Revenue Hurdles

In the years before the crisis, no-one talked about prime brokerage ‘revenue hurdles’ because there wasn’t any need. Managers were generating good numbers, primes had clients who were profitable already or going to be, and the only time the topic came close to being discussed was when a manager failed to make the cut for an exclusive cap intro event. Now, amidst a period of truncated margins and fierce competition, it is not just the elephant in the room, but part of the conversation.
September 2017

Report Overview

Price hikes for unprofitable clients

The impact of the new status quo is twofold: prime brokers have not only been reassessing smaller clients, but squeezing larger ones trading less profitable strategies and encouraging them to use instruments not as heavy on the balance sheet. That has meant more OTC derivatives and fewer security loans. Rehypothecation issues have also had a knock-on effect. The EU is yet to follow the US in introducing rehypothecation limits, but activity is relatively low, reflecting how politicised it has become. Several bank-backed mini and smaller primes do not rehypothecate, and bigger banks have started to phase out the practice, possibly before regulation rules it out. Such limits would increase the pressure on primes to seek revenue elsewhere.

Repricing has been an obvious solution for primes with clients running less profitable strategies. Many hedge funds wanting to continue in top-tier relationships have had fees on excessive cash balances increased, while clients primarily trading futures and synthetics are being passed on to execution-only brokers. A 2015 study from EY conducted in the aftermath of the Basel III revelations found that distressed securities funds saw a 41% increase in prime brokerage fees, while fixed income/credit funds saw a 32% increase, event driven a 26% rise and macro funds a 24% hike. Equity managers interviewed by EY appear to have been less adversely affected.

Primes ranked by equity

AuM Highly-leveraged long/short equity funds may be out of favour with regulators and investors, but those tipped to last are receiving plenty of love from their primes. According to HFM Data, Morgan Stanley leads Goldman Sachs in terms of equity client AuM, although both have significant leads on third-placed Credit Suisse (Exhibit 2.1). The duo’s grip on the industry may have loosened since 2008, but their strength in profitable equity AuM is evidence of their continuing influence. One notable difference between the two is Goldman’s superior global AuM, which when combined with respective mandate totals noted in the previous chapter suggests the larger average client of the two (Morgan Stanley’s bigger average in Exhibit 1.5 is likely due to the chart’s focus on Regulatory AuM and the bank’s higher equity AuM). Morgan Stanley’s leniency towards smaller managers will be discussed later.

Exhibit 2.1 Analyst Note: Ranked by combined equity AuM. US data collected in May/June 2017. Europe and Asia data collected in February/March 2017.

Below the top two, HFM Data suggests that Credit Suisse, JP Morgan, UBS, Deutsche Bank, BAML, Citi and Barclays are the only prime brokers regularly competing for profitable US equity hedge fund mandates. European primes are particularly well-represented in the lower echelons. The four smallest primes by client AuM in the group of 12 are all headquartered in Europe, while the bottom three by overall client AuM have a clear majority of clients running non-equity strategies out of Europe. HSBC has significant equity AuM, but all with non-US clients. By prime services client AuM, Credit Suisse is the European standout, well ahead of its institutional compatriot, UBS, and sits second overall.

Primes ranked by revenue

Prime services revenue rankings, however, tell a different story. Although Credit Suisse was the third biggest prime broker last year by overall client mandates and equity client AuM, it didn’t make the top six for revenue, sitting below both UBS and Deutsche Bank in a ranking compiled by Coalition (Exhibit 2.2). The Swiss bank’s strong numbers in European business and split mandates, combined with its apparent status as ‘back-up prime’ of choice, is, it seems, proving costly. The bottom three primes in the table of 12 are, again, all headquartered in Europe. Morgan Stanley has taken the top spot for each of the last four years – HFM Data suggests the US bank’s equity clients accounted for a significantly higher proportion of prime brokerage AuM than at any of its tier one and two peers.

In terms of revenue, JP Morgan strikes a sharp contrast with Credit Suisse. While the US bank ranked fourth by mandate numbers and fifth by equity AuM last year, it was the second biggest prime services revenue generator. Its success has been built, in part, on winning the profitable ends of US mandates. Prime brokerage executives interviewed suggested the largest US clients generate $10m a year and more in revenue for their primes, compared to $2-5m in Europe – and HFM Data shows that JP Morgan had the second largest AuM by US prime brokerage mandates in 2017. The bank’s success last year pushed Goldman Sachs back into third place in Coalition’s revenue rankings – after being usurped in 2015 – despite HFM Data showing it had about $100bn less in prime services AuM.

We need to talk about revenue

In the past, the topic of revenue hurdles would normally be raised indirectly, if at all. Numbers and details tended not to be discussed, the prime more likely framing it in terms of an indeterminable internal ranking for a client to aim for or a cap intro event they could no longer attend. Today, while the topic remains awkward, primes are not only more likely to broach the subject of revenues but to mention an explicit target. About 70% of the COOs HFM Insights surveyed said that they knew the revenue hurdle expected by their prime, while just over two thirds said it was something they and their prime had openly discussed (Exhibit 2.3).

 “Just over two thirds of the COOs HFM Insights surveyed said revenue hurdles were something they and their prime had openly discussed”

Other managers HFM Insights interviewed said they had a sense of their hurdle but preferred not to enquire further. “If they don’t bring it up, we don’t,” the CCO of one sub-billion-dollar quantitative hedge fund manager told HFM Insights. “That way the hurdle may not be re-evaluated.” This was not an uncommon response during interviews. Among survey respondents, a little under half of managers said they were ‘very confident’ that they were keeping their prime brokers happy (Exhibit 2.4). Firms with less than $1bn in AuM were more likely to rate themselves as ‘somewhat confident’ than firms with more than $1bn in AuM. Less than 10% of all respondents said they were ‘not confident’.

Revenue hurdle rules of thumb

Now that making a profit is harder, understanding your revenue hurdle has become integral to running a hedge fund business. But calculating it without the aid of a prime broker – if such a conversation is to be avoided – is difficult. A prime’s expectations will be dictated by its tier, as well as the size, strategy and track record of the client (the relationship less so for all but the largest and longest running funds), but other factors, such as a fund’s ‘vintage’, i.e. how it compares to funds launched during the same year or economic period, will also contribute. Below are a few contemporary rules of thumb.

1) Top tier prime / established manager

HFM Insights research suggests the biggest primes will expect to receive at least $300- 400k in revenue annually from their established clients. Funds not reaching these heights have been asked to write cheques for the difference or risk being dropped. One London-based COO of a sub-billion-dollar manager said that he wanted to pay their top tier primes at least $1m per year. “If you’re a single vehicle paying $1-2m per year or above, you are a top tier client,” he said. “$600-700k would be borderline”. Before the crisis, top tier primes had a host of larger clients generating at least $5m a year – failing to hit this figure could have seen a manager miss the cut for the industry’s biggest cap intro events.

2) Top tier prime / emerging manager

A significant shift in the past 12-18 months, top tier primes are taking more ‘bets’ on emerging managers, with several launching dedicated platforms. Typically, clients on such platforms are given three years to prove themselves profitable, after which modest minimum revenue targets dependent on strategy and vintage will be introduced. Several interviewees praised Morgan Stanley as being particularly flexible with regards smaller managers, with no talk of revenues and, unlike its tier one peers, no tail-off in service during less fruitful periods. The COO of a London-based emerging equity manager said one large European prime broker requested a $100k minimum from the outset.

3) Middle tier and mini-primes

Much depends on asset class and the age of the fund, but prime brokerage clients at the smallest providers are expected to generate at least $50-100k per year. Slip too far below $50k and profitability becomes an issue for even the nimblest of mini-primes. In terms of fund AuM, there appears to be a cut-off point of about $5m after which service levels plummet. One manager whose fund dipped below $5m AuM only saw service at his tier three prime resumed once they had received a top-up from the vehicle’s main investor tipping them back over $5m. Revenue hurdles “used to be the elephant in the room, but now it’s a frank discussion,” said an executive at one mini-prime broker. COOs of even the larger firms understand and appreciate an open approach, he added.

 “Revenue hurdles used to be the elephant in the room, but now it’s a frank discussion. COOs of even the larger firms understand and appreciate an open approach”

Unbundling fees

The way managers who engage with European investors or trading with European brokerage desks are charged for prime brokerage is also set to change, as fee unbundling under Mifid II is introduced. Not only are affected firms unsure what their itemised prime brokerage bills will look like, but how their investors will react if significant numbers are on the lines dedicated to so-called value add services, such as cap intro, consulting and research. Such outcomes would result in some uncomfortable conversations between manager and investor, and some similarly uncomfortable conversations between client and prime. In the era of unbundled fees, should the fund be expected to pay for all prime brokerage services? HFM Insights expects the developments in Europe to turn this question into a central issue globally.

What is the value of value add?

The knock-on effects of Mifid II are to be felt first by prime brokers’ hedge fund consulting teams, HFM Insights research suggests. Survey respondents asked to identify the most important attributes of a prime brokerage voted overwhelmingly for ‘Client Service’, while ‘Consulting’ and ‘Research’ received the fewest votes of all (Exhibit 2.5). Established managers are particularly unconvinced by the value of consulting, with one US-based COO suggesting that the knowledge base of most teams was too low to be of value to experienced hedge fund professionals. These teams “wouldn’t be your first port of call” for the types of questions they were created to assist with, he said. With relatively few chances still taken on emerging managers, consulting teams face an uphill battle to stay relevant.

 “Consulting teams “wouldn’t be your first port of call” for the types of questions they were created to assist with”

Few managers HFM insights interviewed expected primes to start monetising value add services, and yet, as fees are unbundled, monetary values will need to be assigned. Certainly, the value of cap intro is easier to calculate. Managers, however, are split as to its worth – less than half of operations professionals surveyed said they would pay for the service (Exhibit 2.6). The COO of one long-running US manager with about half a billion dollars in AuM said that he wasn’t convinced they were receiving a good cap intro service “even when he pushed for it”. He described the benefit as a fifth investor meeting if the manager had already secured four and was struggling to gain one more.

Home truths for cap intro

Managers know two uncomfortable truths about cap intro:

1. It is generally given to funds that don’t need it and not to those that do
2. It is self-serving insomuch that bigger clients mean bigger revenues

Primes know managers are aware of this, but if primes are only providing the best cap intro service to their best clients, and their best clients are best positioned to drive down fees, how will they price the service for smaller clients? The biggest effects of fee unbundling on the prime-client relationship will, therefore, be to expose the disparities between the two sides in the value they assign services such as cap intro, and to exacerbate the frustrations of those managers feeling underserved. Expect this issue to prove a key source of tension in the years to come.