Pulling together

Last year was an odd one for the prime brokerage market. It started with Wall Street avoiding small hedge funds like the plague, and ended with a number of the largest prime brokers returning to the market in earnest.

It was late 2008 when former Bank of America chief executive Kenneth Lewis compared the dangers of prime broking to that of someone crossing a busy road to pick up a small coin - high risk, low reward. The titans of Wall Street - the well-established prime brokers - were content to sit on the sidelines, watching as freshly-launched hedge funds fell into the hands of mini- and mid-prime brokerage houses. But now that the industry has pulled itself back from the brink of collapse, bulge-bracket firms are once again willing to take the risk of crossing that road to snap up smaller hedge fund clients. In this new environment, mini- and mid-sized prime brokers have looked to find new ways of not only competing with their larger counterparts for clients but also complementing those same counterparts at the same time.

"Over 2009, with the bulge brackets staying out of the market, that left a nice opportunity for some of us smaller guys to basically traffic in accounts that may have gone to one of the larger prime brokers back in the day when things were a lot more contained," says Fredrick Scuteri, senior vice-president of prime brokerage services for mini-prime broker, Cuttone & Co. "What we've noticed, though, is that around the fourth quarter of 2009 the larger prime brokers started getting back into the game and reached a little bit lower in terms of the clients they would service."

Scuteri recalls one such instance where a $75-million start-up hedge fund was signed by Cuttone. It was January 2009 when the fund initially approached Goldman Sachs for servicing, but was promptly turned down. Scuteri says the fund's managers disclosed from the outset that they would have liked to have a relationship with Goldman because one of the principals in the firm was a former employee of the Wall Street bank. Prior to the crash of 2008, Scuteri explains, Goldman would probably have taken the hedge fund under its wing, but baulked at the opportunity in what was then an angst-ridden environment.

Fast forward to Q4 2009: the Dow was back above 10,000 points, and Goldman was once again turning pretty profits and even talking about handing out fat bonuses. While Cuttone was servicing the fund providing it with a range of services that it needed, before the end of the year Goldman had swooped in and accepted the fund as a direct prime brokerage client, signalling a change in its fund servicing strategy.

New environment

According to data provider Hedge Fund Research (HFR), it wasn't until the third quarter of 2009 that hedge fund start-ups outweighed liquidations. That change helped bring about the return to confidence in the hedge fund market, an industry hit especially hard by the downturn - there have been 2,000 hedge fund liquidations since the market started heading south in 2008, according to HFR.

In an effort to recoup lost assets, large prime brokerages have lowered their minimum operating thresholds. Scuteri says that at the beginning of 2009, minimum assets under management were in the neighbourhood of $500 million, but as the first quarter of this year comes to a close, that figure has fallen to $250 million, while, in some instances it has dropped significantly lower, most notably when a fund is able to rely on a previous prime broker relationship.

"In my opinion - but I cannot confirm this - a lot of the motivation for the bulge brackets to reach down a little bit lower for smaller-sized hedge funds has to do with regaining asset balances on their balance sheets," says Scuteri. "I get the feeling that they're trying to dip their toe back in and recoup some balances from smaller clients they probably wouldn't have serviced a year or two ago.

"From my experience working at the bulge brackets, I think a lot of the measurable success by the larger firms in the prime broker business is determined by the balances they carry on their books in terms of assets. Following a lot of liquidations at the bulge brackets - both from clients closing [funds] and investors redeeming capital, I think the bulge brackets saw a lot of assets fly off their balance sheets."

It's an interesting dichotomy where smaller prime brokerages are forced to compete for customers with their larger counterparts. Cuttone, for example, has custodial relationships with both JP Morgan and Goldman Sachs.

Taking the multi-prime route

‘Multi-prime' is one of new catchphrases being bandied about on Wall Street. If the collapses of Lehman Brothers and Bear Stearns have taught the industry anything, it's that large institutions can, and do, disappear overnight. And so as clients look to spread their risk exposures, having multi-custodial relationships has become a major selling point for smaller prime brokerages. Ron Suber, senior partner and head of global sales at New-York-based prime broker Merlin Securities, says that starting in the fourth quarter of 2009 he started to see the larger prime brokers "swoop down and take on some of the smaller funds with higher pedigrees and fairly good odds of succeeding and growing. They did not do that prior [to the market crisis]," he says, adding that notwithstanding this trend of the large players poaching existing clients, Merlin was able to add 192 clients in 2009 and another 30 in January of this year, due largely to its multi-prime custody model, which it offers in partnership with JP Morgan, Goldman Sachs and Northern Trust.

"While those bigger firms are terrific, they still only offer one custodian," Suber says.

Certainly, smaller brokers don't have the IT budget that a major investment bank has, although this doesn't necessarily render their offerings inferior. While their product suites may not be appropriate for $1 billion funds, mini-primes can deliver competitive offerings because they don't have as much red-tape to cut through and the testing periods are quicker than those of bulge-brackets brokers, says Scuteri, who used to work at JP Morgan and UBS. Instead of moving a product pitch up the chain of command to get committee and board approvals, Scuteri is happy to report that he has top management's ear from the outset.

"In my five years at Cuttone, it's something that's very rewarding when you have an idea and you walk into an office and you have a conversation and right there and then it's decided whether I can move forward or not," he says.

Additionally, technology vendors have an easier time walking through Cuttone's doors than those of large prime brokerage.

"For what Cuttone is to the prime broker space, there are companies like us in the technology space that deliver very robust, affordable solutions to the lower-tier hedge fund community," he says. "Those are the companies I'm constantly seeking and the ones I always have open dialogues with."

Scuteri acknowledges that it's not necessarily Cuttone's job to have more cutting-edge technology than the industry's largest firms. However, he sees it as his firm's mission to help smaller hedge funds grow and, eventually, to introduce them to Goldman or JP Morgan once they've become too large to service. "That's a problem we all want to have," he says.

No competition

Mike Rosen, managing director at New York-based institutional broker Concept Capital, says, like Scuteri, he's not trying to compete with the bulge bracket brokers when it comes to technology. Rather, his firm tries to work in partnership with Wall Street.

"I don't know that the technologies we have differentiate us from Goldman or JP Morgan, per se," he says. "The technologies that we deploy allow small- to medium-sized hedge fund managers to better use the capabilities that JP Morgan or Goldman have. We supplement their offering."

Rosen points to an alliance with SAS as an example of this scenario. The partnership allows Concept Capital to offer its clients a multi-custodian portfolio, analytic and risk management platform, which is what the smaller hedge fund market is asking for, he says.

"Those are the things that are going to allow us to attract high-quality customers and aggregate business for, and in partnership with, Goldman, JP Morgan and others that we deal with," Rosen says.

He also doesn't view the bulge-bracket brokers reaching down into the smaller hedge fund market as necessarily a bad thing. He says the environment prior to the crisis was a good deal more competitive, but over the last two years the larger prime brokers have introduced smaller clients to Concept and asked the funds to establish relationships with them through Concept as an introducing broker. That wasn't the case a few years ago, he says, and he expects that to remain the norm.

"There was a period of time when large prime brokers were jettisoning many customers," he says. "A year ago to the day [mid-February 2009] the industry was in a whole bunch of turmoil. Things have settled down now and everyone is looking at things in a more rational manner. So yes, large prime brokers are considering customers that they may not have three, six or nine months ago, but the trend is still more favourable, in aggregate, than it was a couple of years ago."

Matt Simon, an analyst at Tabb Group, described the relationship between the large and smaller brokers as symbiotic. Rather than servicing a $100-million hedge fund directly, and putting the technology and human resources behind the partnership, it's more profitable for the large brokers to have that hedge fund go through the multi-prime model instead.

"What the big banks have started to realise is that this isn't a good deal for them," he says. "Even though a big player like a Morgan Stanley, JP Morgan or Goldman Sachs may not be going out and actively soliciting smaller hedge funds, through their mini-prime relationships they're making money. The mini-primes have been able to bring an interesting and enticing business model to the table that at one point didn't seem like it was going to win over much business." ><