Reports in Opalesque this month that the fund administrator HSBC Holdings was terminating agreements with some smaller Asian clients in favour of focussing on their larger ones was no surprise in an industry which has been forced by the financial crisis to focus on its bottom line.
Another news story this month revealed a further example of role swapping in hedge funds as Wells Fargo disclosed it has hired a hedge fund administration sales executive as they are finding that some hedge fund managers are increasingly relying on administrators rather than prime brokers for financing services.
In order to survive, the provision of services to hedge funds, both prime and administrative, has emerged from the debt crisis with tougher business models. The Asian hedge fund industry, struggling to achieve performance and enduring loss of funds under management is at the sharp end of any cutbacks. Faced globally with a wall of regulatory change and stricter capital requirements, banks are reviewing their provision of prime services with new smaller funds struggling to get representation and larger funds getting larger.
Background to prime broking
Back in the 1990s a huge number of what are now household name hedge funds were set up by proprietary traders leaving their City banks, shedding their pin stripes and emerging in denim and suede shoes in well appointed offices.
The range of services provided to hedge funds was immense. While on the one hand a new fledgling hedge fund's pedigree was immediately discernible by who its prime broker was, on the other the prime brokers themselves fought to get the business of the best new managers, offering every conceivable service from office location, full IT support, staffing, administrative support, capital introduction and of course, at the heart of it, broking services.
The relationship between a hedge fund and its prime broker has been described as a 'Faustian pact'. Hedge funds almost never change their prime brokers and as a result prime brokers were able largely to dictate their terms to the managers that they serviced. The shivers that went through the capital markets caused by the demise of Long Term Capital Management in 1998, revealed huge potential systemic risk in the system.
The discovery that the banks behind the prime brokers might be vulnerable to systemic market collapse pushed many hedge fund managers to re-read their contracts with prime brokers and discover that in some cases their terms of business were not necessarily all to the fund managers' (and their investors') advantage.
When managers found that their assets under management had been hypothecated as collateral against their trading activities, many opted to re-negotiate their business and to hire a second or even a third prime broker in an attempt to control the way that they managed their assets.
Ten years on from LTCM's collapse, 2008 saw the collapse of Lehman Brothers, the fourth largest investment bank and prime broker to many hedge funds. The speed with which the ATM effect of panicked investors withdrawing cash and the sudden loss of liquidity in the capital system hit hedge funds, funds of funds and the banks that serviced them was literally breathtaking.
For the most part, hedge funds survived, and, perhaps because of the warning shots across their bows that they experienced in 1998. Many hedge funds in fact became less entrepreneurial and more institutional in their structure, and many returned to the more personal business model of one main prime broker but with the power more equally balanced between bank and client.
A recent report from Barclays who acquired the Lehman Brothers' prime broking business, finds that regulatory developments since 2008 have driven a change in the prime brokerage fund model, to which hedge fund managers and investors must adapt. This is likely to result in increased costs for hedge fund clients, says the report, entitled Evolution of the Hedge Fund Financing Model.
Prime broking Asia
Prime broking operates in a very tough environment across the world: it is estimated that only 400 hedge funds globally are large enough to make it profitable for prime brokers to offer a full service. However this can be good news for smaller funds. Once they find representation they can benefit from the existence of these larger funds, getting access to a better service than their scale might suggest.
David Murphy, head of Prime Finance for Citibank in Asia says of his role in the region: "Prime broking basics are similar however I would say while Asia has some sizeable hedge funds it has more than its share of smaller funds so one aspect is that I think you need to be able to cater for sizeable funds and smaller funds, provide a service that will work for both, larger funds and funds that are working towards being bigger."
And for smaller funds, that can work in their favour. "Asian funds, including the smaller ones, get looked after really well. Prime brokers want to have a global presence with resources here so if anything smaller funds in Asia get looked after better than comparably sized funds in other regions" Murphy says.
The largest prime brokers in Asia are Goldman Sachs and Morgan Stanley, out on top by client assets, closely followed by Credit Suisse and Deutsche Bank. The latter is believed to be the biggest for funds managed in Hong Kong and Australia.
Harvey Twomey, Head of Asia Pacific Prime Brokerage Sales, Capital Introduction and Consulting, Deutsche Bank explains that there are also key structural differences in prime broking Asia. He says: "The key difference in trading Asia is that unlike in Europe or North America, the majority of the markets here that interest investors, some 13 out of 17, are synthetic with respective offshore investors accessing. They can't be accessed directly and hence the greater reliance on the services that Deutsche Bank and our peers provide through our synthetic prime brokerage offerings."
One Asian based hedge fund manager says: "Different brokers are good for different things hence multiple accounts which allow different market access and also access to the ideas of sales trading desks and research departments. You don't need more research in Asia, you need to keep your finger on the market pulse."
Twomey agrees: "Our prime finance offering is very much integrated with our research platform so if for instance we publish a sector-focused research thought piece which is bullish/bearish on a sector, then we can immediately create specific synthetic baskets to enable clients access and gain exposure where appropriate. Typically you will find that the equities sales groups in Asia are smaller, tighter and more integrated; the hedge fund coverage teams including financing are all motivated to offer clients a complete solution from idea generation, best execution, financing and hedging".
And there is some good news in Asia. Twomey says: "Asian Hedge Fund AUM sits at $130-140bn right now, well off the highs of 2007 and pretty stagnant over the past 12 months. It must be said that returns have been underwhelming when compared with the US for the last 18 to 24 months but investors are still very much interested in Asian funds with good pedigree managers that generate alpha, boast solid infrastructure and are institutional in their make-up and approach. The allocations made in 2012 have very much tended towards the second generation spin outs from large global hedge funds".
Citibank's Murphy says: "Our perspective on capital flows to Asia is that we think that with a longer perspective US institutional investors consider themselves underweight Asia so when opportunities arise there is a reasonable amount of demand. But they have a strong preference for a certain type of track record or size and not many meet that criteria."
And for Asia there is the additional constraint in terms of how much capital large overseas investors can deploy because of liquidity: "Critical mass is achieved to attract institutional investors, but then the fund may close to new money relatively quickly" Murphy says.
For Twomey's colleague Anthony Byrne, Head of Asia Pacific Prime Finance, Deutsche Bank and deputy chairman of AIMA Hong Kong, hedge funds are gaining popularity across Asia. "There is increased acceptance across the region by investors and regulators that hedge funds are an asset class they want to encourage. Korea, for instance, has very much embraced setting up a domestic hedge fund industry extending the range of qualified investors, lowering restrictions on management and enabling the development of domestic prime brokerage services. From a standing start they already have approximately $600m in domestic hedge funds in Korea" he says. Mid-October, Opalesque reported that Jun Kwang-woo, CEO of Korea's $340 billion National Pension Service believes that by next year, the situation may have improved enough to institute legal changes allowing investment in hedge funds.
China is also potentially developing its hedge fund market, as reported in Asia Pacific Intelligence last month. "We expect to see a number of things develop in China over the next few years with the onshore hedge fund-esque Sunshine Fund complex; if they keep on developing the way we expect, we will start to see a sophisticated domestic onshore hedge fund industry take shape in Shanghai, Beijing and Shenzhen" says Twomey. "Shorting onshore in China will become a reality in time, and the very liquid futures market will continue to develop. Currently onshore funds are the only approved players in this market; it remains to be seen whether offshore funds will be able access the futures market sometime in the future; it will surely a major boon to liquidity generally if they can."
This article was published in Opalesque's Asia Pacific Intelligence our monthly research update on alternative investments in the Asia-Pacific region.