Nowadays, starting a hedge fund is about more than simply raising the required capital and running trades. Increased investor scrutiny, coupled with today’s regulatory environment, means any successful hedge fund needs reliable partners that will support it throughout its operation.
Whether you’re an established hedge fund evaluating your risk profile or an emerging manager aiming to build your infrastructure, a diversified selection of prime brokers will do wonders in helping you manage and scale your business.
It is worth pointing out that working with multiple prime brokers is not always the best solution. Depending on your financing requirements, strategy, and fund size, you may be better off working with a single prime. This is why most funds benefit from working with organizations that offer prime broker services on a per-need basis.
Factors to Consider When Deciding on a Prime Broker
There are a few key characteristics you need to consider when looking for a prime broker, including but not limited to the institution’s risk profile, balance sheet flexibility, and business model.
As you’ll probably find during your search, the prime broker marketplace has become very competitive, with certain aspects of the business growing increasingly commoditized.
As we stated in the intro, hedge funds can gain an extra edge by having the right combination of prime broker relationships. If you already have a prime broker, compare their products and services to those other organizations offer.
The goal is to find a counterparty that can fill the gaps left by your current partner, rather than mimicking their strengths.
The Changing Dynamic of the Prime Broker Relationship
Back in the day, the role of the prime broker was well-defined — their job was to settle trades and cover financing portfolios and shorts through lending securities.
However, the products and technologies introduced in the past decade have resulted in a faster, more efficient market, requiring hedge funds to generate alpha and create value for investors in new ways.
These market shifts impacted hedge funds across the industry, forcing their financing and trading partners to re-think their value propositions. Add to this the more rigorous regulatory environment, and you end up with a relationship between prime brokers and hedge funds that is more intertwined than ever before.
In short, prime brokers are now more important than ever for the success of hedge funds, and the relationship between the two is not only increasingly valuable but increasingly connected as well. A few key trends have affected this dynamic.
1. Rise of Index Funds and Need for Efficiency
Index funds and a rise in market efficiency have created a viable alternative to active account management and put pressure on hedge funds to prove their value.
Aside from being asked to confirm their success in driving profits, hedge funds are also asked about their strategies and whether they are repeatable.
More and more funds are reviewing their prime broker relationships and scrutinizing both fees and returns. The more diligent approach has affected alpha generation, causing hedge funds to keep re-evaluating the risks they choose to take on the market.
2. Rising Regulatory Bar
The rising cost of complying with regulations is no small hurdle to overcome for hedge funds. These regulatory and operational demands have led hedge funds to become more dependent on their prime brokers for data.
Prime brokers are now expected to boost operational efficiency and ensure their clients meet all transparency and regulatory requirements.
3. New Demands
As an investment class, hedge funds are expected to cater to a wide variety of investors, including endowments, pensions, and high-net-worth investors.
Each type requires greater asset protection and transparency, so primes are expected to provide frequent, more customized reports and pay more attention to detail in operational processes.
We already talked about how today’s hedge funds are required to keep demonstrating value and build client engagement, so it is fair to say that operational load is reaching critical status.
Hedge fund managers are therefore increasingly turning to their prime brokers for more diversified products and offerings to help meet their clients’ needs.
How to Find the Right Prime Broker for Your Fund?
One could argue that a hedge fund’s relationship with its prime broker is the most important relationship of all. The prime broker serves as the prime point of trade information and is, therefore, a fund’s primary point of contact with the market.
Obviously, your chosen prime broker, therefore, must have strong relationships across the market, along with an excellent trading platform.
More specifically, your prime broker needs to be well acquainted with your strategy and any strategies you hope to add as the business evolves.
Prime brokers are more than just traders, though. They serve as the focal point of hedge funds securities financing and lending.
Make sure that your prime broker can accommodate any strategies that require more leverage and deal with any hard-to-borrow, esoteric securities.
When considering applicants, make sure to ask for concrete examples of how they would handle a few hypothetical scenarios they may encounter.
Capital introduction is another huge selling point of prime brokerage. However, do not confuse capital introduction with asset raising — you’re still expected to do the heavy lifting in this area.
That said, you can ask your prime broker about their geographic reach, access, and the level of support they can provide. This will be an essential parameter in figuring out precisely what you can gain from the relationship.
Finally, get all the necessary information on the fees. Aside from the commissions, consider the support riders, data fees, exchange fees, etc. Make sure to clarify which of these are fixed and which are variable.
What to Expect?
With the market made more efficient by technology and the many new investment vehicles available, deciding on a prime broker has never been more challenging. Hedge funds need more value from their prime brokers to be able to compete in the new environment.
Consequently, prime brokers are evolving to deliver greater value and become more comprehensive partners overall, helping managers address some of the biggest challenges they face.
We can only expect the ongoing interconnectivity between prime brokers and hedge funds to grow in an effort to boost efficiency and solve the challenges posed by the ever-maturing industry.
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