One make-or-break decision anyone starting a hedge fund has to face is who to tap as a prime broker.
Pinning down a skill set for this role can prove challenging because one size — or even a dozen — doesn’t fit all. You can’t bring the prime broker’s role in-house and closely control it, and yet you have to live with this relationship for a long time. It’s like a marriage — and it might be a stormy, love-hate one at that. Maybe you stay in it just for the sake of the investors. Maybe it’s even an “open” marriage.
Just as all hedge fund managers don’t have the same skills and experience, neither do all prime brokers. A manager starting a hedge fund “should be looking for a prime broker that specializes in the vehicles they’re investing in,” says Douglas Carpenter, partner in hedge fund advisor and administrator Strategic Asset Management. “If a fund is doing foreign exchange, obviously they need a prime broker with a good f/x platform.”
Regardless of your strategy, according to Carpenter, you should intensely consider your prospective prime broker’s trading platform. Make sure you can easily gain remote access to your terminal, and that you can download all relevant applications to your computer, if not your smartphone.
But let’s not lose track of basic functionality.
“Probably the most critical of the elements are securities lending and financing – essentially the core services that the prime brokerage product offers, says Howard Eisen, co-founder and managing director of FletcherBennett, a New York-based hedge fund capital raising and consulting firm. “For a strategy that is plain-vanilla long/short equity, does not exceed Reg-T margin levels and which does not traffic in hard-to-borrow stocks, then any of the bulge-bracket and many of the mid-tier prime brokers will serve a hedge fund just fine. However, for strategies which rely more on enhanced leverage — greater than Reg-T — or which seek financing of more esoteric assets then a prime broker with more creative ways to utilize their balance sheet are required.”
One supposed advantage of one prime broker over another is capital introduction, but stay away from anyone who’s overselling that.
“CI can and should be an important consideration, so long as it is kept in proper context,” Eisen says. “CI is not asset raising – period. Any fund that expects a CI team to raise assets does not understand the function.”
Eisen advises someone starting a hedge fund to ask who the designated CI contact person would be, how extensive the CI team’s geographic reach is, does the relationship lead to participation in industry conferences, and honestly, what level of CI support can be expected.
“The reality is that CI is a resource that is in scarce supply but is desired across the prime brokerage client base – a handful of professionals for hundreds of clients,” Eisen says.
Prime brokers may also try to entice you with other non-core benefits, such as office space or consulting. Eisen cautions that renting from your prime broker as an investor turn-off, and points out that you can hire consultants just as easily from other service providers.
Benefits — whether plain or fancy — comprise only half the equation, of course. Don’t ignore cost.
“Some funds pay several thousands of dollars per year in prime broker fees,” Carpenter says. “A couple dollars per trade can make a huge difference.”
Even so, he warns that straight commission fees might not be the only charges inherent in your prime broker relationship.
“Per-trade costs, account and data fees,” Carpenter rattled off, “additional fees for special support riders, exchange fees, Nasdaq fee …”
He could go on. The net of it is, be sure you have a clear idea what your all-in costs are going to be for accessing your prime broker as you go about executing trades and marketing your hedge fund, and understand which portions are variable and which are fixed.
The degree to which your prospective prime broker levels with you about fees is the degree to which you’re dealing with a professional. Still, Carpenter notes one other service that some prime brokers handle with ease while others struggle with it: reporting.
Some prime brokers’ “reporting capabilities are abysmal,” he says, noting that, at year-end, a good prime broker should be able to perform an open position analysis for your auditors. “Yet, for some reason, that is a hard to come by report.”
There’s no law saying that you have to be exclusive to one prime broker. According to Carpenter, you might want to deal with different prime brokers in each geography in which you trade — have a European prime broker and an American one, for instance. It might also suit you to have a prime broker who specializes in different asset classes within the same geography, if that’s how you’re trading.
Even so, there’s no need for a manager starting a hedge fund to build up a harem of prime brokers right away.
“Below a certain size … it’s more important to concentrate your purchasing power with one prime broker,” Eisen suggests. “However, beyond that size, investors will take comfort in the fact that you have other prime brokerage arrangements in place should your main prime broker begin to falter, as we observed during the financial crisis.”
