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Big banks act tough with hedge fund clients

Date: Tuesday, July 31, 2012
Author: Laurence Fletcher, Reuters

Major banks face growing pressure to extract more money from, or even sever ties with, unprofitable hedge fund clients as they cut costs in the face of tough trading conditions and try to refocus on the biggest managers.

Industry insiders say prime brokers - which provide services such as stock lending and financing for hedge funds - are sifting through their client lists, in some cases demanding higher fees on trading or a greater share of a fund's business, and sometimes telling funds to look elsewhere.

The moves come as banks, faced with a tough economic environment, higher regulatory costs and looming Basel III capital standards that are set to reduce returns on equity, look to cut costs across the board and focus on more profitable activities.

Small funds, most of which have found it a struggle to attract client cash since the credit crisis, or funds with little leverage or trading activity look less attractive to many banks, although in the secretive $2.1 trillion industry few executives are keen to reveal who has lost out.

Brokers are in many cases instead focusing on trying to capture even a sliver of business from the biggest and most active hedge fund traders, for instance Brevan Howard or Moore Capital, who can deliver tens of millions of dollars in commission to their main brokers.

"Prime brokers are absolutely trimming clients. They're putting more and more focus on key clients. They've got less manpower and physical resources," said one well-placed industry source who asked not to be named.

"A number of prime brokers have told me the same story - they're focusing on key accounts to increase their share of wallet. If you grow from 4 percent to 10 percent of a big fund's trading flow (then that's worth a lot). Goldman Sachs, Morgan Stanley and UBS have all told me they're focusing."

All three banks declined to comment. A source close to Morgan Stanley said: "There is no change in strategy within the prime broking division and it maintains its focus on the same mix of clients."

Earlier this year the Financial Times reported that a number of top prime brokers were preparing to pass on increases to the cost of funding to hedge fund clients.


Banks cutting hedge funds is not in itself a new phenomenon. One hedge fund manager told Reuters they were asked to leave by one major bank after the credit crisis because they traded credit, which was less profitable for the broker than equities.

But industry executives say that the pace has picked up as banks face up to higher costs.

"There's been an acceleration (in prime brokers culling hedge fund clients). There's been a trend of cutting off dead wood," said Dermot Butler, chairman of administrator Custom House Group, which works with funds and prime brokers.

"Prime brokers can't afford to be generous at all. If someone's not making money for them then they're not worth having on the books... Some administrators and prime brokers are sacking smaller funds but retaining big funds from the same house."

Hedge funds typically use three prime brokers, who make money by lending money for trades or securities for short-selling, arranging custody for a fund's assets or even by finding office space or providing advice on regulation or risk management.

Brokers can often look for a fund firm to provide them with at least $250,000 of business per year, said one hedge fund executive, which would be a substantial amount for a manager with, say, $25 million in assets.

"If you're a small fund with $100 million of AUM (assets under management) and you have a strategy that's not hugely leveraged, it may mean you're not paying the broker very much," said one prime broker who spoke on condition of anonymity.

"Some (clients) can be very high maintenance, they can be calling your support teams twice a day."


The moves come as investors flock to the perceived safety of the biggest hedge funds, making them even more lucrative for prime brokers, particularly when clients are in general making smaller trades than before the crisis.

Nearly 65 percent of the $2.1 trillion industry's assets are with firms with more than $5 billion in assets, up from 58 percent three years ago, according to Hedge Fund Research.

In contrast, firms with less than $1 billion in assets control just 11 percent of industry assets, down from 14 percent three years ago.

"It's related to the idea that after 2008 not every fund was going to grow rapidly. Today if you take 10 in and incubate them for a while, a smaller number will grow rapidly," said David Storrs, CEO of fund of funds Alternative Investment Group, who said prime brokers are culling "low pedigree managers".

Banks can adopt a range of tactics with funds that are taking up their time without delivering sufficient revenue.

Some may demand a greater share of a fund's trading business, levy higher charges on trades or ask funds to post more collateral, in a bid to extract more revenue.

If funds still don't provide enough revenue, then brokers can also axe services such as capital introduction - introducing them to their network of potential investors - in a bid to bring down costs.

"Some of the smaller firms we are talking to, they have much more margin to equity than the larger firms, and they are not able to segregate their assets from their prime brokers which the larger guys are able to do," said one investor in hedge funds who talks to both small and large managers.

"These things have only been getting worse this year in our experience."