Fund directors have done little to obtain value for shareholders in connection with mergers of asset management companies, despite having ample leverage and opportunity.
The marked increase in the pace of consolidation in the asset management industry has been widely reported. Last year saw three major deals, including the Franklin Templeton/Legg Mason acquisition, the largest since BlackRock and Barclays combined in 2009. More appear to be on the horizon. One investment bank predicts that only half of the industry’s current asset managers will still exist by 2030, while other analysts predict a smaller series of targeted transactions.
In either case, fund directors will play a critical role in determining whether fund shareholders benefit from these transactions. Thus far, directors have done a lousy job of representing shareholders at the table. Part of the blame might lie with the reticence of fund directors to negotiate like public company directors do under similar circumstances, but more may lie with board counsel and the boilerplate process employed to consider a merger. It’s a process that is designed to fail and, in fact, has failed to deliver tangible benefits to shareholders in almost all instances I’ve examined.
A change in control of a fund’s investment manager is a potentially transformative moment from the perspective of a fund and its shareholders. Fund directors almost never consider replacing a fund’s manager in the normal course. When a manager chooses to be acquired, fund directors are forced to consider it in a unique way, and the fund board has an important role to play in facilitating the transaction. For the deal to close, the transaction parties – the target manager and the acquiring manager – need the fund board to approve not only a new investment advisory agreement with the acquiring manager, but an agreement on the exact same terms as are currently in place so as to justify the transaction price, which was negotiated under the assumption that the acquiring manager would obtain management of the target manager’s assets at the same fee levels.
Therein lies the fund board’s leverage, which directors have done a poor job in utilizing for the benefit of shareholders. Fund boards should be focused on identifying the potential value in the transaction for shareholders and extracting it. Considerations might include:
- Can any of the transaction price be shared with fund shareholders? (Shareholders have paid management and distribution fees for decades to develop the assets that the target manager is now selling.)
- Can any of the expected deal synergies be shared with fund shareholders? (Most deals are expected to result in cost savings, usually in the short term, which are often publicly touted.)
- Can any fee rates, expense caps, breakpoint structures or other expenses be improved for fund shareholders? (After all, the acquiring manager is increasing its scale through the transaction.)
- Can the acquiring manager commit to invest in new technology or personnel to improve investment performance or the quality of services for shareholders? (Investors are assuming the risks of the transaction presumably in return for “something better” on the other side.)
Instead, too many fund board processes proceed like this:
- The fund board learns of the merger transaction after it is signed and has no opportunity to choose its new transaction partner.
- The board has an initial meeting with the acquiring manager, which talks up the deal from the viewpoint of the managers but not necessarily fund shareholders.
- The board’s regular counsel requests routine information from the acquiring manager similar to the type provided in advance of an annual contract renewal meeting.
- The board determines that the new manager is at least as qualified as the old one, the status quo is likely to be preserved in various respects, and the Gartenberg factors support the new agreement for the same reasons as in prior years.
Fund boards often neglect to hire specialized advisers to analyze the deal and assist with negotiation, forgo a review of the deal’s potential value from shareholders’ perspective and fail to negotiate at all for value-enhancing “gets” like lower fees, investments in fund infrastructure, or even enforceable commitments to maintain current fee levels, personnel or investment strategies in the future.
Such a process does not satisfy a director’s duty of care (nor even the duty of loyalty) under state law. Courts have long held, in myriad contexts, that directors may not give away valuable things, including opportunities, for free without a compelling justification. As Delaware Vice Chancellor J. Travis Laster once said, “have leverage, use leverage.” During a merger transaction, fund boards have the most leverage they will ever have: the transaction parties need the board’s approval, assuming they want the funds to be included in the transaction, and in many cases the parties have already publicly touted the deal and want to close.
Under such circumstances, conducting a process intended only to determine whether the status quo might be preserved is incapable, by design, of delivering tangible value to shareholders. Nor does considering the Gartenberg factors save the day. Federal courts developed those factors to determine merely whether a fee is excessive under Section 36(b) of the 1940 Act, not to advance the interests of shareholders in a transformative transaction. For a process aimed at advancing the interests of shareholders, one might look to the well-developed corporate law surrounding merger transactions, but certainly not a handful of cases applying a discrete federal statute.
If all of this sounds a little too, say, rapacious for your liking as a fund director, perhaps remember a few points. You are hired and paid by fund shareholders to represent their interests at the bargaining table, especially with the fund’s investment adviser. Asset management is a highly profitable business, even among firms struggling with declining margins, and mergers are profit-motivated transactions. All stakeholders in such transactions are represented by zealous fiduciaries who have obtained a profit-maximizing result: the acquiring manager and its owners are obtaining investment capabilities and future management fee revenue that they value greater than the transaction price; the target manager and its owners are receiving cash that they value more than the future revenue of their current advisory business; and executives and key personnel of the target manager are receiving, in most cases, fiercely negotiated retention or severance payments. The sole exception, in too many transactions, is fund shareholders, who receive little more than the same deal they already had along with the risks and uncertainties of the merger.
Fund directors should carefully consider the opportunity and obligation to obtain tangible benefits for fund shareholders in connection with future merger transactions. All other fiduciaries involved are certain to do the same for their constituencies. Business judgment may leave space for discretion in deciding what a “good deal” is for fund shareholders, but it does not permit a rubber stamp.