Does the unhappy history of Dillon Read Capital Management, the in-house, start-up hedge fund business into which UBS transferred 150 of its best proprietary traders in 2005 only to close it down at the start of May, provide any useful lessons to the rest of the investment banking industry?
Perhaps it is too odd an episode for that. The most obvious lesson, surely, is that proprietary traders are the key building block on which any securities business rests. If you can trade a market well, that makes you a player, puts you in the flows, provides market intelligence: all of that gives you the basis to build distribution to other investors that your investment bankers can then turn round and sell to issuers of securities to build a capital markets business.
Taking the proprietary traders out of a securities business en masse is a bizarre thing to do. UBS now faces the pain, entirely of its own making, of reintegrating those traders – who had been told they were part of a new hedge fund elite – back into their old shop alongside the survivors among those who had been left behind. Good luck!
Of course any firm might reason that, with the best traders quitting the investment banking industry to set up on their own, its traders are unlikely to be market leaders and more likely to be the market fools. In that case, the more rational approach would be, instead of separating those prop traders out and raising third-party capital for them to manage alongside the firm’s own, rather to wave them goodbye. Instead, allocate the firm’s capital to the very best outside hedge fund managers – UBS after all has the private banking infrastructure and prime brokerage operation to identify, conduct due diligence on and monitor the leading hedge fund managers around the world – and reap the returns. If those external managers fail to perform then, instead of paying them off and managing redundancy, simply reallocate capital to better ones.
That approach reduces proprietary trading to its pure financial return, admits of an inability to compete with the best and also dislodges a key component of the securities business. No wonder, then, that investment banks tend to shun it.
Yet the trigger for UBS to shutter Dillon Read Capital Management, a Sfr150 million ($122.6 million) quarterly loss on sub-prime mortgages following positive returns in previous quarters, doesn’t look such a heavy loss to swallow in the effort to build a fee-earning business designated a long-term strategic imperative to own. The one skill in investment banking for which UBS is renowned above all others is its risk management. It understands how to manage small trading losses as a business cost.
Perhaps senior managers at UBS were already regretting their decision to allow the proprietary traders, led by former CEO of the investment bank John Costas, to set up a new business in which the rewards for potential success were tilted in their favour, leaving the bank to shoulder too much of the costs and the penalties for failure.
When Costas rose through the ranks in fixed-income sales and trading at CSFB and later UBS, his best years were 1994, 1997 and 1998. He was the classic bear market trader who outperformed in down markets and in line with the pack during strong years. That, of course, echoes how hedge funds themselves perform. Maybe setting up a hedge fund was the right move for him, but maybe the terms on which he did it looked unsupportable for UBS. Perhaps it was too smart a trade.
Investors in UBS should be watchful for further repercussions, beyond the $300 million charge UBS has already disclosed, over the next couple of quarters from this episode as the chastened DRCM traders return to the investment bank. Meanwhile, any of UBS’s competitors looking for lessons in how to grow or acquire scale in the hedge fund business have one more good example of how not to go about it. It’s reminiscent of what investment bankers, used to throwing lots of bodies into complex deals, had to learn years ago about internet businesses. Small teams build the best ones.
