Prime Broker: The Hedge Fund's Operational Counterparty

A prime broker is the single counterparty a hedge fund deals through. Marudhar Securities Private Limited, invented, holds the positions of Nilgiri Absolute Return Fund, lends the stock the fund sells short, lends the cash that funds the long book beyond the fund's own money, and sets the margin. Four roles, one counterparty, and that concentration is what the arrangement actually is.

Most descriptions of a hedge fund stop at what it buys and what it sells. The buying and the selling are the visible half. Underneath it sits a second arrangement, contracted separately, that never appears in a performance line and rarely appears in a summary: the arrangement with the party the fund actually deals through. A fund that borrows stock and borrows cash cannot be described by its positions alone, because the positions only exist on terms somebody else is providing. The party a fund deals through does four separate jobs. The four are named below, costed on one invented fund's own contracted rates, and then read together to say what it means that all four sit with one party rather than four.

What is a prime broker, and why does selling short make one necessary?

Start with a shop that has no borrowing at all. A cloth merchant in a market street buys stock with the cash in the till, keeps it in a locked room at the back, and sells it. The merchant needs exactly one arrangement from anybody else: somewhere safe to keep what has been bought. There is no lender, no lending agreement, no collateral, and nobody who can change the terms halfway through the year. One relationship, one job, and if that job stops being done the merchant loses the use of the locked room and nothing more.

Now change one thing. The merchant starts selling cloth that is not in the locked room at all. Somebody else's cloth is borrowed, sold at today's price, and the same quantity of cloth has to be handed back later. And separately, the merchant starts holding more cloth than the till could ever pay for, with the difference funded by a lender. The merchant now needs three more things: somebody to lend the cloth, somebody to lend the money, and an agreed rule about how much of the merchant's own capital has to sit behind the whole arrangement as security. Four jobs, where before there was one.

A prime brokerThe single counterparty a fund holds its positions with, borrows stock and cash from, and posts margin to. is the party that does all four for a hedge fund. Nilgiri Absolute Return Fund, invented, is an open-ended vehicle managed by Nilgiri Alternatives Advisors Private Limited, also invented, and its prime broker is Marudhar Securities Private Limited, invented as well. Every rate below is written into that one arrangement, and a rate agreed between two parties is not a market price.

The fund runs two sides at once. Its long bookEverything the fund has bought. is everything it has bought. At the record date the long book stands at Rs 6,50,00,00,000. Its short bookEverything the fund has borrowed and sold. is everything it has borrowed and sold. At the record date the short book stands at Rs 2,50,00,00,000. Its net assets are Rs 5,00,00,00,000, the value the vehicle carries for the people who subscribed to it. Read those three figures together and two of them are already impossible without a lender: the fund holds Rs 6,50,00,00,000 of things while being worth Rs 5,00,00,00,000, and it has sold Rs 2,50,00,00,000 of stock it never bought.

Stock has to be borrowed before it can be sold short, because nothing can be delivered to a buyer that the seller does not have. Selling short, the recall of a borrow, and the way the arithmetic of a short is shaped differently from the arithmetic of a long are all covered separately. The borrowing itself is what creates the second of the four jobs.

So the four roles are not a menu the manager chose from. The roles fall out of the way the fund runs its book. A fund that buys only what its own money pays for needs one service. A fund that sells what it does not have and holds more than it can pay for needs four. A broker taken for an administrative convenience is a broker misread from the start. Borrowed stock and borrowed cash are what take the count from one to four.

Role one: who actually holds the positions?

The first job is the oldest one and the least discussed. Somebody has to hold the securities and the cash. CustodyHolding the securities and the cash on the fund's behalf. means exactly that and nothing more dramatic: the shares the fund has bought sit in an account in the fund's name, the cash sits in an account in the fund's name, and a third party maintains both and produces a record of what is in them. For Nilgiri Absolute Return Fund, invented, that third party is Marudhar Securities Private Limited, invented.

Think about a household that has bought some gold. The gold is the household's, in the sense that nobody disputes whose it is. The gold nonetheless sits in a locker somewhere other than the household's home, and the household's knowledge of the contents is a statement produced by whoever runs the locker. Both of those things are true at once, and neither is unusual. The point is only that the position and the place the position is held are two different objects, and the second one has a name.

Why this matters for everything that follows is worth stating now rather than at the end. Every one of the other three roles works by reference to what is held, so the party that holds the positions is the natural party to run the other three, and that is precisely how they end up together. Stock lending needs to know what stock is there. Cash lending needs to know what is standing behind the loan. Setting a collateral requirement needs to know the value of everything at once. A party that already holds all of it is the party for which all three are cheapest to do.

The arrangement is not an accident of paperwork and it is not the result of somebody failing to separate duties. Three of the four jobs are simply cheaper and easier to do from inside the first one.

Role two: where does the stock that is sold short come from?

The second job is lending stock. Nilgiri Absolute Return Fund, invented, has a short book of Rs 2,50,00,00,000 at the record date, meaning it has sold that value of shares it never bought. Every one of those shares was borrowed from somewhere before it could be delivered to the buyer, and the fund has an obligation to hand back the same shares later. The party doing the lending, in this fund's arrangement, is Marudhar Securities Private Limited, invented.

The stock borrowBorrowing shares in order to sell them, with an obligation to return the same shares later. is charged for. The fund's contracted borrow fee with this broker is 0.75 per cent a year on the value of stock borrowed, a rate agreed between two parties rather than read off a market. On a short book of Rs 2,50,00,00,000 it produces Rs 1,87,50,000 a year. The Rs 1,87,50,000 turns up again when the whole arrangement is priced, so carry it forward.

A borrowing analogy that holds up: a caterer who takes a wedding booking for three hundred chairs and has two hundred. The extra hundred chairs come from a hire firm, are used, and go back. The hire firm charges for the hundred chairs and for the time, and the caterer's obligation is to return a hundred chairs and not a hundred chairs-worth of money. Chairs and the price of chairs are two different debts, and the distinction is the whole of a stock borrow. The obligation is denominated in the thing and not in rupees, and a move in the price of the thing therefore lands on whoever borrowed it.

The shape of a short position, what happens when the lender wants the shares back, and how the arithmetic of a short differs from the arithmetic of a long are all covered separately. Three facts carry forward: a lender exists, the lender is the same party already holding the fund's positions, and the lending is charged for at a rate this fund contracted.

Role three: where does the cash for a long book bigger than the fund come from?

Cash lending produces more confusion than the other three roles together, and the confusion dissolves the moment somebody writes down one subtraction. Nilgiri Absolute Return Fund, invented, holds Rs 6,50,00,00,000 of long positions at the record date. The vehicle itself is worth Rs 5,00,00,00,000 at that date. The two figures are not the same figure, and the gap between them is Rs 1,50,00,00,000 of things the fund holds and did not pay for out of its own resources. Somebody lent it that money. In this arrangement the lender is Marudhar Securities Private Limited, invented. The same party holds every one of the positions the loan bought.

Slow down on that subtraction. Most of the confusion about borrowing in a fund starts there. Rs 6,50,00,00,000 is what the positions are worth. Rs 5,00,00,00,000 is what the people who subscribed to the fund would share between them if everything were sold and every obligation settled. The Rs 1,50,00,00,000 gap is not a strategy, a technique or an exposure figure: it is a cash loan, made by a named counterparty, on stated terms, and it has to be repaid. Of the Rs 6,50,00,00,000 of long positions, 76.9 per cent was paid for with the fund's own money and 23.1 per cent with the broker's, both shares taken against the Rs 6,50,00,00,000 long book as the denominator.

Lending cash against positions is what margin financingCash lent against the positions, letting the fund hold more than its own money would buy. means. Cash is lent against the positions, and because it is lent against them rather than against a promise, the lender wants the positions where it can see them. Wanting the security in sight is the second reason role three sits naturally with role one, and it is a plainer reason than the first: a lender that already holds the security has less to arrange than a lender that does not.

The loan carries interest. The fund's contracted rate with this broker is 8.50 per cent a year on cash lent. On Rs 1,50,00,00,000 that is Rs 12,75,00,000 a year.

A household version, to fix the shape. A household buys a home for Rs 60,00,000 with Rs 20,00,000 of savings and Rs 40,00,000 of loan. The household holds a Rs 60,00,000 asset and is worth Rs 20,00,000 on that asset. Nobody finds this confusing when it is a house. A fund makes exactly the same subtraction, with two differences: the asset is a book of shares whose value moves every day, and the lender is also the party in whose books the shares sit.

Role four: who decides how much collateral the fund must post?

The fourth job is different in kind from the first three, and the difference is worth naming before any number arrives. Roles one, two and three are services: something is held, something is lent, something is charged for. Role four is a decision. Somebody has to say how much of the fund's own resources must sit behind the borrowed stock and the borrowed cash as security, and in this arrangement the somebody is Marudhar Securities Private Limited, invented.

MarginCollateral the broker requires against a position, which it can raise. is that collateral. Nilgiri Absolute Return Fund, invented, has a contracted maintenance requirement with this broker of 15.0 per cent of the gross value of a position. The gross value of everything the fund has on at the record date is its long book of Rs 6,50,00,00,000 plus its short book of Rs 2,50,00,00,000, being Rs 9,00,00,00,000. Applying the contracted 15.0 per cent to every position in that book and adding the results, the collateral standing behind the arrangement is Rs 1,35,00,00,000, being 27.0 per cent of the fund's Rs 5,00,00,00,000 of net assets.

Now the part that makes role four a decision rather than a service. The requirement is a number the broker sets, and the same party that lends the fund its stock and its cash is the party that decides how much collateral has to stand behind them. The rate is written into this fund's arrangement, and the arrangement is between two parties rather than fixed by arithmetic. Nothing in the fund's positions determines it. A reader who has followed the first three roles will already see why this one sits where it does: setting a requirement against everything at once needs a view of everything at once, and only the party holding everything has that.

The collateral itself is worth naming. Collateral is not a payment and not a cost. Collateral is the fund's own money and securities, sitting where the broker can reach them, for as long as the borrowed stock and the borrowed cash are outstanding. So the Rs 1,35,00,00,000 does not appear in any cost line. The collateral answers a different question altogether: how much of the fund's own property sits with this one counterparty.

What does it mean that all four of those roles sit in one counterparty?

Concentration is the centre of it. The four jobs had to be separated before putting them back together could mean anything precise. Holding the positions, lending the stock, lending the cash and setting the collateral requirement are four different businesses. The four have different economics, they are charged for differently, and nothing in any of them requires the other three. Nilgiri Absolute Return Fund, invented, nonetheless does all four with Marudhar Securities Private Limited, invented, and that is the arrangement described here.

Here is the mechanism that follows, and it is a mechanism rather than anything else. The same party that lends the fund its stock also decides the collateral required against it and holds that collateral, so a change in any one of the four roles reaches the other three at the same moment. Work through why. If the lender of the stock wants the stock back, the fund has to buy it in the market. Buying it in changes the positions the same party holds, and so changes the gross value the collateral requirement is calculated on. If the collateral requirement is raised, the fund has to find resources, and the fastest resource is selling positions held by the same party or repaying cash borrowed from it. If the cash loan is reduced, the long book has to shrink, and the gross value moves again. Four roles, one party, and the links between them are not correlations. The links are the same contract.

Concentration of this kind is a structural fact about the arrangement rather than a verdict on it. A reader who has understood the four roles has understood something about how a book of this shape is actually held together.

The plainest way to hold it is this. In an arrangement with four separate parties, four separate things can go wrong at four separate times, and each one is a different conversation with a different counterparty. In an arrangement with one party, there is one conversation.

The closed-end private fund side is arranged the opposite way, and the contrast is worth naming. In Nilgiri Growth Partners Fund II, invented, four jobs sit with four different parties: Nilgiri Alternatives Advisors Private Limited is the investment manager, Nilgiri Trusteeship Services Private Limited is the trustee, Kolar Fund Services Private Limited is the administrator that strikes the net asset value, and Palani Valuation Advisors, a limited liability partnership (LLP), is the independent valuation agent that values what is not sold. Four jobs, four parties, four separate appointments. Here, in Nilgiri Absolute Return Fund, four jobs sit with one. The detail of who does what on the closed-end side is covered separately. Neither shape is a better one; they are two different ways of getting a vehicle's work done.

What does the arrangement cost in a year, on this fund's own rates?

Two rates have been named and both belong to Nilgiri Absolute Return Fund and Marudhar Securities Private Limited, invented, and to nothing else. The first is 8.50 per cent a year on cash lent. The second is 0.75 per cent a year on the value of stock borrowed. Both rates are written into one invented arrangement, and the arithmetic below is what those two rates produce on that arrangement's own book.

Take the cash first. The broker has lent Rs 1,50,00,00,000, being the gap between the Rs 6,50,00,00,000 long book and the Rs 5,00,00,00,000 of net assets. At 8.50 per cent a year that is Rs 12,75,00,000 a year of interest. Take the stock next. The short book is Rs 2,50,00,00,000, and at 0.75 per cent a year the borrow fee is Rs 1,87,50,000 a year. Add the two and the arrangement costs Rs 14,62,50,000 a year. Of that total, the interest is 87.2 per cent and the borrow fee is 12.8 per cent, both shares taken against the Rs 14,62,50,000 total.

Now put that figure against the fund's net assets, and name the denominator while doing it. Rs 14,62,50,000 on net assets of Rs 5,00,00,00,000 is 2.925 per cent, or 2.93 per cent rounded to two places. Say the sentence in full and it reads: over one year, on this invented fund's own contracted rates, holding this book cost 2.925 per cent of net assets before anybody was paid to choose what went into it.

Then set the total beside the manager's fee. Nilgiri Absolute Return Fund, invented, charges a management fee of 2.00 per cent a year on net assets, and on Rs 5,00,00,00,000 that is Rs 10,00,00,000 a year. There is also a performance fee of 20.0 per cent charged annually and subject to a high-water mark, whose mechanism is covered separately and is not worked here. Over one year, on this invented fund's own figures, the broker receives Rs 14,62,50,000 and the manager receives Rs 10,00,00,000, so the broker receives 1.4625 times the manager's fee, written 1.46 times.

The comparison is one subtraction, two multiplications and an addition, run on two contracted rates and one book that were written down in advance. Neither figure says what a broker or a manager ought to be paid; each says only what one arrangement's own rates produce on its own book.

Why does the fund carry an exposure that no position line shows?

There are two different objects in this arrangement and a reader who runs them together will not be able to read a hedge fund's arrangements at all. The first object is what the positions are worth. The long book of Rs 6,50,00,00,000 and the short book of Rs 2,50,00,00,000 move when prices move, and every rupee of that movement lands in the net asset value. Movement in the value of the positions is what almost everybody means by the risk of a fund, and it is what every position line on every report is about.

The second object has nothing to do with what the positions are worth. One named party is holding all of them, has lent the fund Rs 1,50,00,00,000, is owed the borrowed stock back, and holds Rs 1,35,00,00,000 of the fund's own collateral. The second object is counterparty exposureThe risk that the party on the other side stops performing, which is separate from the risk of what is owned.: the exposure to the party on the other side rather than to anything the fund has bought or sold.

Every position this fund holds could turn out to have been chosen exactly right and this second object would be completely unchanged, because it is not a fact about the positions at all. The two objects come apart most cleanly there. Being right about what is held does nothing to the arrangement with the party holding it. The two are answers to different questions. One asks what the things are worth. The other asks where they are and who is on the other side of the borrowing.

A street version. A vegetable seller keeps the day's cash and the spare weighing scales with the shopkeeper next door, borrows a handcart from the same shopkeeper, and owes that shopkeeper for last week's handcart hire. The seller may have bought the best vegetables in the market at the best price. Buying well is one question, and a good day's work. Where the cash and the scales are, and who the handcart belongs to, is a second question, and no amount of being right about vegetables answers it.

What stops at the same moment if the counterparty stops functioning?

All four roles, and the simultaneity is the whole content of this section. Take them one at a time and then put them back together. The list read slowly teaches more than the list read as a summary.

The positions are held there. The record of what Nilgiri Absolute Return Fund, invented, has is a record maintained by Marudhar Securities Private Limited, invented. The borrowed stock is lent from there, so any demand for its return is a demand from the same party. The Rs 1,50,00,00,000 of cash came from there, so repaying it is repaying that party, and any change to that loan is a change made by that party. The Rs 1,35,00,00,000 of collateral sits there, and the requirement it satisfies is set there too.

Because those four are one contract with one party rather than four contracts with four parties, one event reaches all four at the same moment rather than one at a time. Simultaneity is the reason the four roles were separated at the outset. Separated, they look like four ordinary services. Put back together in one counterparty, they are a single arrangement whose parts cannot move independently, and four independent services is not what this fund has.

Simultaneity is a fact about the shape of the arrangement rather than a fault in it. A reader who finishes knowing that four jobs sit with one party, and knowing why they sit there, has the whole of it.

What does somebody who reads these documents for a living do with all this?

The four roles are mostly used as a reading tool, and that is the honest practical end of it. An analyst covering alternative vehicles, a person at an institution reading a factsheet, or a student meeting one of these arrangements for the first time all do the same three things with it, and none of the three involves acting on anything.

The first is reading a cost. Somebody who has only the four roles in their head reads a fee schedule and immediately knows the fee schedule is one of two documents that determine what a book costs to hold. On this invented fund's own contracted rates, over one year, the fee schedule accounts for Rs 10,00,00,000 and the arrangement with the broker for Rs 14,62,50,000. A person who only ever reads the first document is reading 40.6 per cent of the total of those two figures, taking the Rs 24,62,50,000 combined total as the denominator, and will not know it.

The second is reading a balance sheet as a subtraction rather than as a ratio. When a lender's credit team looks at any borrower, the first move is to ask what is held and what is owed, and the gap between them. Here the same move produces the financing in one step: Rs 6,50,00,00,000 held, Rs 5,00,00,00,000 of net assets, so Rs 1,50,00,00,000 lent. A great deal of writing about hedge funds jumps straight to percentages, and the percentage is downstream of a subtraction that anybody can do.

The third is keeping two kinds of question apart. Questions about what the positions are worth are answered by looking at the positions. Questions about where the positions are held, who lent the stock, who lent the cash and who set the collateral requirement are answered by looking at the arrangement, and the arrangement is a different document. A reader who can say which of the two a given question belongs to can read one of these vehicles far more quickly than one who cannot, and that is the durable thing here.

A household reading its own affairs meets the same split in miniature. The value of the household gold is one question. Which locker it is in, who holds the key, and what was borrowed against it is a second question, and the two are answered by looking at different things. Nobody finds that confusing at household scale. The same split holds at the scale of Rs 9,00,00,00,000 of gross book.