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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.

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Tax Notes: Analyzing the Equity Swap Legislation

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Mike Gaffney, Tax Partner at PricewaterhouseCoopers, has written an article on new tax legislation and its impact on equity financing transactions. A PDF is available here.

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Written by highlineadvisors

July 24, 2010 at 7:44 am

Posted in Equities, Prime Brokerage

Tagged with , ,

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