New York – An article in the International Herald Tribune yesterday discusses the ins and outs of so called “Hedge fund Hotels”. Hedge fund hotels are really just another facet of the prime brokerage industry that is growing very quickly. Fledgling hedge funds receive services, office space, receptionists, phones service, IT services, management consultants, etc. to help them gain traction and hopefully produce significant trading revenues for the prime broker in the future.
The prime broker provides all of these start-up services in exchange for fatter commissions (soft dollar allocations). Since the hedge fund is taking services from the prime broker the trading volume generated is directed through the prime broker trading desk. Of course, part of the commission relates to the cost of execution of the trades, but another healthy slice is dolled out to the prime broker for the services.
Credit Suisse estimates that investment banks made $25 billion from their relationships with hedge funds in 2005. Of this $19 billion was generated through sales and trading operations and $6 billion was generated through prime brokerage.
It seems only natural that the investment banks should focus on the hedge fund community since:
- Hedge funds face less regulation in general
- Are subject to less scrutiny in commission allocation
- Are much more aggressive traders than the long only money managers – therefore greater trade flow
- Tend to be small at the outset and need the services of the prime brokerage community
Despite the apparent beauty of this symbiotic relationship, some regulators are taking a position that these relationships contain inherent conflicts of interest and the services are being challenged via a law suit brought by the Commonwealth of Massachusetts against UBS.
We include the article below:
International Herald Tribune
US Regulators Grow Alarmed over “Hedge Fund Hotels”
By Jenny Anderson, Monday January 1, 2007
Inside a Philip Johnson- designed office tower in the Boston financial district, UBS, the giant Swiss bank, is running a “hedge fund hotel.”
Just as venture capitalists and others during the technology boom created incubators to help entrepreneurs start businesses without the headaches of finding real estate and office support, so a few big investment banks are offering young ambitious hedge fund traders a temporary home, complete with receptionists, espresso machines and consultants to help manage their information systems.
As the technology incubators sought to oversee the birth of the next Netscape, so these hedge fund hotels hope that the small hedge funds may some day become big clients of the bank.
UBS is the leader in this business, with 400,000 square feet, or 37,000 square meters, of hedge fund hotels in a number of cities. Bear Stearns is also active, with space for rent in New York, Boston, San Francisco and Los Angeles.
Some regulators, however, are growing concerned about the relationship between the banks and their hedge- fund hotel guests, looking at whether the banks might be using the real estate-relationship as a way to entice hedge funds to do business with them.
William Galvin, secretary of the Commonwealth of Massachusetts, has subpoenaed UBS, and he is investigating other banks with hedge fund hotels in Boston to determine how the banks are charging for their services.
“It’s a conflict of interest issue,” Galvin said.
A spokeswoman for UBS declined to comment.
At the heart of the investigation is a thorny issue that has dogged regulators for decades. Money managers, including mutual funds and hedge funds, often pay Wall Street with “soft dollars” – inflated commissions that include the cost of trading (typically 1 cent to 2 cents a share) plus an additional few cents a share that can be directed to pay for research and other services.
Soft dollars are controversial because the higher commissions are paid for by clients while the services often benefit the manager most. Higher commissions result in greater expenses for the fund and potentially lower returns for investors.
In the late 1990s, the U.S. Securities and Exchange Commission cracked down on the use of soft dollars by mutual funds, concerned that investors were being duped into paying for services the manager enjoyed.
Massachusetts is now investigating whether hedge funds are improperly using soft dollars to pay for space in these hotels and failing to disclose to investors that they are covering a major expense.
“It’s the same soft dollar question,” Galvin said. “What kind of quid pro quo might be in the placement of an order? What’s the relationship between the entities?”
At the heart of Galvin’s investigation is the understanding that as hedge funds have exploded, so too have the fortunes of Wall Street. Hedge funds typically trade more than other Wall Street clients and they trade exotic, high-margin products, like complex derivatives. Because hedge funds have become such important customers, there are concerns that they may be getting better information than other investors as a result of the business they do with the banks.
The business of servicing hedge funds is called prime brokerage, and it includes financing trades, finding and lending stock to allow hedge funds to short stocks (betting that their price will fall) to structuring derivatives and executing swaps. It can also include hedge fund hotels – securing real estate, receptionists and information technology and even managing, say, the risk of trading currencies in Asia.
The global prime brokerage business generates between $8 billion and $10 billion a year, estimates Vodia Group, a consulting firm for the financial services industry. The business is highly profitable, with a return on equity – a measure of how efficiently the bank reinvests its capital – of a healthy 15 percent to 20 percent. In 2006, Goldman Sachs made $2 billion directly servicing hedge funds, 22 percent more than the previous year.
Prime brokerage is only the tip of the iceberg when it comes to the fees that hedge funds generate for Wall Street firms: billions of additional dollars come from trading for these funds.
Credit Suisse estimates investment banks made $25 billion in revenues from hedge funds in 2004, $19 billion of which came from sales and trading and the rest from prime brokerage.
Hedge funds now control half the volume traded on the New York and London stock exchanges, according to Credit Suisse.
Hedge funds generate about 30 to 35 percent of the equity commission volume of the major Wall Street firms, according to Brad Hintz, a securities analyst at Sanford C. Bernstein.
But that’s only part of the equation.
“Because a hedge fund has broad investment guidelines – it is not constrained like a mutual fund to invest in certain stocks or certain sectors – it allows the hedge fund to really go after some of the more financially attractive products the Street offers,” Hintz said.
In the United States, Goldman Sachs, Morgan Stanley and Bear Stearns lead the pack in prime brokerage, collectively controlling about 75 percent of the market, according to Sanford C. Bernstein.
But neither Goldman nor Morgan Stanley run significant hedge fund hotel operations. (Goldman inherited a small business from Spear, Leeds Kellogg, which it bought in 2001.)
Bear Stearns’ hedge-fund hotel clients tend to be small, though some that started with the bank 10 years ago have built multibillion-dollar systems. Bear Stearns unusual is because it accepts only “hard-dollar” arrangements, rather then venturing into the murky area of soft dollars.
Bank of America exited the hedge fund hotel business 18 months ago because of a lack of demand.
Lehman Brothers and Credit Suisse have been building their prime-brokerage businesses. Lehman has space that it leases to a select group of clients, but it is not a major player in the hotel space. Credit Suisse prefers to cater to a small number of institutional-quality hedge funds that are expanding into high-margin products like structured derivatives and reinsurance.
Jefferies, a bank that caters to mid- market clients, recruited a significant part of Bank of America’s prime brokerage team to build up its business, including hedge fund hotels. Glen Dailey, head of prime brokerage, said the business was too expensive to build.
The banks that provide hedge fund hotels are careful to indicate they do not endorse the fund they are presenting to investors. But that may always be clear to investors.
“When does the corporate veil get pierced here?” Hintz of Sanford C. Bernstein asked. “When is this fund not independent because it depends on its broker-dealer for everything? It could get messy.”
Comment by Bill George:
The International Herald Tribune article mentions that Bear Stearns charges hard dollar “rent” for the space and other services they provide. In my experience most of the investment management “incubators” I have attempted to work with were obligated to execute all of their trades through the host’s trading facilities, without regard for best execution, and the commissions charged on those trades was not discounted from the standard institutional rate of $.05 per share.
Do Bear Stearns’ current space lease agreements provide lessors with competitive “execution only” rates for their trades? Can lessors use their investment discretion to seek best execution? Can they use any broker to execute their trades?
With hedge funds the issue is merely a matter disclosure, with advisors who must comply with Section 28(e), ERISA statutes and fiduciary law the answers to the questions above can raise very problematic legal issues.
Same dance, different tune.