Sources of Tension

Amidst global economic turmoil, regulatory upheaval and increasing competition, the relationship between hedge fund manager and prime broker has become as much a source of tension as it has one of revenue. Prime brokers are being squeezed by rising operational costs and a reduced ability to lend, with hedge funds feeling the after-effects. As a result, the context in which these tensions have developed is an important ingredient in any remedy for the ills in the relationship, and is the natural starting point for this report.
September 2017

Report Overview

Drama and upheaval

The events of the past five years have been as consequential as they have been dramatic (Exhibit 1.1), altering the prime brokerage landscape significantly. The popular narrative has been the disbandment of the historical duopoly, replaced by a new order of half a dozen or so prominent providers and a growing tail of mini-prime and prime-of-prime brokers. In reality, Goldman Sachs and Morgan Stanley remain well ahead of the pack, with only JP Morgan challenging their dominance in any meaningful way. But, for now at least, the prime brokerage business remains comparatively less concentrated.

The shift to multi-prime – an understandable response to Bear Sterns, Lehman Brothers and others leaving $65bn in frozen hedge fund assets – remains among the industry’s most significant recent developments, with more mandates up for grabs, but each one split between a greater number of primes. An HFM Insights survey of senior operations professionals at hedge fund firms found that about a third of respondents had added a prime brokerage relationship in the last 18 months. The mean number of prime brokerage relationships among respondents was just under three (2.6 when excluding platforms and other anomalies who tend to have more than five relationships).

Several hedge fund COOs interviewed by HFM Insights said the multi-prime model had been advantageous beyond simply improving counterparty risk, citing increased negotiating power over fees and service levels. Others lamented the added complications of splitting the wallet, as well as the added costs associated with layers of fees and multiple audits and marketing documents. If a fund is large enough to satisfy their many brokers, then all is well. For many funds, the common trend is to consolidate services with one prime and have a second on paper – a relationship on standby for when a credit event occurs. The other option is to use the secondary broker for secondary activity, such as overlays and FX.

Among the biggest beneficiaries of this need to diversify prime brokerage relationships have been the raft of mini-prime and prime-of-prime brokers to emerge over the past five years. These firms, such as Global Prime Partners and BTIG, have been targeting funds cut adrift by larger brokers, adding clients by advertising a cheaper and more transparent service. Technology platforms are a common means of delivery. Clients are also being offered access to different forms of financing, including peer-to-peer and corporate lending, as well as the balance sheets of big banks.

Unprofitable split mandates

Ultimately, though, the effect of multi prime on the industry has been an uptick in the number of less profitable ‘split mandates’ on a prime broker’s book (Exhibit 1.2). Credit Suisse is a notable component of this trend. Pre-crisis, the Swiss bank was a prime brokerage bit-player. Today it boasts the third most prime brokerage mandates globally behind the historical duopoly. But the bank’s strength is in its split mandates – 451 split mandates out of 495 in the US and 677 out of 793 mandates overall in Q2 2017. It is the third biggest prime broker by split mandates globally, but the fifth biggest by sole mandates.

Bank of America Merrill Lynch (BAML) and Bar- 8 9 clays may have a higher percentage of split mandates than Credit Suisse – BAML’s percentage of split mandates has grown from 68% in 2012 to 90% in 2017 – but the data and HFM Insights research suggests the Swiss bank is the secondary prime of choice, especially for funds looking for a top tier broker to sit alongside Goldman Sachs or Morgan Stanley. Credit Suisse is often chosen to add geopolitical diversity from across the Atlantic, as well as for the perceived strength of its balance sheet relative to other European providers.

As a result, the data can be misleading. Prime brokerage business is not as spread out as it may appear. Most of the COOs HFM Insights interviewed suggested that all providers now offer a similar level of service. But hidden in the multi-prime trend is the extent to which a prime is winning the profitable end of a split mandate or whether said mandate is a ‘paper mandate’. The nature of the multi prime trend, as well as anecdotal evidence, suggests far fewer providers are challenging Goldman Sachs and Morgan Stanley for the profitable ends of mandates than the data indicates.

Regulatory disruption

The reams of new regulation affecting hedge funds since 2008 has been clear to see – but some of the most disruptive changes have come indirectly via their impact on the prime brokerage industry. Deemed systemically important financial institutions (SIFI) under Basel and Dodd-Frank legislation, the bulge-bracket banks have had to recalibrate their businesses to comply with new capital ratios and leverage limits, the effects trickling down to prime brokerage units and their clients (Exhibit 1.3).

In Europe, leniency on rehypothecation compared to the hard 140% limit in the US has meant that European business has often been used by the banks to provide services that may breach US policy. But if the US prime brokers had appeared to be hit hardest, they were also the first to react. Goldman Sachs, Morgan Stanley and JP Morgan have been quick to strengthen their capital reserves. For European banks, the uncertainty surrounding their balance sheets has impacted on the extent to which they can compete for the profitable ends of fund mandates.

An uncertain future

The future still holds many unknowns including the fine detail surrounding regulations such as Basel III and Mifid II. The greatest difficulty of fee unbundling under Mifid II will not be the increased fees, but the change from one to multiple lines being reported. As will be discussed at greater length in the next chapter, investors are likely to decide what they do and do not want to pay for, leading to fees being transferred from the fund to the manager. Basel will restrict liquidity through the NSFR and LCR and the need to hold more capital. All of this will contribute to higher operating costs and a continuation of the difficulties hedge funds face.

The other ‘known unknown’ is the Trump administration’s desire to unwind much of the regulation brought in by the previous administration. The key areas that are likely to be af fected are lending limits and the reintroduction of prop trading which would reduce the number of hedge fund spinouts. Banks’ lower operating costs would see the largest prime brokerage clients push for a reduction in fees, but the majority of other changes would take longer to return. Mindsets have changed with regards the likes of rehypothecation. If such de-regulation were to take place, even an extended period of prosperity would be unlikely to bring about the wholesale return of old practices.

The search for profitable mandates

The largest prime brokers have started to concentrate on the real money makers. Funds of all sizes buying leverage and borrowing securities are key points of focus. Elsewhere, mandate size matters. Hedge fund clients running smaller or less profitable strategies have faced a drop off in service levels, requests for more revenue and/or the prospect of being dropped altogether.

According to HFM data that tracks the regulatory assets under management (RAuM) by quarter of the average SEC-registered hedge fund mandate, Goldman Sachs and Morgan Stanley are among the most consistent when it comes to client size, but sit in the bottom quartile of the group (Exhibit 1.4). This echoes anecdotal evidence that, despite the wider issues affecting the prime brokerage industry, the two banks have not been as quick to cull emerging managers as some of their peers, keeping the number of managers on their client list high and the average fund size relatively low (although it is again worth noting that this SEC sourced data will not include many European and Asian clients, who, as statistically smaller and less profitable, are more likely to have been culled).

Smaller primes, bigger clients

Even though their respective figures are relatively steady, Goldman Sachs and Morgan Stanley still increased their averages between 2013 and 2015 – the period during which the prime brokerage industry at large saw the biggest efforts to cull clients and strengthen balance sheets after Basel III was introduced. The biggest changes can be seen in the middle tiers as BNP Paribas increased its average client RAuM from $230m to $530m between the end of 2013 and the end of 2016. Deutsche Bank and HSBC also saw an upward trend, albeit to a lesser degree.

The only prime broker not to follow this trend was Société Générale. The French bank’s average client had an AuM close to $300m during 2014, the year it purchased CTA prime specialist Newedge. At the start of 2016 the newly merged provider saw its average client RAuM drop to $180m, the lowest among the 12 firms noted. This drop came despite an increase from 53 sole mandates in 2015 to 57 in 2016 and a cumulative fall in split mandates. By 2017, the firm’s average had climbed back up towards $300m.

Primes winning business in 2016

The strength of the largest prime brokers is their consistency in gaining new clients year-on-year. But with start-up pickings increasingly slim, the number of primes able to compete for the profitable end of a large new mandate have decreased. In 2014, the top five primes won 188 available mandates equalling just under $30bn in initial AuM. In 2016 – after effects of Basel III and the like had started to bite – the group won $19bn across 129 firms (Exhibit 1.5).

The bias is even more pronounced at the very top. Goldman Sachs and Morgan Stanley still enjoy their pick of the largest US launches (Exhibit 1.6). Along with JP Morgan, these three took more than 60% of available AuM in 2016. The middle and lower portions of the group, meanwhile, was awash with smaller, European mandates. Citigroup ranked sixth overall after taking four sizable tickets in 2016. The year previous it fell outside the top ten with two – again sizeable – mandates.

Elsewhere, the historical figures throw out three other significant insights. First, winning big in 2016 was not the same as winning big in 2014. Last year’s new business table topper, Goldman Sachs, signed with 36 clients worth almost $6bn. In 2014, Morgan Stanley won out with almost $10bn across 62 mandates (it should be noted that Goldman Sachs’s 2016 total was larger than Morgan Stanley’s table-topping 2015 intake).

Exhibit 1.6 Analyst Note: Recent AuM is most recent available from HFM Data and online research.

Regional differences

Second is the shifting balance of power among European providers. In 2014, HFM counted 12 mandates won by Deutsche Bank, all in the US. These mandates cleared $2bn, a figure that was almost halved in each of the next two years. Last year, Swiss banks Credit Suisse and UBS were first and third for new European client AuM (Goldman Sachs being second), with SEB emerging as a top-tier provider in Scandinavia, where several sole mandates have been won. Despite its high-profile solvency issues last year, Deutsche has retained most of its clients, even if balances have been reduced. Thirdly, the data highlights the increasing importance of winning US business. UBS, for example, won 14 more mandates in 2016 than Citigroup, 18 to 4, yet the US bank’s focus on regional business ensured that the AuM attached to those wins was larger.

The last 12-18 months have seen the largest primes, the likes of Goldman Sachs, Morgan Stanley and BAML, grow increasingly confident and begin to speculate on smaller funds once again, opening their doors to a select band of start-ups. They have secured their balance sheet, advanced their platforms and built up the capital available for redeployment, allowing for more risk to be taken than in the few years previous. One interviewee at a bulge-bracket prime broker said this was a concerted, strategic shift, very recently decided upon, within the bank. However, prime brokerage clients of all sizes remain under considerable pressure to earn their keep – as will be explored in the next chapter.