Downsized cap intro teams lead to the rise of new players
Seasoned veterans are leaving capital introduction roles leading to questions over whether it is a sustainable business or just a value-add. Joe Parsons investigates whether new players are stepping in to fill the void.
The hit-TV series Billions has been critically acclaimed for its likeness to the real world of US hedge funds, and in one episode the show perfectly highlighted the importance of capital introduction. Bobby Axelrod, who is the head of fictional hedge fund, Axe Capital, and played by Damien Lewis, arrives at a capital introduction event at CitiField, hosted by Spartan-Ives (a fictional prime broker). The event sees Axelrod raise $5 billion from institutional investors attending the event, after standing on a soapbox in front of a full room and pitching his hedge fund to new backers with the help of his chief investment officer.
The scene will be familiar to those involved in the process for its likeness to the reality of how hedge funds raise capital. They very much rely on their prime brokers to connect them with institutional investors that fit with their strategies.
The scene is also a reflection on how the biggest hedge fund clients are provided capital introduction services. For the majority of smaller and medium-sized hedge funds, the returns they provide do not warrant the resources required for capital introduction.
“Many of the bulge bracket primes are resource constrained and struggling more every day to support their client base; less balance sheet, less competitive pricing, less cap intro and so forth,” says Emma Sugarman, global head of capital introduction, Cantor Fitzgerald.
“Most of these resources are going to their top 100 clients and there have not been additional primes to add supply to the market – we want to change all of that. In addition, start-ups are increasingly being serviced by even fewer primes.”
One of the biggest problems for hedge funds is the juniorisation of capital introduction teams at the big prime brokers. Many of the most experienced and senior capital introduction experts have left, largely due to the reduced bandwidth they can operate. As a result, they are replaced with individuals that do not have the same amount of expertise and the same amount of relationship status with hedge funds and institutional investors.
Just this year, Citi and Credit Suisse both saw the departure of their global head of capital introduction. Martin Visaries, resigned after serving eight years in Citi’s capital introduction team, while Robert Leonard announced his retirement following his 15-year tenure at Credit Suisse.
Elsewhere, Deutsche Bank’s European head of capital introduction, Sasha Temple-Jones, left after over five years at the German Bank. Within a year, JP Morgan lost both Melissa Carnathan, its European head of capital introduction who joined hedge fund Tages Capital, and Alessandra Tocco, the global head of the capital advisory group.
“The Street’s prime brokers continue to downsize and juniorise their cap intro teams, which is evidenced in some of the senior departures we’ve recently witnessed at some of the Streets largest prime brokers,” says Tom Mahala, founder and CEO of Layton Road, an outsourced capital introduction business.
“Cap intro has a significant operating budget at their investment banks, so smaller teams with less experienced professionals allows them to reduce the size of their cap intro expense footprint. The victims of these moves are the hedge funds and institutional investors they serve.
Picking up the pieces
As well as the juniorisation of cap intro teams, the business is largely seen by many of the big primes as a value-added service. Mandates are focused on financing and execution, with introduction and hedge fund consulting services being an add-on to win the larger hedge funds.
For the majority of small and medium-sized funds, the value-added services are not granted to them, therefore they become excluded from capital introduction. In addition, due to certain structural misalignments, there are several types of hedge funds that receive little-to-no capital introduction services, as their strategies do not reside within the equity prime brokerage verticals of the big prime brokers.
“For example, a CTA or Structured Credit Fund is not likely to have a relationship with an equity prime broker, and as a result, these funds will be orphaned by the cap intro teams of those banks,” adds Mahala.
“This creates a misalignment with institutional investors that utilise cap intro teams to assist them in their sourcing of hedge funds.”
Mid-tier prime brokers winning hedge fund clients is not a new phenomenon. They have been on the scene for a number of years, and since the onset of the capital rules, their rise has been viewed by many. But many of their prime brokerage services have been limited to financing and securities lending, and very few offer capital introduction.
Yet with more of the big primes downsizing resources and cap intro teams, prime brokers like Cowen Group and Cantor Fitzgerald see an opportunity.
Coupled with the shift in power between managers and their allocators, the size of the prime broker is less likely a factor in how hedge funds raise assets.
“As the supply/demand dynamic has shifted away from the hedge funds towards the allocators, the need for the mid-tier prime brokers has expanded their capital introduction offering as a value-added service is in the spotlight and has become a differentiating factor to winning business,” says Brett Yarkon, global head of capital introduction, Cowen Group.
“Most mid-tier prime brokers have a number of clients that are at barely breakeven or in many cases losing money due to the lack of assets under management (AuM). Targeted, high quality capital introduction is often times the reason why business is won or lost due to the desperate need for AuM.”
Furthermore, there is a huge opportunity for mid-tier prime brokers to capture smaller-sized clients. According to Deutsche Bank’s annual alternative investment survey of 436 hedge fund allocators, over half of respondents anticipate making allocations to funds managing less than $1 billion in assets in 2018; including 31% who plan to invest in hedge funds with less than $500 million.
“We work with smaller single strategy equity and FICC managers through to the multi-billion dollar shops that are not getting as much attention, and particularly for fixed income funds to whom we can allocate balance sheet,” adds Cantor’s Sugarman.
“I see it as we have a late mover advantage in building out all areas of our prime offering; we have been able to hire experienced, senior individuals who bring an enormous amount of experience across all of our teams.”
With more specialist and niche hedge fund managers being dropped by the big primes, this has provided an opportunity for mid-tier prime brokers to enter the scene with a more flexible offering.
“We believe that ‘a-one-size-fits-all’ approach is not an appropriate approach for a capital introduction group and that tailored solutions are necessary and becoming the norm,” adds Yarkon. “Our approach focuses on the allocator as much or more, than the investment manager. With regard to the allocator we make certain that when we introduce a manager to them it is because it has been fully diligenced and deemed to be an appropriate product for that particular allocator,”
“From the manger perspective, each firm is different and they all have a strategy that needs to be articulated in a way that differentiates the manager from others.”
The outsourced option
Another option facing the big prime brokers is potentially outsourcing the capital introduction business. BNP Paribas was the first to make this move, opting to outsource capital raising services to Layton Road.
The move has left hedge fund managers wondering whether other prime brokers are likely to follow suit, and what impact that might have on how capital is raised. Mahala hopes to persuade other prime brokers to follow BNP Paribas’ example and outsource to Layton Road.
“One of the primary goals at Layton Road is to onboard our next prime brokerage relationship. Upon successfully onboarding a second prime broker, our hedge fund and institutional investor relationships will begin to see the added fruits of the multiplier effect that is created because of our open architecture of shared ‘investor interest’ among the two distinct cap intro teams,” says Mahala.
“Our model accelerates an investors sourcing activity, whereas one cap intro call can lead to introductions of hedge funds from multiple prime brokers.”
Through a ‘hybrid’ cap intro model, Layton Road has a dual revenue stream whereby it is paid by the prime broker and by managers that independently sign up for its services.
Mahala says the Layton Road business covers a diverse group of institutional investors, including fund of hedge funds, family offices, endowments, foundations, outsourced CIOs, insurance companies, RIAs and bank platforms. Of this group, fund of hedge funds and family office allocators are its two largest investor categories.
The move to an outsourced model would be one that influences the mid-tier prime brokers the most. The rise of split prime brokerage mandates could put further pressures on mid-tiers to outsource, given the fact that the majority of hedge funds have at least one top-tier prime broker as a provider.
However, Cowen Group’s Yarkon disagrees strongly with the move to outsourcing, as for many mid-tier prime brokers, they see capital introduction as an area where they can differ to the big primes to win clients.
“The cap into team is too entrenched in the entire process and if this was outsourced it would be hard to replicate this relationship. The outsourced capital introduction team would also will have little incentive to help the prime sales team win business and they will be too far removed from the everyday ebb & flow of the prime brokerage business to properly sell it,” says Yarkon.
Betting on the start-ups
That is not to say the big prime brokers have turned away from capital introduction completely. Many have simply rebranded the service in order to tie in consulting, research and other services handled by the prime broker.
For example, JP Morgan refers to capital introduction as capital advisory, Credit Suisse labels it capital services, while Barclays has renamed the service as capital solutions.
Under these brands, the big prime brokers aim to use capital introduction as just one of the value-added services that fall under their umbrella, engaging with the hedge fund at all stages of the life-cycle rather than at the launch.
Furthermore, there has been a series of mega-fund launches that have caught the eye of the big primes. In 2018 alone, the four biggest hedge fund launches have attracted more than $17 billion, in comparison to the $13.7 billion investors have allocated to existing funds, according to data from eVestment.
In summer of this year, Michael Gelbrand, the former fixed income trader at Millennium Management, raised more than $8 billion for his fund ExodusPoint Capital Management, making it the largest ever fund launch.
Banks are making bets on what one of these mega funds will result in long-term gains for the entire prime brokerage business, and are therefore doubling down on capital introduction.
“The maturity of clients is changing. Prime brokers have a mix of straight forward client acquisition and start-ups and smaller funds. With this shift, the capital introduction and consulting proposition becomes very important,” says Jonathan Cossey, global co-head of prime services, JP Morgan.
“We continue to focus in the start-up space, and seeing how we can ensure those day-one funds can become a long-term franchise partnership.”
Capital introduction will likely remain a key function within the overall prime broker business. Changing economics between the fund manager and the allocator, combined with the need for tailored capital raising solutions will make the business an important one.
However, what is evident is that the elements within the cap intro landscape are changing dramatically. The juniorisation of cap intro teams at the big banks coupled with the emergence of outsourcing has caused some commentators to question whether cap intro will be a sustainable business.
But many mid-tier prime brokers will see an opportunity to grow in this space, providing specialist capital raising services to niche strategies, as well as serving the majority of smaller-sized fund managers. But to succeed, they will have to adapt to the changing environment faster and become ever more efficient and sophisticated to compete.