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Got Conflicts?

Merill's $8 billion swap with BlackRock fixes its house funds conflicts. Or does it?

Remember when your firm used to hold sales contests to encourage you to move proprietary funds? Those days are clearly gone. A new business model seems to be gaining popularity: retail brokerages spinning off their asset-management businesses but retaining a minority stake. Now that Merrill Lynch has spun out its proprietary asset-management unit to BlackRock, Merrill says its own reps should be free to use the funds in client portfolios without worrying about any perception of conflicts of interest. It should also make it far easier to sell the funds via rival brokerage houses and other third-party advisors who might have regarded Merrill as a rival.

There is little doubt that the new BlackRock, to be operated independently of Merrill once the deal closes (perhaps in the third quarter), will make asset gathering easier. The company says the move alleviates the perception that Merrill's 15,160-strong network of financial advisors are mere asset gatherers for its funds and not truly objective financial advisors. But will it really end questions of conflicts of interest? Merrill, of course, says yes; others say they're not so sure.

“I don't think the conflicts completely disappear but the transaction certainly helps alleviate some of that,” says Morningstar analyst Sonya Morris. After all, Merrill stands to gain if and when Merrill brokers steer their customers into BlackRock funds.

In last month's blockbuster deal, Merrill took a 49.8 percent stake in the new BlackRock, which will become a fund industry behemoth, with $1 trillion in assets under management, and the No. 2 mutual fund powerhouse behind Fidelity. PNC Financial Services Group's interest will drop to 34 percent from 70 percent and BlackRock employees will own the remainder. (PNC scored handsomely in the deal — the bank estimates it will record an after-tax gain from the deal of $1.8 billion on its balance sheet, in addition to a paper gain of nearly $3 billion on the appreciation of BlackRock shares the company holds.)

The transaction comes just a few weeks after rival Morgan Stanley ended negotiations to buy BlackRock outright. From an investment standpoint, BlackRock and Merrill complement each other very well: The combination couples Merrill's giant distribution force with BlackRock's formidable bond fund lineup and institutional portfolio-management expertise.

Critics of the deal — and there are some who don't like it simply because it will likely dampen Merrill's earnings for a couple years — say that the 49.8 stake is too big. Even though Merrill's voting rights will total just 45 percent, they say, this might still be too high to give the new entity unfettered independence. Merrill is quick to point out that current CEO Laurence Fink will still run the new BlackRock. Robert Doll, president and CIO of Merrill Lynch Investment Managers (MLIM), will become vice chairman, CIO of global equities and chairman of the private client operating committee at BlackRock. Stanley O'Neal, CEO of Merrill, will serve on the new company's board along with Gregory Fleming, Merrill's president of global markets and investment banking.

At least Merrill's brokers are optimistic, saying the deal will make it easier to sell Merrill funds. “It will be much easier to present to clients,” says one top-producing Merrill rep at a branch in the Northeast. “You'll be able to evaluate the MLIM funds on their own merit. And not worry about the fact that they're Merrill Lynch, which is what most people here do.”

Another Merrill rep concedes that she forfeited a good chunk of business due to the stigma attached to presenting in-house funds. “It gave competitors a chance to sell against us,” she says. “They could say, 'Oh, they're selling proprietary products.' Performance has improved tremendously and, yet, I've still lost clients to competitors,” she adds. The merger changes all that. “Clients will think, 'Oh, that's BlackRock now.' “ It stands to reason then that the change will generate more revenue for Merrill and its brokers, who generated, on average, an industry leading $734,744 in production last year.

But the merger is likely to have larger implications for non-Merrill reps and the fund industry at large. “On a broader scale, it underscores the importance of asset management being the primary business of a firm rather than just one sector,” says Burton Greenwald, a mutual fund consultant in Philadelphia.

A Changing Landscape

In light of the dustup over conflicts of interest and increasing regulatory pressure, banks, brokerages and insurance firms have been scrambling to separate asset management from distribution, either by renaming their fund managers, spinning off their asset managers or exiting the fund business altogether. Last summer, for example, Citigroup (parent of Smith Barney) swapped its asset-management unit for Legg Mason's brokerage operations, in part because of continued poor performance and sales. And, anyway, the potential compliance hassles loomed like a black cloud. Citi took a 14 percent stake in the resulting Legg Mason fund giant.

Last spring, American Express spun off its retail advisory unit, now named Ameriprise, and its asset-management business, which was rebranded under the RiverSource name. But Ameriprise still owns all of RiverSource. Other sellers include AmSouth Bancorp., which recently sold its fund group to mutual fund company Pioneer Investments. In December, Northwestern Mutual struck a deal to sell its Mason Street Funds to American Century Investments and Federated Investors. And a few months ago, First Tennessee Bank merged its funds into an asset-management unit run by Goldman Sachs. (Fifth Third Bank's fund managers, with $6.6 billion in assets, like the idea of a spinoff, says a knowledgeable source, but senior executives who built the manufacturing unit are said to be cool to such a deal, or even a renaming — for now.)

In Merrill's case, it opted to spin its so-called manufacturing unit out but retain a substantial stake because the firm says it can bring operational expertise to the new company. Oh, and Merrill obviously wants to enjoy a share of the lucrative profits asset managers typically generate. More importantly, by unbundling its asset-management business, Merrill seems to be truly endorsing an open architecture platform, where third-party asset managers are welcomed in its robust distribution force.

In some ways, the transaction is proof that perception can sometimes reflect reality in the fund industry. Historically, the knock on captive funds has been inferior investment performance compared to their pure-play rivals. The sales numbers certainly reflect that. Between 1999 and 2004, the collective assets of house-brand funds at American Express, Morgan, Merrill, Citigroup and UBS shrunk by a quarter to $250 billion, even as the number of funds they offered grew by 25 percent. Compare that to industrywide asset growth over the same period of 19 percent.

It's a maddening problem. Consider this as a motivator for Merrill: Despite MLIM's improved performance under Doll — more than 70 percent of Merrill funds are now above their respective benchmarks — sales have remained sluggish, apparently unable to shake the homegrown taint. MLIM has seen net outflows of $34 billion on a net basis from its stock and bond funds since 1998, according to Financial Research Corp. (FRC). Assets held in long-term MLIM funds stand at $61 billion, FRC says.

It's easy to see why Merrill swept in after Morgan Stanley was unable to close the deal for BlackRock. “This deal should accelerate our efforts to increase third-party distribution because now we don't have to birth a brand,” says Merrill's Doll. “We actually have a brand that has recognition with positive association in the marketplace, products to go with it and some relationships in third-party that we don't have. It also gives us more of an appearance of independence from the financial advisor,” Doll says.

Bye, Bye Princeton

The blockbuster deal also means that MLIM will shed its controversial new Princeton Portfolio Research Management moniker, which was slated to replace the MLIM brand and to get more rival brokers to recommend Merrill funds.

Still, the storm over conflicts seems not entirely dispelled. And the question remains: How much of a stake in an asset manager is too much? Roy Weitz, founder of, a Web site that alerts investors to funds they should consider selling, says, “Follow the money. If it goes into the new entity and half goes to Merrill, how is that not an incentive to push that product? In fact, in the long term, Merrill reps may have a larger incentive to sell them.”

But others are not concerned. “By changing ownership of the manufacturer, not just the branding, much of the regulatory burden and investor scrutiny financial advisors had faced may be eliminated,” says J.P. Morgan analyst Daniel Harris. A spokesman for the SEC declined to comment on whether the commission viewed the transaction as a positive step for the industry.

The move is a major stride toward regaining investor trust, according to one veteran industry analyst. “Reputation and the perceived control over conflicts is vital in convincing investors that they're giving you a reasonable recommendation,” says Jeff Keil, a principal at Keil Fiduciary Strategies, a mutual fund consultancy in Littleton, Colo.

Despite a short-term ding to its earnings, the odds are stacked in Merrill's favor that the marriage will be a successful one. “On paper, it's hard to find a better deal,” Doll says. “But execution is what it's all about. If we get both sides of it right, it's a home run.”

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