JPMorgan Chase & Co. has a deal that will bring it into a less-developed but potentially high-growth segment of the hedge fund servicing market.
The New York banking company's chief executive, James Dimon, has said in the past that it was too late for J.P. Morgan Chase to catch up to the established players in the prime brokerage marketplace - which has been the traditional entry point for large financial services providers catering to hedge fund clients.
Instead, it has adopted a narrower acquisition-driven strategy. In a deal announced Monday, the company said it would acquire the middle-office and back-office operations of the Greenwich, Conn., hedge fund shop Paloma Partners Management Co., the second in its targeted bid to buy its way into the business of servicing hedge funds.
The banking company plans to combine Paloma's daily processing operations with its own hedge fund administration unit, JPMorgan Tranaut, which it created after the October 2004 purchase of Tranaut Fund Administration Ltd. of Dublin., which offered back office capabilities. It has also announced a new business unit in that group, Alternative Investment Services, to support this market.
Servicing hedge funds and alternative investment firms is increasingly competitive, with margins tightening. Bear Stearns Cos., Morgan Stanley, and Goldman Sachs Group Inc. have long been tegh giants in the prime broker industry, and the barriers to entry for new players are high.
JPMorgan says its strategy is to focus on offering back office services, such as shareholder servicing, fund administration, and providing custody of the assets. The new niche, middle office, takes place between the time the trades are executed but before they settle, and includes reconciliation processing, investment accounting, and cash management.
The sale is to close March 1; the deal's price was not disclosed. Paloma has signed a multiyear contract to outsource to JPMorgan Chase the processing work it currently does for itself.
"We believe we are acquiring the optimum platform for hedge-fund services," said Liz Nolan, the global head of alternative investment services for JPMorgan Worldwide Securities Services, in an interview Monday. "Our aim in the marketplace is to be the provider of choice in the alternative investment market."
JPMorgan Chase will be competing against a handful of other hedge fund custodians for the middle-office market, including Bank of New York Co. and State Street Corp. of Boston, as well as other service providers, such as fund administrators and prime brokers that execute the trades.
Ms. Nolan, citing a January report from TowerGroup, said about 90% of hedge funds outsource their back-office operations but only 15% will outsource some or all of their middle-office functions by 2008.
TowerGroup, a market research unit of MasterCard International, said that hedge funds' assets under management could double, to $2 trillion, by 2008 or 2009. Providing middle-office services to the funds could earn $268 million in 2008, up from $71 million in 2005, TowerGroup said.
Matthew Nelson, an analyst in TowerGroup's investment management practice, said banks need to find ways to expand their services to hedge funds in the face of growing competition from other providers. This deal "positions JPMorgan nicely," he said.
JPMorgan Chase has a middle-office processing service aimed at traditional investment funds, but Ms. Nolan said it would have been a mistake to adapt that service to the aggressive trading habits of hedge funds.
"Supporting a long-only fund has different needs from supporting a hedge fund," Ms. Nolan said.
John T. Weisel, a global managing director at the consulting firm Accenture, predicted that hedge funds would increasingly consider outsourcing in response to growing regulatory pressure and thinning profit margins.
Though individual managers are likely to have widely divergent views of that question, Mr. Weisel said, "the outsourcing market for hedge funds is going to be pretty buoyant over the next couple of years."
