In my view, prime brokers and [hedge] fund administrators will increasingly find themselves competing in the same space in terms of the services they can offer," says Rob Schultz, head of HSBC's alternative fund services for North America.
According to a Celent Communications report, "The Burgeoning Business of Prime Brokerage," "Global hedge fund assets will increase at an average annual rate of 16.5 percent over the next five years, doubling to $2.1 trillion by 2009." And as the industry grows, so will demand for support services, the report continues. But, while opportunities abound for service providers, competition will become evermore intense.
Hence the heightened focus from the hedge fund servicing community - prime brokers, third-party administrators (TPAs) and technology vendors - on product and service development. As each looks for revenue-generating opportunities and market share, the challenge is expanding core business areas through the addition of ancillary services. The upshot, says Denise Valentine, analyst with Celent and author of the October report, is increasing overlap between the service models.
"Prime brokers, fund administrators and technology providers are converging on hedge fund managers. The three groups are eagerly adding ancillary services or launching new or enhanced solutions for the hedge fund community. All three are encroaching on each other's traditional service or solution areas," states an earlier Celent report, "A Cottage Industry Goes Mainstream: Hedge Fund Technology in the Spotlight."
Traditionally, prime brokers' core business has focused on trading, clearing and settlement, and custody facilities, as well as the more lucrative aspects of financing and securities lending. However, prime brokers are offering a growing list of additional services, notes Valentine, including portfolio systems, partnership accounting, portfolio risk analytics, margin and cross margin, and aggregated reporting. But, she adds, "Many of these additional services can be duplicated by fund administrators, technology providers and even outsourcing firms."
Certainly, fund administrators are seeking to provide an evolving array of value-added services. Four or five years ago, all a third-party administrator did were month-end net asset values (NAV), while hedge fund managers looked to their prime brokers for portfolio reporting, risk-management systems, performance measurement and attribution systems, according to Stephen Hixon, chief operating officer for North America with BISYS Hedge Fund Services. "That is significantly changing," he says. "What you need to do now is provide what we call daily P&L, where you are posting all the trades on a daily basis, reconciling positions and cash every day, and pricing securities every day."
The driver, Hixon explains, has been the trend among managers to use more than one prime broker. Whereas prime brokers used to provide a lot of information, managers now are unable to get all the information they need from a single broker, so they are looking to their administrators instead, he relates.
Addition Through Consolidation
But, increasingly, being competitive means having the scale and resources to develop and support this expanding range of services, which is where market consolidation comes in. To date, a number of traditional administration firms have moved into the hedge fund space, buying up specialist providers with hedge fund administration expertise: BISYS has acquired Hemisphere and RK Consulting; The Bank of New York has snapped up International Fund Administration; State Street purchased International Fund Services; HSBC acquired Bank of Bermuda; JPMorgan bought Tranaut Fund Administration; and Mellon Financial announced in January its purchase of DPM, a Somerset, N.J.-based hedge fund administrator. Having an alternative-investment capability is another arrow in the mainstream fund administrator's quiver, while having a large parent, particularly a leading custodial bank, provides the hedge fund servicing unit with a lot of additional clout.
For example, as part of HSBC, Bank of Bermuda is able to sell more products to clients, from front- to back-end servicing, says HSBC's Schultz. So, while its core business remains fund administration, Bank of Bermuda has a range of add-on capabilities, including a front-end trade-order-management system. It also has the ability to reconcile daily positions, handle daily position valuations for products that include over-the-counter transactions, provide value-at-risk analysis so clients can do Monte Carlo simulations, offer FX facilities and credit, and provide trade execution for derivatives.
Brian Ruane, executive vice president with The Bank of New York, makes similar observations: "BNY offers a broad array of services to our hedge fund clients, with two of its lead products [being] administration and trade execution," he says. "In addition, we offer a full range of banking and securities services, including cash management, collateral management, clearance, custody, foreign exchange, private banking and corporate trust."
So, is the prime brokerage business under threat from fund administrators? Ruane thinks not. "Hedge funds rely on four key service providers: TPAs, prime brokers, attorneys and accountants. Each delivers distinct services," he relates. "While TPAs have expanded their offerings to include some services offered by prime brokers, they are generally operational in nature."
Seth Weinstein, president of the newly launched Morgan Stanley Fund Services and a former senior member of the firm's prime brokerage business, makes a similar point: "The two, while sharing many synergies, are stand-alone businesses," he says. "In many ways, the TPA picks up where the prime broker leaves off," he continues. "The market differentiation, from both sides, is in how well the respective services are integrated."
One area in which prime brokers continue to predominate, though, is in the servicing of start-ups. If you are working with start-ups, the idea is to get to market quickly, according to Celent's Valentine. The idea that a prime broker can offer a one-stop shop - office staff, administration, a room in a building, phones, a trading terminal - has been very attractive, she relates.
And other areas of prime broker service differentiation remain. "There is the balance sheet, the financing, the stock lending, the credit intermediation piece, which is still going to be the domain of the prime broker," says Marty Malloy, managing director, global head of equity finance, with Barclays Capital. "Those fund administrators that are not part of a large financial institution just don't have those types of raw materials the hedge funds require. So I see these two living in parallel with each other."
The big question mark, though, lies in the intentions of the big bank-cum-administrators: Will they decide to use their considerable resources to push further into the prime brokers' core activities? As BISYS' Hixon observes, "BISYS is not a bank, so in our current state we are not going to compete with prime brokers on their core business of trade execution, securities lending, financing, extending credit. But if you look at some of the other big third-party administrators, are they going to compete with the prime brokers at some point? I would think that some will."
Of course, political considerations will have to be taken into account in any decision. A lot of intertwined relationships exist among prime brokers, fund administrators and custodians, and whether a firm feels it is worth taking business away from one of its clients remains to be seen.
Meanwhile, on the flip side, some prime brokers have moved into the fund administration business, as a means to offer full soup-to-nuts service. The reason, says HSBC's Schultz, is that fund administration is central to the operation of a fund in terms of having responsibility for gathering all the fund's data, reconciling positions and holdings, and reporting the fund's NAV. Administrators are also in a better position to offer middle-office, risk and consolidated positions compared to brokers, he adds. "With so many hedge fund managers using multiple brokers and counterparties, only the administrator is in a position to see everything that is happening," Schultz explains.
By contrast, Barclays Capital prefers to work with external providers for administration services. It seeks to differentiate itself by extending prime brokerage services beyond traditional asset classes, says the firm's Malloy. "Funds are going to want to transact their business with whomever they like and be able to consolidate that with some of their core providers - and not just on the cash side, but on the synthetic side as well," he notes.
Going forward, then, success in this most dynamic of markets will not come without a struggle, whatever side of the fence a firm starts on. As BNY's Ruane concludes, "In order to meet the increasing demands of the hedge fund industry, service providers are going to have to continue to expand and improve their offerings. The technological capabilities of providers for all services will need to improve rapidly to keep pace with the industry's growth," he says. "Given the resources needed to remain competitive, we expect to see continued consolidation in the industry."