Prime brokerage was virtually unheard of until about a decade ago. It is now the hot new area for banks to build. How do they win business in this competitive environment? Natasha de Teran reports.
Every institution from large commercial banks to smaller stand-alone investment banks wants a piece of the potentially lucrative prime brokerage business. The reason for this growing interest is the vast influx of funds into the hedge fund industry.
In August, the Hennessee Hedge Fund Advisory Group, a global adviser to hedge fund investors, published the findings of its annual hedge fund manager survey. The survey results showed that the hedge fund industry had grown by 34% in the first half of the year, to $795bn. Moreover, hedge funds reported they still had the capacity to grow assets by a staggering 197%.
The reason why prime brokerage can be so profitable for banks is that, on average, hedge funds turn their portfolio over three times a year.
Indeed, Credit Suisse First Boston estimates that hedge funds contributed $21bn to global investment banking revenues last year – a whopping 35% of banks’ equities revenues, or 13% of total investment banking income.
Ruwan Weerasekera, a partner in Accenture’s capital markets practice, says: “Prime brokerage has been one of the few bright spots for investment banks in the last three years.
“More and more investment banks are seeing hedge funds as a client segment in their own right and are setting up governance structures across prime brokerage and product divisions to service the clients appropriately. This is in line with continued rapid growth in terms of hedge fund assets and number.”
Morgan Stanley and Goldman Sachs have collectively dominated the prime brokerage landscape since its inception – and the recent Hennessee survey showed they still have the largest share of the prime brokerage industry, with 40% of the market between them. Even so, some other serious contenders have emerged in recent years – most notably UBS, Citigroup and Deutsche Bank.
Developing market
Mr Weerasekera believes that the market will continue to move away from Morgan Stanley and Goldman Sachs to create a top tier of three to five major players. As the competition intensifies, many of the smaller players will exit the market, while the remaining prime brokers will need to continue to develop their services to ensure they differentiate themselves.
Warren Holmes, managing director of the International Prime Brokerage Department (IPBD) at Morgan Stanley in London, says that the original core components of the prime brokerage business are no longer sufficient to win banks business because so many other prime brokers are offering these now.
However, being competent in core areas is still a requirement. “Even though there are claims that the core part of the prime broker’s activity is now fully commoditised, a high-quality core offering can still be a distinguishing factor – for instance, we still win business on having a stronger securities lending service than any of our competitors.”
Although much of the securities lending activity – traditionally the foundation stone of the prime brokerage business – has now become commoditised, Jack Inglis, also managing director in the IPBD at Morgan Stanley in London, believes banks like Morgan Stanley can still differentiate themselves by being able to access hard-to-borrow stocks, or getting hold of stocks in special event situations like mergers, or limited supply in markets like Korea and Taiwan. He says: “We spend a lot of time and resources in ensuring we can do this better than anyone else, and have teams of people whose exclusive job it is to source these assets.”
Bespoke service
Elsewhere, Morgan Stanley claims to distinguish itself from its competitors by offering a bespoke service in which each client service representative will only have a very small number of accounts to manage. Providing value-added services – for instance those that would help in a start-up phase, such as capital introduction – is also integral to its offering.
Morgan Stanley’s long history in the prime brokerage market means that it is probably better placed to understand the needs of hedge funds than many of its competitors.
Patricia Tsien, a partner from Accenture’s US capital markets practice, says that such insight is crucial for a prime broker’s success. “One of the key things is to understand the fundamental characteristics of a hedge fund itself and what it does. That is something that the broker-dealers are probably stronger at than the commercial banks; that said, Citigroup has been able to move into the space because they have the whole Smith Barney and Salomon Brothers’ franchise to lean on.”
Lou McCrimlisk, managing director in charge of fixed income prime brokerage at Citigroup in London, readily admits that the SSB legacy prime brokerage businesses gave Citi strong footholds in the equity and fixed income businesses respectively. But over the past few years, Citi has built up its business, and now has more than 200 equity and 160 fixed income funds globally. “And what we have done more of recently is to bring together the synergies between the groups, adding Citigroup’s own foreign exchange prime brokerage and futures capabilities.”
Lou McCrimlisk: credit profile of the prime broker will become more and more important
With the product and solutions capabilities across these four core businesses Mr McCrimlisk believes Citi is now unique. “Many prime brokers can do two or three products well – I don’t know anyone else that covers these four product lines as well,” he says.
Technology and processing
Mr Weerasekera believes that, as the market continues to develop, the key to servicing hedge funds through prime brokerage will be through technology platforms and processing expertise. Ms Tsien adds: “There is a requirement for an end-to-end technology to support the hedge fund’s own requirements.
“Although there are one or two software products that could provide end-to-end support to hedge funds, I expect that the prime brokers – especially the big ones – are going to need to provide more front-office capabilities if they don’t want to lose clients.”
According to Mr Inglis, hedge funds increasingly want risk analytics as well as portfolio management and reporting systems, so that they can monitor and analyse their portfolios on an active basis.
Unfortunately for the smaller prime brokers, demands like this are set to become increasingly prevalent – and unless they scale up their business, they will not be able to afford the expenditure involved.
Mr Inglis claims Morgan Stanley invests a “vast amount of money” on technology each year. “We do this because we recognise that it is important, and the size of our business allows us to.”
Mr Inglis concedes that there are off-the-shelf systems that smaller competitors could buy to achieve similar ends, but points out that they will still have to pass these costs on to clients.
He also claims these outsourced solutions are also less useful for hedge funds, because they are not comprehensive: “Through Morgan Stanley Client Link [Morgan Stanley’s private, secure web platform for delivering products and services to customers] our clients have one point of entry to everything – research, positions and reporting; outsourced systems don’t offer that.”
Testing times ahead
There are areas, however, where revenues and longstanding leadership alone will be insufficient to ensure continued success. The growing involvement of hedge funds in all asset classes and across all geographies, as well as their increased interest in synthetic solutions and over-the-counter (OTC) derivatives, will test many of banks that are ill-prepared.
Gary Link, managing director in charge of equity prime brokerage at Citigroup in London, says: “Where previously the trend was for long-short investing through the cash markets, we are now seeing significantly increased use of futures and synthetic derivative products within fund strategies.
Gary Link: ‘need to deliver in all areas’
“This is an area, I think, where the market starts to divide itself – those prime brokers that have strong derivatives expertise and the technology to support the trading will succeed.”
Like his colleague, Mr McCrimlisk believes that, as more OTC derivatives trading takes place, the credit profile of the prime broker will become more and more important.
He says: “Because the funds are trading with a number of counter-parties, they have collateral obligations to different banks which all need managing on a daily basis.
“As this activity grows, hedge funds will want to optimise their collateral, using their prime brokers like conduits to mark trades to market, to margin across products, and to re-link trades between different counter-parties, thereby gaining capital efficiencies.
“Only the prime brokers with good credit and sophisticated collateral management and OTC derivatives capabilities will be able to do this.”
Deutsche Bank, which has recently succeeded in making significant inroads into the prime brokerage market, prides itself on the depth and breadth of its offering. Nick Roe, European head of global equity prime brokerage services at Deutsche Bank in London, says: “It is critical to be active in all the markets and have a good synthetic capability.
Nick Roe: ‘critical to be active in all the markets’
“We offer a one-stop shop for post-execution services. Ensuring the service works optimally is actually very complex; it is the age of the multi-strategy hedge funds which trade across many asset classes and securities simultaneously, and most are free and able to follow trading opportunities at any time. The prime brokers that are most successful handle all products and asset classes efficiently, take a proactive financing approach and deliver the complete solution.”
Larger prime brokers concede that niche players have had some success in their specialised areas, but they are quick to argue that many achieved this by competing on price or on leverage – neither of which are sustainable strategies, they say.
“Being a German bank with a strong credit background, we are very conservative, and would never compete on the leverage front,” says Mr Roe. “Having been through the 1994 and 1998 credit squeezes, leverage is not something you can be cavalier with. Hedge funds are looking for a prime broker who is not going to change margin at difficult times.”
Although the downward pressure on fees will have been welcomed by the hedge fund community, Ms Tsien expects there will now be less focus on price and more on service – and service quality.
If that is to be welcomed by the large incumbents, it will also come at a cost. Mr Link says hedge funds’ requirements are constantly changing and prime brokers need to be able to respond to that.
“If hedge funds want exotic synthetic solutions, the prime broker has to be able to deliver and support them, rather than rely on the traditional definition of a prime broker’s activity,” he says.
“Some of the traditionally strong firms have resisted the change that is taking place, while others aren’t as excited about the growing remit. But to continue providing a top-notch prime brokerage service, you will need to be able to deliver in all areas.”
