What’s the Alternative’s Alternative to M&A?

A closer look at the dearth of M&A

Originally published in the September 2009 issue

The traditional asset management industry has in times of stock market downturns often reduced itself to a slash and burn mindset, where even core funds are merged or discontinued; where all non-essential tasks (transfer agency, fund administration, etc) are outsourced to global custodian banks, and where the huge acquisitions and mergers that have been initiated have often been more about economies of scale rather than the strategic rationale of finding new capabilities in markets or product offerings. This mindset is hardly surprising in the long only world where – with a typical 30% net margin in the good times – a 10% reduction in the stock market can lead to a one third reduction in profit if no action is taken to trim costs at the same rate.

To date, the M&A activity in the asset management industry has mostly been in the traditional space (e.g. the sale of the UK asset management business of Société Générale, and those of BGI and New Star, and the ongoing sale process concerning Insight). One must therefore ask the question: if the traditional world is once again looking at M&A and the same pressure on profitability caused by falling assets under management (AUM) and lower performance fees are affecting the alternative asset management industry, why have we seen so few deals in the alternative world?

Why no M&A in the alternative world?
There are of course many reasons, some of which will be very specific to the circumstances of the individual companies concerned. However, based on my own experiences of advising both traditional and alternative asset managers, here are my own personal top five:

1. Dominant management personalities;
2. The unpredictability of AUM;
3. The unpredictability of performance fees;
4. The reliance on one individual;
5. The complex nature of the business.

The alternative industry has more than its fair share of extremely talented, confident and wealthy individuals, perhaps the ideal people to be self-employed entrepreneurs. These same attributes may make them less likely to be employed by a large bureaucratic multi-jurisdictional, multi-product offering financial behemoth. It is telling that whilst the individuals we interact with in the alternative space are interested in M&A, everyone has only seen themselves as the predator and not the prey. Many potential deals will therefore simply never get past the first tentative discussions as disagreements as to whose name will be first above the door will quickly end any chance of a long term business combination. It has been interesting to watch how many managers have wound up operations and returned funds to investors rather than try to salvage some enterprise value in the organisation they have built up by selling it to, or merging with, another manager.

It has been painfully true for many organisations over the last year that their customer base has been less than faithful to any long term investment strategy that they may have once had. In the headlong rush to exits following the collapse of Lehman Brothers, many high quality hedge fund managers have seen their AUM decimated by the “ATM effect”, where investors have only felt safe holding either cash or government securities, and have been willing to redeem any investments that didn’t have gates attached to them, irrespective of the relative performance or liquidity of the fund.

As a potential acquirer or merger partner, concerns about the stickiness of AUM have been the single biggest killer of potential deals once the first date has been successfully negotiated. In the future, potential acquirers will no doubt assign different valuations to the investor base, with the higher values assigned to institutions and then decreasing through high net worth investors eventually down to fund of funds.

For most alternative managers, the management fees (in some cases only just) pay the bills, but it is the performance fees that add the real attractiveness to the business. It can be very hard therefore to hear that a potential partner attaches very little value to this quality, as their sheer unpredictability makes them difficult to anticipate and hence value. It is now even more problematic to value historical performance fees with so many funds significantly below their high water marks and certain investment strategies in jeopardy of disappearing.

So after pointing out that the owners of alternative asset managers are unemployable, I am now going to imagine them being run over by the proverbial bus. There are many businesses where the alpha generating capabilities lie deep within the brain of one or a few select individuals. For anyone entering into a partnership arrangement with such a firm, they must have either a strong belief that the individual(s) can pass on that alpha generating knowledge to his current and future colleagues, or they don’t care and simply want the immediate benefits of the AUM boost in their business.

I am sure that there are many people now wishing that if they hadn’t fully understood the product, they shouldn’t have bought it. If the potential deal is one between similar businesses looking for a way to boost AUM and cut costs (fund of funds are the obvious sub sector of the industry where this should be happening), then the complexity of a similar business shouldn’t hold much fear. If on the other hand you are looking for new markets and products to expand into, the potential pitfalls for those who haven’t fully done their homework are significant.

What might force more M&A?
The answer, in short, is money. As the future flows of significant new money into the industry will come from institutions, managers must adapt to what these institutions want.

Institutions are likely to be less focused on historical performance numbers and more concerned about the safety of their assets. This will mean that they will focus on the governance structures of managers; their risk management policies; procedures and systems, their internal control structures, and how they have been verified (e.g. by internal auditors, or by SAS70 or AAF reports signed off by independent reporting accountants). We will therefore continue to see most of the institutional money flowing to those managers large enough to afford to have this infrastructure in place.

The existing business model of many an asset manager, whether they have outsourced some or all of these services will be to have administration, finance, compliance, legal, and risk management focused on running one product class and one business structure. Whilst it won’t be as simple as keeping all the AUM when two businesses combine and cutting out all of the costs associated with one of the predecessor businesses, there is certainly scope to reduce overall middle and back office costs by up to 80%.

The vast majority of managers in the sub $1 billion mark, will have to allocate an increasing proportion of their revenue to building an institutional infrastructure. They will increasingly get caught in the unenviable situation of needing more AUM to subsidise this investment, but won’t be able to get the AUM until they have made the investment. These managers must consider how quickly and efficiently they can build such an infrastructure, and the increased AUM and higher net margins achieved from combining two businesses will surely not go unnoticed.

The bad news is that managers who don’t wish to target institutions or have all (or even some) of the structures outlined above, will still face the simple fact that their cost burden will increase. It seems obvious that whatever form the EU’s Directive on Alternative Investment Fund Managers takes, it will mean increased regulation, disclosure and transparency – and hence cost – to the industry.
We have already seen the FSA impose higher Individual capital guidance measures of how much additional regulatory capital an asset manager must hold in the traditional world if they have concerns about the governance structure or internal controls, and it is only a matter of time before these measures start trickling down to the alternative industry.

What does the future hold?
For those who believe that the alternative industry will return to its roots of managing money for high net worth individuals looking for unconstrained alpha generation, then the answer has to be, not a lot. Alternative managers will remain predominately small, with the owners of the business being the individuals making the investment decisions, and everything else being outsourced to third parties that specialise in providing administration, finance, compliance, legal and risk management services etc. Their one-product business will continue to manage money in the $50 million to $500 million range and will grow or fail based upon the performance of that one investment strategy.

For those who believe that the alternative industry will quicken its pace to become more institutionalised, then the owners of the industry will need to face up to some hard truths about what type of business they are going to build. I personally don’t expect large scale consolidation of the industry for the reasons outlined above, although there will be some who will be willing to enter into transactions to diversify their product offering and to build a longer term business model.

I do also expect that there will be those managers who see the need to become more institutionalised but yet still wish to maintain some degree of independence. They will in time seek out larger, more diversified institutions which – in return for an equity stake – will provide their brand name, distribution capabilities and expertise in governance, risk management and compliance to allow the alternative manager to grow their business in a structured manner.

Stuart McLaren audits and advises a range of traditional asset managers as well as hedge fund and private equity managers and their funds. He has led the financial and regulatory due diligence on a number of transactions in both the traditional and hedge fund sectors.