Counterparty Risk and Revisiting the Hedge Fund/Prime Broker Relationship
Every now and then a market event occurs that forces a wholesale reevaluation of how hedge funds manage their businesses. This time around the focus is on the relationship between prime brokers and their clients, the former’s risk management and the latter’s leverage.
Pershing Prime Services places the utmost importance on both risk management and transparency. As such, we have continued to see strong demand for our complementary offering as a prime broker that’s part of a clearing firm. Given there is no centralized depository of leverage in the financial system, prime brokers need a holistic view of a manager’s leverage. Managers should be regularly reviewing their counterparty risk and spreading their risk across a suitable number of prime brokers that have the necessary expertise and experience in supporting their investment strategies.
Discussions With Pershing Prime Services' Clients
In recent discussions with clients, the main topic of conversation has been how can they better prepare for these types of market disruption events. Regardless of the cause, the most prudent approach is to work with your prime broker to understand the liquidity of your portfolio versus the redemption cycle of your investors versus the funding you have lined up with financing counterparties. Hedge funds should be doing significant due diligence on their prime brokers to understand everything from their risk controls and median client size down to their organization chart.
So, what might be the most immediate change in the industry following these recent events? One change might be that it adds fuel to the trend of institutional investors moving away from commingled funds and towards separately managed accounts for the added transparency.
More generally, we are approaching a strong first half of the year for hedge funds, where the HFRI Weighted Composite Index shows performance of +8.40% YTD for the sector as of 5/20/21. Markets have continued to trend upward with the exception of sell-offs in high-growth technology stocks. Vaccines are now in play, and the beginning of a return to normal is in sight. However, there is still a level of economic uncertainty, inflationary fears, volatility and associated dislocations which can create a ripe environment for many different hedge fund strategies. While the conversation surrounding SEC oversight on swap derivatives will likely continue after recent events, several topics of conversation have come up repeatedly with Pershing Prime Services hedge fund clients:
Hedge funds remain a key part of institutions’ allocation roster
Investors’ interest in hedge funds is still primarily focused on equity long/short managers, simply because they historically represent the largest strategy and are primed to benefit from today’s volatility and subsequent dislocations. Sector-based funds are also in high demand as there is still a rotational period while the market hesitantly prices in a post-COVID world. Furthermore, interest in ESG strategies continue to grow, with electric vehicles as one example of an extremely hot sub-sector.
Back-to-office remains uncertain
While it seems some cities such as Miami might be returning to a normal way of living, there is still a lot of ambiguity as to what will be on the other side of the pandemic for New York’s financial services industry. With tax rates likely to rise, the move to lower tax states is a topic of conversation that many managers are having right now. Based on our conversations, it also seems as though most firms will not be returning to the office until Fall. Managers remain hyper-focused on the logistics of what back-to-office looks like and where employees will work in the future.
Managers are still adapting to COVID-19 challenges
Beyond the “getting back-to-normal” questions, managers have other concerns on their plates. The first being that capital introductions and fundraising is harder because the industry has become burned out on virtual events. Additionally, market movements are also not matching economic fundamentals, making it harder to short effectively. Outsourcing and co-sourcing of certain middle- and back-office functions is a growing theme as well, and prime brokers have stepped up to provide more support to managers. Prime brokers have been widening their value proposition beyond core services such as securities lending to become data providers as well, and not just to the fund itself, but to its third parties and fund admins too.
Article By Mark Aldoroty, Head of Prime Services and Collateral Funding & Trading