High Line Advisors LLC

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Posts Tagged ‘hedge funds

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:

    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.
    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 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 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.
    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.

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.

Hedge Fund Coverage

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Our recent post on Team Selling as an alternative to cross-selling prompts a larger series on hedge fund coverage. In future blog posts, we will provide some proven techniques for managing complex institutional investor clients across multiple product areas of a bank or broker-dealer. While these techniques have been applied successfully in a global institutional equity business, they may be extended to fixed income or other multi-product businesses that serve the same client.

UPDATE: High Line Advisors has published an article on this topic. Hedge Fund Coverage: Managing Clients Across Multiple Products is available upon request.

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“Team Selling” Over “Cross-Selling”

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[part of a series on hedge fund sales coverage]

Cross-selling” initiatives have always struck us as weak efforts to encourage client-centric behavior in essentially product-centric organizations. Incentives often work against the intent, as sales professionals understand their compensation to be driven by revenues in one product line, and annual bonus discussions fail to reinforce broader behavior.

Most broker-dealers are organized by product. The best aspects of product-centric management are risk discipline, operating efficiency, domain expertise, best-of-breed products, and an excellent client experience. Product-centric management works well when there is a 1:1 relationship between clients and products, as was the case historically. Modern asset managers, hedge funds in particular, are not so well-behaved, and may deploy many products or asset classes within a single portfolio. Without a means of communicating horizontally, product-centric organizations can miss overall client activity and related revenue.

What is needed is an approach to balance product discipline with client coverage across multiple products. This requires a “1:many” solution for covering clients and measuring revenue across products. We call the process of coordinating sales coverage of one client across multiple products “Team Selling.” The team is collectively responsible for covering a client, and collectively responsible for maximizing share of the client’s “wallet,” rather than market share for any particular product.

Harvard Business Review recently conducted an interview with Admiral Thad Allen, USCG (Ret.) (ref. “You Have to Lead from Everywhere” by Scott Berinato). Admiral Allen’s comments on crisis management can be applied to the coordination of multiple product specialists in covering complex clients:

“You have to aggregate everybody’s capabilities to achieve a single purpose, taking into account the fact that they have distinct authorities and responsibilities. That’s creating unity of effort rather than unity of command, and it’s a much more complex management challenge.”

In the context of institutional sales, “unity of effort” implies coordination among separate individuals from different product areas covering the same client (or multiple buying centers at the same client institution), and the “single purpose” they are aiming to achieve is to maximize the profitability of that client.

Using a hedge fund investing in long/short equity as an example, three buying centers can be defined by the investment decision (what to buy), the execution decision (how to buy or express the investment), and the financing decision (how to pay for it). In general, these decisions are made for the fund by different individuals or groups, with the portfolio manager, chief investment officer, or analyst consuming resources to determine what investments to make; the head trader or derivatives specialist deciding how orders are executed, and the chief operating officer or chief finance officer deciding how and where to source financing or borrow stock.

investor client wallet

Traditionally, institutional equity sales teams have been comprised of Research Sales professionals covering buy-side analysts and portfolio managers, Sales-Traders and Derivatives Sales people covering buy-side trading desks, and Prime Brokerage or Stock Loan professionals covering the fund’s COO and CFO.

These client-facing professionals tend to be grouped by product, with Research Sales and Sales-Traders associated with cash, Derivatives Sales with derivatives, and Prime Brokerage and Stock Loan sales people associate with those financing products respectively. In a product-centric organization, these sales groups tend to focus on maximizing the revenue in their respective products, without regard for or regular communication with sales people in the other product silos, even if they cover the same institution.

Without breaking the product-centric organization, management can encourage coordination or “unity of effort” across product areas in covering the same client, simply by empowering teams with information on client revenue across all products, (in addition to the traditional reporting of product revenue across all clients). With the common goal of maximizing wallet share and profitability, a client team can work together to make introductions, deliver resources, solve client problems, and fill revenue gaps across the product spectrum.

While easily piloted, the first challenge in team selling is scalability. Scale is achieved when the same team of sales people from different product areas cover the same set of clients. When this occurs, the number of virtual teams can be fewer and their team meetings can be less frequent and more efficient. Rebalancing coverage assignments is difficult but can be rewarding over time: the organization can over a large number of clients as teams operate independently and simultaneously. Team selling is also a compliment to any key account management program, with team leaders corresponding to relationship or account managers. The larger the account, the more senior the team leader. Armed with the right information, anyone in the organization can contribute to or even lead a client team.

Culturally, teams must believe that they will be rewarded for overall increase in profitability of the clients they cover, not only the revenues in the product they are associated with. Client revenue production, product penetration, and profitability can be added to traditional sales metrics in the determination of compensation.

While cross-selling is a product-centric behavior that is by its nature a secondary priority for sales people, team selling encourages client-centric behavior and awareness of the maximum revenue opportunity from each client that the organization covers.

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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