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Broker biz up for grabs after Bear buyout

Prime competitors nab Morgan's new clients, while B of A can't find a buyer

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As investment banks witnessed key hedge fund clients of Bear Stearns' prime brokerage unit yank their assets from the company last month, in a run that ultimately cost Bear its independence, it's reasonable to think they'd be wary of courting such a chancy clientele.

Nothing could be further from the truth. The already fierce competition among prime brokers, which do everything from lending money and securities to processing and clearing trades for hedge funds, has only intensified with Bear's troubles, as major players scramble to pick up the fallen bank's prized hedge fund customers.

And while the prime brokerage industry has been dominated for years by three firms—Goldman Sachs, Morgan Stanley and Bear, which collectively had two-thirds of the market—other major financial services firms have stepped up their prime brokerage efforts in the past few years, including Deutsche Bank, UBS, Credit Suisse and Merrill Lynch.

"The appeal is simple: It's incredibly profitable," said Matt Simon, an analyst at researcher Tabb Group. "Hedge funds assets are approaching $2 trillion, and the larger investment banks are looking at their prime brokerage units and saying, 'Here's where a lot of our profits are going be coming from, and there aren't that many players in this space.'"

As volatile market conditions persist, it's becoming more important for prime brokers to monitor the day-to-day funding and servicing costs to prevent hedge fund clients from becoming a risk to them (as happened at Bear). Think of prime brokers as the grease for the gears that keep the overall market spinning.

Bear's collapse is also accelerating the trend of hedge funds moving away from relying on just one prime brokerage. "There's a bit of a feeding frenzy right now," said Joseph Gawronski, president and chief operating officer of Rosenblatt Securities, a trading firm. "With everything that happened at Bear, shops that didn't have a second prime broker are now saying they really need to get one."

While there's considerable opportunity for prime brokers right now, there's also risk. Denise Valentine, a senior analyst at Aite Group, a financial services consultancy, explained that even with great risk management, it can often be tough for prime brokers to "see the entire picture" of their hedge fund clients' activities. "Prime brokerage is often lending money to entities," she said, "and if those entities don't follow risk protocols, you could find yourself with an issue."

Prime brokerage can also be difficult for new players to enter, said Michael Guarasci, partner at hedge fund Indus Capital Partners. "We have long-standing relationships with our prime brokers, so if a new company wants to come in and do business with us, it may not get anywhere because we're pretty happy with our service. It's not easy to switch prime brokers."

But Bear's clients are up for grabs. J.P. Morgan's pending buyout of Bear gives the investment bank a quick entry into prime brokerage (J.P. Morgan currently is not a top-10 player), but the firm's success is dependent on locking down Bear's hedge fund clients. Late last month, Jeff Penney, co-head of Merrill Lynch's global markets financing and services unit, told Bloomberg that the firm received calls from more than 20 hedge funds in the three days after Bear's collapse; he also said Merrill has increased its hedge fund clientele by 50% over the past year.

Indeed, the definitive survey of the industry by Global Custodian recently ranked Merrill Lynch as the second-best global prime broker behind top-ranked Deutsche Bank. Bear Stearns was third, followed by Morgan Stanley, which fell from its top position in the survey last year. The poll doesn't include market share, but is based on hedge fund ratings of nine services, including consulting, securities lending and technology. In terms of market share based on assets, as of year-end 2006, the most recent data available, the Lipper HedgeWorld prime brokerage league table ranked Morgan Stanley first (with 23% of the market and $153 billion in assets), followed by Bear (21%, $136 billion), Goldman (18%, $119 billion), UBS (7%, $47 billion) and Credit Suisse (4%, $25 billion).

Not every i-bank believes the risk of prime brokerage is worth the reward. In January, Bank of America announced it was putting its prime brokerage unit on the block to shift "investment away from activities that do not directly contribute to the success of the company's integrated model," according to a company statement.

Some observers speculate that Bank of America's prime broker business, which catered to a broader range of hedge fund clients, may not be what other big players are looking for, since nobody's bid for it yet.

Mr. Simon estimated that there are roughly 120 large hedge funds (with $5 billion or more in assets) that all the prime brokers are targeting. "The big clients are where the money's made," he said. "The smaller funds just don't generate the fees that make them worth servicing. At Bank of America, management may have decided the returns just weren't worth the work."

Added Ms. Valentine: "Since nobody's picking it [the B of A unit] up, the inkling is that things must not be good. Alternatively, people could be of the mind-set that the crisis is not over—and while this may be a good opportunity, it's just not the right time."

A Bank of America spokesman declined to comment.
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