Since last autumn relentless assaults have been made on almost every aspect of Merrill Lynch’s business. Merrill, it was said, had finally fallen victim to overweening pride, and now found itself forced irrevocably towards being subsumed into a commercial bank (Chase Manhattan has long been the favourite candidate). Behind the slide lay a series of mistakes and miscalculations that seemed to affect almost every aspect of the US investment bank’s business.
Merrill’s response was calm. It still talked to the media, still talked to analysts. And its executives showed they had kept their sense of humour. At the start of June when the firm announced its long-awaited internet strategy for its huge private-client business, chief executive David Komansky’s tongue was firmly in his cheek. “We’re here today,” he began, “to announce the biggest merger in history. Between Merrill Lynch and you, the investing public.”
It was an obvious swipe at the merger rumours of recent months but also a clear statement that six months of setbacks and bad press had not quelled the firm’s desire, and ability, to continue to grow as an independent institution.
Nonetheless, it has been tough at Merrill of late, remembering the success enjoyed for most of the previous decade. The big questions about the performance and future of the bank began to be asked in late autumn last year, but the mumblings began as far back as November 1997.
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Komansky: tongue-in-cheek announcement |
It was then that Merrill paid $5.2 billion for Mercury Asset Management, a UK institutional fund manager of great repute whose more recent performance in some high-profile funds left a lot to be desired. Surely that was too high a price to pay? Merrill Lynch Asset Management, the core of Merrill’s US franchise, had been having performance problems of its own.
Next was Merrill’s foray into Japan. In February last year Merrill hired 2,000 former Yamaichi brokers after their firm went bust. High start-up costs and no revenues to speak of raised questions about the wisdom of the move.
But that was nothing compared to what happened next. Merrill Lynch, bond house supremo in the US since 1987, and in Eurobonds since 1994, lost $894 million on debt and preferred securities and announced its first loss-making quarter in nine years.
The division went into a tailspin for three months and was forced to focus on sorting out its huge bond inventory – reports put it as high as $60 billion – a task that market illiquidity made all the more difficult. Roughly 500 people were sacked from debt markets – just under 20% of the workforce – including more senior managers than the bank had ever lost in such a short time.
Merrill became the prime target in a debate about the merits of full-service brokers versus internet-based discount brokers such as Charles Schwab. Merrill’s approach, said its detractors, was outdated, its 14,000-strong broking force a bunch of Luddites opposed to technological changes that might cut their commissions or make them superfluous.
Yet Merrill is still an exceptionally strong bond house. New Mercury investment products have raised over $2 billion in the US since last November, and the brokers – known as financial consultants – are still bringing in over $300 million a day in new assets. The firm’s brand name is still strong, it has some talented staff, not least in the bond division, and some criticisms have over-simplified the issues.
Comfortable margin
Full-service broking is not dead. Schwab charges $29.95 to execute a trade for a client on-line, Merrill charges over $100 to do the same trade over the phone, often much more. But there’s a huge difference between full-service Merrill, offering advice and research as well as trading, and the mainly trading-only option at Schwab.
“The argument has been made for nearly two decades that with cheap and abundant discount services available, full-service [broking] would soon be extinct,” wrote Salomon Smith Barney securities firm analyst Guy Moszkowski in March.
The other side of the coin is that Schwab is operating in a low margin business; an execution-only strategy has its own risks, and Schwab has admitted that to grow its business it has to consider how to offer more services. And last year was a successful one for Merrill’s retail brokerage and private-client operations, with new accounts up 30% on 1997.
Overshadowed by the problems in other areas of its business is Merrill’s foreign expansion outside of debt products. M&A advisory, for example, always a strength in the US, was only begun in earnest in Europe four years ago. Now Merrill ranks in the top five.
At one point last year it looked as if the momentum might have stopped: “No-one was immune to the market disruption last year,” says Justin Dowley, co-head of European M&A. “But that has passed and it now looks more like a blip rather than having any real long-term negative effect on the business.” Merrill froze all money for investments in the business for two months last year, but now Dowley is free to continue expanding his business into Europe, especially France, Germany and Italy.
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Allison: tradition of reinvention |
The equity markets business is also moving at a healthy pace. It is now run by Paul Roy, a British banker who with Michael Marks facilitated the sale of their UK brokerage house, Smith New Court, to Merrill in 1995. At $803 million, it was considered by many to be too expensive at the time.
But it has since served as the base for Merrill’s non-US expansion in equity markets – Roy’s elevation to global head last year is evidence of this. “In four years our business has been dramatically transformed from being US-centric to the point where half of the revenue now originates from abroad,” he explains. “Smith New Court was the base for that, but our other acquisitions have built on that.”
In research and in secondary trading Merrill is a consistently top performer. In all the analyst rankings it comes at or near the top. If anything is lacking, it is a first-class origination effort. As with other US banks, Merrill has done well out of European privatization, but still feels there is more to be done. “We need to build the origination effort off our secondary trading business more, especially in Europe ex-UK,” says Roy. “That’s why, for example, we hired Dante Roscini from Goldman Sachs earlier this year. We expect to take two or three years to build effectively.”
Successes, though, and prospective successes, should not hide the fact that Merrill Lynch has suffered several major setbacks within a short time. Komansky and other senior executives readily admit that there have been major challenges for the firm of late, but prefer to place them in the context of the firm’s development over the past 25 years.
Herb Allison, president, chief operating officer and heir-apparent to Komansky, likes to label the firm’s history “a tradition of reinvention”.
Having started as a US-centric retail brokerage house, Merrill went through three distinct changes, each one adding to, rather than detracting from, the previous franchise. In the 1970s, Merrill introduced the cash management account, designed to allow its clients more flexibility in handling investments as well as day-to-day banking. It was a smart way of offering a bank account by an institution forbidden by the Glass-Steagall act to be a commercial or retail outlet. It took 10 years to make a profit, but is now successful, and has been copied by several other institutions in the US.
Next, in the 1980s, Merrill went full speed into the debt markets. Starting in the early 1980s, by 1987 it was leading the US league tables, and has done so ever since. Equities and M&A followed, and now Merrill is regularly in the top two or three for both products.
That leaves the third major development, begun in 1995 when Komansky was president and chief operating officer. The acquisition of Smith New Court in the UK set in motion four years of acquisitions and organic growth designed to diversify Merrill in two ways: away from a heavy reliance on US earnings and, in the international arena, on debt capital markets. None of the 19 major acquisitions and capital outlays from Smith New Court onwards has added to Merrill’s debt-markets capability, and only one was a US acquisition – that of the West Coast institutional asset management firm Hotchkis and Wiley.
“What we’ve been doing for the past five years is building a long-term business around the world,” says Jerome Kenney, executive vice-president and head of corporate strategy at Merrill Lynch. “We’re in 41 countries now, in a diversified series of products. We aim to be the investment banking equivalent of, say, AIG, which spent a few years building its insurance presence abroad, often without recognition, and now holds an unassailable position.”
So, in mid-1998, after its last major acquisition – Midland Walwyn in Canada – but before the Russian crisis hit, Merrill was a firm viewed by many as the unerring financial services innovator of the moment. A stark contrast to the view of the last few months that the firm is irrevocably damaged.
Walking on water
That, according to Komansky, has been part of the problem. “Any firm that is central to the industry and is covered by the press and analysts as much as we are tends to have its positives and negatives magnified. Until the Russian crisis and the problems with Long-Term Capital, hardly a bad word was written about us in nearly three years. One would think we walked on water.” From October onwards, Merrill was clad in concrete boots.
Nowhere did this seem more the case than with the firm’s attitude to the internet. Received wisdom had it that Merrill considered use of the technology for financial services to be a flash in the pan. At the annual Securities Industry Association in 1997 IBM chairman and chief executive Louis Gerstner gave a stark warning to brokers that “your entire industry will move to the net.” Komansky’s answer was dismissive: “We do not see ourselves competing with the on-liners and the discounters.”
Back then, that was more or less true. A year later, it was John Steffens, executive vice-president and head of Merrill’s private-client group – the very business Gerstner had been talking about – who put his foot in it. “The do-it-yourself model of investing, centred on internet trading, should be regarded as a serious threat to Americans’ financial lives.” Steffens contends that his comments were related more to day traders; certainly some stocks, especially technology stocks, have been exceptionally volatile because of the buy-to-sell mentality of these investors.
Given two such definitive statements from executives at the very top of the firm, it’s easy to see why Merrill could so readily be portrayed as being averse to the idea. But none of the full-service brokers has a strategic internet service (Morgan Stanley’s Discover Brokerage is an internet discount brokerage not a tool used by the firm’s broking force). But Merrill contends that it has been working on a comprehensive strategy for nearly a year, and in February it paid $25 million to buy DESoft, DE Shaw’s technology development team, to help out.
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| Dowley: market disruption was just a blip |
And for the largest full-service broker in the US, an internet strategy takes time. Komansky says the firm wanted to wait until all elements were in place. “We’ve had the technology to do it for some time. But the challenge has been how do we do it in a way that makes sense, and to be certain that when we introduce it it’s the right type of offering at the right time. We’re not going in there half-hearted or halfway and then build it up over a period of time. We want to be able to compete at the top of the market the first day we go in.” What pushed the issue for Merrill was the effect the internet-based brokers were having on its business over the past 12 months. “We spent a lot of time travelling around the country canvassing 200 of our accounts about the services we and others offered,” explains Steffens. We found that many were using our broking service, but increasingly also taking some of their business to the internet brokers. Also, the majority said that if we were to offer the right service, they’d bring their accounts back in part or in full.”
So Merrill’s internet strategy is twofold. First, it intends to abolish commissions per trade and set up a new account service. For $1,500 a year, clients can get all the research and advice they received before, execute trades in person, over the telephone or on the internet, and be able to make virtually unlimited trades. Steffens says that for practical purposes, this means somewhere between 500 and 1,000 trades a year. This will be rolled out in July. In December comes the second part, the counter to Charles Schwab. For $29.95, anyone can use Merrill to trade over the net.
Most attention has focused on the response to Schwab, but it is the first element that Merrill considers crucial, as it is here that the bank has the opportunity to marry technology with advice. And far from expecting a decline in brokers, Steffens reckons more will be needed. “There are a total of 19 million individuals who fit our investor profile of $100,000 or more to invest. By 2005 we expect that figure to be 40 million. And no matter how you look at it there will always be people who’ll want and need advice.” Steffens expects to need between 17,500 and 20,000 brokers by 2005.
Merrill’s strategy has been well received. Joan Solotar, securities industry analyst at Donaldson Lufkin & Jenrette jokes that, if it goes as well as Schwab’s service has, Merrill could trade at $633 a share (that is, some eight times its current share price). Ray Soifer, bank analyst at Brown Brothers Harriman, calls it “a well thought-out offering, though they are playing catch-up”.
Now it is up to the other full-service brokers, such as Salomon Smith Barney, PaineWebber and Morgan Stanley Dean Witter, to respond.
Expense accounts cut
The biggest shock for Merrill, though, was not incursions into its retail investment business but the effect of the Russian meltdown and global credit crunch last year. Many banks suffered, but few as publicly as Merrill Lynch. Job cuts affecting 3,500 staff worldwide were announced – roughly 5% of the overall workforce – investment in people and technology was temporarily put on hold (even in areas, such as non-US M&A, that are still expanding) and expense accounts were cut dramatically.
But it was the fixed-income division, where Merrill has been US leader for 10 years and international leader for five, that was the worst hit. Five hundred of its staff, nearly 20% of its overall complement, were sacked. It is virtually impossible to overstate the impact of this on both the market and the firm itself. Over the years Merrill had withstood everything its peers could throw at it in an attempt to dislodge it from the top spot in debt underwriting; now it seemed Merrill had imploded, doing the job for them.
For the last three months of 1998, and part of January, Merrill’s attention was not on the markets but firmly on trying to put its own house in order. It had developed a reputation for taking on risk, and taking on large inventories of paper as a way of being able to provide liquidity to its clients – as well as being able to make money for itself from the long-term trend of spread-tightening on debt products. Merrill did this across the board, but three asset classes in particular were singled out: emerging markets, US high-yield debt and US investment-grade corporate debt. In other words, the very asset classes that suffered most in last year’s meltdown.
Merrill lost $890 million in bond trading and set aside another $288 million for lay-offs in the final quarter of last year, leading to the first quarterly loss the firm has recorded since 1989. During this crisis period, senior managers insisted that the sales force would have to guarantee that the vast majority – some put the figure at 90% – of a deal could be placed before they would agree to accept mandates. Capital allocation to the business was cut drastically, and changes at the senior management level were unprecedented.
In October Kelly Martin was put in charge of the fixed-income division; former co-heads Seth Waugh and Conrad Voldstad were now to report to him. Martin, a 17-year Merrill veteran, was a virtual unknown in the debt markets. He had spent two years, until 1990, heading the fixed-income sales effort in London. But that was his last direct contact with the debt markets – he subsequently spent three years running equities sales and trading, and then was COO of investment banking, from 1993 to 1995 under Allison, before becoming technology officer for the corporate and institutional client group.
“We aim to be like AIG, which quietly built its business abroad and is now unassailable”
For Martin the first task was to concentrate on a basic question. “The challenge that faced us was how to continue to extend our lead in the debt markets when we’re already number one.” He started a two-month review of the business, focusing on how the division got where it was, what it was now doing, and where it should go in the future. Two main conclusions were drawn: “First, we realized that we had strayed from our core task of serving the client,” says Martin. “In part that is because the nature of the market had moved to being conducive to firms taking on big positions, in part because the nature of the client had changed, and we had not stopped to consider enough the effect of that on our business. And secondly we had grown quickly around the world and had not been rigorous enough in our total investment in our people and operating infrastructure.”
While this review was under way, however, market liquidity all but dried up, and the effect of the changing nature of the marketplace soon became apparent. Martin was forced into crisis management. “We had so many big positions in our inventory that, rather than servicing our clients, sorting through our own balance sheet became a necessary priority for nearly three months,” Martin says.
Always known for keeping a big and varied inventory for its clients, Merrill, so some former employees say, found itself stuck with up to $60 billion in bond positions in an illiquid market.
Hidden among the mess, though, were some nuggets. “We took the view that we could either sit back and worry, or get on with business as best we could,” says Niall Cameron, director of global client products and new issues in London. “In the event, in the three months after the Russian collapse we took our market share from 9% to nearly 14%.”
Outsiders looking on were convinced that something drastic was happening – less capital, less risk-taking, huge losses, huge job cuts, uncharacteristic mistakes, and a new man at the top who hadn’t worked in the debt markets for more than eight years. Merrill, it was decided, was pulling back. In the space of four months Merrill lost more senior managers than ever before.
Voldstad had been seconded to sort out LTCM two weeks before Martin’s appointment, but almost immediately his future was thrown into doubt. Rumours have been circulating that Voldstad received a letter towards the end of last year from the firm’s president, Herb Allison, informing him that there would not be a job for him once his stint at LTCM was over. Allison, Martin and Voldstad deny any such letter was sent. But it isn’t clear what Voldstad’s role will be when he finishes his work on LTCM.
Waugh left in February to join Quantitative Financial Management. Others who have departed include David Tory, who left for personal reasons, Nabeel Nabulsi, head of sales in Europe, and Tom Gahan, the former global head of leveraged finance, who was promoted to that role in December but left two months later to take up a similar role at Deutsche Bank in New York. Gahan has since poached several members of Merrill’s leveraged-finance team.
‘We got bloated’
Some of those who left the firm in the last few months feel that they were let down by their bosses. “Management got scared,” says one. “They abandoned the flag carriers and ran to the hills to save their own asses.” Certainly, senior executives had been asking whether the division was sufficiently robust to withstand a downturn in the market, but the lure of the money to be made from the business at the time was great. “Let’s not forget that for almost a 10-year period before the crisis the market made money for you if you were long bonds,” says Komansky. “From now on I think that’s changed. As I reflect back on that period, I think what happened was that the exuberance and profitability of the market probably led to us focus our attention a little less on the disciplines of the business than we should have. We did get bloated, we did get overstaffed, and we were very focused on emerging markets.”
So when did Merrill’s senior managers first notice that a change was due? If it was before the crisis, they were slow to do anything about it, say some who have left the firm. “Once the crisis hit, however, they completely overreacted,” says one. “The whole thing created a feeling of mismanagement.”
Merrill says it began to reduce its emerging-market inventory two years ago. “After the Thai baht crisis in July 1997 we began to reduce positions in emerging markets,” says Allison. “By July 1998 we had reduced some of our positions by up to 75%.”
But it was not just the inventory levels that caused problems, but the management structure of the division. Voldstad and Waugh had been appointed co-heads in May 1997, and their brief was to enact a broad realignment of the global debt business, integrating products and regional operations in an attempt to build a flatter organization.
It didn’t quite work out that way. Waugh and Voldstad were very different individuals. Waugh was more of a team player than Voldstad, who is described by his colleagues as the rocket scientist who came up with an exceptionally devolved and complicated business structure. “His plan was to compartmentalize each part of the business and have it run to extract as many basis points as possible,” says a former colleague. “In the good times, that can work, but as soon as there’s any problem a concerted response is very difficult to achieve. There was such an incredible series of checks and balances that it made it very difficult for us to progress.” Another problem was that the two co-heads were not as disposed to contact each other to discuss difficulties as perhaps they should have been.
“We can take more risk that we did before because we are doing it more intelligently”
Insiders acknowledge that the structure posed some problems. “The organization of debt capital markets was overly complicated,” says one. “We’d been trying to integrate the division on a global and regional basis, and as a result had 28 different direct reporting lines coming into us. So it was not as responsive as we’d have liked, there were too many people in the chain of command, and as a result we made some sub-optimal decisions. We realized there were problems after seven or eight months, and started to change them, but it wasn’t an easy process.”
One of Martin’s first moves was to reduce the reporting lines. Instead of 28, there are now just 10. And, after three months of readjustments Martin now has inventories being turned over at least twice a month, as opposed to the once a month or less that was more common.
In public, no blame is being attached to any individuals. “According to the models we were using last year, the meltdown was a statistically infinitesimal possibility,” says Allison. “We haven’t blamed anyone because it was unprecedented. But we needed to reposition the debt business after the crisis, and that’s often best done with a new face, and that’s why we put in Kelly [Martin].”
A Merrill source reflects: “Senior leaders have to have character, actively perform as part of a team and be able to operate at an exceptionally high level all the time. It is a bit of a balancing act, but it’s sometimes the case that the big producers don’t necessarily make the best managers.”
Steve Bellotti, Waugh’s replacement in Europe, admits that morale was very low when he took over earlier in the year. But both he and Martin have taken steps to change this. “I’ve had many meetings, one-on-ones, with small groups and larger groups, to explain our strategy,” says Martin. “And also explaining that we expect honesty and an exceptional ability to perform from our senior managers.”
A strategy takes shape
The first-quarter suggest that Martin and Bellotti are beginning to turn things round. Revenues for the debt business were up 14% on the same quarter last year, and the firm is at or near number one in most league tables.
And the new strategy is starting to take shape. “We want to apply a balanced portfolio between liquidity trading, credit, derivatives and origination,” says Bellotti. “That involves taking a more integrated approach to client solutions.”
As for capital and risk allocation, far from being reduced, both are being put to use more effectively. “We can actually take more risk than before because we’re doing it in more intelligent ways,” says Martin. “And we’re managing our assets and liabilities much more actively. We have inventory and will carry it, but we’ll do it based on client inquiry. So if one of our clients wants to bring, say, a $5 billion issue, we can take a piece of that issue if necessary – and will do it every time. We don’t want to have inventory based on our traders around the world taking different positions.”
Put another way, it becomes a question of relative worth to the firm as a whole. “What we don’t want is for the risk profile of our debt operations to put the rest of the franchise in jeopardy,” says Kenney. “That nearly happened last year when the depth of the debt problems overshadowed the development of our consumer business.”
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| Kenney: debt problems cast a shadow |
Komansky is even more emphatic: “We had a problem, we fixed it, and we’re moving forward. I do not intend to retreat from our overall presence in the bond markets and the fixed-income markets on a global basis one iota. Nor do I intend to have the fixed-income business be any less important than it ever has been, nor do I intend to see it be any less of a factor in the financial equation of this firm.” Martin has spent much of the last few months earmarking the main growth areas for the debt business. One, unsurprisingly, is Europe, and is the area where Martin and his team are most bullish. “There are between 300 and 400 rated corporate borrowers in Europe,” says Martin. “That’s not a great deal. But it is increasing, and if that market were to look anything like the US then there’d be more like 4,000 rated borrowers.”
US banks have found this market a tough one to break into this year, though, Merrill included. In euro-denominated international paper, Merrill is not on the radar screen yet either for corporates or financial institutions (in fact, Morgan Stanley is the only US bank to appear in the top 10 of either list). As more corporates restructure, and turn in part to the bond markets, Merrill and other US firms may increase their share.
But the biggest growth area by far for Martin lies in adopting technology. As erstwhile chief technology officer for the whole of the corporate and institutional client group (CICG) Martin contends that technology will allow Merrill access to far more clients. At present the firm serves roughly 3,000 in fixed income (both issuers and investors). Martin’s plan is to adopt technology in such a way as to expand that base exponentially. “We hope to be able to serve as many as 15,000 clients in a few years’ time,” he says.
Where will these clients come from? Martin cites mid-size corporates in Europe, Japan and Asia as examples. “There are many such companies which are not big enough to make traditional corporate finance coverage economically feasible at present, yet are prime candidates for disintermediation from their house bank relationships. We’re in the process of creating a full-service on-line service model to be able to work with these clients effectively and efficiently.”
To that end Merrill has set up a support and research agreement with MIT, and in May announced that it had launched an internet platform for the whole of the CICG. Known as direct markets, it assimilates the 100 or so separate internet sites which various parts of the group had set up over the last couple of years.
Asset-management expansion
Less glamorous than fixed-income is the asset-management business at Merrill. It has been a growth area but also one causing concern of late.
Merrill began expanding at the end of 1996 with the acquisition of US west coast institutional fund manager Hotchkis & Wiley. It is hardly a big firm, and concentrates heavily on investing in deep-value stocks.
With its next move, Merrill took a slightly different approach. After months of analysis, Kenney recommended that the firm bid for UK fund manager Mercury Asset Management. With that Merrill was catapulted to being the second-largest active asset manager in the world, and the third-largest in all products. The idea was that MAM would be the engine for providing the institutional products, and Merrill Lynch Asset Management and the brokers would concentrate on distribution.
It also gained Merrill a presence in Europe. No US institution, and in fact few European ones, have enough of a presence Europe-wide to gather large amounts of assets, but MAM was a good first step for Merrill. “We’d built this huge dollar-based asset-management business, and were pushing into 41 different countries around the world,” explains Komansky. “We’d bought MacIntosh in Australia and FG Inversiones in Spain, yet had neither an Aussie-dollar product nor a Spanish-peseta product. So we had to get a non-dollar manufacturer of asset-management products. And it wasn’t really rocket science. We drew up a chart of the top 100 non-dollar asset management firms, and the three of them which weren’t buried in banks or insurance companies were MAM, Flemings and Schroders. The latter two weren’t for sale at the time, MAM was the best, and the cleanest asset to begin with as it wasn’t tied up within a larger organization. It jumped off the wall at us, and was clearly worth more to us than to others as we had built up this infrastructure around the world already, and we had to get a non-dollar manager.”
Komansky was prepared to pay what he admits was a full price – £3.2 billion ($5.2 billion) – and as a sign of the firm’s importance to Merrill, MAM co-heads Steven Zimmerman and Carol Galley were given seats on the bank’s executive management committee. It was a full price because at the time MAM had been experiencing two years or more of below-par performance in some of its products. Index funds were reaping the benefits of the bull run, and several of the well-known active managers, including MAM, were lagging behind.
MAM is regarded as a somewhat stuffy institution by some, and it had never managed to establish a reputation outside the UK. Since the acquisition, MAM has been in the headlines for high-profile account losses, including UK supermarket chain Sainsbury’s and conglomerate Unilever, which has been contemplating taking MAM to court for negligent care of its funds.
And Merrill Lynch Asset Management has been experiencing problems of its own. Many of its funds have been disproportionately geared towards investing in value stocks in the US, which have not been the best performers in the past three years. For a firm determined to diversify its business to maximize potential earnings, relying heavily on one investment style appears strange.
Some have established a link between the poor performance and the retirement of former asset management head Arthur Zeikel, who left the firm at the start of the year with half a dozen of his closest colleagues. Some of these have been replaced from outside the firm: the new chief technology officer was hired from Morgan Stanley Asset Management, the head of marketing from Goldman Sachs Asset Management, and the head of risk from Putnam.
“I don’t think our aspiration should be to have a $200 billion market capitalization”
In the past 12 months performance has improved dramatically. The main benchmark in the US is the Lipper Quartile. In the year to May last year, 46% of Merrill’s funds performed above the Lipper median, and only 13% of these were in the top quartile; this year, that has risen to 73% and 71% respectively. “That’s probably not a figure we can sustain in the long term, but it shows we have been robust in addressing our performance problems, says Jeff Peak, president of Merrill Lynch Mercury Asset Management, as the division is now called. He attributes this to several factors.
“First, US stocks have been behaving more rationally this year as a whole, and are not being driven by just a few stocks. Also, value stocks have performed much better, and we have been impressing upon our portfolio managers the need to focus more on performance.”
As for the over-reliance on value investing, says Peak: “We are recruiting more portfolio managers so that we can expand beyond our value-investing dominance.”
Two recent hires are a new head of equities and Bob Doll as chief investment officer of MLAM. He previously held the same post at OppenheimerFunds Inc. Peak is also planning to grow the index funds business, which stands at just $6 billion under management at present, and to develop a bigger presence in quant funds.
The one area where Merrill has had success in institutional asset management is in Japan, where it now controls roughly $20 billion in assets, double last year’s figure. This is still largely perceived as being Mercury’s business: there is still little evidence of Merrill and Mercury integrating yet, according to one of the firm’s clients in Japan.
Merrill’s Japanese retail division, which dominates its business in Japan, has not developed in the way Merrill had planned. In February last year Merrill stepped in and hired 2,000 brokers from the bankrupt Yamaichi.
This was seen as a coup at the time. Japan had just begun to deregulate its market to allow foreigners more access to Japanese savers and Merrill was one of the first to make a move. Nonetheless, in the short term it was a gamble. No one knew how long Japan would be in recession, nor how receptive the Japanese would be to a foreign firm.
One initial gamble did not pay off. “We thought we’d moved quickly enough that a lot of Yamaichi’s assets would pass to us,” says Wyn Smith, head of Merrill’s international private client business. “But it was too late. Most had pulled out already.” Nikko, Nomura and a number of banks benefited from that, as did the underside of a few mattresses.
Also, the quality of the staff was not quite what Merrill expected. According to one story, a group of former Yamaichi were being shown how to use the Merrill computer system. The instructor asked them if they had used computers before and all immediately said yes. But when the instructor asked them to click on the Merrill logo at the top of the screen with the mouse, several of them picked up the mouse and held it against the screen.
Undeterred, in six months Merrill managed to create what in effect is a new firm. With all the start-up costs and hiring fees, to create a new company and report only a $300 million loss is hardly a disaster. Nor were the costs unexpected. “When we modelled those business opportunities, we modelled the costs side perfectly, uncannily so in fact,” declares Komansky. It was on the revenue side that there was disappointment. “But we overestimated our ability to generate revenue over a given period of time. I’d say we probably overestimated our ability to drive a new paradigm into the Japanese market.”
Merrill overlooked one characteristic of the Japanese market, explains Komansky. It didn’t realize the reliance of the Japanese retail investor on using cash. Merrill doesn’t deal in cash anywhere around the world, and it transported that policy to Japan That turned out to be a problem.
Though embarrassing, this is at least an error that can be dealt with. By the end of May the company had $5.6 billion under management and 47,000 accounts. It is still about a year behind its initial target of 2001 for breaking even. “But,” says Komansky, “I still feel that we would never have had the opportunity to acquire 2,000 employees in one go the way we did. Acquiring distribution in Japan has always been the barrier for foreign companies. If I had the opportunity to do it all over again, I would. I think it was a once in a lifetime opportunity.”
The big question
It would appear, then, that Merrill Lynch is working through its rough patch. Its debt capital markets division is back on track, leaner, more risk-aware and client focused. A strategy is in place for asset management: all that remains now is for a sustained period of convincing results. And Merrill has convinced the market that it has got to grips with the power of the internet in business.
One more question remains unresolved. Will Komansky take Merrill Lynch into a merger or other link-up? The rumours about Chase Manhattan persist. Chase’s corporate relationships and own strengths in US investment-grade and high-yield debt could make for an even more powerful debt house, and Merrill’s equity and M&A prowess worldwide would sit well in a bank that has no equities presence, and a US-centric M&A team.
So why hasn’t it, or any other merger, happened. Komansky explains: “We interpret it the following way. Do we have the financial wherewithal to execute the strategy that will create shareholder value?”
Komansky continues: “I don’t think our measurement or our aspiration should be to have a $200 billion market capitalization, or this or that. What I want to be sure we have is the earnings power and the balance sheet to execute our strategy. As long as we have that, then there would have to be some sort of compelling strategic reason for us to consider a merger.
“Is there something about a particular merger partner that would create value so much above and beyond what we could offer on our own? That’s really the issue for us. And every one of these situations that we’ve looked at or been approached about, basically what the other party would bring to us is a huge balance sheet and very little in the way of strategic leapfrogging.
“So until such time as we see something that is absolutely compelling, we think we can create enough shareholder value as an independent company.
