Hidden behind the high-profile announcements of City of London fund managers’ Brexit relocation plans, a revolution is quietly sweeping through a little-known but integral part of the investment management industry.
A wave of dealmaking activity has taken hold among third-party management companies, the administrators that provide governance and compliance services to asset managers. Triggered by the UK’s vote to leave the EU in 2016, the trend is now gathering momentum as the Brexit transition period nears its end of year deadline.
While management companies, or “mancos”, may seem peripheral, they carry out a key regulatory function on behalf of fund managers: all EU investment funds must appoint a manco, which is tasked with making sure portfolio managers stay within the bloc’s investment rules. Crucially, mancos offer fund managers a straightforward path in gaining a regulatory foothold in another country, making the service providers more important than ever in the wake of Brexit.
While some investment managers have established their own mancos in the EU, many have turned to third-party providers based in Luxembourg and Ireland — Europe’s largest fund domiciles — in order to access investors in the bloc without having to move staff from London.
This has made third-party mancos highly prized and explains why buyers, often backed by private equity groups, are swooping on the sector.
Last month, fund servicing group Apex, which is owned by buyout investor Genstar, acquired FundRock, Luxembourg’s largest third-party manco which oversees $100bn on behalf of clients, for an undisclosed price. Private equity groups Carlyle and Pacific Equity Partners also in October tabled two bids to buy Link Group, whose manco business oversees assets of £86bn on behalf of asset managers, including Neil Woodford’s former fund. Link rejected the offers, the second of which gave it an equity value of $2.9bn, but has opened its books to the consortium in the hope of securing better terms.
Revel Wood, co-founder of One, a newly launched manco, says he is “constantly being called by private equity groups” who are rubbing their hands at the prospect of increased outsourcing and consolidation across the sector.
More approaches are anticipated, according to Marco Boldini, a partner at law firm Orrick. “Private equity groups are aware of the potential of third-party mancos and want to take advantage of a business that is flourishing,” he said. “We will see more transactions in future.”
The manco industry has slowly evolved over the past decade as fund managers have outsourced more of their operations to cut costs in the face of falling fees. Yet the sector is still relatively immature compared to other outsourced areas, such as fund custody or administration. Third-party mancos oversee just 7.5 per cent of fund assets in Luxembourg and Ireland, according to investment bank Stephens.
But the picture has begun to shift as a result of Brexit — in 2015, that share stood at just 4.5 per cent — and it is expected to continue to grow as fund groups also focus on their core business of managing money. Stephens projects the proportion could rise to 10 per cent within the next few years.
This is appealing to potential buyers who see an opportunity to grab a slice of a consolidating market where size counts.
“As more people are looking to outsource, you need to be a scale player,” says Des Fullam, chief product and regulatory officer at Carne, which provides manco services covering $1tn in assets.
Regulatory changes in the past few years have benefited larger mancos but strained smaller players. After the Brexit referendum, fears that UK asset managers would use mancos as a workaround to avoid setting up a fully fledged EU presence pushed regulators to raise the bar for how many employees they should have.
Mancos in Luxembourg and Ireland now require a minimum of three full-time employees, although staffing levels are expected to increase in line with their asset base. This, combined with increased competition for qualified workers in the two fund hubs, is significantly driving up costs for mancos.
David Rhydderch, global head of financial solutions at Apex, says that only large mancos have pockets big enough to absorb the added costs. “If you don’t have €25bn of assets, it’s incredibly difficult for a manco to make a profit,” he says.
According to PwC Luxembourg, staff costs for the top 50 mancos in the grand duchy increased by 40 per cent between 2015 and 2018, while net profits dipped by 13 per cent.
Ryan Johnson, head of Lloyd Expert Consultancy, says that buyers are looking beyond mancos’ limited scope to raise their prices and are attracted by the potential for building scale. “It’s not about revenue, it’s about size,” he says. “Once you have a silly amount of assets, the costs balance themselves out.”
Another factor driving consolidation is the growing need for mancos to have a global presence. This is becoming more important with Brexit as managers set up funds in multiple locations to retain access to different clients.
Recent examples of deals that have enabled groups to expand their geographic reach included the tie-up of Dublin-based DMS with Luxembourg’s MDO earlier this year, and MJ Hudson’s recent acquisition of Dublin-based Bridge Group.
For large groups such as MJ Hudson and Apex, which also offer fund administration and other services, buying or starting a manco is a way to become a one-stop shop and potentially cross-sell services to clients. Matthew Hudson, chief executive and founder of MJ Hudson, recalls catching “the next plane to Luxembourg” in the wake of the 2016 referendum to set up a manco.
But the future of the sector now hinges on the shape of post-Brexit regulation. In August, the European Securities and Markets Authority called for a toughening of the rules concerning delegation — a model which allows an asset manager to domicile a fund in the EU and carry out portfolio management outside the bloc, for instance in the UK. It questioned the extent to which mancos should be able to delegate to non-EU fund firms.
Requiring fund managers who wish to retain access to the EU to beef up their presence in the bloc could benefit mancos and drive further M&A.
However, some fear that a potential tipping point — for instance if the fund managers themselves have to be located in the bloc — would deter some UK-based managers from selling to EU clients entirely, a development which could have a devastating impact on mancos.
Olivier Carré, a partner at PwC Luxembourg, believes that M&A activity among third-party mancos will continue barring any radical interventions by policymakers. “We expect further consolidation and concentration unless there is a change in the regulatory environment. The regulator is the big unknown.”