The End of the World as We Know It?

Merrill Lynch's purported shopping of its investment management unit has some juicy implications for the nation's largest brokerage operation, but it also could be a signpost of a much more important event a history-making shift in Wall Street's business model. The much-rumored Merrill deal involves a sale of Merrill Lynch Investment Management (MLIM) to Baltimore-based Legg Mason. (Legg does have

Merrill Lynch's purported shopping of its investment management unit has some juicy implications for the nation's largest brokerage operation, but it also could be a signpost of a much more important event — a history-making shift in Wall Street's business model.

The much-rumored Merrill deal involves a sale of Merrill Lynch Investment Management (MLIM) to Baltimore-based Legg Mason. (Legg does have retail distribution, but two-thirds of its revenue are generated by asset management.) The motivation for such a transaction can hardly be in doubt. Regulators have fixed their sights on the relationship between asset management units of securities firms and their retail distribution. And no firm needs that scrutiny right now.

The most visible sign of this regulatory interest is the $50 million fine levied against Morgan Stanley for allegedly pushing its own funds on its clients (it subsequently closed 13 proprietary funds).

Bob Doll, head of MLIM, has acknowledged that a sale of all or part of its asset management business could “ease regulatory conflicts.” Sources say that Doll even wanted to move MLIM out of the firm's Plainsboro, N.J., complex to a more remote location as an outward sign of the unit's independence from Merrill's retail distribution.

This begs a grand question: Is the traditional model for securities houses — investment banking, research, asset management, retail brokerage all coexisting under one roof — more trouble than it's worth?

Take a look at the current state of affairs. For starters, the time-honored habit of manufacturing financial products and then stuffing them down the distribution network is no longer acceptable. Second, Wall Street is under fire from not only federal but also state regulators for how firms compensate their FAs. (New Hampshire recently joined the fray in suing Morgan Stanley for hosting “steak-a-thons,” rewarding brokers for selling in-house mutual funds with raw meat.) Then there is the fallout from the research scandals, which have forced firms to erect barriers between their research departments and their investment banking units.

It is in this context that securities executives must decide how to structure their business going forward.

“Things move really fast in this business sometimes, and what seemed like a good idea two years ago could leave you real vulnerable today,” says an executive at a regional b/d with an investment banking division. He says his firm isn't currently looking to get out of the asset management business, but “it's obviously something that, if things continue, we'll have to keep an eye out for. You have to be careful you don't become a dinosaur.”

The details of Merrill's potential sale of MLIM remain sketchy, though a source close to the firm says that investment bankers are salivating over the idea and would “love” to engineer a sale of the unit, perhaps as much as 49 percent.

But that might be a bit of wishful thinking, others say. “I don't think that's the way they'll end up going,” says Jeffrey Harte, an analyst at Sandler O'Neill in Chicago. “But you have to think they're seriously considering it. They have to at least think about it. You never know what kind of regulation is going to go down; it would be irresponsible of them not to look into it.”

Many believe a decision to sell hinges on reputation. If a firm — or asset manager or mutual fund company, for that matter — has had its reputation sullied by scandal, it might be in its best interest to sell off assets to a firm untouched by regulatory investigations, thereby burying the sullied name.

Besides, a prominent industry executive argues that asset managers of big securities firms, such as a Merrill Lynch or a Morgan Stanley, don't carry the same weight they did, say, 15 years ago.

Further, asset managers won't be as profitable in the future, the executive says. Selling off the assets and re-deploying the capital to another use might allow the firm to maximize earnings.

Firms are asking themselves, he says, “‘If I need to grow 20 percent in the next period of time, is it easier for me to do that internally or externally?’ You could well see many firms thinking they need to go external.”

Or big firms could put the scandal behind them by buying independent firms. “It could work in the opposite direction,” says John Coffee, a law professor at Columbia University. “Smaller firms that have been caught up in some of these scandals might move to sell their assets to controlling interests with a strong brand name.”

There is precedent. Recently, Bank of America's Nations Funds family, which stands accused of late trading by New York Attorney General Eliot Spitzer, was acquired by Columbia Management Group, the new name for Bank of America's asset management group. Clients formerly in Nations Funds are now under the name Columbia, allowing them to avoid the stigma involved with the fingered funds.

That said, asset management arms of securities firms are unlikely to vanish any time soon, because it remains a lucrative business, for now.

“The advantages of vertical integration go well beyond the effects of scandals,” Harte says. “But no one really knows how this is going to play out. In an extreme worst-case scenario, regulators could say that because of the inherent conflict of interest there can be no proprietary asset management arm at a retail brokerage.”

“Will that happen? Probably not,” he continues. “But it's certainly something firms have to be aware of and careful about.”

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