GAIM Ops Paris 2012: Emerging managers most at risk as PBs confront regulatory costs and falling revenues
Emerging or sub-$150 million managers will be disproportionately impacted as prime brokers increasingly cull smaller hedge fund clients as they grapple with regulatory capital costs and falling profits, operational due diligence executives have said.
Speaking at GAIM Ops Paris 2012, operational executives said prime brokers were becoming increasingly ruthless with managers which fail to meet AuM targets. Some prime brokers have hiked the minimum level of revenue they expect to earn from smaller clients, which are invariably unprofitable at first, and remain so if they fail to add assets rapidly.
“Prime brokers are struggling to make money in this environment. Leverage is substantially down at hedge funds, which is hurting prime brokers’ profit margins. Some prime brokers are getting rid of clients they view as being less profitable, similar to administrators. This disproportionately impacts smaller or emerging managers,” commented Eric Lazear, head of operational due diligence at FQS Capital Partners, a fund of funds.
A recent report by Barclays Prime Services on the changing nature of prime brokerage finance highlighted how higher capital and liquidity ratios was making it harder for prime brokers to live with the maturity mismatch between their assets and liabilities. With rehypothecation under scrutiny from hedge fund investors as well as regulators fretting about `shadow banking,’ it is also becoming harder to fund clients’ profitably by re-using client assets.
Managers are themselves changing the model, chiefly under pressure from their own investors. Removing the right to re-hypothecate assets from prime brokerage agreements is one challenge for primes. The growing use of third party custodians is another. Hedge funds are paying more than lip service to multiple prime brokerage, and placing balances with several primes to cut counterparty risk. When these factors are combined with underperformance, redemptions or failure to increase AuM, a manager can be vulnerable to being dropped by a prime broker.
“Prime brokers are efficient at client selection and they understandably prune routinely underperforming relationships. They look to be efficient not only at client selection but client retention and that is where a non performing relationship may find itself put under pressure via altered service provider fees,” said Trevor Simon, partner at Hilltop Fund Management, a London-based fund of funds.
Nevertheless, Simon added emerging managers can still negotiate terms with prime brokers. “Emerging managers may find a prime broker amenable to lock-out periods during which time fees cannot be increased,” he said.
It is not just prime brokers that are terminating relationships. The fund administration arm of HSBC, which has trimmed the former Bank of Bermuda client list aggressively since it acquired the bank in 2004, recently ceased working with a number of smaller Asian clients as part of a renewed effort to refocus on larger and more profitable businesses.