How can Asset Managers maximize the value of their partnerships with Prime Brokers?
In this Insight article, we aim to highlight how Asset Managers can navigate the challenges of choosing and maintaining a symbiotic relationship with their Prime Brokers and where this function can sit within their organisation. At the time of going to press, the Basel 4 regulations are being digested, meaning the importance of this dynamic is likely to increase further.
Choosing the right Prime Brokers
For Asset Managers to choose the right Prime Brokers in order to meet their requirements is one challenge, how to get the best out of the relationships, making them reciprocal is another one altogether. But getting this right is key to ensuring their Funds retain access to markets for maintaining portfolio stability, whilst staying ahead of any difficult conversations around pricing, capital usage and return on asset calculations.
Unlike other services which are somewhat commoditized, the relationships with Prime Brokers goes deeper and offers hedge funds a wide range of services that transcend just financing and clearing services. This includes customised solutions, capital introductions, talent referrals and even advice on office spaces (these are very useful services for start-ups and smaller Funds).
When choosing the right Prime Brokers, there are of course some important considerations:
Diversification of risk: The manager should consider reducing concentration risk by employing a multi-prime broker approach. This can in some instances bring difficulties in ensuring there is enough business to spread around and for the Fund to remain attractive to the Prime Brokers (more to come on that in a while), but it is an important route to ensuring the Fund is protected from unexpected events, both market-wide or a localised credit event. Geographic diversification should also be a consideration which can help protect from regional contagion.
Access to multiple markets: does the Prime Broker have expertise in the asset classes, regions and markets the Fund needs now and just as importantly will require in the future? Some Primes will have strengths in areas (for example they may have a presence or solution in a non-conventional market or asset class), but they may have less market access in others. These types of scenarios can be uncovered with a sound selection process, which should also include aspects such as pricing, technology capabilities and the resource vs revenue metric the Prime employs and ultimately the hurdle rate the Fund needs to achieve.
Once the Prime Brokers have been chosen, the ongoing challenge is how to ensure the relationships work to provide value to all parties. This challenge typically sits well within a Treasury function at the Manager.
The Treasury Function – Adding additional value
The Manager’s Treasury team should already have multiple significant responsibilities, including Liquidity, Cash and Collateral management, but in addition, the Treasury team can act as the “orchestrator”, ensuring the Funds optimise their portfolios, for example, dynamically managing the mix of long & short financing requirements, changing portfolios from physical to synthetic (e.g CFD’s) which should result in optimal funding costs. Having this knowledge centralised should also ensure that the margin requirements of each Prime is understood, resulting in further optimisation opportunities.
This work can be grouped with the overall counterparty management responsibilities which could also cover important aspects such as:
- Monitoring ongoing credit health of counterparts and managing exposures accordingly
- Ensuring rehypothecation allowances are not exceeded
- Coordinate the implementation of broker scorecards
It’s worth highlighting that as we are now set to be in a higher (maybe normalised)? interest rate environment, the responsibility to optimise cash management is even more critical to the performance of a Fund. Aside from more vanilla US Government bond purchases & Money Market Funds, there are some alternative neat solutions to this problem that we will cover in later Insight articles.
Prime Broker Metrics
From the Prime Broker Side, large hedge fund financing balances do not automatically equate to large profits. If for example, the Fund has an asymmetric portfolio of long physical positions to finance without an offsetting short portfolio, this may be unattractive as it could be detrimental to its balance sheet, funding & capital metrics. This is why Prime Brokers actively monitor each Fund relationship via a metric such as “Return on Asset” with the goal being that each of their relationships exceed a hurdle rate.
The complexities of this return on asset methodology can obviously vary greatly at each Prime Broker, but at its core, it’s simply a method of capturing all relevant data in order to calculate the profitability of the relationship.
The type of data used in this calculation would typically include the net of revenues received from financing, clearing & commissions offset vs the costs of servicing the portfolio (their own financing, securities lending and execution costs). This net revenue number would then be measured against the utilisation of resources such as balance sheet and capital.
If a Fund does not meet the prescribed minimum hurdle rate of profitability for the Prime Broker, it could result in difficult conversations around portfolio re-pricing, re-balancing or the nuclear option of being removed from the platform. This clearly has huge implications for the Fund.
With this in mind, the Manager’s Treasury function must have good visibility on each of its Prime Broker’s pressure points and whilst it won’t be able to replicate with 100% accuracy each Prime’s Return on assets metric, it should at the very least be cognisant of the impact each portfolio has and how, with diligent management, it can be optimised.
Regular communication between the Prime Brokers and the Fund is also imperative to ensure the relationship is periodically evaluated and any change in the Fund strategy is considered. This two-way communication is also a good opportunity for the Prime Broker to disseminate any regulatory challenges on the horizon that may be impacting the markets the Fund trades in, or causing the Prime additional capital or funding costs (more to come from Basel 4 when the impact is fully digested on Capital, Liquidity and Credit Counterpart Risk requirements).
Conclusion
In summary, amidst the ever-evolving regulatory landscape, discerning methods to enhance the value of partnerships with Prime Brokers remains a pivotal endeavour for Funds. An experienced Treasury function can help foster this relationship and ensure it’s maximised for both parties.
How can bailrigg+ help with this? With our experienced client optimisation team, led by Chris Maynard , who previously created a Treasury Function at a preeminent Hedge Fund and who has also worked in the sell side, we can assist in numerous ways, including reviewing your existing Prime Brokerage relationships including optimal portfolio splits, excess cash reinvestment capabilities, counterpart due diligence and ongoing monitoring arrangements.
For further details, please reach out to Tom Hutchings, Head of Business Development or Chris Maynard .
Author: Chris Maynard – Client Strategy and Optimisation
September 2023