In the wake of the Bear Stearns and Lehman difficulties, many hedge fund managers have migrated toward a ‘multi-prime’ environment, in which more than one prime broker is utilized by the fund. On closer examination, a number of hedge funds have not only failed in their dual objectives of setting up a true multi-prime relationship and reducing their overall operational risk. Indeed, quite a few hedge fund firms have increased their operational risk without even realizing it. This article examines steps that hedge fund managers can take to achieve their objectives and enhance their operational risk profile.
Multi-Prime Involves Multiple Relationships for Each Fund
The use of multiple prime brokers (yes, a contradiction in terms!) allows a fund to maintain assets in more than one location, thus diversifying the fund’s counterparty risk. In an efficiently managed multi-prime environment, the hedge fund manager can optimize the use of each prime broker to obtain better rates and gain regional or instrument-specific coverage for borrowing and / or research. Yet hedge fund managers that have established multiple prime broker relationships in which Fund A is held with Prime Broker 1 and Fund B is held with Prime Broker 2 do not provide the manager with the facility to rapidly move assets from Prime Broker 1 to Prime Broker 2 in a crisis. Thanks to Know-Your-Client (KYC) and Patriot Act regulations, prime brokerage firms require extensive compliance reviews of any new account opening. The demand to open new accounts has hit all-time highs at prime brokerage firms, often delaying what was already a slow process. To ensure nimbleness in turbulent markets, open accounts now for each fund under management with multiple prime brokerage relationships.
Size Does Matter
While hedge funds are becoming more astute about their prime brokers’ strength and stability, the brokers themselves have become more selective in terms of the clients they accept. Smaller hedge funds may find themselves unable to secure the services of the larger firms altogether, much less having an ability to establish multiple prime brokerage relationships where the assets under management are spread across multiple primes. For firms with larger overall assets under management, it is generally more prudent to establish two to three firm-wide prime brokerage relationships across all funds than for each individual fund to have its own independent set of prime brokers (resulting in a much larger number of relationships). Overall relationships are important to prime brokers when establishing pricing and determining the suite of services to offer a hedge fund manager. These bundled service offerings can be challenging at best to decipher in terms of costs and savings. Not generally known as philanthropic organizations, prime brokers are looking to make money, too, so hedge fund managers are well advised to evaluate the prime broker’s perspective during negotiations. Hedge funds that are unattractive clients could find themselves without service providers.
The Emergency Backup Approach
Some hedge funds have opened a second prime brokerage account and are only leaving small balances with the new broker, still utilizing a single prime brokerage relationship for the majority of their business. They believe this environment secures their ability to make a rapid switch away from their main prime broker to the backup firm in the event potential trouble is identified on the horizon. There are a number of flaws with this logic. In some instances, hedge funds may not be able to secure borrows for all short positions at the backup broker, particularly during market turbulence. Interfaces may need to be built between the hedge fund’s trade and order management system and a second prime broker.
Operational oversights may limit the manager’s actual ability to shift prime brokers at a moment’s notice. User IDs may not have been established with the new broker, staff may lack training on the new broker’s systems and reports to manage the fund on a day-to-day basis may not have been identified.
Perhaps most important of all, there may be no forewarning of trouble with the main prime broker. In such a scenario, close to 100% of assets will have been placed at risk unnecessarily.
While having accounts opened for each fund at another prime broker does provide some additional maneuverability in the event of trouble, the operational risk that is introduced without appropriate planning is unnecessarily high and unattractive to current and potential investors.
Consolidated Information
For a single fund to truly maintain significant assets at more than one prime brokerage firm, it is often necessary to establish an internal facility to track the fund’s investments on a consolidated basis. Historically, many firms opted to utilize hearsay reporting in which one prime broker takes portfolio data from another prime broker and reports it to the hedge fund manager on a consolidated basis. This approach has several drawbacks. To begin with, the prime broker providing hearsay reports cannot – and will not – vouch for the accuracy of the information supplied by other prime brokers. In addition, for those hedge funds who would like to keep their prime brokers in the dark regarding the fund’s overall positions and activities, hearsay reporting is an undesirable option. Further, if the prime broker that performs the hearsay reporting is the one to end up in trouble, operational problems at the hedge fund could escalate at precisely the moment when accurate and timely information is perhaps most critical.
Other internal processes or systems are developed by a number of hedge fund managers to consolidate information at the fund level. Some firms will rely on a front-end trade and order management system to provide a consolidated view, though many such applications do not track all of the instrument types that a fund might trade and generally will not track a security’s location. Others will implement a data warehouse, often an expensive solution and, if home grown, possibly lacking an audit trail. Quite a number of firms have embraced the most popular application utilized in the investment management community – Microsoft Excel. This latter option, however, should be viewed as anything BUT a risk-averse solution.
The most common approach will involve the implementation of a system to perform shadow investment accounting on the portfolio. One of the many advantages to shadow accounting is the ability to track separate accounts as well as hedge fund portfolios, thus allowing the hedge fund manager greater flexibility in responding to investor demand in this area. However, the introduction of any new system necessitates additional reconciliation and other care and feeding. This requires competent and qualified staff, documented workflows and appropriate segregation of duties. Without proper system selection and implementation, the hedge fund manager may not only experience higher levels of operational risk, but also significant financial expenditures.
With the likelihood of increased regulation on the horizon for hedge fund managers, the attractiveness of implementing a shadow accounting system is only enhanced. With such an environment, hedge fund managers can then implement a variety of best practices currently used by traditional investment managers. When effectively implemented, shadow accounting systems can assist managers with having a consolidated view of their fund while reducing their operational and financial risk profiles substantially. Shadow accounting can also improve the accuracy and timeliness of information available to the portfolio manager. In addition, a well-implemented shadow system can go a long way toward reducing a fund’s audit costs. Current and potential investors prefer to invest with firms that have established a shadow accounting capability.
Other Considerations
All firms, regardless of whether they are moving toward a multi-prime environment, should take strides to better understand their prime brokers’ fee structures. Knowing the rates changed by each prime broker and making optimal use of each firm’s services will result in improved portfolio performance. Remember, portfolio returns are net of such fees, so careful management of expense ratios is important.
Disaster recovery plans need to be reviewed and possibly updated as a result of any change in systems, workflows and / or service providers. The addition of new prime brokers can implement business continuity plans in a variety of ways. Such plans should be reviewed annually anyway, but waiting for the annual review is not prudent when making significant changes to the way the firm operates.
Finally, all hedge fund managers need to remember their own obligation to perform adequate due diligence on the prime brokers – and fund administrators – they select. Questionnaires, requests-for-proposals, face-to-face meetings, financial / credit evaluations and document reviews are all important parts of the process. This is not a one-time process that occurs only when a prime broker is initially engaged, but an ongoing process that requires constant oversight and updating. Hedge fund managers should set clear criteria for prime broker evaluation and selection and ensure that all prime brokers in their roster continuously meet those criteria. In addition, records should be maintained to document the initial and ongoing review process.
Conclusion
Moving toward a multi-prime environment, when well thought out, is a terrific move toward reducing operational risk. But when poorly planned, a multi-prime scenario can introduce new risks to a firm and fail to provide the intended safe harbor in times of distress. Hedge fund managers and their investors need to ensure that any multi-prime environment is logical, effective and executed appropriately.
Stone House Consulting, LLC 