Outlook 2005: Money management

Money management executives are cautiously optimistic about the new year, but their investment bankers — anticipating a pent-up wave of industry reshuffling — sound downright bullish.

"We're expecting quite an exciting year" — a sharp pickup in merger and acquisition activity with some fairly sizable transactions to boot, said Donald H. Putnam, chief executive officer and managing director of Putnam Lovell NBF, a San Francisco-based investment bank focused on the financial services sector.

Few major deals were announced in 2004, after New York Attorney General Eliot Spitzer's September 2003 announcement of the first of many market-timing settlements sparked a regulatory inquisition that left industry executives unsure what their world would look like when the dust settled.

The last 12 months have been a case of "the dog that didn't bark," said Matthew R. Barger, deputy chairman of Hellman & Friedman LLC, a San Francisco-based private equity firm that invests in asset management companies.

The coming year should be different, with investment bankers and money management executives saying the pressures percolating over the past 15 months have had time to work their way through the industry.

The past year has been one of caution and reflection on the part of financial institutions, as regulators picked through the industry's dirty laundry, said Brad Hearsh, managing director of UBS Investment Bank, New York. But that regulatory uncertainty has diminished, and as time passes, people will be making decisions, he said.

Whether it's regulatory issues, more aggressive boards or litigation fears, a broad array of pressures is forcing people to rethink their business models and decide "what businesses they really want to be in," said Raymond A. "Chip" Mason, chairman, president and chief executive officer of Legg Mason Inc., Baltimore.

A major area of change is likely to involve untangling the nexus between the manufacturers of investment products and their distributors. Ownership changes will be a major trend for the industry in 2005, and one focus could be those financial conglomerates that started out with great distribution and added money management operations in search of "synergies," said Charles "Ed" Haldeman, president and chief executive officer of Putnam Investments Inc., Boston. Over the past year those "synergies" have become "conflicts of interest," he said.

Putnam Lovell's Mr. Putnam agrees: "You're going to find brokerage- and bank-owned money managers front and center" in 2005, he said. The thinking used to be: "If I'm your broker, why shouldn't I also be your money manager? … and how about borrowing against your house?" But as a result of the "Spitzer effect," the banks, insurers and brokers that built up money management operations are under pressure to "create a level playing field" for third-party investment products, undermining the reason for forming a conglomerate in the first place, he said.

Rumors about investment bank parents looking to unload their hefty money management arms circulated in 2004, but industry watchers say it isn't clear how the situation will play out.

Robert Doll, president and chief investment officer of Merrill Lynch Investment Management, Plainsboro, N.J., said speculation that money managers with investment banking parents will inevitably find themselves in play doesn't apply to his shop. MLIM's challenge now is to take "the excellent performance we've had and grow (those sales) channels we haven't been in for a long time, such as non-proprietary retail distribution," he said. Parent company Merrill Lynch & Co. is fully committed to MLIM, he said.

Another focus of change will be on firms in the mutual fund business. Price pressures — reflecting the reduced scope for "soft-dollar" use, fee reductions and sharply higher spending on compliance staff and systems — will leave some asset managers in the mutual fund space saying "why bother," predicted Mr. Haldeman.

UBS' Mr. Hearsh said only part of 2005's M&A activity is likely to count as "consolidation," in the sense of one money manager gobbling up another. But the retail sector is one where the prospects for that kind of deal "are probably greater than they've ever been."

The tepid outlook for major U.S. financial markets is another factor likely to promote M&A deal flow. If expectations of lower-than-normal investment returns over the coming decade prove true, then pressure will grow to mull M&A, joint ventures or other combinations as an alternative to organic growth, said MLIM's Mr. Doll.

That all adds up to an unusual amount of change looming on the horizon, analysts say.

"If you look at the top 50 (money management) firms, it's entirely possible — even probable — that half of those firms will not be there five years from now," said Kevin P. Quirk, a founding principal of Casey, Quirk & Associates, a Darien, Conn.-based consultant to the money management industry.

One thing that won't be so different in 2005 will be the continued proliferation of alternative investment shops, especially hedge fund operations. Putnam Lovell's Mr. Putnam said investment banking deals in alternatives should grow at double-digit rates for at least the next five years.

The duet between plan sponsors looking for creative ways to extract adequate returns from pricey financial markets and money managers seeking to answer that demand has become deafening, observers say.

"I've never seen anything like this" wave of plan sponsors all asking, "What are you doing that's new?" said Jeremy Grantham, a founder of Grantham, Mayo, Van Otterloo & Co LLC, Boston.

Mr. Grantham said his sense is that plan sponsors might be reaching for returns at precisely the wrong time. Markets historically retrench in the first and second years of a presidential term, and investors would be better served by hunkering down and going into risk-avoidance mode, keeping their powder dry to fight another day, he said.

Industry players said not everyone will rush to offer more exotic products. "You don't have to have it all. You just have to be extra good at what it is you do," MLIM'S Mr. Doll said. David Barse, CEO of Third Avenue Management LLC, New York, said his firm boosted its assets under management during the past year to $11 billion from $7 billion by sticking strictly to its concentrated equity value discipline. Mr. Barse added that the firm won't deviate from that focus even if interest shifts to other market niches in 2005.

Executives say a number of uncertainties will continue to cloud the markets in 2005. Among the things that keep him awake at night, Mr. Grantham said the dollar is his top concern — precisely because so many people share his negative views about the U.S. currency. "I can't remember in my entire life being part of such a broad consensus," he said. GMO — which has less than 30% dollar exposure on its $80 billion in assets under management — has reduced its bet against the dollar by about one-third, he said.

Other executives are more sanguine about the outlook. Issues such as the U.S. budget deficit and oil prices are certainly a concern, but on balance, 2005 should be an "up market year," with equity prices climbing about 8% to 10% during the coming 12 months, said Legg Mason's Mr. Mason.

Asked if he would be looking to take advantage of the expected pickup in ownership changes, Mr. Mason said Legg Mason is watching the situation with "a little more interest than normal." With international equity markets likely to log stronger growth than U.S. markets over the coming year, that's a pond in which Legg Mason might want to fish, he said.