Mini-Prime Boom

Concerns over counterparty risk accelerate the move towards using multiple prime brokers, creating new technology challenges for smaller hedge funds-and new opportunities for mini primes. By Emily Fraser

The near-collapse of Bear Stearns in March 2008 and the bankruptcy of Lehman Brothers in September have put an intense spotlight on counterparty risk. Hedge funds that had swaps agreements with Lehman Brothers at the time of its collapse lost hundreds of millions of dollars, and some funds have spent months trying to retrieve assets that were frozen as part of bankruptcy proceedings.

To minimize the fallout should a big bank ever fail again, institutional investors are now demanding that hedge funds of all sizes use multiple prime brokers as a default setting, and smaller prime brokers-also known as mini primes-stand to benefit.

The move to multi-prime per se is not new. Over the past few years it has become a best practice for larger funds managing upwards of $1 billion of institutional money to use more than one prime broker. "Larger funds have between three and 10 prime-broker relationships, with the average being four or five," according to Chuck Molinary, managing director of Boston-based buy-side technology and operations consultancy Citisoft. But given recent concerns over counterparty risk, institutional investors are looking for a multi-prime strategy in smaller funds as well, and it is not uncommon for a fund managing $500 million in assets to use multiple providers, sources say.

Most hedge funds start out on a single prime-broker model, where the fund relies heavily on the prime broker for technology and reporting services. "When you set up a fund, you need a good relationship with your broker. You have limited leverage and it's an asymmetrical relationship-it's the only way to get off the ground," says Frédéric Ponzo, managing director of European consultancy Net2S.

But as hedge funds grow, and take on more complex and diverse trading strategies, or perhaps even trade overseas, they typically take on additional prime brokers to serve those needs. "Each prime has different expertise and, especially for hedge funds that were investing overseas, it was very typical that they would add another prime that had expertise in that region," says Peter Curley, managing partner at Nirvana Solutions, a financial technology vendor. They also diversify for competitive reasons, he says: "You want to have your primes compete for your business, and if your prime knows you've got two others waiting in the wings, they are going to be a lot more competitive."

Other advantages include having multiple sources of credit as well as the ability to split large block orders across different counterparties so that no one broker knows the fund's exact trading intentions, preventing the broker's proprietary traders from front-running an order. "In many ways it's an inflection point for the life cycle of a hedge fund," says Curley. "In the beginning their single prime gives them everything. Once they decide to go multi-prime that's when they become a business and that's where they have to build out their operations." 

WHICH BROKER

Exactly which firms these funds turn to when looking to add to their prime-broker pool depends on a number of factors.

Historically, hedge funds have preferred to have the Goldman Sachs of the world as their prime brokers. "You need firms with an underlying capital base that are willing to finance certain positions. The number one attribute in a prime broker that they are looking for is finance in terms of cash, or ideas, as well as securities finance in the form of stock lending. You need to have a certain balance sheet and tolerance for risk to be a player and you need an inventory of securities in order to be an effective securities lender," says Tim Lind, managing director, strategic planning at post-trade, pre-settlement services provider Omgeo. Naming the top-tier primes as a counterparty can also be helpful when raising capital.

However these big players are harder to enlist for smaller funds. "It becomes a profitability game," says Fredrick Scuteri, head of prime brokerage services at institutional broker-dealer Cuttone and Company, who has worked for bulge-bracket brokers. At many large firms, he says, "There is an optimal number of hedge funds that the infrastructure can support and the thought is that every time you add one hedge fund above that optimal number you diminish productivity and bring service levels down. There is basically a number that they gear to every year and when they add new larger accounts, it is the smaller accounts on the bottom that unfortunately don't make the cut and are asked to leave," he says.

Heavy losses and the need to sell assets because of redemption calls have meant that some funds have suddenly found themselves below the minimum threshold to continue doing business with the larger primes. "With the net asset value of holdings going down, some funds risk going below the thresholds for some primes," says Ponzo at Net2S. There are also reports that some of the larger primes have raised the threshold, increasing the minimum requirements for funds to become or remain their clients. For example, if a prime broker previously required a minimum assets under management (AUM) of $200 million to consider it worthwhile to service a hedge-fund client, they might now be hiking that minimum to $500 million. This will leave some funds on the lower end of the spectrum out in the cold.

There are many hedge funds that are too small to do business with the big players, but are still coming under pressure to spread their counterparty exposure. This provides expanded opportunities for the mini-primes, such as Cuttone and Company, or New York-based Concept Capital, which serve the smaller end of the market.

NEW CHALLENGES

Whichever counterparties a hedge fund chooses, adding new prime brokers brings new challenges. In a single broker model a fund can rely on that broker to provide risk overviews, reconciliations and so on. But when there are more counterparties it gets more complex.

When a fund adds a second prime broker, there are now two relationships to manage instead of one. This effectively doubles the day-to-day operational burden, as well as adding new challenges that a fund does not encounter with a single prime-in particular that of aggregating positions and data from both providers in order to give a universal view on risk and performance. "You also have to determine an allocation strategy," says Omgeo's Lind. "You now have accounts at both primes and have to determine on any given trade how to allocate that trade to multiple providers, when before allocation wasn't really an issue because it was always the same bank," he says.

How well a fund deals with new challenges depends a lot on how technologically sophisticated it was before the move to multi-prime. "If they are a shop that has an order management system (OMS), an accounting system, a fund administrator, most of those products and services already support multi-prime. It's the smaller funds that are still managing their funds out of Microsoft Office and have a lot of manual processes that will have a problem," says Joseph Amarante, senior vice president of professional services at technology consultancy NorthPoint Solutions. "If they don't have systems that will do position consolidation, cash management, reconciliations, and things like that, it becomes more difficult for them to handle going to a multi-prime model as opposed to a fund that already has a well-established operations and technology platform," he says.

NorthPoint Solutions provides data aggregation tools to hedge funds that do not want to make a large investment in technology products, but need a way to consolidate their data. They typically build a custom-made tool that pulls in start-of-day files from the fund's brokers and consolidates these into a staging database. They present this data either in the existing Microsoft Excel platform or a very lightweight custom-built platform that enables the fund to do position, risk, and cash management out of the box, says Amarante.

For those funds that are unwilling to invest in technology, a fund administrator can be a natural aggregation point for trading, risk and accounting information, Omgeo's Lind says. Those funds that do not already have a relationship with a fund administrator and are ill-equipped or unwilling to invest in the new technology that is necessary to manage that aggregation will likely seek to outsource it to a fund administrator, he says.

A fund administrator also provides asset valuation and partnership accounting, which are attractive to institutional investors that have become jittery following the $50 billion Bernard Madoff alleged Ponzi-scheme fraud. "Having an independent and neutral administrator to determine the valuation of the assets-I think that is going to be a big selling point for hedge funds that need to attract new institutional investors that have gotten burned as of late," Lind adds.

Other funds instead choose one of their prime brokers-usually their original one-to provide heresay reporting, effectively acting as a prime-of-primes, aggregating all the information for them, says Amarante. This provides the advantage of centralized reporting, but means funds still have the disadvantage of having one prime broker that knows all of their positions, he says.

Furthermore, the appeal for a prime broker to serve as a prime-of-primes dwindles the fewer total assets they service. The more prime brokers a fund takes on, the smaller the piece of the pie each broker will ever see. "From a bulge-bracket perspective, if you are a $100 million fund and a broker is only priming $10 million of your assets, to them you are only a $10 million fund. The larger guys want all the assets, and having smaller subsets isn't efficient and is a drain on resources," says Cuttone's Scuteri.

NEW OPPORTUNITIES

Mini primes, such as Cuttone or Concept, that have traditionally served smaller funds see significant opportunities from the move of smaller funds to multi-prime, in the realms of both prime brokerage and technology. Both these firms have launched or are in the process of launching new technology platforms in partnership with Nirvana Solutions to help smaller funds deal with the challenges of going multi-prime. Delivered on an application service provider (ASP) basis, these tools provide portfolio management (PMS), OMS and execution management (EMS) functionalities. Funds can use as many or as few of these components as they need-for example if they already have a satisfactory OMS they might just look to use the PMS function in order to get an overview of their fund's performance and exposures.

Cuttone launched its new product Compass in December and has 24 hedge fund clients in the pipeline, with three already committed, according to Scuteri. The firm's prime brokerage unit has 22 prime brokerage accounts and 44 sub-accounts. Compass is available to any hedge fund, whether or not that fund uses Cuttone as a prime broker, he adds. Concept Capital's offering, Concept One, launches in the middle of February after a period of beta testing.

The software provided by Nirvana through firms like Cuttone and Concept provides real-time views on risk and exposures. It is increasingly important for funds to have a handle on risk in real time and many data aggregation tools are not fast enough, says Nirvana Solutions' Curley. Many prime brokers are used to reporting T+1 but this is no longer sufficient, he says.

Custodians could also stand to benefit from the multi-prime trend. "Some hedge funds are going to look at custodians for certain aspects of their asset base, as a reliable holder of assets," says Lind, who predicts that the whole account structure of hedge funds will fragment. "Custodians generally do not finance their trading strategies nor do they take a lot of collateral for financing strategies, therefore the collateral is not rehypothecated or redelivered to outside parties. In a buy and hold or long-short situation, long assets with a custodian seems like an effective way to store your securities," he says.

Custodians will be looking at certain aspects of the prime brokerage model in terms of settlement and custody services, he says, although there will be some areas where a prime broker cannot be replaced. "The financing through a custodian is going to be a little bit more challenging because custodians haven't typically financed strategies. Funds will use multiple prime brokers to finance positions as well as for ideas-specific expertise in certain types of structured products," says Lind. -->