Legg's list: International equity shop wanted

Legg Mason CEO Joseph Sullivan has mounted an aggressive plan to dump the company's money-losing affiliates while searching for a way to fulfill his biggest initiative yet: expanding the company's equity offerings beyond the U.S. “We need to add or build a non-U.S. equity brand,” Mr. Sullivan said in an interview. ”We need to move aggressively on that because we need a better capability.” Several of Baltimore-based Legg Mason Inc.'s investment affiliates have international equity strategies, including ClearBridge Investments and Royce & Associates. But none is sizable, he said. “We don't have a singular brand that we can build and leverage in the international space,” he said. Mr. Sullivan said an acquisition would be the fastest way to build a non-U.S. equity franchise, but noted the process can be long. He said he is open to other possibilities, such as a combination of an acquisition and organic growth. Analysts say buying a major international equity franchise might prove difficult for Mr. Sullivan. But without it, he is going to have a hard time achieving the growth he wants. Robert Lee, an equity analyst at Keefe, Bruyette & Woods Inc. in New York, said Mr. Sullivan needs to fix Legg Mason's investment offerings to keep pace with competitors in such areas as alternatives and international equities. He said a non-U.S. equity franchise is key. “Not having a broad global capacity has certainly hurt,” said Mr. Lee. Legg Mason will not be able to compete adequately in overseas markets without offering major international equity strategies, said Greggory Warren, a senior stock analyst at Morningstar Inc. in Chicago. He said overseas investors will not be satisfied with just buying U.S. strategies. “The only real growth is going to be overseas,” he said.

Rising interest rates

Growing the firm's equity capabilities is important as bond managers, such as Legg Mason's largest affiliate, Western Asset Management Co., Pasadena, Calif., face the prospect of rising interest rates. WAMCO, which had $435.6 billion under management as of June 30, was hit hard by the financial crisis, as its overweight positions in housing and financial company securities led to investment losses and large outflows. Investment performance has improved over the last several years, and outflows have stabilized, analysts say. But now there is a new issue. David J. Chiaverini, an equity analyst with BMO Capital Markets in New York, said fixed-income and liquidity assets combined make up about 75% of Legg Mason's total AUM, a larger concentration than at other major asset managers. A large majority of those Legg Mason assets are managed by WAMCO, making the firm and its parent not as well-positioned as other major money managers for a great rotation from fixed income to equities that Mr. Chiaverini predicts will occur gradually over the next three to four years. “As the great rotation occurs from fixed income to equity, I fear that their fixed-income assets may dwindle while their equity assets may not grow as fast,” he said. Mr. Chiaverini estimates Legg Mason's inflows will continue to grow in coming years, but only at 1% annually, less than the 3% he estimates for publicly traded money managers in general. While Mr. Sullivan has made building an international equity franchise a top priority for Legg Mason, Mr. Chiaverini said the depressed multiple at which Legg Mason trades — 13½ times earnings, compared with an average of 16½ for the typical publicly traded money manager — would make it more difficult to expand through a large acquisition. “It would be difficult for Legg Mason to make a sizable accretive acquisition,” Mr. Chiaverini said. He added that an international equity manager with top performance and strong asset growth could sell for 20 times its earnings. Thus, in an all-stock deal, it would be dilutive for Legg Mason to issue stock at 13½ times earnings for a company that was trading at a much larger multiple. He said an all-cash deal for a smaller manager is possible. He noted Legg Mason has $667 million in cash on hand, but most likely would want to keep at least half in reserve. Mr. Chiaverini also said Legg has used cash to fund some of the more than $1 billion it has spent on a stock buyback program over the last few years. Mr. Sullivan might be forced to follow the slower process of building an international franchise organically, or making a smaller acquisition of a manager or team and then using that as a platform for growth.

Daunting task

Mr. Sullivan was named CEO in February, after four months as interim CEO. He was tasked with turning around a publicly traded money manager that started losing its footing as investment performance slipped ahead of the financial crisis. Today, Legg Mason stock trades at less than 25% of what it did in 2006. The firm reported assets of $654 billion as of July 31, down 35% from the high of $1 trillion in 2007. Mr. Sullivan has been quick to make changes, reducing the number of Legg affiliates to eight from 11, while purchasing an alternative investment firm. In January, when he was interim CEO, Mr. Sullivan merged Legg Mason Capital Management, Baltimore, with ClearBridge Investments, New York. Legg Mason Capital was a shell of its former self; its assets had plummeted to $7 billion at the time of the merger from around $70 billion in 2007. That affiliate had been the parent company's most visible public face because of William Miller, its chief investment officer and star portfolio manager, who had outperformed his benchmark for 15 straight years until 2006, when he went on a severe losing streak. One of the key mutual funds Mr. Miller managed lost almost 66% of its assets in 2008 while another lost 55%. Mr. Miller has since regained his footing. Last March, Legg Mason acquired London-based Fauchier Partners LLC for an undisclosed amount. The $6 billion funds-of-funds manager's operations will be integrated into Permal Group, a Legg affiliate specializing in alternative investments. On July 25, Legg Mason announced it was selling Private Capital Management, an equity manager in Naples, Fla., to its management team. The affiliate's assets were down to $1.2 billion as of June 30; vs. $32.5 billion eight years earlier, according to data provider eVestment LLC, Marietta, Ga. Earlier this month, Legg Mason announced it was closing Esemplia Emerging Markets, with $500 million under management in emerging markets and Chinese equities, and returning investors their money. Legg Mason formed London-based Esemplia after purchasing Citigroup's global asset business in 2005. At its peak in 2007, the firm managed $6.8 billion, eVestment data show.

Not salvageable

Sources with knowledge of Legg Mason corporate decisions said company officials felt the brand was not salvageable because investment results were poor. Meanwhile, Mr. Sullivan got some good news: Legg Mason reported $200 million in inflows in long-term invested assets for the quarter ended June 30, the first inflows since 2007. The company had net outflows of $8.5 billion in the quarter if money market funds are included. During an earnings conference call on July 25, Mr. Sullivan called the inflows “modest” and said he was “very pleased, though not satisfied” that inflows had turned positive. Improved investment performance at Legg Mason's key investment affiliates has helped stem the tide of outflows that have plagued the company for years, said Keefe, Bruyette & Woods' Mr. Lee. “I don't know if it's off to the races, but they are certainly in a better position today." (Randy Diamond is a reporter at sister publication Pensions & Investments.)