Friday, February 02, 2007

Great-West Buys Putnam

Scotia Capital, 2 February 2007

• We believe attractively financed deal has limited downside and provides an opportunistic entry point into a business that only makes sense in the long run. No question in our minds that if you're in the retirement business in the U.S. (as is GWO in 401(k) business and 457 business) than it makes sense to be in the U.S. mutual find business, provided you can find an attractive entry point. We believe the effective and tax-efficient financing of the deal, a desperate seller, and what has proven to be a turnaround story of late; all point to what we believe to be an attractive opportunity. Financing the transaction with a limited number of shares, and thus capitalizing on a US$550 million tax asset to help finance the deal, perhaps put the company at an advantage over other bidders, as did its employee friendly plan to not "slash and burn" but rather assist Putnam as it more or less continues to "synergize itself". Putnam management "buy-in" is key, in our opinion, and will own about 5%-6% of Putnam.

• It’s a margin improvement and net sales improvement story - but that's what Putnam has been doing. Net sales have improved from negative US$63 billion in 2003 to negative US$52 billion in 2004 to negative US$34 billion in 2005 to negative US$21 billion in 2006, as gross sales are now running at least 10% better, and redemption rates have come down from levels north of 25% to those in line with industry average (18%-20%). EBITDA margins, which Putnam now suggests are running at 20%, have improved substantially as well, but still have lots of room to improve to be near industry averages of 25%-30%. Finally, for a company that is one-half the size it was about five years ago, it has maintained distribution shelf space in both domestic retail (60% of its US$192 billion in assets), and domestic institutional (20% of its assets) as well as international (20% of assets). For the first time in several years assets are up YOY (2006 AUM are up 2% over 2005).

• We get $0.06 EPS accretion in the first 12 months following the Q2/07 close assuming the company's target is achieved, and limited downside risk of $0.03 dilution if there is no margin improvement. The math is relatively simple. The "planned improvement" scenario, which as per management, implies about 8 to 10 points of EBITDA margin improvement (2/3rds due to cost and 1/3 due to revenue) and net flows going from negative US$21 billion in 2006 to negative US$1 billion in 2007, yields $242 million in Putnam earnings (based on the company suggested 14.5x multiple on the US$3 billion price for Putnam assuming these "planned improvements"). Removing current inter-company capital, loans, overhead, as well as earnings from T.H. Lee Partners, GWO management suggests the margin on the business is below 20%, or in the 16% range. Thus, assuming the 8 to 10 points of margin improvement as well as the improvement in net sales, i.e., the assumptions underlying the $242 million in Putnam earnings, we get the "target" EPS accretion scenario of $0.06. Assuming no improvement in margins we get EPS dilution of $0.03, and assuming margins improve 5 points over and above the target we get $0.11 in EPS accretion. Naturally margin improvement goes hand-in-hand with fund flow improvement, but if fund flows remained at negative US$20 billion next year but the margins improved to the targeted levels we would decrease our EPS estimates by $0.02 maximum. Details are below in Table above.

• We see several sources of margin improvement. One, we believe GWO will get some expense relief as retention bonuses are "relaxed" to some extent going forward. Retention will be fostered through a new employee ownership plan. Two, we believe the absence of some Marsh & McLennan overhead charges, as well as the absence of inter-company shared expenses will help margin improvement. Thirdly, we believe that leverage from an extensive internal cost-cut program, one that has cut the employee base in half over the last several years, will increasingly impact the bottom line. Finally, this is a leverage game, and we believe that with redemption rates and gross sales growth rates continuing to improve, there is substantial upside.

• We believe our estimates are conservative for several reasons. One, we haven't incorporated the impact of the company purchased 25% ownership in the private equity firm T.H. Lee Partners. Management indicated it sees the opportunity to improve cash flow matching in its Canadian individual insurance fund with the T.H. Lee assets. Lift here, as well as additional investment income, could be in the $0.02 per share range. Two, we haven't incorporated any additional revenue synergies with GWO's exiting retirement businesses, namely its 401(k) and 457 businesses. Three, we haven't incorporated the potential benefit from GWO "rejigging" any current Putnam distribution or fund management agreements. Four, we have conservatively increased our EPS by only $0.04 in 2008 (as opposed to the "targeted" $0.06 per share) and by only $0.01 in 2007 (as opposed to the targeted $0.03, assuming the deal closes at the end of Q2/07). Five, financing is not finalized yet. Equity financing could be lower than the assumed $1.2 billion maximum.

• We expect Power Financial to contribute about one-half of the maximum $1.2 billion equity financing. On the call Power Financial indicated it likely would contribute less than its ownership (currently 70.6%) but more than the 26% in GWO stock it purchased to support the Canada Life deal.

• Favourable views from rating agencies. With little balance sheet impact (debt-to-total capital ratio will climb from 30% to 32%, far below the 35% leverage ratio the company had at the close of the Canada Life deal), the initial reaction from Moody's, S&P and Fitch have all been positive.
Financial Post, Duncan Mavin, with a file from Sean Silcoff

Great-West Lifeco Inc.' s US$3.9-billion acquisition of Putnam Investments nabs the Canadian life insurance company not only a large-scale asset manager in the United States but also a stake in a significant player in the red-hot private-equity industry.

As part of GWL's acquisition of Putnam, the Winnipeg-based life insurer -- a unit of Power Financial Corp. -- gets a 25% stake in Thomas H. Lee Partners, a private-equity firm with funds of US$19.7-billion.

The Putnam deal, announced yesterday after months of speculation, values the stake in T.H. Lee at US$350-million.

Robert Gratton, chief executive of Montreal-based Power Financial, described the investment in T.H. Lee as "one of [Putnam's] jewels."

That being said, acquiring Putnam's stake in T.H. Lee was not crucial to the deal, said GWL chief executive Ray McFeetors.

"But it is a key opportunity to Great-West Life," Mr. McFeetors said. "It's rare, if ever, that you can acquire an interest in an entity like this. We're very excited about the financial opportunity that it brings as a seasoned private- equity investor."

The global private-equity industry has grown at a rapid pace in recent years. Private-equity funds are forecast to raise up to US$500-billion of new capital in 2007, up from a record US$432- billion record set last year.

However, GWL's acquisition of a stake in a private-equity firm is the first foray of its kind by a Canadian life insurer, and surprised some analysts. However, the deal could provide a way for GWL to grow its equity investments without becoming overexposed to the instability of the equity markets.

"It's an interesting back door into investing in equities," said Genuity Capital Markets analyst Mario Mendonca.

GWL will take a share of the returns on T.H. Lee's equity investments "without getting the volatility that you would get from investing directly in equities that would then have to be marked to market for accounting purposes," Mr. Mendonca said.

T.H. Lee's six funds are expected to return profits over a long period of time, and this would match well against GWL Canada's insurance policy liabilities.

Mr. McFeetors said the deal to buy Putnam Investments from U.S. insurance brokerage Marsh & McLennan Cos. Inc. was concluded at two o'clock on Thursday morning and has been in the works since last October.

Putnam is the 10th-largest mutual fund manager in the United States with US$192-billion of assets under management.

It has operations in Europe and Japan as well as the U.S. The Boston-based company has a strong brand in the U.S. investment management industry and has 169,000 financial advisor relationships.

Putnam will operate as a separate business unit within GWL, and existing management of the company will also be retained after the deal, Mr. McFeetors said.

"Putnam is one of the oldest and largest investment managers in the U.S. and carries credible brand equity," said Desjardins Securities analyst Michael Goldberg. The acquisition is an "opportunistic expansion of [GWL's] business platform," Mr. Goldberg said.

However, Putnam has also had its problems in recent periods.

The company's reputation took a hit when it was caught up in a fund-share-trading scandal in the U.S. mutual fund industry in 2003, and it has also suffered from low margins and net redemptions of investor funds.

Executives at Putnam said they have a plan to improve margins, while net fund outflows have slowed.

The asset manager saw total net redemptions of US$63-billion in 2003, and US$52-billion in 2004. However, that figure was down to US$21-billion last year, and Putnam is forecasting net redemptions of less than US$1-billion this year.

"We don't think we're catching this at the bottom, we're catching this as it's rebounding already," said Power Financial's Mr. Gratton.
Financial Post, Sean Silcoff

It's well known in Canadian business that when Paul Desmarais is buying, it's not a good time to sell, and when he's selling, it's not a good time to buy.

The wily 80-year-old billionaire, and his two sons, Andre and Paul Jr., sit atop Power Corp. of Canada, which indirectly controls Canada's largest mutual fund firm, IGM Financial Inc., and multinational insurance giant Great-West Lifeco Inc, (GWL) among other global interests.

That you probably already knew. If you needed reminding, Power got there in part with some shrewd deal-making, including the sale of Montreal Trust and Consolidated Bathurst, a pulp and paper firm, in 1989, at the top of the market.

It is that track record that won a lot of goodwill from the market yesterday, because there are many aspects to GWL's purchase of U.S. mutual fund firm Putnam Investments for US$3.9-billion that had some observers quietly wondering whether the Desmarais clan had lost its Midas touch.

"They're buying something that isn't very good, so we have to put a lot of faith in management," Genuity Capital Markets analyst Mario Mendonca said. "If it was another company ? I'd be tempted to downgrade the stock."

Putnam hardly seems like typical quarry for Power. The sullied mutual fund unit of Marsh & McLennan Cos. Inc. was likely worth more than US$20-billion in 2000 when it had US$371-billion under management.

That asset base has fallen by almost half since then, due to poor fund performance in the early 2000s, and then Putnam's role in a U.S. mutual fund industry scandal involving price-fixing, bid rigging and fund trading.

The results since then have been, what's a kind way to put it, relatively less awful. Net redemptions improved from US$63-billion in 2003 to US$21-billion last year. A new executive team led by Charles Haldeman improved margins and put better managers in place of some key funds. Putnam is now a place where rules are followed, and closely.

Putnam is seen as a loser, with a lot to prove. The mutual fund industry in the U.S. is still under pressure, with heavy redemptions. A turnaround "is going to take a very long time," said a top executive with a Canadian asset management firm. "It's damaged goods."

Enter Power. In fact, Putnam is exactly what GWL/Power has been looking for, said Robert Gratton, executive chairman of Power Financial (the holding company between Power and GWL). "We don't think we're catching this at the bottom, [but] as it's rebounding already."

In fact, for a group that has been eyeing expansion outside of Canada for three years, Putnam is a sensible catch. The Haldeman team is not just staying on, but throwing in $200-million of their own skin into the purchase. That is a good sign. They believe net redemptions will shrink to less than US$1-billion this year, and they can get margins up from 20% to 27%, close to industry averages. The bad rep from a few years back has passed, Power/GWL executives concluded after interviewing hundreds of industry professionals. In fact, Power shows no interest in actively managing Putnam, believing the upside will come if the team they've inherited just do their jobs.

"We were not fazed by the fact there were temporary market conditions," Mr. Gratton said. "We're in these businesses for the long term. The demographics are there. The market will continue to grow. In the U.S., our focus has been and continues to be of retirement accumulation of savings and retirement. Mutual funds are an essential component of any retirement plans."

There's growth in them thar Boomers. Plus, more U.S. firms are shedding their managed pension plans: The amount of Fortune 200 firms with defined benefit plans shrunk to 53% last year, from 82% in 1996, leaving more people to control their own retirement nest eggs through tax-deferred 401(k) plans, according to Mercer Human Resources Consulting.

That means more mutual fund buyers. "That's a very big plus," Mr. Gratton said.

Putnam may be no overnight success story, and there are still risks. But this is a long-term bet: that a robust 70-year-old business will get over a hiccup and return to form. Just imagine 10 years from now. Marsh will look like it sold out of a solid business at a low point. And everyone will be talking about how old Paul Desmarais made yet another savvy and well-timed deal, smiling all the way.
Financial Post, Sean Silcoff

Great-West Lifeco, a subsidiary of Power Financial Corp., yesterday said it would buy Putnam Investments's mutual fund management business and a 25% stake in T.H. Lee Partners for US$3.9-billion. The Financial Post's Montreal bureau chief, Sean Silcoff, spoke to Power Financial executive chairman Robert Gratton and chief executive Jeffrey Orr about the deal. Here is an excerpt of their conversation:

Q Why are you buying Putnam, a company that seems in need of a fix?

JO The existing management team is already three years into a plan to have Putnam back into a growth mode, and that plan is well-developed and well underway. So we're coming in, we think, at a very good time. We also understand the asset management business very well. So we can add our expertise to the expertise management already has.

Q Is the turnaround working?

RG If one looks at the net flows, which have been negative for four or five years, there's absolutely a vewry clear pattern of those numbers improving in the last three years in a dramatic fashion. The performance of the funds themselves has also changed in a very significant fashion over the last three years. We don't think we're catching this at the bottom, we're catching this as it's rebounding already.

Q Putnam was at the centre of a scandal in the mutual fund industry in the U.S. earlier this decade. Is there any residue left over?

JO We think that has faded significantly. All of our work talking to financial advisors and distributors in the U.S. would confirm that. There is a great store of goodwill in the Putnam name.

RG We saw that especially in the institutional market, which is of course even more sensitive to that than the broad retail market. There's a clear, positive perception there now about the name and reputation. And we've surveyed that before we bought.

Q Did you feel it was important to be more careful with this purchase? How did you approach differently than past deals?

RG I hope we've always been extremely careful on each one. I believe this was no different than the others -- the same level of due diligence, the same review. What's different about it is with this one there's no combination anticipated with another company because we don't have a mutual fund company in the U.S., whereas the other large acquisitions we've made in the last 10 years all had some form of combination. Therefore the action plan and the business plan that results from this one is different. The improvements to the business of Putnam will be internally generated by management. When we approached this one we had to be absolutely satisfied the team there was broad enough, competent enough to implement the full business plan.

Q And you had to be absolutely satisified all residue of scandal had to be gone?

RG Another piece of the reputation has to do with the compliance area, because they had regulatory problems. They've been through compliance audits, reviews by outside people each year. The results coming out of that are very very positive. There's a culture of compliance now.

Q Why did you want to buy into mutual funds? It's a sector that hasn't done well lately. Did you smell an opportunity?

RG Indeed. We're in these businesses for the long term. We're extremely bullish on the market for value-added financial services for the next 15 to 20 years. The demographics are there. The market will continue to grow. One of the best products is the range of mutual funds that one can buy. So in the U.S. our focus has been and continues to be of retirement accumulation of savings and retirement. And mutual funds are an essential component of any retirement plan. That is why we got there. We were not fazed by the fact there were temporary market conditions.

Q Why did Power Financial choose GWL to be its growth platform in the U.S.?

RG Lifeco chose itself first. They've got a very large business there already, and [when management reviewed] their strategy with us in terms of expanding their U.S. business, we identified mutual funds as a good place to be. But some other day, it could be Investors (Power Financial subsidiary IGM Financial) that comes forward with something they'd want to buy. There's room for [Great-West] and IGM in Canada; there sure is room for Lifeco and IGM in the United States.

Q Do you think you got a good price?

RG We think we got the company at the right price. And we did not buy it for some optimistic future scenarios. We bought it on the basis of the current economics of the business, at a low multiple compared to the rest of the industry.
The Globe and Mail, Andrew Willis, 2 February 2007

The Desmarais family signalled it wants insurer Great-West Lifeco Inc. to join the top ranks of U.S. money managers yesterday with the $4.6-billion acquisition of Putnam Investment Trust, the 10th-largest U.S. mutual fund company.

Great-West is buying a Boston-based money manager with $225-billion in assets and global reach, and betting that Putnam will rebound from poor fund performance and the 2003 market-timing scandal.

Putnam parent Marsh & McLennan Cos. Inc. put the unit up for sale in September as the insurance brokerage moved to streamline its businesses.

Winnipeg-based Great-West is a strong player in all sectors of the Canadian insurance market, but its U.S. operations are focused on group life insurance.

Chief executive officer Raymond McFeetors said the company decided in July of 2005 to bulk up its offerings of retirement savings products, "so we've been looking at mutual fund companies for two years."

"The U.S. asset management industry is just starting to consolidate. My view is we will end up with half a dozen companies, each with well over a trillion dollars under management," said Mr. McFeetors, who added that Great-West is "a proven consolidator" that aspires to be in that elite group.

U.S. mutual fund leader Fidelity Investments has $2.9-trillion in assets.

Great-West has $197-billion in assets, so the Putnam acquisition doubles the company's size to $422-billion.

The insurer is 71 per cent owned by Power Financial Corp., a holding company controlled by Power Corp. of Canada, all of which are part of the Desmarais family's empire.

The Montreal-based conglomerate is already the top player in the domestic fund industry as the owner of IGM Financial Inc., parent to Investors Group and Mackenzie Financial Corp., which together have $107-billion of assets.

Putnam CEO Charles Haldeman and his team will remain in place and will own 4 per cent of the company, compared with management's current 11-per-cent stake.

"Uncertainty in ownership was troublesome in the marketplace," said Mr. Haldeman, who joined Putnam three years ago as part of an executive housecleaning. The Harvard MBA said he looked forward to boosting sales and cutting costs with Great-West's help and moving profit margins that are now under 20 per cent back to industry norms of 28 per cent.

"They can teach as a lot, and challenge us a lot," Mr. Haldeman said.

Power Financial chairman Robert Gratton said his company's due diligence with stockbrokers and institutional investors showed Putnam is coming back.

"The trend is clear. We've done extensive blind surveys during the due diligence," Mr. Gratton said. He said Great-West, not IGM Financial, was the natural buyer of Putnam because of its extensive U.S. operation.

Great-West won a hotly contested five-month auction, with a number of U.S. and foreign money managers bidding on Putnam. This deal was finally signed early yesterday morning in the lobby of Toronto's Four Seasons Hotel, only after the executives' last-minute negotiations were interrupted by the noisy arrival of a visiting NBA team, the Washington Wizards.

Putnam is a 70-year-old franchise that represents one of the better-known mutual fund brands. The company's recent woes mean Great-West is buying at a discount price: Putnam is changing hands at 14.5 times earnings in a sector that typically commands 22 times earnings.

Analysts agree there is a potential market leader in this union if investors continue to return to Putnam, which boasted $420-billion (U.S.) of assets just five years ago.

"Upfront financial benefits look slim, but we credit Great-West with the ability to foster improvement over the medium term and drive acceptable economics," said insurance analyst Jason Bilodeau at UBS Securities.

As part of the purchase, Great-West also acquires Putnam's 25-per-cent ownership stake in one of the leading U.S. private funds, T.H. Lee Partners. The $12-billion Boston-based fund has been around since 1974, and has been called "the teddy bear at the gate" because of its preference for friendly deals. T.H. Lee has owned companies such as Snapple and Dunkin' Donuts.

To finance the deal, Great-West has figured a way to cash in on future Putnam tax deductions related to the goodwill incurred in the purchase.

Great-West will use what's known as a "securitization" to raise $644-million (Canadian), a sum that will be paid back as Putnam generates future tax benefits.

In addition, Great-West plans to sell up to $1.2-billion of shares, with Power Financial ready to purchase a portion of this equity. The insurer will borrow up to $1.6-billion to finance the remainder of the purchase.

Great-West was advised by Morgan Stanley. Marsh's financial advisers were Goldman Sachs Group Inc. and Merrill Lynch & Co.

New York-based Marsh, the world's largest insurance brokerage, is expected to use the money from the sale to pay down debt and expand its Mercer consulting and Kroll security units.

Great-West shares closed up 35 cents yesterday at $34.84 on the Toronto Stock Exchange, while parent Power Financial saw its stock rise 95 cents to close at $38.52.

Power surge

Power Corp. patriarch Paul Desmarais Sr., Canada's fifth-richest man, got his start in business by buying his parents' bus company in Sudbury for a dollar in 1951. He now heads the 31st-largest company on the Standard & Poor's/TSX composite index. Power Corp. of Canada has a market value of $16-billion, and Mr. Desmarais Sr. has a net worth of $4.41-billion, according to Canadian Business magazine.

Mr. Desmarais Sr. began his foray into financial services by buying control of insurer Imperial Life for about $12-million in 1963. He then acquired Montreal newspaper La Presse, and by 1968 had gained control of Power Corp., at one time an electric utility. Through a web of holding companies, the Desmarais family controls fund firm IGM Financial Inc. and insurer Great-West Lifeco Inc.