Hedge Fund Report: Joined at the Hips

Hedge funds are spending more and more on prime brokers, those who cater to the specific trading, clearing, settlement and sometimes fund-raising needs of their hedge fund and institutional clients.

Because hedge funds trade more frequently than the average mutual fund, and because they sell stock short or employ leverage, they pay prime brokers hefty fees in commissions or interest rates in order to borrow securities or secure loans or trades. And that's good for Wall Street. In fact, it has become so good that some worry about the implications of the relationship between banks and hedgies in the event the hedge fund bubble were to burst.

U.S.-based hedge funds will spend $10 billion in prime brokerage services this year, according to advisory firm TABB Group. That figure represents a 25% increase from the $8 billion spent two years ago, says Adam Sussman, senior consultant at TABB and co-author of the report, which was released Thursday and based on a survey of 89 U.S. hedge funds with a combined $89 billion of assets under management, or 15% of the U.S. hedge fund asset base. Interviews were conducted between January and March.

This increase in prime brokerage spending contributed to a large extent to the surge of profits posted by most banks in the first quarter. Prime brokerage represents 29% of the net income of Goldman Sachs(GS Quote), 21% for Bear Stearns(BSC Quote) and 20% for Morgan Stanley(MS Quote), according to TABB Group estimates.

And the trend may continue. As hedge funds explore new markets in Asia and Latin America and venture into new asset classes such as equity derivatives or credit instruments, their reliance on prime brokers will increase.

"The perception is that the U.S. markets are overcrowded with too much cash and not enough opportunities," says Matt Simon, co-author of the study. The cost of prime brokerage is likely to keep on rising, as it is more expensive to trade foreign or illiquid and exotic securities, the TABB study finds.