Hedge fund servicing business is expected to grow strongly after period of uncertainty
Slash and burn were the words of the moment on a March morning when Credit Suisse announced the latest plans to restore the fortunes of its investment bank. But, buried among all the drastic measures, was a little-noticed decision to reinvest in a business that the Swiss bank was believed to have consigned to the scrap heap.
Prime brokerage — a capital-intensive unit offering securities lending, cash management, trading and other services to hedge funds — was an endangered species marked out for “optimisation” when Credit Suisse’s new chief executive Tidjane Thiam unveiled the first draft of his restructuring plan back in October.
By the March version, it had been quietly elevated to “maintain/invest”.
“Tidjane demonstrated he was flexible, assuming we could resize the business and improve returns” says Mike Paliotta, Credit Suisse’s global head of prime services, adding that prime is now set to benefit from a reallocation of capital as the bank speeds up the restructuring of its global markets division.
Credit Suisse’s change in tack echoes a broader market shift that has elevated prime brokerage from the problem child of markets businesses’ to one of the most heavily-contested areas as banks jostle to profit from the growing hedge fund sector.
Despite high-profile losses at some of the world’s most prominent hedge funds in recent months, the sector is projected to keep growing strongly as investors bet on the chance of making higher returns in an ultra-low interest rate world. PwC has forecast that by 2020 the industry, which had $ 3.2tn of assets under management at the end of 2015, will be worth nearly $ 5tn.
Deutsche Bank — the other European major that many expected to reduce prime brokerage because of its capital intensive nature — is also eyeing growth. “We are in expansion mode,” says Ashley Wilson, co-head of Deutsche’s prime business. “We want to go and attract new business . . . and we have more balance sheet capacity to deploy. We don’t feel constrained by capital resources.”
Citigroup, which fell just outside the top six global operators in the prime services business last year according to league tables compiled by Coalition, is on a quest to break into the “top tier”, its head of global investor services Okan Pekin says. Morgan Stanley, Goldman Sachs and JPMorgan are showing no signs of loosening their grip on a global market they have dominated for the last three years. Smaller European operators such as Société Générale are also trying to grow.
“It [the competition in prime] is counterintuitive given the concerns around leverage ratio shared by most banks,” says George Kuznetsov, head of research at Coalition. The leverage ratio means banks have to maintain a set amount of capital relative to their total balance sheet; it is particularly penal for prime brokerage since prime brokers typically finance their clients’ holdings by extending credit, which inflates their balance sheets.
[Competition in prime] is counterintuitive given the concerns around leverage ratio shared by most banks
– George Kuznetsov, Coalition
It was concerns about the leverage ratio — and other regulations around banks’ funding and clearing requirements — that made analysts and bank investors cast a critical eye over prime brokerage as a business.
“The balance sheet intensive stuff where you’re actually putting an asset on the balance sheet . . . is under a great deal of regulatory pressure,” says Guy Moszkowski, banks analyst with Autonomous in New York. “For people to blithely say they are expanding prime brokerage probably requires more explanation.”
Several senior executives say market “re-pricing” has been a key factor in making prime brokerage more attractive. “The days where balance sheet was free and revenues were being made at very low rates are over,” says Mr Wilson.
Banks have also made their prime brokerages more efficient by narrowing their client focus. Citi’s Mr Pekin says clients with less than $ 250m of assets “tend to be a drag on your return” and so his bank has made a “significant adjustment” towards bigger clients in recent years.
Credit Suisse has slimmed down its client list — though it believes that smaller funds can be profitable clients if they are doing certain kinds of business — and Mr Paliotta says that his extra balance sheet will be put to work providing additional services for those clients, not growing the client roster.
We want to go and attract new business . . . and we have more balance sheet capacity to deploy. We don’t feel constrained by capital resources
– Ashley Wilson, Deutsche Bank
With a more focused client list, and better market conditions, bankers say the prime business is a very attractive one. “The prime business brings benefits over many years, it’s not a quarterly thing,” says Mr Pekin. “If you want to have a leading prime business, a strong markets franchise can be a strong enabler.”
Mr Moszkowski agrees that prime brokerage “can be a good use [of balance sheet] if providing controlled access to that balance sheet . . . opens up the potential for more revenues to flow across other areas” and says the US market leaders have had some success with that strategy.
Mr Wilson of Deutsche also praises the “good stable return” of prime. Coalition’s data shows that prime brokerage has had the most stable performance of all key lines of markets’ businesses in the seven years since the financial crisis.
Unfortunately for banks looking to grow, Coalition’s Mr Kuznetsov describes prime brokerage as one of the most “sticky” businesses for investment banks, with clients reluctant to switch providers. “Under normal market conditions it is challenging for any given dealer to grow market share more than 10 per cent per annum,” he says.
These days, Mr Kuznetsov says clients are “increasingly taking into account broader considerations beyond just balance sheet commitment, such as operational efficiencies and the overall equities franchise a bank can offer”.
Citi’s Mr Pekin agrees “balance sheet is key, but it’s not the only thing” and says his bank’s ascension to the top tier will be through organic growth and therefore will not happen overnight: “It’s extremely difficult to imagine any inorganic growth . . . for us or for anybody.”
Ashley Wilson, co-head of prime services at Deutsche, said he had already hired 20 “front office” people this year and would hire another 40 IT personnel by the end of the year to support prime’s growth. The hiring — although not large numbers — contrast starkly with the bank’s plan to cut 9,000 jobs across its businesses.
Mike Pailotta, head of Credit Suisse’s prime brokerage business, said his unit would get additional resources from the latest iteration of a group-wide restructuring plan, even though the overall plan involves deeper cuts for the markets division that prime brokerage sits within.
Mr Wilson said the business was a “very attractive one” for his bank, because it had stable earnings and was very client focused.
Mr Paliotta said prime services would be a beneficiary of Credit Suisse’s latest strategic plan, which includes an extra 2,000 job cuts from its markets division and the withdrawal from some activities.
“What management decided to do was reallocate some of that capital into less volatile businesses like prime that are core to our equity strategy,” said Mr Paliotta.
He said his business had been reshaped in the fourth quarter of last year after being listed among the businesses that new CEO Tidjane Thiam wanted to “optimise”.
“We resized our client list, we are more efficient with our balance sheet, we will probably do less lending for certain types of products . . . we exited the foreign exchange prime brokerage business,” he said.
Mr Paliotta said that Credit Suisse also benefited from a broader re-pricing, as “the market got tighter and prices improved” in key areas such as high-yield debt.
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