January 25, 2010 / 11:28 AM / 10 years ago

Banks target new fee stream in servicing hedge funds

HONG KONG (Reuters) - After years of earning huge fees from hedge fund clients, investment banks are eyeing yet another way to extract revenue from these treasured customers.

Banks such as Morgan Stanley and Credit Suisse are looking to mine their lucrative prime-brokerage businesses by charging a fee to raise money for their hedge fund clients.

The initiative is not without potential conflicts, as hedge funds that haven’t signed up for the service may find their prime-broking bankers favoring clients now paying for capital raisings.

With hedge funds increasingly using multiple prime brokers, competition is urging banks to find ways to generate fees from existing relationships and keep clients within their stable.

While still a relatively new and fledgling operation, capital raising for hedge funds is a potential cash cow for banks as fees charged will come as a percentage of the funds raised.

By one estimate, a $500 million capital raise for a hedge fund could bring as much as $10 million, or 2 percent, for a prime broker.

Hedge funds managed $1.48 trillion in assets last year and that is expected to rise to $1.78 trillion by the end of 2010, according to data from research firm Eurekahedge.

Any initiative by U.S. banks involving hedge fund services needs clarity from Washington D.C. President Barack Obama has threatened to fight banks with a new proposal preventing financial institutions that own banks from investing in, owning or sponsoring a hedge fund or private equity fund.

Obama’s plan, however, faces an uncertain political fate and would take years to come into effect.

EARLY MOVERS

For now, banks are forging ahead.

Morgan Stanley has set up a global capital-raising platform dubbed the ‘alternatives capital group’, with a presence in New York, London, Hong Kong and Dubai, a company spokesman said.

The new group sits outside the bank’s prime brokerage unit.

Credit Suisse has launched a similar service, according to sources with knowledge of the matter. Officials at Credit Suisse were not immediately available to comment.

Various prime brokers have in the past provided capital-raising services to select clients, either bundled with other prime services offerings or under other guises, said an official with a bank, who did not want to be named.

What’s new now is that capital raising is being spun off as a separate unit by the banks, in an effort to focus more on the service itself.

Capital-raising services for hedge funds also have to be run separately from prime-brokerage services to address concerns about conflicts of interests.

The new initiative may make prime-broking clients that historically haven’t paid banks for capital-introductions wonder if hedge funds that are paying for that service are getting favorable treatment from the bank.

While banks splash out on annual capital-introduction conferences, arranging for investors from across the world to meet their hedge fund clients, the actual commitments that can be directly attributed to the service are difficult to estimate.

“The bank has to persuade managers who are used to the free capital-introduction services that they can perform miracles with capital raising and should get paid for it,” said a hedge fund manager based in Hong Kong.

The prime services offered by banks typically include securities lending, leveraged trade execution, custody and clearing as well as capital introduction, which seeks to match hedge fund clients with potential investors free of charge.

LONG TERM OR SHORT TIMERS?

Traditionally many hedge fund managers hire third-party marketing consultants or distributors who help them raise capital from institutional investors, fund-of-funds, family offices and high net-worth individuals.

The third-party marketers make money by charging a small retainer while also taking 20 percent of the fund’s fees through the duration of their relationship with the client.

“The typical fee structure charged to hedge funds by boutique capital introduction firms ensure that the interests of the hedge fund manager and the third party marketer are aligned,” said Alexander Mearns, CEO of Eurekahedge

Third-party marketers target investors that are likely to be more long term, said Mearns, and banks will need to replicate this model and incentivise their staff appropriately to successfully raise capital.

Other prime brokers are expected to jump into the fray, as the timing of this capital raising initiative is no accident. Hedge funds across Asia (excluding Japan) achieved average gains of 38 percent in 2009.

Asia saw the launch of about 60 hedge funds in 2009 but most start-ups were relatively small — under $50 million — after a disastrous year for the industry in 2008 kept investors gun-shy.

A stellar performance last year has served to change investor sentiment toward the industry but assets under management in Asia-Pacific fell slightly in 2009. The region makes up about 8 percent of total assets under management at global hedge funds.

Editing by Michael Flaherty and Muralikumar Anantharaman

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