Banks' new frontier: prime brokerage- Hedge funds are industry's last great yield generator

Date: Tuesday, June 24, 2003

Keith Kalawsky: Financial Post- Last week, BMO Nesbitt Burns Inc. eagerly played the role of matchmaker by bringing together institutional investors and hedge funds for an afternoon conference in Toronto billed as "Six in the City." In this Bay Street version of speed-dating, 11 hedge fund managers were given six minutes each to win the hearts -- and assets -- of more than 40 potential investors. On a sheet of paper, BMO asked investors to check off whether they wanted more information or to schedule a meeting with any of the hedge funds after the rapid-fire sales pitches. "BMO Nesbitt Burns will take care of the rest!" the brokerage then promised in its handout. "We're still pretty excited about this," says Andrew Papierz, the head of the bank's prime brokerage unit. "One of things we want to do is help our clients grow, because if they grow, we grow." Playing Cupid is part of BMO's effort to stake a sizeable claim in one of the last frontiers of Canada's investment industry: prime brokerage. Several of the big banks are hustling to offer a full slate of brokerage services, from securities lending, clearing, settlement, custody, research, trading and margin lending to Canada's embryonic but expanding hedge fund industry. Profits in retail brokerage have been ravaged by three years of depressed equity markets. But several banks see enormous potential in prime brokerage mainly because institutional and retail investors are beginning to pour more money into hedge funds in search of better returns. "It's a huge growth opportunity," Mr. Papierz says. "The performance of the markets over the last two or three years has forced institutions to look for new ways of increasing their yields. And clearly alternative investments, in the form of the hedge funds, has been a key focus for them." BMO is planning another matchmaking conference for the fall. Hedge funds, private capital pools typically requiring large minimum investments, use sophisticated and speculative strategies to make money, such as short-selling, swaps and arbitrage. Given the many strategies at their disposal beyond buying and selling securities, hedge funds aim to profit in any kind of market environment. That means hedge fund managers trade in good and bad times, a key reason why the banks consider prime brokerage an important opportunity amid volatile capital markets and stubbornly weak revenue from retail brokerage. So far, RBC Dominion Securities Inc., BMO, and TD Securities Inc. are leading the pack in prime brokerage, but competition is expected to intensify. Scotia Capital Inc., under the leadership of Jim Mountain, head of institutional equities, has been working on a prime brokerage initiative over the last several months. "I think others are recognizing that this is still a growth opportunity and in a sector that hasn't had a lot of growth opportunities over the last couple of years," Mr. Papierz says. "Whenever any business looks like it's doing well, it'll attract the attention of others." "I understand the ones that aren't [in prime brokerage] are certainly looking at it quite seriously," says Lionel deMercado, managing director at TD Securities and head of its prime brokerage unit. The explosive growth of hedge funds and prime brokerage in the U.S. has caught the attention of the Canadian banks. There are nearly 6,000 hedge funds in the U.S. managing about US$600-billion in assets, estimates the U.S. Securities and Exchange Commission. In 1990, by comparison, there were only US$50-billion invested in hedge funds. Also, the industry is relatively small in Canada and it is growing strongly. There are about 153 funds offered by 68 companies, with $6.1-billion in assets under management. At the end of 1999, there were only 45 funds offered by 31 sponsors, with $2.1-billion in assets, according to research and consulting firm Investor Economics Inc. And in the U.S., where prime brokerage is a far more mature industry, about 6% to 7% of the assets managed by institutional investors are committed to hedge funds. But in Canada, investors have allocated an average of 2% to 3% of their portfolios to alternative investments, according to Mr. Papierz. Ontario Teachers' Pension Plan has $4-billion or 7% of its portfolio invested in hedge funds. "The mega-large institutional accounts, like the pension funds, are starting to employ some assets into Canadian hedge funds, but it's in the very early stages," Mr. deMercado says. Many hedge funds in Canada are not very mature, so they do not have a long enough track record of success to lure the big pension managers. But that track record, and the interest of big institutional investors, will come, Mr. deMercado argues, creating more business for prime brokerages. TD Securities Inc., a unit of Toronto-Dominion Bank, launched its prime brokerage about a year ago, and has established relationships with 14 money managers running hedge funds, which range in size from a few million dollars to about $550-million. "We have viewed hedge fund business as one of the last frontiers that we can capitalize on," says Mr. deMercado. Like other prime brokerages, TD's goal is to handle the day-to-day operations of hedge fund managers so they can concentrate on selling, marketing and trading their portfolios. TD's clients are free to trade through any brokerage, but the bank is trying to capture a larger share of this revenue. To that end, TD will launch a sales and trading group to work exclusively with hedge fund managers, Mr. deMercado says. Although the Canadian banks are enthused about prime brokerage, they are facing stiff competition from U.S. players, which boast significantly larger budgets for sophisticated trading technology and deep links to potential hedge fund investors around the world. The top two U.S. players in prime brokerage, Morgan Stanley and Goldman Sachs, attract hedge funds because of their global capital introduction departments. A fund manager looking for investors is more likely to favour a firm with this kind of global presence. "It's a pretty effective and efficient way for people with money to meet the people that want to run it," says Jim McGovern, chief executive of Arrow Hedge Partners Inc. in Toronto. "Global introduction has been a pretty big selling point for a lot the prime brokerages." Some hedge funds are looking for specialized firms to handle their business instead of large brokerages, Mr. McGovern says, so the idea of providing one-stop shopping for money managers may not be a runaway success. "The jury is out. For a period of time, everybody thinks aggregation is the way to go. By the time that is done, everyone wants to decentralize things and go with specialists and boutiques," Mr. McGovern says. But Mr. deMercado at TD believes the business model will work. "It's proving to be highly beneficial, because what we're saying to the hedge fund community is that we're here to offer you a dedicated service," he says. Prime brokerage is also a natural fit with TD's other businesses, from foreign exchange and fixed income. "So far the business is working extremely well."