Mini primes: Will they stay or will they go now?

25 Feb, 2011

Despite their long history, mini primes or introducing primes only truly exploded onto the scene post-2008 as many of the bulge bracket investment banks offloaded their smaller hedge fund clients in desperate bids to get shot of some of their riskier customers. By removing these smaller clients from their balance sheets to reduce their counterparty risk, these organisations provided mini primes with an opportunity and a niche in the months following the financial crisis.

This reversal of fortune resulted in firms - who had traditionally shied away from the prime brokerage business – entering the fray. These included the likes of Conifer, FBR Capital Markets and Lighthouse Financial Group to name but a few. As hedge funds panicked over counterparty exposure, these organisations sprang up enabling fund managers to diversify and give peace of mind to jittery investors.

However, as the major banks offloaded smaller hedge funds because of this risk, the market started to become overpopulated by mini primes - concerns about the viability of mini primes therefore started to come to the fore. The last year or so has been a somewhat turbulent time for these outfits. A series of closures and mergers has raised doubts about the long-term survival of these institutions. In January 2011, the New York Times reported FBR Capital Markets planned to close its prime brokerage unit – having only set it up in August 2009. Late last year, Lighthouse Financial Group and its prime brokerage business, which was only established in March 2009, ceased operations. In December 2010, Lighthouse Financial Group filed for bankruptcy protection with $14.6 million in debt. There is unsurprisingly speculation and rumour that other shops plan to close their prime brokerage businesses in the foreseeable future.

Nevertheless, not all of these companies are shutting their doors. There have been a series of mergers and acquisitions among mini primes. This has been due to a variety of reasons – firstly, to create economies of scale but also because some institutions require an aggregated client base to enable them to continue providing their services and ultimately stay in business. ConvergEx, for example, acquired NorthPoint Trading in April 2010 – a merger that individuals close to the firm say has bolstered their service offering to clients. In November 2010, it was revealed that the US derivatives brokerage firm I.A Englander & Co had been in acquisition talks with Alaris. Such a move, it is hoped, would enable Alaris to offer multi-prime solutions and ultimately compete in a mid-tier space. The merger would also potentially give Alaris smart order routing for equities, options and futures given I.A Englander & Co’s excellent derivatives access. Most recently in January 2011, Cantor Fitzgerald acquired PCS Dunbar’s prime brokerage division.

However, it remains to be seen whether or not these mergers will pay off.

Some commentators have written off mini primes. But why is this the case and is there cause for concern? One of the major arguments explaining why mini primes have been stuttering recently is that the market conditions, which initially favoured their business strategies, have changed significantly. This has hurt some of these companies immensely. As things stand – interest rates are low, volatility is low, trading volumes are low and there are fewer fund start ups – all of these factors have hindered the mini primes’ development.

Couple all of this with the low fees numerous mini primes charge, it could be argued their business and value proposition model do not make much economic sense. Given that it is unlikely many of their clients trade significant volumes, it seems mini primes could possibly struggle due to the lack of money they are making. This is further compounded by the stringent demands from hedge fund clients and their underlying investors. Many of these people expect solid risk management and infrastructure as a prerequisite for doing any business. These added technology costs are most likely proving a struggle for mini primes lacking capital.

To add further woes to mini primes, it is becoming increasingly clear that larger prime brokers are going after smaller clients. One industry source said a major prime broker was speaking to funds with assets of less than $20 million – a scenario that would have been deemed unthinkable a few years back. During the crisis, smaller to mid-sized funds proved to be incredibly resilient to the financial turbulence going on around them. This could have influenced major prime brokers’ interests in these firms.

Prior to 2008, many solid, impressive and good performing hedge funds found it an uphill struggle to find a bulge bracket prime broker – that has since changed. This means mini primes need to work much harder in delivering a quality and differentiating product to both existing and potential clients. However, some mini primes do not have strong banking balance sheets which would enable them to offer acceptable levels of leverage and provide finance against a full range of securities. This ask could therefore be a bit of a tall order.

Mid-primes such as Merlin Securities and Jefferies Prime Brokerage are also gaining traction by eating away some of the clients that might have gone to mini primes. Merlin Securities, for example, currently boasts 535 clients and last year picked up its first $1 billion hedge fund client. Hedge funds are increasingly opting for what they perceive to be safer institutions to put their assets into. This trend is reinforced by demands from sophisticated investors, particularly institutions, who post-crisis are taking far greater note of where their cash is being held. These institutions, particularly conservative pension want their cash in organisations which have a large, global balance sheet. It has also been argued that mini primes have a further disadvantage because sophisticated investors will demand their hedge fund managers work with a brand name prime broker who they are familiar with and can trust. While a mini-prime may offer a superior service to a bulge bracket, investors want a quality name.

Not only are hedge funds and their underlying investors demanding exposure to brand name prime brokers but these same bulge bracket organisations have started to terminate their clearing relationships with some mini primes. But why is this happening? It doesn’t appear to have anything to do with these big primes removing unwanted competition. Some commentators have argued mini primes don’t even come close to competing with major prime brokers for hedge clients in the first place – in fact they predominantly competed among themselves.

The general consensus among industry experts seems to be that the bulge brackets just do not want exposure to the risks associated with the mini primes. A lot of low capitalised mini primes took on small hedge funds with low margins making it difficult for them to make profits. Some of these mini primes, according to one industry expert, did not do appropriate due diligence when taking on clients – due to the lack of an established compliance culture and infrastructure – therefore these outfits could pose a risk to major primes.

Bulge bracket organisations reducing their risk exposure should not come as a shock. Attitudes to risk have changed significantly since 2008 – it is unsurprising that risk managers and compliance staff at these firms are reluctant to have excessive credit exposure to the lower or smaller end of the market that may or may not have solid balance sheets.

However, is it harsh to suggest the mini prime model is unsustainable? Mainstream opinion acknowledges that most mini primes offer execution facilities and a few provide research capabilities. Some mini primes are expanding their service offerings to attract more hedge funds to the table. Nowadays mini-primes have evolved and some have their own trading desks, operations and back offices – providing everything from sales trading coverage, trading technology and reporting engines straight through to capital introduction and third party marketing. This is a far cry from the old model whereby most firms typically consisted of a back office/trade support staffer and one or two sales persons. In addition to the core service, most mini primes now offer their clients multiple choices of custodians and some even provide a dual-prime infrastructure to assist in reducing counterparty risk. This mini-prime model is ultimately a very attractive model to the small and mid-sized hedge funds.

Despite the naysayers writing off the mini prime model, some of these institutions will flourish. Yes, it is true the major alternative investment managers may not want to put money in them but there is ground for optimism. Those with high quality services and personalised client relationships could do very well. Their selling point is that they do cater specifically for smaller hedge funds with fewer assets under management – there are still quite a few of these small hedge funds around. Hedge funds after all are still short of their January 2008 asset peak of $1.9 trillion. It is inevitable that a major prime broker will not constantly be at the beck and call of a hedge fund with just a couple of million dollars in assets. It does not make economic sense giving disproportionate attention to these smaller players – Enter the mini primes. Smaller funds with limited assets are going to be more dependent than some of their larger peers on their prime broker – this is for obvious reasons.

A smaller manager cannot be expected to have the technology infrastructure and personnel to do everything in-house and sometimes might not always be able to get a major prime broker to sit down with them and explain issues such as best practice on a regular basis. By reducing these managers’ workloads, mini primes can help ensure these smaller firms can focus on what they do best – managing assets and making decent returns for their end investors. Furthermore mini primes will often have a personal touch in their service – their client relationships due to their smaller size are often more hands on.

The mini prime market was overpopulated and in typical Darwinist style, the strongest survived either through merging or adopting sound strategies when times got tough. To survive this tumultuous period, mini primes must play to their strengths and the services they provide that differentiate them from other larger firms.

Smaller funds do need a strong client service in order to thrive and mini primes must cater to their needs. It is inevitable some mini primes might not succeed while others will surely merge especially as the big investment banks and mid-sized primes continue to gobble up smaller funds. It will be a testing time for those in the mini prime industry where only the fittest will survive.