Running a prime brokerage operation in today’s market is a challenge, and it is about to become a lot harder from precisely January 3, 2018 when the Markets in Financial Instruments Directive II (MIFID II) becomes EU-wide law.
In addition to the core securities lending and financing services, prime brokers provide capital introductions and consultancy to hedge funds. Both utilities bring value to hedge funds, particularly during their early launch days. Consultancy is a useful knowledge tool for hedge funds trying to navigate an increasingly complex regulatory and institutional landscape whereas capital introductions give managers access to investors in intimate settings.
MiFID II, however, creates a problem for both of these add-on services through its provisions around unbundling of charges. In other words, the sell-side needs to be totally transparent in what it charges clients and this may require the prime brokers to disaggregate their charges and ban inducements.
Ancillary services such as capital introductions and consultancy will be construed as being inducements, or at least this is the position being adopted by the UK’s Financial Conduct Authority (FCA) and Germany’s BAFIN. This will ultimately force prime brokers to charge for consultancy and capital introductions.
"Under MiFID II managers are not allowed to receive any payment or benefit - anything of value really - from a third party in relation to their management services apart from certain limited ‘minor non-monetary benefits’ and, even then, only when they are of benefit to the fund and if there is no conflict and they are disclosed to the fund and investors. Everything else has to be paid out of the managers' own pockets. Prime brokers have yet to release their costings for capital introductions and consultancy. There is no first mover advantage for prime brokers to announcing charges for such services as they will probably get undercut by the competition subsequently," said Neil Robson, partner at Katten Muchin Rosenman.
The question then is whether hedge funds will pay for either service. “Most hedge funds believe that capital introductions and consultancy are inducements and will be looking to pay for these services separately out of P&L. Even so, the costs of prime brokerage consultancy and capital introductions relative to other affected services like research are minimal. But the position is not cut and dry as prime brokerage centres around financing and not trade execution, so a manager could reason that it can continue to receive the services without paying because they have not been ‘induced’ to trade more with the broker,” said Adam Jacobs-Dean, global head of market regulation at the Alternative Investment Management Association (AIMA), a hedge fund trade body.
Capital introductions has faced its own problems over the last three to four years. Some managers complain they struggle to raise cash off the back of capital introductions, but this is more symptomatic of the problems facing the hedge fund industry as opposed to any issues in prime brokerage.
"The prime brokerage model of capital introductions and consultancy is potentially under threat because many hedge fund managers are being squeezed on fees and costs. They may insist on moving to execution only relationships with their prime brokers. We have already seen a dramatic descaling in headcount at some of the prime brokerage consultancies," said Robson.
The costs of running a capital introduction arm have certainly increased as a result of EU regulation, most notably the Alternative Investment Fund Managers Directive (AIFMD). Non-EU managers not regulated under AIFMD face stiff penalties if they market to EU investors through any means other than reverse solicitation.
It has forced capital introductions teams to spend money on lawyers drawing up exhaustive terms and conditions for events held inside the EU where hedge funds and investors will interact. Many capital introductions conferences nowadays refer themselves as being educational summits as opposed to marketing events. "Prime brokers are very careful to describe capital introduction events as not being marketing," said Robson.
Some speculate whether the stringent terms imposed on AIFMD and cost implications of MiFID II may put an end to capital introductions, at least in the EU. There is certainly this risk, but some believe the prime brokers will reinvent capital introductions and digitalise it through some sort of disruptive technology.
Technology firms are already doing this. ALTX, for example, compiles huge amounts of data on hedge funds enabling investors to analyse and compare performance across managers. As such, it is likely that MiFID II will accentuate the digitisation of capital introductions at prime brokers.
Consultancy, however, is facing pressure from the big four. Having spun out their consultancy businesses amidst the conflict of interest fall-out from the Enron Scandal, the big four are now rebuilding them. In short, they are now competing with prime brokerage teams, and even recruiting from them. If prime brokerage consultancy is no longer “free”, hedge funds may look elsewhere.
Overall, prime brokers have had a testing few years. Hedge funds – collectively – have struggled to produce the returns which made them famous in their glory days, meaning prime broker revenues have taken quite a hit. Equally, many of the larger primes have had to fire a lot of their smaller, mid-sized or overly illiquid hedge fund clients due to Basel III capital constraints, and prioritise the biggest managers instead. The business rationale is understandable, but sacking any client can have obvious long-term repercussions.
There is also emergent competition to traditional prime brokerage via the custodian banks. State Street, for example, recently launched an enhanced custody service where it will provide leverage and financing to hedge funds. Some even wonder whether cash-heavy private equity houses could complement financing to hedge funds, although this is probably more unlikely. While MiFID II will not totally undermine prime brokers, it will make their job much more difficult.