A potential merger of Rathbone Brothers Plc and privately owned financial services firm Smith & Williamson has been welcomed by analysts as a "sensible" strategic move to build scale, and could be a foretaste of more consolidation to come in the U.K. wealth management industry.

Brewin Dolphin Holdings Plc, emerging from three years of restructuring, is the most obvious candidate, either as a target or as a buyer itself.

FTSE 250-listed Rathbone Brothers is reported to be in exclusive talks to buy Smith & Williamson, in a £2 billion deal that would create a British fund manager with over than £50 billion in assets under management. Rathbone Brothers managed around £36 billion in assets at the end of June, while Smith & Williamson managed £19 billion.

In an environment with low margins, high competition and increasing regulatory costs, building scale through a merger is a logical option for a wealth management business, according to Keith Baird, director of Equity Research Financials at Cantor Fitzgerald.

"There is a huge amount of scrutiny [of] fees, and maybe the only defense against that is scale. Rathbone Brothers are best in class in terms of operating profitability, and that partly comes from scale. The question is, can they maintain that level of profitability?" he said in an interview.

Rathbones made a pretax profit of £26.6 million in the first half of 2017, up from £22.8 million a year previously.

MiFID costs

The merger comes against the backdrop of heightened regulatory requirements for investment managers, including the second Markets in Financial Instruments Directive (MiFID II), a European directive that requires a higher level of disclosure and transparency from fund managers, and the General Data Protection Regulation, which strengthens client data protection. MiFID II comes into force in January 2018, and the GDPR follows in May.

Rathbones estimated in its first-half results that the cost of preparing for MiFID II plus the General Data Protection Regime, which also takes effect in 2018 and requires companies to inform clients about how their data is being stored, transferred and used by third parties, would run to around £15 million.

Strategically speaking, the deal "makes sense" as Rathbones has been struggling to deliver organic growth of much more than 3% of funds under management in recent years, according to an Aug. 21 analyst note from Liberum.

The wealth management activities of Smith & Williamson would be a good complement to Rathbones' existing business, according to Liberum equity research analyst Justin Bates. The fate of Smith & Williamson's tax and business services division would be "one of the deciding factors" in the deal," Bates said.

Smith & Williamson provides corporate finance advice to companies looking to buy, sell, list or expand. However, investment management made up 73% operating profit during the fiscal year ended April 2016.

The only potential downside to the merger would be losing clients and senior staff, according to both Bates and Baird.

"The downside with any merger will be attrition. You tend to see that everywhere. Can they hang on to their clients? Can they hang onto their staff?" Baird said. "But if the businesses are a good cultural fit, there is less risk of that happening. And I trust Rathbones to buy something that is a good cultural match."

Additional costs, pressure on margins and steep competition have created a perfect storm for further consolidation in the U.K. wealth management industry, and talk of a merger between Smith & Williamson could be a forerunner for similar moves by their peers.

Brewin restructuring

"Brewin Dolphin aren't in a position where they immediately have to do something, but they may decide to follow Rathbones' example," Baird said.

The firm has dramatically improved its performance since embarking on three years of restructuring, and may now be in a position to start looking at more acquisitions again, Bates said.

Brewin Dolphin's reshuffle has involved cost cutting measures including a wave of redundancies and the closure of seven regional offices.

But it could equally be an acquisition target itself, Bates said.

"It's a very important asset strategically, and it's a business that has improved greatly under new management in recent years. I wouldn't be surprised to see a North American or European business looking for a strong foothold in the U.K. try to buy it. They've gone through a process of self-help, and it is now an asset with improving performance and a lot to recommend it."

Brewin Dolphin managed total funds of £39.2 billion as of June 30, a 3.7% increase on the previous year. This includes the recent acquisition of Duncan Lawrie Holdings Ltd.'s Duncan Lawrie Asset Management in May 2017.