Prime Brokerage - a Rose by any other name

From the desk of Roy Zimmerhansl,

Practice Lead, Pierpoint Financial

As time goes on, more of the story surrounding the recent Archegos debacle will come out. I will learn about it as most of you will – through the media and company statements. Instead, I will focus on generic Prime Brokerage as this seems to be at the heart of much of the discussion.

Before I do that, I have a couple of recommendations for you that are also relevant to this story.

Leverage / Illiquidity / Concentration

I recently listened to the Epsilon Theory podcast episode 8, where they talked about three blow-ups in three months: Archegos, Greensill and Melvin Capital. According to the podcast, these three had the following in common:

“Insane leverage employed to maximize private gain, provided by lenders that can socialize losses.”

With respect to leverage, illiquidity and concentration, one of the podcasters described a process and lesson learned from colleagues when he worked in the hedge fund team at Texas Teachers:

“You can almost always get away with one. You can almost never get away with three. In a normal market you can handle two. In a bad market you can’t.”

If you listen to podcasts, listen to this one. If you don’t listen to podcasts, make an exception. (Also, look for another exceptional podcast I recommend at the end of this post).

Bloomberg Opinion

My second recommendation is to read opinion pieces of Bloomberg’s Matt Levine which deliver fascinating insights. Last week he provided thoughts on Archegos, including the use of leverage, how portfolio diversification is supposed to work, why long/short portfolios are in theory less risky than long-only and ultimately how the Archegos collapse was simple Supply/Demand economics.

For example, as Archegos was aggressively buying ViaComCBS (and other stocks), the demand drove the prices higher, but in the wake of Viacom’s $3 bn additional stock sale, which didn’t meet buyer demand, the price collapsed. The stock dropped 9% the day before it announced the pricing of the issuance and another 23% after the company announced the pricing of the issue.

Archegos and Prime Brokerage Losses

The losses suffered by Archegos created conditions whereby Archegos was forced to get its PBs together to agree on a strategy for liquidating the portfolio. From what I have read, no agreement was reached, and it became every bank for itself.

The full financial impact of Archegos hasn’t yet been uncovered, but Credit Suisse has admitted to estimated costs of $4.7 bn with Nomura’s losses estimated at a further $2 bn. As I understand it, there were either minimal or no losses at Goldman Sachs, Morgan Stanley, Deutsche Bank, UBS and Wells Fargo.

The Origin of Prime Brokerage

Unsurprisingly the first PB was created at the time of the first acknowledged hedge fund, launched by Alfred Winslow Jones. The prime broker was Neuberger & Berman. The word “Prime” referenced the financial arrangements whereby the hedge fund did all of its business through Neuberger – executions, borrowing to cover shorts, leverage and financing. A.W. Jones & Co, traded with many different brokers outside of their PB, and investors of all types do this to get ideas, access to information, inclusion in deals and IPOs etc. However, everything got booked via Neuberger as the “Prime” Broker – the broker that had a view on the entire AWJ fund. That provided Neuberger with a holistic understanding of the entire portfolio.

And that is the beauty and essence of Prime Brokerage – by doing everything through the PB, (assuming the PB has robust risk modelling), it can adapt and adjust the leverage, financing and limit or fuel the fund's activity.

Competition

Of course, prime brokerage generates considerable fees, revenues, commissions, and spreads so there is competition. Inevitably competition creates opportunities for hedge funds to have more than one PB. In fact, hedge fund AUM was skyrocketing during the 1990s. Many new firms jumped on the PB bandwagon (including Nomura, my employers 1993-1998). The growth shown in the graph below looks more interesting as you move closer to the present but consider that the expansion from 1990- 2000 was a twelve-fold increase!

Estimated Annual Growth of Hedge Funds AUM Source HFR Inc.

Suddenly many funds opted to add a second ‘prime’ broker. In addition to giving large hedge funds the opportunity to play off one PB vs the other for pricing and access, different banks and securities firms had different strengths. This created natural competition for pricing and capabilities, and both the funds and the PBs gained from that arms race.

Then LTCM came along with the leading securities firms and banks exposed to potentially huge losses (by prevailing standards). LTCM was due to highly leveraged trading strategies and lack of visibility of LTCM’s trading partners into the whole portfolio picture. The PBs were caught up in it, but it was leverage through derivatives and portfolio diversification that resulted in concentrated rather than reduced risk that was the focus.

In the early part of this century, many investors into hedge funds required that those funds had more than one PB and those that didn’t have the stipulation before the Lehman default certainly added it afterwards.

Lehman Brothers

Then the Lehman default happened, and many things changed. I will only highlight a few fundamental changes.

• Lehman largely marked the end of independent securities firms in the business for example, Goldman and Morgan both became bank holding companies, and Merrill Lynch was acquired by Bank of America. Bear Stearns had been acquired by JP Morgan earlier in 2008.

• In the aftermath of Lehman, regulators have forced banks to reshape their businesses, demanding higher capital and effectively eliminating proprietary trading.

• Some funds that only had Lehman were frozen for some considerable time, and many shut down before extricating themselves. Funds and their investors added PBs for diversification.

• The increased cost of capital caused PBs to reassess their business models, and many exited numerous clients. This body of funds in search of PBs realigned the deck chairs, and new firms announced planned entry into the PB business. “Mini-primes” were all the rage, aggregating many of these displaced funds and using full-service primes to support them, akin to a retail/wholesale model.

There were other changes, but the impact of those listed above have two direct impacts on the Archegos story, in my opinion. First is that the hedge fund wallet is spread across a wider universe of market participants and, in some cases adding extra layers. That impacts Prime Brokerage profitability.

The second is that PB service provider diversification results in the prime broker not being in a prime position to know, see or understand the overall exposure of a given client.

So when Archegos comes along PBs see a client with a strong pedigree (let’s ignore the SEC insider trading admission and fine) who is aggressive, wants leverage, will generate massive revenues and wants to do it via more capital efficient synthetics, then BOOM! That’s a winning proposition.

It apparently didn’t matter so much that it was a Family Office rather than a hedge fund. Family Offices represent a bigger pool of capital than hedge funds, and as they are managing their own assets, the regulatory filings are de minimis. That means there was less information available to the PBs to risk-assess Archegos and presumably, they all knew or suspected they weren’t the sole PB.

So what?

Regulators have discouraged leverage, increased the amount of capital banks require and the cost of that capital has increased or at least the focus on return on capital has increased.

Prime brokerage can still be a very profitable business, managed in a capital-efficient way, but it is extremely competitive for the most attractive clients.

The risk management systems and processes of several (but not all) of Archegos’ PBs stood up well, and no systemic risk concern arose even for firms that suffered losses.

Ultimately here, this situation couldn’t have arisen if there was a truly PRIME broker for Archegos. The size, concentration, and leverage would/could not have been provided by any individual PB. I am not arguing for a return to sole PBs as there are obvious advantages for investors, funds, regulators and even the PBs who can turn down trades and strategies that they would feel compelled to take on if they were the only provider to a fund. I get that, and I’m not sure what the solution is other than more reporting and transparency obligations for Family Offices.

Somehow that doesn’t seem enough.

If however, that does come to pass in time, as with all regulation, it also doesn’t seem fair to those who weren’t breaking any rules or using excess leverage or in the case of GameStop, over-trading.

Labels are often hard to change in this world, but I just don’t see the description of “Prime” Broker as carrying much meaning anymore. My old friend Roger Dunphy, a man with many decades of prime brokerage experience around the world, told me recently he used to say to his hedge fund clients (which he refers to as “partners”):

“We always want to be your PRIME Prime and NOT your SUB-Prime.”

Doesn’t get more accurate than that.

PS – the other podcast which you MUST listen to: Peer Connections – the NBIM model. All of the Peer Connections are very good, but this one gave insights into the NBIM programme which I haven’t known before.