Financial Services Point of View Series: Issue 9 November 19, 2008 Author: Dr. Stefan Jaecklin, Partner in Oliver Wyman s Wealth and Asset Management practice The Crisis and Asset Management: A Catalyst for Change The asset management industry is under significant pressure and is facing an extensive transformation and consolidation at both the global and local levels. In our continuing series examining the impacts of the recent financial crisis, Dr. Stefan Jaecklin, Partner in Oliver Wyman s Wealth and Asset Management practice, looks at how the developing core-satellite strategies will be affected, as well as how traditional asset managers will weather the storm. Dr. Jaecklin believes that the emerging winners (including exchange-traded funds, multi-satellite players, consolidators and insurance companies) need to take advantage of immediate opportunities and of long-term changes to their investor bases in order to be successful.
Asset management: major change ahead The asset management industry is undergoing a profound change. Factors leading to the overall industry decline include the widespread deflation of asset values, sizeable retail investor redemptions, and fund reallocation to lower-risk and lower-margin products by both retail and institutional investors. With industry revenues shrinking by between 20% and 40%, this restructuring is putting pressure on both specialised and traditional players. The satellite model (for example, hedge funds and style specialists), will suffer due to the disadvantages of limited business diversification, heightened fixed costs hurdles (to develop and maintain risk management and distribution networks) and low brand recognition. Pressure on larger players will also intensify, as increased cost pressure will require downsizings of investment offerings and reductions in their geographic footprints in cases where they are sub-scale. Satellites are under siege The past few years have seen the emergence of two distinct core satellite investor strategies in the asset management industry. Core players are highly cost-efficient and excel in providing clients with exposure to a variety of markets at very low prices, but, importantly, they do not attempt outperformance (providers of exchange-traded funds would be examples of this approach). Satellites, by contrast, are highly specialised players that aim to outperform the market in specific areas where they have deep expertise. The specialisation logic underlying this general coresatellite trend will remain unchanged by the current crisis, largely because the requirements of a successful core player are very different from the ones that a successful satellite player has to fulfill. What has changed, however, has been the ability of satellites to generate outperformance, and a realisation that outperformance as such may have mattered less than simple exposure to the right markets. As a result, we can expect a significant reduction in the number of satellite providers, with some grouping into larger multisatellite players and others disappearing altogether. A number of drivers are contributing to this transformation: Reduction in inexpensive credit is grounding more leveraged satellites: A major portion of the growth in the satellite model was driven by satellite managers (including many hedge funds and private equity players) applying leverage to market risk. As credit is being repriced (e.g. by prime brokers), this is damaging the ability of satellites to reach their required risk-adjusted return expectations. 2 Copyright 2008 Oliver Wyman
Changing incentive and compensation structures are reducing their attractiveness for managers: Satellites with significant crisis damage will find themselves in a compromised position as they seek to retain talent, since their performance fees may have been wiped out due to high-water marks (as performance fees are only earned if the fund s valuation is above its high-water valuation mark). In addition, investors will likely put pressure on alternative players to reduce the asymmetry in fee structures that provided managers with a performance share when outperforming, but no share in the losses when underperforming. The resulting asymmetry can be reduced, for example, by deferring part of compensation and allowing for clawbacks, but any such change in compensation structures would reduce the fund s attractiveness for managers. Increased earnings volatility is forcing greater business diversification: Business risk from earnings volatility has increased significantly. This dramatically increases the risk of operating smaller investment activities and pursuing less diversified investment approaches. This presents a major challenge to highly specialised satellites due to the fact that in-house business diversification is difficult to achieve. Going forward, specialised satellites are likely to seek out diversification by joining with others to form multi-satellites. Required investments in risk management and distribution are increasing fixed costs and the importance of economies of scale: Whether market-driven or introduced through regulation, future requirements on satellites to implement sophisticated risk management and disclosure mechanisms will increase costs, which will hit smaller players disproportionately. Even before the crisis hit, the massive increase of satellite offerings moved the market from being supply-constrained to demand-constrained. In light of these constraints, future requirements to make significant investments into their distribution capabilities will be even more difficult for smaller players to afford. Only a few satellites with extremely strong track records and solid reputations can afford not to comply with increased investor requirements. Pressure on traditional asset management intensifies Many traditional players have chosen not to participate in the coresatellite specialisation over the past few years. Instead they have continued to provide a relatively broad investment product offering, often benefiting from captive retail client distribution networks. Prior to the current crisis, a number of traditional asset managers had experienced net asset outflows, often due to the shift of assets towards core-satellite offerings, but also due to the success Copyright 2008 Oliver Wyman 3
of structured products being offered by investment banks. In the current crisis the situation has deteriorated further as asset values have dropped across major asset classes and retail investors have continued to redeem assets. Institutional investors have thus far proven to be much more stable in the crisis than retail investors, but they too are now moving away from high-margin products to low risk, low margin products. The demand for competing products, such as investment bank-issued structured product offerings, has now reduced significantly, as many of these products were designed for a market with limited volatility coupled with strong bank counterparty ratings and trust. However, the released funds are often not flowing back into higher margin asset management products. The overall decline in industry revenues has a number of additional effects. Retail-oriented managers, in particular, are suffering due to exposure to both falling asset values and swift retail client de-risking. At the new, lower revenue levels the industry exhibits significant overcapacity, which could be eliminated via a reduction in the breadth of investment offerings, as well as a reduction in the number of players offering similar products. Banks which own asset managers will likely review the strategic importance of asset management and some will consider a sale, particularly where these entities are subscale and/or disadvantaged in terms of quality, and in cases where capital is required to repair the group s balance sheet. It is likely that industry consolidators will gather the better production capabilities and distribution access of traditional asset managers and create a small number of large asset management companies that will benefit from increased scale in production and brand recognition. Given the current disappointment with some of the global brands, coupled with the realisation that investor protection is typically of a local nature, there will clearly be opportunities for local consolidators, not just global ones. However, gaining scale alone is unlikely to be enough to remain competitive in the future. New players also need to anticipate critical longer-term demographic trends, such as the ageing of society and the resulting demand for products that provide protection from longevity and greater certainty during decumulation. Because such products often involve long-term guarantees that insurance companies are specialised in, co operation models involving insurance companies and asset managers are likely to develop that take advantage of their combined strengths. 4 Copyright 2008 Oliver Wyman
Who are the likely winners? In light of these significant changes to the industry landscape, we expect a defined set of winners to emerge: Exchange-traded fund (ETF) managers: ETFs have liquidity features and provide cost efficiency that has proven popular during the crisis for allocation purposes. The shift to more transparent management strategies in both institutional and retail distribution will benefit ETF players, given the much greater transparency of the ETF product. Multi-satellite players: At scale, diversified multi-satellite players with recognised brand names and proven performance capabilities are well positioned. These players are advantaged due to their ability to strategically manage and diversify their business portfolios towards lower earnings volatility, their ability to scale middle- and back-office costs, and their ability to retain top talent through a more stable compensation pool. The more selective approach of banks and prime brokers in providing liquidity will accelerate the process of determining winners and losers in this space. Industry consolidators: Collapsing investor assets and difficult long-term prospects will drive industry consolidation in asset management. Better capitalised players are well positioned to lead this consolidation. In addition to global consolidators, we see a role for local consolidators, especially given the more recent recognition that investor protection is local in nature. However, in order to be successful, consolidators will need to do more than just realise consolidation synergies. They will also need to form a clear view of the long-term trends, particularly in investor demographics and in continued core-satellite specialisation. Insurance companies: Provided they survive the crisis and emerge with strong credit ratings, insurance companies will be strongly positioned to provide longer-term capital guarantees to a highly riskaverse investment community. They will also benefit from a possible shift away from Defined Contribution back to Defined Benefit pension plans. However, many insurance firms are not particularly well known for their in-house investment expertise. In order to produce more attractive investment returns, insurance companies may benefit from partnering with leading asset managers. Copyright 2008 Oliver Wyman 5
Conclusion The financial crisis is obliging all asset managers to review their strategic positioning. Severe revenue declines and a changed industry outlook over both the short- and long-term will trigger a strategic reappraisal by all players and drive a reduction in current overcapacity. In this new environment the owners of many embedded players face diminished economics and may no longer view these activities as core to their strategies. At the same time, a number of the previously high-flying satellites are being grounded and those that are not must expect that the rules of the game have changed fundamentally. Not just in terms of overcapacity, but also in changed investor appetite and approach to investment confront the asset management industry. This mix of factors will catalyse the industry into action and create a new generation of leading asset managers. 6 Copyright 2008 Oliver Wyman
Oliver Wyman is an international management consulting firm that combines deep industry knowledge with specialised expertise in strategy, operations, risk management, organisational transformation, and leadership development. For more information please contact Dr. Stefan Jaecklin by email at stefan.jaecklin@oliverwyman.com or by phone at +41 44 553 33 33 Copyright 2008 Oliver Wyman Limited. All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Oliver Wyman and Oliver Wyman accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions in this report were prepared by the author. This report is not a substitute for tailored professional advice on how a specific financial institution should execute its strategy. This report is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accountants, tax, legal or financial advisers. Oliver Wyman has made every effort to use reliable, up-to-date and comprehensive information and analysis, but all information is provided without warranty of any kind, express or implied. Oliver Wyman disclaims any responsibility to update the information or conclusions in this report. Oliver Wyman accepts no liability for any loss arising from any action taken or refrained from as a result of information contained in this report or any reports or sources of information referred to herein, or for any consequential, special or similar damages even if advised of the possibility of such damages. This report may not be sold without the written consent of Oliver Wyman.