February 2010

INDUSTRY CONSOLIDATION: rise of the elite boutique

Have investors benefited from the creation of super asset managers or will boutiques serve their needs better? Patrick Armstrong, of Armstrong Investment Managers, considers the changing nature of the business waiter.jpgThe merger of BGI/BlackRock, creating the world’s largest asset manger, may mark a watershed moment in the consolidation and growth of super asset managers. This mass consolidation of asset managers coincided with many of the fund ranges belonging to these asset managers also being consolidated. The rationale behind this, from a corporate profitability perspective, is obvious, but have investors benefited from this consolidation or have they lost out? What will the consequences of this consolidation be?

The Darwinian nature of business, with asset management being no exception, means that only the strongest and/or most nimble firms are able to survive and prosper. Financial strength has been of the utmost importance during the credit crunch. Much of the recent consolidation has been from financially sound organisations buying less financially sound asset managers, or buying from parent companies in financial distress. The sale of Insight, which was owned by Lloyds TSB, for only 0.3% of assets under management and the sale of New Star to Henderson for pennies per share are two examples. Recent months have also seen the aforementioned BGI being bought by BlackRock, parts of Credit Suisse Asset Management, and RBS Asset Management bought by Aberdeen Asset Management, Allianz bought Commerzbank’s Cominvest and French banks Crédit Agricole and Société Générale announced a merger of their fund management divisions.

The benefits of scale in reducing costs, and synergies created by putting many bright minds together in a single firm are often cited as the reasons to grow and merge asset management groups. However, the emergence of these behemoths is not all good news for investors.

Big, not always beautiful
With greater size comes greater potential risk and the need for growing corporate control. House views on investment style and economic outlook are required to create consistency across managers and create some control. The drag of internal politics and various committee meetings starts to take precedence over investment performance. Retaining the brightest and the strongest-willed staff, who are usually the top fund managers, becomes more difficult.

Successful fund managers require the flexibility to adapt their process to meet market conditions. Behemoth asset managers need to impose strict investment processes and controls on managers to have any semblance of control. Flexibility is lost and the result is either underperformance or forcing more strong-willed or entrepreneurial managers out.

Despite the momentum behind mergers and the wave of fund closures we think that the inevitable cyclicality of the asset management industry is bound to lead to the break-off of many fund managers from the large organisations to join or start their own investment boutiques. The reason for this is that the rise of mega asset managers often carries with it the seeds of their demise as alpha managers. With a required focus on corporate consistency, the search for alpha becomes more difficult. A new potential void is created to be filled by a boutique. 

We do not expect the end of the behemoth asset managers as a consequence. Actually the natural conclusion of the Darwinian process is a more pronounced barbell in the industry. We foresee the survival of the largest companies which can prosper on relatively low to very low margins, based on huge asset bases, and the emergence of more nimble boutique asset managers which can deliver higher alpha, and more intimate bespoke client service and reporting for its clients.

Mid-sized mortality
The undifferentiated middle ground, mid-sized asset managers, which may not have had the balance sheet strength to survive or the innovative entrepreneurial culture to adapt to the new harsh environment, will be the victims. Many of the mid-sized asset managers are boutiques which have grown quickly and now find themselves in a position where they need to reign in staff and create a more formalised house view, which in turn stifles the innovation and creativity that led to their success. Others may be large asset managers that have failed to grow and are facing redemptions due to poor performance. These companies often have the very large fixed cost base of a large organisation, but amid falling revenues based on asset outflows and falling markets, they become a victim of the operating leverage in this structure.

The most recent phase has been characterised by industry consolidation and we expect that the next phase of the cycle will be the growing importance of boutiques. A shifting competitive environment in which larger asset management companies benefited from large balance sheets, and often the backing of a larger parent company, worked in favour of ever larger companies the past three years and this led to the wave of consolidation. The largest asset managers have targeted a range of investors across retail, high-net-worth individuals and institutional investors. They positioned themselves as the answer for all types of investors and tried to deliver a range of products to meet client needs. The lack of focus creates the potential jack-of-all-trades-but- master-of-none risk.

Winning features
Boutique is a vague term, but we think of it as a firm that is largely owned by its principals and the key members of the firm have the power to make tactical and strategic decisions. Boutiques are usually focused on a particular type of strategy or a single region and generally do not offer a product in all asset classes and regions. Boutiques concentrate on what they do best and better than their lower cost larger rivals.

When analysing the potential advantages of a boutique structure, most of the focus is on the ability to generate superior performance, with motivated management, to create bespoke solutions. Coupled with the personality attributes of the founders, these can all be beneficial for investors. Most academic research shows a significant outperformance from emerging managers and the data also shows emerging managers have a lower volatility than established large managers. Data has shown outperformance of emerging managers in almost all segments, whether it is large cap equities, or more specialised hedge fund strategies. Another significant competitive advantage, particularly in this cycle, is the potential boutiques have to create a more gratifying client service experience.

The market sell-off in 2008 saw many investors become more critical of large bank-owned asset managers and the large faceless organisations which aggressively sold to clients when things were going well and then seemed to disappear when things got tough. There is a well-documented and growing mistrust of large financial organisations among many subsets of investors.

New start-ups and nimble boutiques can quickly change their model to meet clients needs for investment solutions and deliver a more bespoke client service. The intimacy of a boutique structure allows face-to-face contact with owner managers of the business and a boutique structure allows the required flexibility to adapt to ever-changing client needs.

Financial flexibility is one final advantage, which is important to asset management companies in the current environment. The largest companies may have the largest balance sheet, but smaller employee-owned boutiques may have the most flexible cost structure. Owner managers are often willing to forego or reduce salary in difficult times, whereas this is difficult, if not impossible, to achieve within larger organisations.

Banks and insurance companies have been the largest consolidators of asset management companies over the past decade. Many of these financial organisations will now choose to adopt open architecture, selling funds from a variety of manufacturers. We expect many will increasingly question the merits of retaining their own in-house asset management company.

The end of the momentum from this consolidation, and all the opportunities created by the consolidation of the past, will lead to a change in the asset management industry. Given the dynamic nature and competitiveness of the industry, if clients lost out through fund closures and industry consolidation, inevitably their needs will be addressed. This is the overarching force, which we believe will lead to the next phase of the cycle being the rise of the elite boutique.

• Patrick Armstrong is a managing partner at Armstrong Investment Management ©2010 Funds Europe

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