Hedge Fund Investing: A Practical Approach to Understanding Investor Motivation, Manager Profits, and Fund Performance

Prime Brokers

The choice of prime broker is another crucial decision for a hedge fund manager that has significant implications for investors. A prime broker is a designation for a single commercial or investment bank that provides central clearing, financing, and reporting for a hedge fund's equity, fixed-income, and sometimes its derivatives trading.

Hedge funds may in fact trade with many firms; however, they usually look to consolidate their positions at the end of each day in a single or in a few prime locations where they can get immediate access to their consolidated positions, risk, and cash balances. Managers also seek to consolidate their activity so that they can negotiate the best possible terms with one firm to provide margin loans or lend them securities. Hedge funds want to be big enough at a prime broker to get the attention of senior management and a fair allocation of the bank's balance sheet or services.

A good relationship between a hedge fund and a prime broker can lead directly to enhanced performance via lower financing costs, commissions, or fees and higher IPO allocations or access to hard-to-borrow securities. Equally important, as was the case with hedge funds that used Lehman or Bear Stearns, the choice of the wrong prime brokerage relationship can be costly or even catastrophic in certain cases or jurisdictions.

Investors need to take great care in understanding the prime brokerage relationships in place at a specific hedge fund to ensure that the fund ...