FinancialAdvisor's College Class (FACC)

[FinancialAdvisor]

Hedge Fund Services May Bring Wall Street Record $7.5 Billion

Hedge Fund Services May Bring Wall Street Record $7.5 Billion

Nov. 14 (Bloomberg) -- Hedge funds will pay Wall Street record fees this year for brokerage services, a business dominated by Morgan Stanley, Bear Stearns Cos. and Goldman Sachs Group Inc.

The securities industry's annual revenue from lending shares and cash, clearing and settling trades, and providing risk-analysis software to hedge fund managers will rise to $7.5 billion, up 32 percent from 2003, Sanford C. Bernstein & Co. analyst Brad Hintz estimates. So-called prime brokerage has become the fastest-growing source of income from trading clients as institutions ranging from the University of Texas to the Virginia Retirement System increasingly diversify their investing with hedge funds.

Morgan Stanley, the No. 3 securities firm by market value, Goldman, the second biggest, and Bear Stearns, the fifth largest, have a hammerlock on hedge fund services after spending more than $200 million a year on trading systems, offering more stock for short sales and courting former employees who left to start their own hedge funds. Only providing mergers and acquisitions advice generates higher profit margins for securities firms, said Robert Sloan, 42, who ran Credit Suisse First Boston's prime brokerage unit for six years until 2002.

``One of the costs of making money is the fees that are charged by prime brokers,'' said Steven Persky, co-founder and managing partner of Dalton Investments LLC, a Los Angeles-based hedge fund with $1.1 billion in assets. ``There's not a ton of transparency in pricing and they don't go out of their way to highlight how much money they're making.''

Rising Fees

Prime-brokerage fees may increase by almost a third to $9.9 billion in 2009, Hintz estimates. A survey by Tremont Capital Management Inc., an industry consulting firm in Rye, New York, shows that New York-based Morgan Stanley, Bear Stearns and Goldman are preferred by 60 percent of hedge fund managers.

Dalton Investments uses Morgan Stanley for two Asia funds with $59 million in assets because of the firm's prowess in the international markets, Persky, 47, said. Bear Stearns, which he says is ``very, very strong in fixed income,'' is Dalton's prime broker for a $367 million fund that invests in the debts of troubled companies.

Goldman's access to securities that can be borrowed to bet on declining stock prices makes it a logical choice for $86 million in two global equity funds, Persky said.

The $7.5 billion in fees that Hintz estimates for this year would make prime brokerage an even bigger business for U.S. securities firms than stock underwriting. Wall Street gets the largest share of revenue from trading, which generates about $43 billion in commissions and gains from proprietary investments.

Dominant Three

Morgan Stanley, among the first securities firms to create a prime brokerage in the 1980s, remains the No. 1 choice for 22 percent of hedge funds, according to Tremont's survey. Hintz said it probably reaped $2 billion in prime-brokerage fees last year.

``In the early days of this business, we focused on building a scalable model and partnering with our colleagues in operations and technology,'' said Richard Portogallo, 46, who heads Morgan Stanley's prime brokerage unit and oversees a staff of 550. ``That created a real advantage for us that we're still capitalizing on today, because the barriers to entry are still very difficult.''

Bear Stearns is second at 21 percent and Goldman Sachs is picked by 17 percent of hedge funds. The combined share of the three firms has dropped by just 1 percentage point since 2003, Tremont reported. UBS AG, Europe's biggest bank, and Merrill Lynch & Co. are struggling to close the gap three years after making prime brokerage a priority.

Soros, Robertson

``There are three guys that absolutely dominate that business,'' said Gerald Hassell, 54, president of Bank of New York Co., the biggest handler of trades for independent brokerage firms. ``Numerous people have tried and failed to crack that.''

A decade ago, Wall Street salespeople paid comparatively little heed to hedge fund managers such as George Soros, 75, Michael Steinhardt, 64, or Julian Robertson, 73. Investment banking was the fastest-growing business as the highest stock- market returns in 20 years and low bond yields spurred a boom in equity sales and mergers.

Pension funds, endowments, foundations and other institutional investors account for almost 40 percent of net new flows into hedge funds, compared with less than 5 percent in 2000, according to consultants at Casey, Quirk & Associates in Darien, Connecticut.

`Future Retirees'

The University of Texas System has a quarter of its $9.5 billion Permanent University Fund in hedge funds. The California Public Employees' Retirement System in Sacramento, the largest U.S. public pension fund, has $1.2 billion invested.

``Institutions need cash to meet their obligations to future retirees, and hedge funds are a way for them to get a better return,'' said Patrick Egan, president and chief investment officer of Philadelphia-based Attalus Capital, which has $1 billion in hedge funds on behalf of clients.

Since 1990, hedge fund assets have soared to about $1.1 trillion from $40 billion, according to Chicago-based Hedge Fund Research Inc. Hedge fund returns averaged 12 percent a year in the past decade, exceeding the 9.5 percent gain of the Standard & Poor's 500 Index.

The search for novel ways to make money led Ken Griffin, who runs Citadel Investment Group LLC, a $12.3 billion Chicago- based hedge fund, to start trading natural gas and power in 2001, adding to an array of investments that includes stocks, convertible bonds and the euro.

Shorting Delta

Most of the largest hedge funds, including David Shaw's $19.3 billion New York-based D.E. Shaw & Co. and Bruce Kovner's $12.3 billion Caxton Associates LLC, also based in New York, buy and sell stocks, bonds, currencies and commodities worldwide.

The variety and frequency of hedge fund trades translates into a bonanza for Wall Street. While hedge funds have only one- eighth as much in assets as mutual funds, they account for 40 percent to 50 percent of the daily trading by value on the New York and London stock exchanges, 70 percent of all convertible- bond trading, and 20 percent to 30 percent of all trading in credit-default swaps, a type of debt insurance, according to a report published in March by Credit Suisse First Boston.

Most mutual fund managers, by contrast, are restricted from engaging in short sales and hold onto their stocks and bonds for months or years.

The interest rates that prime brokers charge to lend stocks, typically 0.5 percent, can escalate from for shares that are in high demand.

`Profits Are Huge'

Persky, the Los Angeles hedge fund manager, said he shorted Delta Air Lines Inc. shares in the months before the company filed for bankruptcy protection on Sept. 14. At the time, borrowing the shares from Bear Stearns cost the equivalent of about 10 percent a year in interest, or almost double the prime rate available from commercial banks at the time.

``The profits are huge because the prime brokers haven't committed any of their own capital,'' said Adam Reed, a finance professor at the University of North Carolina's Kenan-Flagler Business School in Chapel Hill. ``It's the short seller's or the hedge fund's capital that is invested.''

Because there are no publicly quoted rates for services such as stock loans, hedge funds are at the mercy of their prime brokers for pricing. As a result, the pretax profit margin for prime brokers is 40 percent to 50 percent, said Sloan, the former CSFB executive, who's now a managing partner at S3 Partners, a New York-based firm that provides financing services to hedge funds.

Delta Bet

Brokers have ``historically made an enormous amount of money from lending securities and money,'' said Steinhardt, an industry pioneer who closed his hedge fund in 1995 after 28 years in the business.

Persky's Delta bet has returned 84 percent so far because the stock has tumbled to about 65 cents from $4. He said he doesn't ``begrudge'' prime brokers the rates they charge because both parties are trying to ``maximize their profitability.''

Morgan Stanley has maintained its top ranking in part because of client loyalty. The firm was the prime broker to Robertson's Tiger Management, the world's biggest hedge fund in 1998. It's still favored by ex-Tiger employees, the ``Tiger Cubs,'' who now manage hedge funds of their own, Sloan said.

Goldman started its prime brokerage in the early 1990s. Many of the firm's hedge fund clients are former Goldman traders and executives, including Peloton Partners LLP's Ron Beller, 43, and Eton Park Capital Management LP founder Eric Mindich, 38.

``If you're a hedge fund and your prime broker is Goldman or Morgan Stanley, there's a comfort level with potential investors,'' said Denise Valentine, a New York-based analyst with financial-services consulting firm Celent Communications.

ABN Amro Takeover

Zurich-based UBS made a push into prime brokerage in 2003 when it acquired ABN Amro Holding NV's U.S. unit catering to hedge funds for $250 million. The takeover added 160 employees and about 300 hedge fund clients. Before the purchase, UBS had a prime-brokerage staff of 165 and served about 200 hedge funds.

That same year, the bank hired Alexander Ehrlich, a 20-year Goldman veteran, to run prime brokerage. Ehrlich, 46, has since added 100 traders and salespeople, and 200 technology specialists and consultants for a total staff of more than 600, according to a UBS presentation to investors in Stamford, Connecticut, in May.

UBS gained ground to become the favored prime broker for 7.1 percent of hedge funds, up from 5.9 percent two years ago. Merrill's standing slipped to 4 percent from 4.6 percent, according to Tremont, which got survey responses from hedge funds with total assets of $449 billion.

Tremont says the rankings aren't foolproof because they count only one prime broker per fund and most hedge funds with at least $100 million under management use at least three.

Merrill's Ambition

Merrill declared prime brokerage one its top seven priorities in 2002, the same year E. Stanley O'Neal, 54, took over as the New York-based firm's chief executive officer.

Like UBS, Merrill, the biggest U.S. securities firm by market value, raided the market leaders to staff its prime brokerage. Last year, it appointed 14-year Morgan Stanley veteran Peter Donovan to be co-head of global equity financing sales with Howard Blechman, 67. Blechman left last year. The firm also hired Morgan Stanley's David Barrett, 46, who helps raise money for hedge funds.

Paul Galietto, 49, who oversees Merrill's prime brokerage as head of global equity financing and services, said the firm is the second or third broker to some of the largest firms, so its true market share is larger than the Tremont survey shows.

``We are very comfortable with the success we've had in the last two to three years, and we will continue to make further progress,'' he said.

Bank of America

Charlotte, North Carolina-based Bank of America Corp., the second-largest U.S. bank, is the lead prime broker to 2 percent of hedge funds, according to Tremont. Christopher Pesce, 39, a former Goldman executive who joined in 2002, said Bank of America's share of prime-brokerage revenue is closer to 12 percent to 15 percent and rising as hedge funds seek bigger loans.

Greenwich Associates, a consulting firm in Greenwich, Connecticut, estimates that hedge funds using three prime brokers allocate 67 percent of their balances to their first choice, 23 percent to the second and 10 percent to the third.

To stay ahead, Morgan Stanley and Goldman each spend about $100 million a year on technology for hedge fund services, Hintz estimates.

``The incumbents' investment in their platforms established an early-mover status,'' said Philip Vasan, New York-based global head of prime services at CSFB, the securities unit of Credit Suisse Group of Zurich.

`Too Late'

CSFB has about 5 percent of the prime-brokerage market, up from 2.2 percent in 2003, according to Tremont. Instead of trying to dislodge the top three firms, Vasan, 46, said CSFB is targeting new hedge funds and managers with more complicated trading strategies that require specialized service.

``We're more interested in the incremental business,'' Vasan said.

JPMorgan Chase & Co. President James Dimon, 49, doesn't see the point of even trying to compete with the likes of Morgan Stanley or Goldman in prime brokerage for stock trades. It's ``just too late,'' he said on a January conference call. Instead, New York-based JPMorgan, the third-largest U.S. bank, is trying to serve hedge funds in debt trading, a business where it's strong.

Meantime, Morgan Stanley CEO John Mack, 60, is setting his sights even higher. He said on an Aug. 18 conference call that prime brokerage is ``one of our really good businesses,'' and the firm may ``beef up the investment, as we did 15 years ago when we started it and got such a lead on the market.''

``It's the perfect environment to make money,'' Sloan said. ``If you're not making money now, you never will.''

To contact the reporter on this story:
Bradley Keoun in New York at [e-mail];
Katherine Burton in New York at [e-mail].


LINK: http://quote.bloomberg.com/apps/news?pid=10000006&sid=a56XbYWIbxA4&refer=home