Chairman & CEO ● State Street Corporation
Three years* have elapsed since Ron Logue became CEO of State Street. It is a measure of what he has achieved since then that the circumstances in which he took charge are largely forgotten. Back then, State Street was a bank under pressure. Chairman and CEO David Spina had surprised the industry by reversing a decision to stay on. The integration of the Deutsche Global Securities Services (GSS) acquisition had created plenty of opportunities for competitors to snipe at the bank for taking on too large and complicated a task. Operating costs were spiralling, but a redemptive 2003 cost-cutting package had proved too successful, attracting nearly twice as many applicants as the management expected. Rumors that Citi was interested in buying Stat Street were proving remarkably persistent.
How circumstances change, and how they stay the same. Apart from his own advancing years, the 61-year-old Logue is challenged by nothing now but his appetite for the job. For him, the Deutsche acquisition proved the opposite of what the critics said at the time. “It is our biggest success,” he says. “The fundamental, core competency of this company is that we know how to integrate very well, and we have proven it time and time again.” This year alone, State Street has agreed to pay $564 million for foreign exchange trading platform Currenex and another $4.5 billion for Investors Bank. Far from cutting costs, Logue watched payroll climb 19% last year, while operating expenses grew by only 12%. The only ghost of 2004 that even Logue cannot banish is the constant speculation about industry consolidation.
The specter is scarcely personal. The consolidation of the custody industry has reached the point at which the targets pick themselves: State Street, RBC Dexia and Northern Trust. The State Street share price has tracked the S&P 500 faithfully for the last five years, but just as faithfully underperformed the S&P Financial. Logue himself believes no American financial services company is untouchable until it is among the top 25 companies by market capitalization. At $23 billion, State Street is a tenth the value of Citi or Bank of America, a seventh that of JPMorgan Chase, and a quarter that of Wells Fargo or Wachovia. “Market capitalization is always a concern for us,” says Logue. “It is going to have to grow. We need to be a much higher market capitalization company. We need space to manoeuvre.”
And what is his recipe for getting there? “Consistent performance and smart acquisitions executed flawlessly,” says Logue. To the question whether shareholders will give him time to prove his strategy, Logue offers a predictable rebuttal (“Not if I have anything to do with it”) and a stark choice (consolidate or be consolidated). He knows which he prefers. “It is clear to us that we are in a consolidating industry, and that it is not going to stop,” says Logue. “The important question is: What is the end-game? I think the endgame is going to be maybe three very large players, with a few boutique players, and no mid-tier players left. I want to make sure we are one of those three players left. Getting there is not going to come exclusively from organic growth. It is going to have to come through acquisition. We have to be a buyer, and we are a buyer, and we are going to continue to be a buyer. Size does matter.”
RBC Dexia Investor Services is the kind of mid-tier provider Logue ought to be considering, though he dismisses the idea. Yet, buying the Canadian custodian could enlarge the State Street business in Canada substantially, add further bulk to an already large operation in Luxembourg, and offer further exposure in Asia and Australia. It is not of course for sale, yet. “The next spate of acquisitions in this business is going to come during the next economic downswing,” predicts Logue. He knows: State Street bought the Deutsche Bank global custody business at the bottom of the last downturn in 2002. “That is when difficult choices have to be made. Right now, everyone will say, ‘That is a nice little business. We are making some money.’ Wait until the next set of bad times, and then see how much money the mid-tier players are making.”
This is a none-too-subtle tilt at banks that refuse to decide whether they are a commercial or a universal or a retail or an investment or a custodian bank, and whose ranks include JPMorgan Chase as well as Royal Bank of Canada. “There are going to be fewer and fewer custodians because the cost of being in this business is just too much,” says Logue. “For those organizations that are commercial or universal banks, and happen to do this, it is getting awfully expensive. Focus is becoming more important for the sustainability of this business.
There are going to be fewer and fewer custodians doing more and more in the asset management industry because there will be very few of them that can afford to stay in the game. Those that are going to be able to afford it are going to have a real focus, and not have so many other businesses. If this business is less than 5% of your total business, you have to question why you are in it, especially if the costs keep going up.”
This helps to explain why Logue is not dismayed by the intrusion of the major sub-custodian networks-BNP Paribas, Citi and HSBC-into the traditional preserves of the global custodian, including fund accounting and investment management outsourcing, albeit mainly at the local level. “The difference between being a sub-custodian and being a full-service custodian, accounting agent and administrator is the difference between night and day,” says Logue. “And it is measured in terms of the consistent investment in dollars. I do not think many sub-custodian banks are willing to spend the money to move up to that category because most of them are owned by traditional commercial and universal banks. They have got other places to spend their money. History shows the opposite happens, as it did at Deutsche Bank.” Certainly Logue will not be looking to buy them. “We are already at the top end of the product cycle,” he says. “That would be going down to a more commoditized product cycle.”
Global custodians such as State Street have of course done the most to squeeze the sub-custodian business. According to its 10-k, the bank is spending nearly $500 million a year on settlement and sub-custodian fees, and the costs rise in line with transaction volumes. With staff costs climbing by nearly 20% a year, network managers can make a significant contribution to keeping operating expenses under control. During the three years before Logue became CEO, State Street allowed costs to grow faster (9.8% a year) than revenues (4.0%), but since he took charge revenues (8.4%) have outpaced costs (6.5%). “The trick is to make sure revenue grows faster than expenses,” says Logue. “We have, for 11 quarters in a row down to the end of June 2007, grown revenue faster than expenses. Eleven consecutive quarters of positive operating leverage-that is the trick. I am not concerned if expenses grow 12% as long as revenue is growing 14-15%.”
This trick is of course easier to pull off in a bull market. What will happen now the markets look likely to slow down again? His recipe is the same. “If revenue grew only 7-8% you have to make sure expenses are less than that,” says Logue. “If you can do that-if you create that kind of flexibility-then I think you will have some success and you will be rewarded in your stock price.” He was. Revenue at State Street was up 15% last year, faster than any of its competitors, and the stock price climbed 23% on the back of it. “I am a lot more comfortable than I was three years ago,” says Logue. “Proof of the pudding? First of all, this is about revenue. Nobody is going to become a leader in this business by cutting costs. This business is about top line revenue generation. Some of our competitors do not get that.” He insists that the stock analysts, those important arbiters of the future ownership of State Street, do get it. “We are a growth company,” he says. “What do growth companies do? Grow revenue.”
But even the best managed custodian bank cannot insulate itself completely from the direction of stock markets. The revenues of both of the businesses in which State Street is invested are linked directly, by means of ad valorem fees, to the value of the markets. “I am sure there are some investment banks out there that would love to put a very expensive hedge on for us,” says Logue. “I am not sure that is the best interests of State Street. I think we need to create natural hedges. We need to have lots of levers to pull.” He argues State Street has already diversified sufficiently, chiefly by cross-selling to existing clients. The bank estimates in its 10-k that a 10% move in the equity markets would make only a 2% dent in the revenue of the bank, and a 10% move in the fixed income markets just 1%. Logue cites securities lending (up 17% last year), foreign exchange (up 31%) and other trading services such as brokerage, commission recapture and transition management (up 11%) as key areas of diversification. “Transition management has been one of our fastest growing businesses,” he adds.
If it is true that State Street has managed 800 transitions in the last 12 months, the bank clearly has no objection in principle to competing with investment banks. How curious then that another fast-growing business at State Street-hedge fund servicing-is one where the bank has chosen deliberately to eschew competition with the investment banks in the most profitable part of the hedge fund servicing industry: prime brokerage. Yet, it offers an obvious alternative to the strategy State Street is pursuing, and a more rapid ascent to the ranks of the untouchables than consistency, synergistic acquisitions and a focus on keeping revenue ahead of costs. It is not by chance that Goldman Sachs and Morgan Stanley are worth three or four times as much as State Street. Their revenues are six times as high; their return on equity twice as high; and their profit margins one and a half times as rich. If State Street was willing to become a prime broker, its earnings multiple might sink from 20X to investment banking levels (7-8X), but it would enjoy the security of the higher dividends and share price that stem from being invested in a more profitable business.
In fact, State Street Global Advisers (SSgA) does of course manage absolute return strategies. Yet, in the securities services business, the bank is content to limit its exposure to the least profitable aspect of the booming hedge fund industry (administration) and to lending the assets of its institutional clients to prime brokers at one price, knowing that they will charge the hedge fund borrowing the stock at least twice as much. So what prevents State Street getting into the prime brokerage business? Logue is not saying, but the disincentives must include capital constraints, investor expectations, the lack of an investment banking arm, and a reluctance to compete with investment banks that are important clients in other parts of the business, notably securities lending.
After all, at the end of last year, State Street was providing liquidity and credit enhancements worth $24 billion to the off balance sheet asset-backed commercial paper arbitrage programs known as “conduits. ” The bank entered the business 15 years ago chiefly, says Logue, because money market mutual fund clients wanted the additional yield. (The profile of these vehicles rose somewhat during the subprime crisis this summer but State Street pointed out that it was experiencing no difficulty rolling over its commercial paper programs, since the conduits that it backs are invested solely in investment grade assets). The willingness of State Street to take even limited risks of this kind is unusual among custodian banks, but its conduit strategy is scarcely a radical departure from the usual conservative approach. Its respect of the custody-investment banking boundaries is absolute, but the trouble is that the investment banks do not respect the boundaries at all. They see 130/30 funds-invented, ironically enough, by SSgA-as a direct route into the trillions of dollars managed by the institutional fund management industry. “I am not overly concerned about the prime brokers getting into our part of the business because they are making enough money doing prime brokerage,” says Logue. “They do not need to do this. It is a clear line, and I think that line is going to stay in place.” He is “not overly concerned” by the fact that traditional fund managers are already signing prime brokerage agreements and says the bank has not lost any business to prime brokers. Logue even sees growing opportunities in consolidating data for hedge funds, as multiple prime brokerage starts to complicate matters in the middle office. “At the end of the day, when it comes to servicing, it is all about performance and trust,” he says. “The question is: Are you going to go to a prime broker who is just beginning to get into this business, or are you going to go to a trusted, large, well-capitalized organization? I think there is a big difference between having a capability, and what is behind that capability.”
Logue also argues that focusing on securities services is not incompatible with increased profitability. “Our logic is to continue to develop value-added products, and sell higher margin services,” he says. “Custody and fund accounting is just the base for doing that. It is the exact opposite of just getting bigger, in terms of assets under custody. The issue for us is how many dollars of revenue we can earn for every dollar of assets under custody.” The cross-selling ratio has become a key indicator of the value of every relationship to State Street. “We have way more products than our competitors,” says Logue “And at scale too.” The top hundred customers buy an average of 14 products from the bank, he says. Logue bridles at the idea that cross-selling is no more than a refinement of the traditional global custodian business model of giving custody away in order to exploit the assets on securities lending, cash management and foreign exchange. “We have never given away custody for free,” he says. “That is a philosophical difference between us and our competitors. We will not do that. It is a fool’s game. We do not need to be the biggest custodian in the world. We need to be the most profitable.”
Despite that constraint, assets under custody at State Street have risen from $9.4 trillion when Logue took over to $13 trillion today-a rate of growth exactly in line with the increase in profitability over the same period. That may be coincidence, but the acquisition of Investors Bank & Trust (IBT), which will add another $1.7 trillion to assets under custody, is not. Yet, if AUC is not the test, it is hard to understand the logic of the purchase. A modest operation in Dublin apart, plus some private equity administration clients, Investors Bank offered State Street nothing but increased exposure to the US mutual and hedge fund industries. In fact, owning IBT means State Street is now not only the biggest mutual fund accountant in the US, but the largest hedge fund administrator as well. Logue agrees that the main effect of the acquisition was to bolster an already strong position in the US mutual fund industry, but says the acquisition is “mischaracterized” as a purely domestic play.
“Why did IBT sell the business?” he asks. “Because they realized they would have to spend a significant amount of money to build a non-US infrastructure to support the emerging needs of their customer set. Because of that, their growth rates would not be what they were in the past. What we purchased was a very strong book of business with US household names who are going global, and need a service provider. I would suggest that the majority of the future products and services we will sell to this customer base will be non-US.” One of those household names is of course BGI, which accounted for 18% of the revenues at IBT. As the major competitor to SSgA, and having placed its international business with JPMorgan already, competitors are inevitably encouraging speculation that BGI is not likely to retain State Street as its operational services supplier at home or abroad. Logue counters that the degree of competition between BGI and SSgA is “overblown” and does less than justice to the maturity of the relationship between the two firms. “I do not know what is going to happen to BGI, just like I do not know what is going to happen to all the other customers,” says Logue. “Nobody has said they are going to leave.”
He points out that the success of SSgA has rarely posed a problem for a client of the securities services business, partly because the fund manager has remained exclusively institutional, limiting the number of actual and potential customers the bank might find itself in competition with. “This is a much more mature industry than the outside world gives it credit for,” says Logue. “People understand that at times they are going to be competitors as well as counterparties and customers of each other. We have to prove we can service BGI just like we have to prove we can service anybody else because they are going to look at their options just like any other customer is. That is natural. Any time something like this happens, customers look at their options.”
Despite the value of the BGI contract, State Street paid a full price ($4.5 billion) for IBT. The loss of the contract would of course eliminate an expensive outsourcing operation in San Francisco, boosting the cost saving synergies even as it diluted the revenue synergies. As Logue points out, IBT is not the only recent acquisition in Boston, and State Street may well benefit as much if not more from the merry-go-round of providers and clients. “I am sure that all of the IBT customers, and all of the BNY customers and all of the Mellon customers, are looking at their options,” he says. “The indicator you need to watch to determine the success of those acquisitions is the revenue growth rates in the latter half of 2008. That will give you a clear indication of who won and who lost because it will take that long for the business to move. So we will not know for a year or two how it works out, just as it took a while to work out how the Deutsche Bank acquisition turned out for us.”
In the end, says Logue, it turned out well. In the years immediately following the Deutsche GSS purchase, State Street had to revise downwards its expectations in terms of client retention, but not by much. Logue says now that State Street retained 8 8 % of the revenue, which is not far short of the 90% target set in 2002, and well above the industry average in acquisitions, even if much of the business was in-house at Deutsche. “That is the key,” he says. “Do the customers stay? Do they become growing customers? Do you sell more products to them? Do you acquire critical mass in markets where you did not have it before?” The questions are rhetorical. Logue says cross-selling to former Deutsche Bank GSS clients was worth $75 million in 2004.
He also notes that the Deutsche acquisition took State Street from a market share in Germany of less than one half of one percent to over 17%, which was exponentially faster than the organic approach adopted by JPMorgan, and manifestly more successful than the partnership-led approach taken by Bank of New York. Logue says that, even in retrospect, he would not have handled any aspect of the Deutsche GSS acquisition differently. His chief measure of success is the ease with which the Deutsche clients were transitioned from five accounting systems on to one. “A strength of State Street is our very strong custody and accounting platform,” says Logue. “A lot of our competitors use vendor systems.”
But a larger reason for thinking fondly of Deutsche GSS is that it has helped State Street grow abroad. Today, 43% of the revenue of State Street comes from outside the United States. This is already a far higher proportion than BNY Mellon (26%), but one that Logue has committed State Street to increase to around 50%. He knows there are only three ways to fulfill that ambition: win books of business that invest globally, increase exposure to the hedge fund industry, or acquire competitors based abroad. Logue reckons State Street has already penetrated the Continental European markets with large asset pools-notably the UK, France and the Netherlands as well as Germany, plus Dublin and Luxembourg-and sees richer opportunities in Asia, and especially in China and Japan,. “In the next couple of years, we are going to see the Asia-Pacific region really take off,” says Logue. He sees US fund managers penetrating an increasingly equity-minded Japanese retail savings pool as a particularly promising way of moving the bank beyond the institutional custody market in Japan, not least because State Street has a fund accounting platform in place in Tokyo already.
One recent acquisition is going to both facilitate and benefit from the global ambitions of State Street: Currenex. With more assets in custody abroad, demand for foreign exchange bargains will increase. “That gets back to the cross-sell, and the higher margin businesses,” says Logue. Though the Global Custodian survey finds that the proportion of fund management clients that use their global custodian for foreign exchange execution is as low as 60%, Logue reckons bolting Currenex on to FXConnect will eventually help State Street retain the foreign exchange business of custody clients by keeping the bank competitive on ease, speed and transparency of execution as well as price. At the moment, Currenex services non-custody clients only, such as hedge funds and corporate treasurers. Indeed, Logue believes the Currenex functionality will extend the State Street foreign exchange client base well beyond institutional fund managers, to include other non-custody clients as well.
“What we need to do is consistently anticipate the future needs of our customers,” is how Logue explains the Currenex acquisition. “It is clear to us that the foreign exchange market is going to change and change rapidly. The days of a customer picking up the ‘phone and calling three FX brokers for quotes and finally picking one is going to end. Transparency, and speed of execution, is going to be critical in the foreign exchange market. There was a capability out there to do electronic execution, streaming prices, and hosting of those quotes, in a very transparent way. We have been lucky enough to acquire the technology to do that, as opposed to spending the time and money to build it. We believe we have acquired the technology that will service the foreign exchange markets of the future.”
The technology State Street has not acquired is the single, scalable fund management outsourcing platform that seemed possible when the bank pioneered the business on both sides of the Atlantic with the GE, Federated, PIM-CO and Scottish Widows mandates. “Nobody has a single platform for this yet,” says Logue. “Maybe the back office, but not the middle office. There is no platform out there that has integrated the middle office, no matter what people say.” He insists that the single outsourcing platform is not the principal challenge anyway, arguing that integrating multiple products on multiple systems is the real test. “It is difficult and expensive,” he says.
The difficulties are obvious, in the wake of the Schroders-JPMorgan and Mellon-F&C debacles. State Street has avoided an embarrassment of that kind, though it had to bid aggressively to retain the Scottish Widows contract. “The definition of custody has changed,” says Logue. “Twenty years ago, custody used to be about settling trades and collecting income, and processing corporate actions. Fifteen years ago custody became custody and accounting, whether it was mutual fund or pension fund or insurance accounting. Five years ago custody was re-defined again to include custody, accounting and all those things that take place in the middle office.”
The middle office is a famously elusive concept, but State Street is confident that it knows what happens there. Its list identifies 17 separate activities that take place in the middle office, not all of which the customers wish to outsource. “I have not seen an asset manager yet who cares about how they reconcile with custodians,” says Logue. “But they really care about how they do trade order execution and pre-trade compliance, and they probably want to do those things themselves with their own products. Our job is to create a platform to integrate all of those things. And when I say ‘integrate’ I mean-this is probably the hardest part-integrate everywhere around the world. Because what we have as clients is large global asset managers with operations in multiple markets. Every one of these asset management operations could be different because they have been cobbled together by acquisition. But what the asset manager wants is still one integrated platform. That is hard to do, everywhere around the world, and that is where the expense comes in.”
Axa, which State Street poached from BNP Paribas primarily because it could provide that international reach, is a case in point. Yet, the platform Sate Street built for Axa is still not a scalable one. “Or not 100%” says Logue. “This is what some custodians do not get. They think investment management outsourcing is like custody, and all you have to do is build a factory, and everything is the same. It is not. Things are customized. There is 60-70% you can do the same. The other 30-40% is going to be different for each one.”
Tom Swayne said the same about the JPMorgan-Schroders outsourcing contract five years ago (see “Setting It Straight, Global Custodian, Summer 2002) years ago-but it is the ability to act on it that distinguishes success from failure. Why should State Street be any different? “Because I do not have a commercial banker or an investment banker or a retail banker or credit card banker at my door looking for money,” replies Logue. “This is the only thing we do. I have the luxury of spending all my investment dollars on just two businesses.”
It is a remark that encapsulates the twin claims to uniqueness of Ron Logue’s State Street: the staying power that comes from specialization. “The stakes have been raised,” says Logue. “It is very expensive to get into the investment management outsourcing business. Only scale can support the investment now required to remain competitive. My bet is that, as this industry has raised the stakes, there will be some players who get up from the table and walk away. But those that stay at the table will get something very valuable-an annuity stream, with 10-year contracts. Those that can do it will create long-term annuity schemes. That is the end-game.”
This outlook issues a more robust challenge to the logic that drove the Bank of New York-Mellon merger, and the logic that drives the Citi and HSBC strategies in the securities service industry, than the tone suggests. It rejects growing assets under custody as a route to salvation. “We have to get wider and broader, not necessarily bigger,” says Logue. “The way we are going to grow is by growing faster in markets that are growing faster.” More speculatively, the Logue strategy rejects the idea that a universal or commercial bank can ever bring its balance sheet (in the shape of its retail and commercial banking franchises) and its wits (in the shape of its investment banking capabilities) sufficiently into alignment to kill a specialist provider such as State Street on price or innovation.
It is a bold strategy, and one which hinges on never making an expensive mistake. After all, State Street is a bank that offers institutional clients collateralized indemnities against loss through securities lending of over $650 billion on total balance sheet footings one fifth the size of that commitment. There is risk at State Street, as well as annuity streams and consistency and focus. The paradox is that there may not be enough of it for some investors, though the turbulence of the financial markets this summer may well have reacquainted them with the steadier benefits of fiduciary banking.-Dominic Hobson
*This profile originally appeared as “Still in the End Game” in Global Custodian, Fall 2007.