As an emerging new asset class, prime brokerage services provided by investment banks to hedge funds have drawn increasing attention from investors recently. Gaining a proper understanding of what prime brokerage is, what services it offers, and how hedge funds utilize it, will allow investors to grasp the landscape of alternative investments more comprehensively. This article will explain what constitutes prime brokerage business in detail, illustrate how top investment banks like Goldman Sachs and Morgan Stanley generate revenue from it, summarize key information and conclusions around prime brokerage service models and market shares, as well as share actionable insights on how to invest in prime brokerage business or hedge funds that use such services.
Prime brokerage offers a full suite of services to hedge funds
Prime brokerage is essentially the full suite of services provided by investment banks to hedge funds and other institutional buy-side clients. This includes a wide spectrum of offerings – from administrative services like fund establishment and distribution, to trading-related functions like trade execution and securities lending, to post-trade support such as custody, valuation and reporting. By centralizing multiple capabilities under one roof, prime brokers become a “one-stop shop” for asset managers’ diverse needs. This unique business model creates economies of scale and allows banks to cross-sell various products to sticky institutional customers.
Trading services and financing activities drive prime brokerage revenue
Investment banks earn money from prime brokerage business mainly in two ways. Firstly, they collect trading commissions and fees by executing transactions for hedge fund clients. This trading-related income accounts for around 20% of total PB revenue. Secondly, more importantly, banks generate financing income by providing securities and cash lending to hedge funds engaging in long/short strategies. This lending & borrowing activity contributes approximately 70% of PB profits. Other revenue streams like custody and reporting constitute a smaller share, but are essential for retaining large clients.
Goldman Sachs leads in prime brokerage market share
According to filings by investment advisors to the U.S. Securities and Exchange Commission, Goldman Sachs served the highest number of hedge funds as prime broker in 2020, providing services to over 3,400 funds. Other top players include Morgan Stanley, J.P. Morgan, Credit Suisse, Bank of America Merrill Lynch, UBS, and CitiGroup. The dominance of bulge-bracket banks underline the need for scale and balance sheet strength in the PB business.
Investing in prime brokerage businesses or hedge fund clients
For investors interested in gaining exposure to the prime brokerage industry, one option is to invest in market-leading investment banks with top PB franchises like Goldman Sachs and Morgan Stanley. Another avenue is to identify promising hedge fund managers that extensively utilize prime brokerage services to implement leveraged trading strategies, and invest in those alternative investment funds. This allows benefiting from the risk-adjusted returns generated by PB lending activities.
In summary, prime brokerage offers a broad array of essential services to hedge funds and generates revenues from financing/lending activities. Leading global investment banks dominate the PB market. Investors can gain exposure by investing in top PB providers or hedge fund clients.