2009 Ernst Young Business Risk Report Asset Management

8/9/2019 2009 Ernst Young Business Risk Report Asset Management

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The 2009

Ernst & Youngbusiness risk reportAsset management


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The 2009 Ernst & Young business risk report Asset management

About this report

Ernst & Young continues to be heavily engaged around the world in seeking to identify

leading practices in the area of risk management. Properly approached, the process of risk

management can add value even if, fortunately, the feared events never happen. In working

through scenarios and impact analysis, companies may nd many opportunities to tighten

processes and controls that can make them more agile and able to operate more effectively,

in whatever market conditions arise.

Our work with companies around the world suggests that there is a body of leading risk

management practice emerging, but that many companies are still doing too little in this

area. Our research has shown that, while strategic risks have become more important,

companies have been focusing on the easier-to-manage areas of operational risks.

In looking to general practice, the implications for different sectors can be blurred.

One persons challenge is frequently someone elses market opportunity. Even within

each sector, the risks for each company may vary. Risk management must be carried

out at the company level.

We have consulted widely but this is not an exhaustive list of risks. Inevitably it is a snapshot

of the risks we see at this time. We encourage you to read this report in a questioning

manner. Do you agree with the risks? How do they impact you? We hope that some of the

risks identied surprise you and some of the weightings that we attached to them in the

rankings differ from those that you would apply. You should have your own equivalent of

a risk radar and your own ongoing dialogue around this, within your own organization.

We believe that company leadership must:

Conduct an annual risk assessment that denes key risks and weights probability and

impact on business drivers. The risks in this report can provide the start of that process.

Assess risks beyond nancial and regulatory risk to consider the wider environment in

which the organization operates and the full extent of its operations.

Conduct scenario planning for the major risks that they identify and develop a number

of operational responses (possibly as part of the planning cycle).

Evaluate the organizations ability to manage the risks that they identify in particular

ensure that the risk management processes are linked to the actual risks that the

business faces.

Have effective monitoring and controls processes to give both earlier warning and

improved ability to respond.

Keep an open mind about where risks can come from.

Sometimes, of course, the risks that we fear actually come to pass. Few of the risks that

have devastated the nancial services sector and badly hurt the wider economy were

unpredictable economic bubbles generally burst. It is now, in the hardest of times,

when seeking to gain opportunity from adversity, that we will see the evidence of

effective risk management and those companies which mastered it.


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The 2009 Ernst & Young business risk report Asset management 1

Introduction 2

The Ernst & Young business risk radar 3

Executive summary the top 10 for asset management 4

The top 10 business risks 6

1. Dealing with the market crisis 6

2. Threats to the reputation of the industry 9

3. Accelerated pace of change in the industry 11

4. Geopolitical, macroeconomic or regulatory shocks 12

5. Poor execution of globalization strategies 13

6. Competitionfromotherareasofnancialservices 15

7. Model risk 17

8. Missing growth opportunities 18

9. Poor execution of M&A 19

10. Prolonged reduction in investors risk appetite 20

Contacts 21

Contents


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The 2009 Ernst & Young business risk report Asset management2

The crisis experienced in the nancial markets during 2008 has had a

dramatic impact on asset management. Understanding and mitigating

market risks is placing great pressure on managers as they seek to deliver

value for investors.

The nancial crisis will force asset management companies to address the challenges

identied in this report head-on and at an early stage in order to manage the challenges

effectively and transform them from risks into opportunities.

We have been talking with Ernst & Youngs global industry analysts, together with leaders

in the industry to identify the leading business risks and have then rated the severity of the

risk management challenge posed by each.

The top 10 risks most likely to affect asset management companies during 2009 and

shape the industry are discussed in this report. An understanding of how to respond to

these challenges is essential for asset management companies to manage risk effectively,

improve performance and increase value for investors.

The purpose of this report is to stimulate discussion around these risks within asset

management companies, so they can ensure their medium- to long-term business

strategies take account of these issues and seek to address them. Whilst it is not

exhaustive, the top 10 risks identied in this list give a broad-based overview of theissues faced by the industry.

I would like to thank all of our panellists for their valuable time and insights.

Introduction

Ratan Engineer, Ernst & Young


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3The 2009 Ernst & Young business risk report Asset management

The Ernst & Youngbusiness risk radar

The Ernst & Young risk radar is a simple device that allows us to present

a snapshot of the top 10 business risks for a company or a sector.

The risks at the center of the radar are those that the analysts we interviewed thought

would pose the greatest challenge to the leading global rms in the asset management

sector in the year ahead.

The radar is divided into four sections that correspond to the Ernst & Young Risk

Universe model. Compliance threats originate in politics, law, regulation or corporategovernance. Financial threats stem from volatility in markets and the real economy.

Strategic threats are related to customers, competitors, and investors. Lastly, Operational

threats impact the processes, systems, people and overall value chain of a business.

Risk weighting andrisk prioritization

Phase 1:

We interviewed commentators and

academics representing the asset

management sector, asking each

interviewee to identify the top

business risks for 2009. We asked

the panelists to focus on risks for

the leading global rms in the

asset management sector. We also

asked each panelist to provide

commentary on why each risk

was important, how each risk had

changed since last year, and which

of a companys value drivers each

risk might impact.

Based on these interviews we drewup a long list of risks for the asset

management sector.

Phase 2:

In order to prioritize the top

risks for the sector, we interviewed

panels of sector professionals.

The composition of the panels

varied and included CEOs, strategy

planning executives, analysts,

journalists in trade publications,

advisors and our own Ernst & Young

practice professionals. We asked

each panelist to provide their own

ranking of the top 10 risks for their

sector. The panelists ratings were

aggregated to select the nal top

10 risks for asset management

companies.

Fina

ncia

l

Stra

tegic

Com

plia

nce

Dealing with the

market crisis

Threats tothe reputation

of the industry

Accelerated pace

of change inthe industry

Geopolitical,

macroeconomic orregulatory shocks

Poor execution

of globalizationstrategies

Competition from

other areas offinancial services

Model risk

Missing growth

opportunities

Poor executionof M&A

Prolonged reduction

in investors

risk appetite

Opera

tions

The top 10 business risks for asset management


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Executive summary the top 10 for asset management

The top 10

1 Dealing with the market crisis

2 Threats to the reputation of

the industry

3 Accelerated pace of change inthe industry

4 Geopolitical, macroeconomic or

regulatory shocks

5 Poor execution of globalization

strategies

6 Competition from other areas

of nancial services

7 Model risk

8 Missing growth opportunities

9 Poor execution of M&A

10 Prolonged reduction in investors

risk appetite

Aggregating our interview results worldwide, the top 10 business risks for

multinational rms that are leaders in the asset management sector are:

Dealing with the market crisis1

The crisis has battered the entire asset management spectrum, across investment classes

perceived to be both the riskiest and the safest. We have moved into a new global economicand nancial environment during the past year[it will be some time] before traditional asset

allocation methods may be used with condence again, wrote one analyst.

Threats to the reputation of the industry2

The crisis has caused a dramatic decline in the trust of clients and the public.

Recovering this trust will be crucial to the recovery of the sector.

Accelerated pace of change in the industry3

The strategic challenge posed by industry transition remains acute, and this year,

the title of the risk focuses particularly on the pace of change. Converging product

and diverging business models are creating a complex competitive environment.

Geopolitical, macroeconomic or regulatory shocks4

This year the challenge expands to include the risk posed specically by regulatory shocks notably the governmental regulatory responses to the credit crunch and market crisis.


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Poor execution of

globalization strategies

5

The asset management sector is now more global as a result

of falling barriers to cross-border investments, technological

advances, and the need to achieve scale to support cost reduction.

But the risks associated with going global have been exacerbatedby the ongoing nancial crisis.

Competition from other areas ofnancial services

6

There was signicant debate among analysts around the severity

of this risk in 2009. Generally, however, those who were

increasingly worried about this threat, given the weakened position

of many leading rms in the broader nancial services sector,outnumbered those who were more complacent.

Model risk7

Models can produce a false sense of security. Asset managers

need to re-evaluate the assumptions and inputs used in their

models, the process by which values are determined, and the

approach used to validate the models based on real transactions.

Missing growth opportunities8

The analysts we interviewed highlighted the strategic challenge

of identifying and taking advantage of growth opportunities in

the current economic environment at a time when many asset

managers will be thinking defensively.

Poor execution of M&A9

Although there has been an increase in M&A activity in recent

years as part of the ongoing industry transition, some of the

analysts we interviewed felt that in general this has not delivered

shareholder value.

Prolonged reduction in investorsrisk appetite10

The market crisis has brought an immediate reduction in risk

appetites, as exemplied by the pace of redemptions in the

hedge fund sector. There is signicant accumulation of capital;

but much is not invested as investors are waiting for the bottom.


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policy that did not target asset prices were major contributors to

the credit crunch, one analyst contended. Others felt that poor

corporate governance in banking, dislocation of risk between

product manufacturers and investors, misaligned compensation

structures, or weaknesses in international nancial regulation

contributed to the crisis and its severity.

Analysts were unconvinced that the systemic threat from the

credit crunch has entirely abated. Major hedge fund failures

could adversely affect a network of counterparties in the nancial

sector, wrote one analyst. Others worried about possible crisis

aftershocks such as a collapse of major currencies, instability in

China, or an excessive strain on public nances. At present

banking authorities have acted to rescue stricken banks but will

there be sufcient repower and willingness to continue to do so?

was one such comment.

The steps taken by asset managers in response to the market crisis

fall into two broad categories. First, companies are concentratingon maintaining their business by preserving capital. As margins

are squeezed, they are adopting a granular approach to cost

containment with, for example, heightened controls around time

and expense management, and looking at areas such as workforce

rationalization and right-sizing the organization.

Secondly, companies are re-evaluating their risk management

capabilities and controls. They are focusing to a greater extent

than before on enterprise risk management specically on the

ability to aggregate exposure not only across product portfolios

but also across the broader enterprise. They also need more

intelligence on their counterparties, including the geography they

reside in, as insolvency can have very different implications in

different international jurisdictions.

Even as the immediate nancial shocks fade, dealing with the

market crisis is likely to remain at the top of asset managers risk

agendas for some time. As one analyst wrote: No one knows what

to expect because everything we have expected so far has changed

at this point.

Dealing with the market crisis1

It is wholly unsurprising that the nancial crisis and its

consequences are preoccupying companies in the asset

management sector. At times of crisis, short- and long-term

issues coincide, ultimately to the point of survival a sharp

focal point for management. During 2008, the crisis escalateddramatically as condence in the banking sector collapsed.

Interbank liquidity evaporated, sending overnight lending rates

soaring and making the crisis a systemic threat. At the time of

writing, unprecedented monetary lending and banking sector

recapitalization programs in the US and Europe appear to have

stemmed the crisis and avoided a systemic collapse. But nancial

markets remain very volatile and the Organization for Economic

Cooperation and Development (OECD) countries have moved

rapidly into recession. [As] we have moved into a new global

economic and nancial environment during the past year[it will

be some time] before traditional asset allocation methods may

be used with condence again, wrote one analyst.

The market crisis poses an immediate threat, even to the very

existence of the asset management sector. The crisis has battered

the entire asset management spectrum, both those perceived to

be the riskiest and the safest investment classes. Hedge funds

have suffered tens of billions of dollars in redemptions and some

prognosticators have predicted the closure of as many as 35-40

percent of the funds in the sector. Meanwhile, money market

funds in the US, traditionally one of the safest investment classes,

produced losses (broke the buck) because of their exposure to

faltering insurers and investment banks, and suffered a surge of

redemptions as a result.

Some market pundits have claimed that asset managers,most particularly hedge funds, played a signicant role in the

escalation of the crisis an accusation that is questionable.

Governments imposed bans on short selling and hedge fund

managers were brought to testify before the US Congress.

Most analysts we interviewed, however, felt that the hedge funds

were unfairly targeted, and had little to do with either the causes

of the crisis or its escalation. Low interest rates and monetary

The top 10 business risks


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Steps companies can take to respond to this risk

Not letting the near-term focus overshadow long-term

strategic opportunities. As companies struggle to cope they

may be inclined to adopt a near-term approach (such as

reducing staff to cut costs), but it is crucial that they do not

jeopardize the long-term goals of the company (such as the

development of new products). As the market eventually

stabilizes, a company that has cut back on key staff may

face a longer climb to recovery.

Evaluating the product portfolio strategically, in light of

drastically changed demands and expectations from

investors. This entails identifying and understanding the

most protable products, ensuring that products offered

will deliver what they say they will (including evaluating

and disclosing risk exposures), and adjusting the

inventories to make sure the products available are those

that will be needed to deliver value as the situation evolves.

The survival of asset management rms increasingly

depends on their ability to anticipate and project for the

new economy.

For companies undergoing a change due to acquisition

or divestiture, ensuring that the operational capacity

and infrastructure is in place to enable operations to

continue without interruption or diminished effectiveness.

Acquirers must also do a thorough evaluation that includes

accurate allocations of people and infrastructure costs.

(See also risk nine.)


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As the effects of credit market disruption have spread,

each new phase has led to falling asset prices.

Crispin Rolt, Global Asset Management

Markets leader, Ernst & Young

Structural factors have exacerbated

the effect of the credit crunch

The credit crunch and its impact on

nancial markets have moved through

several phases since August 2007.

As the effects of credit market disruption

have spread, each new phase has led to

falling asset prices.

The speed with which an apparently

localized problem developed into a global

sell-off has been a dening feature of

the crisis. So too, has market volatility.

Not just equities but even gold and the

main reserve currencies have

experienced exceptional uctuations

in value. Another notable feature has

been coordinated price falls across

asset classes which many investors

had believed or hoped to be

negatively correlated.

The speed with which the crisis has

spread has been exacerbated by

structural factors. The downward march

of equity prices was reinforced by

feedback loops as market falls triggered

further automated sales.

Despite adverse conditions,

rms can take immediate steps

to protect themselves

The most important short-term

responses can be grouped under two

headings: controlling costs and limitingnet asset outows.

The former includes approaches such

as simplifying products, reducing

compensation costs, consolidating the

back ofce, reviewing outsourcing and

focusing on procured spending. The latter

includes initiatives such as loosening

terms of business, focusing on key

institutional clients, reducing investor

churn, retaining key talent and improving

compensation structures.

Success will depend on the ability to

meet changing customer needs

The future of an entire industry cannot

be easily predicted, but breaking the

issue into two parts may be helpful.

How is customer demand likely to evolve?

And how will individual rms need

to respond?

We can draw on observable trends

already in the marketplace to answer the

rst question. The most important drivers

of future investor demand will be:

Baby boomers in the developed world

becoming spenders, not savers.

Asian economies becoming the drivers

of global growth.

Governments taking steps to addressunderfunded pension liabilities.

Investors abandoning long-only

equity strategies.

The second question is harder to address.

However, we see little in the current crisis

to suggest that the dening trends of

recent years such as increasing demand

for passive management and liability

driven mandates will be reversed.

We also expect some key topics to

generate considerable debate within

the industry over the next two years.

In particular, rms will begin to assess

their own ability to:

Meet demand for capital protection

and income generation as well as

capital growth.

Develop products that combine equity,

xed income and derivatives to

generate absolute returns over very

long periods.

Deliver genuine alpha on a

consistent basis.

Recruit and retain a sufcient rangeof expertise.

Generate sustainable prots from

any passive or quantitative platform

that does not benet from global

scale economies.

Conclusion: grasping the nettle

It is too early to call the end of the credit

crunch, its impact on fund ows or its

knock-on effect on asset managers.

Similarly, it is far too soon to make

denitive predictions about the long-term

impact on the industry as a whole.

Even so, asset managers are not

powerless to respond. Firms can take

steps to limit the immediate impact of

the crisis, and for those with a clear

vision of the future, there may even be an

opportunity to rethink strategic direction.

This could actually be a good time for

asset managers to consider investors

changing needs, and to begin to plan a

considered response.

/ Managing through the market crisis


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one analyst, affects the net ows into the asset management

space and therefore the size and revenue generated by the

industry. Hedge funds may focus on providing investors with the

absolute return hedging products that gave the sector its name,

rather than seeking leveraged returns; fee structures are likely to

come under pressure, especially in alternatives.

Threats to the reputation of

the industry

2

As one analyst put it: [The nancial crisis] will give the whole

sector and system a bad reputation. Some major casualties of the

crisis may never recover from the damage to their reputations

even if they do survive the crisis.

Shocks to the expectations of investors have led to a lack of trust.

Products that have been marketed as safe have proved to be

riskier than expected. As noted above, certain money market funds

that were forced to break the buck jeopardized the reputation

for safety of the entire asset class. The auction rate securities

situation has further dented condence, and US state attorneys

general have threatened investigations that could further damage

reputations. The industry is now faced with the extraordinary

scandal surrounding Madoff Investment Securities involving an

alleged $50 billion fraud, which may be the rst of a number that

emerge as a result of the crisis. Public and investor trust in the

nancial system as a whole has been seriously eroded. Much of

the negative press coverage about the current credit crisis has

centered on structured nancial products. Financial innovation

has to an extent been discredited by the crisis, wrote one analyst.

The lack of trust is becoming evident in several ways. With global

markets tumbling, overall fund performance waning and

redemptions at levels previously unseen, investors are subjecting

asset managers to closer scrutiny. There are new calls for greater

transparency and enhanced processes and controls. In Europe,

for instance, rms are being challenged over their fees, which tend

to be higher than those of their US counterparts.

This lack of trust is also evident in the political arena. Hedge fundsare in danger of becoming scapegoats for what are, in reality,

larger market forces. The recent ban on short selling and new

requirements for disclosure of short positions are examples,

and may challenge the way asset management rms do business

in the future (see also risk four).

Asset managers are currently undergoing a time of industry

housekeeping. While historically, sales were generated from

developing innovative products, today the focus is on defending

core competencies. Companies are concentrating on performance,

transparency, simplifying products, and rationalizing compensation

structures. Investors lack of condence in the industry, wrote

Steps companies can take to respondto this risk

Working proactively for acceptable, meaningful

regulation. While regulatory over-reaction to the crisis

is a serious threat (see risk four), regulation is likely

to play a key part in restoring the reputation of the

industry. Asset management rms should expect

increased scrutiny of their performance; more calls

for transparency; and more challenges to the way they

do business. While dealing with these challenges will

be difcult, given the events that have taken place,this may be necessary to restore public and investor

trust. In the current sensitive market environment,

the asset management industry cannot afford a

credibility challenge. Trust and condence will be key

in energizing a recovery, wrote one industry analyst.

With the industry in the public spotlight, engaging in

proactive communication will be key. To diminish the

threat of an escalating and increasingly politicized

reaction to the crisis, it is important that companies

are ahead of issues rather than responding reactively

to events. Companies need to be able to describe the

products they offer and be in a position to clearly

explain the risk prole.

Maintaining adequate infrastructure, controls and

oversight, even during periods of workforce reduction,

to ensure sufcient controls exist to monitor risks and

trading activities. This is especially crucial in a time of

volatile markets, when there are incentives to push the

envelope to achieve performance.


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Accelerated pace of change in

the industry

3

The challenge of responding to the accelerated pace of change

in the industry is the third most important risk facing the asset

management rms. Although the polarization of business models

remains a signicant strategic risk, its immediate importance isdiminished due to bigger problems such as signicant redemptions

and asset re-allocations to more risk averse products. Nonetheless,

the strategic challenge posed by industry transition remains acute,

and this year, the title of the risk focuses particularly on the pace

of change.

There are a number of different aspects to the change that

is taking place in the industry. Firstly, there is a divergence

between business models, often referred to as the barbell effect.

The markets asset ows have been gravitating to either smaller,

innovative, niche rms or larger, asset-gathering rms. Firms

without a conscious and well thought out strategy are likely to

ounder in the middle.

Secondly, while this polarization takes place, alternative

investments are becoming more institutionalized, and traditional

managers are innovating rapidly. Meanwhile: Alternatives have

grown and are arguably [more] mainstreamThey still provide

a signicant threat to the traditional asset management space,

as one analyst commented. This is creating a convergence of

product offerings between alternatives and traditional managers

with products such as 130/30 funds and commodity funds. (It was

in this aspect of sector transition that analysts saw the greatest

uncertainty following the crisis, because of the possibility of a

serious re-evaluation of alternative trading strategies.)

Steps companies can take to respond

to this risk

Preparing for changes ahead and taking advantage

of the opportunities that present themselves as the

industry transforms. This means identifying and

evaluating lessons learned now, rather than waitingfor a return to lower volatility, in order to avoid being

at risk as the industry continues to transform itself.

It also means that companies must be both tactical

and strategic when undertaking measures such as

product rationalization.

Positioning for the upturn. For some asset managers,

the crisis could provide some breathing space, but the

pace of transition and convergence will surely surge

again. For some managers, this will mean preparing

to serve new clients, and for a more tightly regulated

environment. (For instance, hedge funds must

prepare to deal with potential regulation andrelated compliance.)


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Globalization has been driving business for at least two decades,

but the hedge fund industry has come to grips with this force

only relatively recently.

Samer M. Ojjeh, Ernst & Young

As Western nancial markets continue to

mature, hedge fund managers must seek

new opportunities and capital in Asia-

Pacic and the Middle East. However, only

by building the necessary infrastructure,

managing overseas talent and conducting

business in different ways will funds nd

success in these new locations.

Despite the nancial markets turmoil,

the maturation of the hedge fund industry

continues. Recent estimates indicate a

contraction in assets under management

by hedge funds due to investment

performance and substantial redemptions.

These events may reshape the hedge

fund landscape with a new leaner level

of participation and number of hedge

fund managers.

Although these changes are signicant,

progression to a more global hedge fund

business model is ongoing. Globalization

has been driving business for at least two

decades, but the hedge fund industry

has come to grips with this force only

relatively recently.

Hedge fund managers in mature markets

are increasingly competing for the same

investments and capital. This has induced

more of them to seek new markets in

Asia-Pacic and the Middle East.

While these regions are ripe with

opportunities for expansion, success is

far from guaranteed. The push abroad

compels fund managers to create new

operating models to tackle business

challenges on a much wider scale:

Constructing frameworks that

support trading, risk, regulatory and

compliance functions across multiple

time zones.

Building or buying technology to

ensure the funds systems run

seamlessly and in real time on

different continents.

Hiring, relocating and managing

personnel in far-ung locations.

Establishing new relationships with

third-party service providers, such asprime brokers and fund

administrators.

Navigating business and regulatory

climates in different cultural and

political environments.

These new global operating models must

be assimilated into a funds strategy and

culture, taking into account the regions

in which it intends to trade. Managers

must therefore take a close look at the

challenges and opportunities

in each region.

Asia-Pacic, Australia and the

Middle East

Western hedge fund managers moving

into these locales are looking for new

investment opportunities within their

trading portfolios and, for some, new

sources of capital, which may be a means

to gain access to permanent sources of

capital. They are nding that they must

establish local ofces, to take pressure off

employees based in the US and Europe

who would need to trade overnight and

gain a local perspective on investments,

regulation and talent. A local presence

also enables smoother operations and

better risk management.

While most Western hedge funds manage

their middle- and back-ofce functions

in the West, some are investing in

technology to turn their foreign ofces

into one-stop shops for all aspects

of trading.

Many of the worlds hedge funds have

a presence in Australia in addition to,

or instead of, Hong Kong or Singapore.

Australia is often used as a hub for doing

business in Asia, citing the benets ofAustralias clear and stable regulations

and that English is the native language.

The development of the hedge fund sector

in Asia-Pacic and Australia is years ahead

of the Middle East. But change is coming

quickly, and funds are beginning to put

down roots, particularly in Dubai.

Just 10 years ago Dubai had no formal

capital market or stock exchange, but it is

now home to a rapidly expanding nancial

services industry driven by high liquidity

in the region and an entrepreneurially

minded government. In 2004, the

government opened the Dubai

International Financial Centre (DIFC),

a free zone that enables 100% foreign

ownership of nancial services rms and

a regulated environment free of taxes on

income and capital gains.

However, regulations in Dubai remain

more onerous than in the Caymans,

where most Middle Eastern hedge funds

are domiciled. Thus, Dubai does not serve

/ Hedge fund maturation requires a globaloperating model


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Competition from other areas of nancial services6

There was signicant debate among analysts around the severity of this risk in 2009.

Generally, however, those who were increasingly worried about this threat, given the

weakened position of many leading rms in the broader nancial services sector,

outnumbered those who were more complacent. New entrants may be able to take

advantage of higher margins while not being subject to legacy liabilities (includingreputational ones), one industry commentator warned.

In recent years, traditional asset managers have been challenged by established

institutions from adjacent sectors. Financial conglomerates, such as banks and insurance

companies, have proved to be formidable asset gatherers. These, and other competitors,

could become stronger as the population ages. As baby boomers enter retirement, many

are looking for safer investments and may be attracted to insurance or banking products.

To be sure, many banks especially investment banks have been badly hit by the

nancial crisis. But for those in sound positions, their perceived skill in client relations

could be an advantage. One commentator argued that in a difcult market, retail clients

were more likely to sever their relationship with asset managers than with banks, so the

crisis could place surviving banks in a stronger competitive position. Indeed, regulatory

reactions such as the capital injections from governments into banks that are too big

to fail could have the effect of making banks seems safer than asset managers in the

eyes of investors.

Steps companies can take to respond to this risk

Conducting a systematic evaluation of the client base and market research.

This includes understanding and addressing the perceptions of clients regarding

banks and insurance companies and their products, given the crisis, and the

changing regulatory landscape.

Working to restore condence. This entails a structured strategy going forward,

which must include communicating proactively with clients and the public

drawing on a PR rm if necessary. Communications cannot be ad hoc; they must

have a strategic purpose.

as a hedge fund center. Traditionally

managers have gone there to seek deals,

leaving middle- and back-ofce functions

in the West.

Outside of such hubs as the DIFC, local

laws require local ownership majorities,

so structuring fund investments can

be complex. Also, understanding the

investment principles of Sharia (Islamic

religious laws that deal with aspects of

day-to-day life) can be advantageous.

No longer an option

Even in challenging times, opportunities

exist for hedge fund managers to expand

their global franchises. Markets inAsia-Pacic and the Middle East

continue to grow in importance by all

economic and nancial measurements.

Success in these regions will be a

requirement for global hedge

fund managers.

The winners will have holistic strategies

that work across their entire operations.

That means relocating their talent, hiring

native and local experts, enabling their

ofces with technology and employing

support services that excel, rather thansimply tick the boxes.

Hedge funds already rank among the

most entrepreneurial ventures in

Western nancial sectors. With foresight

and proper management, their push

into Asia-Pacic, Australia and the

Middle East will uncover many

new opportunities.


18/24


The pressure on banks for further disposals and

pressure on players across the industry to cut costs

are likely to continue to drive industry consolidation.

Jens Tholstrup, Executive Director and

Director of Consulting at Oxford Analytica

Jens Tholstrup is an Executive Director and

Director of Consulting at Oxford Analytica.

Prior to joining Oxford Analytica in 2000,

Jens had an extensive career in

investment banking.

There can be little doubt that the

nancial crisis will result in seismic

changes for the asset management

industry. Some of these changes arealready apparent but others will emerge

over time. The primary focus for

managers at present is to navigate the

turbulent markets for almost all asset

classes and to respond to the pressures

for investor redemptions and de-risking.

In the medium- to longer-term,

asset management rms will have to

consider a likely future with lower

volumes and lower margins. Many rms

will not be viable in such an environment

and this will accelerate strategic changeand industry consolidation through M&A.

All investors will be rethinking their

approach to investing as a result of

this crisis; many have suffered

substantial losses and most have lost

condence in markets and in managers.

The subsequent actions of both

institutional and retail investors will

determine how the industry will look in

the future. Survey data suggests that

many will rethink the choice of manager.

According to a recent survey of over400 European institutional investors by

Greenwich Associates, 77% of such

investors are or will be reviewing their

investment management arrangements.

The same survey also revealed that

many European institutional investors

are planning to reduce the share of

assets outsourced to external asset

management rms, and hiring new

professionals to expand their own

in-house management capabilities.

Another trend that has emerged through

survey data is a reduction of exposure

to equities as an asset class. In the

October data for UK funds issued by IMA,

there was a net retail outow of 500

million of which 373 million (75%) was

in equity funds; in the same month there

was an outow of 1.1 billion from unit

trusts and OEICs held by institutional

funds of which 635 million represented

equity funds (57%). There is further

evidence, which suggests that the

reduction in exposure to equities may

be more than a short-term phenomenon:

a recent survey of European and North

American pension funds suggested that

53% of such investors with more than

US$1 billion under management will bereducing their exposure to equities over

the next year.

The volume of redemptions that hedge

funds and property funds are currently

facing indicate a similar reduction in

exposure in the alternative asset sector.

Overall the picture suggests that asset

managers are and will continue for some

time to see a reduction in assets under

management (partly through market

losses and partly through withdrawals)

and that such losses will be weightedtowards higher margin assets. If this

trend continues, individual asset

managers will face considerable

challenges in maintaining protability

and many are likely to look to sell or

combine with other industry players in

order to achieve cost synergies.

An important feature of industry

consolidation has been and will continue

to be the sale of asset management

businesses owned by banks. Most banks

are under pressure to raise additional

capital and in view of the difculties in

raising new capital, many will consider

disposing of non-core operations

including asset management subsidiaries.

According to investment banking group

Jefferies Putnam Lovell, M&A deals

involving asset managers rose in the third

Quarter of 2008: there were 69 reported

asset manager transactions in this period

compared to 52 in the corresponding

period the year before, an increase of 33%

and the total of assets under management

changing hands rose more than three-fold

to US$1 trillion.

The pressure on banks for further

disposals and pressure on players across

the industry to cut costs are likely to

continue to drive industry consolidation

in an industry which has hitherto

been characterized by fragmentation

and relatively low barriers to entry.

The winners are going to be those rms

with lower costs, strong brands and a

competitive track record. In a world

of limited trust and condence, brand and

track record become increasingly

important. Weaker rms will need to

seek to nd buyers or merger partners.

Many will be sold and will merge, andmany will disappear altogether.

/ A coming wave of consolidation


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Model risk7

Model risk is a new entrant to the top 10. Relying on backward-

looking nancial models can leave asset managers ill-prepared

for change and exposed to new risks as demonstrated by the

market impacts from the credit crisis. The credit crunch revealed

widespread failures of internal controls to monitor risk positions,wrote one panelist.

Models relying exclusively on historical data may fail to capture

the possibility of extreme events. Clearly, these models produced

a false sense of security. Panelists suggested various reasons

for the failure of models to prepare rms for the depth of the

nancial shock. Some blamed a lack of sophistication in modeling.

The forecast of global nancial shocks was traditionally done

using very basic nancial and econometric modelsThe fact that

traditional models cannot forecast shocks does not mean that

[shocks] cannot be statistically modeled and forecast it is

very difcult indeed but possible, claimed Svetlozar Rachev*.

Others postulated that the models used were out of date.Asset managers still rely on their classical understanding of the

marketrather than embedding their empirical (and thus very

valuable) knowledge with modern theory for volatile markets, tail

risk measures and a corresponding new set of performance ratios,

was one such comment.


to this risk

Acquiring a better understanding of the workings

of models including those provided by third parties.

This entails an enhanced level of understanding of the

assumptions and inputs used in the models, the processby which values are determined, and the approach used

to validate the models based on real transactions.

Evaluating the re-calibration of models. This includes

understanding how models are updated to reect the

most current market conditions, not just historical data.

* See page 20


20/24


Thecurrentdownturnmeansrmswillemploy

cost saving strategies, such as pooling and locating

activity and services offshore.

Missing growth opportunities8

The panelists we interviewed highlighted the strategic challenge

of identifying and taking advantage of growth opportunities in

the current economic environment at a time when many asset

managers will be thinking defensively.

Asset managers are under constant pressure to improve short-term performance, and this often comes at the expense of

long-range planning. It has become even clearer in the current

environment of nancial shocks (see risk one) and sweeping

changes in the sector (see risk three) that asset managers are

at risk of missing potential growth opportunities. Troubled times

provide opportunities for those with solid foundations and

opportunistic strategies, one industry commentator noted.

Asset managers struggling to cope with the current crisis can fall

into the trap of short-term thinking. Decisions regarding pricing

structures are especially susceptible to this problem. As one

panelist pointed out: Greater scrutiny of performance in the

wake of the current nancial crisis and the lack of condence in

asset managers by investors means that correct pricing needs

particular attention. It is important that new product lines are

assessed for long-term sustainability and risk management

compatibility, and not created to merely take advantage of

temporary market trends.

Taking a long-term view when implementing cost controls is

also important. The current downturn means rms will employ

cost saving strategies, such as pooling and locating activity and

services offshore. A related cost cutting device that has received

headlines recently is the restructuring of remuneration packages.

Investors are asking if the substantial amounts being paid to

portfolio managers really reect their value received.

However, in an effort to slash costs and generate prot in the

near-term, asset managers could make their predicaments even

worse. Entirely preventable crises have occurred due to a

preference for immediate returns rather than sustainable growth,

asserted one panelist.


to this risk

Allocating resources responsibly to create long-term

stability while satisfying immediate results. This entails

potential workforce rationalization initiatives as a means

to reduce costs. However, caution should be taken toensure sufcient infrastructure controls, compliance and

oversight remain, to maintain and grow the business now

and in the future.

Evaluating the existing business model and inventory

of investment products. This may include a targeted

analysis of specic product protability and determining

a core set of products. Additionally, current

circumstances provide an opportunity to retrench back

to those strategies that have been most effective and

may be best suited to perform in the new market

paradigm, which will emerge post-crisis.

Evaluating potential alliances and access to capital.

With the de-leveraging of the nancial system the

access to capital and leverage has changed dramatically.

Asset managers should consider capital sources and

permanency of capital relative to working capital needs.

Strategic alliances, minority equity sales and joint

ventures may provide alternatives to support future

growth and transition.


21/24


Poor execution of M&A9

Poor execution of M&A is a signicant strategic risk in 2009,

as nancial market shocks and aftershocks have increased the

pressure on the sector. While it is a challenge that is widely

appreciated within the industry, as one commentator noted,

it remains a critical issue, especially as there has been a dramaticincrease in the pace at which an M&A transaction is executed,

owing to the current nancial crisis.

Recent large mergers, acquisitions and arranged buyouts are

creating a new (and condensed) eld of players in the nancial

services sector. De-leveraging in the nancial services sector

means challenges for asset management rms related to nancing

opportunities, while the reduction in the number of traditional

prime brokers has led to signicant changes in the way alternative

managers operate. Firms will need to consistently reassess where

they stand in relation to these new players.

Although there has been an increase in M&A activity in recent

years as part of the ongoing industry transition (see risk three),

some of the panelists we interviewed felt in general this has not

delivered shareholder value. Several prior combinations of

organizations with strong distribution channels, with organizations

with strong product manufacturing, are being reevaluated to

determine long-term viability, one sector panelist noted.

There has also been a trend towards more minority, non-controlling

acquisitions recently, with the aim of providing either permanent

capital or possible succession planning currency for alternative

managers. In such cases, product line offerings may be

enhanced but legacy entrepreneurial operating practices are

maintained (rather than complete integration of organizations).

Managing these combinations creates further operational

challenges. In addition, with the signicant changes occurring in

the traditional nancial services sector, private equity rms may

be interested in broadening their footprint and becoming buyers

of asset managers. The private equity model has traditionally

been a more active, controlling buyer and therefore integration

of people and infrastructure should be top of mind issues.

The past year has witnessed a new dimension to M&A activity.

Major mergers have happened literally overnight, often without

the chance to exercise exhaustive due diligence. Mergers or

acquisitions without thorough assessment of the potential

consequences could have lasting and profound effects across

the nancial sector. In these cases, the challenge is to conduct

post-closing due diligence thoroughly.

There is no consensus on how to evaluate M&A activity and there

is plenty of uncertainty in planning long-term scenarios after M&A

takes place. As one commentator put it: Unfortunately, there is

no satisfactory model for valuation in [the current] M&A setting.

Steps companies can take to respondto this risk

Evaluating strategic t in terms of client base,

organizational structure and corporate culture.

In addition, accounting, nance and taxation issuesare key, particularly for cross-border mergers.

Buyers must prepare up front and know the nancial

and tax exposures of the target.

Not letting nancial opportunity override operational

due diligence. Faster transactions are more challenging

due to the speed with which the deal has to be executed,

although the issues that need to be considered are

the same.

Effectively managing the post-merger integration.

Many acquisitions fail because of poor integration

strategies. Making the deal and paying the price is

only the rst part of an acquisition or merger;

implementing an efcient integration process can

often be the most difcult part.


22/24


Companies need to evaluate their product portfolio

and ask such questions as: What is the inventory of

high and low risk products I have in my portfolio?

Prolonged reduction in investors

risk appetite

10

Our nal risk in the top 10 is the risk of a prolonged reduction

in investors risk appetite. The market crisis has brought an

immediate reduction in risk appetites, as exemplied by the pace

of redemptions in the hedge fund sector. The commentators weinterviewed worried that this could become a long-term trend,

with investors sitting on the sidelines and not investing beyond

perceived safe investment products.

Investors have struggled to develop a considered response to

the crisis, becoming increasingly reactive to market news.

Retail investors in particular have rapidly reined in their risk

appetite. Selling during or after a crash may run contrary to

theory but it is an instinctive response, one that may have

been reinforced by investment goals dened in terms of

relative returns, noted one panelist.

There is signicant accumulation of capital; but much is notinvested as investors are still gauging the extent of the market.

This could prolong the current crisis and delay recovery as

investors turn overly cautious. Although, as with many risks,

this could be an opportunity for some. For large beta players

offering less risky products this is a chance to gain

market share.


to this risk

Engaging in product rationalization review. Companies

need to evaluate their product portfolio and ask such

questions as: What is the inventory of high and low

risk products I have in my portfolio? What is the proton a lower risk portfolio and how does this impact

the business?

Enhancing communication and disclosure. This includes

adopting a proactive approach to communication with

investors and distributors, and development of reporting

that addresses the risk concerns in the marketplace.

Rory Macleod, Managing Director of Objective Analysis and the

former Head of Global Fixed Income at Baring Asset Management

Dr Stephen Satchell, University Reader and Fellow of Trinity

College, The Faculty of Economics, University of Cambridge

Svetlozar Rachev, Co-founder of Bravo Risk Management

Group, Chief-Scientist at FinAnalytica and Professor and Chair

of Econometrics, Statistics and Mathematical Finance, School

of Economics and Business Engineering, University of Karlsruhe

Panelists quoted on the record are noted below. We thank also the industry experts who participated anonymously.


23/24


Name Telephone Email

Ratan Engineer (Global Asset Management leader) +44 207 951 2322 [email protected]

Sue Cote (Americas leader) +1 212 773 8700 [email protected]

Roy Stockell (EMEIA leader) +44 207 951 5147 [email protected]

David Sung (Far East leader) +852 2846 9882 [email protected]

Carlyon Knight-Evans (Far East leader) +852 2846 9608 [email protected]

Graeme McKenzie (Oceania leader) +612 9248 4689 [email protected]

Koichi Hanabusa (Japan leader) +813 3503 1100 [email protected]

Crispin Rolt (Global Asset Management Markets leader) +45 3587 2535 [email protected]

Mike Lee (Americas Markets leader) +1 212 773 8940 [email protected]

Contacts


24/24

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