BLOG - The New Economics of Prime Brokerage and the Smaller Hedge Fund - Nov 20, 2008
The credit crisis and the subject of counter party risk is proving to be the final nail in the coffin for the hedge fund industry's single prime brokerage model. Funds of all sizes now demand multiple custodial relationships.
The problem the high-cost-structure leading primes now face is that without the assurance of the captive single prime model the economics of servicing smaller funds no longer make sense. This reality combined with the primes' decreased risk tolerance means that we are seeing a mass exodus away from the top-tier primes. Anecdotal evidence suggests that these primes are now in the process of weeding out clients that manage less than $100 million or that do not generate annual revenues of at least $250,000. We are also witnessing primes becoming more selective about what type of funds they are willing to service. Funds whose strategies involve less liquid securities and/or high leverage are now finding the bar set much higher.
This retrenchment by the leading primes raises the obvious questions - Who will fill the void and offer prime services to the lower end of the market? Who will provide the financing, stock loan, technology infrastructure etc. necessary for smaller funds to generate alpha?
Before we answer this question let’s take a moment to think about why this smaller hedge fund segment is so key to the future success of the industry. It is no secret that size kills alpha. Many successful funds follow a familiar arc. They gain attention (and funds) by earning outsized returns, as they grow in size their primary strategy reaches capacity and they experience a leveling off of returns. If they are not lucky enough to find another successful strategy, returns will continue to suffer, capital will begin to flow out and ultimately investment talent will go in search of new opportunities. This regeneration process is vital to the health of the industry and for many investors, it is the promise of catching a smaller fund during this growth phase that motivates them to invest.
Historically the group charged with picking up the crumbs left by the leading primes was a group known as the mini-primes. This term is rapidly becoming obsolete as the mini-primes now find themselves expanding their offerings to attract the funds that have been displaced. Perhaps the two remaining differences between the mini-primes and the leading primes are that they still use the clearing services of their larger prime broker brethren, and more importantly, their cost-structures evolved in a way that allows them to offer prime services profitably at this lower end of the market. Interestingly we are also seeing a number of new entrants to this expanded segment of the prime brokerage industry. These are for the most part more traditional brokers who see an opportunity to increase the stickiness of their execution services, as well to develop new revenue streams, by building out a prime brokerage offering.
Only time will tell who will be successful in this greatly altered landscape of prime brokerage. The winners will be the firms that understand that the new economics of prime brokerage demand a new industry infrastructure. This prime infrastructure will rely heavily on cost-effective technologies that can offer aggregated multi-prime reporting, as well as real-time views of critical data such as P&L and Risk, right to the desktop of the hedge fund. This restructuring of the prime model will ensure the health of the industry by continuing to offer a relatively low barrier of entry to the all important small hedge fund segment.
Peter Curley