The 2015 Alpha Awards: Top Prime Brokers

Teresa Heitsenrether has a history of stepping into new jobs just in time for big changes. She joined J.P. Morgan in 1987, fresh out of Fordham University, entering the banking business and beginning her executive MBA studies at New York University’s Leonard N. Stern School of Business at about the time the world was reeling from the stock market crash in October of that year. She moved from J.P. Morgan’s treasury department into the prime brokerage division in a year of more upheaval: 2008. Back then the bank had a small prime brokerage division, but it grew overnight into one of the three largest in the world — the so-called bulge-bracket prime brokers — when JPMorgan Chase & Co. bought Bear Stearns Cos. After the collapse of Bear Stearns and then Lehman Brothers Holdings, hedge fund managers were worried about the solvency of their counterparties, and the largest funds were retaining anywhere from three to five or even more prime brokers.

“We embarked on a growth campaign, with a plan to round out our products internationally,” Heitsenrether explains.

Now, as global head of prime brokerage at J.P. Morgan, No. 1 overall in the 2015 Alpha Awards for prime brokers, Heitsenrether is steering the firm through the biggest change yet, as banks and their prime brokerage divisions adapt to a new regulatory climate. The 2015 Alpha Awards, which grade hedge fund service providers on a variety of factors, are based on a survey of more than 625 hedge fund firms, including many in the Hedge Fund 100, our ranking of the world’s 100 largest hedge fund firms. Fund managers were asked to rate the quality of service they received from their prime brokers over the past year in ten different service areas. J.P. Morgan jumps to the top spot after coming in at No. 7 last year. Credit Suisse ranks at No. 2 this year, up from No. 3 last year, switching positions with Deutsche Bank.

Heitsenrether says regulatory changes are forcing prime brokers to reassess their relationships with hedge fund clients. “The regulations say that growth at a bank has to come with adequate capital to support it, so you can’t grow your balance sheet to unlimited anymore,” she says. “That means we have to set up strategic relationships with our clients so that their business generates the appropriate returns on an aggregate basis.”

If that sounds like a weighty demand on hedge fund managers, it is. The regulation in question is Basel III, the third round in a set of reform measures from the Basel Committee on Banking Supervision aimed at making sure banks never again lend money or take risks that they can’t back with their capital reserves, as Lehman Brothers and Bear Stearns did in 2008. Banks are now strengthening their capital reserves to make sure they’re fully compliant when the accord comes into full implementation in 2019. Under Basel III banks have to be sure that the loans they make will be highly profitable, so they are in some cases restricting the lending and financing they provide for hedge fund trades, and in other cases they are charging more for those activities.

What this means for hedge fund managers is that it’s now a mark of prestige if your prime broker wants to keep doing business with you. In that sense, prime brokers now have the upper hand over their clients, but the responses to the Alpha Awards survey indicate that what hedge fund managers appreciate in return is a prime broker that takes a leadership role in showing them how to work with the various divisions of the bank so that they can add to the profit margins.

“Basel III means that not all balance sheets are created equal,” says Heitsenrether. She helps hedge fund customers to be what prime brokers are now calling good clients: those that help the parent bank bring in more liquid reserves in proportion to lending. It helps a lot, in other words, if they are active clients in many different divisions of the bank.

The written-in comments this year were telling. J.P. Morgan also scored at the top in areas that respondents deemed most important, coming in at No. 1 in Asset Protection and No. 2 in Client Service as well as Clearing & Settlement.

Goldman Sachs — the largest prime brokerage in the world, with approximately 18 percent of all hedge fund business, according to London-based alternative-asset research firm Preqin — comes in at No. 6 overall on the Alpha Awards survey. That’s down from No. 5 last year and No. 1 in 2013. To be fair, the results are subjective, and Goldman did receive a strong share of accolades from clients, including one who said, “Goldman Sachs has the best client service and the most knowledgeable staff no matter who you contact.” But the current environment can be expected to cause some fraught relationships, and Goldman also received some criticism. Part of the dissatisfaction may stem from the fact that Goldman is being very selective about its hedge fund clients, keeping only those that produce the most trading volume.

A spokesman says Goldman has been holding this kind of conversation with fund manager clients for the past several years, letting them know whether their balance sheets measure up. The firm’s selectivity might be paying off: After unimpressive performance early last year in its securities services division, which houses the prime brokerage business, revenue in the division rose 3 percent for 2014 over the previous year, to $1.4 billion.

At the same time, the voting for the Alpha Awards has rarely been about size, and this year is no exception. When it comes to share of the hedge fund market, Morgan Stanley serviced 13 percent in both 2013 and 2014. J.P. Morgan is now No. 3 in market share among the three biggest bulge-bracket firms, servicing 12 percent of all hedge funds in 2014, a slight decline from its 13 percent market share in 2013.

Now the message to hedge fund managers is “Be a good client, or else.” The so-called midtier prime brokers have not been immune to the pressure to shed unprofitable clients. Deutsche Bank, which has about 6 percent of all hedge fund business, also is said to have asked clients to leave. Bank of America Merrill Lynch, which is No. 4 in the Alpha Awards and has about 4 percent of all global hedge fund business, reportedly cast out some 150 hedge fund clients last year to bring costs down.

One survey respondent was unhappy with J.P. Morgan because of the precarious situation for hedge funds, commenting, “J.P. Morgan is in the process of asking us to prime broker elsewhere and offering weak service in the interim.” J.P. Morgan declined to comment on specific clients.

Not all prime brokerage heads want to talk about the state of their industry. Deutsche Bank and BofA Merrill declined to comment for this article. But Heitsenrether is, more than most prime brokerage heads, speaking out publicly about what is going on in the financial services industry.

“The capital adequacy requirements are a positive development overall,” she says. “It will be better for the banking industry. But the biggest concern we’re hearing from hedge fund clients these days is what the new financial architecture means. It doesn’t mean the same thing for every hedge fund. We have to consider the return metrics and the costs of funding for each client.”

Inevitably, that kind of evaluation has led to prime brokers telling some clients that their business is no longer wanted. Even the largest hedge funds aren’t always desirable clients for prime brokers, although they are more likely to have an advantage. But all hedge fund managers have to consider whether their return on assets achieves a certain hurdle rate, or the rate of return that surpasses the risk, says Robert Sloan, founder and managing partner of S3 Partners, a hedge fund financing firm in New York that services about $100 billion in assets. As such, he is less a competitor to bank-owned prime brokers than an alternative provider of financing. He has found new opportunities in the current market, offering hedge fund managers a data analysis of the costs of every transaction they make so they can see how much their business is costing their prime brokers.

“The hurdle rate is more important than commissions or fees,” Sloan says. “In the past, a $10 million customer, if that was what the prime broker was making from them, was always better than a customer who produced $5 million in revenue. But now the $5 million customer who uses no cash from a bank’s capital is way better for a prime broker than the $10 million customer who does use cash.”

It costs more now to fund certain strategies. Borrowing costs have risen for arbitrage and less liquid fixed-income instruments, and for financing through shorter-term repurchase, or repo, agreements. Sloan thinks the costs of trading have cut into the returns of strategies that require a lot of borrowing. Event-driven and managed-futures strategies, both of which did especially well in 2014, benefited from stepped-up M&A activity on the one hand and some clear trends in the markets on the other. But Sloan says there may have been another factor at work. “Maybe it was luck and maybe not, but if you look at these strategies, they also use almost no balance-sheet capital,” he says.

This doesn’t mean that in the future capital-intensive strategies will be out in the cold, without prime brokers. After the financial crisis the larger funds developed the practice of retaining multiple prime brokers. If one prime broker drops a large fund manager, there will generally be others to fall back on. Meanwhile, the boutique prime brokers are making an aggressive effort to go after smaller and midsize hedge funds. There might be some shifting of who’s who among the biggest prime brokerage industry players over the next few years, say people familiar with the industry.

There is a lot of discussion within the hedge fund industry about alternative methods of funding trades, such as centralized clearing hubs or hedge funds taking the place of banks in lending to other hedge funds. But most alternative lending tends to be in less liquid areas than hedge funds and might be difficult to pull off. Instead, hedge fund managers say, the world might be headed toward a future of less leverage — the main goal of Basel III — and a system in which fund managers will have to be highly knowledgeable about what kinds of business their prime brokers want from them.

At the same time, fund managers continue to expect their prime brokers to excel at providing consulting services that aren’t strong revenue producers but add value to what the prime broker offers. These include the broad categories of Client Service, rated No. 3 in importance, and Hedge Fund Expertise, ranked No. 6, as well as Capital Introduction and Business Consulting.

Within the standard array of services, prime brokers say, is an increasing emphasis on cybersecurity consulting and helping hedge fund managers get access to senior managers at corporations that are clients of the parent bank.

“We’ve seen increased demand for access to management teams,” says Dean Backer, president of the hedge fund services division at Goldman Sachs in New York. “Many established investors are even more focused on this kind of access, and others are interested because they’re getting into sectors, such as health care and energy, where they might not have trafficked in the past and want to learn more about the fundamentals.”

In changing times, hedge fund allocators also have a lot of questions, and prime brokers say they are spending more time talking with portfolio managers at institutions that invest in hedge funds. Robert Leonard, global head of capital services at Credit Suisse in New York, is in charge of the prime broker’s investor relations. He says investors performing due diligence are asking the same questions they’ve had since 2008. Their concerns revolve around capital preservation: They want to know how hedge fund managers have dealt with risk in the past and whether they’ve ever had a margin call.

“But investors are also becoming more inquisitive about the regulatory developments impacting their hedge funds and the underlying strategies,” Leonard says. “A typical conversation now is often about the investors trying to get their heads around how increased capital requirements and the costs to the prime broker might impact various hedge fund strategies.”

As the prime brokers see it, the current climate dictates that they develop deeper business relationships with the clients they keep on, so that those fund managers will have incentives to contribute capital to multiple divisions of the bank. “You have to be selective about clients, but it’s more about their value to the whole franchise,” says Heitsenrether. “Fund managers want to make sure they can have access to research and senior partners as well as to the balance sheet. When you look at return metrics, the more the client is ingrained across the organization, the better.” a

— Jan Alexander

HOW WE COMPILED THE RANKINGS
Institutional Investor’s Alpha compiled the 2015 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 more than 625 hedge fund firms, including many in the 2014 Hedge Fund 100, our ranking of the world’s 100 largest hedge fund firms. This year’s survey voter universe was based on hedge fund contacts supplied by Ipreo’s Bigdough database of global institutional contacts, profiles and ownership data, in addition to Institutional Investor’s own internal contact files. Hedge funds were asked to rate the quality of service they received for the 12 months ended August 31, 2014, 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.