Rapid growth in the number of hedge funds continues to stoke competition among prime brokers, who do everything from clearing the funds' trades and lending them money to introducing them to investors and giving them office space.
Hedge funds - which may number more than 8,000 - are more active traders than other institutional in-vestors. The funds generate 30% of Wall Street's equity commissions, or an estimated $7.5 billion this year alone, according to Sanford C. Bernstein & Co. LLC.
Chasing those fees are universal banks, which have been building their capabilities in prime brokerage, adding technology and products, and stealing talent from the big three: Bear Stearns Cos., Morgan Stanley, and Goldman Sachs Group Inc.
But the competition is depressing prices and squeezing margins. And despite their intense efforts, competitors have not seriously threatened the big three, who have two-thirds of the market. Smaller competitors include UBS AG, Merrill Lynch & Co., Lehman Brothers, Deutsche Bank AG, Citigroup Inc., Bank of America Corp., and Credit Suisse First Boston Corp.
The challengers may need to consolidate, Brad Hintz, a Sanford Bernstein analyst, wrote in a Feb. 24 research report on prime brokerage. Bear Stearns, which among the big three gets the largest portion of its revenue from prime brokerage, is often mentioned as the most likely seller.
But a market-transforming deal is viewed as unlikely for now, partly because stringent capital requirements make a leap into prime brokerage less attractive. New capital standards expected to take effect next year might alleviate that concern.
"We do not believe that an acquisition of any of the top three prime brokers is imminent, at least not until after Basel II is adopted at the end of 2006 and regulatory capital requirements are adjusted for the universal banks," Mr. Hintz wrote.
Overlap is another barrier to a blockbuster deal between a universal banking company and a major prime broker. Bear Stearns, Morgan Stanley, and Goldman are major competitors with universal banking companies like Citi in capital markets and advisory services. Any buyer would have to be willing to take the rest of the company and integrate it or pull it apart.
The most likely consolidation scenario is a takeover of small or midsize brokers by up-and-coming universal banking companies, Mr. Hintz said. That happened in late 2003, when ABN Amro Holding NV sold its prime brokerage to UBS for $250 million.
But other experts say consolidation is not inevitable or necessary. Demand for prime brokers' services keeps growing along with hedge funds.
"The barrier to entry is very high, but the barrier to success is actually quite low, because if you have made the investment to get into the market, you're going to get market share," said Robert Sloan, the managing partner of S3 Asset Management in New York, which advises hedge funds.
The big three have another advantage: Customers are usually reluctant to switch prime brokers.
"It is very difficult to convince most prime brokerage clients that a move away from one of the market leaders is warranted," Guy Mozkowski, a Merrill analyst who follows Goldman, wrote in a Feb. 22 research note.
Revenue pressure may also make universal banking companies pause before they buy a major prime brokerage. Hedge fund-related fee growth will probably not keep up with broader measures in the industry.
Mr. Hintz forecasts prime brokerage revenues to grow at 5% to 7% over the next five years.
Some banking executives are hesitant about entering the business, which observers say requires an annual investment of about $100 million for products and technology. JPMorgan Chase & Co. is still absent from equity prime brokerage.
In January, James Dimon, JPMorgan Chase's chief operating officer, said it is too late to build an equity prime brokerage from scratch.
It is "too hard to do," Mr. Dimon said. "You won't catch up."
