Do Prime Brokers Matter in the Search for Informed Hedge Fund Managers?

Abstract

Using the setting of funds of hedge funds (FoFs), we show that prime brokers (PBs) facilitate investors' search for informed hedge fund managers. We find that FoFs exhibit PB bias, a disproportionate preference for hedge funds serviced by their connected PBs. This PB bias is stronger when the cost of hedge fund due diligence is higher relative to capital and when the FoF's management firm generates higher prime brokerage fees. PB bias also predicts FoF performance: the highest PB-bias quartile outperforms the rest by 1.54%-2.77% per annum, after adjusting for differences in their risks.

Keywords: Hedge funds, prime brokers, search frictions, due diligence, funds of funds

JEL Classification: G11, G14, G23, G24