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Distributors are Squeezing Asset Managers in Revenue Share Negotiations

by Steven

Asset managers need distributor-specific P&Ls to be able to make strategic bets in negotiating new revenue sharing agreements.

Banks have been hit hard by the economic crisis. Therefore, they are out to maximize their own profits, whatever it takes. For example, the merged Morgan Stanley and Smith Barney entity is seeking a pretax profit margin in excess of 26%, up from the current mark of 18.8%. How can they achieve this radical increase in profits?

Between the discussions at our recent National Accounts Roundtable and the research for our report, Evolving Distribution Amid Bad Markets, we found that many distributors are looking to create more advantageous revenue sharing agreements that will squeeze asset managers even more.

In the past, asset managers saw themselves as partners to the distributors. However, its clear that in times of turmoil the pain gets passed upstream in the value chain. What previously looked like "partnerships" gravitate back to supplier/buyer relationships.

So, how are asset managers supposed to respond to these negotiations? Firms need to recognize there are three pillars to the asset manager / distributor relationship: product, service, and the financial arrangement. In order to negotiate better terms for one pillar, firms need to ensure that they are bringing value to the discussions about the other pillars:

1. Product - is only a lever if the product offered is something unique in the marketplace or if the performance is significantly better than other products in its category. An example of this is PIMCO's Total Return Fund, which is the darling of the industry today.

2. Service - will not get you on the shelf, but it might enable you to negotiate a better revenue sharing agreement. Most of the distributors are looking to outsource their advisor training and development to the asset managers. But we caution firms on using this lever. Most of our research has shown that value-added services do not translate into long term asset flows unless the value-added program specifically fits with the asset manager's brand.

3. Financial - revenue sharing is seen as a toll to get on the shelf. The revenue share does not provide you any additional flows or additional considerations in the analysts' recommendation. For some firms, this might be the only lever they can use to get into the discussion, but remember that a revenue share alone will not get you shelf space or assets.

In order to defend their own profitability from being squeezed, asset management firms have to utilize one of the first two pillars in their negotiations. But to be honest, this will be very difficult for most firms, because most do not have a product that is unique or that has great relative performance, and most firms cannot provide substantial marketing and sales support.

Firms should begin calculating profitability using two main areas of their business in order to understand how to prioritize relationships and determine where to commit dollars:

• Channel - prioritization will help firms decide where to invest in both marketing and wholesaling resources. Firms need to consider if, in light of new revenue sharing agreements, the bank/wire channel is still the most profitable channel, or if the independent and/or RIA channels will be more profitable.
• Distributor - P&L assessments enable firms to make strategic decisions about placing one product with a specific distributor or not. A financial analysis of profitability may lead a firm, for example, to pull its mid-cap value product from Merrill Lynch and decide to place it only with UBS.

Only if a firm understands the economics of its various relationships can it make the right strategic decisions.

In these tough times, distributors cannot afford to care about the asset manager's profitability. They have their own profitability to worry about. Unless asset managers have distinctive leverage via product or service, they will not be able to withstand the squeezing that profit-conscious distributors will put on them. As we identified in our recent study, asset managers have already reduced cost structures by about 12%. Even so, we estimate that net profit margins industry-wide have fallen from 20% to 8% over the past year. To prop up profits in a low asset environment, asset managers must rely on distinctive product/service combinations that will allow them to capture a fair portion of margins from distributors.