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The implications of the Schroders deal with Cazenove

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In the halcyon days pre-credit crisis, high flying fund managers routinely left their employers for chunky pay packets elsewhere or to set up on their own. Yet the credit crisis ensured that managers were too insecure to shift groups voluntarily, and only the real superstars branched out alone. But with Richard Buxton’s departure from Schroders, it felt like old times. Then, as Schroders and Cazenove announced their deal, it suggested a new confidence emerging in the UK fund management industry. But plenty of pressures still lurk. Is this apparent new confidence actually a recognition that the industry is facing real challenges and it is wise to be prepared?

The period since the credit crisis has seen the UK fund management dogged by the unpredictability of markets, a slew of regulation and the changing preferences of investors. Merger and acquisition activity has been limited to a few ‘distressed’ deals such as Henderson/New Star and Henderson/Gartmore with the odd ‘prize asset’ such as Thames River Capital or Rensburg Fund Management absorbed into a larger group.

Fredrik Johanssen, asset management partner at PWC, says M&A activity in the UK fund management industry has, to date, largely been concentrated on the wealth manager space. He adds: “Of the wealth management deals, a number have been corporates taking advantage of market consolidation to increase volumes or acquire capabilities such as distribution and products, and a number of deals have been “buy and build” strategies, some of them private equity backed, for example Bridgepoint’s acquisitions of Quilter and Quilter’s subsequent acquisition Cheviot.”

The Schroders/Cazenove Capital deal was on a whole new scale – at £424m, it was almost three times the size of the Thames River deal. Of course, it was a wealth management deal as well – the real prize was Cazenove’s high margin private client/charity business, but the fund management side is important too.

The deal as a whole has been largely welcomed by advisers and analysts. Analysts believe it is a good use of Schroders cash pile and should bring cost synergies of £12m to £15m per year from distribution and infrastructure restructuring. Advisers have said that the two groups are a good strategic fit, but are keen to see the Cazenove funds ring-fenced.

Buxton’s move to Old Mutual Global Investors in itself was suggestive of new confidence in the industry. Manager movement has diminished significantly since the start of the credit crisis as managers were increasingly grateful simply to have a job. Buxton’s reasons for moving are not known, but it suggested that OMGI was happy to pay up for a ‘star’ manager, despite already having well-recognised names such as Ashton Bradbury in its stable. It was also telling that it was willing to pay up for a fund manager managing unloved UK equities. This was the worst-selling sector for much of 2012.

There have also been other indications that the fund management industry is becoming more confident about the future. There have been significant dividend hikes by a number of the listed asset managers, all citing greater optimism about the future as the driver.

Michael Dobson, chief executive of Schroders, says: “The increase in the dividend is a sign of financial strength. Markets are improving and we are confident we can grow and give more back to our shareholders,” while Edward Bonham-Carter, chief executive of Jupiter Fund Management, says: “Our increasingly robust balance sheet and confidence in our growth prospects has led the board to recommend increasing our total dividend by 13 per cent.” Richard Wilson, chief executive of F&C Asset Management, says: “We have cut costs and now we are looking at growing the company.”

But is this simple the rhetoric of chief executives? After all, on the face of it, the industry has very little reason to be feeling confident. In this context, deals such as the Schroders/Cazenove deal may look more like fortifying a house ahead of a hurricane than a bold statement of confidence in the future.

Most notably, pressure on fees is building. The latest results from Henderson and Jupiter both showed declining fee revenues before the RDR is even in full swing.

Andrew Power, lead RDR partner at Deloitte, says: “The RDR is leading to increased transparency of fees and therefore more pressure on fees across the range. The client sees the platform fee, the adviser fee and the asset management fee. There is pressure on all of those, but because the relationship is between the adviser and the client, that is probably the most defendable. Also because of rebates, advisers recommended the companies from which they got rebates. Now they are more likely to recommend trackers. It is putting pressure on advisers to shift the mix of their investments. This will reduce the fees for active managers, particularly where active managers can’t demonstrate value.”

He says that the fee pressure is likely to mount in earnest in the second half of this year: “Fees in general have been under pressure for some years. Passive was picking up market share from the active industry even before the RDR. Equally, managers have long been struggling to extract performance fees, because they have struggled to perform in this environment.” He notes that fees in the UK are much higher than in the US and might be expected to move down to US levels over time.

Clearly, the industry is aware of the threat, Schroders and JP Morgan have already launched lower cost funds. To date, they have not generated significant assets, but they may get more now that the RDR is in force. The low cost passive group Vanguard has seen 190 per cent growth in assets under management over the past year.

Mike Webb, chief executive of Rathbone Unit Trust Management, says the pressure is mounting on fees in other ways as well.

He says: “In the last couple of days alone, HMRC has said that unit rebates and cash rebates are taxable as income tax. This is very significant for a number of larger platforms. Higher rate tax payers will see the value of their rebates almost halve. As a result a number of the groups have said that they want to move to clean share classes. There are huge levels of pressure building up in the system for fund managers to launch new share classes at reduced annual management charges.”

There is also regulatory pressure mounting from Europe, which will impact directly on the bottom line of asset managers. First there is the sheer volume of regulation, which may shape the industry. It makes the level at which it is economical to run a fund lower and it has been suggested that it will concentrate assets in the hands of the larger players who can afford the hike in costs. This is particularly true in the alternatives arena – where smaller, owner-managed businesses are more common – with the advent of the Alternative Investment Fund Managers Directive .

Power says that this may have been over-played: “Compliance costs are increasing and there are so many regulations – PRIPS, Mifid, AIFMD to name a few. There is undoubtedly a level of compliance fund managers have to do regardless of whether they are a big player or a boutique. As a proportion of overall costs, it is higher when you are a small group, than when you are a BlackRock. However, of itself, it is unlikely to make the difference. It will not drive consolidation. That, combined with more pressure on fees and top line growth may do it, however.”

He sees a different problem, that a higher compliance may get in the way of industry development: “What these higher regulatory burden can do is consume management attention. This means they might not focus on new products. The focus is internal rather than external. It can mean that – for some groups – their competitive position erodes.”

Anouk Agnes, deputy director general at Luxembourg fund association ALFI, says that the compliance burden has held back asset managers over the past few years, but is changing.

Agnes says: ” We hear a lot about the regulatory tsunami. Fund managers are certainly suffering cost-wise and is has been difficult to put anything in place. But the legislation is there, it is binding, so we have to play by the rules. Finally after three or four years, we see that there is an acceptance of the new rules of the game and a recognition among companies that they need to apply it and to make it work. Asset managers want to start expanding their businesses again. Now they are looking to the future and being willing to get started again.”

That said, she sees no immediate end to the regulatory tidal wave: “There is plenty still in the pipeline – Ucits VI, for example. However, it was the same with AIFMD at the start. Everyone was against it, and saw it as an additional burden. But the industry is getting ready and the general feeling is now that it is going to be an opportunity to generate business and fund managers should make the best of it.”

The potential restriction on fund manager pay is a more dangerous turn for the industry. The EU’s economic and monetary affairs committee narrowly voted in favour of limiting fund manager bonuses to 100 per cent of their base salary at the end of March. There have been some signs that it is willing to soften its stance, but Webb says it is a worrying trend.

Webb says: “What policymakers are doing is extremely dangerous. It has been designed primarily for bankers. Asset managers are paid lower base salaries and higher bonuses in order to align their interests better with those of their clients. Bonuses should be designed with a long-term time horizon, deferred and co-invested into the product range. Forcing businesses to pay lower bonuses can only lead to an increase in base salary. It is not a good thing if you are trying to manage the cost base of an asset management group.”

Power agrees: “The restrictions on pay will mean a move to higher fixed pay. This is part of general squeeze on asset management and will create a higher fixed cost base. As a result, this may see fund management activities gravitate from Europe to elsewhere. Asset management is a competitive market and the best asset managers are likely to move elsewhere if the pay is not competitive.”

There are also more macro pressures on the fund management industry. The past 25 years have been driven by unprecedented credit expansion. Gervais Williams, managing director of Miton Group, says that it is no coincidence that this period has also seen significant expansion in the fund management industry.

Williams says: “There was more cash in the system, therefore more people were required to look after that cash. This was good news for the fund management industry. There was a proliferation of new businesses, big and small.”

However, in a climate of little or no credit expansion and weaker growth, fund managers are facing a headwind. Williams sees a ‘raising of the drawbridge’ for new businesses. Rather than this being a compliance issue or a problem with the availability of quality research, it is simply a lack of customers: “There was a huge vibrancy to the industry prior to 2008, with new hedge funds cropping up, but issues such as Madoff muddied the waters, now people need to do more due diligence on groups – establishing that they have a strong balance sheet, or good third party relationships.”

He says that this will be more important in driving consolidation in the industry. “If a group is very narrowly-based, focused on a small number of customers, with not enough distribution, it will difficult to sustain without having asset growth at the same time.”

Williams says the dominance of a relatively small number of big groups with big brands and big distribution will continue. However, they may not be as profitable because the cost base has become so high. Smaller groups will be able to pick up market share in those areas generally done badly by larger companies – small and mid cap investing, for example.

Webb sees a similar trend: “We are on the edge of some consolidation. Driven by transparency, margins for asset managers have become extremely visible and cost pressures are only going to increase. If you are a benchmark hugger, the cost difference between that and a passive fund is going to become very apparent. On the other hand, if you are a genuinely active manager, benchmark unconstrained, there will be less pressure on fees. You havestill got to produce the goods, of course. The way to protect margin is to be genuinely active and control the capacity of the funds you are running.”

He adds: “You need to look for increasing scale. This does not mean you need to be big to be profitable, but it is about understanding what you want to be and managing your cost base accordingly.”

There is likely to be some shift in the power balance of fund groups simply from market movements. It seems unlikely that, overall, markets will bail asset managers out in terms of increasing revenue and sales. But it has been an extremely weak time for certain assets – UK equities, for example – and an extremely buoyant time for others such as fixed income. If the much heralded ‘great rotation’ finally happens, some groups may suffer.

Power says: “Most groups are fairly balanced. The fund groups that have been owned by insurance-related groups that tend to have more fixed income and property may not have the experience in terms of equity management. But the industry as a whole should be able to deal with the shift.”

Most believe that the winners will be those with multi-asset and income products, extending the trend of the last few years. Johanssen says: “The businesses that are currently doing well are those that have strongly performing products and consumer focused solutions that can meet changing investor demands and behaviours. Investors are increasingly interested in outcome focused investment solutions (for example lifestyle funds) as opposed to more strategy driven traditional products.”

Webb concludes: “The Cazenove/Schroders deal is unlikely to be part of an enormous change in the industry towards consolidation. That deal was an extremely good strategic fit and not part of a rush to buy up anything. Schroders was looking for a bigger footprint in the wealth management business and this is likely to continue. There are far too many small wealth managers struggling to cope.”

It would be wrong to see the Schroders/Cazenove deal, or even Buxton’s departure as part of a wave of new confidence in the industry. Given the pressures on fund managers, it appears more as a prudent use of an unproductive cash pile to shore up margins and defend market share. There is likely to be more consolidation as managers move to protect themselves. The markets may have become more forgiving, but the structural headwinds for the industry are profound.

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Help from the UK Government?

The UK Government believes that the asset management industry needs fixing. Alongside the recent budget, HM Treasury published a paper entitled “The UK investment management strategy”. The introduction written by the Chancellor states “I am committed to making the UK one of the most competitive places in the world for the investment management sector.” He plans to achieve this through taxation, regulation and marketing and announced a series of measures, including the abolition of stamp duty reserve tax on unit trusts and Oeics

The UK is a large financial centre, but has remained primarily focused on domestic UK buyers, losing out in more internationally-focused business to jurisdictions such as Dublin and Luxembourg. The Government’s move aims to capitalise on the UK’s experience in financial services to build a world-class funds centre. The UK has also been an early leader in AIFMD compliance, which may be an attempt to catch up on opportunities it missed on Ucits.

It is an understandable and admirable ambition, but it is by no means guaranteed of success. Luxembourg and Dublin have a 20 year head start on international distribution and fund administration and have been just as disciplined about the implementation of the AIFMD to protect their market share.

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Key trends

Andrew Power, lead RDR partner at Deloitte

1) The growth of passive – how it grows and how quickly. Will there be something that causes an acceleration in growth? Within this will be the growth of exchange traded funds. This has exploded in the US – will it happen in the same way in Europe.

2) The role of the ‘middle’. It is easy to see the role for passive groups with scale and for niche active manager in markets where they can add value, such as emerging markets, but can a group be in the middle with balanced mandates? There is a lot of money there, so there may not be a dramatic change, but there is an important question on how will they defend their position.

Mike Webb, chief executive, Rathbones Unit Trust Management

1) Businesses will be leaner to cope with margin pressures.

2) Fund managers will focus on what they do well and not try to be all things to all men. Big businesses only tend to succeed in a small number of areas.

3) There will be many more strategic asset allocation products brought to market: multi-asset with embedded advice.

Fredrik Johanssen, asset management partner at PWC

1) Lower cost products such as ETFs will play an increasing part in delivering outcomes or executing an investment strategy as part of a core of lower cost products allied to a range of active products.

2) As pricing continues to become more transparent, performance will become an even greater determinant in consumer choice and funds and their managers will need to be able to show they merit their charges.

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