Breaking away

With great expectations Merrill Lynch bought Hotchkis and Wiley in 1996. Five years later Merrill shut the unit down. It's a cautionary tale.

By Rich Blake
September 2001
Institutional Investor Magazine

Just back from their July 4 holidays, employees of the California firm learned that their company was breaking up. Many would lose their jobs; packing cartons and file boxes soon lined the corridors.

Another dot-com demise? Not this time.

The downsized staffers worked for Merrill Lynch & Co.'s Los Angeles-based asset management unit, the remains of the old blue-chip pension manager Hotchkis and Wiley. With great expectations and considerable fanfare, Merrill had paid $200 million to acquire the privately held firm (total assets: $10.1 billion) in 1996. Five years later the troubled alliance finally came undone. Merrill looked to sell the group, whose assets were still hovering around $10 billion, to Stilwell Financial, parent of Janus Capital Corp., but the deal collapsed when two star portfolio managers quit. Now a group of principals will buy a piece of the firm, and the rest will be shut down - a sorry coda to a deal that began with real promise.

"Our goal on the day we bought Hotchkis and Wiley was to make it successful, and that goal never changed," says Jeffrey Peek, the president of Merrill Lynch Investment Managers. "That the acquisition did not work out was a disappointment to everyone, and that most certainly includes us." Peek suffered a disappointment of his own this summer when rival E. Stanley O'Neal, Merrill's brokerage chief, was named president, COO and heir presumptive to CEO and chairman David Komansky.

Staffers in LA are more blunt about the breakup. "Merrill chewed the place up, and now they're spitting it out," says one.

When H&W decided to give up its independence in the mid-'90s, the world's biggest brokerage saw an opening into institutional money management, an important market that had eluded Merrill for many years. But the deal was snakebit from the start, plagued by internal feuds and client defections, which were exacerbated by cultural clashes and basic mismanagement. And talk about rotten timing: In buying H&W Merrill purchased $7.5 billion in deep-value portfolios just as the investment style was about to endure its worst run in nearly 30 years.

H&W might have made a go of it inside Merrill, but in late 1997 the giant brokerage shifted strategy, paying a stunning $5.3 billion for the U.K.'s $180 billion-in-assets Mercury Asset Management. Suddenly, Mercury became Merrill's ticket to the global institutional game. H&W, Merrill's partner of little more than a year, was effectively jilted for a more enticing catch. Eclipsed by the larger Mercury operation, which naturally attracted the lion's share of the brokerage firm's attention, H&W staffers resented Merrill's turnabout.

Says Peek, "We tried to integrate the two firms, but we saw it wasn't working."

Mercury soon suffered its own minimeltdown. Within a month of the Merrill deal, a major client, the Unilever pension funds, sued Mercury for mismanagement. (Merrill denies any wrongdoing in the Unilever case, which remains unresolved.) Soon after, many other clients defected.

"Hotchkis and Wiley clearly was a disappointment, but Mercury hasn't turned out as well as Merrill had hoped either," says Bear, Stearns & Co. analyst Amy Butte.

The dismantling of Hotchkis and Wiley will barely touch Merrill Lynch's bottom line. Overall, asset management kicked in revenues of $2.5 billion, or 9 percent of Merrill's total last year; it contributed $537 million in profits, about 9.4 percent of the firm's net earnings. H&W represented just 2 percent of the asset management group. In light of Merrill's dreadful second quarter, with profits off an unexpected 42 percent, the giant wire house confronts more pressing problems.

But the demise of H&W serves as a cautionary tale about how even the best-intentioned mergers can unravel. In buying the prestigious boutique, Merrill thought it could slap its name on the door, throw some money around and watch the assets rush in. Instead, the brokerage giant sparked employee resentment and client skepticism; accounts slipped away.

It's a tale all too frequently told: A prize entrepreneurial shop is sold by its founders, who are looking to cash in or hoping to gain scale they could not afford on their own. Often the tale ends, like this one, in tragedy for the smaller firm. Indeed, Merrill is hardly the first financial services company to bungle a money manager purchase. In 1996, for example, Mellon Bank Corp. (now Mellon Financial Corp.) bought a well-known boutique, Boston Co. Asset Management, only to see half the firm's $24 billion in assets vanish within a year. "The very characteristics that created a successful asset management team - independent thinking and entrepreneurial spirit - can be incompatible with the environment of a megafirm," says Mary Choksi, managing director of Strategic Investment Group, an Arlington, Virginia-based consulting firm.

The Hotchkis and Wiley saga is part of the larger disappointment of MLIM, Merrill's $533 billion asset management group, which ranks No. 5 on the II300 (after Fidelity Investments, Barclays Global Investors, State Street Global Advisors and J.P. Morgan Fleming Asset Management). Peek has turned around the retail side of the house, increasing net cash inflows from negative $1.5 billion a year ago to positive $4 billion at the end of the second quarter of 2001. But MLIM operating margins fell to 19 percent in the second quarter, down from 23 percent in the second quarter of 2000 and a far cry from the industry average of 31.4 percent.

In its institutional business ($258 billion in total assets, with $111 billion in the U.S.), Merrill confronts one persistent problem: Some two thirds of U.S. assets are either in cash accounts or index funds. Overseas high-level turnover increased recently at Mercury when joint chief operating officers Carol Galley and Stephen Zimmerman announced their retirements shortly after their employment contracts expired. None of this improved Peek's prospects for becoming president.

Warning signs flashed even before the H&W acquisition closed. Like many small firms founded by two strong partners (in this case, John Hotchkis and George Wiley) who have begun to step back, H&W fell victim to an internal power struggle. This one pitted Wiley's daughter, Gail Bardin, who received equity in the firm before Merrill came along, against Hotchkis's daughter, Sarah Ketterer, who had not. Merrill might have discovered the depth of these tensions. But Michael Quinn, who was orchestrating the acquisition as chief of Merrill's institutional business, was impatient to get a deal done. He wasn't even fazed when, four months before the deal closed, H&W's fixed-income team left to launch Metropolitan West Asset Management, taking $1.4 billion of H&W's $2 billion in bond assets.

Says one insider, "It was bad press, a horrible debut."

Not securing the fixed-income team was just the first of a series of strategic blunders Merrill made. Planning to amass new accounts by directly approaching CFOs and sidestepping pension consultants, the brokerage firm aimed to exploit its investment banking connections. But Merrill underestimated the power of intermediaries in H&W's world. It's a decisive characteristic of institutional money management, one that Merrill overlooked at its own risk.

"Irrespective of how it turned out, Merrill Lynch was 100 percent true to its word in terms of what it promised to do for Hotchkis and Wiley, and then some," insists Quinn, who retired in 1999. "If it didn't work out, it wasn't for lack of effort on Merrill Lynch's part."

Merrill also downplayed the risk that H&W, transformed from small boutique to corporate outpost, could become vulnerable to client defections. By the end of the first year, H&W had lost several big equity clients, including a $700 million account from the Oregon Public Employees' Retirement System, on top of its earlier fixed-income loss.

Then performance tanked. Merrill could not be blamed for that, but it suffered the fallout. Between 1997 and 2000 H&W's flagship large-cap value portfolio returned 11.1 percent, compared with 18.8 percent for the Russell 1000 value index. In the previous three years, performance had been better but was hardly impressive, with the portfolio matching the benchmark's 18 percent average annualized return.

Acknowledging the problems at both H&W and Mercury, Peek is determined to grow Merrill's asset management business. "Among our top strategic priorities going forward is to build up the U.S. institutional business," he says. "We have the first true global platform in investment management. There's no reason why Merrill Lynch shouldn't be one of the few really dominant asset managers in the next decade."

Entering the past decade, which would bring such explosive growth to the money management industry, Merrill claimed $100 billion in assets and ranked sixth on the II300. But only $14 billion of those assets were institutional.

During the late 1980s and early 1990s, a rash of outside consultants and Merrill task forces recommended that the brokerage firm pursue institutional asset management. But the head of money management, Arthur Zeikel, a Dreyfus Corp. veteran who had joined Merrill in 1976, resisted. Why chase 40-basis-point fees from pension funds, he argued, when Merrill Lynch brokers could sell retail products for 120 basis points?

In early 1995 Komansky became president and CEO-designate and ended the debate, proclaiming that Merrill should grow its institutional accounts from roughly $25 billion in mostly short-term cash accounts to $100 billion by 1997. To kick-start the operation, Komansky named Quinn to run asset management. Quinn had earned his stripes helping to turn around Merrill's mortgage desk after it lost $400 million in April 1987. He later served as head of global equity trading.

Quinn's strategy was simple: Merrill should buy a pile of assets. "The only way we were going to get to $100 billion was by making an acquisition," he recalls.

By the start of 1996, Quinn had tried and failed to close deals to buy Wells Fargo Nikko and RCM Capital Management, and he felt increasing pressure from Komansky and Merrill's chief strategist, Jerome Kenney, to cut to the chase. In the winter of 1996, to further his cause Quinn recruited Mark Hurley, a former West Point cadet and Goldman, Sachs & Co. investment banker. Hurley was a co-author of an influential 1995 report on money management that predicted that firms with less than $150 billion in assets could not survive.

At Goldman Hurley had stumbled upon a small, prestigious West Coast institutional money manager named Hotchkis and Wiley; apparently, the firm might be up for sale. Hurley passed the information along to Quinn, who late one February night placed a call to the Los Angeles firm.

Founded in 1980, H&W was the joint creation of George Wiley, the son of a Michigan farmer and a fighter pilot in World War II, and John Hotchkis, a descendent of California's prominent Bixby family. The Bixby fortune dated back to the 18th century, when the clan became the beneficiary of Spain's largest land grant, amassing much of what is now Long Beach.

Hotchkis and Wiley struck up a friendship in 1979 when Hotchkis, who was then managing high-net-worth accounts at Los Angeles-based Everett Harris & Co., called on Wiley, a pension consultant at Callan Associates. "After many long meetings and lots of coffee at the Biltmore Hotel in downtown Los Angeles, we were able to form a partnership," Wiley recalls. One year after they opened for business as a value equity shop in 1980, the two had reeled in $8 million in accounts.

Buttressed by strong performance in the early 1980s, H&W landed some major clients, including the then-$20 billion Oregon pension fund, which signed up H&W in 1982 to run a $400 million portfolio, and the pension plans of Chrysler Corp., GTE Corp. and Ciba-Geigy.

Messrs. Hotchkis and Wiley ran their shop with a light touch, attracting portfolio managers who relished the freedom. The firm grew steadily, from just a dozen staffers and assets of $1.5 billion in the mid-1980s to 40 employees and $5 billion in assets by 1994. Performance was strong. The flagship large-cap value portfolio posted an average annual return of 19 percent between 1991 and 1994, versus 15.5 percent for the Russell 1000. The firm's international equity portfolio, launched in 1990, returned an average annual 19 percent between 1990 and 1994, versus 10 percent for the Morgan Stanley Capital International Europe, Australasia and Far East index. Meanwhile, the fixed-income team delivered the best-performing short-term bond fund ranked by Morningstar, with a total return of 12.8 percent in 1995, compared with 9.7 percent for Lehman's short-term government bond index.

"By 1995 Hotchkis and Wiley had become one of the premier firms in the institutional industry," recalls Marianne Feeley, consultant with William M. Mercer Investment Consulting in Chicago. "They were attracting a lot of new business."

Yet behind closed doors, a power struggle simmered. By mid-1995 Wiley, at 72, had stepped back from an active management role. He and Hotchkis, 64, turned over a minority equity stake to four new partners, value portfolio managers George Davis, Michael Baxter, Roger DeBard and Bardin, Wiley's daughter. The ownership shift predictably antagonized several of the younger portfolio managers, especially Ketterer - Hotchkis's daughter - Laird Landmann, Tad Rivelle and sales chief Donald Steinbrugge. They made their feelings known to the two founders and all but threatened to leave.

Into this morass stepped Michael Quinn of Merrill Lynch.

When Quinn contacted DeBard in early February 1996, he saw H&W as a prestigious but low-profile firm whose aging founders might be ready to cash out. He was unaware of any internecine feuds.

Though Hotchkis was reportedly ambivalent about the sale - in the first meeting with Merrill executives at the Bonaventure Hotel in Los Angeles, he fell asleep, according to two people who were there - in late March 1996 the two parties agreed to a $200 million purchase price. Merrill would pay $120 million up front, with the bulk going to Wiley, who retired immediately, and an additional $80 million over the next five to seven years, to be paid on the condition that client assets and revenues hit certain targets.

On April 4, 1996, H&W staff learned of the sale. The following week, Quinn and Hurley walked into a crowded conference room and introduced themselves to H&W's 50 employees, several of whom stalked off in disgust.

"All hell broke loose," recalls one person who was there. Not surprisingly, H&W staffers worried that Merrill would run roughshod, destroying the firm's identity as an institutional manager now that it was part of a retail-driven company.

"It was quite clear to Quinn that there was hostility toward this merger, and he went ahead with it anyway," says a former H&W staffer. "He didn't care whether people liked it."

Quinn thought he could write some hefty payroll checks and bring the team on board, and this crucial misjudgment testifies as much as anything to Merrill's carelessness. Portfolio managers didn't just want Merrill's money (though, of course, the money had to be there). They wanted autonomy and independence as well, and if they couldn't find it with Merrill, many were prepared to take their clients and run.

On July 31, 1996, Quinn's 50th birthday, the four-person fixed-income team led by Landmann and Rivelle made a break for the gate, launching Metropolitan West Asset Management on the other side of town. Soon $1.4 billion of the bond team's $2 billion in client assets followed them out the door.

The six Hotchkis and Wiley partners sued the rebels, accusing them of stealing proprietary client information (Merrill supported the move). The case was settled out of court before the acquisition closed. The defendants did not admit to any wrongdoing but agreed to pay several hundred thousand dollars to make the case go away. For Merrill it was an embarrassing setback.

Quinn's deputy, Hurley, who acted as Merrill's point man in LA, may not have been the best choice for the job. He provoked several staffers with frequent references to his pedigree - West Point, Stanford Business School, Goldman Sachs - and many employees found him arrogant. Convinced that Merrill could sell money management services directly to the firm's investment banking contacts, treasurers and CFOs, he proclaimed that pension consultants "will be dead in five years."

H&W staffers thought that was nonsense, which it was, and they pushed Quinn to replace Hurley as a final condition of the sale. Heading into 1997, Quinn drafted a new deputy - Charles Beazley, who had overseen Merrill's institutional efforts in Europe - as Hurley's replacement. (Hurley left Merrill at the end of 1996 and in 1998 started a Dallas-based fund-of-funds called Undiscovered Managers.)

Quinn remained optimistic. At the start of 1997, Merrill's institutional asset management group claimed $40 billion, $10 billion of which came from H&W.

In a strong year for value stocks, the flagship large-cap value portfolio returned 32.9 percent in 1997, versus 35.2 percent for its benchmark. Consultants became leery of sending their pension fund clients to the new division of Merrill Lynch.

"There was a belief that the merger with Merrill Lynch was not going to be a positive thing," says Jay Fewel Jr., senior equities investment officer at the Oregon fund that jettisoned the former H&W after 15 years. "The feeling was that the thundering herd would impose its corporate philosophies on a small firm, and that would upset the people and the process."

By mid-1997 the man leading the herd - Komansky - was determined to move Merrill into the front ranks of global asset management. Hotchkis and Wiley, clearly, would not take Merrill there. Komansky's chief strategist, Kenney, identified a handful of plausible acquisition targets for Merrill, all of them U.K.-based: $176.7 billion Mercury, as well as $30 billion Schroders and $107 billion Robert Fleming Holdings.

Merrill's purchase of Mercury created a $446 billion asset management group, which ranked third on the II300. The deal stunned the H&W partners, who suddenly found themselves playing second fiddle to their British colleagues.

Quinn confronted his own unpleasant surprise in December 1997 when Komansky named Peek - the former co-head of investment banking and chief of global research - to run the newly christened Merrill Lynch Mercury Asset Management and act as Quinn's new boss.

Peek argues that Merrill executives had no choice but to concentrate their energies on Mercury. "We had just spent $5 billion, and I had to be sure we got the deal right," he says.

Whether more attention from Merrill would have bolstered performance at H&W is an open question. But no sooner had Merrill taken the reins of Hotchkis and Wiley than the firm's large-cap value equity performance dramatically deteriorated, even compared with other value managers. In 1998 the portfolio produced a return of 6 percent, versus 15.6 percent for the Russell 1000. The following year the H&W portfolio lost 2.7 percent, versus a 7.3 percent gain for the index.

Several pension clients bailed out. Ketterer's international portfolios struggled as well, returning an average annual 11.4 percent between 1997 and 1999, versus 15.7 percent for the EAFE.

During this period Peek found himself more and more consumed by the problems at Mercury. The British firm seemed to be unraveling before his eyes. Clients were fleeing. Many, such as the Tyne & Wear Development Co. pension fund, replaced Mercury as their sole manager with a roster of firms. Performance weakened: Mercury's U.K. equity funds returned 12 percent in 1997, compared with 16.6 percent for its pooled equity fund benchmark. The following year the funds produced 9.6 percent, compared with 10.5 percent for the benchmark.

Mercury's British staff chafed at the brash Merrill style, epitomized at a Christmas party a month after the acquisition: Merrill staffers wore baseball caps with bull horns attached.

To the extent that Merrill tried to integrate the Mercury and H&W operations into one unit - and the efforts were fitful at best - the strategy fizzled. For example, in 1998 Merrill formed an investment council of top portfolio managers. The notion: Mercury and H&W would share investment ideas and strategies. Mercury had no U.S. equity presence and was in theory receptive to suggestions from its American colleagues. H&W sent two partners, Hotchkis and Baxter, to the first meeting in London. Hotchkis and others made clear that they had no interest in sharing anything with Mercury, least of all their best ideas. It was the first and last council appearance by H&W representatives.

In LA staffers resisted Merrill's efforts to build a unified global marketing campaign. Many were especially resentful when, in the spring of 1998, Merrill, after moving the LA group into a new downtown headquarters at Citicorp Towers, hung a Merrill Lynch Mercury Asset Management sign in the new lobby.

"Jeff Peek got a lot of hate mail for that one," says one Merrill staffer. By June 2000 Merrill had shelved the name Hotchkis and Wiley altogether.

Eventually, Peek decided to cut his losses. In early 2001 he began shopping the group around and soon found a buyer in Stilwell. But just as Landmann and Rivelle had jumped ship before Merrill bought H&W in 1996, Ketterer and Harry Hartford, managers of the international equity portfolios, turned their backs on multimillion-dollar lock-in contracts to make a go of it alone. On June 8, just two days before the deal with Stilwell was scheduled to close, Ketterer and Hartford left to start Causeway Capital Management.

The news blindsided Merrill and killed the sale. On July 6 the brokerage firm announced that it was breaking up the LA operation.

"Once it was clear the LA platform was no longer a strategic fit, our No. 1 priority was to make sure the group was given a proper home," says Peek. "Obviously, we would have preferred to sell it intact."

Even without the Hotchkis and Wiley debacle, Merrill's asset management group, like all money managers, is struggling with the bear market. At $533 billion, total assets are up just $1 billion over the past year.

Peek thinks he can grow the business, though his ambitions have been tempered. Before the Nasdaq composite index cracked last year, he envisioned MLIM reaching $1 trillion in total assets by 2003. In March 2001 Peek told analysts that he was now shooting for $825 billion. "When the indices are moving sideways to down, the goals become less about asset growth and more about profitability."

Though MLIM cut fixed expenses by 20 percent this year, through a mix of layoffs (900 jobs out of a total of 3,600), outsourcing and belt-tightening, its operating margins remain well below the industry average.

"The only realistic way to improve margins is to increase revenue and hold costs," Peek says. "But when revenues are going down, it's difficult to cut costs enough to keep pace. You can't control the market."

Peek thinks Merrill can grow institutional assets partly by taking some of its highest-quality equity retail funds and repackaging them as separate accounts. That gambit often fails.

"I'm not sure Merrill will succeed," says consultant Geoff Bobroff. "Their process is designed for the fund world. It's not as disciplined as what's required in the institutional market."

Might Peek leave Merrill now that he has been passed over for CEO? Peek says he is "committed to the firm," and most industry watchers feel that he will stick around, at least for a while.

Meanwhile, out in California former H&W portfolio managers Davis and Bardin have signed a definitive agreement to buy the core of Merrill's LA operation - and they are happily dusting off the old Hotchkis and Wiley name. For the right to manage about $4.8 billion in value equity assets, they are believed to have paid a multiple of less than 1 percent of assets.

"We're tremendously optimistic," Davis says. Merrill has transferred management of the remaining $3.3 billion in international equities to London, though Causeway has snagged several large clients; about $2 billion in fixed-income portfolios will move to MLIM's Princeton, New Jersey, offices.

Peek, for his part, is philosophical. "I hope we've learned something from Hotchkis and Wiley," he says.

Look before you leap.