Hedge funds > personal fairness | USAEMALL.com

Rupak Ghose is formerly a financials research analyst at Credit Suisse and head of corporate strategy at ICAP/NEX, and now writes a Substack.

Private equity firms have for decades been among the largest clients of investment banks, to the point where even many in the industry joke about the unhealthily codependent, publicly warm but often privately resentful relationship.

After all, whenever private equity buys and sell companies, takes them public or issues bonds and loans to finance them it generates hefty fees for investment banks. Because they do all this a lot — far more than “normal” companies — they have long been central to Wall Street’s profits.

More recently, private equity firms have morphed into broader “alternative asset managers” by charging into areas like private credit and infrastructure. As a result, Wall Street’s biggest rainmakers nowadays are often the ones with the closest relationships to the private equity industry.

In contrast, portfolio financing for hedge funds is not as visible or exciting. That’s pretty understandable. After all, the hedge fund industry has in aggregate grown at a much more pedestrian rate in recent years.

HFR estimates the hedge fund industry has seen its assets under management increase from $3tn to $4.5tn over the past decade, but that is overwhelmingly only thanks to rising markets. Bain estimates that the buyout industry has grown from $1.6tn to $4.7tn over the same period, and the overall private markets assets — including private credit, infrastructure, real estate and venture capital — is around $10tn today.

However, if you look more closely there seems to be a subtle shift in who actually matters most for Wall Street these days. Every major investment bank has in recent years been citing the strength of prime brokerage balances and demand for financing from hedge funds and similar clients.

Could traders — at hedge funds, family offices and proprietary trading firms — now be an even bigger client base than the private equity universe? The numbers suggests it might be so.

Last year, “financial sponsors” paid $20.4bn of investment banking fees across M&A advice, bond and loan arrangements and equity issuance, according to Dealogic. That was up 62 per cent from 2023 — an annus horribilis for Wall Street — but still well down from the record $33.3bn they made out of private equity firms in 2021.

In contrast, BCG estimates that revenues from prime brokerage services that investment banks provide to hedge funds and other traders have grown by 50 per cent over the past four years, to around $36bn last year.

Getting granular data on this is tricky, as each bank reports a little differently, and it’s unclear exactly how accurate BCG’s estimates are. Its prime brokerage numbers include futures, but this will be a fairly small revenue source for most big banks, and BCG’s estimates roughly tally with others in the industry.

The banks themselves are certainly talking up their strength in prime brokerage — and especially the bit that extends financing to clients.

Goldman Sachs alone made $5.5bn from equity financing revenues in 2024, with growth of about 20 per cent per annum over the past five years. In fixed income financing, it made $3.64bn last year, and things seem to be accelerating.

Here’s what Goldman’s CFO Denis Coleman said on the investment bank’s first-quarter earnings call, with Alphaville’s emphasis below:

FICC net revenues were $4.4 billion in the quarter. Intermediation results were driven by higher client activity in currencies and mortgages, offset by lower performance in credit, rates and commodities versus a strong prior year. We produced record FICC financing revenues of $1 billion, driven by solid performance in mortgages and structured lending. We remain confident in our ability to prudently grow this business over time and always with an eye towards risk management. Equities net revenues were a record $4.2 billion in the quarter. Equities intermediation revenues of $2.5 billion rose 28% year over year, primarily driven by strong performance in derivatives.

Record Equities financing revenues of $1.6 billion were higher year-over-year on better portfolio financing results and record average prime balances for the quarter. Across FICC and Equities, financing revenues of $2.7 billion rose 22% versus the prior year, reaching a new record for a fifth consecutive quarter.

Yes, Goldman is particularly strong in prime brokerage, but it isn’t an outlier. Morgan Stanley and Citi also highlighted growth in prime brokerage in their first-quarter results.

Moreover, revenues in the broader markets businesses of the five largest US investment banks are up 50 per cent over the past decade, and dwarf those in investment banking. Some of this is probably driven by hedge funds. For example, recent outsized growth of equity derivatives trading revenues at Goldman Sachs and Morgan Stanley is almost certainly underpinned by their core hedge fund client base.

But a similar trend has been seen across most fixed income markets. It’s pretty well known by now that hedge funds and proprietary trading firms have become increasingly important in the US Treasury market, but as this chart from the ECB shows, the same is also true in European government bond markets.  

Leverage is crucial to this. Prime brokerage and repo borrowing by hedge funds have both roughly doubled over the past five years to about $2.5tn each.

Underlying this data has been a stark increase in gross leverage within the fast-growing multi-strategy and “pod shop” hedge funds, and especially a the largest firms. But this is not just about financing and trading. Traditional asset managers are no longer paying much for sell-side research. As a result, analysts depend increasingly on small number of very large pod shops for their commissions.

It isn’t just hedge funds bolstering prime brokage businesses. A lot of family offices that collectively manage about $6tn are either former hedge funds — such as Mike Platt’s BlueCrest and Louis Bacon’s Moore Capital — or are quasi-hedge funds in their investment style.

But the fastest-growing contributors are the prop trading firms, which are also increasingly clients of prime brokerages even as they compete with banks in a growing range of markets. One of the best known of these is Jane Street. In its recent bond prospectus, there are 35 references to dependence on prime brokers. For instance:

We depend on the services of prime brokers to provide us with liquidity and assist with our trading operations. The loss of one or more of our significant prime brokerage relationships, or a disruption in prime brokerage services generally, could lead to liquidity constraints, increased transaction costs and capital posting requirements, as well as have a negative impact on our trading operations.

Much has been written about the troubles faced by the private equity industry, and the knock-on impact on banks that service them. However, given the locked-up capital and lagging marks it is likely to be slow bleed.

On the other hand, the increasingly huge amount of business that investment banks do with hedge fund and hedge fund-like entities could quickly dry up very quickly if markets nosedive again.