Last spring, as a wounded Bear Stearns Cos. fell into the arms of JPMorgan Chase & Co., hedge fund manager Lee Ainslie III sprang into action. Like most of the former Tiger cubs who came of age under the tutelage of renowned global macro manager Julian Robertson Jr., founder of Tiger Management Corp., Ainslie housed a sizable percentage of his firm’s assets at Morgan Stanley, which has long boasted one of the leading prime brokerage franchises on Wall Street. Ainslie’s $9.7 billion long-short equity shop Maverick Capital also had smaller relationships with six other prime brokers, including Lehman Brothers Holdings. But with the credit crisis intensifying and investment banks like Lehman, in particular, looking vulnerable, Ainslie began cutting Maverick’s balances at that firm and opened talks with three universal banks: JPMorgan Chase, which had taken over Bear’s prime brokerage operations, Credit Suisse and Deutsche Bank.
He didn’t stop there. When Lehman collapsed into bankruptcy on September 15, throwing the bank’s 3,500 counterparty relationships into turmoil, many feared that Morgan Stanley could be next. With that bank’s shares in free fall and credit default spreads on its debt widening dramatically, Ainslie wasn’t taking any chances. Within a month, according to a presentation at Maverick’s annual investor meeting in New York in October, he had withdrawn all of his firm’s assets from Morgan, divvying them up among his new prime brokers, with the majority landing at Credit Suisse.
“Before Lehman [collapsed] people thought these institutions were too big to fail,” notes David Nissenbaum, a partner with law firm Schulte Roth & Zabel in New York. “Even when hedge funds had multiple primes, they were often more heavily weighted toward the one they liked the most in terms of relationships and pricing.”
Not any longer. Rattled by Lehman and reawakened to the stark realities of counterparty risk, many hedge funds have followed Maverick’s lead, diversifying their prime brokerage relationships and upending the long-standing pecking order.
At the same time, Wall Street’s prime brokers are themselves undergoing a major transformation. As the hedge fund industry swelled in size, reaching a peak of about $2 trillion in assets last summer, prime brokers reaped a windfall, posting revenue of more than $12.4 billion in 2008, according to senior banking analyst Brad Hintz of investment management firm Sanford C. Bernstein & Co. Prime brokers also captured billions of dollars in fees and trading commissions for their firms. But with banks fighting to survive in the aftermath of the Lehman bankruptcy, their prime brokerage units slashed balances, changed lending terms and axed small hedge fund clients. The major banks cut prime brokerage staff as well. Many senior executives left or were let go. Stuart Hendel, Morgan’s well respected prime brokerage head, was a high profile casualty. He left Morgan Stanley in mid-May and will be replaced by Alexander Ehrlich, who had been global head of the prime brokerage business at UBS.
Morgan Stanley has been among the hardest hit. Together with Goldman, Sachs & Co., it dominated the prime brokerage business for close to a decade, with more than half of all hedge fund balances shared between them. But both firms lost market share in the wake of Lehman’s failure. By December prime brokerage assets at Morgan Stanley had fallen for the year by as much as 65 percent, a result of market declines, withdrawals by hedge funds and the bank’s own decision to cut balances.
Concerns about counterparty risk, as well as the bank’s rising cost of funding hurt Morgan Stanley’s prime brokerage franchise. Richard Portogallo, head of institutional clients and services, nevertheless insists, “recognizing our historical leadership in prime brokerage, coupled with the secular shifts in the industry, Morgan Stanley continues to remain fully committed to our prime brokerage business and delivering innovative solutions to clients.”
That may be. But the once highly profitable business of providing financing, lending, custody and support services to hedge funds is experiencing a major shakeout. Banks and hedge funds alike are being forced to rethink the business.
“It is not going to be a smooth process,” says Christopher Pesce, who resigned as head of Bank of America Corp.’s prime brokerage unit in October 2007 and until recently was COO of an event-driven hedge fund created by Blackstone Group. “Different funds are going to get different treatment from different banks depending on who they are and how important they are to the bank overall.”
Most estimates suggest that the hedge fund industry’s assets could decline by 50 to 75 percent from their peak. That dramatic contraction alone could contribute to a 32 percent drop in prime brokerage net revenue and a 52 percent drop in earnings in 2009, estimates Bernstein’s Hintz.
Yet the industry must contend with much more than a shrinking hedge fund pie. With funds rapidly diversifying their prime brokerage relationships, the Morgan Stanley/Goldman Sachs duopoly is crumbling, creating new opportunities for boutique providers and second-tier players that have long been scrambling for market share. Global custody banks, which haven’t traditionally focused on hedge funds, are also profiting: Thanks to their reputation for stability, they have become a safe haven for hedge funds’ cash balances and securities that aren’t pledged as collateral for loans.
Not everyone will survive. During the boom years just about every major sell-side firm entered the prime brokerage business — and many were all too happy to relax their standards in an effort to win a wide range of business from hedge funds, which last year contributed more than
$25 billion in annual revenue to the global securities industry, according to the Bank of England. But prime brokerage costs as much as $1 billion a year for a major bank to operate, says Michael Spellacy, former head of the alternative-investments practice at Boston Consulting Group. With hedge funds now contracting, he says, “there isn’t enough room available for all the primes.”
When Alfred Jones launched the first-ever hedge fund in 1949, he brokered with Neuberger Berman in New York. But prime brokerage as it is known today didn’t exist, and pioneers like Jones had to keep track of their own trades, manually consolidate their investment positions across their multiple brokerage relationships and calculate their own performance, a cumbersome process. Even by the 1970s few Wall Street firms were offering prime brokerage services to the then-fledgling hedge fund industry. Goldman Sachs did but called the business its “courtesy department.”
In those days, and for much of its history, prime brokerage was not glamorous, flashy or lucrative. Nor was it powerful. It was a behind-the-scenes custody and settlement business, an offshoot of institutional equity trading populated by humble equity or operations guys like Glen Dailey. The son of a New York City cop, Dailey grew up on Staten Island and fell into prime brokerage after landing temp work as a messenger for investment bank A.G. Becker & Co. in New York in the late ’70s. By the end of his first summer on the job, he was managing the entire team of 37 messengers, most of whom were old enough to have been his grandfather.
“I knew more about Social Security than any 17-year-old in America,” recalls Dailey, who today runs prime brokerage at New York–based investment bank Jefferies Group.
At the time, A.G. Becker provided clearing and settlement to New York investment boutique Furman Selz. The driving force at Furman Selz was Louis Ricciardelli, the head of prime brokerage and an innovator who was among the first to foresee the profits to be earned from clearing and settling hedge fund trades and providing managers with financing. When Furman Selz decided a few years later to move its clearing business over to Bear Stearns, Ricciardelli asked Dailey to join Furman to help with the transition. In 1982, Ricciardelli was hired away by Morgan Stanley to launch its prime brokerage operation, and Dailey soon found himself running the Furman Selz business.
At Morgan Stanley, Ricciardelli managed to land Tiger, which would become one of the most successful hedge fund firms in the history of the industry. That was the beginning of a crucial relationship for Morgan, not just because of Tiger itself but also because of the many Robertson protégés who followed, including Maverick’s Ainslie, who began his hedge fund career as a technology analyst at Tiger.
“Every one of those Tiger cubs ended up at Morgan Stanley,” notes the head of prime brokerage at a rival firm.
Goldman Sachs and, to a lesser degree, Bear Stearns were also well on their way to building market-leading franchises. Like Morgan Stanley, Goldman excelled at client service, invested in topflight technology and offered superior products. Morgan and Goldman also pioneered capital introduction — the business of setting up hedge funds with potential investors through conferences and road shows. Cap intro became a crucial element of prime brokerage, helping funnel billions of dollars into the hedge fund industry and cementing long-term relationships. (The best-known cap intro event is the three-day conference Morgan Stanley hosts every November at the Breakers resort in Palm Beach, Florida — a spectacle ruthlessly caricatured in Hedgehogging, the 2006 memoir by former Morgan Stanley global investment strategist Barton Biggs.)
In the 1980s and early 1990s, prime brokerage may have been important to the banks and institutions that offered it, but it still wasn’t a huge profit center. Then again, hedge funds weren’t yet very important: In 1994 the hedge fund industry had only $167 billion in assets, according to Hedge Fund Research in Chicago.
That would soon change. Burned by the bursting of the dot-com bubble, institutional investors rushed headlong into hedge funds. Assets nearly doubled, from $490.6 billion in 2000 to $972.6 billion in 2004, reports HFR. At a time when institutional equity trading commissions were otherwise on the decline, hedge funds emerged as the ideal Wall Street client: As active traders, they threw off billions of dollars in commissions. They were also the biggest purchasers of many of the more innovative products and strategies that banks had to offer.
The impact on the prime brokerage industry was dramatic. In a 2005 research report, Bernstein’s Hintz estimated that Morgan Stanley, Goldman Sachs and Bear Stearns, which by then controlled almost 60 percent of the market, were each generating more than $1 billion in annual revenue from prime brokerage, including the ancillary trading and banking business those operations generated. The banks’ generous, seemingly low-risk returns on equity from prime brokerage ranged from 18 percent to 23 percent.
A flood of new players entered the prime brokerage business, drawn by the potential for healthy profits. To break the oligopoly’s stranglehold and win over big hedge funds, many firms began to provide increasingly attractive terms on securities and margin lending, facilitated by the then ample liquidity sloshing around the financial system.
For their part hedge funds became adept at extracting cheap financing from prime brokers. This was especially true of the biggest payers of trading commissions, multistrategy convertible arbitrage specialists such as Chicago-based Citadel Investment Group and Amaranth Advisors, the Greenwich, Connecticut–based hedge fund that collapsed in 2006 after its natural-gas bets soured. They struck financing agreements with prime brokers that guaranteed set margins and fees for an agreed-on period (assuming no massive losses at the fund). Initially, these ran for 30 days, but they stretched to 60 days and then 90 days. By 2008 some managers were getting 360-day agreements.
Increasingly hungry for leverage, some hedge funds were looking for ways to skirt Regulation T, the U.S. Federal Reserve Board rule that restricts how much broker-dealers can lend on margin (no more than 2-to-1 in the case of equity securities). This rule encouraged hedge funds to broker assets offshore in a practice known as arranged prime brokerage, in which banks lent out, or rehypothecated, all of a fund’s assets, not just those the manager was borrowing against. The quest for leverage also helped fuel interest in synthetic prime brokerage, which involves financing margin loans with swap contracts and is also handled offshore, beyond the reach of Reg T limits.
European banks, with their traditional strength in derivatives, led the charge, but U.S. institutions followed suit. At Goldman, an early leader, synthetic prime brokerage was developed by Pesce, who was then hired away by Bank of America to do the same thing. There he joined forces with Dailey, who after leaving Furman Selz had co-founded the prime brokerage business at Montgomery Securities, which had been acquired by BofA.
Dailey, who ran traditional prime brokerage at the Charlotte, North Carolina–based bank, says that BofA’s head of equity business wanted to reel in giant hedge funds with synthetic prime brokerage and believed that Pesce, with his Goldman connections, “could get balances out of the multibillion-[dollar] guys.”
Equity securities lending has always been among the most important activities in prime brokerage, making up about 50 percent of revenue. But in their hunger to win business from the biggest players, banks began to lend against more and more types of assets. In a typical transaction a broker lending money takes securities as collateral. These securities are in turn rehypothecated to short-sellers (in the case of equities) or used to obtain financing in the repo market, the short-term lending market in which banks fund themselves by exchanging collateral for cash. By moving the illiquid and hard-to-value securities off of their own balance sheets, the banks reduced their cost of capital.
“There was a time when the lenders of cash would take anything as collateral,” says one prime brokerage executive.
The power of prime brokerage was on display in November 2005, when Morgan Stanley promoted Portogallo, the long-standing and well-liked head of the business, to run all of Morgan’s global equities businesses. The competition among prime brokers was intense. That year, JPMorgan CEO Jamie Dimon bowed out of the business. BofA CEO Kenneth Lewis followed suit, putting his bank’s prime brokerage operation up for sale in October 2007. Sensing opportunity, JPMorgan made an offer for BofA’s business the week of March 10, 2008. But the bank lost interest a few days later when it acquired Bear Stearns with backing from the Federal Reserve. One prize was Bear’s prime brokerage unit.
Bear’s demise was a watershed: It marked the moment when the mutually beneficial relationship between hedge funds and investment banks turned ugly. Bank CEOs had watched in horror as hedge funds pulled prime brokerage balances from Bear and bought credit default swaps to bet on its demise. They became hostile toward hedge funds, blaming them for banks’ falling shares and widening CDS spreads.
Hedge funds, increasingly nervous about counterparty risk, began yanking assets from the investment banks. And banks, for their part, were worried about the state of their prime brokerage units’ balance sheets, particularly their lending against hard-to-finance assets used by convertible arbitrage and distressed-debt managers. Last fall Goldman merged its futures and electronic trading business with its main prime brokerage platform and brought in John Willian, who had spent 16 of his 19 years with the bank in fixed income, to co-head the group. The firm wanted someone with more credit experience watching its balance sheet.
Then Lehman filed for Chapter 11. The repo market froze. Banks wouldn’t lend to one another. The investment banks, soon to be transformed into commercial banks, had to get their leverage down — and fast.
In this new environment banks tightened the screws. The list of assets that prime brokers were willing to lend against shrank to almost nothing. Prime brokers changed terms and made margin calls. Overnight, prime brokerage went from a booming business to a drag on overleveraged balance sheets.
Convertible arbitrage managers, who had become so adept at extracting attractive funding terms from the banks, were hit particularly hard. A final indignity was supplied by Lehman. The firm’s London unit had about $65 billion in client assets when it went into administration, most of which had been rehypothecated in accordance with the U.K.’s lighter regulatory regime. Hedge funds now face an extended, possibly futile, fight to get their collateral and cash back, although the U.K. administrator says it hopes to begin returning assets in September.
“A lot of fund managers didn’t appreciate the dangers of certain prime broker structures,” explains Robert Sloan, founder of S3 Partners in New York, a firm that advises fund managers on prime brokerage relationships.
The shakeout has only just begun. Bernstein’s Hintz, who has produced some of the most comprehensive research on the prime brokerage industry, figures that the days of hedge funds’ concentrating and pledging all or most of their assets to a single prime broker are “unlikely to return.” As a result, he argues, more prime brokers will capture a share of each fund’s assets.
Europe’s universal banks are already profiting. Barry Bausano, Deutsche Bank’s head of prime brokerage, notes that the effort to bring in top clients has become easier with the events of the past eight months.
“Particularly in September and October, many hedge funds that had not yet moved business to Deutsche Bank had our phones ringing off the hook,” says Bausano, whose operation is benefiting from its parent firm’s relative stability and comparatively strong balance sheet, despite fourth-quarter trading losses that hurt the bank.
Credit Suisse also picked up clients in the aftermath of the Lehman bankruptcy, as did BNP Paribas, which entered the U.S. prime brokerage business with its acquisition of BofA’s platform in a deal that closed in October, at the height of the credit crisis.
“Given the changes in the marketplace, there is no reason we can’t be a dominant prime broker,” says Jeffrey Lowe, BNP’s New York–based head of prime brokerage structuring. “We want to build a business that can sustain the volume to be a top-three prime broker in a very short period of time.”
Although it may be far too early to declare a victor, the biggest winner to date appears to be JPMorgan. The bank wasn’t even on the radar in prime brokerage until it acquired Bear’s platform in May 2008. The business had been losing assets as Bear teetered, but it suddenly became a safe haven in the fall after the banking behemoth took over. Although balances had declined, “the relationships never went away,” says Louis Lebedin, co-head of prime brokerage at JPMorgan, who had run the business at Bear. And those accounts have come back in droves. When Lehman went down,
JPMorgan was receiving hundreds of calls a day from funds anxious to come on board.
Bear’s franchise was strong in clearing, risk management and reporting, but it was weaker than the more global Morgan and Goldman businesses. Hintz expects JPMorgan to build out the platform’s international execution capabilities and use its custody business to offer one-stop shopping to hedge funds looking for someplace safe to park assets or cash that they don’t need to post as collateral. He reckons that by 2012 the bank will be the world’s largest prime broker, with roughly 20 percent of the market.
That growth will come at the expense of Morgan and Goldman. The two firms have been paring funds to reflect more sober realities. Changes at Morgan, in particular, have been a shock to hedge fund managers. They were used to Goldman’s playing hardball, but when Morgan began to resize its business last fall and CEO John Mack joined the bank brass in calling for a temporary ban on selling financial stocks short, managers were taken aback. “Morgan Stanley is going to have to win back the clients it lost, and to do that the bank’s senior management needs to make a clear, firm commitment to the business,” says Ricciardelli, who now runs his own consulting firm, BPB Associates, in New York.
Prime brokers are likely to start charging for many of the services they once provided to hedge fund managers for free. Lebedin says this is something JPMorgan is considering. “For those services where we can recover a fee, based on a new pricing model, that is something we will think about,” he says.
Cap intro and distribution are two areas potentially ripe for monetization. In March news leaked that Morgan Stanley had struck a distribution deal with London-based hedge fund behemoth Brevan Howard Asset Management, which oversees $26.8 billion in assets. Still, banks face pitfalls: If they actively recommend funds to investors, they open themselves up to potential liability if one of those managers turns out to be the next Bernie Madoff.
“The fear is that it creates a higher level of responsibility,” says Schulte Roth’s Nissenbaum.
As banks cut the smaller clients — those with $150 million or less in assets under management — the boutique prime brokers are stepping into the breach. Dailey, who left BofA in 2006 to join Jefferies, signed a deal in April to take over about 100 small clients from BNP Paribas. Many are accounts that Dailey worked on at BofA.
For the smaller primes the economics still work because they can make their revenue through ancillary businesses, mostly agency trading. Justin Press, co-head of prime brokerage at New York–based boutique BTIG, says that, unlike the bulge-bracket firms, which historically have made most of their prime brokerage money from financing, firms like BTIG earn most of theirs from trading commissions. But few of these smaller firms clear and settle their own trades; they rely on the major banks to perform that service and to provide financing (Jefferies is a notable exception).
Another open question is whether the global custody banks can hold on to the hedge fund balances that poured in as concerns about the stability of big banks intensified last fall. What happened to cash balances and hypothecated securities at Lehman’s London unit frightened hedge funds, which are now much more concerned about where their cash and securities are being held. In the custody model these assets aren’t pledged and are thus more protected. But the problem for the global custodians — firms like State Street Corp. and Northern Trust Co. — is that they don’t have major investment banking operations and cannot offer all of the products and services that hedge funds demand. The custodians also face a major technology hurdle.
Nonetheless, Hintz predicts that as much as 75 percent of hedge funds’ fully-paid-for assets will be moved to global custodians. He foresees a new prime brokerage ecosystem emerging in which some custodians work with prime brokers to form hybrid service models while others, namely the big global players like JPMorgan and Bank of New York Mellon, seek to become go-to firms and to roll up clients’ holdings and exposures from secondary prime brokers.
Given the new realities of prime brokerage and financing, some hedge funds — particularly those focused on credit and requiring a lot of leverage — will be left out in the cold.
“I don’t think we’ll ever see the hedge fund business go back to the same levels of leverage that were being used,” asserts Jefferies’s Dailey.
Even if the major primes wanted to lend to hedge funds as before, their banks’ credit departments won’t let them. “The prime brokers are no longer run by the business units,” says one hedge fund executive. “They are run by the treasury and credit functions.”
Still, there are signs that prime brokerage is regaining normalcy. After canceling its glitzy annual capital introduction conference in March, Goldman rescheduled it for May, moving the venue from a swank Miami hotel to Manhattan’s Chelsea Piers, an athletic and conference center. Goldman CEO Lloyd Blankfein was the luncheon speaker, and featured hedge fund attendees included heavyweights Cliff Asness, founder of AQR Capital Management; Steven Cohen, founder of SAC Capital Advisors; and Daniel Och, founder of Och-Ziff Capital Management. Maverick’s Ainslie also made an appearance.
The title of the event was “Industry Leaders Discuss the Lessons of 2008 and the Opportunities of 2009.” With loyalty in short supply and market share up for grabs, participants no doubt had plenty to talk about — and will for some time.
See related story, " A Baker’s Dozen ”.
