U.S. regulators grow alarmed over 'hedge fund hotels'

Date: Monday, January 1, 2007
Author: Jenny Anderson, IHT.com

NEW YORK: Inside a Philip Johnson- designed office tower in the Boston financial district, UBS, the giant Swiss bank, is running a "hedge fund hotel."

Just as venture capitalists and others during the technology boom created incubators to help entrepreneurs start businesses without the headaches of finding real estate and office support, so a few big investment banks are offering young ambitious hedge fund traders a temporary home, complete with receptionists, espresso machines and consultants to help manage their information systems.

As the technology incubators sought to oversee the birth of the next Netscape, so these hedge fund hotels hope that the small hedge funds may some day become big clients of the bank.

UBS is the leader in this business, with 400,000 square feet, or 37,000 square meters, of hedge fund hotels in a number of cities. Bear Stearns is also active, with space for rent in New York, Boston, San Francisco and Los Angeles.

Some regulators, however, are growing concerned about the relationship between the banks and their hedge- fund hotel guests, looking at whether the banks might be using the real estate-relationship as a way to entice hedge funds to do business with them.

William Galvin, secretary of the Commonwealth of Massachusetts, has subpoenaed UBS, and he is investigating other banks with hedge fund hotels in Boston to determine how the banks are charging for their services.

"It's a conflict of interest issue," Galvin said.

A spokeswoman for UBS declined to comment.

At the heart of the investigation is a thorny issue that has dogged regulators for decades. Money managers, including mutual funds and hedge funds, often pay Wall Street with "soft dollars" — inflated commissions that include the cost of trading (typically 1 cent to 2 cents a share) plus an additional few cents a share that can be directed to pay for research and other services.

Soft dollars are controversial because the higher commissions are paid for by clients while the services often benefit the manager most. Higher commissions result in greater expenses for the fund and potentially lower returns for investors.

In the late 1990s, the U.S. Securities and Exchange Commission cracked down on the use of soft dollars by mutual funds, concerned that investors were being duped into paying for services the manager enjoyed.

Massachusetts is now investigating whether hedge funds are improperly using soft dollars to pay for space in these hotels and failing to disclose to investors that they are covering a major expense.

"It's the same soft dollar question," Galvin said. "What kind of quid pro quo might be in the placement of an order? What's the relationship between the entities?"

At the heart of Galvin's investigation is the understanding that as hedge funds have exploded, so too have the fortunes of Wall Street. Hedge funds typically trade more than other Wall Street clients and they trade exotic, high-margin products, like complex derivatives. Because hedge funds have become such important customers, there are concerns that they may be getting better information than other investors as a result of the business they do with the banks.

The business of servicing hedge funds is called prime brokerage, and it includes financing trades, finding and lending stock to allow hedge funds to short stocks (betting that their price will fall) to structuring derivatives and executing swaps. It can also include hedge fund hotels — securing real estate, receptionists and information technology and even managing, say, the risk of trading currencies in Asia.

The global prime brokerage business generates between $8 billion and $10 billion a year, estimates Vodia Group, a consulting firm for the financial services industry. The business is highly profitable, with a return on equity — a measure of how efficiently the bank reinvests its capital — of a healthy 15 percent to 20 percent. In 2006, Goldman Sachs made $2 billion directly servicing hedge funds, 22 percent more than the previous year.

Prime brokerage is only the tip of the iceberg when it comes to the fees that hedge funds generate for Wall Street firms: billions of additional dollars come from trading for these funds.

Credit Suisse estimates investment banks made $25 billion in revenues from hedge funds in 2004, $19 billion of which came from sales and trading and the rest from prime brokerage.

Hedge funds now control half the volume traded on the New York and London stock exchanges, according to Credit Suisse.

Hedge funds generate about 30 to 35 percent of the equity commission volume of the major Wall Street firms, according to Brad Hintz, a securities analyst at Sanford C. Bernstein.