NEW YORK — After the near-collapse of a giant hedge fund in 1998, Wall Street investment bank Citigroup Inc. scaled back its exposure to the freewheeling investment funds.
But as hedge funds exploded in popularity in recent years, Citigroup changed its thinking. Now, like the rest of Wall Street, it is aggressively courting hedge funds for their lucrative securities trades and other business.
"The way the firm approaches hedge funds has changed dramatically in the last two years," said Tom Tesauro, managing director of global equity finance at Citigroup.
Just as investors are rushing toward hedge funds in search of oversized profits, so is traditional Wall Street. Hedge funds have become one of the fastest-growing sources of revenue for investment banks, generating about $25 billion in 2004, or more than one-eighth of the total, according to Credit Suisse First Boston.
Hedge funds turn out profits for brokerages in several ways. Their frenetic trading produces fat brokerage commissions -- an estimated 30% of total stock commissions, according to Sanford C. Bernstein & Co.
Fund managers also are eager buyers of derivatives, the complex investment concoctions whose value is based on factors such as the direction of interest rates or the prices of foreign currencies.
Citigroup and other investment banks sell derivatives to hedge funds and other clients at hefty profit margins.
"Hedge funds have become extremely important to the revenues and profits of Wall Street firms," said Jim Melcher, a hedge fund manager at Balestra Capital Management in New York.
Hedge funds also have begun buying stakes in companies and pushing for them to be sold, generating work for the banks' mergers and acquisitions units.
Investment banks service hedge funds through so-called prime brokerage units, which handle a variety of services including securities trades and helping funds find investors.
"A prime broker's job is to handhold," said Ali Hackett, who heads Citigroup's prime brokerage unit with Tesauro.
The leading prime brokers are Goldman Sachs Group Inc., Morgan Stanley and Bear Stearns Cos.
Prime brokers can be highly profitable, with operating margins at top firms of 45% or more, according to Deutsche Bank. At Goldman Sachs, prime brokerage revenue surged to almost $1.8 billion in fiscal 2005, up from $1.3 billion in 2004 and $1 billion in 2003.
