The prime brokerage industry has undergone a significant transformation over the last ten years, with little let up in the regulatory and economic turmoil. This report focuses primarily on the events of the last five years and how they have shaped the way prime brokers and their clients interact. Unusually, the agents of change during this period have been external forces rather than internal policies, which may help to explain why the relationship generally has not only become driven by numbers, but also unapologetically more formal.
In the first chapter, we provide the backdrop against which these changes have taken place, outlining the key events of the last five years and identifying those primes winning business in 2017 compared to 2012. This prompts an exploration of the contemporary multi-prime model, the uncomfortable reality for some providers behind the rise in split mandates, as well as the impact of various regulatory changes, such as Basel III and MiFID II. Some primes, it seems, are not doing as well as their numbers on mandates and AuM might suggest.
We go on to analyse how prime brokers aim to stay profitable, while also looking at which firms have secured the ‘best’ business, the size of these managers and which strategies they employ. We identify how the location of a prime broker affects their trajectory and where prime brokers, from differing locations, are likely to be headed in the near future. HFM Insights breaks down these trends and examines the key drivers behind them.
Interviews with hedge fund and prime brokerage professionals form the backbone for our research, shining a light on behind-the-scenes discussions. Once the elephant in the room, revenue hurdles are now an explicit part of the conversation, as are fees. We provide ‘rules of thumb’ on the level of revenue primes expect and the circumstances in which minimum hurdles are imposed. At some primes, their bark is worse than their bite. Several top tier providers are quietly showing interest in emerging managers again, with at least one offering extended clemency on hard targets.
The report’s final chapter explores the other factors driving the selection and deselection of primes, from a bank’s risk of default to the undimmed importance of having one, if not two, top tier providers. We identify those primes holding ‘tier one’ status, an unsurprisingly small group, albeit one with at least one notable absentee. Far from reducing their number of tier one primes, many managers are aiming for two ‘full’ relationships as a means to compare, rank and squeeze their providers on fees. External factors may be forcing primes to talk tough with their clients, but managers, too, are finding equally practical means to push back.
Rises in split mandates have papered over the cracks in some prime brokerage businesses
All notable prime brokers increased their proportion of split mandates versus sole mandates between the start of 2012 and the start of 2017, suggesting the multi-prime model has been picking up speed even after the initial post-crisis shift. Of the primes HFM Insights studied this year, all but one (UBS) had at least 75% of their prime services business in split mandates – two had 90% or more. The rise in split mandates also muddies the water in terms of who is winning profitable business, helping to explain why some primes have strong mandate numbers and client AuM, but relatively low revenues and middling reputations.
JP Morgan is a credible third option for managers seeking a tier one provider
Managers and, more significantly, investors remain as keen as ever for their funds to have ‘tier one’ prime brokers, meaning that even as service quality across the industry continues to improve, much core business has been hoovered up by the historic duopoly. Morgan Stanley and Goldman Sachs are winning swathes of new clients, the biggest new launches and, most importantly, the profitable ends of split mandates. However, they haven’t had it all their own way, with JP Morgan now a credible third option at the very top. Indeed, while the duopoly is not dead, the prospect of a new triopoly down the line isn’t out of the question.
Most managers know their revenue hurdle, and those that don’t, don’t want to
Close to 70% of hedge fund managers know how much revenue they need to generate each year in order to keep their prime broker happy, and a similar proportion have discussed it with their providers. But just because the topic is out in the open and likely to be discussed it does not mean that managers are comfortable with the new status quo. Many COOs are of a mind to ‘let sleeping dogs lie’. That is, if their prime broker hasn’t yet brought up the topic of revenue hurdles, they have no intention of jumping the gun. After all, doing so runs the risk that the current state of affairs will be re-evaluated in the provider’s favour.
Tier one primes expect at least $300-400k from their established prime services clients
Most brand-name prime brokers will expect their established clients to generate at least $300k a year in prime services revenue to maintain service levels, although tier one primes will be looking for closer to $400k. Clients failing to hit these targets will have their predicament flagged by their provider and, in some cases, be asked to write a cheque for the difference or dropped altogether. But even clients generating such revenues will be looking over their shoulders. For a manager to be comfortable in its relationship with a tier one prime broker, they will need to generate at least $600-700k a year, ideally over $1m.
Managers are questioning the value of their primes’ cap intro and consulting teams
Teams providing ‘value add’ services at a prime broker face an uncomfortable few years as new regulation and a cultural shift away from ‘relationship’ themed services threaten their relevance. Many European managers are nervous that their prime brokers are going to start allocating significant cost to the value of their value-add services, such as cap intro, as part of the unbundling of fees through Mifid II, promoting push back from all their investors. Managers are also questioning the value of consulting teams who, with fewer start-ups on the ground, will continue to thin out as resources are directed elsewhere.
‘Back-up’ status has seen Credit Suisse fall behind in the race for the top three
Credit Suisse has established itself as the top prime broker in Europe and, for a fair while, the third prime broker globally. However, its revenues in 2016 were behind those of several peers on both sides of the Atlantic, and its client AuM saw it slip back to fourth place in the US rankings. Many managers are using Credit Suisse as a ‘back up’ or ‘paper’ prime, a provider hired primarily to offer geographical credit risk diversification, sitting alongside, typically, US primes providing the core services package. Market hearsay suggests the Swiss bank may be back on the up following a successful reorganisation of its prime resources.
Managers are pushing back on fees by pitting their primes against each other
Those managers who can, are splitting their core prime business between two tier one providers who will then compete for the profitable ends of the book. This ‘full dual model’ is allowing managers to compare and rank their primes across a range of variables and drive down fees accordingly. Before a second tier one prime is added, a manager is likely to have one or two primes providing counterparty risk relief and/or additional niche services. Not every hedge fund firm has the asset class or AuM to implement such a strategy. Among those well positioned are long/short equity managers with at least $150m in AuM.
Movement last year in Deutsche Bank’s CDS spread had adverse effects elsewhere
Goldman Sachs and Morgan Stanley may still be the ‘gold standard’ with regards to prime service and status, but the close correlation in their credit default swap (CDS) spread has prompted some managers to take an either-or approach. This follows the issues at Deutsche Bank last year. The uptick in the German bank‘s CDS price spread saw several prime clients move assets from close relationships, although its mandate total at the start of 2017 suggests any regression in client numbers has been clawed back. A bank’s CDS is still the most popular means managers have for checking the health of their prime services providers.
Start-up funds are back en vogue, but some primes are more forgiving than others
Most larger prime brokers have started looking at emerging managers again after a nervous post-Basel III period spent culling smaller clients. Several providers have launched emerging manager platforms designed to cater for start-ups, each with premium services and minimal revenue requirements. However, the goodwill lasts longer at some platforms than at others. Morgan Stanley has built itself a reputation for being particularly generous with smaller managers, imposing no revenue hurdle or time limit, and ensuring service levels – and perks – are maintained when performance dips. Other primes will have notably less patience.
The findings in this report were based on three primary sources: research interviews conducted in person and over the telephone, a proprietary online survey, and analysis of in-house and third-party data. Research was gathered between April and June 2017. In total, more than 50 firms contributed to our research. These were primarily hedge funds represented by operations staff, as well as service providers and investors.
Several of the exhibits in the report use data from HFM’s annual prime brokerage surveys, produced by Absolute Return for the US (data as of April/May), EuroHedge for Europe (data as of February/March), and AsiaHedge for Asia (data as of as February/March). The calculation method for the US survey changed in 2017 to include additional AuM data from firms listed in HFM’s ‘billion dollar club’ rankings.