What has changed in the prime brokerage industry? And what have you and your peers noticed over the past year?
The most meaningful development over the past year without a doubt has been the continued implosion of the formerly large European prime brokers as highlighted by the Credit Suisse debacle. Several issues have followed as a result. First, it’s created more anxiety for hedge fund managers, particularly those that aren’t the largest revenue generators at the bulge bracket banks. Second, though balance sheet demand didn’t change, availability has as that big bank went away, and it wasn’t going to be made up by the rest of the industry, certainly not by the big banks alone.
So, what does that mean? Hedge funds with smaller capital and balances have found themselves on the receiving end of difficult conversations with their bulge bracket prime brokers. As these banks absorbed the larger clients in the Credit Suisse shakeout, they’ve had to make room on their respective balance sheets by reigning in their balance sheet allocations elsewhere to make room for that. We and some of the other independent mid-tier providers have seen this manifest in a trickling down of clients previously the exclusive domain of the largest banks.
It’s also become evident that balance sheet has become more expensive. I don’t just mean in absolute terms because interest rates have gone up substantially over the past year, but more specifically because as some big banks have vacated the market, the remaining balance sheet that’s available industry-wide is now more valuable. Pricing has therefore firmed and there’s somewhat less sensitivity to pricing than there might have been 12 months ago.
What has that meant for Cowen specifically?
The industry fallout of the past year allowed us to gain traction with a group of funds that previously were principally aligned with bulge bracket prime brokers, most notably in EMEA. We continue to seek opportunities in these markets to help meet the needs of our clients and provide the resources and support they need.
In the latest survey, we’ve noticed a slight drop in scores across the market, not drastic, but notable. Do you think that’s a reflection of the unsettled environment or is there something else going on?
I think that has certainly played a role, particularly as it relates to capital introduction. It’s been a difficult year for the vast majority of funds to raise new capital and for start-ups in particular. That certainly has an impact on how managers might think of their service providers. This has been exacerbated in some cases by the funds’ own performance, but has nevertheless played into the perception that their prime brokers have not been as helpful as they could have been.
Looking ahead to the next 12 months or so, what do you and your peers need to be preparing for now?
As we’ve discussed, it’s becoming more difficult for funds to raise capital. The data’s mixed, with the aggregate amounts of new money flowing to fund managers remaining at decent levels, but the beneficiaries of those flows representing a rather narrow lot. In the past 12 months there have been some notable standouts, but they sucked most of the air out of the room, so to speak. The rest of the hedge fund sector really hasn’t had such positive experiences.
I think that we as an industry need to be prepared for that to continue. It’s not an inexpensive proposition to run a hedge fund business successfully and to institutional standards. With this in mind, we should expect to see more closings than we’ve typically seen historically, and that may further affect access to funding. Firms like ours will be looking to find ways to do more for our clients, so the services they’re receiving from us is more valuable, but not necessarily costing them more.
That’s been an ongoing part of our strategy. Whether it’s operational support, enhanced portfolio reporting, trading technology implementation and support, outsourced training, these are areas where we’re alleviating the need for firms to build out and maintain the capabilities themselves while providing them with high-quality alternatives with broad capabilities at a variable cost.
In short, while we have to be concerned with these macro tends impacting hedge funds, it’s crucial that we remain sensitive to our clients’ needs and committed to serving them as best we can with assistance in areas that are not just helpful in running their funds, but also mindful of their cost structures.
This has been an attractive pitch for us over the years, and particularly resonates in the current marketplace, particularly for start-ups. As a client, you don’t have to worry about some minimum revenue hurdles that we’re going impose on you that perhaps some of the big banks might, and you can pick and choose from the potential services we provide and incorporate them into the pricing we negotiate so they aren’t an incremental out-of-pocket expense.
For existing clients, what are the kinds of things that you think your clients are ready to offload from their internal systems to you?
Because of the skew of our historical customer base, we’ve always had a very strong trading relationship with the vast majority of our clients. That doesn’t necessarily mean they’re using our outsourced trading desk; it just means that they’re using our trading capabilities, whether they’re electronic or high touch, to effect a significant portion of their transactional activity. That’s something that does set us apart from the traditional prime broker, where the client relationship is for the most part a balance sheet driven one. Even in really good times for the prime brokerage industry, we’ve always generated a significant part of our revenues from transactional activity, rather balance sheet activity.
Then there are related support services. For example, we’ll do reconciliation work for clients and report on all the accounts they manage, even if they’re not prime brokered with us. That’s something that the big banks don’t do. Because we’ve embraced technology over the years that enables us to aggregate all of the client’s accounts, and present it to them in a way that allows portfolio managers to run their portfolio in aggregate and not have to think about how their positions are distributed across their various primes. That’s an important operational burden that we’re taking off their plates.
Much of the solutions we offer are operations functions that the firm might otherwise need to do internally. We’re allowing our clients to leverage the technology stack we’ve put in place to manage those processes and to ustilize our personnel who are proficient in that area to support them.