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Prime brokers and custodians vie for hedge fund mandates

Date: Wednesday, April 30, 2008
Author: Ben Wright, Financial News Online US

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The collapse of Bear Stearns last month added urgency to the fight between prime brokers and custodians for hedge fund mandates.

There has been increasing convergence between these previously distinct service providers.

On the prime brokerage side, Goldman Sachs, Morgan Stanley and UBS have started to offer fund administration services. Custodians, on the other had, are busy trying to roll out prime brokerage services.

However, since the start of the credit crunch—and in particular the collapse of Bear Stearns—hedge funds have become wary of concentrating the number of counterparties with which they operate.

It would be bad enough if the next bank to collapse was either your prime broker of your custodian; it could be disastrous if it was both.

Paladyne Systems, a provider of alternative investment systems, has released a paper predicting that hedge funds would be looking to work with more, not fewer, counterparties.

It said on average, each hedge fund would have three prime brokerage relationships to support its trading and operational needs, up from the present average of 1.9.

Mary Fenoglio, global head of custody at Citigroup, said this was no reason for banks not to offer a broad range of services.

She said: “Clients are understandably cautious in the current environment and some are choosing to spread their assets between different custodians and prime brokers and possibly to use a separate prime broker and custodian.

“But being a one-stop shop allows us to offer any combination of services with which they might feel comfortable. We have done a great deal of work on our technology to ensure that we are totally modular in our services and clients can pick and choose the best solution to meet their needs.”

Citigroup has launched an integrated prime brokerage and administration business to service hedge funds and attempt to take market share from the relatively few prime brokers in the market. The attractions of such a strategy are clear—the net margin for prime brokers runs at about 100 basis points compared with four to five basis points for custody.

Citigroup has a strong launch pad from which to begin its attack on prime brokers. Its $800m (€510m) acquisition of fund administrator Bisys, which was finalized at the end of last year, has made it the world’s third-largest hedge fund administrator.

Fenoglio, who joined Citigroup in 2004, has more than 20 years of experience in securities services, many of them at State Street, which has a strong reputation in alternatives.

At State Street, Fenoglio was responsible for the bank’s securities settlements, asset servicing, and full service custody operations and was a member of the executive management group.

Lee Waite was last year appointed to oversee the Bisys integration and Citigroup is looking at cross-selling opportunities for its hedge fund servicing package.

Fenoglio said: “Clearly there have also been benefits on the Bisys side and since the acquisition, the mandates it has won in the alternative investments space have doubled in size. We can also cross-sell global custody and securities lending to Bisys’ existing clients so they have access to a full suite of products.”

Citigroup’s hedge fund servicing package includes prime brokerage, financing and capital introduction as well as administration. It has moved Steve Bowman, former head of fixed-income sales at the investment bank, to run the operation and ensure it delivers a more flexible and comprehensive service than the prime brokers.

Fenoglio said: “With hedge fund services we really wanted to develop a three-pronged – prime brokerage, fund administration and middle office – open architecture that would allow us to build solutions for individual clients, whether they are hedge funds or traditional fund managers that are moving into the alternatives space with products like 130/30 funds.

“The middle office functionality is being developed but we hope to have a full suite of processes to handle alternative investments ready by early in the second half of this year.”

Fenoglio said Citigroup has seven new fund administration mandates in Europe, the Middle East and Africa and roughly the same number in the US.

Although her business is growing fastest in Asia, good growth is also being achieved in Europe and the US. This month, Andrew Gelb was made head of securities and fund services in Emea and will also run the investor services products in the region.

According to an internal memo, Gelb will continue in his previous role as global head of direct custody and clearing and will be announcing his team and regional reporting structure in the coming months.

Fenoglio’s division has won 300 mandates globally since the beginning of last year.

Revenues for the securities and fund services division were up 45% last year compared to the previous year and climbed by 63% in the first quarter of this year compared with the same period last year.

Some, but not all, of that growth has been thanks to the acquisition of Bisys, though Fenoglio is keen to emphasize the strength of Citigroup’s custody offering.

She said: “We have a broad geographical reach and a broad range of capabilities that we can draw on from within Citigroup.”

The bank’s size helps it address the perennial problem of the custody industry—attracting and retaining talented staff.

Fenoglio said: “This business is all about people. Custody and fund administration mandates are the ultimate in outsourcing because clients are trusting us with a piece of their value chain.

"Because of that, making sure there is not too much turnover among our staff is vital.

“On the one hand, we are lucky because Citigroup attracts a great number of talented people because of the opportunities it can offer them in their careers. On the other hand, we also benefit from the talent that our rotation programs bring into the business.”