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The Age of Scale - How BlackRock Redefines Scale

by Steven

The BlackRock/BGI merger will create the world's largest money manager with $2.714 trillion in AUM and clients in 60 countries. The biggest impact on the asset management industry will be increased pricing pressure, leading to a decline in profitability. Only firms that have significant scale, or those that are small enough to be niche providers with differentiated product strategies, will be able to thrive in this new world.

The global asset management industry, like many other industries before it, will evolve into a natural barbell. On one end there will be giant asset managers who have the scale to compete globally along the entire value chain in multiple product lines. These firms will subsist on minimal margins within commodity areas, which will be sustainable due to massive scale. On the other end of the barbell will be boutique shops that specialize in specific pieces of the value chain - either through differentiated products or by focusing on particular geographic areas.

A recent blog of mine, as well as our report, Evolving Distribution Amid Bad Markets, explain that distributors are looking to create more advantageous revenue sharing agreements that will squeeze asset managers even more. The squeeze will primarily apply to any commoditized utility product, such as actively managed funds, ETFs, or index funds that fit into one of the nine traditional Morningstar style boxes.

This will not only be the case for firms domestically, but also globally. Distributors have already started to centralize their research functions in order to acquire favorable global revenue sharing agreements. Only the asset managers that are truly global will be able to partner with distributors globally and win the best distribution agreements.

Having significant scale will enable firms to lower their fees, similar to what Wal-Mart has achieved in the retail world. Scale also impacts firms' spending abilities. For example, an asset manager with $1 Trillion in AUM can afford to have 200 external wholesalers while maintaining a desired profitability level. Logically, a firm with $100 billion in AUM should then be able to spend one tenth of what a larger firm might spend, while matching the larger firm's profitability. Are 20 wholesalers enough to support all the major bank/wires, independents, and RIAs? Most $100 billion firms with traditional wholesaling models will need at least 40 wholesalers to cover all channels. Relatively speaking, with 40 wholesalers, their cost is double that of the $1 trillion firm. This example helps to show why firms will need to revisit their wholesaling models(perhaps including or increasing cost-effective hybrid wholesalers), not to mention their overall business strategies.

Unless an asset manager has significant scale, lower profits are going to be the norm for firms who provide utility products. We estimate that net profit margins industry-wide have already fallen from 20% to 8% over the past year. Unless firms scale up, they will have to evolve their products and provide significant additional value to justify higher fees.