2006 Alpha Awards - Top Prime Brokers

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Last November, Morgan Stanley promoted Richard Portogallo to global head of equity financing services, with joint responsibilities for prime brokerage and U.S. equities. Portogallo has spent 20 years with Morgan Stanley, most of it serving hedge funds as head of the firm’s market-leading prime brokerage unit in New York. His ascent within the firm signifies how important this onetime backwater business has become for investment banking firms like Morgan Stanley.

“Prime brokerage is not just about equities anymore,” says Portogallo, who was one of the very first employees hired into Morgan Stanley’s prime brokerage group. “Our fixed-income division benefits. Equities benefits. The firm and our clients all benefit from having a strong prime brokerage franchise.”

The strength of Morgan Stanley’s prime brokerage franchise is evident in the 2006 Alpha Awardsª. For a second year in a row, Portogallo’s firm takes the overall top prize. This time, however, the voting was very close. Morgan Stanley narrowly beats out second-place finisher — and longtime rival — Goldman, Sachs & Co. The competition was especially intense among the top five firms. Goldman moves up one spot from last year’s finish, while Credit Suisse, No. 2 in 2005, falls to fifth place, right behind Banc of America Securities and UBS.

Morgan Stanley and Goldman have long dominated prime brokerage. Between them they accounted for about half the securities industry’s $5.5 billion in prime brokerage and related net revenue in 2005, according to estimates by Sanford C. Bernstein & Co. senior analyst Brad Hintz. Their ability to retain market share despite an onslaught from increasingly hungry competitors keen to lure away clients and talent is a reflection of the depth of their benches and the power of their brands. For a new manager starting a hedge fund, having the imprimatur of Goldman Sachs or Morgan Stanley as prime broker can help attract assets.

At Morgan Stanley management responsibility for prime brokerage is split among regional business heads: Patrick Mortimer in the U.S.; Warren Holmes and Jack Inglis in Europe and Kurt Baker in Asia. All four report directly to Portogallo and are part of an 11-person operating committee that holds weekly conference calls and meets more formally once a quarter to discuss strategy.

Clients like the results. Morgan Stanley ranks first in four of the eight different aspects of service categories used to determine the overall prime brokerage winner — business consulting, capital introduction, client service and financing. (Algorithmic trading was not used in the calculation because it is already included as part of the trade execution and trading technology scoring category.)

Morgan Stanley shines in client service — not surprising since that’s what nearly half of the 500 or so people in prime brokerage were hired exclusively to do. Even Portogallo and the regional heads get in on the act. “I’ve been dealing with clients for 20 years,” says Mortimer, who still personally handles some key accounts.

Goldman receives praise for its client service too, finishing third in that scoring category behind Morgan Stanley and BofA Securities. Goldman relies on two global heads, Mitchell Lieberman and Ravi Singh, and regional executives to keep the business tapped into the bank’s central nervous system.

Goldman tops Morgan Stanley in three scoring categories — securities lending, trade execution and trading technology, and algorithmic trading. Goldman owes much of its success in trading to the firm’s 2000 acquisition of broker Spear, Leeds & Kellogg and its Rediplus electronic trading system, which is used by many of the firm’s prime brokerage clients. “We have a very strong platform, with a very strong regional presence in Asia, Europe and the U.S.,” says Lieberman. “We are totally integrated.”

Total integration — that is, the ability to trade seamlessly in all markets all the time — is important both for clients and for their prime brokers. It helps firms like Goldman capture the business of multistrategy hedge funds, which tend to trade more actively and generate more revenue than traditional long-short funds.

Technology is one area in which the up-and-coming prime brokers say they have an edge over their more established rivals — and few speak with more conviction than Banc of America. In January, BofA launched its new liquid-products prime brokerage platform, which handles interest rate derivatives, Treasury products and futures. Christopher Pesce, who joined BofA from Goldman in 2002 to expand its prime brokerage operations beyond equities, says the bank was able to get its new platform up quickly because it didn’t have to design around an existing technology.

“We aren’t saddled with legacy systems, so we were able to recruit people from other firms, avoid problems and grow our platform with new technology that is now available in the marketplace,” says Pesce, the New York–based global head of prime brokerage. The firms that pioneered prime brokerage operations 20 years ago — Goldman, Morgan Stanley and Bear, Stearns & Co. — have to build around existing, more antiquated systems, he adds.

BofA’s rapid growth in prime brokerage — the firm had 190 people in prime brokerage when Pesce joined; today it has 450 — is reflected in this year’s results. The bank jumps two places to No. 3 overall and ranks first among clients in both operations and reporting and reporting technology.

Pesce reckons BofA can do even better. Unlike his former employer Goldman, which makes much of its money from proprietary trading, BofA bases its business largely on financing and lending. “The balance sheet and capital that the bank has are second to none,” Pesce says of BofA’s lending capabilities. “Now we have a full product suite, we expect to continue gaining market share.”

To do that, BofA will need to expand its international footprint, as more hedge funds are looking to trade globally. Prime brokers that cannot provide access to non-U.S. markets are at a disadvantage, says Ron Suber, president of Chicago-based Spectrum Global Fund Administration. “Brazil, Russia, India, China, Asia and Europe — you’ve got to be there because that is where the hedge funds are going to go for alpha and opportunity,” explains Suber, who was head of Bear Stearns’ prime brokerage sales before joining Spectrum in the spring. Clients say one of the reasons Suber’s old firm falls in the Alpha Awards this year is that the New York–based investment bank is not sufficiently global to keep up with hedge funds’ demands.

UBS, Credit Suisse and Deutsche Bank finish in a tight pack. The three big European banks have been making a push to gain market share. At UBS, global head of prime services Alex Ehrlich has been busy adding people and services since he left Goldman to join the Swiss bank in New York three-plus years ago. “It became clear that the effort to create one of the world’s leading prime brokerage businesses was going to cost hundreds of millions of dollars, require hundreds of people and take years,” says Ehrlich, whose firm is starting to see the fruits of his labor. UBS moves up one place, to No. 4.

Credit Suisse’s slide to No. 5 this year is a reflection of just how competitive the prime brokerage field has become. Credit Suisse is still gaining traction. It scored a major coup earlier in the year when it was hired as lead prime broker for New York–based Old Lane Management, a $3.5 billon hedge fund firm formed by a group of high-profile former Morgan Stanley executives.

Unlike some of its rivals, Credit Suisse has taken a very targeted approach to prime brokerage. “We are a high-touch prime broker with a relatively low ratio of clients to representatives who service them,” says Philip Vasan, global head of prime services with Credit Suisse in New York. “This comes by maintaining a deliberately handpicked client base.” In contrast to Morgan Stanley and Goldman, each of which has upwards of 700 hedge fund clients, Credit Suisse says it has chosen to service just 400 managers.

Deutsche Bank is also moving up in the eyes of its clients — and in the rankings. The big German bank has been extremely active in building up its prime brokerage business, hiring 40 people this year alone, including several senior executives. It places No. 6 overall in this year’s Alpha Awards, rising one place from 2005.

Known for its expertise in credit derivatives, swaps and other synthetic securities, Deutsche is launching a fixed-income prime brokerage business. It recently hired Mel Gunewardena from Goldman to run it. The bank has also been expanding its geographic range to countries such as Pakistan and other Asian emerging markets, says Mark Haas, the firm’s global head of prime brokerage.

Even firms that finish lower down in the ranking are showing strength. New York–based investment bank Lehman Brothers is plowing more resources into prime brokerage. Two years ago, Lehman combined its equity and fixed-income prime brokerage groups — and it is benefiting from hedge funds’ increasing enthusiasm for bonds, where the firm is known to have a strong franchise. Lehman ranks in the top five in four categories — algorithmic trading, financing, securities lending, and trade execution and trading technology. It wins algorithmic trading, which has become an important product offering for most prime brokers.

Even Merrill Lynch, No. 10 overall among prime brokers in our survey, may finally be starting to live up to its potential after several false starts the past few years. The bank has been building its prime brokerage resources. Last year it hired Jeffrey Penney from Morgan Stanley to build its equity derivatives; this year he was given responsibility for global financing, including prime brokerage. Clients say the firm is already much improved. Merrill finishes No. 3 in financing and No. 4 in securities lending, two staples of the business.

Does the increased commitment from investment banking rivals like Merrill and Lehman, not to mention the major push being made by the big European banks, worry market leader Morgan Stanley?

“Obviously, we take our competitors seriously, but quite frankly, this has been going on for 15 years,” says Portogallo.

Morgan Stanley’s Mortimer says that many firms don’t really understand the enormous effort and resources that firms need to put into the basic blocking and tackling work of prime brokerage. As a result, he adds, these firms either lose their enthusiasm or produce a lesser-quality product.