15 Sep, 2014

“There seems to be no end to hedge fund start-ups,” says Simon Monson. “And those who have been stuck at the $20 million assets under management (AuM) level for many years appear now to be on the move.” Monson is sales director at Linear Investments, a London-based investment house and mini prime broker that services start-up and early stage hedge funds. His firm is now looking after 30 or so managers with 40 funds pursuing a wide range of strategies. Originally on the equity derivatives desk at brokers James Capel – a venerable firm eventually merged (along with Samuel Montagu and Midland Global Markets) into what is now HSBC Investment Bank – Monson came to Linear two years ago, having raised capital for a hedge fund start-up in a still-depressed market. He says plainly that “conditions are a lot better out there now.”

It is not just start-ups and early stage managers that are benefiting from the more buoyant mood. Well-established managers discarded by the major prime brokers are now looking to replace the middle and back office services they used to receive from a major investment bank. “The major prime brokers have substantially increased minimum wallet thresholds in the last year,” says Monson. “And new capital and liquidity requirements are making it prohibitively expensive for the major investment banks to offer full prime brokerage solutions to smaller clients in terms of AuM. Many managers at this level in their growth cycle are finding that their business is no longer commercially attractive to the top prime brokers. As a result managers in the sub-$75-100 million AuM range are now casting around for new providers.” Linear Investments is one of them, alongside other firms — Jefferies, Newedge and Global Prime Partners – that are prepared to service managers. “$75-100 million managers are totally viable entities, but will not generate anywhere near the sort of revenues to feed a big bank machine,” says Monson. “It is generally held that having a prime broker is a key requirement for funds looking to attract and retain investors but the market definitely lacks service providers in the lower AuM segment, this is why firms such as ourselves exist and are able to grow at such a significant rate.”

Linear Investments Directory Entry

What Linear offers is an outsourced dealing desk, agency-only equity and fixed income trading, a portfolio management system to look after cash and securities, calculate net asset values (NAVs) and margin positions, an equity finance desk to source or place stock, third party clearing and custody services, a capital introductions service, and even office space with technology support and disaster recovery for those managers that require it. “Linear has long standing prime broker and clearing relationships with major name investment banks,” says Monson. “Because of the level of aggregated business the firm does, it is able to pass through cost structures in leverage and execution and clearing that smaller managers would not be able to find in a stand-alone environment.” Clients are of course free to clear trades and custody assets with other banks, just as they are free to execute trades elsewhere, but Linear wants to be a genuine mini-prime and not just an introducing broker.

That said, the firm began as a pure Direct Market Access (DMA) house, offering electronic execution through a global network of brokers. It made use of systems designed and built by the founder of the firm, Jerry Lees. He was formerly with W.I. Carr in Hong Kong and with Credit Agricole Chevreux in London, at both of which he learned a great deal about electronic and algorithmic trading which he parlayed into a financial technology consulting business. His CEO, Paul Kelly, is also an electronic execution expert, having headed wholesale execution in Europe for Citi in London. Kelly also had a spell at NYFIX, and has experience of brokerage technology from the vendor perspective at Tamesis and Sungard.  “Because of Jerry’s and Paul’s experience in the DMA world, we have an infrastructure here which enables clients to just plug into us and get access to global markets directly,” says Monson.

Importantly, Linear also offers funds a regulatory umbrella, for which it charges a fixed monthly fee that enables managers to predict their compliance costs accurately. “We are permissioned by the Financial Conduct Authority (FCA) to run an appointed representative programme,” explains Monson. “Our target audience is start-ups and early stage funds. This is the area of the market we really understand.” Interestingly, Linear is now adding a second umbrella service to help funds that must meet the requirements of the Alternative Investment Fund Managers Directive (AIFMD). Another big bank name will provide depositary (and depositary “lite”) services, with Linear Prime Services acting as sub-custodian.

Although Monson downplays the chances of success — keeping expectations under control reflects his first-hand knowledge of how hard it is for start-ups to raise money — Linear does not simply leave its clients to raise whatever they can under its regulatory umbrellas. The firm also offers a capital introduction service. It comes in the obvious form (introducing clients to potential investors) but is supplemented by a seeder fund that Linear is in the process of setting up with an initial $30 million from internal investors. The ambition is to grow it to $100 million by the end of the year. In addition, the Linear cap intro team will seek investors from their network of qualified investors worldwide. “We actively work with our hedge fund clients to provide them with an effective introduction to targeted groups of investors who have an interest in the particular strategies,” says Monson. Linear says its investor contact list includes pension funds, institutions, family offices, funds of funds, endowments, foundations and high net worth individuals. Their services include one-to -one meetings with selected investors, participation at industry conferences, roundtable discussions, investor road shows, online portals and selective calling.

The prospect of meeting investors will not fail to attract the interest of managers, but it is not the principal axis of growth identified by the management at Linear. Instead, it sees its outsourced trading desk as an obvious means of adding business. Clearly, an outsourced trading desk will appeal to cost conscious start-ups and smaller managers as an alternative to setting up an in-house capability. Linear says half of the 30 hedge fund clients of the firm already work their orders through the Linear service. The firm has ambitions to recruit larger managers as well. The outsourced business is jointly led by managing directors Richard Lilley and Jonathan Callow. Lilley was previously a sales trader who started as a stock jobber at Wedd Durlacher (eaten by Barclays) before moving to Savory Milln (devoured by SBC) and a variety of securities trading start-ups for Nordic banks. Though he did not meet Jerry Lees until they both worked at Credit Agricole Chevreux, his network is more than helpful.

“Over the last 20 years, I have developed good relationships with most of the buy-side dealing desks,” says Lilley. “Jerry invited me to expand his outsourced trading concept.” He has since persuaded Callow, a former head buy-side dealer at Thames River Capital, to run the trading desk. The two work in partnership, jointly leading the drive to convince hedge funds, pension funds, family offices running their own money, and the larger hedge funds to embrace the concept of outsourcing. “Medium-sized managers have a dealing desk, but need to ask themselves whether their in-house dealers are offering them value for money, and whether they are essential to their core function of managing money,” explains Lilley. “Would they benefit from outsourcing the role? That is the big question which COOs and CFOs should be asking themselves.”

Lilley and Monson both recognise that persuading larger fund managers to outsource dealing is a major challenge to their culture and systems of controls. After all, many hedge fund managers have a dealing background, and it entails confronting colleagues on the dealing desk, but Lilley is undaunted. “There are no charges levied by us,” he says. “A hedge fund plugging into our services will not be charged for our services. Effectively, they get a bespoke, personalised dealing service in equities, fixed income, foreign exchange and exchange-traded derivatives. If a manager wants to lose an in-house dealer painlessly, we are able to on-board the dealer, including paying salary and benefits. All the manager has to do in return is undertake to pay us their commissions. In other words, they pay the rates they are currently paying to the market to us instead. In essence, we take all of the associated costs of a dealing desk straight off the bottom line of a fund.”

Linear obviously believes it can achieve better terms for its clients than the clients can for themselves. The firm uses the exchange memberships and DMA systems of Citi, J.P. Morgan, Morgan Stanley, and Instinet (which is owned by their clearing broker, Nomura) to complement existing broker relationships. In theory Linear extracts its margin by leveraging higher volumes of business and consequent efficiencies in trading. When volumes grow, margins will surely increase. If they do, we will know that the current surge in start-ups is not just another illusion conjured up by extraordinary monetary policies, but the rebirth of the hedge fund industry in the United Kingdom.