State Street’s agreement to acquire Investors Financial Services for what some analysts saw as too high a price showed its determination not to fall too far behind rival Bank of New York.
The deal will boost State Street’s assets under custody to $14,000bn (€10,700bn), putting it slightly ahead of JPMorgan Worldwide Securities Services with $13,900bn of custody assets, but still trailing BNY, which following its recent merger with Mellon Financial Corporation will become the world’s largest securities services player, overseeing assets worth $16,600bn.
In the wake of such mergers, analysts are quick to talk up the anticipated benefits of consolidation. Ray Soudah, a leading consultant on M&As in European financial services commented that BNY/Mellon deal was a positive development for custody clients as the new entity “will have the ability to cut costs”. Whether or not BNY does cut pricing for clients remains to be seen.
State Street expects cost savings of between $345m and $365m in the first two years after closing from technology, staffing and property consolidations. Will it pass on these savings to clients through lower pricing of custody and fund administration services? Only time will tell.
So far the signs are not particularly encouraging. For years now, consolidation in the custody industry has been leading to a smaller number of ever-larger players without exerting any significant downward pressure on pricing. While service-providers point out that a core package of commoditised or standard services is offered at a competitive price, any degree of customisation will attract a premium. Custodians argue that over time these value-added services become part of the core package, so they face a constant challenge to develop new products and services.
That might be so. However, an examination in this issue of how hedge fund administrators approach pricing and prospective clients suggests that custodians and fund servicers retain the upper hand and are not afraid to use it.
Denise Valentine, an industry analyst for researchers Celent, commented that the emergence of large hedge fund administrators with deep pockets is not leading to the significant decline in pricing that one might expect.
And like retail bank customers who are unhappy with the charges they are paying but can’t be bothered moving their accounts, hedge funds also appear keen to avoid the hassle of changing their service-providers.
If fund administration clients feel the level of service they are getting is worth the price they are paying, then fine. If not, they should vote with their feet before further consolidation leaves only a small handful of giant service-providers with an iron grip on pricing power.
Upping the stakes
Not a day goes by without another alleged hedge fund fraud being reported in the financial media. Given the existence of an estimated 10,000 hedge funds, the chances of falling victim to a fraud are still far less than the likelihood of losing money on account of poor performance.
Individual investors are more vulnerable to fraud than their supposedly sophisticated institutional counterparts. And the Securities and Exchange Commission in the US knows it. That’s why it has proposed Rule 509 which would require a person to have a minimum net worth of $2.5m (currently $1m) in addition to an annual income of at least $200,000, in order to qualify as an eligible investor.
This proposed new ruling might sound draconian, but according to a commentary by Adam Sussman of researchers, Tabb Group, hedge funds are not losing any sleep over it. Why? Because the potential loss of new inflows from rich individuals will be more than compensated by the significant increase of inflows from corporate and public pension plans. In August 2006, a bill was enacted to allow much more pension plan money to be invested in hedge funds.
In addition, hedge funds like Fortress Investment Group are looking to raise upwards of $1bn through Initial Public Offerings on Wall Street. The stock is likely to be bought by retail investors denied access to hedge funds.
However, Mr Sussman reckons the bigger threat to hedge funds is not ‘regulatory suffocation’ but competition from low-cost “cloned” products such as exchange-traded funds which track hedge fund returns. Any hedge funds that cannot beat a tracker index risks losing investors to these lower cost alternatives.
Despite a Hennessee Group survey showing that hedge fund assets grew 21 per cent from $1000bn to over $1223bn last year, the days of exorbitant management and performance fees could be numbered, especially if the returns of funds of funds continue to disappoint. That would be no bad thing.
Henry Smith, editor
henry.smith@ft.com
