How do prime brokers and hedge funds work together?

What is a prime broker?

A prime broker offers a package of services to investment vehicles – chiefly hedge funds – to help facilitate and coordinate complex trades in various financial instruments.

While prime brokers provide a wide range of services intended to optimise a fund’s operations, at their very core prime brokers are the middlemen between hedge funds and two key counterparties.

One of these counterparties includes commercial banks (who may also be prime brokers) that have the cash to provide loans for margin purposes. On the other hand, you have institutional investors (such as pension funds) that have large equity holdings. These act as an important source of securities that can be lent to hedge funds for the purpose of short-selling.

By connecting these counterparties with a hedge fund, the prime broker is essentially opening the fund up to margin financing, which can be used to leverage investments and bolster returns. The hedge fund can also take advantage of the additional securities by borrowing them from the institutional investors for large-scale short selling.

In return for these services, the prime broker will either charge the hedge fund a retainer, a commission on transactions, interest charges for cash lending or a combination of all three, depending on the services required by the fund.

Other services prime brokers provide

As hedge funds have become increasingly popular investment vehicles over the years, so too have prime brokerages – and with many now tailoring their services to suit the needs of their clients. These services may include:

Security management

Prime brokers can provide the clearing, custody and servicing of securities

Capital introduction

Prime brokers may set up meetings or give presentations to introduce a particular hedge fund to prospective investors, effectively marketing the fund on its behalf

Vast research capabilities

Institutional prime services are also provided by some of the world’s largest investment banks who often have entire research departments that are able to produce valuable and insightful data on practically anything

Regulatory advice

The laws and regulations of the finance world are complex and constantly evolving. Because prime brokers have an extensive network of connections with lawyers, they’re able to advise their clients on potential legal changes, thus helping them stay on the right side of the law and governing bodies

Reporting

Many prime brokers offer a level of performance analytics reports, either pre-set or customisable according to their clients’ needs. Realtime portfolio reporting and specialised reports support informed investment decisions, founded on in-depth analysis and knowledge

Other miscellaneous services

On top of the standard services expected of a prime broker, some go as far as providing niche services, such as additional lines of credit and even sub-leasing office space. For a hedge fund that’s just starting out, they may even be given assistance with admin and HR tasks and in some cases, employee training

Do hedge funds need a prime broker?

Put simply, yes. The services of a prime broker are highly regarded as a determining factor in a hedge fund’s success. If a hedge fund hopes to make strong gains on its investments – while hedging against risk – then it’ll most likely need to borrow cash and securities to trade with. In addition, the broker that a fund decides to go with may hold sway over potential investors, for better or worse.

Although a prime broker can be the agent between a hedge fund and all of its brokers, providing a central source for closing and servicing assets, it’s worth noting that some hedge funds will look to spread their balances across multiple prime brokers. In doing so, the fund can position itself to make the most of the services and resources on offer across the prime broker market, simultaneously minimising counterparty risk.

Spreading balances across multiple prime brokers does come with additional costs and complications, and it may not be an ideal practice for a young hedge fund. However, such challenges can be overcome, and there are plenty of large hedge funds reaping the benefits of working with more than one prime broker.

To summarise, hedge funds are as reliant on the services that prime brokers provide, as the brokers are on the revenue made from offering their services. This symbiotic relationship is an integral part of the financial sector as for many large institutions, a prime broker is a one-stop-shop that makes their business process easier and more efficient.