Assets matter

Watson Wyatt has been studying the impact of 2008 on managers’ assets under management and has interviewed a number of them to determine how they have fared and what actions they are taking as a result of lower assets under management and the resulting lower profitability.

The majority of the decline in capital markets occurred in the fourth quarter of 2008. The impact of this on managers’ revenues was relatively muted in 2008—earnings are estimated to be down 10% to 15%, on average, from 2007. However, many managers are starting 2009 with revenues 30% to 50% below the levels at the beginning of 2008.If market returns are flat, then manager earnings in 2009 will be much lower than in 2008.

The asset management business model is based on ad valorem fees, which are fees that are charged based on the proportion of the value of assets under management each year. Normally, managers seek to increase their earnings in one of three ways:
• Higher market returns, which are hard to engineer;
• New inflows of additional assets to manage; or
• Raising fee rates on remaining assets (although current economic conditions are unlikely to be the easiest of conditions under which to make this option successful).

Since revenues are hard to control, managers are also considering reducing costs. For most managers, total staff compensation represents over 50%of total costs. Therefore, this is the most obvious area from which to seek reductions with options limited to cutting headcount and/or compensation levels.

Given the above listed options, what are managers likely to do? Some will do nothing in the hope that markets will bounce back strongly. A lack of action implies that if markets do not rebound, the manager will see reduced profits (or bigger losses). The natural consequence of the latter will be cost cutting. A third potential action is for the manager to restore operational leverage by acquiring more assets. Let’s explore these options more fully.

Manager options
The do-nothing option is, in reality, open only to those managers in a relatively strong financial position, who have substantial cash on their balance sheets and/or whose parent companies have the cash flow and appetite to wait out the market downturn.

For those who wish to cut costs (or are forced to do so), reducing headcount is usually the first step, often starting with employees in non-core roles. Our research in the U.K. suggests that managers are looking to reduce headcount by about 10% and costs by around 20% (either done at the end of 2008 or being undertaken currently).

The situation appears to be the same in the U.S. Further staff cuts would be into muscle, i.e. key investment professionals, which would reduce revenue as well as costs. Non-core staff tend to be lower paid than investment staff, so meeting headcount reduction targets does not reduce overall cost by much. Achieving sufficient cost reduction will require reduced variable pay.

One interviewee thought that management could only do this once (potentially storing up profit pressure for later). Another phrased the issue more bluntly, saying, “There will be no pay rises this year, and the bonus is that you have still got a job.”

It is likely that the financial pain will be greater in 2009 than 2008, and bonuses for the current year (to be paid in 2010) are very likely to be less than 2008.

What about people turnover?
Often, reduced compensation leads to the departure of key talent, however, there are two mitigating factors:
• The majority of managers are in the same boat, so compensation is unlikely to be higher elsewhere;
• The hedge fund route is effectively closed.

There is anecdotal evidence that headhunters have been recruiting talent for some large firms and see this as a good opportunity to invest in human capital. Some boutique firms view this as an opportunity to entice talent from larger organizations. Given the situation, we expect to see some continuation in the rotation of talent around the industry.