While many large investment banks have sold their hedge fund administration businesses in recent years, those who remain are said to be putting increasing efforts into providing managers with a holistic service across admin and prime.
The likes of Goldman Sachs, Citigroup, UBS, Credit Suisse, Wells Fargo and Deutsche Bank have all sold their administration arms to competitors over the last six years as their levels of cross-sell diminished and senior management found it hard to justify them as standalone operations.
When Citi’s AIS business was sold to SS&C in 2015, a key driver behind the sale was the low levels of cross-selling Citi was able to achieve between its admin and brokerage businesses. However, those that retain admin and PB capability are looking to take advantage of cross-selling opportunities to increase their ‘wallet share’ and diversify the services provided to funds.
Some years ago, it was not uncommon for large banks to be aggressive in their pitches to hedge funds, mandating that firms must use their administration platforms to gain access to their prime brokerage services.
While this model has been somewhat consigned to the past, several hedge fund pros and senior admin sources have told HFMWeek that they have seen examples of aggressive pricing models over the last year, particularly involving Morgan Stanley, to ensure clients take up administration alongside their PB services.
Morgan Stanley and JP Morgan are the biggest hedge fund primes to retain an administration arm, although HSBC and BNP Paribas both operate in each space and MUFG Investor Services is looking to offer certain financing services to hedge funds alongside having an admin offering.
Over recent years there have been several rumours that JP Morgan would look to offload its admin and hedge fund operations, and finance pros have lamented mixed signals they have received over that time with regards to its commitment to the market.
However, sources close to JPM say there is a full commitment to retaining the admin operation, which is seen as an important part of a broad range of prime and other services the bank provides to hedge funds.
In 2015, JPM corporate and investment bank CEO Daniel Pinto said the firm was creating more collaboration between its prime brokerage, admin and cash equity businesses as part of a move to mitigate capital ratios related to prime brokerage due to Basel III requirements.
Meanwhile, Morgan Stanley has always been strong in cross-selling its services and has seen a spike in admin business recently. HFM’s last admin survey notes the bank gained 19% in AuA for the six months to the end of October, from $220bn to $263bn.
Data from consultancy and analytics business Convergence, gathered from regulatory filings with the SEC, shows Morgan Stanley has a 73% cross-sell rate between its PB and administration arms, rising from 68% in 2014.
JP Morgan boosted its cross-sell levels to 42% from 28% over the same period. Convergence says these figures are compelling evidence that banks are now more actively selling integrated fund administration and prime brokerage. These figures relate to funds where the firms are either a single or multi-prime.
Convergence chairman John Phinney says hedge funds can benefit from lower overall pricing where PB and admin are bundled together and, from the bank’s perspective, the model is attractive because of the diversification of its revenue stream.
“The pricing should be more cost-effective to buy a bundle of services rather than uniquely in the marketplace. The diversification of services enables banks such as JPM to have deeper, more long-term client relationships,” he adds.
Mifid II concerns
Citco head of hedge fund services Kieran Conroy says as well as pricing, banks are restricting preferential levels of access to certain prime brokerage services unless firms use their admin platforms. This model is particularly prevalent in North America, with Mifid II rules in Europe potentially restricting cross-subsidisation within investment banks.
“Our sense, from speaking to North American clients, is that some firms are only giving preferential access to PB services such as to leverage rates, stock lending and/or research if the fund uses the same business for admin also,” he says.
“In a European context, if you think through Mifid II – the intent is to be transparent, that people are paying a fair price for the service and to ensure that one part of a business is not paying for another.”
One fund services head from an investment bank adds that any model where prices are not justified separately and without subsidy would be hard to justify long-term form a business perspective.
“You need to charge properly for individual services and if you don’t then you run the risk of compromising everything. It is wrong to buy assets, that is a dangerous road to go down.
“You need to be paying for the services you are getting and, in particular, the elements that are purporting to be third party and independent.”
Operations due diligence experts point to several possible conflicts of interest in the cross-selling model that need to be managed and stress the importance of ensuring Chinese walls between businesses. This segregation is of critical to allocators, ensuring the managers they invest with are able to protect their strategies from traders.
“One of the potential conflicts I see is if the fund’s positions, which the administrator has full transparency into, are leaked to the prime brokerage side and end up on a trader’s desk,” says SkyBridge Capital managing director Virginie Kolesnikov.
However, she adds that while there is a preference for separate admin and prime broker counterparties, it is down to individual managers to carry out the requisite due diligence to ensure the separation of parties if choosing to go with one service provider.
“When we meet with managers who use the same firm for their administrator and PB, we make sure that those managers have done adequate due diligence work and are satisfied with the level of segregation between the PB and administration businesses,” she says.
“It is important that the manager ensures there is an adequate Chinese wall between the two conflicting businesses and that there is no movement of confidential data between the two.”
“From a compliance perspective there is more pressure on hedge funds to avoid the perception of a conflict of interest,” according to Corgentum Consulting managing partner Jason Scharfman.
“Admins may be forced to get more independent pricing sources than they would if it was not the same entity because there is more of a concern around conflict of interest.”
Rival admins also highlight another potential conflict that must be managed in terms of the admin arm of the cross-selling bank being able to view the levels of business being placed with another PB and financing rates.
“If you had two prime brokers, the PB will be able to see financing rates and it doesn’t give you very much bargaining power and they will know what balances you have with different prime brokers. You may not want that information known,” says Centaur Fund Services head of business development Gavan McGuire.
However, other investor ODD pros are more sanguine. Aon Hewitt principal Mark Flanagan says that when it comes to managers using huge institutions such as Morgan Stanley and JP Morgan for PB and admin, he would be reassured due to their status as “established behemoths of the industry”.
He also plays down fears over sufficient Chinese walls between different arms within investment banks.
“When you are talking about such firms, you can be comfortable that there is good segregation between different parts of the bank. The reality is that admin arm and prime brokerage are probably not in the same country.
“We would take comfort that if something went wrong they are large enough to write a cheque to cover the loss because they couldn’t afford damage to their reputation.”
Another head of ODD at a large US-based investment consultant agrees that he would have confidence that huge institutions, now obsessed with compliance procedures post-crisis following a host of fines, would have the correct procedures in place.
The CFO of a multi-billion dollar long/short equity fund is more blunt. “They would never do it as they’d know we’d fire them in five seconds if it came out,” he says.
Although he does not have any worries of appropriate Chinese Walls being established, a bigger concern is the history of bank admins “flip-flopping” between desperately wanting a firm’s business and then pulling out or at least becoming less competitive.
He adds: “Over 30 years I’ve heard the same pitch again and again and I’ve then seen the results a few years later. I’m not sure how much has changed.”