The Prime Qualities Of A Prime Broker
The question posed is what are the qualities that a Hedge Fund Manager and a fund administrator look for in Prime Brokers? On the face of it, it seems a simple question and the answer seems equally obvious and can, perhaps, be summarised as: financial strength; flexibility; market capability; and administrative efficiency.
Many years ago, in the 1960s, I used to be involved in the design of, what were then considered to be, the ultimate in sophisticated sound systems ? the sort of sound system that even that long ago cost several thousand pounds. When pitching for a contract, I would submit a detailed quotation itemising every little component and the question I was asked most often was ?Why pay so much for the cartridge and the stylus?? - remember this was BCD (before CDs). My answer was always the same ?Your sound system is as good as its cheapest component?. You are probably wondering what this has got to do with Prime Brokers. I think it is fair to say that this philosophy applies to almost any complicated structure and the package of services that most Prime Brokers offer today can be extremely complex and therefore, I suggest is likely to be only as good as the weakest component of that package.
Twenty years ago, the concepts of the ?Full Service Broker?, who could act in all markets, and the ?Clearing Broker?, who would take on, consolidate and hold clients? positions, which had been opened with several different brokers on a ?give up? basis, were both considered quite innovative. In the last few years, the markets in which Hedge Fund Managers trade, the instruments that they use and the strategies that they have developed, have all become increasingly complex and sophisticated. On top of this, the demand for performance enhancing leverage has grown at the same time and, what now seems to be the relatively simple concepts of the Full Service Broker and the Clearing Broker have combined to become the Prime Broker ? a ?one-stop-shop? for the modern Hedge Fund Manager.
Hedge Fund Managers ? and, therefore, their clients ? are so dependant upon their Prime Broker that any weakness in their service can become critical. Therefore, the Manager must consider all aspects of the services he requires when selecting the Prime Broker. But first and foremost, he must be entirely comfortable that the Prime Broker is not just financially secure but, in today?s markets, very strong and very well capitalised. Every so often, something comes along to remind us how vulnerable we all are, particularly to unrelated third party risk. In hindsight, it is probably more luck than judgement that there was no major broker failure following last October?s WorldWide-Whiplash. It is, of course, impossible to totally protect yourself, but it goes without saying that opening a Prime Brokerage account with an institution capitalised at several billion Dollars is much safer than opening an account with a Prime Broker capitalised with a ?mere? few hundred million Dollars.
But capital isn?t everything - the Manager must also feel comfortable that the management of the Prime Brokerage house fully understands the business that the Prime Broker is involved in today and, as it evolves into more esoteric and sophisticated fields, the Manager must be comfortable that the Prime Broker?s management is capable of managing that business. I was talking to an ex-banker at the recent MFA Network ?98 meeting in Florida and he expressed serious concerns over one of the, now huge, regional bank groups in the US, which has grown from less than US$10 billion to around US$250 billion in just a few years and, as a result, has become increasingly active in derivatives, swaps and other exotic markets. His
concern is that that bank today has the same ?small town? management that it had ten years ago, when it was a ?small town? bank. There is no doubt in his mind that, in this case, the business and consequent risk has outgrown management capacity and capability. It has to be said that to be sure that the selected Prime Broker is not at management or financial risk, the Manager is probably restricted to using one of the major Wall Street firms. I quote a French money manager based in London who said on this subject ?You have the Americans ? and then the rest?.
Having satisfied himself as to the financial strength, which is often supported by a substantial insurance policy, and satisfied himself as to the management of the selected Prime Broker, what other qualities should the Manager look for.
If the Manager?s investment strategy is relatively simple ? perhaps a market neutral US equity fund only trading in leveraged long and short positions in equities, with the occasional stock index overlay, it is probably fair to say that almost any US Prime Broker should be able to provide an efficient service. However, for more complex trading strategies, the Manager must look carefully to see if the Prime Broker is, in fact, able to service all aspects of his business.
The Prime Broker must have the financial resources to offer margin and leveraging support as well as the human resources to provide market support. It is essential that the Prime Broker?s personnel, not only fully understand the market sector and the investment strategies being used by the Manager, but also have the research capacity to support that Manager.
We have recently been appointed as the administrator of a new Hedge Fund ? the Lone Wolf Fund ? managed by Paul Chain of Lone Wolf Asset Management. This fund specialises in US and other high yielding fixed income securities and Paul Chain was absolutely specific in his selection of the Prime Broker ? one of the US giants ? because, in his experience, there was no other choice. The firm he selected was the firm that, in his opinion, above all others, really understood the markets in which he traded. He was also impressed by their back office and the quality of the people in that back office, who really understood the systems and this, of course, as administrators, is one of our main concerns. That is not to say that we don?t care about the Prime Broker?s market expertise ? its just that we, as administrators, are not really capable of assessing that; that is the Manager?s function. We, as administrators, are, however, concerned with the efficiency and flexibility of the Prime Broker?s back office, which is of paramount importance.
On the subject of flexibility and in the context of the front office ? trading ? it has to be accepted that not all Prime Brokers can be ?all things to all men?. It is, therefore, important that, if your selected Prime Broker does not have the best expertise in one particular area, whether that be emerging markets, European equity markets or whatever, that the Prime Broker offers the flexibility for the Manager to trade elsewhere and to arrange for the transactions to be ?given up? to the Prime Broker. Prime Brokers are naturally reluctant to offer this facility because this affects their commission revenue, but, providing the Manager doesn?t abuse the situation, most quality Prime Brokers offer this facility, as, indeed, they should, because they also have a fiduciary responsibility to ensure that the ultimate client ? the investor - gets the best service and execution possible.
Efficiency in the Prime Broker?s back office does not just mean accounting and reporting but also risk management and control, which is essential with leveraged accounts and funds that are trading in volatile markets. If the Manager and the Administrator are not entirely convinced that the Prime Broker is ?on top? of the risk management on a full, real time basis, they should close that account and move on elsewhere. The fear is that another client of the Prime Broker might be severely over trading and, if the Prime Broker is not on top of the situation, a disaster could occur in an October 1997 type market, with a possible knock-on effect on the Manager?s clients? accounts.
This brings us to Custodial services. It is essential that any assets of the fund held by the Broker, that are not being utilised for collateral or margin purposes, are held in secure segregated custodial accounts and not vulnerable to any third party credit risk. This is in fact a requirement for any hedge fund listed on the Irish Stock Exchange and should be a requirement for all accounts with any Prime Broker.
Notwithstanding my comments above, efficient accounting and reporting, supported by first class systems and interfaces, is also very important ? obviously inaccuracies in valuations and reporting of portfolio positions can be disastrous if they result in the Administrator publishing the wrong NAV for a fund and that disaster is exacerbated if shareholders buy or sell shares on the basis of inaccurate NAV. Therefore accuracy is of paramount importance. Less disastrous in the short-term, but no less disastrous in the long term, is late reporting. Delays in publishing NAVs can upset investors who may then dis-invest. There is no excuse for repeated delays in reporting positions and valuations with modern technology and, of course, consistent delays of this sort can only lead to concerns over the Prime Broker?s internal controls, as one must assume that, if the Prime Broker cannot report the fund?s positions to the Manager or the Administrator, then he presumably does not have the information to hand and so we are back at lack of control of risk management, as discussed above.
So to summarise once more ? the essential qualities of a Prime Broker are: firstly, financial strength and integrity; and then in no particular order: flexibility and efficiency, both in back and front office applications; a strong custodian facility and financial resources for leveraging. And if any part of this package is below par, the complete package, as a whole, is affected.