Blast from the past

When BlackRock Inc. agreed June 12 to acquire Barclays Global Investors, the asset management arm of the U.K.'s Barclays plc, the $13.5 billion deal instantly transformed the industry's top tier. The combined firm will rank as the world's biggest money manager, with $2.8 trillion in assets, roughly twice as large as each of its two nearest rivals, State Street Global Advisors Inc. and Fidelity Investments.

Will the BGI-BlackRock deal set off a rush of big-time dealmaking throughout the sector? Probably not. Small deals may be struck, but outsized mergers and acquisitions look unlikely for the foreseeable future.

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The asset management business has gone through periodic phases of consolidation punctuated by breakouts, in which divisions are spun off, and by the rise of boutiques, when stature trumps size. Potential sellers might be easy to identify -- know any banks or insurers looking to raise capital? -- but financing problems scare away most potential acquirers. Equity markets bounced back from lows, and green shoots are being spied in the unlikeliest places, but debt is hard to come by, as would-be private equity buyers know better than anyone.

Sober dealmakers will also recall a fundamental fact about the business, which many empire-building money management executives have learned at their peril: There are no real economies of scale. Compensation is by far the biggest expense, at 50% of revenue and 75% of costs. It typically goes up proportionately with each merger and acquisition.

Dealmaking has already slowed. According to research firm Dealogic, in 2008 the asset management industry struck 899 deals with a total value of $44 billion. As of June 16 this year there were 319 deals worth $34.1 billion.

It's a shrunken industry. Assets under management fell by 27% in the U.S. in 2008, according to Fox-Pitt Kelton Cochran Caronia Waller in New York. The European Fund and Asset Management Association reports that assets managed by the European industry fell by 21% last year. "Asset managers haven't exactly covered themselves in glory, and they are under pressure," says Peter Thorne, an analyst at broker Helvea SA in London.

They're under pressure, yes, but still quite profitable. Last year, the industry posted a 30% median operating margin, according to Darien, Conn., consultancy Casey, Quirk & Associates LLC, down from 34% in 2007. When the financial crisis exploded, money management firms cut costs, but couldn't do it quickly enough to preserve margins. That's one reason Casey Quirk estimates operating margins will fall to 21% for 2009.

Margin pressure could intensify. In the wake of the financial crisis, and the widespread meltdown in their portfolios, institutional investors especially are questioning the fees they pay active money managers. According to Chicago research firm Morningstar Inc., in 2008 only 31.8% of equity mutual funds outperformed the S&P 500 and just 9% of fixed income funds outperformed the BarCap U.S. Aggregate Bond Index.

"Institutional investors have been steadily moving toward passive management," says Michael Rosen, a principal at Los Angeles consultancy Angeles Investment Advisors LLC. "Thirty years ago, basically no one had it. Now 10% to 30% of institutional assets might be passively managed."

The industry's big names will likely survive, if not thrive, and probably expand. As Roger Smith, a financial services analyst at Fox-Pitt Kelton, sees it, about four groups in the U.S. are in a position to make substantial acquisitions of asset managers: Franklin Resources Inc., Affiliated Managers Group Inc., Invesco Ltd. and Ameriprise Financial Inc. Franklin is reportedly interested in acquiring American International Group Inc.'s money management arm for around $500 million. It may face a rival bid from New York private equity firm Crestview Partners LP.

In Europe, most acquisitive companies are based in the U.K. rather than on the Continent, says Kevin Pakenham, a London-based managing director at Jefferies Putnam Lovell, a unit of Jefferies & Co. The U.K's Henderson Group plc, Aberdeen Asset Management plc, F&C Asset Management plc and Schroders plc have all said they are looking for acquisitions. As independent, listed companies they have the right structure, but probably not the scale, for big acquisitions. This is the reverse of the position in continental Europe, where the big firms are owned by large banks and insurers and so lack the shareholding structure, or the strategic direction, necessary for acquisitions.

Companies that can raise equity will have the edge. Schroders, the largest of the firms mentioned, has a relatively modest market capitalization of less than £2 billion ($3.3 billion). It is, however, reported to be a bidder for U.S. insurer Lincoln Financial Group's Delaware Management Holdings Inc., which could be worth up to $450 million. Aberdeen, which acquired Credit Suisse Group's U.K. asset management division in all-share £250 million deal last December, is also reportedly interested in Delaware, as are U.S. private equity investors Hellman & Friedman LLC and Advent International Corp.

Some distressed opportunities will be too tempting to ignore. Henderson, for instance, acquired fellow London firm New Star Asset Management Group plc, which had run out of cash last year after borrowing £300 million for a payout to shareholders, for £115 million in January. New Star, which colorful veteran fund manager John Duffield founded, had floated in 2005 for £700 million.

But for bigger, more ambitious deals such as BGI (which netted Barclays president Bob Diamond $36 million, among other distinctions), vendor finance will be crucial. Says Jefferies' Pakenham, "Vendor finance will be important for large independent asset managers, as it will be for private equity firms. It also makes good commercial sense, as it allows banks to retain an interest in asset management."

Adds Rainer Skierka, an analyst at Bank Sarasin & Co. Ltd. in Zurich, "Financing is an issue."

Even mighty BlackRock made use of a Barclays-led syndicate to acquire BGI, drawing on a $2 billion revolving credit facility that a source described as "very attractively priced."

The auction of Bank of America Corp.'s Columbia Management Group LLC unit will be an interesting test of the level of finance available in the market, especially now that BlackRock, previously a front-runner, has said it is not considering any further acquisitions. Analysts estimate Columbia's value at up to $3.5 billion.

Vendor finance will be especially important for PE-backed deals, about which there has been plenty of talk. CVC Capital Partners Ltd. had originally agreed to buy Barclays' unit iShares, a deal that would have been funded largely with debt supplied by the seller, before the bank decided to sell the whole of BGI. Apax Partners Worldwide LLP and Hellman & Friedman had also bid for the unit, as did a combination of Bain Capital LLC and Colony Capital LLC.

London private equity firm Permira Advisers LLP, which is looking at potential money management deals, believes it is possible to raise enough debt even for bigger transactions.

James Fraser, head of financial services, says, "Asset management is a key area of focus for us now. It's an attractive business offering good returns, and it is also a good fit with private equity. It also helps that there are plenty of willing sellers at the moment across Europe and the U.S."

"Prices are now sufficiently low for private equity firms, even some with no history of involvement in asset management, to be attracted by opportunities," says Cathy Pitt, a corporate finance partner at Norton Rose LLP. "It is possible for firms with good banking relationships to raise sufficient finance for many of the businesses now up for sale."

Financial sponsors must be more selective than strategic buyers, according to Pakenham.

"Private equity firms looking at targets owned by banks will, however, be wary of taking on businesses which would struggle to operate independently. Some asset management units of banks have the advantage of good distribution but are not strong performers."

The history of money management deals is decidedly mixed, as any smart buyer will know. For every success -- Allianz-Pimco, Franklin-Mutual Shares-Templeton, Invesco-Perpetual-AIM -- there are cautionary tales like Merrill Lynch Asset Management (see sidebar).
Hedge fund managers, as always, are a separate case, and these days quite a grim one. By most measures, the industry is imploding. According to International Financial Services, a London-based association, during 2008 total assets under management in the global hedge fund industry fell by nearly 30%, to $1.5 trillion.

Other estimates point to a 50% decline. The most recent high-profile collapse came on June 17 when Cantillon Capital Management, run by industry star William von Mueffling, reportedly told clients it is closing its hedge funds.

The average hedge fund lost 15.7% last year, far better than global equity markets but small comfort for investors who paid hefty fees, typically 2% of assets and 20% of fund profits. The fee structure is especially onerous for many hedge funds that have high watermarks -- arrangements with their investors in which the fund collects no fees at all until total assets return to previous highs. "Hundreds of hedge funds have gone away, and many more will," says consultant Rosen.

"Scores of 'boutique' alternative asset managers will be squeezed out of the market either through M&A consolidation or through liquidation," adds James Hatchley, managing director and COO Europe of Freeman & Co. LLC in London.

Even the biggest hedge fund names, such as the U.K.'s £5 billion market cap, Man Group plc, are reluctant to consider acquisitions. Man has made small purchases in recent years, but a source at the firm said it would now be easier for Man to purchase assets or to hire people than to pay for equity.

One of the few firms prepared to make hedge fund acquisitions is New York-listed, London-based GLG Partners Inc., the alternative assets manager that bought Société Générale's U.K. asset management business in December for an undisclosed, nominal amount. It reportedly is seeking further deals.

GLG will tread carefully, as will any other prudent dealmaker in money management. Certainly financing will remain scarce, even for buyers with proven track records. Among even the most attractive -- or vulnerable -- targets, assets have fallen, fees are under pressure, profit margins are squeezed. Money management is still a sweet business, but it's not what it was.

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