Back to the Future

Aaron Steinberg: The short answer is yes, the landscape does look different than it has over the past few years. There's been a continued evolution in the hedge fund space. A lot of that has been driven by investors, investor requirements, investor interests, and regulation. I think in the emerging manager space, it has become increasingly challenging over the past 10 years or so to launch a fund. The hurdle to new business launches has become higher. It's more expensive and there's more internal infrastructure needed. The regulatory requirements to launch have expanded. Finally, the types of things institutional investors are looking for have gotten more sophisticated.

Over the past two years, while we've been dealing with COVID-19, some of those changes have been exacerbated as emerging managers have had to figure out, along with investors, how best to conduct due diligence while, in most situations, not being able to see people in person. That has slowed the manager launch space over the past two years. In Q2 2020, for obvious reasons, we saw some of the lowest launch rates that we've had in a long time.

That number rebounded up this year. There were more new funds registered in the first quarter of this year than there had been in a long time. That doesn't just mean new managers. It means managers that hit the critical mass at which you have to register. My personal opinion is once we figure out how to extract ourselves from an environment where we have to be remote and people get back to more in-person meetings, we should see a further boost. The good news is investor appetite continues to increase for alternatives.

GC: Has that bounce back had any impact on the provider landscape? Roughly put, you've had the bulge brackets, a large mid-tier group, and mini-primes or firms catering to the smaller end of the market. Does that segmentation still exist?

AS: The major players are still there. At the same time, I think as hedge funds have evolved, there is an increased appetite to have a broader diversity amongst their prime brokers. I don't think that the psychological aspect exists as much as it did before of, “I have to be with the big players for validation with investors”. I think investors have gotten sophisticated enough to know the full landscape of the prime brokerage marketplace and understand the value that different firms bring.

You see in the Global Custodian survey that the prime brokers who get the highest scores in things like client service are not necessarily the largest firms. I do think that there has been an increased appetite amongst the hedge fund community, both large existing funds and newer managers, to consider counterparties that might, in the end, be a better fit for them than just going with the biggest.

GC: Are there any areas where hedge funds and their investors most need handholding or where they're most nervous about what the PBs provide?

AS: I wouldn't necessarily select one particular area, but I will say that this year and over the past few years, investors'interest in counterparty risk and risk in general and their desire to understand their counterparties has grown. Investors and managers alike are thinking about their prime brokerage counterparties, how their balance sheet is managed, how the risk profile is managed, what the different products and services are that they offer them as well as their other clients and how that may end up impacting the business that they have themselves.

GC: I'm wondering why the scores for capital introductions in this year’s survey are relatively low. They are in the bottom quartile across the survey as a whole. Is it because clients always expect more than they can get from cap intro as a service?

AS: We do cap intro a little bit differently at Pershing. We have a small team dedicated to providing individualized bespoke introductions to our client base. We have a business that has been grown in a controlled fashion. When we make an introduction, we know it's to somebody who has a legitimate interest in that particular fund, in that particular strategy.

But to answer your question directly, I think the feelings that managers have around cap intro have probably not changed in the past 15 years that I've been in the business. I think ultimately what drives investor interest is risk-adjusted returns and the quality of returns. Managers who have good performance and good business development people and are looking to raise capital typically have had fewer complaints about cap intro or capital raising. But when you come to a point where the returns are a little bit less exciting, it's harder to market the fund.

I think there are high expectations for cap intro. There are some firms that use it as a selling point to bring folks on board and as a result there can be a mismatch of expectations. Ultimately it really is the manager and their performance and their systematic way of executing on that performance that drives the interest from the investors. No matter how good the cap intro team is, they're not going to be able to change an investor's appetite for something that doesn't fit into what they're looking for.

GC: Finally, has COVID had a negative impact on the way you do cap intro?

AS: COVID hasn't had any positive effects and the pandemic has caused a lot of tragedy. But strictly from the capital introductions perspective, it's paradoxically had a positive impact for us. There are a number of firms with bigger cap intro teams that have historically had a lot more events with a lot more networking. And they attract a lot of people there, but because of COVID, everyone has had the same tools and resources to get in front of people; in particular, phone and video calls.

So my team now has all the resources that all the big players do. Between that and people not commuting, working longer days, and not travelling, investors and managers alike have had a lot more time to meet. And so we’ve probably met with even more investors virtually than we do normally in a physical setting. And it's really given us the ability to further expand our investor database and deepen the relationships that we've had. I'm hoping that when things get back to in-person meetings, that we'll be able to leverage that and strengthen those relationships even more.