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April 3, 2008

The Young Guns of Prime

Pershing and Fidelity target hedge funds with stock lending

By John Hintze and Gregory Bresiger

Pershing and Fidelity, two recent prime brokerage entrants backed by deep-pocketed parent companies, hope securities lending will propel them among the elite primes. Still, these prime brokerage units-launched by financial services giants Fidelity Capital Services and BNY Mellon's Pershing-are competing with long-established, bigger firms like Bear Stearns and Goldman Sachs.

"Fidelity, as an agency-only broker, could be an effective prime broker player," says Josh Galper, managing principal with the consultant Vodia Group.

Galper, however, questions if Pershing's prime brokerage's unit, also an agency only broker, will receive adequate support. He says this is because its parent's core custody business at BNY might end up competing with the prime brokerage unit for some would-be accounts, so the unit might not receive the support it needs.

Hurdles Ahead

Without a doubt, Fidelity's and Pershing's prime units face many hurdles. Recent history hasn't been good for new primes. Industry observers say that entrants typically have ended up competing for the scraps, aiming their services at the small and midsize hedge funds that the bulge bracket primes ignore.

But Fidelity and Pershing hope they have a wedge that will help them become significant players-securities lending. It will be a key factor in making inroads into the booming hedge fund business, officials of the two firms say.

Pershing launched Pershing Prime Services last July. It now has 20 clients. Half are mutual funds engaged in 130/30 strategies.

Jeremy Todd, who runs the prime brokerage's sales effort, says some customers may have as little as $100 million in assets, but that the median size is about $2 billion.

By contrast, Fidelity Prime Services has been around for a few years, according to Mark Haggerty, president of Fidelity Capital Markets Services. Its largest client manages some $10 billion in assets. "We could have some portion of those assets," Haggerty says.

Galper notes that Fidelity could make an effective securities lending argument with hedge funds because it has access to a huge equities pool. Fidelity Prime Services has about $1.5 trillion in customer assets, according to its Web site. However, not all these assets are lendable.

Fidelity Should Push

A hedge fund manager, who declined to be identified and who mostly uses a bulge bracket's prime unit, says that "the question about Fidelity is: Why haven't they been more aggressive in pushing their prime service?"

Constance L. Hunter, a portfolio manager and partner at New York-based Coronat Capital Management, with $45 million in assets, thinks the two new primes offer benefits.

"They would make for good supplemental prime brokers," says Hunter, who uses prime brokerage services. She adds that it's reassuring for asset managers to use secondary or tertiary counterparties.

One benefit of Fidelity and Pershing to date is that neither has been affected by recent subprime issues. Therefore, using them reduces custodial risk, according to Hunter.

But market problems may or may not be gone in a relatively short period. So after the market turbulence, how will Pershing and Fidelity sell themselves as alternatives to the big primes? Haggerty says Fidelity's prime has been "highly focused" on funds pursuing long/short strategies. They have access to the securities Fidelity handles for correspondent broker-dealers and registered investment advisors. Fidelity also has a big retail brokerage customer base.