Volatile markets, falling revenue and a topsy-turvy economy are pushing small and medium-sized players in Canada’s financial services industry into the arms of their larger competitors.

Without the necessary assets to withstand a prolonged downturn in their top lines, a growing number of firms — both asset managers and distributors — are facing an unenviable dilemma: find a deep-pocketed strategic partner or risk withering away to the point of extinction.

The past few months have been littered with examples of real and imagined deals. The summer holidays were barely over when Montreal-based investment dealer National Bank Financial Ltd. added Quebec’s Retirement Option Group and its $1.5 billion in assets under management to its string of recent acquisitions. And before the ink was even dry, NBF agreed to take a 12.5% interest in Winnipeg-based Wellington West Capital Inc., infusing $38.5 million into the cash-challenged dealer.

Not long before that, Quebec-based Industrial Alliance Insurance and Financial Services Inc. acquired Winnipeg-based money manager Sarbit Asset Management Inc.; and Toronto-based firms Sentry Select Capital Corp. and C.A. Bancorp Inc. picked up two-thirds and one-third, respectively, of hedge fund manager Waterfall Investments Inc., also of Toronto.

Those deals are the latest in a recent flurry of merger and acquisition activity that has seen Toronto-based RBC Asset Management Inc. acquire Vancouver-based Phillips Hager & North Investment Management Ltd.; DundeeWealth Inc. acquire up to 60% of Aurion Capital Management Inc.; and Mackenzie Financial Corp. buy Saxon Financial Inc. (The latter four firms are all based in Toronto.)

The general consensus is that the current trend will continue, and even pick up steam.

That’s because the current state of the markets has encouraged many investors to park their money on the sidelines, says Paolo De Luca, chief financial officer of C.A. Bancorp, leaving many of the industry’s smaller players struggling to earn fees.

“People are scared. They’re putting their money in guaranteed investment certificates and money market funds instead of equities. They don’t want to invest more money,” De Luca says. “So, you have the same number of players chasing fewer dollars. That creates the [ideal] conditions for consolidation.

“The fact that a lot of these players are smaller and weakened,” he adds, “is why more of these transactions will be happening.”

Bill Holland, CEO of CI Financial Income Fund in Toronto, agrees. “The environment for small broker-dealers is very difficult right now,” he says. “There are too many of them and there are too many problems. I don’t expect it to improve anytime soon. If Merrill Lynch & Co. Inc., Lehman Brothers Inc. and Bear Stearns & Co. Inc. can’t make it, I’m not sure that’s an environment that’s good for small dealers in Canada.”

Among the rumoured targets is Toronto-based CI subsidiary Blackmont Capital Inc. The mid-sized investment dealer is an attractive target, but Holland, who orchestrated CI’s purchase of Blackmont’s parent, Rockwater Capital Corp., in early 2007, says Blackmont — contrary to rumour — is not being shopped around.

“Blackmont is a very small portion of our business,” he says. “We have earnings before interest, taxes, depreciation and amortization of $750 million. Blackmont is a few million dollars.”

However, Holland admits, he has looked at various merger possibilities to make Blackmont “bigger and stronger” as the middle ground becomes Death Valley for many firms.

“We’re entering an environment,” he says, “in which you’d like to be either very big — $40 billion or $50 billion — or very small — less than $1 billion.”

But while many people believe the sky is falling, the situation isn’t as bad as they think, says Ian Russell, president and CEO of the Investment Industry Association of Canada in Toronto. The market started to “come apart” only in mid-July, he says: “If you look through the end of July, the quarterly [investment industry] figures in 2008 for retail revenue are down about 3% from the average quarter in a bull market.”

Russell adds that many small and mid-sized firms won’t be in truly dire straits unless the negative trends continue into next year.

“These are unprecedented times,” he says. “The media is painting an overly negative picture of developments in the market, especially in the U.S. financial sector. Sure, there are lots of problems there, but lots of firms are able to handle the problems.

@page_break@“There’s a lot of evidence that we’re near the bottom, in terms of financial turmoil,” he adds. “We may see the markets turn around in anticipation of a recovery later this year. If that happens, investors will come back quickly.”

But, says Dan Richards, president of Strategic Imperatives Ltd. , a Toronto-based financial services consulting firm, the pure and simple economics of doing business has crippled many smaller asset-management firms.

“Having sales and marketing people on the road is a significant cost,” he says. “If you spread that cost over $20 billion of AUM or if you spread it over $500 million in AUM, the economics are very different. Being part of a larger family, you’re going to be considered in a way you weren’t before.”

Larry Sarbit of Sarbit Asset Management couldn’t agree more. He says running his own firm when U.S. stocks — his long-time specialty — have been out of favour for so long has been difficult. When expensive regulatory requirements were added on top, it made sense for him to find a deep-pocketed partner.

“It’s a highly regulated market, and that’s expensive,” Sarbit says. “If you’re small, the regulatory requirements are the same as if you’re big. Scale is important; we didn’t have that.”

So, Sarbit found a buyer so he could get back to doing what he enjoys. “I just want to go back to being a full-time money manager,” Sarbit says, “as opposed to being a money manager and trying to run a firm. We might have been able to make it, but it’s tough. I’m unloading a business that is very tough to be in. I’m relieved to pass this off to somebody else who knows how to handle this better than me.”

Sarbit is confident the backing of Toronto-based IA Clarington Investments Inc., the company with which his firm was merged under the Industrial Alliance umbrella, will open more distributors’ doors to his funds than he could have opened on his own.

“I’m expecting that it will be a lot easier with these guys with their strengths, connections and experience,” he says. “They can do things a small firm just can’t do.”

Since the launch his firm in 2005, Sarbit was able to bring in only $130 million in AUM, a far cry from the more than $2 billion he managed during his stints at AIC Ltd. and Investors Group Inc. He admits he is looking forward to having IA Clarington’s 22 wholesalers working on his behalf, an increase from the three he had at his own firm.

David Scandiffio, president of IA Clarington, says that with growing barriers to entry on the manufacturing and distribution sides, he can understand why Sarbit was shopping his firm around: “It can be quite difficult to keep up unless you build up your asset base. That’s the challenge, getting in the door and keeping up with the pressures of our industry.”

Since Sarbit launched his firm, Scandiffio says, regulatory requirements have increased significantly, including the need for independent review committees, more client reporting and management reports on fund performance.

“They’re all good individual initiatives, from a regulatory standpoint,” Scandiffio says. “But for a smaller producer, they’re additional costs without the upside, from a revenue or business standpoint.”

With IA Clarington’s $7.6 billion in AUM, Sarbit’s AUM wasn’t the main attraction. Instead, Scandiffio says, he wanted to be able to offer Sarbit’s investment style to IA Clarington clients.

“It was the ongoing relationship on an exclusive basis that made the deal much more attractive,” Scandiffio says, noting IA Clarington has made 14 transactions since the early 2000s.

That pace of acquisition is one of the reasons why Richards isn’t sure how much more consolidation is yet to come, as so many of the smaller players have already been gobbled up: “Sometimes, big players say small players are small players for a reason. Is [acquiring] them worth the bother?”

Sarbit says he’s not disappointed to have sold his firm because, at the same time, he bought something for himself — time.

“I want to have the patience to wait for wonderful opportunities to arise. ‘Wonderful’ to me is cheap,” he says. “Nothing would please me more than to have the opportunity to buy some of these marvellous businesses at cheaper prices. When you have a partner like IA, you have the time; you don’t have to hurry.” IE