PBs warned on short-termist behaviour with unprofitable hedge fund clients

Prime Brokerage
28 Feb, 2013

Prime brokers have been advised to take a less short-termist approach to unprofitable or underperforming hedge fund clients.

Several prime brokers have culled their smaller, sub $150 million hedge fund clients, as they increasingly grapple with regulatory capital costs and falling profits. One hedge fund executive, who wished to remain anonymous, said he had heard of prime brokers terminating agreements with just three months’ notice, although added other primes had told some clients up to 12 months in advance that they did not want their business anymore.

“Some hedge funds have blips in their performance but they can recover. If a prime broker terminates an agreement without much notice because of concerns over profitability, the relationship with the hedge fund is irreparably damaged. If performance picks up, then that hedge fund is unlikely to work with that prime again,” said the hedge fund executive.

One prime broker agreed, adding smaller managers were often not given much notice period to contract terminations. “Most prime brokerage agreements for smaller managers will give a month’s notice period although in practice, this might be a bit longer. Prime brokers have certainly become more short-term in their approach to dealing with these clients over the last five years,” he said.

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.

Another expert said prime brokers did not adopt a ‘one-size fits all’ approach to ending business relationships with unprofitable clients. “It varies between prime brokers. Some banks are likely to give more time to underperforming clients than others. Some prime brokers, however, navigated the crisis very well and they have a queue of hedge funds waiting to be signed up by them, so they might be more ruthless in culling poor performers,” said the expert.

A recent report by Barclays Prime Services on the changing nature of prime brokerage finance highlighted how higher capital and liquidity ratios were 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.

Nonetheless, the hedge fund sympathised with the prime brokers’ position, and highlighted culled clients often returned to the prime providing the contract is terminated with decent notice and in a cordial manner.

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.

“Some prime brokers are not unafraid of kicking off big clients if they have a small account with them. A multi-billion dollar hedge fund might use a prime broker as their seventh prime, and this might not generate any revenue for the prime broker in question,” said the expert.

If a prime broker does sever a relationship with a hedge fund, it can usually sound the death knell for that manager, particularly if they are a new entrant or struggling. “If a prime kicks off a manager, it can kill some hedge funds because it illustrates to investors that the prime is not confident in their success anymore,” added the expert.

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