The last decade has been a rollercoaster journey for the prime brokerage industry. Beginning in 2008 when hedge fund managers found assets and collateral stuck in Lehman Brothers, panic ensued and they endeavoured to spread counterparty risk across as many prime brokers as was feasibly possible. There were stories of sub-$100 million hedge funds jumping into bed with more than half a dozen primes. Having a single prime brokerage relationship was an absolute red flag for institutional investor due diligence irrespective of hedge fund size, although some have since mellowed. In short, the first few years after the crisis were not a bad time to be a prime broker.
This changed with Basel III, which turned prime brokers’ hedge fund clients from being a cash cow to a capital intensive strain on their balance sheet. The prime brokers had to de-risk, and that meant getting rid of unprofitable hedge funds. The purge was brutal, and many hedge funds were blemished by the experience. But prime brokers ultimately had little choice, and their books now comprise of respectable hedge funds or emerging managers showing promise. It also means hedge funds have reduced the number of prime broker counterparties instead concentrating their relationships with a small handful of providers.
But another challenge is emerging for prime brokers, and it is one the industry – certainly among the lawyers and a band of vigilant managers – feel is not being addressed. The Markets in Financial Instruments Directive II (MiFID II) will become law in eight months, and compliance teams at asset managers have been burrowing away trying to ensure their firms are ready. Most of the focus has been on getting the reporting obligations right, or putting systems in place to pay for brokerage research, rather than using dealing commissions as was the norm before. Unbundling is central to MiFID II, but what does it mean for prime brokers?
“MiFID II is pushing an unbundling agenda and it is clear that the sell-side including the prime brokers will have to disaggregate what they do in terms of their charges. The major banks are making assessments on this issue. The regulatory objective is that the sell-side must be totally transparent in what it charges, and this will apply to prime brokerage services,” said Bobby Johal, managing consultant at Cordium, a regulatory compliance firm.
Ancillary offerings at prime brokers beyond execution may include consultancy and capital introductions and reports suggest the UK Financial Conduct Authority (FCA) and Germany’s BAFIN want these non-execution related services to be identifiable. Inducement is forbidden under MiFID II and this is highly likely to apply to consultancy and capital introductions.But full disclosure of capital introductions’ costings as demanded by MiFID II may put off managers, particularly as some – especially smaller hedge funds – question the actual value of the service. “Unbundling under MiFID II will apply to prime brokerage. This means prime brokerage charges to hedge funds will be itemised and managers will have greater transparency over their service provider fees. The issue for prime brokers is that services like capital introductions and consultancy are very resource heavy, and may well be very costly for hedge funds. Some hedge funds may baulk at paying high prices for capital introductions and consultancy as a result,” said a chief operating officer at a London hedge fund.
Others agreed. “Capital introductions have faced a number of pressures due to AIFMD, and it will likely face further scrutiny on pricing as and when MiFID II’s unbundling rules impact them,” said Johal. That being said, capital introductions could become an online service thereby shaving costs and creating huge efficiencies. Many banks already have a strong focus and interest in disruptive technology, and capital introductions is an area where innovation could have an impact.
Some speculate, however, that these prime brokerage services could be classified as a non-monetary benefit. A list of what constitutes non-monetary benefits was identified in the Level two measures. An article by King & Wood Mallesons said this was classified as conferences or training, or “reasonable de minimis hospitality such as refreshments at such a conference or training course.” Many prime brokers would certainly argue that capital introduction falls into this bracket.
Capital introduction and consultancy at prime brokers have faced a number of threats over the last few years. The Alternative Investment Fund Managers Directive (AIFMD) introduced hugely restrictive rules on non-EU fund managers soliciting EU investors, which led some to question whether the capital introductions industry in the EU would survive. It did endure, largely as a result of clever lawyering which saw capital introduction events subtly rebranded as networking or educational forums. Lawyers strenuously insisted any manager-investor interactions facilitated by a capital introductions team be documented to avoid any regulatory issues.
The advisory businesses at prime brokerage themselves have faced challenges. As the Big Four sought to diversify their revenues beyond core fund structuring and tax advice, many jumped into hedge fund consultancy. Some of the Big Four have even hired high-profile executives from the prime brokerage world to complement their teams. The risk of MiFID II to prime brokerage consultancy is probably less pronounced as that will come down to competition on pricing. If a Big Four provider is significantly more expensive for a hedge fund than a prime brokerage consultant, then the latter will end up triumphant.