Multiprime Migraine

15 May 2009

Katie Gilbert

More hedge funds are asserting their independence from their prime brokers.

Although $3 billion hedge fund firm Trafelet & Co. has used multiple prime brokers for each of its 11 underlying funds since late 2007, its main reason for doing so changed in 2008. The original rationale was that a multiprime setup would ensure that the firm got the best pricing on deals, but by the middle of last year, the big worry had become the potential for counterparty failure.

“In the past going multiprime was more about shopping around,” explains Matt Johnson, chief technology officer at New York–based Trafelet. “In 2008 it became about diversifying your risk.”

So Trafelet added two more prime brokers to its roster of five and made some subtler adjustments too, reducing its exposure to its two or three biggest primes to limit potential counterparty damage should one of them fail. From those changes followed a new set of not-so-subtle operational and technological demands.

“We can’t really depend on any [single] prime for reporting across our whole portfolio because they don’t have a full picture of our portfolio anymore,” Johnson notes. 

Industry experts say the rest of the hedge fund industry is following suit, taking on more prime brokers and giving less business to each one. Prime brokers themselves are pushing the trend: As enormously expensive prime brokerage divisions grow less profitable (see “The Sweet Here­after,” page 46), thanks to the credit crisis and the shrinking of the hedge fund industry, primes are beginning to do away with the bells and whistles — such as technology platforms that offer trading, position reporting and risk management — that used to be included with basic service.

As fewer clients clear the revenue hurdle, more of them are turning to third-party vendors. Now those services are increasingly being seen as add-ons that can be offered only to the biggest and most active hedge funds.

“What you’re seeing now is more funds asserting their independence from their prime brokers when they’ve been very tied in with them from a reporting and technology standpoint,” says Peter Donovan, head of U.S. prime broker sales at Banc of America Securities–Merrill Lynch.

Prime broker technology platforms have traditionally provided capabilities for trade execution, portfolio accounting, risk aggregation, net asset value calculation and performance reporting. As hedge funds become less tied to a single prime broker, they typically eschew such full-service platforms, and they face challenges in aggregating and reporting the information coming in from each of the brokers with whom they’re trading.

Luckily for firms like Trafelet — and there are many — a host of third-party technology vendors are moving to fill the void by rolling out service packages that offer the same information management that prime brokerages do, or did.

The idea behind four-year-old Paladyne Systems, for instance, was to offer a suite of applications that would provide daily accounting, data management, cash and position reporting, and trading. Sameer Shalaby, the New York–based firm’s CEO, says the beauty of such offerings is that they are “broker neutral” and they combine and organize a client’s data as it pours in from multiple brokers. In 2006, Paladyne partnered with Credit Suisse to make its multiprime technology available to Credit Suisse prime services clients because, Shalaby explains, the bank saw it as a way to retain business.

Shalaby adds that after the collapse last fall of Lehman Brothers Holdings, interest in Paladyne’s technology solutions soared; the company saw 70 percent growth in its client base from September 2008 to March 2009, compared with a 50 percent increase for all of 2007.

San Francisco–based Advent Software — known for its portfolio management and accounting platform Geneva — is also capitalizing on the rush among hedge funds to diversify brokerage relationships. Traditionally, Advent marketed its software to the biggest hedge funds, but Chris Momsen, the company’s senior vice president and general manager of global accounts, says he sees smaller hedge funds — those with less than $500 million under management — as a strong new client base because many of those funds are taking on multiple prime brokers for the first time.

“Advent was always seen as something that you grow into — kind of the big-Cadillac solution once you become that billion-dollar fund,” Momsen explains.

Advent, however, will soon launch a scaled-back pricing program that it expects will allow small hedge funds to come on board. The company’s Geneva software helps managers track positions and risk exposures among several brokers, a task that can be complicated at best and chaotic at worst.

Demand for such services has fueled growth in a variety of more specialized products. Central Trade Manager, for example, a software product by Boston-based Omgeo, a trade management software company, offers backup confirmation on the terms of fixed-income and equity trades between buy-side managers and their brokers.

Tim Lind, managing director of strategic planning at Omgeo, likens what traders get from CTM to a receipt for an electronic airline ticket ­— it serves essentially as a contract. The service was originally intended to help long-only investment managers handle trades among multiple service providers, but Lind says that as the multiprime model has swept the finance industry, hedge funds have become the fastest-growing segment of Omgeo’s client base.

Software developer Portware also reports a boom in hedge fund business. “The hedge fund clients that have recently come on board with Portware have all mentioned that our broker neutrality fits into their strategy of using multiple primes,” says Harrell Smith, head of product strategy at the New York–based company.

More technology outfits are expected to join the fray, says John Borse, a former chief information officer at Chicago-based hedge fund firm Citadel Investment Group who in 2005 founded buy-side technology company Sky Road. Borse predicts that multiprime relationships will become the norm and that prime brokers will struggle to be cost-competitive. As a result, he expects prime brokers to strip back their service offerings to the basics, and their technology platforms could be the casualty, fueling the rise of third-party technology vendors.

“There could be a couple of versions of prime brokerage,” Borse says. “Maybe there will be a really full-service version for single prime and a reduced, more price-competitive type of offering for multiprime institutions.”