The 17th annual Global Custodian survey of the clients of prime brokers, published today, provides a first assessment of an industry emerging from the trauma of the financial markets crisis of 2007-08. It finds both change and continuity. Credit Suisse and Deutsche Bank, the two major beneficiaries of the anxieties of the last quarter of 2008 and the early months of 2009, have definitively emerged as industry leaders. But it also shows that Goldman Sachs and Morgan Stanley, which dominated the industry going into the crisis, have retained industry leadership.
“Credit Suisse is grateful to our clients for their naming us the world’s best-in-class prime broker for the second consecutive year,” says Philip Vasan, managing director, prime services, at Credit Suisse in New York. “Our promise to them remains to deliver a premium offering that meets standards that they and their investors can look back on years from now with pride. We continue to focus on a select client base of established firms and marquee start-ups, to give them the best of not only Credit Suisse but the market, to maintain the steadiest hand over the cycles, and to help them outperform both in the bottom line and the business around it.”
Credit Suisse scores particularly well among the largest and most sophisticated hedge fund managers that it has pursued as clients since it embarked on a new strategy in 2003. The attractions of this type and class of client are obvious. Prime brokers earn revenues primarily by lending money and securities to hedge funds, and it is the largest funds that borrow the most money and the most securities, and generate the most significant trading commissions and spreads.
While Credit Suisse collects its best scores from the largest and most sophisticated hedge fund managers, Deutsche Bank scores best among smaller funds, as does Goldman Sachs. “We thank our clients for their ongoing support,” say James Paradise and John Willian, the global co-heads of prime brokerage at Goldman Sachs. “We continue to be committed to delivering our global platform and the best of Goldman Sachs to our clients around the world.”
Importantly, in a market environment more sensitive to counterparty credit risk and the safety of client assets, all but two of the leading prime brokers are now owned by major universal banking groups. They include Barclays Capital (which acquired the American equity finance franchise of Lehman Brothers), J.P. Morgan (which acquired Bear Stearns in the spring of 2008) and Merrill Lynch, which has recovered strongly since its acquisition by Bank of America in the Fall of 2008, and which is now adding staff and balances. “Hedge funds are actively seeking to expand and are looking for strong, stable prime brokers with integrated, global product offerings to help them achieve their performance goals,” says Syl Chackman, co-head of global markets financing & futures at BofA Merrill Lynch. “We are optimistic about the future of the hedge fund industry and continue to invest and grow our team and our platform.”
Indeed, many prime brokers are now reversing the decisions they made during and immediately after the collapse of Lehman Brothers, and not only hiring again in the areas of the business hit hardest in the Fall of 2008-client service, capital introductions and hedge fund consulting-but investing in technology once more as well, especially in terms of client reporting. However, despite the apparent return to normalcy, all prime brokers recognize that they are now operating in a changed marketplace.
The strong improvement in hedge fund performance in the last three quarters of 2009 has proved hard for many funds and strategies to sustain in 2010, and the degree of uncertainty and lack of conviction remain unusually high. Consequently, the volume of both short positions and leverage are still lower than they were before the financial crisis. This means the revenues and profits of prime brokers remain under pressure too. Lower customer balances at prime brokers reflect lower assets under management by hedge funds, and reduced leverage within the hedge fund industry.
On top of these challenges, the industry is also facing the prospect of heavier regulation of both hedge funds and investment banks, across capital allocations, proprietary trading, OTC derivatives and fiduciary responsibility. With capital and compliance costs already rising, the hedge fund industry that is now emerging is one with fewer but larger hedge funds. More importantly, it is also one in which investors are more influential. As the Global Custodian survey shows, the increased influence of investors is having a profound impact on the structure of the prime brokerage industry.
The most obvious sign of that influence is the continuing trend toward multiple prime brokerage. Few even of the largest prime brokers can claim as much as half of their respondents use them as their primary prime broker and, of those that do, most are smaller funds. This reflects the continuing pressure on hedge fund managers to diversify their counterparty credit risk exposure by appointing more than one prime broker.
Though the trend toward multiple prime brokerage is scarcely new-hedge funds have long disliked placing all of their business with a single investment bank, not least because of the risk of information leakage-the financial crisis has prompted sustained demands from investors that hedge fund managers not only diversify their risk away from standalone investment banks in particular, but establish and monitor carefully the operational soundness of the firms that they do business with.
The standalone prime brokers that are not owned by a creditworthy universal bank have as a result shed balances, if not clients. This has not prevented both Goldman Sachs and Morgan Stanley increasing their rate of response this year and returning excellent scores. However, the survey also shows that the universal banks which benefited most from the diversification of counterparty credit risk and the flight to quality in the winter of 2008-09-notably Credit Suisse and Deutsche Bank, but also J.P. Morgan and Barclays Capital-have retained and expanded the business they won during those months.
Though both BNP Paribas and Newedge have also benefited from the search for diversification, investors have lately expressed concern about the credit risk and other uncertainties posed by some European banks. This has further increased the attraction of the prime brokers owned by the banks with the strongest balance sheets, and not only because the risk of catastrophic financial failure is more remote. The better informed and longer term institutional investors of today also know that the performance of the hedge fund managers they choose depends as much on the continuity of financing as its price and availability.
Hedge fund managers themselves, who witnessed the rapid and arbitrary withdrawal of financing in the fall of 2008, are more alive to this consideration than ever. The prime brokers that score best in the survey on financing for larger hedge funds are Citi, Credit Suisse, Deutsche Bank and J.P. Morgan. In fact, it is bank-owned prime brokers in general (notably Credit Suisse and Deutsche Bank, but also Bank of America Merrill Lynch and J.P. Morgan) that tended to score best on financing in the survey this year.
Some of the highly rated Canadian banks that last year absorbed cash and securities from American hedge fund managers seeking stronger balance sheets have attracted more responses this year, though there is also evidence in the survey that balance sheet is not enough: service and product expectations are rising among clients of BMO Capital Markets, CIBC, National Bank Financial Prime Services, Scotia Capital and TD Securities. Fidelity Prime Services, which also benefited in 2008-09 from diversification away from investment bank counter-parties, is already investing heavily in the enhancement of its services.
In fact, although counterparty credit risk remains important, firms of all kinds are now less likely to win business on balance sheet strength (and availability) alone. Indeed, recognition in the survey of the value of the asset segregation and “bankruptcy remote” structures most prime brokers introduced in the wake of the crisis is not yet borne out by enthusiasm for making use of them, as the transfer of assets between custody and brokerage accounts remains essential but awkward. Besides, as markets have recovered, asset-raising has become a more pressing concern for hedge fund managers than asset safety. It has also become more difficult, because investors remain more cautious in their investment decisions than their predecessors of 2006-07.
Exhaustive due diligence, which includes in-depth assessments of the counterparty and operational risks represented by hedge funds, means investors take longer to commit money. This cautious approach has further tilted the balance in favour of larger, institutional quality hedge fund managers with established track records, a reliance on discipline and teams rather than individual fund managers, and a willingness to offer both transparency and liquidity when investors wish to disinvest. Most major prime brokers, following the lead set by Credit Suisse, are now seeking to service larger and more profitable hedge funds.
This means 2010 is not an easy environment for a hedge fund start-up to attract either a prime broker or assets to manage. Even the prime brokers that specialized in smaller hedge funds back in 2006 or 2007 are today tending to emphasise scale over potential. In this context, it is telling that the only groups to return lower average scores for capital introductions in the survey this year are the smallest hedge funds (those managing less than $100 million) and those pursuing a single investment strategy.
But the shedding of smaller funds by the major prime brokers has encouraged the growth of a new class of smaller prime brokers to service funds managing assets of $250 million and less, at least in the United States. Most act as execution-only brokers, and outsource clearing, settlement and custody to one or more of the major broker-dealers. Among the smaller houses to receive responses in the survey this year were Alaris Trading Partners, Gar Wood Securities and the BNY Mellon-owned Convergex|North Point Trading Partners.
However, there is an enormous range in terms of client size, business strategies and service capabilities among the firms servicing smaller clients. One firm offering a comprehensive set of prime brokerage services to smaller funds, many of which it acquired from BNP Paribas after the French bank purchased the former prime brokerage business of Bank of America, is Jefferies & Co. Its specialization in relatively small equity long/short funds at competitive prices has secured the firm high scores as well as new business from a much-enlarged client base-albeit one still based exclusively in the United States.
Another way in which the increased influence of investors is being felt by prime brokers is pressure to improve technology and reporting. The transparency demanded by investors is forcing hedge fund managers to seek more up-to-date, informative, analytical and integrated data from their prime brokers. The survey suggests that not all prime brokers yet have systems in place to meet these needs. This has given a particular opportunity to Merlin Securities, an intermediary that has always invested heavily in reporting technology, to shine.
The survey also suggests that this need for comprehensive data spanning synthetic as well as cash prime brokerage, equity, credit, rates and exchange-traded derivatives positions has increased the frustration among hedge fund managers with prime brokers that maintain internal silos between different parts of their business. The survey demonstrates that the degree of integration varies widely between different prime brokers, though some (notably Bank of America Merrill Lynch) have clearly used the crisis and its aftermath as an opportunity to accelerate progress in bringing businesses together. Internal integration will become a key service differentiator between prime brokers as the hedge fund industry continues to institutionalize.
The appendix contains a summary of the ratings and best in class awards collected by the prime brokers that took part in the survey, along with an indication of the global and institutional reach of their business, based on the survey data. A PDF copy of the published survey is available here. This includes a series of tables showing the performance of all the prime brokers that took part in the survey in a variety of categories. The average and weighted average scores are based on 3,215 authenticated responses received on behalf of 21 prime brokers. The number of responses was up 54% by comparison with 2009 (2,081). This is one measure of the recovery of the prime brokerage industry from the nadir of early 2009, in the immediate aftermath of the collapse of Lehman Brothers and the Madoff defalcations.
The full results of the Prime Brokerage survey, and a full explanatory methodology, are available for GC subscribers here.
Contacts:
Dominic Hobson, Editor in Chief, atdhobson@www.globalcustodian.comor +44 (0) 207 228 3013
Allison Cayse, Surveys Editor, atacayse@www.globalcustodian.comor +1 513 574 0220
Muzaffar Karabaev, Survey Reprints/Research Enquiries, atmkarabaev@www.globalcustodian.comor +44 (0) 207 148 4289