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Did BlackRock Pay Too Much for BGI?

BlackRock snaps up Barclays Global Investors for $13.5 billion.

BlackRock chief executive Laurence Fink has a well-deserved reputation as a shrewd deal maker. So this spring, when Barclays was desperate for money, markets were still reeling from the financial crisis and investors were redeeming funds in a mad scramble for liquidity, the conditions were ideal for Fink, one of the most powerful CEOs in the U.S., to snap up the troubled U.K. bank’s money management business at a discount and create a $2.7 trillion-in-assets financial titan that would dwarf its competition and control more cash than the U.S. Federal Reserve.

Yet by some accounts, the $13.5 billion that Fink agreed to pay for Barclays Global Investors was anything but a bargain. "BlackRock is paying full price for BGI," says Robert Lee, a research analyst at Keefe, Bruyette & Woods in New York. Lee values the cash portion of the deal at 11.1 times San Francisco–based BGI’s estimated pretax earnings for 2010, the first full year after the deal is expected to close. That’s in line with the multiple for asset management firms before the market meltdown, which was ten to 12 times earnings. Considering that such shops have sold at steep discounts in recent months and that many, including Bank of America’s Columbia Management, have languished on the market, the question is: Did BlackRock pay too much?

The team that pulled the deal together says the price was right and defends the $3 billion in debt they assumed to buy the business. "We need the scale to support the global presence that we think is going to be required," says Susan Wagner, chief operating officer of BlackRock.

Scale is no longer a problem. BGI gives BlackRock the reach it needs to keep costs down and expands its global footprint at a time when the money management industry is desperate to tap new markets like India and China. The combined firm’s arsenal will include a wide range of products across the risk spectrum. "BlackRock is one of the few, if not the only, firms that have the breadth of product to accomplish this," says Joseph Hershberger, a managing director at Credit Suisse Securities, a lead adviser for BlackRock on the deal. "Except for Pimco, nothing of this quality has ever traded." The new BlackRock Global Advisors will oversee everything from stocks, bonds and money market instruments to passive and alternative investments, for both institutional and retail investors.

BlackRock’s top executives say the big prize was iShares, BGI’s exchange-traded funds business, but Fink wanted to get his hands on the rest of its huge passive portfolio as well. The $325 billion-in-assets iShares has been on a tear that industry heavyweights say shows no sign of letting up. "Fink has bought the ‘secret sauce’ for the next generation of the mutual fund," says Donald Putnam, managing partner at merchant bank Grail Partners. Between 2004 and 2008, iShares’ assets grew at a 26 percent annualized rate, compared with 2 percent for BGI’s overall business. Experts estimate iShares’ profit margin to be as much as 90 percent, not counting distribution and other costs. Robert Kapito, president of BlackRock, won’t reveal margins but claims the 90 percent figure is on the high side. He does say the potential is huge: "There will be significant growth in the ETF business."

ETFs can also easily cross borders. "If you’re talking to a family in Switzerland, France or Cincinnati, you’re dealing with different regulatory regimes," notes Putnam. "ETFs have the potential to level that playing field." There’s upside as well in the defined contribution space, as ETFs are likely to increase their penetration into the 401(k) market. The deal will make BlackRock the fourth-largest manager of DC assets, says Douglas Sipkin, an analyst at Pali Capital.

BGI also adds strength to BlackRock’s non-ETF passive fund management. "There’s been a fairly large movement to passive because of the volatility in the stock market in the last couple of years," notes Kapito. With the acquisition, BlackRock’s passive portfolio climbs from $45 billion to an estimated $1.05 trillion.

But being a giant is no easy task — integration may be the most serious risk hanging over the combined firm. "The big question is what happens to the culture of BGI, the investment teams that have driven its success over the years," says Scott Powers, CEO of State Street Global Advisors, one of BGI’s close competitors in indexing and ETFs.

The cultures of BGI and BlackRock are similar in that both are strong quant managers, but there are also key differences, says Blake Grossman, CEO of BGI, which was Wells Fargo’s asset management arm before Barclays acquired it in 1996. The firm had already developed its academic bent, adopted from nearby Stanford University, where Grossman was a protégé of Nobel Prize–winning economist William Sharpe; today BGI is still packed with researchers who hold Ph.D.s in mathematics and economics.

BlackRock’s work environment, by contrast, is entrepreneurial and grew out of the expertise Fink gained in the brokerage industry in the early years of structuring mortgage products in the 1970s. It became more corporate when the firm merged with Merrill Lynch Investment Managers in 2006. "Larry’s drinking his own Kool-Aid when he says there is only one culture at BlackRock," says Putnam. "The critical culture question becomes how the individual teams will be integrated, and Larry is no better than anybody else at that."

Then there are the financial risks. BlackRock is sandbagging itself with $3 billion in debt, about $1 billion of which it plans to repay from existing lines of credit while seeking short-term loans from other lenders, one of which is Barclays. In June, citing refinancing risk, Standard & Poor’s cut BlackRock’s counterparty credit rating to A+/A-1 from AA-/A-1+, with a negative outlook.

Grossman predicts that the deal will have a "transformational" impact on the industry, possibly triggering a wave of consolidation. Many concur. "Passive investing is going to have a role in the institutional market and the consumer market," says Jes Staley, CEO of J.P. Morgan Asset Management. "This deal was less about the financials — it becomes a strategic gut check for the major money managers."

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