Into the third generation
The global investment management industry is entering a period of rapid transition that presents its participants with formidable challenges, but also great opportunities. Firms that are committed to success will have to initiate a significant change in management thinking. European firms, like their non-European counterparts, will simultaneously compete to secure their domestic market share while attempting to successfully grow their business across borders.
We characterise this new environment as the third generation of investment management. We derive the phrase ‘third generation’ from the US market, though the evolution is relevant globally. The first generation in the US, from the early 1970s to the mid-1980s, moved the industry towards a professional footing; the second has been marked by rapid growth but also by multiple inefficiencies. To prosper in the new climate, asset managers must aim to become what we call ‘complete firms’, understanding that efficiency, professional business management, and the highest quality manufacturing and distribution standards are the factors most critical to success.
The catalysts of change
Three primary forces are driving this rapid industry maturation: expectations of a more normal return environment, rapid advances in technology and globalisation. These forces are creating greater competition as the supply of quality investment management services catches up to global demand.
A reversion to more normal rates of return will force firms to address the excesses induced by a long bull market. Many firms have developed multiple inefficiencies, including: overstaffing (in particular, over-developed investment manufacturing capabilities relative to distribution), under-investment in technology, incomplete business models, high fixed costs and a proliferation of mediocre, unprofitable products.
Technological advance is facilitating the instantaneous dissemination and retrieval of information. This is allowing buyers and intermediaries to arbitrage the quality differences between products and enabling investment management firms to deliver more specialised and sophisticated service to their target clients. Technology is also allowing investment manufacturing functions to do greater things with significantly less human capital.
Globalisation is now a reality as firms look across their borders to sustain growth. More sophisticated buyers and intermediaries are driving best practices that are fast becoming universal, superceding local market norms.
Understanding the implications
Leading firms must recognise that there are four principles that define the third generation environment:
1) The client-partner-competitor (CPC) paradigm connects us all. The traditional lines of competition are no longer clearly defined. Leading firms are interacting with other market participants as clients, partners, and competitors simultaneously, forging strategic relationships with each other, in the form of alliances, joint ventures or outsourcing arrangements. This paradigm is being driven by buyer demand for the best products and service.
As a result, leading firms recognise that focusing on core competencies, or ‘do what you do best,’ is vital to success. They concentrate on functions where they have the greatest expertise and leave the rest to others. Some are adopting the model of single-platform manufacturer, focusing on specialised asset classes or investment approaches with manufacturing quality as their defining quality.
Other firms are adopting a distribution specialist business model, using one or more proprietary distribution channels to supply primarily third-party investment products on an open architecture basis. The distribution specialist has minimal or no manufacturing capabilities of its own, preferring to focus on its competitive advantages of managing client relationships and delivering advisory services.
2) Product quality reigns. Successful manufacturers must create products that specifically articulate the risks to which they are exposed and consistently deliver returns appropriate to that level of risk. The market will increasingly favour managers with transparent, consistent and repeatable investment processes that incorporate risk management and attribution feedback mechanisms.
As a consequence of this increased scrutiny, sophisticated buyers and intermediaries will employ a more rigorous ‘risk budgeting’ approach to investing. Investment managers’ skill and risk allocations will be scrutinised more closely. Buyers will supplement low active risk core strategies with ‘satellite’ allocations to managers that take and are rewarded for active risk.
3) Client segments matter. A firm’s ability to understand the needs of its existing and potential clients becomes critical in the third generation. Historically, investment management firms have been product-driven, first developing products and then finding the markets in which to sell them. As growth requires taking market share away from competitors, firms must develop strategic marketing skills to create products from the perspective of their clients’ preferences.
4) Efficiency energises true talent. Talent in this industry is most productive when unencumbered by bureaucracy and when empowered by leading technology. Top professionals will seek highly efficient organisations. To remain competitive in the search for retention of true talent, many firms may be forced to reduce staff in certain functional areas (especially investment manufacturing).
However, the key to success or failure in retaining rare talent is meaningful equity ownership. This applies equally to independent firms and to those that are part of larger financial institutions, where equity may be offered in many forms. Any incentive plan must be broad enough to appeal to the next generation of talent, not just current senior management, and ownership agreements should remain valid in the event of future mergers or acquisitions. Importantly, the CPC paradigm and the intellectual capital-intensive nature of investment management will continue to support low barriers to entry for the most talented professionals.
The complete firm
Successful third-generation investment companies must be complete firms. Complete firms will achieve a balance of excellence between manufacturing and distribution, whether or not these capabilities are owned or sourced from outside relationships. Manufacturing must display clearly defined added value and the highest, global standards of investment process. Distribution must be under-pinned by strong channel management and strategic marketing skills.
A critical defining quality of these firms is excellent business management, which is essential to fully developing and retaining two primary assets: people and competitive advantage. Vision and leadership, strategic planning and journey management, effective corporate development and alliance management, and human capital and knowledge management are just some of the capabilities required.
While complete firms will share a common set of characteristics, this does not imply that they will be homogeneous. There are four business models that we believe will be viable in the third generation. We’ve already described the distribution specialist and single platform manufacturer models. Two other viable business models are the franchise conglomerate and the financial holding company. The franchise conglomerate incorporates multiple independent investment platforms that share a common distribution capability. Financial holding companies are collections of stand-alone complete firms that forgo the potential economies of shared resources, but also the challenges of integration.
For European financial institutions seeking to expand their presence internationally, whether by acquisition, partnership or alliance, complete firms are attractive since they are setting the highest standards. They are also scarce. Only a few firms have begun to systematically prepare for the new generation and it requires diligent research to track those that have recognised the implications and aligned themselves accordingly.
The best advice for prospective global market competitors may be ‘Do your homework well’. The opportunities are rich and plentiful for those who are best prepared.
Christopher J Acito and Kevin P Quirk are managing directors at BARRA Strategic Consulting Group in Darien, Connecticut