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Custodians face competition = from prime=20 brokers

Richard = Greensted
06 Aug=20 2007

Hedge funds are looking for integrated = servicing packages=20 from investment banks

Some time in the third quarter, Citi = will become=20 the world=E2=80=99s third largest hedge fund administrator. Its = acquisition of fund=20 administrator Bisys,=20 overwhelmingly approved by shareholders last month, will create an = alternatives=20 processing business that will be able to compete with industry leaders = such as=20 State=20 Street, GlobeOp and Citco.

Despite its = acquisition of=20 Forum Financial in 2003, Citi has been a marginal alternatives player. = Forum may=20 have taught it a lot about acquiring small independent businesses but it = did not=20 ultimately deliver the kind of market share that Citi was looking for. = Bisys=20 fills that gap as well as adding new functionality, including private = equity=20 administration.
This time round, Citi is taking a much more rigorous = approach: it has appointed Lee Waite, a seasoned investment banker, to = oversee=20 the Bisys integration programme, an indication that Citi is looking = ahead to the=20 cross-selling opportunities for its innovative hedge fund servicing = package that=20 it launched this year.

The custodians have big ambitions for = alternatives=20 servicing. Anxious to catch up after initially missing the surge in = alternative=20 investing, they have been on a prolonged buying spree. The latest = example is the=20 recent agreement by Caceis, a fast-growing French investment services = provider,=20 to buy Olympia Capital=20 International with $69bn of assets under administration.

The = deal=20 will propel Caceis into the top flight of hedge fund administrators as = well as=20 spelling the end for yet another independent provider.

As = custodians=20 continue to pick off independent participants, prime brokers are = preparing their=20 response. They are equally keen to offer a fuller range of services to = hedge=20 funds and are wary of any incursion by custodians into what they regard = to be=20 their territory. Under pressure from hedge funds that no longer stick to = the=20 original concept of prime brokerage but appoint several counterparties,=20 investment banks are looking at ways to hold on to their clients with a = more=20 integrated service offering.

Paladyne Systems, a provider of = technology=20 solutions to hedge funds, has looked at the challenges faced by prime = brokers=20 and has come up with suggestions about how they might evolve. In a = paper, The Next=20 Generation Prime Broker, Paladyne said prime brokers need to become = more=20 flexible if they are to hang on to hedge fund clients. =E2=80=9CWhile = competition among=20 prime brokers heats up and margins continue to get squeezed, managers = are=20 demanding more services from their prime brokerage relationships in = traditional=20 areas as well as expanded multi-prime services. =

=E2=80=9CClearly, prime brokers=20 will have to take concrete steps to improve the quality of services in=20 combination with expanding their offerings.=E2=80=9D

What = Paladyne believes will=20 happen is that prime brokers will adopt an open architecture approach. = Instead=20 of trying to lock in clients to a single relationship, Paladyne said the = next=20 generation will have to package and deliver services from independent = providers.=20

The paper said: =E2=80=9CThese brokers will offer technology = that is truly=20 broker-neutral and is operated and maintained by an independent = provider. The=20 independent provider aspect is critical to insure the privacy of the = fund=20 managers. These prime brokers will offer a full set of ancillary = services,=20 including middle and back office support, fund administration, and = consulting,=20 which will be provided by strategic third-party = specialists.

=E2=80=9CThe=20 third-party relationships will be branded or white-labelled by the prime = broker=20 and will be transparent to the manager. As such, prime brokers can focus = primarily on the trading needs of their clients, yet have a full service = offering largely independent of the bank.=E2=80=9D

Paladyne = points to examples of=20 this model. Bear=20 Stearns has a strategic stake in Quintillion, while Credit=20 Suisse has a link with Viteos as well as an = =E2=80=9Copen-prime=E2=80=9D partnership with=20 Paladyne. Citi has partnered with Beaucham= p=20 Technology, part of Linedata=20 Services, to launch a multi-prime solution for hedge funds. Paladyne = sees=20 this as a growing trend.

Paladyne said: =E2=80=9CGoldman Sachs, = Morgan=20 Stanley and UBS offer = complete=20 fund administration but others are scrambling to assemble or acquire = this=20 capability. To avoid any potential conflict of interest or privacy = issues, we=20 expect to see prime brokers team with existing administrators to offer=20 strategically branded or white-labelled fund administration services.=20

=E2=80=9CWe expect relationships such as Credit Suisse/Viteos = and Bear=20 Stearns/Quintillion to become more of the norm, as opposed to primes = paying=20 inflated valuations to fully acquire these firms.=E2=80=9D

If = Paladyne is right,=20 this spells trouble for custodians. The trust banks have been careful to = avoid=20 getting too close to the execution end of the hedge fund business, = either=20 because they do not want to upset the investment banks or because they = do not=20 want to put their capital at stake. Yet investment banks accept no such=20 limitations and Paladyne=E2=80=99s model would see them moving more = aggressively into=20 administration and middle-office outsourcing.

Only Citi has = reacted to=20 this. Its hedge fund servicing package includes prime brokerage, = financing and=20 capital introduction as well as administration. It has drafted in Steve=20 Bowman, former head of fixed income sales at the investment bank, to = run the=20 operation, and it is his job to carve out a greater market share with = hedge=20 funds.
Adding Bisys clients will help his cause as long as the bank = can=20 prove it can deliver a more flexible and comprehensive service than the = prime=20 brokers.

Other custodians need to re-evaluate the threat from = investment=20 banks. As their traditional asset management clients become more = involved with=20 alternative investment strategies, through vehicles such as 130/30 = funds,=20 custodians must ensure investment banks do not take the opportunity to = move=20 beyond hedge fund servicing into the mainstream sector. =

Custodians have=20 staked a lot of money on their ability to win the turf war in the = alternatives=20 market but prime brokers are not ready to roll over and give up without = a=20 serious fight.

=E2=80=A2 Richard=20 Greensted is a consultant to the custody industry and editor of=20 www.scrip-issue.uk.com

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