Milltrust Perspective on the Prime Broker Relationship

September 21, 2018

BY Alexander Kalis

Manager perspectives on the prime broker relationship

By James Williams

With the rise of social media platforms over the last decade, led by Facebook, the way we think about connecting and interacting with people has drastically changed. LinkedIn provides a similar experience for our professional lives, while Amazon and Netflix seemingly know what we want to buy or watch before we’ve even thought about it.

This has created a unique experience where the customer feels as if they have a close relationship with the platform provider, despite being one of millions of people all benefiting in the same way.

Within the hedge fund space, one of the most important client experiences for any manager is the prime broker(s) they appoint to the fund. All primes are different and excel in some areas – electronic trade execution, cap intro, research, hard to access stock inventory, competitive finance costs, etc – better than others. But with today’s new and emerging managers, who have grown up with the Internet, they now expect superior client support and transparency more so than they did a decade ago.

Prime brokers are very mindful of this. Alexia Weiller is Global Head of Prime Solutions, Societe Generale Prime Services. She says the bank’s long-term strategy is to deliver superior client service where managers know exactly what costs they are paying.

“Even though there might be tough conversations on the level of service, the expected level of profitability, etc, when you are grounded and transparent I think clients appreciate it and are receptive to it.

“The more sophisticated millennial managers are trying to automate things as much as possible with all of their service providers. To do that, you have to be more transparent. They are pushing us to improve and giving us new ideas. We continue to find new ways to interact with them,” comments Weiller.

It is fair to say that pricing among different prime brokers remains somewhat of a black box. Trying to compare the cost of shorting emerging market stocks across four or five different primes remains a challenging exercise.

But as Weiller is quick to state: “We’ve actually been trying to sell the pricing and analysis of profitability as a differentiating factor at Societe Generale Prime Services. What I mean here is being able to explain to the client what their capital and equity footprint is, how their business is impacting our balance sheet, and how we look at their business holistically across all different activities (depending on trading strategy) and products.

“If, at the end of that discussion, a manager wants us to be more competitive, we might suggest they change the duration of their rates portfolio, for example.

“We analyse the trading pattern of the portfolio manager to try to gain a deep understanding of how they trade and how it has an impact on capital and liquidity. Then we explain to the manager how we compute the numbers so that they can do it themselves. It is the opposite of a black box, in that sense.”

One global market neutral multi-strategy shop that Hedgeweek spoke to runs a fund portfolio that comprises multiple different sub-strategies with different accounts and is well aware that some PBs treat asset classes better for margin relief than others.

“We therefore look to see how we can leverage one PB who might be better in fixed income compared to another PB who might be better in international equities, or one that can provide better intraday leverage for day trading. There are different leverage levels depending on the nature of the instruments being traded so leverage and pricing is an important consideration.

“Another big driver for us is knowing what the cap intro resources are. As we allocate to underlying sub-strategies, we find it useful for cap intro teams to send us suggestions for traders we should look into as well as make investor introductions,” they say.

Alexander Kalis is Managing Partner and Head of Investments at Milltrust International LLP, an institutional allocator based in London and Singapore, which currently manages a range of specialist emerging market-focused fund products. Speaking with Hedgeweek on how he thinks about prime brokerage relationships when allocating to managers, he says that prior to the financial crisis, he would take into account the calibre of the PB a lot more than today because managers typically used a sole prime.

“Post the financial crisis, hedge funds started diversifying and using multiple prime brokers and I think the playing field has levelled out today, in terms of quality. Most primes are on par now in terms of their offering to managers and investors,” says Kalis.

Expanding on the comment regarding the importance of cap intro teams, from Kalis’s perspective as an investor in hedge funds, he thinks there is less enthusiasm and corporate support because a lot of these teams simply do not have the budgets or resources they once had. “It’s become more commoditised and there’s been a lot of turnover in cap intro teams over the years,” he says.

“A lot tends to fall through the cracks, possibly because they assume investors won’t be interested, which might not be the case. I now find myself having to do a lot more of my own research. It helps that there are technology fund platforms available that help bridge the gap.”

Milltrust invests mainly in emerging markets and Asia Pacific-based fund managers which tend to be smaller in AUM, on average, compared to their US and European counterparts. Kalis understands that they might be too small for tier one prime brokers to justify using up their balance sheets and believes that managers are now more open-minded to working with specialist primes. Ultimately, there has to be a right fit, not just from an economic perspective but a cultural perspective.

“Emerging market strategies tend to be more long-biased for structural reasons and it means that primes get less revenue because they aren’t shorting as much as US or European hedge funds.

“Banks don’t have the budget or the bandwidth anymore. Their PB teams are getting smaller and they are trying to do more with less. The PB business has always been something of a cost centre. Now, with the multi-prime model being used by managers, it’s harder for PBs to get the same bang for their buck,” argues Kalis. “The timing is right for something to disrupt and improve the existing PB model.”

Speaking off record, another hedge fund manager tells Hedgeweek that although they trade frequently with their PB, and therefore generate a lot of commission dollars, they do not receive capital introduction support because of their size:

“We understand that they can’t really do anything about it – it is a resource constraint for the bank. Given our size, however, the fact that we have a relationship with a tier one prime is very helpful. As an emerging manager, we regard ourselves as being lucky that we are able to work with one of the industry’s top brokers but we understand the fit with cap intro might not be there.

“What we value most is the pedigree of the prime.”

This suggests that in the early years of growing their fund AUM, some managers still highly value the kudos of a tier one prime, even if the overall quality of the client experience is less than optimal.

Smaller funds place a lot of emphasis on wanting to partner with bulge bracket primes because they think it has marketing value but in reality, investors don’t care too much.

“The risk to these managers is that they might get squeezed out. I’ve seen that happen,” says the multi-strategy manager.

Multi-strategy hedge funds are in many respects, ideal clients. They might be market neutral, use leverage, do a lot of shorting, and perhaps have quantitative strategies in the portfolio that do a lot of trading.

“Therefore, making sure we are giving enough wallet to each of our primes is not too much of a concern for us. At the moment we have counterparty relationships with six PBs. One or two have less exposure to us at the moment but they are happy to grow with us. That’s why getting the right relationship in place is so important,” says the multi-strategy manager.

Over in Palo Alto, George Sokoloff is the Founder and CIO of Carmot Capital LLC, a sophisticated statistical arbitrage hedge fund that uses cutting edge deep learning algorithms to trade US equity markets. Over the last five years, he says that the ability to partner with a global PB has been hugely

important because Carmot’s investment strategy relies on extremely high quality trade execution; something that a smaller PB might not necessarily be able to offer.

“Although we are a sub-USD100 million fund, we are trading a lot. In terms of gross trades, it is around USD2 billion a year so commission levels are extremely important, as is the quality of execution. We look closely at how well the PB handles our trades, how much slippage there is, etc.

“There are many aspects to the relationship so I wouldn’t want to overemphasise one over the rest,” says Sokoloff.

He says that the fund does not rely on the prime broker to provide any research services and believes that one of the reasons the relationship works well is because the strategy is quite unique and uncorrelated with most things on Wall Street.

“That appeals to them from a fundamental growth perspective.

“One of the things that the big primes bring to the table is a variety of algorithms and good electronic trade execution options. We’ve been very happy with the variety of algorithms our prime broker has been able to offer,” concludes Sokoloff.

There are many different aspects that constitute what makes a good PB relationship. Ask 100 different hedge funds and you’ll get 100 different responses.

What remains clear, however, is that while PBs scale back resources in some areas like capital introduction, new technology platforms will continue to step into the breach to improve the way fund managers connect with investors.

It wouldn’t be surprising if some of the banks acquire technology groups to bolt on to their prime businesses over the coming years.

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