Can Fidelity's loss be L&T's gain?

Alexander Treves has pulled a fast one on us. In our January edition, the head of investments at Fidelity India had urged investors to buy into the India growth story unless they thought it was structurally challenged. A couple of months later, Fidelity just did the opposite. After making its debut in 2004, the Boston-based privately owned fund manager sold its mutual fund business to L&T Asset Management. To be fair, there’s no point blaming the chief investment officer; he had a job to do and is not accountable for a business decision taken by the parent’s board sitting thousands of miles away.

But what’s surprising is that one of world’s biggest mutual fund managers chose to exit a country where mutual funds are grossly under-penetrated. The industry’s net assets, at ₹6.7 lakh crore, is a little over 7% of India’s GDP, compared with 84% in the US and 41% in Brazil. The reason — for every ₹100 saved in the country, only ₹5 is invested in equity-oriented assets (including mutual funds). So, if the potential was really so huge, why did Fidelity choose to walk out?

The answer to that lies partly in the way the fund major operated in India but, more importantly, it has a lot to do with the DNA of the second-largest mutual fund player in the US (after Vanguard Group). Says Ashu Suyash, managing director and country head, Fidelity India, “We didn’t see scale coming in India unless we started mimicking other players, and that’s not how Fidelity operates elsewhere in the world.”

Suyash insists that in India, “it is all about having small offices spread across the country and having local products. But Fidelity’s success globally comes from its ability to run very large institutional mandates by way of managing insurance and pension money. But here, when we talk of retail money, it is a different ballgame.” That’s true. Of the $1.52 trillion that Fidelity manages back home, about $725 billion comprises individual retirement accounts. But in India, pension money is still a state subject. The Employees’ Provident Fund Organisation invests a chunk of its ₹3.5 lakh crore corpus in government debt and is averse to investing in equities. “We recognise that markets evolve over a period of time, but in the case of India the evolution is taking much longer,” opines Suyash.

However, industry rivals believe a rigid business approach by foreign fund houses is the reason behind their limited success in a fiercely competitive market. Sundeep Sikka, CEO of Reliance Asset Management, the country’s second-largest mutual fund house, says, “You cannot simply have a plug-and-play model in India just because it works well in other markets. The need of the hour is to customise to suit local requirements.”

Suyash chooses to differ. “One needs to appreciate that every organisation has its own strengths. Fidelity does not run a standalone local model elsewhere. Yet, it had localised itself substantially in India.” In its eight years of existence, Fidelity garnered close to ₹9,000 crore across seven equity funds, six fixed income and two hybrid funds. From 2005 to 2008, when new fund offers was the buzzword, Fidelity chose to stay away. It was also selective about its distributors and ensured its funds were not mis-sold. Today, on average, the top five fund houses have around 23 equity schemes compared with just seven for Fidelity.

But while Fidelity took the right approach by not chasing assets under management (AUM) by hook or crook, it went horribly wrong on the cost side. As of FY11, the fund house had accumulated losses of ₹307 crore, especially owing to an eight-fold rise in employee expenses from ₹9 crore in FY05 to ₹68 crore until FY11.

In fact, juxtaposing the remuneration against revenues makes for a dismal picture. Employee costs accounted for 91% of its revenue of ₹75 crore in FY11. As a result, the 16th largest MF player topped the list of 26 fund houses that were loss making as of FY11. While Fidelity did have the option of cutting down on its costs, it chose not to do so. Says Suyash, “If you are running a high quality franchise, especially in a fiduciary business, scaling down and leaving the business in a ‘maintenance mode’ is not, perhaps, the best option.” Soon enough, following a yearly review, the board decided to put the India business on the block. The exercise ended with L&T buying the assets for ₹550 crore or 6.25% of the AUM, thus catapulting the asset management company (AMC) from the bottom quartile into the big league. But the bigger question here is: can L&T Finance finally achieve what Fidelity couldn’t?

On the house

To begin with, L&T Finance has no history in the fund management business; the AMC division came into existence when it acquired DBS Cholamandalam in 2010. But until the Fidelity acquisition, L&T was a fringe player with AUM of less than ₹4,000 crore, of which 95% assets were in the fixed income category. But with the Fidelity deal, it now has a sizeable equity AUM. While L&T Finance refused to participate in the story, media reports quote YM Deosthalee, CMD of L&T Finance, as saying, “We felt it was important to go to the next level. With this acquisition, we are a step closer to achieving our vision of being among the top players in the Indian mutual fund industry.” That scale will help L&T Finance improve its odd for financial success. As of FY11, the AMC had accumulated losses of ₹124 crore, including the loss of ₹40 crore incurred in FY11.

A Financial Times report quotes L&T finance director N Sivaraman saying that the losses will not create any handicap for the company. Indicating that cost cuts were in store for the new entity, Sivaraman goes on to say, “The costs and assets under management will have to be changed, and that is one way we can really achieve an accelerated improvement.”

Despite emerging as the 13th largest fund house because of the buyout, L&T will have to be content with a market share of just 1.89% compared with 0.6% as a standalone entity. While L&T will now be eager to break into the top 10 that controls 80% of the industry’s AUM, it will need the support of distributors and the vote of confidence from Fidelity’s investors.

As far as the distribution network is concerned, while Cholamandalam gave L&T access to independent financial advisers, Fidelity comes with its highly concentrated distribution network comprising mainly foreign banks. Though Fidelity has 292 distributors, it’s the top 10 that account for 60% of its sales. And for now they are keeping their fingers crossed. Vishal Kapoor, head, wealth management, Standard Chartered Bank, the fifth-largest distributor of Fidelity, says: “We will wait and watch how the whole transition takes place. Though L&T does not have long standing in the mutual fund business, it is a reputed brand. But a lot will depend on how the final entity and the new investment team shapes up.”

And that will be the litmus test for L&T, which does not have an impressive track record in managing funds. However, Suyash points out, “A lot of Fidelity’s investment processes will be put in place and only once the new team is fully equipped will the portfolio managers move back to Fidelity.” While Fidelity’s equity porfolio managers are not part of the buyout deal, Suyash along with the business and fixed income teams will be joining the new entity.

While that may quell investor concerns for now, L&T has its task cut out. It will have to convince distributors and investors that it can quickly put together a high quality investment team that can sustain the performance that Fidelity delivered.

Says Vicky Mehta, senior analyst, Morningstar India, “Fidelity’s three mutual fund schemes were rated ‘Gold’, the highest rating offered by Morningstar. But now the ratings are under review, given the uncertainty over who will be at helm of the funds in L&T, the kind of investment process that will be applied and what the fund’s character will be.”

For now, L&T has won half the battle as it will not have to run the high costs that made Fidelity’s business case weak in India. But to win the war, it needs to put together a good investment team at half the cost. It’s only good performance that can keep the faith of investors and help it garner sustainable assets. Else, Fidelity’s loss may not quite result in a profit for L&T Finance.