Picky banks play hardball with hedge fund clients
For Jonathan Kinlay, no novice at setting up a hedge fund, this time round was much harder.
In the traditional Grand Tour of investment banks looking for help to finance his trading, he was politely turned down by no less than six for being too small.
The response, says Kinlay, chief investment officer of New York-based Systematic Strategies LLC, was the same at each of them: "We'd love to help you. We know you. Give us a call as soon as you've got $50 million."
Kinlay's experience highlights sweeping changes underway in banks' prime brokerage units, which provide funds with services such as lending money or securities and settling trades.
Mounting regulatory pressure since the financial crisis is prompting banks to cull smaller and poorly paying clients. Many of the funds which do make the cut are being asked to pay more in fees or pump higher-quality business through the bank.
"You're seeing large funds look to consolidate their activity with fewer large primes so they are relevant enough in terms of wallet," said the head of prime brokerage for Europe at a leading investment bank.
But even that is not enough for some.
Credit Suisse Group is reportedly set to scale back its prime brokerage activities after a wide-ranging review by new Chief Executive Tidjane Thaim, who would rather use the capital elsewhere.
As well as raising the bar for hedge fund launches, the changes are also leaving funds open to greater counterparty risk as they are forced to use fewer banks - a sharp reversal of the trend seen in the industry just after the 2008 crisis.
Then, hedge funds – spooked by the collapse of Lehman Brothers - had sought to diversify away from the dominance of Goldman Sachs and Morgan Stanley, giving a chance to rivals such as Deutsche Bank and Credit Suisse to boost market share.
This year, less than 3 percent of hedge funds launched with the help of three or more prime brokers, down from 11.4 percent in 2014 and a high of 14.5 percent in 2008, data from industry tracker Eurekahedge showed.
More than 70 percent of the launches used just one bank, up from 61 percent in 2014 and a low of 55 percent in 2012.
BANKS IN CHARGE
That change mirrors the changing power relationship between the funds and their banks.
For many years, funds received the red-carpet treatment from brokers. Pre-crisis, funds often picked brokers on the basis of a bank's specialism and service offering, while post-crisis there has been a greater focus on diversifying credit risk.
Now, though, the banks are in charge.
"The industry is now in the third phase of the evolution of the prime brokerage-hedge fund relationship, which is about regulatory capital, balance-sheet and liquidity," said Dan Thomas, head of Wells Fargo Securities’ client trade services.
Since Basel III rules on leverage began to go live, crimping the amount of balance sheet they could extend to funds, banks have seen the profitability of their prime units slide.
While most just give high-level revenue figures, data from other industry watchers shows the scale of the hit to banks' bottom line by the rule changes.
Data from industry tracker Coalition showed average 2014 return on equity for nine of the top brokers based on risk-weighted asset-based capital was 17.2 percent. Using new leverage rules, the profitability fell to 6.3 percent.
And that trend is likely to get worse as banks brace for the onset in 2016 of Total Loss-Absorbing Capital (TLAC) rules, designed to bullet-proof the industry against future shocks and which will see big banks hit more than their smaller peers.
That flux is proving a boon to cash-rich investment banks such as Wells Fargo, which is ramping up its prime offering and attracting funds rejected or asked to pay more by industry leaders.
Determining which fund is attractive to which bank and at what price is complex. It hinges on a host of factors including the size of the bank, its geographic footprint, the trading flow of both fund and bank and the fund's growth plans.
Among the most attractive fund strategies, in theory, would be those which do not take up much balance-sheet, such as equity market neutral funds or long-short, where a fund bets on stock prices rising and falling.
Less attractive strategies could include less liquid debt markets, or ones which require a bank to take the opposite side of a complex derivatives trade, but it is possible for a fund that looks 'good' for one bank to look 'bad' for another.
"You're seeing hedge funds set up financing desks equivalent to a PB (prime brokerage) house so that they understand how we evaluate the clients, so they can help optimise their activity," the Europe prime brokerage chief said. "Because every prime has a slightly different sweetspot across markets."
While return on equity calculations would differ at each bank, as would where the return came from - financing, execution or custody, for example - most brokers would be "broadly happy" with a return on assets of at least 100 to 125 basis points.
Data from hedge fund tracker Eurekahedge also shows the impact of the shake-up, with traditional prime brokers attracting more assets from bigger hedge funds and second-tier primes building up their business.
Eurekahedge estimates top-5 banks have captured 71 percent of the market, up from 67 percent before the crisis. The next five prime brokers have also increased market share to nearly 20 percent, up from 17 percent before the crisis.
The Europe prime brokerage chief said he thought most big firms - those with more than $5 billion in assets - would likely settle at four or five prime brokers.
The wide-ranging nature of the changes in the industry mean investors are also showing more forbearance, said Graham Rodford, chief operating officer at London-based Omni Partners, which has cut its prime brokers to four from six.
"Investors are also aware that there's pressure on prime brokers and if you tell them that you are consolidating prime brokers, they see it as less of an issue than they did in the past," he said.
"Before, managers were reluctant to appoint a lesser known prime broker. Now investors understand."