Investment Banks Are Too Dependent on Hedge Funds: Matthew Lynn
March 21 (Bloomberg) -- Hedge funds have never been short of critics. They have been accused of overcharging, underperforming, destabilizing the financial system and ripping off investors.
Still, there is one charge that might have some substance to it: An unhealthy relationship is emerging between hedge funds and investment banks.
Indeed, the greatest risk posed by the funds may be to the banking industry.
Earlier this month, New York-based Credit Suisse First Boston examined how much money the world's hedge funds were paying to their investment bankers. It came up with an estimated total of $25 billion for 2004 -- about $19 billion of that came from sales and trading, and the rest from prime brokerage, which consists of providing loans and facilities to hedge funds.
That represents more than an eighth of the investment-banking industry's total revenue pool.
Although huge, that's not an unrealistic figure. CSFB isn't the only organization to probe the massive flow of fees streaming out of hedge funds and into investment banks.
Boston Consulting Group Inc., for example, estimated last year that servicing hedge funds generated revenue of about $14 billion for the investment banks in 2003, and about $5 billion to $6 billion in profits. ``Hedge funds are one of the most attractive customer groups for investment banks,'' it concluded.
Meanwhile, McKinsey & Co. estimated that the banks are raking in $18 billion a year from hedge funds, according to CSFB.
Dangerous Codependency
Clearly, it is possible to disagree on exactly how much the banks are making from hedge funds. It is a complex sum because the banks don't publish figures on income from different clients.
Still, it's a lot of money.
That helps clear up one mystery. We now know why investment- banking profits have been soaring in the past few years, even though mergers and acquisitions have been flat for most of that time, and equity markets have been moribund. All those new fees from hedge funds have been filling their coffers.
So is there a dangerous codependency emerging between hedge funds and investment banks? ``In any client relationship there is going to be an issue of conflicts of interest,'' said Marc Rubinstein, a London-based CSFB analyst, in a telephone interview. ``The key lesson the banks have learnt over time is that they have to make sure they are managing those conflicts.''
There are two main points to draw from the relationship between the banks and the funds.
$1 Trillion
First, hedge funds are paying their bankers an extraordinary amount of money. Suppose the CSFB figures are right. An industry with an estimated $1 trillion in assets under management is paying $25 billion in banking fees, or 2.5 percent of the money they manage. Add their own fees, and they probably have to make 5 percent a year just to stand still. In the short term, that kind of trading may work. In the long run, it isn't sustainable.
Hedge funds may have created a way of doing business that is too expensive to be viable over time.
Next, the banks are becoming dependent on the funds. In any walk of life, people will bend over backward to please the customers who help pay their wages.
When hedge funds submit to those kinds of fees, how many bankers will ask tough questions? Will they pause to examine loans? Will they create a fuss if a fund is trading too aggressively, or using derivatives to take highly leveraged positions?
Not likely. It takes guts to be rude to a client generating millions a year in fees.
`Incestuous Relationship'
Then think about the closeness of some of the relationships that are being created.
``It has become a very incestuous relationship between the banks and hedge funds,'' said Tim Price, senior investment strategist at London-based Ansbacher & Co., in a telephone interview. ``They are selling hedge funds, managing hedge funds, lending to them, and competing with them through their own trading desks. In effect, Wall Street has found a way of trading with itself.''
Banks such as Switzerland's UBS AG are among the largest managers of hedge funds in the world.
And some of the biggest hedge funds are run by people who have just stepped out of investment banks themselves. Star figures such as Gavyn Davies, a former British Broadcasting Corp. chairman and Goldman Sachs Group Inc. partner, have started hedge funds. Business relationships are overlaid with personal ties. The result is a dangerous codependency.
About 9,000 hedge funds have been launched. The law of averages suggests some of them will go bust and lose a lot of money. It is just a matter of time before one of the main investment banks is caught up in the mess. When it happens, it won't be pretty. |
