During the era of easy money, the prime brokerage arms of Wall Street titans thrived by lending money to hedge fund clients. Many managers used the leverage to amplify the returns they made on conservative plays and to make large bets in far-flung places. But things came unglued pretty rapidly last year.
Laden under the deadweight of bad mortgages that triggered the ongoing financial crisis, the U.S. banking industry remained on extremely thin ice for most of 2008. Following the initial eruption of the credit bubble in the summer of 2007, problems exploded during the second half of 2008, claiming as casualties the storied firms Bear Stearns and Lehman Brothers and pushing a few others to the brink. By September, a number of firms were on the Federal Reserve's dole, a move that crimped their risk-taking ability. These developments rocked the financial world around the globe, including that of hedge funds and their service providers.
The aftershocks have been pronounced, especially during the October to December stretch when the massive alleged Ponzi scheme perpetrated by the once high-flying Bernard Madoff came to light. It's no surprise that 2008 has earned the blemish of being the worst year on record for hedge funds, both in performance and asset outflows. Some experts expect the industry's assets to halve from a peak of nearly USD2trn.
In response, some of the largest players in the prime brokerage arena, notably Goldman Sachs, Morgan Stanley and Merrill Lynch, now part of Bank of America, are altering their business units servicing these funds. Some are even stripping them down to the bones, at least for the time being. To be fair, this also plays into the banks' attempts to de-leverage their balance sheets.
Additionally, they are also scaling back capital introduction events. Among the larger players, Goldman Sachs and Merrill Lynch have pulled out of their large-scale annual hedge fund conferences in Florida and will now reconvene them on a smaller level in New York. This is partly because the banks can't be seen hosting extravagant events while accepting handouts from the government. J.P. Morgan, meanwhile, is maintaining its schedule of educational client seminars in small, intimate settings, in keeping with the style of Bear Stearns, which it acquired last year.
'There are momentous shifts occurring in the marketplace,' says Jeremy Frommer, the New York-based head of RBC Global Prime Services, a Royal Bank of Canada unit that sells prime brokerage, trading technology, securities lending and capital introduction services to hedge funds.
Some firms admit that they have altered the terms at which they sell leverage, with little or no advance notice to managers. Mostly, they have substantially reduced the amount of available financing while upping margin and collateral requirements. Some funds, especially those pursuing risky bets outside the U.S., have seen their margin and collateral terms go through the roof. In public, prime brokerages insist they're doing their best to maintain client relationships. Most argue hedge funds have become a higher risk business, given that investors are redeeming en-masse at a time when their asset valuations are ebbing.
'The overall prime brokerage business is less profitable now,' says Jeremy Todd, the business development director at Pershing Prime Services, the Bank of New York Mellon's prime brokerage business. 'In absolute revenue terms, there's less money to be made because the market place is smaller and business risks have widened.'
Yet, opportunities abound for some mid-tier firms.
'We're capturing market share due to a combination of two things: Lesser competition and our methodical, conservative approach to risk,' says RBC's Frommer. Its parent's tight risk control is among the reasons why it has weathered the ongoing financial storm unscathed. So far Canadian banks have performed well during the bust due to their limited risk taking. 'As an institution, we continue to be focused on controlling risk.' Even as Frommer's business has benefited from this firm-wide tight risk management, its services such as a dark pool access product called 'RBC Dark' and the algorithms suite 'RBC Quants' are helping it gain market share.
Despite an unfavorable fund-raising environment, Frommer expects increased fund-launches from 'top of the heap-type' portfolio manager spin-offs and proprietary traders who were made redundant by shrinking banks. It is positioning itself to meet the increased operational and risk control needs arising from both the Madoff scandal and proposed regulatory changes. Adds Frommer: 'While the high-octane leverage of recent years is certainly something the hedge fund industry in general will reconsider, it's premature to say it will go completely out of style.'
Pershing's Todd, meanwhile, says his Jersey City, N.J., firm has tripled its business in the last three months, albeit from a smaller base, and is one of the few prime brokers that's adding to headcount. He adds: 'We've lofty plans to continue to grow the business smartly, in a controlled manner, and in the new direction we see the prime brokerage business evolving into.'
Pershing is seeing interest rise in its separately managed accounts offering. In managed accounts, investors' assets are held separate from those in the co-mingled fund, resulting in greater transparency and control for limited partners. Previously, managers were less amenable to such structures. But in the current unfavorable fund-raising environment, the balance of power has shifted back to investors, says Todd.
The Madoff debacle has greatly heightened interest in managed accounts, experts say. Madoff's broker-dealer had custody of clients' assets while a no-name firm acted as the fund-administrator.
Pershing's clients want to diversify counterparty risk; they don't want a repeat of the Lehman bankruptcy scenario where receivership proceedings have yet to untangle assets of prime brokerage clients. This month, the Bank of New York Mellon also launched MarginDirect, a liquidity tool that helps hedge funds manage margin positions and reduce counterparty risk.
Fund administrators are adapting to the new reality and market opportunities. Stuart Feffer, co-chief executive of New York-based LaCrosse Global Fund Services, says declining asset levels are hurting overall administration business and will result in consolidation of players. At the same time, business prospects are healthy as more managers are now looking to outsource their internal middle office and operational support functions in a bid to lower their fixed costs.
Additionally, investor sentiment toward the industry will turn in 2009, he says. There's a large amount of capital sitting on the sidelines that will return to good quality managers who can present a compelling investment thesis and a solid operational infrastructure. But fee schedules will be different from before, though. Says Feffer: 'Investors aren't going to stuff their money under mattresses forever. Capital will eventually look for alternatives to the current low-interest options.'
Strategy rotation, which occurs every five-seven years, is currently underway, he says. And LaCrosse, which has 300 staff, aims to take leadership in strategies that are garnering investor-interest. For instance, it expects to launch a new administration and middle office operational service targeting mortgages and whole loans. This sector has already begun drawing in managers and investors.
Robert Caporale, who heads the hedge fund services business of J.P. Morgan Chase, says he too is fielding more inquiries from self-administered funds looking to engage third-party firms. Furthermore, its customers are asking for its help to meet their investors' heightened due diligence needs. 'We're hosting a number of requests from managers whose existing and prospective investors now want to personally meet with their service providers to ask us questions about asset-pricing, valuation processes and systems.'
Says Caporale: 'Following the short-term fallout of last year's 'unprecedented developments,' hedge fund outflows and performance somewhat stabilised during January and February, aiding the view that long-term industry growth prospects remain positive.' For the time being, J.P. Morgan Hedge Fund Services is focused on strategies conducive to current market trends. For example, it has expanded its distressed debt offering, particularly on the loan portfolio side, including processing, accounting, capturing trades and reconciliation of swaps. Still, the unit services a diverse portfolio of funds and can handle all hedge fund strategies, says Caporale. The business employs 500 people in Stamford, Connecticut, Dublin and Hong Kong.
Another administrator, Meridian Fund Services, says demand for its services is rising amid heightened regulatory oversight. 'Increased scrutiny and regulation means that more and more hedge funds will be looking to third party administrators to add a layer of independence to their operations, especially in providing services such as independent pricing verification,' says Meridian's general counsel Natasha Concepcion. 'In addition, hedge funds will need to work closely with their administrators to impose robust due diligence, compliance and corporate governance schemes going forward,' she adds.
Law firms, meanwhile, are inundated with work stemming from the Madoff scandal. Widespread redemption freezes and gates are another area that lawyers are digging into on behalf of their investor clients. Attorneys are also preparing their clients for imminent changes in taxation of carried interest. 'We've seen a significant up tick in the amount of work over the last few months,' says Jedd Weider of Morgan Lewis in New York.
Due to a variety of complex factors, Donald Chase, a partner of New York-based Morrison Cohen expects the Madoff suits to be drawn out for a number of years. 'Madoff's a full litigator employment act,' says Chase. At his firm, 10 or so lawyers from the financial services practice are busy scoping various angles of this alleged fraud.
Under the threat of higher litigation and other recent developments, hedge fund insurance costs are rising. 'Two years ago was definitely a better time to buy coverage,' says Tom Clark, who recently joined insurance broker Theodore Liftman in Boston, Massachusetts. Managers buy policies to cover themselves against potential damages from investor suits and regulatory reviews. Investors mainly insure themselves against manager fraud or negligence and huge losses. 'Clients now require hand-holding. The biggest fallout from the Bernie Madoff issue is the panic it's spread among investors. Unfortunately, he's given a bad rap to the whole industry.' As a result, underwriters now provide less coverage for more money.
Trading technology needs enhancement. Managers want to be ready with the ability to invest in all asset classes, says Peter Sibirzeff, chief executive of trading technology firm Alphacet of Stamford, Connecticut. Nobody wants to be left out from a huge market shift because of inefficient legacy systems.
From a compliance perspective, 'transparency is the key word in the industry,' says Martjin Groot, director of product marketing at Asset Control, a data management company. 'Requirements for transparency have changed meaningfully following 2008, the industry's most severe stress test so far.' More managers are looking to sign up the firm's key aggregation service that presents key data including asset prices and terms of securities in a format that managers can navigate easily and precisely, says Groot.
Judith Gross, principal of JG Advisory Services, expects that under proposed legislation, unregistered investment advisers will have to put in place a written compliance manual and code of ethics. They will also have to follow applicable document retention and proxy voting requirements, among other obligations, and have in place a designated compliance chief. Additionally, she indicated funds would be required to establish the anti-money laundering program and report suspicious transactions.