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Rating:Wirehouse Worries Not Rated 4.5 Email Routing List Email & Route  Print Print
Friday, June 04, 2004

Wirehouse Worries

Reported by Theresa Sim

By now, everyone has heard the news: Merrill Lynch is considering a sale of their Merrill Lynch Investment Managers to Baltimore money manager Legg Mason.

Permutations of the deal are flying, with Merrill Lynch possibly partnering with Legg Mason to create an operations-only company, the two creating a stand alone asset management company, Merrill Lynch selling MLIM outright, or Merrill Lynch selling MLIM but retaining interest in the company.

The range of rumors seems to convey the broad confusion in the industry. On one hand, it makes sense for Merrill Lynch to accept that wirehouses and funds just don't mix. But does it make more sense for Merrill to jettison the entire asset management unit, or just the skinny-margin operations side? And how much is the business worth? MFWire.com examines the deal's underbelly.

Regulatory Pressures

With finger-pointing rampant in the industry, it is likely that regulatory issues are playing a part in the rumored deal. After all, if Merrill sells MLIM, Merrill Lynch brokers can be free from the worry of recommending (or not recommending) in-house funds, and the investment banking arm cannot be accused of dumping initial public offering stocks into non-existent in-house funds.

Although the issue of brokers playing favorites with in-house funds is not new, it has been receiving more attention from regulators and the media recently. On Thursday, Milberg Weiss announced it was suing Citibank's Smith Barney for paying undisclosed fees to its brokers selling in-house funds.

The SEC also revealed in May that it had been investigating, for months, the relationship between investment banks share stuffing into their related mutual funds.

Merrill's Motivations

Not so fast with the regulatory assumption, says longtime industry consultant, B.J. Greenwald (he told the MFWire.com that he has no first hand knowledge of the rumored deal). While regulatory issues may play an important role, Greenwald chastens watchers who are overlooking economic motivations: "regulatory issues have tended to put a focus on th[e] possibility [of a sale], and once the possibility was raised, I think the immediate reaction was it's a win, win, win on every count, not the least of which is the valuation issue."

First on his list is the three, four or five times the book value of the unit that Merrill Lynch stands to gain from a sale. Greenwald cites public competitors like T. Rowe Price and Franklin Resources with high valuations.

Publicly-held money managers T. Rowe Price, Franklin Resources, Gabelli Asset Management and Eaton Vance were trading at more than 20 times earnings, as of Thursday.

In addition, MLIM's funds could become more attractive to third party intermediaries and could overcome a distribution bottleneck from a sale to Legg Mason, said Greenwald. That translates into a unique situation for Merrill Lynch and Legg Mason -- the fund could be more widely distributed, and therefore of higher value, to Legg Mason than to the financial services mammoth.

Merrill Lynch spokeswoman Megan Ochampaugh did not return a call seeking comment.

The NY Post's anonymous sources had a different spin on the deal -- they reported on Friday that MLIM will partner with Legg Mason and to spin off its operations arm, with Merrill Lynch owning a majority of the combined company.

Legg Mason, Times Two

From Legg Mason's point of view, MLIM's $513 billion in assets under management represent a hefty bite -- not far from double their current asset base of $286 billion.

A $20.3 billion chunk of Legg Mason's assets under management is in mutual funds. And of that $20.3 billion, 54 percent, or $10.1 billion, is in the Value Trust, a fund run by star manager and Legg Mason CEO, Bill Miller. The next closest in terms of size are the Opportunity Trust and the Special Investment Trust funds. The superstar manager also heads both of those funds.

The Opportunity Trust fund had $3.1 billion in assets, or 15 percent of total mutual fund assets and the Special Investment Trust had $3.4 billion, or 17 percent of total mutual fund assets, both as of Tuesday's close. The Value Trust has outperformed the S&P for the last 13 years, returning 16.98 percent since the fund's inception in 1982.

But with three funds (out of twenty) responsible for an outsized 86 percent of total mutual fund assets, MLIM's wide array could help diversify the group's fund palette.

How will the two groups work together? Legg Mason has historically let their acquisitions operate independently -- "that's just their philosophy," said Greenwald. But it is unclear how an acquisition twice the size of the acquiring firm may change that historical legacy.

Sticker Shock

While Bloomberg and the Baltimore Sun both cited sources estimating a hefty $6 billion or greater price tag, it is unclear what that price includes.

Merrill's wrap account business, although part of the MLIM unit, is a product that is near and dear to Merrill. It seems unlikely that advice-driven, comprehensive product would be given up as part of the sale. "If you look at Merrill, they have been aggressively moving towards fee-based advice, managed account programs, fee-based brokerage, and building up their advisory arm," a CBS MarketWatch article reported Cerulli Associates' Ben Phillips as saying.

The $6 billion price tag may be much compared to what public asset managers are going for.

Scandal-tainted Janus Capital can be bought lock, stock and barrel for approximately $3.9 billion. According to Financial Research Corporation data, the Janus family managed $81.5 billion in assets in March, whereas MLIM managed $57.6 billion. Is a relatively untarnished firm (they're being sued for revenue sharing) worth the extra $2 billion and fewer assets?

Why Now

In 1992, when Charles Schwab introduced OneSource, their mutual fund supermarket product, MLIM had already begun their slow slide, ranking seventh in fund assets. Fidelity, Franklin, Vanguard, American Funds and Scudder Investments rounded out the top five fund groups.

A little more than a short decade later, the group has managed to drop to 18th, far behind the crowd that it was once in the company of, according to Financial Research Corporation data.

Notably dropping in the ranks in the same time period include fellow wirehouses Smith Barney dropping from 12th to 20th, Morgan Stanley falling from 8th to 26th (not including Van Kampen funds; Morgan has closed in-house funds to push the Van Kampen products), Prudential sliding from 16th to 30th, and UBS nosediving from 32nd to 70th.

Fast forwarding to 2002 -- current MLIM head Robert Doll was brought in just a few years ago to change that tide. One of his mandates was to increase third party distribution. Greenwald said that MLIM and Doll have mainly failed in that effort. Has MLIM hit a wall?

It may be the same wall that fellow wirehouses Morgan Stanley and Prudential Securities hit, causing them to stake definitive claims in the ongoing battle between distribution and fund management.

Morgan Stanley has taken a similar approach to Merrill Lynch, although not going as far as selling their money management unit. Morgan Stanley acquired the Van Kampen fund group in June 1996 and has worked to move their funds to that independently branded line of funds.

Prudential Securities decided to go the opposite route, merging its distribution arm with Wachovia Securities in early 2003.

If a deal on the scale of MLIM goes through, it could set the stage for a flurry of further acquisition activity in the industry, said Greenwald, adding: "[it] might be the thing that broke the damn."

Fellow national wirehouses Smith Barney and UBS PaineWebber take note. 

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