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Shifting Prime Relationships Burden Smaller Funds

Hedge funds adjusting to the new prime broker

March 2, 2009
By John Hintze

It's a difficult time to be a small hedge fund. Many funds that manage less than $300 million have reportedly been shown the door by their prime brokerages, and others, even if they've generated positive returns, are now being charged for technology development and other services that once were free.

On the other hand, falling revenues may also be prompting prime brokers to deliver their services more efficiently.

Last year, Wall Street's most storied brokerage firms either became commercial banking companies or were acquired by one, effectively ending the era of high leverage. Providing leverage, however, has been the prime brokers' main source of revenue. As lending tightened, bulge-bracket firms began reassessing the size and business priorities of their prime brokerage units and analyzing the profitability of their clients--and deciding what level of service to provide them.

When Nemesis Inflation Preservation Fund's assets fell from a high of $150 million to less than $100 million, Goldman Sachs said the fund could no longer be maintained on its prime brokerage platform, according to Mohammad Ahmad, COO and chief risk officer of Global Macro Investments (GMI), which acts as Nemesis' adviser. Ahmad noted that the fund, which started up in January 2008, saw its assets drop because the company seeding it pursued massive redemptions later in the year. "But in terms of performance, it's up 3 percent to 4 percent from last year," Ahmad said.

Now, Nemesis uses Newedge, formed last year by the merger of the brokerage arms of Crédit Agricole and Société Générale. Smaller funds that lose access to one of the premiere primes must turn to an introducing broker-dealer that clears through someone else or a self-clearing firm like Newedge.

Zug, Switzerland-based GMI's own Bernina Fund, which started at $5 million and is now at $17 million, has seen a 17 percent return since its April launch, he said. Despite its size, Goldman is still providing Bernina with prime brokerage services. "Its global-macro strategy is in vogue now and it's a potential allocation target for their clients," explained Ahmad.

Nevertheless, Goldman is no longer as generous with its services. The firm introduced GMI to Imagine Software, a New York-based company whose risk management tools provide on-the-fly scenario analyses and assist in monitoring and developing investment strategies. Goldman, said Ahmad, continues to provide access to technology such as its RediPlus execution management system; margin and collateral reports for products including over-the-counter instruments; and portfolio-level analysis that helps the fund understand how the prime broker views its risks against various market scenarios.

However, Goldman now wants customers to shoulder some of the operational costs. "We have Imagine in-house, so Goldman will say that to develop a new interface for FX transactions, you'll have to either cover the development costs or pay a ticket fee," Ahmad said.

Previously, such costs were assumed by Goldman, which generated revenue by providing financing, he noted. Now it's $8 per ticket, and Goldman is charging Bernina a flat fee of $40,000 a month. "It's quite an expense for a small fund," Ahmad said, citing additional fees for services like fund administration. "We have a fixed-cost basis of $70,000 to $75,000 a month just to stand still."

But Goldman is one of a shrinking pool of custodians that investors still favor. In fact, GMI may be fortunate to claim Goldman as its provider at all, since the biggest primes are weeding out clients that do not pass revenue minimums or show little prospect for growth.

Prime broker relationships have been smoother for many of the bigger hedge funds. According to Adam Stern, chief executive of AM Investment Partners in New York, his firm has yet to see any service changes. AM Investment's assets under management peaked last summer at just over $1 billion. Last week, said Stern, that number was closer to $800 million--still respectable, given how far the markets have fallen.

AM Investment in 2001 introduced its first fund, a convertible strategy that has suffered in the recent downturn, said Stern. The firm also manages merger arbitrage and volatility funds, the latter of which provided positive returns last year.

Although Stern declined to name his firm's prime brokerages, he noted that "we want to have a solid U.S. bank, a European bank and a solid brokerage such as a Morgan Stanley or Goldman Sachs." He added that peers have received difficult phone calls from their primes saying rates or margin requirements are increasing.

Part of the reason that AM Investment's services have not been altered, said Stern, may be its relatively low use of leverage. That practice is likely attractive to prime brokers, who are seeking to remove leverage from their balance sheets. And, of course, the fund company's assets place it among the sizable funds that top primes are most eager to do business with.

Stern praised the quality of his primes' risk-related reports, which his firm compares to those provided by its fund administrator, GlobeOp Financial Services, and the risk analyses it generates with third-party software--AM Investment also uses Imagine Software.

One change that Stern has seen is the way that banks his firm deals with view their prime brokerage unit. Previously, the prime, cash-equity, over-the-counter derivatives, futures and other desks operated separately from one another. As a result, the OTC derivatives desk might have denied services to a hedge fund starting out in that market with low volumes, even though the same fund was a major customer of the futures desk.

That approach continued through the second half of last year but has more recently turned around. "I see increasing cooperation across desks," Stern said. "Whereas before people were focused on their own business, now they're saying, 'Let's look at this fund's business holistically,' and prime brokerage is just one of the pieces to look at."

Stern said his firm is very active with the options desk of a major financial firm, which he approached last summer to propose using as a prime broker. The brokerage responded that Stern's firm didn't use enough leverage to open the account. Then, in late December, when "the dust had settled" after three months of volatility, said Stern, the broker came back to AM Investment and asked about its other business opportunities, in an effort to consider the hedge fund's overall relationship.

"They're not going to make prime brokerage a loss leader for their other businesses," said Stern. "But if the firm had a profitability hurdle to pass if we were only a prime brokerage client, then they would probably give us a bit of a discount if we were profitable in other parts of the firm."

That change is significant, said Stern, considering the competition for profits that had existed between a large broker's various desks. It is also a more effective way to draw business at a time when belts are being tightened. And with hedge funds' increasing adoption of multi-prime strategies, capturing a fund's other types of business has become even more important. AM Investment not only has several primes, but two for each account. "After a year like last year," observed Stern, "you have to continuously assess your counterparties, and you may have to make dramatic decisions to move balances to protect investors' assets."

As is to be expected, prime brokers are paring their services and staff to adjust to the reduction in revenues. GMI's Ahmad said services such as capital introduction are still available at the big primes, but those groups are thinner, perhaps because their focus on funds that are already large makes finding new capital less urgent. And ancillary offerings like conferences have mostly been eliminated, said Ahmad.

Although GMI is a relatively small fund, it opened up a second prime brokerage account in January at Newedge. While the Paris-based firm's prime unit is far from the largest, it offers one feature that eludes even Goldman Sachs. "There's an implicit state guarantee with Newedge that we don't have with GS," Ahmad said. "They only came out of their nationalized state a short while ago, the government still owns a substantial part of their equity, and Sarkozy is standing behind them."