the aggregated portfolio regardless of where the rest of the fund’s assets are held, not just on the part of the portfolio that is held with us,” states Seibald.

When asked what he believes are one or two red flag issues that managers should be aware of before entering into an agreement with a prime broker, Seibald offers the following advice in conclusion:”The two red flags that we try to avoid at all costs is firstly the notion of establishing minimum revenue expectations. We want to understand a manager’s business at the outset and then decide whether to enter into a relationship or not. Establishing minimums, in our mind, potentially gets the new partnership off on the wrong foot. Or worse, it may establish the price at which the service is valued, thus limiting future revenue potential for the prime.”

The second red flag is overpromising on capital introduction. It’s the one thing that new hedge fund managers want most and is the one thing that prime brokers have the least control over. Regardless of how well their efforts, they don’t have the power to influence the outcome.”
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