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Will the spurt of M&A activity in financials create a wave of mergers?

| February 21, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The Bank/Financial sector saw two consecutive deals this week in areas that have not seen much M&A activity in recent history. Although Morgan Stanley’s purchase of E*TRADE generated the most headlines, Franklin Templeton’s buyout of Legg Mason seems the more likely of the two to fuel further consolidation within the asset management industry. Investors should maintain an overweight on the Broker/Asset Manager/Exchanges sector, where potential M&A candidates include Affiliated Managers Group, Ameriprise Financial, Eaton Vance, Lazard and Neuberger Berman.

Background on recent deals

Franklin Templeton (BEN: A2/A+) agreed to buy Legg Mason (LM: Baa1*+/BBB*) in an all-cash deal for $50/share, valuing the firm at roughly $4.5 billion plus the assumption of LM’s debt obligations. Two days later, Morgan Stanley (MS: A3/BBB+/A) announced that they had reached an agreement to acquire E*TRADE Financial (ETFC: Baa2/BBB) in an all-stock transaction for $58.74/share in a deal worth about $13 billion, plus the assumption of ETFC’s $2.5 billion in total debt.

There had been speculation about ETFC’s potential as a merger candidate in wake of the Charles Schwab (SCHW) bid for TD Ameritrade (AMTD), announced in late 2019, and the rampant step-up in pricing competition in the industry. Both MS and its peer Goldman Sachs were presumed to have interest as both competitors have been ramping up efforts to build out their respective retail platforms for self-directed trading. GS was seen as the more aggressive of the two, leaving the door open for a possible competing offer, and/or deals for smaller competitors. There aren’t many candidates remaining with the size/scale of either ETFC or AMTD, and SCHW with an existing market cap over $60 billion would appear far too large a candidate for GS to take down standalone without potentially drawing the ire of regulators.

Potential M&A or merger candidates

The asset management industry has already seen a fair share of activity over the past several quarters, such as the purchase of Oaktree Capital Group LLC by Brookfield Asset Management (BAM) in early 2019 for $4.7 billion (APS: Brookfield/Oaktree – Jun ’19). IG Index constituents that could potentially see M&A pressure or speculation in wake of the BEN/LM deal include: Affiliated Managers Group (AMG: A3/BBB+)—which is itself an amalgamation of independent money managers—Ameriprise Financial (AMP: A3/A), Eaton Vance (EV: A3/A-), Lazard (Baa3/A-/A-) and Neuberger Berman (NEUBER: Baa2/BBB+). Less likely IG constituents that could conceivably be drawn into the merger conversation, as either candidates for Goldman/money center banks to pursue or MOE candidates, include: BGC Partners (BCGP: BBB-/BBB-), Raymond James Financial (RJF: Baa1/BBB+), and Stifel Financial (SF: BBB-/BBB). These operators do not fit the profile that E*TRADE strategically provides for Morgan Stanley, but Goldman or another competitor seeking to build out their client facing trading operations could conceivably target them.

Based on the potential for additional M&A activity, investors should maintain an overweight on the Broker/Asset Manager/Exchanges sector in the IG Corporate Bond Index, with a current aggregate OAS of +88, yield of 2.35%, with duration of 6.45. The group slightly underperformed the Index in FY2019, though lower-rated credits within the segment outshined much of the broader Index.

Exhibit 1. M&A Impact on Bond Spreads

Source: Amherst Pierpont, Bloomberg/TRACE indications

There are only a handful of debt issues outstanding between LM and BEN, but the LM bonds reacted swiftly to the announcement (Exhibit 1). The higher-rated BEN (A2/A+) is about twice the size of LM, and stated that they will fund 100% of the $4.5 billion transaction with its existing balance sheet cash stockpile, which was just under $8 billion at year-end including liquid ST investments (~$6 billion in true cash). It is interesting that they do not plan to bring a debt deal (at least not initially) given how attractively BEN could price debt in this environment, but they are under absolutely no pressure to do so given the amount of liquidity they currently maintain on the balance sheet. They will also fully assume the existing $2.5 billion in LM debt.

The news was an obvious positive for LM bondholders, while for BEN it is only a modest near-term negative with longer-term upside. Both Moody’s and S&P affirmed BEN’s ratings, while placing LM’s rating on watch positive and developing, respectively. Running some basic pro forma figures using the $4.5 billion proposed transaction price, it appears that BEN would still remain with net negative leverage (net cash) position and only about 1x leverage on a gross basis. Those basic credit metrics appear supportive of low-to-mid single-A rating without taking into count any debt reduction or synergies. The companies project debt reduction or synergies could be as much as $200 million annually, though not necessarily a primary driver of the transaction.

Exhibit 2. Pro Forma M&A Estimates – BEN/LM

Source: Amherst Pierpont, Bloomberg LP, Company Filings

Meanwhile, the ETFC purchase should be credit neutral for MS since it is being structured as all-stock. While that is the best way to keep regulators at bay, MS could have easily cut a check for the full amount and filled the gaps with other forms of capital with only moderate impact to its overall credit profile. It is a far more interesting credit story for ETFC (Baa2/BBB) bondholders and shareholders. The rating agencies have not yet weighed in, but the swift reaction of bonds spreads (Exhibit 1) reflects the expectation that MS will fully assume the debt obligations.

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