The Hindu Business Line : Challenging times for MFs

Mutual funds have been facing challenging times lately. A declining equity market has shrunk the asset base of most equity funds, the liquidity crunch has had corporates and institutional investors lining up with redemption demands, and collections from new fund offers have dwindled to almost nothing.

Many believe that this could set off a trend of cost cutting in the industry. A prolonged slowdown in new fund flows may lead to cutbacks on recruitments and salary cuts.

Some fund houses are already said to have reduced or done away with the variable pay component to their staff.

Though the worst of the liquidity crisis seems to be over for the industry, with RBI efforts and slowing redemptions helping, the fall in assets under management has the potential to impose a considerable squeeze on the revenues of the asset management companies (AMCs), whose fee is linked to the asset size.

Until the start of this year, with the bull phase in its fourth year, the markets were flooded with new fund offers of equity funds.

These collected record sum. As the fee and expense structure for AMCs is pegged to asset size by SEBI mandate, that meant rising revenues and profitability for AMCs.

Fund houses normally deduct 2.5 per cent of the asset size annually as expenses under each scheme managed. These go under various heads — fund management fees (1.25 per cent), marketing expenses (about 1 per cent) and operational expenses (about 0.25 per cent).

NFO overdrive

For new fund offers (NFOs), regulations requite that expenses incurred on the issue related to sales, marketing and distribution are met out of the entry load charged to investors, with any excess expenses being borne by the AMC. Open end funds during their launch, usually charge an entry load of 2.5 per cent for investments up to Rs 2 crore or Rs 5 crore, depending upon the AMC, while entry loads are waived for big ticket investments.

However, in the bull markets of 2006 and 2007, the bulk of this entry load collected may have gone to pay the distributors’ commission. While small distributors usually received a 2 per cent commission, larger distributors usually received 2.5 per cent. Incentives on top of that commission, for select distributors were also common.

As a result, there have been select instances when commissions on NFOs went up to as high as 5 per cent. (There was an instance in early part of this year when a fund house paid 5-5.5 per cent as commission for a close ended NFOs).

Fund houses focussed on the metros may have to pay out a much higher commission than those with a wider distribution presence. In these cases, the additional expenditure in excess of the entry load would have been borne by the AMC.

In the above cases, AMCs would have been looking to recover the capital pumped in during the initial offer, by way of fund management fees and other charges in future years. Those are subject to SEBI specified limits starting from 2.5 per cent of the first Rs 100 crore, going down to 1.75 per cent on assets beyond Rs 700 crore and depend on the assets managed.

But such projections may have gone awry with the market fall. In a bull phase, as markets go up sharply, the assets too will expand, enhancing the fund’s income. On the other hand, a 50-60 per cent slippage in assets due to a market fall, as has happened now with many equity funds, can reduce the AMC’s fee and expense receipts by half. To earn the money spent on the NFO may then take much longer or may have to be written off.

Austerity the key

Austerity measures during a bull phase may save fund houses from a crunch situation later.

Moderate compensation structures and a tight rein on administrative expenses can help retain a fund’s profitability at a reasonable level during the good times, while not impacting it unduly during the bad times. A senior fund manager recently pointed out to Business Line that despite being eligible to travel by Business Class, he still travels by economy class.

As per the 2007 annual report of a leading AMC whose authorised capital is Rs 50 crore, the total fee-based income received by the fund was Rs 113.6 crore. Of this, Rs 68.57 crore is accounted for by employee, administrative and other expenses. You can imagine the impact a 30 per cent decline in this fund’s fee receipts will have on profitability.

It should be remembered that with employee costs accounting for a chunk of expenses, new players may have little room to save on such expenses, given that employees have to be attracted mainly by offering compensation structures that at least match existing players. For a company with a AUM of Rs 20,000 crore( equity fund which earn higher income that debt scheme) by way of expenses it can deduct maximum of 2.5 per cent based on the scheme slab and it will not be beyond Rs 50 crore.

Given the circumstances, it would not be surprising if smaller AMCs and newer entrants find the twin challenges of a high cost structure and shrinking asset base quite difficult to handle.

For the industry, it may be the right time to review the practice of giving high incentives to distributors to procure business during the good times.

Seen in light of the assets managed by Indian AMCs today, the minimum authorised capital required to float an AMC, of Rs 10 crore, may need to reviewed. Increasing the capitalisation norms for fund houses based on the assets under management may be necessary to cushion the mutual fund industry from any future crisis.

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