Morgan Stanley and Goldman, Sachs & Co. have long ranked as the two biggest names in prime brokerage, lending their gilt-edge imprimatur to hedge fund clients. But the ongoing financial crisis is fraying the old order. Morgan Stanley and Goldman remain at the top of the heap — repeating as Nos. 1 and 2, respectively, in the just-released 2008 Alpha Awards, a rating of hedge fund service providers by Institutional Investor’s sister publication, Alpha — but the disappearance of Bear Stearns Cos. and Lehman Brothers Holdings has forced hedge funds to rethink their dependence on a handful of Wall Street giants for capital raising, trading, leverage and other support functions. Numerous hedge funds have had to line up as unsecured creditors in the Lehman bankruptcy, an unhappy lesson in counterparty risk that firms are loath to repeat.
Morgan Stanley and Goldman have both been shaken by brutal market conditions. Morgan Stanley reported “significant outflows” that market sources said amounted to almost one third of its prime brokerage assets in September alone, and Goldman is reducing jobs in prime brokerage as business has fallen off. Other firms are picking up the pieces. Prominent among them is JPMorgan Chase & Co., which acquired Bear Stearns’ prime brokerage as part of its $1.5 billion purchase of Bear assets in a government-assisted fire sale in May and brings the strength of its capital and vast deposit-taking prowess to the table. Bank of New York Mellon Corp., Credit Suisse, Deutsche Bank and Fidelity Investments are among the other winners.
BNY Mellon’s clearing division, Pershing, is seeking to capitalize by combining services from a modest-size prime brokerage that was once part of Donaldson, Lufkin & Jenrette and was acquired by Bank of New York in 2003 with those of its parent bank’s custody business. Jeremy Todd, head of business development for Pershing Prime Services, says that hedge funds can reduce risk by keeping their short positions at the prime brokerage while holding all other securities at BNY Mellon, the biggest custodian in the world. Before the financial market collapse, few hedge funds took this two-pronged approach because of the operational complexities involved in moving collateral between banks and brokerages. But Pershing, says Todd, can set up triparty agreements that allow securities held at the bank to also serve as collateral for shorting.
This idea isn’t unique to Pershing — hedge funds can make similar arrangements with unaffiliated banks and brokerages — but the BNY Mellon connection makes it easy to implement under one roof. It’s a pitch that JPMorgan and Deutsche, with their secure bank balance sheets, can also make. “Hedge funds like this,” says Todd, noting that Pershing will add 20 funds in November to its existing roster of 50, including a number of $1 billion-plus firms. Assets have grown by 300 percent (to an undisclosed total) in two months. Hedge funds get “access to exactly what they need to finance transactions. Everything else is segregated,” he says.
Fidelity is stressing its balance-sheet strength and its avoidance of conflicts of interest with an investment bank to sell the services of its five-year-old prime brokerage. “We don’t have investment banking, we don’t have derivatives, we’re a low-leverage shop, and we don’t have CDO portfolios,” explains Mark Haggerty, president of Fidelity Capital Markets Services. The unit increased assets 40 percent, he says, between late September and late October and expects to add 50 clients to its total of 300 by mid-November.
Stephan Vermut says that the turn in the market is allowing him to realize his vision for Merlin Securities, a firm he started in San Francisco in 2004 to cater to hedge funds with less than $1 billion in assets, which he believes are underserved by the prime brokerage giants. Merlin provides a “front end” service linking funds to JPMorgan or Goldman, along with a reporting system that aggregates data on assets at those or any other prime brokerage — a key to meeting the needs of funds setting up multiple prime relationships to diversify their risk. Vermut, who founded the prime brokerage operation at Montgomery Securities before it was acquired by NationsBank Corp., now Bank of America Corp., in 1998, says Merlin will add $2 billion in prime brokerage assets this month, up from $1 billion in October, and is on pace to double the size of its business between the third and fourth quarters.
