Federated Investors Inc.'s Monday deal for Banknorth Group's fund unit would be the fourth purchase of a small bank's fund group by the Pittsburgh fund company as many look to leave the proprietary fund business.
Federated says it did the deals, and has more in the pipeline, in order to maintain relationships with banking companies that want to get out of proprietary fund management but remain in the wealth management business.
The latest fund deal came on the heels of the Portland, Maine, banking company's Thursday announcement that it plans to sell a majority stake to Toronto-Dominion Bank. J. Christopher Donahue, Federated's president and chief executive officer, said in an interview that he had been in talks for Banknorth's $265.5 million-asset fund family for six months to a year and was unaware of the Toronto-Dominion deal.
"This deal is a confluence of circumstances that only now do we fully understand," Mr. Donahue said. "It is a combination of things" from Banknorth's standpoint. "Between their merger, their desire to move to open architecture, and the current regulatory environment, this is a smart move for them."
Jeff Nathanson, the director of corporate communications at Banknorth, said the two deals' timing was pure coincidence.
"The decision to sell the assets to Federated was really independent of our discussions with Toronto-Dominion," he said. "We are not getting out of the wealth management business as a bank, and we will continue to grow this business, but on the mutual fund side it didn't make sense to offer proprietary funds."
Mr. Nathanson said Banknorth will continue to work with Federated to offer its funds among other nonproprietary products. Given that the proprietary funds were not growing, not attracting new money, and likely to cost too much for regulatory compliance, it was time to quit that aspect of the fund business, he said. Mike Scott, the mergers and acquisitions research manager at SNL Financial LC in Charlottesville, Va., said Banknorth decided to unload its fund unit because it knew it had the deal brewing with a strong multinational bank that has well developed wealth management capabilities.
"Banknorth is trying to expand its banking presence in the Northeast," he said. "The bank cut its proprietary fund business to focus on banking." The deal wasn't about making itself more attractive to Toronto-Dominion, he said.
Mr. Donahue said more small and midsize banks are looking to sell their mutual fund families. Federated added $774 million of assets under management when it bought fund units during the past two years from FirstMerit Corp. in Akron, Ohio; Riggs Bank in Washington; and Citizens Bank of Michigan in Flint.
Despite the deals, Federated has not grown in the past two years. When it announced the FirstMerit deal in August 2002, it had $185 billion of assets under management. In announcing the Banknorth deal, it remains a $185 billion-asset company.
Mr. Donahue said the company's assets under management have fluctuated in the past two years but have fallen recently as money market funds declined when the Fed increased rates.
Federated is acquiring in order to develop scale and maintain relationships with small and midsize banks, Mr. Donahue said. His company helped roll out funds with all four of these banks, but as the portfolios began to lose assets and the banks lost interest in selling proprietary funds, Federated was willing to buy the funds to keep the banks as customers, he said.
"This is not just about growing our assets in mutual funds; we are trying to develop business with small banks," Mr. Donahue said. "We want to sell our products. We want to be able to offer them managed accounts. We want to build this relationship year after year."
He said more deals are in the pipeline.
"When we look back in three to five years, you will be able to say with confidence that there were a lot of deals that occurred. This is an accelerating trend," Mr. Donahue said.
Analysts and executives agreed that as small and midsize banks continue to lose assets from their proprietary fund groups, the interest in selling would grow.
"The real squeeze is going to be on mid-market banks that have their own proprietary fund families," said William Reid, the president and CEO of ICBA Financial Services. "It becomes hard to justify the costs of compliance as profit margins decline." A "negligible" number of community banks offer proprietary funds, he said.
Financial Research Corp. has forecast that tighter fund regulations will increase costs 14% industrywide and trim revenues by 10%. The Boston research company has said it expects profit margins to fall from 36% at the end of 2002 to 19% by the end of next year.
Karen Kruse, a senior vice president of wealth management at First Tennessee Bank, a unit of First Horizon National Corp. in Memphis, said it is a "definite possibility" for small and midsize banks that have fund families, like her First Funds, to consider altering their wealth management strategies.
"Everything I have read since the scandals broke in September indicates that a firm needs $5 billion to break even, and we are not there yet," she said. About 79.9% of fund companies have not reached the $5 billion threshold, Financial Research says.
First Funds had $1.7 billion of assets under management, including $1.17 billion in long-term portfolios at July 31. Financial Research said assets in the bank's long-term portfolios have declined 7.7% since the end of 2002. First Funds is one of six bank-owned fund families whose assets have fallen in the past 19 months.
Two large banking companies whose fund groups have lost assets in this period, Mellon Financial Corp.'s Standish Mellon Asset Management and HSBC USA's HSBC Fund Group, said they remain committed to offering their own mutual funds. The families' assets have declined 27.3% and 25.7%, respectively.
Joe Ailinger, a spokesman for Mellon, said Standish Mellon, the Pittsburgh financial company's fixed-income ar m, is emphasizing separately managed accounts over mutual funds for clients but is not leaving the fund business. Pamela Plehn, a spokeswoman at HSBC USA, said the Buffalo company remains committed to its mutual fund group.
For small banks that have lost assets, the choice is more difficult.
One bank-owned fund family that has lost assets in the past 19 months has been sold. Citizens Bank of Michigan, whose Golden Oak Funds' assets under management fell 9.7%, to $336.6 million in long-term funds at July 31, sold its seven portfolios last month to Goldman Sachs Trust and Federated. More could follow its example.
Jim Schmelter, the president and chief executive officer of Citizens Bank Wealth Management, said the Golden Oaks Funds never reached the critical mass needed to compete in the industry.
"We didn't have the distribution network necessary, and we knew we had to get out of the business," he said. "But what really made us get it done at this point in time was the increased regulatory rules coming into effect this year. It all came together at once, and we just decided we had to do it this year."
Mr. Schmelter said new SEC regulations would have required additional infrastructure and the parent bank, which had $7.7 billion of assets at June 30, would have had to hire people, including a chief compliance officer.
"There are a lot of large fund complexes out there hovering and waiting to pick up the assets of smaller complexes ready to fall by the wayside," said First Tennessee's Ms. Kruse.
Given the regulatory environment and the desire at First Funds to offer open architecture, she does not know whether First Tennessee will offer proprietary funds two years from now, she said.
"I've got a lot of questions about the viability of offering proprietary funds, not just for me but for all proprietary fund groups going forward," she said. "The whole industry is moving to open architecture, and the roar is louder than ever."
Banks have been slow to adopt open architecture on their sales platforms, and this hesitance is costing them customers, research indicates, especially those with more than $5 million of investable assets. Banks managed 62% of this group's assets in 1992 but 24% by last Dec. 31, according to a report from Celent Communications.
Mark Hendrix, a spokesman at Riggs Bank, said it was still ahead of the curve when it decided to commit itself to an open architecture strategy and sell its fund unit to Federated in July 2003.
"The mutual fund business is becoming an economies of scale business where you have large, efficient factories running giant complexes. They can bring more expertise than a small bank can," he said. "Our decision to exit is consistent with the evolving industry trend for small and midsize banks to get out of this business."
Katherine Taylor, a spokeswoman in Rockford, Ill., for Amcore Financial's Vintage Funds, whose assets have shrunk 4.5%, to $510.6 million, since the end of 2002, said the decline had accompanied a move to offering a wider array of nonproprietary products.
Federated's Mr. Donahue said open architecture, increasing compliance costs, and falling revenue are creating a smaller group of large companies that dominate asset management.
"What you will see is more oligopolization," he said. "The bigger will keep getting bigger. If you don't have a $100 billion ticket, it is hard to get into this game."
