Tier two or ‘mid-tier’ prime brokers are winning a significant number of mandates from hedge funds which have either been exited by bulge bracket primes or who are struggling to be on-boarded by traditional players.
Basel III capital requirements have forced banks to be more selective about the hedge funds they do business with. Liquidity Coverage Ratio (LCR) rules require banks to hold enough high-quality-liquid-assets (HQLAs) to withstand a 30-day market stress event, while Net Stable Funding Ratio (NSFR) provisions seek to reduce the risk of liquidity mismatches. Hedge funds, particularly those which adopt leverage and pursue illiquid strategies will become significant balance sheet costs under this new regulatory regime.
As such, prime brokers are exiting clients which do not bring in sufficient revenues, or those that have failed to grow or deliver decent returns. Several major prime brokers have terminated a number of hedge fund relationships over the preceding two years. Prime brokerage fees have increased as well. 41% of distressed debt hedge funds and 32% of fixed income and credit managers said their prime brokerage fees had increased in an Ernst & Young (EY) survey conducted in 2015.
“It has been well documented that larger prime brokers are restricted around the type of hedge funds they can onboard. As a result, mid-tier prime brokers, which may not offer a full suite of services – such as consultancy or capital introductions –or offer complete market coverage, are gaining business and growing. Many of these mid-tier primes will have lower fees and will not generally exit a client if AuM falls or fails to grow beyond $50 million or so,” said Peter Northcott, executive director at KB Associates, a hedge fund consultancy.
Failing to be on-boarded or being abruptly exited by a prime broker can lead to investors questioning a fund’s strategy. Scaling back the number of prime brokerage counterparties as well can also lead to awkward questions with investors who may express alarm at the potential counterparty risks. It is important that managers clearly articulate with investors about what is happening in the prime brokerage space to avoid confusion or alarm.
There are indicators too that mini-primes, written off several years ago as large banks sought to win as many hedge fund mandates as possible irrespective of AuM, are generating more traction. Mini primes are particularly attractive to very small hedge funds running less than $50 million, or those without an auditable track record. Many act as incubators allowing hedge funds to build a track record before soliciting capital beyond family and friends. Furthermore, mini primes will often have clearing and custody relationships with larger banks. In addition, fund managers including Blackrock are developing their own prime brokerage offerings too.
Investor attitudes to mini primes and mid-tier prime brokers are varied. “Early stage hedge fund investors such as high-net-worth-individuals and family offices recognise that smaller hedge funds may struggle to be on-boarded by a major prime broker and they are broadly content with them working with high-caliber mid- tier and mini primes. Some large institutional investors may have concerns about counterparty risk and balance sheet capital strength at some of these smaller primes and will prefer their hedge funds to use brand name banks. However, these institutions which include major pension funds and sizeable insurance companies, will typically not have small hedge funds in their portfolios,” said Northcott.
Equally, many hedge funds have found their financing being restricted or becoming more expensive as banks scale back. There was a belief that private equity or credit hedge funds may fill the void providing financing to other hedge funds in exchange for a fee. Proponents highlighted a fixed income stream through the provision of financing would bolster returns in what has been a fairly lackluster performance environment for hedge funds. Nonetheless, there are concerns these managers would not have the infrastructure of a prime broker to provide an effective financing solution, while it would require significant due diligence on borrowers.
“There was a lot of talk about hedge funds and some private equity managers who had yet to make investments providing financing to other hedge funds who were deprived of it. This was because alternative asset managers are excused from Basel III. In reality, I have not seen many alternative asset managers providing financing to hedge funds,” said Northcott.
Hedge funds have struggled to make returns of late, and have faced a number of regulatory challenges. Capital raising at smaller hedge funds has been difficult and highly competitive, particularly as seeding appears to have dried up following the decline of funds of hedge funds.
Northcott was optimistic though. “New entrants are starting to seed start-up hedge funds. These include other hedge funds and private equity, who will seed in exchange for equity stakes and revenue shares. While funds of hedge funds have retreated and consolidated, a growing number of consultants are exploring seeding as well. This ought to help managers hoping to raise capital and institutionalise,” said Northcott.