A prime time to invest
Choosing a prime broker can be a daunting task for any hedge fund manager. David Walker met Lehman Brothers' Gunner Burkhart for some tips on how to make the right decision and avoid the political pitfalls common in some investment banks
Gunner Burkhart does not hesitate when asked what a hedge fund should look for when faced with a potentially confusing array of prime brokers, all trying to differentiate themselves.
"There are three basic questions to ask, before you delve into the quality and characteristics of the products.
"First, 'Where and how is the prime business positioned in the firm?'" he says, "and make sure you get a very clear answer on that. This is crucial to understanding both the degree of strategic importance of prime to the firm, and how your prime relationship will be viewed by the broader firm."
Second, Burkhart continues, they should ask "Which products actually reside within the P&L of the prime business?" By way of explanation the head of capital market prime services for Europe at Lehman Brothers in London continues, "I would ask which asset classes and products are within the P&L of the prime business, for example, where does the financing/reporting of credit, rates, the FX and derivatives and so on actually sit?
"And third, 'By establishing a prime relationship, what else do I get from the bank?' As a hedge fund, you need to ask if a prime relationship gives you access to other parts of the bank away from prime. Historically, funds did not think about what leverage can be gained from prime revenue."
So, if you're paying handsomely for margin lending or stock loan, Burkhart says it is worth using that to gain greater access to all sorts of other products within the bank, such as strategic advisory services, liquidity management products, quantitative portfolio analysis, and IT tools, for example. While esoteric products, or access to private equity deals may be more flavour of the month than such questions, try accessing products if the prime broker's business is not set up effectively for hedge funds and one can end up fighting a bank's impenetrable internal politics rather than just trying to access products or services.
"Your prime relationship should enable you to work through an entire firm without worrying about someone, with a different P&L, refusing to talk to you," Burkhart says.
Lehman has gone beyond pure products or instruments in its business advisory, a service Burkhart explains historically was focused on office space, technology and people, but which Lehman has expanded into strategic advice.
"If a fund wants to develop in Asia beyond just setting up an office and they want to tap into investors and strategies and want to understand regulations, we have people with experience in China, for example, who will help to see some of the opportunities and pitfalls."
On staffing, Lehman can also help with advice on structuring deferred compensation packages. "From the institutional side it is a big concern for them creating two tiers within their previously homogenous organisation. Should they have a different compensation structure for their hedge fund employees versus long-only team members?" Burkhart says.
"While the stock loan is important and other areas of financing and capital solutions, there are elements of that that are quite commoditised," Burkhart says.
"That's not what wins you the mandate these days, it's the other content you can bring to the table." Burkhart knows the questions to pose, first because these were the kind of questions Lehman Brothers asked itself two years ago before restructuring its prime services business in an effort to be "product-agnostic and client-centric". Second, Burkhart has sat on the client's side of the desk as a global executive committee member for Deutsche Asset Management dealing with the restructuring and inetrnal/external positioning of its 17 companies. This role involved a great amount of time dealing with investment banks and how to optimise them for DeAM.
"It was fascinating to see how the investment banks responded to their clients," he says, adding, "It was very different from bank to bank."
The one commonality among them, however, was that their services were all provided out of silos. By its very nature this structure meant that the line or product managers had a vested interest in winning as much business for their own product, and no compensation- or P&L-incentive to put clients in touch with other parts of the business. This is fundamentally not the case at Lehman Brothers, Burkhart says.
Some areas of product design are, of course, cutting edge, and Burkhart draws attention to some of the complex credit instruments such as tranches of CDOs and CLO structures, and Shariah-compliant products.
"You're also starting to see more private investments in some portfolios and physical assets," he says, noting these can demand of prime-broking departments new skill sets among employees.
Burkhart adds that Lehman Brothers offers "administration lite" directly for hedge fund managers who are its clients, but not as a full-blown, end-allocator facing service. "We will do an indicative NAV and do all the reporting and valuation of the underlying assets but we do not go down the route of providing a firm NAV."
For those end-allocators who wish to allocate to managed accounts instead of to off-the-shelf fund portfolios, Lehman Brothers has a number of its fund clients on its customised managed account platform, which offers position-level transparency of those managers on it, although liquidity terms are negotiated between investor and investee.
In the shallow end
On instrument liquidity Burkhart makes note of the illiquidity in many formerly liquid instruments over summer, adding there is now "quite some reluctance across the industry to get involved in the financing of assets where there is questionable ratings clarity, unquestionable illiquidity or unquestionable opacity in the asset."
(On the topic of illiquid private investments - another theme Burkhart sees arising in ever more hedge fund portfolios - he says knowledge is power, and potentially also flexibility on the part of a prime broker for margining and collateral. "We look for specific in-depth knowledge around an asset or sector and the geography, and the timescale, or when the asset is planned to become public, or more liquid." Where Lehman co-invests with clients - an area in which the bank is very active - there may also be an added level of comfort.)
In extremely complex or opaque circumstances of course Lehman Brothers could ask for 100% margin on assets, but in understanding them Burkhart feels Lehman Brothers holds an advantage.
"Not having a siloed approach means we can work easily in such situations with our structured credit and structured ABS colleagues in giving us a good understanding of them. When liquidity dries up we have people very well versed in the modelling of the assets," Burkhart says.
"Go back to August and there was a huge amount of disarray in the marketplace, not just in the cash markets and volatility of securities, but also in the financing markets and in how things could be priced. One of the differentiating factors then comes down to the ability of the prime broker to understand and price the assets, not in an easy environment - anyone can do it then - but in a difficult environment."
Constant dialogue
The other important activity, Burkhart says, is constant dialogue between funds and their prime brokers.
"What happened in August, and to some degree today, is that some prime brokers are changing their margin pricing without a full-blown dialogue with clients," he says. "So as a fund manager you're operating a fund where you think costs are X, and you get notification the following day that they're 2X." It may be due to short-term funding difficulties or balance-sheet tightening at some banks, he says.
"We have constructed a scenario margin-based methodology which stretches across asset classes, cash and derivative instruments, listed and unlisted. So for multi-strategy funds, for example, when a client comes to us we can find their cheapest, most efficient form of financing, because with us all assets are considered in one space, as opposed to multi-P&L demands within a firm. We can incorporate all the assets and take a holistic decision on pricing, as opposed to an amalgamation of pricing for different businesses with different constraints and pressures on them." This can also apply to execution pricing, Burkhart adds.
"Our prime services sit across all of equities, fixed income, banking and investment management departments. Most investment banks' structure is their greatest flaw in facing their client."
Ian Maynard, head of financing for capital markets, prime services, Europe for Lehman Brothers, adds, "Competitors can appear as flexible in their margining approach as we do and the margins there are in the product range, but the hedges with the portfolio intra-product do not get picked up in margin systems. Although you're running a credit margin and interest rate margin, these may not be being put together.
"If you have a flexible margining platform that really represents a flexible approach to risk and maintenance of risk capital, that for the COO of the fund is a strong selling point to an institutional investor base. You're addressing both valuations and risk capital."
And why are more prime brokers not structured thus, client-facing and product-agnostic? Two words come to Burkhart's lips - legacy and politics.
"You should not discount the politics involved and every investment bank has been structured along product lines each of which is given its own P&L, each of which motivates its people. We start with the perspective of the client rather than of a product, whether they want prime broking, or access to dark liquidity pools, or equities or high yield, and so on."
At Lehman Brothers by contrast, he says, hedge funds are likely to find investment products delivered agnostic of how or where they come from in the bank. (Lehman's staff are compensated on an attribution basis according to a client P&L, if you like, rather than a product-led basis, Burkhart explains.)
This is helpful for Lehman Brothers, of course, in that they can develop a more thorough and multi-faceted relationship with a hedge fund. However, it is also strategically useful in a climate where Burkhart says, with a couple of exceptions, successful hedge fund launches in the past five years have typically involved portfolios with more than one underlying asset class - and it is also these types of funds already in existence which he says are taking in the large slabs of money.
Burkhart supports the 80/20 rule, citing pension and other institutional investors as wanting "more robust and scalable institutional-like managers, and that tends to be with the bigger hedge funds with the financial wherewithall to build out an institutional-type organisation.
"Most funds feel that if they cannot get to $100m quickly in their first year their future growth will be difficult. The bifurcation of larger funds getting larger and smaller strategies closing is getting more extreme," Burkhart says.
One of the main users of large multi-strategy funds in the future, it could be reasonably argued, would be institutional investors in their various guises, moving from diversified and more focused FoHFs into single, yet more flexible, hedge fund portfolios.
Burkhart explains that such investors constitute but one of the categories of allocators introduced to clients through "capital solutions".The others categorised by Lehman Brothers are family offices, funds of funds, foundations and endowments, and banks and insurers. Lehman's pension solutions group may already be talking to trustees about how best to manage their liabilities, and may mention capital solutions, Burkhart says, or the introduction may also go the other way.
"Then you have what are considered at the present moment as the 'great diamond' among allocators - sovereign wealth funds (SWF)." Lehman has individuals whose sole responsibility is contact with such funds, predominantly in the US and Europe.
Burkhart stresses that capital solutions will leave neither party - fund client nor potential investor in them - uneducated about what the other one can offer or is looking for. He adds that, while in the past hedge funds may have looked for introductions to such funds, in the Gulf for example, now Lehman Brothers' clients should not be surprised if an SWF comes looking for a suitable hedge fund to invest in.
"I see sovereign wealth funds as growing in importance," Burkhart says. "Are some developing their own internally managed hedge funds? Yes. Are some investing in hedge funds and taking stakes or providing leverage directly or sometimes in an indirect way? Yes. I see all of those as areas of future dialogue and opportunity for us."
Another opportunity may arise for investment banks in helping SWFs as clients understand how to conduct due diligence and risk analysis on hedge funds as an investment option.
"A number of them are in quite an early stage of their own development and are trying to figure out, like any good manager, how to risk-manage their portfolio and how to understand and do due diligence and get introductions to and build relationships with credible managers. Many of them are therefore seeking advice on these matters.
"Hedge fund managers have come to us and said, for example: 'I am going to the Middle East; can you put me in touch with someone you rate highly?' But over the last two years we have seen SWFs saying to us increasingly: 'Can you advise me on matters?'"
WHERE TO FROM HERE?
Lehman Brothers' prime services team is optimistic about the hedge fund industry in the future.
Burkhart notes some slowing in the pace of growth, to about 600 funds launched in the first half of 2007, "but that puts us on a launch pace back to 2003/2004 of around 1200 funds in a year," he notes.
He says, however, that he expects some slowing in the third and final quarters of 2007 after summer's turbulent markets and possibly some allocators holding off investing.
Burkhart adds that Europe has displayed higher growth rates in the industry than has the US, with about 10% of hedge fund assets globally managed out of Europe in 2003/2004, increasing to around 30% today.
Burkhart sees a continuation of growth in dynamic extension products, with around $100bn already invested in 130/30-type portfolios.
Ian Maynard adds, "Every large asset manager and some hedge funds in the UK are talking about this product or thinking about launching it and about 25% of them have launched some product already, some of them quite quietly, and many with internal seed money to build up a track record."
Anecdotal evidence suggests that Lehman Brothers has been retained as prime broker for nearly the most, if not the most of these launches and given the ability of 130/30 funds to borrow the physical as well as using synthetics to short could see prime brokers even more involved in the retail space.
Burkhart also sees a continuation by some managers down the liquidity curve when it comes to investments. "Historically you saw 30- or 60-day lock-ups as the norm, but increasingly managers are asking for one-, three- or five-year money from some of their investors."
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