The hedge fund industry's growth is intensifying competition among banks and brokers to provide the funds with processing and record-keeping services, as well as more profitable products, such as loans and derivatives.
Morgan Stanley, Goldman, Sachs & Co., and Bear Stearns Cos. still dominate the market for hedge fund services. But many rivals, including several large banking companies, are challenging them by adding services, stepping up marketing, and raiding their bigger competitors for talent.
A higher pro- file in the business could be a double-edged sword for bank-run prime brokers. As federal regulators consider tighter regulation of hedge funds as part of their ongoing investigations into the mutual fund industry, and as disgruntled fund investors file lawsuits, banks could find themselves in an unwanted spotlight, too.
Prime brokerage - or hedge fund servicing, as it is known outside the United States - is a range of functions that broker-dealers handle for hedge funds. Fees vary according to a fund's size and the services it uses. Those services can include trade clearing, settlement, and reporting; supplying office space, financial management, and other administrative support; stock loans for short selling; margin lending; and other types of financing.
The business can be highly profitable, experts say. Hedge funds tend to trade more often than other big investors, such as pension or mutual funds, so they offer a steady stream of trading commissions and other fees.
But those services are becoming a commodity. The biggest attraction for commercial banks may be the emergence of hedge funds as customers for the most sophisticated corporate banking and risk management products. In fact, some argue that demand for bigger, more sophisticated financing may give global commercial banks an advantage over traditional brokers.
"The banks have a competitive edge," said James Rowen, the global head of equity prime services for Deutsche Bank AG. Hedge fund strategies continue to evolve in complexity, requiring sophisticated financing and other nontraditional services "that banks such as Deutsche Bank have been dealing with for years."
A Growing Industry
Hedge fund assets have ballooned more than 70% worldwide since 1999, to $820 billion, as investors have sought higher and more consistent returns, according to Van Hedge Fund Advisors International Inc., a Nashville investment and research firm. The funds use variety of strategies, from long/short equity investing to arbitrage to betting on global economic and political shifts.
At yearend there were 4,875 hedge funds in the United States, up 14.7% from 2000, and another 3,225 elsewhere, up 43.3% from 2000, Van estimates.
And after several years of consolidation, the number of companies providing services to hedge funds appears to be growing again, though exact figures are elusive. Industry surveys typically list about 15 major players worldwide, with Goldman, Morgan Stanley, and Bear Stearns at the top of the list.
Robert S. Sloan, a managing partner of S3 Asset Management LLC, a New York hedge fund management firm, estimates that collectively the 15 largest global prime brokerages collect about $7 billion of fees a year. About seven of the brokerages can be called truly global, he said.
In addition to Morgan Stanley, Goldman, and Bear Stearns, Deutsche also is a major competitor and probably the largest global commercial banking company in the field. Others vying for a share of the business are Credit Suisse First Boston Corp. (where Mr. Sloan once ran the prime brokerage), Barclays Capital, Lehman Brothers, ABN Amro, Merrill Lynch & Co., Citigroup Inc., UBS AG, and Bank of America Corp.
Meanwhile, new entrants are continuing to emerge, often initially to pursue a niche strategy. Royal Bank of Canada announced this month that it has started a U.S. prime brokerage in New York. Peter Sanchez, Royal Bank's head of hedge fund services, worked for NatWest Capital Markets before joining Royal Bank 15 months ago.
Gordon Nixon, Royal Bank's chief executive, said it entered the business because it is a "high-margin, fee-based business."
Experts warn that the costs of building a competitive prime brokerage can be high and that some newer players may have difficulty catching up.
"Getting a new prime brokerage up and running is extremely expensive," since a prime broker cannot develop complex financing and risk management tools overnight, Mr. Rowen said.
That expense may help explain why a few major banking companies have avoided the field. J.P. Morgan Chase & Co. is not in the business, nor are two of the largest processing banks - Bank of New York Co. and State Street Corp. - even though these three companies offer services a prime broker would offer, including processing.
David Spina, State Street's chairman and chief executive, said it has eyed the business, but the size of the task has kept it on the sidelines. "We have looked over the edge, but we do not have any plans to get into that business right now," he said in an interview following State Street's first-quarter earnings report.
Still, experts say there may be enough business for newcomers and existing players, depending on which market segment they target.
"I think there's enough business to go around, because the hedge fund industry is booming," said Elizabeth Rowe, a senior consultant with New York financial services research firm Find/SVP Inc. "My sense is that among the larger banks, they are trying to expand their product suites to serve their existing customers."
Among hedge fund service providers, competition now goes far beyond clearing and settlement to banking products and services.
"If you want to compete for the biggest platforms and provide those services, what business is that? That's your derivatives business. That's your research business, your full equities platform," Mr. Sloan said.
Often, an effort by banks to provide prime brokerage has emerged from or is closely tied to banking services they offer. Deutsche's business is a case in point. Many prime brokers grew out of securities lending or processing businesses, but Deutsche's unit evolved from a previous derivatives business.
Mr. Rowen says banks, because of their credit ratings and large balance sheets, are more capable than some traditional brokers of creating alternative forms of financing to better match hedge fund strategies.
As hedge funds "start to demand something other than short-term liquidity, then the traditional broker-dealer community is having issues with providing flexible liquidity terms as well as longer-term financing," he said.
Legal Pitfalls
And new risks are emerging, for both new entrants and established players.
Hedge funds have played a role in the mutual fund trading scandals since last fall; they have been accused of using mutual funds and bank trading operations to conduct improper or possibly illegal trades. William H. Donaldson, the chairman of the Securities and Exchange Commission, has made no secret of his desire to impose tighter controls on hedge funds.
The SEC has yet to act, and Mr. Donaldson's views are not unanimous among policymakers. But in recent testimony before the Senate Banking Committee, he complained that the SEC "is limited in its ability to gather information that could help protect millions of investors" under current rules. "I fundamentally believe that the commission has a legitimate interest in obtaining the information, and imposing appropriate record keeping and other regulatory requirements, if needed, to protect investors."
One suggested change would require hedge funds to register as investment advisers; about half already do so. But even without that change, regulators' interest could take them into hedge funds' back offices, and on to the turf of prime brokers. Because prime brokers already are regulated as broker-dealers, they may be asked to feed information to regulators about hedge funds' trading practices.
That means prime brokers will have to tread lightly and make sure they are on top of their game and "prudent" in their monitoring practices, said a prime brokerage executive, who did not want to be named. The increasing scrutiny "probably will put a little more onus on the prime brokerage industry to provide more data to regulators," he said.
James Spellman, a spokesman for the Securities Industry Association, said the industry is not opposed to regulation, in principle.
But regulation may not be the only risk. Lawsuits are another, and they could more damaging, according to bankers. Clients seeking to recover lost investments may target not only funds, but the "deep pockets" associated with them, such as bank-owned prime-brokers.
One noteworthy case making its way through the courts involves Banc of America Prime Brokerage, a division of Banc of America Securities. Industry executives and analysts are watching the suit closely as a possible precedent.
Banc of America Prime Brokerage, a unit of the nation's second-largest banking company, was the prime broker to Lancer Management Group LLC, a hedge fund family the SEC shut down last summer for allegedly defrauding investors of $570 million. A group of former Lancer clients, including institutional investors and pension funds, sued Banc of America Securities, as well as Lancer's auditor, PricewaterhouseCoopers LLP, and the funds' administrator, seeking to recover their money.
The suit, filed in the U.S. District Court for the Southern District of Florida in February, alleges that the B of A unit and Lancer's other service providers helped Michael Lauer, Lancer's chief, misprice his portfolios to drive up fees.
Shirley Norton, B of A's spokeswoman on legal matters, said it has yet to file a response to the suit but believes "it is without merit." The Charlotte banking company believes "there is a lot of confusion" among investors over the role a prime broker plays in a hedge fund, she said. "We are a prime brokerage. We are not involved with customers. We provide custodial services to the hedge funds."
Ms. Rowe of Find/SVP said the hedge fund services industry is watching the suit closely.
"People will sue where they think the money is," she said. "We're all waiting to see if the courts will draw a line" that says "the bank, by fulfilling its obligations, is going to be held blameless."
