THE HEDGE FUND head has been pondering his choices. Should he diversify his portfolio? Should he really make use of that new illiquid product that appears to promise better returns than the usual strategies? Should he sell out to a bank?
Rather than merely relying on his computer models and his traders for thoughts, he has also decided to call up his investment bankers, the specialist corporate financiers that know his industry so well.
That, at least, is the future as seen by UBS, which in July set up its alternative capital group. It’s not designed to raise or place investment assets, nor is it part of the bank’s expanding prime brokerage division. Rather, it is a group of specialists who will offer strategic advice to hedge funds. “It’s similar to the way an investment bank would cover sectors such as industrials or technology, but it’s probably closer to the way we cover financial sponsors,” says Suzie MacCagnan, who co-heads the newly announced group with Richard Royden. “We looked at the pool of capital represented by hedge funds and set about how to talk to them as an enterprise, whether about investment ideas or strategic decisions such as M&A. We regard hedge funds as corporate clients and treat them as we would a Fortune 100 company.”
Leverage for coverage
The UBS group comprises staff from different departments at the bank. MacCagnan used to run the European private-equity coverage and Royden the equity risk arbitrage desk. “This is a joint operation between investment banking and equities,” says MacCagnan. She says she hopes to add staff from fixed income soon. “In this way we are best leveraging our ability to provide the best coverage to our client base.”
It was, perhaps, just a matter of time before this happened. There are now more than 8,000 active hedge funds, and they are no longer the shadowy, nimble trading houses they used to be, pouncing on opportunities that the larger, traditional asset management firms either avoided or were incapable of executing. Hedge funds are now central figures in all parts of the financial markets and no longer simply global macro or equity long/short traders, even if the latter strategy still accounts for most hedge fund assets.
They now participate in almost every asset class from credit markets to insurance products, often in numbers and positions large enough to make them dominant players. Some are adopting roles traditionally undertaken by banks, such as asset-based lending and financing; others have applied for and been granted broker-dealer licences. They have become such a force in private equity that many investment banks have already set up dedicated teams in their financial sponsors groups to cover them.
Such developments have made hedge funds the darlings of the investment banks’ trading desks. But they have also got senior bankers wondering whether they need to find new ways of interacting with these firms beyond the usual trading desks and prime brokerage departments.
“The pool of assets and investors that make up hedge funds is becoming more important across all aspects of the firm, not just the trading desks,” says MacCagnan. “Given their nature – that they are flexible and invest on an absolute return basis – the group has come to the forefront as an alternative source of capital across all products.”
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“Every financial institutions group
is trying to find hedge funds that
want to do deals”
Philip Vasan |
They are also emerging, albeit slowly, as firms in an industry that is set for more change and consolidation. A few have already latched onto the latter trend. Highbridge Capital, a successful multi-strategy hedge fund, sold a majority stake to JPMorgan Fleming Asset and Wealth Management last year, and Ospraie Management sold a 20% stake to Lehman Brothers in April.
The rapid incursion of hedge funds into almost all financial products, and a general belief that consolidation is on the way, has some banks rethinking just how to deal with hedge funds. CSFB set up a unit within its prime brokerage group two years ago to consider these factors, and to work on them with their hedge fund clients. Here’s why.
“Capital continues to flow into hedge funds, and with it pressure to find alpha,” says Philip Vasan, head of prime brokerage at CSFB. “That increasingly involves looking at non-standard assets. It could also mean consolidation. We’ve been advising on both for a couple of years now.”
What these two developments add up to, Vasan explains, is a shift in the way the financial markets perceive hedge funds and how those funds perceive themselves. “The traditional way of looking at hedge funds as trading shops, whose talent could walk out at the end of the day, is being replaced by the realization that leading hedge funds are looking increasingly institutional,” he says. “They follow best practices, are developing diversified strategies, and increasingly have components more reminiscent of traditional asset management businesses. All this will help achieve better franchise value than that of a trading shop.”
Lasting performance
And the only reason to want that is so that they can buy, sell or merge, whether among themselves or in the wider context of other financial institutions; or so that they can issue shares and go public. “We see capital markets events as the natural long-term outcome of factors hedge funds employ to improve their businesses over the next couple of years, including looking to generate more lasting financial performance,” says Vasan. “We have to get the most powerful service offering in place in the interim to meet that.”