Questions Mount Over Hedge Funds' Bank Relationships

by Carla Johnson, Investors Offshore.com

24 March 2005

CSFB's recent report that investment banks generated $25 billion in revenue from hedge funds in 2004 has set a lot of people speculating about what may be a very unhealthy relationship.

Credit Suisse First Boston estimates that inflows from hedge fund fees made up more than 10% of total investment bank revenue last year. The dealings between hedge funds and banks are very complex and take many forms, including trading, lending, 'prime brokerage' and other services, making it hard to work out whether or not this income stream is a good thing for either party.

CSFB thinks that prime brokerage (clearing and settlement services) account for about $6bn of the $25bn, with trading accounting for most of the rest. The total amounts to approximately 2.5% of the assets under hedge fund management ($1 trillion), and Bloomberg points out that together with hedge fund managers' own fees, this probably means that the funds have to make 5% on their trading just to break even. This may not be sustainable.

"It has become a very incestuous relationship between the banks and hedge funds,'' Tim Price, senior investment strategist at London-based Ansbacher & Co., told Bloomberg 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.''

There has been a growing chorus of critics of hedge fund fee levels in recent months. But it has yet to stop the flood of money transferring into the sector. In Canada, for example, $2bn of new money in February took total hedge fund assets to $16bn - and this in a month when one major fund appears to have gone pear-shaped with more than $700m of investors' money at risk.

Pretty soon, there is going to be a spectacular hedge bust, somewhere in the world, and it is going to take a bank with it.

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