Legg Mason's Big Swap

Over the past 20 years or so, major financial institutions -- like Citigroup (NYSE: C  ) and Morgan Stanley (NYSE: MWD  ) -- have extolled the virtues of one-stop shops. Want an IPO or a merger? Asset management? A credit card? A mortgage? The big institutions offered all those services and more, consolidated in one place.

It was a nice theory, but it appears to have been much harder to pull off. In fact, these mega financial firms are in the process of shedding these synergistic assets. This might represent a departure from the recently favored "bigger is better" mentality, as key players pare down their assets, focusing on those niche areas they're best able to serve and excel at.

The latest deal came last week with Citigroup and Legg Mason (NYSE: LM  ) . Essentially, Citigroup traded its asset management division for Legg Mason's brokerage segment -- a transaction that has a value of about $3.7 billion.

With the deal, Citigroup will boost its number of brokers to 13,543, making it one of the top networks in the U.S. The biggest is Merrill Lynch, with 14,100 brokers.

Moreover, Citigroup won't have to worry about the conflict-of-interest problem of owning asset management anymore. In light of the mutual fund scandal and more onerous regulations, it is tough for a company like Citigroup to provide financial planning services as well as proprietary mutual funds.

As for Legg Mason, it will now be the No. 5 asset management company in the U.S., with assets under management growing to $830 billion from $437 billion. No doubt, shareholders were ecstatic about the deal, as Legg Mason's stock rose 15.31% to $98 on Friday. But this may be a short-term burst.

Even though Legg Mason is a top-tier asset management company, this is still a highly competitive industry that includes giants like Fidelity and Vanguard. In fact, such firms may also strike their own deals to scale their businesses, though they tend to use an organic approach -- the two firms generally favor indexed funds, which can be built internally. The relative significance here is the fact that Legg Mason's strategy of making selected key acquisitions has created a top contender within the fund industry -- a strategy other firms might be inclined to examine if it proves to be successful.

Furthermore, last week Legg Mason spent $800 million to buy an 80% stake in Permal Group, the world's fifth-largest fund-of-hedge-funds manager (with roughly $20 billion in assets). This is Legg Mason's first entry in the hedge fund world, ostensibly influenced by the big-dollar fees and returns from these funds recently. However, hedge funds are difficult to manage, and there has been a flood of capital into them, making it much more difficult to achieve competitive returns -- which might serve to undermine profitability, because hedge funds' fees are most often heavily weighted toward fund performance. Besides, keeping key employees at Permal may be difficult because in the competitive hedge fund marketplace, top employees typically go to the biggest opportunities. And, employees at Permal have already received a windfall.

There are also the challenges of integrating Citigroup's asset management properties. This will certainly take time. And, keep in mind, Citigroup's funds have not been star performers, either. Thus, for stockholders, it probably makes sense to wait before jumping into Legg Mason stock.

Fool contributor Tom Taulli does not own shares mentioned in this article.


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