The popularity of ETFs within the European asset management industry has increased dramatically over the last five years. Last year, we saw Barclays Global Investors delivering a substantial increase in its assets under management in ETFs with its Euro 240m acquisition of Indexchange of Germany. With a large number of smaller players still active in the market1, a number of commentators are speculating whether the present market turmoil may result in some of those smaller players falling victim to further consolidation in the European ETF market. This article seeks to identify the key high level issues that should be considered in any proposed acquisition of an ETF business.
Some key due diligence issues
Given their potential impact, it is important that the buyer makes enquiries as to the frequency and extent of any pricing errors in the funds over, say, a three year period prior to the acquisition. This will at least give an indication as to whether fund pricing errors may be a material issue in the target business. Ultimately however, appropriate protection will need to be sought in the relevant purchase agreement.
Index licence agreements
The index licence agreements are the key documents in any ETF business. These are the licences pursuant to which the relevant ETF provider is permitted by the index provider2 to list and trade ETFs that are linked to the particular index. There are a number of issues that need to be considered in relation to such agreements, in particular:
- Most Favoured Nation clauses - whereby the licencee may be required to increase its licence fees to match any higher fees that are payable under any new agreements entered into with other index providers. A buyer should also have regard to its own existing licence agreements and the potential impact on any MFN clauses in those licences;
- Term and fee levels - understanding the duration and termination triggers of the licences and the ability of the index provider to increase the fee levels or alter the basis of the fees is key; and
- Obligation to launch funds - it will be important to assess the extent of any obligations to launch new funds as an ongoing condition of the licence.
Given the commercial sensitivity attached to these documents, the relevant target business may be extremely reluctant to disclose their terms, particularly the fee levels, to a potential buyer until completion of the deal is certain. This issue should be addressed early on in the transaction, as the buyer has to assess whether the terms of the licence agreements necessitate engagement with the relevant index licence provider ahead of signing the deal.
Securities lending, market making, custody and IT support arrangements
It will be important to identify at an early stage any limitations on the level of securities lending fees that can be levied in the particular target business jurisdiction. The current restrictions in relation to short selling may also have a bearing on any securities lending activities; these should be considered in the context of the overall business case numbers.
In addition, the terms upon which other key services are provided to the ETF business, including custody and market making, must be reviewed. Given that a large number of ETF businesses sit within large global banking groups that provide these services from within the group, an important consideration for any seller will be the extent to which the buyer is prepared to commit the target ETF business to continue using the custody and market making services of the seller group or whether it proposes to provide these services itself from within the buyer group following the acquisition.
Given the nature of the business, IT system performance and support is crucial and the key IT licences and arrangements for any transitional services following the acquisition should be a focus area from the outset.
Some key transaction issues
As it involves regulated businesses, the deal will almost always be made conditional upon the receipt of approval from the relevant regulatory authority in the target jurisdiction. Depending on the expected length of the gap between signing and closing, the buyer may look for additional comfort beyond the usual series of restrictions on the conduct of target’s business during this period. An increasingly common tactic for buyers is to insist on a condition that the target’s assets under management (AUM) have not fallen below a specified minimum level between signing and closing. Such a condition is, not surprisingly, strongly resisted by sellers. However, where such a concession is ultimately made, it is important from the seller’s perspective that determination of the AUM figure at closing excludes the effects of any market movements.
Where the proposed transaction is caught by applicable competition regulations, a key issue for the competition authority considering the transaction will be to determine the “market” of which ETFs form part. Clearly, a “market” which is limited to ETFs only may result in a very different outcome to one where the “market” is, for example, determined to be asset management services generally3. The question of whether there could be smaller segmentation of the asset management services market in specific cases has been left open by the European Commission4.
Given that many ETF businesses reside within large global banking groups that may carry on a variety of asset management related activities, the accurate identification of the products in relation to which the seller group is not entitled to compete is likely to be a key area for negotiation as the seller group will be keen to ensure that the non-compete undertaking does not inadvertently prohibit or restrict its other asset management activities carried on within the group.
With a number of financial institutions retreating from non-core activities as a result of the impact of the current market conditions, and with organic growth in the ETF space a relatively expensive and time intensive pursuit, it will be interesting to see the extent of any consolidation amongst the smaller players in the coming 12 months.