Citigroup is betting on distribution, swapping its money management business to Legg Mason Inc. for LM’s brokerage force. In contrast, Legg Mason is doubling down on money management, augmenting the Citi deal with another acquisition.

Citigroup today announced it has signed a definitive agreement under which it will sell substantially all of its asset management business in exchange for the broker-dealer business of Legg Mason, approximately US$1.5 billion of Legg Mason’s common and convertible preferred shares, and approximately $550 million in the form of a five-year loan facility provided by Citigroup Corporate and Investment Banking.

The transaction does not include Citigroup’s asset management business in Mexico, its retirement services business in Latin America or its interest in the CitiStreet joint venture. The total value of the transaction is approximately $3.7 billion and will result in an after-tax gain to Citigroup upon closing of approximately $1.6 billion, both of which are subject to adjustment.

Citigroup and Legg Mason have entered into a three-year global agreement under which Citigroup will continue to offer its clients asset management’s products and in addition, inherit Legg Mason Wood Walker’s position as the primary domestic provider of Legg Mason’s equity fund family, including the top performing equity funds of Legg Mason Capital Management Inc. managed by Bill Miller. These will be offered through Citigroup’s Global Wealth Management businesses, Smith Barney and the Citigroup Private Bank, as well as Primerica and Citibank. All offerings will be subject to usual suitability and performance standards.

“We have been assessing our options for the asset management business and have found, in Legg Mason, a partner with an excellent product set that both complements and enhances our existing product offering to our customers,” says chief executive officer of Citigroup Charles Prince. “In addition, we are adding 1,354 experienced financial advisors in 127 branch offices to our Wealth Management business. We are pleased to welcome the high quality team of financial professionals at Legg Mason to Citigroup. Deepening our relationships with clients is a top priority, and through this transaction, we are even better positioned to meet their investment needs. We are continuing to focus our resources on strengthening competitive advantages and building our leading businesses.”

The transaction is expected to close during the fourth quarter subject to certain regulatory approvals and customary closing conditions. In connection with the transaction, Citigroup is seeking approval of asset management’s mutual fund boards and shareholders.

Along with the Citi deal, Legg Mason is acquiring The Permal Group, one of the five largest funds-of-hedge-funds managers in the world, with approximately $20 billion of assets under management, from Sequana Capital and Permal Group management. Under the terms of this transaction, Legg Mason will acquire an 80% interest in Permal at closing with the right to purchase the remaining 20% over the next four years.

The initial payment at closing is expected to be $800 million, subject to potential downward adjustment, of which up to $200 million may at Legg Mason’s option be in the form of Legg Mason common stock, and the remainder in cash. The aggregate price for 100% of Permal is capped at $1.386 billion, with a $961 million floor.

Legg Mason says the deals will complete the transition of the firm into a major “pure play” global asset manager of equity and fixed income products. “As a result of these strategic initiatives, Legg Mason becomes a singularly focused, more profitable and certainly more influential organization within the global asset management community,” says Legg Mason chairman and CEO Raymond “Chip” Mason.

“The business swap with Citigroup should benefit both companies. On our part, we expect to more than double our assets under management, broaden our geographical reach into critical global markets and, through a joint three-year global distribution agreement, significantly expand our ability to distribute our retail money management products around the world through a financial powerhouse,” he says.

The acquisition of Permal adds a new market and a new business model to Legg Mason’s family of asset managers. It also further diversifies Legg Mason’s investment disciplines by adding expertise in managing multi-manager funds and alternative products. Mason comments, “Permal’s long history in the alternative asset space sets it apart from its peers, and its consistent performance has enabled it to build broad and deep distribution relationships with world-class, geographically diverse partners. The addition of Permal will further enhance and diversify our growing asset mix and offer our shareholders excellent growth potential.”

@page_break@Standard & Poor’s Ratings Services says the sale of Citigroup’s asset management business, coming hard on the heels of the divestiture of its life insurance business and other smaller assets, will not affect Citigroup’s ratings.

“The sale marks perhaps the final touch to a plan of reshaping the organization,” says Standard & Poor’s credit analyst Tanya Azarchs. “While not transformational, these divestures have marginally reduced diversification. The asset management business in particular represented an element of a more stable business, with lower correlation to the equity markets than the retail brokerage business.”

S&P notes, the sale may be prompted partly by a desire to get out ahead of any risks, legal or political, which could occur. “Manufacturing and distributing mutual funds can create conflicts of interest. While controls on sales practices can mitigate those concerns, they diminish any synergies that ever existed between manufacturing and distributing investment products,” it says. “A single channel for investment product distribution also hampers the growth of the retail asset management business.”

“What is perhaps more important, the sale is also prompted by Citigroup’s desire either to be a leader in a product or not to be a player at all. In addition, the business has suffered from underperformance in some of the funds. Thus, it makes sense for Citigroup to focus on the distribution functions, where it is in a position of strength,” it notes.

Standard & Poor’s says it still believes, even without synergies, the asset management business represents a valuable form of diversification. The presence of a major asset management business has generally been a factor in supporting the ratings of many financial institutions. When well managed, it remains a very attractive business line with high returns. “Success in this type of business will hinge on fund performance,” it says. “However, asset management is not necessary to the development of a strong wealth management business, where customers clearly prefer the open architecture model.”

It adds, the swap for retail brokerage operations brings the Smith Barney brokerage unit up to a close number-two position behind that of Merrill Lynch & Co. Inc.