U.K. money manager Hermes’s ardent pursuit of wee Scottish firm Edinburgh illustrates the perils (and the promise) of bargain-hunting for distressed asset managers.
By Andrew Capon
Institutional Investor Magazine
AT 9:00 A.M. ON A DANK SCOTTISH morning in late November, the directors of Edinburgh Fund Managers gathered in the Georgian splendor of the Queen Street offices of Noble Grossart, Scotland’s leading merchant bank, for a hastily called board meeting. Two hours later four of the seven directors resigned, including the firm’s chairman, banker John Wright, and the vice chairman, investment banker Sir Angus Grossart. Two of the remaining board members then ganged up against the third -- voting to sack 57-year-old Scot Iain Watt, who had run Edinburgh Fund Managers with a strong will and, some say, an arrogance to match since 1985.
That Thursday evening, November 28, the money manager’s investment trust clients gloomily assembled at Edinburgh’s drab Donaldson House head office, hard by the Scottish capital’s Haymarket rail station, for their annual get-together. Greeting them was a large sign showing the firm’s Edinburgh Castle logo. Underneath was the inadvertently ironic motto “Rock Solid.”
The ouster of CEO Watt was act 5, scene 1 of a long-running drama that for more than a year has improbably swirled around Edinburgh, a firm with a paltry £4.5 billion ($7.2 billion) in assets, a dismal overall investment record and a shrinking roster of clients. But Edinburgh also has a reputable retail brand -- its Edinburgh Portfolio fund of funds is a standout -- and good links with financial intermediaries, and that was enough to attract interest from a firm ten times its size, London’s Hermes Pensions Management. Hermes has basically two big clients: Royal Mail and BT Pension Scheme, which also conveniently owns Hermes. A merger “would have taken Hermes into the U.K. retail market, a business we have always been interested in,” says Hermes’s CEO, Irishman Tony Watson. “It was a viable entity with a reasonable reputation.”
The 57-year-old Watson, a onetime barrister educated in Belfast, attempted to acquire Edinburgh, at first politely but then, as his exasperation mounted, with escalating aggression. His efforts culminated in the boardroom banishment of the overwhelming impediment to a merger: Watt. Unfriendly takeovers are a rarity in money management, and Hermes’s pursuit of Edinburgh suggests why in abundance.
Today Hermes still doesn’t control Edinburgh Fund Managers; it owns less than one third of the London-listed asset manager’s stock. And that stock, for which Hermes paid as much as £5 to £6 a share in the summer of 2001, was trading in mid-January at £1.31. The Scottish firm’s assets are not much more than half of their £8.5 billion peak of just two years ago. Moreover, Edinburgh’s long-term performance confutes the notion of the Scots as canny investors: Former flagship client Edinburgh Investment Trust endured a cumulative return of 132 percent in the ten years through last March (when it began reviewing its relationship with Edinburgh), compared with 209 percent for the typical U.K.-equity-focused investment trust, according to Standard & Poor’s. The trust bolted three months later.
Edinburgh Fund Managers is now scouting for a new chairman. A leading candidate is Scot Dugald Eadie, founder and former chairman of British investment performance measurement firm WM Co., which Eadie sold to Bankers Trust Co. in 1987. After a falling-out with Bankers Trust in 1993, Eadie left the following year to run London-based fund manager Henderson, which he also sold, to AMP in 1998. A University of Edinburgh mathematics graduate who developed Britain’s FTSE stock indexes, Eadie, 58, is a well-respected senior statesman of the global money management business. He could help restore faith in Edinburgh and buy the firm time to get back on its feet -- or gussy it up for sale (though not necessarily to Hermes).
Joint managing directors Anne Richards, the chief investment officer, and Rod MacRae, the chief operating officer, are effectively running Edinburgh now as co-CEOs. Richards, 39, a former portfolio manager for Merrill Lynch & Co. and J.P. Morgan, says her goal is to “reestablish Edinburgh as one of the leading specialist fund management businesses in the U.K.”
But from the start of their reign, she and MacRae have been preoccupied with crisis management. It began on November 28, the very day that CEO Watt was sent off into the gloaming: The pair scrambled to reassure the firm’s toughest customers -- the investment trusts that represent one third of Edinburgh’s dwindling asset base and an even larger chunk of its revenues. “It was a slightly surreal atmosphere and had clearly been a trying day, but Richards handled it well,” recalls one of the trust directors. “There was actually quite a buzz about the place. Many of us had lost faith in the old guard and saw it as a new beginning.”
EDINBURGH FUND MANAGERS COULD CERTAINLY use a fresh start. Founded in 1969 to manage the 115-year-old Edinburgh Investment Trust, one of the largest such closed-end investment companies in the U.K., Edinburgh has never truly flourished as an independent firm. Hermes’s own Scottish misadventure, its entanglement with Edinburgh, dates to just 1996. That was when Goldman Sachs Asset Management acquired CIN Management, the company that managed British Coal Pension Schemes and happened to hold a 32.5 percent stake in Edinburgh Fund Managers. Goldman, its eye on the U.K. institutional market, decided to shed this Scottish encumbrance. Edinburgh bought back one quarter of its shares and placed the rest with institutions, including Hermes.
Hermes progressively added to its holdings and by May 2001 owned 24 percent of Edinburgh. Tony Watson, then Hermes’s CIO, was appointed to Edinburgh’s board. That August Hermes raised its stake to 29.3 percent, just below the 30 percent limit that automatically triggers a takeover bid under British law.
Merger talks started in earnest in September 2001. Edinburgh’s overriding attraction was that it would diversify Hermes’s client base: 95 percent of Hermes’s £45 billion in assets come from those two giant clients, Royal Mail and BT Pension Scheme. But first Watson had to win over Edinburgh’s CEO, Watt.
Educated at prestigious Edinburgh Academy, Watt had gone on to university in Hull. His first big job in the investment world was running the Bank of Scotland pension fund. Watt joined Edinburgh in 1985 as a director and head of asset allocation, becoming managing director in 1991. Despite his pedigree and position, Watt never seemed to fit into Edinburgh’s financial establishment. He kept his distance from the Charlotte Square set and the habitués of the New Club. Though charming when he wanted to be, Watt could be obdurate and irascible, say many.
Hermes’s Watson, who’d moved up to CEO, had no idea that he was about to encounter a human obstacle as immovable as Edinburgh’s Castle Rock. Above all, Watt was convinced that Edinburgh Fund Managers was a terrific business with a great future as a stand-alone firm -- with himself firmly in control. “What one can certainly say about Iain is that he really believed in the business and the strategy,” says Martin Cross, a speciality finance analyst at U.K. brokerage Teather & Greenwood.
Watt had no intention of letting Edinburgh be taken over by another firm. Edinburgh’s chief investment officer, Mike Balfour, quit the firm in October 2001, purportedly because he favored a merger with Hermes and realized that Watt was unlikely ever to consent to it.
Edinburgh and Hermes officials nevertheless continued to talk inconclusively until late November, when Watson was forced to tell the London Stock Exchange that Hermes had bid for Edinburgh and been rejected. Watt publicly disparaged the bid as “derisory” and the merger overture as an “amateur” move. Watson, though he may have been seething, was forced to stay his hand. As Ray Soudah, founder of Zurich-based fund management M&A specialist Millenium Associates, points out, hostile takeovers are almost unheard of in money management because “the acquirer has too much to lose.” The assets, human and monetary alike, can walk out the door.
If Watt, meanwhile, was hoping to smoke out a bigger offer from Hermes or a rival bidder, it was a high-risk tactic. Edinburgh is no sweepstakes prize. For a start, it’s a ragtag investment house, say critics, spread thinly over too many asset classes and client segments -- an investment boutique that thinks it’s a money management supermarket. At its apex of assets under management, in 2000, Edinburgh had roughly £321 million in fixed income and £8 billion in equities -- £5.5 billion in the U.K., £600 million in Asia-Pacific markets, £290 million in Japan, £930 million in the U.S., £582 million in Europe and a modest amount in emerging markets. And although Edinburgh had a recognized retail brand and a stable of 13 investment trusts, it boasted only a handful of institutional clients.
To maintain their wavering allegiance, moreover, the firm would have to do something fast to pump up performance. Edinburgh’s balanced fund at least is consistent, ranking in the bottom decile year after year in Russell/Mellon CAPS’ pension fund universe: 74th out of 88 funds for 2002 through the third quarter, 71st out of 75 over three years and 59th out of 65 over five years. The firm’s U.K. equities fund hasn’t fared much better: Its 28.3 percent return placed it 75th out of 92 funds for the first three quarters of 2002, although it did manage to finish 39th out of 70 funds over three years.
Even during the headiest days of the bull market, Edinburgh hardly grew at all. True, from £3 billion in 1995, assets under management reached a peak of £8.5 billion in less than six years. But that occurred almost entirely because in 1996 the firm bought £5 billion-in-assets Dunedin Fund Managers. Edinburgh’s share price has tumbled more than 80 percent from its 1995 peak of £7.86.
But for all of Edinburgh’s flaws, Watson remained enamored. The persistent suitor bid again for the Scottish firm in February 2002, this time upping his offer to almost £6 a share, or £150 million, according to sources close to the negotiations. The bid represented a modest premium over the prevailing share price but a rich fraction of 3 percent of assets -- the kind of offer that is hard for a board to legally refuse. And indeed, the parties were said to be close to an agreement on valuing the business.
But halfway up the aisle, Hermes faltered. As a precaution, the firm had asked a key Edinburgh client -- the £1.4 billion Edinburgh Investment Trust -- about its attitude toward the takeover and gotten a less than enthusiastic response. Lord Eglinton, the trust’s chairman, had been unhappy with Edinburgh’s performance for some time and took the view that a change in control would trigger a reexamination of the trust’s contract with Edinburgh. The trust had already cut its contract notice period from 12 months to three. Faced with the probable loss of a client that accounted for one fifth of the firm’s assets and one third of its profits, Watson sought to renegotiate.
Watt balked, and the deal fell apart on March 4. Observers contend that Hermes erred in not taking the temperature of Edinburgh clients sooner and in not making allowance for inevitable client defections. “You have to factor in an attrition rate for investment trusts and mutual funds in any takeover,” points out Millenium’s Soudah. “That’s hard to do as an outsider, but you must try and get reasonable market intelligence before you go ahead.”
Edinburgh Investment Trust, giving the minimum notice, quit Edinburgh for Fidelity Investments just four months after the deal collapsed, in July 2002. Lord Eglinton wrote in the trust’s annual report that performance was the paramount issue but that uncertainty over Edinburgh’s fate played a part.
Clients weren’t the only malcontents. Watt’s strategy of independence at virtually all costs had left Edinburgh adrift in a turbulent market. Director Angus MacDonald, proprietor of the Financial News, a weekly newspaper, resigned from the firm’s board in March. “Iain Watt was not the right person to run the business,” he says. “He didn’t have the respect of the investment industry and, increasingly, his own staff. The business was subscale in all areas except investment trusts . . . and the board was not prepared to sack him.”
The directors’ stubborn loyalty was about to be tested further. At the September 2002 half-year mark, as assets continued to seep out of the firm, Edinburgh suspended its dividend. In the fiscal year that had ended the preceding quarter, the firm’s profits had been halved, to £6.5 million. Watson resigned in exasperation and began hatching his plan to give the boot to Watt and his allies on the board.
The Hermes CEO and MacDonald alike had been confounded by the board’s backing of Watt even as Edinburgh obviously floundered. His doughtiest, and most formidable, defender was board vice chairman Grossart, the de facto clan chief of Edinburgh’s financial establishment. His merchant bank, Noble Grossart, has its fingers in every mutton pie in Scottish corporate life. Grossart is a vice chairman of Royal Bank of Scotland Group and a director of brewer Scottish & Newcastle, newspaper publisher Trinity Mirror and Scottish Financial Enterprise, a private group that promotes Scotland as a financial center. A former chairman of trustees at the National Galleries of Scotland, Sir Angus, 65, was knighted in 1997 for services to art.
Says one large shareholder in Edinburgh Fund Managers: “Grossart was vice chairman in name but much more powerful than that. He is a figure with clout. Grossart set against a bunch of nonexecutive nonentities [on the board] was far from merely a case of primus inter pares.” The board’s only other notable banker was chairman Wright, the former CEO of Clydesdale Bank.
Grossart won’t discuss his role at Edinburgh, nor his reasons for steadfastly backing Watt. “He doesn’t believe it is appropriate to comment on past history,” says an aide. But some note that Edinburgh paid substantial advisory fees to Noble Grossart going back to the firm’s acquisition of money manager Dunedin in 1996 and the disposal of British Investment Trust’s Edinburgh shares the following year.
Watson set about rallying Edinburgh shareholders to pressure the board to get rid of Watt and Grossart. M&G Investments, a Prudential-owned money manager that owns 5 percent of the Scottish fund manager, was an early ally. Watson persuaded enough shareholders to go along with overthrowing Watt that, with Hermes’s 29 percent holding and M&G’s 5 percent, he put together the 50 percent-plus majority needed to act.
So he prepared a so-called irrevocable-undertaking letter for board chairman Wright and select directors that contained a blunt message: The board must fire Watt and Grossart or face the shame of seeing them voted out of office at an extraordinary general meeting. The ultimatum was delivered to directors Wright, Richards and MacRae at a meeting at M&G’s City of London offices on November 26; they’d been led to believe the occasion was a routine get-together with a major shareholder. Rattled but also resolved to act -- “We had no alternative,” says Richards -- she and MacRae did what many an employee secretly yearns to do: sack the boss.
Hermes and the rebellious shareholders thought they had won a clear victory, but Watt and Grossart still had a sting in their tail. The shareholders had wanted two seasoned nonexecutive board members -- banker Wright and property executive Donald MacDonald -- to stay on, so that the board could function properly. Instead, all the nonexecutive directors were persuaded to resign en masse to demonstrate solidarity in the face of outside interference.
What will become of Edinburgh Fund Managers now? Richards and MacRae must move quickly to stabilize the firm and calm its shaken employees (237 in all) -- and clients. Observers are paying the closest attention to the investment trusts. US Tracker Trust, at £560 million in assets, is the biggest account, but by far the most important in terms of fees is the Dunedin Income Growth Trust; it pays Edinburgh 37.5 basis points a year on its £440 million in assets. In late January Max Ward, Dunedin chairman, wouldn’t comment on whether it would stick with Edinburgh. Some trusts, though, are likely to leave unless Richards can engineer a rapid change in perception and performance.
Teather & Greenwood analyst Cross puts a valuation on Edinburgh’s investment trust business of precisely zero. More charitably, Merrill Lynch specialty finance analyst Philip Middleton reasons that, “If they haven’t upped and gone already, then it seems safe to assume these assets are actually quite sticky.”
There is speculation that one major client likely to sack Edinburgh is the Bank of Scotland pension fund, according to an authoritative source. The fund is conducting a beauty parade for new managers and is expected to reach a decision this month. Currently, Edinburgh manages £700 million in U.K. equities and fixed income for the fund.
One bright spot is Edinburgh Portfolio. The fund-of-funds manager, acquired in 2001 from property company Liberty International, has £625 million in assets. Managing director Paul Talbot expects assets under management to grow some 20 percent this year, after a comparable spurt in 2002. Standard & Poor’s has given the flagship Edinburgh Fund of Funds Portfolio the portfolio awards for one- and three-year performance in 2001 and 19982001, respectively, and Bloomberg Money magazine named Edinburgh Portfolio the best fund-of-funds manager in 2002. The flagship fund gained almost 177 percent since its December 1989 launch, compared with 98 percent for the typical fund of funds.
Edinburgh Portfolio could be attractive not just to investors but also to fund managers. One did try to buy it by itself but was shown the door. “Why would Edinburgh sell Edinburgh Portfolio?” asks Talbot. “We are a growing and successful business. Edinburgh would be falling on its own sword if it sold us.”
Co-chief Richards confirms that Edinburgh Portfolio is not for sale. Indeed, she’s weighing whether to expand the business by developing a fund of funds aimed at pensions. Edinburgh also boasts good prospects in large-cap U.K. equities, which since May 2001 has been the bailiwick of respected former Phillips & Drew portfolio manager Robert Waugh.
Richards, who got a first-class degree in electronics from the University of Edinburgh and who was a research fellow at particle physics laboratory CERN, demurs that it’s too early to talk strategy. Whoever is named chairman in the next couple of months will no doubt want to put in a word as well. But a boutique business built around U.K. stocks and funds of funds would be cutting Edinburgh’s tartan cloth about right, suggest knowledgeable observers. In the meantime, Richards must keep reassuring clients that things will get better. Luckily, her former boss at J.P. Morgan, Thomas Madsen, now head of equities at UBS Global Asset Management, says that communicating with clients is one of her great strengths.
As for Hermes, its Highland fling appears to have evolved into a long-term relationship -- but not necessarily an intimate one. Watson says he fully supports the new regime at Edinburgh but stresses that he has no interest in making yet another offer for the firm. “It is obviously a very different animal without the Edinburgh Investment Trust mandate, and our thinking has changed,” he explains. “We also felt it would clear the air if we were no longer seen as a bidder. We are a long-term shareholder interested in the long-term share price performance of the company, not just for ourselves but for the other shareholders.”
He denies, however, rumors that the conservative trustees of Hermes’s owner, BT Pension Scheme, have reined him in. Nor does Watson believe Hermes’s dalliance with Edinburgh damaged its reputation. “We behaved very well throughout and tried very hard to make this deal happen,” he says. “But ultimately, there was a disagreement over price.”
Other Edinburgh shareholders are less forgiving. “Hermes got themselves into a bit of a mess and to some extent created more uncertainty over the future of Edinburgh, which hasn’t helped,” says one. Still, this shareholder backed getting rid of Watt. “This was a business that was going nowhere,” he contends, “and that was squarely the responsibility of the former chief executive.”