Building an Effective Hedge Fund-Prime Broker Relationship
The following article is part of our Hedge Fund Insiders Article Series and was contributed by Wells Fargo Prime Services. Read more articles from the Series HERE.
All business relationships are driven by the belief that both sides will receive a mutual benefit that will allow for a long term sustainable partnership between the firms. For a prime brokerage /alternative asset manager relationship this principle is no different. An alternative asset manager (“AAM”) looks for certain services from its prime broker (“PB”): financing, access to balance sheet, securities lending, Capital Introduction, research, Corporate Access, technology and other services that are essential to the AAM as it deploys its strategy. PBs are looking to generate an attractive after cost return based on the revenue generated from the client vs. usage of financial resources such as balance sheet and capital.
Driven primarily by post financial crisis regulatory pressures, banks and prime brokers are being faced with significant new requirements, which has changed the client interaction dynamic and has led to changes in balance sheet strategy, business objectives, and capital markets activity. While the fundamental nature of the business relationship has not changed between hedge funds and prime brokers, AAMs need to understand the impact of regulation on prime brokers and how best to optimize their impact on the prime brokers balance sheet in order to optimize the overall relationship.
While Basel III is the primary driver of this change, perhaps the most significant shift in the PB model has been the introduction of the return on assets “(ROA”) metric on a pre-tax basis as opposed to the pure top line revenue that previously drove the business. In summary, a balance sheet denominator has been added to the revenue numerator creating an ROA equation that now determines the health of a prime brokerage relationship. To be most effective, funds should understand how to minimize the balance sheet denominator as well as their impact on other relevant metrics:
Liquidity Coverage Ratio (LCR)
Net stable funding ration (NSFR)
Tier 1 capital ratio
High-Quality Liquid Assets (HQLA)
Open Communication Is Essential
When selecting a prime broker, AAMs should establish an open line of communication with senior management at the PB. Preliminary discussions should aim towards being as transparent as possible so that both parties develop a deep understanding of each other’s methodologies and motivations, as well as pain points that may drive financing decisions. Maintaining this type of relationship and open line of communication will also foster a better understanding of trends and market color impacting the PB, and may serve as a resource for any impending changes that could impact the relationship. Further, transparent and open lines of communication will help the AAM reconcile the portfolio and leverage needs of the fund to the funding model of the PB, where feasible.
In short, selecting a PB should be based on comprehensive data and mutual understanding, not just financial considerations. Establishing connectivity with management within credit and risk, in particular, can also be an effective strategy, especially in times of market stress. Having this form of dialogue with a PB facilitates the AAM’s ability to utilize each PB relationship in a manner that maximizes the value of its portfolio to each PB, and make it a more efficient client. One example is how much leverage to use for a portfolio – if portfolio margin is the most balance sheet efficient method of financing with a particular PB and is adequate leverage the AAM should not push for a more balance sheet intensive form of leverage for that PB (i.e., enhanced leverage). This requires an open dialogue with the PB to be familiar with legal entity structure and other items which might impact the PB’s balance sheet efficiency.
Transparency Between Hedge Fund and Prime Broker is Key
Transparency and an open dialogue are key components to a successful AAM/PB relationship. In addition to leverage, AAMs often have several touch-points with a counterparty, and may therefore utilize PB resources apart from financing and securities lending, such as capital introduction and/or business consulting services. An AAM needs to appreciate its impact to the liquidity profile of its PB, as well as their overall value to the institution holistically. Ongoing conversations may also help manage expectations as to what being a more “efficient” client means to its PB(s), as it may vary from prime broker to prime broker. This requires a fund to identify its portfolio balance sheet utilization and the overall ROA its business represents to the PB. It is also crucial to understand how each prime broker defines ROA as each counterparty may view it differently.
Depending on the AAMs size and complexity of strategy, the AAM may need to allocate resources to a dedicated treasury function focused on maximizing efficiency and transparency across their funding counterparts. Treasury management starts with the fund having a thorough understanding of its balance sheet footprint, which includes transparency around prime broker’s funding models, liquidity of collateral, impact of margin lock-ups, increased cost of funding due to regulatory initiatives and its ability to rebalance portfolio positions among prime brokers while retaining internal capital efficiencies.
Another key component of treasury management that has surfaced over the past few years is the dialogue between funds and their PB’s around enhancing portfolio efficiency by sharing lists of position needs / excess with their prime brokers to increase the internalization of the client’s portfolio and enhance the return profile. Allocating shorts and longs in this manner increases portfolio optimization which leads to enhanced returns on balance sheet and capital– especially for market neutral strategies employing significant leverage. Another way to optimize an AAM’s balance sheet footprint is to work with PBs to make collateral allocation adjustments that create mutually beneficial optimization.
In summary, the key to building an effective PB relationship is for AAMs to have frequent dialogue with their counterparties and to understand key financing return metrics that are important to the Prime Broker. In addition, AAMs should consider their overall wallet share with PBs and move towards a more holistic client relationship that tracks overall resource consumption including secondary resources such as Capital Introduction, business consulting, corporate access versus trading, and financing revenues generated. The overall wallet of an AAM should be considered when allocating commission dollars to those counterparties providing balance sheet in order to increase the attractiveness of the client from an ROA and return on equity perspective.
The opinions expressed in this article are general in nature and not intended to provide specific advice or recommendations. Contact your investment representative, attorney, accountant or tax advisor with regard to your specific situation. The opinions of the author do not necessarily reflect those of Wells Fargo Prime Services LLC or any other Wells Fargo entity.