Bear market roils asset managers

Given the unprecedented decline in the global equity markets over the last six months, it was not too surprising to see the stocks of asset management firms fall apart during the last half of 2008. With assets under management (AUM) significantly below year-ago levels, we expect to see some significant changes in the industry as revenues decline dramatically, forcing companies to cut costs wherever they can. With investors shell-shocked, it may take some time for the markets to work their way back, leaving the asset managers struggling to improve their sales and profitability in the near term. Given this environment, we expect to see competition for assets heat up, with the advantage going to those firms that have had stronger relative fund performance, can offer a broad array of products to investors, and have fairly diverse distribution channels in place.

Asset Management Is (Usually) an Attractive Business
In most markets, the asset management business is exceedingly attractive. Firms running this type of business collect fees based on the level of assets under management; although in some cases--such as with hedge funds and private-equity investments--performance-based fees can significantly outweigh these investment management fees. The best part of this arrangement from the asset manager's point of view is that most investors are either barely cognizant of the fees that are being levied on their investments or don't see the fees as being overly cumbersome. As such, revenues continue to flow regardless of how well the firm manages its AUM, with a firm needing only to have a good year (of absolute growth) in the markets and/or increase the flow of funds into its products to realize an increase in revenues. Granted, this is a bit of an oversimplification, because an asset manager that does a terrible job managing money is likely to have investors pull out of its funds, but it does highlight how the firms make their money. (Fund investors would do well to note, however, that our fund analysts believe fees are a crucial factor in predicting future outperformance and that is vitally important for investors to seek low fee offerings).

The asset management business is also a scalable business, where incremental revenues cost less to generate than current revenues. As a rule, it generally doesn't take twice as much personnel to run twice as much money at an asset management firm. This means that any increase in AUM, which is the main driver of investment management fees, drops almost completely down to the bottom line, allowing operating margins to expand as revenues increase. With operating margins generally running in excess of 25% of annual sales, and the businesses themselves requiring very little in the way of capital investments (with returns on invested capital exceeding 50% in many cases), the asset management business has some very attractive characteristics. That said, the operating model tends to break down when revenues decline dramatically (as they have recently), with negative operating leverage taking hold as firms are unable to reduce their costs quickly enough to offset their lost revenues.

Firms that have either diversified their product portfolio, or have some inherent stickiness to their client base, have also been able to build some stability in this business model (which is, ultimately, influenced by random movements in the markets). Asset management firms that handle a number of different asset classes--such as equities, fixed income, and money markets--have tended to have more stable levels of AUM during market gyrations than single-style managers. And while stickiness is oftentimes difficult to produce in the asset management industry, general apathy on the part of retail investors (who tend to leave fund investments in place once they've made the initial investment) does create some stability for fund managers.

Asset Managers Face Challenges
This savage bear market, however, is having a significant impact on the industry. As the global equity markets swooned, the level of AUM at most asset managers was impacted not only by the declining market value of their holdings but also by nervous investors pulling their money out at a record pace (which put even more pressure on portfolio managers to sell assets in order to meet redemptions, which put even more downward pressure on the markets, which increased investor anxiety, and on and on). Because of their close ties to the markets, the stocks of the asset managers moved in tandem with the broader equity indexes (albeit with a slightly higher beta).

With AUM having declined by as much as 50% at many equity-based funds, and the investment management fees earned on money market funds and fixed-income and hybrid strategies lower than those for equities, we expect revenues for the industry to drop sharply in the near term. As investment performance is still the single largest driver of flows in and out of funds, we believe it will take some serious outperformance to recover those lost revenues. In the meantime, active fund managers will face even tougher competition for investor inflows from index funds and exchange-traded funds (ETFs), which offer index-like returns with significantly lower fee structures.

The age of the star portfolio manager may also be waning as many have had their reputations shredded by the financial crisis. In a business where past performance drives inflows and outflows, the level of underperformance seen over the past couple of years from well-known managers of active funds is not only going to have an impact on the reputation of the asset management firms they work for but also on the revenue-generating abilities of their funds. The bigger problem for the asset managers, though, still resides in the near term, where revenues have declined so rapidly that many managers will find it difficult to cut costs quickly enough to keep their profit margins from falling dramatically this year. With compensation being the single largest cost for the asset managers, firms have had to make difficult choices--such as reducing headcount or lowering (or even eliminating) bonus pools--in order to offset the lost revenues.

Although we expect most companies will do what they need to do to shore up their profitability, the likelihood that any one firm gets it exactly right is bound to be miniscule. If an asset manager doesn't cut costs far enough, it runs the risk of an even greater drop in operating profits should the markets decline further this year. Whereas those that cut costs too far run the risk of losing top performers and/or disrupting their operations to the point where performance suffers.

Another major challenge for the asset managers involves getting investors back into the markets. While institutional investors are likely to increase their equity exposure in order to restore their asset allocation levels, retail investors are under no obligation to step back into the markets. And if corporations move to cut, suspend, or even eliminate matching contributions for their pensions, even as participants are already reducing their own contributions in response to economic conditions, is bound to have an impact on a fairly steady source of inflows for the asset management industry.

Long-Term Opportunities
That said, the industry still has two positive trends working in its favor. First, in most of the developed world, the baby boomer generation is fast approaching retirement age, with most of the responsibility for funding retirement income falling on them (rather than on defined benefit plans or government pensions). While the poor market performance over much of the past year has dealt a serious blow to the retirement savings of many investors, the equity markets are likely to be the only way for many of these investors to claw their way back.

The other long-term opportunity for the asset managers resides in many of the emerging and developing markets around the world. Despite the current economic slowdown, the rapid growth in these markets over much of the past decade has already created a significant amount of new wealth, with the expectation being that these markets will continue to expand longer term. As such, the asset management industry stands to benefit from what will be an influx of sovereign funds and wealthy individuals into the investment pool. Some have even speculated that the business created by the expansion of the Asian and Middle Eastern markets longer term will present opportunities that the asset managers haven't enjoyed since the funding of corporate pension plans and then the subsequent shift to defined contribution plans during the last century.

While the long-term trends look favorable for the industry, there are still some near-term issues that will need to be worked through before the asset managers are on solid footing again. Aside from the cost-cutting that will need to take place with regard to compensation, some asset managers may find it necessary to rationalize their product lines (eliminating poorer-performing funds and/or merging funds with similar style mandates), while also cutting back on the level of new product offerings. We have already seen a strong uptick in this activity across Europe in 2008. We also expect there to be another wave of consolidation in the industry, as the larger players with the strongest balance sheets take advantage of what are significantly lower valuations for many of the asset management firms to enhance their own product lines.

Given the current environment, we continue to believe that the larger asset management firms that offer a broad array of products and have fairly diverse distribution channels--such as Blackrock and Franklin Resources--are likely to outperform the group over time. But in the near term, the direction of the market will dominate all of these companies' results.

Lacking any real insight into the ultimate depth of the market decline, the level of outflows, and the timing of any stabilization, we would advise caution and we're sticking with a high uncertainty rating for most of the asset managers that we cover. We do, however, expect to have a better handle on the operating profitability of most of these firms once they report results for the fourth quarter of 2008, which should happen over the course of the next couple of weeks. Armed with that information, we should be able to sift through the wreckage, better differentiate amongst the group, and potentially tighten the range around our valuations.