Marriages Made in Heaven or _____?

US consultants Callan Associates has studied the outcome of 125 investment industry mergers over a 15-year period and asks: for whose benefit? Ann de Luce reports

T he financial industry started a trend several decades ago that continues today with increased vigour: the merging of investment management firms. From the early 1980s through the late 1990s, more than 125 institutional investment management firms merged1,# and today manage a reported $2trn. While three-quarters of that activity is based in the US, there are notable public overseas acquisitions such as that of SBC/ UBS/Brinson. The stakes are rising, with larger firms now buying each other. This changes the rules as an overlap of product becomes an issue. The mergers do not appear to be slowing down; some economic forecasters predict that over the next five years, 70% of all investment management firms will undergo ownership changes.

Do these 'marriages' benefit all of the parties involved - the buyers, the sellers, their employees and most of all, those that support these businesses, namely the clients? Callan followed the track record of merged firms during this 16-year period to answer that question. In this report, Callan addresses the Who, What, Where, When, Why, and How of investment management mergers. Are these marriages made in heaven or, well, somewhere less pleasant?

Why Did the Marriage Occur? For the acquirer, investment management mergers and acquisitions are attractive as lucrative, but potentially complex, forms of business growth, although prices can be steep. Status is another appealing factor for many new parent companies - a 'keeping up with the Jones's' philosophy. Perhaps many companies feel they can't stay in the game if they aren't acquiring or haven't achieved some 'critical mass'.

Many of these companies view acquisition as the opportunity to increase scale and presence quickly across multiple product markets or geographic diversification. In the cases of most mergers, they acquire a tested and funded product-line track record that would otherwise take years to build up. Finally, acquisition offers the opportunity to access additional distribution channels, whether it is the mutual fund arena, 401(k) business, non-US-sourced assets or other high growth distribution channels.

For the acquired, these marriages make sense for a variety of reasons. The investment management industry has matured to a point where many founders were approaching retirement age and still owned a majority of firms' equity. These founders wished to provide future incentives for primary and secondary professionals so that those 'assets' that ride the elevator down every night will continue to ride it back up again the next morning. Finally, firms hoped to expand business opportunities, or believed they could gain strategic advantage by pooling resources.

Who's Tying the Knot? Callan tracked mergers of 125 institutional-oriented firms that merged from 1982 to 1997, which accounted for $2trn in predominately US dollars. The left pie chart in Figure 1 illustrates the number of transactions by new parent type, while the right pie shows the acquired firms' assets in today's dollars.

A series of these transactions dominated the market, such as United Asset Management (UAM), with a quarter of the marriages that occurred. Financial services entities also purchased 30 firms over the past 16 years.

Callan also reviewed the amount of acquired firm assets as of year-end 1997. Though UAM transactions made the news most often, its deals actually didn't comprise an overwhelming percentage in terms of assets under management. In fact, insurance companies dominated the merger dollars. The average sized insurance company transaction was approximately $43bn versus UAM with $4.5bn.

When Was the Big Day? As shown in Figure 2, the number of transactions per year have increased in the last three years and comprise one half of the marriages over this 16-year period. Before that, the transactions were fairly evened out from year to year.

Callan's research into this annual data shows that the stakes have been getting bigger over time, with large firms now buying each other. With this in mind, instead of complementary product offerings (and people), a consideration historically, overlap can be a factor in evaluating the success of the merged organisation. Thus, many marriages need to prove themselves. This brings about a host of new issues and means many different decisions need to be made with respect to evaluating which group of products and people will prevail.

As an interesting side note, of the 125 firms tracked, more than half were young: between five and 20 years old, and 20% being less than 10 years old. Many firms have been in existence a relatively short amount of time with a sizeable number of firms flipping ownership in as little as four years.

Where are They Located? Though the majority of transactions have been US based, there have been some notable public overseas acquisitions. As Figure 3, illustrates, five organisations have a US parent acquiring an overseas firm and managing US money. One example is UAM purchasing Murray Johnstone. On the bottom left, non-US firms acquire US managers, such as Dresdner Bank acquiring RCM.

How Did They Fare When the Honeymoon Ended?

Once the buyout transpired, Callan sought ways to measure whether ownership expectations were borne out, particularly once the honeymoon period ended. With each merger, both sides have expectations. For the marriage to be successful, all parties need to see benefits at each stage of the transaction. At the onset of the acquisition, the acquired hoped to see increased resources in current product lines and back-office services. They expected the acquirer to lend their expertise in other product areas and to add to the product lines. Finally, they expected assistance in multiplying current distribution channels. Whether in new marketplaces, such as mutual funds or non-US sources, or broadened parent company sales opportunities, the goal was to diversify and grow the revenue stream.

With the original owners of the new company often getting cash out of the deal, remaining professionals need appealing compensation to remain committed and driven. Retaining personnel is crucial for the merged company if they are to continue to provide expert management of their portfolios, service current clients and continue to build the business.

Measuring Marital Bliss In an effort to determine whether or not these merger marriages were heaven-sent, devil-bound or somewhere between, Callan identified four ways to quantitatively measure whether the new organisation was a 'happy' one, i.e., if it was successful after the change.

First, Callan analysed portfolio performance to determine if investment professionals were concentrating on portfolio management, or if some or most of their attention was focused on other business issues. Callan also reviewed two forms of growth: asset growth and client growth, as bellweathers of increased business, current client satisfaction (as evidenced by additional funding) and/or expanded distribution channels.

The fourth variable chosen for measuring the organisation's continued success, was the post-merger job satisfaction of the purchased firm's personnel, as investment management is a people business. Although personnel data were limited, we were able to count the number of professionals who remained with the firm after the big event. Assessing the impact of specific individuals departing and/or remaining with a firm is a vital step in the evaluation of a the success of a merger; however, such case-by-case analysis goes beyond the scope of this paper.

Callan's analysis of these marriages incorporates several components. 'Ownership change' is defined as an instance where in any institutionally oriented investment management firm the current owners have been bought out (nearly) entirely by a third party organisation. Most of these firms were owned by their investment professionals. The time period analysed for these changes was 1982 to 1997. For this universe, Callan identified firms offering traditional equity and fixed income products. Also, some of these firms were counted in the study more than once if they underwent more than one ownership change. The goal of the analysis was to determine if the ownership change had a positive, negative or no influence on the firms' business success going forward.

The performance universe included one traditional domestic equity and domestic fixed income product, and if available, an international equity product, from each of the 125 firms. In an effort to neutralise investment style influences, Callan ranked each product's annual performance relative to its appropriate peer group. Each set of performance rankings was baselined to isolate annual performance prior to and subsequent to the year of ownership change. Each year's ranking results were then averaged to obtain the information shown in Figure 4.

Each dot on the graph represents the average of the combined product rankings for the years preceding and succeeding the ownership change. A first percentile ranking is the highest and 100th the lowest. The right side of the graph represents the years prior to the ownership change and the left side represents the years after the change. The dashed line highlights median performance.

As shown in the middle of the graph, the first year before the ownership change, managers on average achieved a 48th percentile, or slightly above median, performance ranking of their products. The year following the change, that performance ranking rose to the 38th percentile.

One conclusion that may be drawn from these two data points is that while managers are undergoing an ownership change, their performance tends to soften, perhaps because their focus is on the business aspect of the change. They can get back to focusing more on portfolio management once the ownership change is behind them and thus raise their relative performance.

Figure 5 overleaf, which covers the tracking period for domestic equity products, illustrates that relative performance just prior to the change is ranked on average in the 47th percentile and then jumped to the 41st just after the change. A few years down the road, however, this product returned less than the median performance five out of 10 times. As the chart shows, the performance was not quite as favourable after the change as it was before. Is it the organisation structure - the reporting or product lines - that takes away from the investment managers' ability to attain the good performance they once enjoyed? A case-by-case analysis can reveal the answer to this question.

There have been more transactions in recent years and data of post-ownership change is limited. What Callan's data reviews is how transactions were structured in the early 1990s, not necessarily how they are structured now. When Callan first ran these numbers several years ago2, there was a more pronounced trend of good performance before the change than afterwards. With the revised data presented in this document, one could conclude that the trend now is that these transactions are improving because the performance results before vs after the change are not so dramatically different as were experienced in previous studies#.

As Figure 6 illustrates, domestic fixed income relative performance is mixed. However, performance is more consistent before the ownership change, but fluctuates more after the change.

What Does This Performance Analysis Mean?

These data suggest that four or five years following a merger there is a dip in relative performance. Plan sponsors, pleased with the burst in relative performance following a merger, could get disturbed at this point and take corrective action. To do so would cause them to forgo a subsequent period of good relative results. As long as the people, philosophy and process remain intact, the patient buyer will likely be rewarded.

Asset & Client Growth Callan measured two bell-weathers of successful organisations: the rate of net asset and client growth with available data; this information is illustrated in Figure 7. There are two sets of information reviewed. First, total firm net-asset growth is in green squares, and institutional client growth is in orange circles, with each value representing change or growth from one year to the next.

For example, two years prior to the change, assets grew at a 30% rate, while the number of institutional clients grew by nearly 18%. Asset and client growth rates were relatively high before the ownership change, which is likely a reason why the parent company was interested in buying them in the first place.

During the year of the change (in the middle of the graph), the rate of growth of clients declined faster than that of total assets.

A surprising result is the decline in the rate of growth for both sets of data after the buyout occurs.

Perhaps the firms had completed their big growth spurts and settled into a normal pattern at the time of the change, or maybe something about the new organisational structure is impinging upon their ability to grow. As stated previously, both partners in the marriage (as well as the marketplace) needed to see their expectations borne out; one of those expectations is continued expansion. These firms have continued to grow, but not at the rate previously enjoyed. Nor is there evidence, in terms of net new assets or clients, of improvements in distribution channels, asset gains, or the diversification of the asset base and other business opportunities that would encourage the growth of the firm.

Personnel Growth Firms' personnel is another component of the data reviewed. Asset management is a people business. The stability of key personnel matters to clients and also helps determine the ultimate success of the marriage. Figure 8 represents the average year-on-year growth in head count.

The right side of the chart shows that just before the ownership change, the number of personnel climbed. Again, these were often firms with growth potential - a major reason the parent companies were attracted to them in the first place. During the ownership change there is a fairly significant decline, as can be expected. After the marriage, there may be a realignment of personnel, producing an increase in staff. This is not a surprising result, given a firm might not grow much during the year of change. However, just after the change, the new parent may allocate additional resources to the firm. Senior people, in particular, would want to remain to see any benefits of the new organisation, such as pay-out contracts.

What are appropriate reactions to 'impending' marriages? Plan sponsor clients should carefully weigh the costs and benefits of an account transition, a process which can be expensive, versus the continuation of the relationship with the money manager undergoing an ownership change. Ask questions before taking any drastic measures such as termination. If a plan sponsor were doing a search today, would this manager qualify to meet the search criteria? Plan sponsors should have guidelines in their fund's investment policy statement which address such issues as expectations about ownership change and include broad termination guidelines. This document can lend objectivity to what can be an emotional analysis. Managers undergoing change should be placed on a watch list. This will put them on alert if nothing else, and might encourage continued focus on expertly managing portfolios.

A plan sponsor should set parameters for the changing manager and evaluate the results. Upon completing this full due diligence, then action should be taken. In today's environment of big firms acquiring big firms, the associated issues of overlap in product and people may necessitate more rapid decisions be made and action be taken than perhaps was necessary in the past.

Important Due Diligence Criteria There are several important issues to cover during the abovementioned due diligence phase. We have covered the benefits to the investment management firms of the merger, but what are the benefits to their clients? Managers should be able to clearly delineate from the beginning how their clients will benefit. If they find that their clients do not see benefits, they will loose business.

The client should have a clear understanding of the strategic rationale of the change, including new ownership structure and reporting lines. What is the delineation of responsibility for both investment and business management? Who is reporting to whom? How do product lines fit within the corporate structure and culture? This is important, particularly in this age of giants acquiring giants, which may mean that not all of the overlapping products prevail.

Assess the investment versus the business management of the new firm. Is it a cultural fit? Take a proactive stance to find out, both internally in the new firm, as well as externally. Interview both parties independently: nothing is more telling than getting different answers to the same question.

Clients need to understand the incentives for primary and the (at times forgotten) secondary professionals. The new firm needs clear long-term wealth-building opportunities for all professionals, not just for the key owners. Employment contracts can work both ways, ensure stability or guarantee jobs. Confusion on these issues leads to turnover of clients and people.

Plan Sponsor Client Courses of Action: It's an individual decision Ultimately, the decision of what to do with the new firm is based upon individual plan circumstances: there is no one right answer. There are several courses of action a plan sponsor can take:

Place the firm on a watch list. Allow the firm to continue to manage assets until a better determination can be made on the success of the new ownership structure.

Depending on the circumstances, use an outside party (consultant or investment manager) or in-house staff to monitor the merged firm's situation for further development.

Allow the acquired manager to continue while conducting a contingency search for a possible replacement, should it become necessary.

Terminate the firm, but only after conducting a search for a replacement.

Only in the event of extreme circumstances, terminate the firm immediately, transfer the assets to a transition manager to maintain asset exposure while conducting a search for a replacement.

Conclusion The nature of such organisational changes have caused Callan to proceed with caution in evaluating these firms, but definitely to not forget that there are many quality firms in the marketplace which have undergone change. On average, though, firms are slightly worse off from a performance ranking and net asset growth perspective, as a result of the buyout.

Ultimately, each ownership change should be evaluated with proper due diligence and thorough analysis, but also, experience in dealing with these types of changes, and with a whole lot of intuition. In the end, it's more of an art than a science at properly evaluating the impact of an individual organisation's ownership change on its potential success in the future.

1Represents investment firms with predominantly US-sourced institutional assets under management where ownership change impacted more than 50% of the original ownership

2Callan Letter article, 'Investment

Management Mergers,' Fall 1996

Ann de Luce is senior vice president responsible for research and education at Callan Associates in San Francisco