Selection and Oversight

Throughout our interviews with hedge fund professionals, one observation in particular was often repeated: the relationship between prime broker and client has become increasingly “business-like”. Certainly, the drivers behind the recent increases in fees – the result of external factors rather than internal policy – have given primes reason to be hard-headed, and managers have responded in similar fashion. But although the prime brokerage environment may resemble a meritocracy, it does not mean that primes are being selected, dropped and/or saved based purely on quality of service.
September 2017

Report Overview

All change

As has been discussed, the prime-client relationship has endured a rocky few years. Monogamy has long been dispensed with and both sides are on the lookout for more attractive opportunities. Among the hedge fund firms surveyed for this report, more than 70% had in the last 18 months either replaced a prime broker, placed one on watch and/or reduced their balance (Exhibit 3.1). That a greater proportion had added one or more prime brokerage relationship (37%) than severed one (30%) suggests the multi prime model, if not the industry at large, remains in good health.

Exhibit 3.1 Analyst Note: 18-month period in question is from January 2016 to June 2017.

The undimmed power of tier one

One thing that hasn’t changed is the importance of brand. Despite the break-up of the duopoly and the improvement in service generally, hedge fund managers of all sizes are as keen as ever to ensure that at least one of their primes is considered ‘tier one’. Why? The advantages are twofold. Firstly, and perhaps most importantly, investors still consider a prime’s brand and reputation during the due diligence process. Funds may not need all the ‘bells and whistles’ of a tier one prime, but the perception is that investors still want to ‘tick a box’ when it comes to service providers, said the COO of one US-based sub-billion-dollar manager. Another interviewee suggested investors were being less flexible on this, not more. Tier one simply means fewer awkward questions.

Secondly, the primes at the very top are still considered to have a materially better service offerings than their peers. Managers HFM Insights interviewed were split as to the extent this was true. Most agreed that the very largest US primes had the most advanced technology plat forms and best-quality staff. As one UK-based COO put it, Goldman Sachs and Morgan Stanley have been in the game the longest, spent the most money and been particularly quick to strengthen their balance sheets in the wake of Basel III. They also offer the greatest range of services and the biggest cap intro events. Many managers will hire both in some capacity if possible – their combined star power and expertise (including tips for investor pitches) are worth the small risk of the two teams butting heads.

But HFM Insights also found a broad assumption that everyone gets a comparable service. Echoing the sentiments of several managers interviewed, one former top tier prime brokerage executive stated that the service had been commoditised, and the only difference was branding and the quality of staff a manager deals with. Mini primes, non-bulge bank primes and the firms that started as FX brokers advertise nimble, customisable services, and are no longer tied to limited markets, but have access to tens of thousands of assets across the globe. For many funds, there are no practical disadvantages from partnering with a mini prime and their benefits can be enjoyed in tandem with those of a tier one.

Who is in tier one?

Exhibit 3.2 offers a flavour of how managers perceive the industry’s main prime brokerage providers. Unsurprisingly, Goldman Sachs and Morgan Stanley occupy the top two spots. But greater insights can be gleaned from the spread below them. JP Morgan – currently the second-largest prime broker in the US and second-largest primes services revenue generator globally – was regularly cited during research interviews as a tier one prime and the only provider that could currently be considered in the same bracket as the historical duopoly. The survey results bear this out: JP Morgan received 80% of its votes for tier one, and was the only prime outside the top two not to receive any votes for tier three.

Other notable providers may have to wait before being admitted to the top table. Credit Suisse, Bank of America Merrill Lynch, UBS, Deutsche Bank and Citigroup all received tier one voting percentages between 65% and 40%. For most of the providers in the list’s lower echelons the consensus erred towards tier two, although all primes picked up votes across multiple tiers (12 providers received votes in all three). The survey’s results suggest only BTIG, Cowen Group and Global Prime Partners can be comfortably classed as tier three. Even then, all three received a few votes each for tier two.

Exhibit 3.2 Analyst Note: Respondents were asked to pick the tier (1-3) they thought best conveyed the status of a prime brokerage provider.

How funds are using tier one primes

This infatuation with ‘tier one’ has meant that, even as the industry shifts towards the use of cost-effective mini primes, managers of all sizes are doing their utmost to hold on to at least one tier one relationship. A London-based executive at one mini prime broker said their client roster was divided fairly evenly into three groups:

1) The cost-cutter 

Established managers that have dropped one of their multiple tier one prime brokers and added a mini prime for non-core services;

2) The go-getter 

Emerging managers that start out with one tier one prime and one mini prime to attract and appease investors while benefiting from less costly services; and

3) The no-choicer 

Smaller managers – emerging and established – who have decided or needed to sever their top tier providers in favour of multiple mini prime relationships.

Several smaller managers HFM Insights interviewed stressed the importance of having a tier one prime brokerage relationship early on in their lifecycle if possible. The COO of one sub-$100m US-based manager with one top-tier prime, one mini prime and one clearing account said he planned to add a second tier one prime as soon as it was economically viable. This ‘dual model’ would not only provide the firm with additional counterparty security – perceived or otherwise – but, more importantly, greater negotiating power on fees. It would become feasible to add a second tier one provider only once the firm hits AuM of $150m, he suggested.

Understand your ‘snowflake’

There is paradox at the heart of contemporary prime brokerage. On the surface, service quality appears similar. But also, each prime broker has a distinct style that needs to be understood in order for an existing client to get the most from the relationship or for a prospective client to be taken on. One London-based COO at a multi-billion-dollar manager put it succinctly: “They’re snowflakes.” Three notable ways this distinction can manifest itself are outlined below.

i) The blend of prime services that will generate revenue 

If no two primes are alike, the same can be said for hedge fund managers. Rules of thumb say that most primes will fight for long/short equity mandates and be less enthused by credit strategies and futures traders. But, with each manager’s trading style slightly different and each prime’s profit centre unique, mandates will mean different things to different primes. Understanding the combination of services, at the right levels, that will grab a tier one prime’s attention is vital to those funds on the cusp of being accepted.

ii) The relationship a prime services team has with its parent 

Most apparent at the bulge bracket banks, several managers HFM Insights interviewed had experienced push-back on certain requests or a squeeze on prices and service levels that were a result of pressure from on high. Some managers said they felt the prime broker was on their side, others less so. One interviewee said the prime services team at one US prime broker seemed to be in a constant battle with the wider division.

iii) The prime broker’s client service culture 

Before the credit crisis, the few primes winning business did so with a grin on their faces. After all, with every new fund expected to hit several billion dollars in AuM, and generate accordingly impressive revenues, it paid to keep clients of all sizes sweet. Today, though the relationship is generally more formal, the style of service varies by provider. Some tier one primes have a reputation for allowing service levels to drop in line with a client’s revenues, others are more forgiving.

Style drift – Goldman versus Morgan

When it comes to service culture, the notable dichotomy is Goldman Sachs and Morgan Stanley. Goldman’s reputation for being details orientated has helped establish the firm as the number one prime broker in the US, if not the world, but it has also had a knock-on effect in this era of austerity. HFM Insights interviewees bemoaned Goldman’s varying service levels and ‘small print’ costs. The COO at one UK-based sub-$100m manager said that at Goldman Sachs the “wining and dining” dries up when performance does, but not so at Morgan Stanley. “When we speak with Morgan Stanley it’s more about the relationship. When we speak with Goldman Sachs it’s a much more numbers-driven conversation.”

Goldman’s focus on the bottom line means smaller/emerging managers will experience the sharp end of this contrast. Both the prime brokerage industry’s top two providers have made a concerted effort to take on more emerging managers in the past 12-18 months, but HFM Insights research suggests Morgan Stanley is more “open-minded” when it comes to new clients: an executive at one mini prime said they were more likely to see Morgan Stanley competing for mandates than Goldman Sachs. There’s no suggestion of nepotism though. Indeed, Goldman partners launching their own fund are expected to generate revenues as quickly as all clients, a former executive said.

Morgan Stanley’s increased appetite for start-up funds – demonstrated by their lenient approach to revenue hurdles outlined in the last chapter – has coincided with rising mandate numbers at the firm. It saw a net increase of more than 100 prime brokerage mandates last year, well ahead of its nearest rivals (Exhibit 3.3). Between Q2 2014 and Q2 2017, Morgan Stanley added net 338 mandates globally, compared to 122 at Goldman Sachs and 73 at JP Morgan. How far this ‘cast the net wide’ approach translates to revenues remains to be seen, but those funds that do go on to become the industry’s next titans will, almost certainly, be on the bank’s books. 

 “At Morgan Stanley it’s more about the relationship; Goldman is more numbers-driven”

Monitoring your primes

In Europe, the spectre of credit risk loomed large in 2016. But if, as media reports suggested, Deutsche Bank lost nervous clients to rivals last year, it made up the numbers elsewhere (Exhibit 3.4). One fund of hedge funds manager HFM Insights interviewed said they were monitoring all counterparties of all underlying funds during that period such were the concerns about the risks spreading. Some funds using Deutsche Bank had closed relationships, others had reduced assets. According to HFM data, only UBS among Europe’s top three providers saw a net decline in mandate numbers last year. Deutsche Bank saw net declines in 2015, the year primes were reported to be dropping smaller clients; and 2013, the year managers and investors reacted to Basel III.

A bank’s CDS spread, then, is an important data point for managers monitoring their prime brokers. COOs at some of the more sophisticated managers will have ‘hard limits’ – numerical thresholds that when breached raise red flags – but HFM Insights research suggests most COOs take a ‘low touch’ approach, monitoring the CDS spread of a prime’s parent bank manually and intervening when it starts to deviate from the historical norm. Exhibit 3.5 demonstrates just why Deutsche Bank clients, and to a lesser extent Credit Suisse clients, were so concerned during 2016, and why all managers were nervous during the ‘Eurozone Crisis’ of 2011-2012.

There are two additional takeaways from Exhibit 3.5 worth noting. Firstly, the strong correlation in CDS spread between Morgan Stanley and Goldman Sachs during 2016 – the primary reason some managers are now taking a ‘one but not both’ approach to the pair, choosing to disperse counterparty credit risk by adding a less correlated European prime brokerage provider, such as Credit Suisse, often as a back-up or ‘paper’ prime. And secondly, the relatively steady numbers for JP Morgan over the last five years – likely a contributing factor to its recent growth in prime brokerage business. CDS spread, stock price, credit rating and – more recently – a Bloomberg score combing several factors, are all used by managers to monitor the credit worthiness of their primes (Exhibit 3.6).

Exhibit 3.6 Analyst Note: *Credit Suisse data only available from late 2014.

Ranking your primes

The data managers are using to monitor and compare primes is also being used to rank them. For example, many COOs at multi-billion-dollar managers will have reams of data comparing all their primes on a monthly or quarterly basis on cost, accuracy, timing and client satisfaction, giving them the ability to rank their primes overall and across multiple variables. These rankings can then be used to negotiate fees and improve service levels. This negotiating power is perhaps the biggest benefit of the ‘multi’ and ‘dual’ prime models for managers with several top-tier primes providing comparable services.

Hedge fund firms running managed accounts wishing to make use of such rankings for clearing brokers must do so indirectly. Here, managers disappointed in the performance of the clearing broker cannot make a change as the counterparty has been appointed by the investor. However, the concept of ranking still applies, albeit with an additional level. In this example, the rankings are presented to the investor who is then encouraged to replace the broker or press them for improvements.