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December 3, 2018

When is vertical integration OK?

When is vertical integration OK?

Our industry has grown up relying on vertical integration- a model coming under increasing pressure. The banks are divesting from their wealth businesses, and there are strong views being expressed that the model is no longer fit for purpose, that it should be unwound.

Notwithstanding the public flaying of the Royal Commission, such a binary perspective on the vertically-integrated model ignores the advantages for consumers and institutions. 41% of customers of our industry have bought into a fully vertically-integrated model. That is, all the services and products they buy come from a single institution. That number rises to 76% when we expand the definition to cover customers that buy more than one (but not all) services from a single institution. Or, said differently, only one quarter of our industry’s consumers piece together their wealth products and services (advice, platform/admin, investments) from multiple unrelated providers.

However, just because vertical integration is such an integral part of our industry today is not an excuse for maintaining the status quo – the Commission has certainly exposed the pitfalls of a model that can’t or is unwilling to properly manage the conflicts that arise when shareholder, management and customer interests don’t align. Under the right conditions, though, we think vertically-integrated businesses can genuinely benefit consumers.

So when is vertical integration OK?

We look at this from two perspectives: when does it make commercial sense to vertically integrate, and also – when does it make sense for consumers?

Reducing costsThe driver here is normally that a firm believes it can replicate what its suppliers are offering, but at a lower cost. This might be because there are high costs of acquisition (which needn’t be incurred in the vertically-integrated model), or on a less generous view perhaps suppliers are just fee gouging. And that’s certainly part of the thesis for industry funds vertically integrating and internalising investments and offering members personal advice propositions.

Ensuring supply

Guaranteeing you have the ‘ingredients’ to be successful is important. A simple illustration here uses the company Ferrero, which makes Nutella. Clearly, Ferrero needs a lot of hazelnuts, and if they run out or can’t source them, it’s a big problem. And so they own hazelnut processing plants and farms to ensure supply. You might wonder how this is relevant in our industry, but it surely applies to large institutions who want access to capacity in specific types of investment strategies when they need it.

Improved coordination

The third and probably most interesting rationale for vertical integration is improved coordination. Proximity can help the different parts of the value chain work better together and produce better outcomes for consumers and better commercial outcomes as well. For example, an insurer with an in-house asset manager who can get exactly the type of reporting it needs to manage its liability exposures. That improved coordination is a real benefit of vertical integration. The question is whether it can apply to vertically integrated firms including financial advice where there is a legislated duty to clients that trumps both the duty to the firm and its shareholders. And we think it can. There’s an opportunity to have an advice process that is unique, requires specific things from a platform that aren’t otherwise available (eg investment modelling or tracking designed for a particular segment of clients) and possibly require specific characteristics from asset management products as well. Through linking these propositions up, you can create a unique offer for consumers. Something that arguably would be much more difficult (and costly) to do if the component parts weren’t all sitting under the same roof.

It has to be said, this is one area where the industry hasn’t covered itself in glory. We see a lot of product development at NMG and can list many cases of products being launched by asset managers only to be vetoed by the (internal) advice research folks who don’t add them on their menu or on the APL.
Improving coordination is the best opportunity we have to demonstrate the tangible benefits of vertical integration, but firms need to work to make it true. Instead of a myopic focus on building products in the hope of convincing consumers to pay for them, work more closely together with other internal businesses to identify and build things consumers need…things that non-vertically integrated firms will find difficult to replicate.

If your vertically-integrated model meets all these tests, it’s likely to be good for the consumer. The big question is whether as an industry we’ve messed up the opportunity to make our case because of the low levels of trust that comes from collectively failing to manage the age-old agency problem.


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