Merrills sets sail for ever-expanding horizons

Merrill Lynch's prime brokerage offering has been busy rolling out new products - and team members - in 2006. As managing directors Edward Platt and Jeff Penney explained to David Walker, innovation and adaptation have been at the heart of the Merrill Lynch meritocracy for quite some time

If you think hedge fund managers have had to move quickly to keep speed with the markets, their peers and investors' demands, spare a thought for the prime brokers.

To say there is 'never a dull moment' for Jeff Penney, Merrill Lynch's US-based managing director and co-head of global equity financing and services, would be understating the case, as the unit at Merrill Lynch serving hedge funds globally has continued expanding its services, staff and coverage at pace for hedge fund clients.

The changes that will be evident to Merrills-facing clients come as a result of thorough internal change.

adapt and thrive

Edward Platt, UK-based head of EMEA equity financing and services, says the improvements are typical of the firm's willingness to adopt and adapt best practice for hedge fund brokerage from the industry.

Worth noting is the fact Merrill Lynch has also been not slow in absorbing and attracting new staff members as well, including Penney from Morgan Stanley 14 months ago, and Slyvan Chakman (co-head of global equity financing and services) also from Morgan Stanley. The recruitment wins were announced in February.

Barely one month later Merrill Lynch combined its equity and debt prime brokerage, financing and financial futures and options businesses in the EMEA region under the leadership of Ted Platt and Gonzalo Chocano. And all this on top of hiring Paul Dackombe, Gary Francis and Andy Brown from Dresdner Kleinwort Wasserstein to head debt prime brokerage sales and marketing at the start of 2005.

"Merrill Lynch has its own culture," Platt emphasises, "but it is very good at adopting and adapting the best practice from around the Street. It's not that Merrill Lynch is not comfortable in its own skin; indeed, it is so much so that it is willing to listen to where competitors may be doing things well."

Those who come to Merrill Lynch's prime broking team from its peers, says Platt, will find a "very flat" management hierarchy with very approachable senior management and a culture "more interested in the collective victory than individual business silos."

This will be evident to hedge fund clients, Penney adds, in the staff they deal with being expert across a range of product areas and instruments - reflecting hedge funds being those most likely to have most fingers in most pies throughout the financial markets and asset classes.

bridging the silos

"We draw a very broad circle around the financing business," Penney explains. "Whereas a professional in another business may have been in a stock-loan silo or the dividend-trading silo or swaps silo we encompass all of that, plus professional trading services and across asset classes.

"People can move across that fairly freely and it's very compelling to people who want an interesting job, it's been the principal draw for us lately (that) we are not just hiring a stock-loan guy or a swaps trader. People have the flexibility to move around product and market to get business done."

And what this means for the end client? "We're trying not to have clients deal with many parts of Merrill Lynch. We would have them deal with us as a financing business broadly and we can service a complex portfolio across instruments and asset classes," Penney says.

"To be able to deal with complexity across asset classes with structured finance capability, with basic services and with all areas of the liquidity spectrum is something that sometimes falls outside the comfort zone of traditional equity long/short houses."

Yes, it can make it harder to recruit, Penney says, "but that's because the business of prime broking is changing dramatically."

business consulting

Arguably the clearest evidence of this statement is Merrill Lynch's establishment in the summer of 2006 of a consultancy group for its hedge funds. These people can offer advice - or steer funds in the right direction to get advice - in areas from domiciles to disaster-recovery planning. While Merrills does not offer advice in the fiduciary sense, offering counsel to start-up as well as existing managers on business planning as much as investing and legal/regulatory extends the services available.

client understanding

At a strategy level, Penney says a closeness to the client leading to a thorough understanding of their strategy and how they execute it is of key importance.

"We have to be able to help our clients generate alpha to add value to them, so you have to have an awareness of their strategy, what markets they're in, what instruments they use, what assets they're likely to own across the capital structure.

"Not all parts of the capital structure are equally liquid or can be financed by convention in the same way. There's a repo market in fixed income, special-purpose vehicles (SPVs) set up for some asset classes in addition to margin lending and synthetic markets."

Hence at Merrill Lynch clients have seen experts possessing derivatives and risk-management skills on top of operational skills enter the financing business.

"You cannot be a successful prime broker if you have limitations in how you can respond to a client," Penney adds, "I don't think Merrills can be a niche player, we are too big and we're in too many asset classes and markets."

Geographically, the reach of Merrill Lynch may also preclude it from being dubbed 'niche'. The list of locations in which Merrill Lynch has equity finance experts - not just prime brokerage representatives - is extensive indeed: Tokyo, Hong Kong, Sydney, San Francisco, New York, Chicago and London.

In the past, says Platt, Merrill Lynch has been the full service prime broking provider to a "smaller number of important clients," multi-strategy and multi-product groups with more than $1bn. As such, part of its latest push into the market is to increase its profile among others, and Penney notes Merrill Lynch does not have minimum AuM levels below which it will not take on new clients.

the offering

The other portion of the group's push in prime brokerage has been in increasing scale on the products it offers and adding to the hedge fund strategies it can serve.

(Overall, it has been serving hedge funds fromLondon since 1988 and, as London's first prime broker, had as clients some of its current competitors.)

In March 2005 Merrill Lynch launched a global equity portfolio swap product and a fixed income derivatives give-up service, as well as enhancing its ML Prime service.

"The landscape is changing dramatically and we are getting to a true multi-asset class model," Platt says, adding: "You have to be able to be relatively indifferent to whether a client's position is held synthetically through derivatives or through physicals. Physicals are pretty easy to trade with lots of brokers, but with derivatives it used to be a very bilateral market." Merrills expansion of its abilities in credit and derivative intermediation has helped develop "more of a tri-party arrangement and product.

"We built out credit default swap intermediation and the ability to finance munis and high-yield and corporate bonds some time ago. We have a large platform now and expect to be able to prime broker commodities contracts later this year," Penney says.

If one investment by a hedge fund offsets risk of another position, Merrill Lynch has also introduced the centralisation of risk and cross-product margining to require collateral based only on the fund's net risk exposure.

transparency benefits

The advantages such netting can bring in terms of collateral tied up are obvious - they do, however, require a deepening of the relationship between a fund and its prime broker, which Penney clearly sees as mutually beneficial. "A lot of products are risk-mitigating for hedge fund positions, so it's very important we see those because if you draw a circle around the physical and synthetic trading together, you probably end up with a better risk-managed portfolio and one we are much happier financing.

"The aim of the prime broker is to finance what we see, it's a collateralised lending model," Penney says. "If you start to go down the road of credit-based lending, the question is: 'Do you have full transparency into the business?' The answer is: 'You don't'. Although we do undergo credit analysis on every client we do business with, that establishes a different type of relationship with the client. The more you can see what the client is trying to achieve, and with which assets, the more comfortable you can feel.

"The principal concern with risk management is: 'Are the assumptions you are making with the collateral adequate and accurate, and is it as liquid and volatile as you think?'

"Those are the two factors that tell you whether you get your loan value back in the event of a default. I worry about the implicit illiquidity because [when] you take an asset trading a certain number of shares per day and look at a portfolio and what it contains, you worry about the degree to which that position is held by a number of portfolios. If sentiment turns simultaneously, instead of one day's trading being up for sale, you have several. That can change our risk profile dramatically."

Some commentators have suggested a twofold or threefold better use of capital when positions are centralised with one provider. For the prime broker, the resulting transparency potentially gives them more comfort offering more leverage, if the fund so wishes.

(The centralisation and give-up of trading by the fund also translates to the fund manager posting less collateral around the Street, hence greater operational efficiencies and superior cash management.)

net benefits

"When netting collateral calls to one point in the firm, you're dealing with collateral requirements of the different legal entities set up to help clients trade various products - you may have a regulated dealer trading securities, and an unregulated entity set up to deal in unregulated instruments..

"To have a client not have to face Merrill Lynch four times is the primary exercise, then we ask: 'Do we see risk mitigants within the activity collectively that would allow us to release more buying power?'"

While a willingness by prime brokers to offer more leverage to clients in cases of greater transparency has been interpreted by some commentators as brokers simply throwing cash at funds to endear themselves to the highest commission generators, Penney says simply: "As a business manager, I would not lead with my chin.

"Risk control and intelligent lending is at the forefront of our thinking at Merrill Lynch."

worlds apart

Platt adds that on a macro-financial level, today's hedge fund industry is dissimilar to 1998's. "The asset distribution is a lot wider and the relative dominance of Long Term Capital Management or Soros (Fund Management) or Tiger (Management) in 1998, for example, was much greater than anyone is by size today," he says.

"The large hedge funds are quite different in terms of strategy or size and are quite different animals in trading strategies and styles."

He adds, however, that regulators and declaration rules have a clear role to play where previously unseen concentrations built up and correlations became manifest.

In regard to correlations and market turbulence, Platt notes while May and June 2006 may have seen some funds have a "pretty bumpy time", he does not describe the moments as a "market stress period...and, in some ways, some of the things that happened last year with GM and Ford and credit events were a little bit more dramatic, for a short period. "But, whatever happened in May or June, you were better off in a hedge fund than in an index fund."

at your service

The business-consultancy function Merrill Lynch announced in the summer is perhaps one of the clearest signs of how the hedge fund industry and those who serve it are changing.

As Jeff Penney explains, the "traditional Wall Street coverage model has been to say: 'Let me help you build your portfolio,' but with the prime broking business, we have also had to move to say, 'Let me help you run your business.'"

This, he notes, may include assistance with where a manager is set up and domiciled, whatever reporting do they need to do, tax-efficiency, and discussions on what kind of markets they need to get into. Future operational needs may also form part of the discussion between hedge fund and consultant at Merrill Lynch, as may business-contingency planning and internal software applications.

"The service was established to help established businesses or new launches by market participants such as prop traders who wake up one day and say they'd like to work for themselves. Such clients may ask us to help them understand what the regulatory environment will look like in two to three years' time so they can adjust to it. We have got to be careful in some areas where we can't take a fiduciary advisory role, but we can explain best practice and ideas and specialists who can help with more detailed matters," Penney says. "Also, by strategy, we span everything in fixed income prime brokerage to derivative intermediation businesses, the full traditional equity prime broking, including synthetics, and we service hedge funds as well as professional traders.

"Our client base is institutional as well as hedge funds. We can aso assist institutions operating under Ucits III and launching new product types, whether it's 130/30 or 120/20 investment techniques." With the proliferation of hybrid long-only/hedge strategies and partial hedge fund products, will this leave prime brokers such as Merrill Lynch in an industry without pure hedge funds in years to come? Edward Platt thinks not.

"The changes are not to say hedge funds will disappear and the world will belong to a few absolute-return managers, far from it," Platt says. "But the focus is spreading beyond just hedge fund investors. They still need clearing custody, stock-loan and leverage and various solutions to more complex variants of the absolute-return puzzle."