The 2014 Alpha Awards: Top Prime Brokers

John Stathis took over Barclays Prime Services last August with a mandate to make his firm one of the biggest prime brokers in the business.

It won’t be an easy task. The so-called bulge-bracket players — U.S.-based megabanks Goldman Sachs Group, Morgan Stanley and JPMorgan Chase & Co. — have dominated the prime brokerage industry since 2008. And Barclays’ European competitors Credit Suisse and Deutsche Bank have gained enough ground over the past couple of years to rank with the major brokers.

These are make-or-break times for the prime brokerage divisions of large European banks. Stathis, who is based in New York and previously headed Barclays’ sales, research and distribution divisions for the Americas, knows his institution can’t compete forever in the second tier. With the goal of expanding Barclays’ prime brokerage assets by 20 percent in 2014, he has set the bar high. “We believe we can get into the top tier,” Stathis says. “We feel like we are on a path to get there.”

Hedge fund clients appear to be pleased with the firm’s efforts. Barclays ranks No. 1 among prime brokers in the 2014 Alpha Awards, after capturing the No. 2 spot last year. Deutsche Bank jumps five spots to No. 2, followed by Credit Suisse, which repeats at No. 3 overall. Bank of America Merrill Lynch comes in at No. 4, rising a full six places from a year ago, while Goldman Sachs, the 2013 winner, drops to No. 5. The Alpha Awards are based on a survey of more than 400 hedge fund firms in which we asked managers to rate the quality of service they received from their prime brokers in ten different areas, ranging from Financing and Securities Lending to Asset Protection and Capital Introduction.

When it comes to size, the prime brokerage divisions of Goldman Sachs, Morgan Stanley, JPMorgan, Credit Suisse and Deutsche Bank dominate the industry. Barclays, BofA Merrill, Citi and UBS rank as large prime brokers but have fewer assets than the bulge brackets. However, this is a business in which hedge funds can shift their assets fairly easily, and the Alpha Awards survey suggests that some of the prime brokers on the rung just below the top might be trying just a little bit harder.

Prime brokerage is an industry with finite revenue and about 20 players going after the same hedge fund clients. Prime brokers earn their money not from selling service per se but from hedge fund transactions, generally through spreads on financing, commissions on trades and settlement fees. As a result, their fortunes tend to rise and fall with those of the hedge fund industry. Global prime services brought in approximately $11 billion in revenue in 2012, according to the latest estimates by Boston Consulting Group, based upon a sample of 28 banks. The revenue figures reflect the path of hedge fund trading, especially the more lucrative trades in derivatives and short sales.

The revenue was higher in previous years — $12 billion in both 2011 and 2010 and $16 billion in 2009.

Although prime brokers do not make their asset figures public, James Malick, a New York–based partner in the financial institutions practice at Boston Consulting, estimates that Goldman, Morgan Stanley, J.P. Morgan and Credit Suisse provide prime brokerage services for at least 65 to 75 percent of the $2.6 trillion in global hedge fund assets. What has opened the doors to competitors, however, is the now-standard practice, at least among hedge funds with $100 million or more in assets, of retaining two or more prime brokers. The financial crisis put an end to the days when a hedge fund manager trusted his or her capital to one firm. Hundreds of hedge funds lost assets when Lehman Brothers Holdings went bankrupt in 2008, and it became a measure of prudence to spread the risk around. The financial crisis made J.P. Morgan a major player in prime brokerage through its acquisition of Bear Stearns Cos.; Barclays expanded its prime brokerage business when it bought Lehman’s investment banking and trading divisions.

These days a multibillion-dollar hedge fund firm might use three to five prime brokers, each one clamoring for larger shares of its business. Part of the reason for choosing a particular prime broker is strategy. Morgan Stanley and Goldman have historically held the lion’s share of long-short hedge fund strategies. Barclays is a specialist in quantitative strategies, although prime brokerage chief Stathis says the firm is looking for growth opportunities by taking on more global macro, debt and long-short equity funds. Deutsche Bank is known for its expertise in more-complex strategies, including convertible arbitrage and distressed debt.

Hedge fund managers gravitate to prime brokers that give them personalized service as well as knowledge of the hedge fund industry, judging by the Alpha Awards. Respondents were asked to comment on where they thought their prime brokers excelled and where they thought there was room for improvement. “Goldman Sachs’ client service is best in class,” says one manager. Another adds that Goldman has been a very valuable adviser in helping to minimize risk in European markets in such areas as currency exposure and stock exchange fees. One respondent singles out BofA Merrill’s “outstanding white papers on all relevant issues of the day.” On the negative side one participant complains about “a condescending attitude when dealing with smaller funds” at J.P. Morgan. Even the top dog isn’t immune from criticism: One commenter complains that Barclays’ services are not individualized enough.

The Alpha Awards survey also asked respondents to rank prime brokerage services in order of importance; Asset Protection tops the list. This alone might be a clue to the rising popularity of Barclays and Deutsche Bank, both multinational, European-based banks with strong balance sheets.

Barclays ranks No. 1 in Asset Protection, followed by Deutsche. Since the collapse of Bear Stearns and Lehman, hedge fund managers and their investors have learned that counterparty risk is a major concern. Just as a prime broker’s management might become concerned if a hedge fund’s value dropped drastically or if a majority of investors started demanding redemptions, a hedge fund and its investors might ask for an explanation if a debt rating agency suddenly lowered its rating on a bank or if a bank’s credit spreads widened.

For prime brokers there is something of a chicken-and-egg situation at work. A prime broker needs a strong hedge fund business to be able to protect its clients’ assets, so the heads of prime brokerages have to put their efforts into cultivating relationships through so-called soft services like capital introduction and consulting. They also have to compete for the best terms and prices in securities lending and financing — the revenue-driving part of their business. Competitive pricing is becoming a real challenge.

In the past, the costs of transactions were fairly low for prime brokers because they were able to self-fund their activities, using the collateral of one client’s assets in transactions for others. The self-funding model is pretty much gone thanks to resistance from clients along with regulatory guidelines aimed at balancing prime brokers’ liabilities more closely with their assets. Prime brokers are still absorbing the costs, though most have active campaigns under way to keep their clients informed about why lending costs will eventually go up for them as well.

Before Stathis stepped into his present position at Barclays, his predecessor, Ajay Nagpal — now chief operating officer at New York–based hedge fund firm Millennium Management — launched a campaign to let clients know about the rising costs of liquidity and securities lending. Stathis has continued the effort. “The cost of securities lending has been a big part of our dialogue with clients,” he explains. “We spend a huge amount of time educating clients on the impact of regulatory change on markets and the financing business. Some of the changes will be in cost, some in availability, and it will affect different types of funds differently. We’ll have to be more selective about what we do with whom.”

As Dean Backer, global head of sales and capital introduction at the prime brokerage division of Goldman Sachs, sees it, competitive pricing is becoming less important than acting as a partner: An affiliation with a big bank allows hedge fund firms to tap into new sources of capital. Although capital introduction and consulting don’t produce direct revenue, prime brokers view them as important services to help clients grow assets, which presumably will lead to more spending on transactions.

Soft services are useful to the prime brokers too, as a way of capturing business through an all-encompassing relationship. The banks’ credit ratings and economies of scale depend on having a secure, steady cash flow, and hedge fund clients are in an excellent position to provide that. The prime brokers are seen as bringing in business for the banks in a very efficient way, as well as serving as a portal to the banks’ other services. The drawback is that the hedge fund might not be keen on all of the bank’s services.

Among the positive survey comments this year was an accolade for Citi, No. 9 in the prime broker ranking, for a new line of business that most large brokers hope will become a meaningful revenue stream in the next few years — over-the-counter derivatives clearing and settlement: “Their client service and OTC clearing platform has been super.” The ability to clear and settle OTC derivatives trades is an important outgrowth of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires that most OTC derivatives be traded on a central clearing platform to reduce pricing risks.

Paul Germain, global head of prime services at Credit Suisse, is also getting into the OTC derivatives business. He recently put together a symposium for clients on OTC clearing, and three 6-foot-high white block letters — O, T and C — left over from the event still stand in the office of Jeffrey Jennings, global head of prime derivatives services. “It’s difficult to predict the ultimate size of OTC clearing, but we see it as developing into a core requirement for clients,” says Germain.

Top-ranked Barclays would also like to be a leader in OTC derivatives clearing. “There are a lot of complexities around margin requirements and the costs of clearing to clients,” says global head Stathis, adding that to be successful, a prime broker has to be a strong counterparty. After all, hedge funds’ No. 1 concern these days is protecting their assets.

HOW WE COMPILED THE RANKINGS
Institutional Investor’s Alpha compiled the 2014 Alpha Awards ranking of top prime brokers, hedge fund administrators, law firms and accounting firms based on voting from last fall and early winter by some 500 hedge fund firms, including many in the 2013 Hedge Fund 100, our ranking of the world’s 100 largest hedge fund firms. Hedge funds were asked to rate the quality of service they received for the 12 months ended August 31, 2013, across a variety of attributes. The scores were weighted according to a voting firm’s assets under management and then averaged for each service provider within each attribute. In the accompanying tables we rank only those firms for which we received a minimum number of responses. To be considered for the overall ranking, prime brokers needed to rank in at least seven of the ten prime brokerage attributes; administrators needed to rank in at least five of the nine hedge fund administration attributes; law firms needed to rank in at least four of the six law firm attributes; and accounting firms needed to rank in at least four of the five attributes. The Alpha Awards survey was conducted by Senior Research Editor Jane B. Kenney.