RIA Valuation
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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

RIAs continued to outperform the S&P in Q4 2024, with alternative asset managers boasting an impressive 60% price gain year-over-year. In 2024, traditional investment managers saw the strongest AUM growth, while alternative managers proved better at converting this growth to revenue. We explore further in our Q4 2024 Market Update.Download update

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.WHITEPAPERPurchase Price Allocations for RIAsDownload Whitepaper

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

Halloween is the ultimate extend-and-pretend film series. From the original 1978 Halloween to 2022’s Halloween Ends, moviegoers estimate that Michael Myers apparently died eight times but somehow appeared in all thirteen films over the series’ 44-year history. The cynical (but likely accurate) rationale for this inconsistency is that the studios recognize that it makes the most economic sense to extend the Halloween saga after each movie and pretend Michael didn’t die in the last one. Private equity firms with investments in RIA aggregators appear to be facing a similar (though less haunting) predicament. A recent CityWire article noted that private equity firms are extending their holding periods for RIA aggregator firms to take advantage of the industry’s higher margins and long-term growth prospects. This stalling tactic shouldn’t spook their LPs since the RIA sector is renowned for its recurring revenue, above-average margins, and demonstrated ability to grow cash flows over an extended period of time. Not many industries have businesses that can sustain The Rule of 40, which posits that venture investors prefer to invest in businesses in which the profit margin plus the growth rate adds up to at least 40%. The investment management industry is a notable exception since it typically boasts EBITDA margins in the 20% to 30% range and annualized growth in revenue on the order of 10% to 15%. It’s like candy corn with a lasting sugar high to prospective investors. So what’s so scary about paying +15x EBITDA for these businesses? If we use the EBITDA single-period income capitalization method to build up an applicable EBITDA multiple for RIA aggregators based on their current cost of capital and expected long-term growth rates, that math probably looks something like this: This analysis suggests that an RIA aggregator’s cost of capital and growth profile support a 15x EBITDA multiple. There’s also market evidence to affirm these valuations — Goldman is estimated to have paid ~18x EBITDA for RIA aggregator United Capital, and PE firm Clayton, Dubilier & Rice purchased Focus Financial for ~13x EBITDA last year. Market evidence supports extending holding periods for these types of investments rather than flipping them to the next investor. PE firm GTCR purchased a 25% stake in RIA acquisitive Captrust Financial Advisors in 2020, which valued Captrust at $1.25 billion before Carlyle bought another minority stake in the business, valuing the firm at just over $3.7 billion three years later. An extended holding period for an RIA aggregator investment at a 15x EBITDA entry multiple appears very reasonable for the PE firms backing these businesses. What about the multiple that these aggregator firms are paying for their underlying RIAs? That math looks a bit different since these investment management firms tend to be much smaller, riskier, and have little or no access to (cheaper) debt financing: When we do see RIA transactions in the +15x EBITDA space, much of the total deal value is typically paid in the form of an earnout or contingent consideration payment based on the target firm’s future financial performance, usually 1-5 years out from the initial down payment. These multiples are often calculated based on the total deal value (including contingent consideration) divided by trailing twelve-month EBITDA prior to closing, even though the earnout portion is unknown at that point, and the time value of money is not factored into the calculation. Paying north of 20x EBITDA for these businesses with no buyer protection in the form of earnout payments could be more horrifying than a hayride with Michael Myers on his ninth life. We’re here to help (with the former).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.

RIAs outperformed the S&P in the third quarter of 2024, with alternative asset managers experiencing the strongest returns amid multiple expansion. All groups examined experienced growth in AUM and revenue year-over-year. We explore further in our Q3 2024 Market Update.Download Update

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.WHITEPAPERValuing Asset ManagersDownload

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

Despite persistent inflation, elevated interest rates, and heightened geopolitical tensions, the asset management industry and the stock market as a whole saw a resurgence during 2023.  Our index of publicly traded asset management firms generally tracked the movement in the broader market, with stock prices for smaller asset managers (AUM under $250 billion) up 30.3% and large asset managers (AUM over $250 billion) up 22.0% over the year ended March 31, 2024, while the broader market (S&P 500) was up 29.9%.Fund FlowsWhile market movement is often the dominant contributor to AUM changes over a particular period, it’s a variable that’s largely outside a manager’s control.  On the other hand, organic growth 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 periods.Many asset managers have struggled with organic growth in recent years, partly due to rising fee sensitivity and the influence of passively managed investment products.  This year proved no different, with our index of publicly traded asset/wealth management companies seeing $103 billion in aggregate net outflows, compared to aggregate net outflows of $62 billion in 2022.As expected, considering the performance of the stock and bond markets over the past year, market movement was the primary driver of the change in AUM, accounting for $551 billion additional AUM for the index during 2023.  During the challenging market conditions of 2022, the index saw an aggregate $922 billion decrease in AUM due to market movement.Click here to expand the image aboveOutflows from Active Funds AccelerateWhile asset managers saw net outflows over the past twelve months, there were significant variances between active and passively managed funds.  Fund flow data from Morningstar (table below) shows that total outflows across active funds for the year ended March 31, 2024, were approximately $377 billion.  The aggregate outflows over the past year were most severe for U.S. equity, allocation, and international equity, with these asset classes shedding a combined $427 billion in assets.  All categories of actively managed funds except alternative investments, taxable bonds, alternatives, and nontraditional equities saw net outflows over the past year.On the other hand, passively managed funds continued to outpace active funds in terms of net new assets over the past twelve months.  The Morningstar data shows that total inflows across passively managed funds for the year ended March 31, 2024, were approximately $621 billion, with all asset classes except commodities and miscellaneous assets reporting positive net inflows.Click here to expand the image aboveAs you can see from the following chart, there has been a trend over the past ten years of investors moving from active to passive funds, and this trend accelerated with the market downturn in 2022.  The relative underperformance of active managers, when compared to their benchmarks over the past ten years, has driven investors to low-fee passive funds.  This trend will likely continue to pose a challenge for many types of active asset managers in attracting new assets.Click here to expand the image aboveOutlookThe 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.With inflation starting the year higher than expected, it remains to be seen if the Fed will be able to implement the rate cuts that many investors expect to come during 2024.  With the prospect of interest rates remaining higher for longer, persistent inflation, and geopolitical tensions, there is much uncertainty in the market heading into 2024.  Despite these challenges, the industry enters 2024 with higher starting AUM levels, offering a potential boost to revenues and earnings.  Navigating these uncertain times requires a proactive approach to capitalize on emerging opportunities and mitigate risks effectively.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.

Following a year where deal volume in the RIA industry nearly matched the all-time high of 2022, RIA M&A activity cooled in the first quarter of 2024. Fidelity’s March 2024 Wealth Management M&A Transaction Report listed 50 deals through March 2024, down 29% from the 70 deals executed during the same period in 2023. RIA deal activity experienced a greater decline than the broader M&A market. The number of M&A transactions for all industries (excluding the RIA industry) decreased 9% year-over-year through the first quarter of 2024 (per Bloomberg), compared to a decline of 29% in the RIA industry. Despite the decline in the total number of deals, there was a significant uptick in total transacted AUM during 2024. Total transacted AUM through March 2024 was $139.2 billion—a 63% increase from the same period in 2023. The average AUM per transaction during the first quarter of 2024 was $2.8 billion, a 128% increase over the prior year. The increase in deal size has been an encouraging sign, given the rise in the cost of capital over the past two years. The growth in deal size resulted from the completion of several large transactions during the first quarter of 2024, coupled with the overall increase in AUM levels due to market performance. Per Echelon’s RIA M&A Deal Report, “This elevated number of larger transactions, in light of buyers facing a higher cost of capital and economic uncertainty, demonstrates buyer resilience and likely indicates that $1BN+ deal activity will increase to 2021 levels or higher once macroeconomic headwinds, namely higher interest rates subside.” Another contributor to the increase in deal size has been RIAs partnering with private equity firms. According to Fidelity’s March 2024 Wealth Management M&A Transaction Report, private equity backing was involved in 88% of the transactions in March. Per Echelon’s RIA M&A Deal Report, “Another driver of deal size was the heightened creativity in deal structures, adopted by private equity firms seeking to get deals across the finish line in the face of higher borrowing costs. Structured minority investments, with features such as paid-in-kind and preferred distribution rights, have become more popular in the largest transactions, especially those involving sellers with more than $10 billion in assets.”Noteworthy transactions backed by private equity include Caprock’s acquisition of Grey Street Capital, Mariner Wealth Advisor’s purchase of Fourth Street Performance Partners, and Hightower’s acquisition of Capital Management Group of New York.The prevalence of serial acquirers and aggregators has continued in the RIA M&A market. In recent years, the professionalization of the buyer market and the entrance of outside capital have driven demand and increased competition for deals. Serial acquirers and aggregators have increasingly contributed to deal volume, supported by dedicated deal teams and access to capital. Such firms accounted for approximately 70% of transactions during the first quarter of 2024. Mercer Advisors, Miracle Mile Advisors, and Allworth Financial completed multiple deals during the fourth quarter.Deal activity has also been supported by the supply side of the M&A equation, as the impetus to sell is often based on more than market timing. 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 during market downturns.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. 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 seen. 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 than their 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, where valuation considerations are top of mind. Internal transactions don’t occur in a vacuum, and the same factors driving consolidation and M&A activity have influenced valuations in internal transactions as well. As valuations have increased, financing in internal transactions has become a crucial secondary consideration 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, an increasing amount of bank financing and other external capital options can provide 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 are 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.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.

Share prices for most publicly traded asset and wealth management firms trended upward with the broader market during the first quarter of 2024. Alternative asset managers continued to outperform the market and other RIAs, ending the quarter up about 12.6%. On a year-over-year basis, all sectors of RIAs experienced growth as the markets rebounded from the 2022 slump. RIAs directly benefit from improving market conditions as they result in a stronger asset base on which to collect fees.Performance by SectorThe market uptick in Q1 translated to increased share prices for most public RIAs. Prices for alternative investment managers experienced a stronger increase than the S&P 500, increasing by 12.6% compared to the S&P’s 10.6%. Both larger RIAs (AUM over $250 billion) and smaller RIAs (AUM under $250 billion) lagged the S&P 500, seeing price increases of 4.3% and 10.3%, respectively, during the quarter.Pricing TrendsThe median Enterprise Value to LTM EBITDA multiples for public RIAs increased modestly during Q1. Smaller RIAs had the strongest increase at 5.4% during the quarter. Alternative asset managers saw a 2.4% increase and larger RIAs saw an increase of 0.3%. After trending downwards for the first three quarters of 2023, multiples began to increase during the fourth quarter of 2023 and into the first quarter of 2024.Growth TrendsOn a year-over-year basis, all sectors of RIAs experienced growth in AUM as the markets rebounded from the 2022 slump. The largest increase came from larger RIAs, which had a median increase in AUM of 13.3% over the past year. The second largest increase in AUM came from smaller RIAs which had a median increase in AUM of 10.8%. This was followed by alternative asset managers, which had a 7.7% increase in AUM over the past year. Revenue growth lagged AUM growth for all groups, reflecting lower effective realized fee levels. Both the larger (>$250B AUM) and smaller (<$250B AUM) groups of traditional asset managers reported negative EBITDA growth.Growth in AUM for the smaller RIA group ranged between 4.6% (Westwood Holdings Group) and 22.1% (Wisdom Tree). For the Larger RIA group, AUM growth was between 3.4% (Affiliated Managers Group) and 16.6% (Janus Henderson Group).Most RIAs experienced organic AUM outflows during the twelve months ending March 31, 2024. These organic outflows were offset by market growth, which led to a net AUM increase for all RIAs we measured.For the smaller RIA group, revenue growth ranged from negative 6.5% (Diamond Hill) to 21.0% (Westwood Holdings). Revenue growth for larger RIAs was between negative 8.1% (Affiliated Managers Group) to 7.1% (Federated Hermes).For the smaller RIA group, EBITDA growth ranged from negative 36.1% (Diamond Hill) to 48.1% (WisdomTree). EBITDA growth for larger RIAs was between negative 25.8% (Invesco) to 7.6% (Federated Hermes).

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

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.

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

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.

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

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

Two weeks ago, Westwood Holdings Group (ticker: WHG) completed its acquisition of Salient Partners’ asset management business.  The purchase price consisted of $35 million in cash at closing plus a potential $25 million in earn-out payments (in WHG stock and cash) contingent upon hitting specific revenue retention and growth rates over the next 2-3 years.  The deal is expected to add $4 billion in AUM and $31 million in annual revenue to WHG, pricing the total consideration (cash up front plus earn-out payments) at 1.5% of AUM and just under 2x revenue, which is right in line with WHG’s public peers.Click here to expand the image aboveThis valuation seems reasonable, especially considering 42% ($25 million) of the $60 million purchase price is contingent upon hitting specific revenue retention and growth objectives after closing.  These metrics support WHG management’s assertion that the deal represents an “attractive valuation, structured with back-end protection through prudent growth and revenue retention hurdles.”Another (unstated) rationale for the deal is AUM and revenue replenishment.  WHG assets under management and revenue peaked in 2017 at $24 billion and $134 million, respectively, and have since fallen to $11.5 billion and $68 million, respectively (prior to this acquisition).  Westwood’s stock price has followed a similar trajectory, peaking at $70.84 in October 2017 and currently sitting at $11.27.  This acquisition added 33% in AUM and 47% in revenue and should be immediately accretive to earnings.  The Street agreed, and WHG’s stock price increased 6% on the day of the announcement.Masking losses through acquisitions is typically a risky proposition, but this may be an instance where it actually makes sense.  WHG had some excess cash and investments on its balance sheet, which it employed to purchase a sizeable asset management business at a reasonable price.  By acquiring an asset manager with distinct energy infrastructure, private investment, tactical equity, and real estate strategies, WHG will be able to diversify its predominantly U.S. value product offering while earning a higher effective fee on total client assets.  As part of the transaction, Westwood will also acquire a 47% stake in Broadmark Asset Management, which subadvises a liquid alternative strategy on the Morgan Stanley platform.In a year where most investment management firms have endured a precipitous drop in AUM, revenue, and earnings, this acquisition could be a blueprint for future transactions.  Asset manager values are down significantly over the last year, so there’s ample opportunity to add client assets and revenue for a reasonable price.  These deals also tend to accrete immediately, and earn-out consideration provides downside protection against adverse market events or client losses.  We’re still seeing strong deal flow for wealth management firms without the corresponding gains for asset manager M&A.  If this deal goes well, we could finally see a year where asset management dealmaking outpaces RIA M&A.  As always, we’ll keep an eye on it and report back.

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.

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

We haven’t blogged about the bond yields of RIA aggregator firms in the past because there hasn’t been much to report. Before this year, yields didn’t move much and generally stayed between 2% and 8%, depending on the term and credit quality of the issuer. That all changed last November when the Federal Reserve and other central banks began raising interest rates to fight mounting inflationary pressures in the global economy. Now RIA aggregator bond yields are in the 6% to 14% range after fairly steady gains throughout this year.Click here to expand the image above.Corresponding bond prices have fallen over this time, and we use a recent Hightower issuance to demonstrate the inverse relationship between bond yields and prices.Rising interest rates have also affected equity prices, particularly in the RIA sector, which has doubled the market’s loss over the last year.The driving forces behind the sharp decline in RIA stocks are relatively straightforward. Stock prices are strictly a function of earnings and a multiple (E x P/E = P). Earnings are lower because revenue and AUM have declined in the capital markets, with inflationary pressures driving costs up and margins down. Rising interest rates have pushed up the costs of debt and equity capital resulting in higher discount rates and lower multiples. The cumulative effect of these forces is a ~50% decline in RIA aggregator and investment manager stock pricing since last November.We haven’t seen these pressures play out in the M&A market for investment management firms.That could change in the coming quarters as M&A activity is often a lagging economic indicator, as deals can take months or even years to close after their announcement. The adverse effects of rising interest rates, higher inflation, and lower earnings also impact closely held RIAs, so they’re also vulnerable to reduced valuations and transaction multiples as prospective buyers anticipate lower cash flows on a diminished AUM base.Deal volume could also suffer in 2023 as much of it is driven by RIA aggregators, who are reeling from higher financing costs and lower valuations. CI Financials CEO Kurt McAlpine noted that their pace of acquisitions has “absolutely slowed down” in a recent earnings call. The combination of rising debt costs and lower expected returns in the RIA space could cause the other aggregator firms to follow suit, which would likely curtail deal-making in the sector until markets recover. The M&A market for RIA firms tends to be resilient, so we’ll continue following these trends and report back.

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.

The RIA industry extended its losing streak last quarter with all classes underperforming the S&P, which also continued its decline. The market itself is part of the problem as this industry is mostly invested in stocks and bonds, which have been down considerably since the first of the year. The additional underperformance for asset and wealth managers is likely attributable to lower industry margins as AUM and revenue fall with the market while labor costs continue to rise. Rising interest rates have exacerbated this decline for alternative asset managers and RIA aggregators, who frequently employ leverage to make investments. The one bright spot for the industry is the group of smaller (under $10 billion in AUM) publicly traded RIAs, which is the only segment to outperform the market over the last year. This group is still down over this time but holding up relatively well due to the lack of aggregator firms in its composition. These smaller firms have also tended to trade at more modest multiples with higher dividend yields, so these lower-duration stocks have held up reasonably well in a rising interest rate environment. As valuation analysts, we are 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 throughout 2021, LTM earnings multiples for publicly traded asset and wealth managers have dropped nearly 40% this year, reflecting investor anticipation of lower revenue and earnings from the recent market decline and rising cost structure. 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 closely held RIAs should be made with caution. Many 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. Also, most closely held RIAs are smaller than their public counterparts and often transact at lower multiples because of the heightened risk profile associated with smaller businesses.Despite industry headwinds, the M&A market for the RIA industry has remained strong though valuations have started to level off a bit. M&A is often viewed as a lagging economic indicator since deals take several months or even quarters to complete, so we may not see multiples start to come down for a few more months. As always, we’ll keep an eye on it and report back next quarter.

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

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.

Last week, ATO held its annual meeting at the JW Marriott in Las Vegas to discuss industry trends, practice management, and recruitment during the Great Resignation. As a sponsor and panelist, here are our main takeaways from the meeting:1. Your Capital Requirements Might Be Going DownTom Blank of Shumaker, Loop & Kendrick, noted in his regulatory update presentation that Peak Trust Company received conditional approval earlier this year from The Office of the Comptroller of the Currency (OCC) for its national charter, which required a lower-than-anticipated capital base of $7 million. This reduction could mean lower capital requirements for other OCC regulated TrustCos and possibly state-regulated firms moving forward. If industry capital requirements are ultimately reduced, more cash reserves would be available for distributions and acquisitions, but it would also lower the barrier to entry for prospective competitors.2. Service is the New SalesDavid Lincoln of Wise Insights presented on trust company performance trends and reported that a substantial portion of the industry’s new business in 2021 came from net additions from existing clients rather than acquisitions. He recommended maintaining elevated levels of client engagement with existing customers and noted that many firms were developing a more structured approach to client service and outreach strategies. Gaining new business from existing clients is generally much less expensive than revenue gained by acquisition, so retention efforts are typically more accretive to earnings.3. The Best Time to Start Thinking About Succession Planning is YesterdayPaul Lesser of Cannon Financial Institute and I participated in a discussion panel on recruitment, retention, and disruption in the TrustCo space during the Great Resignation. We both acknowledged an increased utilization of equity compensation and more deliberate succession planning to recruit and retain key staff members. It’s never too early for TrustCo owners to start planning for their eventual retirement and identifying future successors for their ownership and managerial responsibilities. Best practices typically involve a mechanism for transitioning equity and client relationships over time, which is more of an ongoing process than an eventual outcome.4. Special Assets Require Special Resources and Special FeesMelody Martinez of Farmers National, Chris Procise of CIBC National Trust Company, Brooks Campany of Argent Financial, and Mike Tropeano of Broadridge Financial Solutions discussed best practices in administering and feeing special assets held in trusts. These closely held assets require increased due diligence with less available information and a specialized skill set to manage, which poses unique challenges to trust administrators with fiduciary responsibilities. These presenters recommended a careful cost-benefit analysis to ensure the fees are commensurate with the risks associated with administering real estate and private equity assets.5. 2022 is Poised to be a Rough Year for TrustCo EarningsAlmost every attendee I spoke to about their business lamented that year-to-date earnings have declined from peak 2021 levels. AUA and revenue are down with the capital markets and costs are rising with elevated inflation levels, so industry margins are feeling the pressure. Many TrustCo principals have responded by reining in new hires and encouraging the next generation of management to buy equity that has suddenly become affordable.The conference was well attended, and there were other great topics and presentations were not referenced in this blog (see meeting slides). We would certainly recommend it for trust company officers seeking intel on the state of the industry and hope to see you at next year’s meeting in New Orleans.

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

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.

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

We’re sometimes surprised when we hear about buyers paying 20x EBITDA for RIAs with under $1 billion in assets under management, so you can imagine our reaction to MassMutual Ventures, Bessemer Venture Partners, and Khosla Ventures paying an implied valuation at 20% of AUM and 20x revenue for Farther Finance Advisors, a start-up, tech-heavy RIA with $250 million in AUM. We’ll explore the logic and potential pitfalls of this valuation in this week’s post.FarsightedAccording to Farther’s 2020 Form ADV, the firm had $19.5 million in AUM at year-end 2020, and recent reports have client assets at $250 million, which is 12.8x the amount from eighteen months ago with little or no market tailwind. If we extrapolate this growth for another eighteen months then AUM will reach $3.2 billion by the end of 2023, and a $50 million valuation would certainly be justified (1.6% of AUM at that point). We’ve seen RIA start-ups achieve this kind of growth with the right investment performance, market penetration, and/or technology offering. Recent examples include Facet Wealth and Vise AI Advisors, which have both raised significantly more capital with a similar AUM base and trajectory. It’s somewhat rare for RIA firms to achieve this level of growth and investment shortly after inception, but investors are handsomely rewarded if the firm’s ambitious projections are realized.Farther intends to use its proprietary wealthtech offering to enable advisors to focus on client needs and business development rather than the administrative challenges of working for a wirehouse or managing their own practice. This plug-and-play advantage likely explains how it has already recruited 27 advisors from independent channels and wirehouse firms. Farther’s technology also enables these advisors to work remotely, so there are no geographic constraints to serving clients across the country. Continued recruitment of advisors with established books of business should allow the firm to maintain its growth trajectory regardless of market conditions. Current and historic operating losses also create valuable tax shields in future periods to enhance cash flow when the business becomes profitable.ShortsightedIn our experience, RIA investors are generally more focused on earnings (EBITDA or net income) rather than activity (AUM and revenue) metrics since their returns are based on the firm’s underlying profitability. Recent reports state that Farther has 50 employees, so it’s probably safe to assume that it’s still losing money despite its impressive growth trajectory. Much of the firm’s future growth is contingent upon hiring additional advisors and existing advisors growing their book, but the payout to advisors goes from 50% to 75% after their first $500,000 in production, so Farther’s retention ratio declines when this happens. Management fees also start at 1% of AUM (account minimum of $100,000) and decline at higher asset levels, so it's difficult to see Farther entering the black this year even with continued growth in client assets.There’s also the issue of chronic dilution as advisors can gain equity in the firm, which has already completed two capital raises since its founding in 2019. Additional rounds of equity financing may be needed to fund future growth if time to breakeven takes longer than expected.You Have to be Farsighted to Justify This Investment Farther is effectively a long duration asset. It’s currently unprofitable and probably won’t reach breakeven for at least another year, so there’s no real prospect for interim cash flows (dividends) in the foreseeable future. There’s also no immediate market for the stock since it’s illiquid and has only a few shareholders. Farther’s current investors are banking on it to continue its recent growth and eventually hit a normalized margin, but this could take some time given its current headcount and payout structure.We’re used to looking at these businesses through the Fair Market Value lens that focuses on the prospective returns that a hypothetical buyer would reasonably expect to achieve with his or her investment. From that perspective, 20% of AUM and 20x revenue for an unprofitable RIA doesn’t make a lot of sense, but that’s not how its current investors are evaluating this investment. These are sophisticated investors with a long-term horizon and willingness to assume a high level of risk for an investment with extraordinary growth (and value) potential. We hope it works for them and will definitely keep an eye on it.

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.

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

Last week Pzena Investment Management, Inc. (ticker: PZN) announced that it had entered into an agreement to become a private company again via a transaction in which holders of PZN Class A common stock would receive $9.60 per share in cash, a 49% premium to its closing price before the announcement ($6.44). In this week's post, we attempt to rationalize this premium and any implications for the investment management industry.We haven't interviewed any members of Pzena's Special Committee or Board of Directors that ultimately approved the deal, but we'll speculate on their reasoning for taking PZN private. An obvious explanation is that Pzena management wanted to avoid the additional costs and scrutiny that come with public filings. PZN is smaller than most public companies, and the publicly traded portion of its stock represented 20% of its equity capital, so it was likely devoting a significant amount of time and resources to a relatively modest float of $163 million (transaction price of $9.60 a share multiplied by 16.9 million publicly traded shares). It's very conceivable that Pzena management thought being public was more trouble than it was worth.Public markets haven't been kind to Pzena, as their stock hasn't performed well. The firm went public in 2007 with an IPO price of $18 per share, and it's lost nearly half its value during relatively favorable market conditions. PZN pays a modest dividend, but not enough to overcome the decline in share price. Much of this decline is attributable to the challenges the asset management industry has faced over this time relating to fee pressure and the rising popularity of passive investment products. The dominance of growth investing since the Financial Crisis of 2008-09 has compounded these issues for value managers like Pzena.PZN Founder and CEO Richard Pzena told Citywire in a 2020 interview, "Value investing is more upbringing and personality. Growing up, we learned that the same stuff you pay full price for, you can get at half price sometimes." If his firm was willing to pay a ~50% premium for PZN stock, maybe he felt it was finally half off.There's also been the recent recovery in value stocks and Pzena's (relatively) strong investment performance with its John Hancock Classic Value fund (ticker: PZFVX) outperforming the S&P 500 by just over 500 basis points year-to-date. Alpha often leads to asset inflows, so PZN management is probably optimistic about the firm's prospects despite its lackluster share price performance since the IPO.Does this mean asset managers are worth more as a closely held firm than a publicly traded company? Not necessarily. All else equal, investors will generally pay less for a nonmarketable interest than an otherwise comparable interest that is freely tradable in a public market. This differential in value is commonly referred to as a discount for lack of marketability or DLOM. DLOMs exist in the investment management industry but are generally lower than discounts in most other industries since RIAs and asset managers tend to fully distribute their earnings to shareholders, which enhances their liquidity and lowers their applicable discount.The implication of this transaction is not that private investment managers are worth more but that the public option may not be a viable solution for asset managers (or RIAs) that are PZN's size ($45 billion in AUM at June 30, 2022) or smaller.The investment management industry is not a fixed asset-intensive business that requires substantial investments in property or equipment, so the need to raise capital through an IPO or other form of financing is usually minimal. They're also typically owned by insiders, so it's not essential for their shares to be publicly traded such that third-party investors can enter and exit their position at will.We could see some of the smaller publicly traded investment managers (GBL, HNNA, DHIL, SAMG, and WHG, to name a few) follow Pzena's lead and pursue the private route, but more likely it will serve as further evidence that it doesn't make economic sense for most RIAs and asset managers to go public. We hope that's not the case since we often find public RIA and asset manager pricing instructive in our industry valuations. Nevertheless, it could be a while before we see another IPO in the space. Investment management principals at sizeable firms that are considering a public offering will likely think twice if the Board of one of the larger asset managers ultimately determined that it was in the shareholders' and company's best interest to go private. There are plenty of other exit and liquidity options for RIA and asset management principals, which we're happy to discuss.

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.

The most frequently ignored topic in the wealth management industry may be its first cousin, the independent trust industry. While many still associate trust work with banks, and banks still represent more than three-quarters of the trust industry, the growing prominence of independent trust companies is causing many participants in the investment management space to take another look. In some regards, independent trustcos look a lot like wealth managers, only more evolved.FeesSince the credit crisis, 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 have been forced to cut trading fees to zero. 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, with fees at least flat if not headed 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 CorrelationThe 2022 bear market is having 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, equity prices are down around 20% year-to-date.The effect on trust company profitability will depend on the length and severity of the economic slowdown caused by the market dynamics and the potential of a looming recession.Normally, trust would be shielded from some of the market volatility because of a higher exposure to fixed income. Unfortunately, the change in the term structure of interest rates this year means bonds are also well off their prices from a few months ago. Consequently, 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 market dynamics and the potential of a looming recession. 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 economic climate.Favorable DemographicsAs America becomes older and wealthier, the number of potential clients for the trust industry is poised to grow markedly.Trust companies primarily service high net worth and ultra-high net worth clients, and both demographics are growing in number. Credit Suisse’s Global Wealth Report estimates that fully 1% of Americans are millionaires, numbering almost 22 million people in 2021. This is more than double the number a decade ago, and represents more than a 20% increase over the prior two years. At the same time, the median age in the U.S. has increased by 1.5 years in the past decade, and the oldest members of the baby boomer generation are now in their mid-70s.The average age of millionaires in the U.S. is 62, and over a third of U.S. millionaires are over the age of 65. Consequently, there is a growing pool of clients in need of the kinds of services that the trust industry provides, and that points to a sustained period of organic growth for the industry. While this will also provide a tailwind for wealth management firms – who often start working for clients around the time they retire – it is a more certain opportunity for trust providers, especially to the extent that wealth transfer services are part of a client’s equation.Regulatory TrendsAs 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 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.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.SuccessionIn our experience, the ownership profile at independent trust companies is often similar to that which we see at wealth management firms, and ownership succession is often a topic of conversation. Ownership issues include concentration at the founder level or even extensively held by outsiders who helped capitalize the firm’s startup. As with most investment management businesses, independent trust companies tend to be owner-operator businesses, so finding ways to include younger partners and key staff in equity participation is sometimes a challenge.As we’ve written about in articles, blog posts, and whitepapers on buy-sell agreements, 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 risks becoming a costly distraction. As the trust industry ages, we see transition planning as potentially being either a competitive advantage (if done well) or a competitive disadvantage (if ignored).OutlookMany independent trust companies performed remarkably well over the past decade and much better than expected during the pandemic. The current bear market is an immediate headwind, but demographic trends in the U.S. and the increased visibility of independent firms as an alternative to bank trust departments should form a solid basis of growth for the foreseeable future.

The RIA industry extended its losing streak last quarter with all classes underperforming the S&P, which also continued its decline. The market is part of the problem as this industry is mostly invested in stocks and bonds, which have decreased considerably over the last six months. The additional underperformance for asset and wealth managers is likely attributable to lower industry margins as AUM and revenue falls with the market while labor costs continue to rise. Rising interest rates have exacerbated this decline for alternative asset managers and RIA aggregators, who frequently employ leverage to make investments. The one bright spot for the industry is the group of smaller (under $10 billion in AUM) publicly traded RIAs, which is the only segment to outperform the market last quarter. This group is still down over the last three months but is holding up relatively well due to the lack of aggregator firms in its composition. 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 quarter of 2021, LTM earnings multiples for publicly traded asset and wealth managers declined modestly in the back half of last year before dropping nearly 40% so far this year, reflecting investor anticipation of lower revenue and earnings from the recent market decline. 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 closely 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.In contrast to public asset/wealth managers, much smaller, private 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.Notably, the market for privately held RIAs remained strong in 2021 as investors flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Deal activity for these businesses continued to be significant in 2021, and multiples for privately held RIAs tested new highs due to buyer competition and a shortage of firms on the market. As these dynamics continue into 2022, the outlook for continued multiple expansion and robust deal activity remains favorable, assuming interest rates and market conditions stabilize in the near future.

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.

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

Last week we introduced our series on compensation structures for RIAs. That post outlined the three basic components of compensation at investment management firms.Three Basic Components of CompensationBase 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. Last week we focused on variable or bonus compensation, so this post covers the equity component.Equity CompensationIf the other forms of compensation are meant to attract (salary) and retain (bonus) qualified talent, RIA equity is intended to align shareholder and employee interests while rewarding long-term contributions to firm growth and value. This structure inherently blends returns to labor (employee comp) with returns on investment (shareholder distributions) by its very design. It is typically the most complicated and misunderstood component of RIA compensation but can be highly effective when implemented correctly. We often use the following depiction to simplify the distinction between these sources of return: Unfortunately, this distinction between returns to capital and labor becomes blurred when the business is owner-operated like most investment advisory firms: As a result, most investment management firms offer their key employees some form of equity compensation to align their interests with shareholders and incentivize them to continue growing the business. Equity comp can also be a differentiator that allows some RIAs to recruit top talent from other investment management firms that don’t offer any sort of stock consideration to their employees. Equity comp has become more common during the Great Resignation and is part of the reason we’re seeing so much turnover in the industry now.Common Equity-Incentive PlansWhile implementing an equity incentive plan will typically have a dilutive impact on existing shareholders, a properly structured plan will facilitate attracting and retaining the right talent and motivating participating employees to grow the value of the business over time. In that sense, a well-structured equity incentive plan is accretive to existing shareholders, not dilutive.Some of the more common equity-incentive plans are discussed below:Direct Equity Ownership: For most investment management firms, equity is held by senior management. As these executives retire or leave the business, equity is transferred to the firm’s next-generation management. In these cases, the internal market for the company’s shares serves the function of an equity incentive plan by placing equity ownership in the hands of the individuals with the greatest influence on the performance of the company. Direct equity incentive plans are typically the most straightforward way of transferring equity to the next generation but may not be the most practical if the current principals are unable or unwilling to relinquish ownership or control of the business, or if next-generation management is unable or unwilling to purchase equity.Stock Option Grants: Stock option grants give employees the right, but not the obligation, to purchase equity in the company for a specified period of time at a specified exercise price. Typically, the exercise price is equal to the fair market value of the company’s shares as of the grant date, which allows employees receiving the option grants to participate in any appreciation in value over the value at the grant date. Stock option grants may be subject to vesting periods in order to promote employee retention.Synthetic Equity Plans: Under synthetic equity plans, employees receive something that mimics equity ownership from an economic perspective, but typically without the non-economic rights (such as management and voting rights) that accompany direct ownership. Examples of such plans include phantom equity and stock appreciation rights (SARs). Under these plans, a select group of employees (usually senior management) receive payments tied to the company’s stock value at a certain date or dates. In the case of phantom equity plans, the payments can be based on the value of the stock at a certain date (a full value plan) or only the appreciation in value relative to the grant date value (an appreciation only plan). These plans can be highly customizable with respect to dividend participation, vesting schedule, and triggering events for redemption/forfeiture.Profits Interests: RIAs structured as LLCs can issue profits interests, which represent an interest in the future profits or appreciation in value of the firm. Profit interests offer potential tax advantages in that they should not result in taxable income for the recipient when they are granted, and the appreciation in value may be taxed as capital gains rather than ordinary income.ConclusionThere are advantages and disadvantages to each type of plan, and the most appropriate one for your firm will depend on what you and your aspiring owners are trying to accomplish. We’re happy to walk you through this if you need some guidance.

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.

As we’ve been writing in recent blog posts, consolidation efforts in the RIA space are facing multiple headwinds. Among them, market conditions and inflation are motivating buyers to scrutinize profit estimates more than ever. In that light, we thought our readers would appreciate this guest post by our colleague, Jay D. Wilson, Jr., CFA, ASA, CBA, who works with banks and FinTechs. We’re getting more requests for QoE assessments from both the buy-side and sell-side (the latter wanting to buttress their CIMs).Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

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

You’re not the only one dealing with turnover.  The pandemic spawned the Great Resignation, and rising inflation means there’s probably a better salary (or signing bonus) out there for anyone that’s looking.  The ensuing talent war has created more industry turnover than the end of broker protocol in 2017, and RIA principals are having to invest more time and resources into recruitment and retention than ever before.This trend actually started last year when the RIA industry was relatively healthy.  Favorable market conditions and rising AUM levels meant that most investment management firms could easily afford to replenish departing staff members to service a growing revenue base.  So far this year, the fixed income and equity markets have reversed course, and most RIAs are suddenly having to deal with declining assets under management and fee income.  Add inflationary labor and overhead costs into the mix, and declining margins and profitability seem almost inevitable this year.This doesn’t necessarily have to be all bad for you and your firm.  As Petyr ‘Littlefinger’ Baelish once proudly reassured Lord Varys during particularly turbulent times at King’s Landing in Season 3 of Game of Thrones, “Chaos isn’t a pit. Chaos is a ladder.”  Fidelity Investments seems to agree and plans to make 28,000 hires in 2021 and 2022 to increase industry dominance as its competitors struggle with thinning margins and a fleeting workforce.  James Lowell, editor-in-chief of Fidelity Investor, elaborates, “The discrepancy in the numbers of Fidelity hires suggests a new game is afoot: gaining market share of talent which will, in turn, better enable them to out-compete on service, not just products.”That’s probably easier for a firm like Fidelity which has $11 trillion under management and countless resources at its disposal. There are still ways for smaller RIAs to capitalize on this chaos or at least minimize the damage until normalcy is restored:Increase the payout percentage to leading advisors. In all likelihood, their compensation is falling with AUM and management fees.  Increasing their payout will soften the blow and incentivize them to continue growing their book of business and servicing clients.  If you don’t, there’s a good chance a competitor will.Offer some sort of equity compensation to key staffers. Our RIA contacts continue to tell us that an increasing number of tenured employees (and sometimes even prospective hires) are asking about ownership or some form of equity consideration as part of their total compensation package.  In some cases, their inability to offer equity or a clear path to ownership has led to retention issues since many of their competitors can offer these benefits.  Equity ownership is the best way to strengthen employees’ ties with the firm and align their interests with other RIA principals.Don’t offer the same raise to all staffers (in percentage or absolute terms). It’s highly unlikely any RIA’s employees are equally productive and deserving of the same bump in pay.  Your revenue is likely declining with the markets, so an across-the-board increase in salary (at currently elevated rates of inflation) will compound the adverse effect on margins and profitability.  Varying raises and shifting towards more performance-based forms of compensation should minimize undesired turnover and further declines in profitability.Consider establishing a bonus pool for key employees tied to firm profitability. Many RIAs have established a bonus pool that sets aside a certain percentage of pre-bonus operating income for its management team.  This structure will incentivize them to run the business efficiently and maintain profitability when revenue hits.Articulate a plan on how the firm will weather the storm and potentially come out stronger. This probably isn’t the first market downturn that your firm has endured.  Your AUM, revenue and earnings are still probably higher than the COVID bear market and almost certainly higher than the last Financial Crisis.  The next few months (and maybe even quarters) will likely be rough, but there’s no reason to believe you can’t endure this cycle and be in a better position when the market recovers.  Your staff needs to be reminded of that. Many of these suggestions may dampen your distribution or ownership in the short run, but it’s likely a worthy sacrifice to avoid losing key staffers in addition to AUM and management fees.  It may not be a ladder, but it’s certainly a lifeline.

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.

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

2021 may be remembered as both the busiest M&A year in history for the investment management industry, as well as the year in which valuation multiples in the space peaked.  Transaction volume surged last year and carried into the first quarter, as deals negotiated during a period of cheap money, strong multiples, and the threat of changes in tax law drew both buyers and sellers to the negotiating table.  Between Thanksgiving and New Year’s, however, we began to detect a change in the atmosphere for RIA valuations that, in hindsight, may prove to have been a turning point.  It was around the same time that the topics of inflation and interest rates began to dominate the financial press, and it’s no coincidence.  With the Fed in tightening mode, it’s time to question what impact the change in market conditions has for the investment management space.Many industry observers believe anticipated rate hikes will have little or no impact on the sector since most RIAs don’t have any debt on their balance sheets.  While it’s true that most investment management firms do not employ leverage in their capital structure, rising rates will nonetheless have an impact on their cost of equity and, consequently, their valuations.  We can illustrate this by way of a common decomposition of the most prevalent valuation metric in the RIA space, the EBITDA multiple.In the interest of simplicity, and to avoid trying to show side-by-side discounted cash flow models, we’ll use the EBITDA single period income capitalization method.  We won’t dwell on every detail, but you can read more about it in a related article on our website.This method uses the capital asset pricing model (CAPM) to develop EBITDA multiples based on a company’s risk/growth profile, interest rate levels, and historical returns on publicly traded stocks.  We’ve incorporated it here to determine what happens to EBITDA multiples when interest rates go up.  This methodology is especially useful to the RIA industry because EBITDA is the most cited performance metric since AUM and revenue rules of thumb tend to vary with profitability.  Further, EBITDA is usually a good proxy for cash flow when capital expenditures and interest payments are minimal.In the first example, we’ll demonstrate the impact of a 250 basis point increase in interest rates on EBITDA multiples for RIAs with no debt in their capital structure.  We’ve assumed this increase based on an expected 2.5% increase in the Fed Funds Rate from the end of last year to the beginning of 2023 (year-ends depicted on the X-axis below).  (Some are now anticipating a 300 bps increase.)A sample build-up in the cost of capital for an RIA might look something like the illustration below.  The cost of equity is the sum of expected equity returns in excess of long-dated treasuries, plus a non-systemic, or company specific, risk premium.  The cost of debt is typical of covenant-light loans from non-bank lenders to the space, set at a premium to some base rate, illustrated here as Libor.  Most RIAs operate without debt, so the weighted average cost of capital, or WACC, is the same as the cost of equity.  If you subtract expected growth in cash flow from the WACC, you’re left with a capitalization rate (the inverse of which is a multiple) applicable to debt-free net income.  This can be grossed up by the firm’s effective tax rate to derive an EBIT multiple, and further adjusted for depreciation to derive an EBITDA multiple.  In this case, the implied EBITDA multiple is one that would be familiar to many industry participants.Of course, this illustration derives an implied EBITDA multiple prior to expected increases in interest rates.  As noted below, a 2.5% increase in the federal funds rate (which we’re using to approximate changes in the risk-free rate here) results in a 25% decrease in the EBITDA multiple (holding everything else constant) even though we’ve assumed no interest-bearing debt in the capital structure.  The reason is higher interest rates raise an RIA’s cost of equity capital because investors in these businesses will require the same incremental return over riskless alternatives to induce investment, so a higher risk-free rate means a higher required return on RIA investments.  Sellers will have to offer lower prices to satisfy a buyer’s need for an increased return, and the EBITDA multiple (assuming no changes in EBITDA) will fall with the transaction price.Last week we noted that RIA acquirers and aggregators now account for roughly half of the industry’s deal volume.  Since these firms are responsible for a significant portion of the sector’s acquisitions, changes in their cost of capital will affect how much they’re willing to pay for RIAs and the resulting multiple for many industry transactions.  In a rising interest rate (and cost of capital) environment, they’ll have to transact at lower prices to generate an ROI that justifies the investment.RIA consolidators typically use debt to purchase investment management firms, so their cost of capital can be viewed very differently than a pure-play RIA with little or no leverage.  Aggregators employ debt financing because it’s cheaper (lower required rate of return) than equity capital, and interest rates have been hovering at historic lows until recently.The illustration above shows an 80/20 equity/debt capital ratio, which is more conservative than many consolidators have employed.  Push the capital structure more toward the debt-side, and you’ll quickly get to the 20x or more multiples we’ve heard private consolidators use to describe their valuations.The higher the multiple, the greater the impact from rising interest rates.  Unlike most investment management firms, rising interest rates adversely affects both debt and equity financing costs for RIA consolidators, so their cost of capital has likely gone up dramatically in recent months.  If we illustrate that same 250 basis point increase in rates for a consolidator, the impact on EBITDA multiples increases proportionate to their leverage.  In this instance, the two and half percentage point increase in rates cuts the EBITDA multiple by more than a third.A couple of weeks ago, we referenced that RIA aggregators had gotten off to a rough start in 2022.  Our RIA aggregator index is off nearly 40% since November when the Fed first started signaling rate hikes to stave off inflationary pressures.Underlying EBITDA is also getting squeezed as labor costs rise and AUM falls with the fixed income and equity markets, and we’ll dive into that more next week.

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.

While wealth management continues to benefit from demographic trends in the U.S. and the general accumulation of investible assets during the pandemic, 2022 is proving to be somewhat more difficult for the sector, and sentiment among investors in wealth management firms has dimmed.Public firms with substantial operations in the wealth management space have been underperforming alt asset managers and the broader market, and aggregator models like Focus Financial and CI Financial (whose share prices currently trade at 52-week lows) will need organic growth to overcome sluggish financial markets, fee pressure, and higher interest rates. Recent market activity is a strong contrast to the uptrend seen for much of 2021. Prices for aggregator models accelerated into December of last year, peaking as transaction activity in the space hit a fever pitch, fueled by higher multiples and the threat of changes in tax law that would make selling after year-end potentially disadvantageous. The annual Schwab survey of wealth management firms confirmed this bullish sentiment, with advisors generally more optimistic about industry growth prospects than they were a year earlier.Source: June 2021 Schwab Advisor Services Independent Advisor Outlook StudyIt’s noteworthy that the survey represents sentiment in mid-summer. In the nine months that have transpired since the survey was taken, the market has had to digest higher inflation, a new uptrend in global interest rates, the Federal Reserve shrinking its balance sheet, and the war in Ukraine. The survey to be taken in 2022 could prove less sanguine.Despite all of the media attention given to consolidation activity in the wealth management sector, it’s noteworthy that the advisors surveyed by Schwab saw ample opportunity to grow their firms organically, with less than 10% of expected growth coming from recruiting or M&A.Also noteworthy is a generally positive look back at the impact of the COVID pandemic on the wealth management industry, with most firms reporting better performance working remotely than expected. Many firms found opportunities for efficiency in video calls, better staff utilization by cutting staff community times, and expense saving opportunities by cuts in travel costs and office space.Technology investment is a continued theme in the wealth management space, as firms look to new resources for investment management, client management, and firm management to improve service and efficiency. Most firms expect technology spending to increase in 2022, and some view it as a way to overcome staffing challenges presented by tremendous growth in clients and lack of available talent.By the spring of 2022, many of the industry trends facing and favoring wealth managers started to shift, threatening margins and valuations.Higher interest rates are undermining valuations in both debt and equity markets, taking an unusually strong toll on everything from U.S. treasuries to tech stocks. This shift creates a downward gravitational pull on assets under management, and therefore revenue, for wealth management firms. At the same time, inflationary forces are pushing up on both labor and non-labor expenses for RIAs. The consequence could be challenging for margins in 2022 and could deflate some of the positive influences on profitability that have provided a tailwind to RIA valuations for several years.Valuations may ultimately suffer as well because of higher interest rates, as other income producing assets provide an alternative to investing in RIAs, and the cost of capital increases on both the equity and debt sides of the equation for leveraged consolidators of wealth management firms.

Access to cheap financing and favorable market conditions spurred significant gains for private equity firms and hedge fund managers during 2021. These tailwinds reversed course in the first three months of this year, and now many of these businesses are in bear market territory. Such volatility is typical for the alt space, which often relies on leverage to enhance returns on its underlying fund investments.Other classes of RIAs didn’t fare so well as the market downturn in January and February erased all their gains over the prior nine months. A closer inspection of the first quarter shows all classes of RIAs down 20% or more at the end of February when the S&P was only off 8%. Investors are likely anticipating lower margins for the RIA industry as AUM and revenue falls with the market while labor costs continue to rise.RIA aggregators also had a rough start to the year. Because the aggregator model is levered to the performance of the wealth management industry generally, the recent downturn for RIA stocks has impaired consolidator valuations too. While the opportunity for continued consolidation in the RIA space is significant, investors in aggregator models have expressed mounting concern about rising interest rates and leverage ratios which may limit the ability of these firms to continue to source attractive deals. Performance for many of these public companies continues 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 RIAs, while larger 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 quarter of 2021, LTM earnings multiples for publicly traded asset and wealth managers declined modestly in the back of last year before dropping nearly 20% last quarter, reflecting investor anticipation of lower revenue and earnings as the market pulled back in the first two months of the year.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 closely 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.In contrast to public asset/wealth managers, many smaller, private 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.Notably, the market for privately held RIAs remained strong in 2021 as investors flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer. Deal activity for these businesses continued to be significant in 2021, and multiples for privately held RIAs tested new highs due to buyer competition and shortage of firms on the market. As these dynamics continue into 2022, the outlook for continued multiple expansion and robust deal activity remains favorable assuming interest rates and market conditions stabilize in the near future.

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.

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

It’s de ja vu all over again. The volatility from the onset of the pandemic two years ago has been creeping back up as investors grapple with the global implications of the war in Ukraine. At the end of last year, most RIA owners were enjoying peak AUM and run-rate profitability. Since then, these measures have likely taken a substantial hit as the S&P 500 and NASDAQ are down 12% and 19%, respectively. When this happened two years ago, the market made a sharp recovery in the preceding quarters, but looking forward, we don’t know where the bottom lies. Most RIA principals are likely grappling with a sizable decline in management fees and earnings for the next billing cycle.The VIX, which calculates the expected volatility of the U.S. Stock market, hit a new all-time high on March 16,2020, of 82.69. It gradually declined until Russia invaded Ukraine several weeks ago and has ticked back up ever since. If one thing has become more clear, it’s that market volatility is likely here to stay – at least for a while. In this post, we explore what this volatility means for you and your RIA.AUM, aka Revenue Base, Is More VolatileFor RIAs that charge fees on a quarterly basis, the fees charged on March 31, 2022, will likely be significantly lower than the fees charged as of year-end (barring any major advances in the market over the next week or so – which is not out of the question). Many RIAs have quickly adjusted to this new normal. Rather than charging fees quarterly, which makes them more susceptible to the large swings in the market, they have switched to charging fees on a monthly basis to smoothen the impact from a swift correction.Active Managers May Be Able to Exploit Mispricing in the MarketDuring times of increased volatility, active managers are generally able to take advantage of the swings in stock valuations away from fair value, allowing them to realize increased returns for their clients. This may be more difficult in the current market as the volatility today is not just driven by increased “fear” in the market, but a lack of liquidity in our financial system.Over the last few months, bid-ask spreads have widened, and trading volumes have generally declined. A lack of liquidity in market structure is associated with increased risk. In a less liquid market, it is more likely that you could get stuck in a losing position. Additionally, in less liquid markets, prices tend to overreact, making market moves less informative. While there are more winning opportunities presented to active managers, there are also more losing ones.Sector-Specific Managers Are Missing Out or Killing ItMuch of the decline so far this year has been driven by tech stocks, which outperformed most other sectors of the economy over the last few years. Conversely, energy sector fund XLE is up 34% year-to-date after underperforming the broader market for several years. Mean reversion has been a major force so far this year to the benefit and detriment of sector-specific asset managers.Internal Transactions Have Been Temporarily SidelinedMany RIA principals are more reluctant to sell at the pricing implied by recent valuations that consider the impact from the market fallout. Additionally, the next generation of leadership may be less inclined to take on the additional risk if their compensation also took a hit. We haven’t seen any evidence of this so far, but it could work its way through the system if these conditions persist over the next few quarters.External Transactions Might DeclineSince many debt-fueled purchases of RIAs rely on variable rate financing, many prospective external buyers will also be sidelined if borrowing becomes more expensive. Lenders could also get spooked by rising volatility and waning profitability for many RIA firms.Planning Is More Important Than EverDuring this time when the outlook for global markets and the economy is uncertain, many RIA principals are working to nail down the unknowns associated with business ownership. RIA principals are devoting more time to working on their buy-sell agreements in an effort to protect the working relationships with their partners and ensure they and their families are protected financially in the event of a divorce, partner dispute, disablement, or death.The current environment is ripe with uncertainty. This presents both challenges and opportunities for principals of investment management firms. As we all know, this will eventually pass, so most of our clients are focused on positioning rather than acting.

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.

As valuation experts, we watch trading multiples closely in both the public and private markets. We diligently follow handpicked investment manager indexes, and we monitor publicly disclosed transactions as well as our own proprietary data collected through our hundreds of valuation engagements. In a valuation context, market pricing is often viewed as a test of reasonableness as to an appraiser’s conclusion of intrinsic value. As any investment management professional knows, the reason may elude public pricing from time to time, but in the long run, market pricing is the only true proxy for intrinsic worth. Studying how multiples change over time helps us contextualize industry trends and pervading sentiments.In recent years, market sentiment for publicly traded investment managers has lagged the optimism seen in the robust private markets for RIAs and other investment managers. This should sound counterintuitive. In most cases, publicly traded companies are priced at a premium to their typically smaller, less liquid peers. Theoretically, public companies enjoy the benefits of liquidity and heightened access to capital which in turn spurs growth. Additionally, publicly traded companies are typically larger and have demonstrated the aptitude to amass scale, institutional backing, and brand necessary for an IPO. To some degree, these trends do bolster public market valuations, which makes it all the more striking that public multiples should trail private market competitors.*Table represents Mercer Capital’s index of U.S. publicly traded investment management firms with under $100 billion in AUM, excluding those specializing in alternative investmentsWhile public companies traditionally warrant outsized multiples, transaction data to is often biased upwards. In most cases, and especially in the investment management industry, deals are made for the purpose of unlocking “transaction value.” This may arise from increasing profitability, growth, or reducing risk. For instance, in joining two firms, advisors may be able to increase margins by sharing overhead and management costs or by streamlining cost-effective operational platforms. In other instances, advisors may be able to tack on new service offerings or expand into more strategic geographies. Any value identified in a transaction above fair market value is referred to as a transaction premium and is often shared between the buyer and seller upon negotiated terms.Transaction premiums vary widely and are difficult if not impossible to quantify without already having determined a specific buyer. In the context of “fair market value” – the most common standard of value used in appraisals — we try to decouple any transaction premiums when relying upon transaction data. In many instances, however, transaction premiums cannot be identified in private transactions due to the inability of a third party to ascertain the value a unique buyer sees in their purchase. For this reason, appraisers are often cautious when using guideline transactions data. A common proxy for a transaction premium, albeit a rudimentary one, is an earnout. Earnouts are contingent money paid out to the seller over time based on future performance. The purpose of an earnout is to align the incentives of the buyer and seller after any transaction is closed. If we consider earnouts to be a decent proxy for a transaction premium, transaction multiples observed from private market data still indicate a premium of 6.4% enterprise value to revenue and 27.4% enterprise value to EBITDA (see table below). We believe there are multiple reasons for this discrepancy in pricing among public and private buyers. First, most publicly traded investment management firms can be categorized as asset managers, specializing in investment products and seeking to generate alpha, while the typical RIA often focuses on wealth management, specializing in a range of services to protect and grow client wealth. Over the past decade or so, asset managers have faced fee compression as passive investment products such as ETFs and index funds have outperformed actively managed funds in both fund flow and return. Wealth managers, on the other hand, have demonstrated exceptional client retention independent of market performance. Consequently, wealth managers are often valued at a premium to asset managers in the current market environment. This may explain to some extent why smaller transactions are trading at multiples above publicly-traded competitors, but probably not entirely. For instance, consider Silvercrest Asset Management Group, Inc. Despite its name, Silvercrest can be considered, for all intents and purposes, a wealth manager. According to Silvercrest’s most recent 10-k, the RIA boasts 98% client retention and promotes itself as a financial advisor offering family office services to ultra-high net worth individuals (net worth above $10 million) along with investment services to institutional investors. While investment research, portfolio construction, and implementation are performed in-house, Silvercrest benefits from the same higher margin, higher retention model of any wealth management firm. Despite the similarities to smaller wealth managers, Silvercrest was trading more or less in line with the median multiples observed among publicly traded asset management firms with assets under management below $100 billion. Compared to our proprietary transaction data, excluding contingent consideration, Silvercrest is valued well below private market indications. So, Who Is Correct?To understand the pricing discrepancy between public and private markets, it is helpful to look to the publicly traded RIA consolidators for perspective.The aggregator value proposition to investors can more or less be summed up as enhanced growth through RIA (typically wealth management) acquisitions done at multiples below the aggregator’s multiple (multiple arbitrages) and financed with cheap (for now) debt. RIA multiples have expanded significantly in recent years, which leaves growth as the primary driver of shareholder return. While the aggregator model may advertise streamlined platforms or expansive service offerings, the business model is more or less the same as those wealth managers they look to acquire. Multiples, however, tell a different story. As seen in the table above, median revenue and EBITDA multiples are well above those observed in our transactions data, suggesting a significant premium on growth in the RIA market.The premium investors place on growth in the RIA industry helps explain the discrepancy in multiples between the private and public markets. The private RIA market is dominated by a handful of aggregators, and the need to achieve growth to appease shareholders may be a primary reason for outsized valuations within the smaller, private markets. Additionally, smaller RIAs, like any smaller company, are able to achieve superior growth during the beginning of their life cycle, better attracting buyers and higher valuations. While in most industries the premium placed on outsized growth for smaller companies is typically offset by higher discount rates attributable to company specific risk, the RIA industry may place a higher premium on growth opportunities than other industries.As independent appraisers, our objective is to render an unbiased conclusion of value that is both aware of while also independent of general market sentiments. This is why it is essential to hire an appraiser with both deep industry knowledge and expertise in business valuation. If you are considering a valuation or a transaction, please contact a Mercer Capital professional.

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

Following up on last week’s post (Three Considerations for Your RIA’s Buy-Sell Agreement), we offer four additional considerations that you should be addressing in your firm’s buy-sell agreement. We’ve seen each of these issues neglected before, which usually doesn’t end well for at least one of the parties involved. A well-crafted buy-sell should clearly acknowledge these considerations to avoid shareholder disputes and costly litigation down the road. We highly recommend taking another look at your buy-sell agreement to see if these issues are addressed before something comes up.1. Formula Pricing, Rules-Of-Thumb, and Internally Generated Valuation Metrics Don’t Withstand TimeSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is a substantial incentive to try to shortcut that part of the process. However, non-professional valuation methods, such as formula pricing, rules-of-thumb, and internally generated valuation metrics are often key reasons for costly disputes or disruptions down the road. The investment management space is particularly fraught, and not too long ago, investment manager valuations were thought to gravitate toward about 2% of AUM.We have written extensively about the fallacy of formula pricing. No multiple of AUM, revenue, or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM (typically expressed in percentage terms) does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.The example below demonstrates the problematic nature of this particular rule of thumb for two investment management firms of similar size, but widely divergent fee structures and profit margins.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.Flawed ownership models eventually disrupt operations which works to the disservice of owners, employees, and clients.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 do not have a long shelf life, even if they made perfect sense at the time the document was drafted. If value is a function of company performance and market pricing, then both of those factors have to remain static for any rule-of-thumb to remain appropriate. This circumstance, obviously, is highly unlikely.But the real problem with short cutting the valuation process is credibility. If the parties to a shareholder’s agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations which works to the disservice of owners, employees, and clients.2. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the date appropriate for the valuation matters. If the buy-sell agreement specifies that value is established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about.Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm, and there is concern about losing clients as a result of the departure. After an adequate amount of time, the impact on firm cash flows of the triggering event becomes apparent. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.3. Appraiser Qualifications: Who Will Perform the Valuation?Once you decide to engage a professional to value your firm, you’ll need reasonable criteria to decide whom to work with. Often, partners in investment management firms feel they are equipped to value their own business as investment management firms (unlike many other closely held businesses) have ownership groups with ample training in relevant areas of finance that enable them to understand financial statement analysis, cash flow forecasting, and market pricing data.What insiders lack, however, is the arms’ length perspective to use their technical skills to determine an unbiased result. Many business owners suffer from familiarity bias and the so-called “endowment effect” of ascribing more value to their business than what it is actually worth simply because it is well-known to them or because it is already in their possession. On the opposite end of the spectrum, some owners are prone to forecast extreme mean reversion such that they discount the outperformance of their business and anticipate only the worst.Partners with a strong grounding in securities analysis and portfolio management have a bias to seeing their business from the perspective of intrinsic value, which can limit their acceptance of certain market realities necessary to price the business at a given time. In any event, just as physicians are cautioned not to self-medicate and attorneys not to represent themselves, so too should professional investment advisors avoid trying to be their own appraiser.Over time, we have reviewed a wide variety of work product from different types of service providers - but have generally observed that there are two types of experts available to the ownership of investment management firms: Valuation Experts and Industry Experts. These two types of experts are often seen as mutually exclusive, but you’re better off not hiring one to the exclusion of the other.Valuation experts can do better work for clients if they specialize in a type of valuation or a particular industry.There are plenty of valuation experts who have the appropriate training and professional designations, understand the valuation standards and concepts, and see the market in a hypothetical buyer-seller framework. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Both require extensive education and testing to become credentialed, along with continuing education. Also well known in the securities industry is the Chartered Financial Analyst designation issued by the CFA Institute. While it is not directly focused on valuation, it is a rigorous program in securities analysis.There are also a number of industry experts who are long-time observers and analysts of the industry, who understand industry trends, and who have experience providing advisory services to investment management firms.However, business valuation practitioners are often guilty of shoehorning RIAs into generic templates, resulting in flawed valuation conclusions that don’t square with market realities. By contrast, industry experts are frequently guilty of a lack of awareness concerning the use and verification of unreported market data, the misapplication of valuation models, and not understanding the reporting requirements of valuation practice.We think it is most beneficial to be both industry specialists and valuation specialists. The valuation profession is still, for the most part, populated with generalists. But as the profession matures, an increasing number of analysts are realizing that it isn’t possible to be good at everything. Valuation experts can do better work for clients if they specialize in a type of valuation or a particular industry. Because our firm has specialized in valuing financial institutions since the day we opened for business in 1982, it was easy to pursue this to its logical conclusion. Ultimately, you want an expert with both professional standards and practical experience.4. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement. If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake.Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and having a valuation prepared will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.

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.

Over the next several weeks, we will be publishing a series of blog posts discussing the importance of buy-sell agreements and other adjacent topics for RIA owners. Ownership is perhaps the single greatest distraction for advisors looking to grow with their firm, but it can also be an opportunity to align interests and ensure continuity of the firm in a way that is accretive for the firm’s founders, next generation management, and clients. As highlighted in the Charles Schwab 2021 RIA Benchmarking Study, planning for a successful transition of ownership — whether through internal succession or a strategic sale – continues to be a key differentiator among top RIA performers.Most wealth 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 closely held businesses in other industries are often owned by members of the same family. In recent years, the profitability and value of many wealth management firms have increased substantially as assets under management have risen with the markets and a proliferation of capital aimed at the wealth management sector has bid up multiples. As a result of these dynamics, there is usually more than enough cash flow to fund the animosity when disputes arise, and what might be a five-figure settlement in some industries is a seven-figure trial for an RIA.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 imperative to minimizing costly and emotional drama that may ensue in times of planned or unplanned transition.Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes a process by which shares of a private company transact. Ideally, it defines the conditions when the buy-sell agreement is triggered, describes the mechanism by which the shares are priced, addresses the funding of the transaction, and satisfies all applicable laws and regulations.A buy-sell agreement establishes a process by which shares of a private company transact.These agreements aren’t necessarily static. In wealth management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to assign who gets what if the partners decide to go separate ways.As the business becomes more institutionalized, and thus, more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of a dispute or other unexpected changes in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, as well as a degree of certainty for shareholders that allows them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then an event occurs that invokes the buy-sell agreement, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized because now they are not simply co-owners with aligned interests but rather buyers and sellers with diametrically opposed interests.Triggering EventsBuy-sell agreements govern the process and terms of a transaction if certain defined events occur. These “triggering events” can stem from voluntary or involuntary circumstances. Many buy-sell agreements call for an independent appraisal upon a triggering event to establish the price at which shares will transact. In cases where ownership is more fluid, some agreements require an annual appraisal to establish the price at which all transactions will take place.Voluntary CircumstancesAt any point in time, one generation of business owners is preparing for retirement, having planned (or frequently not planned) for a successful ownership transition from one generation of business leaders to the next. A buy-sell agreement is one of the most important steps to ensure a successful, planned transition of ownership, and as such, it should complement your succession plan.A buy-sell agreement is one of the most important steps to ensure a successful, planned transition of ownership.An effective succession plan could call for the sale of the retiring partner’s stake to current management or an outside investor group or may require the sale of the entire firm to a strategic buyer.If your exit strategy includes a sale to an insider, it should specify the terms and define the process for determining the price that shares are transacted at as an owner exits to retire. This is often a point of contention as young partners and retiring partners have inherently opposed objectives. A retiring partner will want to exit at the highest share price possible while the continuing partners are ultimately financing this repurchase.Because many wealth management firms are highly valuable, successors are often financially stretched to take over the founder’s interest in the firm. By establishing the process through which price is determined and the terms at which the shares will be transacted, a buy-sell agreement mitigates any potential drama. As such, a buy-sell agreement is foundational for your firm’s succession plan.If your exit strategy is to sell your firm to an outside buyer, you should be aware of your opportunities and make it explicitly known to your firm that this is your intention. For example, you should know the different incentives of potential buyers and what options exist with financial or strategic buyers.You should make sure that your buy sell agreement makes sense in the context of your other operating agreements. A buy-sell agreement should specify the process by which a sale to an outside investor group is agreed to. We once worked with a client whose operating documents required unanimous consent to bring on a minority partner, as this required an amendment to the operating agreement, while the sale of a majority of the Company just required the consent of a super majority.Knowing your exit strategy options will help clarify what is needed from your succession plan and your buy-sell agreement going forward.Involuntary CircumstancesBuy-sell agreements guard against undesirable transitions in ownership from a potential partner to an unaffiliated party; they also define a set price per share to ensure a fair transaction. In the case of death, disability, divorce, and bankruptcy, current partners will ultimately need to redeem the shares of their colleague.For instance, in the event of the death of a shareholder, a buy-sell agreement can protect the deceased’s family, ensuring such shares are bought at a fair price and in a timely manner. It can also protect your company from the inheritors of a deceased owner, who may want to benefit from the firm’s earnings but are not able to contribute to the growth of the business. Life insurance policies for owners are advised to protect your firm in case of an untimely death or a disabling scenario. A life insurance policy will secure your firm’s ability to repurchase shares in the case of the death or disability of an owner.A buy-sell agreement will outline the process through which a price is set and the transaction is financed.Additionally, if an owner files bankruptcy, the firm will need to repurchase his or her stake to avoid the shares being acquired by the owner’s creditors. In the case of a divorce, an owner’s shares may legally transfer to his or her spouse, in which case ownership would be seeded to the ex-spouse. A buy-sell agreement will outline the process through which a price is set and the transaction is financed.Our RecommendationWe recommend revisiting your buy-sell agreement to ensure that it makes sense in the context of your firm’s vision and in partnership with its other governing documents. If you do not currently have a buy-sell agreement in place, we highly encourage you to draft one with the help of legal counsel and an independent valuation expert. Doing so will help ensure the continuity of you firm, align incentives, and may even help avoid costly litigation down the road. If you plan on reviewing your buy sell agreement and other governance matters, please give us a call.

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

Alternative asset managers fared particularly well during favorable market conditions for the RIA sector. Access to cheap financing and heightened market volatility spurred significant gains for private equity firms and hedge fund managers during 2021. Other types of investment management firms also benefited from another solid year in the equity markets as traditional asset managers and RIA aggregators outperformed the S&P 500 with 30% to 40% gains on average. Drilling down into the most recent quarter, we see more mixed results with positive gains for all sectors, but traditional asset managers and aggregators lagged the market as investors weighed the impact of the omicron variant and rising inflation on the sector’s prospects. Alt managers continued to benefit from higher allocations to risky assets despite some weakness across all sectors during the back half of the quarter. RIA aggregators exhibited outsized volatility during the quarter but ended on a positive note with the stock market in the last week of the year. Because the aggregator model is levered to the performance of the RIA industry generally, recent volatility for RIA stocks has triggered mixed investor sentiment towards the RIA 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 continues 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 RIAs, while larger 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, LTM earnings multiples for publicly traded asset and wealth managers declined moderately during the most recent quarter, reflecting the market’s anticipation of lower or flat revenue and earnings as the market pulled back modestly in September and November. 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.In contrast to public asset/wealth managers, 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.Notably, the market for privately held RIAs remained strong in 2021 as investors flocked to the recurring revenue, sticky client base, low capex needs, and high margins that these businesses offer.  Deal activity for these businesses continued to be significant in 2021, and multiples for privately held RIAs tested new highs due to buyer competition and the shortage of firms on the market. As these dynamics continue into 2022, the outlook for continued multiple expansion and robust deal activity remains favorable.

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.

Deal count is projected to reach new highs in the fourth quarter of 2021 as market activity continues to gain momentum, likely rounding out another record-breaking year for the RIA industry. In keeping with the rest of 2021, deal volume was driven by secular trends and supportive capital markets. As market activity remains robust, competition for deals continues to favor RIA aggregators such as Mercer Advisors, Mariner Wealth Advisors, Wealth Enhancement Group, and Focus Financial Partners (FOCS), to name a few. The RIA aggregator model largely developed in the wake of the RIA boom after the Great Recession and has since culminated into nearly a dozen firms, each with their own vision of how to marry the independence and client experience of an RIA with a national brand. Over the past couple of years, aggregators have gained private equity sponsors which have fueled their dealmaking capabilities. As we discussed in last quarter’s RIA M&A Transaction Update, this trend has only gained momentum in 2021, with private equity capital infusions at all-time highs. Aside from branding, industry consensus suggests some legitimate tailwinds encouraging consolidation in the RIA industry, which likewise supports the aggregator model. One such trend is a lack of succession planning by RIA founders, which we have written about extensively in prior posts. With immense experience and resources, aggregators offer a streamlined deal process and post deal integration, making many aggregators a convenient solution for principles looking to exit. While all aggregators offer liquidity solutions, each aggregator offers a slightly different value proposition to potential sellers. Consolidators such as Mercer Advisors, Wealth Enhancement Group, Mariner Wealth Advisors, and Goldman Sachs would largely be considered strategic buyers. Strategic buyers acquire firms in order to unlock value through synergy. Systemic issues such as fee compression in the asset management space or the growing cost of operational platforms and overhead in the wealth management space are solved by scale. Integrating with any one of the aforementioned firms should theoretically unlock value for buyers through higher profit margins and growth, but a strategic buyer may be a poor fit for a seller looking for a clean exit. Firms such as Focus Financial Partners lean towards the financial acquirer category in which acquisitions are primarily financially motivated investments. However, even aggregators like Focus provide many in-house back-office solutions and additional service offerings to their partners.Leading RIA AggregatorsBelow are a handful of RIA aggregators that have led M&A activity in 2021.Mercer Advisors. Mercer Advisors was founded in 1985 as a planning-focused RIA and in the last ten years has become an industry leader in the trend towards consolidation, acquiring a total of 45 firms and nine in 2021 alone. Mercer Advisors looks to integrate partnering firms intimately within the Mercer Advisors ecosystem to provide a homogeneous wealth management platform to clients. The Mercer Advisors deal team is led by David Barton, JD – former CEO and current Vice Chairman. Mr. Barton’s transition in 2017 highlights the firm’s aggressive M&A strategy and has since culminated in the majority of the firm’s acquisitions to date. The firm’s sale to private equity group, Oak Hill Capital, in 2019 has further bolstered the firm’s dealmaking activity.Mariner Wealth Advisors. In April 2021, Mariner sold a minority stake to private equity group, Leonard Green & Partners, which has since propelled the firm into 11 acquisitions. Similar to Mercer Advisors, Mariner seeks to integrate investment teams within a larger ecosystem, potentially allowing partners to exit entirely over time. In 2020, CEO Marty Bicknell announced a partnership with Dynasty Financial Partners creating Mariner Platform Solutions which looks to onboard advisors seeking independence from wirehouses and larger RIAs as well as partner with existing wealth management firms. Back-office services such as marketing, technology, compliance, and administrative support are handled by Dynasty Partners.Wealth Enhancement Group. On July 31, 2019, Wealth Enhancement Group was acquired by private equity firm, TA Associates, which has resulted in 13 acquisitions in 2021 alone. Wealth Enhancement Group offers a full suite of wealth management services across a single platform, much like Mariner and Mercer Advisors.Goldman Sachs Personal Financial Management (PFM). While Goldman Sachs did not make any direct RIA acquisitions in 2021, speculation remains high regarding the investment bank’s intentions to move into the wealth management market at scale. The purchase of United Capital in 2019, an RIA aggregator with 34 direct acquisitions to date, marked Goldman’s interest to become a leading RIA acquirer. Since the acquisition, Goldman Sachs has not leaned into the aggregator model as many had anticipated, but speculation rebounded in 2021 when Goldman hired former TD Ameritrade executive, Craig Cintron. The move suggests further development of Goldman’s burgeoning custodian services. Goldman Sachs’ historic brand and scale would make the firm a formidable competitor if it should choose to enter the RIA M&A ecosystem.Focus Financial Partners (NASDAQ: FOCS). The Focus umbrella includes over 80 partner firms (550+ principals) and over $300 billion in assets under management, making it the largest RIA aggregator by any metric. Focus self-proclaims to “preserve the autonomy of every partner firm who joins the Focus team,” and as such, would likely be a poor fit for principals looking for a clean exit. For those looking to remain post-acquisition, Focus provides a pay-out along with an operational scale for partners seeking to grow their firm or perhaps make acquisitions of their own. Accordingly, more partners who have joined Focus have made an acquisition than those who have not.In 2021 alone, Focus Financial Partners made 21 acquisitions, nearly double its deal count in 2020. Looking forward, Focus’s future is seemingly tied to its ability to continue to make deals upon more favorable or convenient terms than anyone else, and its prospects are tied to the backdrop of continued deal availability, pricing improvement, or entry into international markets.Implications for Growing Consolidation in the RIA M&A MarketThe arms race for deals, catalyzed and perpetuated by RIA aggregators, favors experienced buyers who have dedicated deal teams and capital backing. For perspective, the typical advisor operates with eight employees and approximately $341 million in AUM compared to Focus’s +$300 billion in AUM and staff of +4,000. Focus currently staffs a team of about 80 transaction-related professionals responsible for fielding acquisition targets and for integrating RIAs within the Focus Financial Partners ecosystem. Nearly all aggregators have extensive capital backing, either through private equity sponsorship, public capital markets, or both.As aggregators continue to bid up multiples, the sustainability of current M&A trends remains in question. While scale might favor a buyer’s ability to make deals, the verdict is still out on whether the RIA industry benefits from economies of scale. Despite consistent increases in M&A activity over the past decade, the number of RIA firms continues to grow, a fact that perhaps generally contradicts the aggregator investment thesis. However, the ever-increasing number of RIAs may continue to add fuel to current deal volume over the near future.

‘Twas the blog before Christmas, when all through the house Every laptop was purring, every keyboard and mouse; The stockings were hung by the chimney with care, So that backgrounds on Zoom calls wouldn’t look quite so bare;When out on the squawk there arose such a clatter, I refreshed my Bloomberg to check on the matter. Then what to my wondering eyes did appear, But a global growth manager outperforming its peer.With a ghostly old PM so lively and quick, I listened, engaged, to his every stock pick. More rapid than eagles his recommends came, And he whistled, and shouted, and called them by name:“Buy Bitcoin!  Buy Apple! Buy Tesla and Google! ’Cause shorting the future will always prove futile! To the top of the charts, for the big money haul, Go long like you’ve never had a bad margin call!”As I drew down my cash, and was turning around, Down the chimney John Templeton came with a bound. He was dressed like he owned just a few private jets, Which compared favorably to my “work at home” sweats.A bundle of hundreds he had flung on his back, Like an entrepreneur with a new public SPAC. He spoke not a word, but went straight to his work, And filled all my orders, then added a perk:His eyes - how they twinkled! His dimples, how merry! As he talked a new strat that would guarantee carry! And out-money calls bought to cover the shorts, Bringing untold riches to long-only sorts.A wink of his eye and a twist of his head, Made me want to get all of his thoughts on the Fed – And vaccines and rates and bullion and more, But he rose and I followed him out my front door.A magical Gulfstream waited there in my yard, And up the air-stairs sprang the RIA bard. But I heard Sir John claim, as he flew out of sight - "Let your best winners run, and all will be right!"...How much do you know about the RIA industry? Put your knowledge to the test with our RIA Holiday Quiz. Fill out your contact information and if you get a perfect score you will win a prize. Good luck!(function(t,e,s,n){var o,a,c;t.SMCX=t.SMCX||[],e.getElementById(n)||(o=e.getElementsByTagName(s),a=o[o.length-1],c=e.createElement(s),c.type="text/javascript",c.async=!0,c.id=n,c.src="https://widget.surveymonkey.com/collect/website/js/tRaiETqnLgj758hTBazgd_2BAEZcRHJHwtJp1wzgq96QNl8Vvqh42MIevvuINzlilE.js",a.parentNode.insertBefore(c,a))})(window,document,"script","smcx-sdk"); Create your own user feedback survey

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.

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

A recent Schwab survey asked RIA principals to rank their firm’s top priorities in the coming year. We were disappointed but not surprised to discover that developing a succession plan was dead last. This is unfortunate because 62% of RIAs are still led by their founders, with only about a quarter of them sharing equity with other employees to support succession planning. Not much progress has been made, and there doesn’t seem to be much of a push to resolve this issue any time soon. Brent Brodeski, CEO of Savant Capital, describes this predicament more crassly:“The average RIA founder is over 60 years old, and many are like ostriches: They stick their heads in the sand, ignore the need for succession planning, ignore that their clients are aging, let organic growth slow to a crawl or even backslide, and have increasingly less fun and a waning interest in their business.”Fortunately, it doesn’t have to be this way. There are many viable exit options for RIA principals when it comes to succession planning:Sale to a strategic buyer. In all likelihood, the strategic buyer is another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal. They will typically pay top dollar for a controlling interest position with some form of earn-out designed to incentivize the selling owners to transition the business smoothly after closing. This scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees or the company’s name.Sale to a consolidator or roll-up firm. These acquirers typically offer some combination of initial and contingent consideration to join their network of advisory firms. The deals are usually debt-financed and structured with cash and stock upfront and an earn-out based on prospective earnings or cash flow. Consolidators and roll-up firms may not always pay as much as strategic buyers, but they often allow the seller more autonomy over future operations. While there are currently only a handful of consolidators, their share of sector deal-making has increased dramatically in recent years.Sale to a financial buyer. This scenario typically involves a private equity firm paying all-cash for a controlling interest position. PE firms will usually want the founder to stick around for a couple of years after the deal but expect them to exit the business before they flip it to a new owner. Selling principals typically get more upfront from PE firms than consolidators but sacrifice most of their control and ownership at closing.Patient (or permanent) capital infusion. Most permanent capital investors are family offices that make minority investments in RIAs in exchange for their pro-rata share of future dividends. They typically allow the sellers to retain their independence and usually don’t interfere much with future operations. While this option typically involves less up-front proceeds and higher risk retention than the ones above, it is often an ideal path for owners seeking short-term liquidity and continued involvement in this business.Internal transition to the next generation of firm leadership. Another way to maintain independence is by transitioning ownership internally to key staff members. This process often takes significant time and financing, as it’s unlikely that the next generation is able or willing to assume 100% ownership in a matter of months. Bank and/or seller financing is often required, and the entire transition can take 10-20 years depending on the size of the firm and interest transacted. This option typically requires the most preparation and patience but allows the founding shareholders to handpick their successors and future leadership.Combo deal. Many sellers choose a combination of these options to achieve their desired level of liquidity and control. Founding shareholders have different needs and capabilities at different stages of their life, so a patient capital infusion, for instance, may make more sense before ultimately selling to a strategic or financial buyer. Proper succession planning needs to be tailored, and all these options should be considered. If you’re a founding partner or selling principal, you have a lot of exit options, and it’s never too soon to start thinking about succession planning. You will have a leg up on your competition that’s probably not prioritizing this. You’ve likely spent your entire career helping clients plan for retirement, so it’s time to practice what you preach. Please stay tuned for future posts on this topic and give us a call if you are ready to start planning for your eventual business transition.

As we wrote in our most recent investment manager sector highlight, Public Alt Asset Managers Have Nearly Doubled in Value Over the Last Year, alternative asset managers have outperformed all other investment manager sectors in the RIA post-pandemic rebound. According to Institutional Investor, eight of the world’s ten largest investment management firms by market capital are now alternative asset managers. Most notably, the private equity firm Blackstone surpassed the world’s largest investment management firm by AUM, Black Rock, as the most highly valued stand-alone investment management firm back in September of this year.The demand for investment management firms continues to reach new highs and has culminated in a number of prominent acquisitions over the past year. In the past month alone, three deal announcements of alternative asset managers by larger, traditional asset management firms and diversified financial institutions suggest the sector remains bullish.Franklin Templeton to acquire Lexington Partners acquisition – Nov. 1, 2021. At the time of the announcement, Lexington Partners managed $34.0 billion in AUM primarily in secondary private equity investments and co-investment funds. The deal marks Franklin Templeton’s second private equity acquisition in the past three years after acquiring Benefit Street Partners in 2019.T. Rowe Price to acquire Oak Hill Advisors – Oct. 28, 2021. The alternative credit provider, Oak Hill Advisors, currently manages about $52.0 billion in AUM. The $4.2 billion acquisition marks T. Rowe Price’s first in more than a decade.Macquarie Asset Management to acquire Central Park Group – Oct 21, 2021. Central Park Group is a private equity and real estate investment firm located in New York and has AUM of approximately $3.5 billion.Demand Drivers for Alternative Assets vs. Demand Drivers for Alternative ManagersThe deals listed above are indicative of strong demand for both alternative assets and the firms that manage them. While the niche investment expertise and narrow market presence of alternative asset management firms can sometimes complicate transactions, traditional investment managers are nevertheless finding value in the alternative asset management models which have proven to be highly profitable, resilient, and may be bolted on to existing asset management teams. Below, we look at several factors driving investor demand for alternative assets and for alternative asset management firms.Alternative Asset Demand & Performance Drivers:A low yield environment. When interest rates fall, investors are encouraged to take higher degrees of risk to maintain prior levels of return. Certain alternative assets such as private equity and venture capital are generally considered higher risk, higher reward investments. Interest rates have remained at historic lows since the Great Recession and dipped further during 2020.Heightened volatility. In times of heightened market volatility, investors flock to real assets and private equity which is less prone to price swings. Additionally, certain options-heavy investment firms are also positioned to benefit as the volatility on the underlying is directly related to the options value. The historic market volatility throughout the pandemic era has benefited hedge fund performance and left investors flocking to “safer” asset classes.Robust exit activity. While markets have been exceedingly volatile over the past year and a half, they have more than recovered from the lows at the onset of the pandemic. Asset inflation has run rampant, particularly in the private equity and venture capital space which is now well positioned to benefit from strong exit activity in the coming years.Inflation. According to data from Trading Economics, annualized inflation in October 2021 was 6.2%, the highest level in decades. Certain alternative asset classes are widely considered to be inflation hedges. Real assets such as commodities and private real estate traditionally outperform in times of high inflation because returns are tied to capital appreciation.Demand Drivers for Alternative Asset Manager Acquisitions:Positive Fund Flows. According to PWC’s midyear outlook for private equity, investor appetite for private equity has outpaced traditional investment manager fund flows over the past five years. Sector AUM increased nearly 20% in 2020 alone, and the trend seems to be gaining momentum. Currently, PE dry powder is at an all-time high at $150.1 billion, which is reflective of strong fundraising and investor demand.Fees. Alternative asset managers seem to be somewhat immune to fee compression which has been one of the strongest headwinds for asset management for over a decade. The widespread consensus among money managers is that alternative assets justify premium fees due to purported diversification benefits, higher return, and expertise needed to execute such strategies. The opaque nature of the investment strategies and asset classes employed by alternative asset managers may also help these firms avoid fee compression.Diversification. Implicit in most asset management models is operating leverage. Because revenues are directly tied to the performance of the market and expenses remain somewhat fixed to compensation and overhead, diversifying firm exposure by broadening product offering may smooth out the bottom line. For this reason, alternative asset management firms can make strong acquisition targets for traditional asset managers. While fund flows may taper off if systemic tailwinds subside, alternative asset managers will likely remain strong acquisition targets for traditional asset managers due to diversification benefits and superior fees. Additionally, demand for alternative asset managers from other financial institutions such as banks and insurance companies looking to gain exposure to the investment space will also likely remain strong.

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.

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

Industry Overview and HistoryOver the last year, alternative asset managers have bested the market and most other categories of investment management firms by a considerable margin. Favorable market conditions, heightened volatility, strong investment returns, and growing interest from institutional investors are the primary drivers behind the sector’s recent rally. Our alt manager index actually doubled from October of 2020 to August of this year before giving back some of these gains during the market downturn last month. Before this uptick, many alternative asset managers had struggled over the last several years. Asset outflows, the rising popularity of passive products, fee pressure, and underperformance relative to broader market returns had caused many hedge funds and PE firms to lag other investment management sectors. Industry valuations appear to have bottomed out with the market collapse during the first quarter of last year and have since rebounded. Growing investor appetite for risky assets with purported diversification benefits has fueled a fairly substantial turnaround for the sector over the last eighteen months or so. Current pricing is close to the 52-week high, and forward multiples are noticeably lower than LTM multiples, suggesting peaked valuations and expected earnings increases over the next twelve months. While hedge funds have underperformed since the Financial Crisis (the S&P 500 index has dwarfed the performance of hedge funds as measured by the HFRI Fund Weighted Composite Index since 2009), recent volatility has improved their performance on a relative basis. Hedge fund capital typically lags its underlying fund performance, so the market seems to be anticipating that higher inflows in the coming months as investors reallocate their portfolios in light of recent performance. Alternative assets often serve to either increase diversification or enhance portfolio returns. In a near zero interest rate environment, institutional investors have sought return-generating assets. Over the last couple of years, pension funds have started diversifying their portfolios to include alternative investments in order to chase higher risk, higher return assets. It is more difficult for the average investor to gain exposure to alternative assets due to significant minimum investment requirements. While some efforts have been made to expand distribution to the retail market, institutional investors are still the primary target market for alternative managers. Over the last couple of years, pension funds have started diversifying their portfolios to include alternative investments in order to chase higher risk, higher return assets.Over the last several years, alternative asset managers have been largely successful at securing a spot in institutional investors’ portfolios. In terms of diversification, investors have started positioning themselves for longer term volatility due to the pandemic and a slowing IPO market. While investor interest in uncorrelated asset classes such as alternatives fell during the longest bull market run in history (2009-20), recent volatility has pushed investors back to the asset class.Franklin Resources’s (ticker: BEN) recently announced purchase of private equity firm Lexington Partners for $1.75 billion is illustrative of growing interest from more traditional asset managers in the alt space.Practice ManagementToday, the main priority for most alternative asset managers is raising assets. Assets follow performance and fee reduction, especially in the alternatives space, are the most consequential ways to attract fund flow. After a decade of lackluster performance, alternative managers have had no choice but to look to price reduction to bring in new assets. Amidst fee pressure, alterative managers are deviating from the typical “2 and 20” model.While traditional asset managers have been able to reduce fees by achieving some measure of scale, alternative managers must be careful to not sacrifice specialization. Alternative managers have seen some success utilizing technology in the front office or outsourcing certain functions in order to reduce overhead and spare time for management to focus on asset raising.SummaryDespite improving performance over the last year or so, the alt asset sector continues to face many headwinds, including fee pressure and expanding index opportunities. While the idea of passively managed alternative asset products seems like an oxymoron, a number of funds exist with the goal of imitating private equity returns. Innovative products are being introduced to the investing public every day. And while there is currently no passive substitute to alternatives, we do believe that the industry will continue to be influenced by many of the same pressures that traditional asset managers are facing today, despite the recent uptick in alt manager valuations.

Despite the dip in the second quarter of 2021, RIA M&A activity continues to reach record highs putting the sector on track for its ninth consecutive year of record annual deal volume. The same three demand drivers discussed last quarter persisted throughout the third quarter of 2021: (1) secular trends, (2) supportive capital markets, and (3) looming potential changes in the tax code. While fee pressure in the asset management space and a lack of succession planning by many wealth managers continues to drive consolidation, looming proposals to increase the capital gains tax rate has accelerated some M&A activity in the short-term as sellers seek to realize gains at current rates. Increased funding availability in the space has further propelled deal activity as acquisitions by consolidators and direct private equity investments increased significantly as a percentage of total deals during the recent quarter. Private Equity Drives RIA M&AWe’ve written extensively on the prominence of acquisitions by private equity backed consolidators in the RIA industry. Over a decade of rapid growth and persistent profitability has established a class of RIAs with institutional scale as well as an influx of new entrants. According to a recent study by McKinsey, in 2020 there were 15 retail-oriented RIAs eclipsing $20 billion in AUM while approximately 700 new RIAs were started annually over the past five years. This dynamic of a handful of large, financially mature firms surrounded by a highly fragmented market has attracted immense buying activity from private equity sponsors looking to leverage the number of established firms with expertise and scale available to acquire lower valuation, high growth RIA firms in the earlier stages of development.... a handful of large, financially mature firms surrounded by a highly fragmented market has attracted immense buying activity from private equity sponsorsThree-quarters of Barron’s 2020 top 20 RIAs are owned by private equity firms or other financial institutions. Notable examples such as Focus Financial (backed by Stone Point Capital prior to IPO), HighTower Advisors (Thomas H. Lee Partners), Wealth Enhancement Group (TA Associates), and Mercer Advisors (Oak Hill Capital Partners) accounted for an outsized share of total deal volume during the third quarter of 2021, and the percentage of total acquisitions made by consolidators increased from 50% to over 70% of all transactions in the past quarter. Direct investments in the third quarter also reached an all-time high for a total of 12 transactions. Such interest from private equity backed buyers continues to support high valuation multiples.2021 RIA-to-RIA transactions as a percentage of total deal volume is expected to be at a ten-year low largely due to the increase in acquisitions made by consolidators and private equity direct investments. Increased competition for deals favors consolidators who have dedicated deal teams, capital backing, and experience to win larger transactions, and even multiple large transactions simultaneously. The trend is evidenced by increased AUM size per deal, which is on track to reach a record high for the fourth consecutive year. While this is partially a result of increased AUM due to strong market performance, Echelon Partners notes that the persistent increase is also likely due to the deep pocketed supply of capital by sophisticated buyers which has caused demand for acquisitions to outpace the supply of firms looking to sell.While systemic factors continue to be a primary driver of RIA deal activity, the surge in acquisitions made by financial buyers has led some to question the sustainability of recent M&A highs. Notably, while deal volume increased to record levels in September 2021, investor sentiment for RIA consolidators was mixed during the same period as investors have expressed concern about rising competition for deals and high leverage which may limit the ability of these firms to continue to source attractive deals in the future. Private equity buyers, and consolidators acting as private equity portfolio companies, are motivated by investment opportunity. As financial buyers flock to opportunities, they drive up valuations and simultaneously diminish IRR. Recent private equity and consolidator interest in the UK market exemplifies the saturated valuations in the U.S. market as buyers have begun to seek out cheaper entry points abroad.The RIA industry remains highly fragmented and growing.While deal volume has continued to reach new highs for nearly a decade now, there continues to be ample supply of potential acquisition targets (although not all of these firms are actively looking to sell today). 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. Systemic trends and strong buyer demand will likely continue to bring sellers to market, and for now, there are no signs that momentum in deal activity is stalling anytime soon.What Does This Mean for Your RIA Firm?If you are planning to grow through strategic acquisitions, the price may be higher, and the deal terms will likely favor the seller, leaving you more exposed to underperformance. That said, a long-term investment horizon is the greatest hedge against valuation risks. As discussed in our recent post, 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.If you are considering an internal transition, there are many financing options to consider for buy outs. 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 bank financing 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, valuations stand at or near historic highs with ample demand from buyers. That said, 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. A strategic buyer will likely be interested in acquiring a controlling position in your firm with some form of contingent consideration to incentivize the selling owners to transition the business smoothly after closing. Alternatively, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Sellers looking to leverage the scale and expertise of a strategic partner after the transaction may have many buyers to choose from.

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.

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

Selling the business you built from the ground up is a bittersweet experience. Many business owners focus their efforts on growing their business and push planning for their eventual exit aside until it can’t be ignored any longer. While this delay may only prove mildly detrimental to deal proceeds in other industries, in the investment management space, there are very few buyers who will be interested in YOUR business without YOU (at least for a little while).Long before your eventual exit, you should begin planning for the day you will leave the business you built. There are many considerations for investment managers contemplating a sale, but we suggest you start with these four:1. Have a Reasonable Expectation of ValueTaking an objective view of the value of your company is difficult. In many cases, it becomes a highly emotional issue, which is certainly understandable considering that many investment managers have spent most of their adult lives nurturing client relationships, growing their client base, and developing talent at their firm. Nevertheless, the development of reasonable pricing expectations is a vital starting point on the road to a successful transaction.The development of pricing expectations for an external sale should consider how a potential acquirer would analyze your company. In developing offers, potential acquirers use various methods of developing a reasonable purchase price. Most commonly, an acquirer will utilize historical performance data, along with expectations for future cash flow to generate a reasonable estimate of run-rate EBITDA, and an appropriate multiple that considers the underlying risk and growth factors of the subject company.With the recent run-up in RIA multiples observed, and the even faster run-up in headline multiples, setting reasonable pricing expectations given your firm’s specific risks and opportunities is an increasingly important step in preparing for a transaction.Valuations and financial analysis for transactions encompass a refined and scenario-specific framework. The valuation process can enhance a seller’s understanding of how a buyer will perceive the cash flows and corresponding returns that result from purchasing or investing in a firm. Additionally, valuations and exit scenarios can be modeled to assist in the decision to sell now or later and to assess the adequacy of deal consideration. Setting expectations and/or defining deal limitations are critical to good transaction discipline.2. Have a Real Reason To Sell Your BusinessStrategy is often discussed as something that belongs exclusively to buyers in a transaction, but this isn’t always the case.Without a strategy, sellers often feel like all they are getting is an accelerated payout of what they would have earned anyway while giving up their ownership. In many cases, that’s exactly right! Your company, and the cash flow that creates value, transfers from seller to buyer when the ink dries on the purchase agreement. Sellers give up something equally valuable in exchange for purchase consideration – that’s how it works.As a consequence, sellers need a real reason – a non-financial strategic reason – to sell. Maybe you are selling because you want or need to retire. Maybe you are selling because you want to consolidate with a larger organization to reduce the day-to-day headache of running a business, or need to bring in a financial partner to diversify your own net worth and provide ownership transition to the next generation. Whatever the case, you need a real reason to sell other than trading future cash flow for a check today. The financial trade won’t be enough to sustain you through the twists and turns of a transaction.3. Get Your Books in Order Today To Maximize Proceeds TomorrowAs Zach Milam, mentioned last week, in his post on bridging valuation gaps between RIA buyers and sellers, the best time to address a potential buyer’s concerns about your firm is before you start the process.In advance of transactions, sellers should consider an outsider’s perspective on their firm and take action to address the perceived risk factors that lower value. For example, 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.4. Consider the Tax ImplicationsWhen considering the potential proceeds from a transaction, you should contemplate the tax implications. A large number of RIAs are S-corporations and C-corporations, which is no longer the preferred structure as they constrain a company’s ability to easily grow and transfer equity. We recommend consulting with a tax attorney prior to a transaction on the tax implication of different transaction structures. Before selling your business, you should also be aware of the pros and cons of a stock versus an asset sale as well as an all cash transaction versus a combination of cash and stock consideration.How Can We Help?At Mercer Capital, we routinely perform valuations and financial analysis for buy-sell agreements and internal transactions as well as offer fairness opinions for proposed transactions. We can help you better understand the potential risks to your business model and the opportunities for growth, as well as help you establish reasonable pricing expectations so that when you are ready to sell, the process is more seamless.

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.

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

While the wealth management industry is not new, the amount of change, churn, and growth that has occurred in the industry over the past ten years make it easy to forget how far the RIA industry has come since the heyday of broker-dealers.Following a financial crisis brought on by scandal and exacerbated by leverage, the fiduciary model has become the solution to restore trust in the industry among both clients and regulators. Since this transition, AUM has grown dramatically, as has the number of RIA firms. After a ten-year bull run, which was only momentarily stalled by the country’s shortest economic recession, strong performance from passively managed funds has enabled fee compression throughout the industry.Contextualizing the challenges facing the wealth management industry leaves one to wonder if many of these trends are no more than growing pains in the sector’s life cycle. And if so, what might such analysis suggest about the prospects for the fiduciary model?The lifecycle of an industry is often characterized by the following phases: start-up, growth, shakeout, maturity, and decline.Start-Up. During an industry’s infancy, customer demand is at first limited due to unfamiliarity with the new product and its performance. From the aftermath of WWII until the advent of ERISA in the 1970s, the broker dealer model flourished. During the 1970s, bad market conditions kept the lid on RIA growth, but by the 1980s registered reps were leaving wire-house firms and young trust officers were leaving banks to set up registered investment advisors, usually offering a very wide variety of services priced under what was then the new fee-based concept, instead of commissions.Growth. Just as customer demand is limited at first, so is competition which can lead to impressive growth and profits until more players enter the space. However, the inevitability of competitors chasing profits, is an elementary principal of economics. Over the past couple of decades, the count of RIAs, the number of professionals who work for RIAs, and the dollar volume of assets managed by RIAs, has exploded. But, competition has led to the need for differentiation, and that need has led to specialization.Shakeout. Periods of high profits, low market concentration, and pressure for consolidation is often described as the shakeout period because many firms aren’t positioned to survive. As market participants vie for a limited supply of market share, all the while cutting costs to remain competitive, consolidation is inevitable. In theory, ‘economic profit’ in an industry is only temporary. If the recent history of the wealth management industry can be grafted to a typical industry life cycle framework, the wealth management industry may be in a shakeout period. Consider the following trends that have dominated the independent advisor narrative in recent years:The wealth management industry may be in a shakeout period.Product Innovation: Product innovation is the catalyst for every industry lifecycle. That initial great idea, product, or service is adopted by many market players as the industry grows. These adopters often bring their own ideas to the table, or spawn other industries in response. In short, innovation, and the industry life cycle for that matter, is an iterative process bound by serendipity—or disaster as was the case for the fiduciary model after the Financial Crisis. While fiduciary money management has been around for quite some time, its rapid adoption resembles something like a genesis. The growth in the RIA space over the years has been charged by innovation, be it money managers finding new business models that allow their teams more independence or clients demanding new services or increasing levels of specialization. As seen in the 2021 Charles Schwab RIA Benchmarking Study, firms of all sizes are continuing to increase their offerings (across all service types: tax planning, charitable planning, estate planning, family education, bank deposits, and lifestyle management) as firms look to distinguish their value proposition.CLICK HERE TO ENLARGE THE IMAGE ABOVENumber of firms: A shakeout period is often defined by both low market concentration and rapid consolidation as firms use acquisitions to maintain economic profit rather than seek growth organically. As we recently noted, the number of RIA firms continues to grow to record numbers despite intense deal activity that would otherwise be considered a hallmark of consolidation. Meanwhile, wire-houses have consistently lost market share over the past ten years as the myth of corporate brand continues to be undermined by AUM flow. This conflict between the increasing number of firms and the pressure for consolidation is in large part being driven by the same profit dynamics that categorize the beginnings of a shakeout period. Growth & Profitability: While assets managed by independent advisors nearly tripled during the ten years between 2009 and 2019 profitability has begun to lag as clients have become increasingly fee sensitive. Much of the fee compression in the RIA space is being driven by competition with passively managed funds, which until recently have had the longest bull run in history to go unchallenged. But, as evidenced by the record number of independent advisors, competition among firms is just as easily responsible. Regardless, profitability explains the high deal volume in a wealth management space that benefits from economies of scale. Because revenues are tied to AUM and certain overhead costs are more or less fixed, operating leverage can have a positive impact on margins even with modest fee pressure. But it’s not just fees that are feeling pinched. RIAs are increasingly competing for talented money managers who have become more aware than ever of the value of their book of business.Economic utility might just be a better metric than economic profitability for understanding the incentives behind consolidation in the wealth management space.For this reason, economic utility might just be a better metric than economic profitability for understanding the incentives behind consolidation in the wealth management space. In an industry as labor intensive as wealth management, advisors are just as much clients as they are the product, and advisors are leaving wire-houses in favor of independence, often for reasons not always tied to pure economics.Ultimately, as the industry tries to accommodate both the price preference of clients and the lifestyle preferences of its most valuable assets, market concentration will remain low and deal values high. As such, and despite ballooning valuations, acquisitions remain at all-time highs while so too does the number of RIA firms. A shakeout period explains the conflict between the need for scale and the pressure to retain talent as economic utility is being carved out.CLICK HERE TO ENLARGE THE IMAGE ABOVEOr, is the RIA Industry still in Growth Mode?For now, we see no end in sight for the RIA acquisition frenzy. And, despite the large number of RIA transactions, most firms are not looking to sell. In a yield starved environment, RIAs continually are perceived as the ultimate growth and income investment. AUM growth, and ultimately earnings growth, show no signs of slowing. An upward trending market is a further catalyst. So, while there may be a growing quantity of RIA firms, the appetite for acquisitions appears to be greater with many owners holding on.What does this mean for your independent wealth management firm? While the industry lifecycle may be a helpful tool for understanding current industry headwinds, the timeline of industry phases is impossible to predict. Innovations can arise that can propel an industry back into a growth phase or just as likely syphon profitability towards rival industries. Additionally, firms can always achieve high growth through product innovation or superior capital budgeting no matter what industry they operate in. At most, the industry lifecycle helps make sense of the challenges facing the industry today and perhaps where to look for solutions, be that through additional services, reduced fees, or acquisitions.That said, the wealth management industry is competitive and will continue to be so. Fee compression will continue to be a headwind, and as a result staying cost competitive is as important as ever. Higher fees should be justifiable by premium services, value adds or ancillary services. But perhaps equally as important, retaining talent will continue to be crucial as advisors have more market power than perhaps ever before. And while the days of charging 1% of AUM might be waning, the combination of high cash flow and high growth continue to be attractive as evidence by elevated deal volume and multiples.

According to a recent Franklin Templeton Survey, only 14% of RIA principals expect to transact their ownership-interest in their investment management firm over the next year while 36% expect to sell between one and three years from now.Source: Franklin Templeton InvestmentsThese statistics are perplexing for an aging industry where less than half of advisors over the age of 65 have a formal succession plan and acquisition multiples continue to climb higher.Source:Franklin Templeton InvestmentsThere are some explanations to this disconnect. From an economic perspective, many RIA principals are hesitant to forego their high dividend coupon in a yield-starved environment. Additionally, when an RIA principal exits the business, they forfeit their salary and bonus payments, so the sale price would have to justify this substantial loss of annual income. Many principals also prefer to keep their firm employee owned, but it’s often difficult to sell the business to younger staff members who may be unwilling or unable to purchase the firm at its current market value. Additionally, the sale of smaller advisory practices (under $100 million in AUM) may not be practical since the primary principal often manages most of the client relationships, which may not transfer after he or she exits the business.These realities don’t excuse the industry’s ownership from failing to plan for an eventual sale or exit from the business. Most investment management firms have value beyond their founding principals. Not only can planning for that eventuality maximize your sale proceeds, but it can also ensure your key employees and clients will stick around long after your departure.How To Ensure a Successful SuccessionA logical starting point for accomplishing a successful transaction is tying management succession to ownership succession. Many of our clients’ principals sell a portion of their ownership to junior partners every year (or two) at fair market value (FMV). This process ensures that selling shareholders (who hope to sell at a maximum value) are incentivized to continue operating the business at peak levels while allowing rising partners to accrue ownership over time. Many buy-sell agreements also call for departing partners to sell their shares at a discount to FMV if they are terminated or leave within a pre-specified period to ensure they remain committed after the initial buy-in.Simply put, a successful succession requires the alignment of buyer and seller interests. Gradually transitioning ownership to the next generation of management at a reasonable price is one way to align your interests with the next generation of management.A successful succession plan also requires decoupling your day-to-day responsibilities from ownership. This can’t (and shouldn’t) happen overnight. After you’ve identified a capable successor(s), make sure he or she assumes more of your management responsibilities and not just your share count. Your work hours should decrease over this transition period.When advising clients on management and ownership succession, we often tell principals that are approaching retirement to ask themselves where they want to be in five or ten years (depending on their age and other factors) and work towards that goal. We rarely hear that they want to maintain their current work levels for the rest of their career. Have a goal in mind and steadily work towards it as others assume your responsibilities and ownership. It should pay off in retirement.

Independent trust companies are frequently named in wills to serve as the trustee of an estate or living trust. These appointments may create a revenue opportunity for an independent trust company next year or fifty years from now. A trust company is sometimes notified of their assignment but isn’t always. Future fiduciary appointments certainly have some value; but how much and how do you measure it?Valuation MethodologyFuture fiduciary appointments are one element that factors into a trust company’s overall valuation. As such, the value of these relationships isn’t generally considered separately from the rest of the business, and the guidance on how these appointments contribute to the overall value of the business is limited. There are, however, many situations where analogous assets may be valued on a stand-alone basis for accounting or other purposes. These similar concepts from other disciplines or industries can provide direction and perspective on the value of future fiduciary appointments.Future fiduciary appointments are one element that factors into a trust company’s overall valuation.Contract ValuationsWhen a business combination such as a merger or acquisition occurs, accounting standards generally require that an exercise known as a purchase price allocation (PPA) be performed. The purpose of a PPA is to allocate the consideration paid for a business to the acquired tangible and intangible assets, which can include acquired technology, customer relationships, contracts (customer and supplier), noncompete agreements, tradenames, etc. Future fiduciary appointments for trust companies bear some similarity to a customer contract; although, a trust company does not have to agree to a fiduciary appointment, the executor of an estate is contractually obligated to hire the trust company unless it does not accept.There are many different commonly accepted approaches to contract valuation, but the most relevant as it relates to future fiduciary appointments is the income approach. In a purchase price allocation, the value of a contract can be determined using the income approach by projecting out the future cash flows that result from the contract and applying an appropriate discount rate. But in purchase price allocations, the existence of the contracts and terms of the contracts are known, whereas independent trust companies are not always notified of their appointment in a will, and even if notified, the size of the estate and potential revenue is often unknown.Oil & Gas Reserve ValuationsAt first glance, it’s hard to imagine two industries more different than independent trust administration and oil and gas. But the future fiduciary appointments held by trust companies do have a notable similarity to oil and gas reserves. Oil and gas reserves represent a real asset to the landowner, but the size and profitability of these reserves is often unknown. Likewise, future fiduciary appointments are a real asset for trust companies, but the size and profitability of these relationships is generally not known in advance. Oil and gas reserves are categorized as Proven Developed Producing (PDP), Proven Undeveloped (PUDs), Possible (P2), or Probable (P3). PDP reserves currently generate revenue and can be valued using a discounted cash flow analysis. But PUD reserves, which are proven to exist but not currently developed or revenue generating, and probably and possible reserves, which are less likely to be recovered, are not as easily valued.Can future fiduciary appointments be viewed similarly to the PUDs, P2, and P3 reserves?So, can future fiduciary appointments be viewed similarly to the PUDs, P2, and P3 reserves? Are known appointments comparable to PUDS and unknown appointments comparable to P2 and P3 reserves?Valuation practitioners sometimes rely on option pricing to capture the value of PUDs, probable, and possible reserves. As the price of oil increases, PUDs, probable, and possible reserves become more economical to develop. The PUD and unproved valuation model are typically seen as an adaptation of the Black Scholes option model. Applying this same principle to value fiduciary appointments would require significant assumptions about the possible number of appointments, the size of the estates, and the average number of deaths per year. Additionally, a future fiduciary appointment is not necessarily option-like, as there is no set exercise price. And for most independent trust companies who are likely to generate significant cash flows in the near term, the impact of these future cash flows may be too small to matter (once present value math has been applied).The Right Way To Value Fiduciary Appointments May Be More SubjectiveFiduciary appointments do have value, but separating this value from the enterprise as a whole may not be the best way to think about it. Rather than valuing these separately, we typically adjust our projection and discount rate assumptions and our guideline company analysis.Discounted Cash Flow Method. As we discussed above, discretely projecting cash flows from future fiduciary appointments is not always possible. But an analyst can factor in the potential upside of these assignments when selecting the appropriate discount rate and terminal growth rate. Should the discount rate be lower since there are additional future revenue opportunities that weren’t built into the projections? Or maybe the terminal growth rate should be higher, as these appointments will allow the company to sustain higher levels of ongoing cash flow growth.Guideline Public Company Method. Although there are no publicly traded pure-play trust companies, publicly traded investment managers do have a similar structure to independent trust companies. Both earn fees on assets under management / administration and have operating leverage such that when AUM / AUA increase, fixed costs do not increase at the same rate. Therefore, we often use the pricing of publicly traded investment managers to gauge investor sentiment and establish a reasonable range for pricing expectations for businesses that manage or administer assets on behalf of clients.We may apply an adjustment to the implied valuation multiples of the public companies to account for the differences between an independent trust company and the selected group of publicly trade investment managers. While many independent trust companies are smaller in size, have less access to capital markets, and have lower margins (trust administration is labor intensive), some of this risk may be offset by the growth opportunity presented by future fiduciary appointments. How much of that risk is offset is a matter of the facts and circumstances of the particular independent trust company.Who Should Value Your Independent Trust Company?Choosing someone to perform a valuation of your independent trust company can be daunting in and of itself. There are plenty of valuation experts who have the appropriate training and professional designations, understand the valuation standards and concepts, and see the market in a hypothetical buyer-seller framework. And there are a number of industry experts who are long-time observers and analysts focused on the industry, who understand industry trends, and have experience providing advisory services to independent trust companies.At Mercer Capital, we think it is most beneficial to be both industry specialists and valuation specialists.

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.

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

The second quarter was especially kind to the alt manager sector, which benefited from favorable market conditions and growing interest from institutional investors.  Heightened volatility creates more opportunities for hedge funds to generate alpha (when their positions aren’t concentrated in meme stocks), and market peaks often spur interest in alternative asset classes, like private equity and real estate.  These trends initially took root last fall before gaining considerable momentum in the second quarter. Much of this momentum is attributable to the VC space as investors turn to private equity and start-up tech firms for higher returns than more traditional asset classes.  According to CB Insights, a record 249 firms achieved the $1 billion “unicorn” valuation status in the first half of 2021, almost doubling the total tally from last year.Growing interest in the sector also stems from the fact that alt managers are often better positioned during a prospective downturn than their traditional asset management counterparts.  Alt assets aren’t directly correlated to market conditions and are often held in illiquid investment vehicles, which means their investors are locked up for years at a time with no withdrawal rights.While sticky assets can provide a cushion for alt managers in a downturn, the longer-term performance of many 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 last year’s global shutdown presented challenges to their fundraising process that often involves extensive in-person due diligence.  And if new funds are raised, there is the question of how fast managers can put that money to work without sacrificing proper due diligence.M&A declined significantly in the second and third quarter of last year, leaving deal teams at many PE firms on the sidelines before rebounding sharply over the last nine months or so.It’s also important to keep in mind that these alt managers and their assets are still vulnerable to bear markets.  Public alt managers were particularly affected during the selloff last March, reflecting the decline in portfolio asset values and reduced expectations for realizing performance fees.  From February 19, 2020 (the prior market peak), our index of alt managers declined nearly 45% in just over a month.  Since then, an outsized recovery has pushed the index back to all-time highs.Such a sharp gain in alt manager stock prices means the market is increasingly optimistic about the sector’s prospects.  Performance fees and carried interest payments are likely to increase with rising asset prices.  Strong investment performance also tends to entice inflows from institutional investors, which will buoy AUM balances and management fees for most of these firms.  The market is therefore anticipating higher revenues for the industry, which should be accompanied by even greater gains in profitability given the sector’s relatively high level of operating leverage (fixed costs).Many alt manager funds also have high levels of financial leverage (debt) that can augment returns when things go well.  The trouble is that both forms of leverage can exacerbate earnings when revenue dips or investments underperform.  These attributes are what make the alt management industry so volatile and are part of the reason why the sector lost nearly half its value last March before doubling over the next year.On balance, we believe the recent run-up is justified, but it’s important to remember what can happen when alt asset prices go the other way.  Expect volatility to remain as investors weigh the impact of a recovering economy and rising inflation on alt asset returns.

RIA MIA activity slowed somewhat in the second quarter of Q2, but RIA markets are still on track to record the highest annual deal volume on record.In the latest RIA M&A Deal Report, Echelon Partners attributes the pace of RIA M&A to (1) secular trends, (2) supportive capital markets, and (3) potential changes in tax code in the future. As we discussed last quarter, fee pressure in the asset management space and a lack of succession planning by many wealth managers are still driving consolidation. But the increased availability of funding in the space, in tandem with more lenient financing terms, has also caused some of this uptick. Further, the Biden administration’s proposal to increase the capital gains tax rate has accelerated some M&A activity in the short-term as sellers seek to realize gains at current tax rates. But could some of this activity be attributable to the RIA rumor mill and the hype of double-digit multiples in the space? He Says, She Says … "They sold their firm for 12x"Although there are over 13,000 RIAs in the U.S., during times like these, the investment management world feels pretty small. Word travels far and fast, and often with minimal detail.Clients have been asking us about double-digit deal multiplesOver the last few months, more of our clients are asking us about double-digit deal multiples and many owners of small firms are understandably confused when they see our comparably lower indications of value.So how does all this transaction activity affect valuations?Guideline Transaction MethodAs independent valuation analysts, we are tasked with finding market transactions of privately held companies in the same or similar business that may provide a reasonable basis for valuation of the company we are valuing. Market transactions are used to develop valuation indications under the presumption that a similar market exists for the subject company and the comparable companies. Activity and earnings multiples developed using the market transactions method are used to capitalize appropriate estimates of AUM, revenue, and earning power for the subject company.In most of our valuations of investment management firms, we seek perspective on the M&A market’s pricing of closely held investment management firms by evaluating transactions involving acquired U.S.-based investment management firms with between $1 billion and $25 billion of AUM. However, given the lack of publicly available information for transactions in the industry, the data from guideline transactions has limited significance for making inferences.Even when deal multiples are “known,” they can be misleadingEvery transaction has different motivators that affect the buyer’s willingness to accept a certain price and the seller’s willingness to pay up. Most RIA transactions include some form of earnout, which can skew the implied deal multiples. And more frequently, deals include some form of an earn-more consideration that may or may not be reasonable to include when calculating implied deal multiples.Even when deal multiples are “known,” they can be misleading. A transaction priced at, say, nine times pro forma earnings – with normalized compensation, back-office synergies, anticipated changes in fee schedules, and other adjustments – might also be viewed as fifteen times earnings, as reported. So, is the deal multiple nine or fifteen?RIA buyers are, for the most part, very sophisticated, and not disconnected from realityUnfortunately, there is a perverse incentive to talk about the higher multiple. Sellers want to brag about how much they got. Buyers want to be seen as the most generous to attract other sellers into the process (reality can wait until after the LOI is signed). And in a market with surplus of buyers, intermediaries (the investment bankers), naturally, want to encourage sellers however they can.Don’t get us wrong, the RIA market is very strong, and multiples are very high. But RIA buyers are, for the most part, very sophisticated, and not disconnected from reality.Much of the confusion we see in expectations is being fueled by dozens and dozens of deal announcements with undisclosed terms. In the absence of real information, imagination fills the void. Although we have knowledge of the pricing of many undisclosed deals, we can’t directly rely on this information in a business Appraisal (with a capital “A”) – as it doesn’t constitute known or knowable information to hypothetical buyers and sellers. But all this transaction activity and the increase in observed deal multiples has, nonetheless, impacts investment management valuations. This conflict between publicly available pricing information and rumored deal multiples makes it even more important to hire a valuation firm experienced in this space.There is no argument that multiples across the investment management space have increasedBecause reliable guideline transaction information is scarce, it is essential to build the factors driving the volume of transaction activity and heightened pricing into projections and the cost of capital. Improved equity markets have been driving AUM growth. The inherent operating leverage in the business along with the realization over the last year that RIAs can operate just as efficiently with less or cheaper office space, is driving margin expansion. While it is harder to model increased demand for these businesses into a discounted cash flow model, it can serve to minimize risk and reduce discount rates. Overall, these changes to valuations are generally more subjective.But there is no argument that multiples across the investment management space have increased. As our president, Matt Crow, has said before about RIA transaction multiples, “an option has value, even if you don’t exercise it.”

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.

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

To the Moon?A few weeks ago we blogged about how RIA stock prices have increased over 70% on average over the last year. This rapid ascent begs the question if valuations have gotten too rich with the market run-up during this time. To answer this question, we have to analyze the source of this increase.Click here to expand the table aboveMoving from left to right on the table above, we see that financial performance actually deteriorated over this time – revenue declined and margins compressed, leading to a 20% drop in EBITDA on average for this group of publicly traded RIAs with less than $100 billion in AUM. The increase in the EBITDA multiple more than compensated for the decline in profitability and is the primary driver of the overall increase in value from March 31, 2020 to March 31, 2021. At first glance, a 70% increase in value (when year-over-year earnings have actually declined) suggests that current pricing may be overstretched.Back to Earth?When we observe historical levels of RIA valuations, however, we get a much different perspective. Even after the recent run-up, EBITDA multiples are still at the lower end of their historical range. The multiple expansion follows an all-time low for the industry last March when these businesses were trading at 4x EBITDA during the bear market. There’s also a logical explanation for the multiple doubling over this period. These multiples are directly related to the outlook for future revenue and profitability, which tend to fluctuate with AUM since management fees are typically charged as a percentage of client assets. AUM balances have risen with the stock market over the last year, so the outlook for future revenue and earnings has rebounded accordingly. Trailing twelve-month (TTM) earnings in March of last year were also suppressed by the bear market’s impact on profitability during the first two quarters of 2020, so a higher TTM multiple is justified when historical earnings lag ongoing levels of profitability. This trend marks a complete reversal of what happened last March when AUM and run-rate performance declined with the market but trailing twelve-month earnings had not yet been impacted. As earnings figures lagged the abrupt price declines, multiples hit all-time lows. Because of this phenomenon, RIA multiples can be especially erratic during volatile market conditions. ConclusionWhile the significant gains in RIA valuations over the last year is fairly alarming, the fundamentals warrant such an increase. The market’s significant rise over the last year buoyed AUM and ongoing profitability, so investors are rationally anticipating higher earnings relative to recent history. Another correction or bear market would certainly reverse this trend, but at the moment, all industry metrics are pointing to the moon.

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: over 60% of RIAs are still led by their founders, and only about a quarter of them have non-founding shareholders. Yet, when RIA principals are asked to rank their firm’s top priorities, developing a succession plan is often ranked last.What Is a Succession Plan?Despite the headlines suggesting that there is a wave of strategic takeovers that will ultimately consolidate the investment management profession into a few large firms, the reality we’ve encountered suggests that most RIAs will transition ownership and leadership from one generation to the next internally. The reasons for this are fairly obvious.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. Further, 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.When managers at RIAs start thinking about succession, they immediately jump into who buys out whom at what price and terms. While this is one piece of a succession plan, we would suggest, instead, that the starting point is strategic planning for the business.One of the keys to understanding succession planning is understanding what it is not.A Succession Plan Is Not…A succession plan is not a continuity plan. A continuity plan ensures that your clients will have uninterrupted services in the event of a disaster. Your eventual retirement should not be treated in the same manner as a sudden death or earthquake.A succession plan is not an exit plan. An exit plan is a business owner’s strategic plan to sell their ownership to realize a profit or limit losses. This line can be fuzzy, but strategic transactions rarely obviate the need for succession planning. Leadership transition issues can loom large even in strategic transactions.The Time To Plan Is NowIf you’re a founding partner or selling principal, you have several options, and it’s never too soon to start thinking about succession planning. Proper succession planning needs to be tailored, and a variety of options should be considered. See our recent whitepaper for more information on succession planning.ConclusionSince our founding in 1982, Mercer Capital has provided expert valuation opinions to over 15,000 clients throughout the U.S. and six continents. We are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, and independent trust companies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

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.

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

Last week we explained why RIA principals and board members should consider getting a Fairness Opinion; FAIR … The F-word in RIA M&A: Part I; When Do You Need A Fairness Opinion?.Under U.S. case law, the so-called “Business Judgment Rule” presumes directors will make informed decisions that reflect good faith, care, and loyalty. If any of these criteria are breached in a board-approved transaction, then the directors may be liable for economic damages.RIA boards hire valuation and advisory firms like ours to opine on the fairness of contemplated transactions in an effort to protect themselves from potential liability.In a challenged transaction, the “entire fairness standard” requires the court to examine whether the board dealt fairly with the firm and whether the transaction was conducted at a fair price to its shareholders. As a result, Fairness Opinions seek to answer two questions:Is a transaction fair, from a financial point of view, to the shareholders of the selling company?Is the price received by the Seller for the shares not less than “adequate consideration” (i.e. fair market value)? Process and value are at the core of the opinion. A Fairness Opinion is backed by a rigorous valuation analysis and review of the process that led to the transaction. Some of the issues that are considered include the following.ProcessProcess can always be tricky in a transaction. A review of fair dealing procedures when markets have increased should be sensitive to actions that may favor a particular shareholder or other party.Management ForecastsA thorough analysis of management’s projections is a key part of a fairness analysis. After all, shareholders are giving up these future cash flows in exchange for cash (or stock) consideration today. Investment managers’ revenue is a product of the market, which over the past year has withstood significant volatility. A baseline forecast developed in the middle of the COVID-19 pandemic may be stale today. Boards may want to consider the implications of the V-shaped market recovery on their company’s expected financial performance and the follow-through implications for valuation.TimingDeals negotiated mid-COVID, when it was unclear whether the market was in a V-shaped or W-shaped recovery, may leave your shareholders feeling like money was left on the table. It is up to the board to decide what course of action to take, which is something a Fairness Opinion does not directly address. Nevertheless, fairness is evaluated as of the date of the opinion, such that the current market environment is a relevant consideration.Buyer’s SharesIf a transaction is structured as a share-for-share exchange, then an evaluation of the buyer’s shares in a transaction is an important part of a fairness analysis. The valuation assigned to the buyer’s shares should consider its profitability and market position historically and relative to peers. If the purchaser is a public company, it is imperative that all recent public financial disclosure documents be reviewed. It is also helpful to talk with analysts who routinely follow the purchasing company in the public markets.It is equally important to note what a Fairness Opinion does not prescribe, including:The highest obtainable price.The advisability of the action the board is taking versus an alternative.Where an RIA’s shares may trade in the future.The reasonableness of compensation that may be paid to executives as a result of the transaction. Due diligence work is crucial in the development of the Fairness Opinion because there are no rules of thumb or hard and fast rules that determine whether a transaction is fair. The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling stock). We believe it is prudent to visit the selling RIA (if feasible), conduct extensive reviews of documentation, and interview management (either in person or virtually). Fairness Opinions are often memorialized in the form of a Fairness Memorandum. A Fairness Memorandum examines the major factors of the Fairness Opinion in some detail and summarizes the considerations of each factor for discussion by the board of directors. In many cases, the advisors rendering the Fairness Opinion will participate in these discussions and answer questions addressed by the board.ConclusionMercer Capital’s comprehensive valuation experience with investment managers enables us to efficiently provide reliable, unbiased Fairness Opinions that provide assurance to stakeholders that transactions underway are fair and reasonable. We’re happy to answer any preliminary questions you have on Fairness Opinions and when it makes sense to get one.

Fair. It’s the first-four-letter word that most children learn, and it often leads to more arguments than other choice words. Although children eventually learn that life is not always fair, we spend a lot of time ensuring that major economic events are. Transactions are rarely straightforward, and as the pace of M&A activity in the investment management community continues to accelerate, more shareholders are scrutinizing both the pricing and terms of transactions. Over the next two posts, we will explain when you should consider getting a Fairness Opinion and what that involves.What Is a FAIR Transaction?Under U.S. case law, the concept of the “Business Judgment Rule” presumes directors will make informed decisions that reflect good faith, care, and loyalty to shareholders. If any of these three are not met, then the “entire fairness standard” requires that, in the absence of an arms-length deal, transactions must be conducted with fair dealings (process) and atfair prices.Directors are generally shielded from challenges to corporate actions the board approves under the Business Judgement Rule provided there is not a breach of one of the three duties. However, once any of the three duties is breached, the burden of proof shifts from the plaintiffs to the directors. If a Board obtains a Fairness Opinion in significant transactions, they are more likely to be protected from this liability.Questions of value and fair dealing are subject to scrutiny, even in bull markets. Rapidly improving markets may lead your shareholders to question whether the price accepted in the context of negotiating and opining on a transaction could have been better. Below, we outline some circumstances when you should consider getting a Fairness Opinion before closing a deal.9x EBITDA in a 15x EBITDA World Fantasy The prominence of headlines touting impressive deal multiples has led to some unrealistic shareholder expectations around valuation. Yes, average deal multiples have increased over the last decade, more prospective buyers for your RIA exist today than there were five years ago, and maybe an irrational buyer with capacity will stroke checks for double-digit multiples. But the increase in average valuation multiples is being driven by a myriad of factors that do not perfectly correlate with the valuations of small to mid-sized RIAs.Echelon Partners 2020 RIA M&A Deal Report noted that the number of $1B+ transactions has doubled over the last five years. Most of these acquisitions, and especially the ones that attract headlines, warrant these higher multiples due to their sheer scale, rarity, and strategic significance. Not every RIA has the scale, growth pattern, and risk profile to warrant top-tier pricing. And, ultimately, no two asset managers, wealth managers, IBDs, OCIOs, or independent trust companies are alike.Nevertheless, boards facing a mismatch between shareholder expectations and market realities are in a tough position justifying a transaction. The evaluation and negotiation process is tricky when markets continue to climb day after day. Yet, Fairness Opinions can be used as one element of a decision process to evaluate significant transactions.Would You Prefer $10M or $7M Today, and $2M Each Year for the Next 3 Years?Most acquisitions of investment managers involve some form of contingent consideration. When evaluating multiple offers that involve varying amounts of upfront cash; equity consideration; and earn-out payments, periods, and terms, a Fairness Opinion can help Boards evaluate the economic merits of the terms being offered.Unsolicited OffersMany RIAs receive unsolicited offers from their friends, competitors, or institutional consolidators. When there is only one bid for the company and competing bids have not been solicited, the fairness of the transaction can more easily be disputed. Not every sale is best conducted in an auction process, but the prospective buyer making an unsolicited offer knows that it is, at least for the moment, the only bidder. The objective of an unsolicited offer is to get the seller’s attention and cause them to start negotiations, often giving the bidder an exclusive right to negotiate for a fixed amount of time. As the head of our investment management group, Mercer Capital President, Matt Crow, explains, “An unsolicited offer may be a competitive bid, but it is not a bid made in a competitive market.”The Investment Management Community Is SmallAlthough there are over 13,500 SEC-registered investment advisors in the U.S., the investment management community within a given sector or geography is fairly close-knit. Many RIAs join forces or sell to other RIAs they have known for many years. This is part of the reason deals work. In a relationship-driven business, it is hard to merge with or sell to someone with whom you don’t have an existing relationship. But anytime insiders or related parties are involved in a transaction, a Fairness Opinion can serve as a confirmation to a company’s shareholders that improper acts of self-dealings have not occurred.ConclusionWe have extensive experience in valuing investment management companies engaged in transactions during bull, bear, and boring markets. Mercer Capital’s comprehensive valuation and transaction experience with investment managers enables us to provide unbiased fairness opinions that directors can rely on to assure their stakeholders that the decisions being made are fair and reasonable.

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.

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

Nearly all sectors of the stock market are up over the last year, but that’s especially true for the RIA industry.  Even if most wealth management firms don’t employ any debt in their capital structure, their performance is very much levered to the stock market due to its direct effect on AUM balances, and the operating leverage inherent in the wealth management model.  RIA aggregators are even more levered to market conditions, since they typically borrow money to purchase wealth management firms.  It shouldn’t be too surprising that our aggregator index is up 140% over the last year. After a rough Q1 in 2020, wealth management firms have fared particularly well over the last year, with favorable market conditions and rising demand for financial advisory services.  During times of excessive volatility and market turmoil, individual investors rely on their advisors to stay the course and rebalance portfolios in accordance with their investment objectives.  Wealth management firms have capitalized on this reliance as the number of advisors charging financial planning fees on top of asset-based fees or commissions increased 72% in 2020. Despite steady gains over the last year, wealth management firms still face challenges pertaining to fee pressure, succession planning and connecting with millennials who are more interested in robo-advisors and fintech products than being counseled by their parents’ advisor.  Additionally, the switch from in-person meetings to digital communication is viewed by many as another obstacle.  According to a recent Schwab study, 35% of advisors viewed clients’ ability to connect virtually as one of the biggest challenges to their business in 2020.  On the flip side, 37% of advisors view leveraging technology infrastructure to be able to seamlessly work remotely as one of the biggest opportunities to their business. Source: Schwab Advisor Services’ 2020 Independent Advisor Outlook StudyAnother near-term opportunity is the pending reversal of some or all of the Tax Cuts and Jobs Act of 2017, and the implications it has for estate planning in 2021.  Biden’s current proposal cuts the Unified Tax Credit (the exemption on gift and estate taxes) in half from $23.2 million to $11.6 million for married couples and from $11.6 million to $5.8 million per individual.  As a consequence, many high net worth families will have significant gift and estate planning needs from their advisors to avoid a substantial increase in their embedded estate tax liability next year.On balance, 2021 should prove to be another challenging but favorable year for wealth management firms that focus on their clients’ needs and take advantage of rising demand for financial planning services.  Industry headwinds remain, but we’re confident that the industry will prosper, diversify, and expand.

Despite the hiatus in M&A beginning with the onset of COVID-19, 2020 was a strong year for RIA mergers and acquisitions, and 2021 is expected to be even stronger. Many of the same forces that have spurred M&A over the last five years drove deal activity in late 2020 and early 2021.  Fee pressure in the asset management space and a lack of succession planning by wealth managers are still driving consolidation.  But the increased availability of funding in the space, in tandem with more lenient financing terms, has also caused some of this uptick. There has been growing interest over the last few years from private equity and permanent capital providers who find investment managers’ recurring revenue streams and availability for operating leverage attractive.  Investors, hungry for alpha in a low-yield environment, are driving up deal prices leading more firms to hang up a for-sale sign. Additionally, deal activity was bolstered by the low cost of credit and lenient financing terms by historical standards.  As Jeff Davis, our bank guru, explains; “Loans in the commercial banking system declined for the first time in a decade in 2020 and for only the second time in 28 years while deposits remain historically high.  In the current low-rate environment, revenue pressures are high for banks as cash and bonds yield little to nothing.  Without a competitive alternative, banks and investors flush with capital are under pressure to compete for lending opportunities to produce a return while loan demand is weak as the U.S. market rounds what many believe to be the very beginnings of a new economic cycle.”There is a growing number of banks interested in lending to the space. Live Oak Bank pioneered an SBA vertical in lending to RIAs and investment advisor Oak Street Funding has played a role in a substantial portion of leveraged transactions in this space, and most recently SkyView began offering financing solutions for RIAs.Further, the Biden administration's efforts to increase the capital gains tax rate may also accelerate some M&A activity in the immediate short-term as sellers seek to position transactions to be taxed at current tax rates.What Does This Mean for Your RIA?If you are planning to grow through strategic acquisitions, the price may be higher, and the deal terms will likely favor the seller, leaving you more exposed to underperformance.  In a market this competitive, acquirers need to distinguish themselves on more than price.  Sellers are often looking for buyers who can help them achieve scale, reduce the load of managing a business, and/or expand their reach or distribution capability. If you are considering an internal transition, know there are more ways to finance the buy-out than there used to be.  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 bank financing can provide the founding generation with more immediate liquidity and potentially offer the next-gen cheaper financing costs. If you are an RIA considering selling, there are many options, and 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.  A strategic buyer will likely be interested in acquiring a controlling position in your firm with some form of contingent consideration to incentivize the selling owners to transition the business smoothly after closing.  Alternatively, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference.

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.

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

Growth-style investments have outpaced their value counterparts by a considerable margin since the Financial Crisis of 2008 and 2009.  Propelled by an 11-year bull market from 2009 to 2020 and additional lift to tech stocks in a work-from-home environment, growth investing dominated value-oriented equities until just a few months ago.   Now, the long-running trendline appears to be rolling over.With rapid vaccination rollouts and continued improvements in the global economy, value stocks, which were especially depressed by the pandemic this time last year, have soared relative to growth strategies over the last few months. If you believe in mean reversion, value’s comeback was inevitable and probably has some room to run.  We’ve blogged about this before (Are Value Managers Undervalued?), and while we were a bit premature on the timing (we’re never wrong), it appears that this mean reversion is finally taking place.  We don’t know how long this value resurgence will last, but given the duration and magnitude of growth’s prior reign (see first chart above), it’s not unreasonable to assume it could endure for a few more years at least. On the flip side, growth-oriented investment firms may finally have to deal with poor returns (relative to the market) in addition to prevailing industry headwinds like fee compression and asset outflows to passive products.  Most value asset managers have already adapted to this double whammy, so growth firms should prepare for potential AUM losses if we’ve really hit another inflection point in the value versus growth rivalry. Value firms, on the other hand, are finally starting to shine.  After years of outflows and subpar returns, publicly-traded value managers, Gabelli (GBL), Diamond Hill (DHIL), and Pzena (PZN) have significantly outperformed the S&P 500 (navy blue line below) since the vaccine announcement in early November. [caption id="attachment_36465" align="alignnone" width="800"]Source: S&P Global Market Intelligence[/caption] This recent outperformance suggests that value’s dominance could persist a few more years if the market is anticipating significantly higher inflows, AUM balances, and ultimately greater revenue and earnings figures in the coming quarters.  Increased investor optimism surrounding the share prices of value firms is perhaps the best indication of a value resurgence even if we have only just started seeing that in the actual numbers. Value firms may finally be enjoying their heyday, but sector risks remain.  Much of this resurgence is attributable to continued vaccination rollouts and a swift economic recovery, and any setbacks on either of these fronts could derail value’s recent momentum.  Since most U.S. indices are trading close to an all-time high, the market doesn’t seem too worried about this, but last year has shown us how quickly investor sentiment can change.  The quest for yield in a zero interest rate environment has also increased demand for value stock dividends, but the recent rise in Treasury yields could curb their relative advantage. It’s too early to call it a full recovery, given the decade-plus dominance of growth preceding this uptick, but recent progress is promising for the sector.  We may again be premature in calling this, but we are taking note of what appears to be an important inflection point for the active management industry.

As a financial analyst, a CFA charter holder, and a generally reasonable person, I know that Zillow isn’t accurate; but as a homeowner, I can’t help myself.  When I am walking around my neighborhood, I always have the Zillow App open, and am speculating about how the “Z-estimate” for my house compares to my neighbors’.  And, of course, my house always is better. Why? Because I own it.  It’s called the endowment effect.  I (as a homeowner) am emotionally biased to believe that something (my house) is valued higher than the market would ascribe, simply because I already own it.And you, the owner of an RIA, may believe your firm is valued higher than the market value too, and old rules of thumb and recent industry headlines amplify the problem.Old Rules of Thumb:  Your RIA is Worth 2% of AUMWe have cautioned the use of AUM and Revenue-based multiples before, and an example has proven to be the best way to communicate the unreliability of such metrics.  Consider, Firm A and Firm B, which both have the same AUM.  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. Recent Headlines:  Your RIA is Worth 10x EBITDADeal activity in the investment management space has been increasing over the last decade as consolidation has increased and outside investors realized the attractiveness of a recurring revenue stream paired with minimal capital investment.  But the headlines touting impressive deal multiples really seemed to pick-up in 2019 with Goldman’s acquisition of United Capital.   However, most of the acquisitions that warrant headlines are of larger investment managers, which due to their sheer scale, are less risky and therefore warrant a higher multiple.Mixing old rules of thumb, with recent headlines, and the endowment effect typically results in over valuing, which stems from an underestimation of non-systematic risk.Underestimating Non-Systematic RiskMost investment managers understand that their firm, like any publicly traded company in their clients’ portfolios, is exposed to systematic and non-systematic risks.  And most seem to understand that investment management firms are subject to certain industry-wide risks such as the move from passive to active investment products and fee compression. But many investment management firms also have significant “firm-specific risks” that make their firm riskier than a much larger investment management firm.  Many small to mid-sized investment management firms suffer from client concentrations, aging client bases, unclear succession plans, a lack of scale, and minimal asset growth (absent market appreciation).Unfortunately, understanding the value of your RIA is not as easy as applying a multiple to your AUM or run-rate EBITDA.   Value is a factor of cash flow, growth, and risk.  We’ve written a lot about investment management firm valuations:RIA Margins – How Does Your Firm’s Margin Affect Its Value?What Are RIA Valuations TodayValuing RIAs But, don’t hesitate to give us a call if we can be of assistance.

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!

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

Next week, during the inaugural RIA Practice Management Insights conference, we will set aside some time to answer your questions about succession planning.  Roughly two-thirds of RIAs are still owned by their founders, and only a quarter of those have non-founding shareholders.  We won’t solve all the pieces to the succession planning puzzle in our session, but we’ll address succession planning strategies, and what works best under different circumstances.We’ll cover some of these in more detail next week, but here’s a preview of our thinking about various succession planning (and exit) options.Sale to a Strategic BuyerIn all likelihood, the strategic buyer is another RIA, but it could be any financial institution hoping to realize certain efficiencies after the deal.  They will typically pay top dollar for a controlling interest position with some form of earn-out designed to incentivize the selling owners to transition the business smoothly after closing.  This scenario sometimes makes the most economic sense, but it does not afford selling principals much control over what happens to their employees or to the company’s name.Sale to a Consolidator or Roll-up FirmThese acquirers typically offer some combination of initial and contingent consideration to join their network of advisory firms.  The deals are usually debt-financed and typically structured with cash and stock upfront and an earn-out based on prospective earnings or cash flow.  Consolidators and roll-up firms usually don’t acquire or pay as much as strategic buyers, but they often allow the seller more autonomy over future operations.  While there are currently only a handful of consolidators, their share of sector deal making has increased dramatically in recent years.Sale to a Financial Buyer This scenario typically involves a private equity firm paying all-cash for a controlling interest position.  PE firms will usually want the founder to stick around for a couple of years after the deal but expect him or her to exit the business before they flip it to a new owner.  Selling principals typically get more upfront from PE firms than consolidators but sacrifice most of their control and ownership at closing.Patient (or Permanent) CapitalMost permanent capital investors are family offices, or investment firms backed by insurance companies, that make minority investments in RIAs either as a common equity stake or revenue share.  They typically allow the sellers to retain their independence and usually don’t interfere much with future operations.  While this option is not always as financially lucrative as the ones above, it is often an ideal path for owners seeking short term liquidity and continued involvement in this business.Internal Transition to the Next Generation of Firm Leadership Another way to maintain independence is by transitioning ownership internally to key staff members.  This process often takes a lot of time and at least some seller-financing as it’s unlikely that the next generation is able or willing to assume 100% ownership in one transaction.  Bank and/or seller financing is often required, and the full transition can take 10-20 years depending on the size of the firm and interest transacted.  This option typically requires the most preparation and patience but allows the founding shareholders to handpick their successors and future leadership.Combo DealMany sellers choose a combination of these options to achieve their desired level of liquidity and control.  Founding shareholders have different needs and capabilities at different stages of their life, so a patient capital infusion, for instance, may make more sense before ultimately selling to a strategic or financial buyer.  Proper succession planning needs to be tailored, and all these options should be considered.If you’re a founding partner or selling principal, you have a lot of exit options, and it’s never too soon to start thinking about succession planning.  Let us know what questions you have at the conference next week.Only 1 WEEK until the RIA Practice Management Insights conference begins!Mercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?

Salary and bonus discussions are some of the most stressful conversations business owners have each year, and RIA principals are no exception. Since personnel costs are by far the largest expense item on an RIA’s income statement, it is understandable that these principals frequently question (and are questioned about) their compensation decisions. While there is no one-size-fits-all formula for compensation, we have discovered three ways to ease some of the anxiety around these discussions.1) Define the Philosophy of Your Compensation ModelCompensation can do more than simply reimburse your employees for their time, but only if it is well planned and communicated.  A good compensation model can help your company attract, retain, and motivate talent. We often think about compensation in four buckets.2) Pay Bonuses More FrequentlyOne benefit of a recurring revenue business is that a firm’s performance can be calculated on a more frequent basis.  Paying bonuses quarterly, or even bi-annually, can take away some of the stress that annual bonus discussions bring.  Additionally, quarterly bonus discussions provide an opportunity to deliver meaningful feedback to your employees on a more regular basis.  Employees do their best work when they feel valued; why not remind them of that more than once a year?3) Compare Your Margins to PeersWhile there is significant variation in how RIA owners think about compensating their employees (and themselves), there is some uniformity across the industry as to how much RIAs should pay out in total compensation.  As shown below, publicly traded RIAs with under $100 billion in AUM pay out roughly half of revenue as compensation. Considering this metric along with typical operating margins for RIAs (usually 20% to 30% depending on size, type, and location) can help you gauge whether your compensation expenses are in sync with the market. To learn more about more on common compensation questions join us atRIA Practice Management Insights, as Matt Crow and I spend a half-hour answering your question about RIA compensation practices. Only 2 WEEKS until the RIA Practice Management Insights conference begins!Mercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?

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?

Over the years, we have repeatedly said that the wealth management side of the investment management business is healthier than the asset management side.  Unlike asset managers whose clients are likely to jump ship after a few bad quarters, wealth management is based on client relationships and a manager’s ability to inspire confidence in his or her clients.  Wealth managers spent their careers perfecting in-person communications to connect with clients.  2020’s transition to WFH made most of these communications virtual.  In this post, Megan Carpenter provides tips to improve your Zoom communication skills with clients.Megan Carpenter helps RIA firms and advisors connect, communicate, and engage effectively with their target audiences  She will be speaking about the role of marketing in delivering commercial outcomes at our upcoming RIA Practice Management Insights conference to be held March 3-4.  Register now to hear more Megan Carpenter along with keynotes from James Grant, founder and editor of Grant’s Interest Rate Observer, and industry veteran Peter Nesvold, Managing Director of Nesvold Capital Partners.The year 2020 knocked a lot of old traditions off their pedestals—including the ways people connect with each other. Now, you don’t even need to be in the same room to sustain a relationship anymore. A video app is enough.The problem is, you spent years becoming a superstar at in-person communications—learning to press the flesh, read a room and translate body language. Can you learn to translate those skills to a screen, and be just as engaging on video?Fortunately, the answer is yes. But first, you need to commit to doing three things:  Be vulnerable. Practice hard. And learn from your peers. Be vulnerable: It’s what makes you human.On video, it’s easy to spot the difference between honesty and pretense. A newbie might sit bolt upright at his desk in a suit and tie like a sportscaster, leaving the audience wondering if he forgot he’s at home. Someone more comfortable might lean to the side and smile, welcoming you into her living room like she’s about to serve tea.What you say is even more important than how you look. If you’re guarded, everything sounds like corporate happy-talk. For example, we run video DIY workshops for advisors. For one assignment, we asked attendees to make videos about working from home. Most were predictable, boasting about successful transitions or a smooth client process. Out of nowhere, one advisor said, “I realized I’ve never given myself permission to work from home, even though I’m more productive here. I’ve put all of that on myself.” That one crack of honesty in the wall opened up a flood of deeper conversation.Some concrete tips for bringing vulnerability into your communications include:Don’t overproduce; be humanSpeak to one person, not an imaginary audienceKeep your background simple but relatableIf you forget to mention something while speaking, don’t start again. Just say “Oh, I forgot,” as if you were talking to a friendShare your thought process, and explain how your thinking has matured Practice hard: Being “natural” takes work.It's an oxymoron, but it’s true: If you want to be yourself on camera, you have to learn how. And not just learn it, but practice it. It’s taken you a lifetime to master the art of walking confidently into a room and building a human connection. You’re can’t expect to master doing it on video overnight. These skills aren’t intuitive; they have to be rehearsed. Shoot video regularly, get feedback, recalibrate and try again. If you want more guidance and support, consider signing up for workshops or coaching sessions. Learn from other advisors: You don’t have to go it alone.In fact, you can’t go at it alone. You need give-and-take to learn how to connect remotely. The good news is, being vulnerable is a lot less scary when you see your peers doing the same thing. There’s comfort in watching other advisors emerge from their shells, support each other, and feel supported in return. That’s another reason why workshops are ideal for learning video skills.It’s a new world out there. Old voices are losing influence, and new leaders in branding and communications are emerging. If you want to become a video superstar, you have to commit yourself to learning and growing. You don’t have to be perfect. You just have to be willing to break down old habits, listen to others, and stick with your journey.Originally published in WM.com Midyear OutlookAbout the AuthorMegan is CEO and Co-Founder of FiComm Partners, an award-winning agency for RIA firms and financial advisors.Recently named to the Investment News "40 Under 40" list, Meg’s expertise spans over 15 years of helping RIA firms and advisors connect, communicate and engage effectively with their target audiences. Her passion to promote the industry is demonstrated through her involvement with the CFP Board Center for Financial Planning Workforce Development Advisory Group. We’re excited to have Megan speak at our inaugural RIA Practice Management Insights conference.

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

Share prices for publicly traded investment managers have trended upward with the market since March’s collapse.  Aggregators fared particularly well over the last nine months on low borrowing costs and steady gains on their RIA acquisitions.  Traditional asset and wealth managers have also performed well over this time on rising AUM balances with favorable market conditions.[caption id="attachment_35650" align="alignnone" width="959"]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. The fourth quarter was also favorable for publicly traded RIAs of all sizes except the under $10 billion in AUM category.  This underperformance is largely attributable to the lack of diversification in this index and one company’s (Hennessy Advisors) earnings misses rather than any indication that smaller RIAs have struggled over the last few months. [caption id="attachment_35651" align="alignnone" width="862"]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 market’s anticipation of lower earnings due to large decreases in client assets attributable to COVID-19’s impact on the market.  Multiples were inflated in Q2, as prices recovered and earnings lagged—but have metrics have since normalized as prospects for earnings growth have improved with AUM balances. [caption id="attachment_35652" align="aligncenter" width="518"]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 and has now recovered most or all of that loss.  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 larger 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 of 2020.  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.You also need to consider the implications of the recent election and Georgia run-off on your clients’ estate planning needs in the face of higher taxes and lower exemptions (What RIAs Need to Know About Current Estate Planning Opportunities) that could go into effect next year.  And you should always be thinking about practice management issues (RIA Practice Management Insights) and how your firm can thrive in a chaotic market environment.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 fourth quarter was generally a good one for RIAs, but who knows where 2021 will take us following a wild year for RIA valuations and market conditions.A Plug for Mercer Capital’s Upcoming RIA Practice Management Insights ConferenceMercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?

For most independent RIAs, a future M&A transaction is inevitable.  The impetus behind the transaction could be the partners’ desire to retire, gain scale, accelerate growth, meet liquidity needs, reduce the time burden of non-client facing tasks, or some other motive.  Whatever the reason, picking the right partner is critical for the success of the transaction.  For both buyers and sellers, knowing where your firm fits into the RIA M&A landscape is an important first step towards identifying compatible transaction partners.  The universe of RIA sellers can be categorized based on firm culture, the motive behind the transaction, management’s expectations for post-transaction roles, liquidity needs, the status of next-generation management, and the like.  As RIA transactions have proliferated in recent years, several different buyer profiles have emerged that address the concerns of these different seller types.  In this week’s guest post, Louis Diamond of Diamond Consultants identifies four common buyer profiles and the types of sellers that fit well with each.Louis Diamond will be speaking on the topic of advisor recruitment and acquisitions at our upcoming RIA Practice Management Insights conference, to be held March 3-4.  Register now to hear more from Louis Diamond along with keynotes from James Grant, founder and editor of Grant’s Interest Rate Observer, and industry veteran Peter Nesvold, Managing Director of Nesvold Capital Partners.Most acquirers have traits within one of four categories—each offering a unique value to sellers. And having the “right” persona can make all the difference in attracting the right acquisition partners.Many independent firms reach a point in their business lifecycle where they can no longer sufficiently grow or compete on their own. It’s when discussions around finding a way to gain scale and solve for succession hit a wall that firms often consider a merger or acquisition opportunity. Yet finding the right M&A partner isn’t all that easy.As a firm that represents both buyers and sellers, it’s our job to keep a finger on the pulse of the market and listen to many value propositions from prospective buyers. That said, only a handful of firms are truly poised to be meaningful acquirers in this hyper-competitive marketplace. Attributes such as being well-capitalized (given that most sellers expect a decent portion of the purchase price at closing), having a repeatable and battle-tested M&A process, a unique value proposition, and strong leadership are now table stakes in this environment.Buyers and sellers alike often fail to recognize what a marriage between firms can mean for ongoing control, growth and quality of life. Therefore, it is paramount that firm owners are strategic in how they present their value to prospective sellers—and sellers come to the table prepared with clearly identified expectations of the new affiliation.One key area that many buyers often lose sight of – which helps to focus targeting, due diligence efforts and proper alignment – is being clear and honest about what “type of acquirer profile” your firm represents to a prospective seller. It’s equally important to recognize that remaining consistent in this regard is critical; that is, once a firm persona is established, any variances can lead an organization astray of its core competencies and culture, ultimately suppressing enterprise value. And for sellers, recognizing their goals and matching those with one of the four profiles will ultimately translate into a more strategic and focused sale process.The Four Acquirer ProfilesWe find that most acquirers have traits within the following four categories—each of which offer a unique value to sellers.1) Standalone RIAsThese firms are exemplified by a “one brand, one firm, one investment” approach. The most successful acquirers in this group manage more than $1B in assets and have a similar culture, operating structure, and approach as the firms they acquire. They tend to do a small number of deals, so they are typically more strategic in nature than financial. These firms may sometimes allow the seller to maintain an active voice in steering the ship and become a relatively significant equity holder, if so desired. Additionally, all back office and business operations will be taken off the seller’s plate.Another important distinction for those who become an equity owner: There is still the possibility of a significant liquidity event down the road if they take on an investor or sell the firm.Examples: Numerous RIAs have completed a handful of deals and are embarking upon M&A for the first time.Most attractive sellers: Principals who have a longer runway to retirement and are still looking to retain some managerial duties, and those who are primarily focused on a good cultural or local fit. Or an advisor close to retirement who identifies an ideal hand picked successor already at the acquiring firm.Least attractive sellers: Those who value maximum upfront money since these firms are not backed by deep-pocketed investors; those wanting more of a national footprint or brand; or anyone looking to remain fully in charge of operations, since to an extent, investment management and financial planning are standardized across the firm. Also, sellers looking to get a deal done quickly might steer clear of acquirers in this category as these standalone firms tend to be less-experienced deal makers.2) Aggregators or RollupsFirms that are very well-capitalized, prolific deal makers are frequently referred to as aggregators or rollups. They excel at operations, streamlining businesses, standardizing processes, and maintaining strong communities of like-minded advisors. They will take over the entire investment management program, as well as the financial planning process—essentially everything aside from client service. Many firms in this category have cracked the code on organic growth so may have a dedicated business development team, a well-oiled digital marketing or seminar-based lead development system, or be active in the various custodial referral programs.Examples: Mercer Advisors, Beacon Pointe, Mariner, Allworth, and Buckingham.Most attractive sellers: Firms that believe the acquirer has built a “better mousetrap” and are in complete lockstep with the acquirer’s values (i.e., a hard-core focus on financial planning). Also, a good fit those seeking an exit strategy or to gain considerable scale and vastly accelerate organic growth, as well as those who want to step away from the day-to-day operations and just focus on clients.Least attractive sellers: Any principal who is not ready to give up full control.3) Platform AcquirersThese are organizations with many different types of businesses under one roof, but with common middle- and back-office infrastructures. They want sellers to leverage their platform and scale, yet they are all about letting businesses continue to operate in silos.Examples: HighTower Advisors, Kestra Financial (Bluespring Wealth), Stratos Wealth Partners, Sanctuary Wealth PartnersMost attractive sellers: Those who are seeking a partial liquidity event or looking to step back from business ownership, yet still value being involved with portfolio management, financial planning, maintaining their brand, prospecting, and even running their own P&L.Least attractive sellers: Advisors who are close to retirement, yet do not have a succession plan; those who are seeking dedicated resources to fully take on planning, investment management, and day to day client facing responsibilities; and those who are no longer interested in managing a business.4) Financial Buyers or InvestorsThere’s no shortage of capital chasing the independent wealth space as countless private equity firms, family offices, sovereign wealth funds, and diversified financial services companies have made passive investments in larger scale firms. These firms offer prospective sellers the ability to take significant chips off the table by selling a portion of their business. They serve as a strategic growth partner to assist in the sourcing, structuring, and financing of sub-acquisitions, as well as provide the opportunity to retain brand and the client service model.Examples: Focus Financial Partners, Wealth Partners Capital Group, Emigrant Partners, Merchant Investment Management, CI FinancialMost attractive sellers: Those who value maximum upfront cash, retaining day-to-day control of the business, minimizing change, and growing by way of acquisition.Least attractive sellers: Advisors looking to offload the non-client service and business development processes, a firm without an internal succession plan, firms that struggle with profitability and scale, those less interested in focusing on organic and inorganic growth. A merger or acquisition can benefit both parties involved, provided each are equally motivated with compatible needs and goals. By identifying the unique needs and requirements of each party (prior to engaging in an M&A project), the process of meeting the right match can be far more efficient and lead to a successful marriage. About the AuthorLouis has guided many of the top teams in the industry as they’ve transitioned to another employee-model firm or launched RIA firms. And as a next generation leader himself, Louis has a passion for representing complex multi-generational teams.A George Washington University magna cum laude graduate with a BBA degree in Finance and International Business, Louis began his career with some of the biggest names in the financial services industry. His time working as a consultant at Ernst & Young, and in wealth management at Morgan Stanley and UBS, well prepared him to understand the financial world from a client’s perspective.We're excited to have Louis speak at our inaugural RIA Practice Management Insightsconference.

Over the last decade, investors have generally earned a higher net return by investing in passive vehicles rather than actively managed funds.  Heather Brilliant, CFA (CEO of Diamond Hill), says the growth of passive investing has allowed “investors to access beta at a much lower price.”However, the strong performance of large cap indices like the S&P 500 between the 2008-2009 recession and February of this year has also contributed to outflows from actively managed products.  In March of last year, when the stock market fell due to COVID-19, many of our clients thought this would lead to a reversal in the trend.  Active managers could once again shine.When the market quickly recovered and performance was largely driven by a handful of sizeable tech companies, however, active managers continued to struggle to deliver alpha (net of fees).  U.S. trailing twelve month fund flows as of November 2020 were negative for all classes of actively managed equity investments and positive for all passive products.  Passive market share is now greater for U.S. equity investing than active, a first. While large asset managers (i.e. BlackRock), are protected by sheer scale, how do small/mid-sized asset managers stay relevant in this environment? As we noted last week, the multiples observed for publicly traded asset managers are often lower than multiples observed in acquisitions of wealth management franchises.   Asset managers are still facing numerous headwinds, as outlined below, and this higher risk profile and lower opportunity for growth is the cause for lower multiples. Industry HeadwindHow to Stay RelevantUnderperformance Drives Outflows An asset manager’s clients are more likely to jump ship after short term underperformance than clients of wealth managers. A 2016 State Street Study found that 89% of clients will look elsewhere after just 2 years of underperformance.  But outperformance can also drive asset attrition from rebalancing.Educate your Clients Investors who truly understand the risk/ return profile of their investment portfolio are more likely to tolerate short term underperformance. Most asset managers have a style that will work better in some markets than others. Asset Management Industry Barbell Many asset managers are too small to achieve scale yet too big for the investment team to create highly researched and distinguished funds.  Some of these firms are capitulating to consolidation, but there are other options.Commit to Capacity Limits The CEO of Diamond Hill Capital Management, Heather Brilliant, CFA, took the stance in a recent podcast that active management is not a scale game.  While many consider this to be a shortcoming of the industry, acknowledging that your firm cannot work for everyone, but can deliver great returns for fewer investors, is key.  Her advice lines up with the recent growth of the OCIO industry, which commits more time and energy to individual clients’ needs. Fee Pressure As we have written numerous times before, fee pressure in the asset management space has increased over the last decade, as low-to-no-cost products have proliferated and actively managed products have underperformed.Differentiate Products and Trim Expenses There are two ways to increase the bottom line: 1) increase revenue and 2) reduce expenses.  Asset managers can combat fee pressure by differentiating their products by taking a new approach to branding or by considering specialized investment classes such as sustainable investing.  But, without buttressing your fees, the only way to save your margin is to clean up the “back of the house.” Investment management techniques and products have developed tremendously and there is a growing focus to match this development in the back office.A Plug for Mercer Capital's Upcoming RIA Practice Management Insights ConferenceWe’ve decided to put together a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success.  The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.The topic list is unlike that of any other investment management firm forum.  We’ve attended and spoken at plenty of great conferences that cover investment products and M&A, so we’re not going to plow that ground ourselves.  Instead, we have gathered an impressive list of thought leaders who have built careers out of professionalizing the “back of the house” to support the best investment management products and services.Please join us to get their wisdom on how your firm can evolve to become a more sustainable, profitable, valuable enterprise.Have you registered for the RIA Practice Management Insightsconference yet?

Early in the COVID pandemic, PFI Advisors published an article outlining how RIAs could perform an “Operational Diagnostic” to improve their profitability.  Matt Sonnen wrote, “For now, advisors are focusing on exactly what they should be doing – guiding their clients through this turmoil and keeping them calm and focused on their long-term financial goals.  When the time is right, however, I’ll forward this article to our clients so they can begin the work of focusing on the bottom line…”Nine months later, most RIAs and their clients have recovered from the market volatility and ended up having a very good year, at least on paper.  Now’s the time for RIA principals to consider how they can advance their firms to be ready to meet the next challenge with greater ease.We’re featuring Matt Sonnen’s wisdom on operational best practices and business strategy in our upcoming conference, RIA Practice Management Insights, on March 3 and 4.  Registration is open. This article is being published a bit early, I realize that.  When you go to the doctor with clogged sinuses, a splitting headache, and body aches like you’ve never had, you just want some antibiotics that will get you back on your feet as quickly as possible – you aren’t in the mood to hear a lengthy admonishment over your lack of exercise and eating habits.  “Doc – if I survive this thing, I promise I’ll go on a diet and exercise in order to prevent this from happening again, but you’ve just got to help me get out of bed tomorrow, first!” we all say. The recent pullback in the market is putting stress on RIAs from coast to coast.  Revenues are estimated to be down 10 – 15% for the year, putting pressure on profit margins and causing some RIA owners to fret about the viability of their businesses and what cuts they’ll need to endure in the coming months.  We’ve written about the need to focus on profits before (What RIAs Should Learn From Uber and Lyft and The Age-Old Debate: Profit vs. Growth – What’s More Valuable?), and much has been published in the past few weeks about the need to focus on profitability in order to survive this downturn.  Lecturing RIAs about their profit margins right now is a bit like the doctor lecturing you about your eating habits when you are just trying not to pass out from exhaustion, and your body furiously fights off a bacterial infection.  But at some point, it is prudent for you to look at preventative measures that can help you avoid that pain in the future.  For now, advisors are focusing on exactly what they should be doing – guiding their clients through this turmoil and keeping them calm and focused on their long-term financial goals.  When the time is right, however, I’ll forward this article to our clients so they can begin the work of focusing on the bottom line… Why are profits so vitally critical now, you ask?  A recent Financial Advisor IQ article quoted the Boston Consulting Group’s finding that “profits in absolute terms at wealth management companies have yet to reach pre-2008 crisis levels.”  BCG says, “Even when allowing for some profit growth during 2019, the average firm thus has a much lower buffer to absorb shocks.” Philip Palaveev recently stated in a Financial Advisor Magazine article, “Much like the [corona]virus, if someone has health issues, they are very vulnerable and perhaps they need to be looking ahead and taking even more precautions.”  He continued, “Those firms with less than 25% profit margins have less room to wiggle without going to compensation reduction and layoffs.” Brandon Kawal of Advisor Growth Strategies agrees with Palaveev’s 25% profitability hurdle, stating in a recent RIAIntel article, “A healthy operating margin – net of owner and employee compensation costs – is generally between 25% and 30%.  Less profitable firms could potentially face drastic declines in compensation and even resort to cost cutting.”  Kawal continued, “I imagine a lot of owners are sort of stuck in the here and now [tending to clients].  As we go through the coming weeks, it’s going to be time to take a step back and really take a look at the business holistically.” In his recent article, Don’t Waste This Crisis, Matt Crow of Mercer Capital points out, “The value of RIAs and the future of transactions in the industry ultimately comes down to the health of the individual firms.  Fortunately, there is a relatively straightforward way to assess the financial well-being of your firm, and ways of taking corrective action if your firm’s future is threatened.” Crow recommends RIAs take a look at their ongoing revenue and expenses.  Starting with expenses, he advises, “Take your last month’s P&L.  Your biggest expense is labor and benefits; it’s not unusual to see labor costs comprising two-thirds or more of an RIA’s total operating costs.”  For a simpler calculation, he says to leave out discretionary bonuses and just focus on salaries and benefits.  “Once you’ve quantified total personnel costs, look at other fixed costs like rent, research, compliance, technology, systems, etc.  Adding all that together will derive your annualized expense base.” Now it’s time to calculate your adjusted revenue, given the pullback in the markets.  Crow points out, “The beauty of the RIA model is that you can know, on any given day, what annualized revenue is.  Take your closing AUM as of the most recent trading day, filter it through your fee schedule, and you can tell, based on that day’s market pricing of your client assets under management, what annualized revenue is.” He concludes, “With annualized revenue and expenses calculated, you know whether or not you’re profitable, and by how much.” As every episode of G.I. Joe concluded in the 1980’s, “Knowing is Half the Battle.” The next big question is, “What the heck are we going to do about it?” There are only two sides to the profitability equation that you can manipulate in order to boost profitability: you can increase revenue, or you can decrease expenses.  Given the fact that no one knows how the current economic uncertainty is going to play out and the effect it will have on RIA revenue, it is most logical to focus on expenses.  There are hard costs to examine – “Where can we spend less money?” and there are productivity costs to review – “Where are we under allocating resources that we could be more productive and service our clients more efficiently?” In our opinion, the best way to perform this analysis is through an Operational Diagnostic, where you review each of your core back office systems and workflows and ask yourself a few key questions, detailed below.  Maybe you are spending money on systems that your firm is not fully utilizing, and there is a less expensive system that could be implemented without causing any decrease in client service.  Maybe you have underspent in certain areas, which is causing too many man hours to be spent on basic tasks.  The Operational Diagnostic process should reveal these areas and allow you to more efficiently provide high-touch service to your clients. Another area to focus on would be Client Segmentation.  The goal of any client segmentation exercise is to determine the proper resources to allocate across your client base.  Are you profitably servicing every client, based on the complexity of the relationship and the fees they are paying you?  Here are some ideas around a Client Segmentation exercise:One last area worth evaluating is what services are you outsourcing vs. conducting in-house?  We recently wrote an article expressing our thoughts around building vs. buying your RIA’s client portal.  Other areas you may want to consider outsourcing are:PFI Advisors has helped many RIAs think through profitability since our launch in 2015 – whether we are asked, “How do I run my firm more profitably?” or “How do I launch an RIA that will be designed to maximize profitability?” or “How do I successful execute a merger in the most profitable fashion?”  We are always here to help RIAs think through these issues, but this analysis can be done in-house as well, following the guides included below.We’ll make it through this, just like we’ve made it through other economic downturns in the past.  Matt Crow points out, “The current [environment] threatens our physical health as well as our financial health, so it wears on our psychology much more than most economic downturns.”  This one is tough, on many levels.  But when the dust settles, and our physical health is assured, use this wake-up call to focus on the health of your business.  As management guru and former CEO of Intel, Andy Grove, stated, “Bad companies are destroyed by crisis.  Good companies survive them.  Great companies are improved by them.”Originally published in April 2020.About the AuthorMatt founded PFI Advisors to help existing RIAs tackle the various operational and strategic issues that arise as they continue to grow, and to help billion-dollar breakaway teams start their own RIAs. He left Focus Financial Partners in 2015 to launch PFI with his wife and business partner to help RIAs become more successful. Matt understands the importance of efficient systems, as he carried out two full system replacements while COO/CCO of Luminous Capital. He has 20 years of industry knowledge and experience to help your firm reach its full potential.For the past two years, Matt has been hosting a monthly podcast, The COO Roundtable. Through interviews with top operations leaders from around the country, the podcast highlights the incredibly important work COOs perform on a daily basis.  We are excited to have Matt conduct a live interview at the RIA Practice Management Insights Conferencewith two operations professionals to discuss best practices and general business strategy for the RIA industry. With all the disruptions caused by COVID-19, operations professionals have more leverage with RIA owners than possibly any time in our industry’s history. This is bound to be an insightful discussion. To learn more about The COO Roundtable, click here.

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.

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

‘Twas the blog before Christmas, when all through the house Every laptop was purring, every keyboard and mouse; The stockings were hung by the chimney with care, So that backgrounds on Zoom calls wouldn’t look quite so bare;When out on the squawk there arose such a clatter, I refreshed my Bloomberg to check on the matter. Then what to my wondering eyes did appear, But a global growth manager outperforming its peer.With a ghostly old PM so lively and quick, I listened, engaged, to his every stock pick. More rapid than eagles his recommends came, And he whistled, and shouted, and called them by name:“Buy Bitcoin!  Buy Apple! Buy Tesla and Google! ’Cause shorting the future will always prove futile! To the top of the charts, for the big money haul, Go long like you’ve never had a bad margin call!”As I drew down my cash, and was turning around, Down the chimney John Templeton came with a bound. He was dressed like he owned just a few private jets, Which compared favorably to my “work at home” sweats.A bundle of hundreds he had flung on his back, Like an entrepreneur with a new public SPAC. He spoke not a word, but went straight to his work, And filled all my orders, then added a perk:His eyes - how they twinkled! His dimples, how merry! As he talked a new strat that would guarantee carry! And out-money calls bought to cover the shorts, Bringing untold riches to long-only sorts.A wink of his eye and a twist of his head, Made me want to get all of his thoughts on the Fed – And vaccines and rates and bullion and more, But he rose and I followed him out my front door.A magical Gulfstream waited there in my yard, And up the air-stairs sprang the RIA bard. But I heard Sir John claim, as he flew out of sight - "Let your best winners run, and all will be right!"...(function(t,e,s,n){var o,a,c;t.SMCX=t.SMCX||[],e.getElementById(n)||(o=e.getElementsByTagName(s),a=o[o.length-1],c=e.createElement(s),c.type="text/javascript",c.async=!0,c.id=n,c.src="https://widget.surveymonkey.com/collect/website/js/tRaiETqnLgj758hTBazgd7CsENq4E17zRc3oaUw9n_2BzGVsq_2BQvhuHonnFZr_2BMGJt.js",a.parentNode.insertBefore(c,a))})(window,document,"script","smcx-sdk"); Create your own user feedback survey If you're having trouble viewing the survey below, click here.

Last week, Macquarie Group announced its acquisition of Waddell & Reed (WDR) for $1.7 billion.  Waddell & Reed is one of the oldest mutual fund and asset management firms in the U.S. with a range of investment styles and insurance products. Waddell and Reed’s asset management division will expand Macquarie’s investment solutions, boost Macquarie’s annuity earnings, and push Macquarie’s U.S. AUM to $276 billion, making it one of the top 25 active managers in the U.S.The transaction marks a shift in Macquarie’s past acquisition strategy, which has historically followed the old saying, “The time to buy is when there’s blood in the street.”  The firm’s last large acquisition was in 2010 when it acquired Delaware Funds (with $135 billion AUM) for $428 million. Instead, Macquarie is moving when the market is at an all-time high and paying nearly a 50% premium to WDR’s share price.Not only does this mark a shift in Macquarie’s deal strategy, but it is also the first acquisition by Macquarie’s new CEO.  Shemara Wikramanayake, who has been called the most powerful woman in Australian finance, is now dealing with skeptics who ask why she paid such a premium for a business whose AUM has halved over the last six years.Transaction OverviewAt first glance, the AUM and revenue multiples paid by Macquarie Group appear fairly normal for an asset manager, but maybe not for a firm with a 14% EBITDA margin and years of declining AUM.While EBITDA multiples over 11.0x are not unheard of in this space, one would likely expect an impressive growth trajectory to accompany it.  To understand the deal multiples implied by Macquarie’s acquisition of Waddell and Reed, we must dig into the details of the transaction.WDR has historically held lots of cash and investments on its balance sheet, for which Macquarie likely paid dollar for dollar.  Typically, RIAs hold between 6-8 weeks of operating expenses on its balance sheet as working capital, or approximately 10% to 15% of revenue. With an estimated $437 million of excess working capital on its balance sheet, the price for the operating business is approximately $1.26 billion, which implies multiples more in line with the typical range observed in the legacy asset management space. Additionally, upon completion of the deal, Macquarie Group will sell WDR’s wealth management division to LPL Financial (a U.S. retail investment advisory firm, BD, and RIA custodian) for $300 million.  The adjusted transaction price as a multiple of WDR’s asset management division’s AUM is 1.42%.  However, determining the post transaction revenue and EBITDA requires a good bit of speculation. With AUM of approximately $68 billion and pro forma effective fees of around 65 bps, the post-transaction business will likely generate about $450 million of investment income.  A little under 90% of WDR’s underwriting revenue was generated through its advisor network.  Post-transaction, Macquarie will be one of LPL’s top strategic asset management partners, which suggests that Macquarie will not lose all revenue associated with its advisor network.  As such, we have estimated WDR’s underwriting revenue stream could fall by approximately 80%.  There will be expense savings generated by selling this business and additional synergies from merging with Macquarie.  However, buyers don’t often pay for something they bring to the table, so WDR was likely only compensated for the cost reductions associated with selling its wealth management business. Thus, we have modeled a range of scenarios with between 50% to 60% cost savings. Even if Waddell and Reed’s AUM has been falling year-over-year, scale is valuable in the asset management space and we doubt that Macquarie was able to pick up WDR’s asset management business for a 5.0x EBITDA multiple.  But the 7x-11x range seems reasonable.  Macquarie’s acquisition of Waddell and Reed highlights how the success of legacy asset managers is currently dependent upon achieving scale. While the $25 per share purchase price represents a healthy premium to the latest pricing, the market has been down on investment managers since March’s sell-off.  Paying a premium does not necessarily mean that Wikramanayake overpaid.  Some may say that Macquarie is catching a falling knife by buying a business whose assets have been on the slide, but maybe it was just a butter knife…

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.

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

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. Contingent consideration remains a mystery to many industry participantsThis blog series 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 these posts to explore the basic economics of contingent consideration and the role it plays in negotiating RIA transactions.Earn-Outs Are Fundamental to RIA TransactionsAs the saying goes (which has been attributed to at least a dozen famous figures): "It’s difficult to make predictions, especially about the future."  This reality is the single most difficult part of negotiating a transaction in the investment management industry.  The value of an RIA acquisition target is subject not only to a large number of variables but also a wide range of possible outcomes:Performance of financial markets (standard deviation varies)Skill of the investment management staff (difficult to measure)Sustainability of the acquired firm’s fee schedule (not as much a given as in the past)Retention of key staff at the acquired firm (absolutely necessary)Retention of key staff at the acquiring firm (absolutely necessary)Motivation of key staff (absolutely necessary)Retention of client assets (depends on third party behavior)Marketing strength of the merged enterprise (tough to predict) Without faith in the upward drift of financial markets, favorable margins in investment management, and the attractiveness of the recurring revenue model, no one would ascribe material value to an RIA.  But actually,  buying an investment management firm is making a bet on all of the above, and most people don’t have the stomach.Only by way of an earn-out can most investment management firm transactions overcome so much uncertaintyReaders of this blog understand that only by way of an earn-out can most investment management firm transactions overcome so much uncertainty.  Nevertheless, in our experience, few industry executives have more than an elementary grasp of the role contingent consideration plays in an RIA transaction, the design of an earn-out agreement, and ultimately the impact that these pay-for-performance structures have on valuation.If nothing else, earn-outs make for great stories.  Some of them go well, and others go like this.From Earn-Out to Burn-Out: ACME Private Buys Fictional FinancialOn January 1, 20xx, ACME Private Capital announces it has agreed to purchase Fictional Financial, a wealth management firm with 50 advisors and $4.0 billion in AUM.  Word gets out that ACME paid over $100 million for Fictional, including contingent consideration.  The RIA community dives into the deal, figures Fictional earns a 25% to 30% margin on a fee schedule that is close to but not quite 100 basis points of AUM, and declares that ACME paid at least 10x EBITDA.  A double-digit multiple brings other potential deals to ACME, and crowns the sellers at Fictional as “shrewd.”  Headlines are divided as to whether Fictional was “well sold” or that ACME was showing “real commitment” to the wealth management space, but either way the deal is lauded.  The rest of the investment management world assume their firm is at least as good as Fictional, so they’re probably worth 12x EBITDA.  To the outside world, everybody associated with the deal is happy.The reality is not quite so sanguine.  ACME structures the deal to pay half of the transaction value up front with the rest to be paid based on profit growth at Fictional Financial in a three year earn-out.  Disagreements after the deal closes cause a group of advisors to leave Fictional, and a market downturn further cuts into AUM.  The inherent operating leverage of an investment management firm causes profits to sink faster than revenue, and only one third of the earn-out is ultimately paid.  In the end, Fictional Financial sold for about 6.5x EBITDA, much less than what the selling partners wanted for the business.  Other potential acquisition targets are disappointed when ACME, stung with disappointment from the Fictional transaction, is not willing to offer them a double-digit multiple.  ACME thought they had a platform opportunity in Fictional, but it turns out to be more of an investment cul-de-sac.The market doesn’t realize what went wrong, and ACME doesn’t publish Fictional’s financial performance.  Ironically, the deal announcement sets the precedent for interpretation of the transaction, and industry observers and valuation analysts build an expectation that wealth management practices are worth about 10x EBITDA, because that’s what they believe ACME paid for Fictional Financial.ConclusionThis example highlights the difference in headline deal values (total consideration) and what actually gets paid after the earn-out payment.  Sometimes they’re the same but often only a portion of the contingent consideration is realized, which makes total consideration multiples difficult to interpret.  We’ll touch on this a bit more in next week’s post on transaction strategies and earn-out parameters.

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.

The market for sustainable investments has grown to over $12 trillion in the U.S. and the movement of investable assets into sustainable strategies is expected to accelerate. In this week’s post, we link to the newly published 2020 Alternative Asset Manager Update authored by Taryn Burgess, CFA, ABV. The update reviews the growth of sustainable investing over the last decade and considers the valuation implications for your RIA.2020 Alternative Asset Manager UpdateView Report

COVID-19 adversely affected sector M&A for a couple of months when most of the U.S. was under shelter at home/safer in place orders.  However, deal activity is recovering quickly and now could be further accelerated as banks look to replace lost interest income with fee-based revenue.  An increasing number of clients on the banking side of our practice are showing interest in the wealth management space, and it’s easy to understand why.  Long-term rates hovering at historic lows have significantly impaired net interest margins, so banks are exploring other income sources to fill the void.  Wealth management is a natural place to start since so many banks already offer financial advisory services of one form or another. There are many other reasons why banks have wealth managers on their radar:Exposure to fee income that is uncorrelated to interest ratesMinimal capital requirements to grow assets under managementHigher margins and ROEs relative to traditional banking activitiesGreater degree of operating leverage – gains in profitability with management feesLargely recurring revenue with monthly or quarterly billing cyclesSticky client baseAccess to HNW/UHNW client base and opportunity to increase wallet sharePotential for cross-selling opportunities with bank’s existing trust and wealth management clients These incentives have always been there, but COVID amplified the banking industry’s need to diversify their revenue base, and RIA acquisitions are almost always immediately accretive to earnings.  The shape of the current yield curve suggests that long-term rates are likely to stay below historic norms for quite some time, dampening the outlook for bank interest income.  Acquiring an RIA or bulking up an existing wealth management practice with experienced advisors is a relatively easy way to pick up non-interest income and improve profitability.  Building-up non-interest income is also an effective hedge against a further downturn or future recessions that might require the Federal Reserve to lower rates even further. Still, there are several often overlooked deal considerations that banks and other interested parties should be apprised of prior to purchasing a wealth management firm.  We’ve outlined our top four considerations when purchasing RIAs in today’s environment:With most of the domestic equity markets back to near-peak levels, the financial commitment required to purchase a wealth management firm has likely increased in recent months, lowering the prospective ROI of an acquisition. We often see some temptation to pay a higher earnings multiple based on rule-of-thumb activity metrics (% of AUM or revenue), but we would typically advise against paying above normal multiples of ongoing EBITDA for a closely held RIA, absent significant synergies or growth prospects for the target company.Since many wealth management firms are heavily dependent upon a few staff members for key client relationships, many deals are structured as earn-outs to ensure business continuity following the transaction. These deals tend to take place over two to three years with a third to half of the total consideration paid out in the form of an earn-out based on future growth and client retention.  COVID-19’s impact on the markets and economy has elevated the demand for buyer protection, and many banks are now requiring larger earn-out components to protect themselves from future downturns or client attrition.It’s hard to know how the cultures of firms in any industry will mesh after a merger, and this side of due diligence has been most affected by COVID-19, as in-person meetings are still generally being avoided.  The culture issue is especially true for bank acquisitions of wealth management firms.  Compensation, work habits, client service expectations, and production goals can be drastically different at an RIA versus a bank, so it’s important to consider if these discrepancies could become problematic when the firms join forces.  We’ve seen culture clashes blow up deals that looked great on paper.Degree of Operational Autonomy. Wealth managers (and their clients) value independence.  Individual investors typically must consent to any significant change in ownership to retain their business following a transaction and may not be willing to do so if they feel that their advisor’s independence is compromised.  Senior managers at the target firm will likely need to be assured that the new owner will exert minimal interference on operations and strategic initiatives if key personnel are to be retained. These considerations manifest the need for an outside advisor to ensure that proper diligence is performed and the transaction makes sense from an economic perspective.  Bank boards need practical guidance on finding the right RIA at the right price and assessing cultural differences that could wreck the integration after the ink dries.  As always, we’re here to help.

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.

Personnel costs are by far the largest expense item on an RIA’s P&L, but we’ve found significant variation in how RIA owners think about compensating their employees (and themselves).  This is the second post of a two-part series on compensation best practices for growing investment managers. Last week, we introduced two common compensation conundrums for RIAsHow to structure employee compensation when you are not ready to bring on an equity partner.How to structure compensation and your P&L before you bring on an equity partner In our last example, we explained how owners of RIAs can structure employee compensation. This week will focus on how to structure partner compensation.Striking the Right BalanceSince RIA owners are often senior managers in their firm, their compensation and distributions are often intertwined and are subject to shareholder preferences regarding how they like to be paid.  However, this can lead to problems as growing RIAs expand by bringing on new equity partners.Take the example below of an RIA with four partners with equal ownership considering a 25% equity grant to bring on a new partner who will help the company expand its reach.  To minimize their tax burden, the owners historically have not paid themselves a salary and instead were compensated through distributions.  However, if they bring on a new employee with a salary and 25% ownership, the new partner would receive higher compensation (including distributions) than the original partners who aren’t taking any salary or bonus. A similar complication arises for partners that pay out their entire EBOC (Earnings Before Owners’ Compensation) in bonuses to minimize reported profitability.  We often see this in places with state dividend taxes but no state income tax.  Equity incentives in these situations are rarely enticing to prospective hires since dividend prospects are minimal or non-existent as shown below. Before bringing on an equity partner, it is key to balance returns on labor (compensation) and returns on investment (distributions).  To appropriately relate compensation expenses to reasonable returns on labor, owners should consider compensation levels commensurate with job responsibilities and revenue production.  Compensation studies can help determine market levels of salaries and bonus expense, but the range of reported salaries in the RIA industry vary significantly.  It is helpful to think about what it would cost to replace yourself if you decided to step away from the business; however, this may not be relevant for younger staff additions, whose market rates often depend on their relevant course experience and educational background. The return on investment is just the residual income after paying your staff (and yourself) an appropriate (market) level of compensation expense.  RIA owners often think of their ROI as a ROS (Return on Sales) since the requisite capital to start these businesses is often quite minimal.  In other words, they often think an appropriate return on investment is a reasonable pre-tax margin for an RIA of their size.  If, for example, industry compensation costs are 70% of revenue and overhead expenses are 10%, then an appropriate pre-tax margin or ROS is 20% (100%-70%-10%).  If your current margins are much higher or lower than industry norms, your compensation expenses are probably not in sync with the market. Does Money Talk Louder Than Words?Compensation discussions are never easy.  If your company is growing and your employees are smart, they will ask for ownership in the business.  Even if out-right ownership is not on the table, it is beneficial to align employee incentives with your own.  But many owners of growing RIAs make the mistake of waiting too long to share equity ownership and before they realize it, the value of an equity stake in their firm is too expensive for the next generation of leadership to afford.

Personnel costs are by far the largest expense item on an RIA’s P&L, but we’ve found significant variation in how RIA owners think about compensating their employees (and themselves).  We’ll devote the next two posts to discussing best practices from an outsider’s perspective.The Scope of Compensation Costs for RIA FirmsAccording to Schwab’s 2020 Compensation Report, median compensation costs are 70% of revenue for firms with over $100 million in assets under management.  We were a bit surprised by these findings since most publicly traded RIAs are in the 40% to 50% range, and our clients are typically in the 50% to 60% category, but these firms are usually larger than the median RIA in the Schwab study.  There is also significant variation in these measures depending on the location, type of RIA, and how the owners choose to compensate themselves.The study reported that 76% of RIAs are planning to hire in the next twelve months, and 42% of firms recruited from other RIAs in the last year.  The report also noted that 73% of these acquiring firms share equity with non-founders, suggesting that stock incentives are also part of the overall compensation package for the senior management group. [caption id="attachment_33740" align="alignnone" width="910"]Source: Schwab’s 2020 Compensation Report[/caption] The Compensation Conundrum for Newly Formed RIAsThis data illustrates the importance of a compelling compensation strategy for growing RIAs looking to recruit from other firms and retain talent.  Newly formed RIAs don’t typically have the resources to offer higher base salaries and will often consider filling the void with stronger equity or equity-like incentives.  While equity participation is especially lucrative for high growth firms with greater upside potential, partners of newly formed RIAs are generally hesitant to dilute their ownership.Equity offerings can be problematic for growing or newly formed RIAs whose principals do not take a salary or bonus from the business.  While this structure makes sense in states with high income taxes, it overstates profitability and, if not remedied, would overstate income distributions to current (and prospective) owners.Over the next two posts we will delve into these two common compensation conundrums for RIAs:How to structure employee compensation when you are not ready to bring on an equity partner.How to structure compensation and your P&L before you bring on an equity partner. In this post, we address the first problem.Income (Not Equity) Partners Compensation is always a tricky issue, but the situation is especially complicated for RIAs as employees are typically able to estimate the profits of the company and compare their compensation to overall firm profits.Consider an RIA with two owners and two employees.  The two employees know that the firm manages $250 million and estimate that the firm’s effective fees are 85 basis points, so they calculate that the firm likely generates $2,125,000 in annual revenue.  By estimating overhead expenses and subtracting their own salaries, they surmise that the two owners/employees take home around $1.5 million, in aggregate. The two employees know they are paid well but also feel they should be rewarded for their part in the success of the company.  The two owners, on the other hand, took a lot of risk starting their own business and feel they deserve to be compensated for their investment.  They also want their employees to feel that they are being treated fairly. What do the owners do? When principals at RIAs are not ready to dilute their ownership in the business, they can structure compensation such that their employees are income-partners (but not actual equity partners).  If you structure employee compensation to include a base salary and a bonus that is determined as a percent of company profits then your employees have the opportunity to participate directly in the upside of your business, without diluting your ownership positions. As shown in the adjusted model below, the owner’s take home pay did not change significantly; however, the employees are now directly compensated based on the profitability of the firm. Tying a new hires’ compensation to firm profitability is usually good practice but may be too costly if the shareholders aren’t paying themselves a salary and bonus. In the proposed model above, the partners increase their base salary to better align company profits with industry norms. We will dig deeper into this idea next week.

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.

Typically, my love of business valuation and gin and tonics do not go hand-in-hand, and, unfortunately, Ryan Reynolds has never been thrown into this mix.  But last week, three of my favorite things collided in Reynolds’ viral out of office reply.On Monday, Diageo, a European beverage company, announced it would be acquiring Aviation American Gin, owned by Ryan Reynolds (among others), for total consideration of $610 million, and, on Tuesday, Reynolds had a stark realization...Thanks for your email. I am currently out of the office but will still be very hard at work selling Aviation Gin. For quite a long time, it seems.In related news, I just learned what an ‘earn out’ is... And I'd like to take this opportunity to apologize to everyone I told to go f**k themselves in the last 24 hours. My lawyers just explained how long it takes to achieve an 'earn out'... so... turns out I'm not as George Clooney as I thought. The point is, to those listed below, I'm sorry... and I'll indeed be needing your help in the coming months and years. Thanks in advance!Mom, Blake, Peter, Diageo CEO, The Rock, George Clooney, Southern Glazer's, Betty White, TGI Friday's, Baxter, Calisthenics, AMC Theaters, Total Wine, The Number 8, Don Saladino, Darden, The Head of Alfredo Garcia, Soothing Lavender Eye Pillows.Ryan Reynolds Owner ? Aviation American GinApparently, the $610 million advertised transaction price is made up of an initial payment of $335 million and contingent payments of $275 million, based on the performance of Aviation American Gin over a 10-year period.Gin, Business Valuation, Ryan Reynolds, and your RIA Earn-outs are commonly used in RIA deals, and we expect contingent payments to make up an even larger percent of deal consideration for the next few months, quarters, or years depending on how long the current economic uncertainty lasts.  And while we hope most of our clients would be thrilled by the prospect of $335 million in upfront cash payments, we don’t want you to end up feeling as Ryan Reynolds did last week.  In this post, we explain what an earn-out is, why they are commonly used in RIA transactions, and how earn-outs may be used as a saving grace for deal activity in the current economic environment.What Is an Earn-Out? An earn-out is an agreement between a buyer and a seller to defer a portion of the purchase price.  The amount of consideration ultimately paid is determined based on either some measure of post-closing financial performance such as AUM or EBITDA, or a specific milestone that occurs post-closing such as the renewal of a large contract.Contingent consideration allows for risk-sharing between the buyer and the seller.  Deferral of the purchase price functions as a hedge for the buyer against poor future performance, while sometimes simultaneously providing the prospect of additional upside for the seller if they outperform buyer expectations.  Importantly, contingent consideration influences post-transaction behavior.  When it is necessary for the seller to continue operating the business following the sale (for RIAs, this is almost always the case), the presence of contingent consideration can incentivize the freshly-endowed sellers not to “call in rich” (like Reynolds thought George Clooney did in his sale of Casamigos tequila for $1 billion - actually 30% of the total consideration was subject to a 10 year earn-out like in Reynolds’ case), but continue to promote the success of the business.Why are Earn-Outs Commonly Used in RIA Transactions? Earn-outs are commonly used in RIA transactions, as the purchase price is not based on the value of hard assets acquired but expected future cash flows.  Future cash flows of an RIA can vary dramatically as they depend on a large number of variables, including:The performance of financial markets;The skill of the investment management staff;The sustainability of the acquired firm’s fee schedule;The retention of key staff at the acquired firm;The motivation of key staff; andThe retention of client assets. As an example, we consider just one of these variables - market performance - and how an earn-out can be used as insurance to the buyer in case of a market downturn.  While the market has almost recovered back to February highs, thanks mostly to the FANG stocks, some still think that this V-shaped recovery could turn into a W. Assume that RIA Capital buys ABC Investment Management, with $4.2 billion in assets, for a total price of $100 million.  The transaction is structured such that two-thirds of the proceeds are paid up front and the remainder of the purchase price is paid over three years if ABC’s AUM grows by at least 5% per year. In Scenario A, ABC Investment Management’s AUM grows by 7.5% per year, and given the operating leverage inherent in most RIAs, EBITDA increases from $12.5 million to $15.8 million over the earn-out period.  In this scenario, the entire earn-out is paid.  The total consideration paid by the buyer is $100 million, which represents 6.8x average EBITDA in years 1-3.In Scenario B, ABC’s AUM falls by 15% in year one and slowly begins to recover, but, due to the operating leverage, EBITDA falls by almost 40% in the first year (a decline in revenue with little or no decline in expenses results in a larger drop in profitability).   In Scenario B, the seller does not receive any contingent payments.  The total consideration paid by the buyer is $67 million (the amount of the closing payment), which represents 6.6x average EBITDA in years 1-3.While the financial results in Scenario A and Scenario B differ quite drastically, the deal economics (from the buyer’s perspective) are similar.  In both scenarios outlined above, the buyer paid roughly the same multiple of forward average EBITDA despite the difference in ABC’s EBITDA trajectory.Expect a Larger Portion of RIA Deal Proceeds to be Paid as Contingent ConsiderationRIA transaction activity has slowed during COVID-19.  Most deals that were already in motion when COVID-19 hit, were finalized.  However, new deal activity has been minimal.  While a lot of due diligence can be performed virtually, buying an RIA in the middle of so much uncertainty is hard to swallow.  However, the need for succession planning in the RIA space has not halted because of the pandemic.  Rather, during COVID-19, many RIA principles have realized that succession planning is something that can no longer be delayed.So, how do you get buyers and sellers to execute a transaction during COVID-19 when the economic environment is so uncertain and when buyers likely have never set foot in the office they are buying or met management face-to-face?  Part of the answer may be to bridge the gap between seller and buyer expectations by structuring the deal in a way that defers payment of a substantial portion of the purchase price in the form of contingent consideration.If you’re contemplating an offer for your firm that includes an earn-out, talk with an independent expert so you can better understand the value of the payments.  And, Ryan Reynolds, if you are reading this, we would be happy to advise you on your next business deal.

Proposed Tax Changes Hasten Need for Estate Planning ServicesLast week we covered Joe Biden’s proposed estate tax changes and their impact on family wealth transfers if he gets elected in November.  Biden’s current proposals include the elimination of basis step-up, significant reductions to the unified credit (the amount of wealth that passes tax-free from estate to beneficiary) and gift tax exemption, and increasing current capital gains tax rates to ordinary income levels for high earning households.  The cumulative effect of these changes is a substantial increase in high net worth clients’ estate tax liabilities if Biden’s current proposals become law. Fortunately, there are several things you can advise your high net worth clients to do now to minimize their exposure to these potential tax law changes.  Taking advantage of the current high-level of gift tax exemptions ($11.58 million per individual or $23.16 million per married couple) could save millions in taxes if Biden’s proposed lower exemption of $3.5 million per individual becomes law.  Other options include the formation of trusts or asset holding entities to transfer wealth to the next generation in a tax-efficient manner (more on this later).  Proper estate planning can mitigate the adverse effects of higher taxes on wealth transfers, but the window to do so may be closing if we have a regime change later this year.  Further, the demand (and associated cost) for estate planning services may go up significantly in November, so you need to apprise your clients of these potential changes before it’s too late.Low Valuations Compound Tax Efficiencies for Current TransfersCOVID-19’s impact on the economy and financial markets may have depressed the value of your clients’ marketable securities and closely-held business interests.  As my Mercer Capital colleague Travis Harmsrecently noted in his Family Business Director Blog, it does not matter if your client is looking to sell these assets in the near future, the IRS considers the relevant economic and market conditions at the date of transfer according to its Revenue Ruling 59-60:The fair market value of specific shares of stock will vary as general economic conditions change from ‘normal’ to ‘boom’ to ‘depression,’ that is, according to the degree of optimism or pessimism with which the investing public regards the future at the required date of appraisal. Uncertainty as to the stability or continuity of the future income from a property decreases its value by increasing the risk of loss of earnings and value in the future.One of the few positive side effects of the recent downturn is that it provides an opportunity for more tax-efficient transfers of family wealth for estate planning purposes.  Travis illustrates the significance of the current opportunity with an example regarding the transfer of interests in a closely-held company.Consider a family business having a pre-pandemic value on an as-if-freely-traded basis of $25 million.  Although the long-term prospects of the business remain unchanged, the dislocations caused by coronavirus have triggered a temporary reduction in fair market value of 25%.  The founder has yet to do any estate planning and continues to own 100% of the shares. Exhibit 1 depicts the expected value trajectory for the family business both before and after the pandemic.Because of the resilience of the family business, the value trajectory resumes its pre-pandemic path after three years.  The founder’s tax advisers suggest that – since the long-term prospects of the business are unimpaired – the current depressed fair market value provides an excellent opportunity to begin a program of regular gifts.  The current lifetime gift tax exclusion is approximately $12 million, and the founder and his advisers devise a strategy of making an initial gift of $6 million, followed by annual gifts of $1 million in each of the following six years.We’ll examine two scenarios.  In the first, the founder begins the gifting program immediately (the “Decisive” scenario). In the second, the founder defers the gifting program until the uncertainty associated with the pandemic has passed (the “Hesitant” scenario).  In both cases, the shares gifted represent illiquid minority interests, so a 25% marketability discount is applied to derive fair market value.Since the annual gifts are for fixed dollar amounts, lower per-share values result in more shares being transferred, which reduces the ownership interest in the future taxable estate, all else equal.  Exhibit 2 summarizes the shares that are transferred under the gifting program for the Decisive and Hesitant scenarios.Because the gifts under the Decisive scenario were made while share prices were depressed because of the coronavirus, a larger portion of the shares were transferred than in the Hesitant scenario.  As a result, the founder retained just 33% of the total shares after using the $12 million lifetime exclusion, compared with 58% under the Hesitant scenario.  As shown in Exhibit 3, the effect on the resulting taxable estate is compounded because, under the Hesitant scenario, the 58% retained interest represents a controlling position in the shares and the value is not reduced for the marketability discount.  In fact, although not shown in Exhibit 3, a control premium to the as-if-freely traded could be applicable, which would exacerbate the disparity. In our example, failing to take advantage of the estate planning opportunity presented by the depressed asset prices added $7.2 million to the eventual estate tax bill.  Procrastination can be costly. Historic Lows in Applicable IRS Interest Rates Provide Further Opportunity for Tax-efficient TransfersThe current AFR (the IRS-approved Applicable Federal Rate for interest on intra-family loans) is hovering at all-time lows – 0.25% to 1.15% per year, depending on loan duration.  The new §7520 rate (named for that section of the Internal Revenue Code) applicable to Grantor Retained Annuity Trust (GRAT) transfers is also at a historic low of 0.80%.  These low rates allow wealthy families to transfer assets and lock in their low values with minimal financing costs on intra-family loans and trust vehicles.Forbes provides an example of how GRATs and the new §7520 rate can be used to transfer assets to the next generation in a tax-efficient manner:Let’s suppose there is a family with assets worth $25 million; the value is down from $30 million before the crisis.  They have real estate, investment assets, and a family business.  The family wants to keep the business in the family.  The older generation transfers $10 million worth of the business into a GRAT when the §7520 rate is 0.8% (May 2020), with the right to receive an annuity of $1 million a year for 10 years.  At the end of 10 years, the remainder will be distributed to the grantor's children.  Using the IRS Table B factor of 9.5737, the annuity stream is valued at $9,573,700, and the remainder interest is valued at its present value of $426,300.  If the assets grow by 5% and have distributed income of 5%, the grantor will receive a stream of 10 payments of $1,000,000, and the beneficiaries will receive $10,200,416 at the end of the 10-year term (the future value of $10 million, minus ten annual payments of $1,000,000, and growing at 5% per year after income distributions of 5%).  If the assets in the GRAT did not appreciate, the GRAT would invade principal, but would be paying the assets to the grantor. If the parents make a gift of $426,300 (the value of the remainder interest at this low rate), this would use up some of their estate exemptions, but the kids get more than $10.2 million.  That is significant leverage on the use of the estate exemption that might be expiring in the near future.Putting it All Together…The perfect storm of record-low IRS rates, reduced asset values, and the prospect of significant tax law changes early next year make this the ideal time to advise clients to start thinking about estate planning and tax-efficient ways to transfer assets to the next generation.  With asset values trending upwards, vaccine candidates progressing rapidly, and political polling suggesting a high probability of a regime change in November, this perfect storm may not last long.  Take advantage by taking action.  In the current environment, there is little to gain by procrastinating, but potentially a lot to lose.  We’re here to help with any valuation needs your clients (or you) might have to get this done.

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

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.

The outlook for RIA M&A at the end of the first quarter was murky.  While we did not expect deals already in motion to be canceled, we did expect deal activity to temporarily slow.  We theorized that this slowdown could actually benefit the industry if RIA principals used the downtime to think about succession planning.  DeVoe & Company summarized similar expectations for RIA M&A in a "Four-Phase Outlook for M&A Post COVID-19" published in its Q1 RIA Deal Book:   Live transactions get completed.A lull in activity as owners respond to the COVID-19 pandemic rather than seek out new dealsA surge in activity caused by delayed deals coming to the marketReturn to normalcy where the trends of increased M&A continue with an aging ownership base and a need for succession planning So, were these expectations on track?Review of M&A in Q2 2020As anticipated, previously announced deals in the final stages of negotiations did close but new deal activity slowed some in the second quarter. According to Fidelity’s Wealth Management M&A Report, M&A activity in January and February kept pace with 2019 levels but fell off in March, April, and May. There were 24 transactions involving RIAs with over $100 million but less than $20 billion in AUM announced in Q2 2020 (and many of these deals were announced in June 2020).  Still, this represents a decline in M&A activity compared with last year, as shown in the chart below.[caption id="attachment_32836" align="aligncenter" width="675"]Source: Fidelity Wealth Management M&A Transaction Report; Complied by Mercer Capital[/caption] Interestingly, in the second quarter of 2020, independent RIAs, rather than consolidators, drove much of the deal activity.  Over the last few years, we have written about RIA consolidators time after time: 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 (January 2018)Several trends which have driven the uptick in sector M&A in recent years continued into 2018, including increasing activity by RIA aggregators (January 2019)RIA consolidators now account for about half of wealth management acquisition activity—and that percentage has been increasing (January 2020) In the second quarter, two independent RIAs—The Mather Group (TMG) and Creative Planning—accounted for approximately 21% of the total transactions announced, while consolidators accounted for only 17% of the deals. The Mather Group (an independent wealth management firm with seven offices around the U.S.) announced its sixth acquisition in the last 18 months on June 16, 2020, only one week after announcing a previous acquisition.  The acquisition of Knoxville-based Resource Advisory Services, with $116 million in AUM, will bring TMG’s AUM to over $3.9 billion.  TMG’s acquisition of Resource Advisory Services is indicative of a few M&A trends. First, in a relationship-driven business such as wealth management, the fastest way to expand a firm’s footprint is often through acquisitions.  TMG has been working to expand its footprint into the Southeast and this acquisition is a sensible addition to their recent acquisition of Atlanta-based Barnett Financial.  Additionally, this acquisition highlights a struggle many RIA owners face: a need for scale but a hesitation to partner with PE-backed firms who have a reputation for pushing growth at all costs.  Many RIA principals need a succession plan, and private equity capital isn’t always the right answer.  Resource Advisory Services’ founder David Lewis said, “I’m thrilled to partner with a next-generation founder who isn’t private-equity backed, and feel very confident TMG’s long-term vision will support my advisors into the future.” Creative Planning, based in Overland Park, Kansas, is one of the nation’s largest independent RIAs, announced three deals in the second quarter. Its most recent acquisition of Starfire Investment Advisers ($560 million AUM) was Creative Planning’s eighth deal in 2020 and its twelfth deal since it started on its acquisition spree last year.  Creative Planning organically grew its AUM to $48 billion and since February 2019, has added another $5 billion in AUM through acquisitions.  We expect to see more acquisitions from Creative Planning as it strives to reach $100 billion in AUM and become more of a household name.  While Creative Planning is a driver in the trend of consolidation, it differentiates itself from traditional RIA consolidators by acquiring 100% of target companies and integrating them into the Creative Planning brand and investment philosophy.  Additionally, while it is PE-backed, NY based General Atlantic holds a non-controlling minority share. Creative Planning’s M&A activity and investment from General Atlantic makes us ask: When does an RIA shift from being an independent wealth manager to an acquirer of independent wealth managers?  Mercer Advisors (no relation) seemed to make this transition when it first started buying RIAs in 2016.  Since then, it has acquired around 30 advisory firms and has financed its acquisition activity by selling a sizeable stake in the company to PE firm Oak Hill Capital Partners while maintaining an investment from Genstar Capital. The line between independent wealth manager and consolidator can be murky, but the trend this quarter was clear.  Established consolidators, who primarily rely on debt financing or capital from PE firms, slowed acquisition activity in the second quarter.  Dynasty Financial announced two deals in Q2, Focus Financial and Mercer Advisors each announced one deal, and Wealth Enhancement Group and HighTower Advisors did not report any deal activity in the second quarter – while strategic acquisitions by independent RIAs continued. RIA consolidators who use leverage to buy RIAs were much more vulnerable to the decline in the market at the end of March.  Most RIA consolidators have never been through a market downturn and their balance sheets may have not been as well-capitalized as needed to handle what many expected to be a few bad quarters and potentially years.   With leverage on the balance sheet, interest coverage ratios became a concern for consolidators and the downturn in March likely served as a warning for aggregators to reevaluate their balance sheets.  Most independent RIAs, on the other hand, have lived through market downturns previously and had capital built up to slug through a few bad quarters. Some even had the capital to acquire firms when competition from other buyers temporarily eased.Outlook for RIA M&AWhile RIA M&A did slow some in Q2, we don’t expect that this slowdown will continue as M&A activity picked up in June.  We have been contacted by several RIA principals who are using this time to reconsider their buy-sell agreements and their plans for their firms.  These conversations often prompt strategic discussions which can pique some firms’ interest in making acquisitions, can guide others down a path of internal succession planning as they prepare for retirement, and can serve as a wakeup call to others who are tired of dealing with the volatility inherent in many RIA practices.  We also hope that the recent downturn and lack of activity from RIA consolidators will lead buyers to proceed with more caution when partnering with leveraged consolidators.  Amid a market downturn, when RIA principals should be focused on servicing client assets, the charge to save margin to meet interest coverage ratios will trickle down to the principal of those RIAs.

It probably doesn’t feel like it, but most RIA stocks are up over the last year.  Over this time, we’ve had two bull markets and one bear market in one of the most volatile twelve-month periods that I can remember.  This volatility has been especially beneficial to alternative asset managers since hedge funds are usually well-positioned to take advantage of variability in security prices.  The aggregators are the only segment of RIAs that are down over the last year since their models rely on debt financing, which exacerbated their losses during March’s sell-off.Last quarter showed the positive side to leverage as aggregators bested all other classes of RIAs during generally favorable market conditions in April and May.  Other investment managers also fared well since collective AUM and ongoing revenue recovered with the market over the quarter.  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 gained about 20% over the quarter.The recent uptick is promising, 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.  The 11-year bull market run masked these issues (at least ostensibly) as AUM balances largely rose with equities over this time.  Finally faced with a market headwind, the bull market for the RIA industry came to a grinding halt in March before rallying again in April and May.As valuation analysts, we’re typically more concerned with how earnings multiples have changed over this time since we often apply these cap factors to our subject company’s profitability metrics (after any necessary adjustments) to derive an indicated value.  These multiples show a similar rise in Q2 after a sharp decline in the first quarter. There are a number of explanations for this variation.  Earnings multiples are primarily a function of risk and growth, and risk has waned since March’s run-up and growth prospects have recovered.  Specifically, future earnings are likely to increase with the recent rally, so the multiple has picked up as well since March’s bottom.  Conversely, the decline in Q1 reflected the market’s anticipation of lower earnings with falling AUM and management fees.  The multiple usually follows ongoing revenue, which is simply a funtion of current AUM and effective fee percentages, as discussed in a recent post. Implications for Your RIADuring such volatile market conditions, the value of your RIA largely depends on 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.  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 20% in the first quarter (see chart above) before gaining just as much in the second to end up back in the same spot as year-end.  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 appraisal, while being careful not to count good or bad news twice.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 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 couple of months.  AUM has risen with the market over this time, and it’s likely that industry-wide revenue and earnings have as well though year-end is still a high water mark for many RIAs.  July has been kind so far, but who knows where the back half of 2020 will take us in a wild year for RIA valuations and overall market conditions.

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

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

By the middle of March, most RIA owners were hunkering down for what looked to be the next recession.  By the end of March, the S&P 500 had fallen approximately 24% from its all-time high of 3,386 on February 19, 2020 to 2,585 on March 31, 2020.  By the middle of June, however, the stock market and most RIAs’ assets under management have recovered to where they were about a year ago.  While we gave up the gains of the final year of an 11-year market run up, the market and income statements of most RIAs look much the same as they did 18 months ago.  Despite this, most RIA principals feel they are in a very different position than they were a year ago.Due to the COVID-19 global pandemic, the future of the economy has become more uncertain. The VIX, which calculates the expected volatility of the U.S. Stock market, hit a new all-time high on March 16th of 82.69, which was higher than the peak during the financial crisis in 2008.   The recent VIX measure is especially noteworthy given the comparatively sleepy decade which preceded it.If one thing has become more clear, it’s that market volatility is here to stay – at least for a while.  In this post, we explore what this volatility means for you and for your RIA.AUM, aka Revenue Base, is More VolatileFor RIAs that charge fees on a quarterly basis, the fees charged on March 31, 2020 will be significantly lower than the fees charged as of June 30 (barring any significant decline in the market over the next 7 days – which is not out of the question).  Many RIAs have quickly adjusted to this new normal.  Rather than charging fees quarterly, which makes them more susceptible to the large swings in the market, they have switched to charging fees on a monthly basis.Active Managers May be Able to Exploit Mispricing in the MarketDuring times of increased volatility, active managers are generally able to take advantage of the swings in stock valuations away from fair value, allowing them to realize increased returns for their clients.  This may be more difficult in the current market as the volatility today is not just driven by increased “fear” in the market, but a lack of liquidity in our financial system.Over the last few months, bid-ask spreads have widened, and trading volumes have generally declined.  A lack of liquidity in market structure is associated with increased risk.  In a less liquid market, it is more likely that you could get stuck in a losing position.  Additionally, in less liquid markets, prices tend to overreact, making market moves less informative.  While there are more winning opportunities presented to active managers, there are also more losing ones.Sector-Specific Managers are Missing OutMost of the recovery in the market since the March decline is attributable to the resilience of tech stocks.  Investors are willing to bet that tech companies, such as Microsoft and Apple, will emerge from the COVID-19 pandemic stronger than before.  Just five stocks - Microsoft, Apple, Amazon, Google parent Alphabet, and Facebook - account for more than 20% of the market cap of the entire S&P 500 index, according to BofA Global Research.  This means that asset managers without exposure to the tech industry are likely lagging the broader market, as measured by the S&P 500.Internal Transactions Have Been CanceledMost sellers of RIAs are currently unwilling to sell at the pricing implied by valuations as of March 31, 2020, which likely did not forecast the quick recovery in equity markets in April.  Additionally, the next generation of leadership is likely not currently in the financial position to take on additional risk.  Rather, many households are decreasing risk as they prepare for the possibility of another global recession.External Transactions are on PauseUnlike the slowdown in M&A in many other industries, the stall in deal activity in the RIA space is not due to a lack of financing.  Rather many deals have been put on hold as the due diligence process is impeded by travel restrictions meant to limit the spread of COVID-19.   While most business and due diligence can be conducted over Zoom calls, it’s hard to actually sign an eight-figure check without having ever stepped foot in the main office of the company you are buying.  And most sellers don’t want to hand their businesses over to someone they haven’t actually met.Planning is More Important Than EverDuring this time when the outlook for global markets, the economy, and one’s own health and financial well-being is uncertain, many RIA principals are working to nail down the unknowns associated with business ownership.  RIA principals are devoting more time to working on their buy-sell agreements in an effort to protect the working relationships with their partners and ensure they and their families are protected financially in the event of a divorce, partner dispute, disablement, or death.The current environment is ripe with uncertainty. This presents both challenges and opportunities for principals of investment management firms.  As we all know, this will eventually pass, so most of our clients are focused on positioning rather than acting.

One of our first blog posts addressed the fallacies of rule-based valuation measures in RIA transactions.  Our position hasn’t changed, but these so-called rules of thumb have certainly evolved over time.In a recent podcast with Michael Kitces, industry transaction specialist Elizabeth Nesvold of Raymond James explains the history and rationale behind these changes.  For this week’s post, we’ll discuss this evolution and why such measures are usually more misleading than meaningful.Ten to twenty years ago, it was just assumed that all RIAs were worth 1-2% of AUM.  At that time, many RIAs were able to charge 1% of AUM for their services, so a valuation of 1-2% of AUM equated to a 1-2x multiple of revenue, which was also thought to be a reasonable estimate of value.  Over the last decade, AUM-based valuations have broken down with fee compression and the proliferation of non-asset-based sources of revenue.  The example below illustrates how AUM multiples break down for firms with different fee structures and revenue sources. Firm A charges higher fees and has other sources of income.  Its revenue yield (total revenue as a percentage of AUM) is therefore much higher at 1.1% (versus 0.3% for firm B), so a 2% of AUM valuation translates into a 1.8x revenue multiple, which is within a range often observed for investment management firms.  Firm B, on the other hand, charges lower fees and has no alternate source of revenue, so a 2% of AUM valuation would be nearly 7x revenue, well above a reasonable valuation estimate for most RIAs.  Mathematically, the AUM multiple is the product of the revenue multiple and the revenue yield (e.g. 2% = 1.1% of 1.8x for Firm A), so this measure varies directly with realized fees. As fee schedules changed, many RIA owners began valuing their businesses with revenue multiples.  This approach isn’t much better as it ignores how efficiently the business is managing its costs.  Firms with similar levels of revenue can have drastically different EBITDA margins, so blindly applying the same revenue multiple to all of them can lead to nonsensical valuations. Applying a 2x revenue multiple to a low margin RIA like Firm D would likely overvalue the subject company since it would imply an unrealistically high multiple of earnings or cash flow.  Just like AUM multiples vary with realized fees, revenue multiples are directly proportional to profit margins since these cap factors are the product of EBITDA multiples and profit margins (2x revenue multiple= 40% EBITDA margin times a 5x EBITDA multiple for firm C). Because of these shortcomings, many industry analysts now use earnings multiples to value RIAs.  We consider cash flow metrics superior to AUM and revenue measures since earnings multiples take into account realized fees and profit margins.  Earnings multiples are directly related to growth prospects and inversely related to risk, so valuing all RIAs with the same profitability multiple can be problematic as well.  Investment management firms can have radically different risk profiles due to varying customer concentrations, manager dependencies, and regulatory pressures.  Growth prospects also vary with scalability, capacity limitations, and new business development.  Applying a one-size-fits-all earnings multiple to businesses with varying risk profiles and growth prospects will lead to inaccurate valuations. The appropriate multiple also changes over time.  This is true for all industries but is especially true for RIAs, whose business is tied to market conditions, which have been highly volatile in recent years.  The EBITDA multiple for publicly traded RIAs with under $100 billion in AUM has been cut in half in the last two years, so if your firm was worth 8x in 2018, all else equal, that’s probably no longer the case, as depicted in the graph below. Even though the multiple has changed, the methodologies for valuing investment management firms remain the same.Most RIA appraisals include a discounted cash flow (DCF) analysis and a market methodology involving publicly traded investment managers or industry transactions if there are sufficiently similar companies with reported financial metrics.  Rules of thumb are overly simplistic and often lead to nonsensical appraisals.The reality is that there is no magic formula for valuing RIAs, so try not to fall into that trap.  Any reasonable appraisal of your business will include a careful study of trends in asset flows, realized fees, profit margins, client retention, investment performance, stock transactions, shareholder agreements, and budgeted financial performance, among other things.  It’s a lot to keep up with, but we’re happy to walk you through it.

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

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.

After appearing on our Family Business Director Blog earlier this month, we decided to share this post as it provides useful guidance on assessing whether a family office is right for your family. Private investment office…  Family business advisor... Single-family office… The name differs and the definition varies greatly depending on whom you ask.  But the concept remains the same.  Wealthy families often seek assistance to manage their accumulated wealth, organize family affairs, and preserve capital for future generations.The concept of a family office dates back as far as 27 BC.The concept of a family office dates back as far as 27 BC when Emperor Augustus Caesar, who at the time controlled approximately 25% of global GDP, employed a group of appointees to manage his estate, businesses, military, and even lifestyle.  The concept continued to evolve in the sixth century when it was common for the king’s steward to manage the royal family’s wealth.  However, the modern family office, as we know it today, took shape in 1882 when the Rockefeller family (with approximately $1.4 billion, equating to around $255 billion today) founded their family office to organize the family’s business operations and manage their investment needs.A family office is different than a traditional wealth management firm.  A family office typically provides a full suite of services including accounting, budgeting, family education, investment management, insurance, charitable giving, and sometimes even concierge services including travel arrangements, personal security, and miscellaneous other household services. However, it is hard to define the “typical” family office as most develop out of a family’s specific needs.  Additionally, many wealthy families likely employ professionals who carry out such duties, without necessarily defining or even realizing their function is similar to a single-family office.Single-Family Office vs. Multi-Family OfficeA single-family office is tailored to meet your family’s specific needs. However, to warrant the cost of a single-family office, a family’s assets likely must exceed $100 million, and to afford a full investment practice, assets likely must exceed $250 million.  As such, the multi-family office took shape to provide similar services to ultra-wealthy families (typically those with assets in excess of $25 million), while allowing for cost-sharing between multiple families.  A multi-family office can be commercially owned by a group of outside investors or privately owned by a founding family with significant wealth.  For example, the Rockefeller family office, which has served the Rockefeller family for almost 140 years, recently expanded its services to over 250 clients.There are key legal and regulatory differences between a single-family office and a multi-family office.  Because single-family offices serve only one family, they are not registered with the SEC (the Investment Advisor Act of 1940 made single-family offices exempt from SEC registration). Multi-family offices, on the other hand, are typically structured as registered investment advisors (RIAs), which are registered with the SEC, or trust companies, which are typically regulated at the state level.Additionally, a single-family office’s main goal is to preserve and generate wealth for the family. Whereas a multi-family office also seeks to generate a profit for itself.  This results in a somewhat lower return on assets for families belonging to a multi-family office as the profits are split between the families and the ownership base.  We have compiled what the average income statement for a single-family office and multi-family office looks like to highlight this difference. [caption id="attachment_31050" align="alignnone" width="784"]Charts Compiled by Mercer CapitalData per The Global Family Office Report 2019AUM = Global Average AUM for SFOs and MFOs Portfolio Return = Average Family Office Portfolio Return from Q1/Q2 2018 through Q1/Q2 2019 in N America Expenses = Average Global Expenses for SFOs and MFOs[/caption] As shown above, the total return on assets managed by a single-family office (5.2%) is slightly higher than the return on assets managed by the multi-family office (4.9%).  The return generated by the multi-family office, however, is sensitive to our assumption of fees charged for family office services.  We have estimated multi-family office fees to be 1.0% of AUM.  Family offices have varying fee structures but typically include a combination of fixed fees, hourly fees, and asset-based fees.  While these asset-based fees typically range between 50bps to 100bps, for comparability, we have assumed a fee at the higher end of this range to provide an estimate for comprehensive services such as would be provided by a single-family office.Investment Performance At first glance, the average return for the portfolio (5.9% for the twelve months ended Q1/Q2 2019) appears rather low, given that wealthier individuals typically have a greater ability to take risk, leading to generally higher returns.  However, keep in mind that family offices don’t just manage an individual’s investable assets, as does a typical wealth manager from whom you would likely expect a 7%-ish return.  A family office generally manages a family’s entire portfolio, including cash.The “average” portfolio for a family office is shown below. [caption id="attachment_31052" align="alignnone" width="851"]Source: The Global Family Office Report 2019[/caption] Recently, family offices have started investing in more diverse and riskier products, such as private companies and distressed debt, that have typically been reserved for institutional investors.  Family offices have reduced their allocation to hedge-funds over time, unable to justify such high fees for often mediocre performance and have reallocated these funds to direct investments in debt and equity.  Over the last few years, family offices have become somewhat of a disruptive force in the private equity and venture capital space as they are able to offer competitive pricing and terms since their holding periods are longer than the typical private equity fund and they have more flexible investment criteria than a private equity firm who may be working to manage the expectations of hundreds of investors, instead of one family.Growing Presence of Family OfficesEducating your family about how your wealth and/or family business is managed is essential for the preservation of your family legacy.In the 1980s family offices started to multiply as the number of families who were able to afford such services increased the concept. In 2018, EY estimated that there were approximately 10,000 single family offices worldwide, a ten-fold increase over less than a decade.  Looking forward, the number of single and multi-family offices is expected to continue increasing as the number of wealthy families grows and investor preferences continue to shift towards having more control over one’s own wealth.  While family offices are more streamlined than traditional investment firms there are some obvious drawbacks of mixing business and family.  This is why family education and communication is so important.  Educating your family about how your wealth and/or family business is managed is essential for the preservation of your family legacy.As the family office continues to evolve and wealthy families have more options when it comes to managing their wealth, it will be increasingly important for families to ask who can help them best align the family’s interests, making it easier to operate your business, cooperate with other family members, and allow yourself more time to do what is important to you.

Believe it or not, the S&P 500 is exactly where it was a year ago.  It’s been a wild ride, but most diversified investors probably haven’t done as bad as they think during this time.  Unfortunately, that’s not the case for the RIA industry, which is still reeling from the Coronavirus pandemic and numerous other industry-specific headwinds.  Such a divergence is unusual for an industry tied to market conditions, so this week we analyze the driving forces behind this disparity.From a quantitative perspective, most of this deterioration is attributable to rising cap rates.  Earnings multiples (the inverse of cap rates) tend to follow trends in AUM, which are leading indicators for future revenue and profitability.  The market fall-out in the first quarter precipitated a sharp decline in AUM and lowered expectations for future management fees and cash flow.  Trailing twelve month multiples shrank to all-time lows in anticipation of much weaker earnings reports over the next few quarters.  Smaller RIAs have generally fared worse as lower margins and AUM provide less of a cushion against adverse market events.The earnings decline is a bit more intuitive.  The bear market triggered declines in AUM and management fees, which combined with a bit of operating leverage has created margin pressure for most of these businesses.  The cumulative effect of a 10%-15% earnings decline and a 30%-35% multiple contraction is a sharp contraction in equity prices.The recent pullback is certainly a catalyst but not the only culprit here.  Pre-COVID, the industry was already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products.  The 11-year bull market run masked these issues (at least ostensibly) as AUM balances largely rose with equities over this time.  Finally faced with a market headwind, the bull market for the RIA industry came to a grinding halt last quarter.A notable exception in the RIA space is the alt asset sector.  Many of these businesses have actually thrived in the current environment as their AUM is typically not directly tied to equity market conditions.  As a result, they generally did not fare as well over the last decade relative to more traditional asset managers, but recent events have made most of their asset classes more attractive than public equities.OutlookIt’s difficult to assess how long these divergent trends in pricing will hold up.  We’d expect some mean reversion over time, though alt managers should continue to outperform other classes of RIAs in a bear market with elevated levels of volatility.  If, on the other hand, we get more months like April, we should see a bounce in traditional asset manager multiples.  Unfortunately, May hasn’t been so kind.The trends in earnings multiples are a bit more revealing.  Falling cap rates suggests a more promising outlook for alt manager cash flows, though it varies by asset class.  A hedge fund that thrives on volatility, for example, should fare much better than, say, an MLP or commodity investor.  The sharp decline in small cap RIA multiples so far this year tells us that the market is anticipating drastically lower levels of profitability for many of these businesses.  The recent bear market compounded the prevailing headwinds pertaining to asset outflows and fee pressure, and several publicly traded RIAs have lost over half their value over the last year.Implications for Your RIAYear-to-date, the value of your RIA is most likely down; the question is how much.  Some of our clients are asking us to update our year-end appraisals to reflect the current market conditions.  There are several factors we look at in determining an appropriate level of impairment.One is the overall market for RIA stocks, which is down 20% in the first quarter.  The P/E multiple is another reference point, which has endured a similar decline.  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 diminished over the quarter while being careful not to count bad news twice.We also evaluate how our subject company is performing relative to the industry as a whole.  Fixed income managers, for instance, have held up reasonably well compared to their equity counterparts.  We also look at how much 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.  On balance, it’s a lot to keep up with, and we’re happy to walk you through it if you’re considering a valuation.

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

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.

The outlook for RIA M&A has changed rapidly since 2020 began. Coming off of a record year, DeVoe postulated in January that "RIA M&A could hit over 40 transactions per quarter in 2020” saying that “the pace of deals was a testament to the health of the industry.” Until late February, DeVoe’s estimation seemed feasible as industry experts contemplated what the Franklin/Legg Mason deal and Morgan Stanley’s purchase of E-Trade meant for the industry, and we wrote about Creative Planning’s sale of a minority interest to PE firm General Atlantic.Today, however, as many of us work from makeshift home-offices, RIA principals have shifted their focus from strategic planning including M&A to ensuring their workforce is safe and healthy, their client service is unwavering, and their firm still exists on the other side of this bear market.In this post, we look back at RIA transactions that occurred in Q1 2020 and venture what M&A will look like over the rest of the year.Review of M&A in Q1 2020According to Fidelity Investments, there were thirteen deals between wealth managers in January totaling $18.9 billion in client assets. The largest of these deals by AUM was Fiduciary Trust Company’s acquisition of Athena Capital, which has $5.8 billion of AUM. This deal pales in comparison to Fiduciary Trust Company’s parent, Franklin Templeton’s, acquisition of Legg Mason (LM), with $1.5 trillion in AUM, for approximately $4.5 billion. These two deals highlight the differing motivations driving transactions in the RIA space.Partnering with those who already have relationships in a target market is often a faster growth strategy.Fiduciary Trust Company’s acquisition of Athena allowed the company to strengthen its foothold in New England where it already has about $2 billion in client assets. Many RIAs seeking to grow geographically have turned to acquisitions rather than growing organically. Since wealth management is a relationship-driven business, partnering with those who already have relationships in a target market is often a faster growth strategy than building these relationships in new markets on your own. Additionally, Fiduciary Trust Company’s acquisition expanded its product offerings for high net worth and ultra-high net worth clients.The Franklin/LM deal highlights one of the biggest drivers of M&A in the investment management space: achieving scale. There is significant operating leverage in the asset management business, and the Franklin/LM combination created a $1.5 trillion money manager poised to take advantage of this. While management of both companies asserted that there would be no personnel changes after the deal was finalized, back office synergies will likely lead to cost savings that will increase returns to investors.Additionally, in the first quarter of 2020, we continued to see deals driven by RIA consolidators such as Focus Financial and Beacon Pointe who are able to provide scale through back office integration and a solution for ownership succession planning.Outlook for RIA M&A By the end of the first quarter, the tone of discussions in the industry had changed. As of March 31, 2020, the S&P 500 had fallen by 20% since the beginning of the year, and publicly traded RIAs suffered their worst quarter since the financial crisis. The outlook for RIAs depends on a number of factors, but the one commonality is that RIAs are all impacted by the market. The decline in the market, and in turn, in RIAs’ revenue has led industry commentators to ponder the likely impact on deal volume and valuations.Pace of M&A Activity After thirteen wealth manager deals were announced in January, activity slowed with seven deals in February and three deals in March 2020. Although deals become riskier in volatile and bear markets, they don’t happen overnight. The deals that closed in March were likely being negotiated in November and December of 2019. Given the lag between deal negotiations and the signing/closing of a transaction, it’s likely that the decline in deal volume from January to March doesn’t fully reflect the new market reality.While we do not expect deals that are in the final stages of negotiations to be canceled, we do expect there to be a slowdown in new deal activity in 2020 as firm principals, RIA consolidators, and outside investors try to conserve capital and project the length of the downturn and the associated impact on RIA revenues and profit.While financial markets are currently suffering, markets are not down because of blemishes within our financial systems.Historically, recessions have corresponded with lower deal volume. According to McKinsey, “Since 1980, U.S. recessions have led to steep declines in the value of global M&A activity—typically, of around 50 percent during the first year.” We saw this in 2008 as deal activity slowed at the start of the last recession. However, it is important to recognize the limitations of comparing the current market downturn to the last recession, which was caused in part by excess leverage and a lack of regulation in the financial industry. Credit markets essentially collapsed and funding for M&A was suddenly much harder to come by. While financial markets are currently suffering, markets are not down because of blemishes within our financial systems.Deal activity in the RIA industry during this market downturn could be propped up by recent expansion of available capital in the space. M&A volume has increased in recent years as RIAs have gained more access to capital, both equity and debt. It is still too early to know if access to capital will decline. A recent article by Financial Planning predicts that PE money will not dry up. Rather, Echelon founder Dan Sievert believes, PE funding is “going to save the industry.” He predicts PE investors will continue to invest in RIAs and “[S]woop up any companies that are falling on hard times.”There may still be some difficulty finding financing for very large transactions. In 2008, not a single “mega-deal” (value of over $10 billion) was announced. Understanding that “mega-deals” within the RIA space may be defined slightly differently, we still expect there to be a slowdown in larger deals, of which we saw many over the last twelve months. Further, consolidators may reduce the size of their typical transaction as financing for these smaller deals is easier to come by, and a multitude of smaller deals instead of singular larger deals can serve as a means to diversify risk in this volatile operating environment.You Name the Price, I’ll Name the TermsWhile deal multiples may not fall, we do expect deal structures to change.The RIA Deal Room, published by Advisor Growth Strategies before the COVID-19 pandemic, recently asked if “valuations [were] rising due to better financial results, expanded multiples, or both?” They found that “the data suggest that valuations increased for 90% of RIA firms due to sustained financial performance. […] From 2015 - 2018, the median adjusted EBITDA multiple was 5.1, and there was less than 10% positive or negative variation in the yearly median results.”We don’t expect multiples to decline drastically, instead we expect that deals will be structured to more evenly distribute risk between the buyer and the seller through the use of earnouts.A decline in announced deal value in 2020 will likely come as a result of a decline in performance driven by an overall decline in the market, rather than a decline in deal multiples. As Matt Crow explained in a recent podcast, we don’t expect multiples to decline drastically. Instead, we expect that deals will be structured to more evenly distribute risk between the buyer and the seller through the use of earnouts.More than 70% of RIA transactions in 2019 were structured with some form of an earnout and, on average, sellers paid 30% of total deal proceeds as an earnout. Of those deals structured with an earnout, the payments were typically made over three years or less. Given the new uncertain operating environment for RIAs, we expect that more deals will involve some form of contingent consideration and less of the deal consideration will be paid at closing.Additionally, given the current volatility, we expect there will be an increase in the number of deals structured as stock deals. In a volatile operating environment, it can be easier to close a stock deal since the price (value of the shares) essentially moves as the market does.ConclusionIn summary, we expect that deal volume will slow over the next few months, but as Think Advisor recently noted, this slowdown is not necessarily bad news for the industry. During the slowdown “RIAs should take the opportunity to consider how M&A efforts perpetuate the broader objectives of an advisory firm.”Although we expect activity to slow, M&A activity will not come to a grinding halt. Owners of RIAs who find themselves near retirement and without a succession plan will still consider selling their firm. Additionally, the need for operating leverage that is achievable through scale becomes more pronounced in bear markets.The less leveraged RIA consolidators are uniquely positioned to partner with RIAs in bear markets as they are able to offer more operating leverage through back-office infrastructure. Additionally, as these consolidators are often PE-backed, they should still be able to find funding in a bear market.

Last quarter we blogged about how great 2019 was for the RIA industry.  Recent events have rendered that blog post largely irrelevant, as discussions in the industry are now centered on how the COVID-19 global pandemic has impaired RIA valuations.  You can tune into Matt Crow and Mindy Diamond’s podcast for a more in-depth discussion on COVID’s impact on the industry, but this post summarizes the effect it has likely had on RIA valuations.The chart below shows there was nowhere to hide last quarter, as all four components of the RIA industry dipped into bear market territory.  The primary driver behind the decline was the decline in the market itself, as most of these businesses are primarily invested in equities, and the S&P was down 20% over the quarter.  The aggregators are down a bit more since their models rely on debt financing, which exacerbates losses during times of financial strain.Pre-COVID, the industry was already facing numerous headwinds including fee pressure, asset outflows, and the rising popularity of passive investment products.  The 11-year bull market run masked these issues (at least ostensibly) as AUM balances largely rose with equities over this time.  Finally faced with a market headwind, the bull market for the RIA industry came to a grinding halt last month.Regardless, this bear market has to be placed in proper context.  It’s hard to believe, but the industry (excluding the consolidators) is pretty much right where it was a year ago in terms of market caps.  We basically just gave up the gains made in the back half of last year though the decline was far more rapid.As valuation analysts, we’re typically more concerned with how earnings multiples have changed over this time since we often apply these cap factors to our subject company’s profitability metrics (after any necessary adjustments) to derive an indicated value.  These multiples show a similar decline in Q1 after a sizeable increase in the fourth quarter of last year.There are a number of explanations for this variation.  Earnings multiples are primarily a function of risk and growth, and risk has undoubtedly risen in the last couple of months while growth prospects have diminished.  Specifically, future earnings are likely to decline with AUM and revenue, so the multiple has pulled back accordingly.  Conversely, the run-up in Q4 reflected the market’s anticipation of higher earnings with rising AUM and management fees.  The multiple usually follows ongoing revenue, which is simply a function of current AUM and effective fee percentages, as discussed in last week’s post.Implications for Your RIAYear-to-date, the value of your RIA is most likely down; the question is how much.  Some of our clients are asking us to update our year-end appraisals to reflect the current market conditions.  There are several factors we look at in determining an appropriate level of impairment.One is the overall market for RIA stocks, which is down 20% in the first quarter (see chart above).  The P/E multiple is another reference point, which has declined 22% so far this year.  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 diminished over the quarter while being careful not to count bad news twice.We also evaluate how our subject company is performing relative to the industry as a whole.  Fixed income managers, for instance, have held up reasonably well compared to their equity counterparts.  We also look at how much 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.Diminishing 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 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 diminished with market conditions over the last couple of months.  AUM is down with the market, and it’s likely that industry-wide revenue and earnings declined with it.  April has been kinder, but volatility remains.If the bid-ask spread between you and your partners has been too high to get a deal done, it may time to re-examine your price expectations.  The next generation of ownership may be enticed by more attractive valuations and return to the negotiating table, so knowing your firm’s worth may be more important than ever.  We’re happy to walk you through that.

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

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.

Historically, the role of a trust was simply for one party (the trustee) to hold property for the benefit of another (the beneficiary). Over time the role of trust companies has expanded to include managing the distribution, administration, and investment of trust assets.  Fifty years ago, most local banks had a trust officer who performed these services.  Consolidation in the banking industry, changing consumer preferences, and favorable trust law changes in states such as Delaware, Nevada, and South Dakota have led many bank trust officers to leave their local bank and start independent trust companies.  (This shift parallels the shift from the broker-dealer to independent RIA model.)As trusts have become more sophisticated, independent trust companies have become increasingly specialized with respect to trust administration.  Many independent trust companies today focus on specialized types of trusts or beneficiaries.  As part of this trend, trust companies are increasingly outsourcing investment management in order to focus on fiduciary issues.More trust companies are now shifting to a directed trustee model, which absolves the trustee of certain fiduciary responsibilities.  With a directed trust an investment advisor is named on the account so that investment decisions are made by the appointed advisor rather than the trust company.  This allows the trust company to focus on fiduciary issues related to trust and estate administration rather than investment management.  Typically, a directed trustee model calls for slightly lower fees, but much less liability for the trust company.The alternative is a delegated trustee model, where the trustee can delegate fiduciary authority to an investment advisor, as they see fit.  However, in this model, the trustee is responsible for properly vetting the investment advisor and supervising their decisions.The Typical Independent Trust CompanyA trust company’s revenue is a function of assets under administration and its fee schedule.  Expenses generally consist of personnel expenses and fixed overhead costs.AUA.  Over $120 trillion of assets are administered by domestic trust companies /departments.  It is estimated that approximately $18 trillion of assets are administered by independent trust companies, with each, on average, administering $1.5 billion.  Generally, assets under administration (AUA) growth has been highest within the non-managed (delegated or directed) trustee model.Fees. While the rest of the investment management industry has been dealing with fee compression, trust fees have been increasing. Independent trust companies have typically been more willing than bank’s trust departments to increase fees.  Thus, as customers move assets from trust departments to independent trust companies, we expect fees across the industry will continue increasing.Wealth Advisor reported that on average companies charge around 50 basis points per year for vanilla trust services. Trust companies typically don’t require minimum account sizes, but instead require minimum annual fees, which can range from $1,000 to $20,000 depending on the services offered.  Fees are typically structured on a sliding scale, where the first million could be charged 60 bps, the next million could be charged 50 bps, and the next million 40 bps, etc.  If the trust company also manages the underlying assets, fees will of course be higher.  However, larger clients tend to receive discounts, which can correspond to low fees by industry standards, but substantial revenue given the size of the account.Expenses: The relationships between independent trust companies and their clients require the time and energy of a dedicated staff.  Thus, most of a typical independent trust company’s expenses are personnel expenses, which include salaries, bonuses, and other benefits for employees and officers.  Compensation generally tracks revenue fairly closely, making operating leverage more pronounced with overhead costs than compensation related expenses.Overhead costs for trust companies are generally fixed in nature, which allows trust companies to take advantage of operating leverage over time.  Overhead costs include the cost of compliance, technology, and marketing expenditures all which have been increasing over the last few years.  We have seen an increased focus on branding as trust companies seek to connect with clients on a more personal level.  Additionally, corporate trusts can have significant litigation costs from year to year.How Does Your Trust Company Measure Up? Bringing everything together, the average trust company’s income statement looks similar to the one outlined below.Charging slightly under 50bp on $1.5 billion in assets, the average trust company generated $7 million in revenue in 2019.  With an average operating margin of approximately 37%, the average independent trust company had $2.6 million in operating profit, which it could distribute out to its ownership base or invest in new technology or marketing initiatives.A Better ModelAlthough some view the trust industry as mature, the industry has changed significantly over the last decade.  The average client today looks different than the average client did ten years ago, which means the average trust company has changed as well.  The interests of trust companies and their clients are better aligned today than they were when trust officers worked for the local bank rather than the client.  More time is being spent addressing the actual needs of clients, as technological advancements have freed up time and improved service offerings.  This new directed trustee model benefits both the client and the trust administrator which is evidenced by the increase in dollars under administration in non-managed trusts.

February was a record month for headline transactions in the RIA industry.  Peter Mallouk sold a substantial stake in Creative Planning to PE firm General Atlantic on February 12.  Less than a week later, 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 ago.Interestingly enough, the smallest and least heralded deal, General Atlantic’s minority interest purchase of Creative Planning, is probably the most notable from our perspective since our clients are typically more similar to CP than Franklin, E-Trade, and LM in terms of size and product offering.Still, we can’t dismiss the implications of these larger transactions and what they say about two sectors of the investment management industry that many analysts believe are dying – active management and discount brokerage.  The Franklin / Legg deal was touted as being more about “offense not defense” according to Franklin chief Jenny Johnson, who said the acquisition was about building “an all-weather product line-up and world-class distribution platform.”  While that may be the case, the reality is that both firms had suffered significant outflows and increased competition from passive funds.  Combining both firms is expected to generate $200 million in cost savings and stem the tide of waning profit margins.Morgan Stanley’s purchase of E-Trade was likely also a defensive maneuver anticipated to yield approximately $400 million in expense reductions for the Wall Street giant.  It may have also been Morgan Stanley’s counter to Goldman’s purchase of United Capital last Spring in their bid to enter the mass affluent space.  E-Trade’s recent financial woes are primarily attributable to falling commission revenue, which, like active management fees, have been in free fall for quite some time.Both E-Trade’s and LM’s stock price rose over 20% upon announcement, and it naturally leads us to wonder if smaller active managers or broker businesses can expect such a windfall from a prospective acquirer.  Scale still matters for most asset management firms, so consolidation rationales are always going to be there especially for an industry looking to cut costs.  Brokerage firms’ commission revenue is less proportional to client assets, so bulking up just for the sake of it doesn’t make a whole lot of sense.  Many of these businesses are already transitioning to an asset-based revenue model anyways, so we’re seeing fewer acquisitions of brokerage firms in general.Even with asset manager deal-making holding up, the sector’s recent uptick in M&A activity is largely attributable to a growing interest in wealth management firms.  The driving force behind this increase is strong demand from RIA consolidators, PE firms, and strategic acquirers that are drawn to the sector’s recurring revenue model and sticky clientele base.  The lack of internal succession planning is another catalyst as founding partners look to outside buyers to cash out.Despite this uptick, there are still numerous challenges to sustaining this level of M&A growth for the RIA industry.  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.  Minority interest acquisitions (à la Creative Planning) sidestep some of these challenges, but the risks are harder to avoid in control acquisitions.  Well-structured deals and effective integration strategies can help mitigate risks and align interests, but only to an extent.And yet, with over 12,000 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 the coming year.  The current downturn from the Coronavirus could curtail the recent momentum or spur buyers to negotiate lower pricing.  We’ll let you know how it all shakes out.

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

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.

As valuation analysts, we often look to comparable publicly traded businesses (“comps”) to glean an appropriate range of valuation metrics and multiples for the companies we value.  Calling them “comps,” however, is often a stretch, since it is rare that we can find public companies that are truly comparable to the private company we’re trying to value.  The publics are often too large and diverse to be labeled as comps, so we usually seek public companies that are in a similar line of business and call them guideline companies instead.While it’s not unusual for companies in the same guideline group to have divergent share price performance despite facing the same industry headwinds (or tailwinds), publicly traded RIA stock performance can vary dramatically.The past twelve months have been no exception, especially for T. Rowe Price (ticker: TROW), Franklin Resources (BEN), Legg Mason (LM), and Affiliated Managers Group (AMG).  TROW and LM have bested the market and asset manager index while AMG and BEN have fallen well short.Performance Over the Last Twelve MonthsSource: S&P Global Market Intelligence So what’s driving this disparity?  Much of it can be explained by performance net of expectations.  T. Rowe Price and Legg Mason have consistently beat consensus EPS over the last several quarters on steady gains in revenue and earnings.  AMG and BEN have missed Street estimates and recent financial performance has been more volatile. While we would not ordinarily include these businesses in a guideline group (our clients are typically much smaller than these companies), there is a key takeaway from all this variation in stock performance.  Our recurring clients are often surprised when AUM, revenue, and earnings are up year-over-year, yet our valuation of their company goes down.  This usually occurs when these key financial metrics fall short of forecast expectations, and the outlook for the business gets revised accordingly.  This may happen to your clients’ stock holdings, and it’s no exception for the value of your business. We’re sometimes surprised by the variations in RIA share price performance since their revenues are so highly correlated with market conditions.  The reality is that these businesses are unique, and their values can diverge widely on variations in financial performance and the outlook for earnings.  On the qualitative side, new business development, personnel changes, variations in investment performance, and regulatory changes can all drive a wedge in how your business performs relative to your competition.  The market certainly has an impact, but there are many other factors that you and your employees can control. Still, we don’t typically see a 40%+ increase in value (TROW) and a ~25% decline in a bull market (AMG) for two businesses in the same industry, so this disparity is worth a second look.  T. Rowe Price was able to lever a market tailwind with cost-cutting initiatives and net client inflows to its mutual fund business unlike many of its competitors.  AMG, on the other hand, has struggled with the many headwinds facing asset managers and the consolidators that invest in them. Your firm’s value has probably not changed this much over the last year.  You’ve likely benefited from strong market conditions, but industry headwinds persist, particularly on the asset management side.  It’s difficult to assess the net impact of a lot of conflicting forces, especially if you have little or no background in business valuation or corporate finance.  This is why we recommend hiring a valuation firm to appraise your business on a regular basis to gauge your progress and have a feel for what your company could sell for when that day comes.  We’re here to help.

Fidelity recently published a study on M&A activity in the wealth management industry highlighting sellers’ ambitious expectations of the value of their firms.  Fidelity found that sellers today expect EBITDA multiples of between 8x and 10x, even though median deal multiples “are still reasonably close to where they were over the five-year period between 2012 and 2017” - around 5x.  What is causing the discrepancy?  Sellers often focus on “exceptional, highly publicized transaction multiples.”Over the last year, some mergers and acquisitions in the RIA space have touted impressive deal valuations, which many media outlets have highlighted. Echelon Partner’s RIA M&A Deal Report features “deals and dealmakers of the year” with estimated transaction multiples of 8x to 22x EBITDA.  The deal sizes, however, ranged from $600 million to $26 billion.  By contrast, roughly two-thirds of registered investment advisors have under $100 million in AUM.There is typically more information available about these larger transactions than for the sale of a $100 million manager. 5.0x EBITDA doesn’t make as compelling a headline as 18x EBITDA.  But the valuation multiples shown above are by no means normal.  Most smaller deals go unreported, which results in inflated averages for reported deal valuations and inflated expectations for sale prices.Additionally, reported deal values often include a contingent consideration which may never be fully realized.  An excerpt from our whitepaper on The Role of Earnouts in Investment Management M&A illustrates how this can impact seller expectations.ACME Private Buys Fictional Financial On January 1, 20xx, ACME Private Capital announces it has agreed to purchase Fictional Financial, a wealth management firm with 50 advisors and $4.0 billion in AUM. Word gets out that ACME paid over $100 million for Fictional, including contingent consideration. The RIA community dives into the deal, figures Fictional earns a 25% to 30% margin on a fee schedule that is close to but not quite 100 basis points of AUM, and declares that ACME paid at least 10x EBITDA. A double-digit multiple brings other potential deals to ACME and crowns the sellers at Fictional as “shrewd.” Headlines are divided as to whether Fictional was “well sold” or that ACME was showing “real commitment” to the wealth management space, but either way the deal is lauded. The rest of the investment management world assume their firm is at least as good as Fictional, so they’re probably worth 12x EBITDA. To the outside world, everybody associated with the deal is happy.The reality is not quite so sanguine. ACME structures the deal to pay half of the transaction value up front with the rest to be paid based on profit growth at Fictional Financial in a three year earn-out. Disagreements after the deal closes cause a group of advisors to leave Fictional, and a market downturn further cuts into AUM. The inherent operating leverage of investment management causes profits to sink faster than revenue, and only one third of the earn-out is ultimately paid. In the end, Fictional Financial sold for about 6.5x EBITDA, much less than what the selling partners wanted for the business. Other potential acquisition targets are disappointed when ACME, stung with disappointment from the Fictional transaction, is not willing to offer them a double-digit multiple. ACME thought they had a platform opportunity in Fictional, but it turns out to be more of an investment cul-de-sac.The market doesn’t realize what went wrong, and ACME doesn’t publish Fictional’s financial performance. Ironically, the deal announcement sets the precedent for interpretation of the transaction, and industry observers and valuation analysts build an expectation that wealth management practices are worth about 10x EBITDA, because that’s what they believe ACME paid for Fictional Financial. The example above supports Fidelity’s conclusion: sellers of investment management firms often “don’t entirely understand what drives valuation.”  RIA transaction data is haphazard at best.  It’s no wonder why seller’s expectations are inflated if they look only to media sources to understand valuation.  In this post we hope to provide insight to the owners of wealth management firms on how likely buyers value their firm.Cash Flow, Growth, and Risk Valuation firms think of value as a function of cash flow, growth, and risk (or cash flow times a multiple).Sustainable Cash FlowThe first part of the equation is simple.  Higher cash flow (or EBITDA) implies a higher price tag.  But margins have to be real.  Disguising partner compensation as distributions to inflate profitability won’t sell, as buyers are typically sophisticated enough to know there will be a replacement cost for selling partners who retire and want to hand over their responsibilities to someone new.  Low margins are a more obvious red flag, as heavy overhead is difficult to scale down and makes firms vulnerable in down markets.So, margin has most value within what a buyer considers to be a normal range. Fidelity reported the “median operating margin of firms/deals in the past two years was 28%, with respondents saying the ranges for operating margins fell typically between 20 to <30% on the lower end, and between 30 to <40% in the upper end.”There is more mystery involved in the multiple, but it ultimately depends on the growth trajectory and risk profile of your company.  The multiple (and thus the firm’s value) is positively correlated to expected growth and inversely related to risk.Meaningful GrowthAll else equal, a buyer will pay more for an investment manager that is expected to double assets under management in five years, than one in which AUM is expected to double in ten.  Higher growth implies higher future cash flows.Over the past year, AUM at most wealth managers increased significantly as markets surged. However, AUM growth that is entirely a consequence of market activity is not sustainable over the long run. Investment performance does impact value, but buyers of wealth managers view growth in terms of net positive inflows of assets.  Growth driven by market conditions brings short term increases in cash flow.  But growth driven by a new marketing strategy, increased market share driven by a failing local competitor, or a new investment strategy drives long term value.  Manageable Risk A buyer will pay more if the future cash flows are relatively certain but less if there is significant risk that your cash flow could deteriorate post acquisition.In general, there is more risk associated with smaller companies.  Small investment managers typically have a more concentrated client base, are more dependent upon key individuals to generate business, and have less developed marketing and technology infrastructure to support and grow their business.This size/value relationship even exists in firms with much larger scale than the typical RIA. Looking at the implied valuation multiples of publicly traded investment managers, the multiples of managers with under $100 billion of AUM are generally lower than those of investment managers with over $100 billion in assets. This is why highly publicized deal multiples of massive investment managers don’t serve as a reliable benchmark for your firm. Unfortunately, most of the risks outlined above are only truly solved with scale.  Customer concentrations are reduced with more assets.  Key man dependencies are lessened by hiring well-trained investment processionals (which is expensive) or by training younger professionals (which takes time).  Investments in scalable technology are often too costly for small managers.  However, formalizing investment processes and establishing a succession plan with a proper buy-sell agreement can reduce the risk of cash flows deteriorating if key individuals depart post acquisition. What Will a Buyer Pay for Your Firm?Unfortunately, there is not a simple formula to value your firm.A highly concentrated client base may overshadow the high growth potential of your firm.  On the other hand, a stable client base, with a higher probability of recurring revenue, can raise your valuation despite mediocre growth prospects.Many business owners suffer from familiarity bias and the so-called “endowment effect” of ascribing more value to their business than what it is actually worth simply because it is well-known to them or because it is worth more to them simply because it is already in their possession.   In any event, just as physicians are cautioned not to self-medicate, and attorneys not to represent themselves, so too should professional investment advisors avoid trying to be their own appraiser.The first step of any transaction should be to obtain a valuation to establish decision-making baselines and to set transaction expectations.  Mercer Capital’s Investment Management team provides asset managers, wealth managers, and independent trust companies with business valuation and financial advisory services.  Call us today to discuss your valuation needs in confidence.

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

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.

As we enter the new decade, rather than taking time for self-reflection, we prefer to take a step back and reflect on the transformation of the wealth management industry over the last decade.According to the Investment Advisor Association’s 2010 publication, SEC registered Investment Advisors reported $38.6 trillion in assets under management that year.  Today, that number has more than doubled to $83.7 million.  The number of SEC registered investment advisors, however, has only increased by 12% (11,643 in 2010 and 12,993 today).  This means that the average advisor is managing more money today than they were ten years ago, as shown in the graph below.In 2010, advisors reportedly served approximately 30 million clients compared to 43 million today, suggesting that the increase in assets managed by each advisor is a result of having both more and larger clients.These statistics suggest it’s been smooth sailing for wealth managers.  However, the investment management industry has changed radically over the last ten years, and wealth managers have been forced to adapt in order to maintain their client base and remain profitable.  While these changes have not been easy, they have transformed the industry into one more focused on its clients’ needs and better regulated to ensure the safety of its clients’ assets.BackdropThe popularity of passive funds increased in 2009 when the current bull market began.  In 2010, about 30% of U.S. assets were held in passively managed funds; last year, we crossed the 50% mark.  While active versus passive may still be an intellectual debate, there’s no debate that trillions of dollars are managed passively today at much lower fees than they were a decade ago.  The chart below demonstrates the decline in publicly traded investment managers’ effective fees over the last ten years.Wealth managers, however, have largely side-stepped fee pressure so far, and we don’t hear many instances of wealth management firms bending their stated pricing schedules because of client pushback.  However, to justify higher fees in a low fee environment, wealth managers have had to differentiate themselves by providing more specialized solutions for their clients.  Ten years ago, Westwood Holdings, a publicly-traded wealth management firm, described themselves as follows on their website:Westwood is built upon one investment philosophy of controlling overall portfolio risk while providing superior, risk-adjusted returns for our clients.Today Westwood’s website touts:At Westwood, we will champion your values and help make your intentions a reality.Wealth managers have changed their marketing strategy to highlight their more tailored investment solutions (with the underlying message that specialized services are worth the higher fees).  But their ability to maintain their fee schedules will likely depend on their capacity to continue servicing clients’ evolving needs while connecting with their next generation.The trade-off with more specialized investment management is the cost.  Providing tailored investment solutions, takes more time, i.e. more human capital.  One area where the asset management model beats wealth management is scalability.  You can build a bigger wealth management firm, but it usually requires a corresponding increase in advisors and planners.  Additionally, as compliance and technology costs have increased over the last decade, wealth managers have had to pay closer attention to their expense base then they had to ten years ago.At the same time, many principals of wealth management firms reached retirement age over the last decade, often with no plan in place to transition their business.  Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis.  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.  The options for succession planning for aging principals have exploded over the last decade.  Debt financing providers have bettered the terms for RIAs, private equity firms are giving more attention to the industry, and M&A opportunities have increased as RIAs try to achieve scale.Most notably, however, is the increase of consolidators in the space.  RIA consolidators have seized the opportunity to address both the needs of retiring shareholders and continuing principals, by offering liquidity for founders as well as back-office infrastructure.  Consolidators can provide 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 the next generation of management.  Additionally, they can offer back office services such as IT, compliance, and human resources which allows RIAs to preserve their margins despite the cost of hiring more advisors.2020 VisionLooking forward, wealth managers will have to continue streamlining back office processes so that they can prioritize spending on compensation.  Investments in technology and compliance will continue to require additional resources. Wealth managers must make conscious decisions about where they will find cost saving efficiencies without sacrificing superior service for their clients.Going forward, more and more RIAs will have to evaluate offers from consolidators and decide whether this kind of partnership right for them.   Planning ahead for the eventual transition of your business will set you up with more options for retirement and a better understanding of where you are willing to make concessions.

As good as the fourth quarter was for the S&P, it was even better for the RIA industry.  All classes of investment management firms bested the market, which was up 10% for the quarter.  Continued gains in the equity markets have allowed these firms to more than recover from last year’s correction, and many of these businesses are now trading at or near all-time highs. Despite these gains, the asset management industry is facing numerous headwinds, chief among them being the ongoing pressure for lower fees.  Alt managers, on the other hand, are perhaps 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 managers over the last few years despite the recent uptick in stock price performance.  As shown below, EBITDA multiples for these businesses remain well below historical norms, although they have recovered from their low point in December of 2018. Expanding the performance chart over the last year reveals an upward trend in pricing for most classes of RIAs.  Over this longer timeframe, alt managers are still the strongest category, although performance has been volatile.  Other pure play managers have generally moved in lockstep with the broader market while the aggregators lagged with AMG and FOCS’s performance. The relative underperformance of 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 the United Capital and Mercer Advisors deals reportedly occurred at high-teens multiples of adjusted EBITDA. Implications for Your RIAWith EBITDA multiples for publicly-traded asset 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 asset managers 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.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 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 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.

'Twas the blog before Christmas and throughout our staff Analysts were separating wheat from the chaffAs midtown Manhattan glistened with snow We sighed as our Bloombergs warmed us with their glowHedge-funders grinned, computing their carry While raising a glass to the 2 & 20 fairyWith the yield curve corrected, and cap rates back down It’s hard to find a real estate guy with a frownLong-onlys dreamt active would once again pay Before President Warren comes to tax it awayWealth managers gathered at bars with their peers All hoping a Santa-rally soon would appearBut whatever your alpha, this is still a great biz So celebrate the season with our RIA quiz!If you're having trouble viewing the survey below, click here.(function(t,e,s,n){var o,a,c;t.SMCX=t.SMCX||[],e.getElementById(n)||(o=e.getElementsByTagName(s),a=o[o.length-1],c=e.createElement(s),c.type="text/javascript",c.async=!0,c.id=n,c.src=["https:"===location.protocol?"http://":"http://","widget.surveymonkey.com/collect/website/js/tRaiETqnLgj758hTBazgd8FDSSK_2BdJwgb90HhEfWcrQ3mXQw84VAAdJcw4qiJQXV.js"].join(""),a.parentNode.insertBefore(c,a))})(window,document,"script","smcx-sdk");

We’ve hesitated to put together a whitepaper on succession planning because so many people have already written excellent commentary on the topic. Nonetheless, when we surveyed what had been written about succession for RIAs, we didn’t see the kind of nuts and bolts explanation of the corporate finance aspects of succession.The industry is facing at least three major factors: an aging ownership base, an aging bull market, and – paradoxically – an exponential increase in the sources of capital to sell, grow, or transition. Despite the headline emphasis on consolidation, investment management is still an apprenticeship business model and, therefore, internal succession will be the order of the day for most firms.We hope you will find our whitepaper on the topic both unique and useful. We are here to help you succeed at succession. Click the whitepaper below to download.>>Click Here to Download<<

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.

As noted in a recent post, there are many viable options for RIA principals when it comes to succession planning.  One way to transition ownership while maintaining independence is to sell internally to key staff members.  The most obvious roadblock when planning for internal succession is pricing.  But once you establish a price, how does the next generation pay?  An internal transition of ownership typically requires debt and/or seller financing as it’s unlikely that the next generation is able or willing to purchase 100% ownership in a matter of months.  In this post, we consider the expanding options for RIAs seeking debt financing and the typical terms they can expect.Is Debt Financing the Right Solution? Debt financing has become a more practical option for RIA principals working on succession planning as more specialty lenders have entered the market.  Some of the benefits of debt financing are outlined below.Debt financing, as opposed to seller financing, allows the exiting shareholder to make a clean break with the business. This benefits both the exiting shareholder and the remaining principals.  Exiting shareholders, who are likely at retirement age, receive liquidity at close that they can use to diversify their personal holdings, and the remaining principals don’t have ownership lingering in the hands of a former employee.Debt financing, as opposed to equity financing, allows the remaining principles to maintain autonomy. Excluding loan covenants, lenders have no control over your business.  On the other hand, equity partners usually require more intrusive oversight such as a board seat and/or budget approval, which remaining shareholders may not tolerate.Debt financing is cheaper than equity financing. Equity investors, who are subordinated to debtholders, require an additional premium over the average cost of debt.Interest payments are tax-deductible. Interest payments can reduce the borrower’s tax burden during the amortization period. Despite these benefits, debt financing does increase the remaining shareholders’ personal risk.  Debt financing is an obligation to repay the money acquired through it, unlike equity financing which typically does not require repayment.  Debt financing for RIAs also typically includes a personal guarantee, which many borrowers are opposed to.  Borrowers are also more exposed to their own business by levering up to purchase an equity stake.Increasing Number of Specialty Lenders for RIAsAs Financial Planning explained, “the market for RIA-friendly lending options has exploded” over the last two years.  Looking back, Live Oak Bank was one of the first to address the specific needs of RIA principals when they began providing favorable terms to independent advisory firms in 2012.  As explained on their website, “where most banks look for tangible collateral when they lend money, Live Oak Bank lends on cash flow to companies (like advisory firms) which have little to no collateral.”  Prior to this, most RIAs had to turn to local banks, who generally were not comfortable with the asset-light balance sheets and fee-based structure of RIA firms.RIAs now can turn to a growing number of specialty lenders who are accustomed to working with RIAs.  Some of the firms offering debt financing specifically for RIAs include Oak Street Funding, Merchant Credit Partners, PPC Loan, and SkyView Partners.Typical Terms for RIAsAdditionally, one provision may be contingent upon another.  For example, a higher origination fee could reduce the need for a pre-payment penalty. At the risk of providing an example of terms that may be unachievable for some RIAs, we have outlined terms RIA principals can generally expect when seeking debt financing.Most lenders require a personal guarantee, which is a legal promise by the partners to repay the loan made to their business in the event the business defaults.  While it is typical that lenders to small businesses require this additional layer of protection, it is important to understand how a personal guarantee works and what it could mean for your personal finances.Because RIAs do not have fixed assets to use as collateral, a personal guarantee gives your lender the right to pursue your personal assets if your business defaults on the loan.  The SBA is of the opinion that a personal guarantee “ensures that the borrower has sufficient personal interest at stake in the business.”  Notably, a personal guarantee is not released if you sell the business.  While you can ask your lender to replace your personal guarantee with a personal guarantee from a new owner, the lender is typically not required to do so.ConclusionSimilar to evaluating mortgage options, it is important to talk to multiple lenders to guarantee the most favorable terms for your business transition.  Having a knowledgeable advisor to manage this process can allow remaining ownership to stay focused on running the business while ensuring consideration of all appropriate options.

Private equity pervades the RIA industry, but most of their recent interest is through consolidators or roll-up firms.  In this week’s post, we’ll discuss the implications of this trend and other considerations for RIA owners’ contemplating the PE route. You may have not heard much about private equity firms’ addition of RIAs to their portfolios in recent years.  But that doesn’t mean they’re not interested.  The reality is that PE firms collectively have established an indirect interest in hundreds of RIAs via their investments in RIA consolidators.  This strategy enables private equity to achieve diversification and scale in a single purchase rather than buying dozens of investment managers and hoping a majority will work out.  Many of the leading RIA consolidators are or have been backed by PE.  Recent examples include investments made by Stone Point Capital (Focus Financial), Thomas H. Lee Partners (HighTower Advisors), TA Associates (Wealth Enhancement Group), and Oak Hill Capital Partners (Mercer Advisors). Since private equity firms are increasingly interested in growing their RIA exposure, there has been a lot of pressure for these PE-backed consolidators to increase their portfolio holdings via acquisition.  This has largely been positive for wealth manager valuations as consolidators bid up their pricing to grow AUM and appease their PE backers.  Private equity firms have gained broad exposure to the RIA space in recent years through this portal of indirect ownership. Like any other prospective buyer, there are pros and cons associated with a private equity partnership.Does this mean they’re not interested in making a direct investment in your firm?  Not necessarily; but remember that their primary objective (perhaps more than any other type of buyer) is to generate large returns to investors, which may be hard to achieve with an RIA with less than $1 billion under management.  Larger investment managers, though, do offer the scale, (usually) higher margins, and predominantly recurring revenue models that have captured the attention of many PE firms over the years.Like any other prospective buyer, there are pros and cons associated with a private equity partnership.  At the moment, many PE firms are flush with capital and willing to pay a substantial portion of the total consideration in cash up front.  Most can afford to buy a majority interest and typically do so to assume control over future operations.  Sellers generally appreciate the down payment but are less enthusiastic about relinquishing control.  Many RIA owners aren’t comfortable with the latter, so these discussions sometimes don’t get past the initial call.Private equity, however, is not a permanent solution.  PE firms aim to grow their investment as much as possible over the next five to seven years before flipping it to a new buyer at two or three times what they initially paid.  This scenario means they often put pressure on RIAs to take on more clients and/or reduce costs, so they can maximize profitability for a prospective sale.  Additionally, this means a new owner with new demands will take over in the not so distant future.Is a Private Equity Investment the Right Solution for You? Private equity is sometimes used to cash out a former partner or outside investor when the current owners don’t have the capital or desire to take on this additional investment personally.  Selling (outside) partners usually favor this type of investment because PE firms can pay more up front.  Principals remaining in the business usually don’t want any ownership lingering in the hands of former employees, but in this scenario, they’ve effectively swapped one outside investor for another.  There’s no guarantee that the second one will be any better.Private equity can also be a relatively straightforward path to diversification for existing principals.  In many cases, a significant portion of an RIA principal’s net worth is tied up in his or her business with no immediate access to liquidity.  PE firms allow these owners to take some cash off the table and reduce their dependency on the business.  RIA principals will have to weigh the benefits of diversification and instant liquidity with the costs of losing control to outside ownership.Your due diligence on the prospective buyer is just as important as their due diligence on you.On balance, private equity’s interest in the space has been good for the RIA industry.  They’ve likely had a positive effect on wealth manager valuations and are a significant source of liquidity for an otherwise illiquid business.  This doesn’t necessarily mean they’re a good partnership for your firm, so you still need to consider what you’d be giving up in a sale and how it could impact other employees and stakeholders.  Even if the price is right, it still may not be a good fit for you and your team.  Your due diligence on the prospective buyer is just as important as their due diligence on you.We strongly recommend hiring a team of experienced and trusted advisors to help navigate this process.

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

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.

During Q3 2019, most classes of RIA stocks underperformed major equity markets, which are having their best year, so far at least, in more than two decades. In general, base fees for RIAs were up due to higher average AUM (driven by market growth), however, each sector experienced unique challenges. As we do every quarter, we take a look at some of the earnings commentary from investment management pacesetters to scope out the dominate trends.Theme 1: Asset managers are responding to fee pressure either through acquisitions to achieve scale or by outsourcing administrative tasks to reduce overhead.I've been in the investment business well over 30 years and there's never been a time when fee rates have been going up. How you grow and how you achieve attractive margins in this business tends to be based on scale, the ability to offset reductions in fee rates tied to per dollar of assets by growing the base of assets you manage and leveraging the spending in support of that asset management. […] We expect continued modest declines in our average fee rates. – Tom Faust, Chairman & Chief Executive Officer at Eaton VanceWe recognize the pressure that the industry is under, and it is very top of mind with all the senior management to look [at] every kind of saving that we can generate to continue to invest in the parts that we think are going to be incremental to getting inflows and in a few years. – Matthew Nicholls, Executive Vice President Chief Financial Officer at Franklin ResourcesMergers are more immediately accretive because of consolidation benefits. There are many transactions, you have all the obvious consolidation benefits that you would expect, which is office consolidations overhead maybe cross sell, pricing changes or other things here that you would see in a merger, but you wouldn't see in a holding company transaction. – Ruediger Adolf, Founder, Chief Executive Officer and Chairman at Focus FinancialWe always thought there'd be opportunity to save more than $475 million. By the time of the [Invesco - Oppenheimer] transaction closing we only had a clear line of sight regarding the $475 million of savings. After we closed the deal we were able to look deeper into the business and we started making significant progress on the integration. And we now see that we can run the business with this lower expense base. – Loren Starr, Chief Financial Officer at InvescoLeveraging our scale can also take different forms. In certain areas delivering partnerships with industry leading service providers through our affiliates can be more efficient and provide better outcomes, particularly where AMG's scale can improve pricing, access and service. For example, we've recently partnered with ACA Compliance Group to support affiliates seeking to lower their compliance cost and access a greater breadth of services. – Jay C. Horgen, President and Chief Executive Officer at Affiliated Managers GroupTheme 2: Wealth Managers, who are generally more resilient to fee compression, are growing the bottom line by increasing headcount rather than cutting costs.There's no question the resiliency of the overall fees for wealth management has been -- is pretty inelastic so far. We are starting to see some of the e-brokers charge much lower fees than the traditional wealth management platforms in terms of the overall advisory fee. But unquestionably when commissions are free, the investor is going to have to make a choice. Is […] the value proposition of having that advice worthwhile versus having a commission free relationship? And every client is going to have to make that assertion. – Laurence D Fink, Chairman and Chief Executive Officer at BlackRockWe've been staffing up our recruiting department over the last few months and the pipeline has been building. With regard to the advisors that we're focusing on […] the higher performing or higher producing type advisors that are more in line and more consistent with our current average productivity of advisors. […] So, we're continuing to see that expand as we move into 2020 and intend on hitting an inflection point from a growth perspective as we continue to progress forward as the pipeline continues to grow. – Shawn M. Mihal, Senior Vice President, Wealth Management at Waddell and ReedTheme 3: Consolidators attempt to ease investor concerns over their debt burden in the wake of a potential market correction.At the same time we continue to maintain a prudent level of leverage and have repositioned our balance sheet over the last several quarters extending duration while maintaining flexibility and capacity to capitalize on growth opportunities even in challenging markets. – Thomas M. Wojcik, Chief Financial Officer at Affiliated Managers GroupWe are looking at our capital management policy really to align with our overall strategy. We want to create flexibility and right now, our priorities are to delever. About 90% of our free cash flow has gone and probably will go toward delevering. We do have a small buyback program. We do have a small dividend program. We view these as ancillary parts to our strategy. We look at the buyback as a way to manage shares -- outstanding shares. So, we are going to focus on delevering. – David C. Brown, Chairman and Chief Executive Officer at VictoryAssuming constant markets, we anticipate that our net leverage ratio will remain essentially unchanged at 4.3 times from Q3 to Q4. We intend to delever gradually, starting in 2020 as we execute against this solid pipeline and satisfy earn outs associated with the transactions we have closed in the past, and plan to operate with a net leverage ratio between 3.5 and 4.5 times. We are comfortable that this range gives us the flexibility to pursue larger strategic transactions while also accelerating the growth of our existing partner firms in Focus and investing to drive organic growth. […] Please see [the earnings supplement] which provides a sensitivity analysis on the net leverage ratio impact of a material equity market correction. We will continue to manage our capital resources carefully while maintaining sufficient flexibility to invest in the growth of our business. – Ruediger Adolf, Founder, Chief Executive Officer and Chairman at Focus Financial Earnings calls this quarter brought to light the varying challenges and opportunities that different RIAs face. The shift from active to passive investing has 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. Wealth managers are taking a different approach to increase cash flow. The wealth management industry, which depends on the advisor-client relationship, is staffing up as additional advisors can mean additional sales. Meanwhile, consolidators like Focus Financial, AMG, and Victory Capital are providing solutions to both asset managers, who hope to achieve scale, and wealth managers, who look to expand their reach.

Through the first three quarters of 2019, asset and wealth manager M&A has kept up with 2018, the busiest year for sector M&A during the last decade.  Transaction activity 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 mounting cost pressures.Total deal count during the first three quarters is set to exceed 2018’s record levels.  Reported deal value during the first three quarters was down, although the quarterly data tends to be lumpy and many deals have undisclosed pricing.  Dollar value in 2018 was also boosted by Invesco’s $5 billion purchase of OppenheimerFunds. 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 and yet one more approach to building a national RIA brand. Acquisitions by (and of) RIA consolidators continue to be a theme for the sector.Mercer Advisors’ recent sale to Oak Hill Capital Partners is further evidence of growing interest in the RIA consolidator space.  While deal terms weren’t disclosed, some industry analysts estimate a high teens EBITDA valuation that exceeded $500 million. These RIA aggregators have been active acquirers in the space with Mercer Advisors and United Capital Advisors each acquiring multiple RIAs during 2018 and the first three quarters of 2019. Sub-acquisitions by Focus Financial’s partner firms and other firms owned by RIA consolidators are further drivers 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.  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 Rationales Sector M&A has historically been less than what we might expect given the consolidation pressures the industry faces.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.  While these factors are nothing new, sector M&A has historically been less than what 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 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.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 following the correction at the end of last year.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 buyers and sellers for the remainder of this year and the next.

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

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.

In May of this year, assets in passively managed funds equaled assets actively managed for the first time in history.  As investors seek low-cost solutions, alternative managers are working to solidify their place in investors’ portfolios.  Despite the headwinds the asset management industry faces, most investors still value the diversification offered by alternative assets, particularly late in the economic cycle.  In this post, we take a closer look at how alternative asset managers are performing in light of the broader shift from active to passive management and increased fee pressure.Industry OutlookWhile hedge funds are not a perfect proxy for the broader alternatives industry, we can better understand the pressure the industry faces by analyzing hedge fund asset flows.  Hedge funds recorded their fifth consecutive quarterly withdrawal in Q2 2019 and the largest semiannual outflow ($47.4 billion) since the second half of 2016.  Despite this, hedge fund assets under management grew 4.4% since the end of 2018 as positive performance offset fund flows.  While hedge funds have underperformed 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), recent volatility has improved their performance on a relative basis.  Hedge fund capital typically lags performance, so we expect to see asset outflows slow in the coming months as investors reallocate their portfolios in light of recent performance.Alternative assets typically serve to either increase diversification or enhance portfolio returns.  In a near-zero interest rate environment, institutional investors have sought return generating assets.  Over the last couple of years, pension funds have started diversifying their portfolios to include alternative assets in order to chase higher risk, higher return assets.  It is typically more difficult for the average investor to gain exposure to alternative assets due to the often significant minimum investment requirements.  While some efforts have been made to expand distribution to the retail market, institutional investors are still the primary target market for alternative managers.  Over the last several years, alternative asset managers have been largely successful at securing a spot in institutional investors’ portfolios.In terms of diversification, investors have started positioning themselves for longer-term volatility due to increased geopolitical tensions and a slowing IPO market.  While investor interest in uncorrelated asset classes such as alternatives fell during the longest bull market run in history, recent volatility could push investors back to the asset class.Practice ManagementToday, the main priority for most alternative asset managers is raising assets.  Assets follow performance, especially in the alternatives space, and one way to directly impact investor returns is to reduce fees.  After a decade of lackluster performance, reducing costs has become a key issue for alternative managers seeking to bring in new assets.  Amidst fee pressure, alterative managers are deviating from the typical “2 and 20” model.While traditional asset managers have been able to reduce fees by achieving some measure of scale, alternative managers must be careful to not sacrifice specialization in key strategies for scale.   Alternative managers have seen some success utilizing technology in the front office or outsourcing certain functions in order to reduce overhead and spare time for management to focus on asset raising.Industry ValuationsIn the eyes of market participants, the industry has performed well over the last year.  Generally, alternative asset managers have been more resilient to price declines than traditional asset and wealth managers.  Our alternative asset manager index is up 4.4% year-over-year, compared to our index of traditional asset and wealth manages which was down for the year. Price to LTM earnings multiples have recently increased for alternative asset managers as prices over the last year increased by a median of 16%.  Current pricing is close to the 52 week high and forward multiples are noticeably lower than LTM multiples, suggesting that publicly traded alternative asset managers are currently trading at peak valuations and earnings are expected to increase over the next twelve months. Summary Despite improving performance over the last few years, the industry continues to face a number of headwinds, including fee pressure and expanding index opportunities.  While the idea of passively managed alternative asset products seems like an oxymoron, a number of funds exist with a goal of imitating private equity returns.  Innovative products are being made available to the investing public every day.  And while there is currently no passive substitute to alternatives, we do believe that the industry will continue to be influenced by many of the same pressures that traditional asset managers are facing today despite the recent uptick in alt manager valuations.

Continuing with our succession series, this week’s focus is on internal transitions.  If you’ve ever wondered why there aren’t more transactions in the RIA space, it’s largely because most of these businesses ultimately transition their ownership internally to younger partners at the firm.  These deals typically don’t get reported, so you probably don’t hear about most of them.  Still, it’s the most common type of transaction for investment management firms and probably something that’s crossed your mind if you’re approaching retirement.A gradual transition to the next generation is a good way to align your employees’ interests and grow the firm.These types of transactions are common for a reason.  Most RIA owners like working for themselves and will eschew outside interference at all costs (unless the price is right).  Because many clients enjoy working with a wholly independent advisor, internal transitions are a good way to accomplish this in the long run.  Further, a gradual transition of responsibilities and ownership to the next generation is also usually one of the best ways to align your employees’ interests and grow the firm to everyone’s benefit.The most obvious roadblock when planning for internal succession is pricing.  We recommend that all firms have a buy-sell agreement that specifies the terms and the price that shares are transacted at as an owner exits to retire.  Because many wealth management firms are highly valuable, successors are often financially stretched to take over the founder’s interest in the firm.  By establishing the price and terms at which the shares will be transacted, a buy-sell agreement mitigates any potential drama.In their recent book Success and Succession, Eric Hehman, Jay Hummel, and Tim Kochis examine the complexities of the leadership transition process and summarize their findings from their own experience:Both the founder and the successor need to be aware that firm-wide growth often declines in the first year following the change in management, as the founder-centric firm shifts its brand image and the successor takes on responsibility for creating new business. If a successor is unaware of this trend, he or she could feel additional stress regarding the financial burden he undertook when buying out the former owner.  The founder could feel the need to resume full-time involvement in operations, fearing for his ongoing financial benefits from the firm.  The authors advise both founders and successors to take a long-term view and not focus on this short-term pullback.Regardless of the firm’s performance in the first few years following succession, both the founder and the successor need to set definite (as in finite) expectations regarding the founder’s continued involvement or lack thereof. The founder should remain accessible as his or her guidance is crucial when the successor faces major issues early on.  However, it should also be clear to everyone that the successor is now the one charged with minding the store.Though some things do need to change following a succession of management, the successor should avoid creating new positions to retain people who no longer fit into the firm’s long-term goals. One benefit of succession is that the new manager may have a fresh perspective on areas of the firm in which cost cutting measures or other efficiencies are possible.  Although it may be difficult to assess which employees should remain after the transition, allowing those who are poor fits to remain with the firm does significant damage to the firm’s culture and does not set the proper tone for post-transition success.It is crucial to separate compensation for labor from profit share rewards as the exiting owner becomes less involved in the day to day management of the firm. This issue can be resolved through the establishment of a strict reinvestment versus distribution policy going forward.  The authors even suggest that the founder employ an independent financial advisor in order to objectively estimate a fair amount of compensation following the sale.Though it is clear that the founder has taken on a significant amount of financial risk in the creation of the firm, it must be noted that the successor is also taking on risk in the amount of debt that he or she must incur to buy out the owner. Both parties have a lot to gain and a lot to lose in the process of succession, and both bear a significant emotional burden.  The founder may perceive the transition as a loss of a personal identity that is tied to the firm, and the successor must now bear the responsibility of the ongoing success of the firm.Controversy over what is fair or what is “enough” in terms of a sale price can be resolved through a third-party valuation. While it might seem easier to rely on rules-of-thumb metrics or attractive examples, these tactics are purely short term solutions and can result in overly optimistic estimates. The financial terms of the valuation are already emotionally charged. A third party valuation can provide a much needed “reality dose.” Obviously, there’s a lot to think about, and this is certainly not an exhaustive list.  It’s never too early to start planning for your succession.  The longer you wait, the more likely you are going to fall short or have to make series concessions on pricing.  Unfortunately, we see this more often than not, so don’t become another statistic.  We’re here to help with the valuation and advisory aspects, but it’s up to you to get the ball rolling.

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

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.

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 considerations of partnering with a minority financial investor to achieve a successful transition of ownership.What is a minority financial investor?There are two features of a minority financial investor to breakdown: minority and financial.A minority investor does not seek control of your business. Often, a change of control is thought to occur when greater than 50% of the equity changes hands. However, the notion of control can be more complicated with RIAs as an “assignment” of client contracts necessitates client consent. When a “controlling block” of voting shares changes hands, the SEC considers there to have been an assignment of client contracts. While the SEC does not define a “controlling block,” it is typically thought to be the holder of 25% of voting shares or a partner who has the right to receive 25% of the capital upon dissolution.A financial investor is contrasted to a strategic investor. Financial buyers can generally be classified as investors interested in the return they can achieve by buying a business. They are interested in the cash flow generated by a business and the future exit opportunities from the business. Strategic buyers are interested in a company’s fit into their own long-term business plans. Their interest in acquiring a company may be related to expanding into a new market or consolidating administrative tasks to realize efficiencies.Bringing the two together, a minority financial investor is typically interested in acquiring less than 25% of your business to participate in the distribution of cash flow or upside from selling your company in a few years to another investor or strategic acquirer.Is a minority financial investor the best solution for you?As mentioned above, a minority financial investor does not seek control of your business. Therefore, the majority of your company’s management team must agree to stay on after the capital infusion. While the lack of interference in day to day operations is an attractive feature to some management teams (if, for instance, they’re looking to transition out retiring partners, recycle ownership to future generations, and maintain control of day to day operations), a minority financial investor is not the solution for management teams hoping to achieve a clean break.How is a minority financial investment structured?In general, a minority financial investment can be structured as a term investment or a permanent investment. PE firms typically invest for a five to seven-year term with the goal of improving the company’s financial profile in order to sell it at a higher multiple, while permanent capital investors (often single-family offices) are more interested in the business’ long-term cash flow potential.While every agreement with a minority financial investor will have differences in the details, there are generally two ways to structure these deals.1. Revenue Share 2. Preferred EquityRevenue ShareA revenue share is a right to a percentage of revenue instead of a right to distributable cash flow. This structure works exceptionally well for passive minority investments because the minority investor’s distribution is not affected by the operational decisions of management, such as the size of the bonus pool, because their distribution is determined before the removal of expenses. With that, a revenue share generally does not include board representation.There are benefits to a revenue share for businesses that have stable or expanding margins. As shown in the example below, as margins expand and more flows through to the bottom line, the revenue share as a percentage of EBITDA (as a proxy for free cash flow) decreases, and the common equity holders split a larger share of the distributable cash flow. On the flip side, if margins contract, the size of the revenue share as a percent of EBITDA will increase and the revenue shareholder will gain a larger share of distributable cash flow.A revenue share usually includes customary minority protections.  For example, consent is typically required for certain matters such as:Bringing on excess debt or changing the company’s capital structure in a way that would adversely affect the revenue share ownerEntering into a JV, related party transactions, or new lines of businessChanging accounting/billing practices or tax election in a way that would adversely affect the revenue share ownerPreferred EquityLike a revenue share, preferred equity holders participate in the distribution of cash flow before common equity holders; however, preferred equity holders distribution is determined by the bottom line, not the top.  Because of this, preferred equity holders are more interested in operational decisions such as executive compensation and budgeting because their distribution could be reduced with additional expenses. Preferred equity holders typically ask for board representation and veto rights on certain key items.  Such protective rights include:Required distributions of excess cash flowBudget approvalApproval of executive compensationTag along rightsPreemptive rights to protect preferred equity holders from dilution Although preferred equity holder’s rank higher than common equity holders, a preferred equity holder faces more risk than a revenue shareholder. In the example of margin compression explored above, the preferred equity holder would likely face a similar decline in distributions as the common equity holder. Because of the risk profile of each investment, a revenue shareholder may be able to offer more in terms of pricing than a preferred equity investor. A minority financial partner can help you successfully transition ownership from retiring partners but is not the solution for every RIA. In the next few posts, we will continue to discuss other viable exit options for RIA principals when it comes to succession planning.

This post serves as an introduction to our succession planning series, which is intended to address an overlooked but critical issue facing many RIAs today.A recent Schwab survey asked RIA principals to rank their firm’s top priorities in the coming year.  We were disappointed but not surprised to discover that developing a succession plan was dead last.  This is unfortunate because 62% of RIAs are still led by their founders with only about a quarter of them sharing equity with other employees to support succession planning.  Not much progress has been made, and there doesn’t seem to be much of a push to resolve this issue any time soon.  Brent Brodeski, CEO of Savant Capital, describes this predicament more crassly:The average RIA founder is over 60 years old, and many are like ostriches: They stick their heads in the sand, ignore the need for succession planning, ignore that their clients are aging, let organic growth slow to a crawl or even backslide, and have increasingly less fun and a waning interest in their business.Fortunately, it doesn’t have to be this way.  There are many viable exit options for RIA principals when it comes to succession planning.  We’ll outline these options in this post and expound upon them in more detail later in the series.Sale to a strategic buyer. In all likelihood, the strategic buyer is another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal.  They will typically pay top dollar for a controlling interest position with some form of earn-out designed to incentivize the selling owners to transition the business smoothly after closing.  This scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees or the company’s name.Sale to a consolidator or roll-up firm. These acquirers typically offer some combination of initial and contingent consideration to join their network of advisory firms.  The deals are usually debt-financed and typically structured with cash and stock upfront and an earn-out based on prospective earnings or cash flow.  Consolidators and roll-up firms usually don’t acquire or pay as much as strategic buyers, but they often allow the seller more autonomy over future operations.  While there are currently only a handful of consolidators, their share of sector deal making has increased dramatically in recent years.Sale to a financial buyer. This scenario typically involves a private equity firm paying all-cash for a controlling interest position.  PE firms will usually want the founder to stick around for a couple of years after the deal but expect him or her to exit the business before they flip it to a new owner.  Selling principals typically get more upfront from PE firms than consolidators but sacrifice most of their control and ownership at closing.Patient (or permanent) capital infusion. Most permanent capital investors are family offices that make minority investments in RIAs in exchange for their pro-rata share of future dividends.  They typically allow the sellers to retain their independence and usually don’t interfere much with future operations.  While this option is not as financially lucrative as the ones above, it is often an ideal path for owners seeking short term liquidity and continued involvement in this business.Internal transition to the next generation of firm leadership. Another way to maintain independence is by transitioning ownership internally to key staff members.  This process often takes a lot of time and financing as it’s unlikely that the next generation is able or willing to assume 100% ownership in a matter of months.  Bank and/or seller financing is often required, and the full transition can take 10-20 years depending on the size of the firm and interest transacted.  This option typically requires the most preparation and patience, but allows the founding shareholders to handpick their successors and future leadership.Combo deal. Many sellers choose a combination of these options to achieve their desired level of liquidity and control.  Founding shareholders have different needs and capabilities at different stages of their life, so a patient capital infusion, for instance, may make more sense before ultimately selling to a strategic or financial buyer.  Proper succession planning needs to be tailored, and all these options should be considered. If you’re a founding partner or selling principal, you have a lot of exit options, and it’s never too soon to start thinking about succession planning.  You will have a leg up on your competition that’s probably not prioritizing this.  You’ve likely spent your entire career helping clients plan for retirement, so it’s time to practice what you preach.  Please stay tuned for future posts on this topic and give us a call if you are ready to start planning for your eventual business transition.

Due to the historical popularity of this post, we revisit it this week. The purpose of this post is to help you, the reader, 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 transactions between banks and asset managers. As banks of all sizes seek new ways to differentiate themselves in a competitive market, we see many banks contemplating the acquisition of an existing asset management firm as a way to expand and diversify the range of services they can offer to clients.  Following a transaction, the bank is required under accounting standards to allocate the purchase price to the various tangible and intangible assets acquired.  As noted in the following figure, the acquired assets are measured at fair value. Transaction structures between banks and asset managers 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 management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fee margin, 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. Common intangible assets acquired in the purchase of a private asset manager include the trade name, existing customer relationships, non-competition agreements with executives, and the assembled workforce. Trade NameThe deal terms we see employ a wide range of possible treatments for the trade name acquired in the transaction.  The bank will need to make a decision about whether to continue using the asset manager’s name into perpetuity or only use it during a transition period as the asset manager’s services are brought under the bank’s name.  This decision can depend on a number of factors, including the asset manager’s reputation within a specific market, the bank’s desire to bring its services under a single name, and the ease of transitioning the asset manager’s existing client base.  However, if the bank plans immediately to take asset management services under its own name and discontinue use of the firm’s name, then the only value allocable to the tradename would be defensive.In general, the value of a trade name 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 value of the trade name.Customer RelationshipsThe nature of relationships between clients and portfolio managers often gives rise an allocation to the existing customer relationships transferred in a transaction.  Generally, 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.  Many of the agreements we see include a clause that requires a certain percentage of clients to consent to transfer their accounts in order for the deal to close at the stated price.  If the asset manager secures less than the required amount of client consents, the purchase price may be adjusted downward or the deal may be terminated entirely.  Due to their long-term nature and importance as a driver of revenue in the asset management industry, customer relationships may command a relatively high portion of the allocated value.Non-Competition AgreementsIn many asset 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 individuals from soliciting business from existing clients or recruiting current employees of the company.  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.  In the agreements we’ve observed, a restricted period of two to five years is common.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 a relationship-based industry like asset management, getting a new portfolio or investment manager 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 often may command a higher value allocation to the assembled workforce.  Unlike the intangible assets previously discussed, the assembled workforce is valued as a component of valuing the other assets.   It is not recognized or reported separately, but rather 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 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 banks and asset managers, we frequently see an earnout structured into the deal as a mechanism for bridging the gap between the price the bank wants to pay and the price the asset manager 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 bank, while rewarding the asset management firm 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 work for the asset 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.

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).

I was initially intrigued by this match-up. Two of Europe’s greatest soccer clubs and intra-city competitors squaring off in front of a packed crowd on American soil for the first time in their storied history. Fittingly, the game was played in a football stadium because it was that kind of score. The New York Giants and Jets fans that typically frequent the grounds probably appreciated all the action, but Real Madrid supporters and other soccer enthusiasts had a different impression. Despite all the hype leading up to the game, only one team had any interest in being there, and the match itself has been widely panned by most (non-Atleti) observers.The Real/Atleti debacle is perhaps a microcosm for the broader International Champions Cup (“ICC”) in which it is played. The pre-season tournament has been criticized for the lack of quality competition and blatant apathy of the players despite broad participation by most of Europe’s top clubs. Blame the heat, injury aversion, or American nightlife, but it hasn’t been pretty. Like most pre-season affairs, there’s even talk of cancelling it all together, but that probably doesn’t make sense from an economic perspective. The real culprit is the lack of meaning to the games since they have no implications for the teams’ league status and no (direct) impact on the players’ compensation levels. There have been discussions of playing regular season European matches in America (much like the NFL and MLB are doing in London) to remedy this issue, but no definitive decisions have been made yet.I was similarly intrigued (and skeptical) of the recent reports that RIA aggregator Mercer Advisors was looking to fetch a $700 million-plus price tag in a prospective sale by its PE backers at Genstar Capital. A 15-16x multiple on an estimated pro-forma, run-rate EBITDA of approximately $50 million results in a $750 million to $800 million enterprise value for the business, which certainly got my attention. Still, this figure could be as meaningless as the ICC if it’s an unlikely appraisal of Mercer Advisor’s current market value. We’ll address our opinion from a fair market value and strategic value perspective in this week’s blog.The Fair Market Value of Mercer AdvisorsDespite the similar name, we have no relation to Mercer Advisors. On the one hand, this means that our opinion is not conflicted, but it also means that we are not privy to its financial situation, so we’ll have to opine in general terms. The 15-16x multiple feels a bit rich (we’ll address this later) but may not be nearly as big of a stretch as the “pro forma, run-rate EBITDA estimate” to which it is applied. We don’t know what adjustments were made to get from reported EBITDA to pro forma, run-rate EBITDA, but in our experience, they can be substantial and unsubstantiated.Historically, most publicly traded RIAs with under $100 billion in AUM have traded in the 8-11x range.The context of fair market value, according to most definitions, is a transaction between a hypothetical willing buyer and a hypothetical willing seller, both having reasonable knowledge of the facts and circumstances. The word hypothetical precludes any consideration for what an actual, specific buyer would pay for the business. This means that certain synergies that could be realized by a strategic buyer are typically not considered in a fair market value appraisal. Since the pro forma adjustments likely include such synergies, they are probably not relevant from a fair market value perspective.The 15-16x EBITDA multiple is probably also a stretch. Historically, most publicly traded RIAs with under $100 billion in AUM have traded in the 8-11x range, and this has actually ticked lower over the last few years. Even though Mercer Advisors isn’t really an RIA, it is in a similar line of business, so we can’t totally ignore the market’s current pricing of these companies. On balance, an inflated multiple on a stretched earnings estimate is likely outside a reasonable fair market value range for this business as a stand-alone entity. Especially since RIA aggregators market prices have declined over 30% over the last twelve months leading multiples to fall.The Strategic Value of Mercer AdvisorsSince many believe Mercer’s ultimate acquirer will have synergistic intentions, strategic value may be more applicable in determining the likely purchase price.Unlike fair market value, strategic value considers the particular motivations of a specific buyer and the synergies that could arise in a contemplated transaction. Since many believe Mercer’s ultimate acquirer will have synergistic intentions, strategic value may be more applicable in determining the likely purchase price. In this context, pro forma EBITDA estimates become more relevant, and we can look to recent transaction evidence for perspective on what strategic buyers are paying for these businesses. The most recent transaction in the space involved Goldman Sachs’ purchase of RIA aggregator United Capital for $750 million or an estimated 18x EBITDA. This price tag may be a bit rich for Mercer Advisors, which, at $16 billion in AUM, is quite a bit smaller than United’s $25 billion in client assets. Mercer’s pro forma EBITDA estimate may also be more heavily adjusted, so $750 million and/or 18x is probably a bit optimistic.The Focus Financial IPO last Summer offers additional guidance. The IPO price implied a total enterprise value of $2.8 billion or 16x (heavily) adjusted EBITDA. While Focus is much larger than Mercer and United, the 16x multiple may be more applicable here since it is on top of an adjusted EBITDA figure and is reasonably in line with current pricing. Overall, there does appear to be some support for a 16x multiple from a strategic buyer perspective, but we’d like to know more about the pro forma adjustments before validating the $800 million offering price.Where Do We Think this Deal Will Land?Providing a reasonable range of value for this business is nearly impossible without knowing the acquirer or anything about Mercer’s financial situation, but we’ll take a stab at it. If we back off the multiple a bit and revise our pro forma earnings estimate, we get something closer to a $450 million to $650 million transaction value. This estimate is purely speculative, and if $50 million in incremental EBITDA is truly achievable from a buyer’s perspective, then the $700 million-plus price tag looks very achievable especially since Mercer is one of the few independent RIA aggregators of this size left. Overall, we think the $700 million-plus headline value is a bit rich but certainly more meaningful than an ICC trophy.

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

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.

Trust law dates back to the 12th century when landowners who left England to fight in the Crusades retitled their property to another trusted individual to manage the property until the crusader returned home. Upon returning home, however, the land title holder (the “trustee”) often refused to return the property to the crusaders (the “beneficiary”). The Lord Chancellor typically ruled in favor of the returning crusader, requiring the title holder to return ownership of the land to the original holder. Hence, the foundation for modern trust law was formed.Trust companies are changing to meet clients’ evolving needs.Trust law has evolved over time, most recently with modern trust laws in the 1980s and 90s established by certain states such as Delaware, Nevada, and South Dakota. Other states, such as Tennessee, have developed compelling trust statutes in more recent years. Just as trust law has changed with the regulatory environment, trust companies are changing to meet clients’ evolving needs.As demand for trust company services increases with the generational transfer of wealth from baby boomers to their successors, trust companies are competing for new business by changing their model to better serve their clients and altering their marketing strategies to attract new assets.A Fiduciary Minded ModelAs depicted in the illustration below published by Wealth Advisors Trust Company, trust companies have traditionally managed the distribution, administration, and investment of trust assets. However, more trust companies are shifting to a directed trustee model, which allows an investment advisor to be named on the account so that investment decisions are made by the appointed advisor rather than the trust company. This allows the trust company to focus on fiduciary issues related to trust and estate administration rather than investment management. 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. Increased Marketing EffortsTrust companies have historically relied heavily on referrals for new clients.  While the directed trustee model protects these referral relationships, many referral sources have been lost to industry consolidation.  This has led trust companies to increase their online marketing efforts.  Many of our clients have seen a reduction in referrals from their traditional referral sources and have responded by increasing spending on website upgrades and digital marketing.Not only do marketing efforts generate new clients, but those clients tend to stick around.According to Forbes, 80% of trust company clients keep the same trustee for the life of the trust.  This makes effective marketing essential for trust companies, because trust clients are sticky, and once with another provider, a potential client has likely been lost for good.Industry Tailwinds Demand for trust company services has increased over the first half of 2019 as “high-net-worth families re-evaluate[d] their personal exposure to the market and follow[ed] through on any big moves they’ve been putting off.”  This momentum in the industry is driving increased awareness of trusts as an important component of the financial planning process.Additionally, industry participants generally believe that a large portion of the impending wealth transfer from baby boomers to gen X-ers and millennials will be left through real estate holdings, individual retirement accounts, and trusts; thereby providing a tailwind for the trust company industry.Market MultiplesThe market for asset and wealth management firms can offer some insight.While there are no pure-play publicly traded trust companies, analysis of the public markets can lead to a better grasp of trust company valuations.  Even though trust companies are increasingly outsourcing investment management, there are still a number of underlying similarities between the business models of trust companies and asset and wealth managers—the most notable being that revenue for all of these businesses is a function of assets under management.  Because of the similarities, the market for asset and wealth management firms can offer some insight into valuation trends affecting trust companies.Investment manager valuations have started to recover after stumbling in the first quarter following a rocky Q4 across the entire market.  P/E multiples averaged approximately 15.3x LTM earnings as of the end of 2Q 2019, up from 14.1x at the end of the 1Q 2019.  The positive movement in asset and wealth manager multiples is likely to translate, to some extent, to trust companies as well, given the similarities between revenue models.Mercer Capital assists RIA clients with valuation and related consulting services for a variety of purposes.  In addition to our corporate valuation services, Mercer Capital provides transaction advisory and litigation support services to the investment management industry.  We have relevant experience working with independent trust companies, wealth management firms, traditional and alternative asset managers, and broker-dealers to provide timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

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

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.

On June 10th, Fidelity Clearing & Custody Solutions and Merchant Investment Management announced a new partnership to increase wealth managers’ access to capital for acquisitions and growth initiates.With the average transaction size in wealth management M&A increasing 30% in the past year, Fidelity Clearing & Custody Solutions will work with Merchant Investment Management to help firms drive growth and scale in an increasingly concentrated market.Overview of Strategic AllianceFidelity Investment Management, one of the largest discount brokers in the U.S., began offering more customized products and solutions to wealth managers over the last few years through Fidelity Clearing & Custody Solutions, which provides a comprehensive clearing and custody platform to RIAs.  While it is typical for custodians to maintain loose affiliations with specialty lenders in order to address the capital needs of RIAs, Fidelity has taken this to the next level by formalizing a strategic relationship with Merchant Investment Management.The deal opens up a sizable new sales channel for Merchant, and in return, Fidelity’s behemoth platform tacks on additional selling points to entice M&A-minded RIAs.Merchant provides growth capital to wealth and asset managers looking to grow or take advantage of strategic opportunities. The company provides capital in the form of minority, non-controlling equity investments and credit solutions. Additionally, Merchant offers management resources, such as regulatory and compliance assistance, as well as outsourced CIO services. As part of the partnership, Merchant will offer Fidelity’s custody clientsdiscounted loan origination fees, as well as discounted rates to some of Merchant’s products, such as Advisor Assist, which offers a suite of compliance solutions, and Compass, which provides outsourced CFO and accounting services for advisory firms.  The deal opens up a sizable new sales channel for Merchant, and in return, Fidelity’s behemoth platform tacks on a few additional selling points to entice M&A-minded RIAs.Fidelity’s MotivationThe last 18 months have been busy for investment manager M&A. Several trends are driving the uptick in sector M&A, including rising fee pressures, increasing compliance and technology costs, and organic growth strains. Wealth management consolidators such as Focus Financial, Hightower, and now, Goldman Sachs have capitalized on these trends, and Fidelity seems to be throwing its hat in the ring as well.David Canter, head of the RIA segment at Fidelity Clearing & Custody Solutions, explained Fidelity’s interest in this partnership:Today’s most competitive and future-ready firms are achieving scale through M&A.  By our count, there are over 700 RIAs that manage over $1B, and they’re often doing so with national footprints.  But it takes capital to create scale—and with the average deal size increasing three-fold in the past five years, access to that capital can sometimes be a roadblock.  Lending solutions like this one are a game-changer for firms looking to make strategic acquisitions to create long-term, sustainable value.Chasing TrendsAs one of the largest RIA custody platforms, it certainly makes sense for Fidelity to keep its finger on the pulse of the RIA industry. Fidelity has strived to keep up with RIA trends over the last decade, and the partnership with Merchant appears to be the latest in a series of moves aimed at staying on top of the industry.As part of its efforts to keep pace, Fidelity launched a Robo-advisor platform in 2016.  Just a few years later, Fidelity Go was named theTop Robo Advisor in the 2019 winter edition of The Robo Ranking Report from Backend Benchmarking.As passive products have proliferated, Fidelity has backed away from its former strategy ofavoiding low-margin products. In 2018, Fidelity gathered $64 billion in passive products, compared to active product outflows of $17 billion, according to Morningstar estimates. Fidelity was the first discount broker to offer a no-fee index fund.In August of last year, Fidelity “fired major shots in war over fees” when it launched two zero-fee mutual funds and reduced fees for 21 of the firm’s indexed mutual funds.  Fidelity was the first discount broker to offer a no-fee index fund—beating out the likes of Vanguard, Schwab, and iShares. And now, with the Merchant partnership, Fidelity appears to be positioning for further consolidation and M&A activity in the industry.  Assuming recent M&A trends continue, the Merchant partnership may provide a meaningful incentive for RIAs to use the Fidelity platform.Outlook for Strategic PartnershipsWe expect RIAs to continue to seek bolt-on acquisitions that offer scale and known cost savings from increased operating leverage.  Firms struggling with organic growth and margin compression will likely continue using acquisitions to expand distribution footprints and product offerings.  Against this backdrop, we expect to see more strategic partnerships involving RIA capital providers going forward.

Looking BackIf you’re an asset manager, then you’re probably aware of growth investors’ dominance over their value counterparts for the last ten or fifteen years. Since the Financial Crisis, it’s been all growth, which tends to outperform during sustained bull market runs and periods of monetary easing.As most value and growth managers’ clients are primarily (performance chasing) institutional investors, this recent disparity has been particularly challenging for value investment firms looking to grow (or even maintain) their AUM balances. The market has clearly picked up on these issues, especially over the last couple of years – two out of the three public (and predominantly) value-oriented investment firms (Gabelli and Diamond Hill) are in bear market territory while the S&P is up nearly 20% since the Summer of 2017: The economics behind the sector’s fall-out are relatively straightforward. Underperformance leads to outflows and contractions in AUM with corresponding declines in management fees and earnings. Even if the multiple doesn’t slip, the drop in profitability is enough to weigh on share prices. Unfortunately, the multiple did slip, and Gabelli and Diamond Hill have lost a third of their market cap during relatively favorable market conditions. As we’ve noted before, this multiple is a function of risk and growth, so the market either believes their growth prospects have diminished or their risk profile has elevated. In all likelihood, it’s a little bit of both, as growth will likely be adversely affected by lower demand for value products, while the risk of continued outflows remains high. Looking at the MultiplesAgainst this backdrop, we address this post's original question as to whether or not value managers are indeed undervalued at the moment. A quick glance at the P/E graph below reveals that two of these businesses are priced at less than 10x trailing twelve month (after-tax) earnings, while their RIA peers trade at 15.7x (on average) and the broader market is closer to 20x. This is definitely at the lower end of a reasonable range, and is, once again, likely attributable to a particularly high-risk profile and lower growth prospects. The ten-plus year slough of relative underperformance versus growth investing and expectations for continued outflows are the likely culprits. Still, some might contend that this is overblown, or at least short-sighted, if you believe in mean reversion or question the sustainability of the current trend. The last time growth dominated value by this margin was during the tech bubble when the Russell 2000 Growth Index outperformed its value counterpart by 68% (annualized) from October 1, 1998 to March 1, 2000 before giving it all back (and then some) over the next couple of years. The problem for value managers is most of their institutional clients emphasize relative performance over the prospect for mean reversion, so they’re going to have to improve their track records to recover lost AUM. That’s not always a given. Even the world's greatest value investor is struggling.Even the world’s greatest value investor (and perhaps the greatest investor of all time) is struggling to keep pace with the market. Warren Buffet’s Berkshire Hathaway is up just 2% so far this year compared to just over 15% for the S&P 500 and 25% (on average) for the FANG stocks. Fortunately, this hasn’t curtailed Buffet’s ability to raise money for a good cause, as the current bid for his annual charity lunch currently resides at $4.6 million. Buffet’s current predicament is not nearly as dire as 1999 during the Dot Com Crash when the S&P and NASDAQ appreciated 20% and 87%, respectively, while Berkshire lost 22%. Worth noting, however, is BRK-A gaining 32% the following year when the S&P and NASDAQ shed a respective 9% and 45%. We’re not forecasting that level of mean reversion but do want to emphasize how quickly relative outperformance can swing the other way. Looking ForwardThere are very good reasons why value managers’ stocks have performed so poorly over the last few years.The bottom line is that there are very good reasons why value managers’ stocks have performed so poorly over the last few years. Significant underperformance relative to both the market and growth alternatives has led to continued outflows from institutional investors, which in turn has hampered AUM, revenue, and earnings growth despite relatively favorable market conditions. Since the multiple has also slid for these businesses, it appears that the market is anticipating more of the same. That’s probably true since their one, three, five, and ten year track records are lagging, which is what most institutional investors base their hiring and firing decisions on.Regardless, we’re skeptical that this growth-over-value outperformance will persist much longer, given the cyclical nature of investment performance. It’s probably only a matter of time, and if it’s any time soon, that would make value managers (and Berkshire stock) very attractive investments. Otherwise, current valuation levels are justified, and it could be a very long time before the sector regains investor confidence.

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

While it’s no secret that the last year has been especially challenging for the RIA industry, Affiliated Managers Group (AMG) and Focus Financial (FOCS) have underperformed most of their peers by a fairly significant margin in the last few months.  AMG is down nearly 50% over the last year, and Focus has lost over 50% of its value since peaking last September. For this post, we’ll offer our take on the driving forces behind this decline.1) AMG and Focus’ Underlying Investments Have Likely Depreciated with the Industry, and These Losses Have Been Amplified by LeverageIf the RIA sector has underperformed the broader market by 10-15% in the last year (per above), it stands to reason that businesses that invest in this industry would experience a similar decline.  Then you have to factor in leverage.  Both AMG and Focus employ debt financing to make acquisitions, which magnifies losses when things go bad.  Even though the balance sheet isn’t a focal point for most RIAs, AMG and Focus both have growing debt obligations and deficit tangible equity.  Their income statements aren’t much better as Focus remains unprofitable (on a reported basis), and AMG is battling margin compression.Asset managers, in particular, have struggled over the last year, which may explain AMG’s underperformance relative to Focus during this time.  Fee compression, poor investment performance, and continuous asset flows from active to passive products are largely to blame for the sector’s recent woes.2) Market Declines Can be Particularly Damaging to High Beta Securities like AMG and FOCSA quick perusal of the graph above shows how sensitive these businesses are to market gains and losses.  The fourth quarter and recent weeks show significant declines as the market pulls back.  Volatility has likely compounded this issue as nervous investors shun active managers and look to products designed to mitigate losses. While Focus Financial CEO Rudy Adolf contends that Focus is relatively well insulated from market downturns, the reality is that this business (and AMG) levers up to buy companies that invest primarily in stocks or equity funds.  This dynamic creates an inherently volatile and market sensitive security that will almost certainly underperform the market in a downturn or correction.  The opposite is also typically the case, but not always.3) Goldman Sachs’ Recent Entry in the RIA Consolidation Space Means More Competition for Buyers and Possibly Lower ReturnsGoldman’s acquisition of RIA consolidator United Capital could be a game changer for M&A in the wealth management space.  A buyer of Goldman’s scale and resources is great for RIAs looking to sell, but not so great for other aggregators competing for deals.  Hightower also intends to ramp up RIA acquisitions in an already crowded space.  AMG and FOCS’s correction over the last couple of weeks may be attributable to these developments.A buyer of Goldman’s scale and resources is great for RIAs looking to sell, but not so great for other aggregators competing for deals.The public market seems concerned about AMG and Focus’ ability to find deals at attractive valuations (and returns).  While Focus has strung together over 20 acquisitions so far this year, keeping up that pace may be a tall order—especially if competition for deals increases.  AMG, on the other hand, has had a two-year acquisition dry spell that recently ended with the acquisition of Garda Partners.For aggregators like AMG and Focus, acquisitions are a key part of the growth strategy.  While these firms try to foster organic growth as well, acquisitions are still the fastest path to scale.  If the public market’s reaction to AMG and Focus is any indication, the outlook for this strategy appears to be facing some challenges.Don’t Read Too Much Into This…Focus and AMG are often regarded as bellwethers for financial advisory firms and asset managers, respectively.  We disagree.  They’re both in fundamentally different lines of business.AMG and Focus use debt financing to buy RIAs of one kind of another.  They’re not managing assets on behalf of clients (at least not directly).  They have huge balance sheets and debt obligations, unlike most investment managers.  They’re monitoring their own investments, not their clients’.  As publicly traded firms, they’re probably more concerned with the beating the Street and appeasing a much broader ownership base.Sure, the fortunes of AMG and Focus are tied to the fortunes of the firms they invest in over the long run.  But the business of acquiring RIAs is not the same as the RIA business.  So, while AMG and Focus may have lost half of their value in recent months, your business probably hasn’t.…But You Should Still Pay AttentionWe don’t think you should panic because publicly traded consolidators have struggled in recent months.  We do think it’s important to recognize the challenges they’re facing, especially if you’re starting to think about an exit strategy.  The RIA acquisition model isn’t dying, but investors seem to be anticipating a market share shift away from AMG and Focus.We don’t think you should panic over publicly traded consolidators' recent struggles, but we do think it’s important to recognize the challenges they’re facing.It’s also worth noting that these acquirers often use their own stock as part of the total consideration.  For AMG and Focus, you know exactly how much that’s worth.  For closely held aggregators like Hightower and Captrust, their stock price is not readily apparent.  Given what’s happened to AMG and FOCS over the last year, it’s probably reasonable to assume that other consolidators are not worth as much as they once were.  Even if they are publicly traded, you should be wary of any lock-up provisions since their stock prices are so volatile.In all likelihood, these businesses and other consolidators will continue to drive industry M&A.  RIA aggregators like AMG and Focus are just one of many exit options for RIA owners, but we’ll likely see their share of overall transaction volume increase with Goldman backing United Capital, and Hightower changing course to compete with Focus et al.  As the industry ages, these businesses are poised to play an increasingly important role in resolving the succession dilemma.  A few years ago, many of our clients had never heard of AMG or Focus.  That has definitely changed.

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

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.

During Q1 2019, most classes of RIA stocks underperformed the market despite its relatively sharp increase through the first three months. Investors still seemed concerned about the RIA industry’s prospects in the face of fee compression and continued asset outflows.  RIAs are responding to this pressure in different ways.  Some are actively expanding product offerings to meet clients’ changing demands; others are staying true to the traditional RIA model and responding to revenue pressure by developing cost efficiencies.As we do every quarter, we take a look at some of the earnings commentary of investment management pacesetters to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Industry consolidation has been spurred by a challenging revenue environment for RIAs, but firms are going about this in different ways.Consolidation is driven by a need for succession planning.RIAs are also increasingly seeking options to address succession planning, which is another catalyst of M&A. Industry research indicates that over one-third of all RIAs will transition within the next 10 years, putting $2 trillion of client assets in motion.  In our expertise in continuity planning, Focus is well positioned to lead the industry in this area, which will be another important driver of our growth. – Ruediger Adolf, Founder, Chief Executive Officer, and Chairman, Focus FinancialConsolidation is driven by cost savings.We expect to recognize roughly 50% to 55% of the cost synergies by the end of the third quarter. Additionally, by the end of 2019, we'll anticipate capturing approximately 85% of the synergies or more than $400 million in the run rate savings. – Loren Starr, Chief Financial Officer, Invesco (on Invesco’s acquisition of Oppenheimer)Consolidation is driven by the expansion of product offerings to include advanced tech platforms and alternative investments.Last month, we announced the binding offer and exclusive agreement to acquire eFront, the world's leading end-to-end alternative investment management software and solutions provider. As clients increasingly add to their alternatives allocations, the ability to seamlessly manage portfolios and risk across public and private asset classes on the single platform will be critical. The combination of eFront with Aladdin will set a new standard in investment and risk management technology and reinforce Aladdin's value proposition as the most comprehensive investment operating system in the world. – Gary S. Shedlin, Chief Financial Officer, Black RockTheme 2:  RIAs see flows back to fixed income after a volatile 2018.We saw strong re-risking for those who were in cash that allocated back into fixed income. We saw that predominantly a lot of investors were believing that interest rates are going to go higher, central banks really continue to tighten and, obviously the change in central bank forward forecast and their behaviors many investors were underinvested and put duration to work across the board. – Laurence D. Fink, Chairman and Chief Executive Officer, Black RockIn general, investors continue to pursue more defensive strategies, such as fixed income at the expense of international and higher beta domestic equity strategies. Outflows for our international core equity and science and technology strategies, remain somewhat elevated during the quarter.  While our emerging market equity and high income strategies, also continued to experience outflows, it was at a significantly reduced rate from the previous quarter. – Ben Clouse, Chief Financial Officer, Waddell & ReedOn fixed income, generally, I would say that […] I think we're interested in fixed income. We like the differentiated strategies within fixed income, the kind of core kind of bond U.S. and global. [….].  We've seen substantial appetite from institutions for fixed income relative value. – Jay C. Horgen, President and Chief Financial Officer, AMGTheme 3: RIAs continue to respond to the demand for responsible investing.Clients are increasingly attracted to our Responsible and Impact investing portfolio offerings. Assets in a diverse array of responsible equity and fixed income services totaled $1.9 billion at quarter-end, a 23% increase since year-end. – Seth Perry Bernstein, Alliance BernsteinLast week, we launched a Liquid Environmentally Aware Fund or LEAF, as a prime money market fund with an environmentally focused investment strategy. The fund will use 5% of its net revenues to purchase and retire carbon offsets and direct a portion of the proceeds to OUR conservation efforts. Increasingly, clients want sustainable strategies that provide financial returns and target a measurable social or economic impact.  BlackRock's goal is to make those strategies more accessible to more people.  Beyond dedicated sustainable investment funds, we're also integrating environmental, social, and government risk factors across all our investment processes. – Laurence D. Fink, Chairman and Chief Executive Officer, BlackRock Asset managers saw some improvement in performance in Q1 2019, but performance fees remained depressed as products worked back up to their previous watermark.  RIAs are still experiencing headwinds and are responding in various ways.  Under the assumption that fee pressure is the new norm, we are still seeing increased spending on technology in order to lower costs. Others are expending into higher margin products such as illiquid alternative investments.  Overall, RIAs are well positioned to have a stronger second quarter. We will continue to follow the key drivers of consolidation in the industry, as well as changes in fees and asset mixes during the rest of 2019.

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

Ordinarily, we’d expect investment manager stocks to outperform the S&P in a stock market rally.  As the broader indices creep up, so does AUM and revenue.  Higher top-line growth typically leads to even greater gains in profitability with the help of operating leverage.  Assuming no change in the P/E multiple, RIAs stock prices should outpace the market in a bull run.This isn’t always the case though.  So far this year, most classes of RIA stocks have underperformed the market despite its relatively sharp increase through the first three months. The explanation isn’t necessarily obvious.  Investors are likely concerned about the industry’s prospects in the face of fee compression and continued asset outflows.  Alternative asset managers were the sector’s sole bright spot as hedge funds tend to do well in volatile market conditions.  However, expanding this graph over the last year shows that they too have underperformed the market over this time. The fallout over this time is primarily attributable to the decline in the (historical) earnings multiple. Since this multiple is a function of risk and growth, at least one of those factors is weighing on investors.  We believe it is a combination of the two. Rising fee pressure and continuing demand for passive products have heightened the industry’s risk profile while dampening growth prospects.  The forward multiple has recovered some this year, but that’s likely attributable to analysts’ downward revisions of forward earnings estimates in Q1 after the market decline from the prior quarter. As noted a couple of weeks ago, traditional asset managers have felt these pressures most acutely. Poorly differentiated products have struggled to withstand downward fee velocity and increased competition from ETF strategies.  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 wealth management firms as these businesses are (so far) better positioned to maintain pricing schedules. Implications for Your RIA   Your company is probably facing the same industry headwinds and competitive pressures that publicly traded RIAs are dealing with.In all likelihood, your investment management firm is much smaller than the public RIAs, many of which have several hundred billion in AUM and thousands of employees across the country.  It’s also probably unlikely that your business lost 20% of its value last year like most of the public “comps.”  The market for these businesses was particularly volatile in 2018, and year-end happened to fall at the low end of the range.  So far this year, most publicly traded RIAs have recovered some of these losses during more favorable market conditions.Still, we can’t totally ignore what the market is telling us about RIA valuations.  We often get pushback from clients for even considering how the market is pricing these businesses (typically as a multiple of earnings) given how large these companies are relative to theirs.  The reality though is that your subject company is probably facing the same industry headwinds and competitive pressures that publicly traded RIAs are dealing with.  If investors have turned particularly bullish or bearish on the industry’s prospects, we have to consider that in our analysis.A (Less) Bearish 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 are 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.On balance, the outlook for the rest of 2019 doesn’t look great given what happened to RIA stocks at the end of 2018, but the recent uptick suggests that it’s not as bad as it was a few months ago.  The market is clearly anticipating lower revenue and earnings following the Q4 correction, which could be exacerbated if clients start withdrawing their investments.  On the other hand, more attractive valuations could also entice more M&A, coming off the heels of a record year in asset manager dealmaking.  We’ll keep an eye on all of it during what will likely be a very interesting year for RIA valuations.

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.

Over the last year, the stock price declines of publicly traded asset managers were generally more significant than other investment managers and the broader stock market.As mentioned in our latest whitepaper, How to Value a Wealth Management Firm, wealth managers are more resistant to market volatility as shown by their superior performance to asset managers over the last year.  Their resilience stems from the fact that client assets are correlated with the market, but client relationships are not.Asset management firms are more susceptible to market volatility, however, because during periods of volatility or market declines, asset management firms risk losing assets from both downward market movements and client outflows.  Downward market movement clearly has a direct negative impact on AUM, but it can also lead to outflows and lower revenue as clients de-risk or reallocate to lower fee fixed income products.While market declines are a threat to the profitability and valuations of any asset management firm, active managers face the additional threat of relative underperformance driving outflows, even in periods of rising markets.  Low fee passive strategies have become increasingly popular due in part to both the perceived underperformance of active managers and an increasing focus on fees.  But to what extent have active fund outflows been driven by mediocre performance versus competition from passive strategies, and what is the impact on asset management firm valuations?Fund OutflowsIn general, asset managers are experiencing an industry-wide shift away from actively managed investment products.  Over the last 15 years, more than half of all U.S. equity funds have merged or liquidated.  According to MorningStar, 2018 was the “worst year for long-term fund flows since 2008.”  Inflows were less than half the $350 billion average for the prior year, and outflows approximated 4% of beginning assets.At year-end, Morningstar predicted that if current trends in asset flows continued, passive U.S. equity funds would likely catch up with active funds’ market share in the next few months of 2019.  Most of our clients expect this trend will continue for a few more years before stabilizing and ultimately reversing.   January 2019 brought a more positive outlook for actively managed funds which “for the first time in five years outshone their passive counterparts.”Mediocre PerformanceHeadlines have recently brought attention to the mediocre performance of many active managers (“Active fund managers trail the S&P 500 for the ninth year in a row”).  One of the primary reasons for active funds’ lackluster performance is the number of active funds who participate in closet indexing.  Closet indexers claim to manage a unique portfolio designed to generate active returns while their active share (percentage of holdings that differ from the benchmark) is actually quite low.  Last year, thirteen active fund managers agreed to voluntarily disclose their active share in order to increase transparency.  Actively managed funds charge higher fees in exchange for the promise of excess return.  Closet indexers typically generate returns in line with the benchmark but at a higher cost than a passive investment in the underlying benchmark.Competition from Passive AlternativesAccording to Morningstar’s semiannual Active/Passive Barometer (published in February), “just 38% of active U.S. stock funds survived and outperformed their average passive peer in 2018, down from 46% in 2017.”  For the twenty years ending December 2015, the S&P 500 index averaged 9.85% a year, while the average equity fund investor earned a return of only 5.19%.  There has been much written about the shift from active to passive investing, and high costs and active manager underperformance are largely to blame.ValuationsOn average the stock prices of asset managers fell 17% year-over-year.  Trailing valuations fell by over 30% from a median of 15.8x trailing earnings in March 2018 to 10.5x trailing earnings in March 2019.  The broader stock market has recovered somewhat from the pullback observed at year end, but asset manager valuations have improved more modestly.  Forward multiples, however, are more in line with historical norms.Is the decline in active management a result of increased competition or mediocre performance?  We think it’s both.  In general, clients (especially institutional investors and high net worth individuals) are still willing to pay for superior performance.  We think best-in-class asset managers could come out ahead of their passive counterparts in the long run, but the problem is that best-in-class asset managers are, by definition, few and far between.

Last week, Matt Crow, Taryn Burgess, Zach Milam, and I attended the 2019 CFA Institute Wealth Management Conference in Fort Lauderdale.  We didn’t get a total headcount, but attendance appeared to be up from last year’s event.  There are probably a number of explanations for this, but perhaps the most plausible was the interest in this year’s focus on the psychological side of wealth management, which explored behavioral finance tendencies and how emotional decision-making can impact investment performance.  For this post, we’ve elected to summarize some of these presentations and their implications for financial advisors.The Geometry of WealthBrian Portnoy, Head of Education at Magnetar CapitalIn The Geometry of Wealth, behavioral finance expert Brian Portnoy, Ph.D., CFA defines true wealth as “the ability to underwrite a meaningful life” or “funded contentment.”  Dr. Portnoy distinguishes this concept from the blind accumulation of assets, which he likens to a continuous (and often unsatisfying) treadmill experience.  He contends that living a meaningful life and tending to financial decisions should be complementary, not separate, pursuits and uses three basic shapes to help readers visualize how to adapt to evolving circumstances (circle), set clear priorities (triangle), and find empowerment in simplicity (square).  Through this process, Dr. Portnoy maintains that true wealth is achievable for most people but only in the context of a life in which purpose and practice are thoughtfully calibrated.  He addresses the following questions to accomplish this goal:How is the human brain wired for two distinct experiences of happiness and why can money ‘buy’ one but not the other?Are the touchstones of a meaningful life affordable?Why is market savvy among the least important sources of wealth but self-awareness is among the most?Can we strike a balance between pushing for more and being content with enough? Dr. Portnoy advises managers to help clients spend wisely (on experiences, others, and time savers) and hedge sadness as most investors are loss averse.How Client Engagement is Being DisruptedJulie Littlechild, Founder of Absolute EngagementJulie Littlechild’s book, The Pursuit of Absolute Engagement, discusses the trends that are disrupting client engagement and why many advisors aren’t keeping pace with client demands.  She recommends that advisors answer these four questions to effectively respond to a client disruption (or at least stay one step ahead):Who are you designing the client experience to support? (Hint: Define an authentic niche, because you can’t design a compelling client experience around the needs of everyone)What does "extraordinary" look like through their eyes? (Hint: Actively involve clients in defining what extraordinary looks like, because you can’t base this on assumption)What is the client’s journey? (Hint: Understand the steps that clients go through and what they think, feel, and do at each stage because that will uncover their real needs)How will you support clients in their journey? (Hint: Define a communications plan that actively reflects the client journey and supports them along the way because that’s where innovation happens) By answering these questions and anticipating clients’ needs, advisors are able to support their clients on a deeper level by shifting their focus from "good service" to a "meaningful experience."The Behavioral InvestorDaniel Crosby, Chief Behavioral Officer of Brinker CapitalPsychologist and behavioral finance expert Dr. Daniel Crosby emphasizes the importance of understanding human nature and investor psychology in the portfolio construction process.  Dr. Crosby contends that only through developing a deep understanding of why humans make decisions can we really ascertain how we should invest.  Specifically, he says individuals should avoid making investment decisions while in a H-A-L-T phase, that is Hungry, Angry, Lonely, or Tired.  By understanding the context of our decisions and our own behavioral shortcomings, we can become better investors and advisors over time.  Similar to Brian Portnoy, Dr. Crosby posits that true wealth encompasses psychological wellbeing not just asset accumulation.Perception is Reality: Defining Your Value Proposition in a Competitive MarketplaceNikolee Turner, Managing Director of Business Consulting at Charles SchwabThis presentation stresses the importance of branding and perception in developing relationships and a strong referral network from existing clients.  Nikolee Turner discusses how advisors can fine tune their value proposition to compel action from prospective clients and win new business.  One way to accomplish this feat is through the use of firm success stories and concrete examples of helping clients realize their financial objectives.  Turner found that such communication is often lacking as her firm’s research indicates that many advisors can’t even articulate their firm’s value proposition to prospective clients.  As the competition for client assets intensifies, the need for effective communication and a dedicated referral program has never been greater.  Mastering both, Turner contends, is critical for achieving growth goals and gaining market share.All the sessions were well-received, and we’d certainly recommend these presentations and their author’s publications to anyone interested in this topic.  We’re looking forward to next year’s event in Seattle and hope to see you there.

Due to the historical popularity of this post, we revisit it this week. Originally published in 2016, the purpose of this post is to equip ownership to understand the consequences of their buy-sell agreements before a controversy arises, and to make informed decisions about the drafting or re-drafting of the agreement to promote the financial health and sustainability of their firm.The classic car world is full of stories of “barn finds” – valuable cars that were forgotten in storage for decades, found and restored and sold for mint. Similar to the one pictured above, a Ferrari 250 GT SWB California Spyder once owned by a French actor and found in a barn on a French farm in 2014. The car was one of 36 ever made and one of the most valuable Ferraris in existence. Once the Ferrari was exhumed, it was lightly cleaned and sold, basically as found, for $23 million at auction. As difficult it is to imagine such a valuable car being forgotten, what we see more commonly are forgotten buy-sell agreements, collecting dust in desk drawers. Unfortunately, these contracts often turn into liabilities, instead of assets, once they are exhumed, as the words on the page frequently commit the signatories to obligations long forgotten. So we encourage our clients to review their buy-sell agreements regularly, and have compiled some of our observations about how to do so in the whitepaper below. You can also download it as a PDF at the bottom of this page. We hope this will be helpful to you; call us if you have any questions.IntroductionAlmost every conversation we have with a new RIA client starts something like this: “We hired you because you do lots of work with asset managers, but as you get into this project you need to understand that our firm is very different from others.” Our experience, so far, confirms this sentiment of uniqueness that is not at all unique among investment managers. Although there are twelve thousand or so separate Registered Investment Advisors in the U.S. (not to mention several hundred independent trust companies and a couple thousand bank trust departments), there seems to be a comparable number of business models. Every client who calls us, though, has the same issue on their plate: ownership.Ownership can be the single biggest distraction for a professional services firm, and it seems like the RIA community feels this issue more than most. After all, most asset managers are closely held (so the value of the firm is not set by the market). Most asset managers are owned by unrelated parties, whereas most closely held businesses are owned by members of the same family. A greater than normal proportion of asset management firms are very valuable, such that there is more at stake in ownership than most closely held businesses. Consequently, when disputes arise over the value of ownership in an asset 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 an RIA.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. Institutional clients increasingly seem to query about business continuity planning, and the SEC has of course recently proposed transition planning guidelines. There are plenty of good business reasons to have a robust buy-sell agreement in any closely held company, but in RIAs there are client and regulatory reasons as well.SEC Proposed RuleEvery SEC-registered investment adviser must adopt and implement a written business continuity and transition plan that reasonably addressed operational risks related to a significant disruption or transition in the adviser's business.Business Continuity PlanningTransition PlanningMaintenance of critical operations/systems, as well as protection, backup and recovery of dataPolicies and procedures to safeguard, transfer, and/or distribute client assets during a transitionAlternate physical office locationsPolicies and procedures to facilitate prompt generation of client specific information necessary to transition each accountCommunication plans for clients, employees, vendors and regulatorsInformation regarding the corporate governance structure of the adviserIdentification and assessment of third-party services critical to the operationIdentification of any material financial resources available to the adviserKey Elements of the SEC’s Proposal: “Adviser Business Continuity and Transition Plans,” 206 (4)-4Buy-Sell Agreement BasicsSimply put, a buy-sell agreement establishes the manner in which shares of a private company transact under particular scenarios. Ideally, it defines the conditions under which it operates, describes the mechanism whereby the shares to be transacted are priced, addresses the funding of the transaction, and satisfies all applicable laws and/or regulations.These agreements aren’t necessarily static. In investment management firms, buy-sell agreements may evolve over time with changes in the scale of the business and breadth of ownership. When firms are new and more “practice” than “business,” these agreements may serve more to decide who gets what if the partners decide to go separate ways. As the business becomes more institutionalized, and thus more valuable, a buy-sell agreement – properly rendered – is a key document to protect the shareholders and the business (not to mention the firm’s clients) in the event of an ownership dispute or other unexpected change in ownership. Ideally, the agreement also serves to provide for more orderly ownership succession, not to mention a degree of certainty for owners that allow them to focus on serving clients and running the business instead of worrying about who gets what benefit of ownership.The irony of buy-sell agreements is that they are usually drafted and signed when all of the shareholders think similarly about their firm, the value of their interest, and how they would treat each other at the point they transact their stock. The agreement is drafted, signed, filed, and forgotten. Then, an event occurs that invokes the buy-sell, and the document is pulled from the drawer and read carefully. Every word is parsed, and every term scrutinized, because now there are not simply co-owners with aligned interests – but rather buyers and sellers with symmetrically opposed interests.Our Advice: Key Considerations for Your Buy-Sell AgreementAt Mercer Capital we have read hundreds, if not thousands, of buy-sell agreements. While we are not attorneys and do not attempt to draft such agreements, our experience has led us to a few conclusions about what works well and what doesn’t. By “working well,” we mean an enduring agreement that efficiently manages ownership transactions and transitions in a variety of circumstances. Agreements that don’t work well become the subject of major disputes – the consequence of which is a costly distraction.The primary weaknesses we see in buy-sell agreements relate to issues of valuation: what is to be valued, how, when, and by whom. The following issues and our corresponding advice are drawn from our experience of agreements that performed well and those that did not. While we haven’t seen everything, we have been more involved than most in helping craft agreements, maintaining compliance with valuation provisions, and resolving disagreements.1. Decide What You Mean By “Fair”A standard refrain from clients crafting a buy-sell agreement is that they “just want to be fair” to all of 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 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. Being “fair” to that many different parties is nearly impossible, considering the different motivations and perspectives of the parties.Founding owners. Aside from wanting the highest possible price for their shares, founding partners are usually desirous of having 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 ramping 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 necessarily requires consideration of the other stakeholders in the firm. We read one buy-sell agreement where the founder had secured his economic return by requiring the company, in the event of his death, to redeem his shares at a value that did not consider the economic impact of his death (the founder was a significant rainmaker). One can only imagine, at the founder’s death, how that would go when the other partners and employees of the firm “negotiated” with the estate – as if a piece of paper could checkmate everything else in a business where the assets of the firm get on the elevator and go home every night.Subsequent generation owners. The economics of a successful RIA 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 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. Younger partners also tend to underestimate the cost of building their own firm instead of buying into the existing one; other times, they don’t.The firm itself. The company is at the hub of all the different stakeholder interests, and is best served if ownership is a minimal consideration in how the business is run. Since hand-wringing over ownership rarely generates revenue, having a functional shareholder’s 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 do their jobs and maximize the performance of the company. At the other end of the spectrum, buy-sell disputes are very costly to the organization, distracting the senior-most staff from matters of strategy and client service for years, and rarely ending with a resolution that compensates for lost business opportunities which may never even be identified.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 a stable and predictable ownership.Clients. It is no surprise that the SEC made ownership continuity planning part of its recent proposed regulations for RIAs. The SEC may not care, per se, who gets the benefits of ownership of an investment management firm, but they know that the investing public is best served by asset managers who have provided for the continuity of investment management in the event of changes in the partner base. Institutional clients are often very interested in continuity plans, so it is to the benefit of RIAs to have fully functioning ownership models with buy-sell agreements that provide for the long-term health of the business. As the profession ages, we see transition planning as either a competitive advantage (if done well) or a competitive disadvantage (if disregarded) – all the more reason to pay attention.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, dollar for dollar. If the pricing mechanism in the agreement favors a relatively higher valuation, then whoever sells first gets the biggest benefit of that, to 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 (truly the valuation’s day of reckoning) to perfect the agreement. At relatively low valuations, internal transition is easier and business continuity is more certain, but the founding generation of ownership may be perversely encouraged to not bring in new partners, stay past their optimal retirement age, or push more cash flow into compensation instead of shareholder returns as the importance of ownership is diminished. Recognizing and ranking the needs of the various stakeholders in an RIA is always a balancing act, but one which is probably best done intentionally.Buy-Sell Agreements and Contract TheoryThe 2016 Nobel Prize in Economics was awarded to Professors Oliver Hart (Harvard) and Bengt Holmstrom (MIT) for their work in developing contract theory as a foundational tool of economics. The notion of contract theory organizes participants in an economy into principals (owners) and agents (employees), although the principal/agent relationship can be applied to many economic exchanges.Agents act on behalf of principals, but those actions are at least partially unobserved, so contracts must exist to incentivize and punish behavior, as appropriate, such that principals can be reasonably assured of getting the benefit of compensation paid to agents. The optimal contract to accomplish this weighs risks against incentives. The problem with contracts is that all of them are incomplete, in that they can’t specify every eventuality. As a consequence, parties have to be designated to make decisions in certain circumstances on behalf of others.Contract theory has application to the design of buy-sell agreements in the ordering of priority of stakeholders in the enterprise. If the designated principal of the enterprise is the founding generation, then the buy-sell agreement will be written to protect the rights of the founders and secure their ability to liquefy their interest on the best terms and pricing. Redemption from a founder’s estate at a premium value would be an example of this type of contract.If, on the other hand, the business is the designated principal of the enterprise, and all the shareholders are treated as agents, then the buy-sell agreement might create mechanisms to ensure the long-term profitability of the investment management firm, rewarding behaviors that grow the profits of the business (with greater ownership percentages or distributions or performance bonuses) and punish agent actions that do not enhance profitability.If the clients of the firm are the designated principals of a given RIA, then the buy-sell agreement might be fashioned to direct equity returns to agents (partners or non-owner employees) based on investment performance or client retention. An example of this would be carried interest payments in hedge funds and private equity.2. Don’t Value Your Stock Using Formula Prices, Rules of Thumb, or Internally Generated Valuation MetricsSince valuation is usually the most time consuming and expensive part of administering a buy-sell agreement, there is substantial incentive to try to shortcut that part of the process. Twenty years ago, a client told us “asset management firms are usually worth about 2% of AUM.” We’ve heard that maxim repeated many times, although not so much in recent years, as some firms have sold in noteworthy transactions for over twice that, while others haven’t been able to catch a bid for much less.We have written extensively about the fallacy of formula pricing. No multiple of AUM or revenue or cash flow can consistently estimate the value of an interest in an investment management firm. A multiple of AUM does not consider relative differences in stated or realized fee schedules, client demographics, trends in operating performance, current market conditions, compensation arrangements, profit margins, growth expectations, regulatory compliance issues, and a host of other issues which have helped keep our valuation practice gainfully employed for decades.Imagine an RIA with $1.0 billion under management. The old 2% of AUM rule would value it at $20.0 million. Why might that be? In the (good old) days, when RIAs typically garnered fees on the order of 100 basis points to manage equities, that $1.0 billion would generate $20 million in revenue. After staff costs, office space, research charges and other expenses of doing business, such a manager might generate a 25% EBITDA margin (close to distributable cash flow in a manager organized as an S-corporation), or $2.5 million per year. If firms were transacting at a multiple of 8 times EBITDA, the value of the firm would be $20.0 million, or 2% of AUM.Today, things might fall more into the extremes of firms A and B, depicted in the chart below. Assume firm A is a small cap domestic equity manager earning 65 basis points on average from a mix of high net worth and institutional clients. Because a shop like that can earn a relatively high EBITDA margin of 40% or so, a $20 million valuation is a little less than 8x, which in some circumstances might be reasonable.Firm B, on the other hand, manages a range of fixed income instruments for large pension funds who are expert at negotiating fees. Their 30 basis point realized fee average doesn’t leave much to cover the firm’s overhead, even though it’s fairly modest because of the nature of the work. The 15% EBITDA margin yields less than a half million dollars in cash flow, which against the rule of thumb valuation metric, implies a ridiculous multiple. The real problem with short cutting the valuation process is credibility. If the parties to a shareholders agreement think the pricing mechanism in the agreement isn’t robust, then the ownership model at the firm is flawed. Flawed ownership models eventually disrupt operations, which works to the disservice of owners, employees, and clients.3. Clearly Define The “Standard” of Value Effective for Your Buy-Sell AgreementThe standard of value essentially 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.Portfolio managers have a particular standard of value perspective, even though they don’t always think of it that way. The trading price for a given equity represents market value, and some PMs would make buying or selling decisions based on the relationship between market value and intrinsic value, which is what they think the security is worth based on their own valuation model. Investment analysts inside an RIA think of the value of their firm in terms of intrinsic value, which depending on their unique perspective could be very high or very low. CEOs, in our experience, think of the value of their investment management firm in terms of what they could sell it for in a strategic, change of control transaction with a motivated buyer – probably because those are the kinds of multiples that investment bankers quote when they meet with them.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. 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 benefit of a 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.The standard known as “fair value” can be considerably more opaque, having two different origins and potentially very different applications. In dissenting shareholder matters, fair value is a statutory standard that varies depending on legal jurisdiction. In many states, fair value protects minority shareholders from oppressive actions by providing them with the right to payment at a value equivalent to that which would be received in the sale of the company. A few states are not so generous as to providing aggrieved parties with undiscounted value for their shares, but the trend favors not disadvantaging minority owners in certain transactions just because a majority owner wants to remove them from ownership. The difficulty of statutory fair value, in our experience, is the dispute over the meaning of state statutes and the court’s interpretations of state statutes. Sometimes the standard is as clearly defined as fair market value, but sometimes less so.If a shareholders agreement names the standard of “Fair Value,” does it mean statutory fair value, GAAP fair value, or does it really mean fair market value? It pays to be clear.The standard of value is critical to defining the parameters of a valuation, and we suggest buy-sell agreements should name the standard and cite specifically which definition is applicable. The downsides of not doing so can be reasonably severe. For most buy-sell agreements, we 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 more clear.Which Fair Value?Making matters more complex, fair value is also a standard under Generally Accepted Accounting Principles, as defined in ASC 820. When GAAP fair value was originally established, members of the Financial Accounting Standards Board, which is responsible for issuing accounting guidance, suggested that they wanted to use a standard similar to fair market value but didn’t want their standard to be governed and maintained by non-related institutions such as the U.S. Tax Court.GAAP fair value is similar to fair market value, but not entirely the same. As GAAP fair value has evolved, it has become more of an “exit value” standard, suggesting the price that someone would pay for an asset (or accept to transfer a liability) instead of a bargain reached through consideration of the interests of both buyers and sellers.The exit value perspective is useful from an accounting perspective because it obviates financial statement preparers’ tendency to avoid write-downs in distressed markets because they “wouldn’t sell it for that.” In a shareholder dispute, however, the transaction is going to happen, so the bid/ask spread has to be bridged by valuation regardless of the particular desires of the parties.4. Avoid Costly Disagreement as to “Level of Value”Just as the interests and motivations of particular buyers and sellers can affect transaction values, the interest itself being transacted can carry more or less value, and thus the “level of value," as it has come to be known, should be specified in a buy-sell agreement.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. 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 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 RIA 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 RIAs, the owners joined together at arm’s length to create and operate the enterprise and want to be paid based on their pro rata ownership in that enterprise. 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. 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. Ultimately, 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 level of value. We even recommend inserting a level of value chart, like the one you see above, and drawing an arrow as to which is specified in the agreement.One thing to avoid in buy-sell agreements is embedded pricing mechanisms that unintentionally incentivize the behavior of some partners to try to “win” at the expense of the other partners. We were involved in one matter where a disputed buy-sell agreement could be read to enable other partners to force out a minority partner and redeem their interest at a deeply discounted value.Economically, to the extent that a minority shareholder is involuntarily redeemed at a discounted value, the amount of that discount (or decrement to pro rata enterprise value) is arithmetically redistributed among the remaining shareholders. Generally speaking, courts and applicable corporate statutes do not permit this approach in statutory fair value matters because it would provide an economic incentive for shareholder oppression.By way of example, assume a business is worth (has an enterprise value of) $100, and there are two shareholders, Sam and Dave. Dave owns 60% of the business, and Sam owns 40% of the business. As such, Dave’s pro rata interest is worth $60 and Sam’s pro rata interest would be valued at $40. If the 60% shareholder, Dave, is able to force out Sam at a discounted value (of, say, $25 – or a $15 discount to pro rata enterprise value), and finances this action with debt, what remains is an enterprise worth $75 (net of debt). Dave’s 60% interest is now 100%, and his interest in the enterprise is now worth $75 ($100 total enterprise value net of debt of $25). The $15 decrement to value suffered by Sam is a benefit to Dave. This example illustrates why fair value statutes and case law attempt to limit or prohibit shareholders and shareholder groups from enriching themselves at the expense of their fellow investors. Does the pricing mechanism create winners and losers? Should value be exchanged based on an enterprise valuation that considers buyer-seller specific synergies, or not? Should the pricing mechanism be based on a value that considers valuation discounts for lack of control or impaired marketability? Exiting shareholders want to be paid more and continuing shareholders want to pay less, obviously. What’s not obvious at the time of drafting a buy-sell agreement is who will be exiting and who will be continuing. There may be a legitimate argument to having a pricing mechanism that discounts shares redeemed from exiting shareholders, as this reduces the burden on the firm or remaining partners and thus promotes the continuity of the firm. If exit pricing is depressed to the point of being punitive, the other shareholders have a perverse incentive to artificially retain their ownership longer and force out other shareholders. As for buying out shareholders at a premium value, the only argument for “paying too much” is to provide a windfall for former shareholders, which is even more difficult to defend operationally. Still, all buyers eventually become sellers, so the pricing mechanism has to be durable for the life of the firm.5. Don’t Forget to Specify the “As Of” Date for ValuationThis seems obvious, but the particular date appropriate for the valuation matters. We had one client (not an RIA) spend a quarter million dollars on hearings debating this matter alone. The appropriate date might be the triggering event, such as the death of a shareholder, but there are many considerations that go into this.If the buy-sell agreement specifies that value be established on an annual basis (something we highly recommend to manage expectations and avoid confusion), then the date might be the calendar year end. The benefit of an annual valuation is the opportunity to manage expectations, such that everyone in the ownership group is prepared for how the valuation is performed and what the likely outcome is given various levels of company performance and market pricing. Annual valuations do require some commitment of time and expense, of course, but these annual commitments to test the buy-sell agreement usually pale in comparison to the time and expense required to resolve one major buy-sell disagreement.If, instead of having annual valuations performed, you opt for an event-based trigger mechanism in your buy-sell, there is a little more to think about. Consider whether you want the event precipitating the transaction to factor into the value. If so, prescribe that the valuation date is some period of time after the event giving rise to the subject transaction. This can be helpful if a key shareholder passes away or leaves the firm and there is concern about losing clients as a result of the departure. After an adequate amount of time, it becomes apparent as to the impact on firm cash flows of the triggering event. If, instead, there is a desire to not consider the impact of a particular event on valuation, make the as-of date the day prior to the event, as is common in statutory fair value matters.6. Appraiser Qualifications: Who’s Going to Be Doing the Valuation?Obviously, you don’t want just anybody being brought in to value your company. If you are having an annual appraisal done, then you have plenty of time to vet and think about who you want to do the work. In the appraisal community, we tend to think of “valuation experts” and “industry experts.”Valuation experts are known for:Appropriate professional training and designationsUnderstanding of valuation standards and conceptsPerspective on the market as consisting of hypothetical buyers and sellers (fair market value mindset)Experienced in valuing minority interests in closely held businessesAdvising on issues for closely held businesses like buy-sell agreementsExperienced in explaining work in litigated mattersIndustry experts, by contrast, are known for:Depth of particular industry knowledgeUnderstanding of key industry concepts and terminologyPerspective on the market as typical buyers and sellers of interests in RIAsTransactions experienceRegularly providing specialized advisory services to the industryIn all candor, there are pros and cons to each “type” of expert. We worked as the third appraiser on a disputed RIA valuation many years ago in which one party had a valuation expert and the other had an industry expert. The resulting rancor bordered on the absurd. The company had hired a reasonably well-known valuation expert who wasn’t particularly experienced in valuations of investment management firms. That appraiser prepared a valuation standards-compliant report that valued the RIA much like one would value a dental practice, and came up with a very low appraised value (his client was delighted). The departing shareholder hired an also well-known investment banker who arranges transactions in the asset management community. The investment banker looked at a lot of transactions data and valued the RIA as if it were a department at Blackrock. Needless to say, that indicated value was many, many times higher than the company’s appraiser. We were brought in to make sense of it all. Vetting a valuation expert for appropriate credentials and experience should focus on professional standards and practical experience.Professional Requirements. The two primary credentialing bodies for business valuation are the American Society of Appraisers (ASA) and the American Institute of Certified Public Accountants (AICPA). The former awards the Accredited Senior Appraiser designation, or ASA, and the latter the Accredited in Business Valuation, or ABV, designation. Without getting lost in the weeds, both are substantial organizations that require extensive education and testing to be credentialed, and both require continuing education. Also well known in the securities industry is the Chartered Financial Analyst charter issued by the CFA Institute, and while it is not directly focused on valuation, it is a rigorous program in securities analysis. CFA Institute offers, but does not require, continuing education.Practical Requirements. Experience also matters, though, in an industry as idiosyncratic as investment management. Your buy-sell agreement should specify an appraiser who regularly values non-depository financial institutions such that they understand the dynamic differences between, say, an independent trust company and a venture capital manager. While there are almost 12,000 RIAs in the U.S., the variety of business models is such that you will want a valuation professional who understands and appreciates the economic nuances of your firm.In any event, your buy-sell agreement should specify minimum appraisal qualifications for the individual or firm to be preparing the analysis, but also specify that the appraiser should have experience and sufficient industry knowledge to appropriately consider the key investment characteristics of RIAs. Ultimately, you need a reasonable appraisal work product that will withstand potential judicial scrutiny, but you should not have to explain the basics of your business model in the process.7. Manage Expectations by Testing Your AgreementNo matter how well written your agreement is or how many factors you consider, no one really knows what will happen until you have your firm valued. If you are having a regular valuation prepared by a qualified expert, then you can manage everyone’s expectations such that, when a transaction situation presents itself, parties to the transaction have a reasonably good idea in advance of what to expect. Managing expectations is the first step to avoiding arguments, strategic disputes, failed partnerships, and litigation.If you don’t plan to have annual valuations prepared, have your company valued anyway. Doing so when nothing is at stake will make a huge difference if you get to a situation where everything is at stake. Most of the shareholder agreement disputes we are involved in start with dramatically different expectations regarding how the valuation will be handled. Going ahead and getting a valuation done will help to center, or reconcile, those expectations and might even lead to some productive revisions to your buy-sell agreement.Putting It All TogetherIf you have not yet crafted a buy-sell agreement for your RIA, you can see that there is much to consider. Most investment management firms have some shareholders agreement, but in many cases the agreements do not account for the many circumstances and issues briefly addressed in this whitepaper. That said, our advice is to first pull your buy-sell agreement out of the drawer and read it, carefully, and compare it to the commentary in this paper. If you don’t understand something, talk with your partners about what their expectations are and see if they line up with the agreement. Consider having a valuation firm review the agreement and tell you what they might see as issues or deficiencies in the agreement, and then have the firm appraised. If there is substantial difference of opinion in the partner base as to the value of the firm, or the function of the agreement, you know that you don’t actually have an agreement.On the positive side of the equation, a well-functioning agreement can serve the long-term continuity of ownership of your firm, which provides the best economic opportunity for you and your partners, your employees, and your clients. Strategically, it may well be the lowest hanging fruit available to enhance the value of your company, and your own career satisfaction.WHITEPAPERBuy-Sell Agreements for Investment Management FirmsView Whitepaper

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.

There are three general approaches to determining the value of a business: the asset-based approach, the income approach, and the market approach.  The three approaches refer to different bases upon which value may be measured, each of which may be relevant to determining the final value.  Ultimately, the concluded valuation will reflect consideration of one or more of these approaches (and perhaps several underlying methods) based on those most indicative of value for the subject interest.  The chart below summarizes the methods typically used to value wealth management firms under each valuation approach. This week, we take a look at how the income approach is used to value wealth management firms. What is the Income Approach?The income approach is a general way of determining the value of a business by converting anticipated economic benefits into a present single amount.  Simply put, the value of a business is directly related to the present value of all future cash flows that the business is reasonably expected to produce.  The income approach requires estimates of future cash flows and an appropriate discount rate with which to determine the present value of future cash flows.Methods under the income approach are varied but typically fall into one of two categories:Single period capitalization of free cash flowDiscounted future cash flow model (DCF)Single Period Capitalization ModelThe simplest method used under the income approach is a single period capitalization model.  Ultimately, this method is an algebraic simplification of its more detailed DCF counterpart.  As opposed to a detailed projection of future cash flow, a base level of annual net cash flow and a sustainable growth rate are determined. The denominator of the expression on the right (r – g) is referred to as the “capitalization rate,” and its reciprocal is the familiar “multiple” that is applicable to next year’s cash flow.  The multiple (and thus the firm’s value) is negatively correlated to risk and positively correlated to expected growth. There are two primary methods for determining an appropriate capitalization rate—a public guideline company analysis or a “build-up” analysis.  The most familiar method applies the P/E ratio from a guideline public company analysis.  A build-up analysis can be based upon the Capital Asset Pricing Model (CAPM) or Adjusted CAPM (ACAPM).  Both the P/E ratio and the built-up capitalization factor articulate the risk and growth factors that investors believe underlie earnings measures. Discounted Cash Flow ModelWealth management firms are frequently valued using the DCF method because this method allows for detailed modeling of revenue and expense items over the discrete projection period.  A discrete projection period of three to five years is typically employed so that AUM trends, fee levels, and operating expenses can be modeled with reasonable certainty based on the current trends and business model.  Beyond the discrete projection period, it is assumed that the business will grow at a constant rate into perpetuity.  In circumstances where no changes in the business model or capital structure are expected, a single period capitalization method may suffice.The discounted cash flow methodology requires three basic elements:Forecast of expected future cash flowsDetermination of terminal valueSelection of an appropriate discount rateDCF Element #1: Forecast of Expected Future Cash FlowsA DCF model requires a base level of cash flows to use as a starting point to model future growth and profitability.The base rate of profitability is determined by a wealth manager’s current revenue and cost structure, with possible adjustments made.  It is often said that wealth managers generate revenue while they sleep, as revenue is a function of assets under management and is typically not performance or commission based.  The fee-based revenue model used by most wealth management firms allows us to determine an ongoing (run rate) level of revenue by multiplying assets under management at any given day by the business’ average realized fee structure.The base rate of expenses for wealth management firms is typically based on reported expenses over the most recent annual period, with adjustments made for various items (the most significant of which typically relates to normalizing compensation).Projecting Cash Flow for Wealth ManagersWe typically view the discounted cash flow method as superior to the single period capitalization approach as it is more dynamic and allows for the discrete forecasting of cash flows.  Projections of future cash flows rely on many assumptions as explained below.Assets Under Management Trends in AUM growth should include new business gained and expected market returns based on overall asset allocation.  When determining growth in AUM, it is important to ask what has historically driven growth and if it is reasonable to assume that this trend will continue.  For example, has a firm’s historical AUM growth been driven by market movement or by new client generation?  Markets have good years and bad years, but strong client relationships (and the ability to generate new ones) result in a continual source of new assets to manage.  As mentioned in a prior post, "Client assets (AUM) do correlate to a great extent with the market, but client relationships do not."  Without proper relationship management, assets leave and revenue suffers.Markets have good years and bad years, but strong client relationships (and the ability to generate new ones) result in a continual source of new assets to manage.Further complicating new AUM generation, many wealth managers have aging customer bases and are struggling to attract younger clients who are more likely to choose passive alternatives.  As managers struggle to gain new clients in light of the competitive environment, effective marketing has become increasingly important.Realized FeesProjected realized fees are typically evaluated in light of historical levels.  However, fee compression has plagued the industry in recent years, and in light of increasing fee consciousness among clients, many wealth managers are cutting fees in order to stem outflows.CompensationWealth management is a relationship business, and relationships require the time and energy of a dedicated staff.  The majority of a typical wealth management firm’s expenses are personnel expenses, which include salaries, bonuses, and other benefits for employees and owners.  Compensation generally tracks revenue closely, making operating leverage more pronounced with non-compensation related expenses than compensation related expenses.Compensation programs tend to evolve in wealth management firms and over time take on a life of their own.  Inevitably, compensation programs tend to be intertwined with business models and ownership.  The valuation process typically includes an analysis of the compensation program to formulate a normalized margin that can be used to value the firm.The valuation process typically includes an analysis of the compensation program to formulate a normalized margin that can be used to value the firm.The compensation structure for owners is often affected by the tax environment.  The corporate structure of a firm (C Corp vs S Corp or other pass-through entity), as well as the current federal and state tax environment, frequently determines whether firms pay out profit as bonuses or distributions.  For example, in states with high corporate tax rates but no personal income tax, income is more likely to be paid out in the form of bonus compensation rather than distributions in order to reduce taxable income at the corporate level.Non-Compensation Operating ExpensesMarketing expenditures have increased as wealth managers seek to attract new, often younger, clients.  We have seen an increased focus on branding as wealth managers seek to connect with clients on a more personal level.  Additionally, spending on technology has increased as wealth managers update their platforms to increase transparency and cater to younger clients who prefer to manage their accounts online.  This increased reliance on technology has allowed some wealth managers to reduce overhead combatting margin compression.With some exceptions, wealth managers’ non-compensation operating expenses are generally fixed in nature, which allows wealth managers to take advantage of operating leverage over time.DCF Elements #2-3: Terminal Value & Discount RateOnce it is assumed that the business will achieve a constant level of performance, the remaining cash flows are capitalized and represented by a terminal value.  An appropriate discount rate is used to discount the forecasted cash flows and the terminal value to the present.The sum of the present values of all the forecasted cash flows (both the discretely forecasted periods and the terminal value) is the indication of value for a specific set of forecast assumptions.Reconciliation of ValueYour firm’s valuation should clearly articulate the observations, assumptions, adjustments, and empirical data upon which the income method is based.  If your valuation provider cannot develop and report their analyses in a manner that you sufficiently understand, get clarification or a new appraiser.  You may not agree 100% with the conclusion, but you should understand the methods used and recognize your wealth management firm in the report.Additionally, your firm’s valuation should make sense in light of industry trends and valuations observed within the public and private markets.Next week, we will look more closely at the market approach and how it can be used to better understand the value of wealth management firms.

From Broker to AdvisorWealth management firms represent a critical link between asset management firms (who develop investment products) and the highly fragmented retail client channel.  The dominant model by which the wealth management industry connects retail clients with asset managers has changed significantly over the last several decades.  The predecessor to the modern-day financial advisor is the wirehouse stock broker who rose to prominence during the bull market run of the 1980s and 90s.  Typically compensated on a commission basis, the broker was as incentivized to churn client assets as he was to grow them because pay was tied to transactions rather than performance – at least directly.  The result was often a gradual transfer of wealth from the customer to the broker, whose interest ran counter to most investors.  Oversight was minimal, and many regulators were not properly incentivized themselves.  Change was desperately needed.Fortunately, the business has come a long way since the Wolf of Wall Street days.  Evolving client expectations, increased transparency, and stronger fiduciary standards have expedited the broker-to-advisor conversion in recent years.  Brokerage houses fueled by commissions have largely been replaced by wealth management firms whose fee schedules vary with client assets instead of trades executed on their behalf.  A financial advisor’s office now bears more resemblance to a law firm than Stratton Oakmont or Gekko and Co.  The industry has definitely become more boring, which is good news for those in need of competent financial advice.This evolution has had some obvious benefits for advisors as well.  Client attrition rates have plummeted since the broker days as customers are far more likely to stick around when their advisor’s interests are aligned with their own.  High retention rates make it easier to retain the employees who service these accounts, enabling partners to build an actual business rather than a collection of brokers that switches firms every few years.Recurring revenue from asset-based fees is also more predictable than commission income.  A wealth management firm’s ongoing or run-rate revenue is simply the product of its current AUM balance and effective realized fee percentage.  This predictability makes it easier to forecast hiring needs and project future levels of profitability.  These apparent financial advantages combined with the fact that the fee-based model is more appealing to clients explains why the number of broker-dealer firms has declined 24% over the last decade, while the number of RIAs has grown by over 20% just in the last five years, according to FINRA and the SEC.  Asset flows also demonstrate the apparent advantages of the fee-based, fiduciary model; RIAs as a group are growing AUM at a faster rate than other distribution channels and manage a growing share of total AUM.  Look for these trends to continue as investors become more educated on fee structures while regulators crack down on conflicts of interest and suitability concerns.Characteristics of Today’s Wealth Management FirmAccording to ThinkAdvior and a report from Investment Advisor Association (IAA), the typical (i.e. average) SEC-registered investment advisor has the following characteristics:Works with a team of nine employeesHas $359 million in regulatory assets under managementManages 124 client accountsHas at least one pension/profit-sharing plan as a clientExercises discretionary authority over most accountsDoes not have actual physical custody of client assets or securitiesIs organized as a U.S.-based limited liability company headquartered in California, Connecticut, Florida, Illinois, Massachusetts, New Jersey, New York, Ohio, Pennsylvania, or Texas Even though some of the firms included in the report outlined above are not wealth managers, they are generally representative of the wealth management industry since 94% of their clients are individuals rather than institutions.  The report also states that over 95% of RIAs are compensated as a percentage of AUM while just under 4% charge commissions, so it doesn’t include many broker-dealers or RIA/BD hybrids.  Perhaps also in contrast to the Wall Street era, 86% of RIAs reported no disciplinary history at all. The IAA report also states that 57% of RIAs are “small businesses,” employing ten or fewer non-clerical employees, with 88% employing less than 50 people.  Unfortunately, this end of the size spectrum is not gaining market share relative to their larger counterparts.  The report found that RIAs with over $100 billion in AUM grew at a faster pace than smaller advisors last year both in terms of the number of firms and AUM.  The benefits of scale and branding are largely to blame for this discrepancy, and it seems likely that this trend will continue into the foreseeable future.How Does Your Wealth Management Firm Measure Up?According to RIA in a Box’s annual survey, the average advisory fee in 2017 was 0.95%, down from 0.99% in the prior year.  A little math (0.95% x $359 million) implies average annual revenue of $3.4 million.  According to the InvestmentNewsAdvisor Compensation & Staffing Study, the average operating margin for an RIA was 22.8% in 2017, so here’s how the “typical” advisory firm P&L breaks out:While the numbers for 2018 haven’t come out yet, we suspect they’ll be down across the board.  The major indices were down 5% to 10% for the year, and realized fees have been on the skid for quite some time.  Declining AUM and revenue combined with generally higher costs associated with rising compensation expenses means margins will likely be compressed as well.  Valuations of publicly traded RIAs in 2018 echoed these concerns:[caption id="attachment_24163" align="alignnone" width="833"]Source: S&P Global Market Intelligence[/caption] The silver lining for wealth management firms is that they (generally speaking) outperformed other classes of RIAs last year and are up so far in 2019.  Their superior performance is likely attributable to a more adhesive customer base that won’t jump ship after a few quarters of poor returns.  Wealth managers are also generally less susceptible to fee pressure than traditional and alternative asset managers that have struggled to justify their higher rates with the rise of low-cost ETFs and other passive investment products.  Wealth management and financial advisory services are primarily based on client service rather than performance relative to a benchmark, so these firms have been able to stave off fee pressure and client attrition for the most part.  The ability to keep this up will likely depend on their capacity to continue servicing clients while connecting with their next generation.  It’s a tall order, but most wealth managers have learned to cope with this reality for quite some time.  We suspect they’ll continue to do so.

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

Reflective of the headwinds that the industry is currently facing, asset managers generally underperformed broad market indices during the fourth quarter of 2018.  As the broader indices stumbled, many RIA stocks plummeted with falling AUM balances and management fees. As we do every quarter, we take a look at some of the earnings commentary of pacesetters in investment management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Q4 volatility drove investor outflows.Volatility was the dominant theme as 2018 came to a close. U.S. equity markets set record highs during the quarter only to see those gains erased by late December. The selloff experienced toward year-end sent the equity markets into correction territory with virtually every asset class ending the year with negative returns. — Philip James Sanders, CEO, CIO, & Director, Waddell & ReedTurning next to flows. There are a couple of high-level themes that shaped our quarter. In general, elevated market volatility in the fourth quarter increased industry-wide client risk aversion, which led to slowing sales activity and delayed funding. In addition, we had elevated levels of retail redemptions in equities and liquid alternatives due to fourth quarter seasonality, which in the case of liquid alternatives was exacerbated by significant outflows from products with challenging recent performance relative to benchmark. — Nathaniel Dalton, President and Chief Executive Officer, Affiliated Managers Group, Inc.Gross flows for the quarter were strong at $4 billion, while net flows were negative $1 billion as many investors retreated from higher-risk asset classes and rotated into cash. — David Craig Brown, CEO & Chairman, Victory Capital Holdings, Inc.At the end of 2018, the market drawdown, volatility, and industry-wide outflows dominated attention. Our AUM declined by more than 17%, and our stock price declined by more than 30%. — Eric Richard Colson, Chairman, President, & CEO, Artisan Partners Asset Management, Inc.Theme 2: Previously, industry pacemakers suggested that the return of volatility to the markets offered opportunities for active managers.  However, recent volatility has pushed investors to more passive strategies.  While volatility can, at times, provide a favorable backdrop for active managers, and we firmly believe that research and insight can identify differentiated ideas for investors, the flow toward passive strategies remains steady in 2018. — Philip James Sanders, CEO, CIO, & Director, Waddell & Reed Financial, Inc.Our ETF business, VictoryShares, had positive net flows of $121 million in the fourth quarter, bringing full year of 2018 net flows to $1.1 billion. We continue to be pleased with the strong momentum and market share gains we're seeing in VictoryShares and note that we have experienced positive net flows every quarter since our acquisition of the business in 2015. — Terence F. Sullivan, CFO and Head of Strategy, Victory Capital Holdings, Inc.Clients who faced large tax bills while their equity mutual funds delivered negative active returns experienced this firsthand and shifted to ETFs in the fourth quarter.  […]  I truly believe it's becoming more recognized, the superior nature of the ETF structure versus a mutual fund.  We have heard many instances where many mutual funds who had negative NAV at the end of the year, but they also had capital gains, taxes that they were identifying to their clients.  And the clients, I think, in many cases, just got quite aggravated by paying taxes with the negative NAV.  Obviously, with an ETF, you control your tax basis.  And I think this is becoming a bigger and bigger issue.  Tax navigating for the long term, your tax position, for taxable individuals and institutions, is very important. — Laurence Douglas Fink, Chairman & CEO, BlackRock, Inc.Theme 3:  Recent fee compression is largely attributable to a shifting asset class mix on lower equity balances and passive inflows.  Much of this attrition is likely to be temporary in nature. I would say that as you think about the fee movement, it is driven by asset mix shift.  That if you think about it, was a bit magnified in the fourth quarter given the volatility.  I think it's important to focus on mixed shift versus erosion because that is truly what we're seeing here. It's about the asset classes that we're having momentum in.  And I would also say that it is not a permanent movement.  We have asset classes, and therefore fees that range quite broadly as we've discussed in the past.  And we have seen and would expect to see momentum in some of those asset classes that higher–have higher fees, and therefore, could move it in the other direction. — Terence F. Sullivan, CFO & Head of Strategy, Victory Capital Holdings, Inc.Our effective fee rate, what you see trending down, it's really—it is a mix shift topic for us. And you would imagine, in risk-off environments, people putting money in money funds, et cetera, that you see that happen. Oppenheimer [Funds] during the period had the exact opposite. There is an aggressive—or I should say aggressive, quite successful in emerging markets and in international equities, and those are higher capabilities. And again, that is sort of the natural flow of things within an organization. So client demand will drive those mix shifts. There's very little we can do about it. — Martin L. Flanagan, President, CEO, Director, Invesco Ltd.For the fourth quarter, aggregate fees decreased 27% to $1.2 billion from a year ago, and the ratio of aggregate fees to average assets under management declined year-over-year from 82 basis points to 63 basis points, entirely driven by lower performance fees. Notably, the ratio advisory fees to average assets under management remain flat year-over-year. — Jay C. Horgen, CFO & Treasurer, Affiliated Managers Group, Inc. In summary, we continue to see many of the same trends we have highlighted in previous quarters.The industry is still evolving to increased fee pressure.Scale remains at the forefront of conversation as demonstrated by recent M&A activity.Rising yield curve and equity market volatility continue to pull assets into fixed income products. Q4 was rough, to say the least, for most asset managers as both AUM and effective fee rates declined.  However, most saw some normalization of flows in January.  We will continue to follow changes in asset mix, which will drive fee rates in 2019.

Perhaps John Bogle’s greatest legacy is not founding Vanguard (nearly $5 trillion in total AUM), but his common sense (and yet often contrarian) approach to long-term investing. “In investing you get what you don’t pay for.  Costs matter.  So intelligent investors will use low-cost index funds to build a diversified portfolio of stocks and bonds, and they will stay the course.  And they won’t be foolish enough to think that they can consistently outsmart the market,” Bogle told the New York Times in 2012.“Don’t look for the needle in the haystack.  Just buy the haystack.” – John Bogle on the merits of passive investing over active managementUnfortunately, most investors haven’t stayed the course.  For the twenty years ending December 2015, the S&P 500 index averaged 9.85% a year while the average equity fund investor earned a return of only 5.19%.  High costs and market timing are largely to blame, which is why passive investing has dominated active management over this period.Ironically, the king of active management is a huge fan of Bogle’s.  You may recall Warren Buffett’s bet with Protégé Partners that an index fund would outperform their selection of hedge funds over a ten-year period.  Buffett’s investment vehicle was Vanguard’s S&P 500 Admiral Fund (VFIAX), which outperformed Protégé’s fund of funds for nine of the ten years.  Buffett’s advice on investing is right out of Bogle’s playbook, “Stick with big, ‘easy’ decisions and eschew activity.”  Easier said than done, unfortunately.Most active managers probably feel differently.  According to the Associated Press, investors paid 40% less in fees for each dollar invested in mutual funds during 2017 than they did at the start of the millennium.  That’s great for investors, but not so good for mutual fund providers and active managers.“Stick with big, ‘easy’ decisions and eschew activity.” – Warren BuffettStill, there might be a silver lining to all this for some active managers.  It’s hard to envision a world without stock pickers and market timers.  After all, what would happen to asset prices if nobody paid attention to them?  For the active managers that have survived the so-called flowmageddon to passive products, there’s ample opportunity to pick up market share and less competition for undervalued assets.  Best-in-class asset managers could very well come out ahead over the long run.The problem is best-in-class asset managers are scarce.  Over 90% of active managers underperformed the S&P 500 over the last market cycle.  Such underperformance has led to all sorts of problems for the industry, including asset outflows and fee pressure that pushed most of these businesses into bear market territory last quarter.Active managers can’t blame Bogle for their recent woes.  He merely shed light on an obvious deficiency in their value proposition (alpha in excess of fees), and investors have responded accordingly.  What’s especially problematic is the recent trend seems to be accelerating.  An estimated $369 billion flowed out of long-term U.S. active mutual funds in 2018, versus net inflows of $72 billion in 2017.  By comparison, outflows were a little more than $200 billion in 2008.So if you’re a contrarian like Bogle, is now the time to get back into active management?  It could be.  Most active managers haven’t beaten the market since 2008, so they’re long overdue, especially if you consider their outperformance during bear markets:In addition, high dividend ETFs often underperform their active counterparts since many of them are programmed to buy the highest yielding securities, regardless of fundamentals.  Interestingly enough, actively managed Vanguard Dividend Growth has outperformed the Vanguard Dividend Appreciation ETF since 2007 even after fee considerations.Still, we think Bogle would advise most investors to keep it simple and stick with passive investing.  He has undoubtedly saved millions of investors around the world from the higher fees and (often) subpar performance of active management.  So, next time you imbibe, pour one out for John Bogle and, perhaps, the active management industry as well.

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

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.

Trust banks have generally lagged the broader indices since the financial crisis of 2008 and 2009. Against a bearish backdrop for the industry, all three trust bank stocks declined in the last few months of the year with falling client asset balances and rising labor costs.Rough year for trust bank stocks, especially State Street Northern Trust and BNY Mellon performed more in line with the market and traditional banks while State Street’s underperformance is largely attributable to investor skepticism surrounding its purchase of Charles River Systems last summer. Customers Demand Improved Technology OfferingsAs noted during a Conversation with Jay Hooley and Ron O’Hanley at State Street, the industry is going through a “time of unprecedented change.”  Investment firms are devoting more time and resources to keep up with the most recent technological offerings and improve the overall client experience.  These dynamics are especially true for trust banks where increased regulation has encouraged advancement in data management.IT investment is outlined as a clear priority for success.  BNY Mellon invested $2.4 billion in IT last year and plans to spend another $2.7 billion going forward to develop their operating platform.  Northern Trust utilizes technology in order to provide momentum to its growth strategies and cut costs “to take advantage of new technologies such as robotics to slim down its permanent workforce.”Another example of trust banks’ directing resources to technological development is State Street’s recent acquisition of Charles River Systems for $2.6 billion.  Charles River is a financial data firm that runs a software platform used by more than 300 asset management firms.  According to Ron O’Hanley, President and CEO of State Street, “This acquisition represents not only a significant investment in our future but also the recognition that the ability to assist clients in managing their data needs and extract insights from their data is increasingly the most important differentiator for our industry.”Investors disagreed as STT’s share price declined sharply after the announcement (pessimism surrounding the acquisition) as the 38% increase in total assets under custody from the acquisition will not be met with proportional increases in revenue.  At the moment, investors are questioning if State Street’s focus on data management in addition to asset management will, in fact, create shareholder value in the long run.Is Pricing Indicative of Performance in a Down Market?Trust bank trailing and forward multiples have fallen in line with the broader market. A quick glance at year-end pricing shows the group valued at 9-13x (forward and trailing, respectively) earnings, down from 14-16x at year-end 2017 as the outlook on future cash flows has stalled with the recent market correction. Despite trust banks’ underperformance during 2018, investment management fees increased year-over-year (as of the third quarter, the most recent information available).  Servicing fees varied by company. State Street saw a decline in serving fees due to what it explains as “client transitions and challenging industry conditions.”  BNY Mellon’s fees were relatively flat and Northern Trust saw an increase in servicing fees partially due to the UBS fund administrator acquisition which closed in late 2017.  But, as a whole, trust banks saw improved net interest margins due to higher U.S. market interest rates and increases in trading services with the recent uptick in volatility. Are Investors Too Bearish on State Street? State Street’s stock price has been hammered even more than the industry as a whole.  State Street’s ETF business has historically helped it outperform peers.  However, legacy contracts have disabled them from cutting fees in order to remain competitive.  State Street has begun restructuring its ETF business, but it will take time to regain its market position.  Despite these challenges, State Street’s share of the U.S. ETF industry was at an all-time low by July of this year.  Despite the recent struggles with its ETF business and the market’s perception of the Charles River acquisition, State Street ($34 trillion in AUCA) is still on track to surpass BNY Mellon ($34.5T AUCA) as the largest custody bank by in terms of assets under custody/administration.Trust Companies are Bullish on TechnologyTrust Companies are relying on technology to ease some of the pressure from their customers on cost.  More barriers to entry have developed in the industry as regulators have made it harder to obtain approval to operate as a custody bank.  This stricter regulation has forced these companies to adopt technological platforms which, if done properly, can provide a valuable service to its customers.Mercer Capital assists RIA clients with valuation and related consulting services for a variety of purposes.  In addition to our corporate valuation services, Mercer Capital provides transaction advisory and litigation support services to the investment management industry.  We have relevant experience working with independent trust companies, wealth management firms, traditional and alternative asset managers, and broker-dealers to provide timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

Following a decade of (fairly) steady appreciation, RIA stocks finally capitulated with the market downturn and growing concerns over fee compression and asset flows.  As a leading indicator, such a decline suggests the outlook for these businesses has likely soured over the last year or so.What Goes up Must Come Down…Prior to last year, RIA stocks benefited immensely from the bull run that began in March of 2009, besting the market by over 60% during this favorable period for asset returns.[caption id="attachment_24166" align="alignnone" width="814"]Source: S&P Global Market Intelligence[/caption] In 2018, this trend reversed course, and the return of market volatility and negative returns precipitated a broad decline across all industry sectors. [caption id="attachment_24163" align="alignnone" width="833"]Source: S&P Global Market Intelligence[/caption] Traditional active managers have felt these pressures most acutely as poorly differentiated 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 wealth management firms as these businesses are (so far) better positioned to maintain pricing schedules as a result. Reflective of the headwinds that the industry faces, asset managers generally underperformed broad market indices during the fourth quarter.  As the broader indices stumbled, many RIA stocks plummeted with falling AUM balances and management fees.  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 as displayed by their performance in the last quarter. [caption id="attachment_24165" align="alignnone" width="820"]Source: S&P Global Market Intelligence[/caption] Does Size Matter for RIAs?The corresponding RIA size graph seems to affirm this.  The larger firms generally outperformed smaller RIAs, though all categories were down in the quarter.  Still, this trend is, admittedly, a bit misleading since the smallest category of publicly traded RIAs (those with less than $10 billion AUM) was down nearly 30% during the quarter, although this is the least diversified category of RIAs with only two components.  As such, this category is subject to a high degree of volatility due to company-specific developments.  Most of our clients are in this size category, and we believe it is highly unlikely that these businesses lost almost a third of their value (in aggregate) over the quarter as suggested by the graph below.[caption id="attachment_24166" align="alignnone" width="821"]Source: S&P Global Market Intelligence[/caption] Generally speaking, larger RIAs typically attract higher valuations due to the benefits of scale and a more diverse AUM base.  Still, capacity constraints can be an issue, particularly for niche and small cap investment products.  So, unless you’re BlackRock, there’s probably a sweet spot for optimal asset size. A (More) Bearish 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 are 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.On balance, the outlook for 2019 doesn’t look great given what happened to RIA stocks last quarter.  The market is clearly anticipating lower AUM, revenue, and earnings with the recent correction, which could be exacerbated by asset outflows if clients start withdrawing their investments.  Friday’s steep advance could be a silver lining, though volatility remains high.  More attractive valuations could also entice more M&A, which is still relatively subdued despite the recent uptick in dealmaking.  We’ll keep an eye on all of it in what will likely be a very interesting year for RIA valuations.

Happy New Year to all our readers and subscribers!  Here are the five most popular posts from 2018.1. S Corp RIAs Disadvantaged by the Tax Bill: New but UnimprovedFor this post, Matt Crow likens Ford’s lackluster revamp of its Mustang model to the tax bill’s impact on RIA S corps.  As with the Mustang II, the Tax Cuts and Jobs Act took a good thing and made it not so good for certain pass through entities by effectively reducing the tax advantage that S corps have over C corporations, especially for non-distributing firms.  The TCJA also excluded investment management firms from the QBI deduction beyond a certain income limit.  While the tax bill’s reduction on C corp rates was generally beneficial to market returns and AUM balances, it did not necessarily enhance the tax efficiency of S corp RIAs as many industry participants had hoped.2. Summer Reading for the RIA Community – Focus Financial’s IPOThis pre-IPO post emphasized many of the concerns we had on Focus’s valuation that investors seem to be grappling with now.  Specifically, heavy (and controversial) adjustments to reported earnings, continuing net income losses, “organic growth” questions, and the recent market downturn are all weighing on FOCS, which has lost nearly half its value since September.  We’ll keep an eye on this one for its broader implications on RIA aggregators in the wealth management space.3. The Role of Earn-outs in Asset Management M&AThis post is really just a link to our whitepaper on the topic since there’s frankly too much to write about in the blog format.  Despite the relatively high level of sophistication among RIA buyers and sellers, contingent consideration remains a mystery to many industry participants.  We offer this whitepaper to explore the basic economics of earn-outs and the role they play in negotiating RIA transactions.4. The Haves and Have-Nots of the RIA IndustryThis post explores why wealth managers have recently outperformed their asset manager peers and what this means for the broader industry moving forward.  Fee compression and the rise of passive management have seemingly benefited wealth management firms to the detriment of asset managers in recent years.   Volatility over the last few months has likely exacerbated this trend for many active managers, though some mean reversion may be long overdue.5. Asset Manager M&A Activity Accelerates in 2018Zach Milam discusses continuing gains in asset manager M&A despite the industry’s recent headwinds.  RIA aggregators, a rising cost structure, and highly scalable business models are all culprits to yet another banner year for sector dealmaking.  It will be interesting to see how the recent downturn will affect this trend in 2019, which we’ll also be blogging about in the coming months.

‘Twas the blog before Christmas and throughout our staff Analysts were separating wheat from the chaffWe listened to Cramer (who sounds so serene) While gigabytes of spreadsheets danced on our screensWith equities swooning and bitcoin’s collapse Recovering hedgies are risking relapseAnd wealth managers nestled at home with a beer In hopes that a Santa-rally soon would appearAs midtown Manhattan glistened with snow You could almost forget fees had fallen so lowBut regardless of struggles, this is still a great biz So enjoy your Christmas with our RIA quiz!Merry Christmas! We will be back in January.If you're having trouble viewing the survey below, click here.(function(t,e,s,n){var o,a,c;t.SMCX=t.SMCX||[],e.getElementById(n)||(o=e.getElementsByTagName(s),a=o[o.length-1],c=e.createElement(s),c.type="text/javascript",c.async=!0,c.id=n,c.src=["https:"===location.protocol?"http://":"http://","widget.surveymonkey.com/collect/website/js/tRaiETqnLgj758hTBazgd8FDSSK_2BdJwgb90HhEfWcrTtFc_2Bo1XwLsGscpjK7cNEu.js"].join(""),a.parentNode.insertBefore(c,a))})(window,document,"script","smcx-sdk"); Create your own user feedback survey

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

The recent controversy surrounding Ric Edelman’s cease-and-desist letter to his former partner, David Bach, is another reminder of how difficult it can be to sustain wealth management partnershipsdespite their (sometimes) obvious advantages.  This week’s post explores the sources of these disputes and what you can do to avoid them.No Family Feuds in this BusinessUnlike most closely held businesses, RIAs are rarely owned by related parties.  One would think that this lack of corporate nepotism would alleviate some of the ownership tensions and succession planning issues that many family businesses struggle with, but that is hardly the case.  These businesses can be very valuable once they hit a certain scale, so there tends to be a lot to fight over when ownership disputes arise.How Disputes AriseThe recent Edelman-Bach debacle is just a high profile example of what’s going on at RIAs across the country as an industry with aging ownership looks to transition to the next generation of leadership.  Edelman’s case may be more involved since it pertains to an alleged theft of trade secrets and two of the most recognized names in the advisory business, but it still shows how easily a mutually beneficial arrangement can devolve into a costly, litigious affair with no apparent winners.  A lot of our work at Mercer Capital revolves around resolving the valuation component of these disputes, so we see this acrimony firsthand.This case shows how easily a mutually beneficial arrangement can devolve into a costly, litigious affair with no apparent winners.Unfortunately for our clients, this trend is not showing any signs of rolling over.  A near decade of favorable market returns and wirehouse defections mean these businesses are more valuable than ever, and their numbers continue to increase.  These realities, combined with an aging ownership base, likely portend more shareholder disputes and business partnerships that may not work out in the end.  For an industry built on relationships, it seems ironic that so many RIA principals don’t get along, but perhaps this is more reflective of enterprising, type A personalities that often clash over firm direction and succession planning.  In our business, we call them business divorces, and they can be every bit as rancorous (or amicable) as their marital counterparts.Ways to Avoid a Failed PartnershipSometimes partnerships don’t work out, and fortunately, there are things you can do on the front end to mitigate the likelihood of a costly business divorce that can take years to fully resolve.  Here are a few preemptive maneuvers to consider as you’re evaluating a potential arrangement with another RIA principal or firm.Do Your DiligenceThis may seem obvious, but we often see business divorces that would have easily been avoided with an adequate amount of research on the counterparty.  This requires a much deeper dive than a cursory review of AUM history, client retention rates, fee structures, production levels, etc.  This process should involve several rounds of interviews with your prospective partner(s) and his or her staff, meetings with counsel over the anticipated deal terms, and even some correspondence with the partner’s major clients to understand his or her value-added proposition and likelihood of retention after the deal.  This may seem like a huge hassle and distraction from your current job, but no amount of investigation is as costly and time-consuming as a failed partnership.Hire Advisors to Establish Pricing and TermsEven those who are experienced in the world of RIA transactions benefit from some outside perspective on what an appropriate value is for the acquired firm and/or how to structure the partnership moving forward.  For larger transactions, it is common for both sides to hire representation (both legal and transaction-oriented), but it is not unusual for the two parties to jointly retain a single advisor for smaller deals to save costs.  In most transactions and partnership pairings, there can be a widely disparate view on pricing and/or terms, and often it’s up to the advisors to bridge the gap and move the deal forward if doing so is in the best interest of their client.Negotiate a Buy-Sell Agreement While Your Incentives are AlignedIt’s also a good idea to have counsel draw up appropriate agreements (buy-sell, partnership, etc.) that govern not just the initial deal terms, but also the mechanism for future buy-outs and the dispute resolution protocol if one of the parties decides to part ways.  People don’t usually plan for what happens if things don’t work out, but doing so can save you a lot of hassle down the road.Ask Yourself, "Can I Work With this Individual(s) on a Daily Basis?"You’re usually not just pairing with a co-owner but a co-worker as well, which means you’ll likely be spending a lot of time together after the partnership.  Personality disputes are the leading causes of business divorces just as culture clashes are the primary contributors to failed acquisitions in our experience.  Somehow, this usually gets overlooked when a firm or individual is looking for a business partner even though it should be the first thing on their mind.  Business and partner combinations can look great on paper but quickly turn sour if the two parties simply don’t mesh.  We see it all the time, and the fall-out typically leaves both sides worse off than they were before the deal.The best time to manage a dispute with a new partner is before it happens – or better yet – before he or she is your partner.The list goes on, but these are the main things to think about before signing up a new partner or acquiring another firm.  We don’t know exactly how the Edelman-Bach dispute is going to play out, but it will likely be very costly and distracting for both of them.  Perhaps this discourse could have been avoided with a bit more diligence and contemplation.We’re not saying that all RIA business combinations are doomed for failure.  Such partnerships can be (and often are) mutually beneficial arrangements for all parties involved.  We’re just reminding you that the best time to manage a dispute with a new partner is before it happens – or better yet – before he or she is your partner.

Cam Marston and his firm, Generational Insights, provide research and consultation on generational issues.  In his most recent book, The Gen Savvy Financial Advisor, Cam Marston provides a guide to tailoring your financial services to Matures, Baby Boomers, Generation Xers, and Millennials. Financial advisors have personalized their services to meet the needs and expectations of Matures and Baby Boomers, but Gen-Xers are in their prime earning years, Millennials are developing saving habits they will have for a lifetime, and both groups think about their personal finances differently than their parents and grandparents. Marston’s book highlights the challenges that financial advisors currently face trying to earn the business of a new generation of investors.  Because wealth management is a business based on trust, clients need to be comfortable with their advisor, and as your client base becomes more diverse, establishing this connection may not be as easy as it once was.  To meet the needs of each generation of investors, you must understand their distinct concerns. Are We Really That Different?Stereotyping generations is a risky business, but Millennials like me are accustomed to these stereotypes.  My generation has been accused of ruining home-ownership, marriage, newspapers, chain restaurants, and department stores, while we are known to have a weird obsession with smartphones, avocados, and our dogs.Consumers’ buying habits have changed,  but why does this matter for your wealth management firm?While it’s easy to shrug off these stereotypes, the reality is, I wrote much of this post sitting next to my dog I treat like a child, in the house I rent with two roommates, listening to music on a free music-sharing site.  Cam Marston explains that consumers’ buying habits have changed, and financial services are no exception.  But why does this matter for your wealth management firm?At risk of oversimplifying Cam Marston’s insight into simple generational differences, below is a brief summary of the defining features of each generation and Marston’s suggestions to meet the needs and expectations of each.MaturesMarston describes Matures as loyal rule followers who are demanding of respect.  In general, they have under planned for retirement and are facing health concerns, but are a “small yet mighty” group.  Marston suggests showing these clients deference and ensuring they are comfortable by providing quiet spaces for conversation, preparing for memory loss, inviting their children to meetings, and confirming they understand your technology platforms.Baby BoomersControlling over half of the wealth in the U.S., Marston describes Baby Boomers as competitive, nostalgic, idealistic, and young at heart.  You can address the needs of these clients by meeting with them in person, showing optimism despite the fact that many are postponing retirement to take care of elderly parents and adult children who still live at home, and recognizing their successes.Marston further distinguishes between two subcategories of Baby Boomers: Leading and Trailing.  Leading Boomers have begun to reach retirement age, have adult children, have simplified their lifestyle, and are moving investments to more conservative outlooks.  Trailing Boomers, on the other hand, still have children in school and are more focused on paying for their children’s college and building personal wealth.Gen-XersUnlike most, Marston remembered to include Gen-Xers in his analysis, rather than ignoring this in between cohort to focus on Boomers and Millennials.  Gen-Xers are at the peak of their careers; they are tech-savvy, loyal customers, whose referrals should be valued.  They grew up in the information age which means that they are naturally curious and ask many questions.This provides a unique opportunity for financial advisors.  Marston discerns that financial advisors can earn the respect of Gen-Xers by providing them with insight that they were not aware of after extensive research.  Gen-Xers are a captive audience to a firm’s online database of educational resources.MillennialsNow the largest generation, Millennials are well-educated, issue-oriented, individualistic, and impatient.  Millennials were greatly affected by the Great Recession which has led them to become risk-averse.  This leads to an inherent disconnect between Millennials’ comfort level with stock exposure and their lengthy timeline to retirement, which suggests they should be investing aggressively.  To meet the needs and expectations of Millennials, Marston suggests transparency, brevity, up-to-date technology offerings, and recognition of their individuality.Female Millennials have become the most well-educated generation in U.S. history; however, the majority of financial advisors are men (only 16% of CFA charterholders in the U.S. are women).  Financial advisors are more often dealing with female individuals and heads of households, and Marston warns, “Be careful to not make any comments about appearances that may seem […] “creepy.”  While I do not believe that Men are from Mars, Women are from Venus, sensitivity to the current gender environment is key in establishing relationships with female high-earners.The Great Opportunity of Wealth TransitionsValuation firms often view the number of multi-generational relationships in a firm as a measure of risk reduction.  This is an increasingly important metric as Baby Boomers are expected to transfer $41 trillion of their wealth to their heirs; however, as Cam Marston notes, 60% of children fire their parents’ financial advisors after they inherit their parents’ wealth.  Cam Marston devotes a chapter of his book on how to manage these generational transfers.A well-developed relationship with Baby Boomers should lead to an opportunity to work with their children.This transfer provides a great opportunity for financial advisors, who seek to maintain their relationship with Boomers’ children.  Marston explains that a well-developed relationship with Baby Boomers should lead to an opportunity to work with their children.  However, “The Common belief is that Millennials will not do business with their parents’ advisors.  If you treat the Boomers’ children the same way that you treat Boomers, that will be true.”While Marston provides great insight into managing relationships with both Boomers and Millennials, I was left wanting more information on how to effectively manage these relationship transitions.We Can All Learn Something from Marston’s BookWhile this book is directed towards financial advisors, there is something for everyone in the client services profession to learn.The increasing importance of online first impressionsOffering varying levels of technology to ensure different age groups are comfortable with your offeringsBalancing formal and informal relationships As Cam Marston notes, it sometimes feels that you are just on a different wavelength than your prospective clients.  While the soft skill tips in this book can help you connect with different generations, it is just as important to have a diverse staff of advisors who can connect with clients that have different backgrounds, diverse values, and unique needs. While advisors are adapting to earn the trust of different generations, this adaptation is not new.  Advisors have always tailored their services to meet the unique needs of each of their clients.  Today the needs of your clients may vary more, which may lead your meetings to look even more different, but your mission as an advisor is still the same: to bring financial security and prosperity to your clients’ lives.

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

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

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.

Earlier this month, Matt Crow and I attended the BNY Mellon / Pershing RIA Symposium in San Francisco. The conference was well attended, and the presentations were excellent despite the constant drone of fair wage protesting outside the hotel venue. For this post, we’ve elected to summarize some of these presentations and their potential implications for your business.Compensation and Staffing – Key Trends and Best Practices for Advisory Firmsby Matthew Sirinides, Senior Manager, Research & Data, InvestmentNewsInvestmentNews conducts this longest-running industry benchmarking study in conjunction with its Study of Pricing and Profitability as a survey to 385 independent advisory firms, which supply compensation, AUM, client, fee, and profitability dataon an annual basis.  As an appraisal firm that often has to normalize RIA owner compensation for valuation purposes, we’re naturally one of its subscribers.  In this particular presentation, Mr. Sirinides summarized some of their key findings:The industry continues to perform well (AUM and revenue up ~20% and 12%, respectively, over the last year), but much of this is attributable to market gains over organic growth trends.Lead Advisors reported the highest average compensation increase at ~11% for the second year in a row. It’s unclear if this is what the crowd outside the building was protesting, but LAs have certainly done well in recent years.The industry’s total headcount continues to grow, and roughly one-third of the firms surveyed hired for a newly created position. Basically, the industry and its advisors did very well last year.  We agree, but think you should be mindful of what’s driving a lot of this growth – nearly ten years of market appreciation, marking one of the longest and most aggressive bull runs in our stock market’s history.  This advance has more than offset other adverse trends in pricing, asset flows, and organic growth patterns that we’ve been reading and writing about over this period.  Revenue growth lagging increases in AUM suggests strains in fee pricing.  Compounding lower fees with a market teetering on the brink of correction could mean significantly lower levels of ongoing revenue.  Perhaps this is what has spooked the market for some RIA stocks in recent months.  We would advise you to assess your sources of revenue growth (market gains versus new business development) before blindly staffing up in lockstep with AUM additions.Brand New Visibility: Thinking Differently About Your Brandby Megan Carpenter, CEO, FiComm PartnersMegan Carpenter’s presentation was also very informative since a strong brand name is often the most valuable asset not listed on a firm’s balance sheet.  Ms. Carpenter noted that brand value and related reputational assets account for more than 30% of the S&P 500’s market capitalization according to The Economist, but advisory firms spend less than 2% of top-line revenue on marketing expenditures (per IN’s study).  This disconnect probably explains why most RIAs are partnerships or sole practitioners rather than larger corporations with substantial enterprise value.If clients identify with your firm’s brand more than your first or last name, that’s probably a boon for your company’s value.FiComm Partners contends that one way to build lasting enterprise value is through a concept known as scalable marketing, which allows you to “be there without being there,” so your firm can reach new people you otherwise wouldn’t.  Basically, establishing brand infrastructure with the right content creation and distribution allows the current owner/officers to step away from the business as the company’s own reputation and mobile outreach market themselves over time.  This evolution becomes increasingly important as existing owners look to sell their business.  If you can’t step away from the business (without the risk of substantial client loss or investing acumen), then your company probably does not have much transactional value to a prospective buyer.  If clients identify with your firm’s brand more than your first or last name, that’s probably a boon for your company’s value (though maybe not your ego).  We always recommend a gradual process of transitioning clients and management responsibilities, so you have something to sell when you decide to hang it up.The Gen-Savvy Financial Advisorby Cam Marston, CEO of Generational InsightsWhen I saw this presentation on the conference’s itinerary, I braced myself for two hours of millennial bashing like every other forum I’ve seen on this topic.  Sure, there was some of that, but this session was primarily geared towards how advisors can most effectively communicate with clients across multiple generations.  It’s been well-documented that Baby Boomers and GenXers have a hard time relating to Millennials and vice versa, so this topic was certainly in high demand.  Mr. Marston approaches this dilemma by figuring out what seems to matter the most to each generation in selecting an advisor.  Baby Boomers and older GenXers are drawn to track records, tenure in the marketplace, firm history, and brand recognition.  Millennials and younger GenXers are more interested in how things will affect them personally and how you’ll impact their future livelihood.Given these discrepancies, many advisors have difficulty keeping the family relationship when it transfers to the next generation.  Mr. Marston contends that this issue could be avoided by changing the message you have with different generations.  Younger clients probably aren’t going to want to hear about you or the firm’s history (even with your family), but rather what you can do to meet their financial needs.  You also have to change your marketing tactics as Millennials tend to find new advisors through social media and search engines as opposed to word-of-mouth referrals.  Such a drastic change is not easy, but you can rest assured that your competitors are struggling with this as well.  Adapting to this change now could really pay dividends when my generation finally moves out of our parent’s basement and starts saving for the future.We hope to see you at next year’s symposium.  Special thanks to BNY Mellon / Pershing for putting on a great conference!

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.

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

Earn-outs are as common to investment management firm transactions as they are misunderstood.Despite the relatively high level of financial sophistication among RIA buyers and sellers, and broad knowledge that substantial portions of value transacted depends on rewarding post-closing performance, contingent consideration remains a mystery to many industry M&A 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 to explore the basic economics of contingent consideration and the role it plays in negotiating RIA transactions.Download your copy of the whitepaper below.WHITEPAPERThe Role of Earn-outs in Asset Management M&ADownload Whitepaper

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

Since their launch in 1993, exchange traded funds (ETFs) have steadily attracted assets from mutual funds and active managers that have struggled to compete on the basis of performance and overall tax efficiency.  Now many industry observers believe that the same may very well happen to ETFs with the recent rise of direct index investing (DII).  For this week’s post, we look into the pros and cons of DII and the implications for the investment management industry. Exchange traded funds took market share from mutual funds because most active managers do not deliver on their value proposition.  That is, most active managers underperform their relevant benchmark after fees.  ETFs, by their very design, cannot underperform the index they track (ignoring tracking error, which is usually negligible) and are usually quite inexpensive.  ETFs gained traction with this obvious advantage and have dominated asset flows over the last decade. After years of domination, ETFs appear to have a worthy contender in the form of DII.  Both are intended to be a form of passive investing designed to track a certain index.  The key distinction between the two is that a direct indexing investor actually owns the index’s underlying shares in a separately managed account, as opposed to units in a fund that track the index.  Since owning all the stocks in, say, the S&P 500 or Wilshire 5000 (and in proportion to their market weighting) is not feasible for most investors, DII portfolios are usually comprised of a representative sample of securities that should mimic the index’s performance over time. Advantages and DrawbacksThis design creates certain advantages and disadvantages to direct indexing versus ETF investing.  By only investing in a subset of a given index, DII can achieve alpha, unlike passive ETFs.  Of course, direct indexing can also underperform a benchmark, and depending on the sample size, can expose investors to idiosyncratic risk factors that ETFs minimize or eliminate through diversification.  DII is therefore not a purely passive investment vehicle, and advisors should make their clients aware of this fact.Just as ETFs are considered more tax efficient than mutual funds, DII has certain tax advantages over ETF investing.  Since direct indexers are investing in the underlying shares as opposed to a fund that holds the underlying shares, they can harvest losses when some of these securities decline in value.  DII also allows investors to avoid selling the top gainers, while ETF sales effectively involve selling every share of the underlying index pro rata.  Over time, such efficiencies can lead to considerable tax alpha relative to ETF and mutual fund strategies.Direct indexers can also tailor their portfolios to their unique circumstances better than an “off the shelf” ETF.  DII can selectively avoid certain sectors of the economy or pursue businesses with higher governance standards.  Such customization can be highly beneficial to investors with significant portfolio concentrations or ESG mandates.Liquidity is also a concern with ETF investing.  The rising popularity of ETF products has caused distortions in the market when their daily volume exceeds that of their underlying securities.  This disparity can be exacerbated during sell-offs.  On August 24, 2015, a sharp decline in the overseas markets led to trading halts in eight S&P 500 stocks, which precipitated a “liquidity traffic jam” for 42% of all U.S. equity ETFs.  In one example, shares of the Vanguard Consumer Staples ETF (VDC) fell over 30% while the underlying holdings only dropped 9%.Still, DII is often more costly and time-consuming than ETF investing.  Picking representative securities and building customized portfolios can require considerable resources that are not needed for ETF investing.  Trading costs are also higher, albeit at a diminishing rate with advances in rebalancing automation and fractional share investing.  Monitoring costs can also be greater, especially for portfolios seeking to minimize tracking error.Weigh Your OptionsOn balance, DII is not for everyone.  It probably does not make sense for smaller accounts with no diversification issues to pursue such a potentially costly investment strategy.  ETFs and robo-advisors are probably better suited for many retail investors, including the mass affluent.For high net worth clients with significant concentrations and/or ESG needs, on the other hand, direct indexing is likely the superior option.  ETF products and robo-advisory firms are simply not equipped to provide the specialized level of services that DII can accommodate for these investors.  This void creates opportunities for wealth management firms and their advisors.  RIAs providing comprehensive wealth management services can tout direct indexing as a tax-efficient investment strategy that can be tailored to a client’s particular situation.This may sound familiar.  Wealth management firms have been providing these kinds of services well before the invention of ETFs.  The difference is that now, with advances in technology and lower transaction costs, these kinds of services can be profitably offered to most high net worth families and not just the ultra-wealthy.  Given the growing number of high net worth investors and rising demand for personalized investment solutions, direct indexing should be a boon for the wealth management industry as these trends continue to play 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.

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

Recent challenges at Och-Ziff and Hightower highlight the struggles RIAs face in transitioning the business to the next generation of management.  Size doesn’t alleviate this problem and may actually exacerbate it for some asset managers.  In this week’s post, we explore what went wrong in these instances and what you can do to avoid a similar fate.Public MiscuesAs one of the few publicly traded hedge funds, it appeared that Och-Ziff figured out its ownership succession issue.  Legacy shareholders could liquidate their holdings in the IPO or any time thereafter at the market price.  Unfortunately, though, it did not resolve the firm’s management succession question.  In December of last year, founder Dan Och informed the firm’s clients that his protégé and current co-CIO Jimmy Levin, age 34, would not be assuming the reins as CEO when Och decided to step down.  Many believed Levin was the heir apparent after being promoted and receiving a huge incentive package earlier that year (worth nearly $280 million).  Levin’s rapid rise reportedly irked other members of management, a few of which left the firm in recent years.  OZM’s shares are off nearly 30% since this announcement despite eventually finding Mr. Och’s replacement a few months ago.Then, just last week, RIA acquisition firm HighTower Advisors announced that co-founder Elliot Weissbluth would be stepping down as CEO and HighTower would be seeking a new president and head of field services.  Such turnover at the top means HT will likely have to look outside the firm for new leadership, which can be a long and expensive process when you don’t have a successor lined up.Certainly, OZM and HighTower are not the only RIAs with succession issues, and this is certainly not an exhaustive list.Last year, billionaire Ray Dalio, who started Bridgewater Associates in 1975, announced the second shakeup within a year at the top ranks of his $160 billion firm.Israel Englander, CEO of Millennium Management, was caught off guard in January when his potential successor abruptly resigned with plans to start a competing firm.George Soros and Seth Klarman have also struggled to prepare the next generation of leadership at their firms. All of these businesses are industry leaders with tens (or hundreds) of billions under management.  The fact that they struggle with management succession shows just how hard it is to actually pull off in practice.  Firm size and longevity do not guarantee a smooth transition to the next generation of leadership.  In fact, the success of these firms may have fueled complacency and impeded their succession planning – why look for new management when everything’s going so well?  The problem is no one lives forever, and (most) people get tired of working.How to Transition WellSo what can you do now to avert succession issues down the road?  It may sound like a cliché, but it’s never too early to think about the next generation of leadership.  Most RIA principals are baby boomers that are approaching retirement age, and we suspect (mostly from firsthand experience) a fairly high percentage of them don’t have a formal (or even informal) succession plan.  If you intend to evolve your practice into a sustainable enterprise and have something to sell when you retire, you need to be thinking about your likely successors and how to retain them.A logical starting point for accomplishing this goal is tying management succession to ownership succession.  Many of our clients’ principals sell a portion of their ownership to junior partners every year (or two) at fair market value.  This process ensures that selling shareholders are incentivized to continue operating the business at peak levels while allowing rising partners to accrue ownership over time.  Many buy-sell agreements also call for departing partners to sell their shares at a discount to FMV if they are terminated or leave within a pre-specified period to ensure they stick around after the initial buy-in.  Basically, you want your interests aligned with the next generation of management, and gradually transitioning ownership to them at a reasonable price is one way of accomplishing this goal.It’s also important to relinquish your day-to-day responsibilities with ownership.  This can’t (and shouldn’t) happen overnight.  After you’ve identified a capable successor(s), make sure he or she is assuming more of your responsibilities and not just your share count.  Your work hours should go down over this transition period.  When advising clients on management and ownership succession, we often tell principals that are approaching retirement to ask themselves where they want to be in five or ten years (depending on their age and other factors) and work towards that goal.  We rarely hear that they want to maintain their current work levels for the rest of their career.  Have a goal in mind and steadily work towards it as others assume your responsibilities and ownership.  It should pay off in retirement.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.

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.

Despite the old maxim of a rising tide lifting all boats, the current markets are clearly more buoyant for wealth management firms than asset management firms.  Many asset managers are trading at or near all-time lows from a valuation perspective, while financial advisory shops continue to accumulate client assets.  For this week’s post, we’ll take a closer look at this trend, and what it means for the broader industry.The Story for Asset ManagersDon’t interpret this as our being bearish on asset management.  Almost every asset management firm, public or private, is more valuable today than it was in 2009.  The explanation for that is simple: rising markets lead to higher AUM, management fees, and earnings, so many of these businesses are worth 2-3x (or more) what they were a decade ago because profitability has (easily) tripled in the last nine years.  As appraisers, we’re more concerned with the multiple (i.e. valuation) applied to these earnings since that’s what we take from the market and relate to our client company’s performance to derive value.  Here’s how the market is currently pricing some of these businesses:Notwithstanding the run-up in their market caps since the last financial crisis, earnings multiples for asset management firms have mostly contracted, particularly recently.  There are a number of rational explanations for this – fee compression, flight to passive strategies, ETFs, fund outflows, maturing industry, etc.  This seems quite overdone for a business with a strong recurring revenue model and high margin potential through continued gains in AUM (like we’ve seen).So what gives?  You’ll recall from your corporate finance classes in college that this multiple is a function of risk and growth.  While there are certainly risks facing this business today, we don’t necessarily think the business’s cost of capital has increased much (if at all) over the last year as the sector’s risk dynamics haven’t changed much over the last year.  Lower valuations must, therefore, be indicative of sliding growth prospects.  Clearly, the market is telling us that the industry’s current headwinds (regarding fees and outflows) are likely to persist and may even be questioning the longevity of the bull market.Different Story for Wealth ManagersWealth managers chart another path.  There’s not a whole lot of public market perspective on these businesses due to the lack of publicly traded wealth management firms, but there is some.  Silvercrest Asset Management (ticker: SAMG), which provides family office and financial advisory services, is up more than 30% over the last year and currently trades at just over 21x trailing twelve months earnings.Then there are all the recent headlines surrounding Focus Financial Group, a serial acquirer of wealth management firms.  Admittedly, we’ve contributed to some of this.  As a result, you probably didn’t even know about the Victory Capital (multi-boutique asset manager) IPO that happened earlier this year.  The market currently values Focus at nearly 5x revenue and Victory at well under 2x revenue even though VCTR is profitable and FOCS is not.  Arbitrage opportunity?To be fair, these businesses have always been priced differently.  Wealth managers often elicit a higher multiple because of their lower risk profile.  Their clients (mostly individuals) are typically less concentrated and more likely to stick around when performance suffers.  Asset managers on the other hand, typically enjoy higher margins since it’s less costly to service fewer relationships.  This trade-off is nothing new and likely to persist.The Overarching NarrativeThe recent widening of the multiple gap and disparate performance over the last year suggests the two businesses are riding completely different trajectories.  Again, the market seems to think that the fee compression and flight to passive movements are here to stay, and wealth management firms may be the indirect beneficiary of these trends.  We don’t disagree with this but think there will always be a place for active management, especially for those firms with solid long-term performance and steady inflows.  Still, this bull market seems to have forgotten about a sector that typically thrives in a bull market.Moving forward, we expect some mean reversion but aren’t ignoring what the market is telling us about the outlook for asset managers – it’s probably going to get worse before it gets better.  Solid performance can buck this trend for any RIA, but consistently delivering alpha is a tall order.  Since most firms underperform the market after fees, perhaps it’s not surprising that sector has struggled so much recently.  Still, this has almost always been the case, so the industry’s current woes are more likely attributable to fee compression (or fear of fee compression) and surging demand for passive products.  A bear market might actually help (relative) performance as many asset managers outperform during times of financial stress, but that would also strain revenue and profit margins.  Attractive valuations could spur deal-making and consolidation, which could alleviate some of these pressures.  We’ve seen some of this, but suspect more is on the way.  Either way, we’ll continue to monitor these pricing trends and let you know how this all shakes out.

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

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

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.

With the Advisor Rule looming and commissions dwindling, it may be time for some RIA/BD hybrids to take it to the next level: drop the broker-dealer license and register exclusively with the SEC as an investment advisor.  This week’s post focuses on what’s driving the downward trend in BD-only registrants and when it makes sense to abandon the hybrid model. We’ve not included many images of hybrid vehicles on this blog, and for good reason.  They’re usually not the most aesthetically pleasing cars and therefore unlikely to generate good click bait for our readers.  They can, however, be extremely (fuel) efficient and practical in certain contexts.  The same could probably be said of hybrid RIA/BD firms, as the traditional broker-dealer model continues to lose ground to hybrids and fee-only RIAs. According to the Financial Industry Regulation Authority (FINRA), the number of broker-dealers has dropped 24% over the last decade, from 4,891 in 2008 to just over 3,700 today.  The Credit Crisis is partially responsible as the entire industry’s reputation and financial viability suffered a huge blow, forcing many BDs to consolidate or go out of business.  The rise of online DIY trading platforms and low fee ETF products exacerbated this trend as commission income spiraled downward to stay competitive.  The rising expenses and nuisances associated with FINRA registration also pressured firms down the RIA path, and the recent overhang of the Fiduciary (now Advisor) Rule hastened this transition for many industry participants. Many hybrids are considering dropping their BDs.  Should you follow their lead?  That really depends on a number of factors.1. BD Income’s Overall Contribution to Your Total RevenueIf commissions and/or trading income represent less than 10% of your total revenue, then you should seriously consider dropping the BD license.  Your compliance and FA/broker expenses alone may well exceed what you’re taking in from the FINRA registration.  This seems simple and obvious, but many hybrids originally operated as a broker-dealer, and the transition to (RIA) exclusivity can be daunting and sometimes difficult to implement in practice.  The good news is that transition costs are one-time; whereas, the forgone compliance expense associated with dual registration is an ongoing benefit.2. Top Line Exposure to Bear MarketsIt’s been over nine years since we had a sustained market downturn.  We’re probably overdue.  Many hybrids have been transitioning toward the RIA model for quite some time but are reluctant to drop the BD license because it offers some cushion against falling advisory fees when AUM plummets with the market.  The asset-based revenue model has been great for FAs largely invested in equities since the Financial Crisis, but that won’t always be the case.  Commissions and trading income aren’t completely market proof but do offer some hedge against revenue declines from down markets.  If your firm manages mostly equities and primarily charges asset-based fees, you may not want to totally abandon your BD status just yet.3. Emphasis Clients Place on the Fiduciary Standard Over the Suitability StandardMany years ago most your clients probably didn’t know or care about the distinction.  Now your best clients, and particularly your best prospective clients, likely are not only familiar with these terms but understand the implications.  If your hybrid is not technically a fiduciary, you may want to change that before ditching your BD license.4. The Costs (and Headaches) Associated with Dual RegistrationI think most industry participants would agree that less is more when it comes to regulatory oversight, and several clients have told us that FINRA compliance is more burdensome than the SEC’s.  Devoting capital and resources to compliance matters can be a huge distraction.  Abandoning the BD license could be a quick fix if it’s not doing much for you in the first place.5. Your Firm’s IdentityDo your clients and other stakeholders see the company as an advisory firm or broker-dealer?  Are you operating as a fiduciary for clients or selling proprietary products and/or executing trades on their behalf?  Either route may have served you well in the past, but it may be time to choose a path.  Acting as a fiduciary to some (but not all) clients could lead to conflicts of interest and confuse your role to prospective clients.  Picking a side would clarify this message and potentially land more business from investors looking for an RIA or BD firm but not necessarily both.  If, on the other hand, a hybrid culture has been instilled across the firm for quite some time, it may not be worth the hassle or cost to go the exclusive route.Undoubtedly, there are other things to keep in mind if you’re thinking about going exclusive.  You can take some comfort in knowing that you’re not alone.  Industry consultants Cerulli Associates estimates that hybrids have grown to roughly 15% of the industry, up from 7% in 2004 as BD-only firms have declined in number while fee-only RIAs have grown more modestly in recent years.  Still, this trend is probably not sustainable with a looming Advisory Rule, so you need to be thinking about your options if you haven’t already done so.

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

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. 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It’s been several months since Morgan Stanley and UBS departed from the Protocol for Broker Recruiting, and the industry is continuing to feel the ripple effects of their maneuver.  Much remains to be seen, but many analysts expect more firms to abandon the protocol despite Wells Fargo’s and Merrill Lynch’s recent announcements to stick with it for now.  All of these firms were early adopters of the protocol, which has grown to include nearly 1,800 firms today.A Changing TideHistorically, firms have joined the protocol with the expectation that they could maintain a lock on their advisors due to their distinct advantages in trading capabilities and investment offerings over the independent model.  However, recent technological advancements make it easier for advisors to become registered and serve clients on their own.  Advisors also now have the option of the consolidator route through which firms like Dynasty Financial Partners, HighTower Advisors, Focus Financial Partners, and United Capital provide them with liquidity options and greater autonomy to serve clients and recruit other advisors.There’s also the issue of vesting schedules and expiring contracts that were signed at the peak of the last financial crisis.  Many of the brokers who signed retention deals at Merrill Lynch or UBS in 2009 are now fully vested and more incentivized to jump ship.  Meanwhile, the FAs at Morgan Stanley who received retention deals as a result of the JV with Smith Barney in 2009 will become free agents at the end of this year.Another side effect of the protocol is the increasing consolidation of the IBD space.  Many wirehouse FAs are turning to the IBD model to gain access to an RIA platform with the continued support and resources that a broker-dealer can provide.  According to an InvestmentNews report, the three largest IBDs (Ameriprise, LPL Financial, and Raymond James) saw a 42% increase in FA recruitment during 2017.  Simply put, the RIA/IBD hybrid model is a more appealing alternative over the wirehouse model in the eyes of many FAs looking for a change.The UndercurrentStill, firms like Raymond James that have used the protocol to successfully poach advisors from their competitors will likely stick around.  The few net winners in the wirehouse recruitment saga over the last ten years have little or no reason to abandon protocol. Many have lost more advisors than they’ve recruited; therefore, it’s hard to stay with a program that clearly hasn’t helped them.  One could certainly view the departure of Morgan Stanley and UBS as a concession of their own inability to effectively recruit and retain during the protocol era.Many FAs may find it more difficult to sell their book of business (or at least realize full value) in a post-protocol world.  If it’s riskier and more expensive to join another broker-dealer, then current employers could use these circumstances to reduce payouts to their advisors.  It could also be more challenging to transfer clients to another platform, thereby limiting the number of prospective buyers.  In short, FA economics are not likely to improve when their employers decide to break protocol.Impact on RIA Valuations & DealsWhat about RIA valuations?  Abandoning protocol should make it easier to retain FAs but also makes it harder to recruit from other firms that have done the same.  We’ll call that a tie.  If RIAs can use this to gain leverage over their advisors and offer lower payouts, then margins and profitability should improve.  Valuations should improve on higher earnings, so, on balance, this could be bullish for RIAs and the wealth management industry (at least from the employer’s perspective).  Still, not everyone will abandon protocol. Many RIAs do not recruit experienced hires and will likely be unaffected by recent events.The effect on sector deal making will likely be more nuanced.  Matt Sonnen and his team at PFI Advisors see this as a major opportunity for RIAs to recruit from the wirehouses before the door shuts and more firms abandon protocol. It appears that we’ve already seen some of this take place: This trend should continue until the dust settles at which point it will make the transition process riskier and more expensive.  When this happens we could see a curtailment of the recent momentum though it seems unlikely that we would revert back to 2013-14 levels in the absence of another bear market.  We’ll keep you apprised of how all this shakes out in future posts. 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.

As banks of all sizes seek new ways to differentiate themselves in a competitive market, we see many banks contemplating the acquisition of an existing asset management firm as a way to expand and diversify the range of services they can offer to clients.  Following a transaction, the bank is required under accounting standards to allocate the purchase price to the various tangible and intangible assets acquired.  As noted in the following figure, the acquired assets are measured at fair value. Transaction structures between banks and asset managers 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 management firms are unique entities with value attributed to a number of different metrics (assets under management, management fee revenue, realized fee margin, 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. Common intangible assets acquired in the purchase of a private asset manager include the trade name, existing customer relationships, non-competition agreements with executives, and the assembled workforce. Trade NameThe deal terms we see employ a wide range of possible treatments for the trade name acquired in the transaction.  The bank will need to make a decision about whether to continue using the asset manager’s name into perpetuity or only use it during a transition period as the asset manager’s services are brought under the bank’s name.  This decision can depend on a number of factors, including the asset manager’s reputation within a specific market, the bank’s desire to bring its services under a single name, and the ease of transitioning the asset manager’s existing client base.  However, if the bank plans immediately to take asset management services under its own name and discontinue use of the firm’s name, then the only value allocable to the tradename would be defensive.In general, the value of a trade name 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 value of the trade name.Customer RelationshipsThe nature of relationships between clients and portfolio managers often gives rise an allocation to the existing customer relationships transferred in a transaction.  Generally, 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.  Many of the agreements we see include a clause that requires a certain percentage of clients to consent to transfer their accounts in order for the deal to close at the stated price.  If the asset manager secures less than the required amount of client consents, the purchase price may be adjusted downward or the deal may be terminated entirely.  Due to their long-term nature and importance as a driver of revenue in the asset management industry, customer relationships may command a relatively high portion of the allocated value.Non-Competition AgreementsIn many asset 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 individuals from soliciting business from existing clients or recruiting current employees of the company.  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.  In the agreements we’ve observed, a restricted period of two to five years is common.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 a relationship-based industry like asset management, getting a new portfolio or investment manager 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 often may command a higher value allocation to the assembled workforce.  Unlike the intangible assets previously discussed, the assembled workforce is valued as a component of valuing the other assets.   It is not recognized or reported separately, but rather 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 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 banks and asset managers, we frequently see an earnout structured into the deal as a mechanism for bridging the gap between the price the bank wants to pay and the price the asset manager 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 bank, while rewarding the asset management firm 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 work for the asset 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.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. 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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. 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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.

Last week, Taryn Burgess, Matt Crow, and I exhibited at CFAI’s Wealth Management Conference in Los Angeles. The conference was well attended and lauded by most everyone there (most of whom were wealth management professionals at RIAs in the major metropolitan areas along the East and West Coast, unlike us).  A lot of topics were discussed, most of which centered around financial planning, practice management, and servicing private clients with evolving needs and return requirements.  Though we weren’t able to attend all the sessions, we did pick up on a few themes from our discussions with the attendees and other exhibitors:CFAI appears to be placing more emphasis on wealth management strategies and private clients. When I was studying for the CFA exam (2006-08), the curriculum seemed to be more geared towards portfolio managers and research analysts.  On the buy-side, the emphasis was on the asset management sector and investment strategies for institutional clients.  While there was some focus on wealth management and private clients, more of the curriculum seemed to be devoted to portfolio management for pension funds, insurance companies, endowments, and the like.  One of the conference speakers noted that this was likely due to the rising demand for wealth management services and the corresponding decline in active management (and those serving the industry).  We’ve seen a fair amount of asset managers jump ship for the private client side to take advantage of this trend.  It will be interesting to see how their transition shakes out since, in our experience, the cultures and skill sets of asset management firms versus private client RIAs often seem completely incompatible with one another.  In any event, many of the CFAI folks we talked to at the conference noted that the institute is starting to place more emphasis on the wealth management side, and conference attendance continues to rise with the industry’s popularity.Understanding behavioral finance is a key competitive advantage for wealth managers over their robo-advisory rivals. Many of the sessions were devoted to understanding private client’s behavioral tendencies and the proliferation of robo-advisors competing for their business.  It appears that most wealth managers are acknowledging the emerging competitive threat of robo-advisory firms, especially with millennials and younger clients.  Touting the ability to hand hold and have face-to-face meetings with clients is no longer sufficient to ward of the robo-advisory threat, and many wealth managers are turning to behavioral finance to better understand their client’s needs in ways that AI falls short.  It’s not inconceivable that, moving forward, many financial advisors will have degrees in personal psychology to better their understanding of client behavior and cognitive tendencies.  Several speakers discussed new research and developments in the study of behavioral finance and how their firms were using these advancements to communicate with their clients more effectively and help them realize their financial goals.  Once rejected by many industry participants, behavioral finance is increasingly becoming a point of emphasis for continuing education at wealth management firms across the country.  We would not be surprised if CFAI made this a higher priority in future curriculums.Everybody’s asking about sector M&A (or lack thereof). We’ve blogged about this before and don’t think any of these dynamics have changed (though there has been somewhat of an uptick in recent years).  While there weren’t any conference sessions devoted to this topic, most of the questions we got at our booth were about RIA dealmaking and sector consolidation.  Since it was a wealth management conference, there was a lot of interest in what Focus Financial was up to and we can only surmise as to what’s going on there since it remains closely held.  What we do know is that it’s never too early to be thinking about how to maximize your firm’s value even if it’s not for sale.  This means cleaning up your P&L (and possibly balance sheet), making the necessary investments in technology, transitioning client relationships to the next generation, and having succession planning discussions with junior partners.  We can help with the value part (and potential sale), but there may not be much to transact if you haven’t started thinking about some of these topics. The conference was informative and productive.  Hopefully, we’ll see you at next year’s event in Fort Lauderdale.

The Tax Cuts and Jobs Act (TCJA) that was signed into law in December 2017 has already had, and will continue to have, a tremendous impact on the investment management community that warrants considerable attention from partners at RIAs. We won’t mince words – this tax bill is a blockbuster for the investment management industry.Taken as a whole, TCJA has already 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. Although most firms are still assessing the full impact of tax reform, the TCJA will likely impact capital management, M&A activity, and investments in technology.This whitepaper is a compilation of thoughts we have gathered at Mercer Capital in the early days of this new tax regime. We expect to learn more as the year rolls on, as the compliance and tax planning opportunities presented by the TCJA materialize and work through the system. We don’t suggest that this text is an exhaustive list of all of the implications of the tax bill on the investment management industry, but herein, we present what we think are the major issues that RIA partners should consider. Specifically:The tax bill has made investment management firms worth more by:Driving up AUMImproving RIA economicsMaking RIA pre-tax cash flows worth moreHowever, the tax bill has less of an impact on tax pass-through entities because:The tax advantage of S-corps and LLCs, relative to C corporation, is now mutedMany RIAs will not benefit from the QBI deductionYour RIA’s shareholder agreement probably needs to be revised because:Most buy-sell agreements value the business via formulaTCJA renders many RIA valuation rules of thumb obsoleteThe change in RIA valuations is potentially so significant that it calls into question the use of formula agreements entirelyThe tax bill may have a mixed impact on asset manager M&A because:Higher valuations will bring more sellers to the table, and buyers will feel more pressure to complete transactionsInternal succession, however, may be more difficult because individuals won’t enjoy the same increase in after-tax cash flows as corporate buyers Download your copy of the whitepaper below and let us know if you have any questions on how these implications affect your firm. WHITEPAPERThe Impact of the 2017 Tax Cuts & Jobs Act on the Investment Management CommunityDownload Whitepaper

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

The Tax Cuts and Jobs Act (TCJA) introduces the Qualified Business Income (QBI) deduction as a partial offset to the bill’s reduction in the relative tax efficiency of pass-through entities (S corporations, limited liability companies, and partnerships) versus C corporations.  Still, many RIAs will not be eligible for the deduction, and those that do will have a lot to keep in mind as it pertains to reasonable compensation levels and investment income.  We’ll try to sort it all out for you in this week’s post. On balance, the TCJA has been very bullish for the RIA industry.  A significant reduction in C corporation tax rates has helped precipitate a steady rise in the stock market over the last several months, so AUM balances are on the rise.  Operating leverage in the business model compounds this effect, expanding margins as earnings growth outpaces gains in AUM and fee income.  RIA market caps have responded accordingly: However, not all aspects of the bill are favorable to the industry.  The relative tax efficiency of the pass-through structure has been reduced by the bill as personal tax rates have not declined nearly as much as rates for C corporations, and most RIAs are LLCs or S corps (therefore, taxed only at the shareholder/personal level).  For RIAs with low dividend payouts (which is somewhat rare in our experience), it may actually make more economic sense to be structured as a C corp in the wake of the tax bill. At least one alt manager has already done so already. RIA’s ExclusionTo compensate for the narrowing S corp tax advantage, the TCJA introduced the Qualified Business Income (QBI) deduction that allows certain S shareholders to deduct 20% of their pass-through income.  Oddly enough, the QBI deduction is not available to RIAs (above a certain income limit, discussed later). Congress decided to exclude certain “specified service trade or business,” defined as “any trade business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities.”It’s not abundantly clear to us why the investment management exclusion (and the limitation on the deductibility of financial planning fees) was specifically included in the bill.  Perhaps this exclusion was an offset for carried interest miraculously avoiding a tax hike from the TCJA.  Maybe Congress didn’t feel any sympathy for an industry that has performed so well since the Financial Crisis and enjoys relatively high levels of compensation.  Whatever the reason, it’s in there, but like many features of the TCJA, it includes a loophole.QBI EligibilityDespite the exclusion, the QBI deduction remains available to RIA shareholders for whom total income is less than $315,000 for married couples or $157,500 for individuals and is partially available for married couples and individuals up to $415,000 and $207,500, respectively.  Industry consultant Michael Kitces helps us keep this all straight: If you’re the owner of an investment management firm and make over $207,500 as an individual or $415,000 if you’re married, the QBI deduction is not for you.  While a good problem to have, it means many RIA owners will not be eligible for the deduction.  If you find yourself in this category and do not distribute a high percentage of your earnings (that would still be subject to double taxation for C corporations), you might want to consider a C election.  Otherwise, the S or LLC status probably makes the most economic sense even with the relative reduction in tax efficiency. Nuances to ConsiderEven if you’re at or below the income threshold, there are still a few nuances you need to consider in determining eligibility.  One potential hurdle is the prohibition of “reasonable compensation” being classified as QBI, so certain RIA owners will now be incentivized to pay (or at least determine) a market rate for his or her salary and bonuses.  We know firsthand that this is easier said than done and could require consultation with an industry advisor (like ourselves) or compensation expert to make such a determination.  It’s also important to keep in mind that the income must also be domestic and not attributable to securities investments to qualify as QBI (even though REIT income not attributable to capital gains or qualified dividends is allowable).Regardless of eligibility, the QBI and its random countenances are not likely to be a game changer for your RIA.  It is, however, worth understanding these features if you can take advantage of (one of the few) benefits from the TCJA on pass-through entities like S Corps and LLCs.  Otherwise, you can take comfort in not having to keep track of all this.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.

For this week’s post, we’re offering the slides and recording from our recent webinar on the tax bill’s impact on the investment management community.  On balance, we believe most RIAs are better off as a consequence of the legislation, but there are nuances to the “win.”  Specifically, the webinar covers the following observations on the recent bill:U.S. equities have, overall, benefited from the tax billHigher valuations have driven ongoing revenues higher at investment management firmsMany RIA margins will expand as a consequence of improved economicsInvestment management firm valuations will grow in many cases because of stronger cash flowRIAs structured as tax pass-through entities (S corps, LLCs, Partnerships) may want to consider reorganizing as C corporations So feel free to tune in or scroll through if any of these topics are pertinent to you or your firm. Download Slides???

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

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

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.

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

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

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

As noted last week, much has been written about some of the major wirehouse firms abandoning protocol these last few months.  This week we explore what the implications are for RIAs and how it could impact their value in the marketplace. There was a time when broker protocol made a lot of sense to the wirehouse firms.  In an effort to avoid countless hours and company funds on litigation, the major brokerage firms at the time, Smith Barney (now part of Morgan Stanley), Merrill Lynch, and UBS signed the Broker Protocol Agreement in August 2004 to avoid the threat of lawsuits for financial advisors switching firms or setting up their own shop.  At the time, the logic was that talent poaching was happening anyway, and the only parties benefiting from fighting the poaching were litigators.  Several attorneys we’ve spoken with about the potential demise of protocol echoed this sentiment. For years it appeared that broker protocol worked pretty well; today over 1,600 RIAs and broker-dealers voluntarily participate in the de facto cease fire over talent between the brokerage houses.  All was quiet on this issue until late October when Morgan Stanley announced it was abandoning protocol, emphasizing its commitment to training and retaining brokers rather than poaching them from rival firms.  One month later UBS followed suit, similarly citing the firm’s focus on retaining existing advisors over recruiting them from other shops.  From a numbers perspective, these moves aren’t surprising as larger wirehouses have been net losers for several years as protocol made it easier for FAs to switch firms or start their own.  Interestingly enough though, Bank of America Merrill Lynch recently announced that it would be sticking to protocol in favor of advisor flexibility in serving client needs. Merrill’s decision seems counterintuitive until you consider that it uses certain exclusions to the agreement to selectively poach other advisors while punishing those trying to leave; therefore, it is less incentivized to break protocol.  ML allows advisors who generate their own business to be covered by the protocol while those that use firm referrals to do so are exempt.  Similarly, JP Morgan’s commission-based brokers are under protocol while those who receive a salary and bonus to service clients are not.  Smaller independent firms and RIAs have also gamed the system by joining protocol to recruit advisors before exiting the agreement to make it harder for them to leave. Moves by UBS and Morgan Stanley to abandon recruitment will make it much more risky and costly for RIAs to recruit their advisors.  It also limits the market for whom these advisors can sell their book to if many of the prospective buyers are on a different platform, which could compress valuations for advisory firms built under broker-dealers.  In fact, we’ve already seen a bit of a dampening effect on M&A activity as the last quarter tallied the lowest level of RIA dealmaking and advisor breakaways in three years – just 29 such transactions compared to 40 in Q2, according to a new report by DeVoe & Company.  Devoe also attributes the decline to the prior surge created by the expiration of many forgivable loans to wirehouse advisors during the financial crisis and the potential passage of the fiduciary rule in late 2016 or early 2017:Source: Devoe & Company, wealthmanagement.com On balance, RIAs and financial advisors looking to add brokers or sell in the foreseeable future should care about broker protocol.  Sector transaction activity has already taken a hit, and we may be on the brink of another wave of firms abandoning protocol.  Experienced advisor recruitment will also become more challenging as firms continue to exit the agreement.  If, on the other hand, the remaining wirehouses stand firm, we could see a stabilization in M&A and possible mean reversion for broker recruitment.  Wells Fargo’s pending decision on broker protocol could have a major impact on the industry as a whole, so we’ll be watching that announcement very closely. The epitaph for wirehouse brokerage operations has been written repeatedly over the past twenty-five years or more, but Morgan Stanley’s move to exit protocol has opened a whole new chapter in the saga, suggesting that RIAs are indeed making more than a dent in brokerage firm revenues.  We suspect this will remain a major topic in 2018 and will keep you posted on what we think the impact will be to investment management firms. In the interim, feel free to reach out to us if you’d like to talk further. 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.