Dodd-Frank prompts banks to shed prop units, hedge fund teams

Six months after financial reform legislation was signed into law, some U.S. banks already have closed, moved, sold or lost major investment talents on their proprietary trading teams and hedge fund management subsidiaries.

Officials at bank holding companies The Goldman Sachs Group Inc. and Morgan Stanley & Co. Inc. made it clear they are shedding their prop desks. New York-based Morgan Stanley also has divested its 100% stake in multistrategy hedge fund unit FrontPoint Partners LLC.

Sources said so far, J.P. Morgan Chase & Co., New York, is the only the large U.S. bank that confirmed it is converting its prop trading teams into a hedge fund management unit. That unit will move over to J.P. Morgan Asset Management.

The banks are restructuring to comply with the Volcker Rule provision of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, which prohibits banking entities from conducting proprietary trading and limits investment in hedge funds and private equity funds. Most banks have until 2013 to comply with the new law.

“A lot of big banks have taken the position that they need to divest their prop desks to comply with Dodd-Frank requirements. For some, there's some question about whether they absolutely have to do that,” said attorney Grant Buerstetta, partner with the law firm of Blank Rome LLP, New York.

He noted that “many banks are gearing up to get rid of their hedge funds and prop desks so as not to attract any more negative attention about their assets. They are perhaps being more conservative in their interpretation of Dodd-Frank that they really need to be.”

The swift restructuring by some banks already has pushed a wave of prop traders into the limelight and out of their sheltered existence managing bank assets in internally managed multistrategy hedge fund portfolios.

Because of their behind-the-scenes roles at U.S. banks, the elite traders are not well known to institutional investors, and sources said the majority may remain something of a mystery to institutions until they've built track records that will attract the interest of investors and can convince them they're going to stay in business.

“The vast majority of institutional investors are not interested in being venture partners with some of the new firms that prop traders are setting up. There are too many risks in investing in many startups. Running a business is a lot different than running a prop desk,” said Daniel Celeghin, a partner at Casey Quirk & Associates LLC, Darien, Conn., a consultant to money managers.

“Both institutional investors and hedge fund-of-funds managers have a healthy dose of skepticism about these prop desk startups because many bank prop desks relied on a lot of leverage. Trading strategies tend not to make a lot of money — pennies on a trade — so leverage was routinely used to amplify returns. Prop traders could do this very easily, because they could draw on the bank's balance sheet to put on the leverage. Once you hang out your shingle as a hedge fund manager, there's absolutely no way you could go to 40 times leverage,” Mr. Celeghin said.

Boston-based executive recruiter Lynn Tidd, managing director and head of the global hedge fund practice at Russell Reynolds Inc., New York, said many of her searches in the past few months have been on behalf of “teams that have made the leap off the prop desks into their own firms and now are looking for experienced support staff. They realize that they need to fill the seats of chief risk officers, marketing professionals and legal and compliance staff in order to make themselves into more of an institutional firm.”

Mr. Celeghin agreed that “wrapping these prop trading strategies into an institutional wrapper makes a lot of sense, in terms of providing a very robust infrastructure that institutions are looking for.”

Guggenheim Partners LLC, Chicago, launched a new company, Guggenheim Global Trading LLC, Purchase, N.Y., to provide just such an “institutional wrapper,” said Loren Katzovitz and Patrick Hughes, managing partners who are heading the new firm. Messrs. Katzovitz and Hughes said in an interview they plan to hire 20 to 25 trading teams over the next year, largely by setting up new trading teams rather than establishing strategic relationships with existing companies.

The aim is to create a diversified multistrategy hedge fund, build a track record and eventually open the fund to more external investors, Mr. Katzovitz said.

Mr. Hughes said GGT's approach means that extensive “operational due diligence that is becoming increasingly complicated and expensive to conduct on these small trading teams only is done once. A lot of these trading teams would have set up their own hedge funds, but the barriers to entry are a lot higher now that they were a few years ago and a lot of these traders just aren't interested in doing anything but managing money. They don't want to manage a business.”

Guggenheim seeded the new business with $500 million and is looking for a small group of institutional investors interested in taking an equity stake, as well as investing in the new multistrategy hedge fund.

The new company also will manage money for Guggenheim's partners and affiliates and has commitments to manage an additional $1.5 billion on the Guggenheim Global Trading platform.

The timing of GGT's launch coincides with “fantastic opportunities to attract very talented teams. If we tried to do this in 2007, we would not have succeeded because you simply couldn't get the talent to move. But a confluence of regulatory actions globally makes this a prime time to build an institutional multistrategy team,” Mr. Katzovitz said.

Guggenheim Partners manages about $85 billion in traditional and alternative investments and supervises the investment of an additional $15 billion.

Among the bank restructuring moves pumping up the industry's pool of available hedge fund talent is Morgan Stanley's March 1 spinout of Greenwich, Conn.-based FrontPoint Partners. FrontPoint's senior management and portfolio managers now own a majority interest in the company while Morgan Stanley became a minority investor.

Morgan Stanley said in January that employees of the bank's proprietary trading unit, Process Driven Trading, will acquire some of the unit's assets and launch an independent firm, PDT Advisors, at the end of 2012. The bank retained an option to acquire a preferred ownership stake in the new firm, according to the Jan. 10 statement.

All 60 employees will move to PDT Advisors, which will be led by quantitative portfolio manager Peter Muller. PDT will remain part of Morgan Stanley, managing the bank's capital, during the two-year transition period while building out the new company's operational infrastructure and seeking external investors.

“PDT has generated an enviable track record within Morgan Stanley since its inception in 1993. We are delighted to continue our partnership with PDT as it looks to expand its business by taking on third-party investors,” said James P. Gorman, Morgan Stanley's president and CEO, in the statement.

Goldman Sachs Group confirmed in its annual report filed with the SEC on Feb. 28 that “in light of the Dodd-Frank Act” it closed its equity prop trading business in 2010 and this quarter began liquidating holdings of its global macro prop desk, which had been part of its former fixed-income, currency and commodities operating segment.

Stephen Cohen, a Goldman Sachs spokesman, would not disclose the assets managed by both prop desks and declined further comment.

J.P. Morgan Chase & Co.'s plans to move its equity, emerging markets and structured credit prop trading teams from the investment bank into J.P. Morgan Asset Management are progressing faster than predicted.

Last fall, J.P. Morgan Chase executives predicted that the transition would take several years, but a source who asked not to be identified said integration of the trading teams into the money management unit could be finished within the next 18 months.

The source also said the new direct hedge fund investment team within the asset management unit will be seeded with about $2 billion of assets by J.P. Morgan Chase.