Back to the future for prime broker survivors

Date: Tuesday, February 10, 2009
Author: Hedgeweek.com

The collapse of Lehman Brothers last September was the flashpoint of a year that saw the prime brokerage world - along with that of its hedge fund clients - transformed by the ongoing credit crisis and grisly economic backdrop. But for those funds and brokers that come through the turbulence intact, the new landscape offers a broad range of opportunities for the coming years, according to Nick Roe, the London-based head of prime finance at Citi.

While the hedge fund assets that were locked up in London after Lehman Brothers International (Europe) went into administration garnered headlines for a while, Roe argues that just as important was the spotlight turned on rehypothecation - the use by prime brokers of hedge fund assets as collateral for the borrowing they need to provide funding to those clients.

'I believe the regulations regarding rehypothecation will change, with prime brokers forced into much more transparency,' he says. 'But it won't go away, because most hedge funds couldn't cope with the changed economic conditions if prime brokers weren't able to make use of some of their assets to deliver the required levels of funding.'

The sudden focus on credit risk in prime brokerage relationships and the need by newly-fledged commercial banks Morgan Stanley and Goldman Sachs to reduce their levels of leverage has unquestionably benefited Citi and other prime brokers with large universal banks standing behind them. However, Roe says he and his colleagues have been wary about any sudden expansion of their business.

'We made a firm decision not to take on brand-new customers, but to provide our existing customers with additional capacity within their accounts,' he says. 'We recognised the danger of putting a great deal of pressure on our own balance sheet and processing capability, so we took a measured approach. However, it did enable us to consolidate a number of key global relationships where previously we'd not had a very significant proportion of the client's financing business.'

As difficult as the current environment has proved for hedge funds, Roe believes that the survivors will benefit from market opportunities not seen for a decade. 'Hedge funds are down around 20 per cent on average, and they've suffered redemptions on top of that, so the market is probably resetting in size to something around its level of 10 years ago, but then spreads have probably widened out to their level of 10 years ago too, and the prime brokerage market has been reduced to the number of competitors around 10 years ago,' he says.

Rather than throw in the towel, Roe says, hedge fund managers are fighting to restructure their businesses and hang on for better times. 'Many hedge funds are looking to restructure their operation and keep their business solvent, even at a low level of assets. We are seeing a temporary reduction in assets under management, but soon there will be enormous appetite from institutions such as pension schemes and sovereign wealth funds to put a lot of assets into the absolute return world.'

'This represents a great opportunity for the prime brokers still engaged in the market - those that have always had a tight funding operation and have based their operations on internal equity rather than gross prime revenue. Citigroup didn't try to get market share too quickly or buy it, but sought to grow steadily and make sure we ran a profitable business. Over the next two or three years there's a great opportunity for us to become one of the top two or three prime brokers globally.'