Comment: Lehman/Merrill woe will be great news for big hedge funds
The owners of the world's largest hedge funds should spare a minute for a quiet smile, in between navigating difficult markets and soothing anxious clients, at the radically altered investment banking landscape to which they awoke this week.
The initial effect of Lehman Brothers filing for administration and Merrill Lynch falling into the embrace of Bank of America will be anxiety, for hedge funds, for clients and non-clients.
Those that used the banks as prime brokers will be worried about having to close out positions at short notice, while those with any cash deposited with the bank must be concerned about getting out their money when they want it. Estimates relating to 2006, the latest available, published by ABN Amro show Lehman Brothers commanded about 3% of the global prime broking market while Merrill Lynch accounted for about 4%.
Non-clients can expect a knock-on effect from the removal, possibly temporary, of two players from the prime broking market, particularly since this follows trouble at Bear Stearns, which according to the ABN estimates was the world's second largest prime broker with about 21% market share.
Each of these three prime broking businesses may keep going, with varying degrees of likelihood, but many hedge funds will prefer to put their business elsewhere, if for no other reason than the fact that investors in hedge funds like to see rock solid banking names as prime brokers. The remaining prime brokers, primarily Morgan Stanley and Goldman Sachs, can expect an increase in demand from hedge funds, giving them greater power to set stringent terms.
This will cut into all hedge funds' profitability in the short term.
Small hedge fund managers will be most hurt by this, as their profit margins, in dollar terms, are the slimmest. Bankers will also impose the most stringent terms on them because they generate less business for banks than large hedge funds. Under these conditions, combined with net outflows from investors, David Smith, chief investment director of multi-manager business at Swiss-owned GAM, said: "I think you will see an awful shakeout of the smaller hedge fund managers, many of them will prove not to be economically viable.”
In the long-term, this will help the largest hedge fund managers, in three ways.
First, the disappearance of a tail of small managers will clear out competition. Hedge funds have found themselves crowded together in the same positions in the last four years, notably convertible arbitrage managers who came to comprise more than 70% of the convertible bond markets in 2004, according to Watson Wyatt; statistical arbitrage managers, whose computers led them to take positions in the same equities and try to leave them at the same time in early August last year; and managers in Asian equities. Fewer players will bring a welcome relief.
Secondly, a wave of talented hedge fund managers currently locked into their own, small businesses will suddenly become available to be recruited by the large firms. There are limits to the amount of money a single hedge fund manager can handle without loss of performance, and the difficulty of finding good staff has held back firms so much that a war for talent has developed in the hedge fund industry, according to recruitment consultants. The development should allow large firms to increase their capacity.
Finally, the sight of small hedge funds disappearing will reaffirm to investors the desirability of having their money with a large manager. They will particularly favour those that have invested in its operational systems and focused on obtaining reliable sources of finance.
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