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Next Year's Model

Surveying the financial services landscape back in April 1998, Raymond Mason, CEO of Legg Mason, told Barron's how he saw the future: I have believed that there are three businesses over the next ten years that all financial-services companies will have to be in: securities-brokerage, asset management and capital markets, or corporate finance. At the time, with Glass-Steagall, the Depression-era law

Surveying the financial services landscape back in April 1998, Raymond “Chip” Mason, CEO of Legg Mason, told Barron's how he saw the future: “I have believed that there are three businesses over the next ten years that all financial-services companies will have to be in: securities-brokerage, asset management and capital markets, or corporate finance.” At the time, with Glass-Steagall, the Depression-era law that prohibited mixing banking with securities or insurance businesses, in its death throes, the one-stop financial shop seemed inevitable. American Express was the first to try it, with acquisition of brokerages Shearson and IDS and investment banking firm Lehman in the early 1980s. But by the late 1990s everyone was doing it. Citigroup, for example, had just announced its colossal (but ill-fated) merger with insurance giant Travelers; Merrill Lynch was rumored to be in merger talks with Chase Manhattan (Chase eventually merged with JP Morgan); and just the year before, Philip Purcell had neatly laid out The New Vision: He combined an investment banking/asset management company (Morgan Stanley) with a large retail network to distribute the products (Dean Witter).

But that was then. Today, the one-stop shop — the financial multiplex offering retail brokerage, asset management and investment banking — doesn't look like such a no-brainer. In the recent deal between Legg Mason and Citigroup, valued at $3.7 billion and expected to close in December, Citigroup will give Legg most of its asset management business — $460 billion in assets under management — in exchange for Legg's highly productive retail brokers.

In unloading his 1,400-strong retail force, Chip Mason basically shorted distribution and went long asset management, as an executive at one rival firm put it. (Of course, this rival, which offers all three businesses, disagrees: You can offer proprietary products via a captive rep force and “still avoid conflicts of interest,” the executive says.) Citigroup, on the other hand, is shorting asset management and going long banking and brokerage. Asset management, then, marks yet another business Citi has dropped from its repertoire: It sold Travelers to MetLife at the start of the year.

American Express has also given up on the one-stop shop. After unloading Lehman in 1994, it more recently decided to rid itself of both retail brokerage and asset management. The company announced plans in March to spin off American Express Financial Advisors (now called Ameriprise) and keep only its credit-card and travel businesses. In the meantime, the success of the Morgan Stanley-Dean Witter merger has been widely called into question; the company has been dogged by rumors that it is considering a sale or spinoff of some or all of the pieces of its legacy Dean Witter Discovery business — the retail brokerage, asset management and credit-card units.

This is only the beginning, say industry experts and analysts. More Wall Street banks, wirehouses and insurance companies will soon put themselves on the chopping block, with similar divestments of retail brokerage and/or asset management operations, they say. For brokers, it represents a challenge. If they can no longer pad their employer's pockets by selling its products, then they will have to make the firm more money in their own right. That means they will be pushed to emphasize asset-based fees, to grab more high-net-worth clients and to gain the additional expertise that comes with serving more complex accounts, say analysts.

“What you're starting to see is the recognition that, whether it's real or perceived, there is clearly a possible conflict of interest when a proprietary product is distributed by a captive sales organization,” says Burton Greenwald, a fund consultant based in Philadelphia. “You can have proprietary product, while having open architecture, but in most cases, when you're talking about banks and insurance companies, the mutual fund product is not a significant contributor to their earnings, and it raises more issues than it solves. I think you will see many of them spin it off or sell it.”

It's not that the one-stop model never worked. Ten years ago, distribution and manufacturing under one roof made tremendous economic sense: sell (even mediocre) high-margin house-brand products — particularly mutual funds — through a built-in (albeit, low-margin) sales force. The stock market was soaring, and retail investors wanted a piece of the action. Voila: perfect synergies. Assets in proprietary funds ballooned during the 1990s despite often trailing their benchmarks — and independent fund family rivals. Collectively, assets in house-brand funds at American Express, Morgan Stanley, Merrill Lynch, Citigroup and UBS grew 140 percent to $335 billion between 1994 and 1999, according to Morningstar data, while the number of proprietary funds they offered more than doubled.

A Seismic Shift

But a lot of things have changed since the 1990s. For starters, Schwab pioneered the fund supermarket, where retail investors could help themselves to thousands of different funds. Wall Street, in a counterattack, adopted an “open architecture” model, giving brokers and their clients more alternatives to choose from, which, in turn, ate into sales of proprietary product. More recently, a regulatory crackdown on conflicts of interest has put the kibosh on special perks or better payouts for reps that sell proprietary products. In late 2003, Morgan Stanley paid a $2 million fine to the NASD for holding illegal sales contests for brokers selling proprietary products. And in mid-July, Ameriprise agreed to pay $7.4 million to New Hampshire regulators for offering its sales force illegal incentives to sell in-house funds. In the meantime, the NASD says the investigations are ongoing.

At the same time, with the rise of information providers like Morningstar, investors have gotten savvier about buying mutual funds. And as brokers shift towards advice and away from product sales, they're being held to higher standards and don't want to push a fund just because it has their company's name on it. Quite the opposite. One Smith Barney broker says she's now loath to sell an in-house product even when it's head and shoulders above the rest. “I would show my clients what my research showed. But unless the board or committee felt strongly that they wanted it, I'd recommend options No. 2 and 3,” she says. She's glad the Smith Barney funds are no longer in-house. “On the very rare occasions where we do use [Smith Barney products], I won't have to go through the same song and dance.”

Second Rate

The one thing that hasn't changed over the years is the general mediocrity of in-house mutual funds. There tend to be some good ones and some bad ones, but in all, the majority of brokerage-owned proprietary fund families underperform 40 percent or more of their peers over three-, five- and 10-year periods, according to Morningstar data.

Legg Mason's top performing funds are a stunning exception — ranking in the top 7 percent among peers for asset-weighted three-year returns. That performance has translated into an explosion in assets under management — which have soared to $360 billion from $71 billion over the past seven years, while the revenue contribution from brokerage commissions has fallen from 70 percent to roughly 30 percent. Meanwhile, pretax profit margins on Legg's asset management business are around 33 percent, versus 18 percent at the retail brokerage, making a sale of the latter a rather obvious choice for Legg.

Why do big Wall Street brokerages' asset managers tend to offer such middling performance? “Part of the reason for that is they have a hard time attracting and retaining the investment management talent,” explains Darlene DeRemer, a partner with Grail Partners', a merchant bank focusing on the asset-management business. Whereas pure play firms tend to offer money managers a significant equity stake, that's hard for large one-stop shops to do, considering asset management is not generally a major contributor to earnings. (Asset management accounts for 1 percent of earnings at Citi, 4 percent at UBS, 10 percent at Merrill Lynch and a more significant 19 percent at Morgan Stanley.)

As a result, over the last five years, broker-owned funds have, for the most part, not enjoyed growth in assets. An industry consultant estimates that in the early 1990s about half of the mutual funds sold at the leading brokerage firms were managed by affiliated managers; but that ratio has fallen to about 20 percent. Between 1999 and 2004, the collective assets of house-brand funds at American Express, Morgan, Merrill, Citi 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.

The Next Evolution

If the one-stop shop is out, what new formula will take its place? In many ways, the Citi/Legg Mason swap looks like an ideal prototype. Each firm gains scale in its respective business line, but keeps a minority interest in the other, without having to worry about the conflicts that come with housing both under one roof. A three-year distribution agreement that's part of the swap allows Citigroup's Smith Barney to be the exclusive distributor of the outstanding Legg Mason funds, expanding Legg's distribution capability tenfold and turning Legg into something of a subadvisor for Citi. Meanwhile, Citi will take a 14 percent stake in the new Legg Mason, allowing it to profit from the higher margins that can be expected of a well-run asset management shop. In general, pretax operating margins for publicly traded asset management firms are around 34 percent, according to Grail Partners, versus around 20 percent for the best of the retail brokerages.

The thing is, a swap like that is not likely to be repeated, says Russel Kinnel, director of fund research for Morningstar, and other analysts. There simply aren't many other large proprietary fund shops that are strong performers like Legg — that could sell off a retail brokerage force and go it alone. Legg Mason was an unusual case: primarily a retail brokerage firm until it began bulking up on high-quality boutique asset-management firms a few years ago, making that its core business. Lehman Brothers could be the exception. It has a small retail brokerage force (850 brokers) while its asset-management business, with around $16 billion in assets, has ranked in the top 20 percent relative to its peers for the trailing three- and five-year periods, according to Morningstar data.

Whether another swap happens or not, some of the particulars of the Legg/Citi deal — like fund subadvisory, exclusive distribution deals and ownership stakes — could still find their way into sales or spinoffs, say analysts. For any wirehouse that sells off its asset-management business, taking an ownership stake in the buyer makes sense. “If you have a minority stake, it's a back-end way to make it look like there's no conflict, while benefiting from it,” says Kinnel. “Also, if you have sold the business for a low multiple, it might imply a decent value for the firm buying, so that's another good reason to get into that.”

For now regulators don't seem to be getting in the way of the Legg/Citi agreement. The NASD declined to comment specifically on the deal, though at least one industry watcher said regulators might want look into the arrangement.

The Contenders

Morgan Stanley and Merrill Lynch are the most obvious candidates to unbundle next, says Friedman Billings Ramsey analyst Matt Snowling, if only because it's clear that leadership has already taken such moves into consideration. Merrill, in fact, tried to cook up a deal with Legg Mason last year similar to the one done by Citigroup. Only difference was, Merrill wanted a large stake in the resulting Legg Mason asset-management business, around 49 percent, according to sources with knowledge of the deal. On the other hand, now, sources close to Merrill say the company believes it can make the two business lines work together; you simply offer open architecture, don't play favorites and let the advisor choose the best fund for his client's individual needs.

Ameriprise is another probable seller, Snowling says. CEO Jim Cracchiolo also claims he can keep the current model intact; he says that having proprietary asset management can help the firm create more customized solutions for its clients. But until performance improves, the funds will likely be a hard sell.

Ultimately, all of the major financial services firms with both asset-management arms and retail distribution are likely to attempt a sale or a spinoff, says DeRemer, who names Morgan Stanley, Merrill Lynch, Wachovia, UBS, Bank of America and Key Corp. For wirehouses, it's natural that they would look to unload their asset-management businesses, rather than their retail distribution units, even if the latter aren't as profitable. “Distribution matters more to a wirehouse than asset management,” according to Snowling. “At the foundation they're investment banks, and being able to distribute those banking products is crucial. IPOs are more profitable than asset management, so you need that distribution. It's an easy decision for them to make.”

At UBS, investment banking accounted for 33 percent of earnings, versus 4 percent for asset management in the first quarter. At Merrill investment banking pulled in a whopping 91 percent of earnings, compared with 10 percent from investment management. Wachovia got 31 percent of its earnings from investment banking, compared with 10 percent for retail brokerage and asset management combined. And at Morgan Stanley, it was 89 percent versus 19 percent. (Will new CEO John Mack sell its brokers? See related story on page 44.)

As for asset manager buyers, Franklin Resources is at the top of many an industry consultant's list. Franklin, who has been a serial acquirer in recent years, “has the scale and the cash to make one of these deals happen,” says Snowling. Other buyers could include Eaton Vance, T. Rowe Price, Nuveen, AMG or Janus, according to DeRemer. “They all have large enough market capitalizations. Having that public currency is clearly a competitive advantage,” she says.

For brokers and advisors, the business they started working in 10 or 20 years ago is changing a little bit more every day. If in-house asset management goes away, it will be a final signal to investors that what the firms are selling is their advice, not their products. And that might give a little boost to the client-advisor relationship. Says one Smith Barney broker, “Perception is important, and sometimes perception is reality.”

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