Q&A with BNP Paribas Prime Brokerage and Custody

Talbot Stark and Patrick Colle

Originally published in the July/August 2010 issue

BNP Paribas is a relatively recent entrant to prime brokerage. It took the plunge to make serving hedge funds a main business unit through the acquisition of Bank of America’s prime brokerage operation in 2008. Since then, the investment bank has used its substantial resources to build a prime brokerage platform that is seeking to challenge many of the established players. Its plan to develop a business underscores how the market in prime brokerage continues to evolve in new ways in the wake of the credit crisis.

Given BoA’s geographic focus on the domestic US market, it’s no surprise that BNP Paribas has focused closely on understanding that business and integrating it into the bank’s expanding global prime services offering. In doing this, it can draw on a global trading and execution capacity that extends across equities and derivatives, forex, commodities and credit. The footprint across America is a particular advantage for a European bank given the importance of the US market in terms of both managers and investors.

Underpinning the emerging global reach of the prime brokerage franchises is the ‘AA’ rated strength of the BNP Paribas balance sheet. This works like a battering ram for the investment bank’s foray into providing prime brokerage finance, global securities lending and capital introduction to a diverse group of 2,000-plus investors around the world. It also helps buttress the bank’s global reach as a custodian and administrator of hedge fund assets, an area where it has significant experience and is among the market leaders.

As the acquisition of BoA’s prime brokerage business has been bedded down, BNP Paribas has worked at building an increasing presence with top tier hedge funds and major institutional investors. It hosted a forum for US managers curious about UCITS funds in April, while in late June over 300 hedge funds and investors attended the investment bank’s marquee annual event in New York City.

Talbot Stark, Global Head of Relationship Management, leads two teams that focus on hedge fund relationship management and institutional relationship management. Based in London, Stark has 17 years of financial markets experience. Bill McIntosh, Editor of The Hedge Fund Journal, spoke to him and Patrick Colle, the recently appointed CEO of BNP Paribas Securities Services, about the firm’s integrated prime brokerage and custody offering. The following is an edited transcript of that conversation.

Q: BNP Paribas bought the Bank of American prime brokerage business in 2008. What did you get with that? And what have you done to build on it?

Talbot Stark: The acquisition was concluded in October 2008. What we acquired was primarily BoA’s domestic prime brokerage operations with locations in New York, Chicago, San Francisco and Dallas. International was very much at the development stage with an office in London. The capabilities of the prime brokerage platform were mostly targeted at long/short accounts and catered to domestic business. We have changed the focus slightly. We thought smaller funds would be better served by a firm focusing on that size of client so we settled on a threshold of approximately $100 million of AUM and sold the business servicing smaller funds to Jefferies & Co.

Now we are building out our international capabilities. When the crisis kicked in we benefited as a number of key hedge funds were looking to diversify their prime brokerage relationships. We are now servicing approximately 300 hedge funds across the global business. We also have a bespoke BNP Paribas prime brokerage platform that is tailored specifically to over-the-counter equity derivatives transactions. One of the key things we decided to do after the acquisition was to build from one common source the global prime brokerage platform. It is coming along and should be completed by the first quarter of 2011. The main focus of our business is equity, equity linked convertible bonds, as well as a mix of fixed income assets, including corporate bonds and high yield. We are largely focused on liquid products that it makes sense to finance in a portfolio.

Q: How would you characterise the progress you’ve made with the integration and build out that is ongoing?

Stark: First and foremost managing the personnel integration is the most critical thing. I think we’ve done well managing the key people in the acquisition. We’ve brought around 160 people to our New York office. Additionally, we’ve integrated the offices in Chicago, San Francisco and Dallas and we’ve consolidated the London office. From the banking side of the business there was something of a similar culture and this has helped to integrate service offerings to clients. We were conscious that it would be critical to ensure that integration would provide clients with a seamless offering and we have retained 95% of the clients that came from the acquisition absent the client business that was sold to Jefferies. Overall we are pleased. We have added some top tier clients and the international build out will really leverage our place in the market. We are positioned well for the medium term volatility that we see in the market.

Q: How do prime brokerage and custody operations function together and what do they offer hedge fund clients?

Patrick Colle: BNP Paribas’s complementary components of servicing hedge funds include the prime brokerage solution and the pure custody service of keeping unencumbered assets safe. But we also offer other solutions such as fund administration: both administration for single hedge funds and also funds of hedge funds. Going back to how we work together with prime brokerage what we often find ourselves doing is bringing both solutions together: prime brokerage combined with an asset protection structure leveraging our custody accounts where a fund might keep initial margin in combination with a multi-derivative entry. What we very much do is provide the combination of services that a hedge fund might want to access.

Q: Elaborate on this a bit and on what hedge funds have looked to spend money on in the last couple of years to develop their business infrastructure?

Colle: The big thing that has changed is the need to find additional solutions to protect hedge fund assets. That has created demand for asset protection structures. This has increased demand for custody in a bank environment as opposed to a brokerage environment so that a fund can keep its assets completely safe. It is a big trend. You could describe it as a world that has moved from a balanced relationship of a hedge fund to a prime broker to a tripartite relationship in many occasions involving the hedge fund, the prime broker and the custodial bank. BNP Paribas can bring all the sides together – prime brokerage, custody and financing – to the benefit of the hedge fund client.

Q: What is BNP Paribas bringing to the table that differentiates its offering from others? And whatadvantages for hedge funds are there in that?

Stark: Over the past two years since our acquisition of BoA’s prime brokerage business there has been a lot of turnover in personnel among prime brokerages. Underneath that there have been vast changes on the capital introduction side. From talking to a number of clients it seems we are pretty unique with maintaining our US footprint stretching beyond New York to Dallas, San Francisco and Chicago. Globally, the biggest allocators to hedge funds in 2010 have been the US institutional investors, particularly pension funds and endowments. We’ve really benefitted from having continuity in the long sale cycle in developing our relationship with investors like state pension plans or institutions on the west coast and other teacher pension funds across the US. I think our local knowledge with large allocators has benefitted hedge fund clients especially as large allocators have moved from funds of funds to investing directly with single managers. One of our unique competitive advantages is our ability to deliver the US across the country rather than having a New York-dominated prime brokerage business.

On diversification of highly regulated institutions, all the key players have learned their lesson. The focus now is on remaining a going concern. Firms with more than $1 billion of assets are quite cognisant that they need to have a mix of perhaps a US prime broker with one of the European banks to give access to regulatory and tax experience. And now there is a need for our ability to navigate the European regulatory landscape. It’s a strong differentiator. These are all things we are bringing to bear on our international build out as it continues.

Q: Regarding custody, how does BNP Paribas differentiate itself?

Colle: There are a number of things. Obviously our ‘AA’ credit rating is important when it comes to custody of assets and keeping assets safe. In addition to being number one in Europe in the custody business and number five world-wide, our model is that we are a global custodian operating locally in more than 20 countries, and it means we use our own bank. So we are able to protect assets for the large hedge funds throughout the safekeeping chain. The last thing is that we have a comprehensive securities service offering for hedge funds which is made up of three components: the pure custody component, then the asset protection component built around escrow-agent structures to ensure assets are kept separate, and third we also provide single hedge fund and fund of fund administration services from five locations around the world.

Q: What proportion of clients are using both prime brokerage and the custody offering? And what is the advantage to them of doubling the services they take?

Stark: Combining safe keeping of assets with the prime brokerage offering is something we are developing. Progress is going well and we are in a situation where things are in the works.

Colle: We are very much growing and developing the business on a client by client basis. It is very much a developing trend at the moment.

Q: I understand that this is at an early stage. What advantage do clients say they are getting from a combined offering?

Stark: One of the drivers is related to the dominant investors now. Who are they? They are the institutions and though it is stickIer money there is a longer lead-in. The ability of the bigger hedge funds to compete for this institutional money is very much becoming a process with consultants. You need to be able to respond to questionnaires with the same level of detail as your competitors – to specify how your assets are secured, the average credit rating of the prime brokers and of the custodian you are using. All these things are determining how successful hedge funds are in attracting money. Patrick can talk about some of our niche capabilities.

Colle: Our offering is really about one BNP Paribas team working together across prime brokerage and the custody side. It is about devising and providing solutions together for the benefit of our hedge fund clients.

Q: What are some of the new business trends in custody and prime brokerage that you are seeing?

Stark: One of the real significant wins in market share (obtained through the BoA acquisition) relates to the closed end fund sector. Closed end funds in the US pre-crisis funded themselves predominantly through an Auction Rate programme, but that came to an abrupt halt. A very good example of the innovation is combining the BNP Paribas structuring expertise with the experience of the BofA staff in the Chicago and Dallas offices working with their colleagues in New York. Traditionally fund groups have not been associated with a prime brokerage platform for financing. We continue to find some unique applications for this. Another thing we are looking at is a product for funds with fixed target return programmes, which may be looking for a soft downside protection of 80% of NAV with a historical look back. This is where we cut our teeth in the derivatives business in Europe. Now we are bringing those things to bear on the US business and using the BofA platform we acquired to deliver some of these innovative solutions to institutional clients. One big growth area is the convergence we are seeing between institutions and hedge funds. This started out with the closed ends funds but now with retirement funds on the institutional side. We are in conversations at a very senior level with their distribution side and they are also growing their alternatives exposure. There are a lot of exciting opportunities there.

Colle: On our side there a couple of important regulatory developments regarding collective investment vehicles and the AIFM Directive. Out of this there seem to be a lot of hedge funds looking at using a UCITS structure to clone some of their strategies. Another impact of the AIFM, even though the legislation isn’t passed, it looks like it is putting more onerous restrictions on the depositary banks in terms of the obligations for restitution of assets. This means it will be important for custodian banks to control assets as far down the line as possible at the level of the underlying countries. For us, because of local custodial model, it plays to our advantage as we do control the whole chain of assets both globally and locally. A trend is also developing with custodians considering whether they should start having their own local custody shops in different markets. These are two growing trends that are starting to emerge out of legislation that is not yet passed but is close to being finalised.

Q: How has the ‘AA’ credit rating helped BNP Paribas get market share in the prime brokerage and custody franchises?

Stark: For customers, not just limited to the CFOs in hedge funds, there is a focus now on the survivors. 2008 was a big wake-up call. I think that given our credit rating we are sought after. After that the bigger hedge funds want to ensure that they are properly diversified across at least three and up to five prime brokers. With the multi billion plus clients our rating has helped to open the door. They are after a combination of the product offering, the capital introduction and the connectivity of our firm across a wide spectrum of businesses. We are also expecting some exciting news soon about the developments of our equity cash business across the group. Hedge funds now want to pick groups with global capabilities and a solid credit rating – there are only two or three banks in this group – and that is why we are excited about our combined offering.

Q: How have hedge funds reacted to the changes in the risk profile in the eurozone in how they conduct their prime brokerage business?

Stark: First and foremost risk aversion is very high right now. As far as uncertainty, the correlation of financial markets everywhere is very high. Currently the spotlight is on Europe and the austerity measures. But if things get bad here it is going to affect the US. No one is in isolation. We are a large European player but with large businesses in Asia and the US we are quite diversified. I am not aware of any change in the prime brokerage operation because of the situation in Europe. There may be a little more clarity in the US but most savvy hedge funds want to have diversification among US and European prime brokers with probably one other prime broker.

Q: What is your view of what managed accounts offer European institutional investors?

Stark: The use of managed accounts is growing but perhaps not to the extent that might have been predicted a year ago. For each hedge fund it is really about what is the critical level to have a managed account facility. Typically managed accounts make operations much more complicated. Additionally there is a cannibalisation effect. Even for a fund of $2 billion the minimal threshold for a managed account is upwards of $100 or $200 million. Mangers are conscious of not wanting to provide special terms to cannibalise their flagship fund. For hedge funds there is a substantial cost with managed accounts and somebody has to pay that cost.

Q: Some people have commented that with regulation changing, managed accounts offer a way for institutional investors to continue to be able to invest off-shore. Do you see that occurring?

Stark: It depends on the level of the investment owing to the costs associated with managed accounts and what the fee structure is. Each hedge fund is going to make that decision. But the allocation is going to have to be pretty meaningful.

Q: Turning to UCITS funds, what does the growth in the number of funds and assets signify?

Stark: UCITS funds are up to $100 billion now. It is a product particular to the market conditions in 2010. Some investors think that in the current environment they can simply exit the hedge fund structure and move into a UCITS product with a similar profile of return but much better liquidity. In a snapshot that’s true. But most people know given the rules and liquidity terms of UCITS that they are highly unlikely to be able to generate the returns in the long-term that hedge funds do. It is kind of ironic that some of the top managers have found on the UCITS side that it is quite a challenge to raise assets. UCITS is clearly growing but it adds another level of complexity to hedge funds. I think some managers are thinking harder about providing both types of funds and may decide to stick their knitting (with an offshore fund), while others may decide to do purely UCITS.

Q: What are the opportunities and pitfalls for managers of UCITS?

Stark: Is there a growing appetite? Does UCITS service a different investor? Absolutely. That is the allure of it. But the marketing of UCITS is quite different and it tends to be a very different client base. That is something that wasn’t quite appreciated when some managers launched funds. We will see where the money flows when hedge fund performance starts to return. If it does, then we’ll see how sticky the UCITS money turns out to be.

Q: How would you characterise the different client bases of offshore and UCITS funds?

Colle: Pension funds, particularly in Europe, may find a UCITS structure more appealing due to its high level of regulation. It is more generally the case in Europe.

Q: Is there any view among US managers that they will use UCITS to attract capital from European investors?

Stark: We’ve been working with several clients in the US on this. UCITS is a bit of a learning curve and there is a role for us to serve there. There is a lot of appetite and interest. The global hedge funds are well developed. The ones with solely a US platform are quite curious to find out what is required to develop a UCITS product and market it. There is an education and incubation process required.

Q: How would you rate the importance of UCITS in the overall cap intro business that BNP Paribas is running?

Stark: I think it is an emerging story. There isn’t a significant percentage of our clients on the prime brokerage platform who have set up a UCITS fund. Largely because many are mainly domestic with a large domestic investor base so UCITS is a slightly different commitment. Some firms aren’t keen to do it right now mainly because of cannibalisation concerns.

Q: How would you compare cap intro in 2009 with 2010? And how do you see it developing in the next few quarters?

Stark: In 2009-2010 we have continued to build the team and we haven’t suffered from significant turnover. We are looking to add some professionals in Europe and Asia to complement our very strong US cap intro position. There is dramatic change in the fund of fund appetite compared with institutions. That’s helped us because we have a much stronger competitive advantage on the institutional side in terms of the cap intro focus. Feed back I received from a couple of hedge funds is that the speed dating service is of limited value. Now it is much more about knowing your client and giving them the right screening process. I think almost all of our competitors have had major changes on the cap intro side, but we’ve been pretty steady and consistent.