Deutsche Bank’s Prized Hedge Fund Unit in Downward Spiral

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A once-lucrative business within Deutsche Bank AG catering to hedge funds is on its way to becoming yet another casualty of the German lender’s chronic turmoil.

The German firm’s revenue from prime services declined for a third straight year in 2018, while rivals Morgan Stanley, Goldman Sachs Group Inc. and JPMorgan Chase & Co. all saw jumps, according to people with knowledge of the business.

Revenue from the high-stakes business of executing trades and lending securities to hedge funds has dropped by more than a third since 2015, said the people, who declined to be identified because the bank doesn’t publicly detail its prime results. The slump was a major contributor to Deutsche Bank’s loss of about $750 million in its equity trading division last year, according to them. The firm said the reference to the size of the decline was inaccurate.

Deutsche Bank, previously the poster child for European firms seeking to wrest trading dominance from Wall Street rivals, has seen key divisions enter a downward spiral over the past decade as the firm lurched from crisis to crisis. One of them is prime services.

The relationship forged by the prime brokerage divisions with hedge-fund clients can often be the lifeblood of banks’ trading units. Deutsche Bank’s decline in the business is symptomatic of the broader prolonged revenue slide that has left the firm struggling to improve profitability and discussing a merger with fellow beleaguered German lender Commerzbank AG.

Deutsche Bank built up its prime brokerage operations in the wake of the financial crisis by seizing on the weakness of its U.S. competitors. In recent years, that dynamic has flipped, with the bank losing customers concerned about its ability and willingness to devote capital to the unit. The firm’s high funding costs and the risk of a credit-rating cut make lending through the prime brokerage less profitable and a merger with retail-focused Commerzbank potentially more appealing.

After a scare in 2016 led some hedge funds to pull money from the firm, then-Chief Executive Officer John Cryan pivoted the bank away from its focus on institutional clients toward corporate ones. His successor Christian Sewing has trimmed staff and resources in the U.S. over the past year and led the bank to sever ties with funds whose business wasn’t lucrative.

Deutsche Bank’s operations are likely to shrink even further in the short term as it tries to pare assets and costs, said Peter Hahn, a dean at the London Institute of Banking & Finance.

“At the moment, it’s an even guess whether that will be clients leaving the bank or the bank leaving clients,” he said. “It could be both.”

Trading Services

In addition to trading services and lending, prime brokers offer money transfers, market intelligence and, crucially, connections to prospective investors, in exchange for hedge funds and other buy-side firms parking some of their capital with the banks and paying rich fees. Some brokers even offer ancillary services like scouting for talent or office space for these prized clients.

“We have taken proactive steps to successfully reshape our prime business to improve returns and lower our balance sheet,” Kerrie McHugh, a spokeswoman for the bank, said in an emailed statement. “Our clients value our prime product and have stuck with us. We have seen growth in our balances year-to-date, with an attractive return profile, and we expect that trend to continue.”

The firm remains dominant in a corner of the market that provides services to algorithm-based trading firms and multi-strategy hedge funds, according to people with knowledge of the business.

Major clients, including Cliff Asness’s AQR Capital Management and Two Sigma Investments, stuck with the bank after going through reviews of their balances last year, some of the people said. Asset managers typically review the risk of their counterparties, including prime brokers, the people said. Spokesmen for AQR and Two Sigma, both of which have veterans of the German lender among their senior staff, declined to comment.

In December, Asness said on Twitter that he traded with the firm and doesn’t expect it to fail, right after tweeting that major risk factors included “a dodgy German bank failing.”

The prime unit’s struggles — marked by revenue declines in 10 of the last 12 quarters — are weakening a business that became a force on Wall Street following the 2008 financial crisis. Jon Hitchon and Barry Bausano, co-heads of the prime finance division at the time, pitched hedge funds that they should pare their counterparty risk after the failure of Lehman Brothers Holdings Inc. by working with more brokers including at least one European firm, people familiar with the matter said.

The bank also lured talent from rival firms, and the division won the most “Top Rated” awards for six consecutive years starting in 2008 in the annual survey of hedge fund managers and investors by Global Custodian magazine. By revenue, it had climbed into a tie for third by 2012, according to data compiled by Coalition Development Ltd.

But the Wall Street stalwarts had once again started building up their prime-brokerage divisions by the end of 2009, and concerns about European lenders’ funding a couple of years later gave U.S. rivals an opening to take share.

Deutsche Bank’s business faced heightened capital and liquidity constraints, as well as management turnover: it has had eight heads or co-heads over the last five years, including Matt Bowen and Angus Yang, who took the reins in September.

The prime brokerage unit was also dealt a significant blow in September 2016, when fears that U.S. fines would threaten Deutsche Bank’s capital levels spooked clients. Some funds, a small subset of the more than 800 clients in Deutsche Bank’s hedge fund business at that time, shifted part of their holdings to other firms. Among them were Izzy Englander’s Millennium Partners, Chris Rokos’s Rokos Capital Management, and Capula Investment Management, a person with knowledge said at that time.

The bank eventually settled the U.S. probe and went on to raise capital in 2017. By early last year, Deutsche Bank told investors that client balances within its prime division had returned to pre-September 2016 levels and “are expected to drive revenue growth in 2018.” But the boost to its income never materialized.

Renewed concern over the bank’s financial strength didn’t help: the cost of insuring against the lender’s default almost tripled last year, though it has eased so far this year.

The firm spent much of 2018 making a pitch to clients to be their top European prime brokerage, even as it trimmed staff and assets in the U.S. division. Deutsche Bank has also adopted a “farming, not hunting” strategy to maintain existing prime finance clients rather than drum up new business in Europe, a person with knowledge of the matter said.

The bank said in October that client balances had dipped once again. In the Coalition ranking of prime brokerage revenue, the German firm had fallen from third in 2012 to eighth or ninth among global investment banks by the middle of 2018.

Ultimately, hedge funds look for prime brokers with healthy balance sheets that they can rely on, and who are willing to provide services beyond financing, according to George Kuznetsov, head of research and analytics at Coalition, who said he couldn’t speak about individual banks.

“It comes down to the commitment to the business,” Kuznetsov said.

— With assistance by Steven Arons

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