High Line Advisors LLC

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Posts Tagged ‘client strategy

What constitutes a “full-service” Equities business?

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[Part 4 of Equities Context and Content]

Mature Equities businesses offer a complete array of products and services under the umbrella of Equities. The full-service Equities model incorporates five diversified business lines, each of which has a set of products and services that capture revenue in various forms:

  1. NEW ISSUE
    Origination business based on corporate relationships, resulting in direct underwriting and placement fees and indirect revenues from investor clients seeking to participate in their allocation. Examples include: common and preferred equity, convertible bonds, and private placements.
  2. FLOW
    Agency risk transfer business resulting in commissions and the potential for reduced expenses due to internalization. Examples include: “high-touch” and/or electronic order handling in cash equities and listed derivatives.
  3. BALANCE SHEET
    Financing businesses resulting in accrual of spreads in excess of cost of funding. Examples include: prime brokerage, securities lending, repo, and OTC derivatives.
  4. CAPITAL
    Principal trading businesses, including market-making and client facilitation, resulting in revenues from bid/offer spreads and directional risk-taking. Examples include: underwriting, block trading, aspects of program trading, listed options market-making, and certain proprietary trading strategies.
  5. SERVICES
    Low-risk, operationally-intensive agency business resulting in fee income tied to balances or transactions. Examples include: custody, administration, cash and collateral management.

 

A comprehensive offering allows such firms to compete globally for all client segments and to address the entire available revenue pool. As shown in Table 2, McKinsey estimates the global revenues that may be directly linked to Equities at over $120 billion in 2010.

Figure 2 illustrates the five Equities business lines in a way that circumscribes the revenue pool:

Table 2

Table 2: Equities-related revenue pools / Figure 2: Equities revenue map

Diversification can reduce earnings volatility and reliance on new issue activity. Of the five dimensions, flow commissions in cash and derivatives account for 39% of the pool, a fact that leads all competing firms to focus on execution capability. With more than twice as much revenue at stake overall, diversified firms not only access the related pools, but may also have an advantage competing for flow.

The capabilities or limitations of a larger firm directly impacts the ability of its Equities business to compete in each of the five dimensions. For example, the firm’s ability to allocate balance sheet and capital to its Equities business allows Equities to offer financing products or to carry inventory in convertible bonds. Similarly, Corporate Banking could drive new issue supply through the Equities business via its capital markets efforts.

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Written by highlineadvisors

November 9, 2011 at 12:41 pm

Why does the firm context matter?

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[Part 3 of Equities Context and Content]

There are five bank or broker-dealer businesses that can significantly enhance a firm’s Equities business. The capabilities and resources “owned” by these other business units can provide a competitive advantage in attracting equity investors:

  • CORPORATE BANKING
    Direct lending and corporate finance can produce two of the resources most valued by investors: new issues and access to corporate management. The Equities business can in turn provide market color on previously-issued equities and related derivatives to bankers and their corporate clients, earning mandates for share repurchases and block trades. The two business units can also share the cost of Research within applicable regulatory limitations.
  • PRIVATE WEALTH MANAGEMENT
    Retail can be a powerful contributor to an Equities business through the direction of order flow and stock loan balances. A captive source of liquidity and commissions provides a boost to the sales and trading unit, and a unique supply of hard-to-borrow securities can differentiate the prime brokerage unit. A retail distribution network may be viewed favorably by both corporate clients awarding new issues and block trades, and asset managers seeking capital.
  • TRADING IN OTHER GLOBAL MARKETS ASSET CLASSES
    Trading capabilities in complimentary asset classes can provide research, market color, and occasional trade facilitation for equity investors. Single-name credit products such as corporate bonds and credit default swaps can provide investors with deeper insight into corporate capital structures. Index, currency, and rate products offer investors a means to hedge macro exposures in their portfolios. Commodities trading expertise can also provide macro insights as well as deeper understanding of companies in the energy, agriculture, and metals sectors. Broader trading capabilities can provide solutions for cash and liquidity management in repo, government securities, and corporate commercial paper.
  • CUSTODIAL/TRANSACTION BANKING
    Custodial Banking can strengthen relationships with both corporate and investor clients. On the corporate side, credit lines, treasury services, cash management, and payments processing can lead to increased access to management and participation in new issues. On the investor side, clearing, collateral management, custody, securities services, and fund administration can result in operational dependencies between the firm and its investor clients. Banks with a deposit base may enjoy a higher credit rating, thereby enhancing the ability of an Equity business to compete in prime brokerage and over-the-counter derivatives.
  • ASSET MANAGEMENT
    There are a number of regulatory constraints and perceived conflicts that weigh on the synergies between an Equities trading business and a related Asset Management subsidiary; however, a percentage of agency order flow from the Asset Management arm may be directed to the Equities business, and access to stock loan supply can support its prime brokerage and derivatives trading efforts. Partnership in the creation of equity-linked ETFs and structured notes can generate product supply for retail and wholesale investors. Apart from trading, Asset Management provides a means to monetize Research, in some cases alongside of investor clients.

Figure 1 illustrates some of the contributions of these five business units to the traditional business of Equities and its clients:

Figure 1

Figure 1: How Firm Context for Equities Enhances Investor Value

Clients care about what a bank or broker-dealer can do for them overall, without concerning themselves with a firm’s internal product boundaries or management organization. When broader capabilities are called for, collaboration with other internal business units becomes critical to the success of the Equities franchise.

What do investor clients really want?

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[Part 2 of Equities Context and Content]

The needs of investor clients are complex and involve much more than the execution of orders. By convention, clients rely on their execution commissions (and, in some cases, financing balances) to obtain additional resources from their brokers. As clients ascribe less value to pure execution, they are directing the bulk of their commissions toward more valuable services and scarce resources.

Table 1 shows the capabilities of a bank or broker-dealer, some or all of which may be meaningful to an institutional investor:

Table 1

Table 1: Components of an Investor Client Value Proposition

The table also illustrates two challenging aspects of Equities businesses: First, that there is no direct revenue associated with many of these resources and services. Second, that these resources and services can lie beyond the traditional purview of Equities management. A successful Equities business must deploy the full capabilities of its firm and direct them at investor clients to access all potential sources of revenue, direct and indirect.

Equities Content and Context

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We are launching a series and associated white paper entitled “Equities Content and Context: Comparative Business Models Among Banks and Broker-Dealers.”

“Don’t get involved in partial problems, but always take flight to where there is a free view over the whole single great problem, even if this view is still not a clear one.”  —  Ludwig Wittgenstein
“What you see is what you get.” — Flip Wilson

Article at a Glance

Declining revenues and pending regulation are forcing firms to review their Equities businesses. Competing Equities businesses differ greatly from firm to firm in the breadth of capabilities. As a result, some firms may be unable to access revenue pools that make competitors appear more successful in comparison. A closer look at how a firm’s strengths appeal to specific client segments can reveal why an Equities business is underperforming relative to the market or its peers. An understanding of “boutique” models can provide insight for large banks and smaller broker-dealers alike, whether they are contemplating further investment or a pull-back.

The value of an Equities business to investors is largely dependent on the capabilities of the firm in which it operates. Despite an advantage in breadth of capabilities, large firms that fail to deliver a wide range of products may end up with boutique-like results. Small firms forced to compete on a limited product set can still distinguish themselves in specific market segments.

This article explores the following questions as they relate to managing an Equities business:

  • What do investor clients really want?
    What are the products, resources, and services that are most valuable to their business?
  • Why does the firm context matter?
    How can other business lines contribute to the success of an Equities franchise?
  • What constitutes a “full-service” Equities business?
    What do the largest, mature Equities businesses offer to clients? What additional revenues do they capture?
  • How is client value converted into revenue?
    How are products positioned as client solutions?
  • How do Equities businesses align with investors?
    Which clients is the firm most likely to attract?
  • What are the partial or “boutique” Equities business models?
    How do firms successfully differentiate? How can a regional or sector-based strategy succeed?
The article and its diagrams will be provided here in subsequent posts. If you can’t wait for the serialization, download the full article here.

Finding New Revenue Opportunities

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[part of a series on hedge fund sales coverage]

Existing client revenues may be sustained or even increased in a bull market, but a firm stands a better chance of achieving growth even in bear markets if planning is deliberate and focused on specific opportunities. Fortunately, new revenue opportunities may be found through direct client feedback and some basic marketing.

Sales managers need a minimum amount of useful data that can be acted upon for maximum impact on revenue. A practical client plan must be succinct, easily prepared and easily understood. The planning must be done by the salespeople who know the client best, but supported by data and standards for comparison. Many client planning processes either have too little data or become frustrated in their attempts to collect too much detail. At one extreme, plans based on salesperson intuition are not robust and may be clouded by incentives. At the other extreme, it is impossible to collect precise data from clients who are unwilling to disclose the details of their product utilization or spending to the broker community as a whole. Industry-wide surveys and fee pools may be directionally useful but are not specific enough to optimize the unique relationship between an individual broker and client.

Developing Client Plans

In our experience, a basic but useful client plan consist of three items: an organization chart of the client at the fund level, a budget showing revenue expectation at the product level), and one or more action items required to achieve the budget.

At a minimum, an organization chart for an institutional investor should indicate:

  1. assets under management (using size as a rough proxy for revenue potential)
  2. allocation of assets among various investment strategies (using strategy as an indicator of product and resource needs)
  3. decision makers for each strategy (to identify whom to target for relationship building)

It is best to ask the client directly rather than to rely on assumptions that may be incorrect or incomplete. A map of the client organization can expose any misconceptions regarding their investment activity and lead to the discovery of new revenue opportunities. For example, a convertible bond salesperson may not register that the client also has a distressed equity fund until the salesperson is asked to map the entire client organization. The investment strategies used by the client immediately suggest product utilization, which can be confirmed in subsequent discussions with the client. Existing relationships can provide the introductions needed to open up new trading lines. Simply “connecting the dots” in this way does not require elaborate planning and can yield immediate results.

The next step is to identify potential for revenue improvement. We suggest that detailed knowledge of a client’s wallet are not necessary to manage a successful sales effort. Instead, only a few key pieces of information are needed, and these may be readily extracted from the clients themselves:

  1. What is the firm’s rank with the client? For each product the client trades (i.e., single stock cash), where does the client currently rank the firm? #1? Top 3? Top 5? First tier? Second tier? Allow the client to define the way they rank their brokers.
  2. Is it possible for the firm to do better? (i.e., move up in the client’s ranking).
  3. If so, what would be required? Ask the client what actions it will take for the firm to move up. This can be anything from senior management attention, more outgoing calls from analysts, changing sales coverage, or raising capital. These become the action items.
  4. What would it be worth to the firm? Ask the client to estimate the incremental revenue opportunity to the firm in each product if the the actions are taken. The sum of historical revenues plus these incremental amounts becomes the client budget.

The questions may be posed by sales people or independent persons or who are not conflicted over critical feedback. It is in the interest of the client to answer these questions, as they seek honest feedback and express a willingness to improve. Once the feedback is provided, an implicit contract is created between the client and the firm that if requirements are met, revenues will follow. It is equally important to find out if the client intends to reduce product trading, or if there is no way for the firm to do better.

When combined with historical revenues, the answers to these questions comprise a business plan for the client: prior revenues (reflected in the initial segmentation) may be adjusted by the amounts indicated by the client as potential increases or expected decreases. The plan must also document the actions or resources needed to achieve the budget. Clients with greater potential for increased revenues may receive higher tiering in the next iteration of client segmentation than suggested by their historical revenues alone.

Marketing From a Product Perspective

While the interview process seeks to uncover opportunities from a client perspective, a product-driven process can yield additional results. Each product area should have its own view of the client base that covers existing clients as well as prospects, and the priorities of the product areas can be represented in the segmentation discussion. A two-pronged analysis that covers the market from both client and product perspectives leads to a more thorough capture of opportunities. The matrix approach also improves governance.

The “product walk-across” report is very powerful for highlighting new revenue opportunities arising from introducing a client to additional products. Some opportunities are suggested by gaps in expected trading patterns: for example, hedge funds that trade ETFs may be candidates to trade index swaps; clients who trade cash and options in the U.S. but cash only in Europe are candidates to trade European options; clients who trade cash electronically may also be candidates to trade options the same way; macro investors who trade futures may be candidates to trade ETFs. Products that are similar or interchangeable may be new to the client or simply traded with another broker.

Product marketing is a process of identifying target clients and managing a concerted effort or “campaign” to introduce the targets to the product. Product marketers can identify candidates from gaps in the multi-product revenue report, and also draw from anecdotal market information and industry surveys that highlight clients who are known to trade in specific products with other brokers.

Clients are more likely to try a new product if it solves a problem for them. The product on its own merits may be undifferentiated, but the broker may be able to add value by identifying an application for the product in the client’s portfolio. Solutions-based marketing creates “demand-pull” which can superior to “product-push” in stimulating or accelerating product utilization. Clients are also more likely to take a meeting on portfolio themes than product presentations. Common thematic campaigns include risk management and hedging, emerging markets access, and tax efficiency.

The opportunities uncovered though product marketing may be cross-referenced and added to the client plans. The product-driven effort may reinforce findings from client interviews, but should also find potential opportunities that the client itself may not have recognized, as well as identifying clients who are not otherwise covered by existing relationships.

Client Segmentation 1: Protecting Revenues

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[part of a series on hedge fund sales coverage]

Broker-dealers need economies of scale and operating leverage from their client businesses in order to grow. Covering a large number of clients is therefore an exercise in mass customization: each client must feel well-served as to its individual needs; however, the broker-dealer must find solutions that accommodate multiple clients without increasing costs.

Segmentation is the process of sorting clients into groups with similar characteristics. By grouping clients, product and service bundles may be designed and delivered to the clients that are best served by them. Segmentation can also incorporate a hierarchy that establishes the priority or importance of the client to the business and the corresponding value proposition that the client will receive. A tiered segmentation is particularly useful when allocating scarce resources among the entire client base.

Metallic Segmentation

Figure 1: Client Segmentation by Metallic Tiers

The hierarchy of precious metals shown in Figure 1 is a useful segmentation that is easy for a sales team to remember and act on. Segmentation requires action or it is little more than a sorted list of clients: Clients must be monitored over time and promoted or demoted through the hierarchy to maximize revenues and return on invested resources.

1st Iteration

A good place to begin segmentation is product revenue, so that the business delivers the appropriate resources to existing clients and increases the probability that these revenue streams will continue. Segmentation by historical revenue alone is a defensive approach that protects existing revenues and may induce existing clients to pay more. Once the initial segmentation is established it can be refined into an offensive tool to help capture entirely new clients and sources of revenue.

Product Scope

The first decision to be made is the scope of products included in the revenue analysis. The product revenues define the the client universe by including all active clients who trade the respective products. Inactive and potential clients are not captured at this point but will be added in future iterations of the segmentation.

Products are the payment mechanism for clients. Measurement of revenue in a single product may not be sufficient to capture a client’s entire “wallet” or product utilization and payment patterns. Therefore, the products that comprise as much of any client’s wallet as possible should be included in the analysis. For an institutional equity business, we suggest capturing revenues in the following product “buckets”:

  1. Cash: single stock
  2. Cash: programs
  3. Cash: electronic
  4. Cash: new issue
  5. Derivatives: convertible bonds
  6. Derivatives: OTC options
  7. Derivatives: listed options
  8. Derivatives: ETFs
  9. Derivatives: structured notes
  10. Derivatives: futures (execution)
  11. Financing: prime brokerage (margin, clearing, stock loan)
  12. Financing: OTC total return swaps (other delta-one)

Too much granularity in product definitions can diminish the effectiveness of the analysis. However, it can be useful to distinguish product revenue by currency (to see behavior across regions), to break-down electronic execution to include derivatives, and to separate clearing from margin and stock lending (particularly for listed derivatives). The marketing value of this information becomes obvious once the team begins to analyze client behaviors.

Revenue Reporting

For each product it is useful to collect client-level revenue for the prior full-year, and for the current year-to-date, which may be annualized for comparison. Trailing 12-month revenue may be a more recent full-year measure, but discrete timeframes like calendar years are helpful for observing trends. If capital facilitation in cash or derivatives trading is included in the client value proposition, it is helpful to report top line revenues as well as net revenues after losses from client positions.

The report of product revenues by client can reflect all of this data as changes in revenue over time. For example, client revenues in a specific product that have declined more than 5% below the prior year may be shown in red, while clients showing a run rate greater than 5% above the prior year may be shown in green. A single report that reflects absolute revenues as well as trends leads to more efficient review of how clients are responding to their respective resource allocation.

The report of product revenues by client is sometimes referred to as a “product walk-across,” as in walking across the firm’s products to see a full picture of a client’s activity. Designed to drive the segmentation and resource allocation processes, the report of product revenue by client is a powerful management tool that can be used to review different groups of clients. For example, the report may be used to analyze clients of a certain type or strategy; clients in a particular geographic region; clients assigned to a specific sales person; or, clients targeted by a specific product group. This single report, run against different groups of clients, is the single most important tool for managing a sales force. For the initial cut at segmentation, all clients with revenue attribution are included.

The “80-20 Rule”

In the pool of over 1,500 institutional investors in the U.S., most full-service banks or broker-dealers earn 80% of their top-line revenue from approximately 20% of the largest hedge funds and traditional asset managers, or a total of approximately 300 clients, a manageable number for periodic, meaningful review.

The tail can be very long, consisting of over 1,200 clients that must be continually mined for prospects in which to invest. A key decision remains to either ignore the rest or find a “no-touch” service model, relying on technology rather than humans for service, and allocating only resources that are scalable rather than scarce. A low-cost coverage strategy for smaller clients can provide early access to fast-growing clients, as well as low sensitivity to clients that fail.

For a large, full-service institutional Americas equity business, this framework could result in the following segmentation (shown in figure 2):

  • Platinum: the top ten percent of clients, generally “house” accounts, often paying in multiple products or paying so much to one product that they are entitled to firm-wide resources (annual revenues > $10mm)
  • Gold: the next ten percent (11th-20th revenue percentile) of clients ($2mm < revenues < $10mm), representing nearly 80% of total revenues for the product universe
  • Silver: the next twenty percent of accounts (21st-30th revenue percentile), which may be smaller accounts  or those trading in fewer products ($500m < revenues < $2mm)
  • Bronze: all remaining clients, often receiving no resources or coverage from scalable “one-touch” or “no-touch” platforms, and allocation of scalable rather than scarce resources
Client Segmentation by Revenues

Figure 2: Client segmentation based on total revenues and using metallic tiers

The next step in deploying the client segmentation is to assign the correct value proposition to each segment. The value proposition is an investment in the client, made in the expectation that the client will respond favorably. In some cases, maintaining current revenue is an acceptable outcome, but growth in the business is dependent upon clients responding with additional revenue.

The first iteration of client segmentation and resource allocation based on historical revenues does not reflect any information about new or incremental sources of revenue. A better profile of existing and prospective clients is needed to understand their ability to pay and the factors that influence their behavior. This data can then be used to enrich the process and drive revenue growth.

What Is Your Value Proposition?

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[part of a series on hedge fund sales coverage]

When advising banks and broker-dealers in global markets, we are often surprised to discover that client-facing professionals in sales or product management are unable to clearly differentiate themselves from their competition, even to explain why an institutional investor should transact with them before any other firm.

The solutions to this problem lies in understanding the bank or broker-dealer’s value proposition from the perspective of its client, the institutional investor.

The value proposition of a bank or broker-dealer to institutional investors is a bundle of resources that the investor will pay for. Ideally these resources are unique to the bank or broker-dealer. In order to compete effectively, resources must be differentiated in some way, either by comparative excellence or in unique combinations. Any bank or broker-dealer with an incomplete or merely parity offering may find itself able only to compete on the basis of price. Favorable legal or credit terms may bring additional risk, just as favorable pricing may result in lower profitability. These should be balanced commercially rather than included in the base value proposition.

Examples of such resources include: access to corporate client management, knowledgeable analysts, conferences, access to capital or balance sheet, exclusive distribution channels or stock loan supply, expertise in related asset classes, access to global markets and exchanges, risk analytics, client facing technology, operational ease, and so on. For example, a bank with lending relationships to companies in the energy sector that also trades commodities and provides research and makes markets in energy stocks and options may differentiate itself through a comprehensive and deep understanding of the energy sector. The valuable resources in this example include access to the bank’s corporate clients, access to its research (including insights from the commodities markets), thoughts from the bank’s risk managers on sector risks and their mitigation, and more consistent markets from the bank’s traders resulting from deeper understanding of the sector.

Client profitability should be measured across all products of the bank or broker-dealer, with appropriate costing for resource consumption by the client. A common mistake made by bank or broker-dealer management is failure to look outside of a product silo to construct a broad value proposition. For example, investors may value resources that are “owned” by other geographic regions or product areas of the bank or broker-dealer. Better coordination across product and regional silos can yield additional revenues, as investors increasingly pay for resources indirectly, by consuming seemingly unrelated products or services. Only with the support of the bank or broker-dealer as a whole can new business lines hope to grow, as it is otherwise difficult to compete in mature markets.

Resources are distinct from products, which are the primary collection mechanism for client revenues. Simply offering a product is not necessarily valuable to a client; however, the client may begin trading in a product in order to pay for something the client does value. Increasingly, institutional investors are taking a consolidated view of their banks and broker-dealers as opposed to a segmented view across specific product desks. This is most apparent in equities businesses, where hedge funds measure payments to banks and broker-dealers across cash, derivatives, and financing. For example, prime brokerage (financing) may be a profitable product for banks and broker-dealers; however, prime brokerage on its own is difficult to differentiate, particularly for new or smaller entrants. Prime brokerage balances may be a means of payment for resources consumed elsewhere at the broker, such as research or capital facilitation.

In order to drive profitability, resources must be scarce. If a corporate meeting has limited capacity or an analyst has limited time to speak with clients, competition among clients for access to these resources may result. The practice of resource allocation can be used to manage client behavior and to drive profitability. Access to resources may be given  to profitable clients on a priority basis. At the same time, the bank or broker-dealer may invest resources in promising clients with the ability to pay, or deny resources to clients who are not as profitable as they might be. Denying resources is the hardest action to take, but it can be most effective if communicated with tact and supported with accurate data on profitability.

Finally, value propositions may shift over time, often resulting from change in the strategy or organization of the parent company. For example, prior to the sale of Smith Barney to Morgan Stanley, Citi Global Markets may have emphasized its retail distribution, captive order flow, and stock loan supply as differentiating strengths or resources. Subsequently, the group may need to adjust its value proposition to emphasize the custodial capabilities and global network of Citi on the banking side.

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