Attrition and consolidation are the only certainties
I am writing this article at arguably the most pivotal moment for the financial services industry in the last 80 years, and probably the most exciting period of activity for hedge funds ever. It’s way too early to fully understand what the shape of the world is going to be once the dust settles. There are certainly some interesting questions that need to be resolved regarding the structure of the industry, who the key participants will be (service providers, investors and managers) and what the winning investment strategies will be. I wish I could answer these questions definitively, but I can’t. What I can do is highlight some of the issues that need to be resolved and to explore some of the possible outcomes. As always there will be winners and losers in this most Darwinian of industries.
The last few months has seen a consolidation in the industry. Bank of America sold its unit to BNP in June and then Bear Stearns was purchased and integrated with JP Morgan’s prime services unit. The prime broking unit of Lehman Brothers is now on the block as well. This business is in the second rank of global prime brokers and has much more strength in North America and in Europe than it does in Asia. Many of its most important clients are linked back to the Bank through its equity investments in hedge funds in groups such as BlueBay and GLG. So the value of this business will be difficult to establish, but no doubt there will be suitors. It does have business and some excellent people in Asia and I would expect that Barclays for one will be looking closely at this unit in the coming weeks as Lehman’s warm entrails are picked over.
More intriguingly, what is going to happen to Merrill Lynch’s Prime Broking business? This is a front rank global prime broking franchise with considerable strength in the Asian region. The fourth or fifth biggest prime broker globally. It is now owned by Bank of America who, as I mentioned earlier, sold their equivalent business to BNP in the summer. I don’t really know what to make of this. Bank of America now have a powerful global Prime Broking franchise which they didn’t have before. Will this convince them to hang onto this business, or do they so dislike prime brokerage that this part of Merrills will get sold off? Either way client retention at both Lehmans and Merrills will be a priority. If these ownership issues are not settled soon, expect these franchises to decline rapidly in value.
Finally, the way fund managers and the boards of investment funds look at prime broking exposure has changed for ever. Gone are the days when prime broking agreements were effectively taken as read. Counter party risk is at the top of everyone’s agenda. The way a fund’s assets (especially cash balances) are recorded and segregated from the prime brokers’ own assets will be carefully scrutinised and most funds will now employ legal counsel to advise them on this. This is a big change in the way the industry works. Further, even if Lehman was not your prime broker, they may have been the counter party to a derivative contract or structured note that your fund bought. Many of these positions are now frozen by the various liquidators and hence may be impossible to value and to unwind. The reverberations from this will last a while as, at worst, some funds will be unable to operate and some investments may need to be ring fenced or placed into side pockets. Managers and Fund Boards will focus on counter party risk and on risk management in general in a much more concentrated fashion in future.
Attrition rates on Asian based or Asian invested managers are at all time highs and running at an annualized rate of at least 10%. This means that in calendar 2008 over 100 funds and maybe as many as 150 funds with an Asian bias will be closed. It is unlikely given the pace of launches in the year to date that more than 75 Asian focused hedge funds will be started. So for the first time ever we will end the year with fewer managers than we started it with.
Secondly, one of the largest fund of funds managers in Asia has recently pointed out that, in their estimation, 80% of all existing Asian funds are trading at least 20% below their high water mark. This means that no performance fees on these funds will be payable in 2008 and probably not in 2009 either. Most hedge funds run at a marginal operating loss on their management fee income and depend upon performance fees to pay staff bonuses. Thus, expect the closure rate of hedge funds in Asia to remain at current high levels, as this effect works its way through this December and next. One further problem that springs from this high water mark problem is that it will be a lot harder for many firms to retain or attract new talent as they simply won’t be able to afford to pay them. Counter balancing this trend will be an influx of newly redundant financial services professionals looking for jobs! This will drive the prices down in the short term for some positions, but expect the best people to continue to be well bid in the marketplace.
My expectation is that all of this will confirm the trend towards consolidation in the industry that has been in place for a while now. The larger managers who have scale will continue to survive and to attract new assets. It becomes harder and harder, in a world where capital is scarce and getting increasingly expensive, for new managers or smaller managers to attract start up or accelerator capital. Exacerbating this trend will be a renewed focus by asset allocators on manager infrastructure particularly with regard to risk management. This is expensive to lay down and to operate. The cycle is tightening and hence the barriers to entry and to staying in business are getting higher.
Pockets of value are appearing in many markets in Asia. Those Asian managers that are still standing are excited by the relative cheapness of many stocks that they have been following for a while. So perhaps contrary to what people might expect I anticipate that allocators will favour equity based funds over non-equity related vehicles and further, that many allocators will be looking specifically for absolute return vehicles (essentially long only) over hedged vehicles. This should also be good for those managers that run index funds or index plus funds. Pure beta plays will become more popular.
However, it is also noticeable that the breadth of strategies in the Asian alternative world is improving rapidly. This trend will continue too. As a generality, managers are being much more adept at differentiating themselves from the crowd. Areas that are increasing in popularity are speciality debt financing vehicles (especially in consumer finance), pre-IPO funds and multi-strategy arbitrage vehicles. Volatility arbitrage funds are the current flavour of the month but I question for how much longer they will continue to outperform. They do, however, bring much needed permanent diversification possibilities to the asset mix. The range and choice available to investment allocators is set to improve dramatically.
Funds of Hedge Funds
In the short run the Funds of Hedge Funds (FoHFs) industry is in difficulty, especially in Asia. Most of these vehicles are down by at least 10% in the year to date. Not what was expected from funds that were marketed as low risk, diversified vehicles. FoHFs are now suffering increased redemption activity and it appears that most of them are carrying historically high cash balances to meet this liability. This has a number of very negative effects on the industry as a whole. FoHFs are not allocating at present until they better understand their own business dynamics. This constipation will last until the end of the year. They also need to rebalance portfolios towards the better funds (which are now obvious to all) and towards the strategies that will work best in 2009 and beyond. All of this has yet to happen. When it does the dislocation for many of the losing managers will signal the end of their businesses. Longer term I think it will accentuate the trend for managers to seek to diversify their client bases as much as possible. Asia’s investor base is predominately FoHFs. For our industry to mature and to stabilize, we need to attract a higher percentage of institutional assets from both outside and inside the region.
Oh Lord let me live in interesting times!