Matthew R. Crow

There’s been a great deal of interest in RIA acquisitions in recent years from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity.These acquirers have been drawn to RIA acquisitions due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer.Following these transactions, acquirers are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.In this whitepaper, we describe the PPA process, including attributes unique to the investment management industry.

If you ask most people to name an entrepreneur who made their mark in cars, they would probably name Henry Ford or Elon Musk. A third and equally compelling story is that of Bernie Ecclestone, the former chief executive of Formula One Group. Ecclestone grew a fairly obscure and marginally sustainable auto racing series into one of the world’s largest and most widely followed sports, with billions of viewers. Even more remarkable is that Ecclestone didn’t “acquire” his ownership in F1 from anybody—he created it.Ecclestone started his career after World War II as a parts dealer, mechanic, and sometimes racecar driver. In the early 1970s, he cobbled together enough money to buy an F1 team (a much cheaper endeavor then). With the perspective of a team owner, Ecclestone realized that the teams needed to band together to collectively negotiate better deals with track owners and television, and formed the Formula One Constructors Association and later the Formula One Promotions and Administration.Eventually, Ecclestone negotiated the Concorde Agreement, yoking together the teams and associations affiliated with F1 to set the terms by which teams compete in races. He then wrapped all of this up in Formula One Group, effectively his holding company. By the late 1990s, Ecclestone had, piece by piece, constructed an enterprise that controlled Formula One racing, and he controlled that enterprise. It made F1 what it is today, and it made him a billionaire.The Sum Is a Function of Its PartsBernie Ecclestone’s assemblage of F1 from various parts that became greater as a whole is a useful reminder that businesses can be viewed not just as a monolithic enterprise but also as an assemblage of individual functions with their own performance attributes, risks, and opportunities. Like a racecar, the whole may be greater than the sum of its parts, but examination of the parts yields valuable information about the whole.This sort of component analysis can be a helpful way to analyze RIAs. Broadly speaking, RIAs exist to manage money, but that business's profitability (and value) over time hinges on 1) servicing existing clients and 2) attracting new clients. Those two functions are usually not thought of independently of each other. An example P&L for a $5 billion AUM firm might look something like this: For purposes of this discussion, it doesn’t matter what flavor of RIA this is (wealth or asset manager, individual or institutional, MFO or OCIO, etc.). In aggregate, our “Generic” RIA has $5 billion in AUM, generates revenue off a blended fee schedule of 65 basis points, spends a bit over half of that on labor, between 15% and 20% on non-labor expenses, and ultimately generates an EBITDA margin of just over 30%.Existing Business on a Stand-Alone BasisThe value of an RIA is a function of recurring revenue. Investment management engenders long-term relationships between firms and their clients, and the persistence of those relationships provides an almost bond-like series of predictable returns. If you take the Generic RIA we’ve set up as an example and look at the revenue from the existing book of business and the cost of servicing that revenue, you get a stand-alone P&L that looks something like this: Returns from the existing book of business can generally be characterized as more plentiful than returns from new business. In an era of growing fee pressure, existing business usually pays more (basis points) than new business. Labor costs remain significant to service existing business but are lower than the cost of acquiring new clients. Even if we charge for an appropriate amount of occupancy and other G&A, the existing book of business, in isolation, generates a profit margin more than 25% higher than that of the aggregate enterprise. It shouldn’t be surprising that existing business is usually the most profitable business.Performance Metric for Existing BusinessThe golden opportunity for RIAs is the higher and more predictable margins associated with existing relationships. The biggest threat to that opportunity is, of course, client attrition. Mitigating attrition requires spending on client service, and from that relationship, you can glean a valuable performance metric.If you’re looking for a useful KPI to help manage your business, think about the tradeoff between the incremental margin generated by servicing existing clients and the net AUM attrition (client withdrawals and terminations net of market returns and client contributions). Theoretically, more spending on servicing existing clients should stem attrition. Optimizing the margin/retention equation will build value in your firm.(RIA) Growth at a Reasonable PriceThe worst-kept secret in the RIA industry is that most firms struggle to generate organic growth. This is often explained in terms of the industry's maturation, the aging advisor base, and the lack of service differentiation. Arithmetically, though, it’s easy to show that growing an RIA is, if you look at it in isolation, very expensive. Assume our Generic RIA shows net AUM growth of 5% per year, absent market activity. That’s $250 million and probably at a somewhat lower fee schedule than legacy clients pay. Attracting new business doesn’t need much of the client service, compliance, administrative, and G&A costs that servicing existing clients requires, but it does require expensive sales and marketing. The cost of attracting new business in any given year usually exceeds the marginal benefit of that new business in the first year and sometimes in the first several years.Growth is expensive, but it isn’t optionalGrowth is expensive, but it isn’t optional. Growth provides opportunities for staff development, which reduces talent attrition and augments shareholder returns. Growth provides a portion of an investor’s required return and supports the narrative that the firm’s business model is viable and sustainable. For these reasons, among others, the RIA community is racing to find multiple arbitrage opportunities to generate growth that isn’t happening organically.Performance Metric for New BusinessWhat is a reasonable cost for growth? As shown above, efforts to deliver new AUM to manage often cost more, initially, than the revenue generated by new business. In our example case, the total expense for new revenue is nearly three times the amount of new business. Put another way, it will take three years for the new business to pay for the investment to generate it. After the payback period, new business becomes accretive to profitability as it becomes part of that existing book, with more predictable revenue and bigger margins.The payback period for new business is a useful way to think about a firm’s investment in generating new business. If the payback period is too long, an RIA may not have an effective marketing plan. If payback is too quick, the firm may be under-exploiting an excellent opportunity. Optimizing the payback period is a function of the growth and investment tolerance of the ownership, and the margin on existing business. If building a larger book is particularly valuable, you’ll have more margin to invest in building more business.Unfortunately, the opposite is also true. Poor margins on existing business won’t provide the cash flow needed to build the business.Volatility and ValuationSegmenting an RIA into component returns also offers opportunities to think about risk and value to the RIA. The steady returns of existing business, in which market gains and client additions may be more than enough to offset withdrawals and attrition, suggest a bond-like return. Mapping returns from new business can show everything from moderate variability (in the case of mass-affluent wealth management) to very lumpy (in the case of institutional platforms like an OCIO) and should be thought of through the lens of probability distribution.Think about risk and value to the RIAAs such, the cost of capital for the existing book of business is necessarily much lower than it would be for new business. How much lower is a function of fact patterns specific to the RIA and some market-informed judgment? Fortunately, a close look at historical investment flows should reveal a pattern for what to expect in terms of net AUM changes from an existing book of business. Applying a lower than firm-wide discount rate offers clues as to the value of the existing book on a stand-alone basis, as well as the proportion of overall firm value.It’s also interesting to think about the value of growth by modeling the internal rate of return for investment in new business.In this case, we’ve assumed that the EBITDA margin for new business in our Generic RIA would be around 60% and modeled the IRR to receive that return for ten years following the marketing expenditure to land the business. (A more thorough analysis would look at the likely attrition rate on new business and model some residual cash flow at the end of the projection period into perpetuity. For the sake of not putting any more numbers on your screen than necessary, a finite ten-year projection is a good guess.) If the investment amount is higher, or the marginal EBITDA return is a lower percentage of new fees, the IRR compresses. If returns are better or the cost to generate them lower, the IRR will improve. One would want an IRR at a good premium to the firm’s aggregate cost of capital to make marketing for new business worthwhile. Optimizing the investment in new business would likely be a tradeoff between the highest aggregate level of new business (more is more) and the IRR of the effort (more is more).Component Analysis of RiskComponent return analysis is also useful to model the risk attributes of an investment management firm. Certain risks affect the existing base of business differently than new business.Certain risks affect the existing base of business differently than new business.For RIAs in businesses facing legislative action, such as attempts to restrict institutional ownership of rental housing, component analysis helps isolate the stroke-of-the-pen risk that would limit opportunities to raise new funds or make new investments to the “new business” side of the equation, leaving the value of servicing existing relationships intact.Other sorts of exogenous shocks, like severe market corrections, may negatively impact existing client relationships but simultaneously increase opportunities for new relationships. This ties well with our thesis that existing business models are like a bond, where risk is asymmetric to the downside, and new business models more like an option, where volatility is accretive to value.In Closing…There’s much more to say about component return analysis, but we don’t offer it as a substitute for keeping your eyes on the big picture. As brilliant as Bernie Ecclestone was in creating his dominant position in F1, he also became a bigger target and was eventually dethroned and lost his position at Formula One Group. He may have focused a bit too much on the upside when he neglected to pay all of his taxes and, consequently, had to face the downside of incarceration.If you’re curious about how to examine your RIA using component analysis, give us a call, and we will think through the exercise with you. You might be surprised by what you learn.

Understanding the value of an asset management business requires some appreciation for what is simple and what is complex.On one level, a business with almost no balance sheet, a recurring revenue stream, and an expense base that mainly consists of personnel costs could not be more straightforward. At the same time, investment management firms exist in a narrow space between client allocations and the capital markets. They depend on revenue streams that rarely carry contractual obligations and valuable staff members who often are not subject to employment agreements. In essence, RIAs may be both highly profitable and prospectively ephemeral. Balancing the risks and opportunities of a particular investment management firm is fundamental to developing a valuation.

Earnings are a crucial reference point in determining transaction prices negotiated by buyers and sellers of RIA firms. However, reported earnings, even when audited and presented in accordance with Generally Accepted Accounting Principles (GAAP), have limitations. GAAP earnings are backward-looking, reflecting how a business has performed under specific rules in the past. While these historical earnings have their uses, buyers in the RIA industry focus more on the future—what’s visible through the windshield, not the rearview mirror.In this whitepaper, we illustrate how buyers and sellers benefit from a quality of earnings report that extracts a company’s sustainable earning power from the thicket of historical GAAP earnings. We review the most common earnings adjustments applied in QofE analyses and review the role of working capital and capital expenditures as the links between EBITDA and cash flow available to buyers.

Hard to imagine today, but just one year ago, some of the largest prices paid for new cars relative to MSRP were for an EV. The Porsche Taycan, a six-figure ride in any configuration, was commonly selling for 20-25% above sticker. What a difference a year makes. Today, EVs are shunned by many (certainly the press), and Porsche is rushing out a new version of the Taycan for 2025 to address flagging sales. For those who paid premium prices to Zuffenhausen a year ago, the depreciation they’ll experience if they try to trade that year-old Taycan today would be breathtaking. Life’s a gas!Pricing MattersThe backbone of our business at Mercer Capital is valuation, so we have a self-interested bias against formula prices in buy-sell agreements. An independent valuation is, by far, the best way to manage the settlement of transactions between shareholders. Doing so annually has the added benefit of managing everyone’s expectations.Simple is not always betterI’ll concede that annual valuations can be excessive for smaller firms with a few shareholders and transactions that seldom occur. Formula pricing offers a degree of certainty and grounds expectations in what is usually a pretty simple equation. Simple is not always better, however.More often than not, the formula prices we encounter do more harm than good. The simplicity of formula pricing equations means they don’t consider important factors like debt, non-recurring items, loss of key staff or large customers, market conditions, or offers to purchase. Formulas can ground expectations but may set expectations unrealistically low or high, provide a false sense of security, and encourage partner behaviors that do not support the business model.The Object of Transaction PricingIn part, buy-sell agreements offer a mechanism to settle transactions between shareholders when some event forces a transaction. Often the event is many years, if not decades, after the signing of the agreement. Nobody expects to be thrown out of their firm, get divorced, or die — even though we know the former two happen often and, in the case of the latter, happens to everyone. Even retirement is hard to foresee when a firm is in its nascency and crafting a shareholder agreement to handle issues that seem so far off that even the inevitable is irrelevant.Signers to a buy-sell rarely foresee the consequencesAs such, the signers to a buy-sell rarely foresee the consequences of what they’re signing. Many of these consequences involve valuation.If you ask them, most people say they want the pricing mechanism in their shareholder agreement to treat everyone fairly. “Fair” is the first word in Fair Market Value, a standard of value established by the Treasury Department in Revenue Ruling 59-60 and reiterated and expounded upon in professional literature throughout the valuation community.Fair Market Value, generally, is a standard of pricing that considers the usual motivations of typical buyers and sellers, described as hypothetical parties, to distinguish them from the very specific and particular persons involved in a subject matter. The parties to a fair market value transaction are assumed to be funded, informed, and reasonable. Fair market value further assumes an orderly (not forced) transaction, and settlement is on a cash equivalent basis.Most people want something akin to fair market value pricing in a buy-sell agreement, but formulas usually only achieve this by coincidence. Most formulas will either price an interest too high or too low. This creates “winners” and “losers,” depending on who gets the better side of the transaction.When the Formula Price Is Too HighWe often see formula pricing in buy-sell agreements set at what could be called optimistic levels. I suppose this is because these agreements are usually written when firms are first established, too new to evaluate the stabilized economics of the business model when compensation patterns are observable, fee schedules are settled, and margins become regular.Formula pricing commonly relies on rules of thumbFormula pricing commonly relies on rules of thumb that don’t represent the particular economic characteristics of a given RIA’s business model. An example of this would be the old myth that investment management firms were worth 2% of AUM.The 2% rule dates back to the days before wealth management and asset management were well delineated, and money managers commonly earned a realized effective rate of 100 basis points on assets under management. At those fees, a billion-dollar shop could produce pre-tax margins between 25% and 35%. At those margins, 2% of AUM implied a value of 6x to 8x pre-tax net income. At the time, that pricing was reasonable. RIAs were not considered an established money management platform (broker-dealers were still the dominant force), and consolidation activity was minimal. Industry insiders recognized that RIA clients were stickier than those of most professional services firms, so 6x to 8x pre-tax net income was a premium to a more typical 4x-5x for other owner-operator professions.Today, of course, consolidation activity is rampant, and multiples are generally higher. But fees have taken a hit, and not every firm earns a “normal” margin. If realized fees are 60 basis points and margins are 15%, a formula that values the RIA at 2% of AUM looks pretty expensive.There is a very human tendency to get too comfortable with large numbers. Owners like big valuations, even when they aren’t real. And until an event occurs that requires a transaction, people rarely question a robust, if unrealistic, valuation. It’s a game of mental gamma, where everyone hopes imaginary pricing pulls on value like a large block of out-of-the-money call options. It feels good but doesn’t get tested until a triggering event invokes the buy-sell agreement. Then something happens. If a 25% partner in this “Now” RIA passes away unexpectedly, and the buy-sell agreement specifies purchase at 2% of AUM, the transaction price is $5 million. We’re going to posit, for purposes of this post, that the actual fair market value of this interest is 8x-10x pre-tax, the midpoint of which is 9x. At 9x pre-tax, the 25% stake has an implied value of about $2 million. If the RIA is required to purchase the interest pursuant to the formula, they will be paying over 60% of the value of the firm for a 25% stake. The estate “wins,” and everyone else loses. What are the implications of an internal transaction at 22x pre-tax? Let’s assume the buy-sell agreement states the RIA can finance the purchase of the decedent’s interest at SOFR plus 200 basis points (about 7.3% today) over ten years. The annual payment would be nearly $725 thousand, or 80% of pre-tax (a proxy for distributable cash flow). For a decade, 80% of distributions will be claimed by a 25% ownership interest.80% of distributions will be claimed by a 25% ownership interestWe’ve seen this happen, but there are reasons the formula pricing might not hold. Usually, a buy-sell gives the other partners and/or the firm the option to purchase at the formula price but doesn’t require it. In this case, the option is entirely out of the money. In that case, the firm might decide to punt on the option and pay the estate their pro rata portion of distributions ($225K per year, or about $500K less than financing at the formula price). The estate is left as an outside minority owner in a closely held business. If the estate isn’t satisfied with this, the executor will have to negotiate — from a very weak position — with the other partners. In effect, this nullifies the buy-sell agreement.When the Formula Price Is Too LowBuy-sell formulas that undervalue interests are no better than those that overvalue interests. There is no “conservative” or “aggressive” in valuation, only reasonable and unreasonable. If, in the scenario listed above, the formula price specified that the firm was to be valued based on book value, the outcome would be no more favorable.RIAs usually don’t have much balance sheet value. Our valuations in the space rarely employ an asset approach. We consider whether the balance sheet has a normal level of working capital to finance ongoing operations or if it has a material amount of non-operating assets. Beyond that, the balance sheet is rarely more than some cash, leasehold improvements, and short-term payables. Book value for a firm like the one discussed above might be no more than $250K.At book value, that formula would price the decedent’s interest at $62,500 — unreasonable for a stake that was earning over three times that much in annual distributions. The transaction would be highly accretive to the remaining partners, who would share in the distribution stream they got for next to nothing. But the specter of what would happen to their beneficiaries in the event of their deaths would dampen any sense of having won.If this buy-sell formula also applies in the event of retirement or withdrawal from the firm, who would ever leave? It would be very difficult to execute ownership succession for partners who are giving up their distributions in exchange for so little compensation. Of course, without succession, the firm eventually wears out — a circumstance in which book value might be a reasonable measure.What’s Your Aspiration?Ask yourself whether or not you think the pricing of a forced transaction should create “winners” and “losers.” There are legitimate reasons for wanting a somewhat below-market price for transactions because it benefits the ongoing firm and continuing partners. Above-market pricing just creates a race for the exit. But if your formula price is too high and transaction execution is optional, an informed buyer will pass, and you’ll be negotiating as if there were no agreement. Hardly a good solution.If this has prompted you to think about your formula pricing and you’d like to talk specifics to us in confidence, reach out. We work with hundreds of investment management firms like yours to defuse time bombs and create reasonable resolutions. Don’t let your ownership issues disrupt your operations.

As business combinations go, it’s hard to imagine a better press release: Ferrari, the most storied and most successful name in Formula One racing history and the only team to compete in every world championship ever held, boasting a top 16 Constructors’ Championships and 15 Drivers’ Championships……signs Lewis Hamilton, the most recognizable and winningest driver in Formula One, tied with Michael Schumacher for the most Drivers’ Championships, who serves as a global ambassador for Formula One, built McLaren’s reputation and cemented Mercedes’s, and was knighted by Queen Elizabeth.Ferrari brings unparalleled intellectual property and commitment to racing, capital from a robust market valuation, and a history of being on top. Hamilton brings unparalleled driving skills, a following among not just fans but also mechanics and builders, and a history of being on top.What Could Possibly Go Wrong?I’ll get back to the Ferrari/Hamilton deal later. In the RIA community, nothing gets people’s blood flowing like a transaction. Big mergers are fantastic, but even deals involving a few hundred million of AUM are widely reported. For all the hype, making M&A successful requires minding Ps and Qs, and is as much, if not more, about attention to detail and being realistic as it is about sweeping vision and uplifting pronouncements.I’ve written in the past about the perils of focusing on the volume of press releases instead of the volume of earnings. Today, I thought it would be worthwhile to discuss what can go wrong in an RIA deal and how to protect yourself from it.Here’s a partial list of mistakes we’ve seen (some from buyers, some from sellers) in no particular order.Failing to Get an Independent Quality of Earnings AssessmentA Quality of Earnings assessment is like a SWOT analysis of your financial statements, looking at all of the risks and opportunities inherent in your revenue, expenses, and earnings.Is this a seller issue or a buyer issue? Both.The Quality of Earnings analysis is designed to show you how a buyer would look at youIf you are a seller, a Q of E assessment can alert you to issues that will be exhumed during due diligence and held against you by the buyer in negotiations. If you have real opportunities for earnings enhancement, it will help you get paid for those opportunities. The Quality of Earnings analysis is designed to show you how a buyer would look at you so you’re realistic about what you bring to the table and ready to negotiate the best deal for you. Whatever you do, don’t hire the Q of E firm that does regular work for the buyer — they have an inherent conflict of interest, and they will find things that the buyer can use against you in the due diligence process to whittle down the offer price to help create a “gain on purchase” (to buy you for less than you’re worth).If you are a buyer, a Q of E analysis is a deep dive into a range of qualitative and quantitative issues that protect you from simply trusting seller representations. If the seller presents you with their own Q of E, get that analysis in its native format (usually Excel) and hire someone to review and critique it. It’s not unusual to see adjustments to reported results that are realistic. Others might just be possible. Others might be fantasy.Failing to Meet with Multiple Generations of LeadershipIf a selling firm has two owners of retirement age and a half dozen senior managers below them in their forties and fifties, who will ultimately be tasked with making the transaction successful? I know this sounds obvious, but we’ve seen multiple deals in which the buyer didn’t meet with anyone other than the owner selling the firm so they can retire in the foreseeable future.On signing day, the buyer is introduced to the staff, who are presented with employment agreements. This may be a tough announcement if the next-gen was expecting to buy out their owners and take over themselves. And if their existing employment agreements aren’t pretty good, this could be the scene in which the proverbial assets get on the elevator, go home, and don’t come back. Yes, this has happened.Whether you are a buyer or a seller, it’s important to involve all the relevant stakeholders in preparing for a transaction to ensure continuity of operations after closing. It’s not always easy, but it’s always necessary.Misunderstanding the Economics of the Transaction StructurePop quiz: if deal consideration is five times EBITDA in cash, five times EBITDA in rollover equity, and five times EBITDA in earnout payments, what is the deal multiple? If you guessed 15 times EBITDA, you’d make a typical trade journalist, but you would also, very likely, be wrong.Cash consideration is easy enough to understand, but precious few RIA deals are “cash for keys.”Rollover equity is complicated because it’s based on the relative value of the buyer’s equity. Buyers naturally want accretive transactions in which they are picking up more dollars of earnings per share than they make themselves. But if the deal is accretive to the buyer, it’s symmetrically dilutive to the seller. And if the acquiring firm sells one day for a lower multiple than it was valued at the date of your transaction, it will be even more dilutive. We are always surprised when RIA acquirers boast about the high multiples at which they are valued (by firms they hire to value them…); savvy sellers will know those high valuations work against them.As for contingent consideration, the question revolves around how realistic the earnout targets are and whether those payments will be made in cash or stock. And then there’s the time value of money. Our advice is to be realistic about risk adjusting contingent payments and then discount them. It doesn’t take much to turn a 5x EBITDA headline earnout into 3x on an economic basis.So, what’s our hypothetical five-plus-five-plus-five deal worth? Probably less than 15 times EBITDA.Unrealistic Compensation ExpectationsCompensation can be highly idiosyncratic, especially for founder partners. You might only “pay” yourself $100 thousand per year because you get distributions on 40% of your firm’s earnings. That’s fine as an independent enterprise, but a buyer isn’t going to pay a multiple for your compensation just because you characterize it as earnings.Occasionally, you’ll meet an unsophisticated buyer who is willing to pay a multiple on what would be part of a normal compensation package. This never ends well. A selling partner with eight figures in sale proceeds usually won’t exert himself or herself at the same level for comparatively de minimis pay.Conversely, don’t leave money on the table. If you are a selling partner and take out more in wages than it would reasonably take to replace you, make that adjustment and get paid a multiple on the difference.Consider what a realistic, market-based compensation package is for the partnersIn any event, prior to going to market, consider what a realistic, market-based compensation package is for the partners. That may increase or decrease earnings, but it will probably bend the margin toward something a buyer would consider “normal” or at least sustainable. Negotiating deal pricing over partner compensation is unnecessary. Pick a reasonable balance between returns to capital and returns to labor, and craft your transaction accordingly.Viewing a Merger as a SaleIn a typical RIA transaction, the “seller” is making a bigger investment in their “acquirer” than the other way around. Why? Because, outside of the initial cash consideration, the seller is accepting rollover equity and earnout payments in exchange for their company.Rollover equity is essentially an investment in the acquirer, with what might be an indefinite holding period and an uncertain ultimate liquidity event. Earnout payments, also known as contingent consideration, mean the selling principals are actually going to be partners with the acquirer in their firm until such time as those earnout payments are, well, earned (or not).Also, remember that the scale of economics between seller and buyer is disproportionate. The seller is handing over their life’s work, often in exchange for a small percentage of the acquirer’s enterprise. The deal’s success matters to everyone, but it matters far more to the seller.Not Considering Post-Transaction RealityThis one could be titled “Viewing a Sale as a Merger.”For sellers, it’s important to remember that selling your firm, even part of it, is giving up control. There is no such thing as a no-touch acquirer.There are ways to minimize the invasiveness of a new owner with revenue-sharing arrangements and employment agreements. But we’ve seen supposed financial buyers taking minority stakes who find clauses in their agreement that allow them to exert as much pressure as they think they need after the ink dries. The subsidiary leadership’s only leverage is that they generate the revenue and can leave.For buyers, remember that you are hiring entrepreneurs, and entrepreneurs are often that way because they don’t want (can’t live with) a boss. The great irony of the consolidation movement in the RIA space is that the RIA space formed in the first place because ambitious people at wirehouse firms and bank trust departments decided they could do better if they left the mothership and headed out on their own. Consolidation negates much of that spirit, but to the extent it involves second and third-generation leadership at RIAs, those folks may be more accustomed to having a boss and will be more adaptable to working for a parent organization.Press Releases Don’t Build BusinessesGetting back to the dream combination of Ferrari/Hamilton: What could possibly go wrong? Lots.Ferrari hasn’t won a Constructors’ Championship in sixteen years. Not since before the GFC. Translated to our world, that’s a lot of negative alpha. Enzo Ferrari sold road cars to fund his racing ambitions; now, his company is public, a global branding house that races to sell cars, media, and lifestyle accoutrements. If you’ve seen the excellent movie Ford versus Ferrari, you know that Ford tried to buy Ferrari in the 1960s. Today, Ferrari’s buyer would more likely be LVMH.Hamilton. Is. Old. At 225 miles per hour, age isn’t just a number. This is my unvarnished opinion and the subject of much debate in the F1 community, but Lewis Hamilton turned 39 last month, and his last Drivers’ Championship was four years ago. In the past fifty years, only one driver as old as Hamilton has managed to win the F1 season. Even if he’s the greatest F1 driver in history, Hamilton’s instincts, eyesight, reaction time, and nerves are off-peak in a ridiculously competitive field.So, a little due diligence suggests that pairing an also-ran team with an aging icon won’t produce many podiums. But it will garner millions, if not billions, of dollars of free publicity for both Ferrari and Hamilton. If that is their actual ambition, the deal will be wildly successful. For RIAs, unfortunately, press releases don’t build firms.

One of the most exciting things in the vintage car world is when a classic model is “discovered” in a barn or a forest, or a field, covered in mud or dust or worse. Special because they’re untouched for decades, usually in original condition, and often with very little wear from use, these so-called “barn-finds” can sell for extraordinary sums at auction.Forgotten and ignored buy-sell agreements are also exciting, but usually not in a good way. Buy-sells tend to favor the business’s needs and the ownership’s thinking at a particular time. Decades later, the business has changed, the owners’ perspectives have matured, and the agreement—instead of being helpful—becomes a source of contention.Few RIA owners review their buy-sell agreements until something unexpected happensOur consistent experience is that few RIA owners review their buy-sell agreements until something unexpected happens. The partners argue over the future of the business. Someone gets divorced. Someone gets in trouble with the SEC. Someone dies suddenly. At that point, the buy-sell agreement goes from being a forgotten afterthought to the only thing on everyone’s mind. And, unfortunately, that one thing may be subject to interpretation.The biggest problem we see in shareholder agreements: pricing mechanisms.If a buy-sell is triggered and a 25% shareholder is to be redeemed, what’s the transaction price?The worst situations we’ve seen involved fixed-price agreements. Second to that, we’ve seen lots of problems with formula pricing.I probably don’t have to tell you what we think of formula pricing. Formula pricing has the benefit of simplicity, but simple isn’t always better.Is the formula a multiple of trailing, current, or forward earnings? Are appropriate multiples reflective of long-term averages, current market pricing, good times, bad times? Is the formula intended to generate a change of control value? To a financial buyer or a strategic buyer? Rational buyer looking for ROI or irrational buyer making a land grab? Pricing reflective of highly synergistic deal terms (use our vendors, sell our products, adopt our brand) or on a stand-alone basis? Sale of actual equity interests or a hybrid instrument that asymmetrically shares upside but protects the buyer against downside?In one situation, the agreement called for pricing an interest based on “prevailing market value.” What does that mean? Prevailing market conditions might work something like this:RIA with reported EBITDA of $5 million and adjusted EBITDA of $7 million when the LOI was drafted and reported EBITDA of $6 million and adjusted EBITDA of $8 million at the time of closing. Assume the firm sells for upfront consideration of $40 million plus the potential to get an additional $20 million in earnout if profits grow by 25% over three years. Based on this scenario, what’s the multiple? Is it:5x (upfront consideration as a multiple of adjusted EBITDA at closing)?6x (total possible consideration as a multiple of hurdle EBITDA at the time the earnout is paid)?7x (upfront consideration as a multiple of reported EBITDA at closing)?5x (total possible consideration as a multiple of adjusted EBITDA at closing)?8x (upfront consideration as a multiple of reported EBITDA at negotiation)?9x (total possible consideration as a multiple of adjusted EBITDA at negotiation)?10x (total possible consideration as a multiple of reported EBITDA at closing)?12x (total possible consideration relative to reported EBITDA when negotiated)?When people whisper deal multiples, they use the highest number possibleNaturally, the seller wants to believe they sold for 12x, and the buyer wants to tell his capital providers he paid 5x. It does no good to ask parties what multiple was paid. We find that when people whisper deal multiples, they use the highest number possible—in most cases, the maximum transaction proceeds possible as compared to a trailing measure of reported earnings. This serves the needs of all parties to the transaction. The seller gets to brag about what he was paid—and we all value psychological rewards. The investment banker brags about what a good job she did—and she probably did do a good job. And the buyer gets a reputation for paying up, so the potential sellers will return his call. All of this is good for the deal industry but not especially revealing as to valuation.Absent some reliance on formula pricing or headline metrics, you can hire an appraiser (like us), but even that’s complicated. Do you pick a valuation specialist or an industry expert? Valuation folks characteristically rely on projection models that might be more expressive of intrinsic value than market. That’s not me engaging in professional self-loathing—it’s just reality. Then there are industry experts—usually investment bankers—whose perspective leans heavily on the best deal they’ve heard of recently with a highly-motivated and over-capitalized buyer and a pristine target company with strategic relevance.If you hire a valuation expert with ample amounts of relevant industry experience (like us), you should get a balanced approach to the pricing of your transaction. But even the best resources out there (like us) have to deal with pricing expectations set long before we are involved. A buyer who wants something akin to intrinsic value and a seller who wants the highest bid imaginable will have a hard time coming to terms with the result of any valuation exercise. That situation is more common than not.I’ll offer two closing pieces of advice on crafting the valuation mechanism in your buy-sell agreement:Get your RIA valued on some kind of regular basis. If you have a smaller firm, a valuation every few years may suffice. If you have a larger firm, you might need it more than once per year. What this process offers, more than anything, is to manage expectations. The psychological bid/ask spread I describe above is much more narrow when the parties to an agreement are accustomed to seeing particular numbers, methodologies, and metrics used to determine the value of their interest. This is the main function of regular valuations. Buy-sell valuations are five-figure Buy-sell disputes are seven-figure catastrophes.Don’t draft your pricing mechanism to intentionally privilege either the buyer or seller at the expense of the other. We’ve seen estate situations where the company was compelled to redeem a 25% stake for about 45% of the value of the business. The resulting dilution to the remaining shareholders put a significant strain on the business model, ownership transition, and sustainability of the company. We’ve seen shareholder squeeze-outs where a group of shareholders was entitled to kick out a partner for minimal consideration. There’s no virtue in democracy when two lions and one lamb vote on what’s for dinner. Regardless of what you think your RIA is worth, if you aren’t intimately familiar with the terms of your buy-sell agreement, you don’t know what your interest in your RIA will net you in a transaction. Pull your agreement out, dust it off, and read it. If it seems at all confusing as to how it will function when the buy-sell mechanism is triggered, the reality will be worse than you expect.

Compensation models are the subject of a significant amount of hand-wringing for RIA principals, and for good reason. Out of all the decisions RIA principals need to make, compensation programs often have the single biggest impact on an RIA's P&L and the financial lives of its employees and shareholders.There are three basic components of compensation for investment management firms: Base salary/Benefits, Variable Compensation/Bonus, and Equity Compensation. We discuss these and more in this whitepaper.

It has become a tradition for the RIA team at Mercer Capital to end the blog year with a “unique” annual summary of industry events, riffing off Clement Clark Moore’s classic “A Visit from St. Nicholas.” We hope all of you in the investment management community are enjoying the holiday season and looking forward to the many opportunities of the new year. We look forward to hearing from you in 2023. For now, please enjoy the finest only holiday poem written about money management.Happy Holidays from Mercer Capital’s RIA Team!‘Twas the night before Christmas, when all through our firm, We looked back on a year that was filled with concern; The stockings were hung by the chimney with care, In hopes ’23 wouldn’t be such a bear.Our analysts diligenced, scratching their heads, O’re down-sloping yield curves that offered no spreads; And tech stocks deflated, and rates out of sight - Each glance at the Bloomberg made anxious with fright.When out in the hall there arose such a clatter, I set down my coffee to check on the matter; Away to the lobby I flew like a flash, As good bankers do when they fear for their cash.When what to my wondering eyes should appear, But the ghost of Paul Volcker, looking quite debonair; A phantom in grey flannel, the Fed superstar, Who floated in haze from his giant cigar.“Good sir!” I addressed this strange apparition “Is it you: the inflation-fighting magician?” “The same” said the ghost, “and I sense from your query, That interest-rate changes have made your life dreary.”I told him our clients, ‘cross the RIA spectrum, Had found this past year quite a pain in the rectum; Business down, costs up, was the theme of my story, A punch to the gut that was not transitory:“First they killed crypto, then housing, then bonds! Every asset we held faced a flock of black swans! I blame the Fed board for all of this rot, My life was all good, ‘til they changed the Dot Plot!”“Relax!” cried the ghost, “don’t show your stupidity, There is such a thing as too much liquidity; Preserving your wealth is no justification, For letting the world suffer global stagflation.“When I was named Chair, we were on the back foot, But we didn’t give markets an endless Fed put! Your stocks will recover, your bonds will be fine, As soon as Jay Powell makes inflation decline.”He said plenty more, as is such with his work, He answered my questions; then turned with a jerk. A heav’nly elevator appeared there before us, And he boarded to hymns of the central bank chorus.Adjusting his glasses, perched high on his nose, He gave me a nod just before the doors closed. But I heard him exclaim, as he rose out of sight – “Don’t fight what we do, and your bets will go right!”

As the RIA team at Mercer Capital looks back on 2022 and ahead to next year, we’ve noticed a few themes emerge in discussions with clients that we expect to hear more about in the new year. Don’t think of these as predictions but simply the current state of market behavior—the implications of which will soon be evident.1. Dynamic Markets Favor Providers of DiversificationAfter a decade when do-it-yourself investing in a narrow band of large-cap domestic stocks was all you needed to be successful, we see a dramatic shift to dynamic markets which require analysis and judgment. Time will tell if FAANG has gone the way of the Nifty-Fifty, Dot-Coms, and other can’t-lose equity fads. What we know is large-cap U.S. stocks are among the priciest investments available (crypto is another story), and the dollar is punching above its weight. Having lived through the worst year for 60/40 in anyone’s career memory, we now have good opportunities across a broad swath of investment classes. All of a sudden, diversification matters.We think this bodes well for those who traffic in diversification, whether it’s OCIOs, multi-family offices, wealth managers, independent trust companies, or managers in niche asset classes that play a unique role in portfolio strategies. Anyone who suffered by comparison to the S&P 500 is being set up for vindication and possibly some healthy client inflows.2. Compensation Plans Are Being Tailored to Business ModelsHistorically, many RIAs were a variable-revenue, fixed-cost business. That works when markets are steadily rising, but not in times like this. Margin of profitability is also a margin of safety.Volatile markets have wreaked havoc on industry profitability this year, both because of downward pressure on AUM and because institutional investors are increasingly asking to pay lower base fees plus performance fees. In an effort to match expenses with revenues, RIAs are responding by increasing variable pay: bonus structures and equity compensation that directly share in the profitability of the business. In many firms, leaning more on variable compensation can be a smart risk management tool both for bad markets (mitigating margin impact when revenues sag) as well as good markets (paying to retain key staff when money is plentiful).3. Borrowing Costs to Affect M&AFor most of this year, we’ve been writing that Fed behavior was going to rein in transaction activity. Like many market prognosticators, so far, we’re “not wrong, just early.” Historically, transaction activity in the RIA space is a lagging indicator, and the steep rise in rates this year is starting to have an impact.Last week, both Focus Financial and CI Financial announced debt refinancing at higher rates than they’ve had to pay in a long time. Focus closed term financing at SOFR plus 250 bps and SOFR plus 325 bps for maturities between 5 and 5.5 years. If SOFR peaks at 5% or a little higher, Focus will have term borrowing costs on the order of 8%. CI Financial is paying a fixed rate of 7% over the next three years and wants to deleverage. Focus isn’t looking to increase its leverage ratios. Our read on private acquirers aligns with these two publics. We don’t see as much dry powder available to fund M&A in 2023, and that which is available will be deployed more judiciously.4. Minority Transactions Provide the Opportunity to Wait and SeeAs M&A slows, minority transactions are being viewed by many as a way to kick the can down the road. Rather than cede control in an atmosphere of lower AUM, revenue, margin, multiples, and—therefore—value, minority sellers can take some money off the table, satisfy a near-term liquidity need, cash out one or a handful of retiring partners, or otherwise satisfy their basic ownership requirements. Key players can stay in the saddle for markets to recover and sell more in a few years.Regardless of the present conditions, we’ve heard investors in the RIA space make a compelling argument that minority investments work better anyway. Financial buyers don’t want to run RIAs, they just want to own a piece of the success brought about by committed and talented management. If management owns a meaningful stake in the business, outside investors can rest easy. We anticipate an increase in merchant banking over the next few years, especially if markets remain unsettled and interest costs are meaningfully higher.5. Fortune Favors the Bold…and So Do EarnoutsJust as we see institutional investors wanting pay-for-performance relationships and firms using variable compensation, volatile markets and higher borrowing costs favor pushing more transaction consideration toward contingent payments. It gives buyers comfort and sellers opportunity, and we think the prominence of earnout consideration will only increase.6. Buy-Sell Pricing to Mimic Transaction BehaviorBuy-sell agreements provide ownership structures with a contractual mechanism to determine how ownership interests in closely-held businesses will transact. They are a must-have for RIAs with multiple owners, and in our experience, most have some form of buy-sell agreement in place. Unfortunately, many buy-sells are not well-engineered. We get more work than we should helping disentangle disputes involving internal transactions which were supposed to happen smoothly.One recurring issue involves buy-sells that price ownership interests using formulas. Formula pricing promises simplicity, but life is rarely simple. It’s common to see formulas using industry multiples derived from rules of thumb, which might work fine under “normal” conditions.Buy-sells are usually triggered under abnormal conditions, though, when such rules of thumb could dramatically undervalue or overvalue a business. RIAs usually transact with some money paid upfront and the rest contingent on the post-transaction performance of the firm. We wonder why buy-sell pricing isn’t structured the same way.

Most of the 9/30 quarterly results are in, and public RIA performance was all over the map.  Mostly, it was a rough quarter in a rough year.  Sagging AUM led to revenue cuts which dropped straight to the bottom line.  Some firms mitigated their downside by cutting bonus compensation and marking down earnout payments for acquisitions.  We did a survey of a cross-section of asset and wealth management firms.  Ultimately, it appears some business models are working better than others.Click to View Full Screen

When the economic mood soured in 2008, I called an older friend to get his thoughts on the credit crisis and what it would mean. “Jerry” had spent his career running a large heavy truck distributor, and he had visceral experience in more than a few economic cycles. Jerry told me two things on that phone call that have stuck with me.“My manufacturer’s rep called last week and asked me ‘what would I have to give you to put some of my trucks on your lot.’ I answered: A lobotomy.” Jerry then explained that most people are blinded by their own optimistic leanings to underestimate how bad things can get in a recession, and how long they can last.As September of 2022 came to a close, asset management is experiencing one of the most challenging years in history.As September of 2022 came to a close, asset management is experiencing one of the most challenging years in history. Losses are both deep and widespread. The consequence is a tough quarterly letter to pen to investors, a hit to revenue, and an even bigger impact on profitability.A few notes on where things stand:U.S. equities experienced their third straight quarterly loss, which hasn’t happened since 2008.The S&P 500 has lost a quarter of its value this year. The Nasdaq is down a third.Many indexes hit new lows on September 30.Bonds are having their worst year since 1976, with the U.S. Core Bond index falling 16% through September 30.Asset correlations are high, leaving no path for escape through diversification. The classic 60/40 portfolio is said to be having its worst year since 1980. Even TIPS (Treasury Inflation Protected Securities) are down YTD.30-year U.S. mortgage rates are hovering around 7% for the first time since before the credit crisis.The U.S. dollar has surged against other major currencies, eclipsing parity with the euro and threatening parity with the British pound. The dollar has also blasted through previous resistance levels with the Japanese Yen and the Chinese Yuan.Currency fluctuations are straining economies and asset prices globally. The breadth of the financial market strain is not without precedent, but you have to look far back to find a market as bad or worse for so many investors. Asset correlation was a tremendous issue in the credit crisis, and this bear market is seeing deep drawdowns across most asset classes. This doesn’t bode well for industry margins, as AUM declines coupled with fee pressure hit revenues, and inflationary increases in RIA expenses don’t offer a cushion for profitability.According to Morningstar, U.S. fund flows have been net negative so far in 2022, after a reasonably strong performance in 2021. Risk asset flows like equity and high yield have been hit particularly hard, both domestic and foreign. With a few exceptions active funds continued to lose AUM to passive funds, after better performance in 2021. Fixed income has lately been attracting more AUM than we’ve seen in recent memory, as the risk-off mood of the market manifested in asset rotation. Also for the first time in recent memory, there appears to be a pivot from growth to value.One bright spot for asset managers in 2022 is that many more active managers are beating passives. So far in 2022, Morningstar reports that nearly two-thirds of large cap value PMs are beating the Russell 1000 value index, and just over half of large blend managers are beating the S&P 500. Unfortunately, this “beat” means being less down than the index, and despite the win passive strategies are having more success in attracting funds.Perhaps the best metaphor for the moment is a video of Cathie Wood, CEO of Ark Invest, offering an open letter to the Federal Reserve. Wood accused the Fed of misappropriating data to rationalize policy errors which she believes will over-correct and cause damaging deflation. Wood has personal experience with asset deflation; her Ark Innovation Fund (ARKK) ended the third quarter with a year-to-date loss of more than 60%.Unfortunately for Wood and others who worry the Fed is moving too far, too fast, Fed Chair Jerome Powell has repeatedly stated that the Federal Reserve understands the damage potentially caused by their rapid increase in short term interest rates, but that they think it’s worth it to contain inflation. In other words, no matter how far asset prices fall, this time there will be no Fed “put.”

Imagine you manufacture luxury products. You've recently had to raise prices substantially, despite your primary markets being headed into recession. Your buyers use leverage to purchase your products, and interest rates are the highest in a decade and are headed up. On the production side, your supply chain is compromised, skilled workers are scarce, and the cost of powering your factories has skyrocketed because your home currency has devalued. Public market investors shun legacy participants like you because your industry subsector is in the midst of technological upheaval, and the cost of retooling is viewed as greater than starting from scratch. Equity markets are sagging, and the IPO market is dormant. To top it off, there's a major war with an uncertain outcome that has already worsened your supply chain issues, and fighting could spill over into nations adjacent to your home country.Does that sound like an "open window" to list as a public company?Next week, Porsche AG is going public for the first time in ten years. Parent company Volkswagen announced the complex restructure and IPO a few weeks ago, and recently confirmed that Porsche would be organized into 911 million shares (a nod to their most iconic model), half of which will be voting, common shares and the other half will be non-voting preferred shares (not preferred in a sense we're accustomed to in the U.S.). Post IPO, the public will own one-eighth of the company (25% of the preferred shares), while the Porsche family will effectively have a controlling stake.The IPO was initially criticized for its complexity, governance plan, and pricing (at $75 billion, Porsche would trade about 10% lower than VW, which sells more than 30x as many cars per year). By Wednesday evening of this week, the order books were full, eight days early. No marathon for the book runners – more of a 5K.It's a Strange MarketLast week, Zach Milam wrote about some of the conundrums we encounter in valuing RIAs. Fair market value pricing has a tendency to lean in the direction of intrinsic value. The reality is, though, sometimes markets have a mind of their own and don't really care what thoughtful, educated securities analysts think. Fundamental analysis suggests many factors working against the value of investment management firms, and trading in public RIAs confirms that view. Transaction activity tells a very different story.Fair market value pricing has a tendency to lean in the direction of intrinsic valueWe're about to close the third quarter of a record number of transactions in the RIA space. In spite of plenty of headwinds: inflation-challenged margins, sagging AUM, and higher leverage costs, the pace of M&A continues and could equal last year. I say could because, even though we'll head into the fourth quarter of 2022 with a strong lead over 2021, the Q4 2021 comp is a tough one. Last year, fear of change in tax law and the breadth of the bull market drove a ridiculous volume of transactions.Nevertheless, momentum is strong. Even though buyers are getting picky, deal terms are less generous, and consideration is starting to shift more to earnouts; pricing is steady.What's Not to Like? One thing that's different than 2021 is that public market activity is anemic. Public RIAs aren't benefiting from any of this private market pricing activity, and the IPO window is – despite what some people have suggested – nailed shut.It’s difficult to reconcile public market pricing with private market sentimentIt's difficult to reconcile public market pricing with private market sentiment. Public RIAs are commonly trading at mid-single-digit multiples of EBITDA. Private company owners scoff at those metrics, and for good reason. Even though transactions may not always be as generous as some think, they're still better than going public. On the private side, consolidators are lauded for building wealth management empires – all while Focus trades just above its IPO price from four years ago, and CI Financial gets criticized for building a wealth management empire. The doublespeak is staggering. One wonders why more public RIAs don't throw in the towel and go private like Pzena.Who wants to go public in this market? In the first quarter of 2022, we heard about Dynasty Financial and Gladstone Companies going public and CI Financial offering shares in its U.S. wealth management business. None of that has happened, and until market conditions change, none of that is going to happen.Your Mileage May VaryI've heard lots of explanations of the private/public discrepancy in valuation, but nothing yet that's altogether satisfying. Depending on who you talk to, one man's unicorn is another man's glue horse.What we can say with certainty is that the differential in interest in public investment management businesses and private investment management businesses isn't sustainable. What we don't know is when or how. Will higher interest rates eventually wear down leveraged acquirers, as they have in other growth-and-income sectors (real estate, anyone?)? Will PE investors start to question the merits of trading companies from fund to fund instead of testing valuations in the open market? Will the public RIA group follow Pzena's lead and go private? Or will public investors' newfound interest in dividend stocks lead them to RIAs?It's tough to forecast a public RIA resurgence but never say never. Investors may not be pricing Porsche like Tesla, but they're giving it a valuation more like Ferrari (RACE) than Ford (F). In a market full of both prancing horses and mustangs, the public companies may yet win by a nose.

The holy grail for automotive producers is a high-margin (i.e., high priced) product that they can sell in volume. After watching Porsche revive its failing fortunes with a pair of sport SUVs, Lamborghini jumped into the fray with the Urus. Despite an unfortunate name and a face only a Lamborghini driver could love, the Urus has a top speed of 200 miles an hour, seats four comfortably, and has a hatch large enough for a weekend Costco run (just don’t attempt all three at once). Most importantly for Lamborghini, the Urus sold 20,000 units over the first four years of its production run, a number previously unthinkable for the boutique Italian automaker.That unit volume didn’t happen because the Urus is anybody’s idea of a low-cost solution. At $225K plus per copy, the Lambo is proof that there is substantial demand for that kind of all-around product – whether it’s necessary or not.Are RIAs Growth Stocks or Value Stocks?We think of investment management firms as a “growth and income” play. The space has attracted capital specifically because RIAs produce a reliable stream of distributable cash flow with the upside coming from market tailwinds and new clients. For all the trade press touting interest in RIAs, investing trends over the past fifteen years have had a mixed impact on the investment management community.For asset managers, cheap capital makes stock picking less important. Persistent alpha is harder to prove. Passive and alternative products are more competitive. Investment committees are surly. Fee pressure is rampant.For wealth managers, cheap capital has made diversification look kind of pointless and bordering on stupid. In the rearview mirror, owning anything other than the S&P 500 has, since the credit crisis, looked like a mistake. While this may not have had an immediate impact on revenue and margins, it does nothing to cement advisor/client relationships.But what about valuations? Where do RIAs fit in an environment that favors growth stocks?Can RIAs Be Considered Growth Stocks?If you think of growth stocks as companies producing super-normal increases in revenue – double-digit upside that might even exceed their cost of capital – then it’s difficult to put investment management firms in that category. Growing revenue requires growing AUM. Even with favorable markets, consistent AUM growth greater than single digits is difficult to achieve.Breaking down AUM growth into its constituent parts is revealing. A typical client of ours might enjoy significant market returns, even net of fees. But seasoned firms have seasoned clients, and seasoned clients draw income from their accounts and leave for various reasons. Client additions to existing accounts are sporadic, and new accounts can be hard to win. Even with AUM growth, pressure on realized fees can inhibit revenue growth – and increases in realized fees are rare indeed. So, growing profitability faster than AUM requires margin expansion. Margin expansion at an RIA generally requires managing labor costs. In this labor market, that’s difficult.Margin Matters to Value InvestorsSo maybe RIAs aren’t a growth stock, so what about value?Publicly traded RIAs tend to be priced at a discount to prevailing market multiples. IPOs are backed up this year, with several waiting in the wings. The heads of these companies won’t come right out and say it, but most, if not all, are loathe to go public at the six or seven times EBITDA the market is currently offering. Instead, the public investment management space has been characterized by consolidation and buy-back programs aimed at creating shareholder value in the face of increasingly competitive markets.The private market appreciates the promise of strong and consistent streams of distributable cash flow, which has attracted investment dollars in the hopes of building value through scale, enhancing returns with leverage, and multiple arbitrage. An accommodative Fed has made leverage attractive, and the hope of one day selling to a willing public or an aggressive PE firm has kept transaction activity robust. As interest rates march higher and public markets sag, this narrative may become harder to support. Even so, the play on RIAs as a value investment has endured through strong and weak markets for decades, because consistent cash flow margins appeal to certain types of investors.Growth versus ValueOne of the longest running trends in public equities is the persistent outperformance of value stocks versus growth. For nearly 70 years, from the start of World War 2 until the credit crisis of 2008-09, value stocks usually outperformed growth with the exception of brief periods like the dotcom run of the late 1990s. But for a decade now, quality of earnings hasn’t mattered as much as quantity of growth.The recent growth over value phenomenon is easily explained by unprecedented market liquidity, starting with the credit crisis and extending through the pandemic, that provided ample excess capital to fuel demand for financial securities. A quick glance at equity pricing in a low versus a more normal cost of capital environment reveals the impact of cheap money on equity multiples, vis-à-vis expected growth. The specific impact of an accommodative Fed and massive policy stimulus on the cost of equity capital is debatable, but the impact on equity valuations is not. A lower cost of capital leads to multiple expansion, and directly favors growth stocks relative to value. In this rate environment, it’s hard for investment managers to get noticed in the public markets.Everything Has a PlaceIf the automotive market has a place for Lamborghini SUVs, then surely the investor community has a place for RIAs. As it is, the space tends to get ignored as a value play and oversold as a growth opportunity. It’s a bit of both. Those familiar with investor behavior in the SaaS community know about the Rule of 40, in which the sum of revenue growth and cash flow margin are summed (or portioned in a formula) and “better” models produce growth plus margins in excess of 40%.This blended measure of growth and income doesn’t exactly translate into the RIA space, but if we run a sample DCF with some common assumptions about the cost of capital (mid-teens), fee schedules (50 basis points and flat), and margin sustainability (also flat), then we can see implied valuations (measured as a revenue multiple) remaining fairly consistent if you look at a percentage point of AUM growth being worth about the same as 2.5% in margin (say, 25% margin and 5% AUM growth produces about the same revenue multiple as a 30% margin and 3% revenue growth).This example isn’t meant to be probative of anything, except to say that trading some margin for growth can enhance valuations in the RIA space, but it's not an all-or-nothing proposition. Striking a balance between profitability and upside provides more value for investors, and, ultimately, more value for the investment.

The history of the auto industry is full of products that were more hype than reality, but maybe none more than the Fisker Karma. The Karma was the luxury hybrid offspring of legendary automotive designer Henrik Fisker. It was supposed to be the future of four-wheel transport: elegant, comfortable, and efficient. It photographed awfully well, and consequently, Fisker got plenty of free publicity in the automotive press. Unfortunately, the product didn’t live up to the promise, as the Karma was cramped for space, not terribly fuel efficient, and very expensive. Battery problems prompted a recall that ultimately killed the company, after selling less than 2,000 units. As we say in the south, Karma’s a biscuit.Earn-outs and ValuationWe’ve written before about how earn-outs are a key provision in most RIA transactions and recent earnings results from public companies in the space bear that out. What some might have characterized as overpayment for past deals has resolved itself via contingent consideration, resulting in right-sized transaction consideration. This lamentable situation for sellers also represents an earnings cushion for buyers. Consequently, we find that RIA valuations in transactions didn’t get as stretched as they might, to many, have appeared.One impediment to getting deals done in the investment management community is the undercurrent that other sellers have received astronomical multiples for their businesses. Indeed, some nosebleed pricing was achieved in many instances in 2021, prompting Focus Financial’s CEO Rudy Adolf to bewail “drunken sailors” who overpaid for acquisitions. The impact of a few irrational players does more than compete away deals from “disciplined” buyers, it also resets expectations for sellers to stay put unless someone is willing to give them a similar deal. Nobody wants nine times when their industry nemesis got fifteen.Earn-outs Resolve Differences in ExpectationsThe gap between buyer and seller expectations can be thought of as a bid-ask spread, and one which often can’t be resolved simply by splitting the difference.The most common way to bridge the bid-ask spread is by way of contingent consideration, also known as an earn-out, in which the buyer agrees to pay something in addition to upfront consideration if the acquired business achieves certain performance metrics after the deal closes. Earn-outs are commonly tied to:Retention: if the acquired RIA retains, say, 95% of AUM as measured at the closing date for a certain period after the transaction. Such a provision guards against the uncertainty of relationship transitions – especially in smaller wealth management practices – as new advisors take over accounts from sellers transitioning out of the business.Growth: if the acquired RIA increases AUM, revenue, EBITDA, or some other key performance metric in the years following a transaction, buyers might pay more to cover some of the increase in value brought about by post-transaction performance improvement. To the extent that sellers can influence the outcome, growth after the close ensures they get paid for some of the upside in their enterprise, while buyers end up with a stronger franchise and often a lower valuation multiple than if the business underperforms.Margin: to the extent that transaction negotiations involve some debate over cost structure, the maintenance or enhancement of profit margins after the close ultimately prove out, or prove wrong, what operating leverage is inherent in the acquired entity. Earn-outs can be structured any number of ways, but ultimately they resolve something of the differences of opinion about the performance that naturally come up between risk-averse buyers and sellers who don’t want to leave money on the table.Earn-outs Resolve Emotional DifferencesEarn-outs also perform an important psychological function in dealmaking. Buyers can report back to their boards and shareholders that they’re only committed to paying for proven performance. If the deal turns out to be less than advertised, the amount they ultimately paid for the target stays fixed – often much lower than it would have taken to close the transaction with entirely upfront consideration. Sellers get bragging rights, as they often anticipate that they will “easily” achieve the projected performance needed to get earn-out payments.Earn-outs help buyers get over the fear of the unknown, as indeed most post-close surprises are negative. For sellers, earn-outs help them get past what is often called endowment effect, or the syndrome that an asset is usually more dear to its holder than it is to someone else.From an M&A marketing perspective, earn-outs fuel interest in deal activity. Sellers tell their friends they got paid X-teen times, a multiple in which the numerator commonly includes contingent consideration as if it had been paid, in full, at close. Buyers don’t mind this, as it attracts other sellers to their brand. And investment bankers love it because it supports deal flow.When Bad News Is Good News, or #FASBknowsbestRecent activity in public RIAs show the impact of earn-outs on ultimate deal consideration, and why sellers shouldn’t confuse contingent consideration with upfront consideration. Several public RIAs, including Focus Financial Partners, Silvercrest Asset Management Group, and CI Financial, reported writing-down contingent consideration in recent quarters on prior transactions.This write-down activity is a peculiar aspect of GAAP (Generally Accepted Accounting Principles), in which the expectation of the payment of earn-outs is made at the time of the acquisition in what is known as the purchase price allocation.By way of example, consider a deal that includes upfront consideration of $25 million and contingent consideration of an additional $15 million, paid over several years and subject to the performance of the target RIA. The transaction isn’t simply booked at the total potential payments, or $40 million. The contingent consideration is risk-adjusted and present-valued. In this example, the $15 million in earn-out payments might be fair valued at only $10 million, such that the transaction is booked at $35 million (upfront consideration plus the fair value of earn-out payments).Over the term of the earn-out, the value of the transaction is effectively remeasured. If the entire earn-out payment of $15 million is earned, the cost of the transaction is $5 million higher than was estimated at close, and the additional payment is recognized as an expense on the income statement. This has a negative impact on the earnings of the buyer.If, on the other hand, the acquired company underperforms, GAAP prescribes that the contingent consideration is remeasured – for public companies on a quarterly basis – in the form of a write-down. In our example, if none of the $15 million in contingent consideration is ultimately paid, then the $10 million fair value of the earn-out would be written off entirely. That write-off flows through the income statement as an offset to expenses; it is money that was to be paid but instead was not paid. Thus, if a target company underperforms expectations, it can – somewhat perversely – increase GAAP earnings of the acquirer.The impact of these write-downs can be material. Focus Financial announced GAAP pre-tax net income in the second quarter of 2022 of $81.5 million. Of this, more than half, or $42.8 million, was a result of a decrease in expected earn-out payments. At CI Financial, about 25% of their GAAP EBITDA in the most recent quarter was a result of writing down contingent consideration ($75 million of $295 million). And at Silvercrest, a similar adjustment to expected earn-out payments constituted nearly half of GAAP pre-tax net income. Of note, the financial disclosures of each of these companies makes the impact of this adjustment very clear, and each eliminates the impact of changes in earn-out consideration from their adjusted (non-GAAP) EBITDA.Earn-out Support Deal Activity in Bear MarketsOn paper, this is how it’s supposed to work. One reason deal activity can remain strong in tough financial markets is that buyers can use earn-outs to control what they pay for deals, offering more money in the event that markets recover and justify higher valuations, and managing their outlays if performance lags. Recent earnings calls allude to this, subtly, with Jay Horgen from AMG noting “constructive pricing and structure” that “insures to the benefit of our shareholders.” Victory Capital’s David Brown noted “some of the way to deal with the difference between buyer and seller expectation is restructuring and timing of payments and partnering in the future of growth.” As a consequence, Focus Financial’s Rudy Adolf noted “overall industry activity is going to remain high. Competition is kind of…normal.”For sellers, the relevant consideration is bear markets may tank a big part of their expected deal consideration, well beyond their control. A falling tide may not simply work to the detriment of sellers, but also hand buyers a bargain purchase when markets improve. Earn-outs align interests in the near term, but can provide asymmetric benefits in years ahead.Westwood Holdings’s recently announced acquisition of Salient Partners is nearly half earn-out consideration: $25 million on total possible consideration of $60 million. 35 to 60 is a pretty tremendous bid-ask spread, although not uncommon in the RIA space. We don’t know what the exact KPIs are that Salient will have to produce to receive full payment. What we do know is that it’s another example of the prominence of contingent consideration in RIA transactions, a situation that we expect to persist.

In the golden age of asset intensive businesses, companies made giant capital expenditures on fixed assets and research & development to fuel long term growth strategies. In those days, economies had similar opportunities. The U.S. system of interstates, launched by President Eisenhower, is a prime example of major spending in support of long-term opportunities. (I could lament the days of fresh asphalt and real yields, replaced now by potholes and QE, but that’s another blog.)As our economy has evolved to feature more service-based, asset-light businesses, so too has the need to rethink what infrastructure means and what investing in long term growth looks like. Even businesses like investment management have a type of infrastructure, and their long-term growth opportunities require investment in that infrastructure.The Tangible Value of an RIA’s WorkforceOne common feature of RIA financial statements is the simplicity of their balance sheet. We not infrequently work with clients whose asset base consists of little more than a token amount of cash, receivables, and leasehold improvements. On the righthand side of the balance sheet, we commonly see nothing but a few payables and equity.But as the old (pre-pandemic) saw goes, an investment management firm’s assets get on the elevator and go home each night, such that the real infrastructure of an RIA is its staff – sometimes referred to in the valuation profession as the “assembled workforce” – an intangible asset that is more-or-less measurable using a replacement cost methodology (oftentimes achieving a result that is more precise than it is accurate).Our recent blog series has focused on the tradeoffs that RIAs make in providing returns to labor and returns to capital. Ultimately, for each dollar of revenue that an RIA brings in, the process of deriving profitability is largely a function of setting up a compensation structure. The portion of revenue devoted to expenditures other than staff and ownership is comparatively small (and less discretionary in nature).The balancing act between returns to capital and returns to labor is also a balance between current return and long-term growth.But spending on staff isn’t simply a tradeoff with profitability, it is also a tradeoff with growth. Most growth opportunities in the RIA space involve staffing – whether it’s for new initiatives, succession, or further development of the existing business model. Staffing requires spending that may not be immediately accretive to earnings. To the extent that spending on staff is front-loading the costs of opportunities for growth, the margin tradeoff can be rightly characterized as infrastructure spending – building the workforce needed to support more growth and profitability in the years ahead. Most understand the tradeoff, but little has been written about what sort of tradeoff is appropriate.The Rule of 40Elsewhere in the business community, this issue of the tradeoff between growth and margin has been explored thoroughly. In the subscription software industry (SaaS), there is a well-known concept called the Rule of 40. The Rule of 40, or R40, holds that venture investors like to invest in businesses in which the profit margin plus the growth rate adds up to at least 40%.So, if a growing SaaS company shows a profit margin of 30% and a growth rate of 15%, the total margin and growth (30% + 15%) is 45%, exceeding the R40 expectation. Companies with combined growth and margin rates of 50% are top performers and get lots of attention.The R40 function is a shorthand way of determining the strength of a business model, in measuring the degree to which growth requires a tradeoff with profitability (whether through price concessions, marketing, or other customer acquisition costs). If growth plus margin equals more than 40, it indicates a business that can maintain profitability and still expand at better than average levels. Imagine a unique development stage business in a market with lots of upside and little competition – the sort of environment that promotes high growth with the pricing power to maintain substantial margins. On the contrary, a measure below 40 indicates a mature business with few expansion opportunities and increasing competitive threats.Now, which profit margin are we speaking of, and is it unit growth, top-line growth, or profit growth that matters? As with everything, the devil is in the details. But the concept, measuring the aggregate return of growth and margin, has merit in a “growth and income” business like investment management.Is R40 Applicable to RIAs?The most attractive feature of investing in the RIA space is that it generates lots of distributable cash flow and has the market tailwind (recent months notwithstanding) to provide growth. But more margin and more growth is always a better thing. As with SaaS businesses, RIAs that produce more margin and more growth are going to be worth more – ceteris paribus – than those which produce less margin and less growth.What’s a reasonable expectation of “R” for investment management? This is definitely a topic worth further study, but for the time being, let me venture out to offer a few thoughts on using this type of economic thinking to evaluate an RIA’s performance. Established wealth managers commonly produce EBITDA margins in the range of 20% to 30%. So, any measure of the efficacy of an RIA's business model – including evaluating whether it is investing for the long term – should develop an “R” that is in excess of that level. That “excess” metric is growth – but to what extent?Growth from market performance is always welcome, but as we’ve said many times in this blog, organic growth is the key to long term performance. Years like this are a cruel reminder that the market doesn’t always fuel AUM growth, and that a growth minded RIA needs a demonstrable and repeatable strategy to capture new assets. Without real organic growth, clients eventually spend off their assets, pass away, or take their business elsewhere.So, we would look at organic growth. That’s new client assets and additions to existing accounts, net of client terminations and withdrawals. The net growth of AUM, absent any market activity. Organic growth is a question of how quickly one can envision doubling an RIA’s business. 15% organic growth would imply doubling the business every five years. 5% is closer to 15 years. What organic growth rate will your model sustain?R35?If organic growth in the 5% to 15% range can be supported by a 20% to 30% normalized EBITDA margin, the combination of these ranges, or about 35% at the midpoint, suggests that something on the order of R35 is a decent norm to observe – at least in the wealth management space. Totals that far exceed 35% would indicate a more effective business model. RIAs that produce growth plus margin much lower than 25% suggest a comparatively weak model.The Rule of 40 – extended to the RIA space – works pretty well. The higher the “R” (percentage growth plus percentage margin), the better performing the business model – showing less of a tradeoff between margin and growth.We need to develop this idea further, but it’s promising as a diagnostic. R40 works in the SaaS world because the VC community investing in these companies has a cost of capital around 25%. R40 produces approximately the same present value of interim cash flows regardless of the tradeoff between margin and growth, provided they total about 40%. In the RIA space, where WACCs are more in the mid-teens, R35 appears to accomplish a similar parameter.The New GARPGrowth at a reasonable price (margin) is an old concept in investment management, but it bears extending to practice management as well. RIAs are fortunate not to have to spend billions on factories, only to grieve them as “money furnaces” (sorry Elon). But that doesn’t mean RIAs don’t have the same imperative to invest in the people who compose their businesses.

Last month I received an abrupt reminder of the roots of my career when the latest iteration of Shannon Pratt's "Valuing a Business" landed on my desk. At 1200 pages and weighing in at more than eight pounds, the current installment is the sixth edition of what has been the go-to resource for the business valuation community since Dr. Pratt published the first edition in 1981. Shannon didn't quite live to see VAB6 in print, but he was available to provide guidance and moral support to me and the other four members of the working group who saw the sixth edition through to completion, and I know he would be happy with the outcome.While working on VAB6 often felt like a distraction from my day job, it was a useful discipline to remember how the broader finance community views valuation issues outside of the echo chamber of the RIA community. BV still means "business valuation" to the RIA team at Mercer, but there are also "beyond valuation" moments where we're working on consulting engagements that take us far from our traditional "solve for X" profession. And, leafing through my printed copy of VAB6, I'm reminded of the many times long accepted valuation truths that seem to conflict with observed market behavior.Is Private Capital Better Than Public for the RIA Community?Valuation professionals generally accept that public market capital is cheaper and leads to higher valuations than can be achieved by closely-held businesses. The words and actions of market participants who invest in RIAs do not necessarily align with this belief.In a recent webinar, two heads of prominent private consolidators in the investment management space reflected, indirectly, on this dilemma, noting internal valuations with multiples double that of prominent publicly traded consolidators. One went so far as to say that the public markets weren't "ready" for the RIA consolidator model.Anyone can be accused of "talking their book," but that's not my point. These moguls are in a good position to understand this, and they are far from alone. The past decade has seen the ascent of more than a dozen privately funded acquirers of investment management firms, many of whom have prospered even while their public counterparts languished.The news suggests there is no “multiple-arbitrage” available to buy private RIAs with public funding.Public consolidators appear to be caught in a bind. The recent news that Focus Financial Partners was going to use cash to repurchase up to $200 million in stock (instead of using that same money to buy RIAs) and CI Financial's announcement that they were "slowing" (pausing?) acquisition activity to focus on integration got our attention.The news suggests no "multiple-arbitrage" is available to buy private RIAs with public funding. If the evolution of equity ownership can be described as a never-ending search for cheaper capital, the cheapest capital today is not necessarily from public markets.Why Is This Happening?In the valuation world, we use a simple diagram to illustrate the different financial perspectives of public and private investors. It's known as the "levels of value" chart, and while there are different versions, most generally look something like this:The "Levels of Value" Chart The general concept of the Levels of Value chart is the fair market value of equity securities corresponds to the public (or as-if-freely-traded) cost of capital (market risk, or beta), adjusted for idiosyncratic or non-systemic risks associated with a particular company (alpha). That exercise derives a valuation at the "marketable, minority" interest level of value (think public-share equivalent). Deviations from that anchor point are consequent from factors exogenous to the value of the enterprise. Some acquirers of controlling interests in a business might be able to pay more than the as-if-public price because of issues specific to them – usually operating synergies. Holders of minority interests in closely-held businesses might not be willing or able to pay as-if-freely-traded pricing because of the illiquidity inherent in the shares.PE relies on financial synergies (cheap capital and long time horizons) to fund their ambitionsThis chart is sacramental to the business valuation community, but the reality of the RIA industry suggests it's more of a tautology. Minority interests in RIAs often sell to institutional investors for multiples that rival control stakes, as the minority investors prize alignment with management control. And consolidators of control stakes in RIAs rarely have operating synergies available to pay premium valuations. Instead, PE relies on financial synergies (cheap capital and long time horizons) to fund their ambitions. Those financial synergies are fueling PE's competitive advantage when bidding for RIAs.Is Private Equity's Advantage in the RIA Space Durable?Ironically, recent public market volatility appears to be driving more retail investors to private equity from public markets, reinforcing this inversion of the levels of value chart. Will this last? It's hard to imagine the mass affluent providing a sustainable flow of funds to maintain PE behavior, especially if institutional investors reallocate elsewhere. And PE's current advantage may be their undoing.Private equity may be a permanent middle road between public and private ownership, but it’s still subject to the laws of financial gravity.Entry pricing is, after all, a highly reliable indicator of expected returns. Earning enough to justify premium acquisition multiples requires leverage (financial risk), value-added stewardship (operating risk), superior exit pricing (timing risk), or some combination of the three. Plenty of PE skeptics have already been "early," and they don't need me to pile on. But I was raised to profess that public market returns were the logos, the reference point of finance. Our founder, Chris Mercer, had me tape a Levels of Value chart above my desk when I was a junior analyst. Private equity may be a permanent middle road between public and private ownership, but it's still subject to the laws of financial gravity.In the summer of 2008, the head of a prominent community bank told me he was grateful his bank was closely-held so he could avoid all the unpleasantness going on in the stock market. That perspective wasn't durable.

Last week my colleague, Brooks Hamner, took us down the rabbit hole of the impact of higher interest rates on valuation in the RIA space. With the expansion of acquisition multiples over the past few years, it’s a healthy reminder that very low interest rates helped fuel those higher prices, and that cheap debt is a two-way street.There’s more to the story, but, unlike most things in finance, the other economic factors that accompany higher interest rates exacerbate the negative impact on RIAs, rather than mitigating them. The Fed is raising rates, after all, because inflation is higher. Investment management is a labor-intensive business and has an expense base that is, therefore, highly sensitive to inflation. Further, higher interest rates don’t just hit RIA valuation multiples – they also impact the valuations of the very securities that RIAs charge fees against to derive revenue.If you haven’t already (I imagine many of you have), this is an excellent time to stress-test your financial condition to see what impact weakened markets, higher inflation, and rising interest rates will have on your firm.Base Case: Successful Wealth ManagerAssume a successful wealth management firm with $5 billion in AUM that generates fee revenue at a blended rate of 75 basis points. On the expense side, salaries run about $15 million which, at 40% of revenue, is within norms. Variable – or bonus – compensation runs 20% of pre-bonus EBITDA, after consideration of non-personnel related expenses which total 20% of revenue. The net result of this is an EBITDA margin of 32% - very healthy for the sector. With strong margins and a variable compensation structure that buffers some of the impact of changes in profitability, this is the profile of a firm designed to weather most RIA operating environments.Base Case Plus DebtNow, let’s take our sample firm case one step further, and assume that part of this wealth manager’s business was acquired in recent years in leveraged purchases using covenant-light financing from a non-bank lender. Acquisition debt outstanding is $30 million, amortizing over 15 years at a base rate plus 550 basis points, or (until recently) 5.75%. This computes to annual debt service of about $3.0 million.Under the circumstances described in our base case, debt is well within conventional covenants, with debt to EBITDA of 2.5x and debt service coverage (EBITDA to debt service) of nearly 4x.Threat 1: Impact of Bear MarketAs I write this, major U.S. equity indices are down between 15% and 25%. Normally, a wealth manager could expect falling equity markets to be offset by a flight to quality. That market rotation would increase bond prices, or at enable help them to hold steady and offset the impact on AUM from falling stocks. As we all know too well, debt markets haven’t offered any shelter from the equity storm this year, such that it’s difficult to assume much help from fixed income to mitigate the downturn in equity markets. Higher rates appear to be repricing different classes in such a way that we’re seeing more correlation than usual – certainly more than we would prefer.A 20% drawdown in AUM has a corresponding impact on our sample firm’s revenue, but the only expense offset is to bonus compensation. With this one change, our sample firm’s EBITDA margin declines to 17.5%, and the leverage ratio doubles.Threat 2: InflationInterest rates are rising because inflation is well above the Fed’s target. Lots of expenses borne by RIAs are subject to inflation. The biggest expense for a wealth manager is, of course, labor – and especially so in this market because talent is scarce. The RIA industry may actually be experiencing negative unemployment, as the demand for skilled staff from client-facing to compliance positions exceeds the number of people employed in the industry. Peruse your LinkedIn and you’ll see investment management talent playing musical chairs, all of which threatens to increase costs for everyone at something exceeding inflation. In major markets, non-staff costs like rent are back on the rise, and other costs from tech to insurance are at least keeping pace.If we increase fixed costs at 10%, overall expenses grow considerably. Again, because of the hit to profitability, bonus compensation drops – at least in theory. Cuts in variable comp may prompt staff to look elsewhere, increasing talent replenishment costs and reducing the function of profit-sharing schemes in cushioning the blow of lower margins.Couple inflation with the drawdown in markets, and the EBITDA margin is cut even further. At this point, leverage ratios are beyond compliance levels even for non-bank lenders, and our sample company is at risk of not being able to service its debt.Threat 3: Higher Interest RatesIf EBITDA drops when interest rates are increasing, what does that do to our sample firm’s ability to service their debt. Well…it doesn’t help. If interest rates increase by 300 basis points, which seems to increasingly be the consensus, our highly diminished EBITDA barely covers principal and interest payments.Efforts to stave off default mostly include restructuring debt into longer amortization terms and cutting owner compensation. My stepfather often told me that you can always tell which one of a banker’s eyes is glass: it’s the one that shows sympathy.What About You?This illustration is overly simplistic, but useful nonetheless. Consider what this means for your own firm. If you’re interested, shoot me an email and I’ll send you the excel file behind this post that you can use to build your own stress test. Or hire us and we’ll do a more elegant version using your particular circumstances.I was reminded this week of a few comforting words from noted British economist Elroy Dimson: “Risk means more things can happen than will happen.” Given the possibilities I’ve presented here of things that can happen, we can all hope that other things will happen. Dimson probably didn’t intend to be quoted on this matter in the spirit of optimism, but right now it sounds better than President Jimmy Carter’s description of similar times: malaise.

RIA group-think has been pro-consolidation for the past decade, and increasingly so. You've read the headlines about the pace of deals reaching a fever pitch last year and continuing into this year. We've been skeptical of the believed necessity for RIA consolidation in this blog in the past, and have yet to be dissuaded from our position. But opinions are only opinions, and facts are facts. This seems like an opportune moment to check our feelings against reality. How is RIA consolidation performing so far? The verdict from the public markets isn't very encouraging. We look at three publicly traded consolidators of wealth management businesses, Silvercrest, CI Financial, and Focus. Over the past five years, Silvercrest Asset Management Group (SAMG) showed cumulative share price appreciation of less than 65%, underperforming the Russell 3000 by over 2200 basis points. To be fair, SAMG pays a reasonable dividend, and its wealth management clients are probably not 100% invested in equities. Nevertheless, we think of RIA returns as being leveraged to the market, and in an era of strong markets a wealth management firm with organic growth plus an acquisition strategy should – in theory - be able to outperform broad indices. SAMG didn't beat the market, but it outperformed a couple of rivals. Focus Financial Partners trades less than 25% above its IPO price from the summer of 2018, in spite of a tremendous number of acquisitions and sub-acquisitions. Focus doesn't pay a dividend so 22% cumulative return is the total return for FOCS shareholders since going public. CI Financial has fared even worse, as the Canadian shop revered for its willingness to pay top dollar hasn't posted a positive return over the past five years, even if you count dividends. Keep in mind, all of the above happened in an era of strong equity markets and low interest rates – what should be optimal conditions to consolidate the RIA space.Obligatory Car StoryThe business climate of the late 1990s was one in which consolidation was rife in nearly every industry. Rollup IPOs were the SPACs of the day, newly minted dot-coms were trading their highly inflated equity currency for other companies' highly inflated equity currencies, and old economy manufacturers were teaming up to share branding, technology, and overhead. Sometimes this worked very well, and sometimes it didn't.It's often said that most M&A results in failure. The free-wheeling, mass-market managers at Chrysler could never agree on expectations with the hierarchical, engineering-led team at Daimler-Benz. The loveless marriage resulted in unfortunate offspring like the Pacifica crossover and the R-class. Less than a decade after the 1998 merger, Daimler unloaded Chrysler to Cerberus for about 25% of the $36 billion it had originally paid.At the same time, a more unlikely pairing actually worked. The 1998 sale of Lamborghini to Volkswagen's Audi division turned out to be wildly successful. Italian styling and German build quality make a good combination, and today Lamborghini sells almost fifty times as many cars annually as it did before Audi bought it. It hasn't caught up with Ferrari yet, but it's close enough to make the guys in Modena pay attention.Investment ThesisLooking back on the two auto industry transactions sheds some light on the expected performance of RIA deals. One way to compare Daimler-Chrysler and Audi-Lamborghini is to consider why they happened in the first place.Daimler-Chrysler was a bulking-up, bigger-is-better, merger-of-equals. The logic was driven by internally-focused economies of scale, and it wasn't clear who was in charge. That left an environment that was unusually hospitable to culture clashes that undermined opportunities, synergies, and (ultimately) sales.Audi-Lamborghini was product-focused, and it was clear from the beginning who acquired who. Huge increases in Lambo sales and the opportunity to equal or surpass their old rival with the Prancing Horse kept internal dissent at bay.Which transaction looks most like the typical RIA deal? The investment thesis for investing in RIAs (whether asset management or wealth management) is straightforward: sticky revenue and operating leverage produce a sustainable coupon with market tailwinds. In an era of ultra-low yields, it's the best growth-and-income trade available, and it's become a crowded trade with a diverse array of institutional investors and family offices. As we've said many, many times in this blog, it's easy to see why one would invest in investment management.Consolidation ThesisInvesting in RIAs is one thing; consolidating them is quite another. Still, the themes that drive industry consolidation are equally well-rehearsed:Scale. With 15,000 or so RIAs in the United States alone, solving for fragmentation seems like an obvious play. Consolidation wonks tout the financial leverage that comes with economies of scale, enhancing margins, distributions, and value.Access. Larger firms theoretically are able to source more sophisticated investment products, technology stacks, and marketing programs.Problem Solving. Sellers have to have an impetus to give up control over their own destiny, and consolidation is often seen as the solution for aging leadership (or at least aging ownership) without a compelling succession path.Financial Engineering with Debt. Covenant-light debt at low rates has made capital widely available for public and private acquirers alike. Banks will typically lend at 3x and non-bank lenders at as much as 6x. With Libor near zero, even premiums on the order of 500 to 600 basis points make LBOs compelling.Financial Engineering with Equity. Multiple arbitrages has been the handmaid of cheap debt. At one point, it was "buy at five to six times, sell at eight to nine times." Then the spread was 9 to 12. Then it was 12 to 15. Then it went further. The whisper numbers usually outpace reality, but the logic is the same. All the above is widely accepted in the industry, and it's easy to see why. But if Fed activity stalls equity, while at the same time raising the cost of borrowing, things could change abruptly. This wouldn't just threaten industry consolidation for financial reasons, it might also expose some flaws in the consolidation thesis.Diseconomies of ScaleIf you put ten RIAs together that each makes $5 million in EBITDA, your combined operation will make $50 million in EBITDA. Your holding and management operation, however, will probably need an executive team with a C-suite, an accounting department, a marketing department, legal, compliance, investor relations, and a couple of pilots for your jet. They'll all need office space in a nice building, even if they mostly work from home. The subsidiary level profitability will inevitably be eroded by monitoring costs.Some of this expense may be replacing functions that would previously have happened at the subsidiary RIA level, but not all of them. Is there enough expense synergy in consolidation to cover the overhead costs of a consolidator? I doubt it.In the asset management space, there is an argument that AUM can be added faster than overhead, and margins can expand almost infinitely (we've seen some big ones). In wealth management, it's a tough slough. When Focus Financial went public, we thought that, even with massive growth, it would be hard to get their adjusted EBITDA margin above 25% - the level we're very accustomed to seeing on a reported basis at wealth management firms of more modest proportions. A publicly traded consolidator might have more than 100 souls on board at the management company level. That's a lot of payroll to cover with subsidiary-level synergies.AccessibilityAre small firms disadvantaged when it comes to necessary products and services? With custodians eager to accommodate all manner of investment products, outsourced compliance, subscription-based tech, and scalable marketing, it's easier than it has ever been to compete as a sub-billion dollar RIA. Scale enables firms to have positions to manage these functions, but it doesn't provide the functions themselves. We aren't experts in RIA operations, but we haven't yet seen a small firm struggle because it couldn't get what it needed (or wanted).Exit and SuccessionConsolidators offer exit capital for RIA founders. In that regard, they can resolve the standoff between generations of leadership and pay senior members a price that next-gen staff either cannot or will not pay. But a cheaper source of capital (or greater appetite for risk) is not a surrogate for succession.Since most of the consolidators in the industry are relatively new, we don't know a lot about whether these models are sustainable. RIAs are not capital intensive, but they are highly dependent on staff to manage both money and relationships. Often the staff who will generate returns for the consolidator in the future don't get a lot of equity consideration in the transaction. And will the founding generation work as hard for their new boss as they did for themselves?These conundrums have led many consolidators to structure earnouts or develop hybrid ownership models that share equity returns in some form or other with subsidiary RIAs. One touts promising to never turn "an entrepreneur into an employee" – which sounds reasonable. Ultimately, though, the staff at subsidiary operations are sharing equity returns with the parent company, and the principal/agent dilemma is less a dichotomy and more of a spectrum.As such, the consolidator will be paying for a firm run by highly motivated founders and getting a firm that will ultimately be run by differently motivated successors. RIA consolidation is the act of simultaneously acquiring the operating asset and accepting the succession liability.Financial De-EngineeringMost RIAs, by far, operate on a debt-free basis. Usually, this is for the obvious reason that there isn't much of an asset base to finance, so why bother. Consolidators, on the other hand, frequently rely on debt financing and, as deal prices have increased, so have leverage ratios. Financing a cash flow stream that is in many ways leveraged to Fed activity works very well in the era of declining and low interest rates – as we have seen.Rising rates and falling (or stagnant) markets lead to higher debt burdens and lower cash flows to service that debt. Add to that the threat of inflation increasing payroll burden. In normal times, there would be enough equity cushion to protect against default. With higher deal multiples – based on highly adjusted EBITDA measures - and the massive leverage available from non-bank financing, we could be in for some nasty surprises.If coverage starts tightening, deal activity will fall off, and multiples will drop. If multiples drop, acquirers won't be able to exit on satisfactory terms. Without equity compensation as a carrot, producers will find an exit for themselves. The unfortunate reality of leveraged RIAs is that their assets get on the elevator, but the liabilities never leave.Climate ChangeI'm not calling it the end of the RIA consolidation trend. For many reasons, it could continue for years to come. But the performance of publicly traded consolidators has been lackluster, in spite of very favorable conditions in which those business models should thrive. Now that we have the prospect of RIA stagflation, it could become very difficult to maintain a land-grab mentality that operates as if the acquirer is valued on the basis of price-per-press-release.

A couple of weeks ago, the crew of a ship known as The Felicity Ace noticed smoke coming from the cargo hold. Below deck were 4,000 cars being ferried from Europe to Rhode Island, including at least 2,000 Volkswagens, 1,100 Porsches, and nearly 200 Bentleys. The fire spread quickly and the 23 members of the crew were evacuated by a Portuguese military helicopter. The ship was left to drift several hundred miles off the coast of the Azores; bad weather has made it difficult to reach The Felicity Ace and tow it to port. The ultimate fate of the ship and its cargo are still unknown, but it’s certain to be a mess.I was reading about The Felicity Ace while we were publishing our recent blog series on buy-sell agreements (here, here, and here). The former is a decent metaphor for the latter. When RIAs are formed, they often enter into some kind of shareholder agreement whereby the parties agree upon rules to buy or sell ownership interests under given circumstances. No one thinks much about it because the expectation of a terminal event – like the sale of the business or the retirement of a member – is so far off in the future. It’s like loading 4,000 cars on a ship and sending it out to sea, assuming that, at the end of the journey, the cargo will be reliably delivered and offloaded in good condition. No one thinks about the ship while it’s on the way from one destination to another until a fire breaks out.Our consistent experience is that few RIA owners review their buy-sell agreements until something UN-expected happens. The partners argue over the future of the business. Someone gets divorced. Someone gets in trouble with the SEC. Someone dies suddenly. At that point, the buy-sell agreement goes from being a forgotten afterthought to the only thing on everyone’s mind. And, unfortunately, that one thing may be subject to interpretation.Our consistent experience is that few RIA owners review their buy-sell agreements until something UN-expected happens.The biggest problem we see in shareholder agreements: pricing mechanisms.If a buy-sell is triggered and a 25% shareholder is to be redeemed, what’s the transaction price?I probably don’t have to tell you what we think of formula pricing. Is the formula a multiple of trailing, current, or forward earnings? Are appropriate multiples reflective of long term averages, current market pricing, good times, bad times? Meant to represent a change of control multiple? To a financial buyer or a strategic buyer? Rational buyer looking for ROI or irrational buyer making a land grab? Pricing reflective of highly synergistic deal terms (use our vendors, sell our products, adopt our brand) or on a stand-alone basis? Sale of actual equity interests or a hybrid instrument that asymmetrically shares upside but protects the buyer against downside?We had one situation where the agreement called for pricing an interest based on “prevailing market value.” What does that mean? Current prevailing market conditions work something like this: RIA with reported EBITDA of $5 million and adjusted EBITDA of $7 million at the time of negotiating the LOI, and reported EBITDA of $6 million and adjusted EBITDA of $8 million at the time of closing, sells for upfront consideration of $40 million plus the potential to get an additional $20 million in earnout if profits grow by 25% in three years. What’s the multiple? Is it:5x (upfront consideration as a multiple of adjusted EBITDA at closing)?6x (total possible consideration as a multiple of hurdle EBITDA at the time the earnout is paid)?7x (upfront consideration as a multiple of reported EBITDA at closing)?5x (total possible consideration as a multiple of adjusted EBITDA at closing)?8x (upfront consideration as a multiple of reported EBITDA at negotiation)?9x (total possible consideration as a multiple of adjusted EBITDA at negotiation)?10x (total possible consideration as a multiple of reported EBITDA at closing)?12x (total possible consideration relative to reported EBITDA when negotiated)? Naturally, the seller wants to believe they sold for 12x, and the buyer wants to tell his capital providers he paid 5x. It does no good to ask parties what multiple was paid. We find that when people whisper deal multiples they tend to go for the highest number possible – in most cases the maximum transaction proceeds possible as compared to a trailing measure of reported earnings. This makes more than a bit of sense, because it’s also self-serving. The seller gets to brag about what he was paid – and we all value psychological rewards. The investment banker brags about what a good job she did – and she probably did do a good job. And the buyer gets a reputation for paying up so the potential sellers will return his call. All of this is good for the deal industry, but not especially revealing as to valuation.We find that when people whisper deal multiples they tend to go for the highest number possibleAbsent some reliance on formula pricing or headline metrics, you can hire an appraiser…like us…but even that’s complicated. Do you pick a valuation specialist or an industry expert? Valuation people characteristically rely on DCFs that might be more expressive of intrinsic value than market. That’s not me engaging in professional self-loathing – it’s just how my tribe is wired. Then there are industry experts – usually investment bankers – who’s perspective leans heavily on the best deal they’ve heard of recently with a highly-motivated and over-capitalized buyer and a pristine target company with strategic relevance.If you hire a valuation expert with ample amounts of relevant industry experience (like us), you should get a balanced approach to the pricing of your transaction. But even the best resources out there (like us) have to deal with pricing expectations set long before we are involved. A buyer who wants something akin to intrinsic value and a seller who wants the high bid from a strategic buyer in a competitive auction are going to have a hard time coming to terms with the result of any valuation exercise. That situation is more common than not.I’ll offer two closing pieces of advice on crafting the valuation mechanism in your buy-sell agreement:Get your RIA valued on some kind of regular basis. If you have a smaller firm, a valuation every few years may suffice. If you have a larger firm, you might need it more than once per year. What this manages, more than anything, is expectations. The psychological bid/ask spread I describe above is much more narrow when the parties to an agreement are accustomed to seeing particular numbers, methodologies, and metrics used to determine the value of their interest. This is the main function of regular valuations. Buy-sell valuations are five-figure exercises. Buy-sell disputes are seven-figure catastrophes.Don’t draft your pricing mechanism to intentionally privilege either the buyer or seller at the expense of the other. We’ve seen estate situations where the company was compelled to redeem a 25% stake for about 45% of the value of the business. The resulting dilution to the remaining shareholders put a huge strain on the business model, ownership transition, and sustainability of the company. We’ve seen shareholder squeeze-outs where a group of shareholders were entitled to kick out a partner for minimal consideration. There’s no virtue in democracy when two lions and one lamb vote on what to have for dinner. Regardless of what you think your RIA is worth, if you aren’t intimately familiar with the terms of your buy-sell agreement, you don’t know what your interest in your RIA will net you in a transaction. Pull your agreement out, and read it. If it seems at all confusing as to how it will function when the buy-sell mechanism is triggered, it will be worse than you expect. There has been considerable speculation as to what sort of cars are in the hold of The Felicity Ace. Are they all conventional internal combustion engine cars with a minimal amount of gasoline in their tanks, or are some of them EVs carrying highly combustible lithium-ion batteries? Whichever the case, it’s too late now to do anything about it. Don’t wait until your ship is adrift and on fire to check your buy-sell. If business is good and your partners are happy – consider this your opportunity.

Two economists are walking along, and one of them says, “Look, there’s a hundred dollar bill on the sidewalk.” The second economist says, “It can’t be a hundred dollar bill; if it was, somebody would have picked it up by now.”Most economists believe in market efficiency. This belief requires a healthy dose of skepticism, which some see as cynicism. That characterization is unfair.Real Versus RareMy family was staying at the Grove Park Inn a few years ago when we spotted what looked exactly like a Porsche 904 GTS in the motor court (photograph above). It looked just like the mid-60s racing legend, with a short wheelbase, a very low roofline, and a detachable steering wheel (to assist getting in and out of the driver’s seat). Convincing, but I knew it couldn’t be real; highly unlikely that anyone would drive such a rarity to dinner (about 100 were built), even on a beautiful day in the mountains of North Carolina. A little research revealed it to be a kit car made by Chuck Beck – also rare but considerably more accessible than the original.Last week we were surprised by an equally rare sighting, an S-1 filed by a prominent player in the RIA community. Dynasty Financial Partners seeks to raise $100 million in a public offering. The mercifully terse prospectus is less than 250 pages, and is recommended reading for anyone who swims (or fishes) in this pond.The mercifully terse prospectus is less than 250 pages, and is recommended reading for anyone who swims (or fishes) in this pond.As most of the readers of this blog know, DFP is the ten-year-old brainchild of Shirl Penney, Edward Swenson, and Todd Thomson. The company provides a variety of services to both foundling and established RIAs, but principally engineered a plug-and-play back office for RIAs, sifting through the myriad of technology vendors needed for wealth management and organizing them on a proprietary platform called the Dynasty Desktop.The pitch for potential clients is self-evident: RIAs of any scale can access the tech stack of a big firm on a subscription basis. Dynasty stays on top of tech developments better than (most) in-house teams.Complementing this is a TAMP and access to growth capital. Being a Dynasty Network firm situates wealth management shops in a broader community of firms with similar interests, needs, and requirements. Client firms get to focus on what wealth managers do best: stay at the front of the house, developing their business, while Dynasty manages the back of the house, supporting their business.Great narrative. DFP’s financials are promising, if lighter than expected. Dynasty’s PR group is to be commended: the firm has developed an outsized prominence in the industry relative to its actual size.Dynasty has a recurring revenue stream (most of its services are priced as basis points on AUA) and the scale of the business has more than quadrupled in the past five years. Nevertheless, in the nine months ended September 30, 2021, Dynasty reported a bit less than $50 million in revenue and only $12 million in adjusted EBITDA. While adjusted financial metrics sometimes warrant criticism, Dynasty’s reported EBITDA was only off $750K or so for the same period.While full year financials aren’t yet available, we estimate run rate revenues of $75 million or more, with adjusted EBITDA approaching $20 million. Dynasty’s unit economics are enviable, with a growth-plus-margin metric, so often cited by SaaS investors, of nearly 75% (period-over-period revenue growth of 50% plus an EBITDA margin of 24%).What’s Not to Like?As available investment opportunities go, Dynasty looks great except for one thing: it’s available. Why is this hundred dollar bill on the sidewalk? More specifically, why is a firm with this story and size not being funded by private equity?There’s no shortage of private equity investors in the B2B, fintech, or RIA space; Dynasty should appeal to them. As a B2B, Dynasty has a track record of attracting and retaining demanding RIA clients with their platform. As fintechs go, DFP is certainly more interesting than the myriad of buy-now, pay-later startups that seem to attract nearly limitless capital these days. Compared to the many PE-backed serial acquirers in the RIA space, this is an actual business…with products. Surely, selling picks and shovels to RIAs is less speculative than being an RIA.Surely, selling picks and shovels to RIAs is less speculative than being an RIA.Why would management want to go public? Running a public company is no walk in the park, and most management teams don’t choose that path instead of PE backing, especially with less than $100 million in revenue. As such, we have a few questions:Is the Dynasty Desktop a comprehensive, proprietary technology solution for RIAs, or middleware that is easily replicable? The answer may depend on the client, but if it’s the latter, Dynasty is at risk of being exposed to more competition if the market for their platform becomes more visible. Their offerings could be featurized by custodians or custom-engineered by developers. The more success they achieve, the more competition they’ll attract.Is Dynasty’s fee schedule sustainable?We don’t have enough information to infer what Dynasty has been able to charge for their services over time, but current returns suggest a realized fee across all of their segments (tech stack, TAMP, etc.) of about 11 basis points. The S-1 suggests that fees are negotiable, and larger RIAs probably pay fewer bps than small ones. At the same time, Dynasty probably earns most of its profits from larger clients, because the base cost of service won’t be that different for a $200 million RIA and a $2 billion RIA.If the wealth management industry experiences fee compression, what does that mean for Dynasty? RIAs have the option of paying a consultant a one-time or infrequent fee to build a tech stack instead of regular subscription fees. Smaller RIAs have an obvious incentive to get someone like Dynasty to handle the back-of-the-house stuff so they can focus on wealth management. Larger RIAs can disintermediate and build their own margin with direct vendor relationships.What is normalized profitability for this company? Under the right circumstances, SaaS can throw off huge margins. Here, the margin opportunity is hard to assess, although the potential for operating leverage is obvious. Dynasty currently serves 46 firms with 75 employees. How much additional headcount would it take to service 80 firms, and how specialized would those additional staff be? We suspect that DFP’s move to Florida was part of an effort to right-size its cost structure. While many rue the outflow of financial businesses from New York, we see it as both prudent and inevitable. Being public, on the other hand, has costs of its own, and DFP will have to outgrow those costs to make the IPO worthwhile.What is the cost of remaining relevant in this space? It’s easy for in-house tech specialists to fall behind the competence curve. When they do, companies lose opportunities, fall victim to malware, and profits suffer from inefficiency. Outside tech providers can offer the latest and greatest and are pros at keeping themselves and their clients current. But remaining current is expensive, and one wonders if a company the size of Dynasty can handle the tradeoff between the margin they make from today’s products and services and the cost of developing tomorrow’s products and services. Dominant technology companies are either very niched or very large. The Dynasty S-1 is mostly routine, except for one section outlining their efforts to remedy problems with their internal controls. It’s probably nothing, but we’re surprised by this, as competent management of back-office issues is what DFP is supposed to be selling to RIAs. If Dynasty could have waited a bit on their IPO, they could have cleaned up and avoided the disclosure.Price Versus ValueSo what’s the verdict? It all comes down to price. We know Dynasty wants to raise $100 million, and we estimate they have nearly $20 million in EBITDA. How much of that EBITDA will $100 million buy? We’ll soon find out.It all comes down to price.The Beck 904 is faster, more comfortable, and more drivable than an original Porsche 904. It’s not “real,” but it’s real cool. And the Beck is much cheaper than the original, priced at less than 5% of the auction value of the Porsche. At $75K for a fully outfitted Beck and $2 million for the Porsche, each priced to reflect the underlying value of the car.

Knowing why you’re successful is a key to sustaining success.  Porsche made its mark in auto racing in the 1950s by turning the race for better power-to-weight ratios on its head.  While most automakers focused on the numerator, building bigger cars with more powerful engines, Porsche worked to keep the car's light - not only to improve acceleration, but also braking and handling.  The formula worked both on the track and in the showroom, and Dr. Ferry Porsche never lost sight of what made his cars competitive and sought after.  On roads that are a monotonous sea of SUVs, the 8th generation 911 Carrera stays true to an identity that Porsche established in the 1950s with the 550 Spyder and the model 356.  Although the weight has crept up over the years, power increased even faster. Engineering advances have added double-clutch gearboxes, all-wheel drive, four-wheel steering, ceramic-disc brakes, and (to the horror of the Porsche faithful) water-cooling to Porsches.  However, the core identity of the product has remained intact and forms the intangible that Porsche has monetized for over 70 years.  Today, the waiting list for a new one is impressive.Despite the recent volatility, it’s been another very good year for the RIA community.  Markets, on the whole, are strong, tax rates didn’t skyrocket, margins are thick, and transaction activity continues unabated.Success, alas, can be fleeting.  While some in the industry are focused on continued opportunities and upside in the years ahead, it’s hard to ignore calls that corporate earnings growth is slowing, the yield curve is flattening, commodity prices are worrisome, emerging markets are uneven, fee pressure is growing, and the world is bracing for another round of COVID.  Whatever brings about the rollover in industry trend lines, we all know it’s coming at some point.So if, indeed, 2021 is the peak of the cycle for the investment management industry, what will you one day wish you had done now?1. Know What Got You HereThere’s an old proverb that says something to the effect of every ship has a good captain in calm waters.  If your RIA has grown in AUM, revenue, and profitability over the past decade, you’re not alone.  Think about why your firm grew.  Did you add productive financial advisors to your wealth management practice?  Did you add attractive asset management strategies?  Did your assets under management increase because you broadened your appeal to a larger range of clients?  Did you develop deeper relationships with existing clients?  Did you grow organically or was most of your growth the result of acquisitions?  Are your effective fees charged steady or increasing?Most revealing is to look at whether or not your AUM grew because of market tailwinds or because of new clients.  Bull markets come and go, of course, so building the fundamental value of your investment management firm is really contingent on having an asset acquisition strategy (i.e. marketing) to bring in new clients and new client assets net of terminations and client withdrawals.  You will always face some client terminations – you don’t want to do business with everyone anyway.  Even good wealth management clients will eventually spend their money, and institutional asset management clients will reward your outperformance by rebalancing their commitment to you.  We all know that some attrition is unavoidable and, ultimately, healthy.  You just can’t rely on favorable markets to keep your revenue base stable or growing.2. What Will Your Firm Look Like in Five Years?Corporations can be perpetual, but the people who work at them eventually leave.  Because investment management is necessarily labor-intensive, your firm is a function of the career cycles of your staff.  Five years from now, everyone who is still at your firm will be five years older.  Stop for a minute and think about what that looks like.  The RIA industry is, as a whole, facing demographic challenges, and by some measures, there are more financial advisors in the career wind-down stage than there are in the career development stage.So what will your staff look like in five years?  Will any of them have retired?  Will any have new skills and/or credentials?  How will titles, roles, and responsibilities change?  What turnover are you likely to have?  Will you need to replenish turnover from experienced hires or will you train people who are new to the industry?  In other words, as you look at the changes that will likely happen to your staff over the next five years, will those changes grow your firm, maintain it, or are you at risk for attrition to your collective intellectual capital.3. Stress Test Your MarginsIt’s more than a little ironic and unfortunate that there are so many forecasting tools for individuals but so few for businesses.  Just like wealth management firms run Monte Carlo simulations on portfolios to model likely outcomes for clients given different market scenarios, so too you need to think about how your firm will fare during unfavorable external circumstances.Profit margins have a very real business continuity function that is easy to forget after long stretches of upward trending markets.  If your firm currently boasts a 25% pre-tax margin, for example, you could suffer the loss of a quarter of your revenue stream and, theoretically, not have to cut your expenses.  This isn’t pleasant to contemplate, but if a sustained bear market cut your AUM by 20%, and then client financial stress caused a greater than usual rate of withdrawals, you could see a considerable decline in your top line.  Since the only way to meaningfully reduce expenses in the RIA business is to cut staff, responding to unfavorable financial market conditions can have a long-lasting impact on the scale and value of your firm.  It’s worth considering such a likelihood, and it’s much easier when you aren’t under the stress of the event itself.4. Consider Your Exit OptionsWith M&A on the rise, private equity increasingly interested, and new consolidation schemes emerging on a weekly basis, there has never been a more interesting time to consider how you might liquefy an interest in an RIA.  Remember, though, that most ownership transitions in investment management firms are still internal because transacting staff, clients, and culture is difficult, even with favorable industry conditions.  Outsiders don’t always “get it,” and insiders don’t want them.If you had to sell right now, how would you do it?  If you don’t think your firm is ready to take to market, what changes need to be made? If you intend to transact internally, do you foster a culture of succession? There’s no room here for an exhaustive analysis of exit planning for RIA owners, but suffice it to say that you should always be aware of your possibilities.  If you can’t find the door in good times, what will your plan be following the next correction?5. Remember That Long-Term Industry Trends Are FavorableAt some point, things are going to get rough, and the performance of your RIA is going to deteriorate.  When market valuations tumble, clients get nervous, and staff stress rises, it can feel like at least your professional world is coming to an end.  Broad industry trends, though are very favorable to the investment management community.  New retirees make up the largest source of new clients for wealth management firms (and, in turn, asset managers), and the number of retired persons in the U.S. will continue its upward trajectory for decades to come.  Assets continue to flow away from wirehouses and toward independent advisory practices.  And last but not least, markets are – over time – upward drifting.  None of that is going to change with the next bear market.So while the fundamentals of your firm may appear to deteriorate during bear markets, the fundamentals of the industry will continue to drive success for a long time.  Today, the fundamentals of your firm are probably the best they’ve ever been.  That’s why this is the perfect time to consider your formula for success, prepare for the next downturn, and build the competitive momentum you’ll need to ride the industry trends to greater success in the future.

Last week I got an email from the finance company that holds the lease on my car announcing that the “countdown had begun.” My lease ends in May, and the manufacturer was encouraging me to start thinking about my next vehicle – even offering to waive the $575 lease disposition fee if I terminated the lease early. Strange, I thought. Given the scarcity of new vehicles in the market, why is the manufacturer’s finance company offering me incentives to join the line of people who want but can’t get a new car?Eager to uncover the motivation for this surprising act of Teutonic generosity, I reviewed my lease agreement to see if I could solve the mystery. Knowing I had the option the buy the car at the lease’s stated residual value, I also checked some used car listings for comps with the age and mileage my roadster will have in May. This exercise suggested my car will be worth about 40% to 50% more than what I could buy it for at the end of the lease. So, my call option is in the money, and the finance company is keen to let me surrender that option to them.Alas, my good fortune isn’t all that good. If I choose to buy-and-hold my car at the end of the lease, I can’t monetize the option. If, instead, I buy-and-trade my car for something else, I may get market value, but I’ll have to find something to buy. These days that will cost me both in terms of time and money. At this point, the only thing I know for sure is that I won’t be returning my car to the finance company. Sorry fellas.In the Market for a Good Used RIA?A couple of times a week, we get calls from someone we’ve never met saying they’d like to talk with us about their RIA acquisition strategy. About half are RIAs or trustcos looking for expansion, and the other half are private equity or family offices. Very few are calling because they have a particular target in mind; fewer still have begun the process of negotiating with a potentially interested seller.If your acquisition strategy these days is starting from scratch, you’re in a tough spot. There’s nothing on the lot, and what is available looks expensive. That doesn’t mean you should give up, though. Here are some practical tips to pursue an acquisition strategy in this market environment, as well as the markets to follow.Build relationships. Sellers faced with a dozen potential suitors often exhibit a common behavior: they don’t know what they like – they like what they know. Sellers are drawn to preexisting relationships, even when the offer from those parties doesn’t quite measure up to other offers. This makes a lot of sense given that selling an RIA often means going into business with the buyer for several years. Acquisitions are a process, not an event, so get to know the people you might want to be in business with – early and often. It’ll help you win the auction – or avoid it altogether.Deliver what you promise. The most frustrating part of the transaction process is when counterparties (or their advisors) don’t meet deadlines. If indications of interest are due on Friday, don’t call on Friday to ask for more time. You might get it, but you’ll also earn a reputation for not meeting expectations, which will make sellers leery of dealing with you. Sellers are usually represented, and buyers often aren’t. If you need professional assistance in pursuing an acquisition, get them on board so that you’ll maximize your opportunity.Consider alternative structures. Not every seller needs or even wants a check. Some want a partner. Some want your stock. Some want a joint venture. Ask questions about the underlying needs of the seller to find out how you can creatively accommodate their needs and meet yours as well. Winning a deal isn’t always about being the high bid – it’s about being the best bid.Accept pricing for what it is. For lots of very rational reasons, pricing in the RIA space is high. It might not be quite as high as reported, because everyone in the deal community is motivated to dress up the multiples as much as possible (we’ve written before about reported versus pro forma numbers, pricing with and without earn-outs, the impact of rollover equity, etc.). But, like prices for new and used cars, RIAs are worth top-dollar. Neither situation is going to resolve itself anytime soon. Microchip availability may drive the supply/demand imbalance in automobiles for years. Low interest rates and a flood of PE capital may do the same for RIAs.Turn your acquisition strategy on its head. If you accept the fact that this is a seller’s market, why do you want to be a buyer? Think about selling - or merging - into a larger firm. As part of a larger buyer, you’ll have more support (talent and capital) for building through acquisitions, and you’ll have the benefit of firsthand experience as a seller.Don’t get caught up in FOMO. There is a frenzy to buy RIAs, but that doesn’t mean you have to be part of it. Discipline still matters. Some buyers are so desperate to acquire an RIA that they’re willing to look at “opportunities” that don’t make any sense. Remember that opportunity is a two-way street. The bull market of the past twelve years has redeemed a lot of bad acquisitions in the RIA space. These days, everybody on the buyside feels smart.Don’t wait for the market to become rational. If you’re sitting this “period” out because you’re waiting for valuations to come down, find another reason. Prices may drop – but it may be a long time from now. If paying full freight for acquisitions doesn’t suit you, I won’t judge you. But don’t base your expectations for the future on the hope that things will change. They may not change.You might do better on your own. For most firms, organic growth is the best growth. Competing for acquisitions is hard, and integrating them is even harder. Conventional wisdom these days is that organic growth opportunities in the RIA space are narrowing and growth is slowing. But conventional wisdom yields conventional results. If you can devise a way to generate organic growth, you’ll gain control over your future – and a standout presence as a target one day. Shortages and tight markets are more the exception than the rule right now. I’ve heard an emerging theory in fixed income that rates will stay “lower-for-longer.” If so, yield starved investors of all stripes will be drawn to the growth and income characteristics of RIAs – which will keep multiples “higher-for-longer.” Whether or not this turns out to be the case, the shortage of acquisition opportunities in investment management firms will likely outlast the shortage of microchips that’s plaguing car manufacturing, such that even scratch-and-dent RIAs will remain pricey. As a buyer, you can’t entirely sidestep this problem, but you can pursue some basic tactics that will help – both now and in the future.

Several pre-pandemic years ago, my family and I enjoyed a long vacation in England, touring the usual castles, cathedrals, and museums.  At some point in the trip, my kids noticed that many of the buildings we toured and historical objects we saw were in some way tied to, owned by, or were on loan from, the royal family. Whether it was Windsor Castle, the Crown Jewels in the Tower of London, or the Bentley limousines garaged at Buckingham Palace, much of what you see as a tourist in England is recorded on Her Majesty’s balance sheet.I took the opportunity to point out to my kids that a reliable way to accumulate wealth was to invest in assets you would never want to sell, and then don’t sell them. The best assets tend to remain the best, and the avoidance of transaction costs removes a drag on returns that everyone – in my experience – underestimates.The increased prominence of “permanent” capital providers in the RIA space takes me back to the multi-generational buy-and-hold strategy of the royals, not just because of the avoidance of transaction costs but also because of the premium entry prices being paid. In 1852, Prince Albert and Queen Victoria paid £32,000 for a vacation home now known as Balmoral Castle. What was that price relative to market? I don’t know, but 170 years later, it doesn’t matter.GPs at private equity conferences once liked to boast about their success in booking “gains on purchase” – a clever way of saying they could buy at a discount to market. No one talks that way in the RIA community these days. If anything, I’m struck by how sponsor-backed acquirers are willing to state, publicly, their willingness to outbid each other. I won’t call anyone out with specific examples, but they aren’t hard to find.RIAs are probably the best coupon available in a low-to-no yield environment.It’s as if a land-grab is underway, with competing interests looking to consolidate as much market share in the investment management community as they can, as fast as possible. The trouble is that RIAs are a sort of land that is actually still being manufactured. Despite the rampant consolidation in the space, the number of RIAs is steadily on the increase. Nevertheless, there is legitimate cause for enthusiasm.As we’ve written many times in this blog, investing in the RIA space represents a singular opportunity. RIAs are probably the best coupon available in a low-to-no yield environment. They are a growth and income play like none other. They are practically the apotheosis of diversification in a way that Harry Markowitz could have only dreamed of when he started publishing his research nearly 60 years ago.Unfortunately, many reasonable ambitions, stretched far enough, eventually become wellsprings of regret.Returns and valuations are inversely related, after all. An unfettered willingness to pay more is just a race to the bottom on ROI. Financial engineering doesn’t repeal the laws of financial gravity. Taking more and greater risks leads to a greater variability of outcomes. Paying more compresses returns. To my way of thinking, this isn’t prudent – but I’m not paid to manage capital.Professional investors must work in the market they have, not the market they want. It’s all well and good to talk about “patient” capital, but LPs aren’t going to pay 200 basis points for someone to hold their cash, regardless of how advisable that might be. Given that mandate, the question of whether to make investments at these levels pivots to how best to do it. What opportunities are available in the present – and potentially lingering – environment of high entrance multiples?Financial engineering doesn’t repeal the laws of financial gravity.I’ll posit that the rise of “permanent capital” providers is both in response to and appropriate for current market conditions in the RIA space. This is in sharp contrast to the prevailing “fund” behavior in the private equity community, in which LPs commit capital for a specified length of time – ten years or so – and fund managers have to make investment decisions with an expectation of being in and out of an investment in less time than that – say five to seven – to generate the kind of ROI it takes to raise the next fund.Anyone who’s spent a few moments (or a career) with DCF models knows that there are a limited number of levers to pull to rationalize a high entry price with a five-year holding period. You can assume supernormal growth (unlikely in a mature space like investment management), high exit pricing (multiple arbitrage - aka the greater fool theory), squeezing margins (underinvestment), or low discount rates (race to the bottom on ROI).The other possible lever is, of course, leverage. Debt can enhance equity returns so long as it doesn’t wipe them out entirely. Unfortunately, it’s only in hindsight that we know what leverage ratio is (or was) optimal.Making a permanent capital investment doesn’t eliminate the depressive effects of current valuations on returns, but it mitigates them. Without the pressure to generate an exit within the foreseeable future, RIA investors can focus on the opportunities for sustainable and growing distributions. The longer distributions persist and the more they grow, the less of an impact the entry price has on total return.Further, without the financial friction of trading out of an investment in a few years and the costs and risks of reinvestment, the opportunity for superior returns – especially relative to those available at similar risk elsewhere in the current market – is greater.The question of how long “permanent capital” lasts is a good one. The investors backing many of these enterprises tend to be insurance companies with very long time horizons.  The thousand-year outlook of William the Conqueror probably isn’t relevant to investing in RIAs, but the mindset of an indefinitely lengthy holding period leads permanent capital sponsors to different decision making, which may prove useful in times like this. It’s hard to think long term when the M&A headlines keep coming, but the business cycle has a lot of staying power. In this market, investors need staying power as well.

Ideally, our work with investment management firms at Mercer Capital distills both conventional valuation principles and real-world industry experience. These two influences typically align; valuation theory develops to represent the thinking of actual transacting parties, and – in turn – transaction behavior validates theory.Sometimes, though, we witness rational actors engaging in transactions that challenge certain norms of professional thinking. At such times, we ask ourselves whether valuation theory, as we know it, is doctrine or dogma.The pricing of minority transactions in the RIA space leaves some people scratching their head. Traditional valuation theory holds that investors pay less for minority interests than controlling interests. Reality suggests otherwise. Some established institutional buyers of minority interests in RIAs invest at similar, or even higher, multiples to what other consolidators will pay for controlling interests. Some institutional buyers even prefer taking minority stakes in investment management firms – not a circumstance we see much from the private equity community. Even insider transactions don’t always follow valuation maxims, as valuations for succession are colored by considerations far beyond the sterile realm of hypothetical buyers and sellers. It seems to some that the RIA community has turned valuation theory on its head, but the truth is more nuanced.Valuation Vacuum WonkeryConventional wisdom holds that minority interests in closely held companies are worth less than their pro rata stake in the enterprise. A 15% interest in a business that would sell for $10 million is widely believed by valuation practitioners to be worth something less than the $1.5 million that its pro rata stake in the enterprise would otherwise command. The difference between value inherent in controlling interests and minority interests can be illustrated by way of a diagram known as a levels of value chart. The value of an enterprise can be described as the present value of distributable cash flow – and this parameter is useful for thinking about the different perspectives of control and minority investors. A control level investor effectively has direct access to enterprise level cash flows, with unilateral influence over operations, the ability to buy, sell or merge the enterprise, pay distributions, and set compensation policy. Absent special considerations, a control investor can achieve the greatest benefit, and therefore pay (or expect to be paid) the highest price for an enterprise. Most reported transactions in the RIA channel are made on this basis, and M&A multiples reported publicly, or whispered privately, reflect change of control valuations. Minority investors lack two important prerogatives of control: influence and liquidity.Minority investors lack two important prerogatives of control: influence and liquidity. Discounts for lack of control – also known as minority interest discounts – reflect the inability of minority interest holders to direct the enterprise for their own benefit. The marketable, minority interest level of value is analogous to an interest in a publicly traded company, wherein investors can access the present value of distributable cash flow by way of an open market transaction but have no particular sway over a company’s strategy or operations.Discounts for lack of marketability (a.k.a. marketability discounts) capture the lack of access to enterprise cash flows via distributions or a ready and organized market to sell the interest. The nonmarketable, minority interest level of value is what most valuation practitioners think of when they think of minority interests in closely held enterprises: a value which is materially distinct from a pro rata controlling interest.Internal Transactions Challenge Valuation TheoryReal world economics of minority transactions in RIAs can look very different than our professional discipline would suggest, reflecting issues unique both to the industry and to the universe of typical investors in the industry.Much of the reason that RIA transactions don’t always conform to traditional valuation pedagogy is the nature of the investment management model itself. The theory behind the levels of value is intended to represent the perspective of hypothetical disinterested investors. In a world of financial buyers who can choose freely between alternative instruments, this idea holds.But most RIA investors are insiders, practitioners who work at the investment management firms. The lines between returns to labor and returns to capital are often blurred (although we strongly advise structuring your model otherwise). Insiders have different motivations to show loyalty to their employer, and in turn firms often bestow ownership on staff on favorable terms because of the labor-intensive, relationship-based nature of investment management.Insider ownership is often managed by buy-sell agreements, which at the same time restrict owners from certain actions but also provide them with access to liquidity (under specified circumstances) and a claim on returns. Buy-sell agreements often establish particular parameters for valuation as a way to side-step valuation theory to benefit the ownership and the business model of the particular RIA. Valuation theory operates in a ceteris paribus (all else equal) universe, whereas buy-sell agreements do not operate in this vacuum.Valuation theory operates in an all else equal universe, whereas buy-sell agreements do not.Finally, the issue of discounts for lack of marketability – that minority investors suffer from lack of ready access to enterprise level cash flows – is a byproduct of focus on old economy, heavy industry businesses structured as C-corporations in which dividend policy can be parsimonious. Most RIAs are structured as tax pass-through enterprises (LLCs or S-corporations) and don’t rely on heavy amounts of capital reinvestment. High payout ratios (often nearing 100%) mean minority investors do, in fact, typically enjoy regular returns from enterprise cash flows. Consequently, discounts for lack of marketability are usually smaller for investment management firms than for minority investments in many other industries.Institutional Investors Make Minority Investments With Majority ConditionsOne would expect institutional investors, as financially driven actors who are free to invest across a broad spectrum of opportunities, to behave in a manner more consistent with the hypothetical investors described by valuation theory. The institutional community has, however, developed practices to protect itself from many of the vagaries of minority investing. Achieving rights and returns similar to control investors has led to transaction pricing on par with control transactions, a phenomenon which isn’t inconsistent with conventional wisdom.Institutional investors in the RIA space have corrected for many of the disadvantages associated with being a minority investor by way of contractual minority interest protections.Institutional investors in the RIA space have corrected for many of the disadvantages associated with being a minority investor by way of contractual minority interest protections. No two firms handle this the same way, but board representation, performance reporting, rights to change senior management, compensation agreements, bonus plans, restrictions on non-cash benefits, assurance of timing and performance for distributions, and even revenue sharing arrangements can go a long way to putting a minority investor on terms comparable to a majority owner. Without the risks that accompany lack of control and lack of marketability, minority participants can focus on the value of the enterprise.As an added benefit, if management still holds most of a firm’s equity, then outside investors have more assurance that insiders will pay attention to their jobs. This avoids the issue of RIA leadership “calling in rich” following a lucrative recapitalization and mitigates the monitoring costs that accompany most private equity investing. Sitting alongside management on an economic basis, but knowing management is sufficiently motivated, many institutional investors have effectively created the best of both worlds in minority investing: comparable returns without comparable responsibility.Valuation Theory Is the Real WorldUltimately, valuation models are descriptive, not prescriptive. The economic principles underlying valuation models are the real secret sauce.The behavior of insiders and professional investors is often seen in conflict with the notion that minority interests carry a lower value than pro rata control. In fact, these minority investors are not typical, coupling their money with conditions of ownership that mitigate or eliminate the distinctions between value on an enterprise basis and value on a fractional basis. In our view, the behavior of professional minority investors substantiates the presence of valuation discounts for investors who lack similar protections and privileges.About the car: In the late 1950s, while Detroit focused on building huge, heavy, powerful, front engine sedans and wagons, Italian automaker Fiat designed a petite coupe with a canvas roof and a two-cylinder rear-mounted engine. The Fiat 500 was as contradictory to conventional wisdom at the time as it was easy to park and cheap to own. Detroit boomed, but the Cinquecento sold almost four million units over 18 years. Different markets have different needs.

Are RIA transaction multiples getting out of hand? Contrary to the usual laws of supply and demand, each week it seems like we hear about another blockbuster deal rumored to have happened at an astronomical price, and correspondingly, we meet a new capital source we hadn’t known previously who is looking for a way to implement an acquisition strategy in the RIA space. Is this FOMO on a grand scale, or just part of a grander moment in market dynamics? If you weren’t hiding under a rock last week, you probably read plenty about the Robinhood ($HOOD) IPO. Robinhood is a noteworthy counterpoint to the RIA space because it is practically the anti-RIA. RIAs target high net worth investors who want returns and capital preservation; $HOOD targets young speculators with money to burn. RIAs develop recurring revenue streams from investment management; $HOOD builds transaction volume by hyping "opportunities."  RIAs follow a fiduciary standard; $HOOD monetizes clients with margin accounts and payment for order flow.  If you wanted to define the typical RIA business model, you would do well to just assume the opposite of Robinhood.If you wanted to define the typical RIA business model, you would do well to just assume the opposite of Robinhood.Yet, $HOOD’s initial few days of trading bear out a revenue multiple that is mind-numbing, even compared to the high-watermark transactions in the RIA space. I can’t explain it, and I’m tempted to dismiss it as a sideshow altogether. But, a glance at Robinhood, digital assets, or 10 year treasuries for that matter, suggests that the wall of money that has moved an array of asset valuations higher over the past 15 months has yet to abate.Valuation practitioners are wired to respect intrinsic value. We can’t help but view assets like Bitcoin and Meme-stockbrokers with a curmudgeonly air. And it’s hard to get excited about bond yields measured in basis points instead of percentage points, regardless of your inflation outlook. RIA valuations, on the other hand, we can defend.RIAs remain the ultimate growth AND income play.RIAs remain the ultimate growth AND income play. What other business model produces a coupon in the upper single to low double digits, and then increases the dollar amount of that return with market and organic growth? Even at EBITDA multiples that would have made people blanche a few years ago, the return profile on RIAs is hard to match. Low yielding treasuries don’t come close, even on a risk adjusted basis.This isn’t to say that investing in RIAs is without risk. Investment management is labor intensive so much that we’ve been told by one very experienced buyer that he feels one can "rent" an interest in an RIA, but never really "own" one. Many RIAs struggle with genuine organic growth, and the most recent Schwab industry study shows AUM growth outstripping revenue growth, suggesting that realized fees are eroding – even in wealth management. Nevertheless, looking back over the past 18 months, it’s hard to find a business that was more adaptable and resilient than investment management – what looked like bottomless downside turned into banner performance.Our perspective isn’t unique. The problem is that for all the interest in acquiring RIAs, there aren’t that many to be had. While the total count of RIAs is debatable (about 15,000 to 40,000 – depending on who’s counting), what is easier to see is that the portion of substantial RIAs, especially those in the wealth management space (where much of the acquisition interest is these days) is small. There are maybe 500 wealth management firms with AUM in excess of $1.0 billion, and a good portion of those see themselves as acquirers rather than sellers. You can always consolidate smaller firms, of course, but it’s hard to build a $100 billion shop with $300 million add-ons.Acquisition activity is hot, multiples are strong, and there’s no end in sight.Bitcoin aficionados can talk about verifiable scarcity all day, but most people aren’t qualified to audit the bitcoin algo that limits the number of coins. We know what it takes to build multi-billion dollar AUM firms – time – a lot more time than it takes for server farms to mine digital coins. The best growth for RIAs is still organic, but life is short, and most grandiose investment strategies in investment management don’t budget the decades it takes to do it from scratch. Ergo, acquisition activity is hot, multiples are strong, and there’s no end in sight.The Aston Martin DB4 GT pictured above looks very similar to the ones produced in the early 1960s, but it was actually built in 2019. The GT version (more power, less weight) of the DB4 was supposed to total 100 cars, compared to the 1200 or so regular models. The DB4 GT production run ended early, though, as Aston Martin introduced the DB5 (the model ultimately mythologized in James Bond movies) after building only 75. As a consequence, auction prices of the GT version usually had an extra digit compared to those of comparable non-GT series cars.Five years ago, Aston Martin decided to do a special production run of the final 25 cars. Each car took an estimated 4,500 man-hours to build, and all were presold at £1.5 million. Interestingly, the 33% increase in supply didn’t dent auction prices for original DB4 GTs, and I suspect a similar increase in larger RIAs would just add to buyer enthusiasm.I wonder if crypto-investors would have a similar experience.

This week we look back at a post from November 2018. Don't let the dates fool you, the topic is still very relevant today. The announcement from Merrill Lynch last week that it was cutting advisor compensation stood in stark contrast to a lawsuit filed in October by former Wells Fargo brokers, alleging that their practices had been impaired by association with the bank. While Merrill feels comfortable flexing their brand muscles by redirecting advisor cash flow back to the firm, Wells Fargo is accused of actually having negative brand value. These two situations highlight the dynamic interaction between investment management professionals and the firms they work for while demonstrating the significance of branding to build professional careers and advisory firm value.An Ensemble Product With an Ambiguous BrandA couple of weeks ago I was driving around Memphis and spotted a unicorn, or, more specifically, a Bricklin SV-1, an independently produced sports car with a small-block V-8 engine, two seats, a fiberglass body, and gullwing doors. Malcolm Bricklin debuted his eponymous car at a celebrity-studded event at the Four Seasons restaurant in New York in the summer of 1974. Despite the innovative nature and affordable price of the Bricklin, it wasn’t terribly quick (not unusual for cars of that era), reliable (the hydraulic pump for the gullwing doors would sometimes break if you tried to open two doors at once), or practical (it lacked both a spare tire and a cigarette lighter). Only 3,000 or so Bricks were sold in 1974 and 1975, and fewer than half of those are extant today.If the Bricklin were a metaphor for a cohort of RIA practice, it would be an “ensemble” practice. The company was run from Arizona but manufactured cars in Canada, shared taillights with the DeTomaso Pantera and the Alfa Romeo 2000, sourced its engine from American Motors and Ford, transmissions from Ford and Borg Warner, brakes that included parts from three manufacturers, and a steering wheel from Chevrolet. What Bricklin lacked was a compelling brand to pull it all together, so instead of projecting the image of a “best of everything” product, it came off as more of a Frankenstein.Brand substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.Reading through the industry news of late, we’ve been thinking about the role of branding in the investment management industry. Branding is more than a firm name or logo, it encompasses the identity of an RIA such that the practice is elevated above the practitioner, with the potential to benefit both. As such, we consider brand to be more than tradenames or logos; it is a concept that substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.Personal Goodwill and Corporate GoodwillIn the valuation community, there are techniques for determining whether a portion of a given enterprise’s goodwill is (in reality) allocable to one professional or to a group of professionals instead of the company. I’ll spare you the technical details, but suffice it to say that when an RIA matures to the stage that it can report a legitimate bottom line – i.e. that there are profits left over after covering both non-personnel costs and paying a market rate of compensation to all staff – then it has brand value that has generated a return on corporate goodwill. Profitability is evidence of brand value.Returns to Labor Versus Returns to CapitalWhen the C suite at Merrill Lynch decided to cut advisor payouts a few years ago, they were shifting cash flow returns from labor to capital. Advisors probably felt like they were being devalued, and arithmetically they were. But Merrill was also testing its brand value. Could they enhance their return on corporate goodwill by retaining more client fees from existing brokers at the risk of either disincentivizing their advisor network or even running them off to other wire-house firms or RIAs? Merrill’s opting to remain in the broker protocol can be seen as confidence in its brand to attract, grow, and retain an advisor network.Negative Goodwill?At the other extreme, the Wells Fargo lawsuit from about the same time suggested the possibility that negative brand value at the firm level can impinge on an advisor’s income. Two brokers alleged that the string of negative publicity at Wells Fargo made it difficult for them to build their books of business or even to maintain the level of business they built previously. Investment management is a reputation business, and the lawsuit indicated that even association with a tarnished brand can impair a career. It was an interesting lawsuit, because in blaming the firm for advisor performance, it suggested that the advisor/client relationship was more significant than the client’s relationship with the firm – otherwise the advisor could mend the relationship simply by changing firms. Yet the lawsuit was basing the damage claim on the bad reputation of the firm.Brand Value in the Independent ChannelOutside of the bulge-bracket broker channel, it is more common for personal goodwill and firm goodwill to overlap. There is a thread of conventional wisdom that suggests small RIA practices aren’t salable (i.e. don’t have enterprise goodwill). The reality is more nuanced, of course, but to the extent that the identity of a small RIA is really just that of the founder and principal revenue producer, then clients are difficult to transfer and the business is more difficult to transact. Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.There’s more than one way to build brand value beyond the founder, as shown by high profile firms like Edelman Financial and Focus Financial. Edelman employs a highly centralized approach, with uniform and templated marketing programs and client service techniques. While Edelman has successfully built a large and profitable platform from this, the risk is that the secret sauce is vulnerable to being copied. Focus Financial, on the other hand, has employed a highly decentralized approach of acquiring cash flow interests in independent RIAs and then leaving their client-facing identities intact. You won’t find Focus’s name (much less than name of its founder, Rudy Adolf) on any of its partner firms, and thus individual firms (and Focus itself) are far less exposed to reputational risk from bad actors in individual offices. Besides this, Focus doesn’t base its business model on intellectual property that could be replicated elsewhere. What Focus lacks is a certain level of corporate identity and efficiency that comes from uniformity.In the End, Brand Value Is Defined by Your ClientMuch of the debate over the value of investment management firms can be distilled into one question: what is the value of a firm’s brand? More than “what’s in a name?”, the question is an investigation into the relationship between client and investment management service provider. Do clients of your firm define their relationship as being with your firm, or with an individual at your firm? If you can answer that question, you know where your RIA is on the journey to building firm value.

Most of our colleagues at Mercer Capital live in Texas or Tennessee – two states with very low tax burdens. This is not by design so much as by circumstance: our firm grew up where we already lived. Until recently, the relatively low cost of living, short commutes, and moderate climate came with a tradeoff: most of our clients are on the coasts, so regular travel away from home was a necessity.Now that the pandemic has made geographic proximity for many meetings a non-issue, we’re beginning to wonder how many of our clients are ultimately going to join us. Dynasty’s move from New York to Florida and UBS’s relocation to Tennessee got plenty of attention. And we’re starting to hear of smaller RIAs contemplating similar moves. This isn’t a crowded trade yet though; most investment management firms still call high-cost, high-tax states home.Texas and Florida have been climbing the rankings of states with the most RIAs, but two states still dominate this survey – New York and California. New York’s position is even stronger if you include adjacent communities of investment management firms in Connecticut, New Jersey, and Pennsylvania.California is in an enviable position as the fifth largest economy on the globe, not to mention mostly-beautiful weather. That hasn’t been enough for Schwab, which has been migrating staff to Texas, Colorado, and Arizona for years. Now we’re starting to hear from California clients with staff members who moved out of state during the worst of the pandemic and would like to continue working remotely. When will their employers follow?Manhattan is another story altogether, with city tax burdens layered on top of state taxes. With all due respect to Manhattan’s theme song, in the post-pandemic, remote-work world, if you can make it anywhere, why make it there? We have another wealth management client who just relocated from New York to Tennessee – cost structure and concern over the quality of life in Manhattan for the foreseeable future were key factors.What the table above doesn’t show is the value of the talent pools already established in financial hubs like San Francisco and New York. But the relative cost of living may be enough to convince some of that talent to relocate. If that becomes a trend, all bets are off.The wrong corporate structure can exacerbate the state tax differential. Imagine the extreme scenario of a Manhattan based C Corporation that considers moving to Florida and converting to an LLC.After-tax dividends/distributions to the Florida LLC member are about 30% higher than for a shareholder in a New York City C Corporation with the same EBIT (earnings before interest and taxes). But this differential is far greater if you consider the cost of living in Florida versus New York – a difference that will widen further if President Biden successfully rolls back some or all of the reduction in corporate taxes enacted in 2017.As for proximity to clients, there are reasons to expect ultra-high net worth families in California and New York to relocate. Florida still has no estate tax, while New York just raised theirs. Tennessee and Texas (two states with no personal income tax) also have no estate tax, and Tennessee has strong and well-developed trust laws considered on-par with South Dakota.Anecdotal experience supports this trend. Friends on the west coast and in the northeast have told me they have a recurring conversation with their neighbors that revolves around the question: “how much longer are you going to stay here?” The implication of this question is that, as soon as they could, they would decamp for a lower-tax, lower-cost of living part of the U.S. Just as the pandemic accelerated many trends, we expect to see a migration of wealthy clients to more cost-effective jurisdictions, as well as the firms that serve them.

Forty-three years ago, Mercedes Benz began offering anti-lock brakes as an option on its top-end S-class sedan.  ABS had been the norm for commercial airliners and some commercial vehicles for years, but it took considerable development from supplier Bosch to make the feature “affordable” for passenger cars (equivalent to about $4500 today).  Anti-lock brakes improved stopping distances in hard braking and wet conditions dramatically.  Initially, however, it also increased the accident rate.As with “self-driving” or semi-autonomous features being developed today like automatic braking and lane-keeping, the early days of ABS found Mercedes owners a little too secure in the capabilities of their vehicles.  Overconfidence leads to complacency, and complacency leads to accidents.  Long before Tesla drivers were photographed asleep in their moving vehicles, Mercedes drivers were rear-ending cars (because they overestimated their brakes) and getting rear-ended (because they overestimated the brakes of the car behind them).The speed with which equity markets have recovered over the past year has the potential to lead to a similar level of complacency, and RIA management teams would be well advised to keep both hands on the wheel.The risk we not infrequently see is that lengthy periods of strong market performance necessarily lead to upward trends in AUM and revenue that mask underlying problems.  Just as institutional asset management clients learned decades ago to evaluate portfolio performance on a relative basis, rather than absolute return, RIA management teams need to look a step or two beneath the surface to understand why their firm is growing.Gauging performance for an RIA is often thought of in terms of the portfolio, particularly for product companies that specialize in particular strategies.  Even though performance, in theory, should drive AUM flows, capital markets are fickle, and so can be customer behavior.  So, we prefer to start with a decomposition of AUM history, and then explore the “why” from there.Consider the following dashboard that breaks down the revenue growth of an example RIA.  Over a five-year period, this RIA boasted aggregate revenue growth of nearly 40%, increasing from $3.7 million to $5.1 million.  AUM growth was even more substantial, nearly doubling from $600 million to $1.1 billion.  Revenue grew every year, which would lead one to have great confidence in the future of the firm.Looking deeper, though, we notice a couple of unsettling trends.  The five-year period of measurement, 2016 through 2020, represents a bull market from which this RIA benefited substantially.  Cumulative gains from market value were over $600 million, more than the total growth in AUM and masking the loss of clients over the period examined (net withdrawals and terminations of over $100 million).  Markets cannot always be counted on for RIA growth, so client terminations, totaling $183 million over the five-year period, or nearly one-third that of beginning AUM in 2016, is cause for concern.  This subject RIA only developed $35 million in new accounts over five years, and we notice what appears to be an accelerating trend of withdrawals from remaining clients.Further, there appears to be loss in value of the firm to the marketplace.  Realized fees declined four basis points over five years.  Had the fee scheduled been sustained, this RIA would have booked another $336 thousand in revenue in 2020, all of which might have dropped to the bottom line.  Small changes in model dynamics have an outsized impact on profitability in investment management firms, thanks to the inherent operating leverage of the model.  But the materiality of these “nuances” can be lost in more superficial analysis of changes in revenue or changes in total AUM.So, we would ask, what’s going on?  Did this RIA simply ride a rising market while neglecting marketing?  Are clients concerned about something that is causing them to leave?  Does this RIA suffer from more elderly client demographics that accounts for the runoff in AUM?  If the RIA handles large institutional clients, did some of those clients rebalance away from this strategy after a period of outperformance?  Is their realized fee schedule actually declining, or is it not?  Is the firm negotiating fees with new or existing clients to get the business?  Did a particularly lucrative client leave?  What is happening to the fee mix going forward?Decomposing changes in revenue for an investment management firm can prompt a lot of questions which say more about the performance of the firm than simply the growth in revenue or AUM.  Yet when we ask for this information from new clients, it isn’t unusual for us to hear that they don’t compile that data.  All should.  Some drivers have too much confidence in new technology, and some RIA managers have too much faith in the upward lift of the market. The risk to both is the same: ending up in the ditch.

In the mid-1970s, sports car racing requirements changed such that manufacturers could only race models that were also widely available through dealer networks.  Porsche responded by developing the 930 Turbo, a 911 Carrera with upgraded suspension, larger brakes, and an uprated version of its six-cylinder boxer motor enhanced by a large diameter turbocharger.  The 930 turbo became popular with enthusiasts as it was the fastest car built in Germany.  For unskilled drivers, it was also quite dangerous.  With a twitchy, short wheelbase prone to oversteer and non-linear gushes of power from the turbocharger, it was all too easy to spin – even in ideal conditions.  As a consequence, the 930 Turbo earned the nickname that has stuck with it: the Widowmaker.To those who enjoy a direct connection with the road, the difficulty of controlling a vintage 930 Turbo at the limit is a feature, not a bug.  The short wheelbase and rear-weight bias that produce oversteer make the car responsive, not dangerous.  And the surge of power from the turbocharger makes the car undeniably fast – so long as it’s pointed in the right direction.  If you can stay ahead of the car and master the capabilities of a 930 Turbo, you know you’re a good driver.Is human input in investment management a feature, or a bug?  A generation of CFA charterholders have endured a curriculum that forcefully documents the futility of active management.  The second decade of the millennium seemed to back this up, as anyone who owned anything other than a long-only position in an S&P 500 index fund probably regretted it.  Even in an innovation economy, a cap-weighted index that favored big tech beat most alternatives.  Thinking seemed overrated.Then the pandemic hit, and suddenly all asset pricing was non-linear.  With a K-shaped recovery, an unsteady bond market, sagging dollar, a resurgence in value stocks, and talk of inflation, there’s no idiot-proof approach to investing.Does the market agree?  Affiliated Managers Group share price sagged for years, dropping along with prospects for the active managers it acquired over the years.  AMG hit bottom on March 20, 2020, closing under $50 per share.  It’s approximately triple that today – back to levels it hasn’t seen since the summer of 2018.  Franklin Resources’ shares are trading at double what they were a year ago, as are Silvercrest, Diamond Hill, Federated, and T. Rowe Price.  Not every publicly traded asset manager has performed that well, but the turnaround in fortunes on many firms’ five-year charts is worth a look.Sometimes it seems like investment management is going to be entirely performed by one cloud server.  We talk with many in the wealth management space who think active asset management has already been entirely supplanted by indexed products. And we know more than a few asset managers who think wealth management services could be performed just as well by robo-advisors.  Our experience has been that human input finds unique solutions, secures and strengthens relationships, and ultimately provides clients with the best outcomes. Algorithms can be great tools, so long as their user has great skills.The capable but tricky 930 Turbo was not the start of a trend. Today, automakers are focused on building cars that will be self-parking, self-driving transportation vessels to mindlessly convey occupants in hermetically sealed cocoons. Even current iterations of the Porsche Turbo have all-wheel drive, traction control, automatic transmissions, and enough engine management systems to make them practically idiot-proof.  But dumbing down driving doesn’t produce better drivers, any more than dumbing down investment management improves investment outcomes. Thinking still matters in this industry, thankfully.  It’s also more fun.

One year ago this week I was in New York on what I didn’t know would be my last business trip for a long time. I could have never imagined how the year to come would both disrupt and accelerate business plans for us and for our clients, but it’s been strangely great and awful all at the same time.Many of our clients have been unusually reflective about practice management issues over the past year, and that effort has been rewardedMany of our clients have been unusually reflective about practice management issues over the past year, and that effort has been rewarded. After a brief gasp and pause in the second quarter of 2020, we saw many clients accelerate leadership transitions, look for transaction opportunities, shift product and service offerings, rewrite fee schedules, refine marketing approaches, and rethink what it means to be a firm – all while working remotely. As our annual projects came through the shop this winter, we tallied the results: more growth and greater efficiency. 2020 was a good year, at least on paper.Still, for the industry as a whole, focus on practice management is relatively new and, for many, relatively foreboding. Most firms grow from the talents of individuals who enjoy some or many aspects of managing money. They partner with like-minded individuals, start gathering client assets, and when momentum kicks in and the market cooperates, they become a profit-making machine. That formula worked for a long time.The deficiency in the growth story of many RIAs is they employed lots of people to work “in” the business, but not enough to work “on” the business. It’s not unusual for heads of multi-billion dollar firms to still manage client relationships, serve on investment committees, and be the principal in charge of major human resource decisions.Strategic thinking about practice management is a necessity in an industry that has been catapulted into the futureToday, the investment management industry doesn’t have the same growth drivers it enjoyed for a long time, and defending margins has become an active discussion. As a consequence of those forces, and a year where the industry had time to rethink everything from custodial relationships to custom indexing, investment management is becoming subject to creative forces that were very recently as unimaginable as a year without business travel.We have had a great time putting together the conference for this week, but I think we’re only scratching the surface. Strategic thinking about practice management is a necessity in an industry that has been catapulted into the future.Practice management is resource-intensive, but enduring the cost of catching up to the future is prohibitive.Just don’t tell that to the post office, which recently unveiled a new fleet of delivery trucks. The Postmaster General noted that only 10% of the new vehicles would be battery powered, because that would cost extra. The gasoline powered motors could, however, be converted to electric during the vehicles’ estimated 20-year life. Given the pace of innovation at the postal service (Mercer Capital shares its hometown with FedEx, so we’re biased), this fleet plan tells me that the age of the internal combustion engine is rapidly coming to a close.On the other end of the spectrum, McLaren just announced a new sports car, the Artura (pictured above). With a high-performance hybrid engine and an ultra-light carbon fiber monocoque architecture, the Artura is a testament to a future that is beautiful and exciting. We look forward to sharing that future with you at the RIA Practice Management Insights conference this week.RIA Practice Management Insights Is Only 2 Days Away!We are excited to bring this virtual conference to you. The focus is on OPERATIONS – strategy, staffing, technology, firm culture, marketing, and so much more. If you’ve been too busy working in your business to work on your business, this conference is for you!It's NOT too late to register!Use code 30%OFFto save 30% off conference registration This 30% special conference discount is only good until Tuesday, 3:00pm ET. After that, the registration fee returns to $250, so act now and save $75! In the meantime, want to see the conference in a nutshell? Check out the video below to learn more.

Long before Reddit investors discovered that you could Occupy Wall Street more effectively with out of the money call options than you can with tents, Porsche briefly turned itself into a hedge fund and used a similar tactic to try to take over Volkswagen.  The story sheds some light on how market pricing does, and does not, reveal the value of a business.  Benchmarking the value of an RIA off the behavior of a few aggressive consolidators has similar limitations.Barbarians from BavariaAround 2005, a niche automaker from Stuttgart revealed that it intended to become the largest shareholder of the largest automaker in Germany.  At the time, VW Group sold more cars each week than Porsche sold annually, but its share price lagged its industrial scale.  Porsche had a CFO with larger ambitions and developed a strategy to use market manipulation to do what seemed impossible.  Within a year of its announcement, Porsche’s stake in VW reached 25%, and then 30% by March 2007.  Porsche denied mounting a full takeover intent, instead suggesting that it was protecting VW from hostile suitors (an accusation that turned out to be a confession). [caption id="attachment_35773" align="aligncenter" width="690"]For a brief moment, VW had the largest market capitalization of any company on earth, with a closing price on October 28, 2008, of over $1,100 per share, or over 5x its current share price (data from Bloomberg, L.P.)[/caption] By late 2008, Porsche’s ownership stake had climbed to over 40%, and it held options to purchase another 31.5%.  The burgeoning stock price for VW was recorded as a gain at Porsche – profits that exceeded what Porsche made from selling cars.  At the peak, VW was trading for more than 20 times where it was before Porsche started accumulating shares.  If Porsche could’ve gained control of 75% of Volkswagen’s stock, it would trigger a change of control, and Porsche could strip VW’s balance sheet with 8 billion euros.  Alas, the credit crisis intervened on VW’s behalf and Porsche’s self-inflicted wounds created insolvency that could only be remedied with a sale to, you guessed it, Volkswagen.GameStop TheoryBy now you’ve read plenty about the short squeeze on GameStop and other heavily shorted financial instruments and commodities (today it’s silver).  It seems like it was only a few months ago that cryptocurrencies were exciting.  We won’t bite at the opportunity to weigh in on whether or not loosely organized hordes of retail investors at aptly-named Robinhood should be allowed to out-manipulate billionaire hedgies.We will, however, consider the valuation implications of unusual market behavior.  The investment management industry hasn’t been the target of vigilante options traders, and we’re not aware of any sub-billion-dollar managers launching a leveraged effort to take over, say, Focus Financial.  But the RIA press is fond of breathless speculation about ever-higher prices being paid for firms.  One of the absolute truths of the current environment for buying and selling investment management firms is that there has never been a larger number of capital providers offering a greater variety of transaction terms.The question is, what does it mean to you and the value of your firm?The Rules of the GameSome things haven’t changed.  Valuation operates in an alternative returns world.  In other words, the value of any given investment opportunity depends on the rate of return it generates compared to other opportunities with a similar risk and growth profile.Value is a function of cash flow, rate of return (relative risk), and growth.  Assuming cash flow is a constant, for valuations to increase, either cash flow growth expectations must be higher or the expected rate of return must be lower – or both.It is through this lens that we have to view the news about industry consolidation.  When a particular buyer makes an eye-watering bid for an RIA, one or more of these three basic elements is in play.The buyer has a unique circumstance that allows them to extract more profitability from the target firm than other bidders or than the firm could extract on its own.There is ample reason to be skeptical of this expectation.  Investment management is labor intensive, and clients don’t like their relationship or investment people turning over.  While there are some back office efficiencies that come from some transactions, it usually isn’t enough to be meaningful.  In our experience, most buyers are genuinely interested in the talent-acquisition angle of an acquisition, because good and experienced industry veterans are rarely available.The buyer has a unique expectation of the growth opportunities inherent in an acquisition. Organic firm growth comes from market tailwinds and marketing discipline.  It’s hard to forecast market tailwinds, especially in this environment, and marketing discipline can be built more cheaply than it can be acquired.The buyer is willing to accept a lower rate of return than competing bidders. This is the technical definition of winner’s curse.  When Goldman Sachs paid up for United Capital, it wasn’t a big enough deal in the overall GSAM universe to dilute earnings, and it sped up Goldman’s foray into serving the mass-affluent.  So even though Goldman accepted a lower return on the deal from a closed-form perspective, it had larger implications for the company that justified getting it done.  Just because I found an exception doesn’t make it the rule.  All else equal, the highest multiple is the lowest earnings yield, so the buyer is just willing to get less out of the deal.Just Because You Can, Doesn’t Mean You ShouldOne of the pioneers of the RIA industry was a smallcap manager who also happens to be the father of a friend of mine.  One choice piece of wisdom that he passed on to his kids: “just because you can, doesn’t mean you should.”You can rationalize valuing RIAs higher today because interest rates are low and the space offers one of the few growth-and-income plays that has worked well for several decades.  Time will tell, but interest rates are probably low because economic growth is low.  If the market is leveraged to the economy, and RIAs are leveraged to the market, the rules of valuation suggest that low rates don’t necessarily defend higher multiples.Investment management firms used to be considered a value investment.  If that’s no longer true, will internal transactions be possible?  Will firms be compelled to sell into complex financial engineering schemes that cut every analytical corner in an effort to buy high and sell higher?  The NPV of financial engineering, over time, is zero (before fees).  No SPAC is going to change that.Does the high bidder set the market?  On paper, yes.  But the market for RIAs consists of tens of thousands of active participants, many of whom are quietly willing to sit out if financial returns aren’t high enough.  Full stop.A Plug for Mercer Capital’s Upcoming RIA Practice Management Insights ConferenceMercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?

After World War II, British automakers launched a valiant attempt to sell products beyond the Empire.  Several U.K. marques introduced themselves to the U.S. with cute, tiny roadsters that stood out from the chrome-bedazzled land yachts from Detroit.  Just imagine the 11 foot long, 1,455-pound Austin-Healey pictured above parked next to a 23 foot, two and a half ton Cadillac Eldorado of the same vintage.While the British invasion from Austin-Healey, Morris Garage, Triumph, and Jensen (among others) won a few sales, most ultimately surrendered, retreating to their island home.  The problem was that their products, though eye-catching, were unreliable. Oil leaks, busted clutches, and faulty electronics were typical.  A car buyer in the 60s had to face certain tradeoffs: be stylishly stranded on the side of the road, or just drive a Ford like everyone else.If the Brits had developed their mechanical prowess to the same level as their styling, we would all be driving MGs today.  As it happened, the Brits failed to evolve, and the Japanese replaced them with practical and reliable transportation that ultimately challenged the U.S. auto industry in a way the British could not, further one-upping the Brits with their own ragtop – the Mazda Miata.RIA Practice Management InsightsSince the start of the American experience with the pandemic, we’ve noticed our clients spending more time working “on” their business as opposed to simply working “in” their business.  No doubt the work-from-anywhere model has given many people a perspective on their firms that wouldn’t have happened otherwise. We see changes afoot in the industry as a consequence which we believe will outlast WFH.Our clients are spending more time working “on” their business as opposed to simply working “in” their business.Consolidation gets most of the headlines in the RIA press, but too many examples of consolidation are really capitulation – selling out is a path to sidestep lingering practice management issues like sustainability or succession.Despite what you read, not everyone wants to sell.  Over the past year or so, many of our clients have used the “pause” in their normal work lives to reassess their marketing plans, compensation schemes, leadership issues, technology integration, and ownership.  Most aren’t simply playing practice management whack-a-mole but are looking at these issues in a holistic and strategic way to strengthen the internal mechanisms of their firms and build a more sustainable platform.RIAs need to grow their systems, processes, policies, and infrastructure just as fast as their AUM.We’re seeing a subtle, but growing, emphasis on professionalizing the independent investment management industry.  RIAs are no longer an assortment of small, scrappy practices for lone wolfs who don’t want to work at wirehouses or bank trust departments.  As the decades wear on and the billions under management accumulate, many RIAs have become real businesses.  These businesses need to grow their systems, processes, policies, and infrastructure just as fast as their AUM.  And there are threats paired to opportunity: with fee schedules and margins under pressure, many firms who have avoided confronting change can no longer afford to do so.A New ConferenceIn this spirit, we’ve decided to put together a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success.  The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.A virtual conference for RIAs focused entirely on operational issues – from staffing to branding to technology to cultureThe topic list is unlike that of any other investment management firm forum.  We’ve attended and spoken at plenty of great conferences that cover investment products and M&A, so we’re not going to plow that ground ourselves.  Instead, we have gathered an impressive list of thought leaders who have built careers out of professionalizing the “back of the house” to support the best investment management products and services.Please join us to get their wisdom on how your firm can evolve to become a more sustainable, profitable, valuable enterprise.

One November day in the late 1970s my dad noticed an ad on the bulletin board at work that caught his attention: someone had a Jensen Healey MkII for sale. The MkII was arguably the best product Jensen Healey ever made: a lightweight two seat convertible with a Lotus four-cylinder double overhead cam engine with dual Stromberg carburetors. The Jensen my dad was looking at was far from perfect – it was covered with a couple of years worth of dust and had a crease running down the middle of the fragile aluminum hood because someone hadn’t been careful closing it. It needed a tune up and who knows what else (British sports cars aren’t known for reliability). But at 2,400 pounds and 140hp, when it ran, it ran fast. Dad brought the Jensen home for the long Thanksgiving weekend and we drove it around Miami (due diligence) to decide whether or not to take the plunge.Part Two of Our Series on Earn-OutsLast week, we offered an example, ACME Private Buys Fictional Financial, to shed light on several issues presented by the use of earn-outs in RIA transactions. As explained, gathering comprehensive data on ultimate deal value in investment management transactions is problematic as most post-deal performance doesn’t get reported other than AUM disclosures in public filings. And, if the acquired entity is folded into another RIA, you can’t even judge a deal by that. Sometimes bad deals can be saved by good markets, but hope is not a strategy. Consequently, earn-outs are the norm in RIA transactions, and anyone expecting to be on the buy-side or sell-side of a deal needs to have a better-than-working knowledge of them.Earn-Out FunctionAs noted above, RIA transactions usually feature earn-out payments as a substantial portion of total consideration because so much of the seller’s value is bound up in post-closing performance. Earn-outs (i.e. contingent consideration) perform the function of incentives for the seller and insurance for the buyer, preserving upside for the former and protecting against potential losses for the latter. In investment manager transactions, earn-outs are both compensation, focusing on the performance of key individuals, and deal consideration, being allocated to the selling shareholders pro rata. And even though earn-out payments are triggered based on meeting performance metrics which are ultimately under the control of staff, they become part of overall deal consideration and frame the transaction value of the enterprise.For all of these reasons, we view contingent consideration as a hybrid instrument, combining elements of equity consideration and compensation, and binding the future expectations of buyer and seller in a contractual understanding.Earn-Out ParametersContingent consideration makes deals possible that otherwise would not be. When a seller wants twice what a buyer is willing to pay, one way to mediate that difference in expectations is to pay part of the price upfront (usually equal to the amount a buyer believes can safely be paid) and the remainder based on the post-closing performance of the business. In theory, earn-outs can simultaneously offer a buyer some downside protection in the event that the acquired business doesn’t perform as advertised, and the seller can get paid for some of the upside he or she is foregoing by giving up ownership. While there is no one set of rules for structuring an earn-out, there are a few conceptual issues that can help anchor the negotiation.Define the Continuing Business Acquired That Will be the Subject of the Earn-Out.Deciding what business’s performance is to be measured after the closing is easy enough if an RIA is being acquired by, say, a bank that doesn’t currently offer investment management services. In that case, the acquired company will likely be operated as a stand-alone enterprise with division level financial statements that make measuring performance fairly easy.If an RIA is being rolled into an existing (and similar) investment management platform, then keeping stand-alone records after the transaction closes may be difficult. Overhead allocations, staff additions and subtractions, expansion opportunities, and cross selling will all have some impact on the value of the acquired business to the acquirer. Often these issues are not foreseen or even considered until after the transaction closes. It then comes down to the personalities involved to “work it out” or be “fair.” As a friend’s father used to say: “fair is just another four-letter word.”Determine the Appropriate Period for the Earn-Out.We have seen earn-out periods (the term over which performance is measured and the contingent consideration is paid) as short as one year and as long as five years. There is no magic period that fits all situations, but a term based on specific strategic considerations like proving out a business model, defining investment performance objectives, or the decision cycle of key clients are all reasons to develop an earn-out timeframe.There is no magic period that fits all situations.The buyer wants the term to be long enough to find out what the true transferred value of the business is, and the seller (who otherwise wants to be paid as quickly as possible) may want the earn-out term to be long enough to generate the performance that will achieve the maximum payment. Generally, buyer-seller relations can become strained during an earn-out measurement period, and when it is over, no one wishes the term had been longer.We tend to discourage terms for contingent consideration lasting longer than three years. In most cases, three years is plenty to “discover” the value of the acquired firm, organize a merged enterprise, and generate a reliable stream of returns for the buyer. If the measurement period is longer than three years, the “earn-out” starts to look more like bonus compensation, or some other kind of performance incentive to generate run-rate performance at the business. Earn-outs can be interactive with compensation plans for managers at an acquired enterprise, and buyers and sellers are well-advised to consider the entirety of the financial relationship between the parties after the transaction, not just equity payments on a stand-alone basis.Determine to What Extent the Buyer Will Assist or Impede the Seller’s Performance During the Earn-Out.Was the seller attracted to the deal by guarantees of improved technology, new product options, back-office support, and marketing? Did the buyer promise the seller the chance to operate their business unit without being micromanaged after the transaction? These are all great reasons for an investment management firm to agree to be absorbed by a larger platform, and they may also help determine whether or not the acquired firm meets performance objectives required to receive contingent consideration.While bad deals can be saved by good markets, counting on overpromises is not a sound deal strategy. Instead, buyers and sellers should think through their post-close working relationships well in advance of signing a deal, deciding who works for whom, and defining the mutual obligations required to achieve shared success. If things don’t go well after the transaction – and about half the time they don’t – the first person who says “I thought you were going to…” didn’t get the appropriate commitments from his or her counterparty on the front end.Define What Performance Measurements Will Control the Earn-Out Payments.It is obvious that you will have to do this, but in our experience buyers and sellers don’t always think through the optimal strategy for measuring post-closing performance.Buyers ultimately are paying for the future profit contribution from the seller, so a measure of cash flow seems like the obvious performance metric to measure the acquired investment management operation’s success. However, there are at least two problems with using cash flow to benchmark contingent consideration.Returns from markets don’t determine long-term success nearly as much as returns from marketing.First, profitability is at the bottom of the P&L and is, therefore, (potentially) subject to manipulation. To generate a dollar of profit at an RIA, you need some measure of client AUM, market performance, a fee schedule, investment management staff, office space, marketing expense, technology and compliance, capital structure considerations, parent overhead allocations, and any number of other items, some of which may be outside of the sellers’ control. Will the sellers accuse the buyer of impeding their success? Can the factors influencing that success be sufficiently isolated and defined in an earn-out agreement? It is often more difficult than it seems.Second, much of the post-transaction profitability of the acquired business will depend on the returns of the financial markets, over which nobody has control. If a rising tide indeed lifts all boats, should the buyer be required to compensate the seller for beneficial markets? By the same token, if a deal is struck on the eve of another financial crisis, does the seller want to be held accountable for huge market dislocations? In our experience, returns from markets don’t determine long-term success nearly as much as returns from marketing. Consider structuring an earn-out based on net client AUM (assets added net of assets withdrawn), given a certain aggregate fee schedule (so business won’t be given away just to pad AUM).Name Specific Considerations That Determine Payment Terms.Is the earn-out capped at a given level of performance or does it have unlimited upside? Can it be earned cumulatively or must each measurement period stand alone? Will there be a clawback if later years underperform an initial year? Will there simply be one bullet payment if a given level of performance is reached? To what extent should the earn-out be based on “best efforts” and “good faith?”Earn-outs manage uncertainty; they don’t create certainty.Because these specific considerations are unique to a given transaction between a specific buyer and seller, there are too many to list here. Nevertheless, we have formulated a couple insights about earn-outs over the years: 1) Transaction values implied by earn-out structures are often hard to extrapolate to other transactions.  2) An earn-out can ease the concerns and fulfill the hopes of parties to a transaction about the future – but it cannot guarantee the future. Earn-outs manage uncertainty; they don’t create certainty.Above all, contingent consideration should be based on the particular needs of buyers and sellers as they pertain to the specific investment management business being transacted. There is no one-size-fits-all earn-out in any industry, much less the RIA community. If an earn-out is truly going to bridge the difference between buyer and seller expectations, then it must be designed with the specific buyer and seller in mind.Earn-Outs Are Like WarrantiesWhat happened to the Jensen Healey? Over that fall weekend in Miami, we detailed and waxed the car. My dad was able to get the crease out of the aluminum hood by reshaping it with his bare hands. It was a beautiful car and sounded great under power, but even a five-year-old British sports car in the 1970s was cause for concern, and they don’t come with warranties. My dad had lived with an old Jaguar in his 20s and didn’t mind getting grease under his fingernails, but one evening we were diving the Jensen home from dinner and it ran out of gas. The fuel gauge didn’t work; likely one of a string of problems that would lead my father to a level of buyer’s remorse that he had experienced with other cars and didn’t want to deal with again. He didn’t buy it.Like old sports cars, acquisitions don’t come with warranties, so protecting yourself against buyer’s remorse is critical. Even with escrows and punitive terms, you can’t guarantee that you’ll get what you pay for in an acquisition; but, with a properly structured earn-out, you can at least pay for what you get.

Road racecourses were originally built with at least one very long straightaway that allowed cars to reach maximum speed before braking for the turn.  As cars became more powerful, the maximum speed attainable on the straights was dangerously fast.  Racecourses added serpentine curves, known as chicanes, to the straights that require cars to slow down and maneuver before resuming a straightaway.  2020 has been a year of one chicane after another, and at this point, I don’t think anybody expects a direct path to 2021.RIAs Outran Two Challenges in 2020…After a decade of gaining speed, the outlook for the investment management industry suddenly turned fairly grim in March.  With workforces on lockdown and equities falling, the pricing of publicly traded RIAs unsurprisingly trended downward.  But running an investment advisory practice remotely turned out to be much less impossible than many imagined, and AUM rebounded rapidly with the markets.  As such, Q2 did not turn out to be the industry bloodbath that many imagined, especially in the wealth management space.2020, however, is full of surprises, and the third quarter is bringing more.  The persistence of the pandemic and the consequent economic strain on many has shifted political winds in favor of the minority party.  If these trendlines don’t roll over between now and November 3, we’ll have a new executive and legislative regime and, with it, a redirection of tax policy.  It’s not too early to start thinking about what impact certain legislative changes will have on the RIA industry, especially with regard to estate tax law.Estate Planning Rising in ProminenceInvestment advisors are not estate planners per se, but estate planning is a necessary part of financial planning for very wealthy clients.  If political winds shift, more of your clients could be subject to estate taxes and, therefore, would benefit from estate planning.  When my career started in the 1990s, the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) was only $650 thousand, or $1.3 million for a married couple.  The unified credit wasn’t indexed for inflation, and the threshold for owing taxes was so low that many families we now consider “mass-affluent” engaged in sophisticated estate tax planning techniques to minimize their liability.Then in 2000, George W. Bush was elected President, and estate taxes were more or less legislated away over the following decade.  Over the past decade, the law has changed several times but mostly to the benefit of wealthier estates.  That $650 thousand exemption from estate taxes is now $11,580,000.  A married couple would need a net worth of almost $25 million before owing any estate tax, such that now only a sliver of RIA clients (not to mention RIA owners) need heavy duty tax planning.That may all be about to change.  Joe Biden has more than gestured that he plans to increase estate taxes by lowering the unified credit, raising rates, and potentially eliminating the step-up in basis that has long been a feature of tax law in the United States.Biden’s Proposed Tax PoliciesBasis step-up is a subtle but important feature of tax law.  Unusual among industrialized nations, in the United States the assets in an estate pass to heirs at a tax value established at death (or at an alternate valuation date).  Even though no tax is collected on the first $11.6 million per person, the tax basis for the heir is “stepped-up” to the new value established at death.  Other countries handle this issue differently, and Biden favors eliminating the step-up in tax basis.  Further, he prefers taxing the embedded capital gain at death.  Canada, for example, does this – treating a bequest as any other transfer and assessing capital gains taxes to the estate of the decedent.Capital gains tax rates are generally lower than ordinary income taxes, of course, but Biden has also suggested that he would raise capital gains taxes for high earning households to equal ordinary income tax rates, which he also plans to increase.  Imagine a $10.0 million portfolio with a tax basis of $2.0 million.  If your client passed today, it might go to heirs free of estate taxes and with a new tax basis of $10.0 million.  If your client pays the maximum capital gains tax rate of 20%, the unified credit and basis step-up would save them $1.6 million (20% of the $8 million gain).  The entire $10.0 million portfolio would pass to an heir tax free.  If, instead, the unified credit is significantly reduced and capital gains rates rise to, say, 40%, the change will cost your client’s estate $3.2 million, and the bequest would be diminished to $6.8 million.  If an estate tax is levied on top of that, the impact will be much greater.For those who want to minimize exposure to changes in tax law, estate planning can leverage the very low interest rate environment in conjunction with trusts and asset holding entities to transfer wealth efficiently and outside of the reach of the U.S. Treasury.  The problem that may well present itself is the overwhelming demand for these services in late 2020 if the election is decisively in favor of the Democratic Party.  If success in investing is “anticipating the anticipations of others,” this is a good time to think seriously about estate planning before tax planners become as scarce as toilet paper was in April.What is the Next Chicane?Where were you when you first realized that the Coronavirus pandemic was a big deal?  I was in, of all places, New York with my family during the second week of March, and I’ll never forget how every day of the week it became more apparent that COVID-19 was going to change the trajectory of this year, if not beyond.  First, the NBA suspended the season, then Tom Hanks – who was in Australia – tested positive, and then – also in Australia – the Formula 1 racing season was suspended about two hours before it was scheduled to start.F1 resumed on July 5 with the Austrian Grand Prix, and the motorsport, which is essentially a giant logistical exercise anyway, has successfully pivoted schedules, business practices, and financial models to adapt to operating in an environment with plenty of at-home viewers but nobody in the stands.  Even for a business that thrives on making order out of chaos, Formula 1 is going better than expected, and the same could be said of the RIA industry.  But now that you’ve successfully protected, and maybe even enhanced, your clients’ financial well-being and the earnings of your firm, the challenges that loom from political change are coming in fast.  The chicanery of 2020 never ends.

In this whitepaper we review the history of trust companies and how consolidation in the banking industry, changing consumer preferences, and favorable trust law changes have led to the proliferation of independent trust companies. We analyze the average trust company’s income statement and industry-wide trends, such as trust companies’ relative immunity to fee pressure. We consider valuation “rules-of-thumb,” and why they often fail to address the issues specific to a given firm. Finally, we consider the various valuation methodologies, including the use of discounted cash flow models and guideline public company analysis, and how the use of multiple valuation approaches can serve to generate tests of reasonableness against which the different indications can be evaluated.

Not much these days gets me to crawl out of my bunker and risk becoming a victim of the Coronavirus pandemic, but this weekend I had the opportunity to drive a new McLaren flat-out on a closed road course here in Memphis. The question wasn’t “is it worth the risk?” Rather, “where’s my helmet?!”570 horsepower does wonders with barely 3,200 pounds to propel, and even though I “only” got the car up to 145 in the straights, it was the behavior of the car in the curves that really impressed me. McLarens are built on a chassis that is essentially a “tub” of carbon fiber, not the usual cage of metal tubes. Because of this, the ride is exceptionally smooth, even under race conditions. Most supercars beat you to death at speed; no matter how many G's you pull, the McLaren feels deceptively like you’re driving carpool.Contrast this with a few observations I have about the investment management industry’s experience, so far, with the Paycheck Protection Program, which hasn’t gone smoothly at all.Under pressure from many questioning the efficacy and/or execution of the Paycheck Protection Program, or PPP, the Small Business Administration released the program participants’ data. Although the information given is described as “redacted,” it includes plenty, including approximate loan amount, name and address of the borrowing company, industry classification, number of jobs retained by the program, and sponsoring lender.Few industries have generated as much controversy from participating in the PPP as has investment management, probably because asset valuations (and therefore revenue) have held up and in many cases grown because of Treasury’s support of financial market liquidity. That said, we only know market behavior since inception of the PPP in hindsight, and we’re still many trading days away from the end of this pandemic and the recession it has precipitated.In any event, we spent some quality time with the SBA’s release of PPP borrower data to see what impact the program has had on the investment management industry. After scrubbing out some misclassified businesses, we found more than 2,400 program participants (RIAs, trust companies, financial planning firms, etc.) that borrowed at least $150,000 (a separate release covered smaller loans). Even though the borrower pool is relatively small (there are at least 10,000 RIAs that aren’t participating), the demographics of the pool are telling.Loan SizeThe typical loan size that investment firms applied for through PPP is modest. The SBA’s data release classified loan sizes in five categories. Within those categories, about two-thirds (~1,600 or so) of the investment firm participants borrowed between $150,000 and $350,000. About one-quarter of the participants received loans between $350,000 and $1.0 million. 134 firms received loans between $1.0 million and $2.0 million. The remaining 50 firms applied for loans larger than $2.0 million, and we only found four who received loans in the largest category, between $5.0 million and $10.0 million. This suggests that, for all the controversy of large businesses milking the PPP for unnecessary capital, few, in fact, got substantial funds from the program.LocationThe largest pool of investment management firms borrowing through the PPP was not New York, but California, with over 350 borrowers. New York was second, and if you add in New Jersey and Connecticut then that contiguous region had a few more borrowers than California. On a stand alone basis, Texas actually had the third-largest number of borrowers, with nearly 200. Unsurprisingly, Florida, Pennsylvania, Illinois, and Massachusetts all had between 100 and 150 program participants from the investment management industry, with states like Minnesota, Georgia, Michigan, and Washington producing more than 50 each. The data suggests that the industry is not as concentrated in New York and California as many might think, although sixteen states produced fewer than ten borrowers each.Type of CorporationApproximately two-thirds of the borrowers listed themselves as either a Limited Liability Company, a Partnership, or a Subchapter S corporation. This confirms our experience with the popularity of tax pass-through organizational structures in professional services firms.Race/Ethnicity of OwnershipAs the investment management industry has started the process of discussing the lack of minority inclusion in the space, the PPP data offers confirmation. We found only 27 firms (around 1%) that listed themselves as being Native American, Asian, Black, or Hispanic owned. Some minority-owned firms may have chosen not to answer (loan qualifications are not demographic-contingent).GenderSimilarly suggesting the narrowness of opportunity in the investment management industry, only 49 firms listed themselves as being female-owned. Again, some women-owned firms likely chose not to describe themselves that way (we have a woman-owned client who participated in the program but didn’t specify their firm as such), but the order of magnitude is what it is.Veteran-OwnedWe counted fifteen firms as being veteran-owned and were surprised this number wasn’t larger (we also have a Veteran-owned firm as a client).Jobs RetainedThe data release also includes a disclosure for the number of positions used in calculating the PPP loan application, giving a good approximation of the number of full-time equivalent employees of the applicant. The total group listed over 52,000 employees. Consistent with the small size of the average loan amount, fully one-quarter of the program participants listed fewer than 10 employees. The next quartile had 10 to 15 employees. Almost another 25% of applicants had 16 to 30 employees. Only 70 participants showed 100 employees or more.So, if you’re an RIA owner and you’ve now been listed as a participant in the Paycheck Protection Program, was it worth it? The disclosure of program participants puts investment managers in an awkward position if they are simultaneously telling clients that they are safe and well-managed while also accepting government aid. That said, turning down low-cost working capital doesn’t seem prudent to me under any circumstances. Firms can always pay the money back if they don’t need it, and if markets tank next week and RIA revenues plummet, the extra capital will do what it was intended to do: keep the workforce in place until conditions improve.As I told my wife, what could possibly go wrong?

Sports cars are not known for durability. Colin Chapman, who developed the Lotus, reportedly once said that if a sports car wasn’t falling apart as it crossed the finish-line, it was over-built. Jaguar owners once remarked that their cars were so unreliable that they could derisively boast “drove it cross-country and it only caught fire twice!” But the neediest of the marques must be Ferrari, many models of which include regularly scheduled procedures that require the complete removal of the engine. The “engine-out” is needed for otherwise normal things like replacing belts, and adds more to the cost of routine maintenance than my first three cars cost, combined. If you study the market for used sports cars, you rarely see a high-mileage Ferrari – it’s no wonder.We’re now a full three months into the unusual operating circumstances brought about by the Coronavirus pandemic. The RIA industry is weathering this all very well, in no small part because financial markets rebounded quickly enough to stem what could have been a disastrous downturn in management fees, and because technology has enabled most RIAs to serve their clients very well, and in many cases with greater efficiency, from remote locations. Many are talking about how the pandemic has been an accelerant of change, not necessarily a cause. Practice management issues that would otherwise be easy to delay addressing are now seen as warranting more immediate attention. To this end, we’ve had a number of clients reach out to us in the process of revisiting their shareholder agreements.We’ve been an advocate of strong buy-sell agreements for investment management firms for a long time. Orderly ownership transition not only assures that the buyers and sellers of interests in an RIA are treated fairly, but it also helps to ensure the sustainability of the business. Re-writing a shareholder agreement can feel like an engine-out service, but nothing is as costly – both in terms of time wasted and money spent – as a shareholder dispute. To that end, we have a whitepaper on buy-sell agreements. Although this was targeted specifically at wealth management firms, the same issues and themes apply to asset managers, trust companies, and other investment management businesses.Pull your shareholder agreement out and compare it to our whitepaper. You’ll probably find that the “downtime” afforded by working remotely and traveling less is a perfect time to clean up some practice management issues, including your buy-sell.Here's the code with a black border added to the image: htmlWHITEPAPERBuy-Sell Agreements for Wealth Management FirmsDownload Whitepaper

Twenty-five years before the marketing group at General Motors rebadged a humble Yukon to create the first Cadillac SUV, the Escalade, a body shop in California called Traditional Coach Works was modifying Coupe de Villes into a car/truck configuration they dubbed the Mirage.  Whether or not anybody really needed a Cadillac to haul a 4x8 sheet of plywood was beside the point; the car was aptly named for the double-take any casual observer might have upon seeing one.  The Mirage was sold through Cadillac dealers at nearly twice the cost of a standard Coupe de Ville, and in spite of that premium, buyers saw enough function in the form to order over 200 of them.  A few are still around.Since the Coronavirus pandemic settled into the American consciousness in mid-March, industry pundits such as myself have been actively musing about the impact of the crisis on the RIA community.  Two months later, we’ve learned:Most investment management firms can work very effectively on a virtual basis (at least for months at a time), and,The Fed is not afraid of moral hazard, and is, in fact, more than willing to socialize the cost of market disruptions (remember the other Golden Rule: whoever has the gold makes the rules). This should be calming, even inspiring, to shareholders of investment management firms.  RIA operations are mostly unaffected by this pandemic, and RIA financial performance has been supported by massive central bank intervention.  None of this explains the pricing of publicly traded RIAs, however; especially when you look at the impact that slumping valuations have had on RIA dividend yields.Are we really in a yield-starved environment?  One would think so, with longer dated Treasuries priced more on the basis of a return OF capital than return ON capital.  The broader market has shrugged off the likelihood of steep declines in earnings, leaving the dividend yield on the S&P 500 mostly unchanged from what it was before the advent of COVID-19.  RIA pricing, ironically, has not enjoyed the same support.The valuation dysphoria facing the investment management industry does not make sense.  RIAs are viewed by many as an ideal growth and income asset: with durable customer relationships producing revenue streams that drift upward with financial markets, and cost structures that can be leveraged to improve distributable cash flow per dollar of revenue.  Despite this very supportable investment thesis and the absence of many alternatives, the market seems to have lost interest in the RIA sector.  Why?A review of comments from first quarter earnings calls does not suggest that most industry participants are getting ready to cut dividends:Silvercrest Asset Management Group(6.0% yield): “Silvercrest currently pays a generous quarterly dividend of $0.16 or an annual dividend of $0.64 per Class A share of common stock. The firm anticipates that it can support the current dividend for a sustained period of time, even while continuing to invest in the business.” – Rick Hough, Chairman and CEOWaddell & Reed (7.1% yield): “…we feel pretty comfortable with respect to the level of the dividend at this point. There's quite a difference between the cash flows that we generate versus reported net income. And at this point, we feel very comfortable with the current level of dividend, [and] the sustainability of that.” – Philip Sanders, CEOBlackrock (2.9% yield): “As we’ve previously announced in late January, we increased our quarterly cash dividend by 10% to $3.63 per share and have no plans to reduce our dividend during the remainder of the year.” – Gary Shedlin, Chief Financial OfficerFranklin Resources (5.5% yield): “…just to complete the capital management with dividends. We [intend to] keep where they are, as you know we're pretty - a sacrament to us. We want to continue to pay out [the] dividend.” – Matthew Nicholls, Chief Financial Officer The one exception to this otherwise reassuring chorus is Invesco, which has suffered greatly from asset outflows, and recently cut its dividend in half:Invesco(7.9% forward yield): “Our decision to reduce our common dividend by 50% was done certainly with an understanding that the environment could weaken from here. It wasn’t necessarily our working assumption, but certainly we’re not thinking that we’re seeing a snap back going forward. But we don’t intend, and we certainly don’t intend to make another difficult decision like this again, and we do feel confident that this was the right action at the sufficient level to give us the flexibility that we desire to manage the balance sheet, even if the environment were to deteriorate from here, and we’ve stress tested this all which ways.” – Loren Starr, Chief Financial Officer Whether Invesco is the bellwether or uniquely challenged remains to be seen.  On the whole, it’s difficult to rationalize a business leveraged off of market performance that has become priced so differently than the market.  Either the RIA industry is being unfairly punished (and therefore represents a nice yield play at these prices) or broader equity markets are due for a comeuppance, or some combination of the two. Dividend stocks haven’t gotten much love in the growth obsessed market of the past couple of decades.  But with bonds priced to yield very little, talk of negative rates, and little in the way of meaningful income from shares in other industries, the coupon-with-upside opportunity represented by public RIAs won’t go unnoticed forever.  The yields available from much of the public RIA community may seem like a mirage, but they may, instead, prove to be an income oasis in the investment desert of ZIRP.

Travel is one of the freedoms of normal life which I miss these days. One of the earliest celebrations of the great American road trip was a series of shows from the television comedy, “I Love Lucy.” In those episodes, the Ricardos and their neighbors, the Mertzes, drive from their home in New York to Los Angeles, where Ricky Ricardo is embarking on a film career. The 3,000-plus mile journey would have taken nearly two weeks in the pre-interstate 1950s. The couples traveled in style in a gorgeous 1955 Pontiac Star Chief convertible, but the search for gas stations, food, and lodging along the way were more than a challenge without smartphones or GPS.Where Are We?These days, the RIA industry is on its own road trip, and everyone’s searching for “the” map (Hint: there isn’t one). In the third week of March, I think I heard from every single media outlet that covers the investment management industry, wanting to know how the current crisis (COVID-19 pandemic, market swoon, and consequent recession all rolled into one) would threaten RIA valuations and M&A activity. I talked to lots of reporters and said lots of things. No one really asked about the challenges firms face these days just to operate their businesses, and that is the most important topic for now. Valuation and M&A will sort themselves out over time.Road Work Ahead To put it mildly, the operating environment for RIAs of every stripe is disorienting. Equity markets took a 30+% plunge, and now (as I write this), we’ve retraced about half of that. Debt markets have been even more erratic than equities, and many commodities markets have experienced even greater price fluctuations than debt. (Does anyone else notice that the relative asset volatility in the global capital stack seems backward?) It’s hard to find anyone who thinks there’s a quick way out of this, despite the Treasury Department carpet bombing the economy with money. The perma-bears are the only happy people in finance because they’ve been invited back on CNBC. Meanwhile the press is debating what letter of the alphabet best represents the future of the markets (value-added stuff).How Are You Doing?The value of RIAs and the future of transactions in the industry ultimately comes down to the health of the individual firms. Fortunately, there is a relatively straightforward way to assess the financial well-being of your firm, and ways of taking corrective action if your firm’s future is threatened.RIAs have a unique business model in that it is possible, on any given day, to assess whether or not a firm is profitable. Doing so simply requires an assessment of ongoing revenue and expenses.Start with your current expense base. The easiest way to do this is to take your last month’s P&L. Your biggest expense is labor and benefits; it’s not unusual to see labor costs comprising two-thirds or more of an RIA’s total operating costs. For the purpose of this exercise, just look at the fixed cost of salaries and benefits. Leave out discretionary bonuses or other personnel-related costs that are unlikely to be realized in a bear market. Once you’ve quantified total personnel costs, look at other fixed costs like rent, research, compliance, technology, systems, etc. Adding all of that together will derive your annualized expense base.Most businesses can compute a run-rate of expenses, but the beauty of the RIA model is that you can also know, on any given day, what annualized revenue is. Take closing AUM as of the most recent trading day, filter it through your fee schedule, and you can tell, based on that day’s market pricing of your client assets under management, what annualized revenue is.With annualized revenue and expenses calculated, you know whether or not you’re profitable, and by how much.Margin for ErrorProfit margins have a number of functions, but one which is often forgotten is that margins enable a business to sustain itself during a downturn. Most RIAs have lots of “operating leverage” in their P&Ls which allows them to retain a considerable degree of upside in revenue as profitability. Symmetrically, though, operating leverage means that most investment management firms also lose profitability on a near dollar-for-dollar basis as revenues decline. The good news is that the degree of operating leverage in different types of investment management firms tends to be offset by their level of “normal” profit margin.Wealth management (and independent trust company) margins tend to be more modest than those of asset managers and hedge funds, but the impact of a bear market on wealth managers is usually moderated by portfolios with healthy allocations to fixed income securities. In a market decline like we’ve had recently, a fixed income allocation might effectively hedge about a third of the loss in AUM and revenue. Asset managers focused solely on equities, on the other hand, are positioned to face the full fury of a bear market. Fortunately, asset managers usually start with higher profit margins, which allows them to better absorb the loss of revenue. Note that, in both examples, salaries comprised half of revenue in the base case (pre-bear market). Investment management is labor intensive, and we commonly see substantial fixed compensation expense. The real operating leverage for asset managers comes from non-personnel related costs, which are usually fairly minor as a percentage of revenue. In any event, this is a good time to stress-test your profitability to see, on a day-to-day basis, what kind of market activity threatens the sustainability of your firm. Then you can decide what to do about it.Never Waste a Good CrisisIf you check your ongoing margin and it isn’t what you’d like, then what? We won’t try to forecast how deep this bear market will go, or how long it will last. Regardless of the forward look, the magnitude of the current situation presents an opportunity to build some flexibility into your business model that makes it more adaptable to any environment.In the credit crisis of 2008-09, we had more than one client cut compensation across their ranks, usually more for upper level staff and partners than for more junior members of their team. One client went so far as to use the opportunity to reset relative levels of compensation, restoring salary levels for some employees but not others after the market recovered.To us, the current environment illustrates the value of flexible compensation plans, with bonus compensation tied to the profitability of the business. To pick up on the examples shown above, if our example wealth management firm were to reduce fixed compensation by half, and then split half of pre-bonus profits with staff in the form of quarterly bonuses, compensation expense could then adjust to market conditions and margins would become more stable. This example is a little extreme (cutting salaries by 50% is rarely an option), but it illustrates how tying an RIA’s largest expense at least partially to profitability can improve the resiliency of the firm and, ultimately, the job security of the firm’s employees.The Ultimate Road TripEvery bear market is scary in its own way, but the current one threatens our physical health as well as our financial health, so it wears on our psychology much more than most economic downturns. We hope that all of our blog’s readers are safe and well. And while you’re at home, take a moment to think about what unique opportunities might present themselves in the age of COVID-19.No doubt the cast of “I Love Lucy” wouldn’t try to spend two weeks traveling together in the middle of this pandemic, but one team realized that the currently uncrowded roads of America offered the chance for a new coast to coast speed record, and drove a modified Audi A8 from New York to Los Angeles in 26 hours and 38 minutes, quite a bit faster than the Ricardos and the Mertzes. We would urge our clients to find other outlets for their ingenuity.Photo of the anonymous team car that just set the “Cannonball Run” record (New York to Los Angeles) (roadandtrack.com)

Stop and reflect on the significant financial news of the past month - what do you remember?  Coronavirus?  Warren Buffett’s annual shareholder letter?  Morgan Stanley merging with E-Trade? Franklin Templeton buying Legg Mason?It’s hard to imagine, but the most significant deal in the RIA community so far this year happened less than three weeks ago and is already nearly forgotten: Peter Mallouk sold a minority stake in his firm, Creative Planning, to private equity firm General Atlantic.  The transaction is easily one of the largest minority transactions in the history of the RIA industry, and potentially provides a blueprint for others to follow.Deal specifics were not given, and we don’t have any inside knowledge of how the transaction was structured.  What we do know is that Creative Planning reported just under $50 billion in AUM at year-end 2019, twice the size of United Capital when it was acquired outright last year by Goldman Sachs.Creative Planning’s fee structure is not atypical for the industry, and no doubt some fees on upper-end clients are negotiated.  But while we cannot say with certainty what their effective fee schedule is across their overall business, it wouldn’t be unreasonable to assume that Creative Planning realizes 65 to 75 basis points on that $50 billion, for total revenue in the $300 to $400 million range.  Stop and take that in for a moment, as very few investment management franchises have achieved a similar scale.We strongly suspect that the margin Mallouk realizes is enviable.  Creative Planning posts a smaller headcount than United Capital, despite having twice the assets under management.  Investment management is a labor-intensive business, but Creative Planning is efficient, and probably boasts an EBITDA margin north of 25%, maybe as much as 35% (and possibly more).  This suggests that the firm makes on the order of nine figures per year in distributable cash flow.  Of note, prior to this transaction, Mallouk was the sole owner.We strongly suspect that the margin Mallouk realizes is enviable.As for the multiple paid, we remember the high-teens multiples bandied about last year for the Goldman/United deal and the sale of Mercer Advisors.  Mallouk was interviewed by Barry Ritholtz in December and mentioned he was entertaining an offer to sell part of his firm.  In the conversation, Mallouk suggested that an appropriate multiple for a minority stake in a firm was 25% less than if it were a change of control transaction.  If we benchmark that discount off of the major transactions for similarly scaled franchises last year, we estimate that Creative Planning fetched a low double-digit multiple of EBITDA.  That would value Mallouk's business, even on a minority interest basis, at ten figures. The implication of all this is Mallouk sold a “mid-teens” percentage interest in Creative Planning for nine figures, and possibly as much as a quarter-billion dollars.  Mallouk says he’s keeping all this cash in the business, as a cushion to protect his firm in the event of a bad market.  More likely, in our opinion, is that the cash will serve as a war chest to fund growth in the event of market stress.  If Mallouk did draw a strong multiple in a strong market and is now prepared to buy market share and hire talent in a downturn, this transaction will go down as one of the best in the history of investment management. As this bull market approaches its twelfth year, it's worth noting how firms are positioning and repositioning for the long term.  And it’s worth considering what isn't happening as well. Mallouk didn’t sell the firm outright, and he didn’t go public.  He says he sees upside in independence, and he's putting his money where his mouth is. Mallouk didn’t sell the firm outright, and he didn’t go public.The Creative Planning transaction is very different than the more widely reported deals from February.  The Morgan Stanley acquisition of E-Trade is interesting for brand extension into the mass affluent space (a la Goldman/United), and we're curious to see if the Franklin/Legg Mason deal delivers promised expense savings as a larger franchise (we are skeptical).  In both cases, though, the firms are managing their downside from changes (fee compression) in the market – which is not characteristic of the operating environment for Registered Investment Advisors.  The Creative Planning transaction is about taking advantage of the remarkable upside available in the RIA space.  It's the kind of deal we hope to see more of.

Reading up on the commentary about the record number of RIA transactions last year, I’m struck by how simple the predominant narrative is: everybody wants in, valuations are up, and deal-flow continues to flourish.Headlines have their own wisdom, but the underlying reality of M&A activity is necessarily nuanced – especially as we approach the twelfth year of this bull market.  If transaction activity is higher and vectoring to grow from here, what is the catalyst? Investment management is a great business.  Firms that don’t need to sell, don’t sell. If transaction activity is up, does this mean that more firms need to sell?  If pricing and deal terms are better, are the transactions available today really that much more attractive than those available a few years ago?  And is the culture of consolidation that has emerged in the RIA community sustainable? The Go-Go 90s I’m no Marcel Proust, but these days take me back to the closing months of an earlier bull market that, in many ways, set up where we are today.1999 was a big year for me in what is now called “adulting.”  I turned 30, became a CFA charterholder, and celebrated my fifth anniversary of employment (deployment) with the same firm where I, stubbornly, still work.  I became an uncle for the first time, and I was about to become a father as well.My colleagues and I watched in disbelief as equity markets rose relentlessly in 1999, and I vividly remember saying that one day we would look back and talk about the “go-go 90s.”  It was exciting, but it also made me uncomfortable.  Warning signs were everywhere.  Nosebleed multiples.  Pets.com.  Nickelback.  The handwriting really hit the wall when I saw that the keynote address at the major business appraisal conference that October was to be given by the authors of a then hot but now forgotten book: Dow 36,000.Cap Rates and CouponsDow 36,000 is a clever fairy tale written by a journalist, James Glassman, and an economist, Kevin Hassett.  The authors assert that the bull market of the 1990s was fueled, in part, by multiple expansion that would persist as investors came to understand that stocks were no riskier than treasuries.  Stock and bond capitalization rates would eventually converge and - voila! - the Dow would quadruple from the levels at which it was then trading.  The book was panned by grouchy economists like Paul Krugman and perma-bears like Robert Shiller, the CAPE-crusader who has since predicted at least nine out of the last two financial catastrophes. Dow 36,000 forecast a sharp rise in the DJIA within three to five years.  It’s been two decades, and we still aren’t there – at least in the public equity markets.  In the private markets, though, I’m starting to wonder if Glassman and Hassett’s fanciful outlook on valuation has finally been realized.Adjusted RealityWhen the bull market of the 1990s abruptly ended in 2000, one casualty was an energy trading firm with very empathetic accountants.  The death of Enron, and the subsequent murder of its auditor, Arthur Andersen, set a regulatory buildup into motion which made it generally disadvantageous to be a public company.  20 years later, the number of U.S. public companies has been nearly halved, and out of the ashes of the public markets rose the phoenix that is private equity.Private equity can be as much about marketing as it is about markets: convince equity investors to lock up their money for a decade, then convince entrepreneurs to take the money.  Cheap debt brings both parties to the table, goading risk-averse investors to chase returns, and teasing sellers with bigger payouts.Twenty years post-Enron, sponsors have raised the art of “heads I win, tails I win more” to a science.  A smorgasbord of cheap debt has enabled financial intermediaries to routinely outbid strategic buyers for three years now.  Hockey-stick projections have been supplanted by higher order land-grab economics: the first idea to gain monopoly status wins.  Banks compete to lend to sponsors buying asset-light businesses based on EBITDA “addbacks.”  LPs look the other way as reality-check IPO exits have been replaced by mark-to-model fund-to-fund transactions.  And the SEC is talking about relaxing the requirements to be considered an Accredited Investor.  What could possibly go wrong?Barbarians at the Gate 2 – Electric BoogalooThe distorted reality of the sponsor community is having an impact on the RIA space as well.The null hypothesis of the RIA community is that investment management is a relationship business that cannot be scaled.  What we are witnessing today is big money trying to disprove that power rests within the advisor/client relationship through ensemble practices, roll-ups, robo-advisors, etc.The trouble is the current PE model of raising billions to create a monopoly around some lifestyle essential doesn’t work in investment management.  Investment management is fragmented for a reason.  It is an owner-operator business model.  It is a lifestyle business.Further, what is there to buy?  If RIAs only sell when they have to, are consolidators just collections of failed firms?  Are they optimized for a bull market?  Is it possible to stress-test these models for the next downturn?  We’ve recently been passing around a ten-year-old article on consolidation pains in the RIA space that is required reading for anyone who wants to learn from the past, or at least not be blindsided by it.Is there a sustainable consolidation model?  Joe Duran scored big with deliberate, strategic acquisitions of local RIAs into one, nationally branded firm – but the cost of being deliberate is time, something that sponsor-backed enterprises don’t have.  The sale of United Capital to Goldman Sachs is viewed by many (not necessarily me) as capitulation, maybe an admission that competing for deals with overcapitalized sponsor-backed initiatives was pointless.  Some dismiss the strategic importance of the deal because, for Goldman, the $750 million it paid for United wasn’t much money.  That may be true, but Goldman doesn’t do many deals, and didn’t have to do this one.The brains behind the United Capital acquisition model, Matt Brinker, is now at Merchant Investment Management.  Merchant has more of a co-invest mindset, and permanent capital, which says a lot about what the brains of the industry think is a successful consolidation strategy.  The co-invest model, in which a financial partner shares with management in equity ownership on a control or, usually, a minority interest basis, seems to have the most traction.  We think that approach can work, so long as returns to equity are clearly delineated from returns to labor.We may have already reached a tipping point.  Deal volume was up last year, but deal value was down.  The pace of transaction activity established early in 2019 didn’t sustain itself in the fourth quarter – usually a big one.  The most visible acquirer in the RIA community, Focus Financial, was called out last summer for becoming over-leveraged.  Focus management disputed this, but since then their acquisition announcements have been few.…like it’s 1999The song that Prince recorded about 1999 isn’t about the good times; it’s a song about the end-times.  As 1999 drew to a close, people weren’t as concerned about the Mayan calendar or Nostradamus as they were about the disastrous consequences of global IT systems locking up because of bad date programming – a fake crisis brilliantly marketed by the IT consulting community to sell their services.  The only real crisis was a missed opportunity to have a good time.My wife and I went out on New Year’s Eve 1999 to a very underattended extravaganza.  80% of the invited guests stayed home, afraid of what I don’t know.  Instead of the big blowout that most of us expected in the years leading up to the new millennium, the reality was that partying in 1999 meant withdrawing into a quiet paranoia.  If you cringe every time someone talks about selling a company for a big multiple of adjusted EBITDA, you get the idea.

Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. The demographics suggest that increased attention to succession planning is well warranted: a full 62% of RIAs are still led by their founders, and only about a quarter of them have non-founding shareholders. Yet when RIA principals were asked to rank their firm’s top priorities in 2019, developing a succession plan was ranked last. Fortunately, there are many viable options for RIA principals looking to exit the business.

Last week I was planning a trip to watch my younger daughter compete in a horse show in Birmingham when the news broke about Charles Schwab acquiring TD Ameritrade.  For those of you who don’t have fragile but determined children who ride stout but stupid equines over fences, a hunter/jumper competition typically means hundreds of miles of travel and days of standing around in moderately bad weather to watch your dearest risk paralysis for a few minutes in the saddle.  It’s 99% utter boredom punctuated by brief moments of tangible panic.  In other words, it’s not unlike the relationship most RIAs have with their custodian.Custodial relationships were boring until last week.  By now you’ve read plenty about the Schwab/TD Ameritrade deal.  Some have questioned whether or not the transaction will be prohibited by anti-trust regulation, but – in the current political environment – I wouldn’t count on that.  Together, SchwabiTrade will custody on the order of 75% of RIA assets, and while some RIA pundits are concerned about the service that RIAs, especially smaller ones, will receive from such a behemoth, they might also want to look into the cost of these relationships, not to mention what Schwab’s end-game really is.If RIAs were David and the wirehouse firms were Goliath, Schwab engineered the slingshot.Schwab is credited with helping create the RIA space, having launched Schwab Advisor Services over 25 years ago effectively as a plug-and-play custodial offering for independent advisors.  If RIAs were David and the wirehouse firms were Goliath, Schwab engineered the slingshot.  Schwab relentlessly drove down the costs of its RIA backbone over the years, embracing technology and efficiency to build scale and lower fees.  There was room for Schwab and TD Ameritrade (its longtime competitor in serving RIAs) in the investment management space, but that was when the industry was expanding and margins were widening.  Now zero commissions and cheap money may be prompting a new plan of action for Schwab that extends beyond this merger.  David may be facing a new Goliath.The last decade has been witness to oligopolistic consolidation and consequent behaviors across many service industries.  Amazon upended retail.  Uber (and Lyft) decimated local cab companies and car rental companies.  Airline consolidation has raised fares and cut service for many markets, including my hometown.  Without debating the merits or evils of creative economic destruction, what is indisputable is that the rise of modern oligopolies has been tough on incumbent industry stakeholders: owners, workers, and (sometimes) customers.It’s hard to see the advent of SchwabiTrade as a good thing for the RIA community – especially the wealth management community.  If Schwab is looking to recapture margins from zero commission trading and low rates on sweep accounts, it need look no further than the ten thousand plus RIAs now in its eco-system.  Changes will likely be slow and subtle, kind of like how the airlines gradually devalue frequent flyer miles while touting “improvements” to their loyalty programs.  Fees drift up.  House brands replace independent products.  Service declines.  And, eventually, Schwab finds a way to go straight at RIA clients – with proprietary technology and their own advisor force.  The best thing for Schwab is that they can use revenues from the RIA community to fund the strategy, and they have control of the data to know what will work most effectively.Schwab may not be successful.  The sequel to most real-life versions of “The Empire Strikes Back” is indeed “Return of the Jedi.”  WeWork’s abject failure is probative insight into the folly of oligopolistic thinking in industries that cannot be cornered, like office space.  The advisor community is vast and nimble.  Schwab has a huge market share, though, and a forty-year head start.  That’s worrisome.Can RIAs escape this by moving to the Fidelity platform, or BNY Mellon, or Raymond James?  It’s worth looking into, and no doubt this moment is a huge opportunity for other custodians to grab market share.  After the dust settles, though, if Schwab increases fees to “remain competitive,” others will at least try to follow.Real economic profits attract competition.And this isn’t the only existential threat facing wealth management.  Goldman Sachs is trying to figure out how to extend their brand to the mass-affluent, and they aren’t the only private bank pursuing this.  Other discount brokers and robo-advisors are trying to move upmarket.  Suddenly, it seems like everyone has noticed that the stickiest revenue and most reliable margins in the investment community are wealth management firms.  Real economic profits attract competition.None of this offers a very upbeat message for Thanksgiving week in an industry that has enjoyed considerable success in recent years.  We should all be grateful for the opportunities afforded by a great business.  My concerns may be alarmist and unfounded.  But I couldn’t stop thinking about how abrupt the advent of SchwabiTrade is as I was sweeping the leaves off my windshield last weekend.  This is probably the biggest news to hit the RIA community in 2019.  If we’re not paying attention, we’ll all be driving blindly.

Earlier this month we had the pleasure of participating in a panel discussion on the value of wealth management firms in a transaction setting for the CFA Society of New York.  In conversation after the event, one of the audience members asked me what I thought was the most successful business model to follow in the wealth management space.  It’s a question we hear fairly often, and I try to avoid punting on the answer and saying “it depends.”  In reality, though, it does depend. Because I don’t care about movies made about comic book characters, I don’t see many movies these days.  Next month is the release of a movie I can’t wait to see, however. “Ford v Ferrari” is based on the true story of Ford Motor Company’s failed attempt to buy Ferrari in 1963.  Discussions broke down when Enzo Ferrari realized that Ford expected the transaction to include Scuderia Ferrari, his racing team, and not just the road car manufacturer.  Enzo’s business might have been selling cars, but his persona was racing cars. Scuderia Ferrari was not for sale.  Henry Ford II was offended at having been rebuffed, and he vowed to build a car to end Ferrari’s dominance at the annual endurance races at Le Mans.  The result was a grudge match at the 1966 24 Hours of Le Mans.  Ford’s purpose-built car, the GT40, beat the Ferrari 330s decisively, the first win at Le Mans for an American team. Despite the win, Ford gave up competing at Le Mans a few years later, and no longer targets Ferrari on racetracks or in the showroom.  The 1966 win did foretell a Ferrari challenger, though.  The winning driver was Bruce McLaren, a New Zealander whose eponymous racing and road car company is today a major rival to almost everything Ferrari does.The Ford/Ferrari combination failed not just because of egos, but because of mismatched goals.Back to my discussion of business models.  The Ford/Ferrari combination failed not just because of egos, but because of mismatched goals: Ford was a high-volume automaker that competed as a marketing gimmick (“race on Sunday, sell on Monday”).  Ferrari was a low-volume automaker that sold road cars to finance Enzo’s racing teams.  Ford wanted to make money.  Ferrari needed to make money.  It wouldn’t have been an easy marriage.In the investment management industry, the question of the best business model generally comes down to opinions about scalability.  At the atomic level, an RIA is composed of the relationship between one advisor and one client.  Building an RIA is a debate over the best way to grow the size of client relationships, the volume of client relationships, the volume of advisors, or some combination of the three.  By “best” I mean finding the right balance of margin, growth, and sustainability.I think the “best” business model is different for different people, however.  Ken Fisher built a twelve-figure AUM wealth advisory company by creating a social media marketing machine to funnel mass-affluent investors into a network of highly regimented advisors.  Unfortunately for him, Fisher isn’t as regimented in his own professional interactions.  Nonetheless, he proved that a high-volume, homogenous, and replicable approach to investment management is both possible and profitable.The “best” business model is different for different people.On the other end of the spectrum, a friend of mine retired from the hedge fund industry a few years ago and is building a boutique wealth management practice that caters to the needs of successful hedge fund managers.  It is the opposite of the Fisher model: low-volume, highly specialized, and difficult to replicate.  I don’t think either Fisher or my friend would be interested in pursuing the other’s approach to wealth management, but they both found models that worked for them.For some valuable extracurricular reading on this topic, don’t miss Scott Galloway’s blog post on margins, scalability and growth.  Galloway’s August blog post opened the floodgates for criticism of WeWork, and is legendary in our world where frank investment analysis is all too rare.Galloway’s more recent post is a thorough and compact digression on the basics of business models and valuation.  If, as he contends, the world really is shifting from a focus on growth to a focus on profitability, the investment management profession may stand to benefit in two ways: valuations should improve (much to the relief of every publicly traded RIA executive and shareholder) and value investing may finally regain its prominence (and, along with it, active management).  We’ve seen “green shoots” suggesting the latter of these over the past few months in the form of an increase in active manager searches.  It hasn’t shown up in public RIA share prices, though.[caption id="attachment_28540" align="aligncenter" width="819"] EBITDA multiples have sagged for smaller public RIAs in recent years.  Is this the beginning of the end, or the end of the beginning?[/caption] Galloway also offers remarks that could be interpreted as throwing cold water on consolidation efforts in the RIA space.  “Services businesses (high margin) usually involve the most unpredictable and messy of inputs — people — and are dependent on relationships (also not scalable).”  I don’t know if Galloway would describe certain investment management firm roll-up models as “WeInvest,” but it’s something to consider. There may be no perfect business model, but there is a business model that’s perfect for you.  The Ford v Ferrari competition today takes place on the Big Board.  Globally, Ferrari sells about 8,500 cars per year, whereas Ford sells nearly twice that many cars per day.  Despite the obvious scale differential, Ferrari (NYSE: RACE) sports a 50% higher earnings multiple, not to mention a 10% greater equity market cap, than Ford (NYSE: F).  Advantage: Ferrari.

In the late 1930s Henry Ford’s son, Edsel, commissioned a one-off convertible version of the Lincoln Zephyr to drive while he vacationed in Florida for the winter.  While the initial design is said to have been penned in about an hour, legend has it that Edsel Ford kept tweaking the details and wearing out the engineers such that they finally locked him out of the shop to finish the car.  Edsel Ford took his Lincoln, dubbed the “Continental,” to Florida, and came back with 200 orders.  Ford suddenly had a halo car, and Lincoln became a durable brand for decades.The Continental story is significant for many reasons, one of them being that it was a big success for second-generation leadership at Ford Motor Company.  Many businesses start and grow by force of the personality of the founder, and wither and die when there is no successor leadership to take over when the founder is no longer at the helm.  Ford succeeded where many other automakers failed, which is why this blog post is starting with that company instead of Pierce-Arrow, Packard, or Duesenberg.Succession is as often discussed as it is misunderstood.If succession is difficult to achieve in a “products” company like an automaker, it is mind-numbing to engineer in a “services” business-like investment management.  Riffing off the over-repeated metaphor to describe the substance of an RIA, if the assets get on the elevator and go home every night…does a change in assets mean a different company altogether?Succession is as often discussed as it is misunderstood.  While many practice management issues revolve around industry expectations, regulations, client expectations, and basic economics, succession involves all of those things plus personality, culture, and skill sets.  And while much has been written about succession in the RIA industry, we’ve seen plenty of topics get little, if any attention.  This post is dedicated to some of the latter.Internal Succession is the Default Plan for Most RIAsDespite the headlines suggesting that there is a wave of strategic takeovers that will ultimately consolidate the investment management profession into a few large firms, the reality we’ve encountered suggests that most RIAs will transition ownership and leadership from one generation to the next internally.  The reasons for this are fairly obvious.Even though there are on the order of 15,000 RIAs in the U.S. which are all generally in the same business (providing investment management consulting services in exchange for fees priced relative to the dollar amount of client assets), there are also about 15,000 business models.  Investment management firms are idiosyncratic, with practices and cultures unique to the individuals involved in the practice and the market niche served by the practice.Staff who grow up, or whose careers develop, at a given firm understand, inherently, the values and expectations of their workplace, and are in the best position to perpetuate the business after the prior generation of leadership retires.Strategic Transactions Rarely Obviate the Need for Succession PlanningLeadership transition issues can loom large even in strategic transactions.  We worked on a dispute situation a few years ago in which a strategic acquirer bought a substantial wealth management practice without even meeting the next generation of leadership.  The ink was hardly dry on the purchase agreement when generation two started looking for the exit, knowing many of their clients would follow them.  Litigation eventually resolved this in one respect, but most arms’ length observers would conclude that all parties (buyer, seller, and the second generation) were worse off as a result.RIAs often pride themselves on having a team-oriented atmosphere, which is great for serving clients, but not so great for negotiating succession issues.  When team members become buyers and sellers, temperaments that were heretofore aligned become opposed.  Arguments can easily break out between members of buyer and seller groups when goals diverge or perspectives on the future of the firm conflict.Some see strategic transactions as a way to avoid the uncomfortable conversations that accompany internal ownership transition.  Not so.  If the strategic transaction does not align with the priorities of the group responsible for leading the firm after the deal closes, then the likely outcome will be suboptimal.Continuity Planning is the Dog that Wags the Succession TailThe client doesn’t really care who owns your firm.  The client cares about the firm serving their needs.  It’s easy to forget this because…Succession is a Strategic Issue Often Mistreated as a Tactical IssueWhen managers at RIAs start thinking about succession, they immediately jump into who buys out whom at what price and terms.  We would suggest, instead, that the starting point is strategic planning for the business.Ownership should be a consequence of the business strategy, not the other way around.Ownership is the single biggest distraction for most closely held businesses.  But ownership should be a consequence of the business strategy, not the other way around.  Think of the strategic priorities of an investment management firm in the same order they appear on the P&L.Revenue comes first.  So, at a basic level, strategic planning for an RIA starts with growing client relationships and value provided to the clients to maximize revenue opportunities.Next comes operating expenses, which for an investment management firm consists mostly of employee compensation.  Spending on talent and tools to achieve the strategic revenue goals form the organization to be owned.Profits are at the bottom of your P&L for a reason.  They matter, of course, but returns to equity are the residual of client interaction and the organization formed to serve them.  Ownership is a by-product of strategy, and, at best, can be structured to support strategic initiatives.Timing is Everything, and so is TimeAnother famous Lincoln, whose first name was Abraham, famously said that if he was given seven hours to chop down a tree, he’d spend six hours sharpening his axe.  We would say this ratio of planning to implementation is about right for dealing with the issue of succession as well.

Whether or not the road tests and sales figures confirm it, the new Corvette is already a success.  It’s only been two weeks since the car debuted, and I can’t remember another new model launch that generated as much conversation.  Last Thursday I had complete strangers asking me what I thought about it on the elevator ride up to the office in the morning and down that afternoon.  One told me he had already put down a deposit.Unlike previous iterations, the eighth generation Corvette sports a mid-engine configuration, and if you squint it looks like a Ferrari 488.  The Stingray is no Prancing Horse, however.  With a 6.2 liter normally-aspirated (no turbo) V-8 generating 495 hp, GM is eschewing the high compression engines favored by European manufacturers (the Ferrari produces more than twice as many horsepower per liter).  Corvette faithful will appreciate the old-school iron under the hood, if they can accept the “hood” being behind them, an automatic transmission, and a dizzying number of character lines in the bodywork.Focus Got People Talking, and MovingIt’s been a year since the Focus Financial IPO generated a similar level of conversation in the RIA community – and the transaction dominos have been falling ever since.  In that same year, Victory Capital pulled off a major acquisition, Affiliated Managers Group got back into the acquisition game following a two-year hiatus, United Capital was acquired by Goldman Sachs, and Mercer Advisors is soliciting bids.I was thinking about all of this on a road trip across the southeast last week, in-between blasting Tom Petty on satellite radio and dropping in on a few clients.  At one of my first stops, a client asked if I saw a lot of M&A activity in the RIA space.  Yes, I replied, but I see even more headlines about it.  Plenty has changed in the RIA community in the last twelve months, but even more has not.The Focus IPO was a Watershed MomentThe Focus management team is to be congratulated for surviving their first year as a listed company.  Serving private equity masters is no walk in the park, but public company life means enduring the unexplained ups and downs of daily trading activity, the tedium of analyst calls, and half-informed commentary from armchair quarterbacks such as myself.  It must weigh on Rudy Adolf and his colleagues, but they made it this far.  Their share price has been volatile but mostly resilient, and the analyst calls are becoming routine.  The question is: now what?The Voting Machine and the Weighing MachineBenjamin Graham developed the metaphor for the stock market acting, in the short run, like a voting machine (a popularity contest) and in the long run, like a weighing machine (based on sustainable profitability).  It’s a useful way to look at Focus, as well as the overall RIA consolidation movement.  Headline activity attracts capital and acquisition opportunities, and headlines begat headlines as others rush to join a crowded trade.  At least for now.  Eventually, all of these consolidators will have to demonstrate they can do something productive with their acquired businesses, and that’s when the robustness, or lack thereof, of the different rollup models will show.Benjamin Graham developed the metaphor for the stock market acting, in the short run, like a voting machine and in the long run, like a weighing machine.The IPO gave Focus an edge in vying for attention among RIA sellers.  As a quick reminder, Focus Financial is not an RIA.  It is a leveraged investment enterprise that accumulates preferred stakes in RIAs, encouraging their growth with best-practices coaching and sub-acquisition financing.  It is not unlike the European Union: financial bonds without much consolidated governance.  Nevertheless, Focus is viewed as a bellwether for acquisition behavior in the RIA community, and rightfully so.United Capital and Mercer Advisors are more typical consolidation models: national platforms with cohesive branding, marketing, management structure, compliance, and investment products.  Focus’s de-consolidated model probably guarantees independence.  Goldman Sachs, which recently acquired United Capital, could never have fit Focus into their framework.Now that Mercer Advisors has put a for-sale sign in the yard, it will be interesting to see who wants their franchise.  One would expect Goldman to consider the possibility of rolling Mercer into their United Capital unit, which could be awkward because Goldman is running the book, but it could happen anyway.  Goldman also led the Focus IPO, and anyone who doubts David Solomon’s commitment to building an investment management franchise hasn’t been paying attention.  My contacts within the Goldman partner network say 1) Solomon is committed to transforming Goldman Sachs and 2) they are impressed with what he’s doing - a powerful endorsement from a tough audience.For Now, It’s a Land GrabIn the near term, Focus will be judged as an acquisition model, which is much more difficult than it sounds.  Acquisition activity is difficult to sustain.   Focus announced eight transactions in the second quarter.  Skimming the ADVs of the acquired entities, these eight firms came with just under $10 billion in AUM and 83 employees.  That’s not insubstantial, although nearly half of that workforce and 70% of that AUM came from one deal.  The other seven transactions averaged about $400 million in AUM and six employees.When you’re the size of Focus Financial ($100+ billion in partner firm AUM and thousands of partner firm employees), it’s tough to move the needle with small deals.  Focus claims thousands of potential acquisition targets, but a realistic assessment is far fewer.  Their model won’t appeal to every would-be seller, and firms that work much outside of the advice and planning space won’t suit Focus.As Focus grows, the pressure will build to do larger transactions.  The rise of competing acquisition platforms will drive up the competition and the multiples, and limit the opportunities for arbitraging the cost of capital.  Deals will still be accretive in the future, but less so than in the past.  All of the consolidators will face this.How Will Things Look in Ten Years?In the longer term, Focus will be judged as an operating model.  Since Focus allows their partner firms to run independently, they have limited opportunities to widen margins with scale.  Monitoring marketing and compliance activities may become more labor-intensive.  Seeing hundreds of firms through succession issues could prove daunting.  Ultimately, the parent organization will have to justify its considerable overhead by helping partner firms grow faster (organically) or become more profitable (than they would be independently) – otherwise the whole will be worth less than the sum of its parts.As for the more integrated consolidation models, the future of Goldman Sachs’s mass-affluent wealth management practice would be easier to forecast if Joe Duran’s acquisition chief, Matt Brinker, had stayed.  Brinker left on the eve of the Goldman deal closing, perhaps to avoid a non-compete.  While he hasn’t said so, it’s hard not to imagine Brinker resurfacing in a similar role elsewhere.  With Brinker out, will Goldman try to grow this platform organically, or draw on other internal resources to hunt for acquisitions?  We’ll know more when Mercer Advisors announces their acquirer.  If Mercer flips to another PE firm, we’ll see more of the same from them.  Word is strategic acquirers are looking at the deal.  In any event, RIA sellers will have several acquisition models from which to choose.Who’s Paying for All of This?The equity multiples being bandied about for RIA consolidators are dizzying.  We know Focus went public at a high-teens multiple of adjusted EBITDA.  Similar multiples were rumored (and remain unconfirmed) for the Goldman/United transaction, and many have suggested the ask for Mercer Advisors is just as high.  RIAs cannot sustain those valuations, so either the pricing is overstated, the pro forma adjustments are substantial, the expected growth is steep, or these really are the end times.One of the earliest lessons I learned in finance was that labor-intensive businesses don’t handle debt well because all they can really mortgage is future compensation.We can only speculate about much of this.  However, much of this activity is financed with borrowed capital rather than equity, and because leverage is more formulaic, the behavior surrounding it is more transparent.  To that end, we’re puzzled about Focus’s debt burden.  In their Q1 2019 filings, Focus reported term debt of almost $800 million and another $290 million on their revolver.  Management reported that this represented a bit less than 4.0x a defined measure of cash flow.  Focus recently announced consolidating $300 million of revolver debt under the term loan, and then quietly filed an 8-K on Friday that upped that amount to $350 million.Term debt is generally more expensive, but freeing up the acquisition line offers flexibility.  With a $650 million revolver in place, Focus could expand their indebtedness considerably – in sharp contrast to what we’re accustomed to seeing.Most RIAs have unremarkable balance sheets.  One of the earliest lessons I learned in finance was that labor-intensive businesses (such as professional service firms) don’t handle debt well because all they can really mortgage is future compensation.  When leverage ratios get stretched and operating conditions dim, the analyst community becomes agitated.  Until then, with a sympathetic Federal Reserve on tap and a land-grab strategy to execute, it’s going to be tempting for Focus management to lever up.  We expect to hear more about this during the earnings call next week.As For Everyone ElseAt one-quarter the price of a new Ferrari, the new Corvette will attract a lot of buyers for Chevrolet.  GM would probably be satisfied with a lot of lookers.  The Corvette is what is known as a “halo-car," designed to showcase what the automaker can do and get people into the showrooms to look at all of their models (less than 5% of Chevy sales in 2018 were Corvettes).  Attention drives activity.I haven’t touched on Hightower or Victory or Captrust or Fiduciary Network or any of the other consolidation platforms.  And I haven’t talked about the PE platforms like Kudu Investment Management that are making headway in the RIA space.  It’s been an active year since the Focus IPO, and the domino effect that comes from transactions completed at seller-friendly pricing and terms sends ripples throughout the industry.  Whether you plan to jump into the fray in the foreseeable future or not, the marketplace around your firm is caught up in it, and it affects you.

When clients call us seeking advice after receiving an unsolicited offer for their RIA, the first questions they ask generally revolve around two issues:Is the price reasonable? andDo we think the buyer will be willing to improve the offer? “Price” is a sticky wicket that we’ve covered in many posts, but whether or not the first offer is going to change in the negotiation and due diligence process is a certainty: yes.  The only question is which direction (higher or lower) the offer will move before the transaction closes.Universal Truths on Unsolicited OffersIf you receive an unsolicited offer for your investment management firm, you’ll find it is usually difficult to immediately assess the sincerity of the offer.  And while making generalizations about the M&A process can be more misleading than helpful, we will assert the following:An unsolicited offer is made based on limited information. Often the initial overture is based on information beyond what is publicly available on the seller’s website and in regulatory filings. Even with financial statements in hand, prospective buyers making their offer know very little about the seller. The due diligence process involves the review of hundreds of pieces of documentation that can and will shape the purchase agreement.An unsolicited offer may be a competitive bid, but it is not a bid made in a competitive market. Not every sale is best conducted in an auction process, but the prospective buyer making an unsolicited offer knows that it is, at least for the moment, the only bidder. The object of an unsolicited offer is to get the seller’s attention and cause them to enter into negotiations, often giving the bidder an exclusive right to negotiate for a fixed amount of time.Whether the offer is made at the high end or the low end of a reasonable range depends on the bidder’s perception of the seller. If a buyer thinks a seller is desperate, the initial offer may be at the low end of a reasonable range, in which the selling process should evolve to move pricing and terms more favorable to the seller.  In many cases, though, the initial offer is above what the buyer ultimately wants to pay (“bid it to get it”) and will use the due diligence process to beat the price down or insert terms that shift the burden of risk to the seller.  If the initial offer seems too good to be true, consider the latter a distinct possibility.An LOI is NOT a purchase agreement. Many sellers think the deal is done if they receive an unsolicited offer with a strong price and favorable terms.  We don’t want to suggest that buyers never put their best foot forward on the first round, but an unsolicited offer should be viewed more as an overture than a commitment.Once the offer is accepted, the real work begins. Stop and think for a moment about what you would like your employment arrangement to be post-transaction. Do you want a substantial base, incentive compensation, a multi-year arrangement, roll-over ownership, administrative responsibilities or just client-facing work, protections in the event of termination without cause, an internal or external reporting requirement, and/or other arrangements?  Imagine your situation as viewed by the buyer and what they would want. This is just one item which is rarely delineated in detail on the first offer. A legion of issues must be resolved in the process of negotiating a final purchase agreement, which is why “deal fatigue” is a prevalent cause of abandoned transactions.ConclusionThe offer gets the process started, but it’s the process that creates the deal.  Transacting an investment management firm is complicated. Advisors to buyers and sellers have the delicate task of aggressively representing their clients and covering every bit of ground in the due diligence process without killing the deal by exhausting the buyer and seller and making them wonder why they ever started negotiations in the first place.  The primary danger of an unsolicited offer is that it lures potential sellers into thinking the deal is done and the process will be easy.  As with most things in life, if something looks too good to be true, it usually is.

On Mother’s Day several years ago I gave my wife a pale blue t-shirt that read “I used to be cool” on the front; on the back it said “Now I drive a minivan.” Such was her lament until an absent-minded motorist in a Tahoe shortened the rear end of her Honda Odyssey by a couple of feet, and we replaced it with a BMW. Unsurprisingly, the manufacturer of the Ultimate Driving Machine doesn’t offer a minivan.Automakers have been trying to square the circle of fun with function, and vice-versa, since they started inviting their marketing departments to engineering meetings. Sometimes this quest has produced absurd results. In the 1990s, the folks at “boxy but good” Volvo put an intercooled, turbocharged motor in their mainline station wagon and created a rocket with room for seven. Kind of a cool idea, but hard to answer the “why?” question.The Ultimate Investment VehicleThe analogous tradeoff between fun and function in the valuation world is risk and growth. Unlike fun and function, risk and growth aren’t so much a dichotomy as they are co-present, and often in direct proportion to each other. Treasuries pay a modest but reliable coupon – they are essentially a no-risk, no-growth investment vehicle. On the other end of the spectrum, seed stage venture capital investing offers supernormal growth rates, and high expected returns to match. The ultimate investment vehicle is the profitable, high-growth, low-risk security: the Registered Investment Advisor.Valuation orthodoxy holds that value equates to cash flow priced for risk (downside exposure) and opportunity (growth or otherwise upside exposure). All else equal, the greater the cash flow, the lower the perceived risks associated with that cash flow, and the greater the likelihood of growth or other upside associated with that cash flow, the higher the value. The reverse is also true.On paper, the RIA model is a value generating machine: a reliable stream of distributable cash flow resulting from sticky, recurring revenues and growing effortlessly with the investment returns available in a diversifiable variety of financial markets. The reality, of course, is more nuanced.Cash is (Still) KingAt a core level, the most attractive feature of the RIA business model is a steady stream of distributable cash flow. This would be true in any market environment; given the low rate circumstance of the past decade-plus, it’s even more so. Unlike many businesses, investment management is not capital intensive, so EBITDA is more or less equivalent to distributable cash flow if an RIA is structured as a tax pass-through entity. RIAs offer the potential for double-digit yields and future growth. There are no fixed income instruments that look anything like that. And it’s for this reason that every week we read a new announcement about capital chasing the RIA space.You can’t value a revenue stream based on unrealistically high fees.The catch is that an RIA’s margin needs to be a real margin. By that I mean that you can’t value a revenue stream based on unrealistically high fees, nor is a profit margin reliable when owner compensation is so low that distributions are really being used as a substitute for wages. Segmenting returns to labor (compensation) and returns to capital (profits) can be difficult, but the value of an RIA is necessarily based on cash flows to the capital providers, as if they were not also part of the firm’s leadership.De-Risking Your FirmBusiness risk is inevitable, even for the best RIAs. Markets tumble. Clients die, and their heirs choose different advisors. Investment committees punish outperformance by rebalancing.Many risks seem avoidable, though. Just look at the headlines. Last week’s announcement that First Republic lost a team responsible for $17 billion in client assets is a potent reminder that revenue producers who see more upside on their own won’t stick around forever, especially if they have a track record of chasing opportunity. And Creative Planning’s breakup with Tony Robbins is a keen reminder of the sort of personality risk that can come with celebrity endorsements, or – thinking back a bit – with founders who want to be celebrities. A lot of times, it seems the big risks that come to bite firms are born out of a growth strategy that soured.Put another way, when evaluating the various “opportunities” available to RIA owners to increase value, it’s worth remembering that opportunity is a two-way street.When evaluating the various “opportunities” available to RIA owners to increase value, it’s worth remembering that opportunity is a two-way street.But it’s not just the usual business risks that bear consideration (client concentration, key manager risk, etc.). These days, I’m thinking more about how prominent the business communities in which RIAs operate have become: consolidators, IBDs, partnerships, and custodians. In a sense, whether you’re talking about Focus Financial, LPL, Fidelity, Raymond James, Goldman Sachs, Charles Schwab, or others, all of these communities act as eco-systems that present support and guardrails to RIAs. Some of these communities will be a better environment for your RIA than others. The biggest risk you face may be the opportunity cost of choosing the wrong one.Growth as an Offset to RiskMathematically, a given increment of growth can mitigate certain business risks. Many years ago we cautioned a buy-side client that they were overpaying for an RIA to tuck into its bank trust department. They wanted the acquisition and did the deal anyway. We weren’t wrong, but the bull market that followed made most of our concerns about the target irrelevant as the growth in the acquired firm gave the bank a handsome return on their investment.You can’t count on bull markets to bail out bad investments, but (even in a cash flowing business) growth matters because it provides part of the expected return on investment. If a given RIA is valued with a discount rate in the mid-teens, say 15%, and the growth expectation associated with the firm’s model is only a modest premium to inflation, say 3%, then the capitalization rate (also known as earnings yield) is 12% (cost of capital of 15% minus the growth rate of 3%). The earnings multiple is the inverse of the earnings yield, or 1/12%, or 8.5x. That’s an after-tax multiple, and the pre-tax equivalent is roughly equal to an EBITDA multiple, or about 6x. At a 5% growth rate, the earnings yield of 10% converts to an after-tax earnings multiple of 10x, or an EBITDA multiple of roughly 7.5x.You can’t count on bull markets to bail out bad investments.That march through the math of cap rates is admittedly dry, but if you’d like to think about how the market values growth, just look at how Focus Financial, an aggregator of mostly wealth management firms, stacks up against Affiliated Managers Group, an aggregator of mostly asset management firms. Since their IPO almost a year ago, Focus has been one of the most, if not the most, acquisitive of the consolidators, and is currently trading at a mid-teens multiple of EBITDA. AMG just announced their first acquisition in two years and has had a tough time growing earnings in these choppy markets. AMG trades for a little less than 10x reported EBITDA, a big discount to Focus.Just Because You Can, Doesn’t Mean You ShouldWe get asked, regularly, what we think the best value-maximizing model is for an RIA. We can tell you that there are approximately 20 thousand RIAs, hybrid IBDs, independent trust companies, and unregistered investment management firms in the United States. Any one of them can be very successful, and we’ve had the pleasure of working with many that do very well. There is no one size fits all model or strategy. We can tell you that value is directly proportionate to cash flow and growth, and inversely proportionate to risk. Any strategy or model can be evaluated in terms of these three levers, and all are available as a way to increase the value of your RIA.Just be careful before you mix and match strategies. Checking the lap time of a carpool carrier is a little like measuring the towing capacity of a Lamborghini. Ridiculous, but some have tried:One of a series of similar advertisements for Volvo

Brand value is difficult to create, hard to measure, and easy to ruin.In the late 1960s, Porsche and Volkswagen found themselves trying to develop similar cars.  Porsche needed a replacement for the 912, a Carrera look-alike with a smaller engine and a cheaper price, and VW needed an updated version of its top-of-the-range (for Volkswagen) Karmann Ghia coupe.  The two automakers combined forces to joint-venture what became the 914 model for Porsche and the new Karmann Ghia for VW.  Since the bodies and powertrains of the two cars were going to be very similar, Porsche faced the balancing act of preserving its exclusive image while taking advantage of the economy of working with the maker of “the people’s car.”  The automakers resolved this conundrum by deciding that only the Porsche would be sold in North America.  This marketing alchemy worked, and while the 914 is not regarded as the best performing or most beautiful Porsche ever developed, it did become their best-selling product, by far, during its seven-year run.Subsequent “down-market” Porsches like the 924 through today’s 918 series have produced the sales volume necessary for Porsche to be efficient while maintaining the pricing power conferred by a premium marque.  This combination has delivered higher margins for Porsche than other German automakers with a more consistent top line than the more upmarket strategies followed by rivals from Italy.  If you do it right, extending your reach can support your brand, not dilute it.Goldman Sachs Extends Brand to Wealth ManagementSome may wonder whether Goldman Sachs is putting its treasured name at risk by making a bid for the mass-affluent wealth management market in buying United Capital.  We don’t think so.Some may wonder whether Goldman Sachs is putting its treasured name at risk by making a bid for the mass-affluent wealth management market in buying United Capital.  We don’t think so.The announcement last week that Goldman was buying United Capital for $750 million caught many people by surprise, but the more I think about it, the more it makes sense.  The opportunity of consolidating the wealth management industry is well publicized: a highly fragmented and inefficient community of small firms in need of effective ownership transition strategies.  Several different approaches to this consolidation have emerged, not all of which would have suited Goldman.  Some industry consolidators leave acquired firms with their own brands and SEC registrations, which theoretically maintains their sense of entrepreneurship - but also makes national marketing impossible, regulatory compliance more expensive, and may not ultimately govern the ownership transition process reliably.  Joe Duran’s approach was different: bring everyone under the United Capital brand and sell it, coast to coast, as a homogenous wealth management platform with a local presence in nearly 100 markets.If there is one consistent story in these RIA rollups, it’s that building them takes longer than anybody expects.  Duran worked on building United Capital for nearly 15 years.  Some things require scale that cannot be acquired in one lifetime, however, and that’s where the CEO of Goldman Sachs, David Solomon, saw an opportunity.This Really Starts with David Solomon, not Joe DuranImagine you’re David Solomon.  You’ve got a really good job heading a global organization known for producing innovative financial products, outsized profits, and Treasury secretaries.  Your predecessor, Lloyd Blankfein, became a public figure by building Goldman in the wake of a crisis that took down several major competitors.  But the financial universe never stops changing, and despite their high-brow successes, one thing Goldman Sachs doesn’t have is much reach beyond the very wealthy.Solomon inherited a business that did well on large and risky trades but needed to transition into an era that is more staid and regulated.  In this environment, he’s looking to bring Wall Street to Main Street.  The opportunities Solomon sees are not upmarket, they’re mass-market.  Even as it celebrates 150 years of success as a powerhouse that profitably caters to the well-heeled, Goldman Sachs has plunged headlong into commercial banking, corporate cash management, and even a branded credit card, so it makes sense to prepare to court the mass-affluent through a wealth management advisory practice.  Goldman could have started from scratch, but buying United gives Goldman an established platform for outreach to the RIA community to seek other acquisitions, which it will undoubtedly begin to do.Will Goldman Sachs Pay 18x EBITDA for Your RIA?So, what does all this mean to you?It has been suggested that the $750 million Goldman paid for United represents something on the order of 18x EBITDA.  The actual multiple isn’t public, but given United Capital’s AUM of $25 billion, total revenue including management fees should be between $200 million and $250 million on an ongoing basis.  A multiple of 18x EBITDA suggests an EBITDA margin in the mid-teens to just over 20%.  That’s a bit thin, so perhaps Goldman Sachs sees opportunities for margin enhancement that buy-down the multiple.  At a 30% margin and midpoint revenue estimate of $225 million, Goldman would have only paid 11x EBITDA.  On a pro forma basis, at least, that makes more sense.United Capital is Duran’s accomplishment, but Duran’s accomplishment is now Goldman Sachs’s missionary effort.In any event, David Solomon probably didn’t reach his bid on a spreadsheet – at least not looking at United Capital on a standalone basis.  The opportunity is to get a substantial but manageable RIA with consistent branding and systems across a national footprint that puts Goldman Sachs in a position to test the platform and grow it accordingly.  Plus, the deal comes with Joe Duran.  United Capital is Duran’s accomplishment, but Duran’s accomplishment is now Goldman Sachs’s missionary effort.  Goldman will need a front-man to pitch their narrative to skeptics and prospects in the RIA community.  Duran will have more credibility than someone who didn’t grow up in the independent channel.This is Not Wirehouse 2.0Some of the early backwash I’ve heard on the deal is that Wall Street money is sucking another example of entrepreneurship into the machine.  I think that’s flat wrong.  If Goldman just wanted to build a new mass-market wirehouse to push investment products, they could have paid much less for many, many broker-dealers with far more FAs than United Capital.  All signs suggest that Goldman is looking for distribution for existing GSAM products (no doubt to upper end clients of United) and also to develop new ones for the more typical mass-affluent client.  But this is not simply a distribution play.  The decision to do this through a fiduciary practice suggests that this isn’t about Wall Street infecting the RIA community, but that RIA culture has finally come home to infect Wall Street.  If Goldman puts its might behind the effort and builds a national brand investment advisory practice, it will be a game changer.Focus + High Tower + Cap Trust + AMG + … + Goldman Sachs = More options for RIAsAlmost lost in the Goldman/United deal was that AMG recently announced their first acquisition (Garda Partners) in a couple of years.  And it was just earlier this month that a rebooted Hightower announced a plan to grow through investments in new RIAs.  With AMG back in the game, and Hightower muscling in on Focus Financial’s territory, the Goldman Sachs deal suggests that buyer competition is going to be heating up in the money management space – much to the benefit of sellers.  It further suggests that RIAs seeking an exit through a consolidation strategy are going to have a number of options depending on their perspective and needs.Even if you’d rather stay independent, stay tuned.  As we all know, an option has value, even if you don’t exercise it.

Classic car collecting has probably reached its apex, with stories touting old iron as an alt-investment and giving tips for beginners to the space.  Have muscle cars finished their run?  Are 90s cars next to rise?  Are Ferraris and Porsches on the downslope?  And so forth.  The chatter is interesting but mostly misses the point.  Collecting old cars is about nostalgia and stories and traveling to auctions in beautiful locations and very occasionally about making money.  About the only thing you can guarantee by investing in classic cars is that it is cheaper than owning horses.Private Markets for RIAs Have Diverged from the Public MarketsOver the weekend, the Financial Times published an article touting the rising merger and acquisition activity in the U.S. wealth management industry.  The piece echoed much of the typical commentary on the RIA industry’s prospects for deal activity: a large, profitable, but fragmented community of firms needing scale to develop the necessary technology infrastructure and serve sophisticated client needs.  The article talked to leaders in several PE-backed consolidators and some M&A specialists in the space, all of whom talked their book in general agreement that valuations were strong and consolidation was on.  What the article didn’t address is that while private equity has indeed been actively pursuing the investment management industry, the public markets seem to have lost interest.What Goes Down, Can Go Down FurtherIt’s not rocket science: strong fundamentals plus weak pricing equals a buying opportunity.Last July, Barron’s ran an article talking up the investment management industry that looked at six firms with depressed valuations and strongly suggested there was a lot of upside there for the taking.  I’ll admit that I nodded my head in agreement, because many publicly traded investment management firms had double-digit losses, and we knew from talking to our clients that business was actually pretty good.  It’s not rocket science: strong fundamentals plus weak pricing equals a buying opportunity.Fortunately, I didn’t execute on the idea.  In the nine months since the article came out, valuations for this group have generally declined further, with four of the six names covered in the Barron’s piece down even more (Legg Mason and Franklin Resources are up, barely).Public RIA Multiples are Following the Trend LowerOne of my colleagues at Mercer Capital, Zach Milam, has been keeping an eye on EBITDA multiples for smaller money managers.  He updated the chart below through the end of April.The chart mimics what we’re seeing in the pricing of public investment management houses.  Most of the time over the past ten years, money managers traded at high single-digit or low double-digit multiples of EBITDA – a metric that should not surprise anyone.  But last year the group took a nosedive toward the mid-single digits.  Valuations bounced back a bit in the first part of 2019, but it’s hard to say they’ve truly recovered, despite record highs being set by many major equity indices and bond prices firming.  Given the improvement in pre-tax returns yielded by the late 2017 Tax Cuts and Jobs Act, this down leg in EBITDA multiples is alarming.When the Trend is NOT Your FriendEven Warren Buffett is not having much luck with investors, having spent this last weekend facing down questions about the pace of Berkshire Hathaway’s succession planning and why the company has underperformed the S&P 500 over the past decade.  And as I wrap up drafting this, the market is generally reeling from the renewed threat of tariffs on China.  Whether you believe Buffett’s difficulties are isolated, part of a broader transformation in investment management, or a contra-indicator, it’s a tough time to be an active manager.So What Explains the “Red Hot” M&A Pace?What would M&A activity look like if a few of the major consolidators were not pursuing a landgrab strategy?In contrast to the headlines, first quarter M&A activity should probably be characterized as “normal.”  DeVoe’s first quarter transaction review shows 31 transactions, down one from the same quarter last year, and with the average size of the deal (sellers reporting just over $600 million in AUM) well down from last year.  The trend in deal size has fallen consistently since 2016, and one wonders what it would look like if a few of the major consolidators, like Focus Financial, were not pursuing a landgrab strategy.The push from the private equity backed rollups has definitely improved liquidity opportunities for sub-$1 billion RIAs, but we suspect that opportunities for larger firms are mostly unchanged.  Wealth management firms and independent trust companies have many options, whereas buyers of asset management firms are more selective.EpilogueIf you missed the article last week in the Wall Street Journal on Charles Schwab’s ascent, mostly at the expense of wirehouse firms, go read it now.  Just as discount brokers revolutionized the retail investment industry and indexing took on asset management, a myriad of forces are trying to figure out how to capture what are perceived to be outsized profits in the wealth management space.  There’s no Schwab-like trend in place yet, even though everyone is trying to claim there is.For all the talk, the deal volume of the consolidators trumpeted in all the headlines is a drop in the ocean compared to the number of RIAs and the assets they manage.  So far, the model of an independent firm with five to fifty employees billing 100 basis points to manage the investible wealth of mass-market millionaires is proving to be highly resilient.  Many of the trends supposedly driving consolidation, like technology, make independence more sustainable.  And while some smaller RIAs are joining industry roll-ups, other wealth management groups are fleeing wirehouses to go independent.  In the end, it’s business as usual.

Because valuation is a relative concept (one asset is only “worth” something when compared to the worth of other assets), the value of a wealth management firm is very much about context. The particular transactional purpose of a valuation is a context. The firm being valued is a context. The state of the wealth management industry is a context. Each context provides a perspective on the expected returns of an investment in a wealth management firm.This whitepaper is intended to give a brief overview of relevant considerations of these perspectives on the value of wealth management firms. It is not intended to be an exhaustive presentation of every consideration, but as the industry has grown up, so has the understanding of most participants that simply saying firms are worth “2% of AUM” is not enough. As professional valuation practitioners, we always viewed such rules of thumb with disdain, and welcome the attitudes of those who take the financial analysis of their own firms as seriously as they do the analysis of the securities they manage for their clients.ContentsThe Anatomy of a Wealth Management FirmWhen You Need a ValuationWho Should Value Your Wealth Management Firm?How Your Appraiser Will “Scope” Valuing Your FirmValuation Methodology

In a world where non-stop financial commentary is as commonplace as it is tedious, one man’s market insights get an unusual amount of attention: Warren Buffett’s annual shareholder letter.   Buffett is an ironic icon of the investment management industry.  He’s made his fortune from active investment management, but regularly articulates his skepticism of the same.  He’s doubtlessly inspired more people to found RIAs than any other individual, yet his firm, Berkshire Hathaway, is not an RIA.  And his annual treatise on the performance of his company is full of common-sense wisdom that, based on Berkshire’s track record, is anything but common.  Buffett’s annual letter may be the most anticipated event of the financial reporting season, and this year’s letter – released on Saturday – did not disappoint.  My favorite passage, decrying the use of “adjusted EBITDA” as a proxy for operating earnings, recounted a story from another famous American:Abraham Lincoln once posed the question: “If you call a dog’s tail a leg, how many legs does it have?” and then answered his own query: “Four, because calling a tail a leg doesn’t make it one.” Abe would have felt lonely on Wall Street.The Rap on GAAPAlso common to Buffett’s annual letter was his comparing and contrasting intrinsic value (what assets are “worth”) and market value (how assets are “priced”).  Readers of this blog don’t need any further explanation of why he would revisit such a topic each year, but Buffett actually opened this year’s letter with the issue because of a change in accounting rules which requires Berkshire Hathaway to mark the value of its positions in public equities to market on its balance sheet, and report any corresponding gains or losses on the company’s P&L.This new fair value reporting requirement makes sense at first glance (why not use market pricing if available?), but Buffett effectively and emphatically deconstructs this accounting standard by noting that 1) it doesn’t require the company to adjust the value of Berkshire Hathaway’s marketable securities for taxes on embedded capital gains paid at the realization of market value, and 2) it doesn’t have a corresponding standard for the company’s interests in entire businesses which, because they are owned outright by Berkshire, aren’t publicly traded.  So while Berkshire Hathaway’s holdings of Apple and American Express are marked to market, GEICO is held at cost.During the volatile fourth quarter of 2018, Berkshire Hathaway’s marketable securities portfolio registered “gains” and “losses” by this standard of $4 billion on several individual days (an amount equivalent to the company’s reported earnings for the entire year).  Yet Buffett notes the companies owned by Berkshire Hathaway generated operating earnings in 2018 that exceeded their previous high (in 2016) by 41%!  The Oracle’s message is clear: GAAP is actually obscuring Berkshire Hathaway’s performance rather than reporting it.Does the Market Obscure the Value of Investment Management?Market pricing of investment management firms over the recent past has shown a similar level of volatility, such that owners of RIAs, BDs, and trustcos (our clients) may be wondering what the impact of market behavior is on the “value” of their firms.  It’s a simple question with a complicated answer.[caption id="attachment_25140" align="aligncenter" width="1000"] It’s been a rough six months for our indices of traditional asset management and wealth management firms. The drop in broader equity indices brought about even greater selling of investment firms, despite the fact that wealth managers usually have a strong allocation to fixed income and are, therefore, less exposed to market downturns. Even as equities recovered, the damage to market pricing for investment management firms has persisted.[/caption] In the valuation community, there are three traditional approaches to value: asset, income, and market.  The asset approach is a basket of balance sheet focused methodologies that aren’t usually considered to mean much to the value of firms where it is commonly stated that the “assets get on the elevator and go home each night” (more on that later). The market approach can be tricky to apply to the valuation of a closely held asset manager.The market approach can be tricky to apply to the valuation of a closely held asset manager.  How does one compare the public pricing of a behemoth like Franklin Resources to, say, a niche institutional equity manager with $3.0 billion in AUM?  If BEN is priced at 6x EBITDA or 10x EBITDA, is that relevant to a firm with one strategy and a couple dozen employees?  Moreover, if – over the past six months – BEN dropped 15%, appreciated to a recent high, then dropped 20%, and is now priced roughly even with where it was six months ago (which is what has happened), does that mean the value of a closely held asset manager oscillated similarly?Buffett, of course, uses what he perceives as market mispricing to buy securities at a discount to what he thinks they are worth.  By “worth,” he means intrinsic value.  As illustrated by the discussion above, it’s sometimes difficult to derive intrinsic value from market approaches.  The income approach, however, is useful.I won’t drag you through all the numbers, but I modeled a sample wealth management firm through 32 years of market gyrations to see what impact market movements had on the discounted cash flows of the business (a decent empirical estimate of intrinsic value).  My inputs were:Starting AUM of $1.0 billionModest accretion of client assets under management (net of client withdrawals and terminations)Aggregate average portfolio returns of 6.5% after feesDistinction between fixed and variable costs (mostly compensation) in the expense baseDiscount rate of 15% and a terminal multiple of 8x net I ran ten-year DCFs over each year of the model to see 1) if there was a positive buildup of value estimated under this income approach, and, 2) what was the resulting multiple implied in each year of the analysis.  With a 32-year time series, this gave me 22 point estimates of value. The result of this exercise suggests the stability of intrinsic value for investment management firms, regardless of market circumstance.  There was a general upward trend in the estimate of intrinsic value over the forecast period, even in bad market conditions, probably because an upward trending market and a successful client acquisition program are more than enough to overcome the inevitable downturns.  The multiple implied by these intrinsic value estimates ranged from 7.25x EBITDA to 9.25x EBITDA, with the average and median multiple falling near 8.0x.  The multiple derived was, obviously, dependent on the discount rate, but the point is that the range was fairly tight regardless of market circumstance.Narrative over Numbers: What Is the Intrinsic Value of Investment Management?One reason Buffett’s letter is more widely read than this blog is he doesn’t simply bombard his readers with numbers.   He also tells the story of his investments in a narrative format which makes sense without reference to margins and the cost of capital.  In recent years Buffett has not failed to extol the virtues of his investment in GEICO.  He loves the property & casualty insurance business because people give them money (premiums) in advance of them having to give some of it back (claims) and in the meantime they can invest the money (float).  That float has helped build Berkshire Hathaway’s investment base into the powerhouse it is today.  The story tells the numbers even better than the numbers tell the story.It really isn’t fair to say that the assets of our clients’ firms get on the elevator and go home every night.The narrative of investment management goes a long way to explaining the intrinsic value of an RIA.  It really isn’t fair to say that the assets of our clients’ firms get on the elevator and go home every night.  No doubt the talented teams which staff these firms are hugely responsible for their success – and those assets don’t increase or diminish in value with market volatility.  But the team is only part of the story.  Client assets (AUM) do correlate to a great extent with the market, but client relationships do not.  In fact, bad markets can put clients into “play,” offering opportunities to pick up new relationships and new AUM from competing firms.  The opposite is also true—strong client relationships are a source of assets to manage, in good times and bad, and serve to underpin the intrinsic value of an investment management firm.Finally, the intellectual property of a firm: the investment management process, the client service experience, and the marketing program which drives new client acquisition all work to ensure that a firm has a steady (if not always stable) stream of revenue and profitability in bull markets and bear markets.Avoiding the Curveball of Market PricingMost partners in RIAs instinctively view the value of their firms from the perspective of intrinsic value.  We generally agree with this, but caution that market pricing still offers information and parameters which can’t be ignored, especially in a world of alternative returns.  Our assignments often revolve around the concept of “fair market value” – and the second word in that standard cannot be ignored.Even in a fair market value framework, though, it can be useful to remember that buyers and sellers of investment management firms usually don’t perceive the value of these firms to be nearly as volatile as market pricing of publicly traded RIAs.  A useful perspective is that of the antique car market.  With few exceptions, even cars which eventually become very collectible experience steep depreciation during the first couple of decades after their manufacture.  Most never recover, but those with some discernible mystique eventually become worth what they initially sold for, some of those sell for their initial price adjusted for inflation, and a precious few become worth much more.  The value of this last group of sought after automobiles, however, is not the steel and glass and rubber, but the intangibles of beauty and engineering prowess.  Speed and scarcity don’t hurt either.A focus on building intangible assets cements the foundation of intrinsic value for investment management firms, in good markets and bad.  Do that and you’ll have a warehouse full of Gullwings.

Earlier this month, the RIA group at Mercer Capital took some time to outline our points of focus for the year ahead.  Group consensus is that the investment management industry is facing an unprecedented number of cross-currents, making the vision for 2019 anything but 20/20.  Last year was kind of a “meh” year for investment management, with a couple of interesting IPOs and an impressive level of M&A activity, but also generally unhelpful financial markets and pronounced multiple contraction across the space.  Add to that a surplus of economic uncertainty and a deficit of political stability, and we see ample ground to speculate as to the future of the RIA community.  But indulging in guessing games gives you little reason to follow this blog, so we’ve decided to spend more time this year giving perspective as to what money managers can control.A Not-So-Random Walk Through Your Income StatementNow that January is almost over, we know that many of you have wrapped up quarterly investor communications and can now take a moment to think about your firm’s operations, direction, and other practice management issues.  A useful place to begin your plan for 2019 is doing some fundamental research on your own business, starting with the P&L.  It’s easy to take internal financials for granted, but if you take a step back and consider your results from operations as if you were an outsider doing due diligence, you’ll give yourself the opportunity to gain an insight or two that is directly relevant to the outlook for your RIA.  Here are five questions to organize a review of your financial statements.  Simple enough, but these five questions lead to about five hundred more.1) What Do Your Revenue Trends Tell You About the Overall Health of Your Business?One of the more unique characteristics of investment management firms is that, for the most part, run rate revenue can be calculated on any particular day, given closing AUM and a realized fee schedule.  But revenue is a flow rather than a stock, and the trends in what generate revenue for an RIA say plenty about the overall health of the firm.  This diagnostic works best at a granular level.Breaking down trends in revenue into trends in AUM and realized fees is revealing.  In fact, one of the first things we do when researching a new client is to develop a quantitative history of their revenue to evaluate the success of their marketing plan, investment management skills, client retention, and value to the marketplace.You may be a $2 billion manager today, but what about five years ago, and how did you get here from there?  Retracing your steps can be a revealing exercise, regardless of what sort of investment management firm you operate.You may be a $2 billion manager today, but what about five years ago, and how did you get here from there?  Retracing your steps can be a revealing exercise.Regarding trends in assets under management, we’ve noticed over the years that wealth management firms tend to focus on net inflows, and asset management firms pay more attention to investment performance.  We recommend you look at both.  New clients gained net of terminations has implications for the effectiveness of your marketing and client service models, as do new contributions from existing clients net of withdrawals.  Keep in mind that this latter measure may also be indicative of the demographics of your client base, especially if you have more retail clients (as opposed to institutional).  Wealth management firms pay less attention to investment performance, but we sense those days are changing.  We learned last year that the CFA Institute is studying ways to extend GIPS (Global Investment Performance Standards) to wealth management firms, and while this may still be years away, you should start thinking about being ahead of the trend.  The most successful firms won’t hesitate to study their firm’s performance from as many perspectives as possible, looking for ways to improve.As for fees, it has been widely reported that the industry is coming to terms with what investment management services are worth to different types of clients.  Early warnings of an army of robo-advisors turned out to be hype, but there is clearly fee pressure (or at least fee consciousness) in every sector of the industry.  What matters to you is your fee schedule.  What are you earning today versus last year, and can you trace that by the product or service you offer over time?  Are changes in your realized fees earned a product of changes in client composition or product offerings, or are you having to price existing products to existing clients more competitively to gain or retain business?2) What Are Your Labor Costs Relative to Market?Whether you’re part of an asset manager, wealth manager, trust company, or any other sort of investment consultant, your biggest cost is labor.  Twenty years ago, RIAs could afford mostly to ignore labor costs because the growth of the industry, heady fees, and favorable markets offered operating leverage that would reliably outrun any margin pressure from overpaying people.  Those days are gone, however, and what we hear regularly is clients looking for ways to become more disciplined about compensation.  Unfortunately, that isn’t easy to do.Although there are several significant compensation studies performed regularly in the investment management industry, the data isn’t very useful to actually set compensation levels for staff or owners.  Data is usually given in ranges, which can be very broad, and it’s difficult to compare positions across firms since even titles like “portfolio manager” can mean different things in different offices.  In addition, perceptions of what is necessary to recruit and retain staff can vary.  We’ve had some clients in secondary markets report that labor costs were lower there than in gateway cities.  Others report that it takes more money to recruit talent to secondary markets because qualified talent wants to live in New York and San Francisco.  This issue becomes more acute the more specific a skillset is needed on an asset management team.We think it’s more useful to think about labor costs holistically.  How does your compensation program relate to your overall business model?  Is the plan scalable?  Does the plan create an appropriate tradeoff between returns to labor and returns to capital (distributions), or are you disguising senior talent compensation as a benefit to ownership?  There is no one answer.  Wealth management firms necessarily look more at individual production as it relates to compensation, although in ensemble practices it may be more appropriate to consider sharing in firmwide profitability.  Asset managers lean more toward paying for strategy performance, although doing so can be difficult in persistently unfavorable markets.Labor costs are the biggest tradeoff to margin, and at some level speak to the scale and efficiency of the RIA.  That said, one has to expect margins to vary based on the type of investment management business.  An institutional manager with a concentrated strategy benefits from extraordinary operating leverage as compared to most wealth managers.  But margins, and the trend in margins, can tell a story about your business model, and how you are staffing it.3) Is Your Technology Spending Appropriate for Your Business Model?Robo-advisors may not have made a dent in the industry yet, and indeed may never, but technology is becoming more essential to the RIA community anyway, and that trend isn’t going to abate.  The challenge, at this point, is to identify what tech spending is worthwhile, and what is just spending for its own sake.  Technology is a big bucket and means different opportunities to different people.We see a great deal of spending on IT across the investment management firm spectrum, but it seems like the jury is still out in many cases as to whether or not firms are seeing a real payoff from it.  Is your technology spending focused on marketing (like Salesforce) or compliance?  Are you trying to fuel growth, reduce costs, or improve client service?Do your tech spending habits suggest that you have a real technology strategy, or are mostly reactive?  And have you made a conscious decision to have your firm be on the leading edge of tech for asset management (sometimes the bleeding edge), or are you content with being on the trailing edge.  Tech is such a challenge for the industry that many firms have dedicated a position in the organization to follow this area of practice management.  At the very least, others are making it part of the job qualification for a chief operating officer.4) Are Your Marketing Dollars Actually Growing Your Business?When the investment management industry was growing steadily because of new investors and market tailwinds, marketing and distribution were concepts that RIAs could take for granted.  Mixed markets and mature investment allocations have changed all of that, and firm leadership who got into the business because they liked picking stocks have been slowly waking up to the reality that they’re in sales.When the investment management industry was growing steadily because of new investors and market tailwinds, marketing and distribution were concepts that RIAs could take for granted.One value to disaggregating changes in revenue, as discussed above, is seeing the effectiveness (or lack thereof) of your firm’s marketing plan.  Taking a hard look at how much you spend on marketing and where it's being spent is another worthwhile use of your time.  Performance matters to clients, but alpha alone won’t attract new clients or retain as many of your existing assets as you might like.We heard an excellent presentation on differentiating your marketing message last fall, led by Megan Carpenter at Fi Comm Partners.  The upshot of the presentation is that financial services are, from a client’s perspective, generic.  Developing a unique way to differentiate and communicate your service offering keeps you from becoming a commodity and having to auction yourself to your clients.We’re not a marketing consulting firm, but we notice firms having a difficult time connecting their spending on growth initiatives, like marketing, with the actual growth of the firm.  You may not be able to develop a measurable, one-to-one relationship between your spending on distribution and the growth of your business, but if you can’t articulate – even to yourself – the relationship between your monetary commitment to growth and your client asset acquisition rate, then it might be time to find a way to do that.5) Is Your Profit Margin Threatened by Ownership Issues?The profitability of an RIA speaks to more than just the results from operations.  Often, where profits go is more telling than where they came from.Is your firm fully distributing?  That is, are you able to pay out all, or mostly all, of your profits as distributions?  If so, then you must be funding most of your growth initiatives, in terms of human capital development and marketing, within your normal expense structure.  Will this remain the case, or will you be required to use profits to fund partner buyouts or firm acquisitions?  Is your ownership on board with those reallocations of distributable cash flow?  Just like compensation tends to be sticky in downturns, most RIA partners don’t like the feeling of reductions in distributions – even if they understand it intellectually.Are your distributions an investment in future leadership, a payment for current key partners, or a royalty for founders?  Depending on how you structure ownership, you can utilize distributions for any one or all of these, but it’s likely your RIA did this without even realizing it.  Part of the wisdom that comes from interrogating your financial statements is making what was accidental intentional, and in the process developing some greater degree of control over your firm’s destiny.Are your distributions an investment in future leadership, a payment for current key partners, or a royalty for founders?How sustainable is your profit margin?  If markets took a sustained 20% hit, would that wipe out your profitability?  Is your buy-sell agreement up to date or could an ownership dispute derail your business?  What is the trend in the margin (growing, shrinking, stable) and why?For a professional service firm, distributions can be an effective way to reinvest in the business – given that the business is one of human capital rather than machinery and equipment.  The question to consider is whether or not you’re using distributions as a way to grow, sustain, or monetize your business model.If Your Financial Statements Told a Story, How Would it End?The investment management industry has been transitioning from one where a rising tide lifted all boats to one of winners and losers.  Issues that could once be overlooked by clients, like performance and pricing, no longer are.  As a consequence of client behavior, issues that could once be overlooked by RIA leadership, like staffing and ownership transition need serious attention.  We seem to be entering a period where there will be a premium on intentionality and accountability, and the financial results of your operations for last year are an informative source of objective commentary on how you’re doing.If a picture is worth a thousand words, then a detailed P&L is worth several thousand.  Just make sure that your financial statements tell the same story about your business that you tell yourself.  If you’re not allocating resources to support the business you think you’re running, make a New Year’s resolution to seek greater alignment.

Last week was turbulent for equities around the globe, but Focus Financial (Nasdaq: FOCS) was hit particularly hard.  Less than five months since IPO, Focus closed Friday at $27.45, decidedly below where the offering priced at $33, and not much more than half the share price achieved less than three months ago. [caption id="attachment_23631" align="alignnone" width="756"]Source: Bloomberg[/caption] I was thinking about Focus Financial last week when I found myself in traffic behind a Hummer H1.  The H1 was the original Hummer, built by AM General based on their military vehicle, the Humvee.  An H1 is immense, weighing in at about 8,000 pounds.  H1s were capable of climbing boulders and steep grades and fording streams and rivers as deep as 30 inches.  Because of these extreme characteristics, the public initially overlooked how difficult the vehicle was to park, maintain, and even keep fueled.  Sales of the H1 peaked in the mid-90s. In 1998 GM bought the brand and started producing a more civilian variant, the H2, and then an even smaller (albeit still very large) H3.  About a decade later, GM gave up as the public lost interest.  Hummer executives must have been frustrated when the media lampooned their products for being ungainly and inefficient.  After all, Hummer never pretended to be anything else. I sensed a similar frustration in Rudy Adolf’s voice last week as he pleaded Focus Financial’s case at the Goldman Sachs U.S. Financial Service Conference.  The recent share price performance of Focus clearly suggests the market is losing interest in the issue, and it doesn’t seem to have anything to do with Brexit or yield curve inversions.  Instead, the analyst community seems to have soured on the Focus story, which is strange to us because the story hasn’t really changed since the company filed the first version of its S-1 back in May. Focus's Business ModelFocus translates their stake in EBPC into a preferred interest such that they have a beneficial asymmetric payoff.To revisit the narrative, Focus Financial’s principle business is acquiring preferred cash flow stakes in RIAs.  The preferred cash flow stake is a percentage (often half) of a “partner” RIA firm’s earnings before partner compensation (EBPC).   Focus translates their stake in EBPC into a preferred interest such that they have a beneficial asymmetric payoff.  The selling firm’s continuing partners retain all of the downside profit risk and share pro rata with Focus in the profit upside.  The partner firms retain a considerable degree of autonomy in that Focus doesn’t really effect operational control, doesn’t rebrand the partner firms using the Focus name, and doesn’t require partner firms to sell Focus branded investment products.As we have asserted previously, there is good and bad in the practice of transacting preferred stakes.  In theory, the practice puts a floor underneath Focus’s revenue stream in the event of bad markets.  Focus management suggests that only 75% of partner firm revenues are AUM driven, the portfolios generating those fees are only 56% invested in equities (44% fixed income), and there is a 70/30 split of partner firms that bill in advance versus those that bill in arrears.  Focus management states that this means a 10% change in equity valuation only moves Focus’s results by 2.9% in the same quarter (10% times 75% times 56% times 70%) and 1.3% in the following quarter (10% times 75% times 56% times 30%).  The granularity of this data may be more enticing than it is useful.  We know the reality of market impact on Focus is much more complicated, as changes in the margins of partner firms, the impact of bad markets on non-fee revenue, and the cumulative impact on fee producing assets all weigh in on cash flows.  Further, we wonder if a sustained bear market wouldn’t gut the management companies of Focus’s partner firms, as sustaining Focus’s cumulative preferred distributions would deprive the management companies of the partner firms from cash flows needed to maintain market compensation.Differing PerspectivesThe analyst community is fixated on Focus’s growth prospects, accuses the company of underperforming expectations in the third quarter, and is worried that the current market behavior will impede M&A opportunities.  Focus management responds that M&A is lumpy, and that their experience in the credit crisis a decade ago suggests that bad markets can slow larger deals, but small transactions still occur.  Further, management does not believe the company underperformed in the third quarter, just that the analysts expected too much of them.Management has stayed on message of 20% revenue growth and 20% growth in adjusted net income, but the problem is that word, “adjusted.”That comment – that the analyst community oversold Focus – caught my attention.  Having gone public at $33 per share on heavily adjusted earnings, Focus doesn’t have a history of profitability to form a reliable foundation for value.  If Focus had IPO’d at $18 and drifted up over the first few months to the mid-20s, it would be viewed today as a success.  I’m not suggesting that $18 was a more appropriate valuation at IPO, but an excessive valuation at offering can be an albatross for a public company – and that may be how we eventually see this situation.Management has stayed on message of 20% revenue growth and 20% growth in adjusted net income, but the problem is that word, “adjusted.”  Adjusted means they can grow by acquisition, but they’ll be expending cash and equity to fund that growth.  Organic growth is estimated at 10%, but it includes acquisitions by partner firms.  Management justifies this because broker-dealers include advisor recruiting in their organic growth rates.  That’s a risky justification, because the economics of broker-dealers has been eroding for decades, and many see the practice of paying to poach advisors as a sign of an industry in distress.Nine months ago, the investment banking community wanted to see Focus as the ultimate RIA – but it was never that.  Focus is a complex feat of financial engineering which demonstrates, above all, how difficult it is to build a consolidation model in the investment management community.  We think it’s inappropriate to fault management for doing what they said they would do in the S-1.  Nonetheless, like anyone who’s ever driven a Hummer, they could be in for a rough ride.

The announcement from Merrill Lynch last week that they were cutting advisor compensation stood in stark contrast to a lawsuit filed in October by former Wells Fargo brokers, alleging that their practices had been impaired by association with the bank. While Merrill feels comfortable flexing their brand muscles by redirecting advisor cash flow back to the firm, Wells Fargo is accused of actually having negative brand value. These two situations highlight the dynamic interaction between investment management professionals and the firms they work for while demonstrating the significance of branding to build professional careers and advisory firm value.An Ensemble Product with an Ambiguous BrandA couple of weeks ago I was driving around Memphis enjoying the fall weather when I spotted a unicorn, or, more specifically, a Bricklin SV-1, decked out in fall colors.  The Bricklin was an independently produced sports car with a small-block V-8 engine, two seats, a fiberglass body, and gullwing doors.  Malcolm Bricklin debuted his eponymous car at a celebrity-studded event at the Four Seasons restaurant in New York in the summer of 1974.  Despite the innovative nature and affordable price of the Bricklin, it wasn’t terribly quick (not unusual for cars of that era), reliable (the hydraulic pump for the gullwing doors would sometimes break if you tried to open two doors at once), or practical (it lacked both a spare tire and a cigarette lighter).  Only 3,000 or so Bricks were sold in 1974 and 1975, and fewer than half of those are extant today.Brand substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.If the Bricklin were a metaphor for a cohort of RIA practices, it would be an “ensemble” practice.  The company was run from Arizona but manufactured cars in Canada, shared taillights with the DeTomaso Pantera and the Alfa Romeo 2000, sourced its engine from American Motors and Ford, transmissions from Ford and Borg Warner, brakes that included parts from three manufacturers, and a steering wheel from Chevrolet.  What Bricklin lacked was a compelling brand to pull it all together, so instead of projecting the image of a “best of everything” product, it came off as more of a Frankenstein.Reading through the industry news of late, we’ve been thinking about the role of branding in the investment management industry.  Branding is more than a firm name or logo, it encompasses the identity of an RIA such that the practice is elevated above the practitioner, with the potential to benefit both.  As such, we consider brand to be more than tradenames or logos; it is a concept that substantiates the value of goodwill and makes a firm worth more than simply a collection of broker books.Personal Goodwill and Corporate GoodwillIn the valuation community, there are techniques for determining whether a portion of a given enterprise’s goodwill is (in reality) allocable to one professional or to a group of professionals instead of the company.  I’ll spare you the technical details, but suffice it to say that when an RIA matures to the stage that it can report a legitimate bottom line – i.e. that there are profits left over after covering both non-personnel costs and paying a market rate of compensation to all staff – then it has brand value that has generated a return on corporate goodwill.  Profitability is evidence of brand value.Returns to Labor versus Returns to CapitalWhen the C suite at Merrill Lynch decides to cut advisor payouts, they are shifting cash flow returns from labor to capital.  Advisors probably feel like they are being devalued, and arithmetically they are.  But what Merrill is also doing is testing their brand value.  Can they enhance their return on corporate goodwill by retaining more client fees from existing brokers at the risk of either disincentivizing their advisor network or even running them off to other wire-house firms or RIAs?  Merrill's opting to remain in the broker protocol can be seen as confidence in their brand to attract, grow, and retain an advisor network.  Whether that confidence is misplaced or not is something we’ll be able to answer definitively in time.Negative Goodwill?At the other extreme, the Wells Fargo lawsuit suggests the possibility that negative brand value at the firm level can impinge on an advisor’s income.  Two brokers are alleging that the string of negative publicity at Wells Fargo made it difficult for them to build their books of business or even to maintain the level of business they built previously.  Investment management is a reputation business, and the lawsuit suggests that even association with a tarnished brand can impair a career.  It’s an interesting lawsuit because in blaming the firm for advisor performance, it suggests that the advisor/client relationship is more significant than the client’s relationship with the firm – otherwise the advisor could mend the relationship simply by changing firms.  Yet the lawsuit is basing the damage claim on the bad reputation of the firm.Brand Value in the Independent ChannelOutside of the bulge-bracket broker channel, it is more common for personal goodwill and firm goodwill to overlap.  There is a thread of conventional wisdom that suggests small RIA practices aren’t salable (i.e. don’t have enterprise goodwill).  The reality is more nuanced, of course, but to the extent that the identity of a small RIA is really just that of the founder and principal revenue producer, then clients are difficult to transfer and the business is more difficult to transact.  Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.Building an RIA beyond dependence on the founder should be a focus of any firm wishing to build value.There’s more than one way to build brand value beyond the founder, as shown by high profile firms like Edelman Financial and Focus Financial.  Edelman employs a highly centralized approach with uniform and templated marketing programs, and client service techniques.  While Edelman has successfully built a large and profitable platform from this, the risk is that the secret sauce is vulnerable to being copied, and Ric Edelman is pursuing legal action against his former partner, David Bach, for just that.  Focus Financial has employed a highly decentralized approach of acquiring cash flow interests in independent RIAs and then leaving their client-facing identities intact.  You won’t find Focus’s name (much less the name of its founder, Rudy Adolf) on any of its partner firms, and thus individual firms (and Focus itself) are far less exposed to reputational risk from bad actors in individual offices.  Besides this, Focus doesn’t base its business model on intellectual property that could be replicated elsewhere.  What Focus lacks is a certain level of corporate identity and efficiency that comes from uniformity – we wonder how the Focus approach to branding will work over time.In the End, Brand Value is Defined by Your ClientMuch of the debate over the value of investment management firms can be distilled into one question: what is the value of a firm’s brand?  More than "what’s in a name?", the question is an investigation into the relationship between client and investment management service provider.  Do clients of your firm define their relationship as being with your firm, or with an individual at your firm?  If you can answer that question, you know where your RIA is on the journey to building firm value.

About eight months ago, one of Elon Musk’s many business ventures, SpaceX, tested its Falcon Heavy rocket by launching Musk’s own Tesla Roadster into space.  It’s now the fastest car in the universe, on a heliocentric orbit around the sun, complete with a mannequin in the driver’s seat named Starman.  Given the career challenges he’s faced this year, Musk is probably ready to take the wheel himself.Entrepreneurship is an Investment ThemeInvesting in founder-led companies is a strategy favored by many investment managers, including some of our clients.  The logic of the narrative is compelling: founders have interest, drive, and motivation.  In our hometown of Memphis, the archetype for this is FedEx.  Federal Express was a term paper in business school written by the founder, Fred Smith (who reportedly didn’t get a very good grade on the assignment).  Founder-led businesses benefit from unique levels of dedication; Smith once covered Federal Express’s fuel bill with gambling winnings in Las Vegas.  He devoted his inheritance and his life to the company and has retained a significant stake in the equity.  Smith is now 74 years old and remains involved in the business.  While the topic of succession comes up, key executive dependency is a comparatively minor topic when the company employs over 300 thousand people.Not all founders are like Fred Smith, though.  While Tesla’s share price has proved remarkably resilient this year, it has had to be in light of the increasingly erratic behavior of founder, chairman, and CEO Elon Musk.  From smoking pot in interviews to tweeting inaccurate insider information, Musk has made a mess of his leadership role in 2018 and highlighted the potential downside in founder-led companies.Every Company has FoundersTesla’s story is relevant to the investment management industry not just because many asset managers are invested in Tesla or otherwise invest in founder-led businesses.  The Tesla story matters because most investment management firms are also founder-led businesses.  The independent broker-dealer industry was born in the 1940s when wealthy investment professionals had to leave their commercial banking jobs because of Glass-Steagall.  The majority of that generation of BDs are forgotten now because of consolidation or failed succession plans or both.  The advent of ERISA in the 1970s brought about a new wave of money managers who built the RIA industry.  The RIA industry is still expanding, despite a recent wave of consolidation.Most RIAs, independent trust companies, and hybrid RIA-BDs today are founder-led.  The ones we work with are typically successful, having benefited greatly from the talents of their founders, whether in the discipline of attracting clients, choosing investments, or both.  The trouble is that, while companies are usually designed to operate into perpetuity, founders ultimately suffer from mortality.  Given the age of the RIA industry, many firms are facing succession issues, and many won’t survive it.When Vision Becomes a Blind SpotIf you’ve never read up on the theme of “founder’s syndrome,” then you’ve missed out on a key narrative that explains the valuation of many investment management firms.  Founder’s syndrome is an organizational behavior in which a company is built around the personality of a prominent individual in a company, usually in a senior position, and often the founder himself or herself.Strong personalities can build strong organizations, but sometimes people start companies because they can’t work for anybody else.  Can you imagine having Elon Musk as an employee?  To the extent that the needs of a founder are made more important than the needs of the business, the business will suffer.  If an RIA is a small enterprise that is more of a practice than an organization, this is no problem.  In larger investment management firms, however, boards who once promoted the interests of a key professional may find themselves in the position of having to protect the business from that same person.  While Bill Gross’s departure from PIMCO is a prime example, it is far from the only example.  More often, we see situations where a creeping change in behavior leaves a senior professional with an outsized influence over the strategy of the firm, even when that strategy no longer serves the goals of the firm.If an investment management firm grows because of, rather than in spite of, its founder, then the next challenge arises, succession.  Replacing a founder is nearly impossible because a leader in succession is necessarily going to have a different approach to running an organization.  Second generation leadership is more likely to be more disciplined, cautious, and risk-averse.  The organization itself will probably have to adjust to the second generation of leadership such that the needs of the company match the offerings of the executive.Diagnosing Founder’s SyndromeIf you’re wondering whether or not your RIA is suffering from founder’s syndrome, answer these three questions:Does your RIA, BD, or independent trust company principally exist to serve the psychological needs of your founder (i.e. an all-expenses paid ego trip)? The willingness of a founder to identify with their business is a key motivator that leads founders to work harder and longer to ensure the success of the enterprise.  With success, the business returns the favor, and it’s at that point that the founder has to consciously decide whether their firm is really a business or simply an extension of themselves.  This often shows up in compensation plans, when the founder(s) fail to draw a market-based line between their pay as employees and their returns as owners.  Since small RIAs are owner-operator businesses, this can be easier said than done.  But if the economics of the business are sufficiently segregated, then the founder is more likely to be working for the business, rather than the other way around.Is your founder unable to delegate? If your RIA’s success or failure rides on the skills, knowledge, and actions of your founder, then growth beyond a certain point will be difficult (if not impossible).  Many founders are perfectionists and can’t accept work done differently than they would do it themselves.  I once had a founder lead me through the office because he wanted me to meet the many talented people in his firm, only to instruct each one of them very thoroughly in exactly what he wanted them to tell me.  Needless to say, if a founder cannot delegate, then the scale of their company will be necessarily limited to their own capacity to work.Is your founder willing to accept new leadership? Graceful exits are difficult, particularly when your name is on the door.  While founders certainly have a role in “letting-go,” transition plans are an organizational responsibility, so boards and other senior executives share in the role of providing for the sustainability of the organization.  The one theme I’ve consistently noticed is that transition takes much, much longer than people think it will. I learned long ago that people are a package deal – you take the good with the bad and you don’t get to pick and choose what parts of a person you accept.  Like all founder-led companies, RIAs can benefit from the entrepreneurial zeal of the men and women who started them.  Unfortunately, that same appetite for risk-taking can lead to reckless behavior, and the identification of a founder with a namesake enterprise can complicate succession planning.  In any event, the risk associated with a founder-led RIA can lead to extreme results: taking advantage of a moon-shot opportunity, or a business that’s lost in space.

Earn-outs are as common to investment management firm transactions as they are misunderstood. Despite the relatively high level of financial sophistication among RIA buyers and sellers, and broad knowledge that substantial portions of value transacted depends on rewarding post-closing performance, contingent consideration remains a mystery to many industry participants.Yet understanding earn-outs and the role they play in RIA deals is fundamental to understanding the value of these businesses, as well as how to represent oneself as a buyer or seller in a transaction.This whitepaper is not offered as transaction advice or a legal primer on contingent consideration.The former is unique to individual needs in particular transactions, and the latter is beyond our expertise as financial advisors to the investment management industry.Instead, we offer this whitepaper to explore the basic economics of contingent consideration and the role it plays in negotiating RIA transactions.

With last week’s release of the 2018 InvestmentNews Compensation & Staffing Study, trends in pay and performance expectations are making the rounds in the RIA community. Even though we are a valuation firm, we are often asked to weigh in on compensation matters, as officer pay and firm value are typically intertwined. A few months ago, a client who reads our blog regularly sent me a photograph of his first car, a 1957 Chevy Handyman. The Handyman was a two-door version of Chevrolet’s station wagon series with less chrome and a powertrain oriented more to utility than the better known Chevy Nomad series. Because most Handymans were not well cared for (they were fleet vehicles that served manual laborers), examples like the one our client owned could be bought cheap. And because it was cheap, a teenager growing up on the West Coast, such as our client, had no qualms about using it to haul surfboards and damp surfers back and forth to the beach. Unfortunately, what can be bought cheap is often sold cheaper, and such was the fate of this particular Handyman. Today, a Handyman in prime condition is rare, and that which is rare, and sought after, appreciates.Stories like this drive the collector car market, and you can watch the appreciation curve on certain models mature as the demand created by nostalgia for first cars or dream cars meets the supply of accumulated wealth that comes later in life. Muscle cars from the 1960s have shot up in value over the past ten years because collectors who were teenagers in the 1960s have reached the peak of their careers, put their kids through college, amortized their mortgage, and can finally afford to buy back part of their youth at an auto auction. Professionals who follow the collector car market consider the price trends to be fairly predictable based on demographics.In the RIA community, regardless of firm size or type, there is a predictable relationship between staffing decisions (positions, expectations, compensation, etc.) and firm performance. It’s a well-worn phrase that the assets of professional service firms get on the elevator and go home each night, but that doesn’t tell the story of the value of the firm, which is not merely the assemblage of assets, but rather the organization, orientation, and utilization of those assets for a common purpose: serving client needs.Staffing Your ModelWe think compensation surveys offer interesting data, but that data needs to be filtered carefully to provide useful information. No two RIA business models are exactly alike, and staffing needs and compensation requirements of one model do not necessarily translate into another model. So while the averages of reported data are interesting, they have to be put into context to be meaningful.Some RIA models, for example, are highly vertical, focused on supporting the talents of one or two individuals at the top of the firm. In such a situation, compensation might be expected to be very top-heavy, as most employees of the firm serve to leverage firm leadership. This is common for niche asset management firms. Firms with a more horizontal orientation (lots of rainmakers contributing to the revenue stream) are inherently more sustainable, with less dependence on any one individual and an easier system to bring junior talent along into senior positions. Wealth management firms tend to exhibit this horizontal organization – at least most of the time. Aggregate compensation expense and margin can vary in both vertical and horizontal structures. It’s more important to know the “why” of your compensation structure than the “what.”Staffing for MarginMargins can be tricky to interpret. Too low and the viability of the firm is threatened by market downturns. Too high and the firm is vulnerable to market forces bidding away talent or bidding down fees. Since the key variable in firm profitability is compensation, it’s a good idea to keep an eye on your margins relative to market and your aggregate compensation expense relative to market. Most firms aren’t “average,” so there’s no expectation that you would be either. But the average is a benchmark to measure against, and if you can articulate why your margins and compensation costs are different than market averages, you’ll have a better handle on managing those numbers through different economic environments.Staffing for GrowthIn one sense, investment management firms are simply collections of people – and those firms can’t grow any faster than the people who compose the firms. Brent Brodeski published a useful article in Financial Planning a few months ago talking about the tradeoff between current profitability and growth. The message, which is worth reiterating, is that growth isn’t free. A common myth in the RIA industry is that, at a given scale, an upward trending market provides a tailwind that carries firms along whether they intentionally focus on growth or not. The problem is that RIA staff do not live forever, and without investing in subsequent generations of leadership and subsequent generations of clients, every firm will quietly begin to wind-down regardless of the market.Staffing for SustainabilityRIAs are business models that can, if managed thoughtfully, survive most any change in the business climate or market dynamic. Our oldest client firm dates to the 1940s, and during their 75-year history, they’ve experienced several changes in control ownership, client focus, and portfolio expertise. Adaptability is integral to sustainability. That said, having a staff that is motivated to adapt – not just be capable of it – helps provide for the firm’s needs as they change. A firm with 5% client turnover is a brand new firm every twenty years. Are you prepared to start over during the course of the next two decades? This is another place where benchmarking is useful as a reference rather than a rule. With many studies reporting that the average age of financial advisors now tops 50, does the average age of client-facing staff in your office suggest you are building the future firm or simply cashing in on what you built previously? This applies to your staff as a whole and to senior staff needs in particular. What would it cost to recruit a younger version of you today? Have you hired that person?Staffing for ValueWe often say that investment management is not a capital-intensive business, but the capital investment in a typical RIA is in human capital. Technology offers the promise of some relief, assuming regulatory requirements don’t consume those efficiencies over time. Most RIAs could operate at a higher margin than they report, but doing so would require understaffing – either in the number of employees or quality of employees – such that the clients of tomorrow aren’t being recruited, nor is the talent to service those clients being developed. Absent reinvestment in human capital, an RIA becomes a depreciating asset which, unlike collector cars, isn’t likely to evoke nostalgic interest years later.The one that got away

Question: How many CFA charter holders does it take to change a light bulb?  Answer: When you ask “how many,” are you asking for the mean, median, mode, a rolling average, variance or semi-variance to a certain population sample...?Paralysis by analysis often seems like a viable career track in finance, especially when it comes to product development.  Even here, though, history offers a pattern of what to expect.  Product development usually follows one of two paths in investment management: greater innovation or lower pricing.  The former of these is a margin builder, while the latter can be a margin killer.  After watching the price of trading drop for decades, it wasn’t so surprising when J.P. Morgan announced that it would offer free online trading for certain investors last month, but when $2.5 trillion manager Fidelity Investments announced they were going to be offering two “free” index funds, the industry rocked on its heels.  Is this the next leg down for pricing of investment management, a publicity stunt by Fidelity, or something else altogether?Relating this, as I am wont to do, to historical events in the automotive history, I’m reminded of the down-market product disaster that Aston Martin attempted a few years back, the Cygnet.  In 2011, faced with looming and more stringent EU emissions standards, Aston Martin decided the only way to comply was to market a high-volume, high-mileage micro-car that would average out with the automaker’s low-volume, low-mileage GTs.  Developing an all-new car is prohibitively expensive, though, so a committee at Aston decided to license an existing eco-platform, the Toyota IQ, dress it up with leather and fancy badges, and sell it as a premium economy car.  This offspring was priced at about a third of the MSRP of Aston’s other cars, but it was still three times as much as a Toyota IQ.  So, was it an insanely cheap Aston Martin, or a ridiculously expensive Toyota?  When Aston Martin launched the Cygnet (a name which accommodated an “ugly-duckling” appearance by suggesting it was the adolescent version of the company’s beautiful models like the DB9), their CEO stood on a mountain of product research on brand extension and projected annual sales of 4,000 units in the UK alone.  Instead, Brits bought fewer than 300 baby swans over two years before Aston Martin gave up.The big asset gatherers like Fidelity, Charles Schwab, Vanguard, and Blackstone have been creating high volume, low price investment products at an increasingly prodigious rate for years.  With many index products already available at ten basis points or less, the trip to zero was a short one for Fidelity and likely one they expect to recoup in other products and services once the client relationship is secured and the assets are in-house.Fidelity’s move was meant to look revolutionary, but it’s really revolutionary, and I don’t think it says much about where the investment management industry is going.  Look no further than the progress of the robo-advisory business.  I was an early subscriber to Financial Engines’s portfolio evaluation tools, but frankly lost interest in quarterly model analysis and dropped out after a couple of years.  In the first ever “Robo Ranking” by Backend Benchmarking, the top-ranked robo-advisor is Vanguard’s Personal Advisor, mainly on the strength of its human advisor services that come with the algorithm in a competitively priced package.  The lowest ranking robos scored poorly, in part, because of the lack of access to advisors.The ongoing theme of the repricing of investment management is that if value can be articulated and justified, reasonable fees can be charged.  There is also ample evidence that human relationships are still highly valued in the RIA space.  So while investment management products are subject to a high degree of price scrutiny and competition, investment management services are largely unaffected.  It’s more likely that the fees available for investment management are being reallocated, rather than being diminished in aggregate.  Time will tell.In short, I don’t know if the no-cost Fidelity products are going to go the way of the Cygnet, but I don’t think this is a Black Swan event either.

As World War II drew to a close, a military aircraft manufacturer in Sweden saw the post-war consumer economy as an opportunity to expand into cars, and the Saab automobile was born.  For about 45 years thereafter, Saab established itself as a scrappy automaker known for innovation.  Saab was the first automaker to introduce seatbelts as standard equipment, ignition systems that wouldn’t crush a driver’s knees in a collision, headlamp wipers and washers, heated seats, direct ignition, asbestos-free brake pads, and CFC-free air-conditioning.  Saabs were distinctive, substantial hatchbacks with strong but efficient motors and enjoyed a devoted following.  Unfortunately, Saab’s fan base was too small, and as the company struggled to build the scale necessary for global distribution, financial troubles drove them into the gaping maw of General Motors.In the late 1980s both GM and Ford were attempting to consolidate global automotive capacity and bring as many brands under their corporate hierarchy as possible.  With consolidation came homogenization, as global behemoths looked for ways to cut manufacturing costs.  Under Ford’s ownership, Jaguar and Aston Martin starting sharing parts with each other and their Dearborn parent.  Ford, arguably, saved both marques and orphaned them before they were ruined.  Jaguar is thriving today, and Aston Martin is planning its first public offering.  Saab wasn’t so fortunate, with GM blending Saab’s mystique with Subaru (sushi with meatballs?) and Saturn (a space oddity if there ever was one).  Saab struggled for about twenty years in GM’s dysfunctional family, but eventually the brand was wrecked and Saab was no more.Divergent Industry TensionsLike the automotive industry in late 1940s and 50s, the investment management industry is characterized by scores of independent firms who have found success in idiosyncrasy, providing clients a limitless variety of paths and approaches to common investment dilemmas.  Some would suggest that this is the source of the industry’s strength, but not everyone agrees, as evidenced by the Focus Financial IPO two weeks ago.A key element of the Focus market opportunity is “fixing” the fragmented nature of the RIA industry, providing an ownership structure, exit opportunity, and transition mechanism for the thousands of independent advisory practices with a stream of profitability threatened by aging founders.  This opportunity exists in an industry that is far from declining – in fact it is growing in clients, assets, and advisors.  Focus can provide ownership transition capital to bring some order to this creative process and share in the profits along the way.The RIA industry is growing, but it is doing so because it is largely in a stage of de-consolidation, rather than consolidation.  Most of our clients set up their own shops – whether in wealth management or asset management – because they were exiting larger firms they felt restricted their thinking, their business development, and their incomes.  Investment managers are characteristically independently minded and entrepreneurially motivated.  In many ways, the increase in investment advisory practices is an effort to recapture the careers available to what were once called stockbrokers forty years ago.  One client of ours who escaped his wire house environment earlier this year decried how his former firm had been taken over by lawyers and accountants who were conspiring to restrict opportunities for both him and his clients.So many wire houses are now losing advisors to the RIA industry, broker protocol is splintering, and the only BDs reporting growth in advisors are doing so at great recruiting costs, which may or may not be recoverable.  The alternative would be to acquire practices outright, but great entrepreneurs make miserable employees.  Focus aims to thread this needle by acquiring a preferred interest in the profitability of partner firms (defined as Earnings Before Partner Compensation, or EBPC) that assures Focus a basic rate of return on investment but leaves the leadership of partner firms the opportunity for upside.  Further, while the Focus holding company will provide programs in products, marketing, and compliance to partner firms, opting-in to those programs is treated like coaching, rather than being compulsory.Will the Focus “preferred stake in EBPC” work?  Will selling partners be motivated enough to continue to grow their practices profitably?  Will subsequent generations of partner firm leadership have enough upside to stick around or will they seek out other opportunities?  Is coaching through encouragement enough to manage the activity of boutique investment advisory practices?  Can subsidiary firm margins been grown enough to offset the corporate overhead of the parent?The Prevailing RhythmWe are obviously skeptical, but we’re not cynical.  We’ve been around long enough (and have been wrong enough), so we are intently watching and listening to the drumbeat of the consolidators.  Focus has put more thinking and garnered more capital to try to build critical mass in the wealth management industry than anybody else.  They are not the only group trying to do this, but they’ve gone farther than anybody else.  We don’t buy the idea that Focus is the public company barometer of the RIA industry, but it is the barometer of RIA consolidation.  The question for the investment management industry remains: is consolidation the answer?

After Focus Financial filed their S-1 in May, I drew some analogies to Ferrari’s public offering two years ago (NYSE: RACE), as both companies faced considerable skepticism at advent of their IPO.  Last week, the two stories intersected once again, as the man who steered Ferrari to its public offering, Sergio Marchionne, died unexpectedly at 66, and two days later Focus Financial went public (Nasdaq: FOCS).Marchionne leaves behind an indelible imprint on the automobile industry.  He almost single-handedly rebuilt the automotive landscape from its most unlikely corner, Italy, by squeezing $2 billion out of GM to recapitalize Fiat in 2005.  With Fiat rescued from oblivion, Marchionne rebuilt Alfa Romeo, Maserati, and Ferrari under the Fiat umbrella.  He took advantage of the credit crisis to bring Chrysler under Fiat’s control, and then took advantage of the subsequent bull market in luxury goods to take Ferrari public.  He was trained as a lawyer, practiced as an accountant, and fueled by expresso and cigarettes.  Above all, though, Signore Marchionne seemed to really love cars – something lacking in too many automotive executives these days.I won’t go so far as to compare Focus Financial’s founder, Rudy Adolf, to Marchionne, but it’s worth noting that, like Marchionne, Adolf pulled off what many others have tried, and failed, to do.  Now that Focus is public, we have a new channel with which to study and benchmark the industry.  We have lots of questions, but for this post, we’ll just look at the implications of the Focus valuation that is consequent from the IPO.Focus Is Richly PricedAfter a predicted pricing range of $35-39 per share, FOCS went public at $33.  Of the $490 million raised in the offering (after underwriting fees), Focus is going to use a bit less than $400 million to pay down debt, about $35 million to settle equity compensation and other obligations to existing owners, and the remaining $60 plus million they’ll hold in cash for opportunities as they come along.  If the underwriters exercise their greenshoe, Focus picks up another $75 million or so.We heard plenty of chatter about the implications of Focus pricing below the originally suggested range, but we don’t make too much of it.  The $35-39 range was very high (as we’ll get into later in this post), and in any event, the trading activity immediately raised Focus shares up to the range (no doubt guided by the invisible hands of market makers associated with the book runners).  The IPO was a success.Focus Didn’t Sell CheapOne thing we don’t have a question about is the magnitude of Focus’s valuation at IPO – it was expensive by any measure.  In the quarter ending March 31, 2018, Focus reported a net loss of nearly $37 million on $196 million in revenue.  In the prospectus, management provides a series of adjustments to redeem the quarterly loss to a net profit of almost $30 million and EBITDA of over $44 million. We don’t take issue with many of management’s normalizing adjustments, as there are several non-recurring expenses associated with taking a company like Focus public.  We are curious, though, about adding back non-cash equity compensation and the change in fair value of contingent consideration made for acquisitions.  From the perspective of a shareholder, equity compensation is still a drain on earnings, because it dilutes existing shareholders’ claim on profitability.  Since Focus is an acquisition company, it seems that any increased earn-out or other contingent payment expense increases the cost to Focus – whether in the form of cash or stock – such that these aren’t truly extraordinary items that a shareholder would disregard when calculating Focus’s profitability. Any argument with these adjustments takes an already lofty IPO valuation for Focus to nosebleed levels.  At the IPO price of $33 per share, Focus has an equity market cap (absent special allotments for the underwriters) of about $2.3 billion, and a total market capitalization inclusive of net debt of $2.8 billion. If we look at the most recent reported quarter, annualize it to develop a measure of ongoing performance and further look at a year forward assuming a 20% annualized growth rate (10% to the mid-year), we show strong multiples of revenue and earnings (compared to industry standards), and higher-than-usual multiples of EBITDA.  However, that’s only if you accept all of management’s adjustments.  If instead, you don’t give Focus the benefit of adding back non-cash (but nonetheless dilutive) equity compensation expense, the resulting multiples of profitability are other-worldly. The big issue that most analysts seem to have with Focus is that they want to be given credit for inorganic growth on their multiple while adjusting earnings to eliminate the cost of that inorganic growth.  The Focus prospectus and roadshow presentation made much of their 20% growth historical and prospective topline growth, and everyone knows that growth is because of acquisitions.  The prospectus doesn’t actually offer any estimate of organic growth, or same-store sales growth, because they credit organic growth for subsidiary-level acquisitions by partner firms.  It seems to us that the costs of that growth are, indeed, relevant to earnings.  So either we judge Focus as an acquisition company or an operating company, rather than give them credit for the topline performance of an acquisition company and the bottom line performance of an operating company. Peer Comparisons Are DifficultFocus isn’t really an RIA, it holds preferred interests in profit sharing units in RIAs.  Nonetheless, most analysts will lump them into the RIA space.  The question is where?Earlier this year a small RIA called Victory Capital went public (Nasdaq: VCTR).  Victory is an amalgamation of wealth management firms and an ETF offering.  It’s about half the size of Focus, and it hasn’t fared too well since the offering.  Another possible comp is Silvercrest, which probably feels forgotten by the public markets in the wake of attention given to Focus.  Since neither Victory nor Silvercrest are really RIA consolidators, Focus management probably wouldn’t appreciate the comparison to them.  Neither Victory nor Silvercrest have shown the topline growth of Focus Financial, although Silvercrest’s growth isn’t that out of line with what Focus has produced organically – maybe even better.While it’s difficult to find peers to compare Focus to, their valuation prices them more richly than even AMG.  Is it reasonable to compare Focus to Blackrock?  We don’t think so.Pricing ImplicationsMost CEOs appreciate the market validating their strategy with high multiples, but high multiples are a double-edged sword.  In the 1990s, I had a number of clients at Mercer Capital involved in roll-up corporations of one kind or other that went public.  Some worked, and some didn’t.  While Focus isn’t directly comparable to many consolidators, some of what has been observed in other industries holds true here as well.High valuation multiples must be justified, and are often tested stringently with newer public companies.  Focus promises high topline growth, with the implication that the profit margins will sort themselves out with scale over time.  This is a common story for public companies in consolidating industries.  The trouble comes when acquisitions are unavailable at reasonable terms or even accretive pricing, profits are uninspiring, and management feels pressured to do deals that don’t make sense just to demonstrate growth.Based on their own disclosures, Focus will have to continue an aggressive acquisition strategy to achieve the 20% plus growth expectations that it has set for itself.  If that growth is accomplished with new share issuances (as they have employed in the past), the market may not appreciate the dilution.  Focus could, of course, pay cash, as they have a fair amount of it on hand following the IPO; but cash isn’t free either.  What the market will eventually want to see – and several commentators have already mentioned this – is organic growth.  If the firms that sold Focus some participation in their profitability grow their AUM from either existing or new clients, the fees should translate into profit growth that will accrue to Focus.  The S-1 is curiously vague about Focus’s historical organic growth – defining it as inclusive of subsidiary-level acquisitions by partner firms.  We question whether or not this is a true metric of organic growth, and in any event, the numbers Focus has posted with regard to this aren’t terribly impressive: 13.4% in 2017 and mid-single digit growth in the two years prior to that.  We’ve written elsewhere that Focus will eventually have to prove itself as an operating model, and not just as an acquisition model.  Their success or failure in this regard will be judged, at least in part, by demonstrated organic growth.As for inorganic growth, Focus has interests, either directly or indirectly, in 140 plus firms.  This leaves lots of room to grow in an industry with 15 thousand or so firms and a solid growth trajectory.  If Focus stays priced at elevated multiples, it may raise expectations of sellers – especially in the circumstances where Focus is paying with stock.  If, on the other hand, Focus shares settle to more normal multiples of profitability, sellers may be wary of selling into a downward trending share price.  In some ways, it may be easier to attract acquisition candidates as a public company, but in others, it may be more challenging.Margins are another matter.  Most investment management firms benefit from operating leverage as they grow, and Focus has suggested the same opportunity exists for them as well.  Our concern here is that Focus is not a small startup asset manager, they are a $126 billion manager with over 2,000 employees in their affiliated firms and fourteen years of history – yet their EBITDA margin (even on a highly-adjusted basis) hasn’t crested 25%.  It’s possible that additional scale will improve this metric, but being a public company is labor intensive, as is tracking the activities of 140 plus partner firms, seeking out more, and seeking ways to improve the performance of existing firms.  It may be difficult to assess the Focus margin against that of more typical RIAs, but as the Focus story unfolds, management will have to explain how to evaluate the effectiveness of the 70 or so employees at the holding company, what a reasonable cost of operations is, and how much profitability can be expected.Nevertheless, They Did ItSetting all of my armchair quarterbacking aside, though, the fact remains that Rudy Adolf and his team pulled off what many have thought about but failed to do.  The investing public now has a way to be involved in the profitability of the RIA phenomenon, and the RIA industry has a new funding source for transaction activity.  Lots of questions remain, but if Sergio Marchionne could use the public markets to remake a moribund industry from a nation that isn’t terribly investor friendly, executing on the Focus business model should be an easy lap.

Money, being what it is, never sleeps. It also never goes on vacation. I was, however, about to spend ten days away from the office with my older daughter in Scotland and England when Focus Financial (finally) filed for a public offering. One of the most anticipated events in the wealth management industry, the pendency of the Focus IPO didn’t cancel my trip, but I knew that my vacation was going to be at least punctuated by reading the S-1 along with my peers’ commentaries. I’ve now read the 275-page document a few times, and while it’s not your typical beach novel, the Focus prospectus is required summer reading for anyone in the RIA community.The First Question to Ask of Any IPO is “Why?”Initial public offerings are sacramental in the church of capitalism. At one time, IPOs represented a coming-of-age when growing asset-needy businesses could finally have the financing they required to expand into leading, mature organizations. Today, public offerings may just represent the day when private equity backers decide they would rather someone else own a business instead of them. IPOs can, in many cases, be read as a sell-signal.In spite of this, public offerings still generate a surprising amount of enthusiasm. My daughter and I started our trip at the Aston Martin dealership in Edinburgh, and the characteristically friendly Scots there chatted excitedly about Aston Martin’s upcoming IPO whilst making sure my daughter learned the ins and outs of at least a million pounds worth of stainless-steel, aluminum, and carbon fiber. Aston Martin’s IPO not only represents permanent equity backing for a uniquely capital-intensive business, it is also the triumph of a marque bought out of obscurity by a wealthy English industrialist, Sir David Brown. Brown not only manufactured and sold tractors by the thousands, he also understood the halo effect of auto racing to underscore a nation’s industrial competitiveness, and he was tired of seeing English cars lose to the Italians. Sir David was also savvy enough to take a page out of Enzo Ferrari’s business model and financed his passion for auto racing by selling expensive road cars. It was a prescient decision for Brown, as his eponymous series of “DB” cars were adopted by a mythological British figure, James Bond, and the combination sustained the brand’s identity for fifty years. It is highly unlikely that the DB11 would exist today if Sean Connery hadn’t been assigned a DB5 as his company car in the 1960s.Today, Aston Martin is once again following in the hoof-steps of the prancing horse, as Ferrari’s 2016 public listing was a huge success (NYSE: RACE). Ferrari is much more than an automaker, of course; it is a brand. Despite devotees like yours truly, Aston Martin’s intellectual property is no match for Ferrari, which boasts an adjectival name, a primary color, and a mascot that are instantly recognizable and merchantable. For Aston Martin’s listing to be successful, it will have to make it as an automaker instead of a fashion label – no doubt a much tougher slough.What Exactly is Focus Financial?All of this brings me back to Focus Financial, whose business model is a little difficult to, well, focus. The IPO is being hailed as a validation of the RIA industry, but the RIA industry doesn’t really need validation (it is proven and profitable) and Focus isn’t really an RIA.The Focus brand, for example, doesn’t really extend to the investors with their partner firms. If you review many of their partner firm websites, for example, you don’t see much mention of Focus, and any mention certainly isn’t prominent. Focus’s brand is directed at the acquired firm, a back-of-the-house system. The storefront is still the individual tradename and people of the partner RIA. In much the same way, the Focus financial statements aren’t really the consolidated statements of their affiliate firms, but rather a specifically defined interest in the cash flows of the affiliate firms. In mathematical terms, you might say that the calculus of the Focus financial statement is the first derivative of an RIA income statement rather than the RIA income statement itself.Focus acquisition model (adapted from pages 120-121 of the prospectus) Focus Financial is an aggregation of RIA cash flow streams, contingent rights, and responsibilities. The Focus model is to acquire between 40% and 60% of an existing RIA’s earnings before partner compensation, or EBPC, which post-acquisition is referred to as “target” earnings (Focus also has a program for wirehouse broker groups who want to go independent). The remaining EBPC is retained by a management company formed by the affiliate firm as a wage pool for selling partners. Focus takes a preferred position in the affiliate firms’ EBPC; the selling partners are responsible for delivering at least the dollar portion of EBPC sold to Focus (termed the “base” earnings). Any excess above target earnings is split pro rata. This asymmetric payoff dampens the downside volatility for Focus, but obviously also raises it for selling partners. Focus has a handy chart in their S-1 that illustrates the potential repercussions of this on partner firms. As shown in the example above, assume Focus acquires 60% of a selling firm’s earnings before partner compensation and EBPC is $3 million. If revenue grows by 10%, EBPC grows to $3.5 million. In the upside scenario, selling partners and Focus share in this 40%/60%, and selling partners see their management fees increase from $1.2 million (40% of EBPC established at time of sale) to $1.4 million (the $200 thousand increase representing 40% of the overall $500 thousand increase in EBPC). One can see how enough growth in AUM enables selling partners to recover their pre-acquisition compensation level, in addition to receiving proceeds from selling rights to part of their EBPC to Focus. The downside scenario is fairly dramatic, however. In the example, a 10% drop in revenue causes the selling partner compensation pool to drop by almost half, from $1.2 million to $700 thousand, which is less than a quarter of pre-transaction partner compensation. Because we haven’t experienced a sustained bear market since Focus completed most of their acquisitions, the downside implications of this arrangement on selling partner groups (and, in turn, on Focus) aren’t yet fully known. The disproportionate risk borne by the partners of affiliate firms is, presumably, known to them – although knowledge and experience sometimes yield different outcomes. We wonder how selling partner groups would behave in a market environment in which their compensation was severely restricted, remembering that retained EBPC is effectively wages for the continuing efforts of affiliate firm leadership.How Does Focus Pay for This?As anyone who reads this blog is fully aware, RIA transactions are typically a mixture of upfront payments and contingent consideration. Focus is no different, and while the prospectus doesn’t describe a sample transaction, it is clear that Focus uses both cash and equity to provide fixed payments and earn-outs. The equity consideration is valued by Focus, apparently with the assistance of third-party appraisers (not us!). More than one commentator has suggested that a downside to Focus Financial going public is that they can no longer “assign” a value to their stock, as it will now be determined by market. I’m sure that my peers who provide valuation services to Focus don’t appreciate the slight.The valuation of Focus is, at this point, somewhat complicated, and we are very interested to see how the market treats them. In 2017, Focus reported a loss of nearly $50 million on total revenues of $663 million. Last year was a good year for most RIAs, and to explain their loss, Focus management suggests a lengthy list of adjustments to get to a pro-forma EBITDA margin of about 22%. Market pundits so far are suggesting an enterprise valuation of $2.0 to $2.5 billion for Focus, which works out to about 8x to 10x pro-forma EBITDA.The question becomes whether or not you agree with all of management’s adjustments to travel from reported to pro forma EBITDA. Some off these add-backs are not controversial (eliminating non-recurring items such as delayed offering cost expenses), but over a third of management’s adjusted EBITDA for 2017 comes from eliminating non-cash equity compensation expense and adding back the change in fair value of contingent consideration.The analyst community remains divided on how to treat equity compensation, but we quote Warren Buffett’s old saying –“If stock options aren’t compensation, then what are they? If compensation isn’t an expense, then what is it? If expenses don’t belong on the income statement, then where do they belong?”For a shareholder in an acquisition platform like Focus Financial, equity compensation and contingent consideration are dilutive to earnings per share, and one would expect them to be recurring in nature. Further, a 22% EBITDA margin is low for a large RIA – even on a reported basis. Then again, Focus isn’t really an RIA.So we don’t have a good sense of what Focus’s profit margins will be once it matures to a steady-state enterprise. The financial history shown in the S-1 doesn’t really demonstrate the kind of operating leverage we might expect, but, to be fair, I think it’s still too early to tell.What Does Focus Do After an Acquisition?While the 55 Focus partner firms employ over 2,000 people, the holding company itself has about 70 staff members, most of whom are charged with growing cash flows through acquisition or by improving affiliate firm profitability. To enhance organic growth, Focus has staff assigned to affiliate RIAs to provide them with ideas to improve operations and marketing, much as broker-dealers do for their network affiliate RIAs. Eventually, Focus will have to transition from an acquisition platform to an operating platform, and these services will become more critical to fueling the growth engine.It’s worth pointing out that there is a cost to the staff and their activities at the holding company that is borne under the Focus model but not by an otherwise independent RIA. Further, the Focus prospectus doesn’t suggest that this cost is mitigated by explicit post-acquisition synergies such as personnel redundancies, although this probably happens from time to time. In addition, the prospectus is explicit that holding company staff is there to assist partner firms with growth and operations, rather than to impose rubrics and expectations. The idea is to maintain the entrepreneurial spirit of the partner firms and to avoid “turning entrepreneurs into employees.” Can thousands of people be directed with only carrots and no sticks? Probably not, and I’ve no doubt that Focus management realizes that.One test of the Focus model is whether or not the staff at the holding company can pay for themselves. Can they improve partner firm cash flows to more than offset the cost of the aggregation? If so, this will be a big success.Does the Focus Model Work?Focus has been in operation for a dozen years now, but it’s still very much a development stage company. Focus has proven itself as an acquisition platform. RIA transactions are difficult, and Focus has managed to attract and retain 55 direct partner firms. Several of these firms have themselves engaged in acquisitions after they became part of the Focus network, bringing the total number of firms under one umbrella to 140. Indeed, one major asset Focus can boast is its knowledge of the RIA firm landscape and how to successfully acquire and integrate wealth management firms.That said, acquisitions either consume distributable cash flow (the prospectus is clear that the company does not plan to pay dividends, which is very different from typical RIAs) or result in equity issuance (which can be dilutive of existing shareholder returns). Focus can build shareholder value by arbitraging returns if it can acquire firms at a lower multiple than it trades for, but this requires the market giving it a premium multiple on a sustained basis. Since acquisition multiples in the RIA community don’t usually happen at substantial discounts to publicly traded asset managers, it may prove difficult to enhance shareholder returns through acquisition – at least on a sustained basis.No doubt Focus has plenty of room to run as an acquisition platform, but longer term shareholder returns will require Focus to develop an operating platform that widens partner firm margins and speeds revenue growth to a greater degree than those same firms would do on their own. One test is easy to measure, and the other is not. Together, they form a major part of the holding company’s “alpha.”Analysts can look at Focus’s profitability and determine whether the model enhances RIA cash flow or not; as I mentioned earlier, current margins suggest they still have room for improvement. Determining whether or not an affiliate firm is growing faster in association with Focus is more difficult – there are many variables that would have to be isolated to do that. Since management teams share in profit increases, they theoretically have incentive to help the organization grow. Post-acquisition, of course, Focus takes a pro rata piece of that increase in profitability, and while the selling generation of partners gets compensated for this in the form of earn-out payments, successive generations will not. It will be interesting to see how second-generation partner firm leadership behaves.The Focus S-1 reports organic revenue growth – essentially same store sales growth – of 13.4% for 2017 versus 2016. Organic growth for the prior two years was reported in the mid-single digits. Whether or not those organic growth rates best industry averages depends on whom you ask. We think this will be a closely studied metric for Focus as it matures.Further, because Focus is an amalgamation of RIAs which still report independently, it is possible to review ADVs and track their partner firm AUM over time. We’ve done this, and the study predictably shows a wide variety of growth patterns across these businesses which are still run as independent entities. Some appear to have grown more rapidly after being acquired by Focus, and others not so much. It would take a good bit of work to track these growth patterns relative to financial market behavior, industry trends, and to segment out partner firms that are growing at least in part because of their own acquisitions. For now, Focus’s report on organic growth may be the favored big-picture performance measure.What Questions Remain?The most significant remaining queries for Focus Financial revolve around the theme of sustainability. In the near term, can Focus continue to attract enough sellers to monetize their know-how and identity as an acquirer? In the longer term, can Focus transition into an operating brand and grow organically in such a way that it proves the value they add as an organizing force in the RIA space? Will they show growth rates and margins that prove the value-add of the holding company?Focus is organized as more of a quilt (independent businesses) than a blanket (think wirehouse). Given that, can Focus direct their partner firm employees’ and principals’ zeal while avoiding the behavioral risks that come with independence? Will Focus ultimately have to become more regimented in the investment products it offers, the marketing approaches its advisors employ, the training and compliance procedures they require, etc.? There is a natural tension in all investment management firms between development and risk management, and as firms grow, the latter usually overtakes the former.Will succeeding generation leadership at partner firms be sufficiently incented to continue the growth that first made them attractive as acquisition candidates to Focus? The selling partners of affiliate firms have a relationship with Focus that younger members do not share.Why Does All This Matter?Most of the questions I’m throwing out in this blog post apply to the broader RIA universe, and not just to Focus Financial. The Focus IPO is significant because it represents the single-most direct response to major industry issues, while at the same time leveraging industry trends. With managed assets increasingly leaving bank-controlled brokers, the retirement era of the baby-boomers leading more and more assets to independent firms, and a transition planning crisis among RIA ownership groups, someone had to develop a model to organize, if not consolidate, this highly fragmented industry. Fourteen years ago, Focus’s founder Rudy Adolf sat at his kitchen table and decided to do just that.The Focus prospectus makes it clear that engineering a profitable solution to the RIA industries primary conundrums is not, however, as easy as defining the situation itself. As a conglomeration of independent businesses, the Focus financial statements are themselves gerrymandered in a way that takes some getting used to, and we don’t think their results will track the RIA industry as closely as some have suggested.None of this detracts from what Focus has accomplished. They have developed a business model to address very difficult acquisition and integration issues and have steadily grown their brand as an acquirer in the parentage of several prominent PE sponsors. In going to market, Focus management is committing to prove viability in public filings, conference calls, and daily trading. It is a major undertaking for any company, but even more so for the one who goes first. If Focus Financial is, like Ferrari, successful as a public company, no doubt Hightower and United will, like Aston Martin, consider following their lead.We look forward to seeing more.“Dad, which button controls the ejector seat?”

Mercer Capital’s marketing staff is trained to market valuation services, not perform valuations. Nevertheless, these folks have to read a lot about the practice in reviewing our articles, presentations, blogposts, books, and whitepapers, and I’ve wondered how much they absorb of what we write. I think I got my answer last week, when I showed our marketing director a photograph of an early-1960s Aston Martin DB4 and asked if she knew what kind of car it was.“Is it a Porsche?”Incredulously, I had to remind her that Porsche didn’t make GT cars in the 1960s, only rear-engine models like the 911, 356, and 912. The first Porsche with a front engine, grand-touring configuration was the 928, first produced in 1975. The 928 was supposed to be the replacement for the 911, which was expensive to build and difficult to drive (rear engine cars have an unrivaled penchant for oversteer). Porsche enthusiasts (a fandom like none other) balked, and the marque decided to build both the GT and their traditional rear-engine models until giving up on the 928 in 1995.The 928 was a brilliant car, but it wasn’t a game changer for Porsche. I suspect the jury is still out on the tax bill’s long-term impact on the investment management industry as well. One of the more interesting aspects of the 2017 Tax Cut and Jobs Act (TCJA) that is the bill’s potential impact on mergers & acquisitions. Most of the press assumes that the TCJA is going to be positive for M&A, although it cuts differently across different sectors. For the investment management community, the change in tax law is a mixed bag, and we’ve yet to see a compelling case to suggest that, overall, it will tend to encourage or to discourage transaction activity in RIAs on a net basis.Keep in mind that much of the TCJA did not apply to investment management firms. The new rules on expensing capital expenditures don’t matter for the asset manager that spends a few hundred thousand dollars (at most) per year on information technology equipment and licenses, plus a conference room table or two. Incentives to re-shore foreign capital doesn’t apply to most RIAs, and the limitations on interest deductibility won’t matter except for the most highly leveraged transactions. There is an argument to be made that the TCJA is bullish for RIA M&A, but there is a counter-argument as well.Point: New Tax Legislation Encourages RIA TransactionsMost commentators only see positives in the tax bill for M&A activity, and at least some of that extends to investment management firm transactions. We joined in this chorus, noting that rising asset prices have brought many RIAs a surge in AUM, which grows revenues similarly and profits even more, thanks to the magic of operating leverage.For RIAs structured as C corporations, the TCJA significantly improved after-tax cash flows since most firms pay high effective tax rates. And those higher after-tax cash flows are potentially even more richly rewarded by a market willing to pay higher multiples in a time of mostly bullish sentiment.All else equal, higher valuations usually encourage sellers to take advantage – which is important fuel to the RIA transaction community in which buyers usually outnumber sellers by a wide margin. And conglomerates with investment management firm divisions may be encouraged to make divestitures in a time when valuations are high and the taxes on gains they make in the sale would be relatively low.All in all, there are many reasons to believe that the tax act will spur more transaction activity for RIAs. However, there is another side to this story.Counterpoint: New Tax Legislation Does Nothing for RIA transactions, and Might Even Discourage ThemOne drawback of the TCJA is that it does little, if anything, for internal RIA transactions, the most common style of investment management firm transactions. While tax rates for C corporations were slashed, the top tax rate for individuals only declined modestly, from 39.6% to 37%. Most RIAs are structured as some kind of tax pass-through entity, either as an LLC or an S corporation. So taxes on investment management firm earnings are taxed as personal rates rather than corporate rates.Buyers in internal transactions at RIAs pay for their stock with after-tax cash flow (distributions), and purchasing capacity will be little improved by the TCJA (with a few exceptions). Without an improvement in after-tax distributions, internal buyers can’t pay more for their stock. So the tax bill isn’t really bullish for internal ownership transition. Further, to the extent that sellers now have expectations for higher prices, we may witness a widening of the bid-ask spread, which will discourage ownership transition altogether.Risky BusinessBack to my feature car – the 928 could have wound up on the engineering design floor had Porsche not decided to go ahead and produce it alongside the now (if not then) iconic 911. The legacy of the 928 – always a great GT – was eventually cemented onscreen by Tom Cruise in the 1983 film Risky Business. In the alternative, Porsche could have thumbed their nose at rear-engine aficionados and moved ahead with replacing the 911, but by being non-committal, they hedged their bet and ended up extending the brand. We recommend similar caution in assuming the TCJA is only good for RIA transaction activity. It might be, or it might not be. Risky business indeed.“…never driven in the rain.”

In 1973 Ford Motor Company committed brand espionage by replacing its reigning muscle car, the Mustang, with a slow and cramped economy box as an alleged successor: the Mustang II. Whereas earlier versions of the Mustang were fitted with a reasonably powerful V-6 and much more powerful V-8 motors, the best the “II” could boast was a smallish V-6 from the Capri. With all of 105 horsepower, the V-6 enabled Mustang II could meander to 60 miles per hour in about 13 seconds (given level pavement and favorable winds).We covered much of what we think the new tax bill will mean to RIA valuations in last week’s blogpost – and it’s mostly good news. The “rest of the story” involves the bill’s impact on shareholder returns for RIAs structured as tax pass-thru entities (S corporations, LLCs, Partnerships), for which the news is not so buoyant.As with the Mustang II, the Tax Cuts and Jobs Act took a good thing and made it not so good. The S corporation was a fairly brilliant innovation from the 1950s, allowing certain small businesses to benefit from the limited liability of a being a corporation yet file their taxes as partnerships. S corporations (and LLCs) “pass-through” the tax liability on profits to their shareholders rather than pay one layer of tax at the corporate level on company profits and another at the shareholder level on dividends.Why Many RIAs are Structured as Tax Pass-Through EntitiesBefore the Trump Tax Bill, it often made sense to structure investment management firms as tax pass through entities – usually S corporations or LLCs. As shown in the table below, given taxable income of, say, $1 million, a C corporation would only have $650 thousand to distribute after paying federal corporate taxes at a rate of 35%. Even though the same $1 million of taxable income would be taxed at a higher personal rate for S corporation shareholders, the after-tax distribution of $604 thousand would have a higher economic value when you consider S corp shareholders skip the dividend tax (paid at 23.8%) that would accrue to the C corporation shareholder. After grossing up the after-tax dividend to the S corp shareholder at the C corporation dividend tax rate, the S corporation shareholder earns a C corporation equivalent dividend of nearly $800 thousand. Assuming the RIA in this example is valued at 8x pre-tax income, the S corp shareholder experiences a distribution yield that is 180 basis points higher than if his or her RIA were structured as a C (all else equal). The example above assumes a fully distributing RIA, since many if not most RIA clients we’ve encountered over the years dividend out something close to 100% of their net income. But the S corporation yield advantage also exists if, say, an RIA only distributes half of the C corp equivalent after-tax income (or, conversely, retains half of net income). Tax Cuts and Jobs Act Mutes S Corp AdvantageThe new tax legislation has a big impact on C corporation taxes, a more modest impact on personal income taxes, and no effect on capital gains taxes. As a consequence, the economic advantage of organizing as an S corporation or LLC has been whittled away to almost nothing in some cases, and is arguably disadvantageous in other cases.The table below depicts the comparative consequences of the new tax bill on RIAs organized as C corporations and S corporations. For C corporations, the fourteen percentage point drop in corporate tax rates improves the after tax income available for distribution considerably. In our example, a fully distributing C corporation with $1 million in pre-tax income would have $790 thousand in after-tax income to distribute to shareholders – a substantial improvement over the $650 thousand available under the old tax rates. For S corporations and LLCs, however, the taxes on pass-through income are still substantial, as the after-tax distribution only improves from $604 thousand to $630 thousand (yes, it still improves). If you gross this up for taxes that would be owed on the C corporation dividend, you arrive at a C corporation equivalent dividend of $827 thousand, or not much more than the $790 thousand dividend available for the C corporation. The dividend yield advantage narrows from 180 basis points before the tax legislation to 40 basis points after the tax legislation (assuming some improvement in the valuation multiple – as discussed in last week’s blogpost). The comparison is even worse for investment management firms structured as tax pass-through entities but don’t distribute all of their net income. Going back to the example of the firms that distribute half of their after tax earnings (on a C corp equivalent basis), the dividend yield for the C corporation improves under the new legislation from 4.1% to 4.5%, even with a higher valuation. The S corp yield drops, however, assuming the same earnings retention as the C, from 4.6% to 3.5%, notably lower than the dollar amount and percentage distribution yield for the C corporation. (Probably) No QBI Deduction for YouKnowing that they were trimming back the S corporation advantage, the tax bill introduced a new concept, the Qualified Business Income deduction, that allows certain S shareholders to deduct 20% of their pass-through income and, therefore, maintain more of the S corporation differential in tax rates. However, in a very interesting and possibly more revealing move, the QBI deduction is NOT available for investment management firms.Congress decided to exclude certain “specified service trade or business” income from qualifying for the deduction. One excluded business is investment management: “The term ‘specified trade or business’ means any trade or business – (B) which involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).” Of note, Congress had never, to our knowledge, previously singled out investment management for specific treatment as a “specified service trade or business.” Like the limitation on the deductibility of financial planning fees mentioned last week, it appears this administration is taking aim at the RIA community (while inexplicably allowing QBI deductions for architects and engineers).Despite the exclusion, the QBI deduction remains available to RIA shareholders for whom total income is less than $315 thousand; the deduction phases out until it is completely unavailable at incomes greater than $415 thousand. As a result, many RIA shareholders will not get the benefit of the Qualified Business Income deduction.Final Thoughts and Parting ShotsSo, like the Mustang II, the tax bill is new but not necessarily improved for owners of RIAs structured as S corporations or LLCs (excluding the impact of generally higher AUM balances discussed in last week’s post). The Trump administration didn’t aim its product at the investment management community any more than Ford was looking after driving enthusiasts in the early 1970s. It could be worse, though. In the mid-1980s Ford tried to ruin the Mustang’s reputation again with a version that was also underpowered and, this time, front wheel drive. Mustang fans balked, and Ford released the car as an entirely separate product: the Probe, a name that may suggest how some RIA partners feel about the new tax law after they file their 2018 return.1988 Ford Probe: You know the marketing folks in Dearborn loved working with that name (photo: favcars.com)

My seventeen year old daughter is getting pretty deep into her college search; she’s narrowed it down to a handful of schools that are between 1,000 miles from home and 4,000 miles from home, if that tells you anything.  A few weeks ago she told an admissions officer from a really fine school in California that she is “interested in politics,” but that she doesn’t want to be a politician; instead she’s interested in “economics as they relate to public policy, especially tax policy.”  I learned this over dinner one night.I know I should have teared up with pride, but instead I lost my appetite.Having my creative, funny, yet also quantitatively astute daughter sell her soul not just to the dismal science of economics but in particular Washington’s never ending quest to pervert the dismal science...feels a little like an act of betrayal - like her telling me that her dream car is a Saturn.  At least it hasn’t come to that.For Once, Taxes Are Not BoringBecause we like our readers, the RIA team at Mercer assiduously avoids talking about tax policy in this blog.  The Trump tax bill, however, can’t go without mention.  We won’t mince words – this tax bill is a blockbuster for the investment management industry.  Whatever your politics, you can’t ignore the magnitude of the change that is afoot.Among the issues presented by the tax bill is that advisor fees are no longer a line-item deduction for clients, an interesting shot at investors by this administration that doesn’t line up very well with the tax treatment of other professional services.  While this is peculiar, David Canter recently published an interview with industry leaders Brent Brodeski and Michael Nathanson that cautions against making too much of this.We’re staying focused on the implications of the tax bill for investment management firm valuations, and there’s much to consider.The Tax Bill Has Driven Up AUM (for Most)Investment management revenue is a function of AUM, and the impact of the tax bill on valuations across a spectrum of asset classes is significant.  While the impact of this on anyone who derives fee income from managing equities (fixed income shops are a different story) is clear, we don’t think it’s sufficient to just take the increase in market valuations at face; it’s more useful to unpack the issue and consider why.One of our colleagues here at Mercer, Travis Harms, did some research on the impact of the tax bill on valuation multiples to consider not just the what but also the why.  Notably, Travis looked at the impact on pre-tax multiples, such as EBITDA, to interrogate whether or not a dollar of pre-tax cash flow is indeed worth more if it is less burdened with tax liabilities.  Travis is interested in the change in multiples because he works heavily in the portfolio valuation space.  We saw broad implications to his modeling exercise for the investment management community.Travis pulled monthly forward EBITDA multiples for the S&P 1000 (ex financials).  The S&P 1000 is a combined mid and small cap index, consisting of company #501 through #1500.  As shown in the following chart, the median multiple for such firms was approximately 9.0x to 9.5x during the fall of 2016, when a Clinton administration, and tax status quo, seemed inevitable.  By late 2017, the median multiple had expanded by almost a full turn, to about 10.3x.Forward EBITDA multiples for sample equity index (S&P 1000 ex financials) shows movement in multiples that appear to correlate with changes in the outlook for corporate tax reductions. Valuation multiples are, of course, a function of three factors: 1) cash flow, 2) risk, and 3) growth.  To determine whether or not the change in multiples is indeed attributable to a change in tax rates, Travis investigated whether or not there had been an effective change in the cost of capital (risk) or an expectation of increased growth in earnings.  Travis’s analysis inferred an aggregate cost of capital (supply side weighted average cost of capital, or WACC) for his equity basket in September of 2016 as an anchor point, and then looked at the change in the cost of capital over the same period that resulted from a change in interest rates (holding the assumed equity risk premium constant). The risk-free rate (the interest rate on long dated treasuries) gapped up from close to 2.0% in September of 2016 to something on the order of 2.8% in December of that year, pushing the implied supply side cost of capital up to about 9.2%.  Doing some fancy footwork, Travis ran a DCF model on his equity basket, letting the tax rate float.  His DCF model suggests that the market priced in effective tax rates of approximately 20% by the end of 2017.  Significantly, the early expectations for rate reduction seem to have waned a bit over the summer months as the Trump administration experienced a series of legislative failures.  Also significant is that the model assumes there are no changes in the expected growth outlook for the companies in the sample basket, consistent with statements from the Federal Reserve suggesting no material uptick in GDP growth consequent from the tax bill.  Travis didn’t modify expected growth because there is no robust way to review earnings estimates for a broad array of companies on a month by month basis.  Of note, Aswath Damodaran, a finance professor at NYU, thinks the tax bill may in fact increase the sustainable growth rate for U.S. companies. Using a DCF model framework to evaluate the impact of a change in tax expectations on valuation multiples, we can let the cost of capital float with interest rates and hold growth expectations constant, such that the change in valuation multiples can be attributed to the change in tax rates. The implication of Travis’s analysis is that the market repriced as a consequence of lower tax rates, and not because of changes in the cost of capital (which, with higher interest rates, would have caused multiples to fall), nor expectations of higher earnings growth (of which there is little evidence). Put another way, the tax bill appears to have, indeed, inflated equity valuation multiples by reducing the tax burden on corporate profits.  On one level, this is obvious, but the implications of this are interesting if it also suggests that current equity valuations are more sustainable than some believe.  Perhaps valuation multiples gapped higher, as they should have, and will remain higher than they would otherwise be, so long as corporate tax rates persist at these levels.  That would certainly be good news for the asset management community. The Tax Bill Has Improved RIA Economics (for Many)Taking this one step further, the tax bill would seem to have improved returns for many subsectors of the investment management industry.  If public market valuations gapped up 10% or so, would we expect to see nearly a 10% increase in assets under management across the equity space in the industry?  More AUM means more revenue and more profitability?  In short, yes, as we can show in the example below. This table is fairly self-explanatory.  Assuming an RIA with $5 billion under management, of which 80% is managed equities and 20% is fixed income, a 10% increase in equity valuations would have a corresponding 8% increase in overall AUM, ceteris paribus. If the same investment management firm realized fees of 65 basis points on equities and 20 basis points on fixed income, the leverage on the higher AUM attributable to equities would increase revenue a bit more than total AUM, or 9.3%.  One potential problem with this aspect of the model is the assumption that clients with higher AUM balances won’t pass through breakpoints that will lower overall realized fees.  For purposes of this example, however, we have assumed that the fee schedule isn’t progressive with the increase in AUM. When we consider the leverage on operating expenses, however, things really get interesting.  Higher AUM balances can lead to a correspondingly higher expense base if the increase comes from more accounts or assets that are more expensive to manage.  In this instance, however, AUM is simply inflated because of market activity.  We might not assume G&A costs would rise at all, nor would, necessarily, salaries.  Incentive compensation, however, would probably increase.  Assuming bonus compensation to be 30% of pre-bonus EBITDA, we see an almost 20% increase in incentive compensation resulting from higher assets under management.  Even with higher bonuses, however, total expenses only increase about 4%.  The consequence of this is an increase in earnings before interest, taxes, depreciation, and amortization of almost 20%, and a cash flow margin increase of three percentage points. If you’re an asset manager, your reality may (will) be different than our example.  If interest rates continue to rise, our sample RIA might experience some diminution in income from managing fixed income portfolios.  Clients may rebalance to maintain the same allocation between stocks and bonds.  Clients are, on the whole, more fee sensitive than they once were, and may want some betterment of their fee schedule as a consequence of this moment of good fortune.  And your staff will probably notice that there is more cash flow available for compensation.  The market may bid up the cost of talent, or at least salaries and bonuses will increase more than we show here in an effort to “keep a good thing going.”  In any event, if your AUM increases nearly 10% and margins don’t widen, it would be worth looking through your numbers some to assess why.  The opportunity for a significant increase in profitability at many RIAs appears to be on offer. The Tax Bill Has Improved RIA valuations (for Some)Taking this one step further, RIAs may not only benefit from a repricing of market multiples of their clients’ assets, but also of the value of their own returns.  In our example firm, EBITDA increases 18.6% as a direct consequence of the tax bill.  Valuations of RIAs would be expected to increase similarly, if there were no change in the valuation multiples for the RIAs themselves. If, however, appropriate multiples for RIAs gap-up 10% like Travis Harms observed happened in the public equity market, then the combination of that plus improved profitability produces a 30% increase in enterprise values for RIAs, and a corresponding 20% expansion in the implied AUM multiple.  The reason for the increase in RIA multiples is the same as the increase in the market basket of equities Travis studied: a dollar of pre-tax cash flow is worth more when the tax burden on that dollar is less (assuming no change in the cost of capital or earnings growth). Your Results May (Will) DifferWhatever you do, don’t run out of your office and tell your partners that I’ve just proven your firm is worth 30% more than it was two months ago.  There are many variables that affect firm valuation – some discussed in this post, some I’ve left out, and some I probably haven’t thought of yet.  One issue in comparing movement in the public market multiples and private RIAs is that public companies are C-corporations whereas many, if not most, private RIAs are some kind of tax pass-through entity like an S corporation or an LLC.  I’ll be back next week to talk about how the tax bill treats tax pass through enterprises, and it’s not nearly as generous as conferred upon C corps.In any event, the tax bill is bullish for the RIA community.  There may not be a Saturn in my driveway, but a friend of mine who, like me, was born under the astrological sign of Capricorn says that Saturn is in our house this year (cosmologically, a favorable thing).  I don’t know what the “Saturn” effect is for the markets, but for now it appears that the stars are aligned for the RIA community, an augur of good things to come.If you have questions as you wrestle with the valuation implications of the new tax bill on your RIA, give us a call to discuss your situation in confidence and/or register for our upcoming webinar addressing the matter.

When’s the last time you thought about Esperanto?  Not being an “esperantist” myself, it had been a while.  Yet I was searching for some kind of metaphor for bitcoin: a fictional and entirely artificial currency without state backing and having a value tied strictly to facilitating global peer-to-peer transactions when I remembered the fictional and entirely artificial language without state backing and having a value tied strictly to facilitating global peer to peer conversations.  Esperanto still exists, but today it is more known by teenage boys everywhere as a fictional car similar to a mid-70s Cadillac El Dorado in the video game Grand Theft Auto (or so Google tells me – this author loves cars but is no gamer).Esperanto was developed in the late 19th century to be a universal second language.  The idea was simple and appealing: everyone would maintain their native language and learn Esperanto, such that wherever one traveled he or she could converse with the locals.  There would be no need to learn the local language of where you were traveling, and an esperantist could, theoretically, travel anywhere and converse with anybody.  Esperanto was based on an amalgamation of several romance languages with a rigid set of phonetic and grammatical rules that would be easy to learn.  Esperanto’s algo, as they say, was robust.  It sort of caught on, but mostly as a niche skillset.  Today, Esperanto is spoken by between two million and ten million people worldwide – approximately the same number of people who have accounts holding cryptocurrency.We’ve put off writing about bitcoin in this blog, partly because we really don’t understand it, few of our clients invest in it, bitcoin’s performance has little to do with whether the RIA industry performs well or poorly, and we desperately wanted to avoid making allusions to tulips.  The attention that cryptocurrencies received in late 2017 got our attention, though, as a barometer for trends that will buffet the investment management industry in 2018.  Our cursory understanding of bitcoin suggests:1. This Market Craves VolatilityThe financial market experience of 2017 felt like standing in the Whitney Museum watching all eight hours of Andy Warhol’s film, “Empire.”  We kept expecting something – anything – to happen, but it never did.  Despite a raucous political landscape, global instability popping up everywhere, and pinched cultural nerves at home, the financial markets in the U.S. were very nearly sleepy.  With little of interest going on, the market needed a narrative that only a fictive asset with an uncertain purpose could supply.  We have, it seems, made it full circle from the credit crisis, when the only asset class in vogue was cash, to a market in which the only asset in vogue is fake cash.2. Traders Want Their Revenue Share BackIt’s difficult to overstate the degree to which trading revenues have been decimated by technology.  I’m old enough to remember the “5% rule” being a topic on the Series 7 exam.  The thought, today, that prime brokers could ethically charge commissions as high as 5% on each side of a trade is beyond laughable.  Suffice it to say, though, that trading used to command a much higher share of investment management revenues.  Trading was a valued skill.  Technology has destroyed that, as have placid markets and pricing transparency.  Bitcoin is a mysterious asset with an unproven market and substantial bid-ask spreads; traders can exploit it so they love it.  Look for new products that have pricing inefficiency and arbitrage opportunities that can generate trading revenue.3. The Lines Between Asset Classes Are BlurringWe haven’t fully left the 60/40 world where asset allocation meant choosing capitalization brackets in domestic and foreign equities, mixing fixed income investments across different maturities and different ratings, and throwing in some cash for a rainy day.  However, portfolio construction isn’t as simple as it once was, and it probably won’t be again anytime soon.  Bitcoin wasn’t the first shot fired at this way of thinking about diversification, but over time the investment community has become littered with categories of investments and some blurring of lines (i.e. large cap domestic companies tend to generate material amounts of profit overseas – so are they “domestic” or “global”?).  What bitcoin suggests is that investors have come a long way from having to be talked into investing in something other than treasuries and the S&P 500.  “Buying what you know” seems to have lost favor in a world where speculative upside has, at least for some, become more sought after than returns which are measurable and knowable.4. Investors Are Becoming ComplacentAn old and true Wall Street maxim is “every bull market climbs a wall of worry.”  Does it feel like we’ve run out of worry?  From a practical perspective, it appears that the “wall of worry” is lower than normal.  Short interest is in retreat, reserve cash is being depleted, the yield curve is flattening, and nobody cares.  Bitcoin is interesting as a gauge of the market’s appetite for speculation.  A short nine years ago we were in the throes of the credit crisis, interest rates were going negative throughout the world, investors were shunning equities, and my favorite metaphor for the chaos was uttered (I just don’t remember by whom): “We’ve lost the buoys that mark the deep channel.”  Now we’ve swung to the other extreme.  I haven’t wandered down to the office library to blow the dust off our copy of “Dow 36,000”, but I’m getting close.5. Finance Evolves Slowly, But It Also Evolves ConstantlyCryptocurrencies are less than a decade old, but the concept has gained ground rapidly.  Yet the big banks have largely stayed out of the fray, with Jamie Dimon being openly dismissive of bitcoin in October, and Goldman Sachs only recently announcing that it would open a desk to trade cryptocurrencies; even that won’t be operable until the summer of 2018 (!).  So if you feel like you’re being left out of the party, you have good company.  What this all demonstrates is that the financial services community changes slowly, which explains the pushback against the fiduciary standard and the mixed response to large broker dealers leaving the protocol.  Markets move more rapidly than the people and the firms that serve the markets.Final Thoughts on BitcoinAre cryptocurrencies an asset class?  Is bitcoin speculation or a hedge?  Will bitcoin have a permanent place in finance or will the magic fade?  Is it going to $100,000 or zero?  We have no idea.The idea of a universal second language should have worked.  Esperanto still exists, but possibly because it doesn’t reflect the life and culture of any particular subset of humanity, it’s really just an effect for the erudite.  This makes us wonder about the future of bitcoin.  Because it is not state sponsored, it also does not reflect any particular segment of the global economy (except perhaps for that part of the economy that lurks in the shadows).125 years or so after the development of Esperanto, the universal second language is English.  Eight years after the development of bitcoin, the universal reserve currency is the dollar.We don’t expect a revolution from cryptocurrencies in 2018, but the follow-through on the 2017 hype should make for a good show.As always, feel free to reach out to us if you’d like to talk further.

Our colleagues down the hall who focus on the portfolio valuation side of our services to the asset management community have an extensive new study on the Financial Accounting Standards Board’s guidance for recognizing the fair value of corporate venture capital, or Accounting Standards Update 2016-01.  ASU 2016-01 doesn’t exactly roll off the tongue, but it does represent an important step in the continued trek toward financial statements based on the fair value of assets and liabilities, rather than cost.   As more investment activity takes place on the private side, more needs seem to accumulate to assess the market value of investments.  The placid market of the past few years has made this task relatively easy, but we all know that’s not going to last.In any event, enjoy the read.  It goes especially well with eggnog.Read Whitepaper

When we value an asset management firm, we do so in cash equivalent terms, as if someone were to pay that amount, on a given date, for a given firm or interest therein.  On many occasions, clients have asked us how our estimate of value compares with an offer they received for the same firm or an interest in the same firm.  It isn’t unusual for the offer to be ostensibly higher than our valuation, but it is unusual for the offer to be made in cash equivalent terms.  As a consequence, we often have to look beyond the face value of the offer to determine what the economic value of the offer is, which may be much less than the headline number.In this final blogpost on evaluating unsolicited offers for your RIA, we take on this issue of valuing an offer.  Valuing the offer for your RIA can be more difficult than valuing the firm itself.Similar Assets, Priced DifferentlySometimes, things which look similar are actually worth very different amounts of money – so one has to be careful making comparisons.  The headliner offering at RM Sotheby’s latest auto auction in New York was a 1959 Ferrari 250GT California Spider built in full racing spec for Bob Grossman.  The car is, of course, beautiful, but the story behind it is even better.  The apogee of sports car racing was the 1950s and early 1960s, when well-healed amateurs could enter major races against established professional teams and often do very well.  Bob Grossman was a successful sports car dealer and amateur racer in New York.  He ordered the Ferrari pictured above and had it delivered straight to the track to race in the highly competitive 24 hours of Le Mans in 1959.  The car had an aluminum alloy body (one of only eight made that way by Ferrari) and a race tuned V-12 with external plugs.  Grossman had never driven at Le Mans before, was unfamiliar with the car, and had a co-pilot for the race whom he’d never met and who didn’t speak English.  Grossman entered with the 250GT anyway and took third in his class.The car went on to perform very well in subsequent competitions before Grossman sold it.  It doesn’t have leather seats or a radio, but still sold for $18 million.  A similar 1961 Ferrari 250GT convertible, freshly restored but lacking racing heritage, was available at the same auction.  Despite a pre-auction estimate of less than one-tenth the sale price of the Grossman Ferrari, the ’61 failed to sell.  Two very similar cars offered at the same time in the same market; two wildly different valuations.Comparing Offers for Your RIAIf all RIA offers were all cash, this wouldn’t make much of a blogpost.  RIAs rarely sell on simple terms in all cash transactions, however, so converting offer pricing and terms to cash equivalents is critical to determining whether an offer is reasonable or not. Because investment management is often a relationship intensive business, transacting an RIA often involves performance based payments like earn-outs, compensation arrangements tied to client transition, non-compete agreements, and other terms which effect the value of the transaction to the seller.  Oftentimes cash consideration may only constitute two-thirds or so of total consideration offered.A selling client of ours a few years ago was counseled by a friend to assume that the cash he was paid up front would be the only consideration he ever got for his company, and not to take the deal if that wasn’t enough for him.  That’s a little extreme, but the maxim that “cash is cash and nothing else is cash” does establish a hierarchy to think about the value of other forms of consideration.Trading Your Stock…for StockTaking stock in another asset management firm in exchange for some of all of your shares isn’t necessarily a bad idea, but it does double the complexity of the transaction.  In addition to having to determine an appropriate value for your firm, you have to think about what the buyer’s stock is worth.  Sellers can take this issue for granted, but it has a huge impact on the value transacted.Think, for example, about the relative merits of two shares of stock.  If the selling firm’s stock is valued at 8x earnings, and the acquirer values their own stock at 10x earnings, then essentially for every dollar of earnings being given up by the seller, it now has a claim on 80 cents.  There may be reasons why the acquiring firm’s stock is worth more – higher quality earnings, lower risk profile, better growth opportunities, etc.  The trouble for most sellers, though, is that they understand the potential upsides and downsides of their own company, while having much less visibility into the relative merits of the acquirer’s stock.Does a stock for stock transaction involve giving up control of the selling company and taking an illiquid, minority position in the acquiring company?  What is the dividend policy of the buyer versus that of the seller?  Is the acquiring company a C corporation and how does that affect shareholder returns if the seller is a tax pass through entity like an S corporation or an LLC?Rolling your interest into the stock of your acquirer may be a good way to stay in the game.  The question becomes: whose game is it?Is Selling Your Firm Just an Advance on Your Salary?One thing that is very likely to change when you sell your investment management firm is your compensation package.  This is probably something you want to happen – within limits.  If you’re currently taking out, say, $1 million per year in total compensation and you could be replaced (at least in theory) for half of that, then your earnings are understated by $500 thousand.  At a multiple of 8x, that’s a difference in value of $4 million.  You would probably rather pay capital gains tax rates on $4 million today than receive an extra $500 thousand per year, taxed at ordinary income rates, for several years.That said, if there is no clear correlation between compensation give-ups and the value being received from the transaction, it may start to feel like the buyer is paying you for your stock with your money.  In some cases, that may even be true.  If post-transaction compensation is set too low, you and your partners may have little incentive to perform after the ink dries on the purchase agreement, which doesn’t lead to good outcomes for anyone.We usually counsel acquirers to agree to normal compensation levels with their seller as part of transaction negotiations.  If you do that, you’re much more likely to have a common understanding of the profitability of your RIA, and, thus, the negotiation is really about the multiple being paid.Performance Compensation as Risk SharingMany larger and more sophisticated acquirers use bonus compensation as a way to manage their risk.  The typical arrangement we’ve seen is for acquirers to take something equivalent to a preferred stake in an RIA – taking their pro rata piece of the upside and little, if any, of the downside, or holding a stake in which management gets more benefit from increases in earnings and more detriment from declines in earnings.  RIA consolidators seem particularly fond of this arrangement, and while it’s difficult to “value” the offloading of risk from buyer to seller (or continuing minority partner), it isn’t difficult to see who’s getting the better side of the deal.Earn-out Consideration is Never a GivenEarlier this year we had a whole series of blogposts about earn-out consideration, so I won’t rehash that here (Why Earns-outs Matter, Five Considerations in Structuring Earn-outs, and An Example of Structuring Earn-outs).  Suffice it to say that earn-outs are common in RIA transactions and often are necessary to ensure that the value of client relationships and investment products are effectively transferred from seller to buyer.  But an earn-out is only worth as much as it is likely to be earned, and this has to do with the target performance and terms associated with the earn-out.  The time value of money must also be considered, particularly in earn-out arrangements of three years or more.One thing to keep in mind, as a seller, is how likely you are to reach the targets set by the earn-out.  If the minimum growth target is, say, 15%, and your historical growth is less than that, consider how far markets have run to date and how you expect them to perform over the term of the earn-out.  Modest earn-out requirements after a lull in the equity markets are one thing, but robust expectations after a long bull run are quite another.  This issue is particularly poignant given where markets stand today.Don’t Forget to Value the TermsNon-compete agreements, office buildings, life insurance policies, working capital, contingent liabilities – there are a few dozen other issues that can change the economics of your offer.  We can’t cover everything in a blogpost, but I will end with a simple piece of advice that many of these issues should be isolated and dealt with on their own merits – as opposed to being interactive with the operating value of the company.  Even if the buyer wants to treat the transaction as an “all-in” or prix fixe price, you should know the breakdown of the offer on an a la carte basis.It isn’t always easy to determine whether an offer is too good to pass up, or too good to be true.  If you’re considering a proposal to buy your investment management firm – especially one that came in over the transom – let us take a look at it.  Whether you need a sounding board or an advocate, we can help.

Mercer Capital is headquartered in Memphis, where Elvis Presley lived most of his life.  It occurred to me recently that I’ve never written about Elvis's passion for cars, a pretty huge oversight for this blog.  Elvis bought a lot of cars – estimates number his purchases in the hundreds – for himself, family, employees, friends, and occasionally strangers.  A friend of mine who owns a few auto dealerships now was a young car salesman at the local Lincoln/Mercury dealer in the 1970s when he got a call in the middle of the night to "come on down to the dealership…Elvis wants to look at cars."  He and the other salesmen took scores of cars to Elvis's home, Graceland. Elvis sat in a chair on the front porch while they drove the cars, one at a time, past him in the circular driveway.  Elvis would either say "yes" or wave them off. By sunrise, he had agreed to buy a dozen cars – mostly as gifts.If you visit Graceland, you’ll get a strong sense of how the extravagant culture of Elvis Presley's entertainment enterprise was built around him: dozens of cars, customized jet aircraft, strings of horses, collections of firearms, fried peanut butter and banana sandwiches, all night jam sessions in a Hawaiian-themed den with carpet on the ceiling, and a racquetball house with a running track on the roof.Graceland is a perfect study in corporate culture at the extreme. On the Graceland tour, you’ll quickly understand that Elvis was a "package-deal"; you couldn't get the same entertainer from a person who lived a life of moderation. While most RIA founders aren't as "unique" as Elvis, investment management firms tend to be built around the peculiar interests and desires of their founders, and separating the firm from the founder is easier said than done.Culture Is KingCulture is the most glaring omission of any purchase agreement. We may not have any clients who show up to work at their RIA in white jumpsuits, but we have some who wear board shorts and flip-flops to the office, and others who dress so formally we suspect they wear neckties with their pajamas.  Some keep rigid office hours and some are always someplace else.  Some like a team approach to investment management and others act strictly on their own instinct.  Some drive flashy sports cars and others prefer run-of-the-mill SUVs.  None of them wants to change just because they're selling their firm, but what's not written in the purchase agreement is the difficulty in maintaining cultural identity for a seller after the transaction.Transitioning culture wouldn't be such a big deal if founding members of RIAs could just walk away after the transaction.  As we all know, though, even when an asset manager transacts, there are relationships to hand off and successor managers to groom and earn-outs to earn – such that partners usually have to stick around for three to five years after selling.  As a consequence, founders have to undergo a cultural change at the firm they founded, which can be galling.For folks who are considering offers for their investment management firm, we usually counsel them to remember a few things that aren't outlined in the LOI:You're not going to be the boss anymore. One seller was apoplectic when the bank that purchased his wealth management firm changed the color of his firm's logo to match that of the bank. It's going to happen.You're going to have a boss. Sellers often seem surprised that there is a reporting structure of which they are a part, in spite of being assured that the buyer will give them "maximum autonomy." Autonomy doesn't mean you get your own island.Your employees are going to have a new boss. And they might like that boss more than they like you. You think that you want that for them, but it won't do much for your ego.Your clients may question your commitment after the sale. If you start to enjoy your reduced responsibility and increased liquidity too much, your clients will assume you are "calling in rich" – and take their assets elsewhere.  Best to keep the overt transition low key until the earn-out period is complete.The same “founder's syndrome” that helped you build the firm will now fuel your frustration. Founders are driven by senses of identity and autonomy that are completely undermined by selling. So when you get up from the closing table, head straight for the therapist's couch. Elvis Presley's posthumous hit single, "A Little Less Conversation," pleads for actions instead of words. On the contrary, we suggest that founders think about what makes their firm unique and what aspects of that uniqueness you are, and are not, willing to give up in a transaction. Then have a little more conversation with the buyer about their post-transaction expectations for your firm's culture. If you can agree to how you're going to work together before the deal closes, everyone will be more successful after the deal closes. As always, feel free to reach out to us if you'd like to talk further.

In this continuing series on RIA partners responding to unsolicited offers, we thought it would be worthwhile to spotlight the number one killer of worthwhile transactions: deal fatigue.Transaction negotiations frequently take longer than anyone expects and often start and stop multiple times. The process has a tendency to terminate negotiations on bad transactions, but it also takes down many that should happen.Watching deal-making reminds me of car chase scenes in movies: unnecessarily long, fast-paced, often suspenseful, and with the potential for multiple fatalities – or at least bruised egos.The car chase scene that set the standard for the past fifty years was Bullitt, in which Steve McQueen, playing the role of Frank Bullitt, drove a 1968 Ford Mustang GT Fastback equipped with a 390 cubic inch V-8 and a four-speed manual transmission through the streets of San Francisco in pursuit of some hitmen in a Dodge Charger. Fiction being what it is, Bullitt catches the bad guys in his Mustang, even though in reality the Charger was faster. The car scene took three weeks to film, destroyed two Dodge Chargers and one Mustang, and ultimately resulted in a chase sequence lasting almost ten minutes that won the film’s editor, Frank Keller, an Oscar.Three weeks of filming for a ten-minute scene is about the ratio of time it takes to negotiate and finalize an RIA transaction relative to how long people think it ought to take. Many sellers believe that once a term sheet is agreed to or an LOI is signed, the rest is just papering the deal. Not so. Transaction negotiations, even drafting the purchase agreement, take months and sometimes years – but never merely weeks. I’ll spare you dozens of war stories, but I do have a few things to keep in mind if you find yourself going through the process.Have a Real Reason to Sell Your RIAStrategy is often discussed as something belonging exclusively to buyers in a transaction. Not true.Sellers need a strategy as well: what’s in it for you? When deals involving asset management firms fall through, I often hear things like “they just wanted to use our money to buy our firm from us.” Translation: the seller gives up shareholder returns (distributions and maybe bonus compensation) and agrees to work through a transition period (often three to five years) while the buyer capitalizes those same returns and uses them to finance or at least justify the purchase price.Sellers often feel like all they are getting is an accelerated payout of what they would have earned anyway while giving up their ownership. In many cases, that’s exactly right! On top of that, most investment management firm transactions have substantial earn-out payments included as part of the deal, such that the sellers may go from being masters of their own universe to singing for their supper.RIAs are professional service firms and the cash flow that creates value transfers from seller to buyer when the ink dries on the purchase agreement. Sellers give up something equally valuable in exchange for purchase consideration – that’s how it works.As a consequence, sellers need a real reason – a non-financial strategic reason – to sell. Maybe they are selling because they want or need to retire. Maybe they are selling because they want to consolidate with a larger organization, or need to bring in a financial partner to diversify their own net worth and provide ownership transition to the next generation. Whatever the case, you need a real reason to sell other than trading future compensation for a check. The financial trade won’t be enough to sustain you through the twists and turns of a transaction.Be Aware of Your Own PsychologyOne reason why we enjoy working with investment managers is that they are the kind of client who is wired like we are: analysts who think they can reduce most everything in life to an excel spreadsheet. Finance and much of economic theory are grounded in a neoclassical approach that can be expressed in logarithmic equations in which decisions are based on some logical assessment of marginal benefits. The reality of evolutionary neurobiology and the recent development of behavioral economics suggests that real life is much messier than that. People reason out dilemmas to the best of their ability, and then make a decision largely based on emotion.Even earning your CFA charter doesn’t enable you to escape your own humanity. People don’t refer to their firms as their “baby” for no reason – you will be emotional while you contemplate things like handing your relationships with clients and colleagues to a stranger for adoption, so be ready for it. It’s a normal feeling, and if you have the right acquirer, it will subside to relief that someone can carry on these relationships on your behalf, and is willing to pay you for the right to do so.A good analyst can justify his emotional impulse using financial analysis; a great analyst can prove it.One way to manage this through the deal process is to have an impartial counselor be a sounding board while you’re negotiating. This might be a friend or business colleague, but keep in mind you’re going to need a lot of counseling. Ideally, this is the same person who is representing you in the sale, and thus who knows you and the setting for the transaction. Getting this from your advisor requires a financial arrangement in which you can feel comfortable that he or she is representing you and not the transaction.Remember That Money Is Fungible and Value Is RelativeGive up on the notion of absolutes in transaction valuations or deal terms. The eleventh commandment is not 10 times EBITDA nor 3% of AUM, and neither one is engraved on any stone tablets in human history.Everyone wants to sell at the top of the market, but the top of the market for RIAs is usually the top of the market for other assets as well, so if you sell at the top you’ll pay more taxes and your after-tax proceeds will be reinvested in a fully priced market. It’s highly unlikely that your investment management firm will fetch top dollar in a bear market; so in many regards, the purchase price you exact in transaction negotiations only has merit relative to your reinvestment opportunities.This, again, is an argument for looking at the sale of your RIA through a strategic lens rather than a financial lens. Maybe you can do better than the market in selling your firm, but if you’ve been in the business long enough to have built a successful advisory business, you know how difficult it is to beat the market.Conclusion: Keep Your Eyes on the PrizeSo, if you’re entering into negotiations to sell your RIA, buckle up, stay composed, and be mindful of your goals. Steve McQueen was notoriously focused on managing his own career, which enabled him to drive even faster cars in real life, like his Ferrari 250 GT Lusso, shown below.Steve McQueen’s car in real life, a Ferrari 250GT Lusso (gentlemensjournal.com)As always, if you'd like to continue the conversation before our next post, give us a call.

After a fifty-year film collaboration with the James Bond franchise that started with Sean Connery piloting a DB5, Aston Martin pulled out all the stops and created a special model, the DB10, for the 2015 Bond movie, Spectre.  At the time, rumors abounded in the car community that the DB10 would go into production as shown in the movie, but it was not to be.  Aston Martin only built ten copies of the DB10, made from a stretched wheelbase Vantage and lots of custom sheet metal.  Like most concept cars, though, elements of the DB10 design eventually showed up in Aston Martin’s next production car, the DB11.As a rule, concept cars are marketing pieces as much as design studies, rendered to get attention and hold it until the production model (which may bear little resemblance to the concept) is available for purchase.  In the case of the DB10, this method worked, as Aston Martin’s launch of the DB11 has been the marque's most successful in history ("success" is relative; Aston Martin has sold fewer cars in its 104-year history than Toyota typically sells in two days).When clients call us seeking advice after receiving an unsolicited offer for their RIA, the first questions they ask generally revolve around two issues:Is the price reasonable? andDo we think the buyer will be willing to improve the offer? "Price" is a sticky wicket that we'll cover in a later post, but whether or not the first offer is going to change in the negotiation and due diligence process is a certainty: yes.  The only question is which direction (higher or lower) the offer will move before the transaction closes.Universal Truths on Unsolicited OffersIf you receive an unsolicited offer for your investment management firm, you’ll find it is usually difficult to immediately assess the sincerity of the offer.  And while making generalizations about the M&A process can be more misleading than helpful, we will assert the following:An unsolicited offer is made based on limited information. Often the initial overture is based on information beyond what is publicly available on the seller’s website and in regulatory filings. Even with financial statements in hand, prospective buyers making their offer know very little about the seller. The due diligence process involves the review of hundreds of pieces of documentation that can and will shape the purchase agreement.An unsolicited offer may be a competitive bid, but it is not a bid made in a competitive market. Not every sale is best conducted in an auction process, but the prospective buyer making an unsolicited offer knows that it is, at least for the moment, the only bidder. The object of an unsolicited offer is to get the seller’s attention and cause them to enter into negotiations, often giving the bidder an exclusive right to negotiate for a fixed amount of time.Whether the offer is made at the high end or the low end of a reasonable range depends on the bidder’s perception of the seller. If a buyer thinks a seller is desperate, the initial offer may be at the low end of a reasonable range, in which the selling process should evolve to move pricing and terms more favorable to the seller.  In many cases, though, the initial offer is above what the buyer ultimately wants to pay ("bid it to get it") and will use the due diligence process to beat the price down or insert terms that shift the burden of risk to the seller.  If the initial offer seems too good to be true, consider the latter a distinct possibility.An LOI is NOT a purchase agreement. Many sellers think the deal is done if they receive an unsolicited offer with a strong price and favorable terms.  We don't want to suggest that buyers never put their best foot forward on the first round, but an unsolicited offer should be viewed more as an overture than a commitment.Once the offer is accepted, the real work begins. Stop and think for a moment about what you would like your employment arrangement to be post-transaction. Do you want a substantial base, incentive compensation, a multi-year arrangement, roll-over ownership, administrative responsibilities or just client-facing work, protections in the event of termination without cause, an internal or external reporting requirement, and/or other arrangements?  Imagine your situation as viewed by the buyer and what they would want. This is just one item which is rarely delineated in detail on the first offer. A legion of issues must be resolved in the process of negotiating a final purchase agreement, which is why “deal fatigue” is a prevalent cause of abandoned transactions.ConclusionBond’s DB10 wasn't what it seemed to be.  It wasn't the prototype of a production car. It wasn't equipped with Aston Martin's most potent powertrain (what was Q thinking?). It wasn't even built on a "DB" series chassis. It was a movie car, and ultimately a design exercise for Aston Martin to whet the public's appetite for their next production release. That the concept was only a suggestion of the ultimate product is a reasonable metaphor for the relationship between an unsolicited offer and a closed transaction. The offer gets the process started, but it's the process that creates the deal.Transacting an investment management firm is complicated. Advisors to buyers and sellers have the delicate task of aggressively representing their clients and covering every bit of ground in the due diligence process without killing the deal by exhausting the buyer and seller and making them wonder why they ever started negotiations in the first place.  The primary danger of an unsolicited offer is that it lures potential sellers into thinking the deal is done and the process will be easy.  As with most things in life, if something looks too good to be true, it usually is.

A few weeks ago, I spotted a red Alfa Romeo Duetto Spider and my mind immediately wandered to Dustin Hoffman driving a Duetto in the film that launched his career, The Graduate.  Of all the small, four-cylinder convertible sports cars produced in the late 1960s, the Alfa Romeo stands out because of its prominence in the film.  Fifty years after it was released, The Graduate is still relevant because the plot captures a common theme: life is full of moments of great accomplishment that summarily dissolve into concern over what follows.Hoffman plays Ben Braddock, a newly minted college graduate returning home to Los Angeles.  In spite of his successes thus far in life, Ben is disillusioned and nervous about the future.  In the midst of his uncertainty, Ben is propositioned by the wife of his father's business partner, Mrs. Robinson. The movie sorts out the ensuing affair between Ben and Mrs. Robinson, and Ben coming to terms with his romantic preference for the Robinsons' daughter, Elaine. About the time he realizes he's in love with Elaine, Ben finds out she's getting married to someone else. He races to the church (the Alfa characteristically runs out of gas before he gets there), interrupts the wedding, and escapes with Elaine on a city bus. In the closing scene, Ben and Elaine sink into their seats and relish their victory, until satisfaction gives way to dread: now what?Around the time I spotted the Duetto, we were working with a client who had received an unsolicited offer to acquire their wealth management firm from one of the many consolidators trying to build national scale in the RIA space. The offer was calibrated to get our client's attention, with language that focused on “unlocking” value and projections of other-worldly financial returns from agreeing to the transaction. Irrational buyers with capacity don’t come along every day, so when a suitor presents themselves as "the one," you better decide if they are genuine or not.  If so, say “yes” before they change their mind. If the offer is too good to be true, take a pass.  This case was more of the latter.I know this particular consolidator has managed to convince numerous RIAs to join them over the years, so I can’t argue with their approach. Indeed, some of our client's partners seemed more than intrigued by the overture, while others weren't convinced. We were asked to review the offer from a dispassionate perspective and make recommendations to the partners about how to proceed.This wasn't the first time we've been asked to review an unsolicited offer to buy an asset management firm, and it surely won't be the last. As such, we thought it would be worth taking a few blog posts to talk about unsolicited offers, how to approach them, evaluate them, and decide whether to pursue or reject them.Over the course of the next few weeks, we'll cover topics relevant to dealing with overtures from acquirers, including:Be mindful of your own psychology. Selling an asset management firm is an emotional episode disguised with numbers.  Don't confuse your own fears and desires with what may be the largest financial decision you'll make in your career.Just because they want you doesn't mean you have to want them back. There is a strategic approach to selling an investment management firm just as there is a strategic approach to acquiring one.  Are they solving your problem or are you just solving theirs?Know what you are selling. You will be expected to give things up in exchange for the acquirer's check – and some of the most significant items transacted aren't listed in the purchase agreement.Be ready to value the offer. RIA transactions often include contingent consideration and terms that affect the cash equivalent proceeds of a deal.  It is almost unheard of for an RIA acquirer to make payment, take the keys, and be done with the deal.Think about using an intermediary. A third party, compensated to represent you instead of the transaction, can be a powerful way to achieve the best outcome in any transaction. Like young Ben Braddock, looking back on a successful life so far as a student but not knowing what adulthood will bring, partners in mature asset management firms can simultaneously feel both a sense of great accomplishment at what they've built and a great sense of discomfort at what lies ahead. An unsolicited offer is usually intriguing and sometimes presents a bona fide path forward, but it may also be a threat to everything you value. We'll be covering more on this next week, but feel free to give us a call if you'd like to talk sooner.

Risk is enigmatic to investing.  While we might all desire clairvoyance, it would only work if we were the sole investors who could see the future perfectly.  If everyone’s forecasts were proven accurate, assets would all be priced at something akin to the risk-free rate, with no premium return attached.  Uncertainty creates opportunity for investors, because opportunity is always a two-way street.Pricing uncertainty is another matter altogether.  Not everyone “believes” in CAPM, or at least maybe not the concept of beta, but most agree that the equity risk premium exists to reconcile the degree of unlikelihood for the performance of a given asset with the value of that asset.  In an ideal world, a reasonable cash flow projection and a reasonable cost of capital will yield a reasonable indication of value.In the real world, there can be genuinely differing opinions of what the future holds.  Some think the future is all about batteries, with considerably stronger environmental regulations on the horizon (at least in Europe) not to mention the relative simplicity of battery power.  This sentiment bid Tesla’s share price to a larger market capitalization than Ford.  Others have equally questioned the wisdom of this, noting the reluctance of consumers, and many governments, to phase out the use of fossil fuels in transportation.  Naysayers note that Tesla’s 400 thousand plus pre-orders for the Model 3 pale in comparison to, say, the over 16 million Ford F150 pickup trucks sold over the past 20 years.  What would break that trend now?In the vacuum sealed world of fair market value, we can reconcile discordant outlooks with different cash flow projections.  The differing projections can then be yoked together into one conclusion of value by weighing them relative to probability.  The discount rate used in the different projection models captures some of the risk inherent in the cash flow, and the probability weights capture the remainder of the uncertainty.  In a real world transaction, however, buyers want to be paid based on their expectations if proven right, and sellers also want to be paid if outcomes comport with their projections.  With no clear way to consider the relative likelihood of each party’s expectations, no one transaction price will facilitate a transaction.  Risk and opportunity can often be reconciled by contract, however, by way of contingent consideration.RIA Transaction ExampleConsider the example of a depository institution, Hypothetical Savings Bank, or HSB.  HSB has a substantial lending platform, but it also has a trust department that operates as something of an afterthought.  HSB’s senior executives consider options for closing or somehow spinning off the trust operation, but because of customer overlap, lengthy trust officer tenure with the bank, and concerns by major shareholders who need fiduciary services, HSB instead hopes to bolster the profitability of trust operations by acquiring a RIA.Following a search, HSB settles on Typical Wealth Management, or TWM.  TWM has 35 advisors and combined discretionary assets under management of $2.6 billion (an average of $75 million per advisor).  TWM has a fifteen-year track record of consistent growth, but with the founding generation nearing retirement age, the firm needs a new home for its clients and advisors.The Seller’s PerspectiveTWM’s founders are motivated, but not compelled, to sell the firm.  TWM generates 90 basis points of realized fees per dollar of AUM and a 30% EBITDA margin.  Even after paying executives and advisors, TWM makes $7MM of EBITDA per year, and the founders know that profitability has significant financial value to HSB, in addition to providing strategic cover to shore up the trust department.Further, Typical Wealth Management has experienced considerable growth in recent years, and believes it can credibly extend that growth into the future, adding advisors, clients, and taking advantage of the upward drift in financial markets to improve revenue and enhance margins. Given what it represents to be very conservative projections, and which don’t take into account any cross selling from the bank or potential fee enhancements (TWM believes it charges below-market fees to some clients), the seller wants 12x run rate EBITDA, or about $85 million, noting that this is only about 10x forward EBITDA, and less than 7x EBITDA three years hence. The Buyer’s PerspectiveThe bankers at HSB don’t really understand wealth management, but they know banks rarely double profitability in three years and suspect they’ll have a tough time convincing their board to pay top dollar for something without tangible book value.Bank culture and investment management frequently do not mix well, and they worry whether or not TWM’s clients will stay on if the senior staff starts to retire.  Further, they wonder if TWM’s fee schedule is sustainable in an era of ETFs and robo-advisors.  They create a much less sanguine projection to model their possible downside. Based on this, HSB management wants to offer about $40 million for Typical, which is about six times run rate EBITDA.  This pricing gives the seller some credit for the recurring nature of the revenue stream, but doesn’t pay for growth that may or may not happen following a change of control transaction. The CompromiseWith a bid/ask spread of $45 million, the advisors for both buyer and seller know that a deal isn’t possible unless one or both parties is willing to move off of their expectations significantly (unlikely) or a mechanism is devised to reward the seller in the event of excellent performance and protect the buyer if performance is lackluster.  Even though the buyer is cautious about overpaying, they eventually agree to a stronger multiple on current performance and offer $50 million up front for TWM.  The rest of the payment, if any, will come from an earn-out.  Contingent consideration of as much as $30 million is negotiated with the following features:TWM will be rebranded as Hypothetical Wealth Management, but the enterprise will be run as a separate division of the bank during the term of the earn-out. This division will not pay any overhead charge to the bank, except as specifically designated for marketing projects through the bank that are managed by the senior principals of the wealth management division.  As a consequence, the sellers will be able to maintain control over their performance and their overhead structure during the term of the earn-out.The earn-out period is negotiated to last three years. Both buyer and seller agree that, in a three year period, the value delivered to the seller will become evident.Buyer and seller agree to modest credits if, for example, the RIA recommends a client develop a fiduciary relationship with the bank’s trust department, or if the bank’s trust department refers a wealth management prospect to the RIA. Nevertheless, in order to keep matters simple during the term of the earn-out, both parties agree to manage their operations separately while the bank determines whether or not the wealth management division can continue to market and grow as an extension of the bank’s brand.To keep performance tracking straightforward, HSB negotiates to pay five times the high-water mark for any annual EBITDA generated by TWM during a three year earn-out period in excess of the $7 million run-rate established during the negotiation. It is an unusual earn-out arrangement, but the seller is compensated if by steady marketing appeal or strong market returns, AUM is significantly enhanced after the transaction.  The buyer is protected, at least somewhat, from the potentially temporary nature of any upswing in profitability by paying a lower multiple for the increase than might normally be paid for an RIA.  As long as management of Typical can produce at least $6 million more in EBITDA in any one of the three years following the transaction date, the buyer will pay the full earn-out.  Any lesser increase in EBITDA is to be pro-rated and paid based on the same 5x multiple.The earn-out agreement is executed in conjunction with a purchase agreement, operating agreement, and non-competition / non-solicitation agreements which specify compensation practices, reporting structures, and other elements to govern post-transaction behavior between the bank and the wealth manager. These various agreements are done to minimize misunderstandings and ensure that both buyer and sellers are enthusiastic participants in the joint success of the enterprise. As the earn-out is negotiated, buyer and seller run scenarios of likely performance paths for Typical after the transaction to see what the payout structure will look like per the agreement.  This enables both parties to value the deal based on a variety of outcomes and decide whether pricing and terms are truly satisfactory.Structuring Earn-Outs Is the Key to a Successful TransactionMy very limited understanding of neuroscience has led me to a cursory knowledge of the shortfalls of human decision making.  As much as we might like to believe we think analytically, we mostly act on impulse, responding emotionally to our environment faster than we can reason.This capacity kept us alive when rapid escape from a predator was a more reliable reaction than stopping to think about what was happening.  This same brain function causes sellers to focus too much on the headline number offered in a deal negotiation and not enough on the terms surrounding the price.In RIA transactions, those terms frequently include large earn-out payments based on performance outlooks that are highly unlikely, or that at least should be discounted significantly.  As a rule, buyers get more protection from contingent consideration than sellers, and frequently have more experience offering earn-outs than sellers have living with them.  Seller beware!If you’re considering an offer for your firm that includes earn-out consideration, think about having some independent analysis done on the offer to see what it might ultimately be worth to you.  If you’re working the buy-side, prepare to spend lots of time fine-tuning the earn-out agreement – you won’t get credit if things go well for the seller, but you will get blamed if it doesn’t.

As covered in last week’s post, RIA transactions usually feature earn-out payments as a substantial portion of total consideration because so much of the seller’s value is bound up in post-closing performance.  Just as the financial press never writes about periods of “heightened certainty,” so too buyers of RIAs are justifiably concerned about the ongoing performance of their acquisition target after the ink dries on the purchase agreement.Earn-outs (i.e. contingent consideration) perform the function of incentives for the seller and insurance for the buyer, preserving upside for the former and protecting against downside for the latter.  In asset manager transactions, they are both compensation, focusing on the performance of key individuals, and deal consideration, being allocated to the selling shareholders pro rata.  And even though earn-out payments are triggered based on meeting performance metrics which are ultimately under the control of staff, they become part of overall deal consideration and frame the transaction value of the enterprise.For all of these reasons, we view contingent consideration as a hybrid instrument, combining elements of equity consideration and compensation, and binding the future expectations of seller and buyer in a contractual understanding.Twenty years ago, Toyota considered whether the future of automobiles would involve gasoline or batteries and developed a similar middle way, the hybrid engine.  A hybrid motor uses regenerative braking to charge batteries that recapture power to augment or substitute for the car’s conventional internal combustion engine.  Similar technology has been deployed in supercars like the Porsche 918 Spyder, but the Prius is responsible for helping shape the future of automotive transportation by making hybrid technology prevalent.As hybrids go, though, earn-outs are even more prevalent in asset manager transactions than Priuses are in Whole Foods parking lots, and it’s easy to understand why.Earn-Out ParametersContingent consideration makes deals possible that otherwise would not be.  When a seller wants twice what a buyer is willing to pay, one way to mediate that difference in expectations is to pay part of the price up front (usually equal to the amount a buyer believes can safely be paid) and the remainder based on the post-closing performance of the business.  In theory, earn-outs can simultaneously offer a buyer some downside protection in the event that the acquired business doesn’t perform as advertised, and the seller can get paid for some of the upside he or she is foregoing by giving up ownership.  While there is no one set of rules for structuring an earn-out, there are a few conceptual issues that can help anchor the negotiation.1. Define the continuing business acquired that will be the subject of the earn-outDeciding what business’s performance is to be measured after the closing is easy enough if a RIA is being acquired by, say, a bank that doesn’t currently offer investment management services.  In that case, the acquired company will likely be operated as a stand-alone enterprise with division level financial statements that make determining success or lack thereof fairly easy.If a RIA is being rolled into an existing, and similar, investment management platform, then keeping stand-alone records after the transaction closes may be difficult.  Overhead allocations, how additions and losses to staff will be treated, expansion opportunities, and cross selling will all have some impact on the value of the acquired business to the acquirer.  Often these issues are not foreseen or even considered until after the transaction closes.  It then comes down to the personalities involved to “work it out” or be “fair.”  As my neighbor’s father used to say: “fair is just another four letter word.”2. Determine the appropriate period for the earn-outWe have seen earn-out periods (the term over which performance is measured and over which contingent consideration is paid) as short as one year and as long as five years.  There is no magic period that fits all situations, but a term based on specific strategic considerations like proving out a business model, defined investment performance objectives, or the decision cycle of key clients are all reasons to develop an earn-out timeframe.The buyer wants the term to be long enough to find out what the true transferred value of the business is, and the seller (who otherwise wants to be paid as quickly as possible) may want the earn-out term to be long enough to generate the performance that will achieve the maximum payment.  Generally speaking, buyer-seller relations can get very strained during an earn-out measurement period, and after they’re done no one wishes the term had been longer.We tend to discourage terms for contingent consideration lasting longer than three years.  In most cases, three years is plenty to “discover” the value of the acquired firm, organize a merged enterprise, and generate a reliable stream of returns for the buyer.  If the measurement period is longer than three years, the “earn-out” starts to look more like bonus compensation, or some other kind of performance incentive to generate run-rate performance at the business.  Earn-outs can be interactive with compensation plans for managers at an acquired enterprise, and buyers and sellers are well advised to consider the entirety of the financial relationship between the parties after the transaction, not just equity payments on a stand-alone basis.3. Determine to what extent the buyer will assist or impede the seller’s performance during the earn-outDid the buyer lure the seller in with promises of technology, products, back-office support, and marketing?  Did the buyer promise the seller that they would be able to operate their business unit independently and without being micromanaged after the transaction?  These are all great reasons for an investment management firm to agree to be absorbed by a larger platform, and they may also help determine whether or not the acquired firm meets performance objectives to get contingent consideration.We have seen bad deals saved by good markets, but counting on false confirmation is not a sound deal strategy.  Instead, buyer and seller should think through their post-close working relationships well in advance of signing a deal, deciding who works for whom, under what circumstances, and what the particulars are of their mutual obligations to shared success look like.  If things don’t go well after the transaction – and about half the time they don’t – the first person who says “I thought you were going to…” didn’t get the appropriate commitments from their counterparty on the front end.4. Define what performance measurements will control the earn-out paymentsIt is obvious that you will have to do this, but in our experience buyers and sellers don’t always think through the optimal strategy for measuring post-closing performance.Buyers, ultimately, want to see profit contributions from the seller, and so some measure of cash flow is a natural way to pay for the kind of desired performance from an acquired investment management operation.  There are at least two problems with this, however, which suggest maybe another performance metric would be more effective for the buyer (and the seller).First, profitability is at the bottom of the P&L, and is therefore subject to lots of manipulation.  To generate a dollar of profit at a RIA, you need some measure of client AUM, market performance, a fee schedule, investment management staff, office space, marketing expense, technology and compliance, capital structure considerations, parent overhead allocations, and any number of other items, some of which may be outside of the sellers’ control.  Will the sellers accuse the buyer of impeding their success?  Can the factors influencing that success all be sufficiently isolated and defined in an earn-out agreement?  It’s more difficult than it looks.Second, much of the post-transaction profitability of the acquired business will depend on the returns of the financial markets, over which nobody has control.  If the rising tide indeed lifts all boats, should the buyer be required to compensate the seller for beneficial markets?  By the same token, if a deal is struck on the eve of another financial crisis, does the seller want to be held accountable for huge market dislocations?  In our experience, returns from markets don’t determine success, over time, nearly as much as returns from marketing.  Consider structuring an earn-out based on net client AUM (assets added, net of assets withdrawn), given a certain aggregate fee schedule (so nobody’s giving the business away just to pad AUM).5. Name specific considerations that determine payment termsIs the earn-out capped at a given level of performance or does it have unlimited upside?  Can it be earned cumulatively or must each measurement period stand alone?  Will there be a clawback if later years in the earn-out term underperform an initial year?  Will there simply be one bullet payment if a given level of performance is reached?  To what extent should the earn-out be based on “best efforts” and “good faith”?Because these specific considerations are usually unique to a given transaction between a given buyer and a given seller, there are too many to list here.  I have two quick thoughts on that: 1) transaction values implied by earn-out structures are often hard to extrapolate to other parties to other transactions.  2) The earn-out can address many of the concerns and hopes of the parties to a transaction about the future – but it cannot create the future.  Earn-outs manage uncertainty; they don’t create certainty.ConclusionAbove all, we would emphasize that a plan for contingent consideration be based on the particular needs of buyers and sellers as they pertain to the specific investment management business being transacted.  There is no one-size-fits-all earn-out in any industry, much less the RIA community.  If an earn-out is truly going to bridge the difference between buyer and seller expectations, then it must be designed based on buyer and seller considerations.  A bridge that doesn’t successfully link two points is not a bridge, it’s a pier.  A pier will eventually leave either buyer or seller in deep water.We’ll talk more next week about the structuring of earn-outs for RIAs, but drop us a line in the meantime if you’d rather not wait.

Pity the senior auto executive these days: their product is bearing much of the blame for killing the planet, but gas is so cheap they can’t even sell boring fuel efficient cars to the local chapter president of the Sierra Club.  The Economistran a cover story last week calling the internal combustion engine “Roadkill,” and repeated the estimate that car emissions kill more Americans every year than traffic accidents – yet the political climate in America doesn’t suggest that regulatory standards for burning fossil fuels of any kind will be tightening soon.Predicting what kinds of cars people will want to buy next year, let alone five years from now, has never been easy.  Today, there are too many options.  Will car buyers want all-wheel-drive pickups with huge internal combustion engines, or battery-powered autonomous-driving cars?  Will people even own cars in 20 years or will we all be driven around by some Uber-like service, making car ownership, parking lots, and garages obsolete?  Do you test the market with an expensive, limited production high-performance car like the BMW i8, or do you make a more affordable, mass market car like the Toyota Prius?  If you invest heavily in technology, will the market shower you with orders like it did for the Tesla Model 3, or spurn you like the doomed Fisker Karma?M&A in the RIA Community Wouldn’t be Possible Without Earn-outsAs the saying goes (which has been attributed to at least a dozen famous figures), it’s difficult to make predictions, especially about the future.  This reality is the single most difficult part of negotiating a transaction in the investment management industry.  The value of an RIA acquisition target is subject not only to a large number of variables, but also a wide range of possible outcomes:The performance of financial markets (standard deviation varies)The skill of the investment management staff (difficult to measure)The sustainability of the acquired firm’s fee schedule (not as much a given as in the past)The retention of key staff at the acquired firm (absolutely necessary)The retention of key staff at the acquiring firm (absolutely necessary)The motivation of key staff (absolutely necessary)The retention of client assets (depends entirely on third party behavior)The marketing strength of the merged enterprise (tough to predict) Without faith in the upward drift of financial markets, favorable margins in investment management, and the attractiveness of the recurring revenue model, no one would ascribe equity value to an RIA.  But actually buying an asset manager is making a bet on all of the above, and most people don’t have the stomach. Readers of this blog understand that only by way of an earn-out can most investment management firm transactions overcome so much uncertainty.  Nevertheless, in our experience, few industry executives have more than an elementary grasp of the role of contingent consideration in an RIA transaction, the design of an earn-out agreement, and ultimately the impact that these pay-for-performance structures have on valuation. This blog kicks off a series which we’ll ultimately condense into a whitepaper to explore and maybe demystify some of the issues surrounding earn-outs in RIA transactions.  If nothing else, earn-outs make for great stories.  Some of them go well, and some wind up like this:From Earn-out to Burn-out: ACME Private Buys Fictional FinancialOn January 1, 20xx, ACME Private Capital announces it has agreed to purchase Fictional Financial, a wealth management firm with 50 advisors and $4.0 billion AUM.  Word gets out that ACME paid over $100 million for Fictional, including contingent consideration.  The RIA community dives into the deal, figures Fictional earns a 25% to 30% margin on a fee schedule that is close to but not quite 1.0% of AUM, and declares that ACME paid at least 10x EBITDA.  A double-digit multiple brings other potential deals to ACME, and crowns the sellers at Fictional as “shrewd.”  The rest of the investment management world assume their firm is at least as good as Fictional, so they’re probably worth 12x EBITDA.  To the outside world, everybody associated with the deal is happy.The reality is not quite so sanguine.  ACME structures the deal to pay half of the transaction value up front with the rest to be paid based on profit growth at Fictional Financial in a three-year earn-out.  Disagreements after the deal closes cause a group of twelve advisors to leave Fictional, and a market downturn further cuts into AUM.  The inherent operating leverage of investment management causes profits to sink faster than revenue, and only one-third of the earn-out was paid.In the end, Fictional Financial sold for about 6.5x EBITDA, much less than the selling partners wanted for the business.  Other potential acquisition targets are ultimately disappointed when ACME, stung with disappointment from the Fictional transaction, is not willing to offer them a double-digit multiple.  ACME thought they had a platform opportunity in Fictional, but it turns out to be more of an investment cul-de-sac.The market doesn’t realize what went wrong, and ACME doesn’t publish Fictional’s financial performance.  Ironically, the deal announcement sets the precedent for interpretation of the transaction, and industry observers and valuation analysts build an expectation that wealth management practices are worth about 10x EBITDA, because that’s what they believe ACME paid for Fictional Financial.Earn-outs and Transaction StrategyMost post-deal performance doesn’t get reported, other than AUM disclosures in public filings.  If the acquired entity is folded into another RIA, you can’t even judge a deal by that.  Thus, we don’t have comprehensive data on ultimate deal value in many investment management firm transactions.  One example we have reported previously was the disastrous post-transaction performance of Killen Group after it was acquired by Tri-State Capital.  Killen missed by so much that it cut the total consideration paid by almost half and reduced the effective EBITDA multiple paid from nearly 11x to around 6x.  Which multiple represents the real value of Killen?  No doubt the buyer in this case, as in most others, would rather see the kind of performance that would justify paying the full earn-out, and the seller would prefer that as well.ConclusionSometimes bad deals can be saved by good markets, but that’s not much of an acquisition strategy.  As a consequence, earn-outs are the norm in RIA transactions, and anyone expecting to be on the buy-side or sell-side of a deal needs to have a better than working knowledge of them.  We’ll talk more next week about the structure of contingent consideration in investment management firm deals, but drop us a line in the meantime if you’d rather not wait.

One recurring question we hear from clients is what business model builds the most value for an investment management firm.  It’s a reasonable question to ask these days, given the irony of simultaneously strong financial markets and the degree of negativity surrounding the RIA community.  In the past month alone, Focus Financial dropped plans for a public offering, Morningstar reported that passive mutual funds pulled in over $500 billion in 2016 while active funds lost nearly $350 billion, and the parent of AllianceBernstein fired most of AB’s senior leadership.  All of this happened at the same time that the Nasdaq hit new all-time highs.Looked at from this perspective, building value in an investment management firm appears to be fairly challenging, but from our perspective the challenges are uneven.  Further, we don’t know that the secret to building value in an investment management firm is so much about choice of model as it is developing and executing a strategy which no one else can match.  We like to refer to this as finding a firm’s “unfair advantage.”Unfair AdvantageWe didn’t coin the term “unfair advantage”, but we get it from the title of a book about racecar driving by Mark Donohue.  In the late 1960s and early 1970s there were many great race car drivers, but few were as highly regarded at the time as Donohue.  He was important not just because of his success across a variety of racing platforms – everything from sports car racing to Indy cars to NASCAR to Can-Am – but because he approached auto racing more as an engineer than a daredevil.Mark Donohue studied mechanical engineering at Brown and was known on racecar circuits for his skill at reading the handling and performance characteristics of his cars.  Donohue’s most noteworthy success was taming the Porsche 917K.  Porsche had spent so much time developing a twelve cylinder boxer motor that developed over 1,000 horsepower that they neglected attention to the aerodynamics and suspension work that would actually keep the car on the road.  The 917 was ferociously powerful, but it was also nearly uncontrollable.  Donohue took the body off of the car and drove it to check out the drivetrain and suspension first, and then started working on the aerodynamics.  Once he was done, the car was unbeatable, and Donohue’s legend was cast.After several successful seasons in the Porsche, Donohue retired from racing to write Unfair Advantage.  The advantage he sought in a race was not his own talent – Donohue did not think he was a particularly skilled driver – but to have the very best car in the race.  In truth, the unfair advantage that Donohue’s team, Penske, enjoyed during this time was to have an Ivy-League educated driver who could fine tune a car to fit a particular race on a particular track under particular conditions.  Donohue returned to racing in 1974, and died in a crash on a practice lap in 1975.  Were it not for his book, he might have been forgotten.Finding Your Firm’s Unfair AdvantageAfter years of working with investment management firms of all shapes and sizes, it is our opinion that building the most value in an RIA comes down to the same thing: developing and capitalizing on some unfair advantage.  That may sound unnecessarily mysterious or metaphorical, but it really boils down to examining the basic building blocks of firm architecture and finding out where your firm can excel like none other.  We’ll break this down for you over the next few weeks.

A persistent truth about investment management is that no analyst ever saw a piece of information he or she didn’t want.  Professional investors are, by their very nature, research hounds – digging deep into a prospective investment’s operating model, financials, competitive landscape, management biographies, and whatever else might be relevant to try to evaluate the relative merit of buying into one idea instead of another.  This same diligence doesn’t always extend to practice management, though, and we are not infrequently surprised at how little attention management teams at RIAs devote to studying their own companies.I was pondering this vexing irony recently during a long family road trip.  My older daughter is sixteen and wanted to do her part of the driving, which her mom and I were happy to oblige.  That said, sitting in the passenger seat is somewhat unnatural for me, and I couldn’t stop nervously looking over at the speedometer as it crept five, seven, ten, twelve miles per hour over the speed limit.  It didn’t help knowing that my daughter is related to me.When I was sixteen, a friend of my parents came over for dinner in his new Jaguar XJ6.  It was British Racing Green, with biscuit leather seats and wool carpet that smelled like the countryside west of London where Wilton sheep still graze among stone-circles built by Druids.  This was the 1980s, and there weren’t many fast cars made at the time – especially sedans.  The Jaguar had four doors, but it also had the same motor derived from the XK series of the 1950s and 60s, a low center of gravity, and a set of Pirelli racing tires.  I was enthralled.  “Wanna drive?”  He didn’t have to ask twice.Off we went into the Georgia summer evening, looking for uninhabited roads with long straight-ways.  “You can wind her out some if you want to; she stays pretty stable at speed.”  She did, and before long we were approaching triple digits.  I couldn’t stop staring at the speedometer, pondering my good fortune at knowing an enabling adult with a new Jaguar – my dream (or at least one of them).  The XJ6 could do about 135 mph, but we topped out just shy of 120 before a reasonably sharp curve and a bridge appeared in front of us, and I had to back off the right pedal.  “We’ll do this again sometime when you can really open her up,” I was told.  Good thing that never happened, and also good that another friend of my parents, who drove a Ferrari, never offered the same.Looking back on my first experience with speed I’m struck by two things: 1) my parents’ friend was remarkably calm given the circumstance, and, 2) I was far too fixated on the dashboard instead of the road.  Most XJ6 owners are well served to keep an eye on the engine temperature gauge, but anyone traveling north of 100 mph only needs to be looking at one thing: the road ahead.RIA teams, by contrast, seem inclined to the opposite.  If the “road ahead” for an RIA is the financial markets, and the dashboard offers a read on the firm’s internal performance, it seems like many investment managers never look down.Gauging performance for an RIA is often thought of in terms of the portfolio, particularly for product companies that specialize in particular strategies.  But even though performance, in theory, should drive AUM flows, capital markets are fickle, and so can be customer behavior.  So we prefer to start with a decomposition of AUM history, and then explore the “why” from there.Consider the following dashboard that breaks down the revenue growth of an example RIA.  Over a five year period, this RIA boasted aggregate revenue growth of more than 50%, increasing from $3.7 million to $5.7 million.  AUM growth was even more substantial, nearly doubling from $600 million to over $1.1 billion. Looking deeper, though, we notice a couple of unsettling trends.  The five year period of measurement, 2012 through 2016, represent a bull market from which this RIA likely benefited substantially.  Cumulative gains from market value were over $700 million, more than the total growth in AUM and masking the loss of clients over the period examined.  Markets cannot always be counted on for RIA growth, so client terminations, totaling $285 million over the five year period or nearly half that of beginning AUM in 2012, is cause for concern.  This subject RIA only developed $35 million in new accounts over five years, and we notice what appears to be an accelerating trend of withdrawals from remaining clients. Further, there appears to be loss in value of the firm to the marketplace.  Realized fees declined four basis points over five years.  Had the fee scheduled been sustained, this RIA would have booked another $372 thousand in revenue in 2016, all of which would have dropped to the bottom line.  Pre-tax margins would have been almost seven percentage points higher.  Small changes in model dynamics have an outsized impact on profitability in asset management firms, thanks to the inherent operating leverage of the model.  But the materiality of these “nuances” can be lost in more superficial analysis of changes in revenue. So, we would ask, what’s going on?  Did this RIA simply ride a rising market while neglecting marketing?  Are clients concerned about something that is causing them to leave?  Does this RIA suffer from more elderly client demographics that accounts for the runoff in AUM?  If the RIA handles large institutional clients, did some of those clients rebalance away from this strategy after a period of outperformance?  Is their realized fee schedule actually declining, or is it not?  Is the firm negotiating fees with new or existing clients to get the business?  Did a particularly lucrative client leave?  What is happening to the fee mix going forward? Decomposing changes in revenue for an investment management firm can prompt a lot of questions which say more about the performance of the firm than simply the growth in revenue or AUM.  Yet when we ask for this information from new clients, it isn’t unusual for us to hear that they don’t compile that data.  All should.  Some teenage drivers pay too much attention to the dashboard, some RIA managers not enough.  The risk to both is the same: ending up in the ditch.

Clients writing new buy-sell agreements or re-writing existing ones frequently ask us how often they should have their RIA valued.  Like most things in life, it depends.  We usually recommend having a firm valued annually, and most of our clients usually do just that.  “Usually,” though, is subject to many specific considerations.How many shareholders are there in the RIA?  The more owners you have, the more transactions will occur and the more useful a semi-annual or quarterly valuation might be.  Small firms with only a couple of owners typically don’t need to know their value on an annual basis, but checking in on some scheduled basis – such as every two or three years – is helpful to keep track of firm performance, update any life insurance coverage, and to plan for succession issues or sale of the firm.Is your firm growing rapidly?  If so, an annual valuation might become stale very quickly.  Mature firms probably only need to look at their valuation metrics once per year to see how their performance and outlook compares with the greater market for investment management firms.Even annual valuations can be inadequate, however, when an RIA experiences big increases or decreases in assets under management.  Since we have been operating in a low volatility market (at least for U.S. equities) for some time, it’s easy to forget that normal, but nonetheless major, market swings can have a material impact on profitability and valuation.  In the case of a market swoon, even a mature RIA with healthy margins can lose ground rapidly, and a valuation that looked reasonable six months earlier may no longer be practical.  Consider an equity manager with $2 billion of AUM, realized fees of 60 basis points, and a 40% EBITDA margin.  If the regular annual valuation is prepared at an effective EBITDA multiple of 9x, then enterprise value would come in at around $43 million.One might expect that a valuation such as that would satisfy the needs of an investment management firm over the course of a year, until the time came for the next update.  Markets are fickle, though.  Imagine the same RIA endures a significant market downturn late in the summer, and then an event happens which triggers the buy-sell.  AUM drops 20% versus the start of the year, nothing changes in the expense base, and the valuation multiple is steady.  Because of the inherent operating leverage in the asset management business, the profit margin drops from 40% to 25% on 20% lower revenue, and because of that compounding effect value declines by half. This example has more simplifying assumptions than not, and most firm valuations would not move so dramatically just because of a 20% downturn in AUM.  That said, market events and client whims can have an outsized impact on RIA profits and, consequently, valuation, such that an annual valuation may not hold up over the course of a year. So what’s a firm to do?  One option, of course, is to accept the vagaries of the market – any unusual events during the course of the year may be just as temporary as conditions at the annual valuation date.  One of the functions of the buy-sell agreement is to get the parties to agree to what they are willing to live with, and what they are willing to live without.  Many firms do just that. This brings me to the subject of the photo above.  European rally car races have always fascinated me, although I’ve never been brave enough to actually attend one.  During the 1980s Audi ruled the rally scene with the Ur-quattro.  The Ur-quattro was a hatchback that Audi developed after the racing rules were changed in the late 1970s to allow four-wheel drive.  The Audi could handle anything, and to underscore that point the manufacturer used both Italian (“quattro” for four wheel drive) and German (“Ur” for primordial or original) to name it.  Regardless of snow, mud, gravel, flat curves or deep hills, the Ur-quattro couldn’t be beat.  Audi’s rally reputation was such that they started to offer the quattro system in all of their passenger cars, and all-wheel drive has become commonplace today – from Subaru to Lamborghini. A client of ours that is drafting a new buy-sell agreement recently brought us an idea which we think offers a similar level of preparation for any circumstance.  In their agreement, they’ve added a provision which would call for an interim update to their otherwise annual valuation if 1) the prospect of a transaction arises and 2) AUM is more than 10% higher or lower than at the time of the previous valuation.  The annual valuation is important to set a pattern of expectations for parties to the buy-sell of how they’ll be treated in a transaction, and most of the time will suffice when a transaction occurs.  Adding the update provision is a simple way to prepare for the possibility of substantial changes in the financial performance of the RIA.  Even if they never use the provision, having it offers peace of mind for parties to the agreement that they’ll be treated fairly if the company’s performance changes radically over the course of the year. In the decades since the Ur-quattro was introduced, Audi has sold cars with quattro to millions of people whose morning commute is nothing like a rally race.  Most people buy all-wheel drive cars for that “just-in-case” moment that will make the added expense worth it.  Like all-wheel drive, you may never need an event-based update provision in your buy-sell agreement.  It’s nice to know, though, that your buy-sell is all-terrain ready, no matter how rough the ride gets.

Since I gave up politics for Lent this year, I’ve had more time to keep up with the deeper recesses of the financial press, which led me to Warren Buffett’s annual letter to the shareholders of Berkshire Hathaway.  Buffett’s prose is a literary genre unto itself; a remarkably plain-spoken approach to making even the most complex and dull aspects of investment management simple and entertaining.  If all “management letters” were penned as well, shareholders might actually read them.  Perhaps that’s why they aren’t.Press coverage of Buffett’s letter this year focused almost exclusively on the sections extolling the virtues of passive investing.  Buffett updates us on his million dollar bet that a selected group of hedge funds won’t beat the S&P 500, after fees, over a ten year period; nine years in he’s winning handily.  He nominates Jack Bogle for sainthood, and bemoans that wealthy people have squandered an estimated $100 billion (his estimate) on elaborate investment strategies that haven’t been as effective as index funds.  In one of the more colorful passages in the letter, Buffett tells a family story that, while not directly addressing investment performance reporting standards, could be interpreted that way:Long ago, a brother-in-law of mine, Homer Rogers, was a commission agent working in the Omaha stockyards.  I asked him how he induced a farmer or rancher to hire him to handle the sale of their hogs or cattle to the buyers from the big four packers (Swift, Cudahy, Wilson and Armour).  After all, hogs were hogs and the buyers were experts who knew to the penny how much any animal was worth.  How then, I asked Homer, could any sales agent get a better result than any other? Homer gave me a pitying look and said: “Warren, it’s not how you sell ‘em, it’s how you tell ‘em.”Buffett’s story could be the forward to the next edition of GIPS Standards; all you need is the right benchmark.All of this is, of course, a little hard to take from Warren Buffett.  Not only has he made a (very successful) career out of asset management, he has previously been emphatically against spreading investment bets across too many assets – as one would in an index.  Buffett and his longtime partner, Charlie Munger, have more than once characterized such breadth as “di-worse-ification.”  Munger’s famous quote about bad mergers  - “If you mix raisins with turds, they are still turds” – could equally apply to index investing, where the algorithm is to overweight Blockbuster and underweight Netflix.  Despite a lengthy and successful career focusing on a few investments, Buffett appeared to have changed his mind.Predictably, there has been plenty of umbrage taken by the investment management community over the past week because of this.  It doesn’t help that Moody’s latest quarterly Investors Service report tallied continued outflows from active managers in the fourth quarter of 2016. However, I’m not sure that this is the right time for portfolio managers to beat their chest and defend their alpha.  For all of Buffett’s broadsides, this year’s letter is practically an apologia for active management.By my count, Berkshire Hathaway has beaten the S&P 500 in 34 of its 52 years, but more impressive than winning two thirds of the time is the order of magnitude.  While the S&P 500 has produced a total compound annual return of 9.7% since 1965, Berkshire Hathaway has produced more than double that return, at 20.8%.  Thanks to compounding, the aggregate return of Berkshire is 155 times that of the index.  That’s a lot of alpha, and it isn’t just restricted to the early years.  Berkshire has beaten the S&P 500 in seven of the last ten years, producing an average return 2.1% better than the index, and doubling the index return last year.The bulk of Buffett’s letter endorses active management.  Berkshire Hathaway morphed over time from a stock-picking firm to one that also wholly owns businesses (the extreme end of active management).  Consequently, when Buffett is particularly proud of one of Berkshire’s investments, he takes great pains to praise the humans who run those businesses.  In particular, Buffett notes the accomplishments of his insurance company management teams who make profits out of managing underwriting risk and superior investment performance off of those companies’ float.  And, as usual, Buffett gloats on Munger, noting that regardless of the future developments of artificial intelligence: “I will confidently wager that no computer will ever replicate Charlie.”The bulk of Buffett’s criticism of the hedge fund industry focuses on fees.  He estimates that approximately 60% of the gains produced by the five hedge funds be measured against the S&P 500 were allocated to the fund managers.  The issue seems not so much the value of humans in investment management, but the cost.

Neuroscience teaches us that branding matters because our brains remember things by categorizing them.  If we feel an affinity for a particular category of product, whether real or imagined, we are more drawn to that product than similar products that our brains place in different categories.As automotive brands go, Subaru has had more success than most into developing niche products that have a loyal following among specific demographic populations.  Even though the automaker is part of the huge Japanese conglomerate Fuji (the six stars in Subaru’s badge represent the six companies that merged to create Fuji), Subaru is not an all-things-for-all-people automaker.  As automotive products became more homogenized, Subaru used horizontally-opposed cylinder boxer-configuration motors (improves ground clearance while lowering the center of gravity) and all-wheel drive powertrains to make functional cars that serve the needs of the daily commute and the weekend adventure (even if that adventure is just to Costco).Many of my blogposts include stories about automobiles because investment management firms, like automakers, make their way by developing unique products that serve particular customers and particular needs.  All cars are transportation and are ultimately designed to get you from point A to point B.  All investment products are ultimately designed to make as much money while taking as little risk as possible.  But commodification is bad for MSRPs and fee schedules, and ultimately bad for margins and company sustainability.  Product development has been an antidote for commodification since the development of growth versus income strategies 40 years ago, and remains so today.Investment strategies that screen for environmental, social, and governance criteria (ESG) is a still developing product niche that has, until recently, been more about talk than action.  The pitch is that investing in businesses that demonstrate broad-based corporate responsibility provides a pathway to management teams who think long term, mitigate risk, and lead their industries.  Demographic studies have shown that ESG strategy is particularly appealing to millennial investors and women.  Millennial investors will, of course, eventually control the majority of investible assets.  Women already do.The beauty of an investment product like ESG is client stickiness.  Subaru has a remarkable level of customer loyalty (with a 68% repurchase rate), and RIA’s providing competitive ESG products get some escape from the quarterly (or monthly or daily) comparison with the indexes.  Client stickiness adds value to an investment manager in many ways, and ESG holds the promise – at least in the near term – of AUM retention in a way that other investment strategies do not.Nevertheless, in the RIA world, the rubber meets the road at performance, and many investment managers still shy away from ESG screens because they want the alpha that’s often inherent in “sin” stocks, or because their investment criteria just don’t overlay with ESG very well.  For these reasons, the scale of ESG has, until recently, remained modest.  The product category got a big boost a few years ago when Deutsche Bank published a research paper heralding the success of ESG in identifying companies with a lower cost of capital and outperforming business models.  Since then, other studies have generally confirmed the result.As a consequence, the investment strategy is growing in an era when active management is otherwise losing ground.  The question many are asking today is whether or not the election of Donald Trump will cause the trend line to roll over, marginalizing ESG as an idea out of sync with the markets.We think not.  ESG is more common sense than high-minded idealism.  Since the structural framework of ESG is not based in altruism, but in sustainable investing and risk mitigation, there is still ample reason to pursue it.  Studies of investment returns show not only correlation but causation for the value of screening for environmental, social, and corporate governance issues.  Thus, from a fiduciary’s perspective, ESG is prudent.  And regardless of the political climate in the U.S., the crowd sizes that formed across America the day after the inauguration suggest that the new administration is not necessarily going to be a cultural vanguard.  Instead, some political activists may see ESG as a way to right certain issues in the global balance that can’t be accomplished at the ballot box.This isn’t to say ESG will appeal to everyone.  Not everyone wants to drive a Subaru; some prefer a Nissan.  But for those who want it, ESG is a niche product that is still on the rise, and the current social environment in the developed world may provide a catalyst to that.

There are roughly 13,000 Registered Investment Advisors (“RIAs”) in the U.S., and each tailors its services to a unique set of clients and maintains an individualized business model. Be that as it may, most who call us face one common issue: ownership succession.Ownership can be the single biggest distraction for a professional services firm, and it seems like the investment management community feels this issue more than most. In Schwab’s 2019 Benchmarking Study, which surveyed 1,300 RIAs, a full 92% of respondents indicated that they were considering internal succession, but only 38% of firms have a documented path to partnership.Most investment management firms are closely held, so the value of the firm is not set by an active market.They are typically owned by unrelated parties, whereas most closely held businesses are owned by members of the same family.Compared to other industries, a greater-than-normal proportion of investment management firms have significant value, such that there is more at stake in ownership than most closely held businesses.Consequently, when disputes arise over the value of an interest in an investment management firm, there is usually more than enough cash flow to fund the animosity, and what might be a five-figure settlement in some industries is a seven-figure trial for these businesses.Avoiding expensive litigation is one reason to focus on your buy-sell agreement, but for most firms, the more compelling reasons revolve around transitioning ownership to perpetuate the firm and provide liquidity for retiring partners.Clients increasingly seem to ask us about business continuity planning—and for good reason.In times of succession, tensions can run high.Having a clear and effective buy-sell agreement is truly imperative to minimizing costly and emotional drama that may ensue in times of planned or unplanned transition.

No doubt, 2016 will be remembered for two major left-tailed events – Brexit and the election of Donald Trump as President of the United States.  In hindsight, the former should have been a clear suggestion of the latter, but even though some political wonks pointed that out, most of us were caught flat footed on both occasions.I won’t devote this blogpost to a market outlook – there are plenty of those out there written by people more knowledgeable than I.  The purpose of this blog is to consider the implications of the election for the investment management industry, which is no easy feat.  The Trump campaign was generally heavy on rhetoric and light on policy details.  The investment management industry rarely came up, other than when Trump suggested that he would advocate taxing carried interest returns as ordinary income.  He never mentioned, for example, the DOL’s Fiduciary Rule, which is set to phase in three months after the inauguration.The clearest indication of what a Trump presidency means to financial services, so far, appears to be its impact on the banking industry.  The promise of a steepening yield curve and a pullback in portions of Dodd-Frank have sent bank valuations soaring since the election.  If core banking is to become more profitable, banks will either a) be content with their basic operations and stop exploring diversification like asset management, or, b) feel comfortable enough with the outlook of their main business to look for avenues to diversify, like asset management.The Certainty of Uncertainty (about Trump)The striking thing about President-elect Trump is how little we know about him, despite the fact that he has been a very public figure for decades.  He’s never held elected office, so he has no voting record.  In the past, he’s been friendly and unfriendly with both political parties, and he ran his campaign in such a way that, despite being the Republican nominee, he has little, if any, debt to the Republican Party.  This either empowers him to be pragmatic, or makes him a loose cannon.We can expect Trump to be pro-growth, even if the price is spiraling deficits and inflation.  He is, after all, primarily a real estate developer.  Making money in real estate requires risk-taking financed by outsized leverage to create binary outcomes: profits or bankruptcy.  After a career in that industry, and having been brought up in it by a father who practiced a similar craft, he’s unlikely to change his world view.  Trump likely won’t be concerned about the consumer price index, either.  Inflation doesn’t scare people who have appreciating hard assets on one side of their balance sheet and a fixed amount of debt on the other.  This perspective is likely to create a lot of conflict with congressional Republicans, which will probably bother them more than Trump.  Whatever comes of it, it is very unlikely that the President-elect will prove to be fiscally conservative.Trump is also unlikely to prove to be socially conservative.  He has spent his entire adult life in Midtown Manhattan, not exactly the sanctum sanctorum of the Moral Majority.  Social issues, again, are not a subject of this blog, but because he has no stake in that soil, President Trump can use social issues as bargaining chips to entice legislators from both parties to support his agenda, once he clarifies what that agenda is.  Because he is not an ideologue, President Trump will probably reveal his agenda one day at a time, which will be as fascinating to watch as it is maddening to invest around.If these early indications prove correct, the looming Trump Presidency will be hard on segments of the fixed income community, and favorable to pro-volatility segments of the equity management world.  Asset correlations are probably going to be much lower.  All this suggests that active management will be back in style.  It’s amazing sometimes what it takes to make a trend-line roll over.What We Do Know (about Nationalism)Exit polls strongly suggest that Trump was elected on a nationalist agenda.  At the moment, the GOP thinks it controls the White House, and the Democrats feel disempowered.  The truth appears to be more nuanced, as Trump fashioned his message around a careful (and, it turns out, accurate) reading of public sentiment rather than polls or party platforms.Much of Trump’s support comes from middle class voters whose standards of living have either not improved or have declined over the past thirty to forty years.  At the same time, wealthy America has become much more so, and that disparity fueled resentment that led to this election outcome.  There is ample research to suggest middle class America feels left out of both parties’ agenda.  The Pew Research Center has done an exhaustive amount of study on the distribution of income and wealth in America.  One such dataset notes that upper income households in America (those earning twice the median household income) now enjoy a greater share of aggregate U.S. household income than middle income households (defined as those earnings between two-thirds and double median household income).  In the early 1970s, when U.S. middle class life was being celebrated by television shows like The Brady Bunch, middle income households collectively earned twice the amount of national income commanded by upper income households. The trends in household wealth in the U.S. have been even more striking.  The same Pew Research report looks at the median net worth of U.S. households since 1983 – not going back quite as far as the income portion of their study.  In 1983, the median net worth of high income families was a little over three times that of middle income families.  Fast forward 30 years to 2013, and that disparity doubled, to six and a half times.  During that time, the median net worth of middle income families barely changed when adjusted for inflation, but the wealth of upper income households doubled.   Also note that the credit crisis seems to have exacerbated this disparity; upper income households had a median net worth of approximately four times that of middle income households in 2007. Further, as has been widely reported elsewhere, the increase in wealth concentration is greatest at the upper end.  In an oft-cited study published last year by Berkeley professors Emmanuel Saez and Gabriel Zucman, the top one tenth of one percent of U.S. households held between 7% and 8% of household wealth in the 1970s.  Less than forty years later, that share had tripled, with the wealthiest U.S. households owning around 22% of aggregate U.S. household wealth. Middle income Americans may not read a lot of economic studies, but they sense they’ve been left behind by a changing economy; the data just confirms it.  The 117 episodes of The Brady Bunch covered a wide variety of topics, but I don’t remember Mike and Carol Brady reviewing their wealth manager’s account statements and discussing whether or not they were GIPS compliant. Needless to say, the growth of household income and wealth on the right-tail has been a boon to the RIA industry.  Mean reversion might not be as generous to asset management.  Assuming mean reversion, either the middle class is going to accumulate a lot of investible assets, or the wealthiest Americans are somehow going to become less so.  The current nationalist fervor may be a cause of that, or may be just a barometer. What We’ll Be WatchingIn any event, it is difficult to imagine the election of a wealthy New York real estate developer leading to middle income families enjoying a greater share of national income and household wealth, but there are other possibilities that could cause wealth and income trendlines to mean-revert:Declining value of financial assets – Rising inflation and rising interest rates could result in a decline in fixed income and equity valuations, compressing the value of the primary wealth assets held by upper income households. This is obviously not bullish for RIAs.Rising interest rates – In a rising rate environment, borrowers are relatively better off, because fixed cost borrowing is, over time, below market. Symmetrically, lenders (those who save money and invest in interest bearing assets) are achieving returns that are chronically below market.  Obviously, upper income households tend to be lenders, and middle income households tend to be borrowers.Increasing value of housing – All asset values are relative, and homes make up a greater proportion of household net worth for middle income families than upper income families. If housing appreciates (outside of the major U.S. markets where it already has), then wealth redistribution will improve.Taxes – Unlikely in a Trump administration, but higher taxes would probably fall disproportionately on upper income households. Again, this would not be bullish for the investment management industry.Inflation – Inflation is more likely to help wage earners than investors in many financial assets, and thus would cause some long standing economic trends to change. The election of Donald Trump may forestall some of these changes while accelerating others, and the advent of new investment platforms like robo-advisors may help maintain industry revenues and margins if economics improve for middle income households relative to more wealthy Americans.  What is difficult to debate, however, is that the RIA space has enjoyed a tailwind from certain economic trends over the past three or four decades that may not persist.RIA Market is Favorable, so FarAs all readers of this blog know, when the election results started coming in differently than most expected, equity futures and global markets plummeted, and then recovered and rallied.  Publicly traded investment management firms have seen significant increases in valuation since Election Day, with many up between 10% and 20%, so these notes about the potential challenges of economic nationalism don’t appear to be widely held.All in all, though, with a Trump presidency the RIA community is faced with more unknowns than knowns, and despite what the president-elect said in his campaign, governing is very different than campaigning.  The market’s performance so far suggests that most investors were relieved we once again had a peaceful transfer of power, and – whatever fight is coming – at least we’re in the fight.

Barring some extraordinary circumstance, in one week Hillary Clinton will be elected the 44th president of the United States.  Her election will mean a lot of different things to a lot of different people, but since this blog is called RIA Valuation Insights, we’ll narrow the focus of this outlook on her upcoming term as president to the possible impact on the investment management community.A good friend of mine from high school is a Republican lobbyist in Georgia.  Charlie’s mood these days oscillates between stoicism and apoplexy, as his party is not only about to lose this presidential election, but also because the G.O.P. is as divided, if not more so, than it was following Barry Goldwater’s bid for the White House.  For all of Goldwater’s accolades, his 1964 campaign alienated so many voting blocks in the U.S. that the conservative wing of the G.O.P. was suppressed for 16 years.  Indeed, the biggest risk to the investment community may be that Republicans can’t get their act together for several elections to come.Financial Markets Profit from Divided GovernmentIf there’s one thing the financial markets fear absolutely, it’s one-party rule.  The hardest thing for a president to do isn’t working with the opposition party to solve real problems, it’s controlling the demagogues in one’s own party who tend to create problems.  George H. W. Bush had to cope with these kinds of distractions in the first half of his term (flag burning amendment), as did Bill Clinton (don’t ask, don’t tell).  Republican congressional losses in the midterm election in 1990 plus Iraq invading Kuwait got Bush’s presidency on track, just not enough to overcome the recession.  Mid-term losses in 1994 got Clinton refocused on getting legislation through by bargaining with Republicans, arguably turning him into the most conservative president of recent memory - to the delight of financial markets and the chagrin of liberal Democrats.  If the G.O.P. is in too much disarray following this year’s dissection-election, Hillary Clinton won’t need to manage her political capital in the same way.We foresee that financial markets are being set up, in some regard, to be a victim of their own success.  ZIRP has inflated valuation multiples and AUM balances across most financial asset classes, and with nowhere to go but down, some external factor could eventually lead markets lower on a sustained basis.  We don’t say this based on some elaborate technical analysis other than mean reversion.  With low rates and market liquidity, it seems like asset prices can stay up, but it’s difficult to see opportunities for significant topline growth, widening of margins, or multiple expansion.  The question of when financial markets falter becomes when, not if.  In this environment, the markets feel more vulnerable to politics than usual.The Warren AdministrationClinton’s election secures the ascendency of Senator Elizabeth Warren, particularly if Democrats gain control of the Senate.  Senator Warren is going to be very powerful over the next four years and highly influential on President Clinton – at least as much as Vice President Cheney and the Watergate-era cronies were on President George W. Bush.  One helpful thing about Senator Warren is that she makes no secret of her intent; we don’t have to spend a lot of time reconciling what she says in closed door speeches to Goldman Sachs with what she says at political rallies.  Warren is convinced that the financial services community profits to the detriment of the rest of the economy, and she has accumulated more than a little evidence from the credit crisis to back that up.Because of Senator Warren, and the likely new ranking Democratic member of the House committee on Financial Services, Maxine Waters, one theme facing the financial services industry in general, and asset management in particular, is increasing regulation.  Wells Fargo’s ex-CEO John Stumpf may be glad he endured his congressional grilling in 2016 instead of 2017.  You can expect to see more of the same.  There may not be a Basel IV, but we may be in for a creeping reintroduction of some features of Glass-Stegall (ironically repealed under the previous Clinton administration).  That said, it’s difficult to deconsolidate an industry with narrow and shrinking margins.Then there’s the SEC.  Senator Warren famously called for the ouster of Mary Jo White as Chair of the Securities and Exchange Commission, in spite of the fact that the SEC’s investigative and enforcement divisions appear to have become considerably more aggressive on her watch.  We think fair value marks on illiquid securities held by PE funds, BDCs, and mutual funds will get much more scrutiny.  Chairperson White has targeted the PE industry, and any successor is likely to continue this theme.Tax Rates are Headed HigherDespite the brouhaha over Donald Trump’s use of net operating loss carryforwards and accelerated depreciation, both are far too esoteric - not to mention economically defensible - to change under the Clinton Administration.   The story is different for taxes on carried interest, social security, and estates.  An increase in any or all of those tax rates would mean significant changes for the asset management industry – none of them favorable.In some regards, it’s remarkable that carried interest taxes have been treated at capital gains rates as long as they have.  There is some economic rationale for it, of course, and the complexity of explaining performance fees to the average taxpayer has kept the issue from being front page news in most local papers.  Unfortunately for the alt asset business, PE fund managers have been a little too visible in their success, such that it has become easier to paint a target on their back.  One rare area of agreement between Clinton and Trump is taxing carry at ordinary income tax rates.  Assuming tax rates on performance fees change, GPs will be indifferent to being paid through ordinary management fees or carry.  If fee pressure continues, managers might be more interested in a “2 and 10” model instead of a “1 and 20”.  No word yet on what LPs want.I read recently that, had the cap on taxable income for purposes of social security been indexed for inflation, it would be about $250 thousand today, or roughly twice what it is.  This tax is more difficult to change, because the aggregate benefit paid out of social security is proportionate to the taxes paid in.  Nonetheless, the rate may not change, but the cap will likely increase.  A logical cap would be the Section 415 limit (currently $265 thousand).  This could have a big impact on financial planning models in the wealth management space, but little impact on your typical hedge funder.  Many will point out that the least expensive and most logical change for social security would be raising the qualifying retirement age.  Nevertheless, we are probably moving into a period where notions of curtailing benefits are unlikely to gain much traction: a Democrat in office, a growing retiree population, and lagging financial markets.As for estate taxes, under the previous Clinton administration, rates were very high and exclusions were very low, but the law offered lots of leeway for creative estate planning.  Lately, the IRS has been trying to limit key estate planning techniques, and they may or may not succeed.  Candidate Hillary Clinton has suggested lowering the size of estates excluded from taxes, but there’s probably more than a little uncertainty as to whether President Hillary Clinton will pay much attention to this.Peak Margins and the Dearth of Growth OpportunitiesEarlier this year a portfolio manager at one of our clients explained to us his dislike of investing in “spread businesses” like banking and energy.  His argument was simple: because of potentially countervailing forces, businesses that lived by the spread would eventually die by the spread.  Unrelenting economic relationships would, over time, arbitrage away margin.  Asset management is its own kind of spread business: buying investment management talent and reselling it, at a 40% EBITDA margin, to end users.  Spread businesses like banking and energy seem to be more at risk than most in a Clinton presidency.  We don’t mean to imply that the asset management industry is at risk of going the way of prime brokerage, but there’s no rationale to suggest the industry, as a whole, will experience margin expansion anytime soon.  Expect more consolidation.One bright spot for the most beleaguered sectors of the RIA world - active management in general and hedge funds in particular - is the likely return of volatility to the asset landscape.  The slow unwinding of ZIRP, BREXIT and the collapse of the pound, challenges to the sustainability of the euro, the sustained deflationary impact of technology, global aging and global warming, the oil collapse and destabilization in the Middle East, and the rightward political march of Europe in contrast to the U.S. moving to the left all add up to less asset correlation across the globe.  The indexers risk having a huge position in the next Blockbuster Video while missing out on Netflix.  All this is happening right on time as The Wall Street Journal and the CFA Institute declare active management dead and buried.  We may yet have a moment of schadenfreude for active managers.The Only ConstantChange is inevitable, of course; and bemoaning change isn’t productive.  Several long running trend-lines in the investment management industry seem to be rolling over, and that is anxiety inducing.  So I’ll close this blog with some wisdom from an unfortunately departed member of the investment management community, Louis Rukeyser, who said (long before this election):“Roaming the world as a foreign correspondent for more than a decade, I was able to observe how a variety of vastly different nations organized themselves economically.  The inescapable conclusion was that no politician anywhere on the planet has ever actually created a rupee’s worth of prosperity.”He also said: “The best way to keep money in perspective is to have some.”God Bless America.

In the late 1960s, BMW introduced a simple product that made the company what it is today.  The 2002 was a straightforward, useful, two door coupe with a small but powerful motor, light weight, four seats, and a decent trunk.  It was economical, easy to work on, and fun.  It sold like crazy, and morphed over time into what is now known as their 3-series, the mainstay of their global automotive line.  One lesson from this trajectory is that strategy doesn’t have to be complicated to be successful – a lesson that has broad applications, including the topic of this blog post.It’s no secret that banks are facing tough times, with lousy spreads, exponential increases in regulation, indifferent customers, and cunning competition.  There are many fancy ways to navigate this, but one simple one is deploying capital in attractive financial businesses that generate strong margins – such as asset management.Banks looking to diversify their revenue stream with investment management fee income would be well advised to study TriState Capital’s acquisition-fueled buildout of its RIA, Chartwell.  The Pittsburgh depository started with an internal wealth management arm, bought $7.5 billion wealth manager Chartwell Investment Partners in early 2014, picked up the $2.5 billion Killen Group in late 2015, and last week announced the acquisition of a $4.0 billion domestic fixed income platform strategy from Aberdeen Asset Management.The Aberdeen acquisition represents about $4.0 billion in domestic fixed income over four strategies.  Realized fees appear to be just shy of 20 basis points.  Six portfolio managers from Aberdeen are coming with the acquisition, and the operation looks fairly profitable on a pro forma basis, with TSC expecting EBITDA on the order of $3.5 million (annualized on a run rate basis), for a margin of approximately 45%.A few things stand out about the TriState/Aberdeen acquisition.Consistent acquisition criteria. TSC has a well-defined acquisition criterion for growing the RIA that has remained consistent from the original Chartwell acquisition.  Appropriate and well-defined criteria are significant for any bank looking to augment asset management products through acquisition, because in many cases there are too many, often dissimilar, RIAs from which to choose.  TSC seeks out asset management capabilities with compatible product structures, competent management teams, and consistent profitability that will grow and enhance their existing business.  They also have consistently shopped within their existing geographic markets.Attractive Pricing.  TriState’s acquisitions are consistently well-bought.  Aberdeen had a strategic motivation to sell these fixed income products, which were a small enough part of their overall business to let go of fairly cheaply.  As a consequence, TSC is paying 1.5x run-rate revenue, and more importantly, a little less than 4.0x EBITDA – a very compelling valuation that sets up TriState Chartwell for an attractive internal rate of return.Embracing the RIA Strategy.  TSC appears to have gotten past the usual cultural angst that depository institutions have developing an RIA.  The TriState investment management business has a separate identity, and it doesn’t seem to bother bank management that these acquisitions are dilutive to the bank’s tangible book value – in fact, they don’t even mention it.  The RIA does what it is supposed to do – deploy the bank’s excess capital to produce discretionary cash flow.  The bank’s earnings grow, and so does the bank’s valuation. With the latest acquisition, TSC has nearly doubled run-rate assets under management since 2014, putting excess capital at the bank to work in attractively priced acquisitions which have been individually and collectively accretive to earnings.  The strategy has worked well for TriState, and investors have taken notice.  Over the past two years, TSC’s share price is up nearly 80%, while SNL Securities’ Small Cap U.S. Bank Index is up less than half that much.  Asset managers in general have fared much worse, with the broad U.S. Asset Manager Index constructed by SNL showing a modest decline over the same period. Many banks are understandably wary of trying their hand at investment management.  RIAs are a different kind of financial institution in every way, cross-selling is often more myth than reality, and it can be difficult to explain to bank investors how to reconcile the differences in investment management performance characteristics and more traditional bank measures.  Still, in a world where banks are caught in the gravitational pull of low NIMs and Basel III, and the asset management industry is in need of consolidation, there is ample reason to consider the possibilities of pairing up for mutual success.

My older daughter turns sixteen next month. Most parents dread giving their children vehicular independence, but I managed to repress that instinct by concentrating on the more delightful prospect of adding a new car to the family fleet: a Fiat 500. The original 500 (or Quattrocento) came out in 1957, and Fiat sold almost 4 million of them before they discontinued the model in 1975. Since Fiat announced they were returning to the U.S. market and bringing the Italian equivalent of Britain’s Mini or Germany’s Beetle, I wanted one. While I couldn’t make the Quattrocento work for me, I thought the size (big enough for four adults but easy to park), powertrain (peppy but economical), and unique features (like a folding fabric roof) made it perfect for a new driver who appreciates cars like her dad.Unfortunately, as my daughter’s sixteenth birthday approached, my fantasy of what she should drive had a head-on collision with reality. The Fiat’s small size is handy when you have to wedge your car down Italian city streets (I found one on vacation that was EXACTLY five inches wider than my rented Volvo wagon, with the side mirrors retracted), but not so pragmatic in our town, where every third vehicle is a giant SUV that probably wouldn’t even notice a collision with a 500. I think Fiat may have had the same realization, as their U.S. sales have been far lower than expected, and as a consequence has delayed the reintroduction of Alfa Romeo to the U.S. (a real tragedy). There are at least two lessons to be drawn from this: 1) sometimes bigger is unquestionably better, and 2) some ideas look a lot better on paper than in practice.I was reflecting on both of these themes last week after word got out that Focus Financial Partners had started preparing documents to file an initial public offering. Because Focus has less than $1 billion in revenue, it can keep details of the offering private until three weeks before the offering, so unfortunately we don’t have an S-1 to review. The Company itself hasn’t said anything about filing.Focus is another great idea, at least on paper, but has garnered success in a timeline littered with lots of bumps along the way. If they choose to go through with the public offering this time, their S-1 will be a treasure map of information about RIA consolidation, which is probably going to be as painful as it is inevitable.We have so many questions about the Focus IPO, it’s hard to know where to start. For example:Why Now?Focus is a ten year old company that has been headed for IPO since day one. Part of their pitch to prospective RIA targets is enabling them to ride the rise in Focus’s valuation at the offering. Focus previously started the filing process for an IPO last summer. So, in one regard, this isn’t unexpected.Further, Focus is backed by the VC/PE community, having picked up financing by Summit Partners in 2007 and Centerbridge Partners in 2013. Polaris is also still involved. The timing of those deals is noteworthy, because asset manager multiples were at peak levels in both 2007 and 2013 (so much for booking gains on the buy). We wonder if Centerbridge isn’t looking at the stakes Polaris and Summit have held – for longer than they wanted – and are seeking an exit while they can. We’ll probably never know why Focus didn’t go through with an offering last summer. Compared to a year ago, valuation multiples in the space aren’t any stronger, and the IPO market isn’t any more robust. One would think that Centerbridge, which has been in Focus for three years, would be getting impatient. However, if the stock market coughs and the IPO window closes, it could be some time before Focus is ready to go public again.About the only two compelling reasons we can come up with for a Focus IPO today is 1) the SEC’s proposed rules on transition planning and 2) scale. With regard to the former, the Focus IPO narrative will undoubtedly feature that it appears the SEC is going to require RIAs to document some kind of ownership exit strategy. Focus is all over this issue, and has the capacity and expertise to offer a pre-packaged solution to this aspect of SEC compliance. As for the matter of scale, Focus may be big enough now to garner a better valuation…How Much?Thinking about valuation may be a little premature, since we haven’t yet seen the S-1. Numbers on the order of $1 billion have been bandied about, but not whether that’s pre-money or post. Focus has plenty of debt and preferred stock (possibly north of $750 million), but since debt is cheap, one wonders if the company is in a hurry to pay it down. What we do know is that Focus currently has run rate revenue on the order of $400 million. If Focus is running an EBITDA margin between 25% and 35%, and the IPO prices at 9x to 12x EBITDA, Focus could deleverage and wind up with a balance sheet that looks a little more like a typical RIA, and/or get their VC and PE investors liquidity. The RIA managers who got stock by selling their shops to Focus will probably have to wait.Some have suggested that Focus is pulling a stronger EBITDA margin than my range, and could command a higher multiple. We admittedly don’t know enough to comment at length on margin expectations, but the infrastructure necessary to manage a consortium of small to medium size wealth management firms, some of whom are owned outright and some of whom are partially owned, is expensive. As for the multiple, I think it comes down to whether or not the market is ready to accept this business model.How is This Not a Roll-Up?More than anything, the Focus IPO will cast some light on what the market really thinks of RIA aggregators. Focus management has been, and will likely remain, defiant that their company is not a roll-up firm – probably because they don’t want to be compared to National Financial Partners. But I just did, and so will the market. A more favorable comparison might be to Affiliated Managers Group, but AMG’s valuation has also struggled recently, and is down by almost a quarter over the past year.That said, the notion of a national RIA focused on retail clients makes sense. What Focus and other firms like it are trying to assemble looks a lot like the retail side of the old wirehouse firms, absent all the conflicts of interest. But the RIA landscape may be fragmented for a reason, and re-assembling a diaspora of heterogeneous personalities and corporate cultures will undoubtedly prove challenging. I remember a client of mine in a different industry joining a roll-up in the mid-1990s, and being reassured that change would be “evolutionary, not revolutionary.”That sounds attractive, and Focus has made best efforts to create a platform that allowed acquired RIAs to maintain their individual sense of identity. Trouble is that the RIA industry is highly, and increasingly, regulated. The need for compliance and training and comparable pricing and marketing efficiency will create a gravitational force that will pull the dozens of individual RIAs acquired by Focus toward some regimented similarity.Nothing wrong with that; but it sounds a lot like a roll-up.

James Bond’s engineering mastermind, Q, makes his living out of planning for the unexpected. Over the years, the star of the franchise has been saved from nearly certain demise by a remarkable variety of devices – but none of them more preposterous than the one that saved Roger Moore’s character in The Spy Who Loved Me, in which Bond escapes a typical car chase in his Lotus Esprit by driving into the Mediterranean, only to have the car immediately transform into a submarine. The whole scene could have been a metaphor for Lotus Motors itself, which was very much underwater – financially – at the time.Lotus’s founder, Colin Chapman, was a genius at designing sports cars, but had a harder time making the business consistently successful. By the late 1970s, Lotus was gasping for air. Desperate for cash, Lotus got involved with John DeLorean to design his eponymous car, the DMC-12, and promptly got embroiled in the DeLorean scandal. The pressure built on Lotus and on Chapman, who died of a heart attack in 1982 at the age of 54. The untimely death of Chapman, coupled with poor sales and the ongoing investigation, almost bankrupted Lotus. Q may have planned ahead for the unexpected for James Bond, but Chapman unfortunately didn’t do a similar amount of planning for Lotus. As a consequence, the Bond franchise has been, all in all, more successful.Picking up on this, the SEC seems concerned about RIAs doing some planning for the unexpected, and hence they’ve unleashed 206(4)-7. By now you’ve probably read the SEC’s proposed rules on Adviser Business Continuity and Transition Plans. While there are two weeks left on the comment period, I’ve been a little surprised at how few comments have been posted, so far at least. Maybe that means the RIA community has decided this is inevitable, and they’re already looking forward to how to comply with the rules once they’re finalized.Most of the proposed rule simply codifies a reasonable standard for practice management at an RIA. Certain of the proposal’s requirements, such as IT management and being able to conduct business and communicate with staff and clients in the event of a natural disaster, are likely to be met with turn-key solutions from vendors. Mercer Capital has had some firsthand experience with these kinds of issues: we had to move to temporary quarters for a year after a fire in our office building fifteen years ago, and we provided an alternative location for a New Orleans-based valuation firm for a short time after Hurricane Katrina. It’s amazing what you can do with remote hosted data, laptops, and cell phones when you have to.Of more interest is how the requirement for a “transition plan” in the event of the death or incapacitation of an advisory firm owner will be implemented. The primary elements the SEC wants to see on business transition planning are:Policies and procedures that would safeguard, transfer and/or distribute client assets during transitionPlans for transitioning the corporate governance of the adviserIdentification of any material financial resources available to the adviserPolicies and procedures that would generate client-specific information needed to transition client accounts to a new adviserAssessing the applicable laws and contractual obligations governing an RIA and its clients that would be relevant given the adviser’s transition Again, much of this is check-the-box kind of stuff that will become fairly routine over time. The one sticky wicket, as we see it, is the requirement to have a plan to transition the corporate governance of the RIA. In other words, if a key owner becomes incapacitated, dies, or for whatever reason cannot fulfill his or her position on the organization chart, who will? Since corporate governance at an RIA is usually accompanied by ownership, what the SEC is really asking is “who is going to own and manage the advisory firm in the event that a key owner/manager cannot?” Most of the commentary on this topic has been directed at small RIAs with one owner, which essentially operate as sole proprietorships. For small firms, the options are many, but follow a similar theme: sell the firm immediately at a pre-arranged valuation to another RIA that is in a position to take over. The narrative included with the SEC’s proposal is careful not to define the parameters of any particular RIA’s transition plan too specifically. Every situation is going to be different, but eventually, the regulation is going to have to get fairly granular with regard to expectations of transition plans. Thinking ahead to that time, we would suggest the following might be a descriptive (as opposed to prescriptive) guide to what issues are going to be prominent for RIAs, depending on size. As has been suggested by several commentators on the proposed regulation, solo practitioners and smaller RIAs probably have no recourse for a transition plan that provides for corporate governance (and, thus, control ownership) than some version of a living will for their practice that sells it, immediately, to either a peer RIA or a consolidator like Focus Financial (who filed for an IPO over the weekend). One thing to keep in mind, at that size, is counterparty risk; will the contracted acquirer/operator of the RIA be in a position – financially and operationally – to purchase and run the selling firm if something happens to its owner, and will the acquirer be able to do it on a moment’s notice such that client service is not interrupted? Will the SEC require some kind of “fire-drill” to check if the transition plan works? And who will be held accountable (estate of the Seller, contracted buyer, or both) if the transition plan fails when it’s triggered? Transitions don’t always go smoothly even in a regular acquisition setting, when everyone has time to plan for them and when the seller is available to assist with the transition process. As the size of the firm increases, so typically does the number of owners. One awkward size might be the next one, a medium sized RIA with up to $1.0 billion under management, a few owners and a dozen or more employees. At that scale, it’s not uncommon for the founding partner to hold a majority stake or at least a substantial minority stake. An RIA of this size usually generates more value, per dollar of AUM, than a smaller firm. More value means, of course, a higher purchase price. So while it may be easier to manage the client service issue internally, not every RIA in this size range will be in a position to finance the purchase of the deceased or disabled partner. The largest RIAs have the internal resources to protect their clients in the event of an untimely death. At these sizes, the most significant issues are whether or not the ownership agreements providing for repurchase of a deceased or disabled partner are thorough and current, and whether or not the ownership group has some agreement as to the value of the business. We are involved in numerous matters each year where one or more of these factors is not present, and as a consequence there is a material disagreement as to the value of a buyout. We are also involved with many clients who substantially mitigate this risk by reviewing their buy-sell agreements regularly and have annual valuations prepared so the owners know what to expect in the event of the unexpected. Obviously, we recommend the latter. Regardless of how much planning you do, your RIA is unlikely to emerge from an unexpected calamity without a scratch, but at least you won’t be all wet.Photo Credit: Sun Motors

I just got back from a long vacation in Italy, and while I intended to work on the blog while I was there, Brooks and Madeleine were taking care of things so well I hardly had to look up from my Chianti. About the closest I got to working was spending some time in Modena at the Enzo Ferrari Museum, photographing cars to use in future blogposts.The GT pictured above is a very special Ferrari, the 500 Superfast. It was a limited edition car in 1964 that Ferrari based on a “standard” 330 GT – to which Ferrari then added some Pininfarina bodywork and a larger displacement twelve cylinder motor. A few were made with a five speed manual transmission – a rarity then. A Superfast boasted a top speed of nearly 170 miles per hour. They also cost twice as much as a Rolls Royce (there’s been more than a little multiple expansion since then). Ferrari sold three dozen of them. If you’re interested, I noticed one up for auction in Monterey later this month.Some people can rationalize a car like the Superfast as an alternative asset, but really it’s a 20-standard deviation discretionary expenditure. As in no one needs a collector car. Car collectors don’t need a 50 year old Ferrari. Ferrari collectors don’t need a Superfast. I don’t know how many asset managers will be at Monterey this year, but probably fewer than in the past few years, as it seems like there is a dark cloud hanging over the industry. While conventional wisdom always has value, I’d like to suggest that pessimism is not entirely warranted.Yyuuggeee Walls of WorryWe have written at length about bearish signs in the RIA space, and valuation metrics seem to generally reflect a reduced growth outlook. We wonder, though, if things are really that bad. Market prophets forecasting tough sledding ahead for asset management usually point to three things:Fee schedules are compressing because fees are more visible and clients are more interested in passive products.Demographics suggest the populations of developed countries are moving from the asset accumulation stage of their lives to the asset de-accumulation stage (retirement).The lower outlook for investment returns means RIAs won’t just be able to ride the market to grow revenues. For this post, I’ll set aside the first of these. We suspect there is, over all, some phantom fee compression in the industry as assets are allocated to passive instruments and active managers who charge more don’t get the RFP they once would have. This has been written about extensively here and elsewhere. At present it is a trend, and all trends eventually break. The other two common themes focus on demographics and market outlook which are not, necessarily, bearish for the investment management space.De-Accumulation is OverratedBroadly, there is a public policy assumption that people consume more than they produce, save, or invest in retirement and deplete their assets. This is true of the population as a whole, but the investment management community does not serve the population as a whole.In fact, most wealthy retirees actually accumulate investible assets in retirement, according to a recent article in the Journal of Financial Planning by Chris Browning, Ph.D., Tao Guo, Ph.D., Yuanshan Cheng, and Michael Finke, Ph.D., called “Spending in Retirement: Determining the Consumption Gap”. The paper studies the investment and spending habits of retired Americans in various wealth categories in an attempt to measure the typical “consumption gap” – or the amount that retirees under-consume relative to their potential consumption given certain levels of accumulated assets and investment performance.I won’t recite all of the detail in this study, but the gist of it is this: while most retirees do experience de-accumulation (spending down their investible assets in retirement), those in the top quintile (rank based on financial assets) do not. These relatively more wealthy retirees consume much less than they could in retirement, and in fact the average financial assets of this cohort increases during retirement. This top quintile is the only quintile served by the investment management community, and this habit of elderly clients actually growing investment assets during retirement is more reflective of what RIAs should experience.Even though the baby boomer generation is reaching retirement age and a majority are leaving the workforce, this isn’t likely to drain AUM balances in the investment management community as much as some might anticipate.Low Investment Returns Increase AUM BalancesIn theory, lower interest rates and lower expected investment returns should encourage consumption and discourage investment. This basic supply/demand concept is the theory by which the Federal Reserve attempts to manage growth, inflation, and unemployment. Based on this, lower expected investment returns should be negative for investment managers for at least two reasons: 1) clients have a lower opportunity cost of consumption, so they save less, and, 2) investment managers don’t get the benefit of increased revenue from market appreciation. All else equal, the latter is absolutely the case, but all else is not equal.By definition, saving and investing is deferred consumption. Funding that deferred consumption requires saving enough, with “enough” being a function of expected investment returns. Retirement saving is the biggest category of investment in the United States. If the cost of retiring is held constant – which it pretty much is – and the expected rate of return in a retirement account is reduced, the only way to make up the deficiency is to save more.You know the math: to produce $100 in consumption in twenty years requires an investment of about $21 if the expected investment return is 8%. Reduce that expected return to 5%, and the investment required to produce $100 in twenty years almost doubles to $38. For defined benefit plans and insurance companies, this equation is very real. Even for individuals with 401Ks or 529 plans or other designated savings accounts, lower expected returns implies higher levels of required investment for a given desired level of future consumption.We seem to be living in a time where common laws of economics don’t always hold. Low investment returns may spur more savings, as has been the case in Japan for decades.People are Living Longer, Which Should Delight Pension Fund ManagersTwo years ago, the Society of Actuaries officially recognized that Americans are living longer. The revisions to the life expectancy tables added 2.0 years to the life expectancy of an average 65 year old male and 2.4 years to the life expectancy of an average 65 year old female. The study has not been without controversy, but the likely impact on the asset management industry is very positive:Defined benefit plan contributions will have to increase, by law.Defined contribution plan investments will, similarly, have to increase.Many people will use some of their added life expectancy to work later into life, adding to their years of investment asset accumulationRetirees will be more cautious about spending retirement assets, which could exacerbate the phenomenon that Browning et al. wrote about in the Journal of Financial Planning. Add to this further research which suggests wealthier Americans (again, the clients of the asset management community) live even longer than the life expectancy tables suggest, and the AUM required to fund retirement expands even further.See you in MontereyOnly the financial community could make a crisis out of strong markets and longer life spans. There’s no doubt that the RIA community has plenty to fret over, but there are also plenty of reasons to be optimistic as well. Robo-advisors won’t supplant a relationship business. Indexing won’t outsmart human ingenuity. And clients facing the prospects of longer lives and lower returns will need more help, not less, from their investment managers.

Brexit’s full impact on the market is still to be determined, but a quick review of asset manager pricing reveals a valuation gap with the broader equity market that opened over the past twelve months, got much worse in June, and even accelerated over the past week.The headline performance comparison is striking. Over the past twelve months, while the S&P 500 rose modestly, the SNL U.S. Asset Manager index underperformed by over 24%. This trend held for seven of the last twelve months, and accelerated in June with a big blow-out post Brexit. The same asset manager index dropped almost 10% last month, versus a decline of just over 1% for the S&P 500. You can see what last week was like: brutal. Internally, at Mercer Capital, we’ve speculated as to whether or not publicly traded RIAs were essentially a synthetic futures contract on the financial markets. And if asset management firm valuations are falling, does that imply something about sentiment toward the ultimate direction of the capital markets? There is, after all, a lot of other noise to consider. AUM is piling up in passive strategies while only treading water across the industry. Equity markets feel stuck - like a helium balloon on a ceiling – in a narrow trading range at uncomfortably high multiples. The market is awash with liquidity, but actual trading activity seems to be trending downward. So if market valuations in the industry are getting a haircut, what does that mean? If you convert this market activity to some kind of discounted cash flow model, valuations would only drop if a) the cost of capital was rising, b) margins were declining, and/or c) profit growth expectations had dropped. The Cost of Capital for Asset Managers is Probably StableIf you think back to your first or second finance class, you’ll remember that the weighted average cost of capital, or WACC, has two components: the cost of equity and the cost of debt. Most asset managers have very little if any debt in their capital structures, so we really only need to be concerned with the cost of equity. The cost of equity is usually considered to be some premium to the risk free rate, represented by the yield to maturity on government debt. Yields on longer dated Treasuries have collapsed over the past month and the past year, which all else equal would reduce the cost of equity. As for the equity risk premium, in theory this should encompass both systematic risk (volatility of returns relative to the market) and non-systematic risk (issues specific to the individual company). Non-systematic risk isn’t the issue here, and industry beta – which we think of as market neutral or a bit north of 1.0 – is always de-beta-ble. All in all, though, I think it’s safe to say the cost of capital for asset managers has not increased; if anything, it should have gone down a bit. In a yield starved world, the recurring revenue stream of asset management represents a coupon-clipping opportunity that should bid the cost of capital down, and the multiple up, unless something else is also at play.Profit Margins May Have PeakedSeems like we’ve been reading about job cuts and fund consolidations and position realignments every day for weeks now. No one is acknowledging this publicly, but it feels like Q1 board meetings must have been full of internal profit warnings at RIAs. We’ve been watching fee schedules for some time now – particularly at mutual funds – and with the equity markets more or less flat-lining, it’s easy for costs to creep up. Compliance costs are rising – especially at smaller RIAs. Add to this the risk of a market pull back – especially a sustained one – tugging the wrong way on the inherent operating leverage in investment houses, and you see the risk. Hopefully the Q2 management calls will cover this topic; we’ll be there when they do.Growth (or lack thereof) May Be the Big StoryWhere is the growth in the investment management industry? Major indices are not cheap. Indexing is grabbing market share. Clients are more and more fee conscious. Wealth management firms have the built-in relationship advantage, but need a good market tailwind to offset client spending. Client acquisition is always an opportunity, but industry-wide is a zero sum game. So maybe growth challenges (top line or bottom line – your choice) are what we’re seeing in public asset manager pricing. We’ve sounded this alarm before, but the tone of the alarm is getting louder.Moves like JaggerI once saw an interview with Mick Jagger in which he said that, growing up, his most likely career was to be a teacher. His dad taught, and Jagger figured that after he finished with the band-thing he would teach English. By the time he banged up his Aston Martin 50 years ago, Jagger probably knew he didn’t have a future in education. But even then I doubt he foresaw the five decade music career ahead. When ERISA came to be 42 years ago, no one would have expected the asset management industry to grow like it did. As a consequence of that growth, lots of managers got their satisfaction, but after the past eight years many others are probably facing their 19th nervous breakdown.

Detective shows are usually good for automotive product placement, and the 1980s television series, Magnum, P.I., was no exception. It didn't hurt that the show's main character, Thomas Magnum, solved crimes in tropical settings throughout Hawaii, necessitating a requisite number of bikini-clad women sipping Mai Tai's in every episode. But the show's most memorable character was probably Magnum's car, a Ferrari 308. The 308 wasn't the fastest Ferrari of all time; the 3.0 liter eight cylinder motor didn't muster much more than 200 horsepower. It was small enough to have great handling (the seat had to be modified to fit Tom Selleck's 6'4" frame), it had a targa top, and at full throttle it sounded like Barry White eating wasps. With a car like that, a do-gooder role mysteriously funded by an anonymous millionaire, and a very-casual-Friday-everyday dress code, one thing was certain: Tom Selleck had a good job.The closest we get to detective work at Mercer Capital is when we're jointly retained to resolve a shareholder disagreement over a buy-out. Whether we've been court-appointed or mutually chosen by the parties to do the project, we've done enough of these over the years to learn that the process matters as much as the outcome.As a consequence, we've developed some fairly strict procedures for engagements involving buy-sell fights. The backstories for most shareholder disputes in the investment management industry have common themes: long-time partner ends up at odds, usually for economic reasons, with the rest of the ownership and is more or less forced out. There are usually lots of negative emotions on both sides, mistrust, and even impaired careers. The necessity of the buyout is obvious: the ex-partner wants to be paid so he or she can move on, and the remaining partners don't want to share the spoils of ownership (distributions) with their ex any longer than necessary.As the jointly retained appraiser, we're often in the awkward position of serving as judge and jury on the valuation, without the usual protections afforded by a judge or jury (like unlimited indemnification or an armed bailiff). So, like a private detective, we're left on our own to design and conduct an investigation to reach a reasonable outcome. If the process is sufficiently robust and fair, the two parties may not like the result, but they'll have to accept it. Doing so involves focus on a few key issues.Working in a Glass HouseThere is no substitute for transparency. We generally require that all information requested by and shared with us be shared with both parties. We also copy all parties on our communications and request that they do the same. When we conduct interviews with the parties as part of our normal due diligence, we open those meetings to both parties. Typically, the parties agree to not attend each others' interviews so that they'll feel free to speak to us more openly, and inevitably this leads to accusations at some point of our being lied to "in closed door meetings." In reality, no one is blind to the motivations of the parties in a buy-sell dispute, and we usually hear some level of hyperbole from both sides.Separating Fact from OpinionLike any valuation engagement, we start with an information request to get the basic facts of the situation: financial statements, regulatory filings, organization charts, strategic plans, etc. Then we interview the parties, and (frequently) get very different interpretations of those facts. It is not unusual for both sides to have very earnest, if diametrically opposed, opinions of why the facts are the way they are. Squaring those interpretations against what we can discern to be the reality of the situation is part of our job.The Value of Client ReviewIn a normal valuation matter, we prepare a draft report for client review to make sure we understand key elements of the enterprise being valued. In the case of a shareholder dispute, this review process is more structured. We usually have both parties review our work product independently of each other and give a written review that is distributed to us and the opposing party. Then we allow the parties to comment (also in writing) on each other's review. Our expectation is that knowledge of this cross-review process will dissuade the parties from misconstruing issues in their initial comments on our draft. That doesn't always work, but at least we have the benefit of both perspectives before we issue a final report.Economic IndependenceA client in one of these matters told us that he had heard jointly retained appraisers tended to favor the firm over the ex-partner (he was an ex-partner). I haven't heard the same thing, but it's easy to be accused of bias. One of the ways we guard against this is by structuring the engagement such that it is clear our payment is not contingent on the outcome. We start the engagement with a retainer that is applied against the final billing and stipulate that bills be paid current before we release a draft report or a final report. This assures both parties that we're not in anyone's back pocket and that we have the economic freedom to express the opinion of value we think is appropriate.No Man Can Serve Two Masters…Suffice it to say, we've learned a lot of this the hard way. It's no fun to be the punching bag between former partners who no longer want to have anything to do with each other, and business divorces are among the most fractious engagements we find ourselves in. But it doesn't help matters for us to offer to make someone else's problem our problem. Our kind of detective work involves sticking to a disciplined process that is respectful of the facts and allows both parties to openly participate. Unfortunately, it doesn't involve much intrigue, car chases, or hair gel – which probably explains why so few television series are about finance.Tom Selleck on the job as Thomas Magnum | Photo Credit: Magnum Mania!

Usually, I like to start blogposts with the story of some legendary car remembered fondly for its contributions to the automotive community. The car photographed above, a 1990 Chrysler TC by Maserati, is not an example of that. The TC was the mutant offspring of a brief tryst between Lee Iacocca, who headed Chrysler, and Alejandro de Tomaso, who owned the Maserati brand at the time. Iacocca and de Tomaso signed an agreement to jointly produce a sport coupe, and this was the worst they could come up with: a convertible based on Chrysler’s K-car platform, powered mostly by weak Chrysler engines, but tarted up with hand-stitched leather upholstery and inexplicably manufactured in Italy. One might have expected the TC to have had Italian styling and American reliability – instead it was the other way around. None of it made sense any more than the peculiar porthole window in the hardtop. Somehow, over 7,000 were sold. May they rust in peace.Despite talented people, carefully developed business plans, and the best of intentions, not every partnership goes well, and some of those that don’t go well don’t end well either. When a partner leaves an investment management practice, the potential for a major dispute over the buy-out usually looms. Internally, at our firm, we sometimes refer to these situations as “business divorces”, even though the consequent acrimony often exceeds that of a marital dissolution.For the exiting partner who was either pushed out or who left in disgust, it’s usually their last shot at their adversaries. Getting paid in full, and maybe then some, becomes a way to even not only the economic score, but the emotional score as well. For the continuing partners, overpaying risks endangering the business, while a cheap buy-out might be seen as giving the ex-partner what he or she really deserve.Usually, no one sees a business divorce coming until it’s too late to prepare. Once the negative emotions are underway, it’s too late to get the partners to sign a shareholder agreement or modify one that’s inadequately drafted. We started writing about buy-sell agreements at Mercer Capital over ten years ago with the idea that we could help firms avoid costly disputes over ownership. We have succeeded in doing some work in that area, but we are often hired as a jointed retained appraiser to try to help clean up messes after a fight broke out.It is always dangerous to make blanket statements, but I think if we’ve learned one thing from working in the shareholder dispute arena, it’s that a poorly drafted buy-sell agreement may be worse than having none at all. The words on the page look pretty innocuous when everyone is getting along, and unclear verbiage and inadequate guidance can be dismissed (“We know what we mean…”). So, to that end, here are a few mistakes we’ve seen others make, in the hopes that you read this and don’t do the same.Be Clear about the Valuation DateIn one extreme case in which we were involved, there was a $250 thousand hearing just to get the court to determine what the appropriate valuation date was to buy out a joint venture partner. You probably won’t have that big an issue, but the valuation date can be extraordinarily significant. If you have a large RIA with a stable customer base and placid markets, the valuation date may not matter. But what if markets are particularly volatile? What if you’re buying out a partner who left because of FINRA sanctions and now your clients are asking lots of difficult questions? What if a very successful client service partner left for another firm and is now working diligently to move his clients? What if the death of a key partner risks the loss of large mandates? We have seen some buy-sell agreements specify that the entity be valued at the fiscal year end prior to the trigger event for the action, as doing so would value the entity without regard to the issue at hand. That’s one way to handle it, and doing so often benefits the departing shareholder. We have also seen buy-sell agreements specify that the entity be valued at a certain point after the triggering event, to let the dust settle. Obviously, this treatment can be beneficial to the firm if the partner leaving is contemporaneous with some kind of firm trauma. But, more often than not, the valuation date is not clearly specified in the buy-sell agreement. Don’t let that happen to you.Be Clear about How to Choose an AppraiserObviously, you want a valuation expert to handle your business divorce who is both trained and experienced in business valuation and who understands the investment management industry. Your buy-sell agreement should delineate the qualifications of the appraiser or appraisal firm to do the work. But how will he or she be chosen? We have seen agreements in which the appraiser is chosen by the company, and the obvious implication of this is that the departing or departed shareholder is suspicious of conflicts. We have also seen many situations where each party to the agreement chooses an expert who is supposed to agree on a jointly retained appraiser. This works better in theory than in practice, except in instances where the two sides propose the same third appraiser. Whatever you do, be specific about the process. We have been brought in many times after the court had to be asked to intervene on behalf of one side or the other.Be Clear about the Standard of ValueIf your buy-sell agreement doesn’t already specify fair market value as the standard and makes that clear by reference to a definition such as exists in the International Glossary of Business Valuation Terms, then that’s an easy fix. We worked on a lengthy and expensive litigation which was almost entirely related to ambiguity as to the standard of value. Absent clarity, a buy-sell agreement could be settled based on investment value to either the buyer or seller, some notion of intrinsic value, or statutory fair value – particularly since in many shareholder disputes the departing partner could argue for protection under some state fair value statute.Be Clear about Valuation Discounts and PremiumsUsually, the subject interest in a buy-sell dispute is a minority interest in a closely held business. This would suggest that it could be valued, absent guidance to the contrary, at a non-marketable, minority interest level of value (inclusive of discounts for lack of control and lack of marketability). I think it’s safe to say that most partners think of their interest in an RIA as their pro rata participation in the enterprise. If the firm is worth, say, $10 million, and they own 20%, they expect their interest to fetch $2 million per the buy-sell. The acquiring firm has ample economic motivation to argue for discounts, and indeed the continuing partners will benefit if the selling partner is bought out for less than pro rata enterprise value. On the other hand, a well-crafted shareholder agreement will also specify what is meant by enterprise value. Is it going concern on a stand-alone basis (what might be considered a financial control level of value) or is it the value that could be achieved in a synergistic change of control? There is no perfect answer, but think about your firm and how you and your partners would want to buy or be bought out.Best Practice is to PracticeEven with all of the above care given to your buy-sell agreement, it’s difficult to know what will happen once the trigger event has occurred unless you find out in advance. The best practice is to have an annual appraisal done pursuant to your buy-sell agreement. With an annual valuation, you and your partners will know who is doing the work, how the process will occur, and (within a range) what the result will be. It does mean some regular investment of time and money, but the typical dispute we’ve worked on would have paid for a couple of decades of annual appraisals, not to mention the immense frustration and distraction that a shareholder disagreement causes a firm. If you can’t imagine finding yourself or your firm in that situation, now is a good time to start preparing.

The 1970s weren’t too kind to the auto industry. Between the OPEC oil embargo, new environmental regulations and disco, automotive design mostly devolved into underpowered, uninspired boxes. One noteworthy exception to all this was the Pontiac Trans Am. Neither boxy nor underpowered, the Trans Am was a hot mess with a huge motor that overpowered the car’'s weak brakes and lousy handling. All in all, though, it worked. From the driver's seat, you could forget all about the "malaise" while you stared up at the sky through the T-tops or across the giant decal of a flaming bird on the hood. As GTs go, it was no Aston Martin, but it was good enough to help Burt Reynolds smuggle a semi full of Coors across the southeast in Smokey and the Bandit.What was a perfect statement about America in 1977 is not so applicable today. Almost 40 years later, Burt Reynolds is still around, but Pontiac isn't, and people are more likely to cross state lines to buy craft beer than Coors. It's a point worth remembering when thinking about how to value your RIA for purposes of a shareholder agreement: times change.A recurring problem we see with buy-sell agreements are pricing mechanisms that are out of date. Usually, this shows up in the form of some kind of rule of thumb valuation metric that is no longer market relevant. We've also seen buy-sell agreements that cite standards of value that don't exist in the modern valuation lexicon, and even some that specify appraisers from firms that no longer exist.Keeping the language in your agreement up to date is important, but the most reliable way to avoid some unintended consequence of your buy-sell agreement is to have a pricing mechanism that specifies a regular valuation of your RIA's stock. An annual valuation accomplishes a number of good things for an investment management firm, but the main one is managing expectations.If your ownership sees a set of consistently prepared appraisals over the course of several years, they know what to expect. By this I mean there is some level of agreement over who is to provide the valuation, what information will provide the basis of valuation, and how the valuation itself will be constructed. This doesn't guarantee that everyone will be satisfied with the conclusion of value, and our experience is that partners in investment management firms often have differing opinions of the value of an RIA. Some difference of opinion is to be expected, but the process of having a regular valuation prepared by an independent party can go a long way toward narrowing that difference of opinion. If there is little difference of opinion over the values at which ownership in a firm transacts, there will be little incentive to litigate when a sizable transaction comes along.Recommending an annual valuation may sound a little self-serving and, indeed, doing that sort of work is good business for us. We also handle dispute resolutions for shareholder disagreements, however, and the cost of that work is never less than several times the cost of an annual appraisal – not to mention substantial legal fees and the immeasurable cost of management distractions. All in all, we would rather dispense the ounce of prevention than the pound of cure.P.S.: There is an updated edition of the Trans Am available.

Nobody's perfect.You're a successful portfolio manager but you forgot Mother's Day this past weekend. What now? May I suggest you buy mom the ultimate grocery-getter: the Ferrari FF. I spotted the one photographed above outside my hotel last week in Grenoble, France, where I was for an all-too-quick business trip. The Ferrari FF has the credentials typical of Maranello: a 6.3 liter V-12 producing 651 horsepower and 504 foot pounds of torque that through the all-wheel drive system propels the FF to 60 miles per hour in less than four seconds on its way to a top speed of 208 mph.Unlike a new Bentley Bentayga – getting one of these for mom won't imply that you just want her to take over carpool for the grandchildren. Your mom may ask whether or not anyone really needs a two door station wagon that goes two hundred miles per hour and costs $300 thousand. Just tell her that the FF is a good example of the answer to a question that no one ever asked.The subtitle of Chris Mercer's original book on buy-sell agreements is "Ticking Time Bombs or Reasonable Resolutions?" Implicit in this title is that parties to buy-sell agreements too often discover the painful implications of the question never asked. I think about this every time we work on a dispute resolution project involving a buy-sell disagreement. In particular, I think about one of the first ones that I worked on, where maybe there was no disagreement, but should have been.Where There are Winners, There are LosersMany years ago we were hired to do valuation work for the estate of the founder of a successful RIA, who died unexpectedly. We were not asked to value the estate’s interest in the asset management firm as this was provided for by a mechanism in the buy-sell agreement. We were merely asked to check the math and make sure the estate wasn’t being short-changed. Long story short, it wasn't.There's no point in going into the particulars of the pricing mechanism in that RIA's shareholder agreement, (as that would be tangential to the story) but the value implied was rich. It might have been achievable in a change-of-control sale to a highly motivated buyer, with capacity, under the very best of circumstances. As it was, the company was required to redeem the interest with the help of some life insurance and, as I recall, some term financing. The decedent was the largest shareholder at the firm, and to the extent that anyone is a "winner" in these circumstances, the estate got the best of the pricing mechanism in the buy-sell agreement.Unfortunately, where pricing creates winners it symmetrically creates losers. The firm was on the hook for the redemption, which means that the remaining, or continuing, shareholders of this RIA were forced to overpay for the estate's interest, effectively diluting the economic value of their ownership for years to come. Compound this with the loss of the founder's contributions to the firm (he was an important client relationship manager), and the continuing partners had to essentially rebuild the value of their ownership. With favorable markets and good stock picking, they succeeded. We've seen other RIAs that, put in a similar circumstance, would not have fared so well.However, going to the other extreme (forcing buy-outs at a heavily discounted value) isn't necessarily better. Economically, to the extent that a minority shareholder is involuntarily redeemed at a discounted value, the amount of that discount (or decrement to pro rata enterprise value) is arithmetically redistributed among the remaining shareholders. Generally speaking, courts and applicable corporate statutes do not permit this approach because it would provide an economic incentive for shareholder oppression.By way of example, assume a business is worth (has an enterprise value of) $100, and there are two shareholders, Sam and Dave. Dave owns 60% of the business, and Sam owns 40% of the business. As such, Dave's pro rata interest is worth $60 and Sam's pro rata interest would be valued at $40. If the 60% shareholder, Dave, is able to force out Sam at a discounted value (of, say, $25 – or a $15 discount to pro rata enterprise value), and finances this action with debt, what remains is an enterprise worth $75 (net of debt). Dave's 60% interest is now 100%, and his interest in the enterprise is now worth $75 ($100 total enterprise value net of debt of $25). The $15 decrement to value suffered by Sam is a benefit to Dave. This example illustrates why fair value statutes and case law attempt to limit or prohibit shareholders and shareholder groups from enriching themselves at the expense of their fellow investors.Answering the Question Nobody AsksSo, when you look at your firm's shareholder agreement, think about the question – "Does my buy-sell create winners and losers?" If so, are you content with whom those winners and losers might be?Does the pricing mechanism create winners and losers? Should value be exchanged based on an enterprise valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What's not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing.There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the continuity of the firm. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to artificially retain their ownership longer and force out other shareholders. As for buying out shareholders at a premium value, the only argument for "paying too much" is to provide a windfall for former shareholders, which is even more difficult to defend operationally.What Would Mom Do?Ownership works best when it is structured to support the operations of the firm. Maybe this is easier said than done, but the lesson certainly applies to the mechanics of a buy-sell agreement. Your mom probably told you that "nobody ever said life was fair," but she wasn't giving license to promote unfairness. Balancing the fairness to both exiting and continuing shareholders in your buy-sell agreement will support the operations of your RIA, which will help build enduring value in the firm, ultimately benefiting everyone.

In 1961, Jaguar stunned the automotive community by adapting its highly successful D-type race car, which had won the 24 hours of Le Mans three consecutive years in the late 1950s, to create the E-type road car. The E-type was instantly acclaimed. It had everything you could ask for in a sports car at the time: an inline six-cylinder motor that powered it to 60 mph in under seven seconds, monocoque construction, disc brakes, rack and pinion steering, independent front and rear suspension, and a top speed of over 150. Most importantly, it was gorgeous. Enzo Ferrari himself said it was "the most beautiful car ever made."No one ever said a particular buy-sell agreement was the "most beautiful" ever written (even in our office), but some are better than others. And, like a good sports car, you can break down the key elements of a buy-sell agreement that must be there for the agreement to be successful. The first hurdle to clear is for the buy-sell agreement to specify that the company is to be valued within reasonable parameters appropriate to the situation. We don't see many shareholders' agreements in the RIA community relying on "rule-of-thumb" like multiples of revenue or AUM – probably because, while simplicity is appealing, it's too easy for that kind of high level analysis to create unintended winners and losers in a buy-sell action.But that begs the question: if an asset manager's buy-sell is going to specify reasonable expectations for the value of the firm, what are they? We think there are at least four.1. A Buy-Sell Agreement Should Clearly Define the "Standard" of ValueThe standard of value is an important element of the context of a given valuation. We think of the standard of value as defining the perspective in which a valuation is taking place. Investment managers might evaluate a security from what they think it's worth (intrinsic value) as opposed to its trading price (market value) and make an investment decision based on that differential.Similarly, valuation professionals such as our squad look at the value of a given company or interest in a company according to standards of value such as fair market value or fair value. In our world, the most common standard of value is fair market value, which applies to virtually all federal and estate tax valuation matters, including charitable gifts, estate tax issues, ad valorem taxes, and other tax-related issues. It is also commonly applied in bankruptcy matters.Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60. It is defined in the International Glossary of Business Valuation Terms as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm's length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.The standard of value is so important, it's worth naming, quoting, and citing specifically which definition is applicable. The downsides of not doing so can be reasonably severe. Take, for example, the standard of "fair value." In dissenting shareholder matters, fair value is a statutory standard that can be very different depending on the legal jurisdiction. By contrast, fair value is also a standard of value under Generally Accepted Accounting Principles, as defined in ASC 820. GAAP fair value is similar to fair market value, but not entirely the same. In any event, it pays to be clear.For most buy-sell agreements, we would recommend one of the more common definitions of fair market value. The advantage of naming fair market value as the standard of value is that doing so invokes a lengthy history of court interpretation and professional writing on the implications of the standard, and thus makes application to a given buy-sell scenario more clear.2. Unless it is Clarified, There will be Costly Disagreement as to "Level of Value"Investment managers in publicly traded securities don't often have reason to think about the "level" of value for a given security. But closely-held securities, like common stock interests in RIAs, don't have active markets trading their stocks, so a given interest might be worth less than a pro rata portion of the overall enterprise. In the appraisal world, we would express that difference as a lack of marketability. Sellers will, of course, want to be bought out pursuant to a buy-sell agreement at their pro rata enterprise value. Buyers might want to purchase at a discount (until they consider the level of value at which they will ultimately be bought out). In any event, the buy-sell agreement should consider the economic implications to the RIA and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here. If a transaction occurs at a premium or a discount to pro rata enterprise value, there will be "winners" and "losers" in the transaction. This may be appropriate in some circumstances, but in most RIAs, the owners joined together at arm's length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. Whatever the case, the shareholder agreement needs to be very specific as to level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement. 3. Don't Forget to Specify the "As Of" Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to avoid confusion), then the date might be the calendar year end. Consider whether you want the event precipitating the transaction to factor into the value? If not, maybe the as-of date should be the day before the event. Or maybe it matters that, say, a given shareholder died or otherwise left the organization, and it's worth considering the impact of the departure. If that's the case, then maybe the appropriate valuation date is the end of the fiscal year following the event giving rise to the transaction.This blogpost doesn't begin to name all of the reasons that specifying an "as-of" date matters to the appraisal, but you get the idea.4. Appraiser Qualifications: Who's Going to be Doing the Valuation?Obviously, you don't want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of "valuation experts" and "industry experts."Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated matters Industry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industry In all candor, there are pros and cons to each "type" of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor was absurd. The company had hired a reasonably well known valuation expert who wasn't particularly experienced in valuations in the RIA community. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value – much to the delight of his client. The departing shareholder, by contrast, hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company's appraiser. We were brought in to make sense of it all. The buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to consider the ins and outs of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you shouldn't have to explain your business model in the process.Final ThoughtsI'll cover in a later blogpost how the appraisal process itself works, and the considerations above are by no means meant to be exhaustive. But when you consider just these four elements, you can see how ambiguity in a buy-sell agreement can be highly disruptive at an investment management firm. While we do occasionally advise clients on setting up shareholder agreements, more often we are called in when an "agreement" is in dispute. We'll cover one such story in next week's blogpost.

[caption id="attachment_10926" align="aligncenter" width="363"] The Lamborghini Miura was the first mid-engine V-12 road car, and established the company’s reputation for out-of-the-box design.[/caption] [caption id="attachment_10919" align="aligncenter" width="363"] Ferrari’s competitor to the Miura, the Daytona, retained a traditional front engine layout, but its successor, the 365BB, adopted the same mid-engine format as the Miura.[/caption] Legend has it that, sometime in the early 1960s, Italian tractor manufacturer Ferruccio Lamborghini burst into Enzo Ferrari’s office to complain about the Ferrari road car that Lamborghini had recently purchased. He didn’t like the design, thought the manufacture was crude, and was furious that the car was incredibly unreliable. Enzo Ferrari, who had always thought people who bought his overpriced road cars (which Ferrari sold only to fund the company’s racing ambitions) were dupes, told Lamborghini that if he could do better, he should. In 1963, Lamborghini founded a sports car manufacturing company, and Ferrari’s had a competitor ever since. It took a few years for Lambo to gain a footing in the industry, but in 1966 the company introduced the Miura, a two seat sports coupe with a powerful V-12 engine mounted, in a revolutionary fashion for the time, between the passenger compartment and the rear wheels. It competed directly against Ferrari’s more conservative, twelve cylinder GT, the Daytona, and established Lamborghini’s personality as a manufacturer of innovative (and sometimes over the top) sports cars. The Daytona still outsold the Miura two to one, but today at auction a Miura will fetch three times what a similar vintage Daytona will. The more traditional design of the Ferrari appealed to buyers when the cars were new, but in retrospect, Lamborghini’s willingness to experiment is highly regarded. One of the primary differences we observe in investment management firms is not engine placement, of course, but compensation programs. The Miura and Daytona were different approaches to the same product. Our experience is that there are multiple ways to handle staff compensation at investment management firms, and the manner in which compensation is handled often says a lot about the business model and culture of the firm. The “Market” for Investment Management TalentOur experience tells us that the labor market for talent in the investment management community is not terribly efficient – at least not on a position to position, person to person basis. We have seen wide disparities in the compensation program for similar positions, which cannot be explained away by the cost of living in a given market, the size of the asset management firm, or the relative level of profitability.Mercer Capital’s Memphis office is housed in a 34 story high-rise. I’ve often wondered what I would learn by going floor to floor, office to office, in our building and asking what the receptionist in each office is paid. The data would be statistically significant at one level – there are probably 100 people employed as a “receptionist” in our building, all working for services firms and in the same zip code. If I were to do that, how large of a variation in compensation would you expect me to find? Is it possible that the highest paid receptionist in the building would make over twice that of the lowest paid receptionist? And what might account for those differences? Tenure? Size of firm? Profitability of firm? Actual nature of administrative responsibilities? Now imagine that you are, instead, trying to compare senior portfolio manager positions at long/short hedge funds in Kansas City and San Francisco: lining up salary, bonus compensation, performance-based compensation, equity compensation, etc.Our observation is that compensation at RIAs tends to be idiosyncratic, but by this we don’t mean to imply that it is idiotic. Simply put, compensation programs tend to evolve, purposefully, in asset management firms over time and over time take on a life of their own. Inevitably, compensation programs tend to be intertwined with business model and ownership. Internally, they make sense. Externally, they may be hard to compare with the “market.” When we are called in to provide a valuation, we have to make some rational sense of the compensation program to come up with a normalized margin that we can use to value the firm.Compensation Expert AnalysesAt Mercer Capital, we don’t hold ourselves out as compensation experts. But we do encounter a number of compensation experts and their work tends to follow a familiar pattern. Usually, the expert will evaluate the requirements and responsibilities of a given job at an investment management firm, and will use some form of statistical regression analysis to compare a market rate of compensation for that position with published pay data for similar positions at other firms.Not to debate the merits of statistical analysis, but this methodology has some obvious drawbacks. Comparability is hard to establish. No two person’s qualifications are the same, nor are any two positions’ requirements and responsibilities. Does the scale of the firm as measured by AUM matter more to the level of compensation for a CEO, for example, or is it more to be governed by the level of profitability? How are salary, bonus, and equity compensation to be compared – and are each worth the same on a dollar for dollar basis? Is participation in carried interest a factor? If so, finding suitably comparable market data is challenging.Public Company TrendsWhat we can know with some degree of precision is what publicly traded asset management firms spend on staff. This doesn’t answer the question of what a particular position with a particular firm in a particular market would and should pay, but it does give reasonable guidance as to what the compensation/margin tradeoff is for public companies, and in turn gives some idea of what it should be for private companies.Look, for example, at the interaction between compensation and margin at twenty large publicly traded investment management firms. From the trough of the credit crisis through the bull market in 2014, total annual revenues of these twenty firms almost doubled from $25.3 billion to $44.0 billion. If we break down expenses into compensation related costs and non-compensation related costs, we see that operating leverage is more pronounced with non-compensation related expense. Because some compensation related costs get buried in SG&A as distribution expenses or other outsourced services, it’s likely the case that compensation tracks revenue more closely than this high-level analysis suggests. Nevertheless, the big story from this is operating margin. As revenues increase, margin does as well – even at the scale of these public companies. We see this to be the case, regularly, in the private company RIA space, but it’s interesting to see confirmation in the public space, where scale is such that one might expect margin expansion to be more muted. SummaryInvestment management is a talent business, and that talent commands a substantial portion of firm revenue which often exceeds the allocation to equity holders. While there is no perfect answer as to what an individual or group of individuals should be compensated in an RIA, we can look to market data and compensation analysis, measured against the particular characteristics of a given investment management firm’s business model, to make reasonable assumptions about what compensation is appropriate and, by extension, what level of profitability can be expected.

Most of the history of race car development focused on creating larger and more complex motors that would generate greater amounts of horsepower. The tradeoff, frequently overlooked, was that a car has to be in scale with the motor, so more horsepower meant a larger and heavier car. A heavier car is more difficult to handle in corners and requires larger brakes. In racing it consumes more fuel (so more pit stops), and a more complex motor is necessarily less reliable.Colin Chapman was one of the first race car designers to recognize the tradeoff between power and weight, and his mantra, "add more lightness," inspired a whole generation of sports cars. Chapman's first road car, the Lotus Elite, had a small and simple, in-line four cylinder motor which only produced about 105 horsepower. What made the Elite competitive was that the car weighed only about 1,000 pounds (the current generation Chevy Tahoe can weigh six times that), so it handled like a dream and could travel at 130 mph. Consequently, the Elite won its class at Le Mans six years in a row.A similar tradeoff in an investment management firm's business model is that of compensation expense versus profit margin. Compensation is almost always the largest expense on an RIA's income statement and has a direct impact on net income.One of my earliest memories of working with clients in the RIA space was standing in the corridor of a $2 billion AUM equity manager one afternoon as the staff was packing up to go home. The managing partner took the opportunity to show me around the empty office and explain the business model to me: "Our assets get on the elevator and go home every night."Yet the most popular rule-of-thumb metric for valuing RIAs isn't price per employee, but price to AUM. The value of an RIA is not an accumulation of talent, but an accumulation of client assets that produce a healthy profit – after paying for things like talent. The contribution of client assets to profitability may be more consistent than the contribution of talent assets. "The meter's always running," my senior analyst at the time told me.The truth, of course, lies somewhere in-between. Managed assets produce a revenue stream which, after paying for rent and research and maybe a nice client dinner or two, must be divided between the staff (who service clients, manage the shop, and manage the portfolios) and the ownership of the firm (who may or may not be actively involved in operations). At Mercer Capital, our internal language to distinguish the two is return to labor and return to capital. Choosing how to allocate returns between labor and capital often says everything about an RIA's business model.A Tale of Two Managers…Take a look at the following pair of asset management firms: ACME and Smith. Both generate $10.0 million in revenue, and both spend $2.0 million on non-personnel related expenses. In both cases, that leaves $8.0 million to pay staff and provide a dividend stream or other return to shareholders. At this point the similarities end, and because of differences in compensation structure and the resulting differential in margins, Smith is five times as profitable as ACME. Since we are a valuation firm, the question we are most likely to be asked at this point is, which firm is worth more: ACME or Smith? That's an interesting question which deserves more than a little thought. I can think of several occasions where we have been confronted with this very question both formally, when we were working out the share exchange on two similar RIAs with different expense and margin structures, and informally, when we coincidentally valued two very similar firms (for different projects) with approximately the same differential in their respective P&Ls as ACME and Smith. On the basis of activity alone, maybe ACME and Smith are worth the same. If they have a similar fee schedule, then similar revenue implies similar AUM. But Smith is five times more profitable than ACME, so doesn't that mean Smith is worth, if not five times as much, at least considerably more? Absent conflicting information, the answer might be yes. Of course, there's usually conflicting information. "Why" Matters More Than "What"Consider the possibility that ACME and Smith are both equity managers serving high net worth and institutional clients. Each employs the same number of staff, and each operates in markets with similar labor availability and costs of living. Now we know a lot of "what" there is to know about ACME and Smith, but we don't know enough of "why" they show the differential in margins.ACME operates in a state with a high corporate income tax rate, but no personal tax rate, so they pay out owner distributions in the form of bonuses that inflate compensation expense and deflate margins. Smith is neutral on the tax issue, but has a minority private equity owner that insists that partners are paid only modest salaries such that performance is rewarded for all owners, both inside and outside, via shareholder distributions.So Which Firm is Worth More?On the basis of the narrative above, ACME and Smith might be worth about the same. The market for talent being what it is, we might normalize the income statements of both companies and get to a similar margin structure (we will cover how to do that next week). Similar profits might yield similar valuations, but there is a business model difference which matters as well. ACME has more flexibility in its compensation structure and could bonus staff based on ownership and/or performance. This might be a recruiting advantage in the never ending war for talent, thus garnering better "assets" for ACME that will make it more successful than Smith. So is ACME worth more? As a shareholder in Smith, you might be concerned about the firm's ability to recruit talent, but you would not be concerned about sharing your distribution stream with that talent. So maybe the Smith shareholder has less upside, but that upside is better defined.The corollary to Collin Chapman's "add more lightness" here might be to give up on expensive talent and focus on margin, because profits are why businesses operate in the first place. Demonstrated profitability beats adjusted profitability any day. Alas, the early Lotus cars were not known for durability (Chapman also thought that a race car that wasn't falling apart at the finish line was overbuilt), and skimping on talent to the point that it impairs the longevity of an RIA does little to improve the value of the firm.Simple, huh?Next week we will finish the thought with Normalizing Compensation Expense.

In the late 1960s, Enzo Ferrari committed to building an "entry-level" sports car that would appeal to a more mass-affluent buyer than his eponymous marque. His design team engineered a mid-engine two seater with a 2.4 liter, six cylinder motor called the Dino, named after his late son who was to be heir to the Ferrari dynasty. Although Ferrari manufactured the car and eventually badged a later version of it, the original design was never a “Ferrari Dino,” just a Dino. Buyers of the car did well on their entry-level investment – well preserved Dinos now routinely sell at auction for close to half a million dollars.There are a few Dinos for sale right now in Scottsdale, where Brooks Hamner and I are attending Bank Director’s Acquire or Be Acquired conference. We spoke today on how banks can build value through trust and wealth management franchises. It just so happens that there are a number of annual collector car auctions going on here at the same time, and I could draw more than a few parallels between the events.Much like Enzo Ferrari’s strategy fifty years ago, banks are looking to reach a mass-affluent investor community by offering sophisticated asset management services and personal attention once reserved for high net worth and institutional clients. Time will tell if this acquisition binge is as transformational for the banking community as the Dino was for Ferrari (today more than half the cars they sell follow the same mid-engine format). I’m sure acquiring bankers hope that investing in their trust and wealth management businesses will pay off as well as the purchase of a Dino did in the late 1960s – even if ownership may not be quite as much fun.Here’s the slide-deck from our presentation. Even with the present market instability, banks have an interesting opportunity to expand their financial services while diversifying their revenue streams with asset management. We sense some growing demand for sophisticated trust services, and a lot of RIAs in the wealth management space see banks with existing trust departments as a complementary environment to sell into. Give us a call if you’d like to know more. I’ll be back with some conference hearsay next week.

Cold enough for ya?Back in early December when the temperature was unusually high and the VIX was unusually low, many of our clients were calmly contemplating 2016 while they developed their budgets for the year ahead.  Six weeks later, the debate over whether or not weakness in high yield would spread has been settled — and most of the eastern U.S. is covered in snow.Boxer Mike Tyson once said, “Everybody has a plan – ‘til they get hit in the face.”  With equity markets and most debt markets draining AUM from client portfolios lately, many asset managers and wealth managers are reeling.  Between watching firm revenues tail off with all the red on the screen, plus fielding phone calls from anxious and sometimes angry clients, it’s easy to feel out of control, if not helpless.  But out of control and helplessness are two different things.I once read an interview with a veteran airline pilot who said that, when confronted with a crisis, the first thing to do was order coffee.  In other words, step away from the crisis, get control of your own thinking, and consider your options from there.  In that spirit, take a moment to step away from Bloomberg, grab some coffee, and think about the business of your investment management firm.Here are some brief thoughts about five topics, posed as questions, that can make or break the value of RIAs.  These topics have longer term and more strategic implications than the day-to-day fluctuations in capital markets, and while equity research may be more fun, these are more reliably lucrative.1. Do the Right People Own the Right Amount of Your Firm?Ownership is a sticky wicket, and indeed can be the most distracting issue for an otherwise successful shop — all the more reason to focus on ownership now, rather than kicking the can down the road another quarter.  Any ownership program has benefits and tradeoffs.  Usually that tradeoff involves rewards to the builders and producers of the firm versus the sustainers and future leadership.We have some clients with dynamic ownership programs that get tweaked every year.  This willingness to be flexible can allow RIAs to ensure that the ownership is supporting the long term strategy of the firm.  But doing that means giving up some of the “permanence” that is usually associated with ownership, and can make equity participation walk and talk a lot more like a compensation plan.Others have a hard time getting shares moved from generation to generation, usually because the spread between the bid and the ask is just too wide.  A frequent internal quip at Mercer Capital is that RIAs are worth so much that no one can afford to own them.  Some try to solve this with interesting terms or creative financing, but we usually discourage clients from trying to cure price with terms.2. Are Your Corporate Documents Updated and in Order?Specifically, think about your buy-sell agreement and whether or not it supports the long term continuity of leadership at your firm.  What is the pricing mechanism in your ownership agreement?  What happens if someone dies?  What if the partner group has a member who is no longer productive to work with – can you fire them and buy them out?It won’t surprise anyone to learn that we recommend calling for an independent appraisal to establish pricing at the time of a transaction.  Not that we know more about what your firm is worth than you do, but our experience is that, when a valuation dispute arises (often when an owner is kicked out), the bid/ask spread can be huge.  With an independent valuation opinion resulting from a structured process, the matter can be resolved by someone with no skin in the game other than their professional reputation.Of course, the best way to avoid confrontations over valuation is to get a regular valuation analysis prepared by an outsider.  It sets the stage for ownership transitions, and while there is still usually some spread between expectations and reality, at least the spread is much more narrow.3. Do Your Client Demographics Support your Business Model?Just like ownership, the client base of every RIA evolves.  The question is: are you managing that evolution for the long term strategic benefit of your firm?We did expert testimony work a few years ago for a partner in a firm managing $6 billion for 14 institutional clients.  Needless to say, that’s an efficient and highly profitable way to run an RIA – until you post too many periods of negative alpha.Most client concentrations aren’t that extreme, but it’s always worth thinking about whether you have the optimal client composition.  If you run an independent trust company or wealth management firm, you probably have mostly high net worth clients.  What do they have in common?  Did they make their money from the same industry?  Are they geographically concentrated?  How old are they?  How are their kids involved in the family wealth?  Is that money being managed for this generation or the next?We sat down recently with an asset manager who has, over time, managed their client base very deliberately.  They are a straightforward long-only manager, but they have investors via mutual funds, wrap programs with wire-house firms, direct relationships with high net worth clients, direct institutional relationships, and institutional relationships they handle through consultants.  They explained that, because their investment style goes in and out of favor with trends in the market, they wanted clients with a diversity of pressure points and decision timelines.  If their performance dips because of market conditions, not everyone heads for the exit at once.  If they outperform, they don’t immediately slam up against their capacity with a lot of hot money that will leave just as quickly.4. Is Your Firm Growing Because of Markets, or Because of Marketing?As a follow-on to the commentary about customer demographics, it’s important to think about what you’re selling.  Investment performance waxes and wanes, so just selling alpha in good times can really burn a shop when the market turns.  Having a message that resonates about what you do that is unique can attract clients when you are outperforming and when you are underperforming, and it is a more reliable way to accumulate AUM than the steady upward drift of the capital markets.Also, don’t forget to market to (educate) your existing clients.  If they are educated about why you do what you do, they’re less likely to leave when the market doesn’t favor your style.  A dollar of AUM retained is worth just as much as a dollar of AUM gained – maybe more.5. Do You Have a Series of Products Available to Grow Beyond the Capacity of Your Current Offerings?In scarcely a generation, the investment management profession has gone from offering relatively straightforward buy-low-sell-high services to ETFs to ESG.  Clients still want their investment managers to buy low and sell high (or least buy high and sell higher), but the “buckets” have changed some and will continue to change.It’s an obvious statement that you have to be offering products that clients want to buy.  But if you were starting your RIA fresh today, what would your product offering be?  From where you are today, is there a logical progression of product offerings to capitalize on your firm’s strengths and grow your client base and AUM base for decades to come?It’s difficult to know what kinds of products clients will want in the future, but it’s certain that clients will want investment management products in the future, and will probably be willing to pay about 100 basis points for products that are sufficiently differentiated such that clients can see the value.Improving the Value of Your Practice Regardless of Market DynamicsHappiness is expectations netted against reality.  Unless you came into this year massively overweight cash, or with a big short position on energy, you’re not too happy and neither are your clients.  However, it’s a good time to keep your eye on the practice management ball, because it will give you a competitive advantage in a year where most RIA managers can’t get their minds off the ticker.If you can improve the fundamentals of your practice in 2016, the markets will eventually take care of themselves, and you’ll be in a better position to profit when the bears go back into hibernation.  It has been our consistent experience that good practice management builds value in an RIA, and in turn building value in an investment management practice reinforces the better aspects of the business model.In that vein, Brooks Hamner and I will be at the Arizona Biltmore in Scottsdale next week to speak to Bank Director’s Acquire or Be Acquired conference about how banks can build the value of their trust and wealth management franchises.  This happens to coincide with several important collector car auctions, not to mention 75 degrees and sunshine.  Yes, I can hardly contain my excitement.  We’ll post the slide deck, and hopefully photos of some premium iron, next week.

Over the Christmas holiday weekend I had the coveted experience of riding in a friend’s recently restored 1970 DeTomaso Mangusta.  I didn’t take him up on the offer to drive the car as the roads were a little damp and Mangustas are notorious for being a little tail-happy, especially in the wet.  The last thing I wanted was to be responsible for putting so much as a scratch on a specimen car that is as rare as hen’s teeth.  DeTomaso built 401 of them before switching production to the much more common Pantera in 1972.  There are maybe 200 Mangustas surviving today.  This particular car was bought by my friend’s dad at an auction in Florida over twenty years ago.  It had been owned by a member of Pablo Escobar’s drug cartel and still had a bullet hole in the fender.  After restoration, it’s probably better today than new – so despite the sordid provenance I wasn’t too keen on sliding it into a bridge abutment.What’s even more rare than the Mangusta was the announcement earlier this month that Tri-State Capital Holdings, Inc. (traded on the Nasdaq as TSC) bought The Killen Group, a $2.5 billion manager of the Berwyn mutual funds, for about six times EBITDA.  More specifically, TSC paid Killen $15 million cash up front (based on trailing EBITDA of $3.0 million), plus an earn-out paying 7x incremental EBITDA (which could add another $20 million to the transaction price).  So, best case scenario for Killen is for them to deliver about $6 million in EBITDA and get paid $35 million (!).On the surface, the deal looks awfully cheap.  Reading between the lines, Killen has a (very sustainable) effective average fee of 56 basis points, a normalized EBITDA margin of 35%, and a five-star rating form Morningstar on its largest mutual fund product, the Berwyn Income Fund (BERIX).  All good.  So why didn’t Killen make a killing (extract a double-digit EBITDA multiple from TSC)?  No one expects that kind of an asset manager to sell low.  At first glance, it’s the bookend to the Edelman transaction back in October, which appeared to be priced astronomically high.  In the end, though, the two deals have more in common than not.  In both cases the headline price gives one impression of the deal, while the underlying narrative says something very different.Much of the valuation work we do in the RIA space is, for one reason or other, performed pursuant to a standard of value known as fair market value.  The standard of value is essentially a framework for the perspective of a given appraisal.  Fair market value is defined by the American Society of Appraisers as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.When we look at transactions data in preparing fair market value appraisals, one thing we keep in mind is that transactions do not occur at fair market value – or if so only by coincidence.  Transactions involve real buyers and sellers, not hypothetical ones.  They might act at arm’s length in an open and unrestricted market, but usually they have a compelling reason to transact.  It seems like that was the case in the TSC/Killen transaction.The press release and slide deck that went with the announcement didn’t go into detail, but TSC management alluded to Killen reporting $3.0 million in trailing twelve month EBITDA, which was really about $5.0 million net of a trading error.  A $2.0 million trading error is substantial, but we don’t know much else about it.  What we do know from looking at Killen’s ADV is that they also reported some FINRA compliance issues which appear to be connected with their president and chief compliance officer.Admittedly, the disclosure is thin and what is disclosed doesn’t sound terribly ominous.  But some consider any “yes” answer to regulatory issues to be a big red flag, especially in connection with a $2.0 million trading error.  Charlie Munger once said that, in the securities industry “integrity is like oxygen, no one thinks about it until it’s gone – then it’s the only thing they think about.”  If the regulatory issue threatened Berwyn’s five-star rating, it could have a huge impact on client behavior.  Put all of this in the context of a small firm (13 employees) with an aging founder who still holds a control position in the stock, and you’ve got what appears to be a motivated seller.We won’t speculate on what the multiple “could have been” in absence of the factors mentioned above, or what specific role they played in generating the terms of the Killen sale to TSC.  But it appears to be an outlier transaction for outlier reasons, and like the Edelman deal shouldn’t be misinterpreted as signaling anything unusual about valuations in the asset management industry.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

One of the most glorious places on earth to eat is La Colombe d’Or in Saint-Paul de Vence, France – just above Nice. Known as much for its art collection as for its food, just inside the garden entrance at the restaurant is a giant marble thumb, carved by the artist Cesar, to greet you as you enter. The placement appears inspired to give guests the "thumbs-up" on their arrival or departure from the restaurant, setting up the right mood for a tremendous calorie fest (and corresponding tab). It’s impressive, at least until you notice the collection of Legers, Picassos, Calders, and Miros that "Cesar’s Thumb" has to compete with.The shorthand method of valuation in many industries has long been some kind of "rule of thumb", usually a multiple of some measure of gross scale or activity.Twenty years ago, money managers were often thought of as being worth something on the order of 2% of assets under management. Even today, transactions in RIAs often disclose only the transaction value, which when compared to the latest AUM measure in the firm's ADV filling, yields something of a transaction value as a percentage of AUM. Because this is often the only valuation metric available from an RIA transaction, it still receives a lot of press – more than it deserves.A not very close look at the transactions data belies the use of price-to-AUM as a standalone indication of value. While some recent RIAs have transacted at a value that was at or near 2% of AUM, others are very different. And publicly traded asset managers might command 4% of AUM or more.So, obviously, there's more to the story than a measure of central tendency with regard to AUM. The 11,000 plus RIAs in the U.S. come in all shapes and sizes, and the value of any business is typically some conversion from a measure of expected future cash flow, not simply activity.Imagine an RIA with $1.0 billion under management. The old 2% of AUM rule would value it at $20.0 million. Why might that be? In the (good old) days when RIAs typically garnered on the order of 100 basis points to manage equities, that $1.0 billion would generate $20 million in revenue. After staff costs, office space, research charges and other expenses of doing business, such a manager might generate a 25% EBITDA margin (close to distributable cash flow in a manager organized as an S-corporation), or $2.5 million per year. If firms were transacting at a multiple of 8 times EBITDA, the value of the firm would be $20.0 million, or 2% of AUM.The reality, today, can vary widely. If that same RIA is a fixed income manager, the fee schedule on managing debt instruments might only yield 30 basis points, or $3.0 million on $1.0 billion in AUM. Running a fixed income shop of that size might require fewer people than an equity manager, and the cost per employee might be lower. Still, if the EBITDA margin were lower, say 20%, then distributable cash flow might be more on the order of $600 thousand for the fixed income manager, or less than a quarter of that in the first example. Again, if the prevailing multiple of EBITDA is 8x, then the implied valuation, or $4.8 million, is less than half of one percent of AUM, and a quarter of the value implied by the rule of thumb.So what do rules of thumb tell us? To the extent that businesses transact with certain measures of value in mind, they become self-fulfilling prophecy and are instructive as to value. Asset managers are usually pretty savvy with regard to ROI, though, so profitability matters. Fee schedules (realized, not just published) influence the return off a given dollar amount of AUM, as do cost structures. And this is before we talk about concentration risks, growth trends, and overall sustainability of the business model. And it's before we talk about how sought after asset management is today as a sustainable source of profitable returns. Fee schedules may be down. Margins may be all over the place. Risks vary wildly. And multiples may be higher.So the next time someone suggests a rule of thumb to value your RIA, don't hesitate to ask: whose thumb?

Last week brought the news that PE firm Hellman & Friedman had acquired Lee Equity Partners's controlling interest in mega wealth manager Edelman Financial. Edelman is headed by radio-show personality Ric Edelman, and manages about $15 billion for over 28,000 clients. While terms of the deal were not officially disclosed, the Wall Street Journalreported the transaction valued Edelman at a number north of $800 million, a nice pickup from Edelman's going private deal in 2012, which transacted the company at $263 million. The financial press was practically hyperventilating over the price last week, but a little analysis on the number reveals pricing that is more normal than most would imagine.Breathe normallyThe headline optics of the deal are eye-popping. An $800+ million price is more than triple the transaction value only three years ago, and further implies a price to AUM multiple of over 5% (!). The financial press that immediately followed the announcement ballyhooed the deal as proof that RIAs were hot properties fetching premium pricing and that we could expect more of the same. Count us as being a little more measured in our perception of the deal. While we're not going to describe the Edelman deal as a "meh" transaction, the firm's underlying fundamentals are likely far more responsible for the price than an overheated market. Indeed, our analysis suggests Edelman's pricing was fairly normal. Here are a few reasons to be happy, but not ecstatic, about the Edelman sale:Edelman is a growth machineWhen Edelman went private three years ago, the company reported assets under management of about $8 billion. It's almost twice that today. While a 30% CAGR in AUM has no doubt been assisted by bull market tailwinds, most of Edelman's growth has been from growing its investment advisor base and, correspondingly, the number of clients.Past growth explains the change in valuation from the 2012 going private transaction to the current deal, but Edelman is showing signs of continued growth as well, increasing the number of investment advisors by about 20% this year. RIAs can't always count on the market to grow the top line, but if a marketing platform is there to add clients, value will accrue.Edelman fetches premium feesThe real reason Edelman commanded such a high multiple of AUM is the firm's superior ability to extract fees per dollar of AUM.Investment management fee schedules are all over the map, with robo-advisors clocking in at around 25-40 basis points, and wealth managers often sticking between 100 and 125 basis points. Historical disclosures suggest that Edelman commands big fees for what they do. In their last public filing (Q2 2012), Edelman boasted investment management fees of over $32 million. Using that quarter as a proxy for an annual run rate of almost $130 million, Edelman was earning realized fees of 160 basis points on AUM of $8 billion. Even assuming that has been dialed back some by market forces puts Edelman's investment management fee base today at something on the order of $225 million.Add this to the Company's other revenue streams (which probably haven't scaled up to the same extent in the past three years), and we would estimate Edelman's revenue today to be on the order of $300 million. That's no threat to Schwab, but in the independent RIA space it suggests that Edelman has defied certain laws of gravity for wealth managers that have plagued other shops at much lower levels of performance. No doubt the scale of Edelman, the pricing power of their services in the market place, and the potential to grow further attracted a strong multiple.As a caveat to this, higher than market fee schedules are at risk of being "normalized" and doubtless this influenced the valuation of Edelman. That said, it is likely they have been successful at maintaining their value to customers in the marketplace so far.Edelman has revenue sustainabilityRic Edelman built his firm as a radio personality dispensing advice and gathering assets. His advisor network was excellent at client conversion and retention, and that formula has held up. The cult of personality firm, which we have written about in other posts, has drawbacks. Some still suggest that the firm's dependence on Edelman at the helm is a risk. We do not entirely disagree, but note that with 28,000 clients investing on average $536 thousand with Edelman, the firm has a solid lock on the mass-affluent investor market.Client demographics are a big factor in the value of investment managers, and while it's easier to service a few huge clients, if they leave they take firm value with them. The great thing about larger wealth managers like Edelman is that there is client diversification and product diversification, such that revenue is highly sustainable going forward.For a PE manager looking for investment return opportunities in what seems to increasingly be a low return environment, Edelman offers a higher quality coupon than most. We know that better coupons pay lower yields, which in Edelman's case suggests a multiple at the high end of the range.Edelman probably has a solid marginSince Edelman has been private for three years, we don't have a lot of margin visibility, but we can look back to 2012 and see what we can normalize to get there, especially if it's consistent with industry norms. Our analysis of Edelman's run rate at the time of the going private transaction suggests an EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margin on the order of 30% to 35%. That's strong, but not out of range with similar firms in the wealth management space. Edelman may have achieved some margin leverage with the growth it has experienced over the past three years, but probably not much. Thus Edelman's margin provided an optimal circumstance for the valuation multiple, with solid profit performance that does not need "repair" from a new owner, but also not so high as to risk being unsustainable.Edelman likely got a good, but not extraordinary, multiplePut it all together and the Edelman transaction looks fairly normal. Assuming an EBITDA margin at or just about 30%, consistent with the level of profitability the company reported before the 2012 going private transaction, HF paid a high single digit multiple of EBITDA. The deal multiple was likely upward biased by the growth pattern and trajectory of the company, and the risk mitigation afforded by a diverse client base and large scale. Weighing down the multiple was likely some lingering concern over the dependence on Ric Edelman as the spiritual guru of the organization, concern over the sustainability of the firm's fee schedule, and some angst in general over the direction of capital markets. As solid as this pricing was, we wonder if Edelman couldn't have fetched closer to $1 billion a year ago when folks believed the market had more room to run. But that's neither here nor there. Kudos to Edelman and Lee Equity Partners for a solid return on their three year investment in the company, and to Hellman & Freidman for acquiring a great franchise at a reasonable price such that their investors can also profit. All in all, an increasingly rare event in the PE universe.

Mercer Capital had a great time sponsoring the Southern Capital Forum on Lake Oconee last week. The annual gathering of the venture community is a favorite to check in with many of our clients and get a read on capital markets from some intentional listening. Beautiful weather and the bucolic surroundings of Reynolds Plantation helped, and on the second day of the conference, Janet Yellen kept her foot on the cost of capital. So what’s not to like? Despite the generally upbeat attitude of the sponsor community, and plenty of planned fund raisings, we heard one theme repeated over and over again that threatens the broader asset management world: stretched valuations.It was hard to miss that what used to be a Georgia-centric and then a southeastern conference has gained a national following. The Southern Capital Forum now attracts participants from New York, Chicago, and San Francisco. Why? Because the venture communities in New York, Boston, and Silicon Valley have pushed up valuations in those markets to the point that opportunities to invest profitably are few and far between. Funds are going to Phoenix, Ft. Lauderdale, and St. Louis to find opportunities that are not available in nearby incubators, which seem to be popping up everywhere. But the entrepreneur communities aren’t as established in secondary markets, so while the competition for deals is smaller, so is the number of deals. We heard several comments from the podium that gave us pause for the immediate future of alternative investing (and prospectively the investment community as a whole):"Angel investors are back, and no smarter than they were pre-2008." Tourists to growth equity investing, and special purpose vehicles have re-emerged. Investing by these groups is no more intelligent than it used to be, but it pushes up the competition for deals – which pushes down the cap rate, which depresses returns, which could end up depressing LPs.Mega-funds have gone down-market into traditional VC opportunities to try to generate alpha. "90% of VC returns are generated by 10% of the funds" and that seems to be going to the biggest players these days.LPs are "desperate" to get into growth capital funds."You make money when you buy – which is a lot harder these days.""Valuations are stretched and terms are loose." Participating preferreds are becoming less common in Silicon Valley and the other strongholds of VC investing.Capital raises have become a technology company's "defensive moat" to ensure a high enough spending pace to develop expensive products (or to develop products expensively) and buy market share. "We're pushing on the outer level of sustainable valuation and burn rates." In other words, we're past sustainable.The concept of "valuation agnostic" has emerged, with some sponsors suggesting they can use terms to protect against downside risk while creating a coupon."It's become difficult to impossible to build a firm on proprietary deals. Sellers are more sophisticated." There was lots of talk at the conference about "Unicorns" – a term for mega-cap venture companies which didn't even exist two years ago. Some suggest that Unicorns exist because some very successful high growth private companies don't want to deal with activist shareholders. Still, LPs need an exit, and the IPO market has been providing that (though at a more modest pace than 2014). However, venture investment rarely gets a full exit until a secondary or tertiary offering, if they don't have to dribble stock out over time. The upshot of this is a growing concern that there is an emerging venture capital overhang in the public equity markets, as funds seek exits for larger investments.

Understanding the value of an investment management business requires some appreciation for what is simple and what is complex.  On one level, a business with almost no balance sheet, a recurring revenue stream, and an expense base that mainly consists of personnel costs could not be more straightforward.  At the same time, investment management firms exist in a narrow space between client allocations and the capital markets, and depend on revenue streams that rarely carry contractual obligations and valuable staff members who often are not subject to employment agreements.  In essence, RIAs may be both highly profitable and prospectively ephemeral.  Balancing the particular risks and opportunities of a given investment management firm is fundamental to developing a valuation.

Understanding the value of an investment management business requires some appreciation for what is simple and what is complex.  On one level, a business with almost no balance sheet, a recurring revenue stream, and an expense base that mainly consists of personnel costs could not be more straightforward.  At the same time, investment management firms exist in a narrow space between client allocations and the capital markets, and depend on revenue streams that rarely carry contractual obligations and valuable staff members who often are not subject to employment agreements.  In essence, RIAs may be both highly profitable and prospectively ephemeral.  Balancing the particular risks and opportunities of a given investment management firm is fundamental to developing a valuation.

To many people, asset management is the business model dreams are made of. A few skilled people in one office can make millions providing a sophisticated and straightforward service. Billing simply requires deducting fees from client accounts, and the upward drift of the markets propels revenue growth. Looked at from the inside-out, however, it is a fiercely competitive industry in which one is judged unforgivingly by the numbers, and depending entirely on relationships between owners, employees, and clients. Profit margins can be huge, but can evaporate in two quarters of a bear market.On one level, all RIAs (registered investment advisors) are alike, as there are significant similarities between development of fee income and the composition of the expense base to support the revenue that generates and sustains profitability. Nonetheless, recognizing the distinct characteristics of a given investment management firm is necessary to understanding its value in the marketplace.All Businesses SellLike all private companies, ownership interests in RIAs eventually transact. Whether voluntary or involuntary, these transactions tend to be among the most important of the owner’s business life.The table below depicts events ranging from voluntary transfers such as gifts to family members or an outright sale to a third party to involuntary transfers such as those precipitated by death or divorce. An understanding of the context of valuing your business is an important component in preparing for any of these eventualities.Industry Conditions & IssuesThe idea of independent investment advisors gathered steam as high net worth clients migrated from the transactional sales mentality of brokerage firms. The financial advisory business model transformed from large wire house shops, and cold calling staffs paid by transaction-based commissions, to credentialed professionals paid on the basis of assets under management, or AUM. The popularity of RIAs centered on the fiduciary responsibility associated with such practices, as well as the greater degree of accessibility and high touch nature of their business operations. Additionally, the smaller size of independent advisors allowed for greater innovation and more specialized services. The number of total investment advisors registered with the SEC has increased four-fold from approximately 6,000 in 1999 to over 30,000 today (excluding all investment advisors only required to register with their respective states). Parallel to the proliferation of RIAs is the rise of state-regulated independent trust banks in the wake of mega-bank mergers and bailouts following the financial crisis of 2008. While there has been some consolidation of firms, the rate of acquisition in the industry has been far outpaced by startup formation.In spite of all the changes taking place in recent years, there remains some debate regarding whether the asset management industry is mature or evolving. If anything, it is continuing to niche into more discrete asset classes, investment styles, and client focus.Rules of ThumbThere are both formal and informal approaches to value, and while we at Mercer Capital are obviously more attuned to the former, we don’t ignore the latter. Industry participants often consider the value of asset managers using broad-brush metrics referred to as “rules-of-thumb.” Such measures admittedly exist for a reason, but cannot begin to address the issues specific to a given enterprise.Understanding why such rules-of-thumb exist is a good way to avoid being blindly dependent on them. During periods of consolidation, buyers often believe that the customer base (or AUM in the case of an asset manager) of an acquisition candidate can be integrated with the acquiring firm’s existing client assets to generate additional profits. So if most asset managers are priced at, say, 10x earnings and profit margins are 40%, the resulting valuation multiple of revenue is 4.0x. If revenue is generated by average fees of 50 basis points of assets under management, then the implied valuation is about 2% of AUM. Note, however, all the “ifs” required to make the 2% of AUM rule of thumb work.As with other businesses, the revenue of asset management firms is a function of price and quantity. In this case, price represents the rate charged for assets under management, and quantity reflects the asset base or AUM for RIAs. Value, however, is related to profits, which can only be derived after realizing the costs associated with delivering asset management services. High priced services are typically more costly to deliver, so margins may fall within an expected range regardless of the nature of the particular firm. Still, larger asset managers generally realize better margins, so size tends to have a compounding effect on value.Activity ratios (valuation multiples of AUM, AUA, revenue, etc.) are ultimately the result of some conversion of that activity into profitability at some level of risk. If a particular asset manager doesn’t enjoy industry margins (whether because of pricing issues or costs of operations), value may be lower than the typical multiple of revenue or AUM. On a change of control basis, a buyer might expect to improve the acquired company’s margins to industry norms, and may or may not be willing to pay the seller for that opportunity.In the alternative case, some companies achieve sustainably higher than normal margins, which justify correspondingly higher valuations. However, the higher levels of profitability must be evaluated relative to the risk that these margins may not be sustainable. Whatever the particulars, our experience indicates that valuation is primarily a function of expected profitability and is only indirectly related to level of business activity. Rules- of-thumb, if used at all, should be employed with an appropriate level of discretion.As an example of this, industry participants might consider RIAs as being worth some percentage of assets under management. At one time, asset manager valuations were thought to gravitate toward about 2% of AUM. The example below demonstrates the problematic nature of this particular rule of thumb for two RIAs of similar size, but widely divergent fee structures and profit margins. Firm A charges a higher average fee and is significantly more profitable than Firm B despite having identical AUM balances. Because of these discrepancies, Firm A is able to generate over six times the profitability of its counterpart. Application of the 2% rule yields a $20 million valuation for both businesses, an effective EBITDA multiple of 8x for Firm A and 50x for Firm B. While 2% of AUM, or 8x EBITDA, may be a reasonable valuation for Firm A, it is in no way representative of a rational (or non-synergistic) market participant’s realistic appraisal of its counterpart; it would imply an effective EBITDA multiple of 50x. It is our experience that money managers with higher asset balances, fee structures, and profit margins typically attract higher AUM multiples in the marketplace. In the case of RIAs with performance fee components to their revenue stream, the math gets a bit more interesting. Background Concepts of "Value"The industry issues discussed above can and should impact the valuation of asset managers, but a professional valuation practitioner considers other issues as well.Many business owners are surprised to learn that there is not a single value for their business or a portion of their business. Numerous legal factors play important roles in defining value based upon the circumstances related to the transfer of equity ownership. While there are significant nuances to each of the following topics, our main goal is to help you combine the economics of valuation with the legal framework of a transfer (whether voluntary or involuntary).Valuation DateEvery valuation has an "as of date" which, simply put, is the date at which the analysis is focused. The date may be set by legal requirements related to a certain event, such as death or divorce, or may be implicit, such as the closing date of a transaction.PurposeThe purpose of the valuation is significant to how the valuation is performed. A valuation prepared for one purpose is not necessarily transferable to another. The purpose of the valuation is likely to determine the “standard of value.”Standard of ValueThe standard of value is a legal concept that influences the selection of valuation methods and the level of value. There are many standards of value, the most common being fair market value, which is typically used in tax matters. Other typical standards include investment value (purchase and sale transactions), statutory fair value (corporate reorganizations), and intrinsic value (public securities analysis). Using the proper standard of value is part of obtaining an accurate determination of value.Level of ValueWhen business owners think about the value of their business, the value considered commonly relates to the business in its entirety. From this perspective, the value of a single share is the value of the whole divided by the number of outstanding shares. In the world of valuation, however, this approach may not be appropriate if the aggregate block of stock does not have control of the enterprise; in some cases, the value of a single share will be less than the whole divided by the number of shares. The determination of whether the valuation should be on a controlling interest or minority interest basis can be a complex process, and it is also essential. A minority interest value often includes discounts for a lack of control and marketability; therefore, it is quite possible for a share of stock valued as a minority interest to be worth far less than a share valued as part of a control block. Grasping the basic knowledge related to these issues can help you understand the context from which the value of a business interest is developed. Typical Approaches to ValuationWithin the common valuation lexicon, there are three approaches to valuing a business: the asset approach, the income approach, and the market approach.The Asset ApproachThe various methodologies that fall under the umbrella of the asset approach involve some market valuation of a subject company’s assets net of its liabilities. In the case of an RIA, the primary “assets” of the business get on the elevator and go home every night. In some contexts, it may be useful to evaluate the worth of a company’s trade name, assembled workforce, customer list, or other intangible assets. The balance sheet can be significant regarding the presence of non-operating assets and liabilities or excessive levels of working capital, but the value of any professional services firm, including asset managers, is usually better expressed via the income and market approaches.The Income ApproachThe income approach usually follows one of two methodologies, a discounted cash flow method or a single period capitalization method. The discounted cash flow methodology (or DCF) requires projecting the expected profitability of a company over some term and then “pricing” that profitability using an expected rate of return, or discount rate. Single period capitalization models generally involve estimating an ongoing level of profitability which is then capitalized using an appropriate multiple based on the subject company’s risk profile and growth prospects. In either case, the income approach requires a thorough analysis of the risks and opportunities attendant. In the case of valuing asset managers, the income approach can be a useful arena to delineate issues unique to the industry and the particular company.Within the spectrum of asset managers, entities styled as family office operations may exhibit lower growth (which, all else equal, would suggest lower valuations), but also more stable client bases (with higher probability of recurring revenue, which tends to raise valuations). On the other end of the spectrum, valuing a hedge fund manager might require balancing the potential for supernormal earnings growth with supernormal earnings volatility.A wealth manager or independent trust company might fall somewhere in between these two extremes. These RIAs tend to enjoy a loyal (sticky) customer base, but often at the price of lower margins expected in a multi-discipline, high-touch business where client expectations for technical expertise and customer service compound staffing costs. There are similar opportunities for earnings leverage as with any asset manager, but these can be tempered by the nature of services that these asset managers provide.The Market ApproachOf the three approaches to value, the market approach may be the most compelling due to the high availability of pricing data. The market approach can be accomplished in a number of ways: by looking at the valuation multiples implied by outright sales of similar businesses, or by observing the trading activity in shares of publicly held companies.While the market approach may be the most useful way to value assets managers, it is often the most misused. It is possible to find transactions involving investment management companies or publicly traded trust banks and RIAs that are similar to a given RIA, but it is also important to understand and isolate what is different about the subject company that can affect value.Market data also has its drawbacks. Transactions data may offer limited information about multiples paid for various measures of profitability, and there may be no real way to isolate potential synergies reflected in the transaction pricing that might have been unique to the buyer and seller. Publicly traded investment management firms offer more thorough and consistent data, but they tend to be much larger and more diversified than closely-held RIAs.The potential differences in margin and product line have already been discussed in this article, but smaller asset management firms may have other limitations that are a product of scale. These issues include greater dependence on certain managers or clients, the loss of which could be difficult to replace without a detrimental impact on the financial returns of the business. Narrow product offerings or problems in the economic area served by the RIA could also constrain growth opportunities. Of course, it’s also possible that a subject enterprise might have a better than market opportunity because of a particular customer base served or a particular product offering.In any event, the valuation multiples implied by transaction activity or public asset managers may and often do require some adjustment for various factors before application to the subject RIA.Putting It All TogetherValuation analysis is not complete if it is left untested. In the valuation of RIAs, whatever methodologies are employed should ultimately reconcile to a conclusion of value that is reasonable given expectations for the company relative to industry pricing. This might ultimately fit within some kind of rule of thumb, but only by coincidence. Experience has taught us that in the asset management industry, as elsewhere, maximizing opportunity and minimizing risk usually enhances value.

Recently, Russia took on the awesome task of trying to deter rampant narcissism by opening a 24/7 helpline to support anyone thinking they might be addicted to photographing themselves – a selfie hotline – if you will. Russia’s Interior Ministry went to social media to educate its citizens on the dangers of taking selfies, which include falling down stairs, being attacked by wild animals, and being hit by trains. Selfie addiction, according to the Politburo, is very real and very dangerous. Asset managers should take heed, and consider dialing in. Of all the concentration risks that an RIA faces, dependence on key staff ranks at or near the top. Unless you’ve taken the CFA Institute’s indoctrination (advice) and you just run an index fund (in which case, why are you competing with Vanguard?), your business is tied, sometimes to an extreme degree, to the persons who work with you, and maybe you yourself. Talent is everywhere, yes, but clients who choose to invest with a given firm frequently do so, directly or indirectly, based on their confidence in the individual(s) who will be servicing their account and making their investments. The primary assets of an RIA “get on the elevator and go home at night,” and in our country (not sure about Russia), a firm can’t have title to individuals. Even with a non-compete. That said, sometimes good people can be too good. A sector asset manager investing in small cap equities for large institutional clients might be able to run $5 billion with twelve or fifteen people, of whom maybe five are actually involved in the investment research and portfolio management process. A comparable wealth management firm would require 100 employees or more to manage as much wealth. The fee schedules of the two shops might be similar, generating similar revenue streams. But margins are likely to be very different. A sector asset manager as we’ve described could generate twice the EBITDA margin off of the same revenue as the wealth management firm. High margins aren’t everything, though; which one would you rather own? One paradox of value in an RIA is that the driver of growth in a firm, usually an individual, can also be its undoing (e.g. everyone’s favorite selfie-manager, Bill Gross). The small cap manager described above is at risk every time one of its portfolio managers crosses the street in traffic. High margins don’t always portend high valuations, because high margins can be hard to sustain. And, although it takes a strong personality to build an investment firm, that doesn’t mean it has to become an all-expenses-paid ego trip. Consider the asset outflows around the time of Bill Gross’s departure from PIMCO. [caption id="attachment_9013" align="aligncenter" width="500"] Source: Business Insider[/caption] Looking at the chart above, you would think PIMCO was insane to let Gross leave. Janus was clearly trying to reverse asset flow trends when it agreed to take in Gross despite his controversial personality. [caption id="attachment_9014" align="aligncenter" width="500"] Monthly Asset Flows at Janus Capital Since 2009[/caption] And, of course, asset flows do have impact on value. PIMCO’s parent, Allianz, has pretty well underperformed Janus since Gross left. [caption id="attachment_9015" align="aligncenter" width="500"] Source: SNL Financial[/caption] It isn’t so much that Allianz has performed poorly, as that Gross woke things up a bit at Janus. That trend has shown remarkable endurance so far, but the message is clear that key staff and value are interactive in RIAs. This simple fact has so many implications for asset managers that they’re hard to list, but here are a few. Compensation per capita at RIAs can be astronomical. The cure to this is typically to grow AUM faster than staff compensation. Indeed, the more successful a team is, the more assets they attract. This should (and often does) lead to operating leverage, but successful team members can command more compensation. Margins don’t grow forever.RIA transactions are frequently structured with as much as 25% to 50% of total consideration being paid in the form of an earn-out. This may cover some of the risk of client and product transition, but mostly it means that buyers and sellers share in that risk.Many capital providers who invest in RIAs don’t even try to cash out key employees, taking partial positions in the firms so that managers remain invested and economically tied to the firm.The profession is facing something of a physical cliff, as RIAs that began within a decade or so of the start of ERISA (1974) struggle to transition ownership from aging founders to the next generation. This is complicated by many things, most notably high valuations. It’s easy to quip that RIAs are worth so much no one can afford to buy them, but that’s a topic for another day. Ideally, an RIA grows beyond the reputation and attributes of an individual or group of individuals and becomes a brand, such that clients come as much or more for the institution than the people. Easier said than done. But sustainability of the revenue stream over time has a big influence on value. Of course, maybe the investing world will be taken over by index funds and robo-advisors. Until then, though, FINRA should consider installing a selfie hotline.

Mercer Capital's asset management valuation practice is run from our main office in Memphis, Tennessee, and this time of year here means one thing: Death Week. Every year since his death on August 16, 1977, the city of Memphis spends a week memorializing Elvis Presley, the King of Rock and Roll. If you have never been, Death Week is basically seven to ten days of activities in which the Presley faithful arrive from every continent to pay their respects and enjoy what has to be some of the hottest, most humid weather anywhere on the globe.From all the press lately, you would expect that a similar wake was being held for active management, and with it, much of the RIA community. Elvis is dead, and so too must be active management. We live in the age of auto-tune and robo-advisors, a time when big vocal chords and beating the market have become anachronisms – or are they?Academics have been testifying as to the shortcomings of active management for decades, and by the time I was studying for the CFA exams (back in the '90s, as a colleague is quick to remind me), what was then known as AIMR (a midlife identity crisis between its founding as ICFA and what is now known as CFAI) had joined in to "educate" us on the relative virtue of passive investing. Today, ETFs and indexing are common, and in the wealth management community, have done much to streamline asset allocation. For asset management, though, the rise of indexing is the number one threat to the lifeblood of the RIA community: fees.The RIA business model is, after all, pretty simple; AUM times fee schedule equals revenue, revenue minus labor costs and other more mundane expenses equals margin, and sustainability of margin drives value. If active management fees are threatened, it will ultimately threaten to disinflate valuations in the asset management community.There is cause for concern. A study performed by the Investment Company Institute (or "ICI") and Lipper showed average mutual fund expenses and fees declining 30% (!) over the past fifteen years, from about 99bps to 70bps in equity funds (read the study at www.icifactbook.org). Bond funds fared only slightly better, dropping 25% from an average 76bps to 57bps over the same period. The trend-line is basically unbroken with not inconsequential declines over the past three to five years. The decline in fees has been stealthy, as active managers haven't been cutting fees so much as missing out on new assets to manage. During this same timeframe, AUM in equity index funds has increased almost six fold, from $384 billion in 2000 to $2.1 trillion last year. Actively managed funds have reduced fees somewhat: with expense ratios dropping from 106 basis points in 2000 to 86 last year. Some of this can be attributed to the growth in size (and the corresponding efficiencies) created by larger actively managed equity funds, but the competitive threat from equity index funds (with average fees of 11 basis points), has to have kept more than one young manager contemplating a buy-in to his or her RIA up at night. Anecdotally, our valuation practice at Mercer Capital seems to serve an RIA community that is unaffected by all of this. We routinely ask clients if they are facing fee pressure and/or are contemplating revising fee schedules downward, and we are routinely told "no." Institutional clients are reasonably savvy about negotiating fees, but they always have been. High net worth clients just "want to win", and are willing to pay for the opportunity to do so. Who's to say they're wrong? Many commentators have written that active management is more challenging today than ever precisely because of the professionalization of the investment management industry (when everyone is skilled and educated, no one has an advantage). But passive investing could ultimately generate its own demise, as the rise of robo-group-think in the market constrains liquidity in many securities, and creates the kinds of price inefficiencies that favor active management. Passive investing may eventually just be a "style" that falls out of favor. As the old saying goes in economics, in the long run we'll all be dead (or at least retired), so this is no time to be sanguine about fee schedules. Investors of all stripes have more options to put their money to work, investment costs are becoming more transparent than ever, and switching is becoming easier. As clients become more sophisticated, the RIA community will become more so as well, defending fees with unique strategies and service offerings, and defending margins with better use of technology and managed staffing costs. But that's a topic or two for another post.

As noted in Mercer Capital’s presentation to the 2014 Acquire or Be Acquired conference sponsored by Bank Director entitled Acquisitions of Non-Depositories by Banks, the relatively high margins associated with asset management is one of the many reasons that banks and other finance companies have been so interested in RIAs over the last few years.[caption id="attachment_8888" align="aligncenter" width="500"] Source: SNL Financial[/caption] Other often-cited rationales for bank acquisitions of asset managers include: Exposure to fee income that is uncorrelated to interest ratesMinimal capital requirements to grow AUMHigher margins and ROEs relative to traditional banking activitiesGreater degree of operating leverage – gains in profitability with management feesLargely recurring revenue with monthly or quarterly billing cyclesPotential for cross-selling opportunities with bank’s existing trust customers Although deal terms are rarely disclosed, the table below depicts some recent examples of this trend with pricing metrics where available. While multiples for activity metrics (AUM and revenue) can be erratic and tend to vary with profitability, EBITDA multiples are often observed in the 10x-15x range for public RIAs with their private counterparts typically priced at a modest discount depending on risk considerations, such as customer concentrations and personnel dependencies. Powered by a fairly steady market tailwind over the last few years, many asset managers and trust companies have more than doubled in value since the financial crisis and may finally be posturing towards some kind of exit opportunity to take advantage of this growth. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry