The U.K. asset and wealth management industry is currently caught in something of a pincer: fees are down, but costs are up. Pressure on revenue and profit margins has increased in line with greater regulatory focus and investor disenchantment with the active asset management model. At the same time, the capital-light nature of the business, combined with the potential for new strategies to bring success, has attracted new entrants to the market, and enticed back players who left the market after the Retail Distribution Review (RDR) in 2012.

The U.K. investment management sector has over £9 trillion in assets under management (AUM), making it the second largest in the world. Nevertheless, it is an industry in transition. In S&P Global Ratings' view, the changing conditions are largely unfavorable for the sector. Some investors are moving away from actively managed funds, while others expect fund managers to develop greater expertise, in areas such as environmental, social, and governance (ESG). The nature of the U.K.'s departure from the EU means that their future trading relationship has not yet been resolved for financial services firms. In addition, the cost of complying with regulatory requirements is rising. The current slump in investor confidence adds to the sector's challenges.

According to Casey Quirk, a management consultancy, global public asset managers' operating margins fell by an average of 5.2% a year over the three years to 2018, but AUM rose by an average 6.9% in the same period. We believe that the trend is unlikely to have changed in 2019. Margins are being squeezed, in part, by higher operating costs due to heightened compliance requirements. The implementation of the second act of the EU's Markets in Financial Instruments Directive (MiFID II) in 2018 also disrupted the bundled research and trade execution model that was common in Europe. Most fund managers reacted by absorbing research expenses onto their own books.

Faced with rising costs and competition, global consolidation--which affects the U.K. market--has accelerated. In February 2020 alone, we saw:

• Jupiter Asset Management announce plans to acquire Merian Global Investors. The deal would bring £65 billion in combined AUM into one group.
• Interactive Investor, an investment platform, announce plans to purchase The Share Centre. The combined entity will have assets under advice (AUA) of over £36 billion.

These developments are consistent with recent consolidation in the U.S., although the scale is very different:

• Morgan Stanley announced plans to purchase online brokerage E-Trade to form a combined platform of $3.1 trillion in client assets; and
• Franklin Templeton announced that it would acquire Legg Mason, creating a global investment manager with $1.5 trillion in AUM.

The Search For Scale

We anticipate that competitive dynamics in the U.K. investment management sector will continue to fuel further consolidation, as scale becomes a mantra for investors. Despite the large absolute size of the U.K. asset management industry, its players are typically far smaller than U.S. peers such as BlackRock Inc. ($7.4 trillion AUM as of Dec. 31, 2019; AA-/Stable/A-1+) and Vanguard ($6.2 trillion as of Jan. 31, 2020). Of the top 20 global asset managers, Legal & General Investment Management is the only U.K.-domiciled asset manager.

Chart 1

In a bid to combat the squeeze on profit margins and revenue, the U.K. asset management industry witnessed a number of large deals, such as the £11 billion merger of Standard Life and Aberdeen Asset Management in 2017 and the $6 billion merger of Henderson Global Investments with U.S.-based Janus Capital in the same year. Larger players can see better revenue stability, if they operate in various asset classes and are diverse in terms of geography and investor base. Mergers and acquisitions, if executed well, can also help achieve cost efficiencies and partly offset margin pressures over the short-to-medium term, in our view. However, we note that efficiencies take time to materialize and revenue synergies are often elusive. Further, consolidation comes at a cost. Funding these transactions through the debt markets could increase financial risk, especially given that the sector has historically avoided leverage.

Several of the largest U.K. asset managers, such as LGIM, HSBC Global Asset Management UK, and Aviva Investors, are part of insurance or banking groups. This provides them with diversity, scale, and a source of funds, either from life insurance assets or private clients. Even globally, only about half of the top 20 asset managers are independent of banking or insurance groups.

Independence Can Free Up Capital

Compared with Continental Europe, more U.K.-based asset managers have chosen to cut ties with their bank or insurance parent. Capital regimes for asset managers are less onerous than the regulations governing banking and insurance groups. Therefore, operating as a stand-alone asset manager frees up cash from balance sheets.

Some groups also consider that their operating model can become more focused and agile if they separate the businesses. Standard Life Aberdeen (SLA; A-/Stable), for example, became a pure-play asset manager after it sold its insurance operations to Phoenix Group in 2018. Investec Asset Management had £121 billion in AUM and is demerging from its banking parent Investec to become Ninety One. It has announced plans to be listed on the London Stock Exchange. M&G PLC demerged from its insurance parent, Prudential PLC, in late 2019. It now focuses on its dual position as an asset owner and asset manager.

Active Managers Need A New Selling Point

The tide is shifting toward passive index trackers that largely rely on sheer volume to generate returns. This makes it harder for U.K.-based active managers to defend their competitive edge and achieve organic growth at the previous level of profitability. At the global level, we see a negative outlook for the traditional asset manager sector, which is suffering from fee pressures and mixed investment performance.

Some managers, such as SLA, have chosen to hone in on alternative asset classes, such as real estate and private markets. This enables them to cater for the increasing demand for private assets, while maintaining their value-generating capabilities. We consider the outlook for the global alternative asset manager sector to be stable because AUM are largely locked up and investment strategies are harder to index. Alternative asset managers have also seen significant net inflows as a result of good investment returns. The average fund size has increased and platforms have broadened.

Several U.K. asset managers have responded to increasing investor interest by prominently embedding ESG factors in their investment decisions. By promoting their ability to actively manage funds to support sustainability and the environment, they hope to offset some of the growth they have lost to passive funds.

A less-successful approach has been to broaden the client base by offering robo-advisor platforms and other forms of digital advice. This strategy was intended to attract the mass market with affordable advisory fees. However, robo-advice services have seen mixed responses. Some companies, such as Investec, are closing their operations due to low demand.

China is seen as having long-term growth potential. Some U.K. players have therefore reacted to shifting investor preferences in the U.S. and EMEA by expanding into China. In some cases, they have combined this strategy with a focus on alternative assets.

Conduct Gets More Scrutiny

The high-profile Woodford scandal in 2019, which led to a suspension and the eventual liquidation of the Woodford Equity Income Fund, had ramifications for the whole industry. Tighter liquidity rules and greater disclosures regarding service charges and fees could trigger some changes to companies' business models.

Fund management is an industry where the players' fortunes are strongly linked with reputation and investor sentiment. Manager Neil Woodford seems to have had a bit of a cult following--brokers like Hargreaves Lansdown continued to recommend the fund until it was frozen. The size and lack of scrutiny of the fund calls into question the role of the entire fund industry--regulators, trustees, fund managers, intermediaries, and authorized corporate directors.

The Financial Conduct Authority (FCA) has since applied greater governance and conduct scrutiny. Following the consultation into illiquid assets and open-ended funds that followed the liquidation of the Woodford fund, it published new fund liquidity rules in September 2019. Funds that invest in inherently illiquid assets must make higher liquidity disclosures and face enhanced depositary oversight. They are also required to produce liquidity risk contingency plans.

Non-UCITS (undertakings for collective investment in transferable securities) retail schemes that invest in inherently illiquid assets, such as property and infrastructure funds, must suspend dealing if there is material uncertainty regarding the value of more than 20% of the fund's assets. For example, the M&G Property Portfolio fund, suspended in December 2019, remains locked to withdrawals as the company works on raising liquidity from a cash position of 4.8%.

The U.K. regulator will also be carrying out work in 2020 to evaluate the effectiveness of governance and value assessments on funds so that products do not include features that are not in the interest of customers. Examples include funds that track an undisclosed index or fees that exceed target returns.

An Overcrowded Wealth Management Market

The long-term client relationships between independent financial advisors and their clients play a significant role in the U.K. market. As a result, wealth managers are less likely to lose funds under management to a rival than asset managers. That said, competition in the market is being fueled by new players and re-entrants. Not only are global fund managers looking to increase their presence in the U.K., several U.K. banks have also indicated their interest in re-entering the market. Most recently, a Lloyds-Schroders tie-up, Schroders Personal Wealth, was launched, with bullish ambitions.

Banks hope to exploit their established distribution networks and large customer bases to penetrate the U.K. middle market. Most withdrew from the wealth and financial advice market, or downplayed its strategic importance, after the RDR banned investment commissions and rebates in 2012.

Wealth managers such as St. James's Place (rated A-/Stable) and more affordable retail investment platforms, such as AJ Bell and Hargreaves Lansdown, greatly benefited from the absence of the banks, and then grew strongly following the 2015 rule change known as the pensions freedom. This removed the legal requirement that over-55s purchase annuities to access their pension pots, and limited charges for these investors.

The political uncertainty of 2016-2019 stymied new business growth in the U.K. wealth management sector. In the meantime, clients have become even more demanding in terms of investment performance and client service. Given that the market is especially fragmented and nearly all U.K. wealth managers are smaller than their global peers, we see it as ripe for consolidation. Most players are relatively small and have struggled to grow. Simultaneously, they are feeling the pressure from higher compliance costs.

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For example, in 2019, a £1.8 billion merger of Tilney and Smith & Williamson was announced. This remains subject to regulatory approval. Liontrust has also announced its acquisition of Neptune, and Quilter Private Client Advisers has continued its acquisition streak into 2020. Buying Prescient, a financial advice firm, will add more than £800 million of AUA to Quilter.

Change Costs Money

Building and defending sustainable competitive advantages is getting increasingly difficult. Asset managers have launched multipronged initiatives to offset the pressures on fees and fund flows. Although we see potential in the strategies adopted by U.K. asset and wealth managers, we remain cautious.

Transformational initiatives and mergers require significant investment and capital. Given that revenue yields are already facing compression, many organizations are already revamping their cost-saving programs.

The creditworthiness of asset and wealth managers depends on their ability to translate their strategies into stronger and more sustainable earnings in the long term.

Related Research

• Asset Manager Outlook 2020: The Divide Between Alternative And Traditional Asset Managers Widen, Jan. 17, 2020
• MiFID II: Disruptive Regulatory Change For European Financial Markets, Winners And Losers To Emerge Over Time, Jan. 2, 2018