Alphabet (GOOGL) slips after hours despite Street-beating Q2 >>> READ MORE

Hedge Funds Sent Scrambling by Goldman Sachs

The hedge fund landscape is shifting once again, and the smaller outfits are taking the biggest elbows


Goldman Sachs (GS) is recasting its prime brokerage platform and only the most profitable — or the biggest hedge funds — will remain, according to a report in The Wall Street Journal. As a result, those funds simply not producing enough trading volume will get the boot.

goldman sachs stock gsIt’s a blow to smaller hedge funds, which will have to scramble for their financing needs — even as capital is once again flowing into the industry.

The bulge bracket firm isn’t the only one unloading less profitable funds of late, although its decision shakes things up, evidenced by Goldman’s standing as the leading prime broker for hedge funds, according to Preqin data.

It also shows a shift in the underlying trend in the hedge fund business:

Top 10 Prime Brokers Servicing All Hedge Funds (Source: Preqin)

  1. Goldman Sachs: 19%
  2. Morgan Stanley Prime Brokerage: 13%
  3. JPMorgan: 12%
  4. Credit Suisse Prime Fund Services: 10%
  5. UBS Prime Services: 7%
  6. Deutsche Bank Global Prime Finance: 7%
  7. Bank of America Merrill Lynch: 4%
  8. Citi Prime Finance: 4%
  9. Barclays: 3%
  10. BNP Paribas Prime Brokerage: 2%

The Goldman Standard

As a prime broker, Goldman holds assets and provides trading services such as securities lending and financing to hedge funds. It’s turning away business in its prime brokerage for a couple of reasons:

  1. Heightened capital requirements for banks, which restricts the amount of lending and financing they can do and which led Goldman to withdraw from its own hedge fund.
  2. Lackluster revenue in its securities services division, where hedge fund services are grouped.

In the second quarter, for instance, Goldman’s securities services revenue at $373 million was down 1% from $376 million in last year’s second quarter.

In an effort to comply with the changing regulatory landscape, Goldman during the second quarter analyzed “return on asset characteristics” — GS is hunting ways to shrink its balance sheet, so those hedge funds delivering the lowest ROA are being shunned.

“It’s not profitable for them to service smaller hedge funds. They don’t trade as much,” Bulent Ozcan, RBC Capital Markets analyst, told InvestorPlace.

And Goldman isn’t the only one. Dick Del Bello, senior partner at Conifer Financial Services, says the prime brokerage firm is already a beneficiary of the shift.

“Other banks have made the same decision but they have not received the same publicity as Goldman,” Del Bello told InvestorPlace. “In this kind of regulatory environment, everyone is trying to figure out ways to trim their balance sheets and increase ROI and ROE.”

This is in stark contrast to before the financial crisis, when profits were flowing more freely and hedge funds were welcome as long as they were generating returns. Post-financial crisis, hedge funds began diversifying into a multiprime broker model for better risk management. In this latest regulatory environment, things are changing once again.

It’s not that these hedge funds won’t have anywhere to go. Smaller prime brokers without the capital requirements, overhead and infrastructure — like Conifer, whose prime brokerage platform houses hedge funds with assets under management ranging from $75 million to $125 million on its platform — are happy to take the business.

“It’s going to force hedge fund managers to be more judicious about where they are,” Del Bello said. “They won’t be allowed to have multiple accounts at major investment banks without generating income for all of them. Therefore we could experience a trend in having fewer rather than more (prime brokers), but clearly best practice is to have more than one regardless.”

Smaller prime brokers like Conifer have risks, too.

“We have our own capital at work, just like a big bank does. We have the benefit of having JPMorgan (JPM) behind us to provide financing, but we do have our own capital in this business,” Del Bello said.

For Goldman, it’s nothing personal. In fact, Goldman would keep those smaller hedge funds on its platform — for more trading volume or a higher fee — to make it worth their while. But it’s tough enough for hedge funds with fewer assets under management to maintain fixed costs, let alone rising fees.

Asset Flows

It’s not that assets aren’t flowing into hedge funds. Assets under management in the hedge fund industry are rising, evidenced by the $30.5 billion in capital directed to hedge funds in the second quarter, bringing total AUM to $2.8 trillion-plus versus $2.7 trillion in the first quarter, according to hedge fund research firm HFR.

The industry trend, however, is that the bigger hedge funds are getting bigger, making the barriers to entry much tougher for the smaller firms, according to RBC Capital’s Ozcan.

The latest HFR data underscores this trend, evidenced by hedge fund industry assets being mostly parked in the largest funds.

  • Hedge funds with more than $5 billion in AUM: 67.91% of industry assets
  • $1 billion – $5 billion in AUM: 21.97%
  • $500 million – $1 billion in AUM: 4.09%
  • $250 million – $500 million in AUM: 2.76%
  • $100 million – $250 million in AUM: 1.91%
  • Less than $100 million: 1.35%

Bottom Line

Goldman’s decision to unload less profitable hedge funds from its prime brokerage platform is a positive for the firm, as it moves it closer to regulatory standards, frees up more capital (that it would have otherwise directed toward hedge fund financing activities) and removes those funds that were a drag anyway.

For the hedge funds, however, who may have to scramble at first to replace Goldman as their prime broker, it’s a setback, through and through.

As of this writing, Gerelyn Terzo did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

©2017 InvestorPlace Media, LLC