Finance

Duncan Mavin is a former Bloomberg Gadfly columnist.

Hedge funds are bracing for another round of upheaval in the investment banking industry, judged by their closest day-to-day relationship.

Banks are a key link in the hedge fund supply chain. Hedge funds need their prime brokerage desks for access to important corners of the markets and for leverage to juice their trades too.

After the financial crisis, the funds learned to have relationships with more than one supplier of prime broker services rather than have all their eggs in a single basket marked, say, Lehman Brothers.

By 2009, large hedge funds with more than $3 billion in assets had an average of about five prime brokers, up from about one before the crisis, according to data from Tabb Group, a research firm.

The funds' worries eventually waned again as major banks rebuilt their balance sheets and began to look sturdier. The average number of prime brokers each of the big hedge funds worked with fell to fewer than three by 2011.

Recently though, hedge funds have rapidly expanded their prime brokerage relationships -- a sign they're concerned again about the prospect of a disruption to the service.

Spot the Difference
Each of the biggest banks now service a larger proportion of hedge funds
Source: Preqin
Note: Figures refer to the proportion of all hedge funds serviced rather than assets, and take into account funds with multiple prime brokers.

Data from Preqin show that the proportion of total hedge fund clients served by each of the ten largest prime brokers about doubled last year. For several years, there had been barely any change.

The shift is sensible. Sure, the big banks have recapitalized, greatly reducing the chance of an overnight collapse. But the risk that a key link in the hedge fund chain could be broken at short notice is rising because of a combination of tougher regulation on capital requirements and recent poor results.

Short of returns and constrained on capital, banks are forced to allocate their balance sheets to where they can make the best returns. Hedge funds are right to guard against the possibility some banks could cut back on prime brokerage relationships that don't generate enough return on capital -- or even exit the prime brokerage business altogether.

At some banks, the scrutiny may be more intense. Credit Suisse, Deutsche Bank and Barclays -- all in Preqin's list of the top ten prime brokers -- each have new CEOs that are under pressure to deliver broad overhauls. Credit Suisse, in a December strategic review, noted that prime services fell on the wrong side of its target for returns and leverage.

For the hedge funds, diversity is the answer. There are scale benefits -- cheaper commissions, for instance -- to having a lot of business riding on a single prime broker relationship. But there's clearly danger there too.

Hedge funds can't afford to be cut off if a hard-pressed investment bank shuts down or sells a key prime brokerage. Their back-up planning shows they're worried that such an outcome looks increasingly plausible.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Duncan Mavin in London at dmavin@bloomberg.net

To contact the editor responsible for this story:
Edward Evans at eevans3@bloomberg.net