INCREASED COMPETITION AMONG banks and the changing strategies of new hedge funds are transforming the prime brokerage business. Banks have piled into prime brokerage over the last few years and new entrants have been particularly keen to establish themselves by catering to the fast growing – though less profitable – segment of non-equity hedge-fund strategies.
This is starting to eat into the Morgan Stanley-Goldman Sachs global duopoly – challenged only in the US by Bear Stearns. There are now nearly 30 prime brokers in the US, and in Europe there are 15, compared with nine as recently as 1999. Morgan Stanley, Goldman Sachs and Bear Stearns still collectively manage most hedge-fund assets, but their share of mandates for new funds is slipping.
A February 2003 survey by Eurohedge shows that the change is most pronounced in Europe, where Morgan Stanley’s and Goldman’s share of new mandates has fallen over the past year, from 60% of the 149 funds launched in 2001 to just over 50% of the 181 funds launched in 2002. Morgan Stanley, though still the largest prime broker overall, has slipped the most, winning just 36 new mandates in Europe last year compared with Goldman’s 60. Deutsche Bank (25), Lehman Brothers (19), CSFB (15), and UBS (12) have gained the most ground. And some funds have closed down. This affects all prime brokers, but some were surprised by talk that Goldman had seen 10% of its European hedge fund clients go out of business last year.
Second-tier prime brokers court new hedge funds
Weak equity markets and a paucity of convertibles and M&A opportunities have led to a decline in the launch of equity-related strategy funds in favour of global macro, fixed income, relative value, and managed futures funds. This has hit Morgan Stanley’s share of new mandates particularly hard and has benefited the chasing pack of second-tier prime brokers whose new systems were designed to service such strategies from the start.
Morgan Stanley, often described as the creator of the industry, seems unconcerned. It argues that it is reluctant to establish a large non-equity prime-brokerage service because it is not very profitable. “We have not taken on as many new funds as others because that’s the plan,” says Jack Tracy, Morgan Stanley’s head of prime brokerage in Europe. “The fact that our market share has fallen is a reflection of the growth of other strategies away from the ones we’re focused on. We have chosen not to be in this business because it’s not clear how you make money out of it,” says Tracy.
A lot of revenue can be made in prime brokerage but it is also an costly business – Morgan Stanley’s IT budget alone is several hundred million dollars – and the cost of providing the complete range of services including capital introduction, with all its associated risks as well as conferences and lunches, is significant.
Tracy argues that at a time when best execution is a priority for clients they will go anywhere for the best price, so in a fixed-income service for example, it is hard to guarantee adequate flows to a bank’s bond traders. This coupled with the fact that the fixed-income business is a net market as opposed to a commission market means that ensuring satisfactory revenue from a client is difficult. “It’s just not clear where the money gets made,” says Tracy.
In fact, Morgan Stanley is experimenting with a move into catering for non-equity strategies by working closely with former Bank of England monetary policy committee member Sushil Wadhwani’s new global macro fund, backed by Tudor Capital and thought to have over $100 million in capital.
Despite Morgan Stanley’s scepticism about the profitability of fixed-income prime brokerage, which is shared to some degree by Deutsche Bank and Merrill Lynch, other prime brokers, including Goldman Sachs, Bank of America and newer entrants, see the area as central to their aggressive prime-brokerage expansion plans.
Dresdner Kleinwort Wasserstein, which joined the race in June last year, began by developing a product to service equity strategies. However, it changed a few months before launch to incorporate fixed income and foreign exchange services to cater to the faster-growing segment of non-equity funds.
These providers see prime brokerage as a portal through which other revenues such as from trading flows can be generated across the whole bank. Their prime-brokerage businesses are profitable, they argue, but the profit is spread throughout the bank and not easily pinned down. Critics say that Morgan Stanley’s reluctance to make a serious push into non-traditional prime brokerage and to service more non-equity-related hedge funds is because of internal politics over where the profits should be accounted.
The scramble for a slice of the prime-brokerage pie is an attempt to secure revenues from the growing hedge fund industry, which bankers are confident will continue to grow at the expense of traditional asset management and which should provide them with a revenue stream less affected by recessions.
At many firms, the push to make it big in prime brokerage now comes straight from the top. At CSFB, for example, prime brokerage is one of CEO John Mack’s pet projects. But prime brokers admit that total revenues have been stagnant, if not shrinking, over the past few years. Although assets under management in the hedge-fund industry have increased strongly, hedge funds as a whole are reducing their leverage and with it the amount prime brokers make from them. Meanwhile, the cost of providing a full prime-brokerage service has grown, while fees have fallen some 40% over the past two years alone.
At first glance it would seem that the competition is steadily munching away at Morgan’s and Goldman’s share of revenues along with their share of new mandates. But the fact is that not all funds generate the same amount of revenue for a prime broker. The largest funds yield vastly greater fees than do their smaller rivals, with the top 40 funds generating two-thirds of the fee pool. Given that most start-ups are small, and that Morgan and Goldman continue to hold on to the largest funds, the second-tier prime brokers may not be hurting them as much as they would like to believe. In order to justify their massive expenditures on building their prime-brokerage businesses, banks are counting on the continued rapid growth of hedge-fund assets and a return to funds taking on more leverage when market conditions improve.
New prime brokers have to be wary of spending their money on establishing and incubating dud funds that don’t generate adequate returns simply to gain market share. Prime brokers want to avoid a reputation among hedge funds for being selective but all claim in private to be highly choosy. They also accuse their rivals of not being selective enough and of taking on funds that later fail.
For now, with prime brokers competing hard to gain market share, not many hedge funds find themselves unable to get a prime broker, which means that at least some prime brokers aren’t being as selective as they claim.
Competitors have a good insight into the ways of Morgan Stanley and increasingly Goldman Sachs, because a good proportion of their teams originate from the two market leaders, which have indirectly helped their competitors leapfrog into the business.
The top prime-brokerage executives at Merrill Lynch, UBS, Bank of America, Deutsche and CSFB, come straight from Morgan Stanley and increasingly Goldman Sachs. Alex Ehrlich, the new global head of prime brokerage at UBS, is the latest in a string of defections from Goldman. These personnel moves are part of a much wider trend of intensive hiring activity in prime brokerage, particularly in Europe, where demand for talented staff is high and supply is low.
According to James Bridgman, director of equity finance and prime brokerage at head-hunter Pelham International in London, banks have had to seriously widen their search. “Over the last 12 months we have had a lot of interest from banks trying to build their businesses and people wanting to move, but it’s a very small pool of people and we are increasingly having to look outside the field,” he says. For senior positions, Bridgman reckons that the salaries being offered vary from $500,000 to well over $2.5 million, with the average being around $950,000 in Europe and $750,000 in the US.
Goldman’s brain drain
Goldman has been hit particularly hard by defections in Europe recently following its transition to a public company. Goldman’s prime brokers are said to feel they’re underpaid and to be despondent about a lack of opportunities for progression or moving to other areas in the firm. Sources close to the firm also say that the loss of the well-liked Ehrlich, Goldman’s former head of European prime brokerage sales, to UBS was also a heavy blow for the Goldman team’s morale as it increased the direct influence of Manny Roman, global co-chief operating officer of global securities services, who is regarded as a lot tougher and is less popular.
Merrill Lynch, Bank of America, JPMorgan, and CSFB have been particularly busy hiring new people for their prime brokerage businesses. Merrill says it has boosted headcount at its prime brokerage unit by 100% in the last 18 months, while there have been more than 20,000 job cuts across the rest of the firm over the last two years. It has been investing heavily in its prime-brokerage offering after years of neglect, in a move said to have the direct backing of CEO Stan O’Neal. After much talk over the years about wanting to be a top-tier player, Merrill is finally putting money where its mouth is, but has yet to achieve the success it’s aiming for. It won only nine mandates in Europe last year, leaving it in eighth position. But the firm is one of the top destinations for those in search of greener pastures.
