Schroeder’s solution? Follow Morgan Stanley’s blueprint

(Bloomberg Opinion) — The stock market appears to be abandoning the most prestigious name in British investment management, the venerable Schroders Group. New chief executive Richard Oldfield has limited options to restore confidence. But Schroeder’s name still deserves respect, and Oldfield has enough freedom of action to achieve a stock price to match.

Schroders’ market capitalization has halved in three years to 4.8 billion pounds ($6.1 billion), with most of the decline occurring this year. Investors valued the company at a declining multiple of its expected earnings and worried it had no viable growth plan. The decline in earnings was not as rapid as the recent record of 777 billion pounds in share prices and assets under management.

The problems stem from its tepid response to the so-called “barbell” dynamic, which is the industry’s polarization between low-fee passive funds and high-fee alternative strategies offered by hedge funds and private equity firms. Traditional stock picking occupies a painful middle ground.

Previous Schroders CEOs saw the problem and wisely diversified into private equity and other areas. Unfortunately, the UK has been too lighthearted in pursuing these initiatives. What we need is the brash, big-check approach of US giant BlackRock.

Oldfield must now focus on where he can win. Schroders has built a strong wealth management business and has clearly won the trust of a large group of Britain’s wealthy, who will certainly be impressed when Queen Elizabeth II opens its new headquarters in 2018. The franchise includes Cazenove Capital, which was acquired following the Schroders acquisition. Bank of America JPMorgan Chase & Co. has acquired the brokerage unit of Cazenove Investment Bank. Wealth management contributed less than 30% to operating profit in the first half of the year. There is no doubt that Schroders should accelerate its strategy here by acquiring the many boutique firms in Europe that provide services to family offices.

Likewise, Schroders’ so-called “solutions” business, which advises pension funds and insurance companies on portfolio structure and risk management, is a keeper. Revenues can easily fluctuate as large numbers of commissions come and go. But it’s an attractive niche.

Of course, that leaves the core business of asset management, which spans mutual funds, institutional investments and the emerging private capital sector. The business is currently quite profitable, but difficult to grow. It needs scale to reduce expenses and remain competitive.

For Schroders’ business to reach a level comparable to the $2.7 trillion managed by Capital Group Cos., it would need to either be folded into a larger business or acquire other smaller rivals. Collaboration allows you to cut duplicate costs and brutally select the best portfolio managers from the pool.

Easier said than done. First, Oldfield was incapable of engineering buyers. Larger players in the active asset management space have mostly tried to diversify rather than double down on their traditional businesses. Schroders’ share price is so weak that it can barely afford to make its own acquisitions. The use of debt limits resources that can be invested in the more promising parts of the business.

So the default strategy in asset management is probably the most realistic one: make the business as efficient as possible; use cash flow to invest elsewhere; wait and see. As Schroders’ income mix gradually shifts back towards wealth management, the share price should respond. Wealth management stocks typically trade at higher profit multiples than traditional asset management companies. If a partnership or sales opportunity arises at the same time, that’s great. Otherwise, Schroders may gradually win over shareholders and lead the integration on its own.

That leaves private markets arm Schroders Capital. It just requires more client money. How to attract Blackstone Inc., KKR & Co. and Apollo Global Management Inc. as you compete with them? Good luck fighting these buyout giants for money from U.S. endowments and pension plans.

Schroders would therefore be better off aligning itself with one of the existing large private equity firms, giving both parties a greater chance of winning business – first with existing clients as they allocate more of their funds to “alternative investments”. It might be better to share in the bigger gains than to have 100% of Schroeder’s own capabilities.

Under former CEO James Gorman, Morgan Stanley’s stock experienced a staggering rise in ratings — from less than 100% to more than twice its book equity value — —should provide some inspiration. He expanded the U.S. investment bank’s position in wealth and asset management, pursuing a goal of diversifying from volatility trading and corporate finance gains.

How about acquiring Schroder? The business mix makes it look like a good fit for a universal bank. Imagine a merger with the likes of JPMorgan Chase. This will reunite Cazenove’s two franchises and create synergies in wealth and asset management. Or private equity buyouts – the buyout industry has also been targeting the wealth management industry.

The obvious obstacle is the founding Schroeder family and its 44% stake. Understandably, it may not want to sell the legacy – especially after the share price fell significantly. Even now, the company would be a logical choice for any acquirer. It’s a gamble given the well-known downside of asset management acquisitions, namely client churn. A successful bid is not impossible. Small shareholders should know that this is still not possible.

So the fix here is slow – but there is a fix.

More views from Bloomberg:

This column does not necessarily reflect the opinions of the editorial board or Bloomberg LP and its owners.

Chris Hughes is a Bloomberg Opinion columnist covering trading. Previously, he worked at Reuters Breakingviews, the Financial Times and The Independent.

For more stories like this, visit Bloomberg.com/opinion