Earlier this year, two mutual fund management companies, American Guardian, Inc. and Best Management, Inc. entered into an agreement under which American Guardian would purchase all of the issued and outstanding stock of Best Management and merge Best Management into American Guardian. Although the companies are now combined, there are still two separate boards of directors for the funds. Each fund complex retained the same independent board members previously elected by the shareholders, but company-appointed directors were reevaluated and will be consistent for both boards. The combined entity, Best American Management, is now in the process of reviewing existing products and services and looking for opportunities to leverage its increased size.

American Guardian was a 30-year old Boston-based mutual fund complex. This fairly staid, conservative company was well known but had not been particularly innovative in fund distribution or shareholder servicing. It had historically chosen to distribute mainly through broker- dealers and outsourced its transfer agent process. The relatively new CEO of American Guardian firmly believed that in today’s highly competitive environment, mutual fund complexes must “grow or die.” He saw an acquisition as a necessary step to ensure that his firm’s products and services would be attractive to investors and their advisers in the future.

Best Management was a fast-growing Boston-based mutual fund complex. The 15-year old company was recognized as a leader in the use of technology, having invested millions in upgrading its internal transfer agent— shareholder servicing affiliate. Rapid growth had begun to strain the firm’s capabilities, however, and further investment in shareholder servicing was needed for coming years.

FundsBoth complexes had several funds, and a review of Best American Management’s newly combined product line reveals that a few of the funds have very similar investment objectives and holdings. In particular, there are now two domestic equity growth funds sold through the intermediary channel. The possibility of merging these two funds, American Patriot Growth and Best Western Growth, is currently under discussion by Best American management.

American Patriot Growth, Class A (front-end load), has $3 billion in assets and has outperformed 45% of its peers over the past three years. The fee structure consists of a 58 by advisory fee, a 25 by 12b-1 fee (all of which is paid out to the selling broker-dealer) and a 15 by transfer agent- service fee. Total fees are slightly above the industry median for this type of fund (see Exhibit 1). In addition, the fund carries a 5% load, 4.5% of which is retained by the broker who sold the fund. Gross sales for the most recent 12 months are negligible. Fund profitability for American Patriot Growth is forecast to be positive for the year.

Best Western Growth, Class A (front-end load), has above-average performance and has received favorable press coverage recently. The fund has $2.5 billion in assets and has beaten 72% of its competitors in the prior three years. Best’s fee structure for domestic equities consists of a 44 by advisory fee, 35 by 12b-1 fee (30 of which is paid out to the selling broker-dealer) and a 19 by transfer agent—service fee. Total fees for the fund are above the industry median. Best Western Growth also carries the same load structure that American Patriot Growth does. Currently, gross sales are running at 10% of assets, and Best Western Growth is forecast to produce a marginal profit for the year.

Because there has been increased attention on fees throughout the industry, both broker-sold funds have come under some adverse scrutiny of late for their total expense ratios of nearly 1% (100 bp). Management of the new firm has been considering introducing a break point pricing structure to the advisory fee of a potentially combined fund to help address this issue. For example, one idea being considered (after establishing a base advisory fee) is a reduction of 1 by of advisory fee once combined assets reach- $6 billion and an additional 1 by for every $3 billion increase in assets thereafter.

Since both funds are distributed through the intermediary channel, any merged fund would also be sold through the existing network of broker-dealers. American Guardian’s funds were primarily sold through Merrill Lynch and Dean Witter. Although Best Management also had a good relationship with Merrill Lynch, the majority of sales were made through Smith Barney. In general, brokers receive at least 25 by 12b-1 fee on Class A securities from most fund companies, in addition to the front- end load of 4.5%. Any attempt to reduce these fees would likely be met with resistance and might hinder the brokers‘ willingness to promote the fund(s).

Both funds currently incur 25 by of investment management expense, which includes portfolio management, research, trading and investment support. The portfolio manager of American Patriot

Growth has been with the fund for many years. He has indicated a willingness to shift into a different role with the combined firm, should management so desire. The impact of his total compensation and related expenses on the fund management expense is approximately 2 bp. The portfolio manager of Best Western Growth is viewed as a rising star within the industry. She is very popular with the brokerage firms and has a good performance record for the short term and longer term. The impact of her total expense on the fund management expense is approximately 1.5 bp.

American Patriot Growth most recently spent 10 by on sales support, while Best Western Growth spent approximately 15 bp. These expenses consist of a wholesaling sales force and other support for the brokers who sell the fund. American Patriot Growth has three wholesalers, and Best Western Growth has five. The senior sales executive

for the combined firm believes that all of them will stay on and hopes to be able to add two more wholesalers to gather additional assets.

Best Western Growth spends considerably more than American Patriot Growth on servicing (25 by versus 17 bp) due to the fact that it has chosen an internal transfer agent strategy, while American Patriot Growth uses an external third-party servicing agent. American Patriot Growth’s service quality is considered to be adequate, and Best Western Growth’s is above average. The head of operations, who was with Best Management, has estimated that he could service American Patriot Growth with an incremental spending level of half that incurred by Patriot Growth in the last year. However, the expected cost to continue developing their internal servicing capability is substantial. After combining these servicing resources, he estimates that operations expense will grow in line with the expected growth in assets for the next three to five years.

At the December board meetings, company executives must present their recommendations for changes to these funds. This week’s Funds‘ Operations meeting will focus on merging the two similar domestic equity funds. Since fund mergers require director and shareholder votes, the rationale for the merger is extremely important. It must make sense for all major stakeholders: test American, the shareholders of both funds and the brokers that sell them.

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