Financial Journalist

FT Mandate, March 2009

The dire economic situation towards the end of 2008 saw asset-servicers battening down the hatches, but now the institutions have to convince their clients that they provide a safe haven in these troubled times. By Gerry O’Kane.

If 2007 was a relatively low-key year for the asset servicing industry, with the merger of Bank of New York and Mellon Financial Corporation a rare highlight, 2008 was more a year that market players want to remain low-key in discussing, save to say there has been no flight of clients.

It is what happened in the last quarter of 2008 that most preoccupies the sector, with few asset-servicers trumpeting mandates they have won, although major players report clients re-examining the ranges of services they have and how they will stand up in the post-apocalyptic financial world.

“I think it was the speed with which the economic situation deteriorated throughout last year - no one quite expected it,” admits Mark Austin, head of multinational client relationships at Northern Trust.

“The industry will certainly be looking at a new landscape in the coming years, expectations on services like cash management, transparency and risk assessment have all changed because of what has happened,” says Jay Hooley, head of the global investor services business at State Street. Such viewpoints were less common at the beginning of the year.

As the fallout from the sub-prime crisis continued, institutions were more interested in examining their portfolios and trying to discover if they could have better assessed their risk. The search for new asset valuation procedures was on.

“I think it’s true to say there was little action on gaining new custodial clients during most of 2008, however we did see renewed interest in examining portfolios and trying to reassess the risk of these investments,” says Chris Adams, head of product alternatives for BNP Paribas Securities Services.

It is a view that Jim Palermo, co-chief executive officer, BNY Mellon Asset Servicing agrees with: “Prior to October last year, pension funds were being obligated to comply with new accounting rules and that triggered much more attention on getting a full valuation of the portfolio. It was a case of know your exposures globally.”

Transaction revenues up

And while custodians saw their assets shrink alarmingly, market volatility brought increased transaction revenues, at least in the short term. Across the board the issue of increased pressure for transparency and costs reduction compelled clients to outsource certain elements of the value chain that they had not outsourced in the past.

“The net result is that the top service providers could look at increased business because of increased servicing even though the whole market was shrinking,” observes Neeraj Sahai, global head of securities and funds services at Citi.

However by the time Lehman Brothers collapsed in September and the Madoff crisis hit the headlines, investors’ preoccupations had become more focused. “Recent events have brought more to the forefront the risk of a service-provider going out of business, especially for hedge funds, and what we’ve seen is a flight to quality service,” argues Mr Hooley.

Mr Palermo calls it a “dash to strength” and says that BNY Mellon’s win of the federal government’s $700bn (€549bn) troubled asset relief programme (Tarp) helped boost the institutions’ profile of a safe haven. Similarly State Street’s slice helped too. Nobody would accept that being the recipient of federal funds was a bad thing for your reputation; everyone was doing it.

While the asset servicing industry accepts that all institutions including pension funds, looked at reassessing their risk and how reliable their valuations were, the biggest movers in the custodial and administration stakes were the hedge funds. “In order to mitigate risk, hedge funds in particular have considered moving to multiple providers solutions, but are also faced with the need to reduce costs and administrative overheads, they’ve sought out new solutions,” says Mr Sahai.

Counterparty risk

While for some time custodians grumbled that prime brokers had been muscling into their business, the problems caused by the buyout of Bears Stearns and Merrill Lynch and the failure of Lehman Brothers have caused all institutions to review their counterparty risk. Indeed, according to Colin Rainbow of consultants Watson Wyatt, UK pension funds like many other global institutions continued in the market but this time placing assets with six or seven counterparties to further reduce risk.

For hedge funds, assets that were supposedly held safely by Lehman’s prime brokers were not held in their own name and could not be quickly recovered. The rehypothecating of clients’ collateral and assets by prime brokers, by switching the assets into the prime broker’s name so they could be lent out in the repo market to raise cash, brought risk that the investors did not want.

And the response has been swift. Both institutional and private clients to hedge funds have demanded greater transparency of both the assets held and their valuations. It is similar story from most institutions. In an effort to reassure their clients, hedge funds have been seeking safe harbour, usually with the traditional custodians.

“We’ve seen a trend whereby hedge funds are trying to ring fence their assets they’re not using for leverage and we’re seeing an uptake in demand for those sort of services,” says Mr Sahai.

Utilising escrow accounts has become a more common request in the European market accoring to BNP Paribas’ Mr Adams. And as they fled prime brokers in search of security of assets and increased transparency, they brought cash, in spite of record withdrawals. “We saw massive cash inflows in the third quarter,” says State Street’s Mr Hooley.

While the yield offered on cash by the custodians has been nowhere near the levels found from traditional prime broker lending, the quest for generating alpha on these assets is now less important. Perhaps paradoxically these events have led to an increase in over-the-counter trading, making the last few years of investment in handling alternative assets for the biggest custodians a worthwhile exercise.

“Traditionally a pension fund would call the money manager and say I need $20m for an investment call. They can’t do that any more because there is not enough liquidity. At the same time they don’t want to sell into such a down market, so what they are doing to maintain their exposure is to go the derivative road,” explains Dan Wywoda, head of products at BNY Mellon Asset Servicing.

Another consequence of this concern about counterparty risk has been a downturn in securities lending. While Dutch pension funds were early and vociferous on halting all securities lending, other markets have simply reduced it, demanding much higher levels of counterparty risk assessment, usually from custodians. “I’d expect securities lending to continue on a reduced level but on the other side of the coin we’ve seen other collateral vehicles used such as overnight repurchase and government backed loans,” says Mr Hooley.

Other areas of security servicing have seen a definite downturn. “Transition management has fallen away because you’re not seeing institutional investors change managers to the same degree,” highlights Mr Austin. “The last half of 2008 was very much a case of battening down the hatches before the storm broke; now is a period of trying to evaluate the damage and what the long-term environment is going to be.”

As the markets recover so too is there anticipation of the re-emergence of the importance of a transition manager; even so the current crisis has seen Citi close its transition management arm in London.

As for the future of the business? Technology investment spend is likely to be reduced, although BNY Mellon reports an increase this year as the final stages of its merger goes through, but there will be an increased focus on areas such as valuations and risk. As for industry consolidation, the large players have neither the cash nor appetite to digest new companies, but pressures on smaller administrators to both the private equity and hedge fund industry are likely to Increase.

“If you consider that its height the hedge fund industry was worth about $2000bn and this has shrunk to $1400bn today, that reduction is likely to lead to some degree of consolidation among smaller players,” says State Street’s Mr Hooley. With 2000 specialist administrators in off-shore and hedge fund sectors still existing, the loss of one third of your customers’ asset base is likely to have a knock-on effect.

TOP 10 GLOBAL CUSTODIANS (FIGURES AS AT END-2008)

1) Bank of New York Mellon $20,200bn

2) JPMorgan Worldwide Securities Services $13,205bn

3) State Street $12,000bn

4) Citigroup Global Transaction Services $10,700bn

5) BNP Paribas Securities Services $4650bn

6) Societe Generale Securities Services $3563bn

7) HSBC Securities Services $3500bn

8) Northern Trust $3000bn

9) Caceis Investor Services $2780bn

10) RBC Dexia Investor Services $1896bn

TOP 10 GLOBAL CUSTODIANS (FIGURES AS AT END-2007)

1) Bank of New York Mellon $23,100bn

2) JPMorgan Worldwide Securities Services $15,900bn

3) State Street $15,300bn

4) Citigroup Global Transaction Services $13,100bn

5) HSBC Securities Services $6100bn

6) Northern Trust $4100bn

7) BNP Paribas Securities Services $3800bn

8) Caceis Investor Services $3358bn

9) RBC Dexia Investor Services $2900bn

10) Societe Generale Securities Services $2585bn

Source: FT Mandate Research. Ranked by total volume of assets under custody worldwide ($bn)

REGULATING FACTORS

Those companies playing in the securities and capital markets are simultaneously being faced with a downturn in earnings and the need to improve efficiencies and cut costs. On top of that, the hoary old subject of increased regulation is expected to further pressure operations.

“Asset managers are going to be faced with the issue of overcoming increased regulation, reducing risk while tackling issues of cost and that means they’ll take a deeper interest in electronic dealing automation,” advises Christy Bremner, global managing director of Thomson Portia, a systems supplier for the back office of buy-side asset managers.

Apparently, these systems are no longer referred to as straight-through processing (STP) in Asia or North America, but the search for the seamless electronic trading holy grail continues. It has gradually moved down the trading chain, reaching the middle and back office, the less glamorous links and the poorer cousins when it comes to technology investment.

According to Ms Bremner, those on the sell side trading face the biggest hole in their electronic systems, often having issues with settlement and reconciliation with custodians. But, she adds, size doesn’t matter as even the larger houses which may have bigger pockets, were faced with real obstacles in handling their more complex asset mix. “There are no standardised solutions out there, and while firms like Omgeo and SunGuard and custodians have their own answers, none are standard and none seem likely to become so.”

While rates in exchange traded equities are nearly fully regarded as being processed electronically from purchase to settlement, other investable assets are not so far advanced. “It must be said that there has been progress in electronically trading OTC products but there remains much to be done,” adds Ms Bremner.

FT Mandate, March 2009

There are huge opportunities in private equity, but can boutique houses offer the services and security that are in demand? By Gerry O’Kane.

You can almost hear the increasing pitter-patter of the administrators’ heartbeat when they speak about private equity prospects in 2009. While much is made of a grinding down of the sector, fund administrators are rubbing their hands in glee – at least if they are one of the bigger players.

Some of the larger custodians saw private equity administration business grow by as much as 60 per cent in 2008. Many are hoping to realise increases in business of 20 per cent this year. “Best industry estimates say that only about 15 per cent of private equity funds outsource the administrative function,” reveals James Hutter, global business executive, JP Morgan Private Equity Fund Services.

“In these uncertain times, private equity firms may want to hire a strong, global administrator, so they have more time to focus on their core business,” he adds.

“Post-Madoff, regulators and clients are seeking a greater separation of duties and as so many private equity funds do all forms of administration internally, this applies to a lot of companies,” says Jack Klinck, State Street’s head of global investment product services. But the statistics for this sector are nearly as depressing as those for the global banking industry: financial sponsor teams at investment banks reported that the total global revenues generated fell by 79 per cent between the collapse of Lehman’s in September and February this year, according to data provider Dealogic.

In February research from Nottingham University and Barclays Private Equity showed that buyouts hit their lowest level since 1994, while a research paper by Spain’s IESE Business School and management consultancy Boston forecasts that half of them will default on their debt and only one third of buyout firms will survive.

Mr Hutter accepts that the private equity sector may contract, but the need for new services, perceived transparency, and increased efficiency in order to save money will push many of them into the arms of fund administrators for the first time. In terms of systems that provide transparency and a clear line of audit work, most do not have them.