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Legg Mason might acquire big stake in Merrill Lynch

Merrill Lynch has been exploring the possibility of selling a big stake in its investment management business, according to bankers who have been briefed on the discussions.

The firm has long been a gatherer of assets. But the mutual fund trading scandal and increased scrutiny of fund marketing by state and federal regulators have made the business riskier for investment banks.

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In recent months, Merrill Lynch & Co. Inc. has had talks about such a sale with Legg Mason Inc., the Baltimore-based investment management company, the executives said. For Legg Mason, which manages $286 billion in assets, taking on Merrill's $513 billion would lift it into the big leagues of money management.

Merrill's talks with Legg Mason were called exploratory. Both firms declined to comment, noting policies that prohibit them from addressing rumors. Merrill's talks are the most concrete sign that investment banks, which spent billions of dollars over the past decade buying fund companies in pursuit of smoother revenue streams and a stable of in-house funds to sell through their brokers, are reassessing their commitment to these divisions.

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Morgan Stanley, which recently paid a $50 million fine to regulators for improper mutual fund sales practices, closed 13 proprietary funds last month as part of its effort to increase sales of its Van Kampen funds through outside financial advisers.

Merrill has been undergoing a broad reconsideration of its fund business. Robert C. Doll Jr., president of Merrill's investment management division, acknowledged in a recent research note by Richard Strauss, a brokerage analyst for Deutsche Bank Securities, that a partial sale of the fund unit would ease regulatory conflicts.

For a senior Merrill executive to contemplate such a move publicly represents a stark reversal from the view held by past Merrill chairmen that the firm should be ready to provide every possible financial service to its clients no matter the cost.

"That a broker would even think of owning less than 100 percent of its asset management subsidiary speaks to the pressures affecting the industry right now," Strauss said. "But it has become clear that, under Stan O'Neal, Merrill is looking to tap into new avenues for growth."

E. Stanley O'Neal, Merrill's chairman and a former chief financial officer at the firm, has placed more emphasis on cutting costs and maximizing returns - a strategy that has reaped dividends as Merrill's profits soared last year on the back of a boom in the firm's bond trading business.

Like other Wall Street firms and Morgan Stanley in particular, Merrill Lynch originally developed a proprietary fund business to provide its sprawling brokerage network with a ready source of mutual funds to sell.

But spotty performance by these funds, as well as greater restrictions on the incentives that banks can offer their brokers to market these funds, has prompted banks such as Merrill to consider severing the money management and distribution arms of the businesses.

In many ways, Legg Mason could be the perfect partner for Merrill. Unlike many of its peers, Legg has steered clear of any major run-ins with regulators over improper trading in its mutual funds or questionable sales practices by its 1,400 brokers.

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And unlike Merrill's funds, which are managed by a fleet of mostly anonymous portfolio managers, Legg Mason boasts perhaps the industry's best-known fund manager in William H. Miller III, manager of Legg Mason Value Trust, who has a 13-year streak of beating the Standard & Poor's 500 index.

Miller's extraordinary performance record has driven Legg Mason's success in two ways. At the sales level, it has been a magnet for incoming assets. His rigid and disciplined investing style has created a unique and admired stock-picking culture within Legg Mason, and that could be the primary draw for Merrill.

Doll has provided a shot in the arm for Merrill's once struggling funds - 70 percent of assets are now outperforming their benchmark. Still, Merrill's inconsistent performance history suggests that dedicated fund management companies tend to produce better returns than investment banks in the long run.

What remains to be seen is how Merrill's brokers accept such an arrangement, given that Legg Mason brokers compete directly with them in many areas.

But for Merrill executives, the move makes sense on paper.

If Legg Mason were to take a controlling stake in Merrill's fund business, Legg would then have primary responsibility for managing the hornet's nest of potential conflicts that arise when brokers sell in-house funds.


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