State Street expands with buyout of Brown Brothers’ custody unit for $3.5 billion

State Street chief executive Ron O'Hanley

Doing the books for investors is not what you’d call a sexy business.

The job of safeguarding and keeping records on trillions of dollars in investments for clients such as mutual funds and pension plans is expensive, requiring heavy spending on computers, software, and communications systems. Competition is fierce, leaving little room to raise prices. Size is an overwhelming advantage.

You don’t have to tell this to Ron O’Hanley, chairman and chief executive of Boston’s State Street Corp., one of the oldest and largest asset servicing companies, also called custody banks.

Since taking the helm at the start of 2019, O’Hanley has been focused on maximizing efficiency, mostly through automation, but also by wringing out expenses, including through layoffs. But now he’s making an expansion move, announcing an agreement on Tuesday to buy the investor services division of Brown Brothers Harriman & Co. for $3.5 billion. The deal doesn’t include New York-based BBH’s investment banking business, whose roots reach back to 1818.

State Street has been an opportunistic buyer of custody operations, but its growth has come mostly by winning accounts from new and existing customers, coupled with soaring values in the financial markets. That’s the nice part about the business: The higher the markets climb, the more asset-based fees you collect.

There aren’t many companies to buy that would move the needle at State Street, which had $32 trillion in custody assets as of June 30. So O’Hanley jumped at the chance to grab the BBH unit, which has $5.4 trillion under custody.

“You need to have scale,” O’Hanley said in an interview.

The takeover is an incremental step forward; it will begin adding to earnings immediately but not enough to prompt State Street to up its profit target. But O’Hanley said there were several reasons the deal is attractive.

State Street will become bigger overseas, especially in Japan and Latin America. The BBH unit brings with it a communications platform for investment operations and a model for operating 24/7 around the globe that intrigues O’Hanley, who is trying to distinguish State Street from competitors such as BNY Mellon and JP Morgan Chase by offering services that span the front and back offices of investment shops. And most of BBH’s asset servicing employees in the United States are based in Boston, making it easier to integrate the two firms.

The deal will leave State Street with more than $37 trillion in custody assets, which the company said is more than any rival. Throw in the separate category known as assets under administration, and the company serviced more than $42 trillion for clients at the end of June.

State Street is also a giant investment manager; more on that in just a moment.

The BBH acquisition is the largest since the company bought custodian Investors Bank & Trust for $4.5 billion in 2007, adding $2.2 trillion in assets. In 2018, State Street paid $2.6 billion for Charles River Development, a Burlington maker of software that extended the company’s reach into the “front office” of investment customers, providing services such as portfolio modeling and risk management.

State Street said it would finance the all-cash transaction by issuing stock, suspending its common share repurchases until the second quarter of next year, and with cash on hand. On a down day for Wall Street, the company’s shares fell 3.7 percent to $89.43. The stock had gained 28 percent this year, just shy of the 29 percent increase by the Standard & Poor’s 500 index.

The company said it expects to see $260 million in annual cost savings starting in the third year of combination. The senior management team at the Brown Brothers unit will move over to State Street, and Seán Páircéir, currently the firm’s global head of investor services, will join State Street’s management committee.

State Street didn’t say how much of the savings might come from eliminating jobs, though a spokesman said the company doesn’t expect any layoffs “in the short term.”

Cost cutting “is what’s really important in these kinds of transactions,” said Gerard Cassidy, who follows banks for RBC Capital Markets in Portland, Maine. “The No. 1 expense in this business is personnel. There will be certainly be reductions in personnel count.”

State Street employs 9,000 in Massachusetts and 39,000 worldwide; the BBH unit has 4,800 workers.

Custody and administration services — including record-keeping, valuation, dividend and tax management, and securities lending — accounted for more than 80 percent of State Street’s revenue and profit last year. The rest comes from State Street Global Advisors, a money manager with $3.9 trillion in investor assets.

There has been a lot of speculation about whether State Street wants to get out of the investment business, according to Michael Brown, a bank analyst at Keefe, Bruyette & Woods.

I put the question to O’Hanley, who said the fund unit has been growing nicely over the past several years, and requires far less capital than the custody business. It also serves as a laboratory for developing custody services that State Street can then roll out to its clients.

“Right now, we like the business and are committed to the business,” he said.

Makes sense, at least for right now.