Zachary W. Milam

Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. The industry’s demographics suggest that increased attention to succession planning is well warranted: a majority of RIAs are still led by their founders, and only about a quarter of them have non-founding shareholders. While there is growing recognition of the importance of succession planning, it often lags far behind other strategic initiatives with more immediate benefits like new client and staff growth1. In the long run, however, firms with a well-developed succession plan have a distinct competitive advantage over those without. Fortunately, many viable options exist for RIA principals looking to solve succession planning issues. In this post, we review several of the more common options.Internal transition to the next generation of firm leadership. Internal transitions of ownership are the most common type of transaction for investment management firms and for good reason. Many RIA owners prefer working for themselves, and their clients prefer working with an independent advisor.Internal transitions allow RIAs to maintain independence over the long term and provide clients with a sense of continuity and comfort that their advisor’s interests are economically aligned. A gradual transition of responsibilities and ownership to the next generation is usually one of the best ways to align your employees’ interests and grow the firm to everyone’s benefit. While this option typically requires the most preparation and patience, it allows the founding shareholders to handpick their successors and future leadership.Debt financing. Debt financing has become a readily available option for RIAs in recent years as the number of specialty lenders focusing on the sector has increased. External debt financing is often used to finance internal transactions as an alternative to seller financing. Such arrangements avoid introducing a new outside equity partner and can work well when the scope of succession issues to solve is limited to financing the transaction.There are potential drawbacks, however. For example, debt financing for RIAs typically requires a personal guarantee, which many borrowers oppose. Borrowers are also more exposed to their own business by levering up to purchase an equity stake.Sale to a consolidator or roll-up firm. RIA consolidators have emerged, promising a means for ownership transition, back-office efficiencies, and best practices coaching. The consolidator model has been gaining traction in the industry in recent years. Most well-known RIA consolidators have grown their AUM at double-digit growth rates over the last five years, and acquisitions by consolidators represent an increasing portion of overall deal volume in the sector.For RIA principals looking for an exit plan, a sale to a consolidator typically provides the selling partners with substantial liquidity at closing, an ongoing interest in the firm’s economics, and a mechanism to transfer the sellers’ continued interest to the next generation of management. There’s a wide spectrum of consolidator models, and they can vary significantly in terms of their effect on the day-to-day operations of the acquired RIA. RIA owners considering selling to a consolidator should think carefully about which aspects of their business they feel strongly about and how those aspects of the business will change after the deal closes.Sale to a private equity firm. Drawn to the industry’s typically high margins, low capital expenditure needs, and recurring revenue model, private equity managers have sharpened their focus on investment management firms in recent years. Private equity can be used to buy out a retiring partner, but it is not typically a permanent solution. While PE firms provide upfront cash, remaining principals must sacrifice most of their control and potentially some of their ownership at closing.Minority financial investment. Minority financial investments can provide existing ownership with liquidity while allowing remaining shareholders to maintain control and an ongoing interest in the firm’s Minority investors typically do not intrude on the firm’s operations as much as other equity options, but they will seek deal terms that adequately protect their interest in future cash flows.Sale to a strategic buyer. A strategic buyer is likely another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal. On paper, this scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees, clients, or the company’s identity.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.1 See https://content.schwab.com/web/retail/public/about-schwab/2024-Charles-Schwab-RIA-Benchmarking-Study.pdf

There are 15,000 or so RIAs in the US. No two are identical, of course, but broadly speaking, firms that seek to serve the same types of clients tend to end up with similar-looking business models, whether intentionally or through some form of convergent evolution. A firm’s structure—its org chart, compensation model, advisory team model, internal processes, marketing, technology, and so on—tends to reflect the types of clients the firm seeks to serve and, relatedly, the value proposition it offers to those clients. The result is that firms tend to cluster around a handful of distinct models, and identifying what those models are and how they differ can be a useful exercise both in analyzing a particular firm and in thinking about practice management issues.Back in 2021, Ashish Nanda and Das Narayandas—both economists and professors specializing in professional services and client management strategies—published an article in the Harvard Business Review titled What Professional Services Firms Must Do To Thrive. In that article, the authors introduced a framework for thinking about professional services firms based on the type of service they provide to clients. While the framework is generally from the perspective of professional services, we’ve found it to be a particularly useful tool for thinking about asset and wealth management firms.The framework categorizes firms into four buckets based on where they fall along a spectrum of the complexity of services provided. At one end of the spectrum are Commodity Practices—firms that offer undifferentiated services that solve simple problems. Next are Procedural Practices—those firms that offer clients the ability to tackle larger problems that are complicated primarily by larger scope and multiple moving parts. Next are Gray Hair Practices—firms that bring experience and institutional knowledge to solve even more complex problems. At the other end are Rocket Science Practices—firms that solve unique, difficult, and high-stakes problems for sophisticated clients. Firms are defined along this spectrum not by their own self-perceptions but by the selling proposition that brings clients to the firm. If clients select a particular firm because it’s the lowest-cost provider, that’s likely a commodity practice. At the other end of the spectrum, if clients choose a particular firm because they think it’s best suited to solve a particularly difficult and novel problem, that firm is likely best classified as a rocket science practice. What does this look like for RIAs? To illustrate, it’s helpful to look at the profiles of firms that fall in each category. Many firms may have elements that place them into multiple categories, but generally, firms lean most heavily into a single or perhaps two categories at most. For wealth management firms, we think most practices straddle the Procedural and Gray Hair categories.Commodity RIAs. Includes firms that use scale and automation to deliver low-cost, standardized investment services. Firms with algorithm-driven portfolio management strategies and mass-market advisory firms would likely fall into this category.Procedural RIAs. Includes firms with services that involve complex but well-defined processes. For RIAs, this could be offering comprehensive financial planning that follows structured steps. The administratively heavy nature of independent trust companies would also generally place them in this category.Gray Hair RIAs. This category includes RIAs that provide more sophisticated advice to more sophisticated clients than procedural practices, relying heavily on the experience and expertise of their advisors. Firms that predominantly serve ultra-high-net-worth clients, families with multi-generational wealth, or those that offer complex estate planning strategies generally fall into this category.Rocket Science RIAs. Asset managers that utilize complex or novel investment strategies would fall into this category—think those that have developed proprietary, quantitative trading strategies or those that utilize complex, derivative-based hedging strategies or certain alternative investment strategies. This framework has implications for the profit drivers of a business and the resources required to succeed. The farther a firm is towards the commodity end of the spectrum, the more important efficiency and systems for delivery become because these are necessary to deliver while remaining profitable. For RIAs, this typically means that such firms have org charts that are wider at the bottom, lower compensation levels on average, and low margins that are offset by scale and the ability to more easily leverage and grow the business. The farther a firm is toward the Rocket Science end of the spectrum, the more important knowledge management, experience, and analytical expertise become to the firm’s success. For RIAs, this typically manifests in a higher ratio of senior staff to junior staff, higher average compensation levels, higher margins, and less leverage. Such practices are inherently more difficult to scale because they rely more on individual expertise than company-wide systems to deliver their value proposition. Depending on where your practice falls on the spectrum, the type of talent you hire will be different, the way you structure client service teams will be different, the internal systems and processes you develop will be different, the way you market services will be different, and the way you invest in technology will be different.Successful Practices Are Clear About Where They Fall on the SpectrumWhile “commodity” and “rocket science” may elicit different knee-jerk responses in the professional services world, it’s important to note that one type of practice is not categorically better than any other. Success can be found through each of the routes above, and we’ve seen examples from each. But it’s essential to have a clear vision of the type of practice you’re seeking to run. Thinking about the type of practice you’re running is a valuable exercise for identifying the areas you want to lean into and the areas you want to avoid, as it has implications for the resources required for success.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, RIAs, trust companies, broker-dealers, PE firms, and alternative managers.

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.

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.

Compensation models are the subject of significant handwringing 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. The effects of an RIA’s compensation model are far-reaching, determining not only how compensation is allocated amongst employees but also how a firm’s earnings are split between shareholders and employees, what financial incentives employees have to grow the business, and what financial incentives are available to attract new employees and retain existing employees.Compensation models at RIAs tend to be idiosyncratic, reflecting each firm’s business model, ownership, and culture. In an ideal world, these compensation programs evolve purposefully over time in response to changes in the firm’s size, profitability, labor market conditions, and a variety of other factors. However, inertia is a powerful force: we often encounter compensation programs that made sense in the past but haven’t adapted to serve the firm’s changing needs as the business has grown in scale and complexity.Effective compensation programs need to change with the times, and the times have certainly changed. The RIA industry has seen tremendous growth over the last decade. As a result, firms today face increasingly complex compensation decisions that affect a growing list of stakeholders: outside shareholders, multiple generations of management, retiring partners, new partners, possible minority investors, and so on. On top of that, financial and labor market conditions have evolved dramatically over the last eighteen months, leading many RIAs to scrutinize their compensation models more than ever before.Introduction to RIA Compensation ModelsIt’s important to note at the outset what compensation models do and don’t do. Compensation models determine how the firm’s earnings are allocated; they don’t (directly) determine the amount of earnings to be allocated. When it comes to determining who gets what, it’s a fixed-sum game. The objective of an effective compensation policy is to allocate returns in such a way as to increase this sum over time.Compensation for RIAs can be broken down into three basic components, each of which serves different functions with respect to incentivizing, attracting, and retaining employees:Base Salary / Benefits. This is what an employee receives every two weeks or so. It’s fixed in nature and is paid regardless of firm or employee performance over the short term. On its own, base salary provides little incentive for employees to grow the value of the business over time.Variable Compensation / Bonus. In theory, variable compensation can be tied to specific metrics that the firm chooses or may be allocated on a discretionary basis. The amount of variable compensation paid to employees varies as a function of the chosen metric(s) or management’s qualitative analysis of an employee’s Variable compensation is also called at-risk compensation because all or part of it can be forfeited if target thresholds are not met. Variable compensation is most often paid out on an annual basis.Equity Compensation. Equity incentives serve an important function by aligning the interests of employees with those of the company and its shareholders. While base salary and annual variable compensation serve as shorter-term incentives, equity incentives serve to motivate employees to grow the value of the business over a longer period and play an important role in increasing an employee’s ties to the firm and promoting retention.Variable CompensationIn this blog post, we focus our attention on the variable compensation component (we’ll address the others in subsequent posts).Variable compensation plays an important role in incentivizing employees over the relatively short term (1-3 years). The evidence suggests that such incentives work, too. According to Schwab’s 2022 RIA Compensation Report, firms using performance-based incentive pay saw 28% greater AUM growth, 34% greater net asset flows, and 31% greater client growth over five years than firms without performance-based incentives.What Do You Want to Incentivize?As the name suggests, variable compensation changes as a function of some selected metric, typically revenue, profitability, or some other firm-level metric or individual-level metric, depending on the specific aspects that management intends to incentivize. Additionally, a qualitative assessment of employee performance across various areas may factor into variable compensation.In our experience, variable compensation pools tied to firm profitability and allocated amongst employees based on a combination of individual responsibilities and performance provide an effective incentive for most firms to grow the value of the business over time. Such structures tend to work well because linking variable comp to profitability creates a durable compensation mechanism that scales with the business and aligns the financial and risk management objectives of shareholders and management. Variable comp linked to profitability also promotes a cohesive team, rather than the individual silos that can arise out of revenue-based variable comp, which further helps to build the value of the enterprise.In market downturns, compensation mechanisms that directly link employee pay to firm profitability have the additional benefit of helping to blunt the impact of market conditions on firm profitability. Consider the example below, which shows the impact of a 10% AUM increase and a 10% AUM decrease for a hypothetical firm under two comp programs, one in which all compensation is fixed and the other in which there is a variable bonus pool equal to 20% of pre-bonus profitability.Click here to expand the image aboveIn this example, both compensation programs result in $4 million in EBITDA and an EBITDA margin of 24.6% in the base case scenario. In the downside scenario, however, the fixed comp structure leads to a high degree of operating leverage, and as a result, a 10% drop in AUM leads to a decline in EBITDA of over 40% and a decline in the EBITDA margin to 16.2%. Under the variable comp structure, the variable bonus pool helps to blunt the impact of declining AUM. In this example, a 10% decline in AUM results in a 32.5% decrease in EBITDA and a decline in the EBITDA margin to 18.5% under the variable comp program. In the upside scenario, the increase in EBITDA is greater under the fixed comp structure than under the variable comp structure (an increase of 40.6% vs 32.5%).From a shareholder perspective, a variable compensation program such as the one described above effectively transfers some of the risk equity holders bear to the firm’s employees. In downside scenarios, some of the decline in profitability that would otherwise accrue to shareholders is absorbed by employees. Similarly, some of the increase in profitability is allocated to employees in upside scenarios. The logic of such a compensation program is that employees are incentivized to grow and protect the same metric the shareholders care about—the firm’s profitability.ConclusionInvestment management is a talent business, and structuring an effective compensation program that allows the firm to attract, retain, and incentivize talent is critical to an RIA’s success. In future posts, we’ll address additional compensation considerations, such as equity compensation options and allocation processes.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.

Rules of thumb based on a percentage of AUM are frequently cited in the RIA industry as a back-of-the-envelope way to quickly estimate a firm’s value. One reason for the prevalence of AUM multiples is purely practical—AUM for RIAs is a publicly available metric, and it’s often the only window into a firm’s financial performance available to third parties. Another reason for the popularity is simplicity—AUM can be compared across firms without regard to fee levels, margins, compensation structure, and the like.The simplicity of AUM multiples is also the greatest pitfall. AUM multiples condense a significant amount of information into a single metric. In our experience, they’re usually better thought of as an output rather than an input to valuation. To gain insight into what drives AUM multiples, we can (using a little bit of math) decompose AUM multiples like this: From a practical standpoint, a dollar of AUM is worth more when it generates more fees, and those fees are worth more when they yield higher returns (earnings) to capital providers (all else equal). Investors will pay more for an RIA’s AUM when there’s more cash flow behind it. To illustrate, consider the sensitivity table below, which shows the implied AUM multiple for a given EBITDA multiple (in this case, 9.0x) as a function of effective realized fees and EBITDA margin. For sensitivity purposes, we’ve shown a wide range of effective realized fees (55 to 95 bps) and EBITDA margins (10% to 50%) which will encompass most, but not all, firms. A firm at the middle of both ranges (75 bps effective realized fee level and 30% EBITDA margin) transacting at a 9.0x EBITDA multiple would imply a 2.0% AUM multiple—in line with an often cited “2.0% of AUM” rule of thumb. But the range in the table is wide. A firm at the low end of profitability and effective realized fees (10% margin with fees of 55 bps) transacting at the same EBITDA multiple would imply a multiple of AUM of 0.5%. In comparison, a firm at the high end of the range (50% EBITDA margin and fees of 95 bps) would imply a multiple of AUM of 4.3%—a nearly ninefold increase in the multiple. This reality is why we see such disparity in the AUM multiples paid for investment management firms. Firms vary significantly in terms of their asset class focus or allocation, fee levels charged, client base demographics, and operational efficiency. All of these variables (and more) impact how AUM translates into profitability and thus what investors are willing to pay for a dollar of AUM. If a firm has balance sheet items such as GP interests or has non-AUM-based business lines, AUM multiples can be further skewed. When assessing AUM multiples from transactions, it’s important to keep these caveats in mind. If you’re an RIA principal looking to improve the value of your assets under management, the levers to pull are the effective realized fee, EBITDA margin (profitability), and the EBITDA multiple. Since the EBITDA multiple is primarily a function of risk, growth, and market conditions that are largely outside your control, the path of least resistance is probably fee discipline and margin improvement. (Though we acknowledge the difficulties of enhancing your bottom line when markets and AUM are falling while inflation swells your compensation costs and overhead expenses.) The takeaway is to focus on what you CAN control: hiring practices, new business development, incentive compensation structure, operating efficiencies, fee discipline, and cost controls. As the last year has proven, you can’t always rely on a market tailwind to lift AUM and revenue. Developing new business in a cost-efficient manner will increase margins and profitability in almost any market environment. It will also improve your AUM multiple and value by extension.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.

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.

On the earnings call last week, CI Financial reiterated intentions to separate its U.S. wealth management business and Canadian asset management business through an IPO of its U.S. wealth management business.CI’s CEO Kurt MacAlpine reported continued progress toward the IPO and announced an anticipated S-1 filing later this month. After the transaction, the U.S. wealth management business will trade on the U.S. exchange, while the legacy Canadian asset management business will be delisted from the NYSE and traded exclusively on the Toronto Stock Exchange.Since MacAlpine took the helm as CEO in 2019, CI has quickly made a name for itself as one of the more prolific acquirors of U.S. wealth management businesses. Driven by a rapid succession of deals, CI increased its U.S. wealth management AUM more than tenfold in just two years—from C$15.5 billion on October 31, 2020, to C$171.9 billion on October 31, 2022.CI’s share price has fallen over 40% this yearWhile CI has had apparent success at completing deals, investors have not been on board with the strategy. CI’s share price has fallen over 40% this year, and many have publicly speculated that CI’s substantial deal volume is at least partially attributable to its willingness to overpay. While the pricing of CI Financial’s acquisitions is generally not disclosed, the volume of deals that CI has strung together during intense competition from buyers and record high multiples suggests it’s not accustomed to being the low bidder.This year, souring market conditions have thrown cold water on CI’s M&A binge. The firm’s deal pace is slowing, and the focus has shifted to deleveraging and attempting to unlock the value of the U.S. wealth management business built through the planned spinoff. By selling off a portion of the wealth management business via IPO, CI will raise funds that it can use to pay down its debt balance. The spinoff will also present a stand-alone, pure-play wealth management business to the public markets that (CI’s management hopes) will be valued more like a private wealth manager and less like a public asset manager.DeleveragingAfter the transaction, the existing debt and guaranteed payment obligations related to CI’s wealth management acquisition spree will be retained by the Canadian asset management business, while the U.S. business will retain the contingent consideration obligations related to prior acquisitions. The Canadian asset management business will then use the proceeds from the spinoff to pay down its debt balance, which stood at C$3.9 billion on September 30, 2022. After the IPO, CI’s management expects that the Canadian business will not fund any future U.S. acquisitions, nor will it pursue large M&A opportunities in Canada. Future inorganic growth of the U.S. business will be funded by cash flow, partnership units, and public company stock.The focus on deleveraging comes at a time when debt costs have been soaring, putting additional strain on leveraged consolidator models beyond declining revenue and rising costs for component firms. Amidst this environment, early warning signs for CI have started to emerge; in April this year, CI Financial’s issuer credit rating was downgraded by S&P from BBB to BBB- (the lowest investment grade rating). In early November, CI’s credit facility was amended to increase the maximum leverage ratio (funded debt to annualized EBITDA) to 4.5x (previously 4.0x). On September 30, CI’s leverage ratio stood at 4.0x—exactly in line with the covenant prior to amendment.While CI initially targeted a 20% spinoff of the U.S. wealth management business, CI’s CFO hinted that the amount could now be higher. A larger spinoff would presumably allow for greater deleveraging.Unlocking Value?Beyond deleveraging, CI hopes that a pure play U.S. wealth management business will be valued differently from the combined asset and wealth management business. CI’s Enterprise Value / LTM EBITDA multiple peaked at close to 12x late last year, and today CI trades at roughly 7.7x trailing twelve-month EBITDA. Back in February, MacAlpine remarked on CI’s fourth-quarter earnings call that he felt the company was “criminally undervalued” based on where it was trading at the time. “We’re not getting credit for the shift of our business to the U.S. nor the rapid growth of our wealth management business,” MacAlpine added.The disparity between publicly traded asset manager valuations and privately transacted wealth manager valuations has become more pronouncedWhile we doubt CI’s valuation is a criminal offense, MacAlpine may be on to something. The disparity between publicly traded asset manager valuations and privately transacted wealth manager valuations has become more pronounced in recent years. EBITDA multiples for most smaller publicly traded asset managers have trended downwards, reflecting adverse trends like pricing pressure and asset outflows that have plagued the asset management industry. On the other hand, wealth management firms have been less exposed to these pressures and have seen multiples trend up (at least through the end of last year) as a proliferation of capital and acquiror models have competed for deals.We suspect that CI has paid a higher multiple for many of its wealth management acquisitions than it trades at itself. Undoing that reverse multiple arbitrage is something that CI’s management hopes will happen with the spinout, but the current market environment will likely make this an uphill battle. Along with almost everything else, multiples for publicly traded asset/wealth managers have declined this year. According to MacAlpine himself, private market valuations have declined “in lockstep” with public markets. All of this suggests that achieving an attractive valuation for the U.S. wealth management business may prove difficult.

So far this year, many publicly traded investment managers have seen their stock prices decline by 30% or more. This decrease is not surprising, given most firms’ broader market decline and declining fee base. With AUM for many firms down significantly from year-end, trailing twelve-month multiples have declined, reflecting the market’s expectation for lower profitability in the future. For more insight into what’s driving the decrease in stock prices, we’ve decomposed the decrease to show the relative impact of the various factors driving returns between December 31, 2021, and October 25, 2022 (see table below).Click here to expand the image aboveFor publicly traded investment managers with less than $100 billion in AUM, the last twelve-month (LTM) revenue for the most recent available twelve-month period increased about 2% relative to year-end. Due to the operating leverage in the RIA business model, the decline in revenue also resulted in a higher EBITDA margin. The net effect is that LTM EBITDA increased about 5% on average year-over-year for these firms. The fundamentals for the larger group (firms with AUM above $100 billion) fared worse, with profitability generally decreasing due to modest revenue declines and margin compression.While the sub-$100B group generally saw better actual performance than the larger group, both groups saw significant declines in the LTM EBITDA multiple, which was the primary driver of the stock price decreases. Year-to-date, the median multiple for the larger group (AUM above $100 billion) has been cut by nearly a third. In comparison, the smaller group (AUM below $100 billion) saw the median multiple decrease by about 12%.The multiple compression relative to year-end is not surprising, given the market’s trajectory this year. While LTM EBITDA declines have been modest for the larger group and performance has increased for the smaller group, market participants value these businesses based on expectations for the future, not on LTM performance.What’s Your Firm’s Run Rate?The multiple contraction seen in the publicly traded investment managers over the last year illustrates the importance of expected future performance on RIA valuations. The market decline and inflationary pressures that have manifested this year have yet to be fully reflected in LTM performance metrics. But as AUM has declined for most RIAs, so too has the run-rate revenue and profitability. The decline in run-rate revenue and profitability (and expectations for the same) is a driving factor behind the multiple compression observed over the last year in public companies.Market participants tend to focus on the run-rate level of profitability because it’s the most up-to-date indication of a firm’s revenue and profitability and the baseline from which future performance is assessed. This is increasingly true in today’s volatile market as buyers seek to determine a firm’s ongoing profitability after giving effect to the market movements and inflationary pressures that have impacted firms this year.Consider the financial results for a hypothetical firm (ABC Investment Management) shown below. While illustrative, the AUM trajectory and cost structure of this firm since year-end are not unusual relative to those exhibited by publicly traded investment managers and many of our privately held RIA clients.Click here to expand the image aboveIn the example, we assume that ABC began the fourth quarter last year with $2.0 billion in AUM. Market movement is estimated using the market performance of VBIAX (a rough proxy for a traditional 60/40 portfolio). Assuming zero net inflows over the last year, ABC would have ended the third quarter of 2022 with a little over $1.6 billion in AUM, down nearly 20% from a year prior. Given the operating leverage of the business, ABC’s EBITDA in the third quarter declined by over 40% relative to the fourth quarter of last year.On an LTM basis, ABC generated revenue of about $12.4 million and EBITDA of $3.3 million (representing a 27% EBITDA margin). On a run-rate basis, however, the performance is markedly different. Given current levels of AUM and operating expenses, ABC’s run-rate revenue is $10.6 million, and run-rate EBITDA is just $2.1 million—a nearly 40% decline relative to LTM EBITDA. This example illustrates the differing perspectives that emerge in down markets: While sellers focus on LTM metrics, buyers focus on the run rate.Implications for Your RIAWhile multiples for publicly traded asset and wealth managers have been hit hard this year, RIA valuations in the private market have been more resilient as a proliferation of professional buyers and capital in the space have supported deal activity and multiples. Nevertheless, market conditions are beginning to have an effect. Run rate performance for most firms is down significantly, and borrowing costs for leveraged consolidators are rising. The upward momentum in multiples that persisted throughout last year has stalled, and deal structures have started to shift more of the purchase price into contingent consideration to bridge increasingly divergent buyer and seller expectations.

Year-to-date RIA M&A activity has surpassed last year’s record levels in 2022, even as macro headwinds for the industry continue to mount. Fidelity’s August 2022 Wealth Management M&A Transaction Report listed 155 deals through August of 2022, up from 112 during the same period in 2021. These transactions represented $212 billion in AUM, up 16% from 2021 levels. The continued strength of RIA M&A activity amidst the current environment dominated by inflation, rising interest rates, and a tight labor market is noteworthy, given that all these factors could strain the supply and demand dynamics that have driven deal activity in recent years. Rising costs and interest rates coupled with a declining fee base will put pressure on highly leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. But despite these pressures, the market has proven robust (at least so far). Demand for RIAs has remained strong, with professionalization of the buyer market continuing to be a theme driving M&A activity. Serial acquirers and aggregators increasingly drive deal volume with dedicated deal teams and access to capital. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the first eight months of the year. While the current market environment has prompted some serial acquirers to temper their pace of acquisition activity (CI Financial’s CEO Kurt McAlpine remarked on the company’s first-quarter earnings call that their pace of acquisitions has “absolutely slowed down”), we’ve not yet seen that borne out in reported deal volume. Multiples in the industry remain high, although the upward trend in multiples has reportedly leveled off. On the supply side, the current market environment is likely to have a mixed impact on bringing sellers to market. On one hand, some sellers may be reluctant to sell when the markets (and their firm’s financial performance) are down significantly from their peak. On the other hand, a concern that multiples may decline if the current market environment persists may prompt some sellers to seek an exit while multiples remain relatively robust.The current market environment is likely to have a mixed impact on bringing sellers to marketWhile market conditions play a role in exit timing, the motives for sellers often encompass more than purely financial considerations. Sellers are often looking to solve for succession issues, improve quality of life, and access organic growth strategies. Such deal rationales are not sensitive to the market environment and will likely continue to fuel the M&A pipeline even in a downturn. And despite years of record-setting M&A activity, the number of RIAs continues to grow—which suggests the uptick in M&A activity is far from played out.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has trended upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquirer models will likely continue to support higher multiples than the industry has in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions. For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions, as in most transactions. But how the deal is financed is often a crucial secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and, in some instances, may still be the best option). Still, there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs. If you are an RIA considering selling: Whatever the market conditions when you go to sell, it is essential to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a broad spectrum of buyer profiles has emerged to accommodate different seller motivations and allow for varying levels of autonomy post-transaction. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision that can significantly impact personal and career satisfaction after the transaction closes.

When business owners think about the value of their firm, they frequently think in terms of the dollar value that they believe they could sell the business for in an arms’ length transaction.  However, the nuances of real world transaction terms in the investment management industry can often obscure what’s being paid for the business on a cash-equivalent basis.  This blog post explores various industry transaction structures employed in the industry and their relationship to fair market value. The value of asset and wealth management firms depends very much on context.  In the valuation community, we refer to the context in which the firm is being valued as the “standard of value.”  A standard of value imagines and abstracts the circumstances giving rise to a particular transaction.  It is intended to control for the identity of the buyer and the seller, the motivation and reasoning of the Transaction, and the manner in which the Transaction is executed. 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 selected as the standard of value in buy-sell agreements for investment management firms.  Fair market value has been defined in many court cases and in Internal Revenue Service Ruling 59-60.  It is defined by the International Valuation Glossary as follows:A Standard of Value is considered to represent 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, each acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or to sell and when both have reasonable knowledge of relevant facts. Notably, the fair market value standard requires that the price be expressed in terms of cash equivalents.  This is consistent with how many business owners think about the value of their business, but it’s inconsistent with the reality of how many real-world transactions are structured.It’s not unusual for investment management transactions to include earnout structures as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive.  If buyer funding is an issue (as it often is in internal transactions), the deal may include deferred payments or seller financing.  It’s also commonplace for the seller to receive all or a portion of their consideration in buyer stock for which there is no active market (if the buyer is private) or which is subject to a lock-up period (if the buyer is public).  In order to reconcile real world deal terms with fair market value, it is necessary to reduce the non-cash deal components into a cash equivalent value.Consider the table below, which describes three transaction structures designed to be illustrative of different deal structure components employed in investment management transactions.  In each case, we assume that the transactions occur between a willing and able buyer and a willing and able seller acting at arms’ length in an open and unrestricted market, when neither is under compulsion to buy or sell and both have knowledge of relevant facts.Each of the three transactions features a $15 million closing payment and potential additional consideration of $5 million, for total possible consideration of $20 million.  In Transaction A, the additional payment is simply deferred for one year, whereas in Transaction B it is contingent on revenue retention, and in Transaction C, it is contingent on revenue growth.  In terms of risk, Transaction A offers the most certainty, with the additional payment contingent only on the buyer’s future creditworthiness.  In Transaction B, the seller must maintain at least 95% of existing revenue into the second year post-closing.  While this is a relatively low bar assuming the firm is able to grow organically and benefits from the upward drift of markets, the payment is at risk if there is significant client attrition or a protracted bear market.  In Transaction C, the additional payment is contingent on the acquired firm achieving sufficient net organic growth and market growth over a three-year period in order to generate an 8% revenue CAGR.In each case, we can infer that the Transaction implies a fair market value somewhere between $15 million on the low end and $20 million on the high end.  To get more precise, it’s necessary to convert future payments into equivalent cash terms.  The methods used for converting contingent consideration to a cash equivalent basis are beyond the scope of this blog post, but as a general rule, the riskier and farther out a payment is, the less such payment is worth on a present value, cash equivalent basis.The figure below illustrates directionally how the transactions compare in terms of the fair market value they imply.  The most certain transaction structure (Transaction A) implies a fair market value closest to the top end of the range ($20 million), but still below due to the time value of money and buyer credit risk.  The least certain structure (Transaction C) implies a fair market value closer to the bottom end of the range, given the relatively high risk of achieving the growth hurdle.  Transaction B is somewhere between the other two transactions in terms of risk and timing of the payment, and as such the implied fair market value lies between the other two.When analyzing real world transactions, it’s important to keep in mind that the headline deal values we see reported are often based on the maximum possible consideration that the seller is eligible to receive under the terms of the purchase agreement.  Such headline values may not be indicative of fair market value to the extent that they are not expressed in terms of cash equivalents.  As the example above illustrates, making reliable inferences about the fair market value implied by transactions in the industry requires a deeper dive to understand the structure of the deal.  Oftentimes, the details of earnout structures are not publicly available, but real world transactions can nevertheless be informative and serve to benchmark thinking regarding the fair market value of investment management firms, provided the transactions are subjected to a proper degree of scrutiny.

We’re often asked by clients what the range of multiples for RIAs is in the current market. At any given time, the range can be quite wide between the least attractive firms and the most attractive firms. The factors that affect where a firm falls within that range include the firm’s margin, scale, growth rate of new client assets, effective realized fees, personnel, geographic market, firm culture, and client demographics (among others). In this post, we focus in on the client demographics factor, explain how buyers view client demographics and explore steps some firms are taking to reach a broader client base. Client relationships are one of the most significant assets that RIAs possess, and maintaining and profitably servicing these client relationships is key to an RIA’s financial success. In a transaction context, the strength of an RIA’s client relationships and the demographics of the client base can have a significant bearing on the multiple buyers will be willing to pay for the firm. An RIA’s outlook for future asset growth can be significantly impacted based on factors such as expected client retention, which stage current clients are at in terms of wealth accumulation (are they withdrawing assets or contributing assets), and the prospect for future liquidity events within the client base.Client relationships are one of the most significant assets that RIAs possessMany of these factors can be proxied by the age profile of the client base. For most RIAs, the age of the client base tends to skew older (particularly on an asset-weighted basis) simply because older clients generally have more assets. Decades of compounding returns can create some very large accounts for older clients, and these accounts can often be profitably serviced by the RIA. However, with an older client base, the asset base is usually declining as these individuals are withdrawing, rather than contributing, additional funds. And, of course, the remaining life expectancy for older clients is less. As such, the age profile of the client base is a key area of inquiry for many buyers.Because an older average client base tends to suggest headwinds for future asset growth, an older client base is generally seen as a negative (all else equal) from a valuation perspective. In general, the younger the client base, the better the outlook for future asset growth and the higher multiple the firm commands. RIAs can expand their reach to a younger client demographic by increasing focus on retaining assets to the next generation and by positioning themselves to appeal to a younger client demographic.Retaining Assets to Next GenerationIn general, RIAs are not particularly successful at retaining assets to the next generation. According to Cerulli, more than 70% of heirs are likely to fire or change financial advisors after inheriting their parents’ wealth. However, firms that make it a priority to engage and develop relationships with next generation family members today can significantly improve asset retention once the assets are transferred from the current client to the next generation. The earlier this is done, the better the chance at retaining assets into the next generation.Focusing on asset retention today is particularly important, given that more than $70 trillion is expected to transfer from older generations to heirs or charities by 2042. RIAs that can capture or retain these assets as they transfer to younger generations will have a competitive advantage against those that cannot.Attracting Younger ClientsA Wall Street Journal article published last year highlighted the struggle many advisory firms face in attracting younger clients. See Rich Millennials to Financial Advisers: Thanks for the Golf Invite, but You Can’t Invest My Money. As the article suggests, many younger clients are electing to manage their own assets rather than hire a traditional financial advisor. While DIY investment management is popular among younger clients, many see this preference as temporary. Once these clients reach an asset or life stage threshold where their financial lives become more complicated, it’s anticipated that the need for traditional, personalized advice will increase.While attracting younger clients can be difficult, there are several strategies RIAs can use to position themselves to capture this emerging client segment. For one, RIAs should recognize that investment expertise is table stakes for attracting younger clients. These clients are often looking for financial coaching and holistic financial advice that goes beyond simple asset allocation. By offering these “soft” services in addition to traditional investment management, RIAs are better positioned to win younger clients.RIAs should recognize that investment expertise is table stakes for attracting younger clientsRIAs can also attract younger clients by hiring younger advisers. Anecdotally, advisers tend to attract clients that are within plus or minus ten years of their own age. Thus, having a broader age range of advisors can unlock younger client segments (and also contribute to the stability and continuity of the firm).RIAs can also reevaluate their marketing strategies to appeal to younger client demographics. As the WSJ headline suggests, golf invites have fallen by the wayside for most younger clients. While referrals and word of mouth are the traditional sources for new clients, having a strong online presence and digital marketing strategy is critical for attracting a younger client demographic.In order to effectively service accounts for a younger client demographic, RIAs may also want to reevaluate how they determine fees for these accounts. While the traditional percentage of AUM model works well for many clients, RIAs may find this model difficult to apply to a younger client demographic. For individuals still in the prime of their working career, it’s not uncommon to see a significant a significant amount of their net worth tied up in privately held companies. The value of these assets is not generally included in AUM, and thus does not generate fee revenue. Other clients may have significant incomes and financial planning needs, but have not yet accumulated an asset base significant enough for an RIA to profitably service the account using a traditional percentage of AUM model. Many firms that have been successful at attracting a younger client demographic are able to offer alternative pricing arrangements in order to account for situations such as these.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, independent trust companies, and related investment consultancies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

As one of the more active acquirors in the investment management industry, Focus Financial Partners (Focus) has a broad perspective into the state of the RIA industry and M&A activity. In the article below, we summarize five key takeaways for RIAs based on Focus’ recent Q2 earnings release.1. Deal Activity Remains Near Record LevelsWhile deal activity declined for the second consecutive quarter in Q2, the pace of deals remains elevated relative to historical levels despite the macro backdrop (see RIA M&A Update). According to data from Echelon Partners, the total deal count in the first half of the year increased 39.2% relative to the first half of 2021. For its part, Focus closed or announced 14 transactions through August 4, 2022, a slight decrease from 17 transactions during the same period in 2021. Focus CEO Rudy Adolf pointed to succession planning, aging founders, and the need for scale as enduring factors that have helped sustain deal activity even in a down market.2. Rising Rates Beginning to Impact Some AcquirorsFocus (along with many other aggregators) uses floating rate debt to finance acquisitions, leaving them exposed to higher borrowing costs as rates rise. All of Focus’ ~$2.5 billion in borrowings are tied to either LIBOR or SOFR at spreads ranging from 175 to 250 bps (although Focus has effectively fixed $850 million of its borrowings via hedges at 262 bps). Focus’ net leverage ratio was 3.90x at June 30 (relative to a target range of 3.5x-4.5x), and it’s Q2 interest expense was $19.9 million. The earnings deck includes a sensitivity analysis that indicates that Focus’ pre-tax interest expense would increase by $11.9 million if LIBOR/SOFR were 300 basis points higher.On an after-tax basis, such an increase works out to about $0.11 per share (Focus’ adjusted net income per share was $0.99 in Q2). Focus’ management doesn’t consider its exposure to increased borrowing costs to be significant relative to the firm’s approximate $2.0 billion in annualized revenue. However, many of the PE-backed aggregators in the industry reportedly run at higher leverage ratios than Focus and have higher borrowing costs, which could lead to financial strain as rates increase and financial performance of the underlying firms takes a hit.3. Deal Competition StabilizingThe proliferation of PE-backed aggregators and the professionalization of the buyer market have led to a significant increase in competition for deals in recent years, but that may be normalizing in the current market. Focus’ CEO Rudy Adolf described competition for deals in Q2 as stabilizing relative to the intensely competitive environment seen last year and indicated that there has perhaps been a softening in multiples and that some of the more aggressive buyers during the flurry of deal activity last year may have slowed down the pace of acquisitions given rising borrowing costs and declining fundamentals of prior acquisitions.4. Margins Are Under PressureWe wrote earlier this year about the two-front assault on RIA margins (see Hot Inflation and Cold Markets: RIAs Hit With a New Storm Front). Not surprisingly, the Focus earnings call confirms that many of its partner firms have been impacted by declining revenues and rising operating costs, and margins have been squeezed as a result. As firms experience the negative effects of operating leverage, they’re faced with the dilemma of whether to cut costs to preserve margins or maintain expenses in order to take advantage of the upside once the macro environment improves. On the earnings call, Focus’ CEO Rudy Adolf indicated that they’re not pressuring partner firms to cut expenses—at least yet—so that they’ll have the necessary resources to take advantage of the eventual upswing.5. Contingent Consideration Taking a HitEarnouts are frequently implemented in RIA transactions in order to bridge the difference between buyer and seller expectations. It’s not uncommon to see a significant portion of total deal proceeds paid after closing and contingent on future performance, and the deals put together by Focus are no exception. When part of the consideration is contingent, the acquiror records a liability equal to the fair value of the contingent consideration payments, and that liability is later remeasured as the fair value changes over the life of the earnout (see Purchase Price Allocations for Asset and Wealth Manager Transactions). In theory, an increase in the fair value of contingent consideration liabilities is a positive for the acquiror since it means that the acquisition target is performing well and more likely to meet its earnout hurdles. From an accounting perspective, however, the reverse is true: increases in the fair value of contingent consideration liabilities are reported as operating expenses, whereas decreases are reported as deductions to operating expenses.Echoing the “bad news is good news” macro environment, write-downs of contingent consideration have boosted the earnings of several acquirers, including Focus this year (see Bear Markets Cost RIA Sellers, But Boost Buyers). In the second quarter, Focus reported a decrease in the fair value of contingent consideration of $42.8 million, which in turn boosted earnings by the same amount. This non-cash write down accounted for nearly 90% of Focus’ $49.3 million in GAAP net income for the second quarter.Also noteworthy is that the total cash that Focus paid for contingent consideration declined from $57.0 million during the six months ending June 30, 2021, to $21.4 million for the same period in 2022. While the timing of earnout payments is subject to the specific terms of each deal, we find it interesting that the cash earnout payments of a firm that’s consistently grown via acquisitions declined by more than half year-over-year. For RIA sellers, the significant decrease in cash paid for contingent consideration along with write downs of contingent consideration reported by Focus (and other acquirors) serve as a stark reminder that headline deal multiples aren’t always what they seem, particularly in down markets.

Schwab recently released its 2022 RIA Benchmarking Study. The survey contains responses from over 1,200 RIAs representing $1.8 trillion in AUM to questions about firm operating performance, strategy, and practice management. The survey is a great resource for RIA principals to see how their firm’s performance and direction measure up against the average firm. We have highlighted some of the key results from the study below. You can download the full survey here.Firm PrioritiesAs part of the survey, Schwab asked RIA principals to rank the top priorities for their RIA. Perhaps unsurprisingly, amidst the Great Resignation and continued tight labor market, recruiting staff to increase the firm’s skill set and capacity became the top-ranked priority for respondent firms in 2022.Acquiring clients through client referrals and business referrals remained key focus points in 2022, ranking second and third, respectively. Enhancing strategic planning and execution ranked fourth, followed by productivity improvements at number five and acquiring new clients through digital channels at number six.Employee RetentionFirms over $250 million reported a median staff attrition rate of 6.5%, while top performing firms reported a median staff attrition rate of 0%. The survey indicates that top performing firms are more likely to have nontraditional benefits packages and offer more professional development and career support opportunities, which suggests that such benefits may help to promote staff retention.GrowthThe firms participating in the survey have seen strong five-year growth on average. Between 2016 and 2021, AUM grew at a compound annual growth rate (CAGR) of 14.1%, while revenue and number of clients grew at a respective 11.3% and 5.1% CAGR over the same time period. The top-performing firms (Schwab defines this as the top 20% based on a holistic assessment across key business areas) saw more robust AUM growth than other firms due to extraordinarily strong net organic growth. AUM growth has outpaced revenue growth consistently in recent years, suggesting that there has been some compression in the fees realized by respondent firms. All of the RIA size categories identified in the survey reported double-digit annualized growth in AUM over the last five years, although firms managing less than $2.5 billion in AUM generally experienced marginally higher growth than firms over $2.5 billion in AUM.M&AM&A contributed to growth for many firms over the last five years. 6% of firms acquired new clients by M&A in 2021, and 21% of firms have completed an acquisition in the last five years. Over the past five years, 27% of firms gained new clients by bringing on an advisor with an existing book of business.Succession PlanningSuccession planning is a key concern for the industry, particularly since only 55% of firms under $250M AUM have a written succession plan. The number increases slightly to 65% for firms over $250M AUM and 80% for top performing firms. Eventually, of course, all of these firms will need an exit strategy for the partners, whether through internal succession or a sale to a third party.As indicated by the Schwab survey, many RIAs lack a written succession plan, but it’s nevertheless a critical issue that all firms will have to face eventually. For more information on RIA succession planning, refer to our whitepaper, Buy-Sell Agreements for Wealth Management Firms.ProductivityRespondent firms reported increases in productivity between 2019 and 2021. Over this period, AUM per professional increased from $99 million to $112 million, and the number of clients per professional increased from 53 to 59. Also, over this period, hours per client for operations and administration decreased from 17 to 16, while hours per client for client service decreased from 34 to 31, suggesting that firms have continued to improve efficiency.

Year-to-date RIA M&A activity has surpassed last year’s record levels so far in 2022 even as macro headwinds for the industry continue to mount. Fidelity’s May 2022 Wealth Management M&A Transaction Report listed 93 deals through May of 2022, up from 72 during the same period in 2021. These transactions represented $135 billion in AUM, up 12% from 2021 levels.The continued strength of RIA M&A activity amidst the current environment dominated by inflation, rising interest rates, and a tight labor market is noteworthy given that all of these factors could put a strain on the supply and demand dynamics that have driven deal activity in recent years. Rising costs and interest rates coupled with a declining fee base will put pressure on highly-leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. Despite these pressures, the market has proven robust (at least so far). Demand for RIAs has remained strong, with the professionalization of the buyer market continuing to be a theme driving M&A activity. Deal volume is increasingly driven by serial acquirers and aggregators with dedicated deal teams and access to capital. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the first five months of the year. This group of companies, along with other strategic acquirers and consolidators, have continued to increase their share of industry deal volume and now account for about half of all deals. In addition to driving overall industry deal volume, the proliferation of strategic acquirers and aggregator models has led to increased competition for deals throughout the industry. This has contributed to multiple expansions and shifts to more favorable deal terms for sellers in recent years. While there are some signs that deal activity from these acquirers may slow down (CI Financial’s CEO Kurt MacAlpine remarked on the company’s first quarter earnings call that their pace of acquisitions has “absolutely slowed down”), we’ve not yet seen that borne out in the reported deal volume.On the supply side, the motives for sellers often encompass more than purely financial considerations. Sellers are often looking to solve succession issues, improve quality of life, and access organic growth strategies. Such deal rationales are not sensitive to the market environment, and will likely continue to fuel the M&A pipeline even in a downturn. And despite years of record setting M&A activity, the number of RIAs continues to grow—which suggests the uptick in M&A activity is far from played out.Whatever net impact the current market conditions have on RIA M&A, it may take several months before the impact becomes apparent in reported deal volume given the often multi-month lag between deal negotiation, signing, and closing. But at least through May, transaction activity has remained steady or even surpassed last year.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has continued to trend upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquiror models will likely continue to support higher multiples than the industry has been accustomed to in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions.For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions as they are in most transactions. But how the deal is financed is often an important secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs.If you are an RIA considering selling: After years of steadily increasing multiples and fundamental performance, RIA valuations are now at or near all-time highs. But whatever the market conditions when you go to sell, it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a wide spectrum of buyer profiles has emerged to accommodate different seller motivations and allow for different levels of autonomy post transaction. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision, and one which can have a significant impact on personal and career satisfaction after the transaction closes.

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.The effects of an RIA's compensation model are far-reaching, determining not only how compensation is allocated amongst employees, but also how a firm's earnings are split between shareholders and employees, what financial incentives employees have to grow the business, and what financial incentives are available to attract new employees and retain existing employees.Compensation models at RIAs tend to be idiosyncratic, reflecting each firm's business model, ownership, and culture. In an ideal world, these compensation programs evolve purposefully over time in response to changes in the firm's size, profitability, labor market conditions, and various other factors. However, inertia is a powerful force: we often encounter compensation programs that made sense in the past but haven't adapted to serve the firm's changing needs as the business has grown in scale and complexity.Effective compensation programs need to change with the times, and the times have certainly changed. The RIA industry has seen tremendous growth over the last decade. As a result, firms today face increasingly complex compensation decisions that affect a growing list of stakeholders: outside shareholders, multiple generations of management, retiring partners, new partners, possible minority investors, and so on. On top of that, a persistent bull market and the accompanying earnings growth over the preceding decade have made it relatively easy to appease both shareholders and employees. Now, financial market conditions and the state of the labor market have led many RIAs to scrutinize their compensation models more than ever before.Introduction to RIA Compensation ModelsAt the outset, it's important to note what compensation models do and don't do. Compensation models determine how the firm's earnings are allocated; they don't (directly) determine the amount of earnings to be allocated. When it comes to determining who gets what, it's a fixed sum game. The objective of an effective compensation policy is to allocate returns in such a way as to increase this sum over time.Compensation for RIAs are broken down into three basic components, each of which serves different functions with respect to incentivizing, attracting, and retaining employees:Base salary / Benefits. This is what an employee receives every two weeks or so. It's fixed in nature and is paid regardless of firm or employee performance over the short term. On its own, base salary provides little incentive for employees to grow the value of the business over time.Variable Compensation / Bonus. In theory, variable compensation can be tied to any metric the firm chooses. The amount of variable compensation paid to employees varies as a function of the chosen metric(s). Variable compensation is also called at-risk compensation because all or part of it can be forfeited if target thresholds are not met. Variable compensation is most often paid out on an annual basis.Equity compensation. Equity incentives serve an important function by aligning the interests of employees with that of the company and its shareholders. While base salary and annual variable compensation serve as shorter-term incentives, equity incentives serve to motivate employees to grow the value of the business over a longer time period and play an important role in increasing an employee's ties to the firm and promoting retention.Variable CompensationIn this blog post, we focus our attention on the variable compensation component (we'll address the others in subsequent posts).Variable compensation plays an important role in incentivizing employees over the relatively short term (1-3 years). The evidence suggests that such incentives work, too: According to Schwab's 2021 RIA Compensation Report, firms using performance-based incentive pay saw 25% greater AUM growth, 134% greater client growth, 54% greater revenue growth, and 52% greater net asset flows over a five year period than firms without performance-based incentives.What Do You Want to Incentivize?As the name suggests, variable compensation changes as a function of some selected metric, typically revenue, profitability, or some other firm-level metric or individual-level metric, depending on the specific aspects that management intends to incentivize.In our experience, variable compensation pools tied to firm profitability and allocated amongst employees based on a combination of individual responsibilities and performance provide the most effective incentives for most firms to grow the value of the business over time. Such structures tend to work well because linking variable comp to profitability creates a durable compensation mechanism that scales with the business and aligns shareholders' and management's financial and risk management objectives. Variable comp linked to profitability also promotes a cohesive team, rather than the individual silos that can arise out of revenue-based variable comp, which further helps to build the value of the enterprise.In markets like today's, where RIA margins face the dual threat of rising costs and declining AUM, compensation mechanisms that directly link employee pay to firm profitability have the additional benefit of helping to blunt the impact of market conditions on firm profitability. Consider the example below, which shows the impact of a 10% AUM increase and a 10% AUM decrease for a hypothetical firm under two comp programs, one in which all compensation is fixed and the other in which there is a variable bonus pool equal to 20% of pre-bonus profitability.Click here to expand the image above.In this example, both compensation programs result in $4 million in EBITDA and an EBITDA margin of 24.6% in the base case scenario. In the downside scenario, however, the fixed comp structure leads to a high degree of operating leverage. As a result, a 10% drop in AUM leads to a decline in EBITDA of over 40% and a decline in the EBITDA margin to 16.2%. Under the variable comp structure, the variable bonus pool helps to mute the impact of declining AUM. In this example, a 10% decline in AUM results in a 32.5% decrease in EBITDA and a decline in the EBITDA margin to 18.5% under the variable comp program. In the upside scenario, the increase in EBITDA is greater under the fixed comp structure than under the variable comp structure (an increase of 40.6% vs. 32.5%).From a shareholder perspective, a variable compensation program such as the one described above effectively transfers some of the risk borne by equity holders to the firm's employees. In downside scenarios, some of the declines in profitability that would otherwise accrue to shareholders is absorbed by employees. Similarly, some of the increase in profitability is allocated to employees in upside scenarios. The logic of such a compensation program is that employees are incentivized to grow and protect the same metric that shareholders care about—the firm's profitability.ConclusionInvestment management is a talent business, and structuring an effective compensation program that allows the firm to attract, retain, and incentivize talent is critical to an RIA's success. In the coming posts, we'll address additional compensation considerations such as equity compensation options and allocation processes.

RIA M&A activity and multiples have trended upwards for more than a decade now, culminating in new high watermarks for both activity and multiples set late last year. Deal momentum continued strong into the first quarter, but we sense at least initial signs of slowing as the macroeconomic backdrop has deteriorated.What Does the Future Hold for RIA M&A?On CI Financial’s first quarter earnings call last week, CEO Kurt MacAlpine remarked that the company’s acquisition pace has “absolutely slowed down” relative to 2021 as they focus on integrating existing firms and delivering.  We suspect that other serial acquirers will follow a similar path as CI this year, particularly in light of rising interest rates and declining fundamentals for existing firms.  Add to that the challenges of negotiating a deal when equity markets are swinging as wildly as they have been, and it’s easy to imagine at least a temporary slowdown in the pace of M&A in the coming months.The driving force in recent years has been strong demand and low supply for investment management firmsWill we look back at 2021 as the year RIA transactions peaked, or is the current slowdown merely a blip on the radar amidst a longer-term trend of consolidation and rising valuations?  To look forward, it’s helpful to first consider what shaped the RIA transactions landscape over the last decade.  In short, the driving force in recent years has been strong demand and low supply for investment management firms.  On the demand side, the amount of capital and number of acquirer models has increased rapidly in recent years as investors have sought out the high margins, strong growth profile, and low capital intensity that the fee-based business model offers.At the same time, the number of RIAs in the market for a third party acquirer has remained limited, despite the industry’s often cited lack of succession planning.  As the ratio of buyers to sellers has increased, so too have multiples and transaction activity.We don’t see those long-term supply and demand dynamics changing with the current market environment.  Certainly, some buyers (like CI) will be sidelined temporarily, but they’re still around.  When markets eventually stabilize, it’s more than plausible that transaction activity will return to the long-term trendline.What About Multiples?Supply and demand dynamics have certainly played a role in the rising multiples we’ve seen over the last decade, but the macroeconomic backdrop has added fuel to the fire as well.  The era of extremely low interest rates lowered the cost of capital for acquirors and enabled consolidators to finance RIA acquisitions with cheap debt.  And a persistent bull market has made it easy for buyers to justify projections that look like something out of a SPAC deck.A persistent bull market has made it easy for buyers to justify projections that look like something out of a SPAC deckSo far this year, margins for RIAs have been attacked on two fronts: falling equity markets eroded the fee base, while high inflation and a tight labor market threatened to drive up personnel costs and other overhead.  There’s a lot that goes in to pricing, but it’s safe to say that on many recent transactions, the buyer’s projection model likely looked very different than what’s actually transpired so far this year.  While many of these deals may work out in the long term, chances are there are sellers out there who feel they timed things perfectly, and some buyers that feel they’ve been left holding the bag.With the cost of capital for aggregators rising rapidly and the growth outlook for RIAs declining, we expect to see some multiple contraction relative to the high watermarks seen last year.  And while private transactions for wealth management firms have historically been priced very differently than public asset/wealth management firms, it’s equally likely that at least some of the decline we’ve seen in the public firms will translate to the private markets.There’s still much uncertainty about the duration of the current market environment and the ultimate impact it will have on RIA performance and transaction activity.  As it stands, a near-term slowdown in transaction activity and multiples seems likely, but so too does a return to normal once markets stabilize.

RIA M&A activity continued to trend upward through the first quarter of 2022 even as potential macro headwinds for the industry emerged. Fidelity’s March 2022 Wealth Management M&A Transaction Report listed 58 deals in the first quarter, up 26% from the first quarter of 2021. These transactions represented $89.2 billion in AUM, down 2% from the prior year quarter.Deal volume continues to be led by serial acquirers and aggregators. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the quarter. This group of companies, along with other strategic acquirers and consolidators, have continued to increase their share of industry deal volume and now account for about half of all deals. In addition to driving overall industry deal volume, the proliferation of strategic acquiror and aggregator models has led to increased competition for deals throughout the industry, which has contributed to multiple expansion and shifts to more favorable deal terms for sellers in recent years. While deal activity remained robust, the first quarter this year was dominated by macro headlines like inflation, rising interest rates, tight labor markets, and multiple contraction in equity markets—all of which are factors that have potential to impact RIA performance and M&A activity. Rising costs and interest rates coupled with a declining fee base could lead to strain on highly-leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. While the duration and extent to which these trends will ultimately impact RIA M&A are still uncertain, recent pricing trends for publicly traded consolidators suggest that investors aren’t particularly optimistic about these models in the current environment. On the other side of the equation, historically tight labor markets and rising costs could amplify certain acquisition rationales like talent acquisition and back-office synergies. Structural trends continue to support M&A activity as well: the RIA industry remains highly fragmented and growing with over 13,000 registered firms and more money managers and advisors who are capable of setting up independent shops. As advisors age, succession needs will likely continue to bring sellers to market. Whatever net impact the current market conditions have on RIA M&A, it may take several months before the impact becomes apparent in reported deal volume given the often multi-month lag between deal negotiation, signing, and closing. But at least through March, transaction activity has remained steady. The Fidelity report lists 19 deals in March, a record level for the month and in line with the levels reported in January and February.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has continued to trend upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquiror models will likely continue to support higher multiples than the industry has been accustomed to in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions. For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions as they are in most transactions. But how the deal is financed is often an important secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs. If you are an RIA considering selling: After years of steadily increasing multiples and fundamental performance, RIA valuations are now at or near all-time highs. But whatever the market conditions when you go to sell, it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a wide spectrum of buyer profiles has emerged to accommodate different seller motivations. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision, and one which can have a significant impact on personal and career satisfaction after the transaction closes.

In recent years, there’s been a great deal of interest in RIA acquisitions from a diverse group of buyers ranging from consolidators, other RIAs, banks, diversified financial services companies, and private equity. Due to the high margins, recurring revenue, low capital needs, and sticky client bases that RIAs often offer, these acquirers have been drawn to RIA acquisitions. Following these transactions, acquirors are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.A purchase price allocation is just that—the purchase price paid for the acquired business is allocated to the acquired tangible and separately-identifiable intangible assets. As noted in the following figure, the acquired assets are measured at fair value. The excess of the purchase price over the identified tangible and intangible assets is referred to as goodwill. Transaction structures involving RIAs can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset and wealth management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fees, profit margins, etc). It is important to understand how the characteristics of the asset management industry in general and those attributable to a specific firm influence the values of the assets acquired in these transactions. Because most investment managers are not asset intensive operations, the majority of value is typically allocated to intangible assets. Common intangible assets acquired in the purchase of private asset and wealth management firms include the existing customer relationships, tradename, non-competition agreements with executives, and the assembled workforce.Customer RelationshipsGenerally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base.Due to their long-term nature, relatively low attrition rates, and importance as a driver of revenue in the asset and wealth management industries, customer relationships often command a relatively high portion of the allocated value. We can see this in the public filings of RIA aggregator Focus Financial. Between 2017 and 2021, Focus completed 130 acquisitions of RIAs. Of the aggregate allocated consideration for these transactions, a full 51% was allocated to customer relationships. Most of the remainder (48%) was allocated to goodwill.TradenameThe deal terms we see employ a wide range of possible treatments for the tradename acquired in the transaction. The acquiror will need to decide whether to continue using the asset or wealth manager’s name into perpetuity or only use it during a transition period as the acquired firm’s services are brought under the acquirer’s name. This decision can depend on a number of factors, including the acquired firm’s reputation within a specific market, the acquirer’s desire to bring its services under a single name, and the ease of transitioning the asset/wealth manager’s existing client base. In any event, for most relatively successful small-to-medium sized RIAs, the tradename has some positive recognition among the customer base and in the local market, but typically lacks the “brand name” recognition that would give rise to significant tradename value.In general, the value of a tradename can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the tradename value.Noncompetition AgreementsIn many asset and wealth management firms, a few top executives or portfolio managers account for a large portion of new client generation. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the covered individuals from soliciting business from existing clients or recruiting current employees of the company. In the agreements we’ve observed, a restricted period of two to five years is common. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. Factors driving the likelihood of competition include the age of the covered individual and whether or not the covered individual has other incentives not to compete aside from the legal agreement (for example, if the individual is a beneficiary of an earn-out agreement or received equity in the acquiror as part of the deal, the probability of competition may be significantly lessened).Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in relationship-based industries like asset and wealth management, getting a new portfolio manager or advisor up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. The ability of employees to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network may often command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the value of a assembled workforce is valued as a component of valuing the other assets. Under current accounting standards, the assembled workforce value is not recognized or reported separately, but rather is included as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset or wealth manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for RIA acquirors, we frequently see earnouts structured into the deal as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional clients, assets, or product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the acquirer, while rewarding the seller for meeting or exceeding growth expectations. Earnout arrangements represent a contingent liability for the acquiror that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation and transaction work for the investment management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.

So much for transitory: February's CPI growth came in at 7.9% year-over-year (the highest level in recent memory), and the ongoing Ukraine conflict portends further supply chain challenges that could drive prices even higher.  The front-end of the yield curve has shifted higher as market participants reason that rising inflation will force the Fed to raise rates sooner and by a greater magnitude than had been previously anticipated.Historically, a flattening yield curve has signaled an end to a growth cycle, and so far in 2022 that certainly seems plausible.  Markets are down and valuation multiples have declined significantly, particularly in high-flying tech stocks.  So, what does all of that mean for the RIA industry?Revenue Impact on RIAsAlmost all wealth management and asset management firms employ a revenue model where fees are based on a percentage of AUM.  Such a model is unique in that it’s not directly linked to the cost of doing business.  In many other industries, there is a far more direct link between pricing and the cost of doing business.  If a widget manufacturer’s cost of making a widget goes up, it raises prices to compensate.  If a bank’s cost of borrowing goes up, it raises interest rates.  And so on.For RIAs, revenue changes with the value of client assets, not the cost of doing business.  While larger accounts are often more complicated (and costly) to manage than smaller accounts, the relationship between the cost to manage an account and the value of an account is not linear.  If, for example, a $20 million account decreases to $10 million, the cost of managing that account is unlikely to drop by half.  The consequence is margin pressure.The percentage of AUM revenue model works well for the RIA industry because it aligns interests between clients and advisors (fees increase when the value of a client’s assets increases).  In times of rising markets, the percentage of AUM revenue model is an enviable one: market growth can drive revenue growth that is largely decoupled from the cost of doing business, which has allowed significant margin expansion and profit growth in the industry.This operating leverage is the secret sauce of RIA margin expansion.  In recent years, market growth alone has contributed to 10-15% annual revenue growth at many firms—far outpacing formerly modest inflation effects.  Even many firms with negative organic growth have seen growing revenues and profitability as market growth has more than offset client outflows.Current market conditions, however, demonstrate the downside of the “percentage of AUM” revenue model.  Through March 8th, the Russell 3000 index was down over 14% year-to-date.  For all but the most rapidly growing RIAs, organic growth will have done little to offset the market decline this year.  Tiered fee structures may help mitigate the impact (the first dollar of AUM lost is often at a lower fee rate than the firm’s overall rate), but run-rate revenue for many RIAs has likely still taken a significant hit so far this year.  RIAs often bill on a quarterly schedule, so the impact of the current market downturn may not have been felt yet, but it will soon absent a significant turnaround.  Operating leverage works both ways.While RIAs have little control over market movement, they do have control over their fee schedules and fee discipline.  If there were ever a time to increase fees, now would (theoretically) be the time.  Everyone is experiencing rising costs across nearly every aspect of their lives, so price increases are to be expected.  But RIAs are in an awkward spot when seeking to raise their fees—the whole point of the “percentage of AUM” revenue model is that the fees paid scale with the value of the account.Informing clients of increasing fee schedules at a time when their account value is down significantly is unlikely to be well received despite the familiarity of price increases elsewhere.  When you combine that with the secular trend of declining fees in the investment management industry, we think that the ability of firms to raise their fee schedules is somewhat limited.  For new clients, there may be more flexibility to remain disciplined on stated fee schedules in order to more closely align the price of investment advice with the cost of delivering it.Cost Structure ImpactAt the same time that revenue is declining, the fixed cost base for RIAs is facing significant upward pressure.  Tech and software vendors, landlords, professional service firms, and the like are all raising prices at the fastest pace in decades to reflect their own higher costs of doing business and strong demand.  While it takes time for these price increases to make their way to an RIA’s P&L, rising costs seem unavoidable for many RIAs unless inflation retreats significantly.  With rising costs and declining revenue, the potential for margin compression if the current environment continues is very real.Most significantly, compensation costs (the largest component of an RIA’s cost structure) are under pressure given the extremely tight labor market and record turnover.  RIAs will need to balance increasing compensation costs in order to retain key employees with firm profitability.  We’ve said it often in the past, but compensation mechanisms that directly link employee pay to firm profitability (e.g., through a variable bonus pool or equity compensation) not only help to attract and retain key employees, but also help to preserve margins when revenue declines.  How to best structure compensation packages to weather environments like today’s is a topic for another blog post, but it suffices to say here that we see firms with well-structured compensation packages that balance short term (salary), medium term (bonus), and long term (equity) incentives as having a competitive advantage in tight labor markets and volatile financial markets alike.M&A and Deal ActivityM&A activity and consolidation in the RIA industry is driven largely by long-term, secular trends like aging founders, lack of succession planning, and gaining access to the benefits of scale and broader service capabilities.  As such, the longer-term trends in deal activity are likely to continue.  In the short run, however, we could see an impact on M&A deal volume and pricing depending on the duration of continued inflation and the current market downturn.  If revenue declines and margin contraction persists, we may see sellers delay going to market in order to wait for performance to rebound.  For deals that do occur, multiples at the top-end of the current range may come under pressure without the backdrop of a market updrift to rationalize premium pricing.Further, there is the potential for RIA aggregator models (which account for a significant portion of total industry deal activity) to come under pressure if the current market environment continues.  These firms typically rely on floating rate debt and high leverage to acquire RIAs, leaving them particularly exposed if the performance of the underlying firms deteriorates or if interest rates increase.So far, we haven’t seen any downturn in deal activity.  Fidelity’s monthly Wealth Management M&A Transaction Report listed 13 transactions in February, a record level for the month.  But, as we saw in 2020, there can be a lag between market activity and a noticeable impact on deal volume due to the multi-month process between deal negotiations, signing, and close.  Recent market pricing of public RIA aggregators isn’t terribly encouraging; their cost of capital is going up rapidly – but that too is a topic for another post.There’s still much uncertainty about the duration of the current market environment and the ultimate impact it will have on RIA performance.  The upshot to all of this is that revenue growth in recent years has far outpaced the cost of doing business for most firms, allowing margins to expand to healthy levels.  As a result, many firms today are well positioned for a potential downturn given their robust margins and ample cushion to absorb possible revenue declines while remaining profitable.

Working on your RIA’s buy-sell agreement may seem like an inconvenience, but the distraction is minor compared to the disputes that can occur if your agreement isn’t structured appropriately. Crafting an agreement that functions well is a relatively easy step to promote the long-term continuity of ownership of your firm, which ultimately provides the best economic opportunity for you and your partners, employees, and clients. If you haven’t looked at your RIA’s buy-sell agreement in a while, we recommend dusting it off and reading it in conjunction with the discussion below.Decide What’s FairA standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all the parties in the agreement. That’s easier said than done because fairness means different things to different people. The stakeholders in a buy-sell scenario at an investment management firm typically include the founding partners, subsequent generations of ownership, the business itself, non-owner employees of the business, and the clients of the firm. It is nearly impossible to be “fair” to that many different parties, considering their different motivations and perspectives.Clients. Client relationships are often the single most valuable asset that an asset or wealth management firm possesses, and avoiding internal disputes is crucial to maintaining these relationships. Beyond investment advice, clients pay for an enduring and trusting relationship with their investment manager. As the profession ages and ownership transitions to a new generation of management, we see a well-functioning buy-sell agreement and broader succession planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded).Founding owners. Aside from wanting the highest possible price for their interest in the firm, founding partners usually want to have the flexibility to work as much or as little as they want to, for as many years as they so choose. These motivations may be in conflict with each other, as winding down one’s workload into a state of partial retirement and preserving the founding generation’s imprint on the company requires a healthy business, which in turn requires consideration of the other stakeholders in the firm.Subsequent generation owners. The economics of a successful investment management firm can set up a scenario where buying into the firm can be very expensive, and new partners naturally want to buy as cheaply as possible. Eventually, however, there is a symmetry of economic interests for all shareholders, and buyers will eventually become sellers. Untimely events can cause younger partners to need to sell their stock, and they don’t want to be in a position of having to give it up too cheaply.The firm itself. The company is at the hub of all the different stakeholder interests and is best served if ownership is a minimal distraction to the operation of the business. Since handwringing over ownership rarely generates revenue, having a functional shareholders’ agreement that reasonably provides for the interests of all stakeholders is the best-case scenario for the firm. If firm leadership understands how ownership is going to be handled now and in the future, they can be free to focus on maximizing the performance of the company while at the same time avoiding costly disputes over ownership.Non-owner employees. Not everyone in an investment management firm qualifies for ownership or even wants it, but all RIAs are economic eco-systems in which all employees depend on the presence of stable and predictable ownership. The point of all this is to consider whether or not you want your buy-sell agreement to create winners and losers, and if so, be deliberate about defining who wins and who loses. Ultimately, economic interests which advantage one stakeholder will disadvantage some or all of the other stakeholders. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that at the expense of the other partners and anyone buying into the firm. If pricing is too high, internal buyers may not be available, and the firm may need to be sold to perfect the agreement. At relatively low valuations, the internal transition is easier, and business continuity is more certain, but the founding generation of ownership may be perversely encouraged not to bring in new partners, stay past their optimal retirement age, or push more cash flow into the compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an investment management firm is always a balancing act, but one which is typically best done intentionally.Define the Standard of ValueStandard of value is an abstraction of the circumstances giving rise to a particular transaction. It imagines the type of buyer, the type of seller, their relative knowledge of the subject asset, and their motivations or compulsions. Identifying and clearly defining the standard of value in your buy-sell agreements will save time and money when triggering events occur.Portfolio managers are familiar with certain perspectives on value, such as market value (the price at which a company’s stock trades) and intrinsic value (what they think the security is worth, based on their own valuation model). None of these standards of value are particularly applicable to buy-sell agreements, even though technically they could be. Instead, valuation professionals such as our group 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, among others.Identifying and clearly defining the standard of value in your buy-sell agreements will save time and money when triggering events occur.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 benefit of the fair market value standard is familiarity in the appraisal community and the court system. It is arguably the most widely adopted standard of value, and for a myriad of buy-sell transaction scenarios, the perspective of disinterested parties engaging in an exchange of cash and securities for rational financial reasons fairly considers the interests of everyone involved.For most buy-sell agreements, we would recommend one of the more common definitions of fair market value.The standard of value is critical to defining the parameters of a valuation. We would suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of an ambiguous or home-brewed definition can be severe. 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 discussion on the implications of the standard, which makes application to a given buy-sell scenario clearer.Define the Level of ValueValuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest. From a practical perspective, the “level of value” determines whether any discounts or premiums are applied to a baseline marketable minority level of value. Given the potential for valuation disputes regarding the appropriate level of value, buy-sell agreements function best when they memorialize the parties’ understanding of what level of value will be used in advance of a triggering event occurring.Most portfolio managers and financial advisors will already be familiar with the concept of “levels of value,” but they may be unfamiliar with the terminology used in the valuation profession to describe these levels. A minority position in a public company with active trading typically transacts as a pro rata participant in the cash flows of the enterprise because the present value of those cash flows is readily accessible via an organized exchange. This is known as the “marketable minority” level of value in the appraisal world. Portfolio managers usually think of value in this context until one of their positions becomes subject to acquisition in a takeover by a strategic buyer. In a change of control transaction, there is often a cash flow enhancement to the buyer and/or seller via combination, such that the buyer can offer more value to the shareholders of the target company than the market grants on a stand-alone basis. The difference between the publicly traded price of the independent company and the value achieved in a strategic acquisition is commonly referred to as a control premium.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 discount for 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 investment management firm and specify what level of value is appropriate for the buy-sell agreement. Fairness is a consideration here, as is the sustainability of the firm. 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 investment management firms, the owners joined together at arms’ length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. That works well for the founders’ generation, but often the transition to a younger and less economically secure group of employees is difficult at a full enterprise-level valuation.In any event, the buy-sell agreement should consider the economic implications to the investment management firm and specify what level of value is appropriate for the buy-sell agreement.Further, younger employees may not be able to get comfortable with buying a minority interest in a closely held business at a valuation that approaches change of control pricing. Typically, there is often a bid/ask spread between generations of ownership that has to be bridged in the buy-sell agreement, but how best to do it is situation-specific. Whatever the case, the shareholder agreement needs to be very specific as to the level of value.Does the pricing mechanism create winners and losers? Should value be exchanged based on a control level 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 firm's continuity. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to retain their ownership longer and force out other shareholders artificially. 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. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.ConclusionKeeping the above considerations in mind when drafting or updating your buy-sell agreement will help create a document that promotes the sustainability and orderly ownership transition of the firm while balancing the interests of the firm’s various stakeholders and the firm itself. However, this is far from an exhaustive list of things to consider when constructing your buy-sell agreement. In next week’s post, we’ll discuss additional parameters that should be addressed when constructing your buy-sell agreement.

The asset management industry fared well in 2021 against a backdrop of rising markets and improved net inflows.  Strong performance in equity markets was a major contributor to this performance.  The S&P 500 index was up nearly 30% during the year, suggesting that many asset management firms saw significant increases in AUM driven by market movement and ended the year with assets (and run rate revenue) at or near all-time highs.As asset management firms are generally leveraged to the market, market movements tend to have an amplified effect on asset management firm fundamentals.  Our index of publicly traded asset/wealth management firms reflected this in 2021, with the index generally outperforming the S&P 500 throughout the year and ending the year up just over 30%.  While multiples saw modest improvement over this period, much of this outperformance was driven by rising fundamentals.Our index of asset/wealth management aggregators also improved significantly during 2021, ending the year up nearly 40% driven by strong performance in the underlying businesses in which aggregators invest.  Alternative asset managers led the way, however, with this index increasing nearly 90% during 2021 driven by strong net inflows due to increasing investor demand for alternative assets.Return of Organic GrowthWhile market movement is often the dominant contributor to changes in AUM over a particular time period, it affects all asset managers in a particular asset class more or less equally and is (to some extent) outside of a manager’s control.  Organic growth, on the other hand, can be influenced by the quality of a firm’s marketing and distribution efforts and can be a real differentiator between asset management firms over longer time periods.Many asset managers have struggled with organic growth in recent years, in part due to rising fee sensitivity and the influence of passively-managed investment products.  Despite these headwinds, organic growth for our index of publicly traded asset/wealth management companies improved modestly during the nine months ending September 30, 2021 relative to the same period in 2020 (see chart below).In aggregate, these firms saw net outflows of $75 billion during the first three quarters of 2020, compared to aggregate net inflows of $49 billion during the first three quarters of 2021.  While this improvement in organic growth is modest in absolute terms, the switch from net outflows to net inflows is a positive sign for the industry, indicating that these firms were able to grow AUM on an aggregate basis even in the absence of market movement.Fund Flows by SectorWhile overall organic growth improved in 2021, there were significant variances by asset class.  Fund flow data from Morningstar (table below) shows that total inflows across active funds for the year ended November 30, 2021 were approximately $287 billion (relative to aggregate outflows of $188 billion in 2020).  The aggregate inflows in 2021 were concentrated in fixed income, alternative assets, and international equity funds, while US equity funds shed nearly $200 billion in assets over the period.  For perspective, all categories of actively managed funds except taxable bonds and municipal bonds saw net outflows in 2020.Notably, passively managed funds continued to outpace active funds in terms of net new assets in 2021.  This trend will likely continue to pose a challenge for many types of active asset managers in attracting new assets.Improving OutlookThe outlook for asset managers depends on several factors.  Investor demand for a particular manager’s asset class, recent relative performance, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents.  Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets.  Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing and on the performance of the underlying businesses.On balance, the outlook for asset managers has generally improved with market conditions over the last year.  AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well.  Modest improvements in organic growth are also a positive sign for active asset managers that bodes well for continued strong performance in 2022.

An RIA’s margin is a simple, easily observable figure that encompasses a range of underlying considerations about a firm that are more difficult to measure, resulting in a convenient shorthand for how well the firm is doing. Does a firm have the right people in the right roles? Is the firm charging enough for the services it is providing? Does the firm have enough–but not too much—overhead for its size? The answers to all these questions (and more) are condensed into the firm’s margin.What Is a “Typical Margin”?We’ve seen a wide range of margins for RIAs. Smaller firms with too much overhead and not enough scale might see no profitability or even negative margins. On the other hand, an asset manager with rapidly growing AUM and largely fixed compensation expenses might see margins of 50% or more. The “typical” margin for RIAs depends on the context. As the chart below illustrates, different segments of the investment management industry typically have different margins based on the risk of the business model (among other factors). At one end of the spectrum are hedge funds, venture capital firms, and private equity managers. The high fees these companies generate per dollar invested can support very high margins, but the risks of client concentrations, underperformance, and key staff dependence are significant. Traditional institutional asset managers are somewhere in the middle of the spectrum. When these companies get it right, institutional money can pour in rapidly. A successful institutional asset manager may find themselves managing billions more in assets while staffing remains virtually unchanged. The additional fees flow straight to the bottom line, and margins can be robust as a result. But the risks are significant. Institutional money can leave just as quickly as it came if the manager’s asset class falls out of favor or if performance suffers. At the lower end of the margin spectrum are more labor-intensive disciplines like wealth management and independent trust companies. For these businesses, bringing on additional clients translates directly into increased workload for staff, which will ultimately translate into higher staffing levels and compensation expense as the business grows. While margins are lower, the risk is less. Key person risk is also less, because an individual’s impact is generally limited to the clients they manage, and not the entire firm’s investment strategy. Client concentration is less of a problem, because wealth management firms tend to have a large number of HNW clients rather than a few large institutional clients. Performance risk is generally less of a concern as well. Does a Firm’s Margin Affect What It’s Worth?A high margin conveys that a firm is doing something right. But what really matters from a buyer’s perspective is not what the margin is now, but what it will sustainably be in the future. Consider the three scenarios below. In Scenario A, the EBITDA margin starts relatively low (15%), but improves over time. In Scenario B, the margin starts at a higher level (25%) but remains constant. In Scenario C, the margin starts at 35% but declines over time. The sensitivity table below shows the buyer’s IRR in each scenario as a function of the multiple paid. For a given multiple, the IRR is highest in Scenario A (margins low but expanding) and lowest in Scenario C (margins high but declining). In Scenario A, the buyer can afford to pay a higher multiple and still generate an attractive rate of return (a 9.0x multiple results in an IRR of 32.8%). In Scenarios B and C, however, the buyer must pay a lower multiple in order to generate the same IRR, even though the initial margin is higher. The implication of the analysis above is that the prospect for future margins is much more important than the current margin when determining the appropriate multiple for an RIA. The market for different segments of the investment management industry tends to reflect this. Institutional asset managers – while they can have very high margins – tend to command lower multiples than HNW wealth managers, which often have lower margins. The reasons for this are many: asset managers are more exposed to fee pressure, trends towards passive investing, and client concentrations, among other factors. These factors suggest an increased likelihood for lower margins in the future for asset managers. HNW wealth managers, on the other hand, often have lower but more robust margins due to their relatively sticky client base, growing client demographic (HNW individuals), and insulation from fee pressure that has affected other areas of the industry. Margin and ValueHigh margins are great, but what really matters to a buyer is how durable those margins are. A variety of factors that affect this, some of which are within the firm’s control and some of which or not. Where the firm operates within the investment management industry (asset manager, HNW wealth manager, PE fund, etc.) is one factor that can affect revenue and margin variability.While a firm can’t easily change which segment of the industry it operates in, there are other steps that these businesses can take to protect their margins. For example, designing the firm’s compensation structure such that it varies with revenue/profitability is one way to protect margins in the event that revenue declines. See How Growing RIAs Should Structure Their Income Statement (Part I and Part II).Firms can also critically evaluate their growth efforts to ensure that additional infrastructure and overhead investments don’t outweigh gains in revenue. By structuring the expense base in a way that protects the firm’s margin if revenue falls and developing growth initiatives designed to support profitable growth, many RIAs can generate stable to improving margins in most market environments—and realize higher multiples when the firm is eventually sold.

We’re often asked by clients what the range of multiples for RIAs is in the current market. At any given time, the range can be quite wide between the least attractive firms and the most attractive firms. The factors that affect where a firm falls within that range include the firm’s margin, scale, growth rate of new client assets, effective realized fees, personnel, geographic market, firm culture, and client demographics (among others).In this post, we focus on the client demographics factor, explain how buyers view client demographics and explore steps some firms take to reach a broader client base.Client relationships are one of the most significant assets that RIAs possess, and maintaining and profitably servicing these client relationships is key to an RIA’s financial success. In a transaction context, the strength of an RIA’s client relationships and the demographics of the client base can have a significant bearing on the multiple buyers will be willing to pay for the firm. An RIA’s outlook for future asset growth can be significantly impacted based on factors such as expected client retention, which stage current clients are at in terms of wealth accumulation (are they withdrawing assets or contributing assets), and the prospect for future liquidity events within the client base.Client relationships are one of the most significant assets that RIAs possess.Many of these factors can be proxied by the age profile of the client base. For most RIAs, the age of the client base tends to skew older (particularly on an asset-weighted basis) simply due to the fact that older clients generally have more assets. Decades of compounding returns can create some very large accounts for older clients, and the RIA can profitably service these accounts. However, with an older client base, the asset base usually declines as these individuals withdraw, rather than contributing additional funds. And, of course, the remaining life expectancy for older clients is less. As such, the age profile of the client base is a key area of inquiry for many buyers.Because an older average client base tends to suggest headwinds for future asset growth, an older client base is generally seen as a negative (all else equal) from a valuation perspective. In general, the younger the client base, the better the outlook for future asset growth and the higher multiple the firm commands. RIAs can expand their reach to a younger client demographic by focusing on retaining assets to the next generation and positioning themselves to appeal to a younger client demographic.Retaining Assets To Next GenerationIn general, RIAs are not particularly successful at retaining assets to the next generation. According to Cerulli, more than 70% of heirs are likely to fire or change financial advisors after inheriting their parents’ wealth. However, firms that prioritize engaging and developing relationships with next-generation family members today can significantly improve asset retention once the assets are transferred from the current client to the next generation. The earlier this is done, the better the chance at retaining assets into the next generation.Focusing on asset retention today is particularly important, given that more than $70 trillion is expected to transfer from older generations to heirs or charities by 2042. RIAs that can capture or retain these assets as they transfer to younger generations will have a competitive advantage against those that cannot.Attracting Younger ClientsA recent Wall Street Journal article highlighted the struggle many advisory firms face in attracting younger clients. See Rich Millennials to Financial Advisers: Thanks for the Golf Invite, but You Can’t Invest My Money. As the article suggests, many younger clients are electing to manage their own assets rather than hire a traditional financial advisor. While DIY investment management is popular among younger clients, many see this preference as temporary. Once these clients reach an asset or life stage threshold where their financial lives become more complicated, it’s anticipated that the need for traditional, personalized advice will increase.While attracting younger clients can be difficult, there are several strategies RIAs can use to position themselves to capture this emerging client segment. For one, RIAs should recognize that investment expertise is table stakes for attracting younger clients. These clients are often looking for financial coaching and holistic financial advice that goes beyond simple asset allocation. By offering these “soft” services in addition to traditional investment management, RIAs are better positioned to win younger clients.RIAs can also attract younger clients by hiring younger advisers. Anecdotally, advisers tend to attract clients within plus or minus ten years of their own age. Thus, having a broader age range of advisors can unlock younger client segments (and also contribute to the stability and continuity of the firm).RIAs can also attract younger clients by hiring younger advisers.RIAs can also revaluate which marketing strategies they are using to appeal to younger client demographics. As the WSJ headline suggests, golf invites have fallen by the wayside for most younger clients. While referrals and word of mouth are the traditional sources for new clients, having a strong online presence and digital marketing strategy is critical for attracting a younger client demographic.In order to effectively service accounts for a younger client demographic, RIAs may also want to reevaluate how they determine fees for these accounts. While the traditional percentage of AUM model works well for many clients, RIAs may find this model difficult to apply to a younger client demographic. For individuals still in the prime of their working career, it’s not uncommon to see a significant amount of their net worth tied up in privately held companies. The value of these assets is not generally included in AUM, and thus does not generate fee revenue. Other clients may have significant incomes and financial planning needs, but have not yet accumulated an asset base significant enough for an RIA to profitably service the account using a traditional percentage of AUM model. Many firms that have been successful at attracting a younger client demographic can offer alternative pricing arrangements to account for situations such as these.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, independent trust companies, and related investment consultancies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

RIA stocks saw mixed performance during the third quarter amidst volatile performance in the broader market. In September, the S&P 500 had its worst month since March 2020, and many publicly traded asset and wealth management stocks followed suit.Performance varied by sector, with alternative asset managers faring particularly well over the last quarter. Our index of alternative asset managers was up 10% during the quarter, reflecting bullish investor sentiment for these companies based in part on long-term secular tailwinds resulting from rising asset allocations to alternative assets.The index of traditional asset and wealth managers declined 4% during the quarter, with performance reflecting the pullback in the broader market. RIA aggregators experienced a volatile quarter, but ended flat relative to the prior quarter end. The performance of RIA aggregators may be reflective of mixed investor sentiment towards the aggregator model. While the opportunity for consolidation in the RIA space is significant, investors in aggregator models have expressed mounting concern about rising competition for deals and high leverage at many aggregators which may limit the ability of these firms to continue to source attractive deals. Performance for many of these public companies continued to be impacted by headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. These trends have especially impacted smaller publicly traded asset managers, while larger scaled asset managers have generally fared better. For the largest players in the industry, increasing scale and cost efficiencies have allowed these companies to offset the negative impact of declining fees. Market performance over the last year has generally been better for larger firms, with firms managing more than $100B in assets outperforming their smaller counterparts. As valuation analysts, we’re often interested in how earnings multiples have evolved over time, since these multiples can reflect market sentiment for the asset class. After steadily increasing over the second half of 2020 and first half of 2021, multiples pulled back moderately during the most recent quarter, reflecting the market’s anticipation of lower or flat revenue and earnings as the market pulled back and AUM declined. Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with privately-held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products. Many smaller, privately-held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.The market for privately held RIAs has remained strong as investors have flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Deal activity continues to be significant, and multiples for privately held RIAs remain at or near all time highs due to buyer competition and shortage of firms on the market.Improving OutlookThe outlook for RIAs depends on several factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are somewhat tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has remained strong despite volatility over the prior quarter. AUM remains at or near all-time highs for many firms, and it’s likely that industry-wide revenue and earnings are as well. Given this backdrop, many RIAs are well positioned for strong financial performance in the fourth quarter.

Valuation gaps are frequently encountered in RIA transactions. Buyers and sellers naturally have different perspectives that lead to different opinions on value: Where a seller sees a strong management team, a buyer sees key person risk. "Long-term client relationships" in the eyes of a seller translates to “aging client base” in the eyes of a buyer. When a seller touts a strong growth trajectory, the buyer wonders if that will continue.These different perspectives on the same firm, unsurprisingly, lead to different opinions on value, and the gap can be substantial. Bridging that gap is key to getting a deal done. Below, we address four ways that buyers and sellers can bridge a valuation gap.1. EarnoutEarnouts are a common way to bridge a valuation gap. Through an earnout structure, the buyer pays one price at closing and makes additional payments over time contingent on the achievement of certain performance thresholds. If, for example, a seller thinks that a firm is worth $100 and the buyer thinks the firm is worth $70, the deal might be structured such that $70 is paid at closing and an additional $30 is paid over time if certain growth targets are met.Through an earnout structure, if the seller’s optimistic vision for the future of the firm materializes, the price ultimately paid reflects that. Likewise, if the downside scenario envisioned by the buyer materializes, the hurdles for the earnout payment will likely not be met, and the price will reflect that reality. Rather than hoping they get what they pay for, the buyer pays for what they get. Similarly, sellers are compensated for what the firm actually delivers.2. Staged TransactionIf an RIA is being sold internally to next-generation management, then selling the firm in multiple stages is one way to help bridge valuation gaps. This is partly because it’s easier to come to an agreement on valuation when the stakes are smaller. But there’s also many potentially value-enhancing benefits to internal sales which take time to realize. Through internal transactions, founders get to hand pick their own successors and incentivize them to grow the firm through equity ownership. The buyers (next generation management) have a pathway to advance their career and increase the economic benefit they receive from their efforts.However, if an internal transaction is done all at once, the owner does not have time to benefit from the growth incentives management hoped the transaction would provide. By structuring the transaction over time, subsequent transactions will take place at higher valuations that reflect the growth that results from the alignment of next gen management’s incentives with existing ownership. As a result, sellers in internal transactions may be willing to come down on price for early transactions to incentivize employees to grow the business, while buyers may be willing to come up in price for the opportunity to become an equity partner in the business and participate in the upside.Selling an interest over time also lessens the capital requirement for the buyer, which is often a barrier in internal transactions where the buyer may not have the financial resources to purchase a large block of the company at one time.3. Deal FinancingBeyond the price, how the purchase price is paid can make a significant difference in the perceived economics of the deal. While external buyers will generally pay cash or stock at closing (with possible future earnout payments as discussed above), internal transactions are often seller-financed.We’ve seen a number of internal transactions where an otherwise attractive valuation was offset by payment terms that were extremely favorable to the buyer such as seller notes with low interest rates and long repayment terms. Similar to earnouts, such favorable payment terms allow the seller to feel like they are getting full value for the business while making the higher purchase price more palatable for the buyer.4. Mitigate Risk Factors Before You SellSellers can mitigate potential valuation gaps in advance of a transaction by addressing aspects of the firm that could be concerning to potential buyers. Consider an outsider’s perspective on your firm, and take action to address the perceived risk factors that lower value. For example, if transitioning the firm internally, distinguishing owner compensation and regular distributions of excess capital prior to a sale will decrease the buyer’s concern about liquidity and marketability of the investment and increase the perceived value of equity ownership.Similarly, focusing on staff development in client-facing roles, increasing the number of client contacts with the firm, and creating an internal pipeline of talent to manage the business will all serve to reduce key person risk from the perspective of a buyer, thereby increasing the value that the buyer ascribes to the firm.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, independent trust companies, and related investment consultancies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

Consolidation is a theme that has a lot of traction in the RIA industry: that a growing multitude of buyers are scrambling to outbid each other for a limited and shrinking number of firms.Circumstances, such as, aging founders or a lack of internal succession planning are bringing firms to market, where firms are quickly bought up and rolled into any one of a number of acquisition models that have emerged (and continue to emerge) in the industry. Aggregators are bolting RIAs onto their platforms, branded acquirers are assembling RIAs with national scale through a series of acquisitions, and larger RIAs are growing through strategic acquisitions of smaller firms. Competition amongst these buyers for the limited number of firms coming on the market has driven acquisition activity and multiples to all-time highs.With the rapid pace of deal activity in the RIA industry, you might expect to see the number of firms decline, as that is typically the norm for consolidating industries. The banking industry, for example, has been consolidating for three decades and, as a consequence, the number of banks in the U.S. has steadily declined from about 18,000 in 1990 to about 6,000 today. But that’s not been the case in the RIA industry, at least yet.Despite consolidation pressures and record levels of acquisition activity, the reality is that the number of RIAs continues to increase, with formations outpacing consolidation. In 2019, there were approximately 13,000 individual SEC registered investment advisory firms, up from about 10,900 in 2014.Several factors have contributed to the increase in the number of RIA firms. For one, the RIA industry has experienced secular tailwinds from the shift from the broker dealer / commission model to the fee-based, fiduciary model. As the chart demonstrates, the number of FINRA registered broker dealers has gradually declined in recent years—the mirror image of the growth seen in the RIA industry. In many cases, broker dealers have shifted to fee-based models, and firms with dual registrations have gradually shifted to the RIA side of the business.This overarching shift from the broker dealer model to the RIA model is multi-faceted. For one, it’s clear that clients (in general) prefer the advisory relationship offered by RIAs over that offered by their broker dealer counterparts. And a model that’s in demand by clients is also in demand by advisors. Additionally, we’ve found that building significant enterprise value (value attributable to the business, not the individual) is generally easier for firm owners to achieve under the RIA revenue model than the broker dealer model. This prospect of building a business with enduring value that can be sold to an external buyer at the end of the founder’s career or transitioned to next generation management is a key motivation behind many advisors’ decisions to start their own RIA. It also doesn’t hurt that, compared to the broker-dealer model, the amount of capital required to start an RIA is relatively minimal.When looking at the increase in the number of RIA firms, though, there are a couple of nuances to keep in mind. Some acquisition models in the industry result in the acquired firm maintaining its SEC registration, so consolidation doesn’t necessarily mean a decline in the number of registered firms. Another caveat is that the data captures only SEC-registered investment advisors and not state registered investment advisors (generally, advisory firms with over $100 million in AUM are required to register with the SEC, whereas firms below that threshold are regulated by the state in which they do business). These wrinkles aside, the data is unambiguous that there are more SEC registered advisory firms today than ever before—and that’s hardly indicative of an industry in the throes of consolidation.Another way to track consolidation is to look at how assets under management are distributed across firms of different sizes, rather than at the number of firms. The industry hasn’t seen significant consolidation by this metric either. Consider the chart below, which shows the distribution of industry assets across different sized firms in 2011 and 2021. After a decade of significant M&A activity and strong market growth, the distribution of assets across different size firms looks about the same as it did ten years ago. Then, as now, firms under $100B AUM controlled approximately one-third of industry assets, while firms over $100B control approximately two-thirds of industry assets. What we haven’t seen is an erosion of market share for smaller firms; in fact, they’ve maintained market share in a growing market.What does all this mean for the industry? As it stands today, rising supply of RIAs has done little to dampen the pricing for RIAs; instead, it’s seemingly added fuel to the M&A fire. Notwithstanding an increase in the number of firms, attractive firms whose founders are open to selling today remain scarce, and the ratio of buyers to sellers remains high. As a consequence, multiples for RIAs are at or near all-time highs today. Whatever downward pressure there’s been from the supply side of the equation, strong buyer demand has more than offset it.While the consolidation pressure in the industry is real, we are still in early stages. Many successful advisory practices prefer to go at it alone and transition internally, unless circumstances such as age of the principals or lack of next-generation management arise to force an external transaction. Consolidation pressures may ultimately lead to an increase in the number of firms that are on the market and a shift in the supply/demand equilibrium, but as it stands today, sellers are scarce, and building a new firm from scratch is difficult. Time will tell if the RIA industry sees the same level of consolidation as we’ve seen in the banking industry, but at least in the near term, the number of RIA firms appears poised to continue growing as the supply of new firms more than offsets a significant level of M&A activity.

RIA stocks continued to have strong performance during the second quarter, with most individual stocks in our indices hovering near 52-week highs today. Performance varied by sector, with alternative asset managers faring particularly well over the last quarter. Our index of alternative asset managers was up 26% during the quarter, reflecting bullish investor sentiment for these companies based in part on long-term secular tailwinds resulting from rising asset allocations to alternative assets. The index of traditional asset and wealth managers rose 15% during the quarter, with performance driven by rising AUM balances and favorable market conditions. The stock price performance of RIA aggregators trailed other categories, with the aggregator index increasing only 6% during the quarter. Weak relative performance for the RIA aggregators may be reflective of mixed investor sentiment towards the aggregator model.While the opportunity for consolidation in the RIA space is significant, investors in aggregator models have expressed mounting concern about rising competition for deals and high leverage at many aggregators which may limit the ability of these firms to continue to source attractive deals. The upward trend in publicly traded asset and wealth manager share prices over the last quarter is promising for the industry, but it should be evaluated in the proper context. Many of these public companies continue to face headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products. These trends have especially impacted smaller publicly traded asset managers, while larger scaled asset managers have generally fared better. For the largest players in the industry, increasing scale and cost efficiencies have allowed these companies to offset the negative impact of declining fees. Market performance during the second quarter was generally better for larger firms, with firms managing more than $100B in assets outperforming their smaller counterparts. As valuation analysts, we’re often interested in how earnings multiples have evolved over time, since these multiples can reflect market sentiment for the asset class. LTM earnings multiples for publicly traded asset and wealth management firms declined significantly during the first and second quarters last year—reflecting the market’s anticipation of lower earnings due to large decreases in client assets attributable to the overall market decline. Multiples have since recovered as prospects for earnings growth have improved with AUM balances. Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with privately held RIAs should be made with caution. Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products. Many smaller, privately held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.The market for privately held RIAs has remained strong as investors have flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Like the public companies, value likely declined during the first quarter of last year, but these were largely paper losses (not many transactions were completed based on value during the height of the downturn). Likely, not more than a quarter or two of billing was impacted last year by the market downturn. Since then, revenue and profitability have recovered rapidly, and value has likely improved as well similar to the publicly traded asset/wealth managers.Improving OutlookThe outlook for RIAs depends on a number of factors. Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents. The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however. Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets. Wealth manager valuations are somewhat tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure. Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last several months. AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well. With markets near all time highs, most RIAs are well positioned for strong financial performance in the back half of the year.

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, acquirors are generally required under accounting standards to perform what is known as a purchase price allocation, or PPA.A purchase price allocation is just that—the purchase price paid for the acquired business is allocated to the acquired tangible and separately-identifiable intangible assets. As noted in the following figure, the acquired assets are measured at fair value. The excess of the purchase price over the identified tangible and intangible assets is referred to as goodwill.Transactions structures involving RIAs can be complicated, often including deal term nuances and clauses that have significant impact on fair value. Purchase agreements may include balance sheet adjustments, client consent thresholds, earnouts, and specific requirements regarding the treatment of other existing documents like buy-sell agreements. Asset and wealth management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fees, profit margins, etc). It is important to understand how the characteristics of the asset management industry in general and those attributable to a specific firm influence the values of the assets acquired in these transactions. Because most investment managers are not asset intensive operations, the majority of value is typically allocated to intangible assets. Common intangible assets acquired in the purchase of private asset and wealth management firms include the existing customer relationships, tradename, non-competition agreements with executives, and the assembled workforce. Customer RelationshipsGenerally, the value of existing customer relationships is based on the revenue and profitability expected to be generated by the accounts, factoring in an expectation of annual account attrition. Attrition can be estimated using analysis of historical client data or prospective characteristics of the client base.Due to their long-term nature, relatively low attrition rates, and importance as a driver of revenue in the asset and wealth management industries, customer relationships often command a relatively high portion of the allocated value. We can see this in the public filings of RIA aggregator Focus Financial. Between 2016 and 2020, Focus completed 106 acquisitions of RIAs. Of the aggregate allocated consideration for these transactions, a full 53% was allocated to customer relationships and 3% was allocated to other assets, with the remaining 44% comprising goodwill.Expand ChartTradenameThe deal terms we see employ a wide range of possible treatments for the tradename acquired in the transaction. The acquiror will need to decide whether to continue using the asset or wealth manager’s name into perpetuity or only use it during a transition period as the acquired firm’s services are brought under the acquirer’s name. This decision can depend on a number of factors, including the acquired firm’s reputation within a specific market, the acquirer’s desire to bring its services under a single name, and the ease of transitioning the asset/wealth manager’s existing client base. In any event, for most relatively successful small-to-medium sized RIAs, the tradename has some positive recognition among the customer base and in the local market, but typically lacks the “brand name” recognition that would give rise to significant tradename value.In general, the value of a tradename can be derived with reference to the royalty costs avoided through ownership of the name. A royalty rate is often estimated through comparison with comparable transactions and an analysis of the characteristics of the individual firm name. The present value of cost savings achieved by owning rather than licensing the name over the future period of use is a measure of the tradename value.Noncompetition AgreementsIn many asset and wealth management firms, a few top executives or portfolio managers account for a large portion of new client generation and are often being groomed for succession planning. Deals involving such firms will typically include non-competition and non-solicitation agreements that limit the potential damage to the company’s client and employee bases if such individuals were to leave.These agreements often prohibit the covered individuals from soliciting business from existing clients or recruiting current employees of the company. In the agreements we’ve observed, a restricted period of two to five years is common. In certain situations, the agreement may also restrict the individuals from starting or working for a competing firm within the same market. The value attributable to a non-competition agreement is derived from the expected impact competition from the covered individuals would have on the firm’s cash flow and the likelihood of those individuals competing absent the agreement. Factors driving the likelihood of competition include the age of the covered individual and whether or not the covered individual has other incentives not to compete aside from the legal agreement (for example, if the individual is a beneficiary of an earn-out agreement or received equity in the acquiror as part of the deal, the probability of competition may be significantly lessened).Assembled WorkforceIn general, the value of the assembled workforce is a function of the saved hiring and assembly costs associated with finding and training new talent. However, in relationship-based industries like asset and wealth management, getting a new portfolio manager or advisor up to speed can include months of networking and building a client base, in addition to learning the operations of the firm. Employees’ ability to establish and maintain these client networks can be a key factor in a firm’s ability to find, retain, and grow its business. An existing employee base with market knowledge, strong client relationships, and an existing network may often command a higher value allocation to the assembled workforce. Unlike the intangible assets previously discussed, the value of an assembled workforce is valued as a component of valuing the other assets. It is not recognized or reported separately, but rather is included as an element of goodwill.GoodwillGoodwill arises in transactions as the difference between the price paid for a company and the value of its identifiable assets (tangible and intangible). Expectations of synergies, strategic market location, and access to a certain client group are common examples of goodwill value derived from the acquisition of an asset or wealth manager. The presence of these non-separable assets and characteristics in a transaction can contribute to the allocation of value to goodwill.EarnoutsIn the purchase price allocations we do for RIA acquirors, we frequently see earnouts structured into the deal as a mechanism for bridging the gap between the price the acquirer wants to pay and the price the seller wants to receive. Earnout payments can be based on asset retention, fee revenue growth, or generation of new revenue from additional product offerings. Structuring a portion of the total purchase consideration as an earnout provides some downside protection for the acquirer, while rewarding the seller for continuity of performance or growth. Earnout arrangements represent a contingent liability that must be recorded at fair value on the acquisition date.ConclusionThe proper allocation of value to intangible assets and the calculation of asset fair values require both valuation expertise and knowledge of the subject industry. Mercer Capital brings these together in our extensive experience providing fair value and other valuation and transaction work for the investment management industry. If your company is involved in or is contemplating a transaction, call one of our professionals to discuss your valuation needs in confidence.

Over the last year, many publicly traded investment managers have seen their stock prices increase by 70% or more.  This increase is not surprising, given the broader market recovery and rising fee base of most firms.  With AUM for many firms at or near all time highs, trailing twelve month multiples have expanded significantly, reflecting the market’s expectation for higher profitability in the future.  For more insight into what’s driving the increase in stock prices, we’ve decomposed the increase to show the relative impact of the various factors driving returns between March 31, 2020 and March 31, 2021 (see table below).Click here to expand the table aboveFor publicly traded investment managers with less than $100 billion in AUM, trailing twelve month (TTM) revenue for the year ended March 31, 2021 declined about 8% year-over-year.  Due to the operating leverage in the RIA business model, the decline in revenue also resulted in a lower EBITDA margin.  The net effect is that TTM EBITDA declined about 20% on average year-over-year for these firms.  The fundamentals for the larger group (firms with AUM above $100 billion) fared better, with profitability generally increasing despite the market downturn during the year ending March 31, 2021.  These firms saw positive revenue growth across the board, although in many cases the revenue growth was partially offset by margin compression.For both groups, expansion in the TTM EBITDA multiple was the primary driver of the stock price increases.  The larger group (AUM above $100 billion) saw the median multiple increase 70%, while the smaller group (AUM below $100 billion) saw the median multiple more than double.The multiple expansion between March 31, 2020 and March 31, 2021, while extreme, is not surprising given the trajectory of the market over the last year.  While EBITDA was down ~20% year-over-year for the smaller group (and up ~5% for the larger group), the market values these businesses based on expectations for the future, not on LTM performance.  As of March 31, 2020, AUM (and run-rate profitability) was down significantly, and depressed market prices continued to impact revenue for 2-3 quarters for many firms.  But the market recouped its losses relatively quicky and continued to trend upwards.  Today, AUM for many firms is hovering at or near all time highs.What’s Your Firm’s Run-Rate? The multiple expansion seen in the publicly-traded investment managers over the last year illustrates the importance of expected future performance on RIA valuations.  The baseline for estimating future performance is the firm’s run-rate performance today.  RIAs are unique in that run-rate revenue can be computed on a day-to-day basis using the market value of AUM and the fee schedules for client accounts.  After deducting the firm’s current level of fixed and variable costs, run-rate profitability can also be determined.Market participants tend to focus on the run-rate level of profitability because it’s the most up-to-date indication of a firm’s revenue and profitability and the baseline from which future performance is assessed.  As AUM has increased for many RIAs, so too has the run-rate revenue and profitability.  The significant improvement in run-rate revenue and profitability (and expectations for the same) is a driving factor behind the multiple expansion observed over the last year.Consider the financial results for a hypothetical firm (ABC Investment Management) shown below.  While illustrative, the growth of this firm since March 31, 2020 is not unusual relative to that exhibited by publicly traded investment managers and many of our privately-held RIA clients.  During the second quarter of 2020, ABC Investment Management billed on $1.75 billion in AUM at an effective realized fee of 65 basis points, resulting in revenue for the quarter of $2.8 million.  After subtracting compensation expenses and overhead, ABC generated $660 thousand in EBITDA for the quarter.  AUM grew rapidly as the market recovered, such that by the first quarter of 2021 the firm was billing on $2.8 billion in AUM at the same fee of 65 basis points.  For the full year, ABC Investment Management generated $14.2 million in revenue and $4.6 million in EBITDA.As of March 31, 2021, however, the firm’s run-rate performance was significantly higher than its performance over the last twelve months.  ABC’s $2.8 billion in AUM was generating $18.0 million in annualized revenue at the effective realized fee level of 65 basis points.  Assuming the same level of fixed costs and the appropriate increase in variable costs to reflect the higher revenue, ABC was producing run-rate EBITDA of $7.3 million at the end of the first quarter.  That’s a 57% increase relative to EBITDA over the last twelve months.Implications for Your RIAAs always, valuation is forward looking.  In relatively stagnant markets, there might not be much of a difference between LTM and ongoing performance.  But given the shape of the market recovery over the last year, the difference today can be material, as the example above illustrates.  If you’re contemplating a transaction in your firm’s stock, it’s worth considering where your firm is at today, not just what it’s done over the last year.

It was about a year ago that share prices for publicly traded investment managers hit rock bottom, as investors reacted to the downside of having a revenue stream tied to the overall market.  Since then, it’s been a straight-line recovery that’s continued through the first quarter of 2021, riding the wave of the larger bull market.Today, most individual stocks in our indices are hovering near 52-week highs.  Aggregators have fared particularly well over the last twelve months on low borrowing costs and steady gains on their RIA acquisitions.  Traditional investment managers have also performed well over this time on rising AUM balances with favorable market conditions. The upward trend in publicly traded asset and wealth manager share prices since March 2020 is promising for the industry, but it should be evaluated in the proper context.  Pre-COVID, many of these public companies were already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products.  While the 11-year bull market run largely masked these issues, asset outflows and revenue pressure can be exacerbated in times of market pullbacks and volatility. The fourth quarter was also favorable for publicly traded RIAs of all sizes as shown below. As valuation analysts, we’re often interested in how earnings multiples have evolved over time, since these multiples can reflect market sentiment for the asset class.  LTM earnings multiples for publicly traded asset and wealth management firms declined significantly during the first quarter last year—reflecting the market’s anticipation of lower earnings due to large decreases in client assets attributable to the overall market decline.  Multiples have since recovered as prospects for earnings growth have improved with AUM balances. Implications for Your RIAThe value of public asset and wealth managers provides some perspective on investor sentiment towards the asset class, but strict comparisons with privately held RIAs should be made with caution.  Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds such as fee pressure and asset outflows to passive products.  Many smaller, privately held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.The market for privately held RIAs has remained strong as investors have flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer.  Like the public companies, value likely declined during the first quarter of last year, but these were largely paper losses (not many transactions were completed based on value during the height of the downturn).  Likely, not more than a quarter or two of billing was impacted last year by the market downturn.  Since then, revenue and profitability have recovered rapidly, and value has likely improved as well similar to the publicly traded asset/wealth managers.Improving OutlookThe outlook for RIAs depends on a number of factors.  Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents.  The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however.  Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets.  Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure.  Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last several months.  AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well.  The first quarter was generally a good one for RIAs, but who knows where the rest of 2021 will take us.

We want to thank everyone who attended or participated in our inaugural RIA Practice Management Insightsconference last week.  We set out last year to create a conference geared towards the back-of-house issues that are critical to success, but don’t get as much attention as themes like M&A and consolidation at many conferences.  To that end, we were fortunate to be able to compile a speaker list full of well-known experts on various practice management topics like firm culture, marketing, managing your tech stack, and more.Our opening keynote was delivered by the legendary Jim Grant of Grant’s Interest Rate Observer, whose presentation traced the origins of central banking from Victorian England through present day, providing a unique perspective on current asset prices.  To wrap up the event, we were pleased to have Peter Nesvold of Nesvold Capital Partners deliver our closing keynote focused on the state of the industry and predictions for the future of wealth management.Other speakers included the following:Louis Diamond of Diamond Consultants spoke on advisor recruitment and acquisitions, and how to craft a world-class value proposition and targeting strategies.Matt Crow and Taryn Burgess of Mercer Capital spoke on compensation strategies, and how to best structure your firm’s compensation to recruit and retain talent.Matt Sonnen of PFI Advisors hosted a live recording of the COO Roundtable Podcast featuring guests Kara Armstrong of CapSouth Wealth Management and Nick Maggiulli of Ritzholtz Wealth Management.Kristen Schmidt of RIA Oasis spoke about the importance of your entire tech ecosystem.Matt Crow moderated a panel discussion on creating a collaborative firm culture featuring Terry Igo of SanCap Group, Sonya Mughal of Bailard, and Colin Sharp, the former COO of Riverbridge and now co-founder of Knoxbarret.Megan Carpenter of FiComm Partners spoke on developing a “New Skool” marketing mindset to drive business growth.Brooks Hamner and Zach Milam of Mercer Capital spoke on succession planning for RIAs.Steve Sanduski of Belay Advisor moderated a panel discussion on delivering value that goes beyond products and planning featuring Julie Littlechild of Absolute Engagement and Seth Streeter of Mission Wealth. Thanks again to everyone who attended and to everyone who helped make the event a success.  We plan to publish updates regarding next year's conference as they become available. So, stay tuned and we hope to see you next year!

Working on your RIA’s buy-sell agreement may seem like a distraction, but the distraction is minor compared to the disputes that can occur if your agreement isn’t structured appropriately.  Crafting an agreement that functions well is a relatively easy step to promote the long-term continuity of ownership of your firm, which ultimately provides the best economic opportunity for you and your partners, your employees, and your clients.If you haven’t looked at your RIA’s buy-sell agreement in a while, we recommend dusting it off and reading it in conjunction with the discussion below.1) Decide what’s fair.In our experience, buy-sell agreements tend to function well when they attempt to strike a balance between the interests of the various stakeholders in an investment management firm, including the founding partners, next-gen management, employees, clients, and the firm itself.  By balancing the interests of the various stakeholders, a well-structured buy-sell agreement can be a competitive advantage by facilitating a smooth transition between founding partners and next-gen management.  Ultimately, this enhances value for everyone.2) Define the standard of value.Standard of value is an abstraction of the circumstances giving rise to a particular transaction.  It imagines the type of buyer, the type of seller, their relative knowledge of the subject asset, and their motivations or compulsions.  We wouldn’t recommend getting creative here.  Unconventional standards of value can and do lead to different interpretations that can result in wildly different conclusions of value.  For most purposes, using one of the more common definitions of Fair Market Value is advisable.  Fair Market Value contemplates a hypothetical willing seller and willing buyer, both of whom have reasonable knowledge of the subject asset and neither of whom are under any compulsion to buy or sell.  This standard has an almost universally agreed-upon definition and is well established and understood in the valuation and legal communities, all of which helps to remove uncertainty as to its valuation implications.3) Define the level of value.Valuation theory suggests that there are various “levels” of value applicable to a business or business ownership interest.  For example, a non-marketable minority interest may be worth less than an otherwise identical controlling interest.  From a practical perspective, the “level of value” determines whether any discounts or premiums are applied to a baseline marketable minority level of value.  Naturally, sellers would prefer a premium and buyers a discount, but it helps to keep in mind that today’s buyers are tomorrow’s sellers, and today’s sellers are yesterday’s buyers.  When transactions are done on a consistent basis over time, it helps to promote a sustainable marketplace for the company’s shares.4) Avoid formula pricing.We often see buy-sell agreements that use a formula to determine value (usually a fixed multiple of a historical performance metric).  These formulas often reflect what the principals of the firm thought the business was worth at the time the buy-sell agreement was drafted.  As market conditions and the business’ economics change, formula prices can quickly diverge from market value, but the ink on the page remains.When it comes time to buy or sell, perhaps years or decades after the buy-sell agreement was drafted, the formula price will inevitably be benchmarked against the actual buyer and seller’s perceptions on the current market value of the interest.  If the formula value is greater than the perceived value, then the selling shareholder may find there are no willing buyers or no reasonable way to finance the sale.  If the formula value is less than the perceived value, then the selling shareholder may be incentivized to hold on to their ownership longer than is optimal from the perspectives of the firm, next-gen management, and clients.5) Specify the valuation date.A buy-sell agreement should be explicit about the “as of” date of the valuation.  Typically, valuations will consider only what is known or reasonably knowable as of this date.  As a result, a difference of just a few days can have a significant impact on the valuation if an unexpected event occurs at the firm.  Consider, for example, the death of a key executive.  Such an event will often trigger buy-sell agreement provisions, and whether or not the event factors into the valuation will depend in part on the valuation date specified by the agreement.  For firms with larger shareholder bases and relatively frequent transactions, it often makes sense to specify an annual valuation date that then applies to transactions throughout the year.6) Decide who will perform the valuation. We recommend selecting a reputable third-party valuation firm with experience valuing investment management firms.7) Manage expectations. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled.  Testing your buy-sell agreement now by having a valuation prepared can help to center or reconcile those expectations and might even lead to some productive revisions to your buy-sell agreement.For more information on RIA practice management issues, register for our upcoming conference, RIA Practice Management Insights. More information can be found below.Early Bird Pricing for the Upcoming RIA Practice Management Insights Conference Ends in 7 DaysMercer 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.Take advantage of early bird pricing to receive $100 off conference registration. Offer ends next week.Have you registered yet?

After a brief lull during the second quarter of last year, RIA deal activity surged in the fourth quarter, rounding out a record year in terms of reported deal volume.  Concerns about the pandemic and market conditions were quickly shrugged off, as deal terms and the pace of deal activity returned to 2019 levels after the brief pause at the peak of the shutdown.The strong fourth quarter deal activity reflects a continuation of the upward trajectory seen over the last several years.  Fourth quarter deal activity was further accelerated by the backlog of deals that had stalled earlier in the year and by the expectation for increases to capital gains tax rates when the new administration takes over.  The total reported deal volume in 2020 increased 28% from 2019 levels, and while deal count declined 15% from 2019 levels, the decline was almost entirely attributable to the brief slowdown in the second and third quarters.  The average deal count in the first and fourth quarters exceeded the 2019 quarterly average.Deal Terms Remain Robust Deal terms and multiples showed remarkable resilience in 2020.Deal terms and multiples for wealth management franchises showed remarkable resilience in 2020.  While the height of the market downturn caused some buyers to exercise caution regarding multiples and deal terms, the effect was short-lived.  As equity markets rebounded and the uncertainty diminished, deal terms and multiples quickly returned to 2019 levels, with attractive RIA sellers seeing high single digit multiples of EBITDA and meaningful portions of the purchase price paid in cash at closing.The strength of deal terms is not surprising given the influx of new buyers in recent years.  RIA aggregators, strategic acquirers, banks, and private equity have all been elbowing their way to the table, which suggests a continued seller’s market.Consolidators Drive Deal ActivityRIA consolidators and larger RIA strategic acquirers continued to be a driving force behind deal activity.  Wealth Enhancement Group, Focus Financial, Hightower, Creative Planning, CAPTRUST, and CI Financial each acquired multiple RIAs in 2020.  These firms sustained deal activity during the peak of the pandemic distraction, while smaller acquirers without dedicated deal teams were forced to delay or abandon planned transactions.  Consolidators and large strategic acquirers remain an attractive option for many RIA sellers due in part to the lower execution risk resulting from consolidators’ experience in closing transactions.Mega-DealsWhile consolidators accounted for a large percentage of deal activity, these deals are typically relatively small.  The uptick in total deal value during the year was driven by several mega-deals among publicly traded asset managers and discount brokerages.  Back in February, Franklin Templeton agreed to buy rival asset manager Legg Mason for $6.5 billion, and Morgan Stanley purchased online broker E-Trade for $13 billion just a few days later.  In October, Morgan Stanley agreed to buy asset manager Eaton Vance for $7 billion.  In December, Macquarie Group (a diversified Australian financial services company) agreed to buy asset and wealth manager Waddell & Reed for $1.7 billion.The differences between these larger transactions and the smaller wealth management firm transactions are noteworthy.  The recent mega-deals in the industry between public companies have been focused on sectors of the industry that many analysts believe are declining—asset management and discount brokerage.  These sectors have seen significant fee and margin compression in recent years, and as a result, these deals are largely defensive in nature and motivated by cost savings and increased scale to protect margins.In contrast, buyers of independent wealth management firms are typically attracted by recurring revenue, a sticky client base, relatively high margins, and attractive growth prospects due to market appreciation and demographic trends.  As a result of these differing motivations and outlooks, the multiples seen for wealth management franchises are often higher than their publicly traded asset management-focused counterparts.  In the case of the Waddell & Reed transaction, the multiple paid for the asset management component of the business may have been as low as 5x (see our post, Did Macquarie Pay 11x EBITDA for Waddell & Reed? Yes and No), well below what an attractive wealth management business can expect in the current environment.Internal TransactionsMany of our RIA clients have taken time over the last year to work on back-of-house issues like succession planning.  It’s no secret that succession planning is a major issue for the industry, and one of the questions RIA principals must answer when succession planning is whether to engage in an internal or external transaction.  Although there has been a proliferation of external buyers and deal terms remain strong, internal transactions can be an attractive option for a variety of reasons.  Compared to the stringent structure that an outside buyer might impose, internal transactions can offer greater flexibility for retiring partners.  They also sidestep one of the largest issues in RIA transactions—cultural compatibility—since no new parties are introduced and forced to work together.It’s no secret that succession planning is a major issue for the industry.One of the downsides of internal transactions is that the buyers, typically younger firm employees, often don’t have the financial resources to purchase a significant interest outright.  The good news is that capital options to facilitate these transactions have expanded significantly in recent years, with various banks, private equity, and minority investors increasing their focus on the sector.Another challenge with internal transactions is that they require a strong next-gen management team to be in place.  Without a strong bench, external transactions may be the only option for a founding partner seeking to exit the business.  For firms that lack the next-gen management to run the business and turn to external buyers to solve their succession planning problem, it may be difficult to realize full value.We’ll be addressing succession planning along with other operational, back of the house RIA issues at our upcoming conference, RIA Practice Management Insights, to be held virtually on March 3-4, 2021.

In last week’s blog post, we covered five considerations for designing earn-outs.  To recap, these considerations are as follows:Defining the continuing business that will be the subject of the earn-outDetermining the appropriate period for the earn-outDetermining to what extent the buyer will assist or impede the seller’s performance during the earn-out periodDefining what performance metrics will control the earn-out payment(s)Determining other earn-out features (caps on payments, clawbacks, etc.) While there is no one set of rules for structuring an earn-out, keeping these conceptual issues in mind can help anchor the negotiation.  This week, we look at an example RIA transaction to illustrate how these considerations come into play when buyers and sellers are working out deal pricing and structure.RIA Transaction ExampleConsider the example of a depository institution, Hypothetical Savings Bank (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 an RIA.Following a search, HSB settles on Typical Wealth Management (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 commercial bankers at HSB are not overly familiar with the wealth management industry, 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 do not always mix well, and HSB worries whether TWM’s clients will stay if TWM’s 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 TWM, 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 the 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 AUM is significantly enhanced after the transaction, whether by steady marketing appeal or strong market returns.  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 the management of TWM 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 the 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 TWM 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.Conclusion: Earn-Outs are Interactive With the Value of RIAsRisk is an unavoidable part of 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 un-likelihood for the performance of a given asset with the value of that security.  In an ideal world, a reasonable cash flow projection and a reasonable cost of capital will yield a reasonable indication of value.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.

An RIA’s margin is a simple, easily observable figure that encompasses a range of underlying considerations about a firm that are more difficult to measure, resulting in a convenient shorthand for how well the firm is doing.  Does a firm have the right people in the right roles?  Is the firm charging enough for the services it is providing?  Does the firm have enough–but not too much—overhead for its size?  The answers to all of these questions (and more) are condensed into the firm’s margin.What Is a “Typical Margin?”We’ve seen a wide range of margins for RIAs.  Smaller firms with too much overhead and not enough scale might see no profitability or even negative margins.  On the other hand, an asset manager with rapidly growing AUM and largely fixed compensation expenses might see margins of 50% or more.  The “typical” margin for RIAs depends on the context.  As the chart below illustrates, different segments of the investment management industry typically have different margins based on the risk of the business model (among other factors).At one end of the spectrum are hedge funds, venture capital firms, and private equity managers.  The high fees these companies generate per dollar invested can support very high margins, but the risk of client concentrations, underperformance, and key staff dependence is significant.Traditional institutional asset managers are somewhere in the middle of the spectrum.  When these companies get it right, institutional money can flock in rapidly.  A successful institutional asset manager may find themselves managing billions more in assets while staffing remains virtually unchanged.  The additional fees flow straight to the bottom line, and margins can be quite healthy as a result.  But the risks are significant.  Institutional money can leave just as quickly as it came if the manager’s asset class falls out of favor or if performance suffers.At the lower end of the spectrum are more labor-intensive disciplines like wealth management and independent trust companies.  For these businesses, bringing on additional clients translates directly into increased workload for staff, which will ultimately translate into higher staffing levels and compensation expense as the business grows.  While margins are lower, the risk is less.  Key-person risk is less because an individual’s impact is generally limited to the clients they manage, and not the entire firm’s investment strategy.  Client concentration is less because wealth management firms tend to have a large number of HNW clients rather than a few large institutional clients.  Performance risk is generally less of a concern as well.Does a Firm’s Margin Affect What Its Worth?A high margin conveys that a firm is doing something right.  But what really matters from a buyer’s perspective is not what the margin is now, but what it will be in the future.  Consider the three scenarios below.  In Scenario A, the EBITDA margin starts relatively low (15%), but improves over time.  In Scenario B, the margin starts at a higher level (25%) but remains constant.  In Scenario C, the margin starts at 35% but declines over time.The sensitivity table below shows the buyer’s IRR in each scenario as a function of the multiple paid.1  For a given multiple, the IRR is highest in Scenario A (margins low but expanding) and lowest in Scenario C (margins high but declining).  In Scenario A, the buyer can afford to pay a higher multiple and still generate an attractive rate of return (a 9.0x multiple results in an IRR of 23.4%).  In Scenarios B and C, however, the buyer must pay a lower multiple in order to generate the same IRR, even though the initial margin is higher.The implication of the analysis above is that the prospect for future margins is much more important than the current margin when determining the appropriate multiple for an RIA.  The market for different segments of the investment management industry tends to reflect this.  Institutional asset managers, while they can have very high margins, tend to command lower multiples than HNW wealth managers, which often have lower margins.  The reasons for this are many: asset managers are more exposed to fee pressure, trends towards passive investing, and client concentrations, among other factors.  These factors suggest an increased likelihood for lower margins in the future for asset managers.  HNW wealth managers, on the other hand, often have lower but more robust margins due to their relatively sticky client base, growing client demographic (HNW individuals), and insulation from fee pressure that has affected other areas of the industry.Margin and Value High margins are great, but what really matters to a buyer how durable those margins are.  There are a variety of factors that affect this, some of which are within the firm’s control and some of which or not.  Where the firm operates within the investment management industry (asset manager, HNW wealth manager, PE fund, etc.) is one factor that can affect revenue and margin variability.While a firm can’t easily change which segment of the industry it operates in, there are other steps that these businesses can take to protect their margins.  For example, designing the firm’s compensation structure such that it varies with revenue/profitability is one way to protect margins in the event that revenue declines.  See How Growing RIAs Should Structure Their Income Statement (Part I and Part II).  Firms can also critically evaluate their growth efforts to ensure that additional infrastructure and overhead investments don’t outweigh gains in revenue.  By structuring the expense base in a way that protects the firm’s margin if revenue falls and developing growth initiatives designed to support profitable growth, many RIAs can generate stable to improving margins in most market environments—and realize higher multiples when the firm is eventually sold.1 For simplicity, other projection assumptions are omitted.

Share prices for publicly traded asset and wealth managers have trended upward during the second and third quarters after collapsing in mid-March with the broader market.  Alt asset managers have fared well over the last year as volatility and depressed asset prices have created an opportunity to deploy dry power and raise new funds in certain asset classes.  Traditional asset and wealth managers have generally moved in line with the broader equity market, while leveraged RIA aggregators have seen more volatility, both up and down, as the market bottomed in March before trending upward.[caption id="attachment_33973" align="aligncenter" width="950"]Source: Source: S&P Market Intelligence[/caption] Looking at the third quarter, traditional asset and wealth managers and aggregators trended upwards in July and August before pulling back as the market dipped in September.  While the quarter was volatile, both of these categories ended the quarter up about 4%.  The primary driver behind the increase was the increase in the market itself as most of these businesses are primarily invested in equities, and the S&P 500 gained about 8% over the quarter. [caption id="attachment_33974" align="alignnone" width="856"]Source: Source: S&P Market Intelligence[/caption] The upward trend in publicly traded asset and wealth manager share prices since March is promising for the industry, but it should be evaluated in the proper context.  Pre-COVID, the industry was already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products.  While the 11-year bull market run largely masked these issues, asset outflows and revenue pressure can be exacerbated in times of market pullbacks and volatility. Smaller publicly traded asset/wealth managers have been most affected by these trends, which is reflected in their share price performance over the last year.  As shown below, asset/wealth managers with more than $100 billion AUM have performed well over the last year, with the $100 - $500 billion AUM group up 28% and the $500 billion+ group up 4%.  Smaller RIAs, those with under $100 billion AUM, have been down over the last year, with the smallest group (under $10 billion AUM) down 14%. [caption id="attachment_33975" align="alignnone" width="893"]Source: Source: S&P Market Intelligence[/caption] As valuation analysts, we’re often interested in how earnings multiples have evolved over time since these multiples reflect market sentiment for the asset class.  LTM earnings multiples for publicly traded asset and wealth management firms declined significantly during the first quarter—reflecting the anticipation of lower earnings due to large decreases in AUM—but have since recovered in the second and third quarters as prospects for earnings growth have improved. [caption id="attachment_33976" align="alignnone" width="589"]Source: Source: S&P Market Intelligence[/caption] Implications for Your RIADuring such volatile market conditions, the value of your RIA is sensitive to the valuation date or date of measurement.  In all likelihood, the value declined with the market in the first quarter before recovering most of that loss in the second and third.  We’ve been doing a lot of valuation updates amidst this volatility, and there are several factors we observe in determining an appropriate amount of appreciation or impairment.One is the overall market for RIA stocks, which was down significantly in the first quarter but has since recovered to above where it was a year ago (see chart above).  The P/E multiple is another reference point, which has followed a similar path.  We apply this multiple to a subject RIA’s earnings, so we also have to assess how much that company’s annual AUM, revenue, and cash flow have increased or diminished since the last valuation while being careful not to count good or bad news twice.While the market for publicly traded companies is one data point that informs private RIA valuations, that’s not to say that privately held RIAs have followed the same trajectory as their smaller public counterparts.  Many of the smaller publics are focused on active asset management, which has been particularly vulnerable to the headwinds discussed above.  Many smaller, privately-held RIAs, particularly those focused on wealth management for HNW and UHNW individuals, have been more insulated from industry headwinds, and the fee structures, asset flows, and deal activity for these companies have reflected this.We also evaluate how our subject company is performing relative to the industry as a whole.  Fixed income managers, for instance, held up reasonably well compared to their equity counterparts in the first quarter.  We also look at how much of a subject company’s change in AUM is due to market conditions versus new business development net of lost accounts.  Investment performance and the pipeline for new customers are also key differentiators that we keep a close eye on.Improving OutlookThe outlook for RIAs depends on a number of factors.  Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents.  The one commonality, though, is that RIAs are all impacted by the market.The impact of market movements varies by sector, however.  Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets.  Wealth manager valuations are tied to the demand from consolidators while traditional asset managers are more vulnerable to trends in asset flows and fee pressure.  Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations with cheap financing.On balance, the outlook for RIAs has generally improved with market conditions over the last several months.  AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well.  The third quarter was generally a good one for RIAs, but who knows where the last quarter of 2020 will take us in a wild year for RIA valuations and overall market conditions.

Last Wednesday, the SEC announced an expansion to the definition of “accredited investor” to include individuals based on professional certifications and those with certain inside knowledge of private investments, among others.  “Accredited investors” are deemed by the SEC to be sophisticated enough to bear the risks of often opaque private investments, which lack the disclosure requirements and some of the investor protections of their public counterparts.  Under the accredited investor rule, private companies are limited to soliciting capital from accredited investors.Before the recent change, accredited investor status required net worth (excluding primary residence) over $1.0 million or an annual income of at least $200,000 ($300,000 for married couples) over at least the last two years and the current year.The old standard has been criticized over the years.While intended to protect smaller investors, the old standard has been criticized over the years as it effectively limits investment opportunities for unaccredited investors and potentially adversely impacts capital formation for small companies.  Additionally, the wealth and income standards have been criticized as a poor proxy for financial sophistication and ability to bear risk.Another concern has been that the wealth and income standards have not changed since the rule was established in 1982.  After 38 years of inflation, the real purchasing power of $1.0 million today has been significantly eroded.  The wealth and income standards also do not consider geography or cost of living, which vary widely throughout the country.In the updated guidance, the SEC declined to revise the wealth and income thresholds for inflation or geography, saying that doing so would disrupt existing investments and add complexity and administrative costs.  However, in an attempt to more effectively identify investors that have sufficient knowledge and expertise to participate in private investment opportunities, the SEC did add new ways to meet the accredited investor definition.  The new guidance adds the following persons and entities to the accredited investor definition:Natural persons holding in good standing one or more professional certifications or designations or other credentials from an accredited educational institution that the SEC has designated as qualifying an individual for accredited investor status. Initially, the list of applicable professional certifications includes the FINRA Series 7 (General Securities Representative license), Series 82 (Private Securities Offerings Representative license), and Series 65 (Licensed Investment Adviser Representative).  Additional professional certifications may be added from time to time by the SEC;Natural persons who are “knowledgeable employees,” as defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940, of the private-fund issuer of the securities being offered or sold;LLCs with $5.0 million in assets and SEC- and state-registered investment advisers, exempt reporting advisers and rural business investment companies (RBICs); and,Family offices with assets in excess of $5.0 million and their clients. Additionally, “spousal equivalents” is added to the accredited investor definition, allowing spousal equivalents to pool their assets for purposes of meeting the net worth threshold. Will Wealth Managers Need to Vet Private Equity Investments?For most RIAs, the new guidance probably won’t change much.  Under the new definition, RIAs themselves are now considered accredited investors, but RIA clients are not likely to be affected.  Notably, although it was considered, the SEC did not expand the definition to include discretionary clients of fiduciary investment advisors.For most RIAs, the new guidance probably won’t change much.Since discretionary clients are not automatically accredited investors, the impact on RIA clients is limited to those individuals with the applicable professional certifications or who are “knowledgeable employees” of the issuer who were not already accredited investors under the old rule.  The SEC estimates that just over 700,000 individuals hold the professional certifications listed above.  Of these, many would have already qualified as accredited investors under the old wealth and income standard.  For most RIAs who work predominately with high net worth (HNW) and ultra-HNW clients (who were already accredited investors), the incremental number of clients who now meet the accredited investor definition is likely to be quite small.For those that are newly-minted accredited investors, there is still the question of whether the types of private investments available to accredited investors would be an appropriate portfolio addition.  Financial sophistication and the ability to understand the investment opportunity are just one part of the equation.  Private investments often have long expected holding periods, low liquidity, and relatively high probability of permanent capital loss.  While these features are often accompanied by higher expected returns, the high risk and low liquidity often make these investments inappropriate for investors who don’t have the capital base to endure substantial losses.Also, despite the SEC now allowing it, there is still the practical limitation of investment minimums and sourcing investment opportunities that will likely limit the ability of those newly endowed with accredited investor status to participate in private offerings.  For now, the impact of the rule on capital formation is likely to be quite small, although the SEC has indicated the potential for continued expansion of the definition into the rank and file of retail investors.

Despite the global pandemic, the long-term outlook for most alternative asset managers appears healthy due to strong investor interest and emerging opportunities caused by market dislocation.  Demand for alt assets has benefited from increases in alt asset allocations among institutional investors, and this long-term trend appears poised to continue, pandemic or not.  If anything, the current environment has highlighted the benefits of diversification that alt assets can provide.  According to an April 2020 survey of institutional investors by Preqin, 63% of respondents indicated that COVID-19 would have no effect on their long-term alternative investment strategy, while 29% indicated that their long-term allocation to alternative investments would increase as a result of COVID-19.The current environment has highlighted the benefits of diversification that alt assets can provide.In the near-term, however, alt managers are likely to feel the effects of declining asset values.  While public equity markets recovered significantly in the second quarter, the recovery was led by a handful of large-cap tech stocks while small-caps lagged behind significantly.  For PE firms, this means that most portfolio company valuations are likely down (and performance fees are jeopardized), but it also represents an opportunity to deploy capital at attractive valuations.Furthermore, while long-term investing strategies may be unchanged, capital commitments for the remainder of 2020 are likely to decline.  According to the Preqin survey, only 9% indicated that COVID-19 has increased their planned commitments to alternatives in 2020, while 58% indicated that their planned commitments have decreased (33% indicated no change).Of those commitments that are being made, they are likely to be concentrated in asset classes that are poised to benefit from the current environment.  The brunt of the economic fallout from COVID-19 has been borne by a handful of industries, and given the severe short-term impact (and possible longer-term impact) that COVID has had on sectors like hospitality, energy, travel, retail, and restaurants, many investors are exercising caution and reducing exposure to these sectors, at least until there is more clarity about the timeline of the pandemic and the potential long-run consequences.  According to the Preqin survey, 34% of investors plan to avoid retail-focused real estate in 2020, while 28% plan to avoid conventional energy-focused natural resources, and 26% plan to avoid retail-focused private equity.On the other hand, certain alt asset categories like distressed debt and tech-focused venture capital are poised to see increased investor interest.  Distressed debt funds are raising record amounts of capital in anticipation of a rising number of investment opportunities.  According to the Preqin survey, investors are planning to increase allocations to healthcare-focused private equity, distressed debt, logistics, software-focused venture capital, and defensive hedge funds.When it comes to maintaining existing assets, alt managers are often better positioned during a market downturn than traditional asset managers.When it comes to maintaining existing assets, alt managers are often better positioned during a market downturn than their traditional asset management counterparts.  The investor base for alt managers tends to be largely institutional investors with long time horizons and perhaps less propensity to knee jerk reactions than retail investors.  Also, since alt assets tend to be held in illiquid investment vehicles, investors are locked up for years at a time and can’t withdraw funds as easily as if the assets were in a mutual fund or an ETF.While sticky assets can provide cushion for alt managers in a downturn, the longer-term performance of these managers depends on their ability to raise new funds and put that money to work.  Raising institutional capital is often a long and involved process in the best of circumstances.  For many managers, the economic interruption of a global shutdown has presented challenges to a fundraising process that often involves extensive in-person due diligence (35% of respondents in the Preqin survey indicated that face-t0-face meetings are essential for decision making).  And if new funds are raised, there is the question of whether or not managers can put that money to work.  M&A transaction activity has declined significantly over the last several months, leaving deal teams at many PE firms on the sidelines.  It is likely that there will be a huge backlog of transaction activity that will materialize at some point in the coming months/years, but the timeline is uncertain.Public alt managers were particularly affected during the selloff in March, reflecting the decline in portfolio asset values and expectations for realizing performance fees.  Measured from February 19, 2020—the day the S&P 500 peaked—our index of alt managers declined nearly 45% by late March.  Since then, an outsized recovery has left the index down just 8.0% from the market peak.   Of the nine alt asset managers in the index, six were down over the period while three saw price increases, which reflects the varied outlook for the sector depending on asset class focus, among other things.The big winners in the sector were Apollo Global Management (APO) which was up 6.5% between the S&P 500 peak on February 19 and July 31 and KKR & Co. (KKR) which was up 4.8% over the same time period.  APO saw credit AUM increase 43% over the second quarter, positioning the company to deploy capital as a robust pipeline of private credit opportunities emerges in the wake of COVID.  Additionally, Apollo’s recent focus on responsible investing likely contributed to its superior performance as ESG funds outperformed traditional funds in the wake of COVID.  KKR has also been successful at fundraising, adding $10 billion in capital commitments to its already substantial dry powder across its private equity and credit business during March and April.  Those firms with large exposures to affected industries typically saw negative performance over the period.  One of the worst-performing companies in the index was Cohen & Steers (CNS), which was down 22% between February 19 and July 31, reflecting its vulnerability due to its asset class focus (real estate) and predominately retail client base.The observations about the divergence of performance among the public alt managers are likely to apply to privately held alt managers as well.  In the near term, those managers with large exposures to highly affected industries, or those that have seen large asset outflows, are likely to see their valuations decline.  Those managers with less exposure to highly affected industries and those whose strategies and fundraising are poised to benefit from the current environment are likely to see valuations increase.  Over the longer-term, we expect to see alt asset allocations accelerate in the aftermath of COVID-19 as investors seek diversification before the next downturn, which should be a boon for most alt asset managers—particularly those who deliver outsized performance in the current environment.

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.

If you’ve never had your trust company valued, chances are that one day you will.  The circumstances giving rise to this valuation might be voluntary (such as a planned buyout of a retiring partner) or involuntary (such as a death, divorce, or partner dispute).  When events like these occur, the topic of your firm’s valuation can quickly shift from an afterthought to something of great consequence.The topic of valuation is of particular importance to owners of independent trust companies given the typical independent trust company’s ownership structure, where a majority interest is held by the firm’s founders or senior partners, with younger, more junior partners holding smaller stakes.  Such an ownership dynamic—with its (relatively) frequent arms-length transactions and potential for ownership disputes—heightens the need to understand the value of your ownership interest.  In our experience working with independent trust companies on valuation issues, the need for a valuation is typically driven by one of three reasons: shareholder agreements, transactions, or litigation.The situation giving rise to the need for a valuation could be one of the most important events of your professional career.  Familiarity with the various contexts in which your firm might be valued and with the valuation process and methodology itself can be advantageous when the situation arises.  To this end, we’ve prepared a whitepaper on the topic of valuing interests in independent trust companies.In the whitepaper, we describe the situations that may lead to a valuation of your firm, provide an overview of what to expect during the valuation engagement, introduce some of the key valuation parameters that define the context in which a firm is valued, and describe the valuation methods and approaches typically used to value independent trust companies.  If you own an interest in an independent trust company, we encourage you to take a look.  While the value of your firm may not be top of mind today, chances are one day it will be.  Our hope is that this whitepaper will provide you with a leg up towards understanding the valuation process and results, and further that it will foster your thinking about the valuation of your firm and the situations—good and bad—that may give rise to the need for a valuation. WHITEPAPERValuation of Independent Trust CompaniesDownload Whitepaper

At the time the Coronavirus Aid, Relief, and Economic Security (CARES) Act was passed in late March, the S&P 500 index was off roughly 30% from its all-time high, and many RIAs had seen similar declines in AUM and run-rate revenue.  Since then, markets have recovered significantly, although due largely to Fed action rather than fundamentals.  There is still a great deal of uncertainty and a real possibility that there will be a significant revenue hit for RIAs.  With high fixed costs, that has the potential to cause a great deal of financial strain for many RIAs.In order to mitigate the potential impact of the COVID-19 crisis, many RIAs applied for and received loans under the Paycheck Protection Program (PPP) established by the CARES Act.  These loans are intended to help small businesses keep employees on payroll during the COVID-19 crisis and may be forgiven if staffing levels are maintained and certain other requirements are met.The disclosure requirements related to the PPP loans are an important consideration for RIAs—which typically pride themselves on transparency.  The SEC has released guidance stating, “If the circumstances leading you to seek a PPP loan or other type of financial assistance constitute material facts relating to your advisory relationship with clients, it is the staff’s view that your firm should provide disclosure of, for example, the nature, amounts and effects of such assistance.”  The SEC considers using the PPP loan to pay staff providing advisory services to clients, a “ material fact” that requires disclosure.  Many firms that received PPP loans have already filed revised Form ADVs with PPP loan disclosures.Many RIA owners are wondering what signaling effect the loans will have on clients.Now that the loans have been received and disclosure is strongly advised (if not mandated), many RIA owners are wondering what signaling effect the loans will have on clients.  Will clients view PPP loans as a sign their advisor is experiencing financial strain or on the verge of financial insolvency?  Or will clients view it as a precautionary measure rather than a last-ditch effort to stay afloat financially?We think that when properly explained to clients, there’s little reason for clients to be alarmed by their advisory firm receiving a PPP loan.  A candid disclosure and discussion with clients about the receipt of the PPP loan, its intended use, and its potential impact on the firm is likely enough to put clients at ease.As a preliminary matter, it is worth putting the size of these loans in context.  The amounts we’ve seen disclosed range from a few hundred thousand to around a million dollars for firms with assets under management in the $1 to $3 billion range.  For firms of this size, this amounts to a month or so of revenue.  That’s not nothing, but it’s not life changing either.  A PPP loan is not likely to make a significant impact on a firm’s solvency.For most RIAs, the PPP loans are a safety net, not a matter of survival.  Adding capital to the balance sheet makes a lot of sense in times of economic uncertainty for any business.  The balance sheet of an RIA is usually somewhat of an afterthought—money comes in and is quickly used to pay compensation and other expenses.  If there’s anything left, it’s distributed on a regular basis.  All that’s typically retained on the balance sheet is a few months of operating expenses.Given the current economic uncertainty, it makes sense that RIA owners are paying more attention to their balance sheets.  Adding additional capital to ensure the RIA is able to continue to operate at the same level regardless of what happens in the financial markets is a prudent business decision.  It allows the RIA to protect its staffing level, provide security for its employees, and continue providing the same level of service.  That assurance directly benefits clients.Many RIAs applied for PPP loans out of an abundance of caution and not desperation.Many RIA clients are business owners themselves, and many have likely received PPP loans for their own businesses.  We think clients will recognize that in most cases RIAs have applied for PPP loans out of an abundance of caution and not desperation.It's also important to note that the economic situation seemed much more dire just a few months ago when RIAs and other businesses began applying for PPP loans.  At that time, the length of the shutdown was still indefinite and the path by which we would return to normalcy was much less clear.  Now that the uncertainty has abated somewhat, many RIAs have found that they didn’t need the funds from the PPP loan during the peak of the shutdown and don’t think they will in the future.  Some RIAs are considering returning the money because they haven’t needed it.All of that is to say that we don’t view an RIA receiving a PPP loan as a sign for alarm, and we don’t think clients will either as long as the rationale is explained clearly.  The number of RIAs that have received PPP loans is (at least anecdotally) quite large.  At least seven firms on the Dynasty Financial Partners platform have received the loans, as have many of our clients.  While RIA’s profitability may suffer, we ultimately expect that most of the firms receiving PPP loans will weather the COVID-19 crisis with only minimal operational impact, and the PPP loans provide an additional level of assurance that this will be the case.

The recent sell-off in equities have put pressure on the financial performance of most asset managers, given that revenues and cash flows are highly correlated with the market. At the same time, it is also a critical time for these businesses to deliver on their value proposition of alpha net of fees. Active managers have generally underperformed their benchmarks over the past 10 years, which has driven outflows into low-fee passive products. The extreme financial market volatility and dispersion over the last two months has created major price dislocation and the potential to generate outperformance. The current environment may well be the time for active managers to prove themselves by protecting clients’ assets relative to index performance and justifying their fees.Underperformance Has Driven OutflowsFor active managers, the eleven-year bull run that preceded the current downturn was accompanied by relative underperformance, falling fees, and asset outflows. Over the last decade, indexing to the market largely beat out stock picking and asset allocation based on security-specific research or macroeconomic factors. The strong performance of large cap indices like the S&P 500 between the 2008-2009 recession and February of this year has been largely driven by a handful of sizeable tech companies, and active managers struggled to deliver alpha in that environment. Not only did the indices beat the active managers, but the fees on the passive products tracking these indices have also fallen to virtually zero. Not surprisingly, investors have chased after the strong relative performance and low fees of passive index tracking products. In August last year, passively managed assets exceeded active for the first time.Many asset managers have explained underperformance over the last decade in the context of a runaway bull market while suggesting that the merits of active management would be proven in the next downturn. So, now that a bear market and significant volatility are here, will active managers outperform? Intuitively, it makes some sense, as market shocks and liquidity needs in a downturn can cause disconnects between asset prices and fundamentals that active managers seek to exploit. There is some evidence to suggest that active/passive relative performance is cyclical. As the chart below shows, the 10-year bull market through 2019 was accompanied by passively managed funds outperforming. With the bull market over, the era of passive outperformance may be as well.However, initial data from Morningstar indicates that only about 42% of active funds beat their indices between February 20, 2020 and March 16, 2020, compared to 44% during the preceding rally (December 24, 2018 – February 19, 2020). While active funds collectively have not fared well, some asset classes have fared better than others. Some alternatives, commodities, and sector equity funds have outperformed by wide margins during the bear market. Funds with long-short exposure or large cash holdings relative to the benchmark have also had high success rates.Outflows from Active Funds AccelerateOutflows from active funds have accelerated as the global pandemic has caused investors to rapidly shift into cash. As shown in the table below, March saw record outflows from long-term funds and record inflows into money market funds. The outflows in long-term funds were concentrated in actively managed funds. Passively managed U.S. equity funds saw $41 billion in net inflows in March, while all categories of actively managed funds saw outflows in March.Stock Price Performance for Publicly Traded Asset Managers The combination of accelerating outflows and falling asset prices represents a major headwind for active asset managers, and the price movement in publicly traded asset managers has reflected this. As shown in the table below, the stock prices for most of these companies are down 20-30% so far this year. Only Legg Mason and BlackRock are above where they were at year-end, and the performance of Legg Mason is not related to its fundamentals, but rather a fortuitously timed transaction. Franklin Resources agreed to buy Legg Mason for $50.00 cash per share on February 18, 2020, one day before the S&P reached its peak. Since then, Legg’s shares have been anchored close to $50.00, while Franklin Resources’ price has fallen significantly as it is stuck on the other side of a trade that now looks very good for Legg Mason shareholders. BlackRock, on the other hand, has performed well due to its positioning as the largest player in passive products. About 75% of BlackRock’s $7.4 trillion in assets under management are passively managed, and its growth has been driven not just by market movement but by strong inflows into its iShares ETF franchise and other passive products. The strong relative performance of BlackRock’s shares in this environment suggests that the market views BlackRock and its massive passive franchise as better positioned to perform than its smaller, more actively managed counterparts. Outlook for Future Financial Performance Moody’s recently downgraded its outlook on global asset managers to “negative” from “stable,” citing economic headwinds and market declines resulting from the coronavirus pandemic. With asset prices down across virtually across the board, asset management revenues and profitability will take a significant hit in the second quarter and perhaps beyond depending on the market trajectory. The financial performance of asset management firms over the next several years will largely be tied to the shape of the market recovery. As of early May, the run-rate financial performance for asset managers has improved significantly as asset prices have recovered from March lows.The longer-term outlook for active managers depends more on the ability of these managers to deliver alpha net of fees in the current environment and stem the asset outflows that have drained AUM over the last decade. While the initial data indicates that active management relative performance has not improved during the bear market, there is opportunity over the next several months as markets calm and prices reconnect with fundamentals. The coming months will be a critical time for asset managers to prove themselves.

Independent trust companies are a growing segment of the trust industry.  While trust divisions of banks still represent about 84% of the trust industry, there’s been a trend towards independence that parallels that seen in the wealth management industry.  In this post, we highlight some of the trends impacting independent trust companies.FeesOver the last decade, there has been a broad-based decline in pricing power across the investment management industry.  Assets have poured into low fee passive products, driving down effective realized fees for asset managers.  Wealth managers have been more resilient, but the threat of robo-advisors remains.  Virtually all discount brokerages were forced to cut trading fees to zero.  Consider the relationship between effective realized fees and revenue growth over the last five years for US asset/wealth managers (shown in the chart below). The message is clear.  Assets across the financial services industry are gravitating towards lower-fee products.So how have trust companies fared in this environment? Despite the pricing pressure in the broader industry, trust companies have fared remarkably well.  According to Wealth Advisor’s 2019 pricing survey, trust company fees are actually heading higher.  For many of our independent trust company clients, the story has been similar. Realized fees have remained steady or even increased over the last five years, while assets under administration have grown through market growth and net inflows.Market MovementsThe recent coronavirus induced sell-off will have a significant negative impact on the top line for trust companies, as it will for all investment managers that charge a percentage of assets under management.  As of the date of this post, the S&P 500 is down over 20% from its all-time high on February 19, 2020. Trust company revenue will take a big hit.  The effect on trust company profitability will depend on the length and severity of the economic slowdown caused by the pandemic and containment policies. The range of likely scenarios is beyond the scope of this post, but it suffices to say that there is still significant uncertainty regarding the impact on people, markets, and economic activity.Unlike many asset and wealth management firms, trust companies often have revenue sources that aren’t based on AUM (e.g., tax planning, estate administration fees) which should provide some protection during a market downturn.  This, combined with a resilient fee structure, should help trust companies weather the pandemic.DemographicsTrust companies primarily serve high net worth and ultra-high net worth clients, and demographic trends in these markets are favorable for the continued growth of the trust company industry.  The number of high net worth individuals (net worth > $1 million) in the United States has grown significantly over the last decade.  According to Credit Suisse’s Global Wealth Report 2019, there were over 18 million millionaires in the United States in 2019, nearly double the number in 2010.Additionally, the impending wealth transfer as baby boomers age should spur growth in trust assets.  Roughly $30 trillion is expected to change hands between baby boomers and younger generations during the coming years.  To the extent that this wealth is transferred via trusts, trust companies stand to benefit.Regulatory Trends As trust law has developed, a handful of states have emerged as being particularly favorable for establishing trusts.  While the trust law environment varies from state to state, leading states typically have favorable laws with respect to asset protection, taxes, trust decanting, and general flexibility in establishing and managing trusts.  Opinions vary, but the following states (listed alphabetically) are often identified as states with a favorable mix of these features.AlaskaDelawareFloridaNevadaSouth DakotaTennesseeTexasWashingtonWyoming Over the last several decades, many states such as Delaware, Nevada, and South Dakota have modernized their trust laws to allow for perpetual trusts, directed trustee models, and self-settled spendthrift trusts (or asset protection trusts).  The directed trust model in particular is a major change in the way trust companies manage assets, and it has been gaining popularity among trust companies and their clients.  Under the directed trust model, the creator of the trust can delegate different functions to different parties.  Most frequently, this involves directing investment management to an investment advisor other than the trust company (this could be a legacy advisor or any party the client chooses).  The administrative decisions and choices related to how the trust’s assets are used to enrich the beneficiary are typically charged to the trust company. The directed trustee model leads to a mutually beneficial relationship between the trust company, the investment advisor, and the client.  The trust company avoids competition with investment advisors, who are often their best referral sources.  The investment advisor’s relationship with their client is often written into the trust document.  And most importantly, this model should result in better outcomes for the client because its team of advisors is ultimately doing what each does best—its trust company acts as a fiduciary, and its investment advisor is responsible for investment decisions.The directed trustee model leads to a mutually beneficial relationship between the trust company, the investment advisor, and the client.Technology  Trust administration is labor-intensive and requires extensive tax, accounting, legal and compliance expertise.  Trust companies typically employ CPAs, estate planning attorneys, financial advisors, and trust officers, among other professionals.  Many of our trust company clients have spent substantial amounts of money developing software and systems to reduce the administrative and compliance burden on these employees and enable fewer employees to manage more assets.  We expect this trend to continue as trust companies seek to reduce overhead expenses and improve profitability.  Trust company clients should benefit as well from reduced friction and improved client experience.SuccessionThe ownership profile at independent trust companies is often similar to that seen at asset and wealth management firms.  Ownership is often concentrated among the founders, with younger partners owning small pieces of the company.  We’ve written in the past about buy-sell agreements for wealth management firms, and much of that discussion is applicable to independent trust companies as well.  In short, the dynamic of a multi-generational, arms-length ownership base can be an opportunity for ensuring the long-term continuity of the firm, but it also runs the risk of becoming a costly distraction.  As the trust company profession ages, we see transition planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded).Looking ForwardMany trust companies have performed remarkably well over the last decade, aided by the recently ended 11-year bull market and the trends discussed above. The current market environment is one of incredible uncertainty, and the outlook for trust companies and the economy as a whole will continue to evolve rapidly over the coming months.  Beginning next week, we have planned a series of blog posts to explore the impact of the current market environment on investment managers.

As deal activity continues to accelerate into 2020, M&A opportunities remain an area of focus for public asset and wealth management companies.  Notably, however, there is a growing gap in the multiples for private vs public companies which may prove a challenge to M&A for public companies.  At the macro level, there are several trends which continue to impact the industry, including fee pressure, the continued bull market, regulatory overhang, and technology advancements.  As we do every quarter, we take a look at some of the earnings commentary from investment management pacesetters to scope out the dominant trends. Theme 1: Many public asset and wealth managers are eyeing M&A opportunities, particularly in the wealth management industry.[I]t's always been a goal of ours within M&A to increase the size. But I think there's just a few more opportunities today with some of the pressure on smaller firms, keeping up, keeping pace with technology spending and services that are required for their investors. So we're just seeing a few more opportunities for roll-ups. -Greg Johnson, Chairman & CEO, Franklin Resources[W]e're seeing a lot of [M&A] opportunities out there. We have always had a strong interest in private wealth businesses. We find that private wealth businesses are attractive on many fronts particularly because the assets are very sticky, and it dovetails well with what we've been doing around here for 2.5 decades at our Trust company. So we've seen a lot in that area, and we've seen a lot of teams that are stranded, that are looking for a home. And for us, we'd be particularly interested in a firm that has private wealth and has some of the capabilities that we don't currently have such as fixed income. -Brian Casey, President, CEO, & Director, Westwood Holdings GroupAs we have discussed previously, the current M&A environment for wealth management firms remains both active as well as expensive. Silvercrest, however, is involved in multiple conversations at any given time … Regardless of the environment, Silvercrest will opportunistically seek to effectively deploy capital to complement our organic growth … There is a possibility down the road that as the RIA business matures and professionals find themselves unhappy at much larger roll-up type firms or in that situation, they may start to look around the way some of their colleagues are at the brokerages, which is not a fertile hunting ground for us and our business model. It's possible that down the road, that there could be some RIA-type lift outs, but we're not running around seeking those. If you look at the business, the wealth management side with RIAs is highly concentrated. It's not a large number of firms that control a majority of the AUM, Silvercrest being lead among them.  -Richard Hough, Chairman, President, and CEO, Silvercrest Asset Management GroupTheme 2: While public companies see opportunities in wealth management M&A, high pricing is a key consideration particularly in light of historically low multiples for publicly traded asset and wealth managers.Of course, we know that private equity and other wealth managers in the mass affluent wealth space are very, very active. And some of the EBITDA multiples being discussed here in the 15x, 16x-plus area, even in businesses that don't actually have the acquisitions closed yet, for example. So it is a very highly competitive space from a rollout perspective because the economics just make so much sense. -Matthew Nicholls, Executive VP & CFO, Franklin Resources We're certainly looking in [the wealth management] space, and we are keen observers of the price and multiple escalations that's going on there. As we think about our wealth management business and M&A opportunities there, it's really about driving scale. -Ben Clouse, Senior VP, CFO, Treasurer, Waddell & Reed Financial One of the challenges is that the public multiples and the private multiples still do have a disconnect … We really have to think about strategically and long term and creating value for those transactions that would make sense, we would definitely think about it. Obviously, our view is that the multiples that publicly traded managers are trading at are not in line with historical multiples. So we look at it long term. We look at it what is the right way to build value for the future in terms of that. But again, we're disciplined in terms of how we assess those alternatives. -George Aylward, President, CEO & Director, Virtus Investment PartnersTheme 3: Macro trends like fee pressure, the continued bull market, regulatory overhang, and technology advancements continue to shape the industry.   I think we are likely to see more pressure on top line, driven by continuing price competition in the business. At some point, we'll see an equity downturn that will put more pressure on companies. We're -- we think we enter that environment from a position of clear strength with not only a number of market-leading franchises, but also strong balance sheet, strong culture, strong leadership, continuity of approach, focus on this business, great relationships in the market, history of innovation … So we're not all that optimistic at the moment about near-term trends in our industry, but are quite optimistic about our relative position within asset management. -Thomas Faust, Chairman, CEO, & President, Eaton Vance 2019 was marked by heightened geopolitical and trade tensions which created volatility in financial markets. Uncertainty around the U.S. and China trade negotiations, Brexit and other concerns about a slowdown in global growth all impacted investor sentiment, driving industry flows into safer fixed income and cash strategies, cash assets throughout the year … Macro forces are impacting the wealth industry, including a more challenging market environment, heightened customer expectations, more regulation, technology advancements. And this is driving demand for a deeper portfolio -- analytical and risk transparency, portfolio construction, product and scale.  -Larry Fink, Chairman & CEO, BlackRock I regularly speak about the changing distribution landscape: the rise of the wealth channel and relative decline of the traditional institutional market; the importance of reaching people digitally; globalization, a buyer's market in terms of fee structure and vehicle preference; demand for customization and tailored solutions. -Eric Colson, Chairman, President, and CEO, Artisan Partners Asset Management Value investing, as we practice it at Pzena Investment Management, is the process of studying businesses whose stocks have collapsed, of gathering enough data to make a reasoned judgment about whether the history of the business and industry remains a useful guide for estimating future earnings and for investing when the range of outcomes skew solidly in our favor. We sit at one of those moments where a small number of market darlings have driven market returns to record levels and caused enormous dispersion between value and growth strategies. And yet, we judge that with an opportunity set that looks as good or better than it did a decade ago, the odds of our deep value approach succeeding in the next 10 years seems like a much better place to be than to bet that the winners of the past decade continue to defy analysis. -Richard Pzena, Chairman, CEO, and Co-Chief Investment Officer, Pzena Investment Management I do think that in an environment where fees are decreasing and costs are increasing, a lot of firms have to sort of think about, particularly in the smaller end, will they be better off partnering. I think the better firms are not in a situation where they have to do something, but they'll certainly consider looking at that. And then on the demand side, there are probably fewer firms that have the financial flexibility to be in the market.  -George Aylward, President, CEO & Director, Virtus Investment PartnersSummaryEarnings calls this quarter brought to light the varying challenges and opportunities that asset and wealth management firms face.On the asset management side, macro trends like the shift from active to passive investing have forever changed the active asset management industry, and asset managers are having to re-think their cost structure in order to stay competitive.  Increasing operating leverage through acquisitions and outsourcing has allowed asset managers to protect their margins despite declining fees.For smaller wealth managers, an active M&A market and high private market multiples provide an attractive alternative for owners seeking exit options.  Interestingly, there is a growing gap between private and public company multiples.  The higher multiples we’ve seen for relatively small wealth managers are seemingly at odds with some of the historically low smaller public company multiples, which begs the question of whether mean reversion is on the horizon.

Asset and wealth manager M&A continued at a rapid pace during the fourth quarter of 2019, rounding out a record year by many metrics.  Total deal count in 2019 rose 6% over 2018, reaching the highest level seen over the last decade.  While reported deal volume declined by 50% in 2019, this metric can be a less reliable indicator of transaction activity given the lack of disclosed deal terms and the influence of large transactions (the Oppenheimer/Invesco deal accounted for about a quarter of 2018 reported deal volume, for example).The rise of the RIA consolidator model continues to be a theme for the wealth management sector.  Wealth management firms saw a significant uptick in consolidation activity during 2019, which was attributable in large part to strategic consolidators.  According to Fidelity’s December 2019 Wealth Management M&A Transaction Report, there were 139 wealth management transactions in 2019 (43% more than 2018) representing $780 billion in assets (38% more than 2018).  Some of the more active consolidators included Focus Financial, Mercer Advisors, Wealth Enhancement Group, HighTower Advisors, and Dynasty Financial Partners—each of whom acquired multiple RIAs during 2019.RIA consolidators now account for about half of wealth management acquisition activity—and that percentage has been increasing.RIA consolidators now account for about half of wealth management acquisition activity—and that percentage has been increasing.  These consolidators are, in general, well-funded (often by PE backers) and have a mandate from their investors to grow rapidly via acquisitions.  They’re also not shy about knocking on doors to source deals, and given the demographics of the wealth management industry, their pitch for an exit plan often finds a receptive audience.Sub-acquisitions by consolidator-owned RIAs are a further driver of M&A activity for the sector.  These acquisitions are typically much smaller and are facilitated by the balance sheet and M&A experience of the consolidators.  For some RIAs acquired by consolidators, the prospect of using buyer resources to facilitate their own M&A may be a key motivation for joining the consolidator in the first place.There have also been several significant transactions of the consolidators themselves, which illustrates the broad investor interest in the consolidator model.  One of the largest deals of 2019 was Goldman Sachs’s bid to enter the mass-affluent wealth management market through its $750 million acquisition of RIA consolidator United Capital Partners.  Also during 2019, Mercer Advisors’ PE backers sold a significant interest to Oak Hill Capital Partners.Consolidation Rationales Building scale to enhance margins and improve competitive positioning are typical catalysts for consolidation, especially on the asset management side.  One way to stem the tide of fee pressure and asset outflows is to cut costs through synergies to preserve profitability as revenue skids.  The lack of internal succession planning is another driver as founding partners look to outside buyers to liquidate their holdings.Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task.  The risks include cultural incompatibility, lack of management incentive, and size-impeding alpha generation.  Many RIA consolidators structure deals to mitigate these problems by providing management with a continued interest in the economics of the acquired firm while allowing it to retain its own branding and culture.  Other acquirers take a more involved approach, unifying branding and presenting a homogeneous front to clients in an approach that may offer more synergies, but may carry more risks as well.M&A OutlookThe record transaction activity in 2019 marks a decade-long run of steadily increasing consolidation activity in the sector.  In 2020, we expect the trend to continue as many of the forces that shaped the industry over the last decade remain in place.  Consolidation pressures in the industry are largely the result of secular trends.  On the revenue side, realized fees continue to face pressure as funds flow from active to passive and clients become increasingly fee conscious.  On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs.  The continuation of these trends will pressure RIAs to seek scale, which will, in turn, drive further M&A activity. With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies.  Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression.  An aging ownership base is another impetus.  The performance of the broader market will also be a key consideration for both buyers and sellers in 2020.

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.

RIA M&A has been a well-publicized topic in the industry.  There was a record level of RIA M&A in 2018, and so far in 2019 there are no signs that deal pace is slowing down.  Against this backdrop, a new study conducted by Advisor Growth Strategies (AGS) and sponsored by BlackRock sheds light on the realities facing RIA buyers and sellers.  Based on transaction information for over 50 RIA deals, the study examines the relationship between deal price and deal terms.  The full study is available here.The study categorizes RIA deals based on purpose (short-term or long-term), size (small target or large target), and payment structure (certain or uncertain).  The synthesis of these factors impacts the transaction multiple, as shown in the chart from the study below.[caption id="attachment_28869" align="aligncenter" width="493"]Source: Advisor Growth Strategies[/caption] While the deal multiple is a convenient short-hand way to summarize a transaction, as the chart above suggests, it does not tell the full story.  Still, the deal price and multiples are what makes the headlines (if terms are publicly disclosed at all) because the nuances of an earn-out arrangement don’t make for an exciting press release. You Pick the Price, I’ll Name the TermsBecause of the lack of transparency and media focus on non-price deal terms, the market norms and trends for this important aspect of RIA M&A are often unfamiliar to first time buyers or sellers.  However, non-price deal terms can be just as important or even more important than the deal price.  This is particularly true in RIA deals, where buyer stock and/or contingent consideration may account for a significant portion of total deal value.  The AGS study provides some insight into the state of deal terms in the RIA M&A market from the perspective of both buyers and sellers.  We’ve highlighted some of the key takeaways from the study below.While there are many small (and successful) RIAs, the largest 5.4% of firms by AUM control 63.2% of AUM. The largest RIAs command premium multiples, but these firms are a minority.  The study (which focused on smaller RIAs) found that the median adjusted EBITDA multiple for M&A transactions between 2015 and 2018 was 5.1x, and there was little variation over the period.  RIAs must choose between pursuing scale through inorganic growth or maintaining a boutique approach.Large acquirers (e.g., Focus Financial, HighTower, CapTrust, Mercer Advisors) are setting the pace for deal terms. Given the proliferation of capital providers in the space, providing a successful long-term outcome is now the differentiator for these “acquisition brands.”  Compared to smaller, less frequent RIA acquirers, the acquisition brands have a leg up based on their demonstrated and repeatable growth engine, robust human capital and technology, ability to add service diversification, and access to capital.  For sellers, the turn-key offerings provided by acquisition brands are a benchmark for establishing rational expectations.RIA deal terms now provide an average of 60% of cash consideration at closing. For buyers, this means a high barrier to entry and critical need for a solid integration strategy.  For sellers, liquidity at close is nice, but accepting a relatively high upfront payment may not maximize the overall valuation.While RIA cash flows have been increasing, multiples have remained relatively consistent between 2015 and 2018. Buyers must find a balance between price and terms based on the transaction’s purpose to get sellers to commit.Up to 40% of consideration is being paid in buyer stock. In general, larger deals saw a greater proportion of total consideration in the form of buyer equity.  For buyers, this means that it is critical to demonstrate the merits of their business model and to articulate a path to liquidity (particularly for privately held acquirers).  For sellers, the burden is on them to evaluate the investment merits of their acquirer.  When buyer stock is part of the consideration, the buyer and seller are in the same boat after the transaction, so it is critical that both parties evaluate the investment merits of the combined entity.Buyers are assuming more of the risk in RIA transactions. 75% of the transactions in the study had less than 25% of the total consideration allocated to contingent consideration, and the contingent payments were relatively short-term (all were less than three years).  Given these terms, buyers must be willing to assume some of the risk of the transaction and have a clear integration plan.M&A OutlookWith over 11,000 RIAs operating in the U.S., we expect that consolidation will continue and deal volume will remain strong.  The AGS study suggests that, at least for most firms, multiples have been relatively consistent over the last several years.  Without major changes to deal terms and structure, this may continue to be the case.  Market forces have and will continue to impact non-price deal terms.  Acquisition brands are a growing force in the industry, and their influence on deal terms will likely grow accordingly.  At some point, every RIA will likely become either a buyer or a seller and will confront the tradeoffs between price and deal terms and other market realities as they exist at that time.

Broad market indices were generally flat over the last quarter, while most categories of publicly-traded asset and wealth manager stocks were off 5% to 10%.Our index of traditional asset and wealth managers ended the quarter down 5.4%, underperforming the S&P 500 which was up 0.4% over the same time.  Aggregators and multi-boutique model firms declined 8.3%.  Alt managers were the bright spot in the sector, up 3.5%. The asset and wealth management industry is facing numerous headwinds, chief among them being ongoing pressure for lower fees.  Traditional asset and wealth managers feel this pressure acutely, which has likely contributed to their relative underperformance over the last quarter.  Alt managers, which have been the sector’s sole bright spot during this time, are more insulated from fee pressure due to the lack of passive alternatives to drive fees down. These headwinds have contributed to a decline in EBITDA multiples for traditional asset/wealth managers, which in turn has resulted in lackluster stock price performance.  As shown below, EBITDA multiples remain well below historical norms, although they have recovered somewhat from the low point seen last December. Expanding the performance chart over the last year reveals similar trends in asset/wealth manager performance relative to the broader market.  Over this longer timeframe, alt managers are still the only category with positive returns, although performance has been volatile.  Traditional asset/wealth managers generally moved in lockstep with the broader market until the third quarter of this year when relative performance declined significantly.  Aggregators and multi-boutique have declined over 30%. The 30%+ decline in the aggregator and multi-boutique index may come as a surprise given all the press about consolidation in the industry and headline deals for privately held aggregators.  Over the last year, there have been two significant deals for privately-held wealth management aggregators: United Capital was bought by Goldman Sachs for $750 million, and Mercer Advisors’ PE backers sold a significant interest to a new PE firm, Oak Hill Capital Management.  Both deals reportedly occurred at high-teens multiples of adjusted EBITDA. It appears the market may have grown skeptical of the purely financial consolidator strategy.Meanwhile, stock of Focus Financial, a publicly traded wealth management aggregator, has declined significantly.  On September 30th, Focus stock closed at $23.80, about half its price a year prior and about 35% below the price at its July 2017 IPO.So why has Focus stock languished while Mercer Advisors and United Capital have both sold significant interests at attractive valuations?  One explanation is different business models.  The latter two firms are more “true” consolidators, where acquired firms are rebranded and integrated, then presented to the market as a coherent whole.  Focus, on the other hand, is a pure financial consolidator.  Acquired firms continue to operate as they did before the acquisition, and the only real difference (other than some back-office integration) is how the economics of the firm are distributed.  There are pros and cons to each model, but given the poor performance of Focus Financial’s stock since IPO, it appears the market may have grown skeptical of the purely financial consolidator strategy.Implications for Your RIAWith EBITDA multiples for publicly traded asset and wealth managers still well below historical norms, it appears the public markets are pricing in many of the headwinds the industry faces.  It is reasonable to assume that the same trend will have some impact on the pricing of privately held RIAs as well.But the public markets are just one reference point that informs the valuation of privately held RIAs, and developments in the public markets may not directly translate to privately held RIAs.  Depending on the growth and risk prospects of a particular closely-held RIA relative to publicly traded asset and wealth managers, the privately held RIA can warrant a much higher, or much lower, multiple.In our experience, the issues of comparability between small, privately held businesses and publicly traded companies are frequently driven by key person risk/lack of management depth, smaller scale, and less product and client diversification.  These factors all contribute to the less-than-perfect comparability between publicly traded companies and most privately held RIAs.  Still, publicly traded companies provide a useful indication of investor sentiment for the asset class, and thus, should be given at least some consideration.Improving OutlookThe outlook for RIAs depends on a number of factors.  Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents.  The one commonality, though, is that RIAs are all impacted by the market.  Their product is, after all, the market.The outlook for RIAs appears to have improved since the significant market drop in December 2018.The impact of market movements varies by sector, however.  Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets.  Wealth managers and traditional asset managers are vulnerable to trends in asset flows and fee pressure.  Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations and create synergies.On balance, the outlook for RIAs appears to have improved since the significant market drop in December 2018.  Since then, industry multiples have rebounded somewhat, and the broader market has recovered its losses and then some—which should have a positive impact on future RIA revenues and earnings.More attractive valuations could entice more M&A, coming off the heels of a record year in asset manager deal-making.  We’ll keep an eye on all of it during what will likely be a very interesting year for RIA valuations.

As we explained in a recent post, there are many viable exit options for RIA principals when it comes to succession planning.  In this post, we will review some of the considerations when partnering with an RIA consolidator.The opportunity for consolidating wealth management firms is well publicized: an industry composed of many small, fragmented firms with aging ownership bases and no clear succession plans is supposedly poised for consolidation.  RIA consolidators have emerged to capitalize on this landscape, promising a means for ownership transition, back-office efficiencies, and best practices coaching.Acquisitions by consolidators represent an increasing portion of deal volume in the sector.Consolidators have been gaining traction in the industry.  Most well-known RIA consolidators have grown their AUM at double-digit growth rates over the last five years, and acquisitions by consolidators represent an increasing portion of deal volume in the sector.For RIA principals that are looking for an exit plan, selling to a consolidator is one option to consider.  A sale to a consolidator typically provides the selling partners with substantial liquidity at close, an ongoing interest in the economics of the firm, and a mechanism to transfer the sellers’ continued interest to next generation management.There are several considerations when considering a sale to an RIA consolidator.  Price, of course, is the big one.  But after the deal closes, the selling shareholders will typically have to stick around for several years at least (the deal terms will make sure of that).  Thus, another important feature to consider is what life will look like after the deal closes.  RIA owners who are considering selling to a consolidator should think carefully about which aspects of their business they feel strongly and how those aspects of the business will change after the deal closes.Consolidator Models There are several different consolidator models, and they can vary significantly in terms of the effect they have on the day-to-day operations of the acquired RIA.  This is largely a function of the amount of integration that consolidators do for their partner firms.At one extreme, there are consolidators such as Focus Financial that standardize only the minimum level of business processes across their acquired firms, which typically include back-office tasks such as compliance and accounting.  This “stay as you are” model has minimal impact on how the firm is run and theoretically maintains the selling partners’ sense of entrepreneurship.  Acquired firms can retain their own branding and client-facing processes after the deal closes, and there is usually little or no impact from the perspective of the firm’s clients.  This model also mitigates the risk of culture clash since acquired firms aren’t forced into a one-size-fits-all mold.At the other extreme, there are consolidators like United Capital (now part of Goldman Sachs) or Mercer Advisors, which unify the branding of acquired firms and present a homogenous wealth management platform to clients.  Under this model, most functions of the acquired RIA—things like marketing, HR, and technology—are moved under the corporate umbrella.  Sellers have much less control after the deal closes under this model.  Some sellers may see this as gaining freedom from the day-to-day management of their firms, but others may be reluctant to relinquish that much control.Deal PricingThe multiples paid by consolidators will vary depending on the current market environment, but they are generally competitive with other exit strategies.  Different consolidator models can have characteristics that more closely resemble either a financial buyer or strategic buyer, and this classification can impact the multiple that the consolidator is able to pay.Different models have characteristics that resemble either a financial buyer or strategic buyer, which impacts the multiple that it is able to pay.Consolidators like Focus Financial, which make minimal changes to the acquired business, are best classified as financial buyers.  Financial buyers purchase the business “as is”, with few plans to make changes to the way the business operates beyond moving selected business functions to the corporate office.  There may be some plans for expense reductions or revenue enhancement, but financial consolidators are unlikely to pay the buyer for those potential benefits.Other consolidators can be considered strategic buyers.  Companies like Mercer Advisors fall into this category.  By making major changes to the way the acquired RIA operates, strategic consolidators have more opportunity to realize synergies and initiate growth-oriented strategic objectives.  In theory, this gives strategic consolidators the ability to pay a higher multiple, but at a cost to the selling shareholders of giving up more control in how the business is run after the deal closes.Deal StructureConsolidators typically purchase 100% of RIAs, but that doesn’t mean that they purchase 100% of the acquired firm’s economics.  RIAs are for the most part owner-operated businesses, so some portion of the acquired firm’s earnings before owner compensation (EBOC) needs to be diverted to the selling shareholders in order to keep them around and align incentives after the close.  For RIAs, it can be difficult to disentangle EBOC into returns to equity versus returns to labor.  As a practical matter, the normalized or post-closing compensation for selling shareholders is a negotiating point when striking a deal with a consolidator.The selling shareholders are likely to maintain an ongoing interest in the economics through earnouts, employment agreements, or other deal features.  For example, Focus Financial structures its deals so that a portion of the acquired EBOC is directed to a newly established management company owned by the selling shareholders.  Initially, this structure provides the selling shareholders with compensation that varies with the profitability of the firm.  In the longer term, the management company equity can, in theory, be sold to the next generation of management when the selling shareholders retire.Cash vs Stock ConsiderationIt’s also worth noting that consolidators often use their own stock as part of the total consideration.  For publicly traded companies like Focus Financial, it’s clear exactly how much that’s worth at any given time.  For closely-held aggregators like Hightower and Captrust, their stock price is not readily apparent.Even if the consolidator is publicly traded, you should be wary of any lock-up provisions since stock prices for these companies can be volatile.Facilitating M&AAnother purported benefit of selling to a consolidator is that the acquired firm gains access to the consolidator’s balance sheet to pursue its own acquisitions.  The low cost of capital for consolidators can allow the acquired firms to complete their own acquisitions in a way that is still accretive to the selling shareholders.Many partner firms of Focus Financial, for example, have completed their own acquisitions, and presumably, these deals make financial sense for the partner firm’s principals.  For firms that are considering inorganic growth, this aspect of a sale to a consolidator may be a key consideration.Other OptionsSelling to a consolidator is just one exit strategy among many, and RIA owners should carefully weigh the pros and cons selling to a consolidator relative to those of other exit strategies.  In subsequent posts, we will discuss other viable exit options for RIA principals.

Schwab recently released its 2019 RIA Benchmarking Study.  The survey contains responses from over 1,300 RIAs that custody their assets at Schwab to questions about firm operating performance, strategy, and practice management.  The survey is a great resource for RIA principals to see how their firm’s performance and direction measure up against the average firm.  We’ve highlighted some of the key results from the study below.  You can download the full survey here.Firm PrioritiesAs part of the survey, Schwab asked RIA principals to rank the top priorities for their RIA.  Not surprisingly, top-line growth is a top-line priority—most RIAs ranked gaining new clients through existing client referrals or business referrals as their primary focus.  Just behind new client acquisition was improving productivity through new technology (e.g., taking advantage of CRM efficiencies).  Developing or enhancing a succession plan was at the bottom of the list, a result which is generally consistent with our experience working with many different RIA clients.  Succession plans are easy to put off because there is no immediate benefit for developing one.  But eventually every firm will need one, and developing a succession plan may very well be the lowest hanging fruit to enhance firm value, protect clients, and improve career satisfaction.GrowthThe firms participating in the survey have seen strong five-year growth on average.  Between 2014 and 2018, AUM grew at a compound annual growth rate (CAGR) of 7.5%, while revenue and number of clients grew at a respective 9.5% and 5.4% CAGR.  The best-performing firms (Schwab defines this as the top 20%) saw positive AUM growth even in 2018 (the worst year for market performance covered by the survey) due to strong net organic growth.  Interestingly, the fact that revenue growth has outpaced AUM growth suggests that the effective realized fees for these firms has increased over the last five-years, despite reports of fee pressure across the industry.  This could be attributable in part to the fact that the respondent firms reported an increased breadth of services offered between 2014 and 2018.  All of the RIA size categories identified in the survey saw similar growth over the last five years, although firms managing less than $2.5 billion in AUM generally experienced higher growth than firms over $2.5 billion in AUM.M&AM&A contributed to growth for many firms over the last five years.  4% of firms acquired new clients by M&A in 2018, and 18% of firms have completed an acquisition in the last five years.  Over the past five years, 13% of firms gained new clients by bringing on an advisor with an existing book of business.Succession PlanningSuccession planning is a key concern for the industry, particularly since 62% of firms are still primarily led by their founders.  Eventually, of course, all of these founder-led firms will need an exit strategy for the founding partners, whether that is through internal succession or a sale to a third party.  A full 92% of respondents indicated that they were considering internal succession, but only 38% of firms have a documented path to partnership.  Most firms, however, have added non-founders to the ownership base—only 29% of firms reported not sharing equity with non-founders.  26% of firms reported sharing equity with non-founders to support succession planning, while a further 27% reported sharing equity to retain key talent.  These equity purchases are mostly financed either by the employee (self-financing) or by the current shareholders (seller financing), although there are an increasing number of options for third-party financing of equity purchases.ProductivityRespondent firms reported increases in productivity between 2014 and 2018.  Over this period, AUM per professional increased from $88 million to $97 million, and the number of clients per professional increased from 46 to 52.  Also over this period, hours per client for operations and administration decreased from 19 to 17, while hours per client for client service remained flat at 34, suggesting that these gains in productivity were the result of administrative efficiencies, not a decrease in client service.ProfitabilityThe respondent firms reported strong standardized operating margins across size categories, ranging from 26.4% for the $2.5 billion + AUM category to 30.0% for the $1.0 to $2.5 billion size category.  Even the smallest size category, RIAs with $100 to $250 million AUM, reported standardized operating margins of 28.9%.As indicated by the Schwab survey, succession planning is at the bottom of many firms’ to-do lists, but it’s a critical issue that all firms will have to face eventually.  For more information on RIA succession planning, keep an eye out for our upcoming whitepaper, Buy-Sell Agreements for Wealth Management Firms (scheduled for release in early September).

Through the first half of 2019, asset and wealth manager M&A has kept pace with 2018, which was the busiest year for sector M&A over the last decade. M&A activity in the back half of 2019 is poised to continue at a rapid pace as business fundamentals and consolidation pressures continue to drive deal activity. Several trends, which have driven the uptick in sector M&A in recent years, have continued into 2019, including increasing activity by RIA aggregators and rising cost pressures.Total deal count during the first half of the year is on pace to slightly exceed 2018’s record levels. Reported deal value during the first half of 2019 was down significantly, although the quarterly data tends to be lumpy and many deals have undisclosed pricing. Acquisitions by (and of) RIA consolidators continue to be a theme for the sector. The largest deal of the second quarter was Goldman Sachs’s $750 million acquisition of RIA consolidator, United Capital Partners. The deal is a notable bid to enter the mass-affluent wealth management market for Goldman Sachs. For the rest of the industry, Goldman’s entrance into the RIA consolidator space is yet another headline that illustrates the broad investor interest in the consolidator model. If there was any doubt of that fact, just a few weeks ago it was reported that Mercer Advisors (no relation), an RIA consolidator managing $16 billion, is up for sale by its PE backer, Genstar Capital.  Mercer could fetch an estimated $700 million price tag, putting it in a similar size bracket as the United Capital acquisition. These RIA aggregators have been active acquirers in the space themselves, with Mercer Advisors and United Capital Advisors each acquiring multiple RIAs during 2018 and the first half of 2019. The wealth management consolidator Focus Financial Partners (FOCS) has also been active since its July 2018 IPO, although acquisitions slowed during the second quarter of 2019. Focus announced a total of eight transactions during the second quarter, most of which were smaller sub-acquisitions by partner firms, except for the acquisition of William, Jones & Associates, a New York-based RIA managing $7 billion. The prospect of using buyer resources to facilitate their own M&A may be a key motivation.Sub-acquisitions by Focus Financial’s partner firms and other firms owned by RIA consolidators are a growing M&A driver for the industry. These acquisitions are typically much smaller and are facilitated by the balance sheet and M&A experience of the consolidators. For some RIAs acquired by consolidators, the prospect of using buyer resources to facilitate their own M&A may be a key motivation for joining the consolidator in the first place. For the consolidators themselves, these deals offer a way to drive growth and extend their reach into the smaller RIA market in a way that is scalable and doesn’t involve going there directly.Consolidation RationalesThe underpinnings of the M&A trend we’ve seen in the sector include the lack of internal succession planning at many RIAs and the increasing importance of scale against a backdrop of rising costs and declining fees. While these factors are nothing new, sector M&A has historically been less than we might expect given the consolidation pressures the industry faces.Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task. The risks include cultural incompatibility, lack of management incentive, and a size-impeding alpha generation. Many RIA consolidators structure deals to mitigate these problems by providing management with a continued interest in the economics of the acquired firm, while allowing it to retain its own branding and culture. Other acquires take a more involved approach, unifying branding and presenting a homogeneous front to clients in an approach that may offer more synergies, but may carry more risks as well.Market ImpactIn 2019, equity markets have largely recovered and trended upwards.Deal activity in 2018 was strong despite the volatile market conditions that emerged in the back half of the year. So far in 2019, equity markets have largely recovered and trended upwards. Publicly traded asset managers have lagged the broader market so far in 2019, suggesting that investor sentiment for the sector has waned after the volatility seen at year-end 2018.M&A OutlookConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. The continuation of these trends will pressure RIAs to seek scale, which will in turn drive further M&A activity.With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression. An aging ownership base is another impetus. The recent market volatility will also be a key consideration for both sellers and buyers in 2019.

Broad market indices generally increased over the last quarter, and publicly traded asset and wealth manager stocks followed suit.Publicly traded traditional asset and wealth managers ended the quarter up 6.2%, beating out the S&P 500, which rose 2.6%.  Alt managers were the bright spot in the sector, up nearly 18%.  Aggregators and multi-boutique model firms did not fare well, despite all the hype about consolidation pressures in the industry and the high-profile deals in the aggregator space.  These businesses ended the quarter down more than 14%. Ordinarily, we’d expect investment manager stocks to outperform the S&P in a stock market rally, for the simple reason that higher AUM leads to higher revenue and an even greater increase in profitability with the help of operating leverage. This was the case during the second quarter when multiples continued to recover from December lows, and profitability remained steady to improving.  As a result, asset and wealth management stocks saw positive performance relative to the S&P 500 during the second quarter, as shown in the chart above.  Expand the chart over the last year, however, and the story for traditional asset and wealth managers looks less upbeat. Over the last year, traditional asset and wealth managers have trailed the market significantly.  While the S&P 500 is up 8% over the last year, asset and wealth manager stocks are down 5%. While the S&P 500 is up 8% over the last year, asset and wealth manager stocks are down 5%.The asset and wealth management industry is facing numerous headwinds, chief among them being ongoing pressure for lower fees.  Traditional asset and wealth managers feel this pressure acutely, which has likely contributed to their relative underperformance over the last year.  Alt managers, which have been the sector’s sole bright spot during this time, are more insulated from fee pressure due to the lack of passive alternatives to drive fees down.The aggregator and multi-boutique index has declined over 30% during the last twelve months.  Several firms in this category have contributed to this decline, but the largest driver has been Focus Financial’s major pullback from its lofty IPO price.The performance of asset and wealth management stocks over the quarter was supported by an improving price to earnings multiple.  Multiples for publicly traded asset managers fell considerably near the end of 2018 as the broader equity markets pulled back.  While there has been some rebound so far in 2019, multiples remain below the typical historical range.[caption id="attachment_27075" align="aligncenter" width="394"]Source: SNL Financial[/caption] Implications for Your RIAThe multiple expansion in the public markets combined with the expectation for stable-to-improving earnings, given the movement in broad market indices, suggests an improving outlook for privately held RIAs.  If the public markets have relaxed a bit in pricing the industry headwinds, resulting in a higher multiple, then it is reasonable to assume that the same trend will have some impact on the pricing of privately held RIAs as well.But the public markets are just one reference point that informs the valuation of privately held RIAs, and developments in the public markets may not directly translate to privately held RIAs.  Depending on the growth and risk prospects of a particular closely held RIA relative to publicly traded asset and wealth managers, the privately held RIA can warrant a much higher, or much lower, multiple.These factors all contribute to the less-than-perfect comparability between publicly traded companies and most privately held RIAs.In our experience, the issues of comparability between small, privately held businesses and publicly traded companies are frequently driven by key person risk/lack of management depth, smaller scale, and less product and client diversification.  These factors all contribute to the less-than-perfect comparability between publicly traded companies and most privately held RIAs.  Still, publicly traded companies provide a useful indication of investor sentiment for the asset class, and thus, should be given at least some consideration.Improving OutlookThe outlook for RIAs depends on a number of factors.  Investor demand for a particular manager’s asset class, fee pressure, rising costs, and regulatory overhang can all impact RIA valuations to varying extents.  The one commonality, though, is that RIAs are all impacted by the market.  Their product is, after all, the market.The impact of market movements varies by sector, however.  Alternative asset managers tend to be more idiosyncratic but are still influenced by investor sentiment regarding their hard-to-value assets.  Wealth managers and traditional asset managers are vulnerable to trends in asset flows and fee pressure.  Aggregators and multi-boutiques are in the business of buying RIAs, and their success depends on their ability to string together deals at attractive valuations.On balance, the outlook for RIAs appears to have improved since the end of 2018.  The market has recovered following the Q4 correction, and multiples have trended upwards, although they remain below historical norms.More attractive valuations could entice more M&A, coming off the heels of a record year in asset manager deal making.  We’ll keep an eye on all of it during what will likely be a very interesting year for RIA valuations.

Much of the sector’s recent press has focused on the current M&A environment as well as practice management issues for RIA firms, so we’ve highlighted some of the more salient pieces on these topics and a few others that are making news in the investment management industry.Goldman Sachs Readies Splashy RIA Retail Debut as it (Likely) Adds $24-Billion United Capital to $35-Billion AUM Ayco for $59-Billion 82 Office Behemoth; Months After Buying RIA Lure From S&PBy Oisin Breen, RIABiz Goldman Sachs recently completed its acquisition of United Capital for $750 million, marking a major expansion into the RIA space for Goldman and a significant endorsement of the RIA aggregator model.  The deal value represents approximately 3% of United Capital’s $24 billion AUM and a little over 3x revenue of $230 million.M&A Gains Drive Focus’ 33% Revenue GrowthBy Jessica Mathews, FinancialPlanning RIA aggregator Focus Financial reported 33% year-over-year revenue growth in the first quarter.  The growth comes primarily from new partner firms acquired over the last year.  In its IPO filings last year, Focus management outlined a growth strategy based on continued M&A and organic growth at Focus’s partner firms.  While organic growth has faltered somewhat (partly due to market conditions), Focus has clearly executed on the M&A component of its growth strategy.  So far this year, Focus has acquired 21 firms, with 12 of those acquisitions taking place in the first quarter.Bye-bye Broker Protocol: HighTower Exits in Identity MakeoverBy Charles Paikert, FinancialPlanning HighTower Advisors has exited the broker protocol, the industry agreement which allows advisors switching employers to take basic client contact information with them.  Exiting the protocol reflects the evolution of HighTower’s business model from recruiting wirehouse teams to focusing on RIA acquisition activity.  For some, the decision to exit the protocol is seen as a way to increase retention — perhaps in preparation for a future liquidity event.  With recent liquidity events from the other two major roll-up firms, Focus Financial and United Capital, now may be a good time to exit for PE-backed HighTower.U.S. Wealth Management Becomes Hotbed of M&A By Chris Flood, Financial Times Private equity interest in wealth management has continued to increase, given the industry’s growth opportunities and stable cash flows.  The wealth management industry remains highly fragmented but is poised to consolidate.Merger Mania: Why Consolidation in the RIA Space is About to ExplodeBy Jeff Benjamin, InvestmentNews Some industry players see the pace of consolidation picking up.  Ron Carson, CEO of Carson Group, predicts that in seven years there will be a third less firms than there are today.  Historically, there has been less consolidation than we would expect given the size and fragmentation of the industry.  However, given the current dynamics of aging ownership, PE interest in the space, and consolidators offering scale and back office efficiencies, the pace of M&A may accelerate significantly.Kitces: The Ratios That Determine Advisory Firm SuccessBy Michael Kitces, FinancialPlanning Tracking productivity, identifying its drivers, and understanding how to improve are important aspects of managing a successful advisory firm.  Michael Kitces offers his take on some of the key performance metrics for advisory firms. In summary, consolidation and M&A continue to be major trends in the investment management industry.  RIAs continue to receive interest from PE investors due to the recurring revenue and growth potential that wealth management firms offer.  Aging ownership bases have also contributed to the consolidation tailwind.  The RIA aggregator model has now been endorsed by Goldman Sachs with its acquisition of United Capital, as well as the public markets with Focus Financial’s IPO last year.  Whether HighTower’s PE backers will seek an exit in the near term remains to be seen, but given the interest in the Focus IPO and the attractive multiple offered by Goldman for United Capital, it is clear that market interest in the aggregator model is strong.

Last year marked the busiest year for asset manager M&A in the last decade, and the trend is poised to continue into 2019 as business fundamentals and consolidation pressures continue to drive deal activity.Several trends which have driven the uptick in sector M&A in recent years have continued into 2019, including increasing activity by RIA aggregators and rising cost pressures.  Total deal count during the first quarter of 2019 was flat compared to the same period in 2018, while deal count was up 35% for the twelve months ending March 31, 2019, compared to the comparative period ending March 31, 2018.  Reported deal value during the first quarter of 2019 was down significantly, although the quarterly data tends to be lumpy and many deals have undisclosed pricing.2018 marked the busiest year for asset manager M&A in the last decade, and the trend is poised to continue into 2019.Consolidation has been a driver of many of the recent large deals, as exemplified by the largest deal of last year, Invesco’s (IVZ) acquisition of OppenheimerFunds.  IVZ announced plans in the fourth quarter last year to acquire the OppenheimerFunds unit from MassMutual for $5.7 billion in one of the largest sector deals over the last decade.  IVZ will tack on $250 billion in AUM as a result of the deal, pushing total AUM to $1.2 trillion and making the combined firm the 13th largest asset manager by AUM globally and the 6th largest by retail AUM in the US.  The deal marks a major bet on active management for IVZ, as OppenheimerFunds’s products are concentrated in actively-managed specialized asset classes, including international equity, emerging market equities, and alternative income.  Invesco CEO Martin Flanagan explained the rationale for scale during an earnings call in 2017:"Since I've been in the industry, there's been declarations of massive consolidation.  I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike."  Martin Flanagan – President and CEO, Invesco Ltd. 1Q17 Earnings CallRIA aggregators continued to be active acquirers in the space, with Mercer Advisors (no relation), and United Capital Advisors each acquiring multiple RIAs during 2018.  The wealth management consolidator Focus Financial Partners (FOCS) has been active since its July IPO as well.  So far in 2019, FOCS has announced 11 deals (including acquisitions by its partner firms).  Just last week, Silvercrest Asset Management announced the acquisition of Cortina Asset Management, a $1.7 billion small cap growth equity manager based in Milwaukee, Wisconsin.Consolidation Rationales The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, aging shareholder bases, and slowing organic growth for many active managers.  While these pressures have been compressing margins for years, sector M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation.  Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure as long as it doesn’t inhibit performance."Absolutely, this has been an elevated period of M&A activity in the industry and you should assume … we're looking at all of the opportunities in the market." Nathaniel Dalton, CEO, Affiliated Managers Group Inc – 2Q18 Earnings Call"Increased size will enable us to continue to invest in areas that are critical to the long-term success of our platform, such as technology, operations, client service and investment support, and to leverage those investments across a broader base of assets." David Craig Brown, CEO & Chairman, Victory Capital – 3Q18 Earnings CallConsolidation pressures in the industry are largely the result of secular trends.  On the revenue side, realized fees continue to decrease as funds flow from active to passive.  On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs.  Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to realize economies of scale, enhance product offerings, and gain distribution leverage.From the buyer’s perspective, minority interest deals ensure that management remains incented to continue to grow the business after the deal closes.Another emerging trend that has been driving deal volume is the rise of minority interest deals by private equity or strategic buyers.  These deals solve or mitigate many of the problems associated with acquisitions of what are normally “owner operated” businesses (at least for smaller RIAs).  Minority interest deals allow sellers to monetize a portion of their firm ownership (often a significant portion of their net worth).  From the buyer’s perspective, minority interest deals ensure that management remains incented to continue to grow the business after the deal closes.Market ImpactDeal activity in 2018 was strong despite the volatile market conditions that emerged in the back half of the year.  So far in 2019, equity markets have largely recovered and trended upwards.  Publicly traded asset managers have lagged the broader market so far in 2019, suggesting that investor sentiment for the sector has waned after the volatility seen at year-end 2018.M&A OutlookWith over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies.  Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression.  An aging ownership base is another impetus.  The recent market volatility will also be a key consideration for both sellers and buyers in 2019.

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

The market approach is a general way of determining the value of a business which utilizes observed market multiples applied to the subject company’s performance metrics to determine an indication of value.  The “market” in market approach can refer to either public or private markets, and in some cases the market for the subject company’s own stock if there have been prior arms’ length transactions.  The idea behind the market approach is simple: similar assets should trade at similar multiples (the caveat being that determining what is similar is often not so simple).  The market approach is often informative when determining the value of a wealth management firm.There are generally three methods that fall under the market approach.Guideline Public Company MethodGuideline Transaction MethodInternal Transaction Method All three methods under the market approach involve compiling multiples observed from either publicly traded guideline companies, comparable transactions in private companies, or prior transactions in the company’s own stock and applying the selected (and possibly adjusted) market multiples to the company’s performance measures.Multiple MultiplesThe most common multiples used when valuing wealth management firms are enterprise value (EV) to EBITDA1, EV to AUM, and EV to revenue multiples.  The multiples used are generally categorized into “activity” multiples and “profitability” multiples.  Activity multiples are multiples of AUM and revenue whereas profitability multiples are multiples of earnings metrics (e.g. EBITDA).Both profitability and activity multiples have their advantages and disadvantages.Both profitability and activity multiples have their advantages and disadvantages.  Activity multiples can provide indications of value for a subject wealth management firm that are only a function of the chosen activity metric—typically AUM or revenue.  Such an indication is not a function of the profitability of the firm, which can be an issue because the underlying profitability of a firm is the ultimate source of value, not revenue or AUM.  The benefit of activity metrics is that they can be used without explicitly making normalizing adjustments to a wealth management firm’s profitability.  The caveat, however, is that applying market-based AUM and revenue multiples to the subject wealth management firm’s activity metrics is essentially transposing the realized fee structures and EBITDA margins of the guideline companies onto the subject firm—an implicit assumption about normalized profitability and realized fees which may or may not be reasonable depending on the specific circumstances.Profitability multiples, on the other hand, explicitly take into account the subject firm’s profitability, which on its face is a good thing.  Profitability metrics are not without their drawbacks, however.  Differences in risk or growth characteristics will, all else equal, result in different EBITDA multiples.  If the risk or growth prospects of the subject company differ from the guideline companies that informed the selected EBITDA multiple, then the appropriate multiple for the subject company will likely differ from the observed market multiple.Subject Company MeasureOnce a market-based profitability multiple is obtained that reflects the risk and growth prospects of the subject firm, the next question is often: which EBITDA (or other profitability metric) is the multiple applied to?  Reported EBITDA?Management adjusted EBITDA?Analyst adjusted EBITDA?  Wealth management firms frequently require significant income statement adjustments—the largest of which is typically related to normalizing compensation—and so the answer to the question of which EBITDA to apply the multiple to can have a significant impact on the indicated value.It’s often said that “value is earnings times a multiple.”  While there is some truth to be had there, the simplicity of the statement belies the reality that the question of the appropriate multiple and the appropriate earnings is rarely straightforward, and buyers and sellers may have very different opinions on the answer.Guideline Public Company MethodThe guideline public company method is a method under the market approach that uses multiples obtained from publicly traded companies to inform the value of a subject company.  For wealth managers, the universe of publicly traded firms is relatively small – there are only about two dozen such firms in the U.S.The chart below shows historical EV / LTM EBITDA multiples for publicly traded RIAs with less than $100 billion in AUM (the size range which most of our clients fall in).  As can be seen, the public companies have generally traded in a band of 8-11x LTM EBITDA, although the pricing at the end of 2018 had fallen to a historically low multiple of just over 5 times, partly due to increased market volatility observed at year-end. When valuing small, privately held wealth management firms, the use of multiples from publicly traded companies—even the smallest of which is still quite large compared to most privately held RIAs—naturally brings up questions of comparability.  How comparable is a wealth management firm with, say, $1-10 billion in AUM and a few dozen employees to BlackRock, which manages over $6 trillion?  The answer is probably not very. The comparison of the small, privately held RIA to BlackRock is obviously extreme, but it illustrates the issues of comparability that are frequently present when using publicly traded companies to value privately held wealth management firms.  In our experience, the issues of comparability between small, privately held companies and publicly traded companies are frequently driven by key person risk/lack of management depth, smaller scale, and less product and client diversification.  These differences point towards greater risk for privately held RIAs versus the publicly traded companies, which, all else equal, suggests that the privately held RIAs should trade at a lower multiple to that observed in the public markets. The growth prospects for privately held RIAs can differ from publicly traded companies as well.  Because small, privately-held RIAs tend to be focused on a single niche, the growth prospects tend to be more extreme, either positive or negative, compared to publicly traded guideline companies.  A subject company’s singular niche may be growing quickly or shrinking, whereas the diversified product offerings of publicly traded companies are likely to have some segments that are growing and some that are shrinking, resulting in a moderated overall growth outlook.  The growth prospects, of course, impact the multiple at which the subject company should trade.  In some cases, we’ve seen RIAs much smaller than the guideline public companies transact at a premium to the then-prevailing observed public company multiples because of the RIA’s attractive growth prospects.  More often, however, the higher risk of the privately held RIA dominates, and the justified multiple is lower than the guideline public company multiples.  As a general rule, a smaller RIA means a smaller multiple. Despite the less than perfect comparability between publicly traded companies and most privately held RIAs, publicly traded companies provide a useful indication of investor sentiment for the asset class and thus should be given at least some consideration.  However, due to differences in risk and growth characteristics, adjustments to the multiples observed in the guideline companies may need to be made. Guideline Transactions MethodGuideline transactions of private companies in the wealth management space provide additional perspective on current market pricing of RIAs.  The guideline transactions method uses these multiples to derive an indication of value for a subject firm.The transaction data is appealing because the issues of comparability are generally less pronounced than with the guideline public companies.  There are caveats to the guideline transactions method, however.  One unique consideration for the use of the guideline transactions method in the wealth management industry is that deals in the industry almost always include some form of (often substantial) contingent consideration (earn-out).  The structure of such contingent consideration will be tailored to each deal based on the specific concerns and negotiations of the buyers and sellers.  In any event, the details of the earn-out payments are often not publicly available.  The lack of available information on deal terms can make it difficult to determine the actual value of the consideration paid, which translates into uncertainty in the guideline transaction multiples.The lack of available information on deal terms can make it difficult to determine the actual value of the consideration paid, which translates into uncertainty in the guideline transaction multiples.Another important consideration is that deals in the industry occur for unique reasons and often involve unique synergies.  It’s not always reported what these are, and the specific factors that motivated a particular guideline transaction may not be relevant for the subject company.  The type of buyer in a guideline transaction is another consideration.  Private equity (financial buyers) will have different motivations and will be willing to pay a different multiple than strategic buyers.Despite an uptick in sector deal activity over the last several years, there are still relatively few reported transactions that have enough disclosed detail to provide useful guideline transactions multiples.  Looking at older transactions increases sample size, but it also adds transactions that occurred under different market conditions, corporate tax environments, and the like.  Stale transaction data may not be relevant in today’s market.Internal Transaction MethodThe internal transactions method is a market approach that develops an indication of value based upon consideration of actual transactions in the stock of a subject company.  Transactions are reviewed to determine if they have occurred at arms’ length, with a reasonable degree of frequency, and within a reasonable period of time relative to the valuation date.  Inferences about current value can sometimes be drawn, even if there is only a limited market for the shares and relatively few transactions occur.However, even arms’ length transactions in the subject company stock occur for unique reasons and often involve unique synergies which means even these implied multiples are not always a clear indicator of value.Rules of Thumb: Where They Come From and Why They (Sometimes) Make No SenseObserved market multiples are often condensed into “rules of thumb,” or general principals about what an investment firm is or should be worth.  These rules provide a simple, back-of-the-envelope way of quickly computing an indicated value of a wealth management firm.  However, rules of thumb are not one-size-fits-all.  Consider the example below, which shows a “2% of AUM” rule of thumb applied to two firms, A and B: Both Firm A and Firm B have the same AUM.  However, Firm A has a higher realized fee than Firm B (100 bps vs 40 bps) and also operates more efficiently (25% EBITDA margin vs 10% EBITDA margin).  The result is that Firm A generates $2.5 million in EBITDA versus Firm B’s $400 thousand despite both firms having the same AUM.  The “2% of AUM” rule of thumb implies an EBITDA multiple of 8.0x for Firm A—a multiple that may or may not be reasonable for Firm A given current market conditions and Firm A’s risk and growth profile, but which is nevertheless within the historical range of what might be considered reasonable.  The same “2% of AUM” rule of thumb applied to Firm B implies an EBITDA multiple of 50.0x—a multiple which is unlikely to be considered reasonable in any market conditions. We’ve seen rules of thumb like the one above appear in buy/sell agreements and operating agreements as methods for determining the price for future transactions among shareholders or between shareholders and the company.  The issue, of course, is that rules of thumb—even if they made perfect sense at the time the document was drafted—do not have a long shelf life.  A lot can change that can make a once sensible rule of thumb seem outlandish due to changes at the firm itself or in the broader market for wealth management firms. Reconciliation of ValueThe market approach provides useful information about the current market conditions and investor sentiment for wealth management firms, but the method also has limitations and important considerations that need to be made, many of which are specific to the wealth management industry.  Any valuation is as of a specific date and should reflect the market and universe of alternative investments as of that valuation date—which ultimately is what market approach indications of value are informed by.  On the other hand, the fundamentals of a subject company may suggest a valuation that differs from market-based indications.  Whatever the concluded value—it should make sense in light of both the current market conditions and indications of value developed under the income approach.1 Wealth management firms tend to have little “DA”, so EBITDA is typically approximately equal to EBIT and operating income.

Asset manager M&A was robust throughout 2018 against a backdrop of volatile market conditions.  Several trends which have driven the uptick in sector M&A in recent years continued into 2018, including increasing activity by RIA aggregators and rising cost pressures.  Total deal count during 2018 increased 49% versus 2017 and total disclosed deal value was up nearly 140% to $18.0 billion.  In terms of both deal volume and deal count, asset manager M&A reached the highest levels since 2009. M&A was particularly strong in the fourth quarter when Invesco Ltd. (IVZ) announced plans to acquire the OppenheimerFunds unit from MassMutual for $5.7 billion in one of the largest sector deals over the last decade.  IVZ will tack on $250 billion in AUM as a result of the deal, pushing total AUM to $1.2 trillion and making the combined firm the 13th largest asset manager by AUM globally and the 6th largest by retail AUM in the U.S.  The deal marks a major bet on active management for IVZ, as OppenheimerFunds’ products are concentrated in actively-managed specialized asset classes, including international equity, emerging market equities, and alternative income.  Invesco CEO Martin Flanagan explained the rationale for scale during an earnings call back in 2017: "Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike." Martin Flanagan, President and CEO, Invesco Ltd. – 1Q17 Earnings CallRIA aggregators continued to be active acquirers in the space, with Mercer Advisors (no relation), and United Capital Advisors each acquiring multiple RIAs during 2018.  The wealth management consolidator Focus Financial Partners (FOCS) has been active since its July IPO as well.  In August, FOCS announced the acquisition of Atlanta-based Edge Capital Group, which manages $3.5 billion in client assets.  FOCS also announced multiple sub-acquisitions by its affiliates during the second half of 2018.Consolidation Rationales The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, aging shareholder bases, and slowing organic growth for many active managers.  While these pressures have been compressing margins for years, sector M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation.  Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure as long as it doesn’t inhibit performance."Absolutely, this has been an elevated period of M&A activity in the industry and you should assume … we're looking at all of the opportunities in the market." Nathaniel Dalton, CEO, Affiliated Managers Group Inc – 2Q18 Earnings Call"Increased size will enable us to continue to invest in areas that are critical to the long-term success of our platform, such as technology, operations, client service and investment support, and to leverage those investments across a broader base of assets." David Craig Brown, CEO & Chairman, Victory Capital – 3Q18 Earnings CallConsolidation pressures in the industry are largely the result of secular trends.  On the revenue side, realized fees continue to decrease as funds flow from active to passive.  On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs.  Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to realize economies of scale, enhance product offerings, and gain distribution leverage.Market ImpactRecent increases in M&A activity come against a backdrop of a long-running bull market in asset prices that finally capitulated in late 2018.  Over the past several years, steady market gains have more than offset the consistent and significant negative AUM outflows that many active managers have seen.  Now that the market has pulled back, AUM, revenue, and earnings are likely to be lower for many asset managers.The recent market pullback will impact sector deal making in several ways.  Notably, earnings multiples for publicly traded asset managers have fallen considerably during 2018, which suggests that market sentiment for the sector has waned as the broader market has declined.  While the lower multiple environment is clearly less favorable for sellers, market volatility may force some smaller, less profitable firms into selling in order to remain viable.  For buyers, the lower multiple environment may make the sector look relatively underpriced though some may be spooked by the recent volatility.M&A OutlookWith over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies.  Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth.  An aging ownership base is another impetus.  The recent market volatility will also be a key consideration for both sellers and buyers in 2019.

While equity market volatility was relatively subdued during the third quarter, 2018 as a whole has seen much higher volatility than last year.  This volatility may be an opportunity for active asset managers, although the industry continues to face fee pressures and increasing costs.  Scale is increasingly important for asset managers as assets flow into lower fee products due to secular trends in the industry and de-risking during recent periods of heightened volatility.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1:  Periods of heightened volatility may drive some client rebalancing, but there may also be opportunity for active managers.  [W]hen I see this volatility, it's actually a good thing because what it shows is the value of prudent fiduciary advice, which is what our partners are really focusing on.  So as I said in my remarks, in so many ways, I like the volatility. I think it's a good thing.  And I don't see some major impact in terms of our flows or if there's one thing we learned in 2008, our client retention remained excellent.  And what really helped was ultimately the very prudent approach that our partners took towards the constructing their portfolios. – Rudy Adolf, Focus Financial Founder, CEO & ChairmanAsset and wealth managers are rethinking their business models and looking for ways to operate more efficiently and rigorously managing risk in more volatile market environments. – Laurence Douglas Fink, Blackrock Chairman & CEOAnd I think the volatility is, as we said, is an opportunity for our investment teams as well as the business.  And we've seen some rebalancing occur, but the relationships and the long-term clients are very strong, and we think the business is positioned very strong, so we don't see anything abnormal with regards to the rebalancing. – Eric Richard Colson, Artisan Partners Asset Management Chairman, President & CEOTheme 2:  Scale is increasingly important in the industry as firms seek to gain distribution leverage and spread rising costs over a larger asset base.[W]e've talked about the opportunity to potentially leverage our collective scale and find ways to be more efficient.  And we do see significant opportunities there.  As I mentioned, we have early days with respect to procurement, and Pete and his team are working on the common financial platform. And those will yield some real efficiencies for us.  And that will allow us to do three things - One will be to compete more effectively on price; secondly, to be able to invest more in our business as that's being required and needed; and then thirdly, to potentially return more for shareholders. – Joseph A. Sullivan, Legg Mason Chairman, President & CEO[I] think large acquisitions are very difficult.  There's a lot of risk in them, I think, in just the brand and who you are as a firm.  But I think, again, if the right situation came up where you think you can take out a lot of costs and create value, we're going to certainly look at that and be open to that. – Gregory Eugene Johnson, Franklin Resources Chairman & CEOIncreased size will enable us to continue to invest in areas that are critical to the long term success of our platform, such as technology, operations, client service and investment support, and to leverage those investments across a broader base of assets. – David Craig Brown, Victory Capital CEO & ChairmanTheme 3:  Asset flows continue to be impacted by secular trends towards low fee passive products and the recent heightened equity market volatility.[W]e do see a continued move to passive, but we think the rate of that growth probably slows a little bit.  [W]e are believers in active management.  We believe that good, active managers do deliver alpha.  You got to prove it.  You got to earn your fees in that respect.  People are looking for differentiated, uncorrelated returns. – Joseph A. Sullivan, Legg Mason Chairman, President & CEOThe other area where you're seeing, especially from the wires, which is starting to become a bigger driver of their business, and one of the reasons why we believe over the next five years, ETFs will double in size, is how more and more wires as they move more towards away from brokerage and more to a consultative relationship or advice, they're using more models. And in the models are heavily populated by different BlackRock and iShares products. – Laurence Douglas Fink, Blackrock Chairman & CEOWhile we saw a modest pickup in industry flows during the third quarter, primarily attributable to ETFs, we also saw accelerated derisking by many clients in an environment marked by continuing trade tensions, a further slowdown in emerging markets, and the steepening yield curve. – Gary Stephen Shedlin, Blackrock MD & CFOWe have seen fee pressure, which we've talked about on past calls.  When you get into the very large allocations, especially in the public funds or the sovereign wealth funds, and when you get to the sizeable mandates, there's been a real shift in the market price of fees right now.  They've gone much lower than we're willing to go. – Eric Richard Colson, Artisan Partners Asset Management Chairman, President & CEO

Much of the sector’s recent press has focused on succession planning and M&A trends, so we’ve highlighted some of the more salient pieces on these topics and a few others that are making news in the asset and wealth management industries.Why Building a Multibillion Dollar Firm is Not for the Faint of Heartby Charles Paikert, Financial Planning Growing an advisory practice into an enterprise with value beyond its founders is tough work.  Transitioning to a sustainable enterprise means hiring the right group of people to gradually assume management roles, but many firms lack experience developing personnel internally.  Consequently, RIAs are increasingly making lateral hires or expanding through M&A.Mark Tibergien and Dan Seivert Listen Up!  Dave Welling Explains Why Rising Private Equity Involvement in the RIA Business is Flat-Out Greatby David Welling, RIABiz (guest author) Many RIA industry commentators have decried PE firms investing in RIAs as little more than short-sighted financial engineers.  In fact, many RIAs we’ve worked with wear employee ownership and lack of outside capital as a badge of honor.  However, David Welling (CEO of Mercer Advisors, no relation) argues that PE capital may actually be a great thing for the industry and its clients.  To be fair, Welling’s own firm has been PE-owned for 10 years, but nevertheless, he provides an interesting perspective on PE capital and its potential impact on growth and succession planning for RIAs.The Importance of Having Cultureby James J. Green, ThinkAdvisor In our experience, firm culture is a key factor that contributes to an RIA’s success.  Culture is not one-size-fits-all, and there’s certainly more than one way to build a culture that “works.”  However, what successful firms tend to have in common is that they are deliberate about building a culture that values great people and differentiates the firm from the competition.  This article profiles registered rep Steve Rudolph and his IBD firm HW Financial Advisors, and how being deliberate about great culture has helped the firm grow to $600 million AUM with six advisors.Merrill Lynch Cuts Broker Payby Lisa Beilfuss, WSJ Merrill Lynch is cutting broker pay beginning in January.  Merrill’s recently-announced compensation plan for 2019 includes a 3% penalty on brokerage and investment advisory production below $1.6 million annually.  Many of Merrill’s 17,000 advisors see the move as an effort to promote cross-selling bank products, fees from which are not penalized under the new plan.Schwab Studies Zero-Fee Mutual Funds in Wake of Fidelity’s Zero-Fee Mutual Fund Launch, but Schwab CEO Walt Bettinger Still Wonders ‘What’s the Point?’by Brooke Southall, RIABiz Asset managers are taking note after Fidelity won the race to the bottom by launching two zero fee index funds in August.  Schwab CEO Walt Bettinger revealed that the firm is vetting the idea of launching similar zero fee products at the firm’s Fall Business Update.Wealth-Management Firms Battle Over Millennialsby Rob Curran, WSJ Millennials’ financial assets are expected to grow to more than $11 trillion over the next 12 years.  Clearly, this demographic is increasingly important for the wealth management industry, but it is unclear how well RIAs will attract millennials’ assets in the face of stiff competition from fintech products.  On one hand, as millennials gain wealth and their financial lives become more complicated, they may gravitate to more traditional wealth management services.  On the other, fintech products that started with a narrow focus are quickly expanding their product offerings and capabilities to meet growing demand.Top 6 Trends in Wealth Management: Chip Roameby Janet Levaux, ThinkAdvisor Some of these trends are no surprise – growing use of cost-conscious products, greater managed account assets, increasing RIA assets and number of RIAs, etc…  Perhaps more surprising is the persistent importance of baby boomers’ assets in the industry.  Despite the supposed battle for millennials’ assets, baby boomers’ assets are projected to grow from $26 trillion today (50%+ of the total) to $40.7 trillion in 2027 (40%+ of the total). In summary, succession planning remains a major issue for asset and wealth managers, and will likely remain so as the ownership base ages.  For some “enterprise” firms, succession may be best handled internally.  For others, PE or PE-backed aggregators may provide a sensible solution.  For firms in the latter category, the same culture which makes those firms successful may be a barrier to raising outside capital.  To further complicate matters, the industry backdrop remains one of declining fees, evolving products, and a shifting client base.

Asset manager M&A was robust through the first three quarters of 2018 against a backdrop of volatile market conditions.  Several trends which have driven the uptick in sector M&A in recent years have continued into 2018, including increasing activity by RIA aggregators and rising cost pressures.  Total deal count during the first three quarters of 2018 increased 45% versus the same period in 2017, and total disclosed deal value was up over 150%.  In terms of both deal volume and deal count, M&A is on pace to reach the highest levels since 2009. Thus far in the fourth quarter, M&A shows no signs of slowing down.  Just last week, Invesco Ltd. (IVZ) announced plans to acquire the OppenheimerFunds unit from MassMutual for $5.7 billion in one of the largest sector deals over the last decade.  IVZ will tack on $250 billion in AUM as a result of the deal, pushing total AUM to $1.2 trillion and making the combined firm the 13th largest asset manager by AUM globally and the 6th largest by retail AUM in the U.S.  The deal marks a major bet on active management for IVZ, as OppenheimerFunds’ products are concentrated in actively-managed specialized asset classes, including international equity, emerging market equities, and alternative income.  Invesco chief Martin Flanagan explained the rationale for scale during an earnings call last year: "Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike. And, you have to be, as a firm, you have to be able to invest in the future.  And I think a number of smaller-sized firms are finding that hard." Martin Flanagan, President and CEO, Invesco Ltd. – 1Q17 Earnings CallRIA aggregators continued to be active acquirers in the space, with Mercer Advisors (no relation), and United Capital Advisors each acquiring multiple RIAs over the last year.  The wealth management consolidator Focus Financial Partners (FOCS) has been active since its July IPO as well.  In August, FOCS announced the acquisition of Atlanta-based Edge Capital Group, which manages $3.5 billion in client assets.  FOCS also announced several sub-acquisitions by its affiliates during the third quarter.Consolidation Rationales The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, aging shareholder bases, and slowing organic growth for many active managers.  While these pressures have been compressing margins for years, sector M&A has historically been muted.  This has been due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation.  Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure as long as it doesn’t inhibit performance."Absolutely, this has been an elevated period of M&A activity in the industry and you should assume alongside our proprietary calling effort, we're looking at all of the opportunities in the market." Nathaniel Dalton, CEO, Affiliated Managers Group Inc. – 2Q18 Earnings Call "[I] think again these trends towards greater regulation, greater exposure, greater need to diligence managers and all that kind of stuff, greater suitability, all these things are driving towards doing business with fewer managers, larger managers, more diversified managers…" Joseph Sullivan, CEO, Legg Mason, Inc. – July 2018 Earnings CallConsolidation pressures in the industry are largely the result of secular trends.  On the revenue side, realized fees continue to decrease as funds flow from active to passive.  On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs.  Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to realize economies of scale, enhance product offerings, and gain distribution leverage.Market ImpactRecent increases in M&A activity come against a backdrop of a bull market in asset prices that has continued through the third quarter of 2018.  Steady market gains have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years.  In 2016, for example, active mutual funds’ assets grew to $11 trillion from $10.7 trillion, despite $400 billion in net outflows according to data from Bloomberg.  Because of increasing AUM and concomitant revenue growth, profitability has been trending upwards despite industry headwinds that seem to rationalize consolidation.M&A OutlookWith over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies.  Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms have struggled with organic growth.  An aging ownership base is another impetus, and recent market gains might induce prospective sellers to finally pull the trigger, which could further facilitate M&A’s upward trend during the rest of 2018.

Alternative investment managers took off in the wake of the financial crisis when investors flocked to risk mitigating strategies and uncorrelated asset classes; however, during 2015 and 2016 these businesses floundered against a backdrop of strong equity market performance.  Alt managers bounced back in 2017, and over the last twelve months, have continued to perform well.  Despite improving performance over the last two years, the industry continues to face a number of headwinds, including fee pressure, expanding index opportunities, and relative underperformance.Segment StrugglesHedge fund managers, in particular, have struggled since the financial crisis.  Although industry assets reached a record $3.2 trillion in 2018, net inflows have stagnated and the record AUM level is primarily due to market increases rather than investor interest in the asset class.  At the same time, the industry is struggling with fee schedules that continue to decline and a plummeting number of new funds being established.1Despite improving performance over the last two years, the industry continues to face a number of headwindsMany of the hedge fund industry’s woes can be traced back to significant underperformance over the last decade.  Since 2009, the S&P 500 index has dwarfed the performance of hedge funds (as measured by the HFRI Fund Weighted Composite Index), and this underperformance has driven outflows and fee declines.  Part of industry’s underperformance may be attributable to the protracted bull market.  While it may seem counterintuitive that strong market performance would be a bad thing for an asset manager, a long/short fund that seeks to generate positive returns regardless of which way the market moves is naturally going to underperform during prolonged periods of steady market increases.  Recent volatility in the equity markets may alleviate this underperformance, but the numbers haven’t been reported yet.Other categories of alt managers have suffered many of the same difficulties as hedge funds in justifying their value propositions over the last decade.  Alternative asset classes saw major inflows after the financial crisis due to their lack of correlation with traditional asset classes.  Fast forward to today, the S&P 500 index has grown at a nearly 16% CAGR since bottoming out in 2009. Investors holding asset classes uncorrelated to U.S. equities over the last decade probably wish they hadn’t been with hindsight.While performance has been volatile, alt managers closed out the year ended September 30 up 7.8%Industry PerformanceThe industry has endured and performed reasonably well over the last year, at least in the eyes of market participants.  While performance has been volatile, alt managers closed out the year ended September 30 up 7.8% — making them one of the better performing sectors of publicly traded asset managers over the past year.  For all the problems the industry faces, most investors still value the diversification offered by alternative assets, particularly late in the economic cycle.  While active management may not be as lucrative as it once was, it is still sought by many institutional investors to complement their passive holdings.Taking a closer look at the performance of the alt manager index’s constituent companies over the last year reveals that most of the positive performance was attributable to publicly traded private equity managers, with KKR, Blackstone (BX), and Apollo (APO) all beating the S&P 500 while Carlyle Group (CG) was up modestly.  Oaktree Capital Management (OAK), which specializes in distressed debt, was down 5.8% while hedge fund manager Och-Ziff Capital Management (OZM) declined more than 50% over the last year on issues with succession and investment performance.Given the performance over the last year, the market appears to be reasonably optimistic about the prospects for most publicly traded alt managers, at least relative to other categories of asset managers.  Some of the fundamentals are improving as well.  Asset flows out of active products seem to have stabilized, and AUM growth has generally been outpacing fee compression in recent quarters.  We think performance fees will likely continue to fall (in one form or another), but like active management, never be totally eliminated.  So on balance, a modestly improving outlook for the industry appears justified.1 The Incredible Shrinking Hedge Fund.  Bloomberg.

During the recent market cycle, asset managers have benefited from global increases in financial wealth driven by a bull market in most asset prices.  These favorable trends in asset prices have masked some of the headwinds the industry faces, including growing consumer skepticism of higher-fee products and regulatory overhang.Traditional active managers have felt these pressures most acutely, as poorly differentiated active products struggled to withstand downward fee velocity and at the same time, have been a prime target of regulatory developments.  To combat fee pressure, traditional asset managers have had to either pursue scale (e.g. BlackRock) or offer products that are truly differentiated (something that is difficult to do with scale).  Investors have been more receptive to the value proposition of alternative asset managers and wealth managers, and these businesses are (so far) better positioned to maintain pricing schedules as a result.Third Quarter PerformanceReflective of the headwinds that the industry faces, asset managers generally underperformed broad market indices during the third quarter.  While major indices posted solid gains during the second quarter, the returns for asset managers were at best muted even though these businesses generally benefit from rising equity markets.  The operating leverage inherent in the business model of most asset managers suggests that market movements tend to have an amplified effect on the profitability (and stock prices) of these businesses, and in recent quarters that has been the case.  The reversal of that trend over the last two quarters may be indicative of investors’ increasing concerns about the headwinds the industry faces and the general uncertainty that arises late in the economic/market cycle. Taking a closer look at recent pricing reveals that traditional asset managers, which are perhaps the most affected by fee compression trends, ended the quarter down 5.9%.  Trust banks were also down 5.9% during the quarter, driven by poor performance at State Street and BNY Mellon – the index’s two largest components – after both companies reported weak Q2 performance and STT announced that it would acquire financial data firm Charles River Systems at a poorly-received valuation of $2.6 billion (9x revenue).  Alternative asset managers were up 12.2% and were the only sector to outperform the S&P 500.  Alternative managers have generally performed well in recent quarters as the product segment is less impacted by fee pressure than traditional active products.  Wealth managers were up 6.0% during the quarter, buoyed by market-driven increases in AUM, although these businesses face challenges with new client acquisition and maintaining pricing power. While wealth managers performed well during the quarter, they were outpaced by wealth management firm aggregator Focus Financial Partners (“FOCS”), which closed out the quarter up 44% since its noteworthy IPO in late July.  FOCS, of course, is not an RIA, but since FOCS is an aggregation of RIA cash flows, some comparison between FOCS and RIAs is inevitable.  FOCS is not necessarily a proxy for the performance of RIAs since the success of the FOCS business model depends on more than just the performance of its partner firms.  This is particularly true now as FOCS is growing rapidly and investors are arguably more attuned to FOCS’s ability to string together acquisitions at attractive deal terms than on the performance of the partner firms post-acquisition.  Over time, FOCS’s performance should bear some resemblance to that of the underlying partner firms, but right now the performance of FOCS might not be telling us much other than affirming the market’s conviction that it will continue to grow rapidly through acquisitions. Looking at the RIA size graph reveals that the mid-size public RIAs ($100-$500B AUM) were the clear winners over the quarter, up nearly 9%.  RIAs with $10-$100B in AUM were down nearly 4.0%, while the largest category ($500B+ AUM) was down just over 6%.  The smallest category of publicly traded RIAs (those with less than $10 billion AUM) was down over 18% during the quarter, although this is the least diversified category of RIAs with only two components.  Due to the lack of diversification, the smallest category of RIAs is subject to a high degree of volatility due to company-specific developments.  Most of our clients fall under this size category, and we can definitively say that these businesses (in aggregate) have not lost over 18% of their value since July as suggested by this graph. Market OutlookThe outlook for these businesses is market driven, though it does vary by sector.  Trust banks are more susceptible to changes in interest rates and yield curve positioning.  Alternative asset managers tend to be more idiosyncratic but still influenced by investor sentiment regarding their hard-to-value assets.  Wealth managers and traditional asset managers are more vulnerable to trends in active and passive investing.  The outlook for the industry during the rest of 2018 ultimately depends on how the industry headwinds continue to evolve and (as always) what the market does during the fourth quarter.

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.

After reaching record highs in late January, volatility in the equity markets picked up and has remained elevated through the second quarter.  While volatile equity markets and normalizing monetary policy offer opportunity for asset managers, the industry continues to face fee pressure and increasing costs.  At the same time, many asset managers are considering M&A as a means to gain distribution and operational leverage, reflecting the persistence of consolidation rationales in the industry.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1:  Normalizing monetary policy and continued equity market volatility through the second quarter suggest opportunities for active managers. We continue to believe that the uptick in volatility and the gradual trend toward normalization of monetary policy on the part of global central banks will provide a more favorable backdrop for active management over time. – Philip Sanders, CEO & CIO, Waddell & Reed Financial, Inc. [A]t a time of change and transition in the debt markets, we're especially proud of our positioning in fixed income in what is the largest asset class in the world … And I'm quite sure that [our fixed income managers] would tell you that they welcome higher rates and are confident in their ability to find wonderful investment opportunities in such an environment. – Joseph A. Sullivan, Chairman, CEO & President, Legg Mason, Inc.After a strong start to 2018, markets reversed mid-first quarter as escalating trade tensions, inflationary concerns and a flattening yield curve caused investors to pull back.  Market uncertainty continued throughout the second quarter, reflecting ongoing global trade tensions, a slowdown in emerging markets, increased volatility and widening credit spreads.  In the face of an uncertain and evolving investment landscape, clients have paused, deferring their investment decisions until they have greater clarity on the future. – Gary Shedlin, Senior MD & CFO, BlackRock, Inc.I think in a rising rate environment, a different kind of market, the value growth cycle, the 30-year spread of where we are of value versus growth, the strength of the dollar, all of these things can mitigate some of the pressures that we're seeing on the current flows.  So I think that, that's – we don't think that's forever. – Gregory Johnson, Chairman & CEO, Franklin Resources, Inc.Theme 2:  Fee pressure, distribution leverage, an aging owner base, and increasing regulatory compliance costs continue to be key drivers of sector M&A.Our [M&A] approach is very attractive to our target universe, which is prospective Affiliates that are looking for a permanent institutional partner and I would underline the word permanent there.  [A]t the highest level, we're helping solve a demographically driven kind of management ownership and succession problem for these firms, and we have a solution that preserves and protects their unique entrepreneurial cultures across successive generations of management.  That's why that kind of permanent underline is so important … Now in terms of the current environment – absolutely, this has been an elevated period of M&A activity in the industry and you should assume alongside our proprietary calling effort, we're looking at all of the opportunities in the market. – Nathaniel Dalton, President and Chief Executive Officer, Affiliated Managers Group, Inc.I think with the increase, the regulatory increase and the increase in expectations around due diligence, suitability and all of these things, it played – the distribution platforms just can't do it.  Nobody can do it.  And so I think again these trends towards greater regulation, greater exposure, greater need to diligence managers and all that kind of stuff, greater suitability, all these things are driving towards doing business with fewer managers, larger managers, more diversified managers, and then what I said earlier in my remarks, managers that can also work with them to create vehicles and unique structures to serve what they're trying to do for their clients in their region and then also potentially have the distribution support, the sales support, marketing support, all that kind of stuff to support the product and their salespeople, their bankers in the field. – Joseph A. Sullivan, Chairman, CEO & President, Legg Mason, Inc. [W]hen you look at capital, M&A is still the priority for the use of that capital on the balance sheet.  And I think the challenges that you mentioned, and we all know, whether it's fee pressure, passive or just the move to advisory from brokerage, will continue to put pressure on organic growth rates.  So we are, as we said on past calls, very active in looking. – Gregory Eugene Johnson, Chairman & CEO, Franklin Resources, Inc. [W]e also believe that you do need scale to be competitive in this marketplace.  If you asked me about the level of scale you needed 5 years ago, I would not have thought that was such a hugely important factor for success going forward.  It is, because of the demands on money managers going forward, to do more than just manage money for clients and not just invest in investment capabilities, but also in operational capabilities, largely around technology.  So scale becomes really an important factor as you look to success going forward, so you can make these investments all been talking about. – Martin L. Flanagan, President, CEO, & Director, Invesco, Ltd.Theme 3: The industry is continuing to evolve in response to ongoing fee pressure.  The way I think about it is in the core strategies, core fixed income, core equity, we're no different than anybody else.  There's pressure within the industry on fee rates.  That's clear … We're going to get some wins in core strategies, and they're going to be at lower fee rates than they were 10 years ago or they were 5 years ago or they were 3 years ago.  But we're also winning business and we have the opportunity to win business in [alternative] strategies that we didn't have 10 years ago or 5 years ago or 3 years ago that are in higher fee rate. – Joseph A. Sullivan, Chairman, CEO & President, Legg Mason, Inc.I generally think, consistent with the overall industry, as scale becomes more important and fees come under pressure … I think you'll see an increase in the amount of support provided by the model of a multi-boutique as opposed to each individual boutique doing everything themselves because again, it's generally always been a distraction and it's always been a little bit expensive.  But I think now, with some of the competitiveness and the fee pressures, it's just makes more and more sense for that model … to provide support to grow the business, support to distribute the business and to do all those back office and operational things. – George R. Aylward, President, CEO & Director, Virtus Investment Partners, Inc.I don't know that anybody has really true pricing power in this business.  Obviously, the better performance, you have a little bit of flexibility.  But at the end of the day … there are always going to be strong competitive products that have good performance.  And if you don't have competitive pricing structure, it's going to be really tough to grow those assets. – Philip James Sanders, CEO, CIO, & Director, Waddell & Reed Financial, Inc.

Wealth management firms have fared well in recent years on the back of rising markets, but the underlying drivers suggest an industry in flux; global investible assets are at all time highs, intergenerational wealth transfer is accelerating, and FinTech products are poised to disrupt.  Yet, many analysts are skeptical about the industry’s prospects.  Rising global wealth means that there are more assets for wealth managers to manage, and intergenerational wealth transfer means that there are also more opportunities to gain (and lose) clients.  FinTech products threaten competition, but also offer efficiencies for agile firms.  Depending on your point of view, the industry is either poised to grow or on the verge of massive disruption.The Next GenerationOne thing is clear: the wealth management industry has benefited from the fact that global wealth (and demand for wealth management services) has reached all-time highs.  According to Capgemini’s 2018 World Wealth Report, global wealth held by high net worth (HNW) individuals grew 10.6% to more than $70 trillion in 2017.  More wealth means, well, more wealth to manage, and revenue at wealth management firms has generally increased with the market.  However, for wealth managers, business is also a function of who holds that wealth – and that is changing.  As baby boomers continue to retire over the next decade, trillions of dollars of wealth will be transferred to a younger generation.  This massive wealth churn is an opportunity for wealth management firms to attract a new, younger client base, but wealth managers face several challenges in appealing to that new demographic.One such challenge is the industry’s aging advisor base.  According to data from EY, the average advisor is now 50 years old, and only 5% of advisors are under 30.  As assets move from one generation to the next, a weak pipeline of new advisors is a looming threat for the industry.  The age gap between clients and their advisors is poised to create real difficulties in attracting and retaining an evolving client demographic, particularly given the increasing prominence of FinTech-based competition.  A lack of succession planning at many wealth management firms will only exacerbate these problems.FinTech's ImpactWith a changing client demographic, also comes changing expectations.  As a result, wealth management firms face pressure to adapt their service and product offerings, most notably through changing the way that they utilize technology.  On its face, FinTech-based wealth management products appear to be a threat to traditional human advisors, less agile firms will likely find this to be true.  For other firms, FinTech-based solutions offer an opportunity to increase advisor efficiency and meet regulatory requirements by utilizing hybrid advice models.  By utilizing FinTech solutions, wealth management firms can free up advisors from routine tasks and allow advisors to offer a greater breadth of client services and improve client relationships.Despite its potential benefits, technology is also partly responsible for the continued fee-pressure wealth managers face.  According to data from McKinsey & Company, pricing on fee-based accounts dropped by five basis points to 1.08% in 2017.  Establishing a personal connection with clients is one way wealth management firms can differentiate themselves to help maintain pricing power.  According to a 2018 study by Capgemini, only 56% of HNW individuals said they connected strongly with their advisor.  Despite the strong market returns over the last two years, this low satisfaction suggests that performance is not the only concern of wealth management clients.ConclusionThe current fee-conscious environment favors advisors that offer a value proposition that software cannot replicate at lower cost.  Ultimately, such a value proposition will likely need to be based on establishing real relationships with clients.  Growing revenue on the back of strong markets may have masked the changes in the business for many wealth management firms, and the party may end if equity markets normalize going forward.  One thing the industry has going for it is that the demand for wealth management services is clearly there, and increasingly so.  The performance of wealth management firms will depend in large part on how well individual firms are able to adapt to an evolving landscape to capture growing demand.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Over the last several years, asset managers have benefited from global increases in financial wealth driven by a bull market in asset prices.  However, favorable trends in asset prices have masked some of the headwinds the industry faces, including increasing consumer skepticism of high-fee active products and regulatory overhang.Traditional active managers have felt these pressures most acutely, as undifferentiated active products have struggled to withstand downward fee pressure and at the same time, have been a major target of regulatory developments.  To combat fee pressure, traditional asset managers have had to either pursue scale (e.g. BlackRock) or offer products that are truly differentiated (something that is difficult to do with scale).  Consumers have been more receptive to the value proposition of alternative asset managers and wealth managers, and these businesses are better positioned to withstand fee pressure as a result.Second Quarter PerformancePerhaps reflective of the headwinds that the industry faces, asset managers generally underperformed broad market indices during the second quarter.  While major indices regained traction during the second quarter, the returns for asset managers were generally more muted even though these businesses generally benefit from rising markets.  The operating leverage inherent in the business model of most asset managers suggests that market movements tend to have an amplified effect on the profitability (and stock prices) of these businesses, and in recent quarters that has been the case.  The reversal of that trend last quarter may be indicative of investors’ increasing focus on the headwinds the industry faces and the general uncertainty that arises late in the economic cycle. Taking a closer look at recent pricing reveals that traditional asset managers, which are perhaps the most affected by fee compression trends, ended the quarter down 3.7%, while other categories of asset managers generally saw positive returns.  Trust banks were up 2.4% during the quarter, buoyed by a steadily rising yield curve which portends higher NIM spreads and reinvestment income.  Alternative asset managers were up 2.8% during the quarter as this product segment is less impacted by fee pressure than traditional active products.  Wealth managers were up 3.8% during the quarter, buoyed by market-driven increases in AUM, although these businesses face challenges with new client acquisition and maintaining pricing power. The RIA size graph below shows a similar trend for most of its categories.  The smallest category of publicly traded RIAs (those with less than $10 billion AUM) was down nearly 15% during the quarter, although this is the least diversified category of RIAs with only two components.  Due to the lack of diversification, the smallest category of RIAs is subject to a high degree of volatility due to company-specific developments.  Most of our clients fall under this size category, and we can definitively say that these businesses (in aggregate) have not lost nearly 15% of their value since April as suggested by this graph. Market OutlookThe outlook for these businesses is market driven - though it does vary by sector.  Trust banks are more susceptible to changes in interest rates and yield curve positioning.  Alternative asset managers tend to be more idiosyncratic but still influenced by investor sentiment regarding their hard-to-value assets.  Wealth managers and traditional asset managers are more vulnerable to trends in active and passive investing.  The outlook for the industry during the rest of 2018 ultimately depends on how the industry headwinds continue to evolve and (as always) what the market does on the back half of the year.

After a strong start to the year driven by tax reform and global economic growth, markets reversed in February and March and volatility picked up significantly.  While most publicly-traded asset managers posted negative returns for the quarter, the return of market volatility may be an opportunity for certain active managers.  The first quarter also saw notable changes on the regulatory front, with the DOL Rule being struck down and the SEC proposing the new “best interest” standard for brokers.  On the fixed income side, the yield curve continued to flatten during the first quarter, and higher short-term rates may pull cash off of the sideline and into fixed income products.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: The return of volatility to the markets offers opportunity for active managers.[W]hile we have started with the equity markets generally moving upward in January, the trend broke down in February and March as volatility increased as a dispersion across and within those markets.  In this environment, the best active managers were able to outperform, and many of our Affiliates generated meaningful alpha. – Nathaniel Dalton, President & COO, Affiliated Mangers Group, Inc.Over the last year or so, we have seen correlations declining, and more recently, we have seen increased volatility and rising interest rates.  We may be returning to a world in which investment returns are not overwhelmed by central bank policy.  We believe that's an environment in which asset allocators will place greater importance on high value-added investing and an environment in which value-added should be more apparent. – Eric Richard Colson, Chairman, President, & CEO, Artisan Partners Asset ManagementWe are optimistic that this higher level of volatility, combined with a gradual trend toward the normalization of monetary policy on the part of global central banks will continue to improve the investment backdrop for active managers. – Philip James Sanders, CEO, Chief Investment Officer & Director, Waddell & ReedTheme 2: The regulatory environment continues to evolve with the DOL Rule recently being vacated and the SEC’s recent “best interest rule” proposal.Obviously, we're at the very early beginning of [the SEC proposal], which will have a longer road ahead of it before it likely moves forward into any type of finalization of becoming a rule.  But the early indications are based on it being more of a disclosure-based rule.  It does provide for the additional flexibility with regard to the broker/dealer, not causing significant cost increase associated with the broker/dealer and the financial advisers that we support.  So we're going to continue to monitor that.  I don't expect at least in the initial stages that to hamper our ability to increase our advisers' overall annual productivity ranges, but we're going to continue to monitor what happens in this space with regard to the SEC rule proposal. – Shawn Michael Mihal, President, COO & Director, Waddell & Reed With the changes in the DOL rules, a lot of the financial advisers have been using index-like and ETF products to create model portfolios and build those model portfolios with the least expensive products.  But as the cycles start to change, they will start to incorporate more active products in that both active fixed income and active equities. – Robert Steven Kapito, President & Director, Blackrock[T]he new … higher standard of conduct or new best interest standard that is under comment period with increasing the suitability requirements and disclosure.  I think what's important in the proposal is that certainly, brokerage as it exists today, can survive and doesn't have to be modified to a level where you can't have differentiated commissions … And so I think it would slow down the acceleration of movement from brokerage to advisory accounts, and the urgency to do that would not be there. – Gregory Eugene Johnson, Chairman & CEO, Franklin ResourcesTheme 3: Rising yield curve may pull cash from the sidelines and into fixed income products.We see at least three broad opportunities for our fixed income business in a higher rate environment.  First, higher rates are attractive for the retail investor and should increase flows.  Second, higher rates create the need to rebalance into fixed income for many institutional investors.  And third, regardless of the rate environment, the opportunity always exists with strong investment performance to take share. – Joseph A. Sullivan, Chairman, CEO & President, Legg Mason[W]e estimate there's over $50 trillion of cash that's sitting in bank accounts earning less than 1%, in some places, negative.  So as rates go up, especially in the short end, that is going to attract a lot of this cash into the fixed income markets, of which we can manage that money rather directly into the normal fixed income products or into ETF fixed income products, which seem to be getting a lot of the new flows from rises in rates. – Robert Steven Kapito, President & Director, BlackrockWhile the prospects of rising rates tends to push investors away from long-dated fixed income, the flat curve is creating strong relative risk-return opportunities in short duration funds and cash management strategies, which we saw clients take advantage of in the first quarter. – Laurence Douglas Fink, Chairman & CEO, BlackrockMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

A rocky first quarter was particularly volatile for publicly traded RIAs.  After reaching record highs in late January, most categories of publicly traded RIAs ended the quarter with negative returns.First Quarter PerformanceThe weak performance of publicly traded RIAs during the first quarter comes on the heels of significant outperformance during 2017.  Market gains apparently trumped fee compression, fund outflows, regulatory overhang, rising costs, and a host of other industry headwinds that have dominated the headlines in recent years.  There is a simple explanation for the industry’s performance in recent years: the combination of market appreciation and operating leverage have precipitated significant improvements in profitability since the Financial Crisis, eliciting a favorable response from investors, despite everything we’ve been reading about the industry.  However, the return of market volatility and the reintroduction of the idea that markets can, in fact, go down, have brought back into focus the industry headwinds, and investors have reacted accordingly. As illustrated in the chart above, upward or downward trends in the broader market tend to have a magnified effect on the stock prices of asset managers.  Market swings will have a magnified impact on earnings (and stock prices) for asset managers because top-line volatility is tied to AUM movements and some costs are fixed. While 2017 was a great year for the S&P and an even better year for most categories of RIAs, 2018 has been the complete opposite thus far.  This reversal is no surprise, as historically corrections and bear markets have led to more precipitous declines in profitability, due to the presence of fixed expenses in most RIA’s capital structure, a fact illustrated by the significant underperformance of RIAs during 2008 and early 2009. Taking a closer look at recent pricing reveals that traditional asset managers and trust banks have outperformed the S&P and other classes of asset managers throughout the first quarter.  Traditional asset managers ended the quarter up 4.5% and were the only category of asset managers to post positive returns.  Trust banks were down just 0.3% during the quarter, buoyed by a steadily rising yield curve, which portends higher NIM spreads and reinvestment income.  Alternative asset managers were down 5.0% during the quarter as these businesses continue to find delivery on their value proposition (alpha net of fees) elusive.  Mutual funds, which have been battered by active outflows and fee compression, were down 7.1% on the quarter. The RIA size graph below shows that larger RIAs generally performed better than smaller RIAs during the first quarter.  Asset managers with more than $500 billion in AUM were the only category to outperform the S&P, and asset managers with less than $100 billion in AUM had the worst performance.  This is to be expected during periods in which the market declines, as smaller RIAs generally have narrower margins and profitability can shift wildly with small changes in AUM. Market OutlookThe outlook for these businesses is similarly market driven - though it does vary by sector.  Trust banks are more susceptible to changes in interest rates and yield curve positioning.  Alternative asset managers tend to be more idiosyncratic but still influenced by investor sentiment regarding their hard-to-value assets.  Mutual funds and traditional asset managers are more vulnerable to trends in active and passive investing.  The outlook for the industry during the rest of 2018 ultimately depends on how the industry headwinds continue to evolve and (as always) what the market does over the next few months.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Asset manager M&A was robust through the first quarter of 2018 against a backdrop of volatile market conditions.  Total deal count during the first quarter was up 32% versus the first quarter of 2017, though total disclosed deal value was down 25%.  In terms of deal count, M&A is on pace to reach the highest levels since 2014, although we note that the quarterly data can be lumpy.  Several trends which have driven the uptick in sector M&A have continued into 2018, including revenue and cost pressures and an increasing interest from bank acquirers.Notable TrendsThe underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, and slowing organic growth for many active managers.  While these pressures have been compressing margins for years, sector M&A has historically been muted. This is due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation.  Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure for certain firms."Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike. And, you have to be, as a firm, you have to be able to invest in the future.  And I think a number of smaller-sized firms are finding that hard." Martin Flanagan - President and CEO, Invesco Ltd. 1Q17 Earnings Call"You need to have, of course, the right product set. But you need especially to have underlying firms, which are positioned as best they can in terms of alignment and focus to sustain alpha generation. And in that respect, scale is the enemy, not the friend." Sean Healey - 1Q17 Earnings Call, Affiliated Managers Group IncConsolidation pressures in the industry are largely the result of secular trends.  On the revenue side, realized fees continue to decrease as funds flow from active to passive.  On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs.  Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to gain scale in order to realize cost efficiencies, increase product offerings, and gain distribution leverage.Acquisition activity in the sector has been led primarily by RIA consolidators, with Focus Financial Partners (which itself was acquired by Stone Point Capital and KKR in a $2 billion deal last year), Mercer Advisors (no relation), and United Capital Financial Advisers each acquiring multiple RIAs over the last year.  While these serial acquirers account for the majority of M&A activity in the sector, banks have also been increasingly active acquirers of RIAs in their hunt for returns not tied to interest rate movements.  Despite a rising yield curve and the negative impact of goodwill on tangible book value, we suspect that RIAs will remain attractive targets for bank acquirers due to the high margins (relative to many other financial services businesses), low capital requirements, and substantial cross-selling opportunities.The Market's ImpactRecent increases in M&A activity come against a backdrop of a bull market that continued unabated through 2017 but faltered during the first quarter of 2018.  Steady market gains have continued throughout 2017 and have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years.In 2016, for example, active mutual funds’ assets grew to $11 trillion from $10.7 trillion, despite $400 billion in net outflows according to data from Bloomberg. While the first quarter of 2018 saw negative returns for most major indices, the gains seen during 2017 have yet to be eroded.  At the end of the first quarter, the S&P was down nearly 10% from its peak in late January 2018, but the index is still only 2% below year-end 2017.  As a result of increasing AUM and concomitant revenue growth (perhaps notwithstanding this last quarter), profitability has been trended upwards despite industry headwinds that seem to rationalize consolidation.ConclusionWith no end in sight for the consolidation pressures facing the industry, asset manager M&A appears positioned for continued strength or potential acceleration regardless of which way the markets move during the remainder of 2018.  Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back-office efficiencies.  Expanding distribution and product offerings will also continue to be a key acquisition rationale as firms have struggled with organic growth.With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  An aging ownership base is another impetus, and recent market gains might induce prospective sellers to finally pull the trigger.  More broadly, the recent tax reform bill is expected to free up foreign-held cash and increase earnings, which could further facilitate M&A’s upward trend during the rest of 2018.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Publicly traded asset managers had a rough first quarter, as volatility returned to the market and major indices posted negative quarterly returns for the first time in over two years.  While the overall drop in the market was relatively modest, stock price declines of publicly traded asset managers were generally more significant.  It is not surprising that most asset managers have underperformed during periods of declining markets, since the reverse was true during 2017, when most asset managers outperformed the major indices.  To the extent top-line volatility is tied to AUM movements and costs are fixed, market swings will have a magnified impact on earnings (and stock prices) for asset managers. The return of market volatility and the reintroduction to the idea that markets can, in fact, go down, have brought back into focus the industry headwinds which, at least for the last several years, have been allayed by a favorable market backdrop.  Notably, outflows from higher cost funds have continued to increase, as shown in the following chart from Morningstar.  During 2017, the chart shows accelerating outflows from the most expensive active funds and record inflows into the cheapest ones.  These dynamics are problematic for many mutual fund companies and other asset managers that rely on active equity products, which are necessarily more expensive to implement than their passive counterparts. There was one positive development related to asset flows for active managers during 2017: aggregate outflows for active funds in 2017 were stemmed considerably (in fact were nearly zero).  Relative to the significant net outflows active funds have seen the last several years, 2017's low level of outflows seems like a win for the sector (if you count less of a bad thing as a good thing).  Still, if stemming the outflows comes at the cost of lowering fees, the result will be lower revenue yields and profitability. It appears that stemming outflows without significant fee cuts will be an uphill battle.  Active fund outflows are not only attributable to the rise in popularity of low-cost ETF strategies but also sector-wide underperformance against their applicable benchmarks.  Both individual and institutional investors are now more inclined to shun active managers for cheaper, more readily available products, particularly when performance suffers. Active manager performance was better in 2017, although still, less than half managed to beat their passive peers on a net-of-fee basis.  According to data from Morningstar, 43% of active managers outperformed passive peers in 2017 versus 26% in 2016. It appears that as long as active managers are missing the mark on their value proposition (alpha net of fees), ETFs and other passive strategies will continue to gain substantial inflows from active managers, resulting in higher and higher allocations to index products.  With improved performance relative to passive funds in 2017 and a volatile market so far in 2018, the opportunity is there to reverse this trend.  However, it will take a sustained alpha generation before things start to go the other way, and in the interim, funds with a low active share and high fees are not likely to fare well.  We’ve all read that consistently beating the market is nearly impossible, even for the savviest of stock pickers, but none of that research was compiled when passive strategies dominated the investment landscape. We don’t foresee a huge shift back to active management any time soon, but we realize that we were probably overdue for some mean reversion.  It is conceivable that the current market environment could be more conducive to stock picking, but we’ll need more time to judge whether this is truly the case.  Regardless, it is hard to imagine that passive investing will completely replace active management.   Such a scenario could lead to significant mispricing in the securities markets, which would be fertile ground for enterprising investors and mutual funds.  This is why we say that active management may be down but is not out. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Publicly traded asset managers were up nearly 13% last quarter, driven by tax reform and strong equity markets.  The Tax Cuts and Jobs Act has been especially beneficial to the RIA sector, as lower corporate tax rates have had a positive impact on equity markets, boosting AUM and earnings, which are now taxed at lower rates.  Many firms are still assessing the full impact of tax reform, but what is clear is that lower corporate tax rates in 2018 will give asset managers increased flexibility in capital management, M&A activity, and technology investment.  On the fee side, tailwinds for low-fee passive products remain strong, but recent strength in equity markets has shifted the asset mix for many firms towards higher-fee equity products, which may increase realized fees in the short term.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Recent corporate tax reform could spur M&A and other investing activity as firms have increased flexibility in capital management and strategic investment decisions.We're excited by the options created by corporate tax reform and are currently discussing how we can best serve all stakeholders.  These options include committing resources to further develop our financial technologies and investment data science expertise; obviously, M&A activity; investing to optimize our global distribution efforts; and introducing and seeding new products and services.  We also plan to make investments that directly benefit employees and the communities where they do business. – Greg Johnson, Chairman and CEO, Franklin ResourcesI think the difference [post tax reform] is that everything's fairly equal as we look at the world.  [I]n the past, if it was captive offshore cash, and before any tax reform, you may have had a bias to try to do something outside of the U.S.  I think, today, the U.S., it's all fungible cash around the world.  So we would look openly to opportunities as much here in the U.S. as abroad.  I think that the net-net would be you have an opportunity to do a larger acquisition in the U.S. than you did in the past.  That would be the only real change, I think, as far as how we look at the M&A landscape.  – Greg Johnson, Chairman and CEO, Franklin ResourcesClearly, an increase in incremental cash flow from tax reform could impact likely favorably our capital management decisions, and that reflects both potential dividends and buybacks.  And our plan is to – I mean, given the tax reform is basically three weeks old – our plan is to effectively reassess our latest capital management recommendations probably around mid-year once we kind of finalize the impact the tax reform is going to have on BlackRock.  And there's going to be lots of additional guidance that's going to be forthcoming as well as making sure that we are looking at all of the balance sheet, if you will, opportunities that we have over the next several months, including more aggressively seeding and co-investing in new products. – Gary Shedlin, CFO, BlackRockTheme 2: Technology investment and acquisitions will continue to play a key role in expanding product breadth and enhancing client experience; BlackRock makes several FinTech acquisitions.We accelerated the expansion of our technology portfolio during 2017 with the acquisition of Cachematrix and minority investments in iCapital and Scalable Capital.  Our investments in technology and data will enhance our ability to generate alpha and more efficiently serve clients, resulting in growth in both base fees and technology revenue. – Greg Shedlin, CFO, BlackRockTechnology is enabling more productive engagements with more financial advisers than ever before, driving accelerated asset and base fee growth across our platform.  BlackRock is using better data and technology to scale our own wealth advisory sales teams and equipping them with a better insight about our clients, about their portfolios, and giving a much better texture about markets. – Laurence Fink, CEO, BlackRockIn the area of technology, we expect approximately $1 million of additional run-rate costs in 2018 and an extra $4 million of onetime upfront expenses related to the implementation costs for risk management and regulatory initiatives, mostly to further support expanding degrees of investment freedom.  We also plan to implement a new client reporting system, which will enhance the client experience. – Charles Daley, CFO, Artisan Partners Asset ManagementTheme 3: Tailwinds for passive products remain strong, and significant net inflows into low-fee passive products have continued in both the retail and institutional channels.  Despite ongoing fee pressure from passive products, some firms have seen modest fee increases due to market-driven shifts in AUM composition towards higher-fee equity products.Global iShares generated a record $245 billion of new business for the year, representing full year organic growth of 19% with flows split nearly evenly between core and higher-fee noncore exposures.  Since BlackRock launched the iShares core funds 5 years ago, we have seen over $275 billion of net inflows, including $122 billion of net inflows in 2017 alone.  Three of the industry's top five ETFs, in terms of net new assets globally this year, were iShares core ETFs; IBV, our S&P 500 Fund; IEFA for developed international market exposure; and IEMG, our core emerging markets fund. – Gary Shedlin, CFO, BlackRockThe rotation from active to passive has accelerated.  Risk-based asset allocations continue to gain popularity at the expense of the style box approach, and the demand for ETFs and other efficient investment vehicles has grown. – Eric Colson, CEO, Artisan Partners Asset ManagementThe fourth quarter open-end fund fee rate increased to 50 basis points from 48 in the prior quarter due to the impact of lower fund expense reimbursements as a result of the consolidation of service providers and an increase in average assets and higher fee equity products due to market appreciation. – Michael Angerthal, CEO, Virtus Investment Partners, Inc.

All three publicly traded trust banks (BNY Mellon, State Street, and Northern Trust) underperformed other categories of asset managers during 2017, and only State Street outperformed the S&P 500.  While all three benefited from growth in Assets Under Custody and Administration (AUCA) and Assets Under Management (AUM) due to strong equity markets in 2017, the trust banks performed more in line with U.S. banks generally during 2017.  The exception is State Street, which performed comparably to the SNL Asset Manager Index due in part to its large ETF business (State Street is one of the three largest ETF providers globally).  The other two trust banks have less significant ETF business (Northern Trust) or none at all (BNY Mellon).  Due in part to its strong ETF inflows, State Street is on track to pass BNY Mellon as the largest trust bank in terms of AUCA. Throughout 2017, trust banks tended to underperform other classes of asset managers like alternative asset managers, mutual funds, and traditional asset managers.  To put this in historical context, trust banks have lagged the broader indices since the financial crisis of 2008 and 2009, although in 2016 our trust bank index was the highest performing category of asset manager.  With the exception of trust banks, all classes of asset managers outperformed the S&P 500, as rising equity markets and operating leverage combined to increase the profitability of these businesses. Despite the relative underperformance during 2017, trust banks saw increases in their two largest sources of fee revenue (servicing and investment management fees) due primarily to strengthening equity markets.  Trust banks also saw improved net interest margins due to higher U.S. market interest rates.  Trading services revenues, which are a less significant component of fee revenue than servicing and management fees, were generally down in 2017 due to low volatility in the equity markets.  Trust bank trailing multiples have expanded in line with other categories of asset managers since last year, so their underperformance suggests that earnings haven’t kept pace. So have these securities gone from overbought to oversold?  A quick glance at year end pricing shows the group valued at 14-16x (forward and trailing) earnings with the rest of the market closer to 25x, so that alone would suggest that they aren’t too aggressively priced.  Still, the three companies are all trading near 52 week highs, so it’s hard to say they’re really all that cheap either. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Asset manager M&A remained robust in 2017 against a backdrop of rising markets and higher AUM balances for most industry participants.  Total (disclosed) transaction value was up 6% from 2016 levels despite a 6% reduction in the number of deals.  Several trends, which have driven the uptick in sector M&A, have continued into 2017, including revenue and cost pressures and an increasing interest from bank acquirers.The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, and slowing organic growth for many active managers.  While these pressures have been compressing margins for years, asset manager M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation.  Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure for certain firms.Consolidation pressures in the industry are largely the result of secular trends.  On the revenue side, realized fees continue to decrease as funds flow from active to passive.  On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs.  Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to gain scale in order to realize cost efficiencies, increase product offerings, and gain distribution leverage.Acquisition activity in the sector has been led primarily by RIA consolidators, with Focus Financial Partners, Mercer Advisors (no relation), and United Capital Financial Advisers each acquiring multiple RIAs during 2017.  While these serial acquirers account for the majority of M&A activity in the sector, banks have also been increasingly active acquirers of RIAs in their hunt for returns not tied to interest rate movements.  Despite a rising yield curve which should make banks a little more comfortable with their core business, we suspect that RIAs will remain attractive targets for bank acquirers due to the high margins (relative to many other financial services businesses), low capital requirements, and substantial cross-selling opportunities. Recent increases in M&A activity come against a backdrop of a now nine-year-old bull market.  Steady market gains have continued throughout 2017 and have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years.  In 2016, for example, active mutual funds’ assets grew to $11 trillion from $10.7 trillion, despite $400 billion in net outflows according to data from Bloomberg.  As a result of increasing AUM and concomitant revenue growth, profitability has been steadily rising despite industry headwinds that seem to rationalize consolidation. It is unclear whether this positive market movement has been a boon or a bane to M&A activity.  On one hand, many asset managers may see rapid AUM gains from market movement as a case of easy come, easy go.  In that case, better to sell sooner rather than later (and vice versa from a buyer’s perspective).  On the other hand, as long as markets trend upwards, margin and fee pressures are easy to ignore.  In that case, a protracted market downturn could lead to a shakeout for firms with cost structures that are not sustainable without the aid of a bull market (as was the case in 2008 and 2009). With no end in sight for the consolidation pressures facing the industry, asset manager M&A appears positioned for continued strength or potential acceleration regardless of which way the markets move in 2018, although a protracted bear market, should it materialize, could highlight consolidation pressures and provide a catalyst for a larger wave of M&A activity.  With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  An aging ownership base is another impetus, and recent market gains might induce prospective sellers to finally pull the trigger.  More broadly, the recent tax reform bill is expected to free up foreign-held cash, which could further facilitate M&A’s upward trend into 2018. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Despite gaining 5% last quarter, publicly traded asset managers are still coping with a low fee, passive environment and challenges associated with a ramp up towards full implementation of the DOL fiduciary rule.  The DOL rule prohibits compensation models that conflict with the client’s best interests and is expected to induce active managers to provide lower-cost or passive products and accelerate the shift from commission-based to fee-based accounts.  While net inflows into passive products are a secular trend (particularly on the retail side), the passive inflows seen thus far during 2017 may be unnaturally high due to flows that have been pulled forward from next year by brokers in response to the DOL rule as an effort to avoid litigation.  Still, against this backdrop, many industry participants see opportunity, and the market for these businesses seems to as well.As we do every quarter, we take a look at some of the earnings commentary of pacesetters in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Pricing pressure and the DOL fiduciary rule have continued to drive flows into low fee passive products, particularly in the US retail channel."Third quarter long-term net inflows of $76 billion, representing 6% annualized organic asset growth, were positive across client type, investment style and region. Global iShares generated quarterly net inflows of $52 billion, representing 14% annualized organic growth with strength across both core and non-core exposures." —Gary Shedlin – CFO, BlackRock"Total net flows were positive $0.2 billion in the quarter, an improvement from net outflows of $0.2 billion in the prior quarter, as positive flows in structured products, retail separate accounts and ETF more than offset net outflows in institutional." —George Aylward, CEO, Virtus Investment PartnersTheme 2: Changes in the regulatory environment and client expectations have prompted many traditional asset managers to consider expense caps or variable fees tied to performance."I think that our view [on fees is that] as the industry continues to evolve due to a variety of issues, not the least of which are both regulatory and changing client trends, there are a number of active managers thinking about new ways to evolve fee structure.  So we've seen a bunch of announcements of intentions to introduce a new performance-based model.  I think we saw one change more recently in the United States, including the fulcrum fee, which has actually been in use in the U.S. for some time." —Gary Shedlin"With regard to the FlexFee Fund Series … [c]onversations are ongoing with our major distributors; I think they're going well.  We're sort of working up to beginning in earnest at the beginning of the first quarter to begin the process of marketing the [FlexFee Fund Series].  And it will be our focus for the first half of 2018.  We think there's significant potential here to gather additional assets.  We think it realigns client expectation of share of excess returns that managers are taking versus what they, our clients, are keeping.  We think it's a credible alternative to those who are incredibly fee-conscious today." —Seth Bernstein - President, CEO, AllianceBernstein Corporation"We have opened to fulcrum fees with many of our clients, specifically in the separate account space, and [they are] open to it." —Eric Colson, CEO, Artisan Partners Asset ManagementTheme 3: The trend towards fee-based accounts (as opposed to commission-based) has been accelerated by the DOL rule, and product offerings are under pressure to adapt accordingly."I think what we do know is that as you transition from a brokerage to a fee-based account, it's—you may have 1 out of 3 of your products on that lineup instead of all of them, and that's a general statement.  But one that it makes it difficult to capture the assets that you had.  So anybody with multiple products, with one relationship, is going to be under pressure as those assets transition.  But I do think the pressure of the transition could be alleviated somewhat if we have a standard that allows those 2 to coexist." —Gregory Johnson - CEO, Franklin Resources, Inc."[P]art of it is you have to adjust the product line and make sure that you have mandates and styles and sleeves that are cost-competitive that can fit into solutions.  You have solutions that differentiate, whether it's target date funds or multi-asset funds, that we can build.  And part of that is having now ETFs that we can use in a lower cost way as part of that solution and have open architecture solutions that we've done around the globe with other partners.  Those are the, I think, things that we continue to try to adapt to, but we're certainly not sitting around waiting to get back to the old brokerage model because, I think, at the end of the day, we recognize that the fee-based side is going to continue to be the driver going forward." —Gregory Johnson"And as you point out, one of the things we did effectively concurrent with [the launch of the MAP Navigator product] was to add some sub-advised funds that are passive/smart beta-ish. Yes, the uptake of those has been pretty good, I think about $300 million in AUM to-date." —Thomas Butch, CMO, Waddell & Reed Financial"In the U.S., there are 2 major shifts converging in wealth management.  First, in one of the largest asset movements, fee-based advisory assets are expected to double by 2020 in the shift from brokerage to fee-based accounts.  The second, digital technologies are disrupting traditional wealth advisory practices, which create competition for client assets and provide leverage for fast-growing advisory practices." —Larry Fink, CEO, BlackRock"We spoke earlier in the year about having the strong balance sheet and the financial flexibility, to be patient as we acknowledge what the DOL rules will do for our company, and as we open up gradually, open up the architecture in the broker-dealer, I think we're getting a little better read on kind of where those things are settling out.  Product development is something where it's an ongoing process for us internally." —Philip Sanders, CEO, Waddell & Reed FinancialMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

RIAs have long faced structural headwinds and consolidation pressure from increasing compliance and technology costs, broadly declining fees, and slowing organic growth for many active managers.  While these pressures have been compressing margins for years, asset manager M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation.  Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure for certain firms.Current Consolidation ConsiderationsConsolidation pressures appear to have reached critical mass in the last several years, and M&A activity has picked up notably as a result.  M&A activity in 2017, in particular, is on track to reach the highest level in terms of deal volume since 2009. For publicly traded asset managers, at least, the market seems to view recent M&A activity favorably.  Amundi has returned 46% year-to-date (as of October 20) after announcing the acquisition of Pioneer Investments last December.  Aberdeen was up 15% through May 31 after agreeing to be acquired by Standard Life in March.  KKR shares have risen 20% since April 19, when an investor group led by Stone Point Capital and KKR agreed to buy a majority stake in RIA aggregator Focus Financial Partners. Recent increases in M&A activity come against a backdrop of a now eight-year-old bull market.  Steady market gains, particularly in 2017, have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years.  In 2016, for example, active mutual funds’ assets grew from $10.7 trillion to $11 trillion, despite $400 billion in net outflows according to data from Bloomberg.  As a result, profitability has been steadily increasing despite industry headwinds that seem to rationalize consolidation. It's unclear whether this positive market movement has been a boon or a bane to M&A activity.  On one hand, many asset managers may see rapid AUM gains from market movement as a case of easy come, easy go.  In that case, better to sell sooner rather than later.  And vice versa from a buyer’s perspective.  On the other hand, as long as markets trend upwards, margin and fee pressures are easy to ignore.  In that case, a protracted market downturn could lead to a shakeout for firms with cost structures that are not sustainable without the aid of a bull market. We saw the effect a market downturn can have on M&A activity during 2009 when deal volume reached record levels as many distressed firms were sold.  The M&A activity spurred by the 2009 downturn was short-lived, however.  Deal volume was largely subdued between 2010 and 2013.  The fallow period ended in 2014, and deal activity has accelerated since then while broad market indices have marched higher. ConclusionIt seems likely that asset manager deal activity will continue to gain speed regardless of which way the markets are moving, although a market downturn could certainly expedite consolidation.  Asset managers face secular trends that threaten lower revenue and higher costs.  On the top line side, assets continue to flow into low fee passive funds at a good clip.  On the cost side, an evolving regulatory environment threatens increasing compliance costs.  Consolidation allows asset managers to spread compliance costs over a larger AUM base and increase distribution channels and product offerings, thereby combating revenue and cost pressure.But if a protracted bear market does materialize, margins will face pressure not only from the evolving industry dynamics but also from evaporating AUM.  A significant market downturn may highlight the consolidation pressures in the industry and catalyze a larger wave of M&A activity.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

This week, we’re sharing some recent media on trends in asset management, including the breakaway broker phenomenon, M&A activity, and the ongoing shift towards passive products.  Most industry observers foresee a continued flight from traditional wirehouses, an uptick in M&A activity spurred by increasing competitive pressures, and further fee pressure from passive products as we move towards a new equilibrium.  Switching From Wirehouse to RIA – AUM And Revenue Requirements To Break AwayBy Michael Kitces We wrote last month about advisors shifting from traditional wirehouses to independent RIAs, and this post by industry consultant Michael Kitces offers a deep dive into the economics of the switch from an advisor’s perspective.RIAs Poised to Land Wirehouse RecruitsBy Dan Jamieson Going independent doesn’t have to mean starting from scratch: wirehouse advisors are increasingly a recruiting channel for existing independent RIAs, according to this piece by industry observer Dan Jamieson.Advisor Platform Comparison: Wirehouse vs RIA Aggregator vs Independent RIABy Aaron HattenbachIn this guest post which appeared on Michael Kitces’ blog, industry insider Aaron Hattenbach offers perspective gleaned from his own experience on the relative merits of wirehouses, RIA aggregators, and fully independent RIAs, each of which he has worked at.UBS is ‘Constantly Approached’ About Asset-Management UnitBy Patrick WintersThis article from Bloomberg underscores the potential for a new wave of deals in the asset management space: UBS Chief Financial Officer Kirt Gardner indicates that UBS is “constantly approached” regarding its asset management unit.Path to Growth: Why RIA firms leverage M&A as a growth strategyBy Christopher V. Gunderson Increasing operational and compliance costs combined with downward fee pressure may be forcing consolidation in an industry where historically M&A activity has been sparse: according to a survey by InvestmentNews, 44% of RIAs plan to pursue M&A deals over the next five years.Why Critics of Passive Investing Are WrongBy: Kent Smetters Somewhere there’s equilibrium between active and passive asset management, and wherever that equilibrium may be, we are not there yet according to this WSJ piece by University of Pennsylvania Wharton School Professor Kent Smetters.

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.