Cannibal Alert

Aren’t mergers of high- and low-margin firms risky? And is the credit crunch over?

Jim, as you say, there are very many interesting potential outcomes from the iShares/BGI deal.

For what it’s worth, I think that a bid for the whole of BGI will almost certainly ensue, CVC will get its US$175 million break-up fee, and we will see a major fund management house or bank merging itself with iShares’ parent company.

Roy Zimmerhansl, in his blog today, commends Barclays’ management for sidestepping the ABN Amro deal, buying Lehman on the cheap, avoiding falling into the clutches of the UK government, and now conducting an auction process that appears to be heading towards the largest-ever deal for a fund manager. It’s been a seat-of-the-pants ride, no doubt, but the bank appears to be on a roll.

But, as you say, Jim, merging the world’s largest ETF provider with an active fund manager could throw up all kinds of interesting consequences. If this is the ultimate outcome, will the active manager avoid cannibalizing its own higher-margin products?

My well-read edition of “the Art of M&A;” tells me that “when a low-margin operator acquires a high-margin operator or vice versa, there’s usually trouble because they won’t have an operating fit”. Another business strategy book says that “the merger of two dissimilar business models into one organization is fraught with peril because the structural and operational elements in place for one model will be in conflict with those of the other”.

At the same time, the last 18 months have seen a seismic shift in fund management business models, and it’s unsurprising that there’s a whole new wave of interest in the ETF operators from those active managers whose strategies are under pricing pressure. But it’s certainly a risky trade for the higher-margin firms.

Meanwhile, is the credit crunch over?

If there’s been one single driver of the recent improvement in the global equity markets, it’s been the reduction in credit spreads. A chart of the iTraxx Europe Crossover Index, using data provided by CMA, the credit information specialist, shows that spreads have declined over 3% from their 1 April peak.

 

 

Andrea Cicione, senior credit strategist at BNP Paribas in London, thinks that the Crossover index, which comprises the 45 most liquid subinvestment-grade corporate credits in Europe, may have rallied too far. With a spike in the default rate of Crossover constituents to around 20% quite possible by the end of 2009, said Cicione, the current index level is probably too low, since it implies only half that rate.

Reading FT Assistant Editor Gillian Tett’s excellent account of the credit crisis, “Fool’s Gold”, this weekend, I was reminded how equity investors completely ignored the early signs of trouble in the credit markets in the summer of 2007 – the broad equity indices went on to hit highs in November, before commencing their slide. I’m not sure equity markets would be so complacent this time if credit market conditions worsen again, but this index is certainly one to watch for an advance warning of such an outcome.

 

 

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