Getting out of the brokerage business

The Wall Street Journal

Last month, Legg Mason Inc. Chairman Raymond "Chip" Mason engineered a deal cementing the transformation of the firm he founded from a small regional brokerage to a global money-management powerhouse.

The deal will send Legg's 1,400 brokers to Citigroup Inc. and Citigroup's $460 billion asset-management group to Legg. After the transaction closes later this year, Legg Mason, based in Baltimore, will oversee roughly $830 billion.

The swap could prompt other brokerage firms that sell house-brand funds to consider similar deals to sidestep regulators' and investors' concerns about the objectivity of brokers' advice.

For Mason, the deal also closes a personal door. He got his start as a stockbroker in 1969 at his uncle's Lynchburg, Va., firm. In 1962, Mason struck out on his own, founding Mason and Co., which eventually merged with Legg and Co.

In the 1980s, he got into the money management business, launching the Legg Mason Value Trust fund, managed by William H. Miller, who now holds a record for beating the Standard & Poor's 500-stock index for 14 consecutive years. Soon after, the firm acquired California-based bond manager Western Asset Management.

While Wall Street is littered with failed acquisitions of money managers by brokerage firms, Mason found a formula that worked. With Western and subsequent deals, he bought top-quality money managers that focused on different corners of the market and different types of clients. And in contrast with the approach taken by others, Legg let the firms operate independently. In 2001, for example, Legg acquired small-stock specialists Royce & Associates and Private Capital Management, which caters to wealthy individuals.

The Citigroup deal is a departure. It will require the integration of a substantial portion of the Citigroup operation into Legg's Western Asset Management group. In addition, the performance of Citigroup's mutual funds has been uneven and many funds could be merged into Legg Mason funds.

In an interview, the 68-year old Mason discussed the deal, the challenges his firm faces and the future of the money-management business. Excerpts follow:

WSJ: How did you develop the approach that you eventually came to define as Legg's strategy, beginning with Western Asset Management?

Mason: The acquisition of Western Asset turned out to have been a major decision. The goals at the time were to get the firm into a fee-based business, because except for the revenues coming from Value Trust, we were completely a brokerage firm relying solely on commissions.

This was also the first real step into a bigger league because Western was extremely devoted to the institutional world -- virtually 100 percent of their business -- and that wasn't a business we were in. Secondly, it was a bond manager and we were basically an equities firm so it diversified us two or three ways. When you coupled all that together, it was a pretty big turn, but we had no idea how important.

WSJ: As you did subsequent acquisitions, you left them as bolt-on, largely independent groups. That was sort of unusual.

Mason: Our view was that with Western, we had acquired a very good, institutional fixed-income manager and we really knew nothing about that business. I'm not saying it was impossible for us to interfere but it would have been ridiculous because all we would have done is messed it up. So I took the position with everybody that they were to leave them alone and let them run the business. But again it led us down a path that I had no idea was quite as dramatic as it turned out to be.

WSJ: So from the Western acquisition did you learn things that would be applied to future deals?

Mason: Our knowledge level went up but we didn't realize we were gaining a concept that was going to work as well as it turned out to be. I will say, though, that I was never concerned about our not being directly involved in Western, so maybe I was more understanding than I realized.

Where we would tinker was on the distribution side. We would jointly distribute, but we learned over a period of years, as we did other acquisitions, that really it didn't work. We would try and joint market things, but the one who wasn't getting many new assets was convinced that either the marketing people didn't like them or they were being unfairly treated, whatever it may be. As it turned out, they marketed their own products better even though the cost of having two units was more expensive.

WSJ: Another important element is that the deals were all based on a revenue-sharing arrangement, where the units kept a slice of their profits and Legg took its slice. How did that come about?

Mason: That, too, was somewhat fortuitous. We initially did the Western deal on a revenue-sharing basis somewhat at the suggestion of Western. From our standpoint, it was good because we had an idea how much money we were going to make on any given, day, month or year. And from the standpoint of Western asset or anyone else it was the same. They more or less made their own income because they knew they were getting a percentage of X.

The best part is it kept us out of debating issues that you would really much prefer not to debate. If you have issues that are almost immobile or you've got issues with somebody over silly things, you just don't get into them because they are making that decision with their money. And unless it's really out of line or you feel it's causing a problem of consequence you leave it alone -- even if you don't agree.

WSJ: After going through the series of acquisitions that bulked up the asset-management side of the business, how did your thinking evolve about having both a brokerage and money manager under the same roof?

Mason: The plus was ... that if we had very good money managers, that those money managers would do a better job generally helping to manage the customer's asset than the individual broker would do. The more of that we would do, presumably the better off the customer would be.

Also, we were getting our brokers very helpful advice on things like where the financial markets were or where the bond markets were from the viewpoints of very well-thought-of asset managers. These were inputs which helped the broker analyze what the client should be doing and we thought that would help professionalize our whole sales force and I think it worked.

WSJ: But a negative view of this set-up evolved.

Mason: That wasn't until two or three years ago. In the '70s, '80s and '90s, companies wanted to take their product from the minute it was born until it was sold. They wanted to package it, they wanted to prep it -- they wanted to do everything. The theory was they would end up with the best and most streamlined products with as few mistakes and errors as there could be. And to a great extent that's what happened.

Then there was a massive shift in the regulatory attitude and it had a major effect. What the regulators were concerned about turned out to be things that the banks and other financial institutions didn't see as major problems. They had built all these things to hopefully eliminate conflicts but the regulators ended up viewing it quite differently.

At the same time there was a trend going in on in Europe -- which I was watching -- where they were beginning to sell money managers off under the theory that they could buy the products from the money manager far cheaper and easier than they could going the other way. We were very involved in a potential purchase -- which we didn't end up buying -- with a German bank. They were questioning whether or not they as a bank should be -- and could be -- managing a money manager or whether they as a bank should just be a distributor. It was just fascinating to see the logic of how they were approaching it and it really was a preview of the thought process that was going to go on two or three years later.

WSJ: The difference was that you guys were doing well, while other firms were struggling with being both a brokerage firm and a money manager.

Mason: The difference was that our principal product [Bill Miller's Value Trust fund] was outperforming the market each and every year. The only thing we were doing wrong was that we didn't force the customers to buy it so that they would all outperform the market every year!

WSJ: Were you hearing from your own sales force that as good as Bill's group is, they were starting to have issues?

Mason: Not really, until about a year ago when the regulatory side became much louder and more vocal. Prior to that, [Value Trust] was a product that was working very well and it was hard when you've beaten the market 13 or 14 years in a row to have a problem with it. And the customers weren't unhappy. Even in the down markets they still outperformed.

All of this is really about making money for the customer and sometimes it gets lost in everything that goes on. But the underlying concept is to do well for your customer. If you don't you will lose them or you should lose them. So they didn't see the conflict.

I think that brokers in general are far more cognizant of it now and are almost concerned about selling something that smacks of being their product. If you looked at the in-houses [fund sales] of all the major distributors that were also in asset-management business, their in-house piece has been coming down fairly sharply.

WSJ: And that was happening at Legg Mason?

Mason: Probably less so, but certainly to an extent. But we had something going for us that others didn't have!

WSJ: How did the path lead to the Citigroup deal?

Mason: We have been looking at this very hard for the last four or five years but obviously not as hard as we were two years ago or one year ago. We were trying to determine whether we could continue to operate the firm the way it was. Many of the firms in the industry would tell us that we had the best model in the industry. That was up until the viewpoint came around that selling your own product was a bigger conflict.

We had been looking at this pretty hard, trying to determine where this was going and should we do something about it. Was this a short-term trend or was this a permanent change? One of the problems is that if you catch a trend early and you are right you often do extremely well, but if you catch a trend early but it isn't really a trend you end up doing something pretty stupid. But this trend now looked real for the first time.

You had an additional problem which was ... I started with this as a brokerage firm. We hired, trained and added all these people. It was a very -- in my obviously biased opinion -- a very high-quality firm that had a very strong ethical bent. So to eliminate it from the company, it was more than a hard decision. It was wrenching. Every time I tried to think it through my stomach would go in knots, I'd back up and re-examine it and think it through again.

WSJ: And you had discussions with a number of companies?

Mason: A number of them brushed by us, because they are all thinking the same thing. You'd have to be deaf, dumb and blind not to be thinking about it if you are a major player.

We had looked at it very hard, even to the point where we'd been pretty far down the road of thinking we should begin selling our ownership in the broker-dealership off in a public offering. That would have taken us three to five years ... but we could have gotten it done over a period of time. That's more than likely what would have happened in the reasonably near future. That was what we were thinking about as an alternate. In the meantime we were seeing opportunities and with the Citigroup situation a lot of the pieces fit.

WSJ: This deal will present a different set of challenges than previous acquisitions.

Mason: Totally, totally different. It does some good things for us -- it gives us a worldwide platform that we were going to have to build over the next five to eight years. It takes a lot of time not only to open the [overseas] office, assemble the people and make sure they get along. It's a very hard thing to do.

But for us it was a very different transaction, because virtually everything we've acquired over the years has been relatively seamless because we let them manage themselves. We may take over [back-office] operations or pick up their institutional funds business, but we certainly didn't run the asset-management side. We were insistent that what we were after was their skill and talent. And we really didn't have managers that competed with each other. We tried to stay in separate silos.

WSJ: What are the mistakes that you need to avoid with the Citigroup integration.

Mason: There is a very big execution risk in anything like this. You could get a glitch anywhere -- systems, just misreading people or the people have the wrong perception of what you are trying to do. Or maybe it takes longer than you thought or it's harder than you thought. It could be a multitude of things.

WSJ: One place firms often stumble is over-estimating the stickiness of client assets.

Mason: That's completely right. I think that we feel as though the people inside of Citigroup asset-management will view this as a plus and some of them will view it as a strong plus. The reason is that they will now be inside an asset manager and not inside a bank. That's no knock to Citigroup, but our whole thought process is in the same world they are in. I think they -- and the client base -- will probably view what we are doing as a positive.

There will be those that are going to worry about our size, and certainly what we are attempting to do to merge the fixed-income assets into Western is a major undertaking, and probably where the risk is. But Western has a very strong name and is considered to be one of the best in the world. From the client side, although they will question it and look at it and examine it, my guess is being that Western [is involved], they'll accept that as a positive.

WSJ: What does this mean for shareholders in Citigroup's funds? In the conference call with analysts you mentioned names of some better known fund managers -- Richie Freeman, manager of Smith Barney Aggressive Growth, and Hersch Cohen, manager of the Smith Barney Capital Preservation -- and said they'll be sticking around.

Mason: We have signed agreements with four so-called key managers and we think that's a great nucleus from which this can built around. They've got five-star funds and are well thought of in the operation.

What we do not need to do is fill every country or every bucket. In an organization like Citigroup, it was probably important to have a fund group in every country. But in our agenda we wouldn't rank it that high in what we need to do. And the same with filling all the buckets [of different types of funds]. When you are dealing in large areas such as Citigroup, the need to do that is high because they are trying to be all things to all people. But we don't need to have a mutual fund for every cause and concept there is.

WSJ: As far as this shift away from having a money manager and brokerage firm under the same roof, what do you think it means for individual investors?

Mason: I don't know how much difference it's going to make to the individual investor. The real difference will be that individual organizations will continue to find it harder to sell their own product. And unlike others, I don't have a problem with them selling their own product because if it's monitored correctly, frankly, their own product might be as good as any other because their name and reputation is on it. But that's in the eyes of the beholder. I think that it probably will help the individual broker be in a little bit better position in his or her own mind to say I don't have any ax to grind. In the end, will it be a lot different in terms of the investor -- will they come out better? I don't think it's going to matter much. But time will tell.

WSJ: You are often asked about Legg Mason's plans to fill your job once you step down. Now you have just launched a project that is likely to take several years before it's all fully put together. How are you handling the succession question?

Mason: I have told the [Legg Mason] board that I would give them two years' notice, but that they should be working on the succession issue. As it relates to this transaction, I have told them I will certainly stay for at least two years to guide it through.

The board has been very diligent on this issue and has been working on it pretty consistently over the last 15 to 18 months and has had quite a bit of deliberation on the subject and it is my opinion that they are going to soon come forth with their viewpoints.

I would anticipate that this would take place in the not distant future and that we would look for a transition that would run over a two-year period or more. The hope is that this is all soft-landed and the company will be positioned to go forward over the next five to 10 years.

WSJ: Are you looking forward to finally kicking back after all these years?

Mason: One of the things I look forward to is not being the last car out of the parking lot. The board and others say 'Well, just cut back, do less and have other people doing other things,' and we've certainly done some of that. But with the job I have, you can't do half the job. You either do it or you don't do it.

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