Hedge Fund Investing Chapter 12 Part 1: Service Providers - Admin and Brokers
When you think about hedge funds, you think about traders and portfolio managers. Maybe a genius founder in a corner office making billion-dollar bets. But behind every hedge fund is a small army of service providers doing work that nobody talks about. Chapter 12 is about those people.
Mirabile argues that a hedge fund’s choice of service providers tells you a lot about the fund itself. Pick top-tier partners and investors trust you. Pick unknown or cheap ones and people start asking questions. It is one of those things that sounds obvious but many funds got wrong, especially before 2008.
The Four Critical Service Providers
Every hedge fund needs four key partners: a fund administrator, a prime broker, an auditor, and a law firm. Together, they give the fund manager leverage, access to information, and scale. They also form the backbone of the control environment and risk management process.
But here is the thing most people miss. These providers do more than just process paperwork. They give the fund reputational validation. Having Goldman Sachs as your prime broker or Deloitte as your auditor sends a signal. It tells investors: “we are serious, we play in the big leagues.” A no-name service provider does the opposite.
You can find out who a fund uses by reading their pitch book, term sheet, or offering documents. Smart investors always check.
Fund Administrators: The Backbone
A fund administrator is an independent organization that handles the operational and accounting heavy lifting for a hedge fund. Think of them as the back office that the fund does not have to build itself.
What do they actually do? A lot:
- Investment processing. Handle trades in stocks, bonds, options, derivatives.
- Accounting. Daily, weekly, monthly books. Draft financial statements for year-end audits.
- Investor services. Process subscriptions and redemptions. Send monthly statements.
- NAV calculation. Calculate net asset value independently so investors know the fund’s numbers are real.
- Valuation. Independently price the securities in the portfolio.
- Middle office services. Trade verification, reconciliation, collateral management.
The cost is not cheap but not crazy either. Fees range from 5 to 35 basis points with a minimum of $5,000 to $10,000 per month for basic services. Add risk reporting or anti-money-laundering compliance and the bill goes up fast.
Why Should You Care?
Before 2008, many funds did not even use an external administrator. They did everything in-house. One team controlled the cash, invested the money, reconciled positions, and reported to investors. Everyone reported to the same boss. No checks and balances.
Then Madoff happened. And a bunch of other scandals. Suddenly investors and regulators got very interested in who was keeping the books.
Today, institutions almost never invest in a fund without a reputable independent administrator. This is non-negotiable. If a fund tells you they handle everything internally, that is a red flag.
Investors want to see that someone independent is verifying assets, pricing the portfolio, and calculating profits and losses. The administrator bridges the gap between the time you give your money to a manager and the time the annual audit happens.
What to Look For
Mirabile lists several things to evaluate:
- Staff quality and turnover. Good people make good administrators. High turnover is a warning sign.
- Technology platform. Is it integrated or a patchwork of separate systems?
- Match with the fund’s strategy. A simple domestic stock fund has different needs than a global macro fund with OTC derivatives.
- SAS 70 Type II letter. This is an independent verification of the administrator’s processes and controls. Top-tier administrators all have one.
- Service level agreements (SLAs). These create accountability and can include penalties for late or bad information.
The big names in this space historically included HSBC, Citigroup, Citco, and GlobeOp. Market share shifted between 2008 and 2011, with GlobeOp jumping from about 6.5% to nearly 20% market share. The industry consolidated after the financial crisis.
Prime Brokers: More Than Just Trading
A prime broker is a bank that provides central clearing, financing, and reporting for a hedge fund. Hedge funds trade with many brokers during the day but consolidate everything into one or a few prime accounts at the end. This gives them a single view of all their positions, risk, and cash.
What They Provide
Trade clearance. Back in the late 1980s, prime brokers started letting hedge funds consolidate trades from 30+ executing brokers into one account. Free of charge. The prime broker expects to earn money from margin loans and commissions instead.
Margin lending. This is where prime brokers make real money. A fund deposits $50 million, borrows another $50 million to buy $100 million in stocks. The prime broker charges interest on the loan and earns a spread of 25 to 100+ basis points. In Mirabile’s example, a prime broker makes $500,000 on a $50 million margin loan at a 1% spread. Not bad.
Securities lending for short sales. When a hedge fund wants to short a stock, the prime broker borrows shares from an institution (like a mutual fund) and lends them to the fund. The prime broker earns a markup on the borrowing fee plus a spread on the cash collateral. In one example from the book, the prime broker makes $2.5 million on a $100 million short position. Two revenue streams from one transaction.
Capital introduction. Prime brokers connect hedge funds with institutional investors. Pensions, endowments, family offices. This is a free service, but it keeps hedge funds loyal and growing, which means bigger margin balances for the bank.
Technology and reporting. Online risk management tools, order execution platforms, exchange connectivity.
Business consulting. Business planning, vendor selection, technology advice. Usually free, usually reserved for the bank’s best clients.
Why Investors Should Care (A Lot)
Here is where it gets scary. The wrong prime broker choice can be catastrophic.
Refco. Lehman Brothers. Bear Stearns. MF Global. Each one failed and took hedge fund assets with them. Funds that had money sitting at Lehman International suffered business disruptions, lost investor confidence, and in some cases lost actual money.
Before 2008, many hedge funds never did credit analysis on their prime broker. They trusted the brand name and a handshake with a senior banker. When the crisis hit, funds could not answer basic questions about how much of their assets were tied up as collateral versus how much they could actually withdraw.
A prime broker can recall loans overnight. The fund then has to sell assets at fire-sale prices to cover margin calls. Or the prime broker can recall borrowed shares, forcing the fund to close short positions at the worst possible moment.
How to Reduce the Risk
Mirabile outlines four things a fund should do:
- Follow and document a proper selection process
- Track daily exposure to the prime broker
- Monitor the prime broker’s creditworthiness (watch credit default swap spreads)
- Take structural steps to reduce exposure
Structural steps include: keeping business with U.S. domestic accounts where segregation rules offer stronger legal protections, using multiple prime brokers so you can move business away from a troubled firm, sweeping free cash into government securities, and separating fully paid securities from margin accounts.
Most large hedge funds today use multiple prime brokers. A 2008 Merrill Lynch study found that 75% of funds with over $1 billion use at least two prime brokers. More than 35% use four or more. Spreading your eggs across baskets is the lesson 2008 taught everyone.
The dominant prime brokers have historically been Morgan Stanley, Goldman Sachs, and JP Morgan (which absorbed Bear Stearns). Credit Suisse and Deutsche Bank gained significant share after 2008, as the market moved from an oligopoly to a more competitive landscape.
Previous: Chapter 11 Part 2 | Next: Chapter 12 Part 2
This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.