Battling for hedge business

LONDON (Reuters) - Broker-dealers such as Morgan Stanley and Goldman Sachs are losing out in the battle for hedge funds' dwindling pool of assets, as funds seek out banks with diverse sources of funding in a major shake-up of prime broking.

The collapse of investment bank Lehman Brothers (LEHMQ.PK) in September shocked hedge funds, as those with accounts at Lehman when it sought bankruptcy protection had those assets frozen and risked being unable to close trades.

"The Lehman bankruptcy ... led many hedge funds to flee the two largest prime brokers, Morgan Stanley and Goldman, for the perceived safety of the universal banks," said BersteinResearch analyst Brad Hintz in a note.

Prime brokers make money by charging hedge funds fees for providing financing for trading and settlement of trades.

Credit Suisse (CSGN.VX), whose operations include a large wealth management unit as well as prime broking, saw balances in its prime brokerage unit grow 50-60 percent last year compared with 2007, a source familiar with the business said.

Roy Martins, the bank's head of international prime services, said: "There was a peak in terms of business in September and October. All the clients we took on had existing relationships and dialogues with us as they were clients we had been targeting anyway."

Deutsche Bank (DBKGn.DE), backed up by its big retail bank, has also benefited from an influx of business in its prime brokerage in the last six months, a source close to the bank said.

But Morgan Stanley (MS.N) revealed in December that its prime brokerage unit, long a profit engine, saw client balances fall 65 percent in the year to November, although it said it was seeing some hedge funds wanting to move back.

And another broker-dealer, Goldman Sachs (GS.N), said prime brokerage balances had fallen in the fourth quarter, adding that it might have lost some market share, although the business still posted a record net revenue of $3.4 billion.

QUALITY NOT QUANTITY

Some hedge funds are also cutting back the number of their prime brokers and are focusing on the soundest counterparties.

Dealing with a large number of prime brokers is no guarantee of safety, as having even a small proportion of assets with a collapsed prime broker can make it harder to calculate a fund's net asset value and return cash to investors.

"Hedge funds have become transient, they are moving their business around now," said Nick Roe, global head of prime finance at Citigroup (C.N), which saw strong growth in prime brokerage revenue in the third quarter to end-September.

"Some larger hedge funds that had three or four prime brokers are now slimming down to one or two... Balance sheet (strength) is a relatively rare commodity and so is a differentiator when picking the right prime broker," he added.

The prime brokerage industry as a whole is feeling the pinch as assets in the once white-hot hedge fund industry shrink.

Having hit $2.65 trillion (1.74 trillion pounds) a year ago, according to HedgeFund Intelligence, boosted by inflows from investors such as pension funds, funds are now facing a double whammy of performance losses of around 20 percent in 2008 and year-end outflows predicted by some commentators at between a quarter and a third.

Analysts at Morgan Stanley expected industry assets to have fallen to $1.4 trillion by the end of 2008.

And another wave of redemptions could hit this year if bad news continues and funds that have put limits on investor outflows hand clients back their cash.

However, despite this contracting base of potential clients, prime brokers are still anxious to avoid funds that could borrow from them and then run up heavy losses in current volatile and illiquid markets.

"We continue to be selective. There are a lot of clients out there with business models that aren't robust enough," said Martins at Credit Suisse.

(Additional reporting by Douwe Miedema; Editing by David Cowell)