The Merrill Lynch-BlackRock Deal Signals Major Shift in Financial ServicesPublished: March 08, 2006 in Knowledge@Wharton
When one company sells a big part of itself to another, the financial markets often judge one party the winner, the other the loser. Not so with Merrill Lynch's mid-February decision to sell its asset-management operation to BlackRock, a money manager serving wealthy investors and institutions, and best known for its conservative focus on bonds and risk-management products.
Analysts and investors cheered, bidding up the shares of both companies. By acquiring Merrill's $539 billion mutual fund family, BlackRock will quickly broaden its stock-fund offerings and its appeal to retail customers. Merrill, by acquiring just under 50% of BlackRock, will do well if BlackRock can strengthen the performance and appeal of Merrill's disappointing fund operation.
The transaction was valued at roughly $9 billion, representing the value of the BlackRock stake Merrill will acquire, assuming the deal is completed by the end of the year as planned. The deal will make BlackRock one of the world's biggest money managers, with about $1 trillion in assets and 4,500 employees in 18 countries.
But the cheering involves some wishful thinking, as success is far from certain. Merrill hopes to finesse its way out of its disappointing decision to embrace one of the late-1990s hottest fads: the financial supermarket. And BlackRock has to hope that investors don't come to see it as a de-facto Merrill subsidiary, inheriting Merrill's problems without adding value of its own to the asset-management business.
The deal is a clear signal that thinking in the financial-services industry has changed, says Andrew Metrick, Wharton finance professor. "Five or 10 years ago, the investment banks really wanted to get into the asset-management business, and now they want to get out of it."
According to Wharton finance professor Richard Herring, Merrill was forced to adapt to a changing landscape. "I view this deal as another response to the conflict-of-interest problems in selling proprietary mutual funds through one's own broker-dealer network," he says.
One-stop Shopping Loses Its Appeal
Like many financial-services companies, Merrill has long wrestled with the cyclical nature of revenues. Investment banking income -- primarily fees from putting together initial public offerings and other deals -- is very volatile. Trading on the firm's own account creates gains in some years, losses in others. Commission revenue depends on investors' eagerness to trade, which varies as the market goes up or down.
In the 1990s, many firms saw asset management as part of the solution. It includes a range of products such as mutual funds and individually managed customer accounts. Revenue flows smoothly and predictably from fees based on a percentage of assets under management rather than trading commissions. In addition, many firms hope for "cross-selling" opportunities. Their brokers, for example, would steer customers to the firm's own funds, which would produce income through sales loads and annual fees known as expense ratios.
Gradually, the supermarket idea evolved as a way to use the appeal of one-stop shopping to attract and retain customers, who would be offered all sorts of products beyond brokerage accounts and funds, including insurance and mortgages and other products traditionally offered by banks. "The reasoning made sense to me originally," Metrick says. "But I think, in general, the firms are finding that in financial services the specialists are competing quite effectively with the generalists."
The specialists, such as free-standing mutual fund companies like Fidelity and Vanguard, have done far better at attracting fund investors than the multi-function firms like Merrill, which has actually suffered net reductions in fund assets since the late 1990s.
One reason, says Wharton finance professor Jeremy Siegel, "is the fact that the large brokerage firms have not done well. Anyone who objectively looks at them sees that very few have done well. The fees are high and the performance is extremely mediocre."
Merrill has about 61 open-ended mutual funds. About 63% of the assets in them are in funds charging loads, or sales commissions, according to fund-data company Morningstar. Fidelity and Vanguard do not charge loads on any of their funds. Merrill Lynch funds also generally get lower Morningstar ratings. The U.S. stock funds, for example, score 3 out of five, while Fidelity's score is a better 3.5 and Vanguard's is 3.7. Annual expenses on those Merrill funds are 1.21%, compared to 0.73% for Fidelity and 0.22% for Vanguard.
Over the past decade, independent financial advisors have urged investors to steer clear of funds charging loads and high expense ratios, making the going tougher for funds like Merrill's. Annual studies by the Investment Company Institute (ICI), the fund industry trade group, show that investors have indeed gravitated toward low-fee funds. And the ICI says that between 2000 and 2004, annual net cash flow into load funds fell from $80 billion to $38 billion, while flows into no-load funds grew from $96 billion to $136 billion.
Another problem for the full-service firms: One-stop shopping has not been as appealing to investors as its proponents had hoped. "Many people don't want to trust everything to one person," Siegel says. "They like a second opinion.... For some people, the supermarket is fine, but many others prefer to spread their money around a little bit."
Siegel notes that the first food supermarkets provided convenience and low prices for the same products that could be bought at small grocery stores. But the financial supermarket often does not provide the same products one can get elsewhere, and costs are often higher than competitors'.
Moreover, the convenience offered by the financial supermarket was not all that valuable, Siegel adds. With the Internet, it is easy for investors to shop around. And although supermarket advocates had touted the value of having all of one's financial information reported on a single monthly statement, financial software programs can now do that automatically by assembling information online. Some free-standing fund companies, such as Vanguard, currently offer statements that include information on accounts held at other firms, eliminating any reporting edge the supermarket might have enjoyed.
Conflicts of Interest
Many big firms like Merrill had hoped that by offering a wide range of retail products and services, they could attract the "lazy money" from investors who would follow the firm's recommendations without much question, Siegel says. That way, the firms could steer customers to their firm's in-house funds and other products.
But then came the conflict-of-interest scandals of the past few years. In 2002, Merrill paid $100 million in fines after regulators found analysts at the firm had recommended stocks they knew to be no good. At other firms, such as Morgan Stanley, brokers were found to be pushing in-house funds instead of others that were better, often because they received higher commissions for selling the house brand.
These and other scandals made investors sensitive to conflicts of interest, diminishing the appeal of the big brokerage firms' in-house funds, Herring points out. Before the scandals "it was thought to be a real advantage to be able to use one's own broker-dealer network to sell proprietary mutual funds. But once the SEC questioned the incentive systems put in place to motivate broker-dealers, a captive broker-dealer network became more of a liability than an asset. Moreover, customers became concerned about receiving conflicted advice."
Companies also found that advisors at one brokerage were reluctant to recommend funds bearing rivals' names, Metrick says, while Siegel notes that more and more investors have turned to independent advisors who steer them away from brokerage's in-house funds and toward those of the free-standing fund companies. Hence, the big financial-services firms have lost interest in some of the key elements of the supermarket, such as asset management.
Last June, Citigroup, originally one of the strongest advocates of the supermarket model, sold its fund operation to Legg Mason in exchange for Legg Mason's broker-dealer business. (Several months earlier, Citigroup had sold off its Travelers life insurance unit.) Recently, Morgan Stanley tried to sell its money management operation to BlackRock in a deal that fell through. Last year American Express spun off its fund operation.
The Merrill-BlackRock deal is an attempt to have it both ways, Herring said. Instead of unloading the asset-management operation entirely, as Citigroup did, Merrill will keep a stake through its near 50% interest in BlackRock.
Merrill is betting that BlackRock can improve the operation's performance, and that changing the funds' names may eliminate investors' worries about conflict of interest. It is something of a gamble, though. Investors who are aware of Merrill's stake in BlackRock may see the same old conflict if Merrill brokers recommend BlackRock funds.