It has been a long time coming, but the cumulative effect of post-crisis regulation is now starting to bite. Unfortunately, the consequences for prime brokers and the $2.86trn hedge fund industry they serve are substantial.

Gone are the days where a major investment bank bolted on as many hedge fund clients as they desired. The ground rules have changed and relationships are now viewed through an entirely different lens.

“The script is playing out with the major prime brokers saying ‘we are focusing on our core client base,’ which is code for ‘we’re re-pricing or throwing everyone over the side that makes sub-optimal use of our balance sheet,’” explains Chris Caruso, who founded Pangaea Business Solutions in 2012 after leaving Deutsche Bank.

It’s a unceremonious, yet honest, analysis of a situation driven by various bank regulations, particularly those resulting from Basel III or Dodd-Frank, which have imposed tougher restrictions on bank capital and liquidity.

The most notable effect has been on the smaller and more leveraged funds’ relationships with larger investment banks. On the flip side, it has given rise to new prime brokerage models including specialist, non-bank prime brokers offering various alternatives.

Return on assets

Pre-Lehman Brothers bankruptcy, small and medium (and even some large) sized funds typically had single prime broker; post-Lehman concern centred on mitigating counterparty risk so arrangements quickly morphed into a multi-prime model.

Indeed, Pangaea was set-up with the primary aim of helping hedge funds better understand and manage counterparty risk – but things have since moved on. “Post-Basel III is where we are now,” says Caruso. “Prime brokers, feeling pressure from their treasury and funding groups, have started evaluating their hedge fund clients based on return on assets (ROA) in addition to revenues.”

Hedge funds that are below the ROA hurdle rate are asked to restructure their financing balances, face price increases or even possible expulsion from the platform. Hedge funds, some now using as many as eight to ten prime brokers, are reportedly fielding daily calls asking them to shift positions and financing.

“Many of the large traditional prime brokers, in the face of increased regulation – increased capital requirements, added leverage ratios and minimum liquidity requirements – are now focused on target ROA requirements,” says Steve Sanders, executive vice president marketing & product development at Interactive Brokers.

“If a fund doesn’t contribute enough in financing, commissions, banking or other revenue, the prime broker assigns them low priority or may terminate the relationship with that fund altogether.”

Time to talk

Worryingly, Caruso suggests that “a majority of hedge funds” are in some state of denial or are not sure how to approach their prime brokers about the issue. These funds are putting off engaging their prime brokers in a conversation about their profitability and availability of financing. “Perhaps they’re hoping all is good if they don’t get a call telling them otherwise. No news is good news… sometimes.”

For some small and medium-sized funds it’s an issue of finding the time to analyse the situation and engage their prime brokers. There are already many other tasks that they cannot avoid; the urgent inevitably trumps the important.

Investors are also becoming more literate about the impact of Basel III on hedge funds and their prime brokers. “They are going to be asking where their funds stand with each of their financing providers,” Caruso adds. “Explaining that they have not had this discussion with their primes is not a good answer.”

Others, including John Laub, co-head of global prime services at Jefferies, says conversations with hedge fund clients are changing. “Even a year ago, there was still some confusion. One prime broker may have spoken to a client, but another hadn’t. Now it seems fully discussed and clients have more of a complete understanding across the board.”

Pretenders to the throne

Goldman Sachs and Bank of America Merrill Lynch have been streamlining their books for the past couple of years and Deutsche Bank and Credit Suisse have announced pullbacks more recently – but this should not be overstated. It is the traditional giants that still dominate.

For hedge funds that were launched in 2015, the top five prime brokers providing services were Morgan Stanley (36%), Goldman Sachs (35%), Deutsche Bank and JP Morgan (both on 13%) and Credit Suisse (12%).

Nonetheless, a new opportunity has undoubtedly presented itself to specialist prime brokers. Jefferies, Interactive Brokers, BTIG Prime Brokerage and Pershing Prime Services have all had a decent run of late.

Jefferies has been one of the direct beneficiaries of the big shuffle underway in prime brokerage, having attracted more than 400 clients. 

It is neither a mini-prime nor an introducing broker but more in the mould of a traditional investment bank, the likes of which used to be commonplace on Wall Street in previous years. It’s not deemed too big to fail – so will not be impacted by the Volcker rule or Basel III.

The firm’s “sweet-spot”, as Laub puts it, is emerging mid-sized managers with equity long/short strategies. “We’re able to be flexible and a much more complimentary counterparty at a time for hedge funds when the cost of doing business is increasing and the amount of business able to be done is being rationalised.”

Young guns

The shifting regulatory environment has also created opportunities for Interactive Brokers, says Sanders. “Many of the large, bank-owned prime brokers, which currently face balance sheet and other constraints are unable to profitably serve smaller clients.” Interactive Brokers, of course, “gladly accepts” business from these funds.

“Our business continues to grow as funds seek a new prime broker to meet their needs. We do not require revenue or AuM minimums to do business. We’ve automated risk management, account management, trade execution and pricing, streamlining our operation so as to be able to serve funds of all sizes.”

Convergex is another firm experiencing a significant uptick in business. It describes its model as combining boutique service levels and pricing with professional clearing and prime brokerage services, resulting in a package previously available only to the largest institutions.

“Over the past three to four years we’ve seen the hedge fund community embrace our model,” explains Michael DeJarnette, executive director of Convergex’s global clearing and prime services business. 

“There’s certainly no lack of demand for hedge fund services but the field is narrower from a supply point of view, which presents opportunities for firms such as ours. We’ve experienced 80% growth in client assets during that period – that is a sign of meaningful market demand.”

Other, lesser-known boutiques have also been gaining traction, including New York-based Maxim Group, which has attracted 75 clients since it was set up three years ago. Managing director Seth Michaels says it offers a full-service offering, strong financial condition and broad markets coverage.

“As an introducing broker, we also have no balance sheet usage. We work best with institutional and wealth clients, particularly the investment advisor space – individuals managing $200m with several accounts. 

Our broad relationship with Pershing allows us greater flexibility in terms of who we can service. Pershing, which has historically not been a big brand in the institutional or prime space, has been gathering a significant amount of assets and making great strides in improving the capabilities it offers.”

Technology

New prime brokerages are not the only recipients of new business – there is also a flourishing market in technological solutions for hedge funds looking to optimise their relationships.

Fidelity Capital Markets (FCM), for one, has invested in creating a tech-based solution. FCM set up PB Optimize in 2012 as a securities lending pricing tool for hedge funds – but it has since morphed into a more comprehensive service that is used by 100 of FCM’s 130 hedge fund clients.

“Clients can now use PB Optimize as a kind of financing order management system,” says FCM president Thomas Tesauro. “It helps them figure out not just the value of short and long positions, but the total value they have to prime brokers in everything they do, be that margin financing, cash reinvestment or short financing.”

Cash management is another area of technological development. New York-based HazelTree has built capabilities to help hedge funds, fund administrators and family offices. 

“As more banks become 100% compliant with Basel III, the pressure on hedge funds in particular to find alternatives for their cash — or face deposit limits or higher fees — will only increase,” said the firm’s chief executive Stephen Casner after signing a deal with Goldman Sachs Asset Management last December.

Who’s next?

While only smaller hedge funds have so far been affected by the retreat of established prime brokers, increasingly large ones will be forced to consider their options. 

As a rough estimate, houses in the $500m to $1bn range may not yet have been directly affected, but their time may be approaching. “I think they are starting to make plans and read the tea leaves,” says Maxim’s Michaels. “Although, if you’re a hedge fund with over $1bn, you’re probably in a comfort zone.”

So, what can mid-sized hedge fund managers do to maintain their existing relationships, if indeed they wish to? “First, find out where you stand. A good percentage of the larger hedge funds have started to do this and it’s a good first step,” explains Pangaea’s Caruso.

These funds are working to understand whether the profitability they offer measures up to balance sheet usage. If they find they are below the return hurdles they can considering shifting – and perhaps increasing – the mix of positions being financed and maybe even agreeing to a price increase.

“These actions, while important, merely ensure that they won’t get kicked out. But even if they can right the ship and secure their place on the roster it doesn’t mean additional financing capacity will be there when they need it. But it’s good to know if you are about to be culled from the herd.”