Asset Management Focus

M&A Activity increases as economy slogs through the mud

Originally published in the October 2010 issue

The economy and unemployment should be doing better at this point in a cycle; instead we’re stuck in the mud. We think there are four main issues holding us back:

(1) huge uncertainty being created by Washington causing businesses to postpone new investments,
(2) fear of the federal budget deficit and the implications on future taxes,
(3) continued deleveraging at the investor level (e.g. banks, insurers, pensions), and
(4) consumer deleveraging through debt pay downs and higher savings.

The deleveraging at the investor and consumer levels is positive for the economy’s long-term health, but will take time. This leaves Washington with the challenges of inspiring business confidence again and addressing the long-term budget deficit woes. We’re waiting….

Deal Activity / M&A: The number of transactions increased to 106 in 1H 2010 versus 87 in 1H 2009, a 22% increase. Total AUM involved was $417 billion. Average deal AUM size dropped from $36.9 to $5.5 billion. Deals with alternative asset managers increased to 52 in 1H 2010 from 25 in 1H 2009, a 108% increase, as the need for size, scale and distribution continue to drive M&A.

Financial Regulatory Reform and the “Volcker Rule”: The limitations imposed on proprietary trading and private equity/hedge fund sponsorships already have caused global reevaluation of the diversified bank business model, with Citigroup and Bank of America selling private equity/hedge fund business units.

Alternatives: M&A activity in the alternative sector is on pace to exceed 2008 and 2009 levels as firms consolidate, get acquired by larger strategic firms or are spun out by banks facing regulatory issues. As a result, alternative manager deals are on track to outpace traditional manager deals for the first time.

UCITS: UCITS III hedge fund sector now takes up 7% of the total hedge fund industry. There is no sign of its growth slowing. We see an increase in its use by non-European firms who wish to enter the European capital markets.

Deal Activity
Following two straight years of decreased activity, where the number of transactions fell from a total of 240 in full-year 2007 to 179 in full-year 2009, asset management transactions rebounded in 1H 2010. In total there were 106 transactions in 1H 2010 versus 87 in 1H 2009, a 22% increase. By transaction type, 1H 2010 had 96 acquisitions, nine MBOs, and one JV/Alliance compared to 87, seven and three in 1H 2009, respectively. The three largest AUM deals announced in 1H 2010 were Pacific Century Group’s purchase of PineBridge Investments, Nordea Bank AB’s purchase of Nordea Invest Fund Management and Man Group’s purchase of GLG Partners.

All three regions (US, Europe and Asia) witnessed increases in the number of transactions in 1H 2010 compared to 1H 2009. In the US, consolidation pushed the number of first half deals up 11% to 52 versus 47 in 1H 2009. This included 49 acquisitions, two MBOs and one JV/Alliance compared with 41, three and one respectively in 1H 2009. In addition, deal-making in Europe increased from 32 in 1H 2009 to 47 in 1H 2010, a 47% jump. Europe had seven MBOs in 1H 2010, including the management buyout of London-based KBC Asset Management UK ($1.1 billion AUM) from Belgium-based KBC Asset Management. Asset management transactions in Asia have slowed down since record activity in 2007; however transactions increased 14% in 1H 2010 versus 1H 2009 with the total number of deals increasing from 14 to 16. Activity in Asia should continue in the near future as growth prospects remain positive.

Transactions by company type
In 1H 2010, 52 of the 105 transactions involved targets that were alternative asset managers. This is more than double the 1H 2009 number of 25 deals involving alternative asset managers and exceeds the full-year 2009 transaction volume. The trend in the alternative space is smaller alternative asset managers are being acquired by larger alternative managers and other traditional managers or financial institutions that have the benefit of distribution, brand name and/or size and scale.

For the first time, this year is on pace to have more alternative than traditional manager deals. First half 2010 also saw an increase in deal activity involving “other” firms (which include financial planners, trust companies, administrators and private banks) at 22 transactions versus 13 in 1H 2009, a 69% increase.

Deal size
The number of transactions increased across all deal size categories in 1H 2010 versus 1H 2009. The number of large deals, involving AUM over $10 billion increased to 10 in 1H 2010 from nine in 1H 2009. Deals with AUM between $1 billion and $10 billion increased to 35 in 1H 2010 versus 23 in 1H 2009, a 52% increase. Similarly, smaller deals with AUM of less than $1 billion increased 20% over 1H 2009 with 60 transactions compared to 50. Going forward, we anticipate transactions involving asset managers with AUM less than $10 billion to be at the forefront of activity, while larger transformational deals will continue to slow as the market stabilizes.

Significant Deals in First Half 2010 by AUM:

• Pacific Century Group acquires PineBridge Investments ($87.3 billion)
• Nordea Bank AB – Nordea Invest Fund Management ($57.3 billion)
• Man Group – GLG Partners ($23.7 billion)
• Guggenheim Partners – Security Benefit (Rydex SGI) ($22.0 billion)
• AMG and Management – Pantheon Ventures ($22.0 billion)
• Aberdeen – RBS asset management contracts ($19.5 billion)
• AMG and MBO – Artemis Investment Management ($16.0 billion)
• Fortress Investment Group – Logan Circle Partners ($12.0 billion)
• PrinceRidge Holdings – Institutional Credit Partners ($11.0 billion)
• Goldman Sachs Petershill Group – 8% stake in Shumway Capital ($8.0 billion)
• Fiera Capital – Sceptre Investment Counsel ($7.0 billion)
• F&C AM – Thames River Capital ($6.4 billion)

Assets sold by seller region
Overall, assets sold/acquired are down significantly to $417 billion in 1H 2010 compared to $2.7 trillion in 1H 2009. AUM purchased in 2010 is on pace to be much lower than in the past five years, as the wave of large transformational deals begins to slow. The largest transaction in 1H 2010 was the China-based Pacific Century Group acquisition of US-based PineBridge Investments. An analysis of median deal AUM size shows that deals in 1H 2010 (median $1.95 billion) are on par with median deal size in 2009 (median $2.0 billion), indicating that the bulk of transactions are of smaller sized firms. In the US, assets sold dropped to $238 billion in 1H 2010 compared to $1.7 trillion in 1H 2009, a decline of 86% much of which can be attributed to BlackRock’s acquisition of Barclays Global Investors ($1,500 billion), which composed 90% of total AUM in the US for 1H 2009. The story was similar across the Atlantic where total European assets acquired plunged to $155 billion in 1H 2010 from $895 billion in 1H 2009, but Credit Agricole’s merger with Société Generale Asset Management ($808 billion) accounted for 90% of this figure. In Asia, compared to previous time periods, there were minimal amounts of assets sold. The most notable transaction in Asia in 1H 2010 was BNP Paribas Asset Management Australia acquiring Fortis Investment Management Australia ($5.6 billion).

Assets acquired by buyer region
A breakdown of AUM purchased by buyer region shows that US, Europe and Asia all purchased similar amounts of assets in 1H 2010 (between $100 billion to $200 billion). The amount of assets acquired by US and European firms was significantly lower in 1H 2010 compared to 2009 and previous years, again due to large transactions that took place in those years. US-based firms purchased $164 billion of assets in 1H 2010 compared to $1.7 trillion in 1H 2009, a 90% decrease, while assets purchased by European-based firms were down 84% from $859 billion in 1H 2009 to $141 billion in 1H 2010. Assets acquired by Asian-based firms were down 35% from $157 billion in 1H 2009 to $102 billion in 1H 2010. Although AUM purchased by Asian firms was down from 2009 levels, there was a significant increase in 1H 2010 compared to the first half of 2006, 2007 and 2008. Overall, Asia continues to be a net buyer of assets. Since 2006, Asia-based firms have acquired $1.38 billion in assets compared to $619 million on the sell-side. The only region that saw an increase in AUM purchased was Canada, highlighted by Canadian-based Fiera Capital’s purchase of Canadian-based Sceptre Investment Counsel ($7.0 billion). South America and Africa reported nominal activity in 1H 2010.



Reform and the Volcker Rule
The Dodd-Frank Wall Street Reform and Consumer Protection Act, weighing in at 2,300 pages, will surely require much scrutiny and further consideration in a myriad of areas. Law firm Davis Polk & Wardwell recently estimated that a minimum of 243 new rule-makings would be required under the new law. We would like to focus on just one aspect, one which has already received much attention: the “Volcker Rule.” The rule limits bank holding companies (BHCs) from engaging in both proprietary trading, with minor exceptions, and the sponsoring of or investing in hedge/private equity funds, with even fewer exceptions. Specifically, the rule limits BHC’s investments in hedge fund/private equity to 3% of the fund’s assets or 3% of the BHC’s Tier 1 Capital.

Morgan Stanley, Goldman Sachs, JPMorgan and Merrill Lynch, among others, have all historically purchased and grown hedge/private equity funds utilizing their own capital in addition to third party investors. Several of these BHCs will have to determine solutions to structure around the rule as the regulations become clearer. The timing for clarity and solutions is not immediate as the current timeline envisions a two to seven year transition period to come into compliance. To be sure, there will be appeals, definitions and Senate/Congressional elections over that time period. The spectre of the regulation could have prompted the recent sale of Citigroup’s private equity assets to StepStone (as manager) and Lexington Partners (as owner of fund interests) and has surely sparked all the major players to begin assessing the law’s effects. Firms such as Morgan Stanley may spin off hedge fund businesses such as Frontpoint Partners ($7 billion).

Buyers abound for the potential significant divestiture activity as institutional investors drive demand for alternative products that can yield more than Treasury bonds and have less volatility than US equities. Large, diversified managers such as Blackrock, Franklin Resources and Legg Mason may use the opportunity to grow and/or break into new alternative asset classes. We expect large alternative mangers such as Fortress, Blackstone and KKR to continue to expand and diversify in multiple alternative asset segments.

In Europe where proprietary trading typically makes up a lower proportion of revenues, tighter restrictions and higher capital requirements emanating from theBasel Committee on Banking Supervision will continue to have some similar consequences as the Volcker Rule. As we have seen with the recent spinouts at Deutsche Bank and BNP Paribas, BHCs will reevaluate whether the reallocation or divesture of proprietary trading desks and hedge/private equity funds is in their best interest.


Alternatives transactions rise

In the first half of 2010, alternative transaction volume surpassed the full-year count in 2009, totalling 52 and 49 transactions respectively. While average deal size is still lagging, 2010’s total deal AUM of $152 billion is quickly approaching 2009’s full-year value of $205 billion. Among alternatives, hedge funds had the most AUM acquired at $63 billion, in large part due to Man Group’s acquisition of GLG Partners. Very little AUM changed hands in terms of private equity assets ($13 billion in the first half of 2010), while there was $51 billion in fund of funds assets involved in transactions in the first half of 2010. Table 2 shows select fund of fund transactions that have occurred since 2008.

Consolidation in fund of funds

The consolidation in the fund of funds space that was anticipated post the financial crisis has commenced, but activity is stalled for the following reasons: mismatched valuation expectations, lack of financing in the M&A market and unique firm culture management issues. However consolidation will continue as the drivers persist, which include: (1) increasing costs of business as a result of additional compliance, staff costs and risk management systems; (2) institutions becoming the dominating investors resulting in “institutional quality” managers attracting the majority of new net flows post crisis; (3) certain business models exposed (reliance on bank channels, high net worth clients, or Europe private banks; leveraged structured products or Bernie Madoff); (4) overall fee pressure. The merger of Gartmore and Hermes’ private equity fund of funds groups ($6.2 billion) and Crestline’s acquisition of Northwater Capital Management ($2.2 billion) represent the largest consolidation in the space, to date. Strategic acquirers, including traditional asset managers, insurance companies and banks, have been more active acquiring fund of funds. Given the financial regulatory reform and the Volcker Rule, we don’t anticipate many fund of funds being acquired by banks, but the trend of traditional asset managers entering the alternative asset sector via acquisitions should continue as they look to diversify their revenue streams and increase margins with higher fee alternative products.

Renewed interest in IPOs
KKR’s IPO in July marks the first major post-crisis initial public offering (IPO) in the alternative asset sector. This issue demonstrates a common trend among alternative managers, who are seeing lower valuations as investors continue to discount performance fee expectations. KKR’s market cap as a percentage of AUM at 13.2% is considerably less than the 42.3% average that its private equity counterparts, Blackstone and Fortress, garnered with their respective IPOs in 2007. Unlike alternative managers, traditional asset managers have seen continued interest throughout the past five years. Jupiter’s IPO this June marked the first traditional manager IPO of 2010, with successful stock price performance thus far, up 22% (to end-August) over its IPO price of £1.65 and trading at approximately 4.5% market cap to AUM.

Throughout the past five years, market cap as a percentage of AUM has remained relatively consistent for traditional asset managers (1-5%). This is not the case for alternative asset managers. US-based alternative asset managers who IPO’d in 2007 to much excitement (Fortress, Blackstone and Och-Ziff) have witnessed the greatest decline in market cap/AUM. The three aforementioned firms have seen their market cap/AUM drop 91%, 75% and 52%, respectively, since their IPOs. While we have seen these firms’ market cap/AUM ratio fall over the past three years, KKR still IPO’d at a 13.2% market cap/AUM, above the 10.4% average among US-based alternative asset managers.


Hedge funds raising assets

Additionally, new launches of hedge funds have picked up in 1H 2010 with the majority from established players (including Highbridge Capital Management and Paulson & Co.), but launch sizes remain smaller than historical levels. Globally, new launches have raised approximately $20 billion in 1H 2010 on pace to exceed the $35 billion raised in full-year 2009, but far below the $73 billion raised in full-year 2007. Historically, US funds have accounted for approximately 40-50% of assets raised, while in 1H 2010, US funds represented 55% of globally raised assets or $10.9 billion. Concerns about the European economy reduced the amount of assets raised in Europe to 35% of total assets raised or $6.9 billion (including UCITS III). Activity in Asia ($2.1 billion raised) is on pace to exceed asset levels raised in full year 2008 and 2009. A total of 193 funds were launched in 1H 2010: 43 in the US (assets greater than $25 million), 97 in Europe (including 39 UCITS III) and 53 in Asia.

Hedge fund asset flow trends
Asset flows for both hedge funds and hedge fund of funds have taken divergent paths post-crisis. While hedge funds of funds had dominant growth pre-crisis vs. direct hedge funds, HFOF AUM is down 29% since 2007. The major factors driving the loss in fund of fund AUM are large withdrawals by HNW clients, especially in the case of European clients, and the unwinding of all fund of fund structured products (which accounted for $50-100 billion of AUM).

However, institutional asset levels have been quite resilient. Meanwhile, total hedge fund AUM has been quite resilient, up 1% since 2007. The growth has been driven by 2009-1H 2010 market performance and recent net inflows. The net asset flows have not been equal by size of hedge fund. Total assets by firm AUM tier have shown steady market share concentration during the crisis with hedge funds running assets of over $5 billion holding 60% of AUM and hedge funds over $1 billion holding 86% of AUM. Smaller managers (which include launches of new managers) and the largest managers have shown to be the most resilient during the crisis and have been attracting the lion’s share of the net asset flows. Over the last 12 months the smallest managers and new managers (<$500 million) had positive net flows of $12.9 billion or 18.7% of 30th June 2009 levels and the largest hedge funds (>$5 billion) had positive net flows of $28.2 billion or 5.3% of June 30, 2009 levels. On the other hand, mid-sized firms continue to suffer net redemptions as investors are more demanding on infrastructure and operating capabilities. Managers with AUM between $500 million and $1 billion had negative net flows of 0.3% over the 12 twelve months, while managers with AUM between $1 billion and $5 billion had negative net flows of 1.1%.

We thought it was time that we review the UCITS III phenomenon. It does not seem to matter where we are in the world — UCITS III remains a hot topic. In fact, there is a whole sub-industry of platforms both within and outside the investment banking community that has sprung up to serve this product group.

UCITS are required by EU legislation to fulfill three key requirements: transparency, liquidity and diversified portfolios all aimed at providing better risk management for investors. There is an estimated $100 billion of UCITS hedge fund investments in about 980 funds accounting for approximately 7% ofthe total hedge fund universe at $1.5 billion. The number of new launches is growing and our sense is that demand is increasing significantly across the board.

So what is the real attraction of this product and is this a trend that is going to be fundamental to the development of the alternatives industry in the years to come? In terms of attraction, we believe this is another example of two trends that we have spoken of in the past: the continuing institutionalization of the alternative investment markets and the search for an alternative to traditional equity and fixed income exposure. On the former, the UCITS trend is, in part, a mirror image of its institutional cousin, the managed account, which has received increased attention post crisis. In reality, the UCITS concept is very different but does give a level of protection for investors with regard to transparency and liquidity. Moreover, it is delivering a range of what are billed as absolute return products to some institutions/HNW individuals/the upper end of the retail market which are desperate in their search for an alternative to volatile equities and low yielding credit.

From the managers’ perspective there are two very important drivers. First, there is widespread demand which contrasts with highly concentrated allocations in the institutional market, so UCITS appeal to both the ‘great and the good’ of the hedge fund industry and to managers who are not quite in the mainstream trophy institutional flows. Secondly, and of prominent importance to the non-European firms, UCITS act as a form of regulatory arbitrage, offering an exemption from the forthcoming AIFM Directive, the EU law that threatens to potentially limit the activities of foreign managers in Europe. We have already seen the arrival of a number of prominent members of the US hedge fund industry on the UCITS scene and following a recent Freeman & Co. visit to Asia we are aware of a number of Asian hedge fund managers that are preparing European UCITS launches – some of which we expect to be highly sought after.

Part of the legislative requirement for a European base can be satisfied through the use of a bank or independent platforms. Whilst this is the favoured route of some of the larger or more successful non-European firms we see it as another reason why non-European firms might consider co-branding or even mergers with European based firms. In short, the UCITS theme is of real importance now and will remain a focus for most of our clients.


History of valuations

Over the past year stock performance of public asset managers has been mixed for traditional and alternative asset managers. While the S&P 500 Index returned a positive 14.4% over the last year, traditional public asset managers underperformed the index, earning an average return of negative 1.0%. Alternative asset managers slightly underperformed on average, yielding an average return of 11.6%. The stock prices of the traditional asset managers that faired the best and worst over the past one year period gave an average return of 5.1%

Schroders was the best performing stock of the traditional asset managers, returning a 47.7% return over the previous one year period. Conversely, Calamos Investments yielded the worst return, down 34.2% from this time last year. Much of the increase in stock prices occurred in the second half of 2009 with average performance among traditional managers down 16.5% in the first half of 2010.

Among alternative managers the smaller firms (measured by AUM) displayed the most volatility in stock price. Polar Capital Holdings outperformed the market, earning a 54.1% average return over last year, while RAB Capital yielded the worst return, down 34.8% from last year. Similar to traditional asset managers, much of thegains occurred in the last half of 2009, with 2010 YTD average stock prices down 14.0% thus far.