Thinking About Appointing A New Prime Broker?

If you are in the market for a prime broker, you may already know they offer a suite of services from custody, clearing and trade execution to cash management, but prime brokerage is first and foremost a financing business. Simply put, prime brokers offer leverage.

Shopping for a prime broker is not like buying a new car, where you can pick a price range and receive roughly the same product no matter which manufacturer you choose. Selecting the right prime broker is a very important decision for any asset manager, regardless of whether you’re a start-up or a multi-billion-dollar fund – it’s a partnership intended to last years. The stronger the relationship, the better the understanding of each other’s businesses, and the opportunity to generate greater results.

The prime brokerage landscape has changed significantly over the years. Historically, the industry has been dominated by two, maybe three key players, namely the usual suspects – Goldman Sachs and Morgan Stanley, with Bear Stearns not far behind. Following the collapse of the latter and the Lehman insolvency, the spotlight has been thrown on the prime brokerage model, legal agreements and the risks involved in appointing a prime broker. Today, diversification is more than just a trend, using multiple prime brokers became the new standard and an important point to consider from a counterparty risk perspective.

As the number of hedge funds continues to explode, you may find yourself in a position where your current prime broker must approach you to have a conversation about finding a new home, so they can continue to provide competitive services to other clients; or perhaps you may not be fully satisfied with the quality of the existing services or the rates that you’re being asked to pay. Either way, if you’re in the market to appoint a new “prime”, we’d like to offer the three buckets of most important considerations to have answers to when you begin your search.

While it may be tempting to immediately schedule a meeting with the top two prime brokers, arguably – you should first turn your attention internally and decide what your goal is. Asking these questions will help:

• What is your AUM, strategy and key services that your prime broker will have to provide?
• How much margin will you need for your strategy to be successful?
• What other services do you need from a prime broker and exactly how much money will be saved by not having to spend time and resources on managing those tasks internally?
• What level of security is demanded by your investors?

As part of this process of developing a list of potential candidates that meet your initial criteria, it is important to involve all key internal stakeholders and take a holistic approach. Your operations, legal and compliance teams may have certain requirements and needs that your new prime broker may have to meet.

Needless to say, an established equity long short manager will have different needs than a newly set-up commodity futures fund. The Tier 1 prime brokers, will be asking top dollar because of their top ratings and front-to-back offering, which includes advanced technology, integrated reporting, product customisation and all additional services they can provide, such as fund administration, but do you need to pay for top-tier? That depends on the answers to the above questions. Also, remember that nowadays prime brokerage is a competitive market and there are many prime brokers to choose from, including boutique firms that specialize in cap intro services and have strong networks of investors.

2. Legal documentation and on-boarding

The process of appointing a new prime broker can take months; from negotiating a new prime brokerage agreement, setting up any ancillary trading documentation (e.g., master netting agreements or opening jurisdictional markets), to KYC and on-boarding – all these tasks can take precious time away from your fund focusing on implementing its strategy. The key point to note here is to ensure that you plan for this accordingly and take under consideration any legal and on-boarding processes that might come into the picture whilst setting up a new prime brokerage relationship. The following questions will help you frame these discussions:

• What is the quality of your intended prime broker’s legal documentation?  A quick review with your legal team can answer this question, and they would be able to tell whether the documents are well-organized, and might take less time to review and approve, or if they are catastrophic and need months of negotiating. It may be worth considering preparing a term-sheet and agree on the key terms and concepts before the initial drafts are issued.
• Does the prime broker offer client money protection?  If so, what does that protection cost and what are the benefits?
• What rehypothecation rights does the prime broker have?  Your investor agreements may need to cover and/or allow this, so make sure the legal team touches on this point.
• How much interest does your fund receive on deposits?

Develop a list of your key requirements in respect of legal documentation and on-boarding that can be added to your sample portfolio and marketing presentation. Understanding the timeframes and agreeing a project plan will streamline the process.
3. Risk management

Although your fund is in the business of generating alpha, it is always predominately in the business of managing risks. Whether you are fledgling or well-established, you should have plans and strategies in place already, which address the various risks you may encounter, and searching for a new prime carries no less weight. If you got a “great deal” by hiring Bob’s Prime Broker Desk, it may not be a great deal for investors who’ve trusted you with their money, especially if cash management and bank accounts are one of your needs as a fund. Here are some important points to cover when assessing risks involved in appointing a new prime broker:

• Lessons from Lehman – what is the counterparty risk? Think how many affiliates are included in the agreement and which entity is actually providing the services? Also, be mindful of all the entities benefiting from the security interest provisions.
• Prime Brokerage is only one part of a big institution’s business – what else are they invested in?
• What are the rehypothecation limits? Can your prime broker explain the methodology used for re-use of assets and what are the financing terms?
• What are the costs for the services – ALL costs of services?  Be specific and make sure you review and agree your rate card and have the ability to revisit costs on a regular basis.

So far as the procedure of reviewing and appointing of a new prime broker is concerned, you may have an established Request for Proposals (“RFP”) process in-house, which has already been tried and tested and involves your internal stakeholders. Hopefully, some of the above questions can be used to enhance your existing list of enquiries.

If you don’t have a process in place yet, you can follow the standard DDQs outlined by the AIMA to prepare your questionnaire. Make sure you give your candidates enough time to respond to all queries across different categories, and set a clear deadline. Most prime brokers will offer to visit your offices to make a presentation. Take time to review and score all responses, once a decision is made, make sure you communicate this internally first before making any external announcements.   

If you’d like any assistance with your Prime Brokerage Agreements or RFP process, or have any questions about this article, please feel free to email me at edyta@fitlegalsolutions.com.

Best regards,