Is the asset management industry ripe for M&A?

Although the asset management industry was turned completely on its head following the collapse of the credit and equity markets last year, there has been very little consolidation to speak of this year. The biggest deal of 2009, BlackRock's $13.5 billion acquisition of Barclay's Global Investors (BGI), a unit of Barclays, has certainly sent shockwaves through the industry, but much of the deal making (including BlackRock-BGI) has been focussed on divestitures from financial institutions looking to streamline their operations or improve their capital structure. With assets like Bank of America's Columbia Management Advisors (CMA) and Morgan Stanley's Van Kampen fund business still being shopped around, we expect this trend to continue through the end of the year.

What we're less likely to see, however, is rampant consolidation among the remaining publicly traded asset managers, many of whom are still struggling to get back on their feet in the aftermath of the bear market. Much as we believed that a large number of deals would not occur earlier in the year (when most asset managers were struggling to figure out what was happening in their own house, let alone what was going on in someone else's), we think the recent rally in the markets, which has improved the operating results and stock prices of just about every publicly traded asset manager, could be a stumbling block for consolidation.

That's not to say that there isn't interest in mergers and acquisitions, as top managers from Franklin Resources to Legg Mason have noted a desire to add to their product lineups in the wake of the bear market. But there seems to be a disconnect right now between what sellers believe their businesses are worth and what buyers are willing to pay for them--much as what was rumoured to have occurred this summer with Janus Capital Group and its bidders. We believe that over time this will likely work its way out, but with several major banks and other financial institutions looking to sell their asset management businesses, it may be difficult for pure-play asset managers to get a premium valuation in the near term.

What has driven consolidation in the past?
Looking back at past periods of consolidation, with 2005-06 being the most recent, the primary motive behind most of the merger and acquisition activity in the industry has been to increase the scale and scope of the acquiring firm. Legg Mason's 2005 purchase of Citigroup's asset management operations not only doubled its assets under management (AUM), but also focused it squarely on its asset management business (having exchanged its private client and capital markets businesses for Citigroup's asset management unit).

Meanwhile, BlackRock's 2006 purchase of Merrill Lynch Investment Managers (MLIM) not only increased the firm's AUM and revenue by more than twofold, but greatly expanded BlackRock's exposure to equity strategies, splitting its managed assets more evenly across asset classes. And Invesco's 2006 purchase of both PowerShares, a provider of exchange-traded funds, and W.L. Ross, a manager of distressed assets, not only increased its AUM, but also expanded its lineup of alternative investments.

While there have been plenty of offbeat mergers and acquisitions since the last big round of consolidation (like Madison Dearborn Partners' purchase of Nuveen Investments at the height of the private equity binge in 2007), most of the deals have been smaller in nature and firmly focused on expanding the scale and/or scope of the acquiring firm's operations. Eaton Vance's 2008 purchase of M.D. Sass' Tax-Advantaged Bond Strategies business is a perfect example. While the acquisition added less than $7 billion in AUM (versus more than $120 billion for the firm as a whole prior to the deal), it provided Eaton Vance with another niche product that could easily be plugged into its already strong lineup of tax-advantaged equity and fixed-income investments.

BlackRock's purchase of BGI could spur consolidation
Much as BlackRock's purchase of MLIM transformed it from a bond fund powerhouse into a more broadly diversified and dominant player in the asset-management industry, the company's June 2009 purchase of BGI takes it to an entirely new level. With nearly $3 trillion in AUM, the combined firms will not only be twice as large as the second-largest player in the industry, State Street Global Advisors, but will be completely agnostic to shifts among asset classes and investment strategies.

With the top five global asset management firms--BlackRock-BGI, State Street Global Advisors, Fidelity Investments, Vanguard Group, and JP Morgan Asset Management--each managing over $1 trillion in assets (and collectively managing more than $8 trillion in AUM), there's likely to be some pressure on the next five largest firms--Bank of New York Mellon Asset Management, Goldman Sachs, PIMCO (a subsidiary of Allianz), Legg Mason, and Northern Trust Global Investments--to bulk up in size. Not surprisingly, Bank of New York has been talked about extensively this year as a potential acquisitor of either BGI or CMA, but so far the firm has only succeeded in reeling in the $130 billion asset management business that Lloyds Banking Group was divesting.

Given the state of the capital markets and the lack of serious buyers capable of bringing the level of capital required to get larger deals done, we don't expect to see too many transformational deals like BlackRock-BGI in the near term. We also believe that acquisition multiples are currently being suppressed and are likely to remain so until the overhang created by the businesses that have already been put on the block, like CMA and Van Kampen, are worked through the system. This means it will be less likely that smaller, single asset class or style managers will be acquired until their management teams believe they're receiving best value for their businesses (much as we believe was the case with Janus this summer).

What we expect from the more diversified asset managers
Given the size of the BGI deal for BlackRock, we don't expect the firm to be an active participant in any other large-scale acquisitions in the near term. CEO Laurence Fink has stated publicly that the company is no longer in the market for large deals, and while he has danced around talk about BlackRock being involved in some sort of deal for Columbia Management Advisors (given that Bank or America still holds a significant stake in BlackRock), we don't see him breaking his word.

While the management team at Legg Mason has not ruled out acquisitions, given the issues that the firm is currently facing we think that any near-term acquisitions would be poorly received. That said, Legg Mason would do well in the longer term to diversify its AUM, which has a deep value bias (and not only in equities), making firms that specialise in growth strategies, like Janus and Calamos Asset Management, ideal targets for the firm.

AllianceBernstein would also benefit from an influx of growth strategies into its product mix, although with close to 60% of its AUM tied to equity strategies it would be difficult to sell it as a move to diversify its asset mix. What looks enticing, though, is a merger with Federated Investors, given AllianceBernstein's complete lack of cash management operations (which really hurt it during the recent bear market). Federated would also benefit given that more than 85% of its AUM is in cash management, leaving it completely exposed as the equity markets have begun to rally. Ironically enough, AllianceBernstein sold its cash management operations to Federated in 2005.

Franklin Resources has already sized up several publicly traded and privately held asset management firms, including Janus, and has yet to strike a deal with any of them. With more than $5 billion in cash and cash equivalents, the company can afford to be choosy. We expect the firm to take full advantage of its position and wouldn't be surprised to see it in the hunt for any one of the businesses that are currently on the market, but we still believe that it would be well-served to focus on a growth-based equity manager.

While Invesco’s name has come up several times in connection with Morgan Stanley's Van Kampen operations, we're not sure if the firm has earned the right to do such a large acquisition. Since Marty Flanagan took the helm in 2005, Invesco has been focussed on improving the performance of its brands, as well as the profitability of its operations, which continue to lag the industry by a wide margin. Part of Invesco's problem has been that it has not fully integrated businesses it has purchased in the past, keeping it from reaping the full benefits of the size and scale of its operations. Until Invesco finishes putting its own house in order, we would view any major acquisitions sceptically.

Even though T Rowe Price has been talked up as an acquisitor, the firm doesn't really need to do a deal to keep growing. The company continues to benefit from having a significant portion of its AUM concentrated in retirement accounts and variable annuity portfolios, providing it with a much stickier collection of assets than its peers. Much like T Rowe Price, Eaton Vance also doesn't need to do a deal to keep growing. The firm has carved out its own niche with its closed-end funds and tax-managed equity and fixed-income investments and is likely to continue to focus on growing those organically. That said, it could still do small, bolt-on deals like it did with M.D. Sass.

We expect most of the interest to centre on smaller, single-class/style managers
With most of the focus on the smaller asset managers, we expect Affiliated Managers Group to be a more active participant as the year progresses. Unlike most traditional asset managers, AMG does not involve itself directly in the management of investments. Instead, the company acquires equity stakes in successful boutique asset managers, receiving a fixed percentage of revenue in return.

Unfortunately for the publicly traded firms that remain on our coverage list, the company's preferred targets are small and midsized privately held asset managers that are still being run by their founders. While Calamos, Gamco Investors, and Pzena Investment Management are still being run by their founders, it is unlikely that AMG would take a stake in any of these firms unless it was part of some action designed to take them private. It's also unlikely to go after Janus or Waddell & Reed.

While we could argue that any one of these five remaining firms could be bolt-on acquisitions for any number of larger asset managers, there are impediments to the deals getting done. Gamco's future is completely in the hands of Mario Gabelli. He runs the company, manages a large chunk of the firm's AUM, and serves as its public face. He is an unlikely seller, and even if he was interested in selling, shares of Gamco have traditionally traded at such a high premium to the group that it would be hard to imagine anyone paying up right now with so many other options out there.

Even though Pzena is also run by its founder, Richard Pzena, the firm may be less resistant to a takeover than Gamco. That said, Richard Pzena and four other insiders continue to hold more than 70% of the firm's voting rights and even stepped up late last year to loan the company more than $10 million to pay down debt. With the stock still down some 60% from its initial public offering two years ago, and Pzena having such a huge personal stake in the firm, we're not sure that he'd be a willing seller in the near term.

The same holds for Calamos, which would be of interest to several larger asset managers given its focus on growth equities and convertible securities. John Calamos and members of his family collectively control over 97% of the firm's voting rights, and while they did not contribute to Calamos' reduction of its debt load at the end of 2008 they do have large personal stakes in the firm. Calamos' stock is down more than 50% from its highs of just two years ago, so we wouldn't expect the family to be excited about a deal until that situation reverses itself.

That leaves Janus and Waddell & Reed as the only viable near-term acquisition targets at the bottom of the table. Waddell & Reed could prove problematic, however, given that the true strength of its business model comes from its staff of approximately 2,300 financial advisers who sell its products exclusively. Were it to be integrated into a larger asset management firm, there would likely be a huge disruption to the one attribute that allowed Waddell & Reed to hold on to assets at a much better rate than most of its peers during the bear market. That said, we could see the firm fitting in nicely in Legg Mason's "multi-affiliate" business model, which would perhaps provide it with the breathing room necessary to maintain its successful business model over the longer term.

As for Janus, we've believed for a very long time that the company was for sale, having viewed most of the moves made by former CEO Gary Black to get the firm running more like a typical asset management firm as window dressing for a potential sale. He was instrumental in initiating a lot of the programmes that not only strengthened the firm's investment performance and risk management, but also revitalised the Janus brand. Situated in the middle of a bunch of other midsized asset management firms, however, with no discernable niche that would allow it to hold onto assets in a down market, and lacking the distribution capabilities, visibility with investment advisers, and scale necessary to compete effectively with many of its peers, we continue to believe that Janus will be sold--even if Gary Black is no longer at the helm.