Investment management is the ticket to success in financial services today. Everybody wants a piece of the action—and for good reason, it seems. The US mutual fund business has grown by 19 percent per year over the past five years, while the white-hot 401(k) market has expanded at 14 percent a year. Even the supposedly mature defined benefit market continues to grow at an annual rate of 6 percent, despite negative real cashflow.

And just look at the returns. Management fees in mutual funds have risen rather than fallen over the past decade, in spite of massive inflows to the industry. Successful institutional managers enjoy ROEs of over 40 percent. Is it any wonder that so many companies want in?

The desire to enter or grow has led to unparalleled M&A activity. In 1995, over 80 deals were completed in investment management, at an estimated total value of $6 billion. In 1996, more than 70 deals worth in excess of $10 billion were completed.

Many look to acquisition to meet a genuine need, but there is no guarantee that the expected gains will materialize

For many established players and for those seeking to build a position in investment management, the pressure to acquire is intense. It applies to players across the whole spectrum of markets—retail mutual funds, individualized investment management, and traditional institutional and defined contribution—and to the full range of firms, from diversified financial institutions to conventional stand-alone investment houses. While many look to acquisition to meet a genuine need, there is no guarantee that the expected gains will materialize. Many obstacles stand in the way of value creation, not least of which is the difficulty of managing a combined entity effectively. However, the likelihood of success can be increased by several measures: a well-articulated strategic rationale, a creative deal structure, and the pursuit of organizational excellence.

The pressure to buy

Competitors cite many reasons to acquire:

"We need to be in this game"

Demographic trends in most developed countries, the privatization of pensions, and the increasing acceptance of investment products among consumers suggest that strong—if not blistering—growth should continue in the investment management business. Many traditional diversified financial institutions crave the stability of earnings and high returns on equity with which it is associated. As banks and insurers run out of ways to generate substantial earnings growth, the high fee-based incomes of investment management will seem more and more attractive.

"We must be big to survive and thrive"

The retail mutual funds and 401(k) sectors of investment management are becoming increasingly dominated by large players. The need for scale is driven by spending requirements—primarily in the areas of brand building and advertising, technology capability, and product depth. Together, the three largest mutual fund complexes that also compete heavily in the 401(k) business are estimated to have spent in excess of $500 million on advertising in 1995. As the demand for international product grows, the cost of supporting the research, information, and portfolio management capabilities of an international operator is raising scale requirements even for traditionally defined benefit players.

"If we don’t buy it, somebody else will"

Now that many principals or founders of first-generation investment firms are preparing to cash out, something of a "prevent our rivals buying it" mentality has developed among prospective acquirers. This tendency is being exacerbated by the arrival on the market of larger, more branded firms whose current owners are trying to take advantage of the sellers’ market.

"Don’t want to keep all our eggs in one basket"

While many managers have established solid positions in one or perhaps two distinct sectors of the market, few have capabilities that extend to all asset or client sectors. Acquisition is often seen as a quick way to create a successful position across multiple products and markets. The need to be in multiple markets is felt most keenly by the traditionally defined benefit players, many of which lack a strong retail or defined contribution capability. Morgan Stanley’s recent purchase of Van Kampen American Capital and merger with Dean Witter exemplifies this reaching out to new sectors.

Diversification is also taking place geographically, with many firms looking to extend both the investment and the sourcing of funds beyond their traditional regions. The Invesco/AIM combination illustrates such an approach to building geographic coverage.

"Too late to create our own brand; must buy one"

As brand strength becomes more important, especially in the retail and 401(k) businesses, many institutions are looking to acquisition as a way to achieve brand recognition quickly. Believing that the time and resources required to build an effective investment brand are prohibitive, these institutions prefer the certainty of buying an established brand.

"Takes too long to build our own record"

Finally, it can take at least three to five years for a fund or management firm to build a credible retail record that will be rated by such organizations as Morningstar and Lipper and recognized by pension consultants. With an acquisition, on the other hand, the performance record comes as part of the purchase. Franklin Templeton could have invested up to five years in building a domestic equity capability with a good performance record, but by acquiring Heine Securities, it was able to begin selling domestic equities immediately through its current channels.

The difficulty of creating value

However valid and rational these motives to buy may be, there is no guarantee that acquirers will be able to create sustainable long-term value. Indeed, the jury is still out on many recent acquisitions. Why?

"Costly bet"

Investment management firms are extremely expensive. Retail firms sell at an average of 1.5 percent of assets. Several transactions, such as Franklin Templeton/Heine Securities and Invesco/AIM, have been much more costly, at 3.6 and 2.7 percent of assets respectively.

"Source of value rides the elevator"

Despite all the talk of technology and investment process, asset management is a people-driven business. Key managers matter. In the institutional arena, the stability of a management team is a key factor for success; any turnover can be fatal. Many pension consultants will refuse to recommend a firm that has undergone a change in ownership because of the possible turmoil.

Losing a high-performing money manager in an era when strong investment performance is a prerequisite of success can erode a great deal of value

Although individual manager "brands" tend to be less important in retail, they can still make a difference, as they did when funds flowed out of Magellan following its mediocre performance and the "unplanned" departure of Jeff Vinik. The earlier departures of managers like Peter Lynch were much more orchestrated in the press to minimize investor wariness. Similarly, the fact that Heine Securities’ success is inextricably linked to Michael Price reportedly scared off many would-be buyers. Losing a high-performing money manager in an era when strong investment performance is a prerequisite of success can erode a great deal of value.

"Oil and water don’t mix"

As many failed attempts to merge divergent cultures attest, achieving any degree of value-added integration in investment management can be fraught with peril. Much of the value created by a merger derives from the opportunity to build on a culture’s strengths and eliminate its weaknesses, yet the distinctive culture and operating norms of an investment firm are often critical to its success. Faced with this paradox, many firms have responded by avoiding integration, opting to forgo some benefits in order to ensure stability. Among them are Franklin Templeton/Heine Securities and the Swiss Bank/Brinson Partners arrangements. How painful the outcome can be if cultural issues are not resolved is illustrated by the loss of key managers from The Boston Company Asset Management in 1995.

"Can’t cut to win"

While mergers in industrial and retail organizations provide opportunities to reduce or eliminate the duplication of activities, rationalization is unlikely to bring substantial gains in investment management. Administrative functions tend to be limited, and physical locations are seldom an important element of cost. In general, the biggest expenses—portfolio managers, research, sales, and marketing—are core to the business. As a result, mergers do not necessarily produce any major savings.

One exception may be the opportunity to consolidate back-office functions such as fund accounting and shareholder services. However, generating cost savings will demand extensive systems capabilities, and any benefits will be limited, since the option of outsourcing is available even to small players.

"Hard to make 2 + 2 = 5"

If cost cutting isn’t a source of added value, synergies may be. In some circumstances, the whole is clearly greater than the parts: for example, when a firm can plug a new product into an established distribution system. However, many mergers don’t present any obvious opportunities for synergy. While the merged operation may be more diverse, cover more geographies, and offer more products, there is no guarantee that its revenue will grow faster or that its profits will be higher than they would have been for the two separate entities.

"Not enough business people"

Most investment management firms have achieved success through technical rather than managerial excellence. Historically, their narrow focus and the relative simplicity of their business meant they seldom possessed professional management talent. Many investment houses lack well-established management functions in strategic planning, personnel, and even sales and distribution. To realize value from a merger or large-scale purchase calls for vast amounts of day-to-day management that few investment firms are in a position to execute.

"Salary-cap model doesn’t work"

Finally, no salary-cap model exists to ensure that non-operating owners of investment firms generate reasonable returns. It is not unusual to see a firm’s portfolio managers take home large salaries while its bank or insurance company owner receives only meagre returns. In an industry dominated by stars who are scarce resources and enjoy great freedom of movement, it is difficult for owners to exert their influence and limit compensation even when managers perform badly.

Can success be bought?

Maybe. If large-scale acquisitions or mergers are to create value in investment management, they must incorporate three key measures:

• Identify a sound strategic rationale for the purchase or merger
• Develop an effective deal structure—don’t just focus on getting the deal done
• Put in place an appropriate management model and supporting organization.

All three measures demand discipline and analytical rigor—two qualities that can easily get lost in the heat of doing a deal.

Strategic rationale

What makes some investment management transactions look much more promising than others, despite their high prices, is the strategic rationale behind the deal. As recent cases like Franklin Templeton/Heine Securities and Invesco/AIM illustrate, a sound strategic rationale demands that the transaction in itself create added value (Exhibit 1). In other words, the whole must be greater than the sum of the parts.

Since the acquisition premium is unlikely to be earned back by the realization of economies of scale, value creation must come from revenue generation. As excellence in sales, marketing, and distribution comes increasingly to dominate the industry, it will be these areas that see the greatest value creation. The winners will be those that can answer tough questions such as:

• Will this transaction enhance our position in current or target distribution channels (for instance, by providing a product we need, or a stronger track record)? When Mellon Bank acquired Dreyfus in 1994, for instance, it brought its equity capability to Dreyfus and its channels.
• Will it boost our capabilities in sales, marketing, and distribution (for instance, by providing direct distribution capability to supplement our wholesale expertise, by adding a brand name under which we would like to sell our products, or by giving us access to a world-class institutional salesforce)?
• Can we capture the added value in sales, marketing, and distribution without unduly disrupting our investment processes?

In answering these questions, companies should bear in mind that acquisition is seldom the only way to achieve growth—and that not all growth is good. Many of the rationales for acquisition listed above need to be part of a clearly articulated strategy if they are to be valid. Getting into the 401(k) business to diversify your earnings base away from defined benefit is only worth while if you can still generate reasonable returns after paying the large premium required for a second-tier player or the astronomical premium for a top-tier player.

Deal structure

Whether a company has a solid strategic rationale for an acquisition or not, it may forfeit all of the potential value if its deal structure is unsound. Taking the time to craft a deal that benefits all the main parties is essential. These parties include the investment and sales/marketing personnel whose services will create much of the added value. Good deals will display three attributes designed to mitigate the chief risks associated with acquisitions (Exhibit 2):

• Majority voting control secured by the acquirer from the outset to avert the pressures caused by a lack of control over the acquired entity
• A long-term earn-out clause designed to keep key managers in place until an effective transition plan can be executed
• Operating independence for the acquired entity in those areas where it is strongest so that the entrepreneurial spirit and culture that drive its performance can be maintained.

The relative importance of each attribute depends on the nature of the deal and on the quality of the acquired entity.

Organizational excellence

Effective organization may be even more important to long-term value creation than a sound strategic rationale or a thoughtful deal structure, yet it is the least understood of the three. What any owner of an investment management franchise is trying to do is get the best out of a cadre of investment and sales/marketing/distribution professionals, while simultaneously ensuring profitable operations for itself. This is no mean feat when so much value resides in individuals who can walk out the door if they are unhappy, or at least not play the game as well as they should. The key steps to success include:

• Manage a smooth transition. Given the strong culture of the typical money management firm, the evolution to a new entity will call for careful consideration. Morgan Stanley and Miller, Anderson, and Sherrerd formed a joint transition team that worked in near isolation until many key organizational issues had been addressed.
• Ensure adequate professional management within the firm. Virtually all entrepreneurial industries—from autos in the 1920s to software in the 1990s—have eventually reached a point where technical and functional excellence was no longer sufficient for success. Investment management is no different. The art is to design an organization that ensures professional management without impeding the flexibility and autonomy of existing talent to do what they are best at. Successful approaches include separating operational and administrative activities on the one hand from investment, sales/marketing, and client service activities on the other, and creating separate career paths for management and investment disciplines.
• Migrate from "principal-driven" to "institution-driven" marketing, sales, and relationship management. What constrains growth for many firms today is that one or two people—often the founders—are the main or only drivers of marketing, selling, and client service. Not only does this limit the value to be derived from an acquisition, it also exposes the buyer to the "hit by a bus" risk. A clear development program must be implemented to transfer skills from these individuals to the institution. The need to retain and reward the "mezzanine layer" of middle managers at an investment house works in the buyer’s favor. Anxious to broaden their roles within the organization and achieve long-term economic success, many of these next-generation managers will be willing to take on more of the marketing, sales, and relationship management functions.
• Develop a vision for the integration. While there is no single answer to the question of integration, a model must be chosen. In view of the grave shortage of management skills and the costliness and limited supply of professional sales skills, some integration will be desirable if it can be successfully executed. Seeking to preserve their existing positions and cultures, most firms will resist complete integration; however, new markets will provide an opportunity for instant integration. One successful firm has a series of "boutiques" that operate autonomously in their traditional markets but collaborate closely in new markets. This collaboration includes a shared salesforce for 401(k) and international products and a common product development function. Another less contentious though equally valuable approach involves the integration of back-office activities, where functions such as trading, accounting, and reporting can be merged to achieve operational efficiencies and create a pattern of cooperation. While it will always be traumatic (and not necessarily wise) to integrate investment capabilities, it is important to minimize the duplication of capabilities and look for points of cooperation.
• Align incentives. Most investment management compensation systems are unimaginative at best; at worst, they reward mediocre individual performance without regard to institutional results. Compensation systems should be tailored to link individuals and units to the larger entity and to reward real incremental growth and performance with incremental pay. Tools such as equity (options, restructured stock, or phantom stock) and long-term payouts can be used creatively to align individual with institutional performance.

Some compensation systems reward mediocre individual performance without regard to institutional results

The alternative route: joint ventures and alliances

Wary of the risks and costs associated with acquisition, many companies look to joint ventures or alliances as the way out. Are they right? Perhaps. Many new entrants have pursued this route as a means of avoiding large capital outlays. A well-structured alliance or joint venture may be a less expensive way for a bank to bring investment products to its clients than an acquisition. Foreign firms trying to create a position in the US marketplace might test the waters with an alliance prior to or instead of a full-scale acquisition.

However, joint ventures and alliances can pose even greater challenges than mergers or acquisitions. Lack of specific purpose or shared "skill in the game" can lead to mediocre results. Few joint ventures or alliances have achieved much success in the investment management industry, and many have ended in acrimonious divorce. While many meet the tests of strategic soundness and effective deal structure, they tend to fall short on the organizational requirements of long-term success:

• Clarity of purpose. Alliances often lack an integrating vision of their role in fulfilling their parent companies’ strategic objectives.
• Delineation of responsibility. When contributions from the parent companies are not articulated at the outset, they leave a great deal to be resolved by the newly formed entity.
• Operating independence. The new entity lacks the structural and decision-making autonomy to take action independently of its parent companies.

It is these very issues that make pension consultants reluctant to grant an investment mandate to a joint venture or alliance.

While the odds are stacked against success, a few firms have managed to buck the trend. One example is Rowe Price-Fleming, established in 1979. Its strategic imperative was to market the investment expertise that won Fleming high regard in Europe and Asia through the distribution and marketing network established by T. Rowe Price in the United States. By the end of 1995, this vision had translated into a healthy $22 billion in assets, leaving the organization poised to continue growing on the back of past successes (Exhibit 3).

While sound strategy is one pillar of Rowe Price-Fleming’s performance, another is organizational structure. When Martin Wade was asked to lead the independent entity, he had to surrender his executive position with Robert Fleming’s European operation. The fact that the new entity’s investment activity was based in London while marketing was located in Baltimore clearly delineated the responsibilities of each partner. From the outset, the parent companies agreed not to compete with the joint venture, demonstrating their commitment to its success.

Rowe Price-Fleming has proved it can achieve long-term success; the more recent transatlantic alliance of Gartmore Capital Management and NationsBank appears to be heading in the same direction. Created in 1994, this joint venture was established to allow NationsBank to provide its customers with international investment products and to give Gartmore a distribution platform for its funds in the United States (Exhibit 4). Recently renamed Gartmore Global Partners, the entity has placed special emphasis on the independence of its organization. It has its own CEO and board, and maintains an arm’s-length relationship with its parent companies. Each parent plays a clear-cut role in the venture: Gartmore is the sole provider of international investment expertise, and NationsBank supplies marketing and distribution.

The pressure to buy is evident. But should it be resisted? Creating value through an acquisition, joint venture, or alliance can be extremely difficult. In the end, those that succeed will pay careful attention to detail and maintain the discipline, on occasion, to say no.