The role of the asset management industry in the funding of the post-crisis financial system

The asset management industry is a central component of the greater European economy. Over the course of this year, we have seen a gradual return to health, as illustrated in recent industry data.1 In Europe, there are promising signs of a recovery in investor confidence, with net inflows into UCITS funds, for example, increasing to €38 billion in July, in line with a trend of total assets in UCITS rising by 5.4 percent, or €246 billion, since the end of 2008. Net inflows have now been positive for three quarters in a row, following eighteen months of net withdrawals.
by Peter De Proft, Director General of the European Fund and Asset Management Association (EFAMA)

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However, it is not the time to become complacent. Despite the positive signs of growth, we are faced with a much-changed financial landscape and one that is still in a state of flux.

It is important that we properly identify how to steer a safe course through this new financial system and take advantage of following, I would like to outline some of the considerations we must bear in mind as we look to negotiate this landscape. 

BANKS ARE FORCED TO ADOPT A ‘BORING’ BUSINESS MODEL

As a result of the financial crisis of the past two years, banks have been forced to move to a different business model, often called ‘back to basics’, which will have far-reaching implications for the worldwide financial system. This ‘boring’ model will lead to:

• a recapitalisation of toxic losses and increase in capital due to higher T1 requirements;
• a permanent shortage of classic credit availability because of a dramatic reduction in leverage;
• more sophisticated collateral require-ments for assets;
• development of more off-balance-sheet products on both the asset and liability side;
• an increased liquidity level for assets and liabilities on the balance sheet resulting in a pressing need for transferable products, clear valuation rules and central counterparty clearing mechanisms;
• the development of transparent, trust-ed products on the liability side to reconnect with their retail clients.

KEY TRENDS AND CHALLENGES IN ASSET MANAGEMENT

The reshuffling of the banking business model unquestionably implies far-reaching challenges for the asset management industry that will ultimately reshape it. There are four particularly strong trends developing at this point.

Conflicting pressure on products and sales
In the past, conflicts of interest regularly created tension between asset managers belonging to a larger financial con-glomerate and their ‘parent group’. These imposed ambitious sales figures, resulting in the development of creative products that were more of interest to the profit and loss account of the group than to the clients.
For each investment manager, there is clearly now a need to rebuild customer trust and to review the distribution model and the sales policy. Trust will be regained by crystal clear application of transparency in pricing, by avoiding conflicts of interest between sales policy and the customer’s needs, by providing appropriate advice adapted to the client’s profile, and by constantly proving the added value of active management. Products with unsustainable promises will have to be taken off the shelf and cannot be promoted any longer.
From a marketing point of view, the key question about branding that has to be resolved is the credibility or trust of distribution through the parent’s brand versus the asset manager’s reputation and reliability.

Over the past eighteen months, we have already noticed a strong tendency towards consolidation amongst asset managers, combined with a trend for more independence from ‘parents’, be they banks, insurers or other financial conglomerates. These phenomena have originated in and been strongly influenced by:

• an ongoing trend towards open architecture and guided architecture distribution, i.e. distribution by selling products via third-party channels outside of group structures;
• raising cash for impaired banks by selling off their asset managers or parts of the business, sometimes also by MBOs or IPOs;
• pressure on margins pushing towards scale-based mergers or, on the contrary, towards the creation of specialised boutiques.

Asset managers need to reposition services and relations
The decreases in revenues (–14%) and margins (–40%) experienced by asset managers in 20082 are the result of a number of converging factors. These factors include the decline of assets under management (AUM) at the same time as increased focus on higher revenue products, with products becoming more expensive, for instance repos, bonds, and collateral; the decreasing revenues of the decline in securities lending due, for example to a short-selling ban; and the decline in performance and management fees.

As part of the cost reduction exercise, the established sales channels and distribution models are under re-examination, leading to the downsizing of sales offices and investing in associations with new sales channels.

Trading relations with counterparties are coming under scrutiny, with counterparty creditworthiness and business rationale being re-evaluated, as well as with concentration and sovereign risks being reconsidered.

Asset managers need to transform internal processes in order to remain relevant in terms of cost and risk management
Innovation has always been driven by the sell-side companies. Today, asset managers will need to develop products and processes based on their own constraints and goals, and based on their insight into the needs of the client. Sales teams and product development will have to work in a more closely coordinated fashion in order to increase efficiency.

Automation of workflow and the rationalising of systems will increase the volumes treated and reduce the use of manual operations and time of execution.

In a mid-year status report on the evolution of fund processing stan-dardisation published by EFAMA in cooperation with SWIFT during the first six months of 2009, the automation rate of cross-border fund orders was shown to have reached 69%. Although the total automation rate in the Asia-Pacific region lagged this somewhat, there was definite progress as it reached 45% in the first half of 2009, compared to 36% in Q4 of 2008.
 
In spite of the progress made so far, straight-through-processing (STP) still has some way to go.

There is a surge of back office outsourcing models at a much lower cost and a questioning of what constitutes core activities and what does not.

Clearly, the trend is an increased focus on cost reductions:

• The unpredictability of many events has forced asset managers to invent further in terms of risk management and operational infrastructure (non-staff costs have increased by 9% in 2008),3 at the same time, asset managers were able to reduce staff by 9% in 2008.3
• All asset managers are seeking redistribution of margin in the value chain between distribution, transfer agents, financial advisors, asset management, etc.

The constant and increasing pace of change in the regulatory environmentwill have some serious consequences for the organisation of daily business:

• Based on the global credit crisis, the amount of regulation covering advisory business will rise significantly, driving the need for more centralised, auditable advice.
• The increased need for more transparency in alternative investing will lead to strict risk management capabilities.

CONVERGENCE OF CAPITAL MARKET PLAYERS AROUND ASSET MANAGERS TO FILL THE CREDIT GAP

Once market confidence is restored, mezzanine and other tranche financing will return. However, given stronger demand for high-quality collateral and cash flows and larger haircuts by the banks, credit is likely to be restricted for years to come. Therefore, in order to fill the gap, banks and asset managers can facilitate the intervention of off-balance sheet funding with semi-equity instruments such as subordinate loans, high-yield convertible bonds with preferred dividend or guaranteed fees or preferred equity, incorporated into legal entities called Quasi-Equity Vehicles (QEVs). This would allow for a matching of demand and supply in cash with the right risk profile.

These vehicles would offer new investment opportunities and sources of return for their investors. They would create synergies of competency, where:

• investment bankers structure and locate funding for deals, for example through IPOs;
• asset managers package the shares, or semi-shares, and sell them;
• private equity analyses the investment opportunities, providing due diligence and manages the operational aspects of these investment opportunities.

CONCLUSION: ASSET MANAGERS HAVE AN IMPORTANT ROLE TO PLAY AS POSSIBLE TRANSFORMERS OF THE NEW FINANCING WORLD

Along with the strategic goals of our industry of strengthening the relationship between investors and asset managers by increasing product transparency for investors, improving corporate govern-ance in the industry and promoting the need for long-term savings, asset managers have the opportunity to become important transformers of the new financial architecture, filling the gap of deleveraging by traditional banks as described above.

The areas where we can most immediately deliver this transformation as a cohesive group are in mobilising and governing the recapitalisation of the banking system and transforming money-market and longer-term funds into quasi-equity.

The downsizing of the back-to-basics banks will lead to more independent asset managers. There will be more tension between independent asset management/ open architectures and hub and spoke models, versus integrated distribution and production ones. The need for liquidity under stress will, in turn, lead to product innovation. All of these developments point to the asset management industry having an unprecedented window of opportunity for fundamental innovation.

EFAMA is the representative association for the European investment management industry. It represents through its 26 member associations and 44 corporate members approximately €11 trillion in AUM, of which €6.4 trillion was managed by approximately 53,000 funds at the end of June 2009. Just over 37,000 of these funds were UCITS (Undertakings for Collective Investments in Transferable Securities) funds.