Goldman Sachs Dumps Weaker Hedge-Fund Clients

Bank Jettisons Some Less-Profitable Clients as New Capital Rules Take Their Toll

By 

Justin Baer and

Juliet Chung 

Aug. 4, 2014 7:21 p.m. ET

Goldman Sachs Group Inc. GS +0.85% is upending the way it does business with hedge funds, jettisoning less-profitable clients and increasing some fees on others as it adapts to new banking rules, people familiar with the matter said.

The bank has told hedge-fund clients that the regulations have forced it to set aside more capital, crimping profits at its prime-brokerage business, which executes and finances the funds' trades.

The changes, which are playing out at many of the world's largest banks, highlight yet another way Wall Street has tried to adapt to the shifting landscape. Banks already have cut proprietary-trading units, sold commodities businesses, shrunk stockpiles of securities used to make markets and scaled back investments in hedge funds and private-equity funds.

Goldman also is pulling the firm's own cash out of its largest internal hedge fund, according to people familiar with the matter, to comply with other new rules limiting how banks invest their money.

Goldman and rivals such as Bank of America Corp. BAC +0.47% and Deutsche Bank AG DBK.XE -2.01% are seeking to offset the impact of stiffer capital requirements while delivering the higher returns their shareholders expect. Prime-brokerage units brought in an estimated $13 billion in revenue for the biggest banks last year.

Many banks are trying to squeeze more out of client relationships and pulling back from business that ties up more capital, including financing trades. Some, in addition to Goldman, have even cut off funds that don't bring in enough profits.

"It's the most dramatic thing to ever happen in the business," said Robert Sloan of S3 Partners, a financial-analytics firm for hedge funds. "It's a total redefinition of what's a good customer."

Goldman is urging funds to take back the cash they hold in their accounts, charging clients more to finance trades and imposing monthly fees more often on fund managers for maintaining untapped credit lines with the bank, the people familiar with the matter said. In some cases, Goldman has stopped serving clients that produce little or no returns for the firm, they said.

In recent months, Goldman's prime-brokerage unit has been contacting hedge-fund clients to inform them that it now evaluates their business based on the return on assets it produces for Goldman, according to people familiar with the matter. Historically, banks had valued their clients primarily on the revenue they brought in.

Similar discussions have been taking place in meetings and phone calls across Wall Street, as big banks come to grips with the new international capital requirements. Hedge-fund executives say each of the banks is adapting to the new rules at its own pace.

Banks such as UBS AG UBSN.VX -0.58% and Credit Suisse Group AG CSGN.VX +0.36% have spoken to clients about the effect of capital rules on their prime-brokerage businesses, according to people familiar with the plans. Some firms, including Bank of America and Deutsche Bank, are charging clients more to finance their trades, other people familiar with the matter said.

"Everything is being rendered explicit," said Charles Winkler, chief operating officer of Hudson Bay Capital Management, a roughly $3 billion hedge-fund firm, referring to banks' expectations of the profitability of client relationships. "In the old days, it was much more squishy."

The steps Goldman and other banks have taken have led some funds to reconsider their relationships on Wall Street, opening the door for smaller prime brokers that are more willing to work with smaller funds.

"There is less room at the inn" at the major banks, said Noel Kimmel, global head of prime services at securities firm Cantor Fitzgerald LP. As a result, Mr. Kimmel said, Cantor has seen an increase in existing client activity, as well as discussions with new hedge-fund clients seeking to start relationships. Yet many clients are willing to keep their accounts with the big banks if it means they still will enjoy other benefits, including opportunities to buy shares in initial public offerings, the people said.

"It's a balancing act," said Glenn Schorr, an analyst with ISI Group. "You have a conversation, and maybe there's a way of sharing the higher costs."

Cutting ties with certain hedge funds can help Goldman improve the financial health measures that regulators watch closely. Goldman finance chief Harvey Schwartz last month told analysts the firm undertook a "comprehensive analysis" of its books and "identified opportunities to reduce the balance sheet." The effort helped Goldman increase its ratio of capital to total assets, known as the leverage ratio, to 4.5% from 4.3%, closer to the 5% minimum U.S. regulators have mandated as the minimum by 2018.

In all, Goldman sliced $56 billion of assets during the second quarter, or roughly 6% of its total, Mr. Schwartz said. He said the cuts had only a "de minimis impact on our client franchise and earnings potential" and that the firm's prime-brokerage franchise "feels quite strong."

Banks have allowed hedge funds to keep cash in their prime-brokerage accounts as a convenience for clients. But the cash also adds to banks' total assets, weighing down their leverage ratios.

Goldman and other big banks are pushing to streamline their balance sheets before the end of the third quarter. That is the period the Federal Reserve uses when it runs banks' books through a battery of stress tests that gauge how the