A colossus emerges – prospects and industry implications

A new fund management behemoth was formed this year when Barclays Global Investors (BGI) was sold by its parent bank Barclays to BlackRock. Mergers of this sort have a patchy history. By Dr Arjuna Sittampalam, Research Associate with EDHEC-Risk and Editor, Investment Management Review, looks at the issues of how this particular alliance will fare and the wider industry implications.

BGI was an extremely successful company in its own right, and the main motivation for the sale by its parent Barclays Bank was to meet capital requirements, although this is refuted by Barclays Capital chief executive Bob Diamond. He claimed that it was because they were finding the presence of a sister asset manager inhibiting in their investment bank servicing US institutional investors.

Whether or not the merger will work has a lot to do with the two firms’ separate characteristics. BlackRock, and its head Larry Fink in particular, have a strong record of bringing together different cultures. Furthermore, there is not much overlap between their separate activities.

BGI brings a mainly passive culture, with some active tweaking. While BlackRock is strong in quant, just as BGI is, it puts more emphasis on fundamentals. The biggest prize brought by BGI is its ETF arm, iShares, and the related indexed-fund expertise. It is suggested that there might be a culture clash in reconciling their distinct active and passive ethos. But, since there is no need to integrate them, industry experts consider that there is no problem. BGI also brings valued exposure to Middle-Eastern clients and Asia-Pacific.

BlackRock’s feat of climbing to the top of the fund management league tables size-wise is all the more impressive given that it was founded just 24 years ago. It is now an awesome asset management company, and not just in terms of assets under management. One of its arms, BlackRock Solutions, is sought after worldwide for its risk-management and analytics expertise. $7 trillion of assets globally are reviewed by them for various clients, and the firm advises governments, sovereign wealth funds, central banks and top insurance companies. The group was involved in the Bear Sterns and AIG rescue operations and advised Mitsubishi UFJ with regard to their potential involvement with Morgan Stanley.

BGI sale in the industry context

The mega-merger between the two titans has sparked off a flurry of discussion in the media about the long-awaited consolidation of the asset management industry.

The industry is in bad shape, albeit with some recovery this year, and this adds fuel to expectations of disposals, including possibly fire-sales. How bad a shape the industry is in emerges from the statistics.

According to Denis Bastin of Oliver Wyman, the consultancy, 40 per cent of revenues and a third of the assets of the industry have vanished, and Bob Doll, BlackRock’s vice-chairman, suggests that as many as 50 per cent of asset managers worldwide are only breaking even. Andy Maguire of the consulting firm Boston Consulting Group finds it difficult to envisage assets under management regaining 2007 levels, at least for another four years.

There are structural reasons for being pessimistic. Revenue margins are set to decline, because of a change in the asset mix, with more money shifting to lower-margin bonds and passive vehicles. Furthermore, institutional customers are now prone to drive hard bargains on fees, more so than previously.

In the present climate, retail customers are not as profitable as they used to be, because increasingly they are accessible only through big distributing brokers. According to consultants McKinsey, the share of the four biggest asset managers in the US, Bank of America/Merrill Lynch, Smith Barney/Morgan Stanley, Wachovia/ Wells Fargo and UBS, has increased to 60% from nearer 40% before the crisis.

The classic reasons for disposals of asset management arms by their parent insurance company or bank are continually being rehashed. Previously, the asset management arms were considered to be reliable cash cows. In recent years, however, under the open architecture system of distribution, the parent institution has come under pressure to provide independent advice to customers, and any bias in favour of its own in-house asset management arm is perceived to be a disadvantage. So the rise of open architecture has militated against continued ownership .

Another important reason for disposals has come to the fore recently, and that is the rise of the independents, who have been gaining market share at the expense of bank-owned operations. Barclays claimed that this was another reason for selling BGI, having estimated that the independents’ share of the 50 largest asset managers had risen to 59 per cent by 2008 compared with 36 per cent 10 years earlier. They also claim that some clients are wary of conflicts of interest between parent investment banks and asset management arms.

However, selling is easier said than done. Where a bank with a large customer network sells its asset management arm, the purchaser is still dependent on the bank’s distribution network, which the bank will continue to control. So industry experts point to the difficulty of valuing these subsidiaries.

Another difficulty is that other asset management houses that are able to buy what is on offer are thin on the ground and prices obtainable are therefore low. It is suggested that private equity firms might step into the breach and indeed they have shown interest in some sales.

A desired outcome of consolidation among asset managers would be the reduction of fragmentation. Europe has 26,000 mutual funds compared with 8,000 in America, but $4 trillion fewer assets. The average fund size in Europe is less than a seventh of that in the US, and in Asia it is even smaller.

Related facts and recent developments

The following items, reported in recent issues of Investment Management Review are of relevance to the above analysis:

• BlackRock is another group with a significant presence in Europe, and, according to Strategic Insight, one of their funds is the second-largest Ucits III fund (as of August last year), with close to $20bn under management.
• An increasing number of US insurance companies are sub-contracting out the management of their assets to fund management houses. Margins are low and only the bigger houses have the scale to afford the needed risk management expertise and make a profit. BlackRock and State Street Corporation are two of the biggest US players in this field. The Federal Reserve chairman Ben Bernanke stated that BlackRock was one of only a few firms that could handle the job of managing the portfolios of mortgages from the collapse of Bear Stearns.
• The Swiss banking giant, Credit Suisse, disposed of its UK asset management arm to Aberdeen Asset Management in exchange for a 25% stake in the latter…The deal was valued at $250m, representing less than 0.4% of assets under management, which stands in sharp contrast to the 5% that was the norm three years earlier.
• Société Générale has got rid of its UK asset management arm, selling it to the hedge fund giant, GLG. The purchase price was not disclosed, but is believed to be less than $10m, which represents not much over 0.1% of assets under management…this is a new low…

The merger of BlackRock and BGI stands apart from the usual merger in that their separate skill sets are more easily reconciled and they both have a powerful position in their existing field. However, history is replete with mega-mergers that haven’t worked, and only time will tell whether the whole will be greater or lesser than the sum of the two separate parts in this case.

Though open architecture has been put forward as a driver of consolidation, very few of the recent mergers or sales have come under this heading. The BlackRock-BGI merger certainly doesn’t fit. Deutsche Bank and Credit Suisse sold their asset management in the UK, where they had no conflicts with a distributor role. F&C Asset Management, one of the most venerated names in the UK, was not sold by Friends Provident for this reason either.

Neither does the conflict of interests argument with the parent investment bank hold up very well. Goldman Sachs, Morgan Stanley and JP Morgan continue to have thriving asset management arms. Nor does BGI’s claim that independence was a factor hold up, given that BGI had very little in common with Barclays Capital. It smacks of protesting too much and denying that capital-raising was the prime motive.

The fact remains that, particularly in Europe and Asia, banks and insurance companies still have a stranglehold on distribution and there are still no signs of this letting up. Most of the recent M&A activity worldwide has had special reasons and cannot really be fitted into the cosy picture of a genuine commitment to open architecture instigating the hiving off of asset management subsidiaries.

The reduction of fragmentation among European mutual funds does not seem likely any time soon, consolidation talk notwithstanding. One of the factors behind this large number of funds is that, unlike the US, Europe is not one sovereign state but fragmented among nation-states, each with its own fiscal rules and interpretation of regulations, even those originating from the EU. Until a true single European market emerges in this industry, this state of affairs should continue.

References

“Some areas still sparkle – International efforts continued,” Investment Management Review, vol. 4 issue 2, winter 2008/09

“Fund managers join forces – Credit Suisse throws in the towel” and “Hedge fund follows a mainstream manager,” Investment Management Review, vol. 4 issue 3, spring 2009

“Two giants merge” and “BGI sale in the industry context,” Investment Management Review, vol. 5 issue 1, Autumn 2009

“Institutions shed their asset management businesses,” Mike Foster, Financial News, 15.6.09

“Independence becoming de rigueur,” Pauline Skypala, FTfm, 16.6.09

“Rethink on what was once considered to be a core asset,” Kate Burgess, Financial Times, 3.7.09

“Managers focus on effects of concentration,” Phil Craig, Financial News, 22.6.09

“Fund management – wasting assets,” The Economist, 20.6.09

“Banks and managers get ready to divorce,” Mike Foster, Financial News, 18.5.09