According to most sources the hedge fund industry has now surpassed the $1 trillion mark and is still growing at a very healthy rate. Hedge fund service providers are increasingly focused on gaining more of this lucrative market, recently estimated in a CSFB study to have generated over $25bn in revenues for investment banks in 2004, $6bn of which can directly be attributed to prime brokerage fees.
This growth, coupled with the increasing sophistication of the hedge fund industry, has led to consolidation amongst service providers, particularly in the fund administration sector. Many smaller players are desperate to increase their market share, and many more are eager to get into the hedge fund servicing game. Most banks are concentrating considerable resources building up the ability to service the alternative fund industry in some way, even if the majority are well behind the market leaders (Goldman Sachs, Morgan Stanley and Bear Stearns) in the prime brokerage sector. Only one bank, JP Morgan, has publicly stated that they believe they are already too late out of the starting gates to be able to mount a serious challenge to the main players
There is no set formula or model for service providers in the hedge fund space, and increasingly we are seeing the lines between the service providers' business models becoming increasingly blurred.
The hedge fund marketplace dictates that being competitive means having the scale and resources to develop and support an expanding range of services cost effectively. Looking at the alternative administration space, a number of traditional administration firms have moved into the hedge fund space through acquisition of specialist hedge fund administrators. The Bank of New York has purchased International Fund Administration, State Street has purchased International Fund Services, BISYS has acquired Hemisphere, HSBC acquired Bank of Bermuda, Mellon has purchased DPM and Northern Trust recently purchased ING's Barings Fund Services.
All of these ventures have been driven by the wish to create synergies and competitive product offerings. The same is also true of prime brokers who have either set up or bought administration companies. JPMorgan has acquired Tranaut Fund Administration and both Morgan Stanley and UBS, following the example of Goldman Sachs, have hedge fund administration arms now.
As the alternative space becomes increasingly crowded and the pursuit for absolute return becomes ever more complex, prime brokers have had to be flexible and innovative and adapt to the growing demands of theirfunds. There has been a clear move from what can be considered the traditional prime broking areas such as equity long/short and convertible arbitrage managers to emerging markets, FX and multi-strategy funds and the emergence of what could be called multi-asset class prime brokerage. Each prime broker will differ in terms of their product offering and functionality and will have a certain area which attracts a certain type of hedge fund but none wants to preclude themselves from winning business of any type.
Traditionally prime brokers' core business has focused on execution, clearing, settlement and custody as well as the higher margin business of financing and securities lending. However, some prime brokers are now offering a growing list of additional services, such as, portfolio risk evaluation, aggregated reporting, advanced cross margining systems, start up assistance, office set-ups, capital introduction and more.
Fund administration is central to the operation of a fund in terms of gathering all the fund's data, reconciling positions and holdings, communicating with shareholders, and calculating the fund's net asset value. Administrators are also better positioned to offer middle-office and risk management functions than prime brokers. Some fund administration organisations have broken away from the task of just producing net asset value calculations and are now increasingly offering technology and middle office risk management services. Recently we have seen HSBC/Bank of Bermuda take over Gartmore's middle office team and package the service within their fund administration business.
The ability to bundle product offerings can be very competitive in the marketplace. This consolidation is a testament to the fact that demands from hedge fund managers for service quality and depth in service provision are increasing whilst at the same time margins are tightening in the sector. There are certainly synergies with the in-house prime brokerage and fund administration businesses. So what benefit to the hedge fund community is this consolidation between prime broker and administrator, after all, they provide very different services?
The provision of hedge fund start up services is one area where prime brokers generally excel. Many will offer capital introduction and office space to start ups as well as traditional prime brokerage services. Administrators can offer different services such as providing new business teams to aid the start up. As well as gaining from the combined experience of the prime broker and administrator the hedge fund can gain with the co-ordinated effort of one counterparty. A prime broker with an administrator can also price both services in the context of the overall business. For example, the administration function can be priced relatively low, as the traditional prime brokerage services are high margin and will compensate for aggressive pricing in other areas. This is good news for any prospective start up, where business costs in the first year can heavily influence the performance/track record of the fund and ultimately the ability of the fund to survive.
Access to hedge fund clients is fundamental to the success of any service provider. The cross selling opportunities amongst the combined client base can be quite lucrative, especially for the prime broker. It is advantageous for the organisation to appoint a relationship manager that can handle the administration and prime broker relationship as well as manage cross- selling opportunities. Advancements in product offerings from prime brokers or administrators can be cross-sold to a bigger client base.
Numbers of funds of hedge funds (FoHF) have been increasing at an astonishing rate and their growth, especially in terms of institutional money invested in them, is set to continue. This space has become lucrative not only for administrators but also for financing banks, some of whom are prime brokers. The provision of leverage finance and/or different structured products to FoHF is a focus area for some investment banks, looking to enhance traditional financing revenues. More and more banks are entering the FoHF leverage business, and as the market matures we will begin to see more product innovation – such as structured products – combined with the erosion of spreads.
There are differing opinions on whether or not the recent pace of consolidation will continue. It also remains to be seen if all the recent purchases will create the expected synergies for its buyers – and enough benefits for their clients! Consolidating an administration office into a traditional prime broker might not prove to be easy for some. The other way around, it might prove not be as simple to integrate banking services in a traditional administration environment. Anyway, the evolving nature of the alternative investment industry dictates that prime brokers and administrators alike continually need to redefine their product offering. This is certainly good news for hedge funds and funds of funds who will benefit from competitive pricing and access to one counterparty for their fund servicing needs.