Bulge bracket prime brokers risk looking short-termist
The decision by bulge bracket prime brokers to terminate certain hedge fund relationships risks looking short-termist and could provide opportunities for the mini-prime brokerage industry, particularly in London.
This comes as a number of prime brokers including Goldman Sachs and Credit Suisse make it no secret they will cease working with hedge funds they view as being unprofitable or unlikely to grow Assets under Management (AuM) to sufficient scales.
“A number of the prime brokerage arms at the banks are culling hedge fund clients and this spells an enormous opportunity for the mini-prime brokerage market in London to develop. Unlike in the US, there is limited competition in the mini-prime brokerage space in London, and with the large banks scaling back, this could reap rewards for mini-primes. Furthermore, we reject criticism from some firms that investors are not happy with hedge funds using non-bank primes as we have not had any complaints,” said Kevin LoPrimo, global head of hedge fund services at Global Prime Partners, a London-based prime broker specialising in sub $50 million managers.
Finding a new prime broker is a time-consuming task while negotiating prime brokerage agreements is just as arduous. Furthermore, the process would be even more problematic for managers which have suffered the indignity of having a primary prime brokerage relationship severed. Some have argued that severing a hedge fund relationship could appear short-termist although sympathised with the prime brokers’ predicaments given the present market volatility.
The traditional prime brokerage model is under severe threat and revenues are nowhere near as lucrative as they once were. According to reports, Goldman Sachs has responded to these challenges by charging fund managers more to finance trades and imposing monthly fees on clients for maintaining untapped credit lines with the bank.
The costs of hedge fund financing are also going to rise as Basel III capital requirements take effect, said a recent Citi study. A J.P. Morgan white paper in 2014 agreed and highlighted attempts by prime brokers to reduce their dependency on short-term funding, hedge fund and investor restrictions on re-hypothecation of collateral and Basel III capital requirements, were all going to lead to an increase in the cost of financing.
There is also a strong possibility regulators in Europe could clamp-down on re-hypothecation whereby they will impose a 140% cap similar to that of the Securities and Exchange Commission (SEC). While financing is unlikely to disappear, it is going to be a higher cost service for fund managers.
This tightening on financing will disproportionately impact illiquid or highly leveraged strategies. A study in 2013 by Barclays predicted these changes would lead to the average hedge fund’s returns declining by 10 to 20 basis points. Fixed income arbitrage – one of the most leveraged strategies at 13 times Net Asset Value (NAV) – would be hurt the most by the changes with returns falling anywhere between 40 and 80 basis points, said Barclays.