Hedge Fund Hotels: Is the Model Broken?

Overview

Jenny Anderson's story in today's New York Times has caused a bit of stir. So UBS is now being scrutinized by the State of Massachusetts for commission practices in their hedge fund hotel, yet another angle on the "soft dollar" debate that has been raging for the past decade.  From my perspective the analysis is fairly simple: if UBS and others running these hotels are somehow jacking these nascent funds by charging excessive commissions, and using this as the mechanism for absorbing the costs of providing infrastructure support, they are truly stupid and should be hit - hard. Then there is the issue of disclosure, i.e., how the funds operating out of hedge fund hotels are disclosing payment for services rendered, and if soft dollars are being used to pay for expenses that are not soft dollar-eligible. Bottom line: if institutions like UBS are operating in an improper manner, after all that they and others have been through in the IPO "spinning," mutual fund timing and research settlement cases, I will be dead shocked. I just can't see it.

Hedge Fund Hotel Operators and VCs - Birds of a Feather

The economics of firms running hedge fund hotels are somewhat similar to that of firms running venture capital funds: you will have a whole bunch of duds that are hopefully offset by a few home runs. Home runs are a function of variables such as assets under management (which drives loan balances, borrows, capital introduction, etc.) and the profitabilty of the strategy for the prime broker (driven by trading volume and the complexity of the products traded (derivatives, emerging markets instruments, etc.)). Think about it - the costs of setting up a hotel are not small. Solid real estate, high-technology intensity and high quality people support are the tickets to play the game. And the ongoing operating costs of supporting platforms like these are not small. So, the goal is to pick the funds that are most likely to succeed, with the potential for generating the most business for the prime broker.

It Ain't Easy Picking Winners - Adverse Selection at Work

But picking winners is really hard, and there is a measure of adverse selection built into the process: true "rock star" managers aren't going to operate out of a hotel because they don't need to - they have enough cash to start up themselves and to hire a top COO while attracting several billion in AUM on day one. So what you tend to get in hotels are lesser known, riskier names who may well be very bright but may be been the #2 or #3 at a mid-size fund or a strong analyst at a big fund. Again, this is a risky business. But if you catch it - that fund you've helped to incubate turns into a $3 billion multi-strategy colossus - you can ride the gravy train for a long, long time. Once a prime broker becomes embedded in a firm it is pretty painful to rip them out. This is the fervent hope of the hotel operator.

Hotel Operators and Prime Brokers - Supporting Capital Formation

I think prime brokers in general and hedge fund hotels in particular play an important role in the capital formation process. It enables potentially able and talented yet little known managers to get their shot, while both minimizing costs and distractions to the investment process. And this is key to the young manager, who wants nothing more than to generate returns with a couple of trusted partners without having to worry about whether a trade will clear or if a phone will be answered. Some may say, "Screw them; if they can't run an office on their own then they shouldn't be managing money anyway." I take a somewhat less cynical view. There are invariably nuggets of greatness to be found embedded in large firms, where the individual in question may not get their chance to run a big book because of talented people in front of them. Hedge fund hotels simply add incremental liquidity and opportunity into the investment landscape. If a manager can't cut it, they fail and go home. If they do make it, however, riches are bestowed upon them with lesser yet significant riches going to their prime broker. And this is the way it should be.

Conclusion

Do the hotels need to do unethical and illicit things to be successful? I don't think so, especially if the firm has the ability to seed top prospects, reserve future capacity and potentially get a piece of the GP. That said, it is not a business for the faint of heart of thin of wallet, as it requires substantial upfront investment and skill to make it work. And this is my guess as to how UBS is doing it. But if they're not, it will represent yet another unnecessary black eye for the hedge fund business.

Comments

[Kris Tuttle]

Three years ago I took a serious look at starting a hedge fund and BofA in Boston was able to provide an incredible springboard. Great office space, furniture, information services and so forth all for just a promise to use them as a PB which is a set of services you need anyway and one figures they are all more or less the same on price. If one really does have a clear edge that can applied in creating a hedge fund the PB infrastructure is a key aspect in making sure the markets are efficient enough to accomodate it with little or no cost. The economics of hedge fund hotels are obvious and the VC analogy is a good one, especially when you consider the incubator strategy as part of that.

[Yaser Anwar]

Sir, I don't think they would suffer the fate of Big 3 auto. First of all, they’re the custodians for many of the securities, which means they can offer the most competitive rebate rates.

2nd, if they need to lend out money and rely on short-term money markets, they’re probably going to get the lowest cost of capital going.

A Wall Street firm might be single A, where the Big 3 are AA or AAA.

In this game, having your rating even one notch higher matters.

P.S. Check out this list I found while searching for the top Prime Brokers (and I don't even have a Hedge Fund yet ;)

http://bp3.blogger.com/_PZ0YxW8sh_4/RZstaWbNlaI/AAAAAAAAAKs/geQmg0Dbx6k/s1600-h/Prime+Brokers.JPG

[Roger]

Yaser, Goldman, Bear and Morgan Stanley represent approxmiately 75% of the prime broker market as measured by revenues, as I understand the stats. Deutsche, CS, BofA are the leaders of the rest.

Clearly the Big Three prime brokers are not dissimilar from the Big Three US automakers prior to their decline over the past two decades. Whether or not they experience a similar fate only time will tell.

[Yaser Anwar]

Forgot to mention, but would it be fair to say that Prime Brokerage is an oligopoly (GS, Bear, Lehman & CSFB)?

[Yaser Anwar]

Interesting points sir.

After reading your response (as to what top-tier PBs can do) I guess now I know why The largest prime brokers, typically with the strongest cap intro capabilities, have become increasingly picky about who they bring on as clients. Devoting their ultimately limited resources mainly to the funds that offer the greatest source, or potential source, of commission & other revenue.

[Roger]

Bill, the real answer to your question: yes, but only if you can soft dollar them.

[Roger]

Yaser, you are directionally correct but orders of magnitude off. The kinds of cost savings you are describing don't exist in the real world. Furthermore, don't underestimate the power of the prime brokers. Even a large fund doesn't want to piss off its key prime brokers - when the shit hits the fan who is going to be there for you? Your bargain-basement, second tier prime broker or your full service, long-standing top tier prime broker? Also, what about those difficult shorts? Who is going to work overtime not calling you in? Who is (and can) going to turn over every rock? You get the point.

While there is certainly price competition in prime brokerage, once a strong, mutually beneficial, symbiotic relationship is established, it is not going to run away for a handful of basis points. It's just not.

[Yaser Anwar]

Let's assume a hedge fund dealing with two prime brokers has a small piece of its flow to play with. If the fund can get 5% to 10% of its securities lending done at half the price from a third, independent provider, without offending its major primes too much, its definitely going to do that, as every dollar the fund saves goes directly to the bottom line.

Furthermore, if a big fund can show comparative pricing data, it could start doing less business with a Goldman or Morgan Stanley. Or it could come back and show it’s been charged with hefty fees and it would like to shave off 20 to 30 basis points across the board, while still doing business with the broker.

It’s going to be very hard for a Goldman or Morgan Stanley making between $5 million and $50 million a year off a big client to say ‘no,’ if the alternative is losing the business altogether.

What do you think sir?

[Roger]

And who says anarchists are pure of mind?

[Bill a.k.a. NO DooDahs!]

Do hedge fund hotels have hookers?