When The Levee Breaks

“If it keeps on raining the levee’s going to break”[1]

In our case the levee is the prime broker industry and the rain is government regulation of the banking industry. The levee’s not looking too good these days. Recent news from some of the major foreign banks show we have moved, and are accelerating, into the next phase of re-structuring the prime brokerage business.  The script is playing out with the major prime brokers “focusing on our core client base” which is code for “we’re re-pricing or throwing everyone over the side that makes sub-optimal use of our balance sheet”.

“Crying won’t help you, praying won’t do you no good”

Hoping this is all going to work out ignores the reality, and enormity, of the problem. The hedge fund industry continues to expand while the major prime brokers are retrenching and “optimizing” their business. Sitting tight, hoping to ride it out is risky.

I would suggest that a majority of hedge funds are in some state of denial or are not sure how to approach their primes about the issue. These fund are putting off engaging their primes in a conversation about their profitability and availability of financing. Perhaps they’re hoping all is good and that they don’t get a call telling them otherwise.  No news is good news… sometimes.

For some of the small and medium sized funds it’s an issue of capacity i.e., finding the time to analyze the situation and engage their prime brokers. There are many things they have to do that take takes up all their time. The urgent trumps the important.

Hedge fund investors are also becoming more literate on the Basel III impact on the primes and their hedge funds. They are going to be asking where their funds stand with each of their financing providers.  Explaining that they have not had this discussion with their primes is not a good answer.

“When the levee breaks, mama, you got to move”

The time to act is now. The smart money is on the move. The just released EY 2015 EY Global Hedge Fund and Investor Survey found the following:

  •  35% of responding hedge funds added prime brokers in the last twelve months.
  • 20% of funds with $10B or more in AUM are actively investigating alternatives to prime brokerage financing.

To the readers of this site this is not new news. Actually it’s just simple math: The balance sheet available in the prime broker industry as a percentage of financing required is less than one. This is the problem and it will only get worse. Where are all these hedge funds going to go for financing and trade services?  What are the alternatives to the bulge bracket prime brokers?

Here are a few steps to consider:

Mark to Market.  First, find out where you stand. A good percentage of the larger hedge funds have started to do this and it’s a good first step.  These funds are working to understand whether their profitability measures up and where they stand. Where they are below the return hurdles they are considering things like shifting (and perhaps increasing) the mix of positions being financed and maybe even agreeing to a price increase.

These actions, while important, merely ensure that they won’t get kicked out. But even if they can right the ship and secure your place on the roster that doesn’t mean additional financing capacity will be there when they need it (think portability). How much more financing business can each of their primes take? It’s good to know if they are about to be culled from the herd but also whether there are limitations on the amount of financing to which they have access. Once this is known it’s on to the next step.

Non-correlated Diversification. That’s a mouthful but the definition of financing diversification has changed with Basel III. As I wrote in my last post about multi-prime, diversifying by adding more of the same type of providers doesn’t solve the problem. Each of the bulge bracket primes have the same issues brought on by Basel III: contracting balance sheets resulting in decreased funding available for hedge funds. If a fund needs to find additional financing capacity it’s time to look beyond the usual suspects. If they’re being re-priced or are on the verge of being asked to leave it’s time to start thinking about where they might go.

You’ve heard me opine on this subject in previous posts so why go over it again? Two reasons. First my general thesis that a scarcity of balance sheet will result in hedge funds adding, not reducing, prime brokers has gained wider validity with the release of the EY survey. Second, the other shoe has begun to drop with the announcements from Credit Suisse and Deutsche Bank to “right-size” their investment banks and “optimize” their prime brokerage businesses. Barclays new CEO Jes Staley, an investment banking veteran from JP Morgan, has said he is going down the same path. I mentioned the probability of these type of actions when the new CEO’s were appointed earlier in the year.  The foreign banks are in the barrel right now but the US banks are in the same boat. It’s just a matter of degree.  We’ve entered the next phase of regulatory impact on the prime brokerage industry. And to quote REM, another one of my favorite bands, “Don’t waste your time sitting still.[2]”

Let me leave you with the youtube link for “When The Levee Breaks”.

[1] All quotes are from the Led Zeppelin song “When The Levee Breaks” from the album Led Zeppelin IV.

[2] “Sitting Still” from the REM album, Murmur.

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