Hedge funds managers using structured products and other exotic strategies have become toxic for small prime brokers. Small primes, sometimes referred to as “mini-primes,” might have tallied some business with big hedge funds that had exotic strategies. But these days, that is no longer the case, after the credit crunch and the fall of Bear Stearns.
This change in strategy speaks to the severity of the impact that illiquid securities can have on markets.
“Everyone is spooked by the events of the past 12 months,” says Keith Bliss, senior vice president and director of sales and marketing for Cuttone & Co. The firm is an introducing prime broker that gets its clearing services through Goldman Sachs Execution and Clearing Services.
There will be a back-to-basics approach at many small prime brokerages, executives report. Bliss says his firm limits itself to hedge funds using equity and options strategies and looks to stay away from funds with complex investing strategies.
Therefore, those hedge funds using plain vanilla, long-short strategies are going to become more attractive clients, prime brokerage officials say.
“And I think a lot of managers are going to return to traditional long-short equity because of the transparency of the U.S. equity market,” says Douglas Nelson, CEO of NorthPoint Trading Partners.
NorthPoint was founded in Atlanta by former execs at Neovest, a direct-market-access trading platform now owned by JPMorgan. It caters to hedge funds with $200 million in assets or less.
Nelson contends that small prime brokers like his pursue the plain vanilla long-short funds more aggressively than do the bulge bracket firms. The reason, he says, is that these clients are not as profitable to the big prime brokers as are the hedge funds that use structured products. Still, an official at a bulge bracket firm, who declined to be identified, says the big firms have modified their position on plan vanilla investment strategies.
“If there is a billion-dollar long-short fund, the big primes are going to still take it. However, if it is a $30 million one, they’re going to pass on it, leaving it to the smaller prime brokers,” he says.
The newer hedge fund strategies, including those funds using collateralized mortgage obligations, will continue to be the bailiwick of the big boys
Indeed, as Traders Magazine was going to press, an online report said that three of the biggest firms, Goldman Sachs, Lehman Brothers and Morgan Stanley, saw the amount of the illiquid securities they hold increase. For example Goldman says its Level 3 securities, illiquid instruments that firms are allowed to internally price, increased to $82.3 billion at the end of February from $54.7 billion at the end of November.
Why do big firms need and want clients with illiquid instruments? It is because they need more leverage, although they now will be more careful about these funds, Bliss predicts.
Others say the reality is that the smaller primes don’t have effective risk controls to support the complex strategies anyway-including structured products and CMOs.
“The bulge brackets want these accounts because they have high balances and do a lot of transactions,” Bliss says. High balances mean a fund is borrowing and trading heavily, he adds, and that’s how the big primes earn their profits.
Nelson of NorthPoint, which also clears through Goldman Sachs, says his firm is also avoiding hedge funds with sophisticated tastes for complex strategies.
Michael DeJarnette, president of NorthPoint and one of its founders, agrees. “We are not focusing on hedge funds that require enhanced leverage. We don’t focus on funds that use structured finance or really eclectic instruments.”
He adds that his firm doesn’t want hedge fund clients with leverage-to-equity ratios of greater than six to one. DeJarnette says the company’s bread and butter is long-short equity funds.
Several brokerage executives selling prime services to smaller hedge funds, $100 million or less, say they have remained relatively unhurt since the downfall of Bear Stearns. They say this is because they, too, focus on long-short U.S equity managers. These funds are more transparent than other funds using enhanced leverage; therefore, their strategies are less risky, albeit not as potentially profitable as a fund that’s highly leveraged.
Cuttone & Co., which offers only equities and options strategies through its mini-prime brokerage, is using a number of controls to ensure that it won’t open an account that is potentially too risky, Bliss says. However, he adds, in this environment, even the mini-prime brokerages concentrating on everyday long-short equity strategies could run into problems.
“Take a fund going short,” Bliss explains. “The potential gain is finite. But the potential loss in a bad trade is unlimited.”
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