UPDATE: Small Prime Brokers To Consolidate For Needed Scale

As the hedge-fund industry prepares for greater scrutiny from institutional investors stung by the financial meltdown, many smaller prime brokers are being pressured to consolidate to offer the scale and services their clients increasingly demand.

"There has been a general upgrading of hedge fund-related services to cater to institutional investors," said Steve Keller, Bank of America Merrill Lynch's head of Americas financing sales. He added that without a platform that fits the needs of institutional investors, "raising capital would be nearly impossible."

Pension funds are increasingly entering into alternative investments as interest rates remain depressed, making it hard to achieve 8% target returns on their portfolios by investing in fixed-income instruments like U.S. Treasurys.

But with the bitter aftertaste of the financial crisis and the Madoff Ponzi scheme still lingering, many institutional investors are demanding hedge funds partner with service providers that offer assurances through brand name and scale, especially when appointing new fund managers. Prime brokers provide a wide range of services to hedge funds, including securities lending, financing, capital raising and back-office support.

The need to gain a decent scale of business is fueling acquisitions within the prime brokerage industry. U.S. derivatives-brokerage firm I.A. Englander & Co. said last week it was acquiring Alaris Trading Partners LLC, entering institutional brokerage services including prime brokerage to hedge funds. New York-based brokerage firm Direct Access Partners LLC bought First New York Securities' prime-brokerage unit, which was formed just a few months earlier.

Industry sources said several other small prime brokers--also known as mini primes--are in the process of winding down the business or are considering merging with peers, indicating that business isn't as good as firms had hoped.

"It looked like pretty easy business for a while. But the reality of the situation settled in when the wave of new clients, shed from investment banks, dried up, forcing mini primes to find clients on their own," said Dick Del Bello, a senior partner with San Francisco-based fund administrator Conifer Group LLC. "And the investing atmosphere is not conducive to business."

Ron Suber, a senior partner and head of global sales at mid-sized prime brokerage Merlin Securities, said the industry could see a few more acquisitions in the remainder of the year.

"There could be one or two exits by the end of the year, as some firms may want to sell their businesses this year to avoid potential tax hikes on capital gains," he said. The Obama administration is still mulling whether to extend the so-called Bush tax cuts beyond this year. One effect would be to maintain the capital-gains tax at 15% instead of 20%.

The prime-brokerage industry consolidation signals the end of a short-lived expansion spurt among small prime brokers at the onset of the financial crisis. Hedge funds, worried about counterparty risk, were switching their business from big U.S. investment banks to European firms or doing business with multiple prime brokers.

Credit Suisse Group (CS) and Deutsche Bank AG (DB) were the major beneficiaries, though smaller prime brokers also gained market share from industry leaders like Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS). Business for small prime brokers also was propelled by investment banks trying to shed small to medium-sized fund clients and outsource them to smaller prime brokers to lighten up their balance-sheet burden.

First New York Securities, FBR Capital Markets Corp. (FBCM) and Lazard Capital Markets started their prime-brokerage businesses in late 2008 to take advantage of that outsourcing trend, with BNY ConvergEx Group LLC following suit late last year after buying NorthPoint Trading Partners LLC. BTIG LLC also branched out into fixed income prime services in July 2009, on top of equities.

Two years since the crisis, the wind is shifting again, but this time to the disadvantage of smaller primes.

"Funds, instead of branching out to multiple primes as many did following the market downturn, are now largely consolidating their business partners to take advantage of banking services and a broader geographical network to better meet their investment needs," said Keller of Bank of America Merrill Lynch.

To make matters worse, large European banks are entering prime brokerage.

BNP Paribas S.A. (BNPQY) bought a U.S.-based prime brokerage business from Bank of America in September 2008 and relocated its head of capital introduction, Emma Sugarman, to New York from London in August. The bank aims to be one of the top five providers, leveraging its strong European ties. Industry participants said London-based HSBC Holdings PLC (HBC), France's Societe Generale Corporate & Investment Banking and Japan's Nomura Holdings Inc. (NMR) are all jostling in the space, leveraging their banking relationships with hedge funds and the funds' increasing exposure to Asia and Europe. HSBC and SocGen declined requests for comment, while no immediate response was forthcoming from Nomura.

Merlin Securities' Suber said recent developments may mean small prime brokers will "revert back to their execution-only specialization" from before the financial crisis.

-By Amy Or, Dow Jones Newswires; +1 212 416 3142; amy.or@dowjones.com

Fbr Capital Markets Corp. (MM) (NASDAQ:FBCM)
Historical Stock Chart
From Jun 2024 to Jul 2024