The Case for an Independent Western Asset Management

Global fixed income manager Western Asset Management (Western) should get a divorce from its parent Legg Mason (NYSE: LM  ) as the relationship is largely one-sided. Although many dismissed this possibility after interim CEO Joseph Sullivan earned the permanent role, the chairman of the board W. Allen Reed said "we will always consider all options" regarding a buyout after receiving interest from private equity.

Don't believe companies that say they aren't for sale. Everyone has a price. For example, everyone assumed the Bancroft family would never sell The Wall Street Journal until they received an offer they couldn't refuse.

A management buyout could be financed by the involvement of a large pension or sovereign wealth fund. For example, China Investment Corporation bought a stake in Blackstone (NYSE: BX  ) , while Mubadala Development Company and CalPERS bought stakes in Carlyle (NASDAQ: CG  ) .

Western could easily service the increased debt load with its relatively stable management fees as opposed to the volatile performance fees earned by hedge funds and private equity.

The concern regarding the effect of an ownership change on employees and investors is vastly overblown given that both constituencies would probably prefer Western to be properly incentivized.

Benefits of breaking up
Western already has one foot out the door after changing its name as part of a rebranding effort. Moreover, Western sees little value in the Legg Mason distribution platform, which is one of the few reasons an affiliate would join in the first place.

A dedicated Western sales force can do a much better job marketing their own funds than a wholesaler trying to represent multiple fund families. The wholesalers (who are nonetheless extremely professional and competent) have unfortunately been forced to become jacks of all fund families and masters of none. The success PIMCO had in taking control of its sales force surely did not go unnoticed by Western.

There are no obvious operational synergies to being part of the platform as investors (especially institutional ones) only want to work with best-in-breed managers and place little to no value on buying investment products in "bulk" from the same corporate parent.

Western does not need support or advice in running the company. For example, it used the valuable lessons learned from the financial crisis to improve risk management and expand its research teams. As a result, Western is now one of the top performing fixed-income managers in the industry. Management said on the most recent conference call that Western experienced the first quarter of long-term net inflows since September 2007. The strong performance from its unconstrained fund is a positive sign for fund flows since managers will need to be more tactical going forward as volatility increases because of tapering and, eventually, rising rates.

Almost every trader has suffered a large loss at some point in his or her career. What separates the ones who survive from the ones who don't is the ability and willingness to learn from past mistakes. Western clearly has shown both. However, Legg Mason had little to do with the recent success.

Valuation
As shown in the chart below, a fully independent Western should receive a significant premium to the currently low implied valuation.

Source: SEC filings. As of the most recent quarter. Implied value based on median multiple. Peer group of asset managers with at least $100 billion in assets under management.

T. Rowe Price (NASDAQ: TROW  ) and Franklin Resources (NYSE: BEN  ) have higher valuations as higher fee equity/blend assets represent 76% and 57% of total assets under management, or AUM, respectively. 

In contrast, Federated Investors (NYSE: FII  ) has the lowest valuation as money market assets with the lowest fees represent 74% of total AUM. Furthermore, because of the zero interest rate environment, the company has been forced to waive a significant portion of management fees.

Blackrock (NYSE: BLK  ) has a relatively low valuation despite its size as a significant portion of its assets are passive rather than active, and therefore earn much lower fees.

Bottom line
Even if investors never get the opportunity to own Western directly, they should focus on asset managers trading at reasonable valuations with stable or positive fund flows. Remember, fund flows is arguably the most important value driver for asset managers given that the high operating leverage works both ways.

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