Over a 27-year career as a CFO and head equity trader for two large hedge funds, I was a first-hand witness to various market moving events that dramatically affected hedge funds and their prime broker relationships. From the 1987 market crash, which saw a near 16% one-day drop in market indexes and caused many hedge funds to be liquidated by their prime brokers, to the 2008 daily market declines and resultant spike in volatility, which caused over-leveraged firms like Bear Stearns and Lehman Brothers to fold, the importance of picking the right prime broker cannot be overemphasized.
Perhaps by default, due to the potential game-ending consequences of a seismic event adversely affecting the relationship, choosing the right prime broker may be the most important decision facing a portfolio manager, except for making the right investments, of course. While larger, more established hedge funds typically have many well-developed relationships with the Street, for emerging funds, their prime broker will be their main point of contact with the market. Given the critical importance of the relationship, what are the most important factors to consider when choosing a prime broker?
Trading platform and quality of trade execution
Over the years, the independent trading platforms as well as the proprietary platforms used by the major prime brokers have become very similar. It’s generally a matter of personal taste when choosing one over another. However, the quality of the trade execution process is another matter entirely, especially for hedge funds that are actively traded. Some of the things to consider are: price improvement; the percentage of shares executed at a price better than the best bid or offer; the execution price (percentage of shares executed at best bid or best offer; the speed of execution; and the effective spread (distance from the midpoint of the market at the time of execution to the time the order was entered). Another point to consider is that some prime brokers will offer rebates to traders who “provide liquidity.” That means sitting on the bid when trying to buy something – or the offer when trying to sell – rather than hitting a bid or taking an offer.
If your fund intends to use leverage, does the broker’s margin financing include portfolio margin or just Reg T borrowing? (And do you even want to take advantage of portfolio margin if it is available? But that’s a subject for another day.) Another consideration is long lending. If you are a long-term investor and own securities that are in demand by borrowers of securities, will the broker let you take advantage of a long securities lending program? That could be another source of income for the fund.
Also, what is the cost of borrowing, and what is the cost of borrowing stock to cover a short sale? Sure, the historically low interest rates of the past few years have meant that these expenses are now much lower than in decades past, but for firms that run large balances, even a few basis points can make a significant difference in the fund’s performance. And this figures to become a bigger issue as the Fed moves back to more “normal” interest rates in the months and years ahead.
Quality of the reporting package
This can vary greatly from broker to broker. Some firms have really robust packages which offer funds customizable reports that include historical cost, holding periods etc. information critical to good tax planning. Other brokers, mainly the more retail-oriented and cut-rate houses do not offer such robust reporting. (Note: Grassi Fund Administration Services uses Advent Geneva as its portfolio platform, so for hedge fund clients of the firm this issue is not a major concern.) Ask, what risk management reports are available in the prime broker’s report package? Potential investors will always want to know how the fund looks at and manages risk. The more information available via the prime broker system, the better investors will feel.
If this is part of the fund’s trading strategy, then consideration must be given to how the broker allocates IPOs. Are they even in that market? Does a fund have to be a major commission generator to participate?
Last, but certainly not least, cap intro services have become something of a “hot-button” item over the past few years, especially for emerging hedge fund managers. The sad truth is that many prime brokers will tend to over-promise and under-deliver when it comes to cap intro. At a minimum, one would hope to see an active program that includes: single and multi-manager speaking events, one-on-one meetings, assistance with marketing materials, and networking events like “idea” dinners. The fund manager is always going to have to do the “heavy lifting” when it comes to raising capital, but having a prime broker that gets your foot in the door is a big help.
Another result of the 2008 financial collapse was the trend started by the larger hedge funds to use multi-prime brokers. Emerging funds generally are not managing enough capital to be able to effectively spread assets around to mitigate counter-party risk; however, as a fund grows, having more than one prime broker is something to consider.
Whether you are a newly formed fund looking for your first prime broker or an existing fund thinking of making a change, Grassi Fund Administration Services looks forward to speaking to you and helping you consider your options.