Morgan Stanley spent the better part of the past decade as one of two reigning champs of the prime brokerage industry. Together with Goldman, Sachs & Co., the New Yorkbased firm serviced more than half of all hedge fund balances.
All that began to change last fall, after the bankruptcy of Lehman Brothers Holdings sent financial markets into a tailspin and forced some banks to merge with former rivals or face possible collapse. In the immediate aftermath of the crisis, with investors scrutinizing counterparty risk as never before, many people concluded that no firm is too big to fail and thought it would be safer to disperse their assets among multiple outfits. Morgan Stanley disclosed in December that its prime brokerage assets had plunged by 65 percent in the companys 2008 fiscal fourth quarter, which ended November 30; its shares were trading at a fraction of their former value, and the firm had converted to a bank holding company regulated by the Federal Reserve Board after securing a $10 billion lifeline from the government. The future wasnt looking too promising, but Morgan Stanley senior executives have devoted much of the time since to wooing back clients, including some that had been the firms most loyal customers.
Alexander Ehrlich, who became Morgan Stanleys global head of prime brokerage in August, following the departure of Stuart Hendel, says the industrys future hierarchy wont be determined by the events of last fall. "The big question that people will ask about what happened in 2008 wont be about the reordering of the prime brokerage landscape," he says. "It will be, What happened over the succeeding couple of years? Did the firms that benefited from that redistribution of business in the fall of 2008 do the things that they needed to do to hang on to the windfall that they received in that period?"
Morgan Stanley appears to be doing what it needs to do to hang on to and re-attract its own windfall. The firm remains the favorite prime broker among hedge fund managers with $1 billion or more in assets in the fifth annual Alpha Awards, which ranks the preferred service providers of managers of hedge funds both large and small (the latter have less than $1 billion in assets).
The awards originated in Institutional Investor s sister publication Alpha. Click here to view the top-ranked service providers in five broad categories in the Top Hedge Fund Service Providers.
Several hedge fund managers note that Morgan Stanleys near-death experience may have been a boon for its prime brokerage business, explaining that the crisis compelled the firm to re-evaluate its business model and make improvements.
"When a client asks, How do we know youll be a reliable funding counterparty?, we have a better answer than most banks: We lived through a run on the bank and didnt fail," says Ehrlich. "We and our clients learned lessons about linkages between clients funding and Morgan Stanleys funding. As a result, we greatly strengthened those linkages."
Despite facing its own turmoil in the financial crisis, including credit-related losses topping $39 billion, Citi picked up market share lost by pure-play investment banks and is the No. 2 prime broker among managers of big hedge funds; the New Yorkbased firm was unranked in this category last year. Money managers were drawn to Citi for two reasons: its status as a commercial bank came with the assurance of at least some government protection, and its custodial services operations ensured that the bank had greater liquidity than other firms, because custody assets arent mingled with other holdings and cannot be used as collateral. Goldman Sachs and Morgan Stanley were able to offer investors these protections only after converting to bank holding companies.
Citi had been in the process of expanding its prime brokerage operations even before the crisis hit. The firm hired former Lehman executive Alan Pace in April 2008 as head of prime brokerage in the Americas, and three months later another former Lehman executive, Sean McGinty, was named head of product development. In February, Citi picked up Mark Harrison, who established Deutsche Banks European prime brokerage platform and now oversees a comparable platform at his new employer. All told, Citi has added more than 40 employees to its prime brokerage over the past year.
The firms global footprint also appeals to hedge funds looking for a prime broker that can help them trade in any market, an attractive strength in a recovering economy as managers expand their search for new investment opportunities. "Our ability to source hard-to-borrow securities that is very much a priority for us," says Nicholas Roe, global head of prime finance. "We know, being Citi, weve got people on the ground, so we can evaluate certain markets and we can take advantage of certain market conditions very quickly."
Goldman Sachs slips from second place to third among managers of big hedge funds. John Levene, who heads up Goldmans prime brokerage operations in the U.S., says in light of the credit crisis staff reductions were unavoidable (although he declines to say how many people were let go), but the cuts were strategic so that no areas of operations were eliminated. Goldman remains the worlds largest prime broker, in terms of the number of hedge fund clients, according to Chicago-based Hedge Fund Research. Levene says the firm made a conscious decision to cast a wide net and maintain relationships with managers of start-ups which he calls "an important growth engine for our business" even as other prime brokerages curtailed relationships with smaller clients to focus on more immediately lucrative firms.
Case in point: BNP Paribas, which shoots straight to No. 1 among managers of hedge funds with less than $1 billion in assets. Unranked last year, the Paris-based bank entered the U.S. market in June 2008 when it announced it would buy the prime brokerage business of Bank of America Corp.; but in May, BNP sold about 70 of its smallest client relationships to New Yorkbased investment bank Jefferies & Co. so that it could devote more resources to attracting and serving larger funds.
Talbot Stark, global head of relationship management for institutional investors, says that substantial resources went into integrating the new clients onto BNPs platform, and the firm is eager to see a return on its investment. "For us to invest the time and legal expenses, we need a certain expected return," Stark says, making no bones about BNPs desire to be the prime broker preferred by the worlds largest hedge funds.
Administrators regardless of what size hedge funds they service report that business has never been more brisk, even though total hedge fund assets are still down about $400 billion from their 2008 peak of $1.9 trillion, according to HFR. The unprecedented $65 billion investment fraud perpetrated by Bernard Madoff underscored the importance of independent, third-party administration.
"Largely because of events such as Madoff and the collapse of Lehman, theres a drive from investors to see self-administered funds have third-party administration involved," says Cory Thackeray, head of Goldman Sachs administrative services group, which is ranked No. 1 for a third straight year among managers of large hedge funds. "Even though assets in the industry have come down, theres a new group of assets that may not have been available to the administrator space in the past."
Unranked last year, SS&C Technologies is the top administrator among managers that oversee smaller funds. The Windsor, Connecticutbased company also reports rising interest in third-party administration services, according to Fred Jacobs, head of global business development for alternative investments. Jacobs says the ongoing focus on technology SS&C creates and leases its own software benefits its administration clients.
"Since we have our own technology, if we have a client that has a specific, new type of asset and we need to change our system, we can do that ourselves," he says. "We dont have to get in line behind other service providers."
The financial crisis has also sparked a surge in business for law firms serving the hedge fund industry. With fund launches down precipitously and liquidations at record levels, restructuring has become the name of the game. HFR reports that 2008 saw an unprecedented 1,471 hedge fund liquidations, with 668 more in the first half of 2009. The 330 funds launched in the first half of 2009 represents a 32 percent drop from the same period a year earlier.
"This was a year in which you needed, as a hedge fund lawyer, to have not just legal experience but real business experience to add that value to clients," observes Steven Nadel, one of seven partners in the investment management group at Seward & Kissel, which vaults from fourth place to first as the onshore law firm of choice among managers of bigger hedge funds. The firm is certainly not lacking in experience: In February, Nadel was among the Seward & Kissel employees who helped ring the opening bell at the New York Stock Exchange to commemorate their firms having helped establish the worlds first hedge fund 60 years earlier.
New Yorkbased Seward & Kissel, with more than 45 lawyers in the investment management group, "has been at the forefront of some of the newest fund terms that have come out," Nadel says. "Weve set up some fairly interesting claw-back mechanisms which are starting to be adopted by other managers. We have come up with some novel approaches to dealing with the liquidity crunch in terms of not putting up gates and getting money out to investors as quickly as possible, but in a way that doesnt harm the existing investors and doesnt breach the fiduciary duty of the managers."
San Franciscos Shartsis Friese jumps from third place to become the top onshore law firm among managers with less than $1 billion in assets. The firm, with 29 partners and 29 associates, caters to hedge fund clients on the West Coast, where the dominant strategy is longshort equity, and partners John Broadhurst and Christopher Rupright say they have felt relatively insulated from the crisis unfolding on the East Coast. Old-fashioned client service remains the focus.
"When law firms get too busy, they can drop the service ball and be slow on turnaround time and slow on returning phone calls," says Broadhurst. "We stopped taking new clients for three or four years during the dot-com boom earlier this decade, because we didnt want to drop the ball on service. We knew that was one way we could damage our franchise."
Restructuring is keeping lawyers busy at offshore firms too. According to the Cayman Islands Monetary Authority, the number of funds registered, administered or licensed on Grand Cayman fell to 9,838 by September 30, down from 10,291 one year earlier, although the downward spiral seems to be reversing. New fund registrations outnumbered terminations in the third quarter, but just barely, with 319 new registrations or licenses and 289 terminations.
Caymans largest law firm, Maples and Calder (the firm has 208 lawyers, 113 of whom are fund lawyers) is decidedly the favorite offshore legal services provider for a second straight year among managers with more than $1 billion in assets. David Brooks, head of the investment funds group, cites the flexibility of his firm as an advantage in helping hedge fund clientele through a difficult climate.
"We adopt a team-based approach, a bit like the top-tier New York firms," he says. "This is different from a commission-type basis that might lead to other lawyers hanging on to work that might be better done by someone else. Were able to move work around and identify lawyers within our team who are most suited to a particular transaction."
Managers of smaller hedge funds cite another Cayman Islands outfit, Ogier, as their favorite offshore law firm. James Bergstrom, head of Ogiers global investment funds team, says he has seen a change in client expectations in the wake of the financial crisis.
"In the past, when youre setting up products, the clients approach has been, Be sure you involve the associate a lot so the bills not so high," Bergstrom explains. "In the last 12 months, theyve been saying, Its not acceptable unless the partner is doing the work." Ogier, which ranked third in the category last year, has 39 attorneys in the Cayman Islands, 28 of whom specialize in funds.
Administrators and attorneys arent the only professionals to see their businesses surge despite the downturn in the hedge fund industry. Accountants are also reporting increasing demand from clients.
"Investment managers communicated more frequently this year than in the past," says Howard Altman, principal in charge of financial services at Roseland, New Jerseybased Rothstein Kass & Co., the top choice of larger funds for a third consecutive year. "That was necessitated by both sides: Investment managers wanted to make sure that their investors were aware of their views on the market, and investors obviously needed some comfort as far as where things stood."
With hedge fund performance recovering strongly and new fund formations once again outpacing wind-downs, hedge fund service providers can likely look forward to many more years of symbiosis with clients. But the faces of its various businesses will be forever changed.
"Its not just traditional service that the industry is looking for anymore," says Cary Stier, the New Yorkbased head of Deloittes U.S. asset management services practice; Deloitte is the No. 2 accountant among managers of big hedge funds. "Theyre looking for interpretations, theyre looking for solutions."