23 Dec 2010, Robert Angel, Bank of America Merrill Lynch, Hedge Funds Review
The market has seen a seismic shift over the last few years. This has resulted in changes that have impacted what managers look for from their prime brokers and what prime brokers have done to meet changing demands.
After the Lehman bankruptcy and various takeovers, managers learnt how exposed they were to their prime brokers. Since then there has been a move towards the multi rather than the sole prime broker model. In addition there has been a movement of balances away from the established US broker dealers which eroded the pre-crisis duopoly that existed within the international prime brokerage marketplace. Managers realised it was imperative they knew where their assets were being held and whether those assets were segregated from the company.
With the markets on a downward spiral, many new types of investors became interested in absolute return strategies with the aim of limiting their losses or even gaining from bear markets. This has led to new and existing investors to be increasingly selective as to the managers, strategies and structures in which they invest. Investors have started to demand a far higher level of due diligence on both the managers and subsequently on managers’ key service providers, in particular prime brokers.
One of the first effects of these changes has been a demand for increased transparency when negotiating prime brokerage documentation and understanding the granular legal implications and processes around items such as rehypothecation and client money. With the recent UK Financial Services Authority (FSA) paper on client assets, clients and regulators are looking for daily reporting confirming which of their assets have been rehypothecated.
Investors are also putting pressure on managers to ensure that unencumbered assets are segregated or moved away from the entity that is providing the prime brokerage services. With investors being more selective, they are engaging in far more detailed due diligence on their perspective managers and their service providers than before. This has resulted in the necessity for the manager’s core infrastructure to be more robust from an operational, procedural and technology perspective. Gone are the days when start-up managers could begin trading on Excel and without a chief operations officer (COO). If they did this in the current environment, they would find it hard to attract investors – even with a good track record.
The other implication of influence shifting to the investors is that capital introduction and similar services are in higher demand and more critical for most managers than ever before.
With more demand for absolute return strategies comes a wider and more varied potential investor pool. The majority of this new money is institutional. Although more of these investors are now interested in the alternative investment industry, they want to do so on their terms. This has prompted a growing interest in managed accounts and more importantly in onshore, regulated funds.
The explosion in the number of Ucits funds and the money now invested in Ucits – nearly 50% of hedge fund inflows in Europe in the third quarter of 2010 were into Ucits – is a direct result of this. It has also led to a kind of institutionalisation of the industry with long-only managers starting to launch Ucits versions of their strategies, enabling them to go short and use leverage and derivatives but in a regulated way, commonly referred to as ‘hedge fund lite’.
The European Union alternative investment fund managers (AIFM) directive and legislation coming out of the US is likely to change further the prime brokerage model. It is also likely to fuel the momentum around Ucits. Other events such as the short selling rules and Fin 48 have been a further catalyst for moving away from physical to synthetic prime brokerage.
Choosing a prime broker is an important decision for a manager. Even in the multi-prime world, a prime broker is one of a manager’s pivotal partners. For the core services prime brokerage is now fairly commoditised, certainly among the top tier. So in addition to a commitment to partnership and the quality of service provided by the pre and post launch daily contacts, it is value-add services and access to the rest of the company that clients should focus on.
One of the hardest factors for any manager is raising funds. This is the first value add to consider, making the quality and availability of capital introduction key especially in the current environment where investment is tough to attract. Being comfortable that a prime broker is stable, secure with preferably a large balance sheet, and has the backing of senior management should also be understood.
Other value adds can vary enormously. For start-ups selecting a prime broker early in their life cycle is especially important. Some prime brokers have consulting teams. If a manager can get access to them, that team can offer guidance around all aspects of a fund launch including structural and jurisdictional decisions, selecting the right third party providers and detailed operational and procedural expertise which can be invaluable to a start-up manager. The most meaningful advice comes from the consulting teams and companies that are impartial and do not have any direct joint ventures with third parties.
Bespoke structuring solutions can also be important for managers. Whatever strategy or investor segment is relevant to the manager, it is important to select a provider that has expertise in this field.
Perhaps most critical for clients is getting a comfort level that if they become a prime brokerage client, they will then have access to the whole company. This means the company will consider their relationship holistically rather than simply down the financing channel.
This could enable the manager to not just get a good financing service but also to obtain better access to research, derivatives and other products. Managers are now looking for more complete solutions from their financing partner, something that is only possible with access to the whole franchise.
The events of the last few years have changed the prime brokerage landscape as well as what managers are looking for from their prime brokers and how the community has adapted to meet these changes. With the regulatory environment and investor demands continuing to change, it is clear the industry has not yet reached the end of its evolution.
Prime brokerage is a dynamic industry with the ability to keep adapting to meet our clients and the regulators ever changing needs. A prime broker remains a critical partner for managers now and in the future and it is imperative that all issues referred to in this article are considered when selecting a prime broker.
Bank of America Merrill Lynch prime brokerage
Bank of America Merrill Lynch’s prime brokerage has business commitment from the top of the organisation and offers flexible multi asset class margin capabilities and a highly advanced service and reporting infrastructure. The quality and breadth of the offering is reflected by the many recent awards which specifically highlighted the bank’s innovation and service. As a response to clients looking for a remote bankruptcy solution, the bank launched Prime Asset Custody Transfers (PACT). This service is not only operationally convenient but also enables all unencumbered assets to be segregated regardless of whether they are needed as collateral.
In an environment in which capital is scarce, it is important to have a high calibre capital introduction offering. Bank of America Merrill Lynch has a strong and experienced team. In addition it has reorganised its consulting team with particular emphasis on Ucits and operational process and robustness. The consistent feedback from both investors and managers is that Ucits is becoming an increasingly important part of the industry. This prompted the bank to increase its expertise and capabilities in this area. The bank also operates a Ucits platform, Merrill Lynch Investment Solutions. This has raised over $1 billion for clients. The bank also offers a market leading swap product and has experienced teams in both seeding and structuring for Ucits managers.
The bank’s financing services are embedded into the rest of its global markets offering. This means prime brokerage clients are offered access to all parts of the bank. Flexibility and the ability to offer bespoke solutions to clients is a key differentiator for BAML and its success in this area was acknowledged when The Banker recognised the bank with its Most Innovative prime brokerage award 2010.. The Banker commented: “We were particularly impressed with the integrated platform and its capability for bespoke solution that enables this.”