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Jul 3 2007 | 1:55pm ET
A year ago, hedge funds were spending $10 billion on prime brokerage services, according to the research firm TABB Group. Record trading volume and inflows into the alternatives space have pushed that figure even higher, and experts predict demand to continue to rise. This growth has created huge shifts in the industry, with the big three names in prime brokerage—Goldman Sachs, Morgan Stanley and Bear Sterns—scrambling to maintain their place at the top. Meanwhile, other Wall Street players, including Citi and Lehman Bros., have been quietly restructuring their businesses and are winning an increasing share of the market by investing heavily in customer service and focusing on becoming one-stop shops for all hedge fund needs.
“Since we restructured in 2004, we have more than doubled in terms of revenue,” says Ali Hackett, who along with Thomas Tesauro serves as global co-head of Citi’s prime services unit. In addition to more than doubling revenue, the unit has beefed up its technology offerings, more than doubled its head count, and is continuing its hiring spree.
“Our biggest advantage is the firm’s reputation and our ability to leverage other parts of the company,” says Tesauro.
“We have a greater reach in clearing and settlement in more countries than any other prime,” says Hackett. “Our clearing network [Citibank Global Transaction Services] actually clears for many of the other prime brokerages.”
Lehman has also been making a push to expand its prime brokerage services. At the beginning of 2005, the firm combined its clearing, financing, prime brokerage and some of its electronic trading businesses into one business unit, calling the new group capital markets prime services.
John Wickham, global head of client services at the firm, explains that the move was a strategic play. He saw the big accounts getting bigger, creating demand for a broader range of asset classes. Hedge funds that once focused solely on stocks were now getting into bonds, and hedge funds that once only dealt with bonds were launching multi-strategy offerings.
“The core theme in the hedge fund space is that the big accounts tend to get bigger, and as these accounts become larger, there is a natural diversification of their business model,” he says. “They diversify in terms of the regions where they trade, they diversity in terms of the products they trade – cash, derivatives, over the counter derivatives – and broadly they can be diversified across asset classes.”
While Wickham declines to give specifics, he says that the newly restructured business is growing materially faster than the underlying market. “So we are gaining market share,” he says confidently.
Emergence Of 130/30 Creates 'Perfect Storm'
So what is causing the increase in demand for prime brokerage services? Experts say it is the result of traditional managers encroaching on hedge fund turf, as well as an explosion in trading volume in general.
“Fifty-four percent of large traditional asset managers have launched a hedge fund or hedge fund-like product, so they are obviously trying to compete against the hedge funds by creating long/short products,” says Adam Sussman, a consultant at TABB.
But, according to Citi’s Hackett, the trend is not a one-way street. “Not only have the conventional managers gone into the hedge fund space, but the hedge funds have gone back into the conventional long-only space,” she says. “That creates new opportunities for us in prime brokerage. We are not just marketing to hedge funds, but to private equity and to the long-only space, too.”
While estimates of hedge fund assets range from $1 trillion to $2 trillion, this is still a small amount compared with long-only funds. According to the Investment Company Institute, at the end of 2006 there were $21.76 trillion in mutual fund assets worldwide, with $11 trillion in the U.S. alone.
“If the long-only managers are convinced they need to go into the alternatives space, that’s a huge target market for us over the coming years,” says Hackett, who adds that she is amazed at rapid emergence of 130/30 strategies—which is when a manager shorts 30% of the fund, reinvesting the proceeds on the long side. Over the past year, large players such as State Street and UBS have been launching such funds as a way to tiptoe onto the traditional hedge fund turf. Conversely, hedge fund managers such as DE Shaw and AQR Capital Management are launching 130/30 strategies in an effort to attract more institutional money.
“This is an incredible windfall for the prime brokerage divisions of Wall Street firms,” says Alan Glatt, partner at Copernicus/Alpha Equity Management, an alternative asset management shop that has been offering 130/30 strategies for over six years. “It opens up trillions of dollars of long-only money that never needed prime brokerage services.”
Glatt adds that the explosion of interest in 130/30 strategies is a “perfect storm” for the prime brokerage community. “They can educate long-only investors in what prime brokerage services have to offer, and simultaneously speak to long-only asset managers about the opportunities of creating 130/30 funds. They can also talk to the hedge fund community, who have historically done long/short investing and have demonstrated success in shorting, so they are the perfect candidate [to run these funds].”
Wickham says another dynamic affecting the prime brokerage industry is the growth in trading in cash equities, listed derivatives and other over-the-counter products like credit default swaps.
“The actual volumes have exploded over the last number of years, and certainly that poses a whole set of challenges for the managers in terms of them dealing with that increased operational demand,” says Wickham. “In that respect, they are leaning more and more on providers like ourselves to help them cope with that escalation in volume.”
by Deirdre Brennan
This article appeared in the July 2007 issue of FINalternatives Prime Brokerage & Administration.
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