When a mega deal gets announced the impact is felt far beyond the two companies involved. For CEOs in the same industry it’s like a large, threatening clap of thunder. The deal engenders fear. They’d love to crawl under the covers and ignore it but they can’t. Business plans are cast aside with the cosy certainties that informed them. It’s time to go back to the drawing board.
For the asset management industry Merrill Lynch’s swap of its fund business for a 49.8% stake in an enlarged BlackRock is a $9.8 billion-sized thunderbolt. It’s the biggest deal ever by both dollar value and the size of acquired assets ($544 billion), surpassing Merrill’s own $5.3 billion purchase of Mercury Asset Management in 1997.
Merrill faced some specific problems. For much of its history, Merrill Lynch Investment Managers (MLIM) was a US mutual fund shop largely reliant for distribution on Merrill’s awesome brokerage sales force. But in recent years Merrill has found it increasingly difficult to sell home-cooking to its house brokers.
In 2005, 30% of MLIM’s US mutual fund sales were through Merrill brokers, significantly below internal targets. Since New York state attorney general Eliot Spitzer shone a light on some of the darker recesses of the US mutual fund industry, many financial advisers have concluded that it is safer not to sell house product, lest there is the faintest whiff of a conflict of interest.
Whether dispensing with the Merrill brand as a manufacturer of fund products will be sufficient to inspire its 15,160 brokers to sell the BlackRock retreads remains to be seen. Merrill CEO Stan O’Neal points to the high sales of Van Kampen funds through Morgan Stanley, even though Morgan owns the brand. But ultimately the only guarantee of success in an open-architecture environment is to offer products that distributors want – and that is all about performance.
Merrill is cleverly betting on both red and black. As a distributor, it is in a mightily powerful position. A typical distribution deal with Merrill for an equity fund would see it bag 500 basis points of load, the 12b-1 fee (25bp in perpetuity) and one half of the annual management fee for five years (37.5bp) for every $1 of a mutual fund sold. Distribution is the meat, managing the money the gravy, but the dish still tastes better with both.
European fund managers, especially on the Continent, are largely owned by banks and insurers that happily deploy their branch networks and sales agents to sell in-house product. Fees are almost double the typical US equity mutual fund (136bp on average, according to McKinsey & Co) with distributors bagging an equally rich percentage of the overall revenues.
Of the top 10 groups ranked by net new fund sales in Europe in 2005 (according to Feri Fund Market Information) only Fidelity was not owned by a bank or insurer and only Merrill Lynch and JPMorgan lacked significant proprietary distribution clout. That is a very different distribution dynamic to the one in the US. However, a European CEO who concluded that what is happening there is irrelevant would be dead wrong.
With so much of the value pocketed by distributors, banks and insurers with flagging or peripheral captive asset management businesses are rightly questioning whether they remain committed. Even if they do, the impact of open architecture is being felt. For example, an insurer offering only in-house unit-linked product would soon lose market share.
Increasingly, the in-house product is just another offer. With relationships becoming more distant, European parent companies might question, like Merrill, whether retaining 100% ownership is necessary. Flotation allowed Friends Provident, for example, to monetize its investment in Isis (now F&C) while retaining a 51% stake.
Putnam Lovell’s New York-based head of strategic research, Ben Phillips, says: “The question management must ask is: if the fund management arm were to be quoted separately, would it achieve a valuation that reflects the different nature of the business? It’s hard to say in Europe because there haven’t been many deals. But there will be deals done.”
The UK life insurers are an interesting case. Before Aviva’s bid for the Pru introduced froth, the life insurers traded at 10.9 times 2006 earnings. That is 37% cheaper than the average valuation of the large quoted UK money managers (17.3 times). With the sector under scrutiny, releasing value by floating in-house fund managers would be a shareholder-friendly thing to do. It will be fascinating to see what Standard Life does with its booming fund management business when it comes to market this summer.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own.
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