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February 18, 2008 12:00 AM

A hot asset

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    Roger Schillerstrom

    Legg Mason Inc. is on the prowl for acquisitions. Nuveen Investments Inc., a public company taken private by Madison Dearborn Partners LLC last year in the biggest ever money management buyout, is considering adding to its stable of money management subsidiaries.

    TCW Group Inc. could come into play, triggered by recent problems at its parent, Societe Generale SA, including an enormous $7.2 billion trading loss and questions about a lack of controls.

    Volatility is exploding these days not only in the equity and fixed-income markets, but also in the money management industry, and as a result, the industry is undergoing change at a frenzied rate.

    Mergers and acquisitions in money management set a record last year in terms of the number of deals and their total value, with 136 transactions valued at $44.5 billion.

    These changes have implications for pension funds, endowments and foundations, and other institutional investment pools.

    Clients looking for stability in their money managers have nowhere to run. They can't escape market dynamics. They have to deal with it.

    At the very least that means more expense for fund sponsors. They will have to devote more resources to placing acquired managers on watch lists, considering the ownership and organizational implications, possibly renegotiating contracts and, in some cases, conducting searches for new managers and transitioning portfolios.

    The acquisition of a money management firm by a large company can adversely affect incentives for investment professionals, as ownership moves to a more distant corporate level. If the compensation implications of the change of ownership are not handled carefully, key investment management talent might leave.

    Talent can be retained, as companies like Pacific Investment Management Co. have shown. They continue to thrive through ownership changes by providing investment talent with incentives to stay and clients with high-quality investment management.

    But the industry has always offered huge potential rewards to entrepreneurs, making it hard to pin talented down professionals in more bureaucratic structures.

    The industry has no single model for structuring a successful money management company. Nuveen went private, believing market demands for immediate results hurt the nurturing of growth opportunities. Yet, Legg Mason remains a public company.

    The acquisitions also raise concentration issues. The Illinois State Board of Investment made changes when it found that three of its managers were owned by Bank of New York Mellon through a series of acquisitions.

    Convergence also is occurring in the alternatives arena as mainline conventional asset management companies acquire alternative managers. A big reason for the activity: That's where the financial rewards are greatest. Alternative investments account for more than 20% of money management industry revenue, yet they make up only 8% of its assets.

    Fund sponsors, whose fees have skyrocketed as their asset allocations to alternatives have increased, must press for a greater institutionalization of alternatives' pricing, which now is not only higher but also more complex than that of conventional asset management.

    It remains to be seen how instability in money management ownership will play out. But the market provides an indication. As asset strategies become more popular, reducing returns, indexing begins to become practical, commoditizing the investment management and concentrating most assets with a few very large firms.

    With all acquisitions, sponsors should insist at least on a cut in fees so they share in the cost saving the larger money management companies gain from economies of scale, such as from centralized administration and marketing, as well as more rigorous and costly compliance.

    Pension sponsors, acting in the best interest of participants, have long been open to new ideas in more sophisticated investment strategies to improve their funds' risk-return profiles. Yet they have to keep up with the dynamics of the money management industry and become just as enlightened in understanding the impact on performance of new ownership, and new organizational and fee structures, as well as new conflicts of interest that can arise from more complex ownership.

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