Hedge Funds and Prime Brokerage

  Note: This is a transcript of my video “Hedge Funds and Prime Brokerage in an Hour.”

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Good morning. Nice cloudy day. Better for walking than, say, a scorching hot day. So, let's begin it.

One of my subscribers and I'll put it up here somewhere, asked for a walk on Prime Brokerage. But, I honestly can't talk about Prime Brokerage in my opinion, without first really... basing it in a, in a solid understanding of hedge funds.

So I'm going to split this walk into two parts. First, understanding hedge funds and next how prime brokerage speaks to their needs given what we just learned in the first half of the walk. So before we start a second shout out.

Another subscriber (the same dude actually), I'll also put it up here, asked for a walk on Alternatives.

This was a while back and I was like, sweet goodness, Alts is way too broad to cover in an hour. So back then I did a walk on private equity, which is a tiny part of Alts. That user is getting the unofficial part two of the Alts walk today because hedge funds, and funds of funds are another tiny part of the Alts universe.

Third and final note: I did a walk on mutual funds about a year ago the one called "Fund Accounting in an Hour in Chefchaouen Morocco" and last week I touched on ETFs (Exchange Traded Funds: ETFs) while talking about wealth management.

I mentioned those last two walks because you understand things better when you compare them and I'm thinking that we'll be doing those kinds of comparisons on this walk. You know, don't worry if you haven't seen the other walks. I'll try to speak in plain English and explain industry jargon as I go.

So, let's do this.

Hedge funds are alternative investment vehicles (Huh? Alts?) that pool funds from "accredited investors"... which I'll explain in a sec. Hedge funds employ various strategies to generate high returns... in theory, and I'll explain how. The best way to understand the uniqueness of hedge funds is...

A rapid fire comparison between them, mutual funds, and ETFs. Like I said, 10 feet back. Okay, we should start by defining "accredited investors." Because that is one of the differences, right? That's where hedge funds get the money they use for their portfolio and to run the shop.

The term accredited investors should mean a sophisticated investor. And it usually does. But it actually just means an investor with a special status under financial law. Think: regulations meant to protect mom and pop investors. Just means someone or some entity that has more money or sophistication than the average investor... which means they can take more calculated risks and invest in riskier more speculative products like private equity (see my walk on that), venture capital, angel investing-- products where if it goes wrong it can go really, really wrong really, really quickly.

In terms of comparison, a hedge fund needs accredited investors while mutual funds and ETFs don't. Your mom and pop own mutual funds in their retirement accounts. And ETFs can be bought like any other security. So no accreditation is required.

What else? Hedge funds are known for their flexibility in investing across different asset classes: stocks, bonds, derivatives, commodities, anything really, because their investment strategies are as diverse as you can imagine. They are generally small, nimble shops that engage in a variation of, I'd say around four different broad strategies. 1) Equity investing, I think stocks, long and short, and I'll explain shorting down the walk. 2) Macro strategies... that rely on finding and exploiting larger macro or global trends-- think: commodities or currencies, FX. 3) Event driven investing, which takes advantage of significant events in a company or a product's life. And 4) relative value investing, where the hedge fund identifies something overpriced or underpriced and uses arbitrage to extract value from the price difference.

Arbitrage is a big word. It's a, it's a practice of taking advantage of differences in prices in two or more markets. Buying something undervalued and/or something overvalued and waiting to make a profit as they move towards the mean. Arbitrage also means playing on discrepancies in the market prices at which any product is traded.

Now, all of that, the four high level strategies, is a bit broad. They're high level. And we'll hopefully dig into that further down the road. But suffice it to say that, and I've said this before, once you understand all the variations in those four types of strategies, hedge funds are as "diverse, as I said, as you can imagine." In comparison to mutual funds and ETFs, you would think that a hedge fund uses a broader range of investment strategies and you'd be mostly right.

The problem with that statement is that people who run mutual funds and ETFs read the trades. They have conversations with shared clients. They see what hedge funds are doing. So they copy the more successful strategies.

Innovation can only be innovation for so long.

Along those same lines, by the way, hedge funds are also evolving daily. They continually renew themselves and venture deeper and deeper into alternative asset classes. For instance they now play in the private equity space, private debt, financing, IPOs, et cetera, et cetera, et cetera, changes every day.

So as institutional mutual funds and ETFs innovate, and evolve, shaping themselves more into the best that hedge funds have to offer... hedge funds themselves innovate and evolve, creating cool new strategies, the cutting edge of quantitative and statistical modeling.

Hedge funds are also moving towards the large institutionalization that gives mutual funds and ETFs the air of safety and respectability. They understand that their biggest potential investors are the behemoths, the institutional players. And like all big, slow moving beasts, they respect other big, slow moving beasts.

If I had to guess, I'd say that in ten years, it'll be impossible to differentiate, structurally at least, between hedge funds, mutual funds, and ETFs. When you, you know, look at how, who's big and slow and respectable, and who's small and nimble and dangerous. There'll be more and more small, nimble mutual funds and ETFs, and more and more hedge funds that are too big to fail.

Because, as I said, "Innovation can only be innovation for so long."

I gotta keep looking at the ground here because it rained and I'm going down a hill.

Let's, let's get back to what makes hedge funds unique.

Hedge funds are less regulated than... mutual funds or ETFs. That's partly why they need the accredited investors... we talked about. Regulation, at least in the U. S., acts in the interest or tries to act in the interest of mom and pop investors, protecting them from risk.

So, you know, a little patronizing to think that poor people are less savvy with their money than rich people or institutions, but, you know, it's well intentioned. In a perfect world, higher risk financial activity like state sanctioned gambling would be restricted to people who could afford to lose their shirts.

I say state sanctioned because high risk speculative investing is to old school gambling what alcohol is to illegal drugs. It's state sanctioned. It's a state sanctioned drug. I guess that would make lower risk mutual funds coffee? Caffeine? No? I have to think through that analogy.

Your, your savings account would be soda: delicious, but not good for you. Fixed income. It would be tea, kind of bland. Mutual funds and ETFs, coffee. I think I might have gotten that right. Day trading would be alcohol and speculative investing like hedge funds and private equity. They're the hard drugs. There. Analogy fixed. And it explains why the government is involved. They're fixated on hard drugs.

Okay, another difference. Most hedge funds are open ended. Also called continuous funds, rolling funds, etc, etc. That means that there's no planned end date for that fund. All the capital that a hedge fund needs is invested at its start. The opposite of that would be Private Equity - close ended.. If you invest in PE-- Private Equity-- there's a start and end date for that fund. And if you want to get into the specifics, you, you may have to provide additional capital at intervals until the end of the term. Okay. A "term" is jargon for... the deadline for the fund. The end date. That's the term. Hedge funds don't have an end date.

That's why the TV show Billions, on Showtime, could go on forever. If the show, which is about, like, a hedge fund, was about municipal bonds, a closed ended fund, it could only last a couple of episodes. Actually, if you watch the show, you're probably thinking, Hey! Wasn't there... A storyline about municipal bonds and like, Sandicot, New York, something about a casino?

Yes, there was. Because hedge funds can invest in whatever the hell they want. Stocks, Beanie Babies, bonds, Magic the Gathering cards, whatever.

What else? Hedge funds have restrictive lock up periods on Redemptions. That's a lot of jargon for less liquidity for investors than mutual funds or ETFs. In that way, they're more like private equity.

Again, when you put money into a hedge fund or private equity, it will stay in there for a while. And I mean, contractually, that's part of the recipe. You gotta give it time to cook. Mutual funds, you can get out that week or that month. ETFs, you can get out as soon as you hit the sell button. But hedge funds are a commitment.

There's a little dragonfly that flew by.

Are there any exceptions? Good morning. Always. But they're generally only made for monster investors. People or institutions who can and do change contract terms before they invest. It's done via something called a side letter, and I might or might not get into it, maybe a quarter mile up. The point is that accredited investors have specific liquidity requirements, and they know that hedge funds fall somewhere between mutual funds and ETFs. Think daily liquidity. And more closed end funds like private equity. Think five to ten year lockups. Hedge fund liquidity, somewhere between a quarter and a year. But again, they make exceptions for large clients. If you're a powerful enough client, there might not even be a lockup. It's good to be king.

What else? Hedge funds have less transparency than mutual funds or ETFs. There's a whole industry called fund accounting that's in the business of helping mutual funds provide daily transparency. Not just to their clients, but to the broader markets. Not so with hedge funds. But don't take that to mean that hedge funds are black boxes to their investors. Not at all. They communicate with their investors often and in great detail because they know that a well informed investor will stay with them longer, will tell their friends, will drive in more business, theirs and their friends. It's investor relations done properly.

So don't take the words "lack of transparency" as anything other than them not needing to tell the markets every day, how they're doing. Mutual funds do. ETFs do by, you know, just looking at their price.

What else? Hedge funds are comfortable using debt, like leverage and short selling. Jargon again. Leverage is an investment strategy of using borrowed capital, borrowed money, to increase the potential return of an investment. And short selling is what happened with GameStop-- betting that a stock price is going to go down.

Mutual funds don't or usually don't play those kinds of games. ETFs may use some of these techniques in this specific fund or that specific fund, but hedge funds use them all over the place.

Understanding the role of debt... in general, but in this case, and specifically, understanding the role of debt in, in a hedge funds is super important. Hedge funds, borrow money, a lot of money to buy more or sell more of whatever they're investing in. If you're investment thesis says that Apple stock is going to rise by $100 and you have $1M to invest in it.

You can amplify your returns by borrowing another $9M and paying off that with the money you made off the Apple going up. When you finally sell Apple... You return the money you borrowed plus the cost of borrowing it and the returns the rest of the returns are yours. That's leverage.

It's also super risky because your thesis might be wrong or the markets might not go the way you thought and instead of going up by $100, Apple might, I don't know, lose $100... Amplifying your loss. Super risky. ETFs have started to use this technique, blurring the line with hedge funds.

There are two types of leverage, while we're on it. Borrowing leverage, which is borrowing money, like the Apple example, and something called notional leverage, which are financial products that have built in leverage. Think options, or futures. Products that let you invest a small amount of money, rather than buying the whole security, right?

There's also short selling, as I mentioned... about 50 feet back, where you sell someone else's equity position, wait for the price to drop on what you sold, and make them whole by buying what you borrowed at a lower price and giving it back. It's risky because it's a different kind of risky. When you buy stocks the usual way, what's called going long, you have a limit on losses.

If Apple's trading at $5 right now and you buy it, the worst that could happen is that it drops from $5 to $0. You know, that's a max loss of $5 per share. But when you short Apple, say you're betting on it going down, and you short it when it's $5, and their price increases, there's no upper limit for that price increase.

If it rises from $5 to $10, and you short Apple, you've lost $5 per share. But if it jumps to $100 or $500 that risk just explodes in your hands. So shorts are inherently riskier than long positions. That's why mutual funds don't use short selling. I'll have that rock removed later. You don't, you don't take that kind of risk... I'm talking about mutual funds and short selling. You don't take that kind of risk with people's pensions.

Again, the occasional ETF does short selling, blurring the lines with Hedge funds.

Another difference: hedge funds use flow through taxation. Every day, I wish I was a tax expert. I'm not, but I know that hedge funds are not taxed like most corporations. Their returns are only taxed once their returns are collected by investors. The fund itself is not taxed that way. Huge advantage compared to, you know, other investment vehicles.

Yet another difference: hedge funds usually have an incentive fee on top of their management fee. Very private equity like. If you don't know what I'm talking about, see my walk on private equity. An incentive fee is just that-- an incentive-- to the people who run the hedge fund or private equity fund-- a percentage of the profits that they'll receive if, and it's a huge if, they outperform. So, the better they run the fund, the more money it makes, the more money they make.

Mutual funds and ETFs just charge management fees built into their prices. Think 2%. The incentive fee that hedge funds charge is like 10x that. A performance fee. It's good to be a hedge fund manager.

Plus, they focus on absolute returns. That's kind of important. Not relative returns. Absolute returns. There's an industry term you might have heard, alpha... which is, at a high level, the quantity of returns, a number, that's market independent... that's still vague. Okay, if the whole market is up by X percent, and a fund is up by X plus 5 percent, that extra 5 percent is the alpha.

So, hedge fund managers only care about the larger market's returns insofar as their fund can outperform it. That's alpha.

Another difference, for the legal nerds watching, hedge funds use a less common partnership structure than the usual LLC. They use what's called an LP, a limited partnership. Again, very similar to private equity funds, and for the same reasons.

Okay. I've covered a bunch of differences between hedge funds, mutual funds, and ETFs. But before we jump from part one to prime brokerage and how it all applies, probably worth noting, again... that investment strategies between hedge funds, mutual funds and ETFs are converging.

So the main differences between them are structural, not strategic. If an ETF can and does use short selling or leverage... if mutual funds can and do use unusual products like complex derivatives to amplify their exposure... then hedge funds differentiate based on being small and exclusive (structural)... by not having their strategies constrained by regulation (again, structural)... by contractually committing to being less liquid... so the investment strategy, the food has time to cook (structural)... tax benefits (structural)... active managers, and active management that's incentivized to perform and maybe outperform (structural).

All that said, the vast majority of folks watching this walk don't need to pick between hedge funds, mutual funds, and ETFs. We're mostly tech and ops folks watching these to understand how to better serve our business partners and our clients needs. We should stick to our 401ks because speculative investing is a richer person's vice. Hedge funds aren't even allowed to market to us, and that's probably wise, but just because we can't personally use them doesn't mean they're not valuable to the markets, maybe even critical, given the scale of need for hedging and diversity in investment strategies.

Okay, let's get back on track. We're at a really cool... section of the forest where it's a four way. Okay, this next one at least initially isn't something that makes hedge funds unique... when compared to mutual funds and ETF but is when you let it sink in.

The biggest reason why investors put money in hedge funds is not their amazing returns... because they might not have those. The biggest reason like all Alternative investments-- Hedge funds represent diversification for that specific investor or portfolio.

That's where the word hedge comes from. If all the politicians you own are Republican, you need to hedge by buying some Democrats. As the power of one falls, the power of the other rises. Hedging. There's always an equilibrium in play.

You could say that investors are... increasingly using mutual funds to diversify their portfolios, and you'd be right. Same with ETFs, but there's diversification and there's diversification.

Mutual funds and ETFs offer ease of investment, liquidity, transparency, but they're also mostly vanilla, off the shelf investments that have built in diversification across vanilla products. Hedge funds, aren't chocolate.

They're honey, caramel, cashew, chocolate-malt-ball, strawberry-shortcake, cookie, butter, pretzel, sea salt, brownie ice cream. They're personalized flavors crafted for very specific financial tastes. Who's? Accredited investors. We just learned that. But, another way of saying accredited investors: institutional investors, pension funds, insurance companies, ultra high net worth individuals-- institutions, and people who already have mountains of vanilla ice cream, and beyond those mountains, mountains.

To understand any... business that you support... you need to understand its clients, or more specifically, what itch your client's clients are trying to scratch.

In the industry, the clients of hedge funds are also known as allocators because they allocate capital to a fund. And an institutional investor isn't investing a million or two in a hedge fund. More like fifty million or a hundred million. Large numbers.

So, it's reasonable to cater to their demands. They want lower fees. Who are you to say no to half a billion dollars or a billion dollars in investment? They're s o hard to please that the industry established a bar called institutional quality operations-- being able to evidence that you as a hedge fund have third party audited performance records, that you employ a sophisticated risk management discipline, that you have world class compliance processes that given what happened to Lehman Brothers, you have multiple prime brokers, administrators, and custodians, and a ton of additional private investors waiting in the wings. It's a standard of quality, a very high minimum bar before any reputable allocator will give you an allocation... will even consider you and consider investing, you know, in your hedge fund.

Back in the day, people used to think that institutional quality operations were a differentiator, a way to stand out from the hedge fund crowd. These days though, it's a ticket to play. If you don't have a solid world class operating model-- flexible, scalable, resilient-- you're not going to be able to compete for the big money.

That's why side letters, which I mentioned, you know, back down there are so common. The most powerful allocators have very specific needs, so they request custom provisions. So, you know, everyone else in a fund might be contractually obligated to pay a standard 2 percent management fee, but the big allocators have their own bosses and their own clients. So they'll ask for a bargain via a side letter.

Most hedge funds have a mix of small, medium, and large clients. So, side letters are an exception. But, if a fund only has monster investors, well, then the exception, the side letter, becomes the rule. It's understandable when large numbers are in play. At least, I think so.

They'll need better security measures, better safeguards, better terms. I mean really, what's the point of being The 800 pound gorilla, if you can't occasionally use your weight? Use it to lower your fees, your costs, to increase transparency and liquidity. You get the point. The only thing I haven't said yet, that's worth saying about hedge funds, is that...

Mutual funds and ETFs aside, every hedge fund is a snowflake. Which is why it's so hard to talk about them, right? Every one is a snowflake, shaped by the techniques that they use, the founders expertise, the talent that the founders brought in, their investment strategies and all the crazy provisions in the contracts that they sign with their customers: management fees, lockup periods, side letter after side letter after side letter.

The bigger an organization gets-- any organization, really-- the more it looks and operates like a big pile of dirty snow. While they're still small and nimble: snowflakes.

Okay, that's, that's not everything in the world about hedge funds, because that would be impossible to cover. But enough about them and their clients-- the allocators-- that it's a good time to get to part two.

Why would you do that to a tree?

📍 Alright, let's talk Prime Brokerage Services. High level, this is now part two. High level Prime Brokerage, or PB, is a service offered by financial institutions to institutional clients, such as hedge funds. investment banks, large trading firms. PB provides a comprehensive suite of services, including clearing, custody, financing, risk management solutions for, you know, their clients, trading activities. A lot.

Let's step through those services. I love that. They cut a, I don't know if you can see, they cut a way into the path through a log.

Alright, so, let's go through each one of them. The services that PB's offer. One more time. But slowly this time.

Clearing and settlement. I think that's the first one I mentioned. Prime brokers ensure efficient and timely clearing and settlement of trades executed by their clients. I did a walk called Securities Trade Life Cycle in an hour. I don't think it was an hour though. If you don't want to watch that, just know that PBs handle the administrative tasks related to the transfer of securities and funds.

Custody services is something else that PBs offer. Prime Brokers hold and safeguard client securities and other assets in custody accounts. I did a walk on this, my first one, custody banking in an hour. If you don't want to watch that, just know that PBs provide safekeeping, recordkeeping, and reporting services.

And, to be fair, most PBs are one of many businesses that large banks consolidate into their investment banking division. So when you hear that J. P. Morgan's Prime Brokerage offering, which used to be the old... Bear Stearns Shop. When you hear that they offer custody, it means that the business directly to its left, JP's custody business, is really doing the work.

Let's move on. PBs provide financing, money, credit, to enable clients to leverage their trading activities. With the use of the word leverage that I defined earlier. PBs provide margin loans, securities lending, repurchase agreements, which, now that I think about it, I don't think I've ever covered.

So three quick definitions. Think of it like borrowing your, your, your second house based on the equity that you have. Right margin loans, that's what I'm talking about, allow you to borrow against the value of securities you already own. Your own house. It's usually an interest bearing loan that can be used, for instance, by hedge funds.

Huh? Remember how we talked about hedge funds using leverage? Buying more Apple stock than they have money to buy. Where'd they get that money? Potentially, a margin loan.

What else? There were three definitions. So, securities lending. Securities lending which honestly deserves its own walk. But, at a high level, it's the practice of loaning shares of, of stocks, commodities, derivatives contracts, or any other security. Think liquidity play used by other investors. That's what the PB is doing. It's loaning them out as a path to generate additional interest income for long term holders of securities. Also plays a role in short selling, which we talked about earlier.

And what was the third one? Repurchase agreements, or repos, which are a form of short term borrowing, mainly in government securities. The bank sells the underlying security to the investors and, by agreement between the two parties, buys them back shortly afterward at a slightly higher price. Repurchase.

A very literal name. Okay, where were we? We had stepped through the first three services that PB's offer. Clearing and settlement, custody and financing. What else do PB's offer? #4. Risk management. Prime Brokers assist clients in managing their market and credit risks. They provide risk analytics, collateral management, and risk reporting services.

Technology and infrastructure. Prime brokers offer trading systems, connectivity solutions, and data analytics tools.

What else?

Research, research and advisory. Prime brokers peddle their advisory services and a lot of their larger banks advisory services to their clients. And when you think research think market intelligence, trade ideas, access to industry experts, and different kinds of expertise.

And last but not least at least for hedge funds, they offer capital introductions. Prime brokers facilitate meetings with all the right folks. They connect them with potential investors and capital sources.

Remember the first thing we talked about on this walk? How hedge funds need accredited investors. What every hedge fund needs after they've called everyone in their Rolodex are capital introductions to new people, new institutions.

Okay, that's a high level for prime brokerage. and the services they offer.

Suffice it to say that they play a very critical role in enabling their clients to navigate the complexities of the financial markets and enhance their overall trading performance through their various offerings.

What kind of companies uses Prime Brokerage?

These kinds of clients can't use Robinhood for their trading, their front office you know, OMS, order management systems. They often engage in complex, high volume trading activities requiring specialized services and support. Enter PBs that help them optimize execution and operations. And they manage various post trade needs, which we just talked about.

When, when hedge funds use prime brokerage, they do it all for the reasons I listed in the first section. And I'll step through each of them in a minute. I gotta walk on this thing. That's gonna take some balance.

Okay first before we get into hedge fund specifics... when do you not use prime brokerage? If you're small or an individual investor prime brokerage services are typically tailored for institutional clients with high volume of trading activity. Small and individual investors... who don't engage in complex trading strategies... won't require the buffet menu provided by Prime Brokers.

Low frequency traders, traders who execute trades infrequently, won't benefit significantly from PB services. The comprehensive suite of services offered by PB's is really not cost effective for traders who don't require, like, clearing at scale, custody at scale, or financing solutions at scale. You don't need Costco if you live by yourself.

Alright, who else doesn't need them? Low-risk traders. PB's have... ooh... have risk management solutions to help clients mitigate market and credit risk. And guess what? Small and individual investors who engage in low risk trading strategies don't need that or more accurately don't need the associated costs, which brings us to companies with limited resources.

You don't need a PB. PBs can be costly, especially for companies with limited financial resources. Who else shouldn't use PBs? Companies with limited trading activities. If a company doesn't trade much or only trades in a few select markets, it won't be necessary to take the comprehensive global suite of services offered by PB.

Who else shouldn't use PBs? Companies with in house capabilities. Duh. If you roll your own and you're good at rolling your own, keep rolling. Companies with specialized needs. Although that's a conversation with a PB. If a company has a very specific and specialized set of needs that are not covered after a conversation with a PB, you know, PBs aren't the right fit then.

That said, it's highly unlikely because PBs are designed to cater to a wide range of institutional clients. But, who knows? You might have a certain unique set of requirements that are better served by alternative solutions.

Who doesn't use or shouldn't use PBs? Oh!

Companies with existing relationships! Why put your company through the pains of massive change management? I'd say that every PB's best insurance against deterioration of their performance: no one wants to switch PB's. Massive pain in the ass. Same with like, switching custodians.

Anywho, it is important for companies to carefully evaluate their, their trading activities, resources, risk profile, investment objectives when trying to figure out whether this or that or any prime brokerage is the right fit for them.

Okay, we got through that without a heart attack and I only had to turn around two or three times because I'm a little lost. 📍

Let's bring together the first part of the walk with the second part of the walk. How and why would a hedge fund use a prime broker? Okay,

1) Hedge funds, as I said, get the money they invest and the money they use to run the shop from accredited investors. A good prime broker helps hedge funds find new investors. Those accredited investors. How? Capital introductions. We already covered that.

2) Hedge funds are incredibly flexible in what they invest in. Every asset class on the planet. They do a ton of their own research, but it's tied to and validated by everyone else's research. And, guess what? PB's offer a ton of research. Not just their own, as we discussed, but the research from every division in their larger bank.

3) Hedge funds aren't regulated. Prime brokers and the larger banks that they're attached to are regulated. So when hedge funds have to understand the regulatory environment, PBs can... Give them subject matter expertise in regulatory trends.

That's similar to the research in number two right before this. Except that it's expertise. People that sit in a PB or its larger bank. That's advisory gold, I think. Because I can't imagine that certain hedge funds aren't leveraging the regulatory burden of the bigger banks as part of their investment strategy.

What can they do better, strategically, operationally, than their bigger, slower competitors? Because they're not regulated and their bigger competitors are.

Okay, we're on three. Using my fingers here.

4) We talked about hedge funds being open ended. How do... PB's help there? We said it before: PB's help hedge funds find new accredited investors. Capital introduction.

5) Hedge funds have restrictive lockups. We talked about that. PB's can help manage the inflow and outflow of client money because they have large systems and larger operations teams that automate administrative tasks. That's similar to the the way a custody bank helps mutual funds through a function called Transfer Agency. Which now that I mention it, I gotta define it. Transfer Agency manages, at scale all their "subs and reds"-- their subscriptions, subs, and their redemptions, reds. I won't go down that hole, because that's a, that's another walk unto itself.

Where are we? We're at five. So,

6) Hedge funds can have less transparency. We talked through that. Remember that they have world class investor relations. PBs provide performance reporting that helps manage clients communications. When you as a client get comms from your hedge fund, it'll include numbers that you (they) got from your prime broker and a personalized commentary from your fund manager on how they're doing and why that aligns or doesn't align with their investment thesis.

7) Hedge funds use a ton of debt. We talked about that: leverage and short selling. PBs help provide hedge funds with that leverageable debt, allowing them to borrow securities and cash. PBS are ideally placed to do that because they're already holding the hedge fund's, existing securities and debt. So hedge funds don't need to fill out some bureaucratic loan application every time they wanna leverage debt. The PB's tap is always on or reasonably always on. Cause you know, PB's also need to protect themselves against bad behavior.

8) Hedge funds use flow through taxation. PB's because they're a part of large investment banks have tax services.

9) Hedge funds use incentive fees on top of management fees. Now this one's going to be tough because I'm not sure how PBs explicitly help in this case. So let's file this one under PBs help hedge funds find new investors.

Right. 10) Hedge funds use limited partnerships. Again, not sure how PBs explicitly help. Maybe they can provide legal advisory. So let's file this one under PBs having, you know, administrative support, tax services maybe.

And 11) hedge funds have demanding clients. I think this is the most important part, right? The allocators we talked about... that all go side letter happy when they're big and powerful. And they all demand, you know, drumroll please, institutional quality operations. PB's, and this might be their real value, PB's help hedge funds hit that high standard of quality.

I failed at hitting a top 10, because who the hell does a top 11 list?

Okay. I'd normally end the walk here, but given that I was lost twice I have some time before I get back to the house, so let's go back to the original question be cause I, I didn't talk about how tech 📍 has been digitizing PB. (ie.,ClearStreet for reference). ClearStreet, if you don't know, is, and I'm paraphrasing their LinkedIn description. They're building financial infrastructure for clients of all sizes to do clearing, custody, execution, and prime brokerage.

They correctly talk about how the big banks are still using 40 year old COBOL mainframes as their tech and failing to modernize it. And they talk about how ClearStreet isn't burdened by a legacy of old tech. A legacy footprint. Because they're a startup. And they mention that they're building a cloud native clearing and custody system.

Super cool. And I honestly... Don't know anyone there, and I haven't seen their offering. So please don't take this as an endorsement. That said, now that you've heard the walk, you should be wondering how important tech and digitization are to PBs and their clients. Now, I love ClearStreet's focus on custody, clearing, and settlement, but PBs, eh, I'm on the fence.

And as much as I am a techie, and as much as I believe that tech is an amazing differentiator, And that a client's digital experience is make or break in a competitive landscape. I also believe that PBs, specifically, can continue to have their crappy legacy back end systems as long as they put lipstick on that pig. A modern client experience.

So, the 40 year old COBOL system. Should be replaced, no doubt, but mostly because they'll get more and more expensive to support as all the COBOL programmers in the world age out. Most are already retired. So, whether a system is 40 years old or not, whether it's back end is COBOL or Java GPT, that only matters to the provider, not the client, because it'll eventually become wildly expensive to keep it up, resilient, and supported: institutional quality ops!

Should ClearStreet quit pushing its agenda? Of course not. They're a breath of fresh air. And if you listen closely to the walk I just had, you realize that a ton of value PBs add to a hedge fund is not the tech, but the people that, that PB brings to the game. The experience, the relationships, the introductions that can be made, the research that can guide investment strategy, the capital that can be leveraged in the execution of that strategy.

Tech is important. I have to say that because I'm tech. But, there's so much more and more important than me-- tech-- in PB.

Hopefully that was useful.