It's $3 billion or bust.
Industry experts predict that many managers with less than $3 billion or even $5 billion in fixed-income assets will either bail out of bonds or sell out to a larger firm, because they are unable to stay in business independently with such low critical mass. Such firms will join the ranks of Forstmann-Leff International Inc.; Wilshire Asset Management; Atlantic Portfolio Analytics & Management Inc.; Investment Counselors of Maryland; Brundage, Story & Rose LLC; and Anhalt/O'Connell & Steffanci Inc., all of which left the fixed-income business this year.
Most bond managers with "less than $3 billion in assets are seeing no growth in new assets and no market appreciation," said investment banker Paul Holt, managing director of International Partners Inc., New York. "Smaller and midsized bond managers are at the point of vulnerability, without an easy growth path, unless they're a specialized niche player with excellent performance. It's a zero-sum game for them and it is time for some to throw in the towel."
"It's getting harder and harder for the small manager," said Peter Cheung, chief investment officer of Amervest Co. Inc., Los Angeles, which manages a bit more than $650 million, mostly in fixed income. Amervest doesn't even complete public requests for proposals anymore, relying instead on word-of-mouth referrals for its new business. "There is not much hiring," he said, because bond returns have been so bad and "consultants like to deal with household names," perpetuating a syndrome "where the big get bigger, do more and more M&A, and spin off second-generation firms protected under the wing of the large firm."
Rather than leave the business or sell to a larger firm, he said, Amervest is responding to client demands for diversification and has added indexed equity and balanced management capabilities.
But even selling to a larger company is not a panacea for the problems of bond managers, said Peter E. Bowles, president of Fiduciary Capital Management Inc., Woodbury, Conn., which manages $1.3 billion, mainly in stable value. Acquisition inquiries started rolling in during the company's second year in business, with 11 serious requests in 1998 alone. Ohio National Financial Services, Cincinnati, acquired a 51% interest in the stable-value manager in October 1998, with an option to buy the rest of the employee-owned firm. Fiduciary Capital executives "sought to have our cake and eat it, too, by liquefying ownership," he said. Staff hopes for increased distribution of its products by its parent company have not materialized, as Ohio National has been fairly hands-off.
Fiduciary Capital has been desperately seeking assets because "the mandate size is not the problem. The problem is the firm's size," said Mr. Bowles. "Consultants are creating a self-fulfilling prophecy. A $5 billion minimum under management is a very common criteria of RFPs for searches for mandates of the size we are already managing. So we aren't considered for searches for mandates (of a size) we are already managing," he said.
Bond management will only get harder, as bond markets become more complex, more global and much bigger as developing countries issue more debt, said Kathleen C. Gaffney, vice president and portfolio manager at Loomis, Sayles & Co., Boston, which manages $34 billion in fixed income.
With the market for AAA bonds declining and that for lower credit-quality bonds increasing, money managers will need more experienced analysts in more locations, using more technology to "read through the noise and get down to finding where the values are based on the fundamentals," Ms. Gaffney said. That buildup in infrastructure will be very difficult, if not impossible, for smaller firms, she said.
More bailouts predicted
Peter Starr, managing director, Cerulli Associates Inc., Boston, said he "absolutely expects more bailouts. ... If this market continues, a lot of money management companies will get tired of waiting for a cyclical reversion to bonds. It will be very difficult for core fixed-income managers with less than $3 billion under management to remain independent."
And there will be no shortage of buyers looking to pick up bond assets, he predicted. "There is nothing prohibitive about the multiple, so there is no lack of buyers. It's a good time to be a consolidator," Mr. Starr said, like Pareto Partners, London, which acquired Forstmann-Leff's bond business; Utendahl Capital Management LP, New York, which bought APAM's fixed-income book; or Donaldson, Lufkin & Jenrette Inc., New York, which will absorb Brundage, Story & Rose later this year.
For those companies that remain in the bond business, Mr. Starr, Ms. Gaffney and others, agreed the primary determinant of success for core bond managers will be scale - the size of the asset pool - and pricing. "There are three constants: death, taxes and investment management fees," Mr. Starr said. The odds of smaller core managers being in the top quartile are low, "so it's down to pricing," he said, noting that pricing innovations are changing the models many managers use to price their strategies.
"It will have to be index-like management with the ability to invest globally," Ms. Gaffney said, that will permit core managers to survive.
But specialty niche and so-called core-plus active bond managers, which have the ability to invest opportunistically in high-yield bonds, mortgage-backed securities, emerging and international bonds and other, more exotic vehicles, are poised to do well under changing market conditions, said David R. Brief, senior vice president, consultant and director of research at Capital Resource Advisors, Chicago.
"Those managers who can find an edge through exploiting market inefficiencies to find extra value will do well. There are more managers with more money looking under the rocks, so it's getting harder to find that outperformance. For this, you don't need tremendous scale; you need brain power," Mr. Brief said.
Loomis, Sayles, for one, has beefed up the research staff significantly, Ms. Gaffney said, in an example of the "new economy," "which is based on knowledge. Core-plus is an art form. There's a disciplined process and you do use a lot of technology, but you have to know markets and interpret them. We've really invested in brain power."
An increasing number of plan sponsors are persuaded by the core-plus strategy, but consultant Susan McDermott said she senses a division in the plan sponsor community between "those who are content not to take too much risk with fixed income and stay with core managers, and those willing to let their bond managers add value by taking more risk within their portfolios."
Ms. McDermott, a principal with Stratford Advisory Group, Chicago, warned that the sponsors now wedded to core strategies "may shift in the next couple of years, and it could really hurt managers who have stuck to just core management."
But some core managers are doing well, thanks very much, and plan to continue to offer their less exotic styles.
Chris Scibelli, director of marketing at Metropolitan West Asset Management, Los Angeles, a midsized institutional bond manager, said: "Our opinion is that firms don't need to do core-plus to outperform. You can get the return without the risk." MetWest often is included within core-plus searches because performance is similar, he said, but MetWest's managers achieve the return with duration, yield curve and sector positioning, combined with bottom-up strategies. MetWest manages $9.5 billion in fixed income.
Sticking to core
Another, much smaller bond manager, Richmond Capital Management, Richmond, Va., has stuck to the same core bond style throughout its 18-year history - managers there invest only in securities rated BBB or higher - but has been "getting more efficient each year as technology improves," said William Schultz, managing director.
Mr. Schultz, a portfolio manager, said the firm has been using trading data gleaned from its Portia back-office system to analyze the yield curve positioning, diversification and sector contribution within its core bond portfolios, "We know where the risks are in the portfolio relative to the index. We are better able to predict what the portfolio will do under certain market conditions and take corrective action faster. It gives us a greater measure of confidence about our process," he said.
The vast amount of information available on the Internet also has helped this smaller bond manager, which has $3.3 billion under management for a mostly institutional client base. For instance, portfolio managers get Wall Street information faster and easier, as well as getting brokers' inventories by e-mail, which lets them quickly match their needs with available supply of bonds. Also, Free Edgar provides financial statements instantly, eliminating costly delays caused by snail mail deliveries; and TradeWeb has been a great tool, which will be made even better, Mr. Schultz said, when agency bonds become available on the site later this fall.