Small firms could hit wall under tight industry conditions

Institutional money managers are competing with each other for the same piece of a pie that is not growing.

That means a growing number of traditional equity and fixed-income management firms are likely to close in the next few years, say consultants and analysts.

“There is an oversupply of managers in the market right now relative to demand,” said Kevin Quirk, a principal with Casey Quirk by Deloitte in New York. “We're just not convinced that there is room for the number of managers that you see out there.”

Especially vulnerable will be firms with less than $5 billion in assets under management and prolonged weak investment strategy performance, said Samiye Yildirim, leader of U.S. asset management deals, at PricewaterhouseCoopers LLC in New York.

Ms. Yildirim said she believes an industry shakeup will happen quickly. “I suspect it would take two or three years for the weaker firms with no differentiation to weed out,” she said.

Data from eVestment, Marietta, Ga., shows that as of Dec. 31, there were 375 money management firms based in the U.S. with less than $5 billion in assets under management.

Even firms with more than $5 billion in assets could be in jeopardy if their performance falls out of the two top quartiles. While she has not estimated the number of money management firms that will close, “it would be more than dozens,” Ms. Yildirim said.

Existing pressures include the ongoing move by institutional investors to passive equity strategies as active strategies have underperformed and increased compliance costs as the result of regulators' increased scrutiny of money managers since the financial crisis.

Ms. Yildirim said firms with a high percentage of institutional assets will face comparatively less pressure because those assets tend to be more sticky — but poor performers that also run retail assets might see a difficult road ahead.

While some managers might get absorbed by larger firms as part of a merger or acquisition, others will just die. “No one will acquire a manager if the assets are going out the window,” she said.

Mr. Quirk echoed Ms. Yildirim's comments about sticky institutional assets, saying institutional investors have a fairly long investment horizon and are cognizant of the fact that managers can underperform in shorter time periods.

“That said, I do think investors have a quicker trigger finger today,” he said. “I think they will move more decisively and more quickly than they have in the past, and I think there is as much skepticism in the marketplace of active management as we have seen. Investors are seriously scrutinizing their active managers every day.”

Mr. Quirk said the shift to passive strategies from active management means a narrower set of managers is benefiting. Overall, he said, the asset management industry is still very profitable, with median operating margins in the low 30% range.

“It still continues to be a good business, but we don't think it will be a business that everyone will win going forward,” he said. “There clearly is going to some shakeout in the business and some consolidation. At the aggregate level it continues to be a very good business, it's just not all participants are going to be winners in the new operating environment.”

Stephen Tu, vice president and senior analyst at Moody's Investors Service, New York, said costs associated with increased federal regulation of the money management industryare another problem. “The smaller firms also face the challenges that the compliance and regulatory burdens are higher for them, so the costs as a percentage of their revenue base is much higher,” he said.

While 2016 has not seen a rash of manager closings, industry players pointed to San Francisco-based WHV Investments' announcement this summer that it planned to shut down as an example of what comes from net outflows combined with continued poor performance in a key strategy.

In July 2013, CEO and President Andrew Turner, in an interview with Pensions & Investments, said his goal was to grow WHV's $14 billion in asset under management to between $50 billion and $100 billion in three to five years and expand the number of investment teams.

Mr. Turner did add some new investment teams, but they never garnered significant assets for WHV. The firm had about $1 billion in assets in March 31, the last time it reported numbers publicly.

WHV's assets at that time were concentrated primarily in its legacy international equity strategy, which saw outflows because of continued multiyear underperformance, said John Temple, president of New York-based Cambridge International Partners, an M&A advisory firm specializing in asset management.

“It was largely a one-strategy firm, and when things got bad there weren't much assets under management left,” Mr. Temple said.

An announcement in January noting that the international strategy's longtime portfolio manager Richard Hirayama was retiring as of June 30 prompted further outflows. A March 31 Securities and Exchange Commission filing by WHV showed assets in the international equity strategy were $900 million as of that date.

Mr. Turner wrote in a June 22 letter to investors obtained by P&I that the legacy international equity strategy and a smaller global equity strategy ranked at the bottom of the fourth quartile of peer strategies for the one, three, five and seven years.

“With the combination of past and expected future performance, the recent retirement of the legacy strategies' portfolio manager as well as the pattern of recent asset withdrawals and expected future asset losses, the board of directors of WHV determined that these legacy flagship products would likely not be sustainable beyond 2016,” Mr. Turner said in the letter.

While troubled managers might like to merge with healthier firms, the reality is there are more sellers than buyers in today's market and firms with poor performance will find it hard to save themselves through M&A, Cambridge International's Mr. Temple said. “It's like trying to catching a falling knife.”

Mr. Temple said 40 traditional U.S. money management firms were acquired in 2015 and 2016 is shaping up to be a flat year with little or no M&A growth. n