The deal to bring together Bank of New York Co. and Mellon Financial Corp., announced in early December, will create the world's largest provider of custodial services, with $16.6 trillion in assets. But the merger was not motivated by size alone. The combined firm -- to be called Bank of New York Mellon Corp. -- contains the makings of a hedge-fund-servicing giant that promises to help it boost margins and shake up the market for such offerings as accounting and transfer agency, asset valuation and middle-office services.
The combined entity will boast about $160 billion in hedge fund and fund-of-fund assets under administration: BoNY brings $95 billion to the table and Mellon $65 billion. That may be a drop in the firm's overall custodial bucket, but hedge fund servicing boasts margins of 15 to 20 percent, while margins on custody, including related services such as risk management, reporting and performance measurement, typically hover between 4 and 6 percent, according to Robert Hegarty, who heads the securities and investments practice at Needham, Massachusettsbased Tower Group. And hedge fund assets, Hegarty predicts, will grow at a compounded annual rate of 15 percent over the next three years, compared with just 5 percent or so for long-only investments.
Brian Ruane, an executive vice president at BoNY, says the merger will vault the bank into the ranks of the top ten hedge fund administrators. But competition remains fierce. Hedge fund administration has historically been a fragmented business, Hegarty says. The top five administrators control about 50 percent of hedge fund assets; the top 15 have 83 percent. They include noncustodians such as Cayman Islandsbased Citco Group, the No. 1 administrator, which oversees $425 billion in hedge fund and fund-of-fund assets, and New Jerseybased Bisys Group, with $203 billion, as well as custodians such as London-based HSBC Holdings' Alternative Fund Services, with $261 billion in hedge fund and fund-of-fund assets, and Boston-based Investors Bank & Trust Co., a much smaller custodian overall, but with $155 billion in hedge assets.
In merging, BoNY and Mellon were clearly looking to bring scale to bear on the hedge fund administration market, a factor that should force down costs and allow the combined firm to funnel investment dollars into the operation. Equally important, says BoNY's Ruane, is providing the hedge fund world with a one-stop shop that offers a broad array of services, from structured products to execution, in addition to plain-vanilla administration.
"It's one thing to be able to provide administration. It's a different story to be able to provide everything from foreign exchange to execution and order management," Ruane says. "Administration is just our foot in the door." The firm plans to offer corporate trust services for collateralized debt obligations, agency-only execution for equities and fixed income and even a strong private banking operation.
To compete, the bank will have to provide high-touch service, ensure the sanctity of customers' data and make sure applications are delivered in a timely way. Will that strategy work in a fragmented industry whose clients often prefer smaller administrators that cater to their needs with customized services while playing to their paranoia about confidentiality? Robert Mancuso, a senior vice president at rival Investors Bank & Trust, says a primary risk of the deal is hedge funds' dislike of big firms and their often-bureaucratic structures, which inhibit quick development projects and effective customer service. "Our clients want us to be responsive, flexible and quick to come to the table with solutions," says Mancuso. "I don't know how the megafirms will be able to deliver that."