By Hossein Kazemi, PhD, CFA, CAIA Association, FDP Institute, and Isenberg School of Management
Bobby Axelrod had a good day on June 10, 2018. On this day, Axe Capital's manager took the podium in front of a group of institutional and high-net-worth investors to pitch his fund. Thirty minutes later, with the help of his CIO, he had raised $3 billion. This capital introduction event took place at Citi Field in New York City and was arranged by Spartan-Ives, Axe Capital's prime broker. Raising $3 billion from institutional investors during a capital introduction meeting had never been easier, especially for a fund that was still dealing with several legal issues. These events took place during episode 12 of season 3 of the TV series, Billions.
Capital introduction is just one of the many services that prime brokers provide to their hedge fund clients and is probably not the most important one. This note will discuss some of the recent research findings on the relationships between prime brokers and their clients and how they impact hedge funds' trading activities, performance, and funding. For instance, Yang, Kazemi, and Getmansky (2020) provide indirect evidence that investment banks that own prime brokers favor their hedge fund clients when underwriting "hot" IPOs. Further, they increase such allocations if the client hedge fund recently had poor performance. On the other hand, empirical evidence provided by Yang and Kazemi (2021) indicates that hedge funds front-run the analysts who are connected to their prime brokers, buying (selling) stocks that are about to be upgraded (downgraded) by those analysts. Is there selected information leakage? In short, the benefits and services provided by prime brokers are many and have material impacts on their clients' performance.
What Do Prime Brokers Do?
Most prime brokers (PB), which are full-service broker-dealers, are units of large investment banks. They provide a bundle of services to hedge funds and other institutional customers, including clearance and settlement of securities trades and back-office functions. A PB relationship is highly beneficial for a hedge fund because the PB acts as a clearing facility and a source of financing for the customer's securities transactions. The PB also serves as the central custodian for the client's securities and funds. PBs work closely with their hedge fund clients daily, executing transactions, lending securities, and providing leverage. PBs offer other services, such as risk management services, trading technologies, and, as mentioned above, capital introduction services. "Cap intro" does not imply that a PB will actively raise money for its clients. Instead, the PB will invite its clients to investor conferences and arrange individual meetings with potential investors. Cap intro programs are particularly beneficial for small emerging managers. A report by Capital Introduction Group of J.P. Morgan indicates that about 60% of hedge funds surveyed rely to some degree on cap intro programs.
All of these services come at a cost. According to Institutional Investor's estimate, hedge funds generate more than $10 million in annual investment banking revenue for every billion dollars they have under management. According to Forbes magazine, prime brokerage services revenue accounts for about 35% of investment banks' total equities trading revenues. Finally, Bloomberg reported that hedge funds were paying an estimated total of $25 billion in fees annually to investment banks. The current estimates for these figures must be substantially higher as the above estimates are about 10 years old. Finally, the PB industry is highly concentrated. Using the CISDM database, we can see that the top three PBs have brokerage arrangements, with about 45% of all hedge funds reporting to the database. More than 80% of hedge funds reporting to the database have at least one such arrangement with one of the top 10 PBs,
The global financial crisis of 2008 and, in particular, Bear Stearns' default and Lehman's bankruptcy had immense impacts on the prime brokerage industry. The default of Bear Stearns, one of the leading PBs in 2007, brought to light the counterparty risk embedded in a PB-hedge fund relationship. This risk was not fully appreciated before 2008. As a result, hedge funds embarked on establishing relationships with several PBs to diversify and mitigate their counterparty risks. Again, the CISDM database findings indicate that more than 60% of all medium-sized and large funds work with four or more PBs.
Prime Brokers' Impact on Performance
Given available data, we cannot find direct empirical evidence about the impact of PBs on their hedge fund clients' performance. Funds do not change their PBs often enough so that we could measure how different PBs affect performance. However, we could gather indirect evidence. Chung and Kang (2016) find strong co-movement among hedge funds' returns sharing the same prime broker. This reported co-movement is distinct from market-wide and local co-movement. They hypothesize that this co-movement is a result of having access to the same information. The exposure of hedge funds to an index of funds that use the same PB is almost twice as high as the same fund's exposure to broad market indices. Gerasimova (2016) provides additional evidence regarding co-movements among hedge fund returns that share the same PBs. She shows that the average correlations among funds that share the same PBs are about 35% higher than their average correlations with other hedge funds. This has important implications for allocators, as such a high degree of co-movement reduces the diversification benefits of investing in a hedge fund portfolio if they happen to share the same PBs. The critical question is: what are the sources of common information that lead to co-movement of returns?
Information about pending mergers could be one source of common information for merger arbitrage funds. Investment banks work as advisors in mergers and acquisitions and also as prime brokers to hedge funds. Goldie (2012) examines hedge funds' investment in merger targets to determine if there is a change in hedge fund investment behavior when their prime broker is an advisor in merger deals. When investment banks are advisors in merger deals, they possess private information valuable to their hedge fund clients. The paper finds that individual hedge funds' merger arbitrage investments are larger by 60% when their prime broker is an advisor. The probability of investing in the target firm increases by 20% if the fund is connected to the investment bank acting as an advisor. Finally, it turns out that these investments are abnormally profitable. An average fund's annualized alpha from those investments is 400bp higher than similar investments in targets with no connection to the fund's prime brokers.
The apparent sharing of private information between prime brokers and their hedge fund clients is not limited to pending merger activities. In a recent paper, Kumar et al. (2019) find that hedge funds gain an information advantage from their prime broker banks regarding their corporate borrowers. Hedge funds that are clients of these banks' PB make abnormally large trades in the stocks of borrowing firms before loan announcements, and these trades outperform other trades. These investments also appear to perform better if the hedge fund is an important revenue source for the investment bank. Hedge funds' investments in firms about to receive loans from their PBs earn about 25bp more than otherwise similar investments.
As mentioned in the introduction, Yang and Kazemi (2020) report that hedge funds appear to trade stocks ahead of upgrades and downgrades by analysts connected to their PBs. In this paper, they create two indices reflecting the hypothetical return that could be earned by a hedge fund that has perfect foresight and knows that whether a stock is about to be upgraded or downgraded by its PB. They find that connected hedge funds have positive (negative) exposures to the index that reflects perfect foresight about upcoming upgrades (downgrades). Finally, the paper shows that the primary benefit of having a connection to the analysts is avoiding large negative returns. That is, having prior knowledge of upcoming downgrades is more important than knowing about upcoming upgrades.
In the introduction, I referred to another recent paper by Yang, Kazemi, and Getmansky (2021), which examined IPO allocations by investment banks and whether connected hedge funds received abnormally high shares of hot IPOs. The connected funds indeed received relatively higher allocations of such IPOs. The more interesting result was that funds performed poorly in recent months appeared to receive even larger allocations of such IPOs. Also, the relative sizes of these favorable allocations increased during bear markets.
These findings have at least two important implications for allocators. First, having a PB that is active and central to other parts of financial markets could positively influence a hedge fund's performance. Second, these benefits could increase a group's exposures connected to a common source of risk – having the same PB. This risk could become important if there are severe financial shocks.
Prime Brokers' Impact on Funding, Liquidity & Funds of Funds
In the above section, I summarized the findings of a few papers showing how connected PBs can impact their hedge fund clients' performance. The focus was on sharing information and favorable IPO allocations. In this section, I will discuss the role of PB in three different areas: (a) impact of PBs on fundraising for their clients, (b) exposure of hedge funds when a liquidity shock affects their PBs, and (c) the role of PBs in helping its funds of funds clients to improve their manager selections' outcomes.
As mentioned in the introduction, cap intro is one of the services that PBs provide to their hedge fund clients. But how important is this service? There is anecdotal evidence that cap intro is not that important and that PBs have made cutbacks in their cap intro programs in recent years. Sinclair (2020) uses a novel approach to measure the importance of PBs as a source of capital. First, we all are aware that chasing performance is a popular activity among investors. Therefore, there is a significant positive lead-lag relationship between performance and fund flows. But how we measure performance will make a difference. Do investors consider only absolute performance, performance relative to public benchmarks, or performance relative to peer hedge funds? Sinclair shows that performance relative to other funds that share the same PB is the dominant factor in explaining fund flows. This provides indirect evidence that allocators and/or PBs especially care about the performance of funds relative to peer groups that share the same PBs. The paper examines fund flows among these funds and concludes that the relative performance can explain 40% of fund flows among funds that share the same PBs. It is unclear what drives this difference. Do the PBs favor clients that have performed well recently, or do the investors who receive information from the PBs regarding their hedge fund platform tend to chase relative performance? Since fund flows could impact a fund's operations, allocators should learn what factors PBs take into account when planning and organizing their cap intro programs.
We have seen that hedge funds and PBs are deeply connected. Does this mean their performance is connected to the performance of their PBs? If the answer is affirmative, what are the possible drivers of this relationship? As I already discussed, is it the commonality of information among PBs and their clients that drives this result? Dahlquist et al. (2020) provide interesting evidence about the relationship between hedge funds' performances and their PBs'. First, they show that an average hedge fund's performance is affected by the same systematic factors that affect a portfolio of investment banks and PBs. Second, hedge funds with greater exposure to factors that negatively impact financial intermediaries have higher returns, which is interpreted as compensation for risk. Finally, the authors show that liquidity shocks to a PB could have a negative impact on its hedge fund clients' performance but only in extreme cases such as Lehman's bankruptcy or Bear Stearns' default. Hedge funds and their investors appear to have understood this risk. As mentioned earlier, hedge funds now prefer to work with multiple PBs, a move that is supported and demanded by institutional investors.
Many small and medium-sized allocators choose to invest in funds of funds. While the double layer of fees will have a negative impact on performance, funds of funds provide other benefits such as diversification and access to top funds. One significant benefit connected to PBs is due diligence and the ability to select funds that are likely to provide attractive risk-return profiles.
In a recent paper, Aragon et al. (2020) provide interesting results regarding a PB's ability to identify funds that are likely to perform well in the future and how some funds of funds use this information to offer investors' portfolios of funds with attractive risk-return profiles. The authors show that PBs facilitate fund of funds' search for informed hedge fund managers and find that funds of funds favor hedge funds serviced by their connected PBs. This bias toward funds that connected PBs cover pays off. Funds of funds that allocate more to funds connected to their PBs outperform others by 2.77% per year after adjusting for risk. Given the previous discussions about how PBs seem to help their hedge fund clients, it should come as no surprise that funds recommended by them tend to perform well in the future. Asset allocators should use these findings when selecting a fund of funds. They can determine how many of the funds have received allocations from the fund of funds connected to its PB. Other factors that an allocator should consider in selecting a fund of funds are the size of the fund of funds and its PBs. The evidence indicates that larger funds of funds benefit more from relying on their PBs to identify top fund managers. Also, PBs that service a large number of hedge funds seem to offer better recommendations to their funds of funds clients.
Recent academic findings have shown that the close working relationship between PBs and their hedge fund clients can significantly affect their performance and, under some conditions, their liquidity and risk exposures. Asset allocators will be wise to spend time performing due diligence on the network of PBs that service hedge funds they are considering for an allocation. Further, diversifying among funds that do not share too many PBs should be considered. Finally, those allocators who are considering funds of funds should learn how the fund of funds manager identifies the funds that constitute its portfolio and what role, if any, the fund of funds' PB has played in recommending any of those funds.
- Aragon, George O., and Chung, Ji-Woong, and Kang, Byoung Uk, "Do Prime Brokers Matter in the Search for Informed Hedge Fund Managers?" (June 19, 2020). Available at SSRN: https://ssrn.com/abstract=3485354 or http://dx.doi.org/10.2139/ssrn.3485354
- Bloomberg, "Investment Banks are too Dependent on Hedge Funds," (2005) https://www.bloomberg.com/news/articles/2005-03-21/investment-banks-are-too-dependent-on-hedge-funds-matthew-lynn
- Capital Introduction Group of J.P. Morgan, https://www.aima.org/static/uploaded/09555221-8106-4109-97985557a112910e.pdf
- Chung, Ji-Woong and Kang, Byoung Uk, "Prime Broker-Level Comovement in Hedge Fund Returns: Information or Contagion?" (January 1, 2016). Review of Financial Studies, Vol. 29, No. 12, December 2016, pp. 3321-3353, Available at SSRN: https://ssrn.com/abstract=2396522
- Dahlquist, Magnus and Sokolovski, Valeri and Sverdrup, Erik, "Hedge Funds and Financial Intermediaries" (June 10, 2020). Swedish House of Finance Research Paper No. 19-8, Available at SSRN: https://ssrn.com/abstract=3396632
- Gerasimova, Nataliya, "Do Prime Brokers Induce Similarities in Hedge Funds Performance?" (February 12, 2015). Available at SSRN: https://ssrn.com/abstract=2564243
- Goldie, "Essays on Hedge Fund Investment," (2012) The Pennsylvania State University The Graduate School The Mary Jean and Frank P. Smeal College of Business
- Institutional Investor (2005), "Who Wants to Be a Billionaire?", https://www.institutionalinvestor.com/article/b151357cb68f51/who-wants-to-be-a-billionaire
- Kumar, Nitish, and Mullally, Kevin and Ray, Sugata and Tang, Yuehua, Prime (Information) Brokerage (September 2, 2019). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=2996148
- Sinclair, Andrew, "Do Prime Brokers Intermediate Capital?" (May 23, 2020). Available at SSRN: https://ssrn.com/abstract=3222079
- Yang, X, H. Kazemi, and M. Getmansky (2020), "Hedge Funds and Their Prime Brokers: Favorable IPO Allocations," Isenberg School of Management, Forthcoming in Journal of Portfolio Management
- Yang, and M. Kazemi (2021), "Do Hedge Funds Front-Run Analysts?," MIT Working Paper