Can Merrill keep Mercury in orbit?

When Merrill Lynch bought Mercury Asset Management in November last year, it looked like a coup for the US bank, and excellent value for MAM’s shareholders. Merrill paid £17 a share, 33% more than the market price, so valuing the UK fund manager at £3.1 billion ($5.2 billion).

Sure, it was a full price, as Merrill’s chairman and chief operating officer, David Komansky, admitted at the time. But look at what it got them. Combined, the two firms’ funds under management now amount to $450 billion, which catapults them into third spot worldwide behind Fidelity and the Axa group. Merrill gets the advantage of MAM’s brand name – it has always been regarded as one of the top four fund managers in the UK, along with Schroders, Gartmore, and PDFM – as well as its knowledge of institutional asset management. This is an excellent combination with Merrill’s retail mutual funds in the US, and with its formidable force of financial advisers: there are over 15,000 of them in the US.

The fit seems perfect. The only area where there is any overlap is fixed-income investments, where Merrill Lynch Asset Management’s Tim Manna replaced MAM’s Charles Jackson. He had run MAM’s fixed-income desk for 13 years, and was a member of the executive board; he has moved into the new position of head of new product development.

And even culturally, the two are a good fit, contends Stephen Zimmerman, deputy chairman of MAM, and the person who has been in charge of strategic development at MAM since the split with SG Warburg in 1995: “We run very similar operations here. Both of us act as a team, and that is crucial to the success of the deal.”

But are they that similar? Those who have worked at, or with, Mercury, paint a rather different picture. Both might work as teams, but they have markedly different ideas of what that means. “Comparing MAM with Merrill Lynch is like comparing a factory with a master craftsman,” says a UK fund manager who has regular dealings with MAM. “Mercury is a consensus-driven organization. Everything is done by committee, and it takes ages to get anything done. There are very few people there who are able to make a decision without checking it with three other people. It can be exceptionally frustrating when it’s 3.30 pm, something goes wrong and you need a quick decision.”

This approach might work in the UK, where a brand name and university graduates go a long way to convincing trade unions and provincial government organizations to grant their pension mandates to MAM, but will it appeal to the Thundering Herd at Merrill Lynch? “Team work is an integral part of how Merrill operates,” says one fund manager. “But they also grant the individuals a lot of space to make their own decisions.”

Fund managers put this down, in part, to the fact that the US is much more performance-driven; in the UK, fund managers still rely more on the fees they receive and on the assumption that once hooked, clients will stick with them for three years or more. “So if there is a bad year, they reckon that they have time to do something about it,” says one manager. “You hardly get that in the US. The cult of the individual is much more pervasive – it’s people like Warren Buffett who grab the imagination.”

Top heavy

At MAM, vice-chairman Carol Galley appeared to fill that role. Certainly, the UK tabloid press has attempted to portray her as the most powerful woman in the City, ascribing to her the pivotal role in several UK merger deals in the mid-1990s. But Galley now occupies more of a managerial role. And this is the fundamental problem at MAM, according to competitors. Galley and deputy chairman Stephen Zimmerman are, rivals agree, two of the most gifted fund managers in the business, and MAM’s status as one of the top UK fund managers is largely down to them, and Leonard Licht who left to join Jupiter Tyndall in 1992.

But beyond the senior level, it’s a different story. “Carol and Stephen are hardly representative of the machine they’ve built beneath them,” says a senior fund manager in the UK. “We, as with the major US institutions, devolve as much responsibility to the fund managers as possible. That doesn’t happen at MAM. What they have is a machine packaging a product. It’s a very impressive machine, but that doesn’t guarantee performance, does it?”

MAM rejects this, countering that each fund manager has responsibility for choosing stocks. And Jeffrey Peak, president of Merrill Lynch Asset Management, has not encountered any clashes of culture. “We’ve been impressed with the quality of the Mercury people one and two levels below Stephen and Carol, and we’re picking up tips on investment practice from them.”

Looking at recent statistics, MAM has not had an easy time. Its £3 billion pooled pension fund underperformed the FTSE-100 by 10% last year; Surrey County Council last month withdrew its £250 million pension mandate from MAM, citing underperformance; and UK companies Unilever, Zeneca and Sainsbury are said to be concerned at the performance of the funds MAM manages for them.

And MAM made some calls that did not go their way: “Bank and pharmaceutical stocks performed especially well last year,” says Zimmerman. “And we did not have the positions in them which, with hindsight, would have brought in the returns.” That call has been made to look worse by the growth in index-tracking funds, which benefited from the fact that the best-performing stocks were in the major FTSE indices.

None of this is lost on Zimmerman: “Our position in the UK demands a terrific amount of detail assigned to it to face the challenges,” he says. “We’ve seen the attraction of index funds, and it certainly has a role, but have chosen not to follow that route. But yes, life has been more difficult for us over the last year because of their success.”

The growth areas in the UK for MAM, he says, are the retail sector, private-client business, and expanding its coverage in defined contribution. This latter market is still small in the UK, but is expected to follow the US’s lead and become a major part of the pensions market; MAM is already one of the top houses in this market in the UK.

Not all are so sure that there is enough growth left in the UK, though. “As far as the asset-management business is concerned, the UK is a slow-growth market which is undergoing some restructuring and which is overfunded or at least fully funded,” says a rival fund manager. “If Merrill Lynch is to extract value from this deal, MAM will have to become the engine of growth outside the UK.”

Executives at Merrill and MAM argue that this is exactly the point of the deal: that the institutional product knowledge MAM brings with it, combined with Merrill’s huge distribution network, gives the two virtually overnight what it would have taken them years to develop independently: “We certainly paid a very full price,” admits Jerome Kenny, global head of corporate strategy for Merrill Lynch, “And that would especially be the case if it was just based on the UK. But there are tremendous opportunities out there for us to exploit.”

Big push into Denmark

Again, rivals tell a slightly different story. Mercury had been trying to expand outside the UK for several years, without much success. In Germany, it had entered into strategic alliances with first Munich Re and then Allianz, both of which brought little success. “They only real headway they made in Europe was in Denmark, and that was through family friends of a Warburg executive,” says a former MAM employee.

Attempts to break into the US market have been equally futile. “They’ll tell you that they have never cracked the US market because they don’t have the distribution,” says one fund manager. “But the truth is, you can distribute anything if it’s halfway decent. The problem they had was poor performance.” MAM’s operation there, known as Wimmie, was run through two competing desks. “It was an expensive operation and a bureaucratic nightmare.” The biggest failure came in 1987; after the markets crashed, Wimmie transferred a substantial portion of its international asset allocation into cash, just as the markets rallied. “They never recovered from the loss of credibility,” continues the fund manager.

Mercury has been in play since 1995. Formerly part of SG Warburg (with a separate listing of 25% dating back to 1987), it was MAM that scuppered Warburg’s deal with Morgan Stanley. The US firm was more interested in MAM but was not prepared to pay the price the fund managers thought reasonable.

Six months later, MAM replaced Warburg’s stock with its own and sold the investment bank to SBC. In the two years before Merrill Lynch came along, Zimmerman examined the possibility of other strategies, whether mergers, acquisitions, or selling up: “In our internal discussions on strategy, we reached the conclusion that there would be a number of successful asset-management firms in the future,” says Zimmerman. “And a number of different possibilities: niche firms, local firms, multinational firms – which is how I would describe MAM before the deal – and global firms. 

“All of these would need to invest in technology in the future, so if we were to invest internally we knew we might have to raise more capital in the future. We also had several discussions with our competition, but decided that it would be very difficult to put together two manufacturing businesses as the cultural fit and the process of integration might have been messy.”

“Mercury’s principals have been open-minded about being bought since they spun off Warburgs to SBC,” says John Nelson, the investment banker at Lazard Brothers who with his colleague John Dear has acted as MAM’s adviser since December 1994. “A deal with Morgan Stanley was never ruled out, despite what the newspapers said at the time, and there were several others knocking on our door.”

Mercury in the US was “an expensive operation and a bureaucratic nightmare”

Despite the less successful performance last year, MAM has increased its assets under management from £70 billion when it split with SG Warburg, to £104 billion at the time of the sale to Merrill Lynch. And the share price rose sharply as well: in December 1994, when Morgan Stanley made its first approach to SG Warburg, the 25% stake listed on the stock exchange stood at around £7 a share; six months later, when it bought out Warburg and sold it to SBC, the shares were at £9. When the sale to Merrill was announced, each share was worth £12.91, and Merrill paid £17.

There was another factor to be considered as well: security. Extra capital was a resource needed not just for expansion and development, but also in case of emergency. The debacle at Morgan Grenfell Asset Management, where fund manager Peter Young had invested beyond his limit in unlisted companies, had cost the firm, owned by Deutsche Bank, £400 million and potentially a lot of business. The risk of the damage a rogue manager could inflict was accepted, but the affair brought it to the fore. The losses he amassed would have been enough to put all but the largest fund managers out of business.

MAM’s response was swift. Although confident in their own checks and balances, senior managers rechecked them, and in February last year arranged a £250 million standby revolving credit facility in the Euroloan market.

The Morgan Grenfell loss was not reason enough to drive MAM into the arms of a large parent, but it was a factor, at least for Zimmerman: “I think others here might give a different response, but yes, in my mind being part of a large organization was more preferable after what happened with Morgan Grenfell. The extra security it provides is a comfort, especially for our clients.”

The advantages of the deal for MAM seem clear: security, capital and a worldwide distribution network. And Zimmerman and Galley are to run the show, not just MAM’s business, but the combined entity. But why would Merrill Lynch pay such a premium for an old-style firm that is losing market share in its home market, underperforming its rivals, and failing to establish a bridgehead in Europe or the US?

Staff at Perpetual Asset Management have been joking recently that Merrill actually wanted to buy them, but got confused and picked the wrong one by mistake. “Recently I saw what I thought was one of our adverts for PEPs [personal equity plans],” says one insider. Perpetual’s brand and adverts are centred on the tip of the Matterhorn rising out of the clouds. “Then I realized that it was a MAM advert, using a similarly shaped iceberg. Maybe Merrill just got the names confused.”

The similarities don’t end there; both MAM and Perpetual were listed on the stock exchange in the same month in 1987, and both deals were brought by Cazenove. And Merrill’s Kenny had held talks with Perpetual’s chairman, Martin Arbib, early last year.

But it is unlikely that Merrill’s executives were unaware of the problems at MAM. Kenny had already spent a long time considering a large acquisition in asset management. “I and my team had been examining the possibilities of buying into the asset management business for over a year before we bought MAM. We had decided that the Merrill Lynch strategy was to be a global player at all levels – retail, middle-market and institutional – and that the major gap we had was in institutional asset management.” Kenny reviewed several strategies. “We quickly decided that we’d never achieve our goal simply by hiring individual managers.”

Merrill’s shopping list

The next step was to look at asset management businesses in the US – Merrill had already bought Hotchkis & Wiley in Los Angeles in November 1996. “The idea was that we would stitch together several mid-size companies, and we’d had some positive responses to that idea.” Then they started looking beyond the US. “This was the other option: to make one or two major acquisitions abroad which would transform our business overnight. We targeted 100 large non-US firms, and found that only three were not subsidiaries of large banks or other financial institutions.”

Those three were Flemings Asset Management, Schroders Asset Management, and Mercury. “Flemings and Schroders would have been complex because they both have business which overlaps with ours, especially Schroders’ dealer business, and the respective families still hold large stakes in them.” That left Mercury. Thus far, by spring last year, Kenny had not contacted any of the three firms, but had instead done the research through pension consultants and management consultants. MAM was already Kenny’s favoured option: “They had a strong, young management team, good stature, wanted to develop a retail base, and had an early, good position in defined contributions,” he says. “On paper, when compared to all the other options we were considering, it was a very attractive proposition.”

By coincidence, Zimmerman was already in contact with the US bank. He was using Merrill Lynch as adviser on potential acquisitions or tie-ups with asset-management firms in the US. “We were treating them as potential clients for much of last year,” says Justin Dowley, head of investment banking at Merrill Lynch’s London office. “Mercury’s managers had identified that they were at a crossroads. Their core business was flattening off, and they realized that if they were to internationalize their brand, it was unlikely that it could be done wholly internally.”

But there was another, more long-standing relationship between the two firms: with Merrill’s chief executive for Europe, Michael Marks. He had been the head of Smith New Court, the UK investment bank that Merrill Lynch bought for £526 million in 1995, just as MAM was gaining its independence. MAM held a 10% stake in Smith New Court until then, and Marks, Zimmerman and Galley had built a good relationship. “MAM was a huge supporter of Smith New Court,” says Marks. “Since Merrill bought us, we’ve kept in contact, and often discussed what the future holds for our businesses.”

Seeing how Marks and other former Smith New Court acquaintances got on at Merrill Lynch had impressed Zimmerman. Last May he met the main senior Merrill executives for preliminary talks. Komansky, Kenny, and Michael Quinn, then head of Merrill’s capital management group, flew over from New York and met Marks and Zimmerman in a hotel near Heathrow airport. “We talked in general terms about how the business might look if we joined forces,” says Marks. “The talks proceeded at a leisurely pace throughout the summer, just enough to give us some ideas, but nothing too substantive.”

By August, Merrill Lynch decided to to show its hand. “It was obvious that they were the big fit we were looking for,” says Kenny. “We told them so at the end of August and halted the discussions for a month so that each side could do its homework on issues such as dilution and tax treatment.”

A month later they reconvened, this time with the investment bankers present – Lazard Brothers for MAM, and Merrill Lynch used its own investment bankers. With more people present, the risk of a leak grew (there had already been some abortive speculation earlier in the summer).

By now the discussions had moved to the sixth floor of Lazard Brothers’ offices in the City of London, which are situated by a mini shopping precinct and on top of Moorgate, one of the City’s busiest underground stations. Luckily, Merrill Lynch’s London headquarters are just a couple of minutes walk away, so it would not be wholly unusual for them to be near Lazards’ office. But just to be on the safe side, Marks, Kenny, Komansky and the others would enter and leave through the obscured entrance to Lazards’ underground car park.

And so to the price paid. MAM and Lazard Brothers pointed out early on that it had to be a cash deal. “MAM was a UK institution which had made it into the FTSE 100,” says Nelson. “Replacing that stock with US stock would only have led to an unusual leakage of that stock back into the US, which would benefit no one.” Getting the price up to £17 a share was another matter, and Nelson and Dear at Lazards had to work hard to get it. Discussions over the price lasted two days: “We met on the Sunday morning, and put an offer on the table,” says Marks. “By Monday night we were meeting again to shake hands.”

Merrill Lynch may have paid a full price for MAM, but in the end it got what it wanted. Kenny had been preparing for such a deal for over a year, and had told the board that if they wanted to be serious about their role in asset management, they would have to buy big. “It was a full price we paid, but it gets us the name and market position,” says Dowley, who was heavily involved in the talks on the price.

There have been some joint successes already. The combined group – known officially as Merrill Lynch Mercury Asset Management – has already started to pitch for business; Mercury and Hotchkis & Wiley have put in bids to run several large corporate pension schemes around the globe, and won the mandate to manage a US company’s scheme last month.

They have also been quick to consolidate their position. MAM has become one of the major foreign asset managers in Japan, and has a wholesale business that manages pension funds for half the top Japanese corporates, as well as a licence to sell investment trusts. In March, Merrill Lynch hired 2,000 former Yamaichi brokers.

The first clear indication of how successful the combined businesses might be, and whether the Thundering Herd might need to apply the techniques of Merrillization, will come in the latter half of the year. It will be then that the former Yamaichi traders come on board in Japan, and the Merrill Lynch financial advisers in the US start marketing Mercury’s products.

But the real test lies in Europe, in maintaining market share in the UK and expanding into the rest of Europe. MAM has made some headway, with some £10 billion, 10% of MAM’s assets under management, devoted to continental European equities. As yet the firm does not have leadership of any major European market outside the UK, Switzerland and the Netherlands, and, says one US competitor, “buying MAM changes nothing. They’re still at the same level as the rest of us, which is barely at theoretical break-even”.

That’s not a position Merrill Lynch will tolerate for long. So far the integration has been painless: no staff have left, and there is genuine excitement at the prospect of what the two firms can achieve together. But if the UK arm continues to underperform, or if the expansion into the rest of Europe is as unsuccessful as MAM’s previous attempts, it won’t be long before Merrill’s Thundering Herd tramples over MAM’s remaining independence.