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Rupak Ghose is an adviser to fintech companies, the former head of corporate strategy at ICAP/NEX and a former financials research analyst.
Hedge-fund managers can congratulate themselves: Their industry has matured to the point that they’ve become a cash cow for the rest of the financial sector.
Even as dealmaking, commercial real estate and tech sectors have fallen fallow this year, the latest round of bank earnings show that it’s a good business to serve traditional hedge funds. Prime brokerage businesses, which provide financing, capital introduction and other services to hedge funds, have been resilient.
Nowhere is this more evident than in the results of prime-brokerage market leader Goldman Sachs. The latter generated around half its revenues in equities in the second quarter from “financing”. As the bank said in its second-quarter presentation: “Equities financing net revenues were a record and primarily reflected significantly higher net revenues in prime financing”.
Looking at both equities and its fixed-income, commodities and currencies (FICC) business, Goldman’s markets-financing revenues are on pace for around $8bn this year. To compare, they were $2.6bn in 2013.
To be sure, this “financing” designation includes other types of clients and not just hedge funds. But it still illustrates the strength of the bank’s hedge-fund client base.
Some of this is related to GS’s growing market share, of course. Every conversation about prime brokers lately seems to centre on the same three players: GS, Morgan Stanley or JPMorgan. Even so, prime-brokerage revenues have been rising across the industry. And even weaker players like Bank of America said second-quarter performance here was strong. The bank’s decline in 2Q equities-market revenues were “partially offset by an increase in client financing activities”, it said in its second-quarter presentation.
Hedge funds have become more important to equities and FICC intermediation businesses of banks as well as smaller but strategic areas like equity research. While long-only active fund managers have historically been a larger aggregate proportion of clients for sellside banks and market-data vendors, they remain on the decline for well-reported reasons.
The shift of hedge funds from a wide number of equity/short funds towards a smallish number of multi-strategy and fixed income or macro funds will show up in three distinct ways: headcount; investment/infrastructure; and investment style/leverage.
First is headcount. There is a well-publicised land grab for scarce talent in the hedge fund world, especially for portfolio managers with proven track records at other firms. In general, multi-strategy firms, or “pod” shops as they are known, have many more portfolio managers, analysts, and support staff. As a result, they consume far more resources than other types of hedge funds, whether it be sellside sales and research or market data terminals from Bloomberg. This may be duplicated many times over in different and fully separate “pods” in the same multi-strategy firm, to ensure returns are uncorrelated.
The investment and infrastructure required to serve hedge funds is different as well. The days of the hedge-fund manager who traded purely on gut instinct are long gone, and infrastructure costs around data and electronic trading are sizeable.
The whole industry is looking at how to expand into new areas of alpha generation and emulate Citadel’s success. An expansion like Citadel’s into commodities markets is not just about hiring portfolio managers, but can involve infrastructure investments in terms of data, technology and risk management that can cost hundreds of millions of dollars. It’s a small change relative to the outsized reported returns, but is nevertheless a sizeable investment that few peers can afford to make.
And the third and final key difference is in hedge funds’ investment style and leverage. Many of the most successful equity long/short managers of recent decades — such as Viking, Lone Pine, TCI, Lansdowne, and Egerton — had very different investment styles from the dominant multi-strategy shops. The former had more concentrated investment portfolios and less churn, and were closer to long-only growth funds than multi-strategy “pods”. (Remember, capital is often pulled away from a “pod” when it is down 5 per cent, and the “pod” closed altogether if it is down 10 per cent.)
Commissions to sellside banks and data vendors are consequently much larger for pod shops. Similarly, equity long/short funds tend to deploy leverage that is order of magnitudes lower than multi-strategy and systematic firms that are in vogue today, meaning the industry’s AUM packs a greater punch.
A $55bn net outflow in 2022 and $9bn of net inflows in 1Q of this year isn’t really a bull market. But the real change here has been in the institutionalisation of the hedge-fund industry. And more top funds are deploying a “pass through” model, where a huge share of operating costs are passed directly on to their clients. And many star managers like Mike Platt continue to be large leveraged clients of Wall Street, but as family offices.
These structural industry changes are here to stay. But banks, brokers, exchanges, and market-data vendors should remember that, with interest rates at 5 per cent, the hurdle rate for absolute-return businesses like hedge funds is much higher. Some of those hedge-fund cash cows may get sent to pasture, and the financial industry should be prepared.