November 2007

COVER STORY - NOVEMBER 2007: Fully equipped?

As fund managers use ever more complex instruments, some are now selecting prime brokers instead of custodians to service their portfolios. Angelique Ruzicka analyses this emerging trend 07_11_cover_story.jpgMainstream fund managers’  use of exotic instruments is increasing as they seek to compete with hedge funds. Enabling legislation such as Ucits 3 has seen long-only managers implement derivatives to support strategies such as 130/30. Many have also launched classic long-short funds. However, the majority of investment management firms are being held back by operational limitations, according to a study conducted by consultancy Morse in September this year. Traditionally, custodian banks are appointed to service managers’ long-only equity and bond portfolios, but the increasing use of exotic instruments means that custodians’ services are in danger of being exhausted. “Prime brokers offer much wider asset coverage and scalable platforms that process derivatives,” says Tony Freeman, head of industry relations at Omgeo. Could prime brokers genuinely rival the big custodians in the field of asset servicing for traditional asset managers? Though there are signs that this may be an emerging trend, prime brokers approached by Funds Europe are not yet ready to declare war. With business ties to custodians, several did not wish to comment. Dr Chris Sier, a consultant at Morse, puts prime brokers’ reluctance to grab the limelight down to their different style of doing business. “They are a valid option for investment management companies but they are not really ready to call themselves outsource providers yet. They like to dip in and out and won’t do a contract service – it’s a forbidden place.” While this could be a problem for asset managers who are used to custodian’s contractual packaging, custodians are aware that this won’t be a deterrent for long. But custodians have been slow off the mark to solve this dilemma that they face. Most have only relatively recently begun to think about catering to alternatives. “Derivatives have been on the custodian radar for a long time, but only to a very small volume. So they may have automated some of the process but nothing as scalable as the equities, fixed income and cash, which are the three core instruments that custodians cover,” adds Omgeo’s Freeman. The need for experts that know how to cater to exotic instruments is only going to become more important over time. Of the 50 investment managers and hedge funds that Morse interviewed, 28% highlighted the desire to expand further into derivatives-focused areas, revealing that they are planning to offer credit/high-yield arbitrage strategies in the future.

Prime position
As complex instruments such as over-the-counter (OTC) derivatives become more mainstream, industry experts expect prime brokers to do well in competing for business with custodians. Prime brokers are, after all, more used to catering to these instruments. “All custodians are struggling to face off this particular challenge,” admits David Aldrich, managing director of The Bank of New York Mellon, the custody bank and asset servicer. “Both Ucits funds and 130/30 funds are adopting hedge fund techniques, and that means that custodians’ traditional business is under threat because prime brokers will say ‘actually, we can do custody and we can do everything for you, why don’t you just give us the whole lot?’” Even investment managers who are only just embarking on the 130/30 strategy are not ruling out that they will consider using prime brokers in the future. Currently, Henderson Global Investors, with £61 billion under management, has its hedge funds business serviced by a number of prime brokers, including UBS, Merril Lynch and Goldman Sachs, but its European equities 130/30 fund is still serviced by custodian Citi. “We only have one 130/30 fund so we may consider prime brokers in the future. Generally, across the industry, you can see the logic in using prime brokers,” says Richard Acworth, head of communications at Henderson. The danger for custodians is that institutions and their consultants are no longer distinguishing between custodians and prime brokers. In fact, these days, they are evaluating and considering them equally when it comes to outsourcing. “This means the competitive universe has expanded quite dramatically,” says Omgeo’s Freeman. “They [the consultants] aren’t distinguishing between the custodians and prime brokers. They are all seen as solution providers who can service a fund for the institutional investor.” There are some custodians who have begun to take the potential threat prime brokers pose seriously, and have taken measures to counteract it. This year, The Bank of New York Mellon has built some additional services that include functions such as collateral management. It also sports a full triparty platform and derivatives margin management service. “This takes our product to a much broader audience than what a traditional custodian may have,” says Aldrich. “For special hedge fund administration needs, we have alternative investment services. We’ve only done it this year. They are not completely new services, but they are adaptations, and I think you can be really successful when you can adapt your product suite. We feel there is a strong role for players such as ourselves as the market evolves.” Similarly, Citi has also moved into catering to hedge funds. It has created the Hedge Fund Services business, a joint venture between Citi capital markets and transaction services to provide hedge fund clients with financing, prime brokerage, consulting, administration services and operational support. In addition, it has focused on expanding its capabilities through the e1bn acquisition of Bisys. In June this year, hedge fund Nexum appointed Citi to service its Luxembourg domiciled hedge fund. Citi will act as fund administrator, transfer agent, custodian, prime broker and  compliance monitor. Some custodians have even teamed up with independent middle and back office service providers that are active in the hedge fund space. Hans Hufschmid, CEO, GlobeOP Financial Services, says: “We find a lot of custodians have come to us to partner with them. They provide traditional services and then outsource all the derivatives processing, which means we take care of the valuation, the risk calculation of the derivatives and we process documentation if it’s required. Our main clients are hedge funds but custodians that have approached us on behalf of their clients. These include the representatives of Pioneer
and Nordea.” Douglas Nelson, CEO of institutional brokerage and services firm Northpoint Trading Partners, said that though there is an overlap in business, brokers and custodians still cater to different customers. “Most of the prime brokers are [also] custodians so it’s not necessarily competing but just providing the same kinds of services to different types of accounts,” he says. Aldrich, at Bank of New York Mellon, says it is not in a custodian’s best interests to tread too much on the toes of prime brokers. “Our solution to the competition is to broaden our client base into areas where we have experience already. We are not trying to occupy the same space as Goldman Sachs or Bear Stearns ... instead we are redefining our own space.” But whether prime brokers will really make a go of this space and steal the limelight is debatable. The opportunity is there, of course, as no custodian has been singled out as a preferred provider. “These are two distinct communities that are moving towards each other. No one firm has got itself in the middle where it can credibly claim to be a full-service prime broker hedge fund operation and full-service custodian,” says Freeman. Morse’s survey verifies this, as it highlights how investment management firms have had to resort to a blend of administrators to cater to their complex instruments. The survey found that more than half of the respondents (58%) said they used multiple sources for valuing their OTC derivatives portfolios, and a staggering 42% used three or more sources. Although 40% said they only used one source, the source used varied widely across different investment managers, and there was no preferred provider. Worryingly, 5% decided to make their lives difficult by using five or more sources.

Multiple choice
But whichever route investment management firms take, there are pros and cons. Prime brokers are more adaptable to cater to new asset classes and alternative investments than custodians are, but they can be more expensive (see table). “Prime brokers are very expensive when used at scale; hedge fund administrators lack scale and perhaps credibility in the institutional market; and investment banks have yet to decide whether they wish to enter the market,” says Sier. Besides their expense, Sier points out the uncertainty that managers face: “Hedge fund administrators feed mainly off the business of hedge funds and some can, therefore, be flighty organisations. If it’s a small organisation it could fold,” he says. Freeman singles out another advantage custodians have over prime brokers. “Global custodians are scalable and they have risk-averse processes and a ‘safety first’ attitude that is required by institutional investors. Essentially, what this means is that they can do the basics very well and innovate the products on top of that,” he says. Prime brokers will be successful in stealing some market share, feels Aldrich, but not largely, so as managers see the advantages in a division of roles. He adds: “Most investors don’t want to see the main counterparty also being responsible for the administration of assets. “Custodians are the asset servicers, and prime brokers are the leading counterparty, and we can both make money from engineering our space as fully as possible.” Ultimately, there are several options out there for investment management firms if they need help in administering funds that are now dealing in exotic instruments. Options include going to their current provider (usually a custodian), a hedge fund administrator or keeping it all in-house. To get the best service possible, Sier advises that firms be clear about what it is
they want. “It hinges upon the asset managers telling the truth about the volume of business they have. The ‘truth’ often changes. I’ve seen instances where a service provider has developed a certain capability and the client has changed their demands. The
capability that has been built then stagnates – or isn’t used properly – because actually, all the volume has gone elsewhere. This is what’s making service providers slightly nervous about throwing themselves wholeheartedly into this market.” © fe November 2007

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