On March 4th, a shockwave reverberated around the financial management world. Two of the UK’s largest players, Aberdeen Asset Management and Standard Life, announced talks of an all-share merger deal which would see the creation of the largest asset management firm in the country, with a combined total of £660bn assets under management.
This would be one step towards stabilising both companies and establishing a contender comparable to the size of US rivals. The merger, worth around £11bn, would give Aberdeen shareholders 33.3% ownership and Standard Life shareholders 66.6% to reflect their £3.7bn and £7.5bn market capitalisation, respectively. Alas, two household names become one.
Sizing Each Other Up
The past year has been challenging for Aberdeen, who has continued to see investor money withdrawn from their key funds and margins squeezed. Net revenue fell 13.8%, with the final quarter of 2016 responsible for £10.5bn of net outflows alone, albeit partially offset by market gains of £3.3bn. This year has started no better; a recent quarterly report extended the fund outflow losing streak to the 15th consecutive quarter, driven by weaker emerging market sentiment and political uncertainty, for which the EU referendum result combined with the US election of last year both weighed in heavily on investor confidence.
Standard Life, Scotland’s largest insurer, is a company that is transforming its business into a more fee-focussed, less capital intensive, financial manager. In February, the firm with its headquarters 127 miles down the road in Edinburgh, announced a strong rise in profits in 2016, up 9% to £723m, as well as an assets under management increase of 16%, to £357.1bn. Fee-based revenue increased by 5% to £1.65bn, in addition to reported asset growth across all of the group’s “key” growth channels, despite “industry headwinds”.
Industry Strong Headwinds
The main problem facing the active asset management industry is less of a headwind and more of a storm. ‘Passive investing’, a strategy that aims to maximise returns over a long period of time by keeping the amount of buying and selling to a minimum, has benefited from the regulatory pressure hindering active management, a competitive fee structure, as well as being considered ‘better value for money’.
Passive funds received inflows of $505bn last year, now accounting for 29% of assets in the US and 15% in the European markets. At the same time, actively managed funds saw withdrawals of up to $340bn. Vanguard, the industry leader with over $4trn of assets under management, announced net inflows greater than the rest of the asset management industry combined.
The popularity of passive investing has emerged thanks to the poor track record of active management. Just 18% of large-cap active managers outperform their relative index, with mid-caps and small-caps outperforming 13% and 12% respectively, over a ten-year period. In Europe, four out of five active equity funds failed to beat their benchmark over the past five years, which rose to nine out of ten across a period of a decade.
Even Blackrock, the industry leader with assets under management in excess of $5trn dollars, is beginning to feel the heat. The US behemoth recently announced a dip in revenue, whilst also ending six years of continual bonus growth, by trimming extra income paid to its employees by 2-4% across the board.
A Closer Look at the Industry
The regulator has focussed its attentive eye on the industry, as many question whether asset management firms are justifying their higher fees with sufficient returns. Last November, the Financial Conduct Authority (FCA) published a paper exploring the “serious failings in the sector’s treatment of investors and pension funds”. It found that governance bodies were not focussed on value for money, nor was there a clear relationship between price and performance.
Crucially, the one-year study also discovered that fees charged remained relatively unchanged over the past decade, whilst passive fees actually decreased. Regulatory proposals include the enforcement of greater transparency laws to increase the amount, and frequency, of information that asset managers would have to disclose. In addition, enhanced duty of care that will provide the FCA with a clearer path to challenging firms on their pricing strategies, cost control and performance, by analysing the impact of charges on the ultimate investor return.
Finally, under a new pricing model suggested, asset managers would bear the overall risk between forecasting and actual costs, due to a single charge system. This may result in a reduction of appetite for high transactional activity.
Last September, asset managers were also asked to hold more capital to reduce systematic risk. As a result, Aberdeen Asset Management increased its levels of cash for regulatory purposes by 42% to £475m. This call for such a high capital buffer, in addition to calls for cheaper fees, will continue to squeeze the profit margins of the industry’s largest players. If this hostile climate continues then one-third of the profits earned by investment managers globally could be erased by 2018, according to consultants at McKinsey.
What the Future Holds
With this backdrop, it is perhaps no surprise that these two firms will synergise. Aberdeen’s cost base is in need of support; a weak pound will pile on the misery by increasing operating costs by around £35m per year according to HSBC. If the two companies can eliminate 16% of combined costs, then this should equate to around £200m of extra operating profit. At Standard Life’s 13x earnings multiple, then this deal will create an extra £2.1bn of market value.
Strategically, this deal will allow both firms to enhance their presence in the US, as well as help Standard Life utilise Aberdeen’s exposure in Asia. For the employees of both firms, however, this period marks for an uncertain time. Only time will tell the extent of the “job losses” announced by Aberdeen CEO Martin Gilbert, who is looking to make around £200m of savings. Nevertheless, deals such as this one will play a central theme in the years to come, as companies look to survive the many problems facing an industry in decline.