Hedge funds use large investment banking teams in order to penetrate global markets. In turn, investment banking teams revolve around prime brokers. These individuals are the central point of an operation. The success of hedge funds can be said to be reliant on them. Hedge funds who wish to sell short or take advantageous stances in bets using borrowed money would be wise to invest in their expertise.
One may even conclude that the existence of hedge funds are attributable to the presence of large investment banks. Goldman Sachs and Morgan Stanley are notable examples. Institutions like Credit Suisse and Bank of America Merrill Lynch are also strong contributors. This is due to their involvement with prime brokerage services.
Answering the Question
A prime broker is someone who provides hedge funds with the capability in borrowing stocks and bonds. This activity is called “securities lending”. Prime brokers also allow hedge funds to borrow money to acquire stocks and bonds through a term called “margin financing capabilities.”
Additionally, prime brokers serve as intermediaries between hedge funds and counterparties. These counterparties are pension funds and other types of institutional investors who are interested in short selling. On the flip side, commercial banks are also counterparties for the purpose of acquiring money through margin loans. A prime broker is also responsible for services in execution and custody.
Short Selling and Hedge Funds
Investors may resort to short selling with the expectation that a security’s price would fall. This method ensures that price bubbles would burst before creating material consequences in the market. Short-selling can have a painful effect on the target company. However, many experts approve of the fact that it has a positive overall effect that is in offset, and in fact, exceeds the short term pain.
Services Offered by Prime Brokers
Prime brokers do not limit their services solely on lending securities or cash. They also offer concierge services to hedge fund clients such as capital introduction. Capital introduction assists new funds in finding potential investors. While the results may be significantly varied, it helps speed up the fundraising process using strategies and principals that are in demand in the market.
Other than financing, prime brokers have recently included risk management and capital introduction in their offerings.
Borrowing Cash and Securities
Experts find that the difference between borrowing cash and securities worth noting for hedge funds. Cash lending possesses a transparent cost structure whereas securities lending does not. The difference results in a wide variation in spreads and profit.
Prime brokerage requires collateral like most lending mediums. Prime brokers typically hold hedge fund assets as a custodian. When needed at any notice as collateral, entities can transfer them to the prime broker’s account. Because the prime broker would have custody on the fund’s portfolio, they are able to give larger leveraging amounts to borrowers as opposed to traditional bank loans.
It is worth noting that collateralization differs from leverage. Leverage is the usage of borrowed money to acquire stocks and bonds. It is also referred to as “margin finance.”
The prime broker will make available margin terms that will pinpoint the maximum leverage available. The trade makes it possible for funds to be offered additional margin than they want at certain points of time. Thus, hedge fund managers must be familiar with margin rules and how they develop over time. This is a method to ensure that unexpected movements would affect the fund portfolio in a way that is hard to adjust to.
Choosing a Prime Broker
Now that the various responsibilities and roles of a prime broker have been enumerated, we realize that selecting the right one is crucial. Managers would want to consider price, credit worthiness, and access to term lending and securities that are relatively hard to borrow. Many potential investors tend to be comfortable when a new hedge fund manager selects a prime broker in practice. This is attributable to the extent of due diligence exercised in the process.
Prime brokers are typically interested in understanding the individuals involved in the fund manager, management operations, structure, and investment process before beginning a relationship with a hedge fund. However, it is worth noting that their perspective on risk is different from that of investors due to their position as an over-collateralized creditor.
This difference is an important consideration for investors. The prospective relationship by a prime broker towards the fund can be quite long-term. It is crucial for investors to understand this difference while they work with prime brokers for that period.