As the prime brokerage heavyweights are forced to reassess their business models, so called mini-primes specialising in servicing small and mid-sized hedge funds are booming. Kris Devasabai reports

The once-lucrative prime brokerage business has come under pressure in the wake of the financial crisis. Faced with a massive decline in hedge fund assets, the large prime brokers have been aggressively streamlining their businesses. Smaller hedge funds have been shown the door or marginalised as the larger operators have opted to concentrate on their most profitable clients.

Mini-primes are picking up business from hedge funds jettisoned by the large prime brokers and have been signing up start-up managers that fall below the minimum asset requirements of the big players. According to sources in the industry, even hedge funds with up to $500 million in assets are thinking seriously about moving their business to mini-primes because they feel they are not being adequately serviced by the bulge-bracket banks. “This is an incredibly exciting time to be in the mini-prime business,” says Frank Magnani, managing director for prime brokerage sales and marketing at Celadon Financial Group, an independent brokerage firm and mini-prime based in New Jersey. “The prime brokerage business has changed. Hedge funds are looking at the market with an open mind and this is creating tremendous opportunities for firms such as Celadon to win market share,” he says.

Mini-primes first emerged on the scene at the turn of the decade. They essentially act as introducing brokers to the traditional prime brokers and provide execution, clearing and custody services through correspondent clearing relationships with these banks. Miniprimes also have access to the financing and stock loan capabilities of the top-tier prime brokers, so their clients can apply leverage and take short positions.

Mini-primes distinguish themselves from the traditional prime brokers by the level of service they provide, particularly to smaller clients. They tend to have flatter organisational structures and lower overheads than the bulge-bracket banks, which makes them an ideal fit for the type of clients being eschewed by the large prime brokers.

In addition to core execution and clearing services, most mini-primes also provide help with raising assets and deliver operational support services, which can be invaluable for small managers and start-ups.

High-touch client service and the ability to provide operational support are among the main attractions of working with a mini-prime, according to Magnani. “Many hedge funds have cut back on staff as assets under management have declined. They are looking for service providers that can provide an additional level of support and help them manage their business at this time. That’s a role that we see ourselves playing,” he says.

The mini-prime business is diverse, and each firm has its own strengths and areas of expertise. For instance, Celadon has established relationships with two separate clearing banks and has plans to expand this to three soon. The objective is to offer clients multi-prime capabilities within a simplified operational structure, says Magnani.

“The model we have developed gives the client all the advantages of a multi-prime model without any of the operational headaches that come with being serviced by multiple providers,” he says.

Celadon also offers direct market access, and execution and clearing across a number of international markets. It plans to expand its business in Europe. Magnani sees a “tremendous opportunity” to grow the business across the Atlantic, where the mini-prime model is much less developed than in the US. The plans are not yet finalised but Magnani says the idea is to establish offices in the UK and continental Europe to service hedge funds based in the region. A number of managers have already expressed interest in doing business with the firm and Celadon expects to open its first European office soon, he adds.

Conifer Securities launched its prime brokerage service in October 2008. The firm uses JPMorgan’s broker-dealer services unit for clearing and custody services. Sal Campo, head of prime brokerage sales at Conifer, says the banking crisis and the concerns many hedge funds have about counterparty risk have created an opening for service providers like Conifer to step into the business.

Conifer has a unique perspective on the market. The firm provides a suite of operations and business support services for asset managers, including fund administration and a middle office outsourcing platform that serves as an interface between multiple prime brokers. Campo sees prime brokerage as a natural extension of Conifer’s hedge fund services.

“Our business model is fairly simple,” he says. “For larger funds we offer a middleoffice platform that acts as the operational interface between multiple prime brokers, while smaller funds have the option of using Conifer as their main prime broker with clearing and custody services provided by JPMorgan.”

Campo describes Conifer as a boutique provider occupying a specific niche in the market. The firm is geared towards providing hedge funds that have $100– $250 million in assets with a complete range of support services, including prime brokerage. “We don’t see ourselves as having competitors in the market. The breadth of services that Conifer offers for hedge funds is unique. The large prime brokers focus on the multi-billion dollar hedge funds, and that is not our target market,” Campo says.

Conifer maintains strong relationships with the main prime brokers and gains a lot of business through referrals from these banks, he adds. The firm has particular expertise in working with start-up managers, many of whom retain a relationship with Conifer as they grow. “There are a lot of opportunities for miniprimes to work with hedge funds that no longer have a place at the large prime brokers. But we are also very excited about working with the next generation of hedge fund managers that are entering the business at this time.”

Campo sees mini-primes playing an important role in the market as it develops. “It is one of the few business models where everybody wins. The large brokers gain access to business without the complexity of dealing with a lot of small accounts. Hedge funds that choose to use Conifer as their prime broker benefit from the security of having their trades cleared and custodied by a large institution, combined with the advantages of working with a boutique provider that can provide a hightouch service,” he explains.

Conifer is one of a handful of companies to have entered the mini-prime business in the past 12–18 months. The New Yorkbased boutique investment bank Lighthouse Financial launched its Prime Services business in March. The unit is led by co-heads Jamie Caputo and Brian Staunton, who were key players in the rollout of RBC’s prime brokerage business in the US. The team includes a core of RBC veterans and former executives from the bulge-bracket investment banks.

Caputo says Lighthouse has benefited from the displacement of business from the major prime brokers. “Our timing could not have been better,” he says. Small and mid-sized hedge funds are turning to boutique investment banks such as Lighthouse Financial because the major prime brokers have raised their minimums. “The concept of an introducing broker, or mini-prime, was not very well understood in the past. That has changed. Hedge funds with $50–75 million in assets are now comfortable with working with a bank like Lighthouse,” says Caputo. Lighthouse Prime Services is structured like a traditional introducing broker. Execution and clearing services are provided by Goldman Sachs. But unlike a typical introducing broker, Lighthouse has sought to enhance its offering by striking exclusive partnerships with third-party service providers such as Hedge Connection, IRC Securities and Formation Trading Group.

For instance, the deal with HedgeConnection means clients have access to pre-qualified investors and marketing support through a web portal. They can also participate in 12–15 capital introduction events Lighthouse is organising jointly with HedgeConnection.

“Building out a proprietary cap intro group would have taken months and required a substantial capital investment. Working with HedgeConnection meant we could get up and running quickly while also providing a complete suite of services to clients,” says Caputo.

Lighthouse has plans to introduce additional services in the coming months. The firm is in the final stages of rolling out an automated stock loan capability that will enable clients to access supply from multiple sources. This service, which will be integrated into Lighthouse’s front-end technology, is being developed in combination with one of the large lenders.

“There is a huge opportunity for boutique players to profit in this space, but you need to have the right infrastructure in place to be a top player,” says Caputo.

Lighthouse acts as the primary broker for a number of start-up hedge funds, as well some established managers with whom the executives had existing relationships. The firm’s clients have around $20–25 million in assets on average and are growing fast. Caputo says the bank is “very excited” about the potential of the business and is looking to hire new talent and develop its technology.