State Street: A Possible Acquisition Of Goldman's Hedge Fund Business Makes Strategic Sense

| About: State Street (STT)

Shares of State Street (NYSE:STT) are among the few gainers in today's trading session. The financial holding company focused on investment servicing and investment management for institutional clients saw its shares rise 1.5% after a weekend report in the Financial Times suggested the company looks to acquire the hedge fund activities of Goldman Sachs (NYSE:GS).

A Possible Deal

Nothing has been confirmed yet as spokespersons of both companies declined to comment on a possible deal. According to the Financial Times a deal in which State Street will acquire the accounting, valuation and risk management functions of the hedge fund business is in a "late stage". Reportedly the prime brokerage division, the clearing facility for hedge funds, would be excluded in a possible deal. Goldman's hedge fund business has about 250 employees servicing about 500 funds.

Tougher Regulatory Environment

In recent years regulators have stepped up supervision of the previously unregulated hedge fund business. Scandals such as the fraud committed by Bernie Madoff and fears about systemic risks of some larger hedge funds prompted regulators to step up their game. This means that the division is under tighter supervision by regulators and has to oblige to tougher reporting standards. All this added work results in lower profitability for the division which is a non-core asset of Goldman Sachs. The investment bank is focused on trading, investment banking and asset management.

The Numbers

State Street is already among the largest investment service companies for the hedge fund industry. The company currently supervises about $506 billion in hedge fund assets. In comparison, the total hedge fund industry holds about $2.5 trillion in assets according to estimates from Forbes.com

State Street inherited $170 billion in hedge fund assets when it acquired Mourant International Finance Administration in 2009 and a potential acquisition of Goldman's $200 billion division would make it the largest player in the hedge fund servicing industry with roughly $700 billion in assets. The activities are low-profile, some would call it even boring, but relatively profitable as economies of scale apply.

Growth

After the fraud caused by Bernie Madoff and dismal returns in recent years, the industry itself has come under increased scrutiny. This has not just come from regulators but also from investors. Outsourcing crucial services such as risk management and outsourcing allows funds to offer investors an increased feeling of security. Furthermore regulators demand independent valuations of complex hedge fund's positions, especially in the case of over-the-counter derivatives.

The hedge fund servicing industry is rapidly consolidating. Earlier this year SS&C Technologies (NASDAQ:SSNC) bought GlobeOp Financial Services which has about $187 billion in assets in a deal valuing the firm at $879 million.

As the deal makes strategic sense to both parties, it is just a manner of time until a final deal gets announced.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.