Despite the market downturn resulting from the ongoing COVID-19 pandemic, secular trends in the asset management market that made the environment ripe for consolidation during the past five years—namely, fee compression, outflows from higher-cost active strategies, and product rationalization—are not likely to disappear any time soon, according to the latest Cerulli Edge—U.S. Asset and Wealth Management Edition.

In order to combat fee compression, shrinking shelf space, and the rising cost of compliance due to stricter regulations, numerous subscale managers have joined forces. These subscale deals are aimed at strategic expansion into broader markets around the globe and consolidation/rationalization of product lineups to focus on top-performing strategies. “In theory, these are the kinds of M&A deals that make sense on paper, but they can also serve as cautionary tales of the difficulties of melding operations within different firms with varying cultures,” comments Bing Waldert, managing director. According to Waldert, “Mergers of this type typically lead to at least some level of reorganization and staffing reductions that run the risk of disrupting a business in the near term after a deal is finalized.”

For newly created mega-firms, there remains considerable potential for growing pains and uncertainty stemming from their efforts to increase scale through outside acquisitions. A clearer path to success may reside in another type of M&A deal: the strategic acquisition of smaller firms with strong brands and industry reputation. “We have observed an increasing amount of M&A deals that primarily focus on the opportunistic acquisition by larger firms of specific capabilities and brands known for their specialization in a given sector—e.g., alternative investments and environmental, social, and governance (ESG) offerings,” comments David Fletcher, senior editor.

Alternative investment capabilities are an attractive M&A target for many asset managers given investors’ increasing interest in uncorrelated, risk-adjusted allocations and these products’ relatively attractive revenue potential. Alongside the 74% of firms polled by Cerulli in 2020 citing the potential for increasing revenues as motivation for developing alternative investment capabilities, 59% point to business diversification as a chief driver. According to Fletcher, the buy option is attractive to many firms that lack in-house expertise and seek quick speed to market. “Acquisition of firms with strong reputations in niche spaces makes sense for larger managers with the luxury of going the ‘buy’ route as opposed to building internally.” Cerulli survey data suggests that, in the case of alternatives, there will be increased use of in-house teams and affiliates to build product lines in the near term as opposed to outsourcing to unaffiliated subadvisors.

In addition to the alternatives space, there is an increasing number of managers expanding via specialized firm acquisitions in the ESG-related product universe. Nearly one-quarter of firms polled are in the process of developing ESG capabilities during the next two years. For some firms, there will be significant cost to building these processes and staffing them. Therefore, as asset owners continue to place increased scrutiny on asset managers’ business practices and processes, Cerulli expects that more M&A activity related to ESG/responsible investing will occur in the near term.

While pandemic-related uncertainty may impact deal flow in the short term, asset manager consolidation is likely to continue. In addition to monitoring how larger M&A transactions transform the firms involved in coming years, firms should pay attention to the smaller mergers that afford firms with more diversified investment capabilities. These deals could help asset managers broaden their existing product offerings while also expanding their product suites into specialty, niche areas where they may enhance their revenue streams.