THE FIRST RULE of investing is that the value of your portfolio can go down as well as up. Everyone knows this, from the average retail investor to veteran portfolio managers at Fidelity. Yet it’s a rule that seems to have been thrown aside by the banking world when it came to buying asset management companies during the last bull market.
The theory was that as an investment bank your earnings stream is highly volatile. What better way to counter-balance that than to build a global asset management operation? Its revenues are steady and, according to the received wisdom of the time, cycle-proof.
So how does this explain why all of a sudden banks are keen to offload investment divisions?
If the first rule of investing is clear, then so is another: don’t buy at the top of the market and, if you do, don’t then sell at the bottom. While many doomsayers feel that markets still have some way to fall, banks seem ready to take this double hit.
This summer Commerzbank attempted to sell Jupiter, its investment arm, but decided to scrap the sale when it failed to attract good enough bids. Still this has not put it off the idea. Far from it, as it is still looking to offload Montgomery in the US.
Since then, Rothschild, that most traditional of City of London institutions, has revealed that it plans to sell its non-US asset management business and concentrate instead on private banking. This is something of a U-turn as it has been committed to building the business in recent years.
The announcement was stunning for two reasons. First, why sell? And secondly, why tell the whole world, thereby surely talking its price down?
As one fund management M&A banker in London says: “OK if you want to sell your business, that’s one thing, but you don’t start flagging that it’s for sale across the newspapers. It doesn’t make sense.”
What does make sense is that markets are continuing to fall – in London the FTSE slipped down through the 4000 mark last month to its lowest level for almost seven years, while the Dow Jones was heading towards the 7500 mark compared with a year high of over 10,600. These are damaging blows for investment houses, and those who have put their faith, and their savings, with them. Individuals have seen all of the gains made up to 2000 fall away in two years of market carnage. Having paid out management fees on top of that, many will feel they would have been better off putting their savings under the mattress.
Losing their looks
Falling markets have stirred up waves of mutual fund redemptions and this, coupled with falling asset levels, means investment businesses are not looking quite as wonderful as they did at the top of the market.
And if retail business no longer looks so healthy, institutional business is not so great either. There is plenty of existing money to be managed but defined benefit schemes are seen as outmoded nowadays and corporates are more likely to push new employees into defined contribution schemes than pour more money into DB.
Commerzbank and Rothschild are not the only sellers out there. Principal offloaded BT Financial Group to Westpac for less than half the price it paid to Deutsche Bank three years ago. Deutsche itself is pulling out of index management, handing over its passive business to Northern Trust for $260 million – a mere 0.2% of the assets under management.
Suddenly such deals as Merrill Lynch’s acquisition of Mercury Asset Management, praised by the markets in 1997, seem expensive. Merrill paid top dollar for the luxury model, drove it out of the showroom, and promptly saw it break down (see story).
As one fund management corporate financier in London says: “What the Jupiter business shows is that when stock markets go down, the nature of fund management being what it is, earnings fall. People thought that earnings stream was guaranteed and not dependent on volatile markets but it’s not guaranteed at all. Some groups have been losing money or making inadequate returns.”
He says there are already knock-on effects for the market. Is acquisition activity falling away? “Absolutely right,” he says. “We’re seeing fewer deals. There won’t be a scramble for size. There won’t be a scramble for full-service firms. Jupiter is a clear example that those days are past.”
But he adds that it is not simply a result of falling stock markets. In tricky times bankers are being more careful with their money. “Competition for capital within a big bank is much more intense.”
So fund managers will have to work harder to justify themselves to their parents. John Fraser, chief executive of UBS Global Asset Management, says: “A lot of people are scrutinizing their operations. Not just asset management. It is a time for review. I keep saying the golden age is clearly over but I wouldn’t have taken this job if I didn’t believe UBS group was totally committed to us.”
Fraser agrees that banks through the 1990s were caught up in a race to build large investment operations. “There was a sense that to be a global bank you had to have an asset management firm, he says. “People were over-optimistic of the potential in global savings.” This included Europe, Asia and Japan. Meanwhile they failed to take into account the impact of open architecture where one distributor offers end investors products from several different manufacturers.
Above all, banks thought fund management would lend a balance to earnings streams over-reliant on investment banking. “It would provide an annuity income while in investment banking you always have volatility,” he says.
Fraser is in no doubt that too many banks paid too much money for businesses that at best contribute 5% of group earnings. In good years investment arms cannot possibly compete with the fees generated by the investment bankers and in bad years they have been proved not to be the watertight money makers people presumed.
Harsh reality
“The book of great asset management deals of the 1990s is not going to be a big book,” says Fraser. “There are very few that will stand up to scrutiny.” He adds that senior bankers are waking up to a harsh reality. “I think that is absolutely the case that in many instances people paid too much. A lot of the deals in the 1990s were short-sighted. I am not sure people realised the effect of open architecture.”
The chief investment officer of one US house, acquired in the 1990s, takes this line further: he says that the banks did not always do their homework thoroughly.
“It is not clear in certain cases that the buyers fully understood what they were getting into,” he says. “When we were in discussions with potential buyers there were a number of organizations that would have gone on sight unseen. They were coming to us and saying ‘name your price’. We knew that would create a problem. It is just not good business practice. It is not a bad way to turn a quick buck but it’s not a good long-term strategy.”
The problem, he feels, was increased by the competition among big banks to be seen to be big hitters and to have strong operations in all areas of financial services.
“Some of them rushed into it. There’s no doubt about that,” he says. “They paid too much money and they didn’t think about it too hard.” After the party, as bankers wake up on the floor with sore heads, they are wondering what asset management is really worth to them.
A chief fund management strategist at one US bank says: “Firms are reassessing what they’re willing to pay for asset management organizations. In the bull market there were assumptions of market growth of 10% per year and everyone is having to do a reassessment of growth.”
The strategist says Commerzbank’s decision not to pursue the Jupiter deal to its conclusion makes a good illustration. “You have to reconsider pricing and reconsider assumptions of long-term growth.”
Another US chief investment officer, who went through an acquisition in the bull market, says people have to apply a fundamental and common-sense approach to any potential takeover.
“In any acquisition, regardless of industry, a thorough understanding of the motives and expectations of the two parties is critical. Ours is a relative success story in part because of the desire by [our owner] for some first-rate investment talent and due to our desire, pre-takeover, to become more global. Ground rules have been established and abided by and it has worked.”
But he says the chances are more often than not that the two parties will end up disappointed. “Just as in any investing arena, there is a tendency to buy at the top, where the analysis is coloured by recent performance. Combine that with the fact that, on average, managers will perform averagely, before costs, and you can create a scenario of disappointment in many cases.”
It is surprising that in financial services, a business focused on assessing the value of other businesses, there should be such a failure rate. A classic case of people being unable to see what is under their noses?
“Any fundamental investor would want to do their homework,” says the CIO. “In some of the deals both parties probably did a very good job in due diligence and had reasonable expectations for the growth of the business. A lot of those worked out reasonably well.”
Fraser at UBS makes the point, however, that in several cases fund management mergers occurred as an afterthought as bank consolidation ran rife. “In a lot of the acquisitions, asset management was a byproduct rather than the central strategy,” he says.
The fallout from this is still to be seen as some banks will decide that they are not that interested in fund management after all, and look to get rid of businesses they see as non-core.
One asset management M&A adviser in London says this is already starting to happen. “When people were buying there was all this talk about having an earnings stream that was non-cyclical and not dependent on capital markets. Markets being what they are now, some banks will want to realize the business and use the capital better elsewhere.”
One of the catalysts for the race to build big businesses was a Goldman Sachs research report in 1995 that said a handful of global giants would emerge to dominate fund management.
The coming evolution of the investment management industry: opportunities and strategies is now seen by some players as a cynical attempt by Goldman Sachs to talk up its M&A book.
Clear-sighted
However the report was clear-sighted in much of what it said. There was a proliferation of small investment firms in the mid-1990s and it was always likely that many of them would be swallowed up as the industry evolved. “[M]anagement companies will have to compete for the first time on a global basis as the battle to manage the world’s pensions assets evolves into a single market,” said the report.
It added that this unified market had caught the eye of large, well-capitalized institutions who were going on an acquisition spree to develop investment groups offering a global range of products and worldwide distribution.
It also said that these big investment firms would manufacture their products in one or two countries and then export them throughout the world. This would lead to the competition to manage the world’s financial assets evolving into a single market. Broadly speaking, this has all happened.
However, the Goldman Sachs vision of the future was recently dealt a devastating blow by one of the most respected investment figures in one of the world’s biggest markets.
Roger Urwin, head of global investment at Watson Wyatt, the UK’s leading investment consultancy, says the big firms are not producing the goods and furthermore are fundamentally flawed in that their very size makes them unable to produce outstanding investment performance.
“The very big firms that are successful are rare,” said Urwin. “They have developed a size of operation that inevitably leads to a certain amount of dysfunction.”
Urwin is far from convinced of the argument for global firms. “The aspiration to be a global investment firm is pursued by too many firms on the planet,” he says. “It’s a tall order, and not every investment firm needs to be global.” He is more excited by ideas coming out of the smaller boutiques.
This should worry the big global players because it’s fair to say that if the markets were soaring nobody would be going through this soul-searching.
There is another problem for the big managers. As they grow, inevitably they become too big for those individuals who want to work for themselves. The brain drain from the large houses and the subsequent explosion in new small hedge funds has been another hallmark of the investment world over the past few years.
So Goldman’s ideas, written during a wild bull market, start to look outdated today. As one CIO says: “Their paper went a little too strong but there are advantages to scale and there is room for a group of managers that have sufficient scale.”
As for Goldman Sachs, Richard Strauss of its investment research team says it is important not to get too downcast by current market conditions. “Asset management is definitely a cyclical business but it is still a good business,” he says.
Right plan, wrong people
Good business it may be, but according to senior players the problem is that the leadership expertise just isn’t there.
As one chief fund management strategist in New York says: “There is a real lack of business management talent in this industry. It is not easy to find someone who has that global experience, tied to knowledge of the investment process and can appreciate what it means to be part of a bank. The strategies are good but it is the execution that leaves something to be desired.”
This is a damning indictment and it is backed up by disappointing performance among many of the large global houses in recent years.
As one investment consultant points out: “You only have to look at all the biggest names in financial services to see problems: Merrill Lynch, Morgan Stanley, Deutsche… they’ve all got big issues to deal with and it reflects itself in performance.”
But investment bosses argue that they are getting things right. “Globalization isn’t hard,” says one CIO. “Logistics is hard. You need to get to see all your people often enough. You need someone in each office who gives them a sense that they’re part of the team and the process.”
He says that if you get this right, everything else will fall into place. “It is one of, if not the key competencies of a successful money management operation,” he says. “The successful ones do a good job of that and the unsuccessful ones don’t.”
It is likely that the unsuccessful ones will soon find another way to spend their time and money. Investment banks are famously short on patience and it is easy to imagine them simply looking at fund management businesses as playthings to be dropped when they’re no longer much fun and the gloss has worn off them. As more banks decide to pull out of investment management and more sales come to light this image will become stronger.
As one financial services analyst puts it: “Banks are not asset managers. They are far from it. I can’t think of any examples of banks being great at it.”
There is also an issue of perception among end investors. Specialist fund management operations are more highly regarded than those owned by banks which are seen as preoccupied by other concerns.
In the eyes of the investors, specialist fund managers remain committed to investment while investment banks and brokers will never be that focused. “Investors don’t associate an investment bank with being a money manager,” says the analyst. “Banks are focused on banking and brokers are focused on doing deals, so the public goes with names they have known for a long time, such as Fidelity, Franklin or Vanguard.
“Investment banks have a better image than commercial banks because there is a sense from investors that they know how markets work but they think that they only want to put them into proprietary products rather than what is best for them.”
Other market players point to the fact that banks may have deep pockets and like the idea of owning a fund management operation but they are often poor at leaving the investment heads free to run them.
“They can own them happily but they can’t run them,” says a former fund manager turned corporate financier. “It is all to do with how much autonomy they are prepared to give. There tends to be an attitude of ‘we wouldn’t have been clever enough to buy the business if we weren’t clever enough to run it’.”
The biggest mistake banks make, he says, is imposing bankers as bosses on investment professionals. “Portfolio managers spend their lives looking at companies, meeting management and taking a dispassionate view on whether they are worth buying or selling. They can easily project this on to their owner and make the same kinds of judgements.”
The CIO of a US house says banks should not make the mistake of assuming they can make easy money from fund management. “This is not an easy way to make money,” he says. “In fact it may even be a hard way to make money. There are easier ways.”
He adds that banks need to be strong in their other lines of business as well but should not keep the asset management arm away in a corner. “They have to give you autonomy over which stocks you can buy but they also need to talk to you and make you feel an important part of the group. It’s not an easy people-management business and if people feel they’re not being taken seriously they will walk out. Once they’re gone the business can suffer.”
But it is still hard to believe that the banking bosses will really care that much about the business, as even the most successful operations only provide in the region of 5% of annual revenues. That figure is unlikely to rise dramatically and fund managers are coy about giving out hard numbers on this subject.
“We prefer not to give targets,” says Fraser at UBS. “I would like it to be bigger and we believe it can be significantly bigger through organic growth rather than acquisitions. We want to grow the firm dramatically. I think we can be a much bigger part of UBS.”
But even back-of-the-envelope calculations suggest big firms will have to double, or even triple, their assets under management to achieve the sorts of fees that would make a real impact on group numbers. Unless of course they can find utterly revolutionary ways of eking greater profits out of existing assets.
Banks have two options: to commit themselves to building their asset management arms or to sell them off. Rothschild and Commerzbank illustrate that the latter route is increasingly attractive. A joint report from Oliver, Wyman&C0 and UBS Warburg, called The Future of Asset Management in Europe, points out: “…the owners of many European asset managers (banks, insurance companies) may reassess the costs and benefits of owning production.”
Whichever route they choose, the market is revising expectations downwards. As one CIO puts it, realism is the order of the day. “For those that got excited about being in the business there are still a lot of positives,” he says. “For an asset manager, if they can perform they can grow. Asset management is a very profitable business if you have a talented group of people.”
But are the assets really out there to be won and managed? Strauss at Goldman Sachs says that while some of the markets that were predicted to have the most potential have taken off, others have stagnated and the US remains by far the dominant source of assets.
“Some markets in Europe have totally exploded, like Italy, which has been phenomenal” he says. “Japan has been a huge disappointment. Individuals are investing postal deposits in more postal deposits, even at very low interest rates. Anyone who thought they would go over there and manage money it just hasn’t happened. Asset management is still dominated by the US.”
But he remains upbeat about asset management’s earning potential, even in down markets. “The markets themselves have been a big setback but the one thing the industry has is high profit margins even in environments that stink. You can cut costs and still get revenues, so you want that business.”
At one leading US investment house, a senior strategist is confident they can make a success of their operation. “We firmly believe it is a good business to be in,” the strategist says. “A diversified, stable earnings stream isn’t flawed. We know that the market moves in cycles and for asset management companies that are not diversified it is logical that they won’t succeed.”
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The strategist also says that in the current climate of falling markets and fund business sales, it is important that banks do not get too carried away by short-termism. “Why are the banks getting out of it? It is very important to recognize that in asset management businesses, the people, the process is very different to that of banks’ traditional core businesses. Can you manage them in the same way? No, they are different but the banks will get it right.” Still a lot of fans
At State Street, ceo David Spina believes asset management remains an attractive business, with certain provisos. “There is still a lot of demand from people who want to get into investment management, particularly for high-net-worth investors. People might be more hesitant about getting into the institutional game because they recognize the question mark over the future of defined benefit plans.”
But Spina says retail fund management, even despite the jittery nerves of investors, still has a lot of fans among banks, broker dealers and other potential acquirers.
For existing players, he remains upbeat about prospects, though business managers may have to focus more carefully on the areas of their operations with the most profit-making potential at the expense of some other parts. “I don’t think State Street has to get bailed out by equity markets going back up again. We’re well on the way to having the capability and the process to focus on those areas where we can reduce resources and then substitute those into areas that are going to generate growth.” He cites electronic execution for equity trades as one such area, while the growth of hedge funds also offers opportunities.
Spina appreciates that the market is changing, though, and has a warning for those groups that think management fees will just keep pouring in. “In the investment management field it’s going to be hard to maintain that standard 50 basis points for active equity management,” he says. “I don’t like the word discount but we offer indexing here and that’s a very different value proposition for a client. Fees are going to be challenged.”
At UBS, Fraser says there is a good future for large asset management groups, provided they can keep their teams happy. He works to a five- to 10-year business plan rather than two or three years but believes his whole operation has to have a shared purpose. “For the core team we have to have a challenging environment that is intellectually stimulating and with an esprit de corps.” Business managers must be prepared to travel. “There is a great limit to what you can do by phone and managing by email is a disaster.”
At Barclays, the bank seems to have decided to recommit itself to its fund management business after months, and even years, of speculation, that it wanted to sell. The received wisdom was that Barclays Global Investors doesn’t fit comfortably within the group.
Rumours were rife that Naguib Kheraj was put in place as CEO to find a buyer. There was also a lot of talk that there would be a management buyout.
But now Bob Diamond, head of Barclays Capital, has been given the additional responsibility of running the investment arm, it seems its future within Barclays is secure, at least for now. It’s unlikely to stop the sale rumours completely, though, particularly as the announcement will have taken at least one member of BGI’s senior management in London by surprise. “Watch this space,” he told Euromoney days before the Diamond announcement. “There’s been a lot of speculation about our MBO and we should be able to tell you something very soon.”
Elsewhere in the banking world, other operations are pursuing their own strategies. One bank that stayed out of the scramble for scale is Lehman Brothers. As a result, with the benefit of hindsight, it may prove to have played the cleverest game in the long run. Today it has a fledgling business, with less than $4 billion of assets under management, in private equity, real estate and hedge funds. This is negligible when compared with the global operations built by such firms as Goldman Sachs, Morgan Stanley and Merrill Lynch.
But Raul Biancardi, head of private banking and investment management in Europe for Lehman, says: “I was involved in looking at several opportunities through the years and the big issue for us has always been one of price and dilution. Although the asset management business attracted us for some time, the prices and possible impact on our share price has always been a stumbling block. That turned out to be a good decision. Having been disciplined about the type of acquisition we wanted to pursue, that has paid off in that we haven’t suffered the same kind of downturn.”
He says prices are coming down, in some cases for very good reasons, and that Lehman does not rule out making a banner acquisition, if the right deal comes along at the right price. Certainly Lehman is more likely to pick up a bargain, given today’s environment, than its peers who were shopping in a very different market.
So a lot of soul-searching is still to be done by bankers, who have yet to convince investors they are really committed to managing their money. If they remain unconvinced and savings stay under mattresses then banks, never known for their patience, will surely feel more inclined to cut their losses and walk away.
Goldman’s Strauss says the principles that pushed banks into fund management in the first place remain sound. “Is fund management still a good business? The answer is still yes, even though the markets have been pretty bad so now is not the time to own an equity manager,” he says. “Asset management still represents recurring revenues at a time when acquisitions streams are under pressure. It is nice to get an annuity and not have to work for it.”
Try telling that to Rothschild and Commerzbank.
