Brooks K. Hamner

CFA, ASA

Senior Vice President

Brooks K. Hamner, Senior Vice President, is a senior member of the firm’s Investment Management Industry team. He provides RIAs, independent trust companies, traditional and alternative asset managers, wealth management firms, broker-dealers, and investment consultants with valuation services related to corporate planning and reorganization, litigated matters, transactions, employee stock ownership plans, and tax issues as well as valuations of intangible assets, options, and assets subject to specific contractual restrictions. Brooks also consults with investment management clients in the process of buying other RIAs or selling their business.

Brooks also publishes research related to the investment management industry and is a regular contributor to Mercer Capital’s blog regarding the investment management community, RIA Valuation Insights.

Professional Activities

The American Society of Appraisers
The CFA Institute

Professional Designations

Chartered Financial Analyst (The CFA Institute)
Accredited Senior Appraiser (The American Society of Appraisers)

Education

Vanderbilt University, Nashville, Tennessee (B.S., Economics, magna cum laude, 2006)

Authored Content

The Silent Risk in Many RIA Succession Plans

In this article we discuss four of the most common “silent risks” embedded in otherwise well-intentioned succession plans.

What a Cold Snap Teaches Us About Cycles in RIA M&A

Seasonal Market Metaphors

While frigid temperatures disrupted travel and infrastructure across the country, the RIA M&A market has remained anything but frozen. Deal activity continues at historically strong levels, reminding firms that favorable conditions are best used to prepare for the inevitable shifts that come with market cycles.

Leftovers: RIA Themes from 2025 That Will Carry Into 2026

As firms sort through the “leftovers” of 2025, several themes are poised to carry meaningful weight into 2026. Margin discipline, improved client engagement, and rising operational maturity have strengthened the industry’s foundation. Strategic dealmaking, evolving succession plans, and measured progress with AI adoption continue to shape valuations and competitive dynamics. These lingering trends aren’t remnants—they’re the building blocks of a resilient, opportunity-rich year ahead for RIAs.

What to Look for in an Acquisition Target for Your RIA

This week we’re flipping the script on last week’s post, "What to Look for in a Buyer for Your RIA," to analyze transactions from the buy-side perspective. This post focuses on the key attributes that RIA acquirers should look for in a target that should make the transaction successful, value-accretive, and enduring.

Private Equity’s Growing Influence on RIA Dealmaking and Valuation Multiples

Examining the trends fueling PE’s dominance, the valuation multiples shaping transactions, and strategic considerations for RIA owners navigating this transformative landscape

The Growing Appeal of Independent Trust Companies

Within the broader investment management industry, independent trust companies are carving out a significant niche, capturing the attention of high-net-worth clients and investment management professionals alike.

You Can’t Spell RIA Without AI

The Impact of Artificial Intelligence on the RIA Industry

This post explores the multifaceted impact of AI on the RIA industry, drawing on trends observed in Q2 2025 and beyond, while providing actionable insights for firms looking to adapt.

Navigating Valuation Challenges in the Great Wealth Transfer

Over the next two decades, an estimated $68 trillion is expected to transfer from Baby Boomers and Gen X to Millennials and Gen Z in what has been dubbed the “Great Wealth Transfer.” For RIAs and trust companies, this transition presents both opportunities and challenges that directly impact firm valuations.

Webinar Replay: Succession Planning for RIAs

Transition with Confidence

In this webinar, Matthew R. Crow, CFA, ASA and Brooks K. Hamner, CFA, ASA guide you through the critical steps of succession planning, ensuring your firm's legacy thrives while maximizing its value. They discuss different ownership models and their implications, key considerations for maximizing firm value during a transition, and practical tools and steps to start planning for a successful transition today.

Succession Planning and Its Impact on RIA Valuations

For the investment management industry, succession planning is not just a strategic necessity—it’s an important driver of firm value.

The Impact of Market Volatility on RIA Valuations

An Illustrative Example of the Dangers of Formula Pricing in a Buy-Sell Agreement

In this post, we show an illustrative example of how the market volatility we’ve endured so far this year could impact the formula pricing valuation of a $1 billion AUM RIA that has 70% of its clients’ assets in the S&P 500 and 30% in a diversified bond fund.

Webinar Replay: Understanding RIA Valuations

A Guide for Today's Market

In our latest webinar, Brooks K. Hamner, CFA, ASA and Zachary C. Milam, CFA explore the critical elements shaping RIA valuations in today's market. They discuss the key factors influencing RIA valuations, the latest industry trends, methodologies for valuing RIAs, and best practices to maximize firm value.

5 Takeaways from Dimensional Fund Advisors’ Deals & Succession Conference

The 2025 Dimensional Fund Advisors’ Deals and Succession conference was held at Dimensional’s offices in Charlotte, North Carolina. The event focused on the current M&A environment and best practices for internal succession planning and ownership expansion.

RIA Valuations and How to Maximize Yours

This episode of the The Buyer’s Boardroom podcast discusses RIA valuation methods, misconceptions surrounding rule-of thumb measures, key value drivers, and the pros and cons associated with internal versus external sales of your business.

What Does the RIA Valuation Process Entail?

For this week’s post, "What Does the RIA Valuation Process Entail?," we’ll channel our inner Nick Saban and focus on the process.

Are Difficult Partner Discounts Applicable to RIAs?

A few months ago, I attended a business appraisal conference in Portland, Oregon, where I learned about a case involving a “Difficult Partner Discount.” Since we’re often hired when business owners can’t agree on price, we’re well aware of partnership disputes, but I’m pretty confident I’ve never directly applied a “Difficult Partner Discount” to the value of a business or interest therein. That doesn’t mean that partner disputes and departures can’t significantly impair the value of a company, which we address in this post.

WHITEPAPER | Purchase Price Allocations for RIAs

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.

How Will Trump’s Second Term Affect the RIA Industry?

Now that the dust has finally settled on the 2024 election, we can turn our attention to its expected impact on the investment management industry.

RIA Aggregator Investments Trick or Treat

Are Longer Holding Periods a Viable PE Strategy or Just an Extend-and-Pretend Tactic?

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.

Does This Presidential Election Matter to the RIA Industry?

For some reason, we get this question every four years or so, and it’s come up quite a bit in recent weeks. We have to step back and think about what either candidate’s election would mean for the broader financial services industry, taxes, and stock market returns

WHITEPAPER | Valuing Asset Managers

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.

Handling RIA Ownership Disputes

When RIA owners can’t agree on the appropriate price for a shareholder buyout, we’re often jointly retained to value the departing member’s interest in the business pursuant to a buy-sell agreement. Whether we’ve been court-appointed or mutually chosen by the parties to do the project, we’ve done enough of these over the years to learn that the process matters as much as the outcome.

Will Rate Cuts Improve RIA Multiples?

Naturally, we’re interested in how expected rate cuts will affect the investment management industry’s transaction multiples. Many industry observers believe anticipated rate cuts 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, lower interest rates will nonetheless impact 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.

WHITEPAPER | Assessing Earnings Quality in the Investment Management Industry

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

Why Haven’t Higher Interest Rates and Inflation Derailed RIA Dealmaking Activity?

Last year, many RIA industry participants expected a similar cessation to dealmaking in the sector following the adverse impact of higher interest rates and inflation on investment managers’ AUM balances and profitability in 2022. Fortunately for the industry’s bankers, these economic headwinds haven’t derailed the sector’s M&A momentum. Fidelity recently reported 227 deals last year involving RIA sellers with $100 million or more in assets under management, only a 1% decline from 2022 levels.

Are Toxic Cultures the Silent Killers of the Asset Management Industry?

Paul Black, CEO of WCM Investment Management, a $67 billion asset manager headquartered in Laguna Beach, California, provides great insights on the impact of culture on the viability of a money management firm.

What to Look for in a Quality of Earnings Provider for RIA Transactions

A Quality of Earnings (or QofE) analysis is an essential component of transaction diligence for both buyers and sellers. Optimizing your transaction diligence requires assembling the right team. In this post, we discuss five things RIA buyers and sellers should look for when evaluating potential QofE providers.

How EBITDA Margins Affect Revenue Multiples

Whenever someone asks me what their RIA is worth as a multiple of revenue, I respond by asking about their firm’s EBITDA margin. My response is largely driven by the math behind the enterprise value (EV) to revenue ratio.

Will RIAs Be Subject to Anti-Money Laundering Rules?

Last week, the U.S. Treasury’s Financial Crimes Enforcement Network (“FinCEN”) proposed a rule to require investment advisors to comply with Bank Secrecy Act requirements, including implementing anti-money laundering (“AML”) controls and filing suspicious activity reports to FinCEN. The agency has attempted to bring investment advisors under Bank Secrecy Act provisions twice in the past, most recently in 2015. Unlike prior attempts, however, this proposal does not hold investment advisors accountable for identifying their clients. Still, the agency is contemplating a separate joint proposal with the SEC outlining future customer ID requirements for investment advisors.

Will Finfluencers Replace Financial Advisors?

We think finfluencers are more likely to be a marketing opportunity than a competitive threat to financial advisors seeking business from younger investors. FAs that stress their value proposition and key points of differentiation will usually win the clients they want over their conflicted competitors. If that fails, they can always partner with one, but we highly recommend they read CFAI’s report before doing so.

Remembering Charlie Munger

His Investment Wisdom and Legacy

Mr. Buffet took this one step further – “I will confidently wager that no computer will ever replicate Charlie.” Unfortunately, he was probably right.

Memorable Mungerisms

Our colleague Brooks Hamner wrote a great post for sister blog RIA Valuation Insights last week, marking the passing of investing legend Charlie Munger. Brooks’ post unearthed some Mungerisms we had not heard before, and we think Mr. Munger’s wisdom is just as relevant inside the family boardroom as it is for professional investment managers. Enjoy!This week, we step aside from our usual musings on valuation trends in the RIA industry to honor the late Berkshire Hathaway Vice Chairman with our thoughts on some of his famous quotes (that might be relevant to you and your clients):“I think the reason why we got into such idiocy in [personal] investment management is best illustrated by a story that I tell about the guy who sold fishing tackle. I asked him, ‘My God, they’re purple and green. Do fish really take these lures?’ And he said, ‘Mister, I don’t sell to fish.’” – 1994 speech at the University of Southern California Business School We’ve all taken the bait on a flashy investment opportunity that didn’t pan out. We knew better but couldn’t resist the prospect of doubling our money in a short amount of time. Rational investing leads to rational returns, and irrational investing leads to irrational returns (typically below 0%). Maximizing the ratio of rational investing to irrational investing for clients is easier said than done, but one of the primary responsibilities of a prudent financial advisor. Feel free to share Charlie Munger’s thoughts on crypto the next time a client asks about Bitcoin:“A cryptocurrency is not a currency, not a commodity, and not a security. Instead, it’s a gambling contract with a nearly 100% edge for the house, entered into in a country where gambling contracts are traditionally regulated only by states that compete in laxity.” – 2023 Wall Street Journal op-ed piece Charlie Munger often distinguished between investing and gambling, which, in his mind, was the same thing as “investing” in a cryptocurrency. That probably seems obvious to you (and your clients), but unfortunately, that’s not the case for much of the investing public. Interestingly, he had a similar disdain for diversification, which probably isn’t so practical for most individual investors:“A lot of people think that if they have a hundred stocks they’re investing more professionally than they are if they have four or five. I regard this as insanity.” –2021 shareholder meeting for the Daily Journal Corporation Mr. Munger called this ‘diworsification,’ and this philosophy allowed him to achieve above-market returns for several decades and become one of the most successful investors of all time. This mentality probably only applies to active managers (like he was himself) who devote much of their professional careers to investment research and analysis. His colleagues Warren Buffet and Jack Bogle would certainly not recommend this approach to most individual investors.“Usually, I don’t use formal projections. I don’t let people do them for me because I don’t like throwing up on the desk, but I see them made in a very foolish way all the time, and many people believe in them, no matter how foolish they are. It’s an effective sales technique in America to put a foolish projection on a desk.” – 2003 Herb Kay Undergraduate Lecture at the University of California, Santa Barbara Economics Department Since we often rely heavily on projections in our DCF valuation models, it’s probably best that Mr. Munger was never a client of ours (actually, I’m sure he would've been great to work with). We understand the fallacies of projections and contend that all models are wrong, but some are useful (to quote the British statistician George Box) when grounded in reason and reality.“I think you would understand any presentation using the word EBITDA, if every time you saw that you just substituted the phrase, bull**** earnings.” – 2003 Annual Berkshire Hathaway Shareholder Meeting We often utilize EBITDA metrics in our valuation models, so Mr. Munger probably wouldn’t have appreciated that aspect of our analysis either. Mr. Munger clarified this later in the meeting by stating, “There are two kinds of businesses: The first earns 12%, and you can take it out at the end of the year. The second earns 12%, but all the excess cash must be reinvested — there’s never any cash. It reminds me of the guy who looks at all of his equipment and says, ‘There’s all of my profit.’ We hate that kind of business.” Fortunately, your business is the former, and you get to keep most of its EBITDA every year.“I am personally skeptical of some of the hype that has gone into artificial intelligence. I think old-fashioned intelligence works pretty well.” – 2023 Berkshire Hathaway Annual Meeting Mr. Buffet took this one step further – “I will confidently wager that no computer will ever replicate Charlie.” Unfortunately, he was probably right.

Munger Games: Charlie Munger’s Legacy

And His Common Sense Approach to Business and Investing

This week, we step aside from our usual musings on valuation trends in the RIA industry to honor the late Berkshire Hathaway Vice Chairman with our thoughts on some of his famous quotes (that might be relevant to you and your clients).

Can Active Management Survive a Bear Market?

Moving forward, we expect some active managers to improve their competitive positioning but aren’t ignoring what the market is telling us about the outlook for these businesses – it’s probably going to get worse before it gets better.

5 Takeaways from the Association of Trust Organizations' (ATO) 2023 Annual Meeting

Earlier this week, ATO held its annual meeting at the Ritz Carlton in New Orleans to discuss a variety of topics relevant to independent trust companies, including the impact of AI, M&A and financial performance trends, and best practices for evaluating prospects. As a sponsor of this year's conference, here are our main takeaways from the meeting:

What Can We Make of Goldman’s Brief Foray into the Mass Affluent Space?

It seems unlikely that Goldman Sachs intended to own United Capital’s mass affluent business for only four years after its $750 million purchase in 2019.

Compensation Structures for RIAs

Part II

A well-structured equity incentive plan is accretive to existing shareholders, not dilutive. Some of the more common equity-incentive plans are discussed in this post.

4 Considerations for Your RIA’s Buy-Sell Agreement

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.

Four To-Dos Before You Sell Your Investment Management Firm

Considerations for Every RIA Owner

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.

Common Valuation Misconceptions about Your RIA

Old Rules of Thumb, Recent Headlines, and the Endowment Effect

The "endowment effect" refers to an emotional bias that causes individuals to value an object they own higher than its market value. We’ve probably all been guilty of this at various times in our life when it comes to property values or assets that have some sort of emotional or symbolic significance to us.

The Relationship Between Revenue Multiples and EBITDA Margins

Revenue multiples are cited perhaps as much as any other valuation metric in the RIA industry. In this week’s post, we focus on their key drivers and ways to improve the value of your management fees.

Whitepaper Release: Compensation Structures for Investment Management Firms

For this week’s post we’re introducing our whitepaper on compensation structures for investment management firms. Since roughly 75% of an investment management firm’s expenses are compensation costs, figuring out the right balance of salary, performance pay, and equity incentives is always front of mind for RIA principals. This whitepaper is designed to help you navigate the various compensation models to optimize firm growth and employee retention.

WHITEPAPER | Compensation Structures for Investment Management Firms

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

Westwood Looks to Replace Lost AUM and Revenue with Salient Partners Acquisition

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.

Rising Interest Rates Will Likely Affect More Than Just RIA Stock Prices

Higher RIA Aggregator Bond Yields Could Portend Lower M&A and Transaction Multiples in 2023

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.

One Step Forward, Two Steps Back: RIA Stocks Finish the Quarter Down 10% after a Fast Start

Most RIA Stocks Have Lost Nearly Half Their Value Since Peaking Last November

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.

Five Takeaways from the Association of Trust Organizations (ATO) 2022 Annual Meeting

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.

Far(ther)sighted or Blind Ambition: Tech Platform Nets RIA a Big Price

Farther Finance Advisor’s Recent Capital Raise Implies a Valuation at 20% of AUM and 20x Run-Rate Revenue

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.

Pzena Going Private Could Have Larger Implications for the Investment Management Industry

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.

Another Tumultuous Quarter for RIA Stocks Puts the Industry Firmly in Bear Market Territory

Publicly Traded Alt Managers and RIA Aggregators Have Lost Nearly Half Their Value Since Peaking Last November

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.

Compensation Structures for RIAs: Part II

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.

What Can We Make of All This Turnover in the RIA Space?

Some Thoughts on How RIA Principals Can Minimize or Even Capitalize on the Chaos

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.

What Happens to RIA EBITDA Multiples When Interest Rates Rise?

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.

Alt Managers Best the Market and Other Types of RIAs During a Rocky Twelve Month Stretch for the Industry

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.

What Market Volatility Means for Your RIA

Is Volatility the New Normal?

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.

Additional Considerations for Your Buy-Sell Agreement

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.

Alt Managers Best the Market Along with Other Types of RIAs During a Strong Year for Investment Management Firms

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.

Posturing for a Successful Succession

Failing to Plan is Planning to Fail

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.

Public Alt Asset Managers Have Nearly Doubled in Value Over the Last Year

Hedge Funds and Private Equity Firms Capitalize on Market Volatility and Growing Investor Appetite for Alt Asset Products

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.

Why Is No One Selling in a Seller’s Market?

Even in One of Hottest M&A Markets in Recent History, Most RIA Principals Still Do Not Plan to Sell Their Business in the Next Three Years.

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.

Strong Quarter Propels Alt Managers to New Highs

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.

To the Moon or Back to Earth?

RIA Valuations Have Increased Substantially Over the Last Year, but That Doesn’t Necessarily Mean These Stocks Are Overpriced

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.

FAIR … The F-word in RIA M&A: Part 2

What Is a Fairness Opinion?

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.

Strong Gains in the Wealth Management Industry Propel RIA Aggregators to New Highs

Oh What a Difference a Year Makes…

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.

Value Finally Outperforms Growth After Twelve Year Lull

Value Stocks Are Finally Besting Growth, But Is It Sustainable?

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.

Failing to Plan Is Planning to Fail

Just Because Everyone Else Is Doing It, Doesn’t Mean You Should Ignore Succession Planning

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?

RIA Industry Extends Its Bull Run Another Quarter

Continuation of Market Rebound Drives All Categories of Publicly Traded RIAs Higher in Q4 2020

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?

The Role of Earn-Outs in RIA Transactions (Part One)

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.

What RIAs Need to Know About Current Estate Planning Opportunities

Estate and tax planning matters are an important component of the overall financial plan for many RIA clients. The current tax policy and market environment create unique estate planning opportunities that may not last if economic conditions normalize or if Biden wins in November. This webinar addresses the available opportunities that RIA principals and advisors should be aware of in the current environment. Original air date: October 28, 2020

Low Rates and NIM Margins Spur Bank Interest in the Wealth Management Sector

Executives Seek Revenue Streams That Aren’t Tied to Interest Rate Movements

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.

How Growing RIAs Should Structure Their Income Statement (Part II)

Compensation Conundrums

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.

Financial Advisors, Tell Your Clients to Gift Now!

Lower Asset Values Provide an Opportunity for Tax-Efficient Wealth Transfers Before November’s Election

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.

WHITEPAPER | Valuation of Independent Trust Companies

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

RIAs Rally After Worst Quarter in Eleven Years

The Industry Is Now in a Bull Market Following March’s Sell-Off

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.

The Evolution of Rule-Based Valuation Metrics and Why They Still Don’t Work

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.

Why Are Small Cap RIAs Down 40% Over the Last Year?

Most Investment Managers Remain in Bear Market Territory Even as the Broader Market Recovers

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.

RIAs Suffer Worst Quarter Since the Financial Crisis

Most RIA Stocks are Now in Bear Market Territory

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.

What Can We Make from All This M&A Activity?

Recent Deal Flurry Highlights Investor Appetite for Cost Savings and Recurring Revenue

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.

RIA “Comps” Don’t Always Tell the Same Story

Divergent Performances of LM, TROW, BEN, and AMG Show Industry’s Susceptibility to Company Specific Events Over Market Forces

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.

All Classes of Investment Management Firms Outperformed the Market in Q4

2019 Was Also a Bull Market for the RIA Industry

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.

WHITEPAPER | Succession Planning for Investment Management Firms

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.

Private Equity’s Silent Push into the RIA Space

Is Private Equity the Solution to Your Succession Planning Needs?

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.

Acquisitions of Consolidators Continue to Drive RIA Deal Activity

Asset and Wealth Manager M&A Keeping Pace with 2018’s Record Levels

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.

Transitioning Your Business to the Next Generation of Leadership

Successful Succession for RIAs

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.

Posturing for a Successful Succession

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.

Is 16x Pro Forma EBITDA a Realistic Valuation for Mercer Advisors?

Pre-season Soccer and the Mercer Price Tag are Likely More About Form Than Substance

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.

Are Value Managers Undervalued?

Growth Investing Has Outperformed Value for Quite Some Time Now, and the Market’s Taking Notice

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.

Why Has the Public Market Soured on RIA Consolidators?

Recent Capitulations for AMG and Focus Suggest Investors are Starting to Question Their Business Model

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.

RIAs Still Reeling from Last Year’s Sell-Off

Despite Recent Uptick, Investment Managers are Underperforming

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.

2019 CFA Institute Wealth Management Conference Recap

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.

WHITEPAPER | How to Value a Wealth Management Firm

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

The Anatomy of a Wealth Management Firm

A Closer Look at a Business that Continues to Pivot with Client Needs

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.

RIP to the Father of Index Investing

John Bogle’s Legacy Endures with the Prominence of Passive Investing

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.

RIA Stocks Suffer Worst Quarter Since the Financial Crisis

Most Traditional and Alternative Asset Managers in Bear Market Territory After Turbulent Year for Global Equities

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.

Edelman/Bach Rift Highlights Challenges to RIA Partnerships

Partner-Level Conflicts at Firms of All Sizes Continue to Fragment the Industry

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.

2018 BNY Mellon/Pershing RIA Symposium Recap

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!

WHITEPAPER | The Role of Earn-outs in RIA Transactions

Will Direct Indexing Become the Next ETF?

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.

Why Scale Doesn’t Always Resolve Succession Issues

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.

The Haves and Have-Nots of the RIA Industry

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.

Thinking About Going Exclusive?

Five Considerations for RIA/BD Hybrids Looking to Drop Their BD Status

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.

What’s the Latest on Broker Protocol?

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.

Three Takeaways from the CFA Institute’s Wealth Management Conference in Los Angeles

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.

Your RIA May Qualify for the QBI Deduction, But Don’t Get Your Hopes Up

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.

Should RIAs Care About Broker Protocol?

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.

What We’re Reading About Broker Protocol

Most of the sector’s recent press has focused on broker protocol, so we’ve highlighted some of the more salient pieces as a preface to our take on the matter in next week’s post.UBS Exits Protocol, Creating “New World” for Advisors, Clientsby Janet Levaux ThinkAdvisor offers differing takes on UBS’s recent decision to leave the Protocol for Broker Recruiting. Many believe a wave of advisor departures from the wirehouse firms is imminent while some contend that the rule wasn’t sustainable in the first place.UBS Broker-Protocol Exit Shows Independent Channel is Bleeding Wirehouses of Advisersby Bruce Kelly Smaller RIAs and, to a lesser degree, independent broker-dealers, have been taking market share from the big four BDs for the last several years. UBS and Morgan Stanley have broken protocol to stymy this momentum and retain advisors that were previously given a pass on being sued if they jumped ship to another broker-dealer.How UBS Exited the Broker Protocol and Why the Aftereffects May Surpass Those of Morgan Stanley's Earlier Departureby Brooke Southall RIABiz predicts that Merrill Lynch will be the next to abandon protocol, leaving Wells Fargo with a big decision to make in the coming weeks.B/D Advisor Valuations to Compress as the Broker Protocol Unravelsby Michael Kitces The Nerd’s Eye View blog predicts a complete unraveling of broker protocol in the coming weeks as few incentives remain for Wells and Merrill to stay on board now that Morgan and UBS have left the agreement. Mr. Kitces also expects the break to compound the decline in broker-dealer valuations as their market will likely be limited to a more captive audience of other brokers on the same platform. Breakaway Broker Deals a Drag on M&A Activity in Third Quarterby Jeff Benjamin The impact on sector M&A is more unclear though many industry observers foresee a short-term spike in breakaway acquisitions but an overall reduction in deal-making over the long run.Broker Hiring Pact Hurt by Defections Expected to Surviveby Neil Weinberg and Katherine Chiglinsky Many analysts believe the protocol will endure for some firms due to the high cost of litigating and the need for guardrails in handling sensitive client data. Raymond James, for example, has vowed to remain a member if it were “the last firm standing.” In summary, there seems to be a general consensus that Merrill (and possibly Wells) will abandon protocol in the coming weeks. Less certain is the impact on sector deal-making and valuations though it doesn’t seem particularly bullish for either. Stay tuned to next week’s post for more perspective on how we think this will all shake out for the RIA community.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.

Additional Considerations for Leaving a Wirehouse or Brokerage Firm

Piggybacking off of our post from last week, we discuss the various options one faces when leaving a wirehouse firm, including the various pros and cons to doing so. The advisory profession has evolved significantly over time, so we’re writing this post to keep you apprised of your options as you consider the big leap. The industry has come a long way over the last couple of decades if you think about it. The client visits we go on today thankfully bear no resemblance to The Wolf of Wall Street or Boiler Room depictions of life as an “advisor” at a brokerage firm in the 80s and 90s. While Hollywood undoubtedly dramatized this reality for entertainment purposes, these films reinforce the rationale for all the change that has taken place over the last twenty years. Ongoing technological and regulatory shifts suggest that the profession will continue to evolve. All these iterations and alterations to the profession mean that advisors now have a variety of different platforms and businesses models to choose from. The three primary options include RIA aggregators and their network platforms, traditional wirehouse firms / broker-dealers, and independent RIAs. Michael Kitces’s blog, Nerd’s Eye View, includes a recent guest post from Aaron Hattenbach, who worked as an advisor under all three of these models and provides valuable insight on which path makes the most sense.The Evolution of RIAsAs a recent two-year participant in Merrill Lynch’s Practice Management Division (PMD), Hattenbach estimates the program’s failure rate to be 99% (other industry observers have estimated 95%; the wirehouse firms do not publish these statistics for obvious reasons). This sad reality is something an aspiring financial advisor should keep in mind when considering employment at one of the major wirehouse or brokerage firms.It also explains why the industry has such a tough time recruiting millennials to the business. Those who do succeed tend to be aggressive networkers and champions of the wirehouse brand and the breadth of services it can offer clients.Even if you are part of the 1% (or 5%) who make it through the program, the independent or aggregator RIA routes can be enticing. As noted last week, the sheer economics justifies the move to the independent route if you can transition most of the clients and manage overhead efficiently.Independence also breeds creativity and customization as the wirehouse firms tend to be more bureaucratic while offering firm approved, templated solutions to clients on behalf of advisors across their entire network. Hattenbach noted that most of his advisor colleagues at Merrill placed more emphasis on “being compliant” than sharpening their craft, advising clients, or growing their book of business.But independence isn’t the only option. Fortunately, there’s a compromise or go-between for total independence and the wirehouse route.The Tenets of RIA IndependenceThe RIA aggregator model allows its advisors to maintain some degree of autonomy without having to manage an actual business. Aggregators will purchase books of business from advisors and offer an ongoing payout structure after the deal.Aggregators like LPL Financial and Focus Financial have gained popularity in recent years as these businesses did not suffer the reputational (and financial) fallout of their wirehouse counterparts during the last financial crisis. Also, like their wirehouse competitors, RIA aggregators can use their massive scale to negotiate better terms for things like custody fees and trading costs than independent RIAs.Still, a lot of advisors have left the RIA aggregator network, perhaps one of the reasons behind Focus’s delayed plans for an IPO. Perhaps once the advisors get a taste of freedom, they will want full independence and start their own RIA. Even after operating under an RIA aggregator, the transition to independence can be quite the leap, and Hattenrach advises that the following attributes are needed:Operating experience in the investment advisory channelNiche specialty that allows for differentiation from the competition to compensate for the lack of brand recognitionA client base large enough to sustain itself or the financial flexibility and patience to grow it from scratchEntrepreneurial attitude and willingness to put in the many hours necessary to succeedThe ability to effectively multi-task and prioritizeAn advisory study group or professional group of colleagues that can from your “unofficial advisory board” Anecdotally, we’ve heard (and generally observed) that it often takes $500 million in client assets to create an independent RIA that is consistently profitable, depending upon fee structure, location, and headcount, among other things. This may be a bit conservative, but could be what it takes to breakeven in an environment dominated by passive investing, fee compression, evolving regulatory requirements, and rising compliance and compensation costs. We’ve seen profitable RIAs at lower levels of AUM, but to build consistent profitability in the face of all the aforementioned industry headwinds and a potential market downturn, you’re probably going to need a few hundred million in client assets.ConclusionThis is a lot to think about as each route has its own risks and rewards. If the solution were obvious, it’d be the only option. We see the independent and aggregator RIA model continuing to gain client assets and advisors from wirehouse firms, but think the Wall Steet firms and other broker-dealers are too heavily entrenched (and dedicated to fee income) to be totally wiped out anytime soon. Whatever the outcome, as asset management models continue to evolve the relative merits of independence and affiliation will too.

Options for Today's Financial Advisors

Should I Stay or Should I Go?

Ever since the Financial Crisis, wirehouse advisors have been pondering this question as the independent model continues to lure wealth managers from the big banks and brokerage firms. This post discusses the various options that financial advisors (FAs) are faced with today and when it makes sense for them to stick around or do their own thing. It seems unlikely that English punk rock artist Mick Jones could empathize with future financial advisors when he unleashed his hit single, "Should I stay or Should I go" in 1981. Rather, he was probably referring to his own pending departure from The Clash (though he would later deny that contention). Either way, it seems oddly applicable to many FAs' current predicament as they contemplate the pros and cons of staying with their current employer or forming their own RIA.Considerations for Financial AdvisorsPerhaps the most obvious consideration is compensation. Though it varies by firm and location, wirehouse firms generally pay out 35% to 55% of fee income to their FAs, with the larger producers typically taking home a bigger cut of the business, according to industry consultant, Michael Kitces. Larger RIA firms, on the other hand, tend to pay their FAs 40% to 50% of fee income, 20% to 30% in non-compensatory overhead costs with the residual 20% to 30% in profits, depending again on size and location and dozens of other factors. This means that a solo practitioner could earn as much as 80% of his or her fees by starting their own firm, collecting all the fee income net of overhead expenses.Based on this math alone, it's hard to comprehend why over 50,000 advisors and $7 trillion assets have remained at Bank of America Merrill Lynch, UBS, Morgan Stanley, and Wells Fargo alone, according to the InvestmentNews Advisers on the Move database. IN attributes this phenomenon to signing bonuses at the wirehouse firms, the security they offer, increasingly higher compensation packages for top producers, and appealing retirement deals for senior FAs looking to cash out. Or it may be that capturing that margin for oneself is easier said than done.Kitces contends that "end advisors are often able to keep 10% to 20% more of their gross revenue after making the switch" even after considering all the perquisites that the bulge bracket firms are offering. So from a sheer economics perspective, it appears that going independent makes more sense, but there are still other factors to keep in mind. For one, you have to get client consent, which is not always a given, especially if the client identifies more with the bank than the broker, which is often the case with elderly investors. You'll also have to invest time and money in technology, personnel, and other overhead charges that were previously provided by the brokerage firms. In addition, you'll be suddenly responsible for practice management unless you pay someone else to do that for you, which can also be costly. Indeed, if you go, there could be trouble, as Mick Jones warned us.Don't leave without first thinking about your employment agreements, non-compete agreements, non-solicitation agreements, etc. The only thing worse than starting a business with plenty of overhead and no clients is starting a business with plenty of overhead, a few clients, and a lawsuit from your former firm.The obvious advantage of staying with a wirehouse is the plug-and-play platform that allows financial advisors to concentrate on client service and selling, rather than running a business. We hear plenty of grumbling about the big firms being run by lawyers instead of business development staff, spending so much time on defense that there's no time left for offense.Compliance issues are rising in the independent RIA space as well, though, and when you're in charge of your RIA, you're also in charge of the compliance department. Oddly enough, at the same time brokers are weighing leaving big banks to go out on their own so they aren't constrained by back-office regulations, independent RIAs are consolidating to allow their top people to focus on clients instead of practice management.ConclusionThere are plenty of tradeoffs to being independent. But staying could be even more problematic. The independent model allows you to better take advantage of the inherent operating leverage of the asset manager business. Rather than earning a fixed percentage of the fee income from client assets, an independent RIA owner/operator can achieve significant levels of profitability to augment fee income by growing AUM with more modest increases to overhead expenses. We've seen larger wealth management firms (client assets over $500 million) achieve EBITDA margins of 25% or greater when overhead costs remain relatively contained. Potential returns do appear to be commensurate with the risk involved in most of these situations – which is, after all, kind of the theme of investment management.Mick Jones ultimately decided to go, and has enjoyed something of a post-Clash career (although you could be forgiven for not being able to name any songs by Big Audio Dynamite). If you're considering going independent, we just hope you keep this all in mind.

Recent Trends in Asset Management

This week, we’re sharing some recent media on trends in asset management and the outlook for M&A activity. Most industry observers foresee an uptick in asset manager dealmaking as rising costs, asset outflows, and a heightened interest from consolidators incent many firms to pull the trigger on a sale or business combination with another RIA. Global Asset Management 2017 – The Innovator’s Advantageby The Boston Consulting Group BCG provides a detailed profile of the RIA industry, M&A trends, growth opportunities in a passive environment, and optimizing investment management for the digital age.Latest Mercer Move Highlights Hot M&A Demand for Smaller Firmsby Charles Paikert Though no relation to our firm, Mercer Advisors recently announced its fourth asset manager deal of the year, underscoring the desirability of smaller RIAs in a seller’s market.Skill through Scale? The Role of M&A in a Consolidating Industry – Investment Management M&A Outlookby Casey Quirk, a practice of Deloitte Consulting LLP Casey Quirk sees brisk M&A activity continuing in 2017 and beyond as a result of deteriorating economics, distributor consolidation, the need for new capabilities, and a shifting value chain.Asset Manager Deal Wave Has Just Begunby Aaron Black This Wall Street Journal piece predicts continued consolidation in the RIA space as struggling active managers combine to stem the tide of asset outflows.Minority Stake Sales Prop Up Investment Management Dealmaking Activityby Joe Mantone This recent piece by S&P Global Market Intelligence examines the heightened level of minority investments in asset managers in the context of slowing M&A volume for the sector.Renewed Appetite – Alts Manager M&A Heats Upby KPMG With the continued “bar-belling” of investors’ portfolios and strong demand for alternative strategies in the current low-growth, low-yield environment, KPMG sees renewed appetite for dealmaking involving hedge funds and private equity firms. As always, we are available to continue any of the above discussion further. Don't hesitate to call us.

RIA Dealmaking

What’s the Hold-Up?

We’re always perplexed by the lack of transactions in the RIA industry. Sure, there are some out there, but a typical year reports less than a hundred deals in a space with almost 12,000 federally registered advisors. This means that less than 1% of industry participants transact in a given year. How could that be in an aging profession with a highly scalable business model? We offer a few explanations in this week’s post.1. Most RIAs are not big enough to be consistently profitableAccording to the Investment Adviser Association, the “typical” SEC-Registered Investment Adviser has $317 million in AUM, between 26 and 100 accounts, nine employees, and is headquartered in New York, California, Florida, Illinois, or Texas. It’s hard to envision that a business of this size would generate enough revenue to cover overhead and professional staff expenses (likely in an expensive market) and yield much profitability, particularly during a market downturn, especially if you consider that many believe $500 million in AUM to be the breakeven point for many asset managers to generate consistent levels of profitability (depending on size, headcount, location, client type, etc.). If valuation is based on earnings, then the average RIA may not have much to sell.2. Many asset managers don’t have sustainable enterprise value beyond their owner(s)A lot of RIA principals have not taken the necessary steps to transition their client relationships, investing acumen, business development capabilities, and/or managerial responsibilities to other staff or the next generation of firm leadership. To a prospective buyer, this means there is significant risk that the RIA’s accounts and firm viability will not outlive its owners. This is part of the reason why so many asset manager transactions are structured as earn-outs – to protect the buyer against future declines in fees or earnings associated with a principal’s departure or reduced activity levels in the business after the deal.3. Asset managers are (currently) expensiveDespite what you’ve been reading about industry headwinds (fee pressure, competition from passive products, etc.), most RIAs are more valuable than ever. Since the market is trading at an all-time high, many asset managers’ AUM balances are as well, which means higher fees, earnings, and valuations. Such a high price tag makes them less appealing to prospective buyers looking to maximize ROI.4. Many RIAs have distinct cultures that don’t necessarily jive with prospective buyersThis is probably the case with many industries but seems especially true for asset managers. The business and its reputation have come a long way from the Wolf of Wall Street broker culture of the late 80s and early 90s. Still, these businesses tend to have unique attributes and identities that aren’t necessarily conducive to firms in different (or even the same) industries. Banks, for example, have recently taken an interest in the business for its high margins and low capital requirements. In our experience, though, bank and RIA cultures often don’t mesh; this can be an unforeseen hurdle in a deal that may make a lot of sense on paper.5. Asset managers value independence and often prefer to transition the business internallyMost RIAs are employee-owned, and that’s by design. To keep the company’s culture and investment/client relations teams intact, many principals looking to exit the business will often look to the next generation of firm leadership as prospective buyers for their interest. They do this to avoid outside influence and appease institutional investors who often seek independent RIAs wholly controlled by the firm’s principals. Buy-sell or shareholders’ agreements that allow younger principals to buy in at a discount to fair market value are not uncommon for asset managers looking to encourage employee ownership and remain independent.ConclusionOn balance, though, we think the outlook for asset manager M&A is promising. The industry is still fragmented and ripe for further consolidation. An aging ownership base is another impetus, and the recent market gains might induce prospective sellers to finally pull the trigger. Fee compression could also lead to more transactions if RIAs look to create synergies and cost efficiencies to maintain their profit margin. We haven’t come across much of this yet but are seeing more clients and prospects ask about succession planning and exit strategies. Perhaps this is a sign of more to come, which isn’t saying a whole lot.

Why TAMs (Traditional Asset Managers) Continue to Thrive Despite Industry Headwinds

The Memphis Tams from the 1970s and Mike Conley from the Memphis Grizzlies in a Throw-Back UniformCondensed History of the TAMS – An American Basketball Association FranchiseMemphis is home to the NBA franchise, the Memphis Grizzlies. One of the predecessor organizations to our hometown Grizzlies was the Memphis Tams. Aptly named for the only professional basketball team in the [T]ennessee, [A]rkansas, and [M]ississippi tri-state area, the Tams were a quick afterthought in the ABA’s history, enduring a lackluster 45-123 record in just two seasons in the early seventies. My dad was one of the few attendees of their home games, played at the now obsolete Mid-South Coliseum, which never saw attendance crest the 5,000 mark. He recalls a bizarre “mustache clause” in each of the player’s contracts, that offered a $300 bonus to those who would grow one and a rather dubious hat-shaped mascot (apparently “tam” is also short for a tam o’shanter, which is a traditional Scottish bonnet, similar to the one donned by Meg Griffin on Family Guy). It was one of Memphis’s most pathetic sports franchises.Fortunately, this is no longer the case. The current Memphis mascot, though equally dubious given the lack of grizzlies in the tri-state area, is far more intimidating and appropriate for a professional sports franchise. The Grizz are one the few teams to have made the playoffs in each of the last seven seasons and regularly contend for one of the top spots in the tough Western Conference. The club has quietly become one of the league’s most consistent and well-attended franchises, despite attracting virtually no national media coverage or superstar athletes in its 22-year history.Current Performance of TAMS – Traditional Asset ManagersMost traditional asset managers (also sharing the TAM initials), a similarly consistent, yet overlooked subset of the RIA industry, are in bull market territory over the last year in the face of fee compression and continued outflows from active equity products.While hedge funds and PE firms tend to dominate current RIA headlines, TAMs are quietly gaining market share as investors question performance fees and the lack of transparency offered by many alternative asset managers. Indeed, all five components of our publicly traded TAM group below are up over the last year, and four of them have bested the market by a fairly considerable margin.Why Are TAMs Performing Well?We would attribute the group’s gains to both systematic and non-systematic factors. That is, the market’s gain (a systematic force affecting all stocks, especially RIAs) has clearly helped the group’s collective AUM balance, while non-systematic forces such as solid investment performance (PZN), new account additions (BLK), and prior acquisitions (AMG/LM) account for much of the residual success of the individual components. In our experience, most well-established RIAs similarly attribute their success to systematic (market-related) and non-systematic (marketing-related) growth factors.ConclusionSo, despite their name, most TAMs have performed more in line with the Grizzlies rather than its predecessor over the last several years. In fact the last true bear market for the TAMs and the Grizz alike occurred in the 2008-09 downturn when the TAMs collectively lost over half their market cap, and Memphis lost over two-thirds of its games. Since then, the (RIA) TAMs have more than doubled in value, and the Grizzlies have had one of the highest winning percentages in the NBA. Of note, the only time the Grizz had a worse record than the Tams occurred in the 1998-99 season, when the team went 8-42 and played in Vancouver, which is an actual bear market.Mercer Capital provides business valuation and financial advisory services to traditional asset managers. If you’d like to discuss a valuation for transaction need in confidence, give us a call.

A Rising Tide Lifts All Boats

All Classes of Asset Managers Up Over the Last Year

Favorable market conditions over the last twelve months have buoyed RIA market caps to all-time highs. This almost seems counterintuitive against a backdrop of fee compression, fund outflows, and generally negative press (some of it by us), but a rising market means higher AUM balances, leading to greater fees and profitability, regardless of other headwinds facing the industry - not a perfect storm by any means, but good enough to best the broader indices during a relatively strong stock market rally. RIA Market Performance as of 6/1/17 Publicly traded custody banks (BNY Mellon, State Street, and Northern Trust) outperformed other classes of asset managers over the last twelve months, continuing their upward trajectory over the last few years but still lagging the broader indices since the financial crisis of 2008 and 2009. Placing this recent comeback in its historical context reveals the headwinds these businesses have been facing in a low interest rate environment that has significantly compressed money market fees and yields on fixed income investments. Their recent success may, therefore, be indicative of a reversion to mean valuation levels following years of depressed performance, rather than a sudden surge of investor optimism regarding future prospects. Further, pricing improvements for this group appear to be more relative to an improved banking environment than a change in circumstances for trust and custodial services. Still, in recent quarters, most trust bank stocks outperformed other classes of asset managers, like mutual funds and traditional RIAs, as passive products and indexing strategies continued to gain ground on active management. A rising yield curve portends higher NIM spreads and reinvestment income, and the market has responded accordingly – our custody bank index gained 45% over the last year, surpassing the broader indices and all other classes of asset managers. Publicly traded alternative asset managers have also performed well in recent months, but, like custody banks, are still reeling from poor investment returns over the last decade. The value-added proposition (alpha net of fees) has been virtually non-existent for many hedge funds and PE firms over this period despite the sector’s recent gains. Once again, the RIA size graph seems to imply that smaller RIAs have significantly underperformed their larger peers over the last twelve months. The reality, though, is that this segment is the least diversified (only two components, Hennessy Advisors and US Global Investors, both of which are thinly traded) and certainly not a good representation of how RIAs with under $10 billion in AUM are actually performing. Specifically, Hennessy’s weakness is largely attributable to recent sub-par investment performance from its Cornerstone Growth Fund, and US Global’s focus on natural resource investing has taken a hit from softening commodity prices. Most of our clients fall under this size category, and we can definitively say that these businesses (in aggregate) haven’t lost half their value since August as suggested by this graph. Other sizes of publicly traded asset managers have performed reasonably in line with the market over this period. 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. All are off to a decent start in 2017 after a strong end to 2016 as the market weighs the impact of fee compression against rising equity prices.

1Q Call Reports

Despite gaining 4% last quarter, publicly traded RIAs are still coping with a low-fee, passive investment environment and continued delays on the Fiduciary Rule implementation. The proposed DOL rule prohibits compensation models that conflict with the client’s best interests, and is expected to induce active managers to provide lower-cost or passive products and to complete the shift from commission-based to fee-based accounts. Still, many industry participants see opportunity amidst these headwinds, and the market for these businesses seems to as well.As we do every quarter, we take a look at some of the earnings commentary of pacemakers in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Fees are ultimately determined by investment performance and capital market returns, creating serious challenges for hedge fund managers and other active investors that aren’t delivering alpha on a sustainable basis.There is a greater belief that long-term returns are structurally lower than they were ten and twenty years ago. So if you have an expected long-term return of, let’s say 6%, which many people think that might be high when you look at a balanced portfolio. Fees take up a lot of that return. And as long as we believe the world is going to be in a low-return environment, our clients are under a lot of pressure….and so when we talk about fee pressure, fee pressure comes from the real issue of lower expected returns. And I think this is one of the big issues around hedge funds and why we’re constantly reading about some hedge funds closing, some hedge funds are lowering their fees, because the fee structures are just too large versus the returns on a risk-adjusted basis that they’re achieving. – Larry Fink, BlackRock CEO and ChairmanI think fee rates going down are – I think is a reality of what’s happening. Some of that is mix shift. Some of that is changing regulation in terms of distribution. Some of that will ultimately – will accrue to the benefit, obviously, of the end client. I think ultimately, this comes down to our ability to generate sustainable alpha. I think if we can generate sustainable alpha in a way that, in some ways, kind of captures 3x to 4x the fee over time, I think we’ll be fine. If we’re in a period of significantly lower returns and lower sustainable alpha, then obviously, I think fee rates are going to have to come down accordingly. – Gary Shedling, BlackRock CFO and Senior Managing DirectorTheme 2: Active managers continue to justify their fees with investment performance on certain products and [the perception of] lower correlation among certain asset classes.I think performance wins in the end. There’s no question about that. And as we’ve said before, I mean it’s when you have a good quarter or a good year, it may slow redemptions a bit, but it takes a while to build back onto the shelf space. And we’ve seen, I think the number of 4 and 5-star funds for us has quadrupled here in the last quarter. So those are the things that really drive sales and shelf space…And that most of the industry that has more brokerage assets, it, as we all know, creates challenges in the transition to more of the advisory mode. But at the end of the day, if you have performance and you have reasonable fees, you’ll get distribution in that model as well. – Greg Johnson, Franklin Resources CEO and ChairmanOutside of the U.S. market, in lesser developed markets, less-efficient markets, more dispersion, less correlation, I think we still feel very strongly in places like Europe and Asia and certain emerging markets, that frankly, the ability to generate sustainable alpha can support higher fees. And I think our performance has certainly showed that over time. – Gary ShedlinTheme 3: RIAs are still bracing for the DOL’s implementation of the Fiduciary Rule and the Pension Protection Act, which is expected to accelerate assets into passive products.On April 7, the Department of Labor published a 60-day delay of its Fiduciary Rule until June 9. Following that announcement we evaluated the delay in relation to existing projects and the pre-established contingency plans developed in anticipation of the delay. We are continuing our efforts to complete projects established for full compliance on January 1, 2019…Our efforts associated with the new rule have touched nearly every business unit and required significant lift from our employees and business leaders whose commitment remains strong as we continue to work towards full implementation by early 2018. – Phillip Sanders, Waddell & Reed CEOIt’s something that we continue to be very engaged on…So we are very active on that, on the lobbying front. And we’ve been asking that questions, well, what does it mean? What kind of dollar number are we looking at? And I think it’s probably too early to say, because it depends just how clients react to the disclosure…But again, when you have that transparency and the questions, we don’t know how far it extends. And I wouldn’t want to try to extrapolate because we don’t know what that would mean. I think you’re right in saying there’s still quite a bit of uncertainty on it. – Greg JohnsonThe real headwind is in the DOL Pension Protection Act rule. They created a QDI, or a default option, which is primarily proprietary target date funds. Our view is that was going to open up and be more open architecture, customized solutions that would include more outside asset managers such as Artisan. Unfortunately, the litigations have increased the perceived diversification of an all-indexed oriented target date fund, and fee pressure has spurred more and more assets going to the proprietary target date funds, especially if it’s 100% passive. That has lowered our expectations in the short run of the DC assets turning around. We still think over the next couple of years you’ll see more and more customized solutions. But for right now, it just seems the passive solution is the safe approach right now. – Eric Colson, Artisan Partners CEO, Chairman, and PresidentMercer 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.

Q1 Shows Glimmer of Hope for Active Managers and Continued Gains for Trust Banks

This quarter’s newsletter focuses on the mutual fund sector, which has been plagued by asset outflows into ETFs and other passive strategies for most of the last decade. The first two months of this year do, however, offer a ray of hope as 45% of U.S. based active managers beat their relevant benchmark, resulting in February being the first month of inflows into active products since April 2015.The newsletter also reviews RIA performance over the last year by size and type of asset manager. Unsurprisingly, trust banks have outperformed their peers with the prospect of higher interest rates and reinvestment income. On the size front, publicly traded asset managers with less than $10 billion in AUM were bested by their larger counterparts, but this is primarily attributable to the undiversified nature of this index (two components, both of which are thinly traded) and in no way suggestive of some broader trend of client preferences for larger RIAs.The M&A outlook remains fairly robust as owner demographics and the maturation of the mutual fund industry spur consolidation and buying opportunities for those looking to add scale. Standard Life’s $4.6 billion purchase of Aberdeen Asset Management last month is a perfect example of this and may be indicative of future deal-making in the sector.You can read the newsletter below or download it here. If you would like to receive the emailed newsletter each quarter, subscribe here.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.

Active Management Down But Not Out

Fresh off a 111-82 KO from the San Antonio Spurs on Saturday, our hometown Memphis Grizzlies are certainly battered but not totally eliminated from this year’s NBA title race. As this post goes to press, we still don’t know the outcome of Game 2, but it will undoubtedly be an uphill climb for the Grizz as it usually is against their divisional foes in Central Texas. Still, the Spurs/Grizz rivalry over the last ten years has not been nearly as one-sided as the battle for fund flows between active and passive investors in the ETF era. These dynamics are problematic for many mutual fund companies that rely on active equity products with higher fee schedules and profit margins. As a result, most publicly exchanged mutual fund companies are down while the market is up about 15% over the last year. 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. Many active managers and mutual funds have responded by cutting fees or offering their own passive products to stem the outflows, but this has adversely affected their revenue yields and profitability. Another potential headwind is the GOP’s current proposal to treat all 401(k) deferrals as after-tax contributions, which could disincentive employers from offering defined contribution plans that often invest in mutual funds and other active managers. Republican lawmakers still have a lot of work to do in getting this passed, but it is being seriously considered as one way to help finance the new administration’s proposed tax cuts. Despite these headwinds, 45% of domestic active managers were beating their benchmarks for the first two months of this year, after just 31% in 2016, according to Morningstar and The Wall Street Journal. To put this in perspective, the last year that even half of all active funds outperformed their index was 2009. Higher volatility, asset decoupling, and rising market conditions has been beneficial to most stock and bond pickers over the last few months. As a result, actively managed mutual funds posted their first month of positive new inflows in February since April 2015, according to Morningstar. The recent outperformance of some active managers means they may be gaining the upper hand on ETF’s value added proposition, which is all about alpha net of fees. ETFs and other passive strategies gained substantial inflows from active managers since their performance net of (lower) fees has been stronger than most active managers over the last decade, resulting in higher and higher allocations to index products. Active managers are now poised to reverse this trend, but it is going to take more than just two months of alpha to put much of a dent in this trend. 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, much like the Grizz, is down but not out as the series currently stands. 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.

Will the Fiduciary Rule Ever Become Law?

RIA Central Investment Forum Follow-up

Last week, Matt Crow and I presented at RIA Institute’s 3rd Annual RIA Central Investment Forum, and this question was asked to the crowd of 70+ industry participants in attendance

Excuse Me, Flo?

Inflows and Outflows Drive Disparity in Performance between Different Classes of Asset Managers

Immediately before ordering the Soup Du Jour and duping Sea Bass into picking up his lunch tab, Jim Carrey’s character in Dumb and Dumber, Lloyd Christmas, rudely accosts his waitress at the Truk-Stop Diner with this inexplicable reference to the early 1980s sitcom starring Polly Holliday as Florence Jean “Flo” Castleberry. Decades after the movie’s release in 1994, the market seems to be postulating the same question in pricing RIAs. Breaking out the recent performance of various classes of asset managers, we see those sectors that are least dependent on active management (trust banks and traditional managers) as clearly outperforming those more reliant on investment returns (alternative asset managers and mutual funds). While there are other factors at work (a steepening yield curve and hedge fund scandals to name a few), this disparity is largely attributable to investment performance and the impact it has on asset flows. We touched upon this topic in last week’s post, and basically AUM gains (the primary driver of revenue and profitability for an RIA) are attributable to one or two sources – market gains or client inflows (net of outflows). Since one can’t rely on stocks to always go up, asset flows are a more reliable gauge of an RIA’s sustainable performance regardless of market conditions. As shown above, there is a strong correlation between publicly traded RIAs and the market, so the disparity in performance between the various classes of asset managers is largely attributable to net asset flows. Subpar investment performance and the recent flight to passive products have plagued alternative asset managers and mutual funds, but benefited index providers with more competitive fees. The market has taken notice and continues to bid up the valuations of passive managers with positive inflows. Part of this outperformance may also be due to the anticipation of more favorable regulation (e.g. the Fiduciary Rule) surrounding passive investors over active management. Stephen Tu, Senior Analyst at Moody’s Investor Service, says, “Under the new regulation, advisors are expected to ensure investments are in the best interests of their clients, rather than merely suitable for them. In practice, it will become more difficult for advisors to place their clients into higher-cost and more complex investment products. Selling low-fee index products, on the other hand, will eliminate many apparent conflicts of interest and minimize fiduciary risk.” In response, many traditional active managers like Janus Capital, Legg Mason, and Franklin Resources have begun offering passive products to take advantage of the prevailing trend. Despite the high fees and underperformance, we’re not characterizing mutual fund and alternative asset investing as dumb and dumber. The reality is that many active managers do outperform their benchmarks and justify their fees. A proven track record of alpha generation will likely continue to attract assets from institutional clients even if fees aren’t competitive to an ETF that tracks a given benchmark or asset class. It’s just that beating the market on a consistent basis is a near impossible feat, so most active managers are struggling to keep pace with the rise of passive products that offer a cheaper and more reliable alternative. Much like Harry and Lloyd’s rapid accumulation and subsequent squandering of other people’s money, active managers must improve their performance or lower their fees to avoid a similar fate.

Q4 Call Reports

Despite gaining 8% last quarter, publicly traded RIAs are still feeling the pressure from the regulatory overhang on the Fiduciary Rule and continued fee compression on most investment products. The proposed DOL rule prohibits compensation models that conflict with the client’s best interests and is expected to induce active managers to provide lower-cost or passive products and to complete the shift from commission-based to fee-based accounts. Still, many industry participants see opportunity amidst these headwinds, and the market for these businesses seems to as well.As we do every quarter, we take a look at some of the earnings commentary of pacemakers in asset management to gain further insight into the challenges and opportunities developing in the industry.Theme 1: Continued fee pressure and chronic underperformance have caused many traditional RIAs to consider expense caps or variable fee structures that toggle with performance.There is no doubt that investors have felt more comfortable with what is perceived to be low cost and safe passive investing versus choosing active managers at higher fees and suffering on average, because that’s what the average numbers show, underperformance net of a fee. – Alliance Bernstein’s Peter KrausI would say, in general, that we are trying to do something different and say to clients, if we don’t perform, we don’t expect to be paid more than five basis points, and if we do perform, subject to all the limitations in those documents, we would expect that clients would be happy to pay us, and that is a pretty competitive offering to the passive world. – ibidThat’s something we think can be very useful answer to some of these high pressures around just fees and rationalizing versus passive is only paying on the alpha. And that’s something that we certainly are looking at. I don’t think we have the same kind of pressure on the retail side, nor do we think it makes a lot of sense certainly on the institutional side. We think that could be very additive to our overall line-up. – Franklin Resources’s Greg JohnsonTheme 2: The shift from active to passive management is a major headwind for many alpha hunters, but the best in class performers see opportunity for increased market share when the dust settles.Disruption was also a major theme in our industry. Asset flows into passive products continue to accelerate. The availability of these products and the perception that they are low cost, and in many cases lower risk is impacting all aspects of the investment management industry. As a high value-added investment manager, we welcome disruption in the industry. That causes investors to scrutinize their managers and advisors to determine whether value is being added, fees are transparent and rational, and the client’s experience comes first. We believe we are well positioned to benefit from the ongoing shake-up of the traditional active industry, as well as the increasing frustration of hedge fund investors. –Artisan Partners's Eric ColsonFirst and foremost, an oversupply of traditional active strategies resulted in too many products hugging indexes and not delivering value. As less expensive passive products came on-line, offering the same exposure at a substantially lower price, a large migration of assets was inevitable… Not all of those investors will go passive. Our experience over the last several years supports our belief that many of those investors will select managers who offer differentiated strategies with high degrees of investment freedom and strong investment track records. - ibidI think that the headwinds for active management, both long-only and hedged, frankly, remain significant. Relative returns have been largely poor, and fee structures have been high. We firmly believe for ourselves the way to grow is to focus on delivering top quartile or better performance…I think active managers who operate in alternative strategies like we do, and as well as multi-strategy implementations, and can deliver that performance efficiently can be big winners. –Cohen & Steers’s Joe HarveyTheme 3: There remains a great deal of uncertainty around the implementation and impact of the new Fiduciary Rule, but many believe larger fee-based advisors are better positioned to adapt to any large scale changes ahead.I don’t think there’s one consistent view. I think you have a trend that was already in place pre-fiduciary rule of going to more of a planning model against the advisor picking individual funds. That’s going to continue. I think the fiduciary rule accelerated that. I think some larger firms favor that rule because it helps them move towards that platform even faster. And that’s where you get a little bit, I think, some mixed opinions on what to do next. – Franklin Resources’s Ken LewisOur sense is that in some cases – and it depends on the type of assets you have and the average size of account and what product it is. It’s possible the total cost of revenue sharing could go up a bit, it could go down a bit. But the trend towards standardization is I think being well embraced throughout the industry. - Cohen & Steers’s Bob SteersWe believe that success in the post-DOL world will require a more institutionalized product approach to asset management in sales and marketing. Consistent with this approach, we continue to shake the culture and organization of our firm by enhancing our risk management capabilities, sharpening our investment philosophies and processes, evolving toward more team-managed portfolios, investing in our research capabilities, and emphasizing tighter integration between our investment in sales and marketing personnel. - Waddell & Reed’s Phil SandersMercer 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.

WHITEPAPER | Buy-Sell Agreements for Investment Management Firms

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

U.K. Based Henderson Group Acquires Janus Capital for $2.6 Billion

Coming to America

Though probably not as historic as Plymouth landing or even the Eddie Murphy comedy, Henderson’s purchase of Denver RIA Janus Capital last month is a rare sign of confidence in active managers that have been losing ground to passive investors for quite some time. The era of ETFs and indexing has dominated asset flows for quite some time, so this transaction seems to counter the recent trend.Last week, we touched on the recent election’s possible impact on active management, and the gist of it is that potentially heightened volatility and lower asset correlations under a Trump presidency could bode well for stock and bond pickers (though most fixed income investors would not agree with that position at the moment). Indeed, a quick look at active manager pricing over the last two weeks shows several industry leaders (Pzena, Diamond Hill, Hennessy, GAMCO, etc.) up 10% to 20% since the election. Investor sentiment seems to be shifting, or is at least less bearish on the sector than just a few months ago.As for whether JNS or HGG will be more likely to give thanks this Thursday, both sides are up modestly since the deal was announced in early October, though it has been a rocky seven weeks. Janus-Henderson should benefit from the ability to cross-sell each other’s products, though it is often harder to capitalize on this potential in practice. They’ve also both been adversely affected by asset flows out of active strategies, but are now poised to benefit from any semblance of mean reversion. With Janus serving primarily U.S. investors with domestic funds and Henderson having more of a European and global focus, there doesn’t appear to be much product overlap either. Janus CEO Dick Weil recently told analysts that the two companies are “almost mirror images of each other on opposite sides of the Atlantic,” and they certainly do seem to complement one another. Since Janus shareholders will now benefit from a lower (UK) corporate tax rate (and Thanksgiving is not celebrated in England), we suspect they’ll be more inclined to give thanks on turkey day.Looking strictly at the economics of the deal in the context of other recent transactions that we’ve analyzed, it doesn’t appear that Henderson overpaid for Janus with earnings and activity (revenue and AUM) metrics reasonably in line with precedent multiples. Given the size of Janus and expected synergies ($110 million in annual net costs savings) of the deal, one might have expected a higher valuation, but recent share price volatility and client outflows likely precluded much of a premium. Putting it all together, the transaction price appears appropriate to both sides from a financial perspective. One potential wrinkle in the deal is how famed 72 year-old bond investor, Bill Gross, and his new total return fund will be managed by the merged entity. There is also the question of his succession planning and client retention once he finally retires, since there’s certainly the possibility that all those (non-Gross) assets could flow back to PIMCO or another actively managed bond fund. Since Gross’ former co-manager, Kumar Palghat, recently left for another bond fund at Janus and his former boss, Dick Weil, just moved to Henderson’s offices in London (while Gross remains in Newport Beach), investors may hold some concern over the former bond king’s further alienation from the rest of the company. At this point, we don’t yet know if the Janus-Henderson marriage will end up as happily as Prince Joffer’s, but since Janus is named after the ancient Roman god of change and new beginnings, we’re hopeful for a smooth transition.

Recent Bribery Scandal, Another Blow to Alternative Asset Managers

Just a few days ago, the largest publicly traded hedge fund, Och-Ziff Capital Management Group, agreed to pay $413 million to settle federal charges that it disbursed more than $100 million in bribes to African government officials. Even before this announcement, the hedge fund industry was in quite the slump. Since June of last year, publicly traded hedgees and PE firms have lost 40% of their market cap. We’ve discussed the many headwinds facing this industry in prior posts but generally speaking, investors are simply fed up with the low return, high fee combination that has recently characterized the industry, particularly over the last year and a half. The Fed’s anti-volatility campaign hasn’t helped matters, and isn’t likely to abate any time soon. The Och-Ziff scandal reveals another potential headwind that isn’t necessarily company-specific. While difficult to measure, reputational risk is very real for these businesses that rely heavily on investor trust, transparency, and overall status within the financial community to raise capital. FIFA-like scandals are unacceptable to institutional investors already wary of high fees and sub-par performance. With this as a backdrop, it is hard to envision much of a silver lining. Still, as we’ve noted in a prior post, asset bubbles are relative. With a third of the developed world selling bonds at negative yields, and the U.S. stock market trending up after six straight quarters of earnings declines, bidding for any return at all in the private company space looks, at least on a relative basis, attractive. Fund raising is still alive and well in alt assets, and should be for some time to come. The old 2 and 20 management fee / carry model, however, is on life support and probably not going to make it - at least not as the industry standard. The few PE firms and hedge funds still capable of charging such high rates are consistently in the top 5% of investment performance, and sustaining that level of alpha over the long term is nearly impossible. One and ten over a predetermined hurdle is the new normal, and even that could come under pressure if performance continues to suffer while fees tighten for other classes of asset managers. A glance at current multiples doesn’t reveal much except that Blackstone’s earnings are likely depressed, and analysts are expecting some recovery next year as LTM multiples exceed forward P/E ratios for most of these businesses. In an era of fee compression and passive investing, this seems optimistic, though some mean reversion is entirely possible. AUM multiples, on the other hand, have always been high for this sector and are likely to remain that way due to performance fees and non-asset-based sources of income for PE firms. Still, with most of the group trading close to their 52 week high, any significant upside seems unlikely, and OZM shares may never recover. 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.

BlackRock Sees Opportunity in Challenging Environment for Asset Managers

A Whole New World

Often branded as an industry bellwether for its size and breadth of services, BlackRock (ticker: BLK) has been as solid as the name would imply given the recent fallout in asset manager valuations. In last week’s earnings call, CEO Larry Fink attributes the company’s recent success to “the differentiating platform we have built at BlackRock over the past 28 years…, the diversity of our product offerings, the risk capabilities of Aladdin, [and] the market insights offered by the BlackRock Investment Institute.” Specifically, BLK benefited from $126 billion in net inflows over the last year as many RIAs have leaked client assets to passive funds and robo-advisors. BlackRock is clearly gaining market share within the industry and currently manages $4.9 trillion in client assets. This scale has allowed it to make the necessary investments in technology and talent to continue the upward growth trajectory in a sideways market. In addition, BlackRock has also recently invested in ETF businesses to take advantage of the rising popularity of indexing strategies. In essence, BlackRock has used its size (and balance sheet) to evolve with the industry and gain market share in the process. Still, the last twelve months have been anything but a magic carpet ride for most industry participants. A low yield environment dominated by ETFs and passive products has not been conducive to many RIAs, especially active managers like Pzena and Legg Mason, which are down 31% and 43%, respectively, over the six months ended June 30, 2016. As we discussed last week, investors are growing increasingly intolerant of the high fee/low performance combination, so both traditional and alternate asset managers are feeling the heat. Mounting regulatory pressures are additional headwinds as the Financial Stability Oversight Council is currently reviewing six areas of the asset management business for potential enhancements to regulatory oversight – liquidity and redemption, leverage, securities lending, data and disclosure, operational risk of service provider concentrations, and resolvability and transition planning. The SEC is also assessing the sector’s systemic risk exposure and should finalize three proposals on mutual fund and ETF regulation at some point this quarter. While the current trend toward passive investing hasn’t shown any signs of strain, we don’t foresee active management ever going away for good. In fact, best-in-class stock and bond pickers should build market share as enterprising investors seek the few diamonds in the rough (last Aladdin reference, I swear) that have actually outperformed their relevant benchmark. Depressed valuations may induce further consolidation, so this trend could ease the number of stand-alone active management firms as competitively priced passive strategies continue to collect AUM. With over 11,000 RIAs and aging owner demographics, such consolidation is probably long overdue.

Asset Managers of All Shapes and Sizes Continue to Underperform the Broader Indices

Nowhere to Hide

Piggybacking off our post from a couple of weeks back, the downward trend in asset manager pricing has persisted for another quarter, no matter how you slice it. Publicly traded trust banks, alt managers, mutual funds, and traditional RIAs are all down over the last year, with hedge funds and PE firms leading the plunge. Rising compliance costs, fee and margin compression, asset outflows on active strategies, and stalling growth prospects are all culprits for the overall decline, but alternative asset managers have definitely been hit the hardest over the last year. As a matter of practicality, it shouldn't be surprising that the most expensive asset class with the worst overall performance would eventually be shunned by investors. This trend is really just a microcosm or more exaggerated example of what's going on across the entire asset manager landscape – individual and institutional investors no longer have to accept high fees and chronic underperformance, so they're turning their attention to passively managed products or indexing strategies to boost their effective return. John Oliver certainly didn't do the industry any favors with his 20 minute rant on advisor fees in his Last Week Tonight episode from a few weeks back. There was also virtually no size effect. Most every asset manager from GROW (U.S. Global) to TROW (T. Rowe Price) has struggled to keep pace with the broader indices. No matter the asset base, a low-fee, passively biased environment is not conducive to most asset managers of any size, shape, or form. Add rising regulatory costs and a market that's not exactly undervalued, and you get multiple contraction and a bear market for RIAs. So what's the market trying to tell us about the future of this business? Probably that fee compression, asset outflows, rising compliance costs, and heightened market volatility will likely have an adverse effect on future earnings for some time to come. For alternative asset managers, the market seems to be pricing in more pronounced cuts to their fee structure and/or continued outflows. It might also signal a buying opportunity for industry participants looking to add scale since most RIAs have finally gotten cheaper after years of steady growth following the last financial crisis. AMG's recent acquisition seems to be at least partially motivated by recent declines in hedge fund valuations. Further consolidation seems inevitable and might be the most viable way to restore a depleted asset base and profit margin. We'll keep you apprised on deal-making trends in future posts.

AMG Sees Opportunity in Alt Asset Space

Value Play or Falling Knife?

Last week, Affiliated Managers Group (ticker: AMG) announced the completion of its investment in three alternative asset managers — Capula Investment Management LLP, Mount Lucas Management LP, and Capeview Capital LLP. These transactions are the cornerstone of AMG's 6/6/16 definitive agreement with Petershill Fund I, a group of investment vehicles managed by Goldman Sachs Asset Management, LP, to acquire all of Petershill's minority interests in the aforementioned firms as well as two other alternative investment managers, Partner Fund Management and Winton Capital Group, which haven't yet closed.Under the terms of the agreement, AMG will acquire these interests for approximately $800 million to be paid in cash at closing (roughly half of which was just paid for Capula, Mount Lucas, and Capeview with the balance expected to close by year-end). Given that RIA disclosures only present ownership percentages in range form and three of the entities are headquartered in London, the ADV is of little use to us in ascertaining the exact interest acquired in these businesses (though it's probably safe to assume something close to 50% given their typical investment structure discussed in a previous post).Perhaps more instructive is AMG's admission that management expects the transaction to increase economic earnings per share by $0.50 to $0.80 in 2017, availing some insight on deal pricing (though much of this accretion is likely due to synergies). At first glance an effective multiple of 18-29x next year's earnings seems a bit rich, even in this market, but closer inspection reveals pricing more in line with industry peer measures. The high level of variance in the metrics is largely attributable to the uncertain and variable nature of performance fees and carried interest income. Such ostensibly high valuations are more a function of depressed earnings from fee pressure and fund outflows than overly bullish sentiment on the sector’s prospects. In an investing landscape dominated by indexing strategies and passive products, investors are becoming increasingly weary of the high fees and recent underperformance associated with many hedge funds and private equity firms. Publicly traded alternative asset managers have clearly fared the worst over the last year relative to other classes of RIAs and trust banks. AMG apparently sees this decline as a buying opportunity, since these businesses might be the cheapest they've been in quite some time. And although trying to catch a falling knife is typically ill-advised, AMG has partially hedged this risk by investing in established hedge fund managers with over $1 billion in client assets. At any rate, the market doesn't seem convinced — though only time will tell.

Brexit and Killen Underscore the Need for Buyer Protection in Asset Manager Transactions

Black swan events and the very nature of the asset management business illustrate the importance of contingent consideration in RIA acquisitions for prospective buyers. The volatility associated with equity managers means AUM and financial performance can swing widely with market conditions, so doubling down on a one-time payment for an RIA can be extremely risky, particularly at high valuations. Of course, the market can just as easily pivot in the buyer’s favor after the deal closes, but gaining Board approval for such gambles is an exercise in futility if insurance is available in the form of contingent consideration.Back in December, we blogged about Tri-State Capital’s recently announced acquisition of $2.6 billion manager, The Killen Group of Berwyn, PA. The deal terms included an initial $15 million payment and contingent consideration of 7x any incremental growth in Killen’s annual run rate EBITDA in excess of $3 million for the pending calendar year (2016). Upon announcement, the estimated total deal value was in the $30-$35 million range, but when the deal closed in April, this estimate dropped to $15-$20 million. The table below illustrates the implied valuation metrics and returns had this deal been structured as a one-time payment under the two value scenarios. Fortunately for Tri-State, the bank elected to structure the deal as an earn-out whereby roughly half of the total potential consideration was guaranteed and the remaining half had to be “earned” by meeting certain earnings objectives following deal closure. The downward revision implies that the business is not likely to generate more than $3 million in EBITDA this year, and an ~11x purchase for a closely held RIA with compliance issues and a declining AUM balance (ADV disclosures indicate that Killen’s AUM fell 27% in 2015) would have been hard to justify had the total deal value been paid up front. Instead, Tri-State is still likely to boast a decent ROI on this deal without paying another dime for it if the business fails to perform in line with initial expectations. The following table shows the implied total deal value under four different scenarios of EBITDA for this year. Under this structure, the seller is incentivized to ensure the business continues to perform after the initial payment. This assurance is critical in many RIAs that are often heavily dependent upon the selling shareholder(s) for client relationships or investing acumen. If key accounts are not transitioned to the prospective acquirer or the market corrects itself following the transaction, the buyer will likely be off the hook for further consideration. Contingent consideration doesn’t always have to be based on future earnings. Perhaps the most acquisitive business in the RIA space is Affiliated Managers Group, whose investment model includes a revenue sharing agreement whereby the target’s fees are split (at a fixed percentage) into two segments: the operating allocation and the owners’ allocation. The operating allocation covers all operating expenses of the affiliate (target) at the discretion of the target’s management, while the owner’s allocation goes to the firm’s partners and AMG according to their respective ownership interest in the business. [caption id="attachment_11668" align="aligncenter" width="500"]Source: AMG[/caption] This structure allows the affiliate to retain operating autonomy while limiting AMG’s exposure to operating leverage because the owners’ allocation is set at a fixed percentage of revenue, not earnings. Since there’s usually some portion of an asset manager’s expense base that is predominantly fixed, earnings are typically more volatile than fee income, so the revenue sharing agreement is a partial hedge against earnings volatility during a Brexit or other black swan event. Still, the best hedge against a market downturn is a solid profit margin, as we’ve discussed in a prior post. With Brexit coinciding with a quarterly billing cycle for many asset managers, earnings are likely to take a huge hit along with the market. Those RIAs with a robust EBITDA margin will likely stay in the black as opposed to their less profitable counterparts that may be under water until market conditions improve.

Mutual Fund Providers Down Sharply as ETFs Continue to Gain Ground

One streak that remains, albeit less reportedly, is passive funds’ dominance over their active counterparts over the last year. According to Morningstar, active funds endured $268 billion in net outflows over this period while their passive counterparts gained $382 billion in client assets. These dynamics are problematic for many mutual fund companies that rely on active equity products with higher fee schedules and profit margins. As a result, most publicly exchanged mutual fund companies are trading in bear market territory while the market has flat lined over the last year. 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. Through the first two months of 2016, just 28% of large cap mutual fund managers are beating their benchmarks (27% for all of 2015) and only 1% posted positive returns, according to a Goldman Sachs study. Both individual and institutional investors are now more inclined to shun active managers for cheaper, more readily available products, particularly when performance suffers. Many active managers and mutual funds have responded by cutting fees or offering their own passive products to stem the outflows, but this has adversely affected their revenue yields and profitability. Russel Kinnel of Morningstar elaborates on this trend in his recent article, “It’s Flowmegeddon! Outflows add to the challenges facing active stock fund managers.” “The simple answer to this riddle is competition from exchange-traded funds. ETFs have gained the upper hand in the active/passive debate, even over open-end index funds, which generally offer comparable cost benefits. More advisors are switching to ETF-focused strategies, and, when they get a new client, they quickly sell the weakest performing active funds—possible all the actively managed funds—in the client’s current portfolio. Self-guided investors are moving to ETFs, too.”As Mr. Kinnel notes, these redemptions from active funds wouldn’t be so alarming in a bear market, but we’ve come a long way since the Financial Crisis. This current trend is about investor preferences not investor paranoia.On balance, passive funds appear primed to continue their dominance over active management, but we still question the sustainability of this trend over the long run. While fees are likely to continue their descent over time, 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. While we’re more bullish on the prospects of Golden State and Barca this season, we haven’t completely ruled out active managers in the ongoing quest for investor capital and advisory fees.

Asset Manager Valuations Mixed After a Rocky Q1

From a valuation perspective, it appears that alternative asset managers fared the best in Q1. The group’s median multiple rose 60% in the first three months of the year, besting all other classes of asset managers over the same period. Closer inspection reveals a much bleaker quarter for the publicly traded hedge funds and private equity firms in our alternative asset manager index. Despite significant gains in the back half of the quarter, the group lost roughly 5% of its market cap during the first three months of the year. In other words, the E is falling faster than the P/E is rising for most of these businesses. With many names trading at a 40%+ discount to their 52 week high, the market seems to be questioning the long-term viability of many hedge funds and PE firms whose high fees and subpar performance have come under scrutiny in recent years. On the other end of the spectrum, more traditional, long-only managers appear to have taken some market share from their alternative counterparts over the same period. Investors continue to grow wary of higher fees, especially when performance suffers, so this is no surprise to those who follow the sector. Still, hedge funds are typically better poised to profit from market volatility, which might explain the group’s advancement since its mid-February bottom. Moving forward, this disparity is unlikely to persist if many of these publicly traded alt managers are to remain a going concern. The past few weeks have been promising, but the index as a whole lost roughly half of its market cap from July of last year to February of 2016. An opportunistic investor with a high risk tolerance might see this as a buying opportunity. Others will look skeptically at the sector’s prospects in the era of passive investing.

Business Divorces at RIA Firms

A fellow Mercer Capitalist recently purchased this beauty, a 1976 VEB Trabant or “Trabi,” at a car auction in Chicago. Ironically labeled as “the car that gave communism a bad name,” the Trabi was the most common vehicle in East Germany during the Soviet Bloc era and even made the Los AngelesTime’s prestigious “50 Worst Cars of All Time” list. If these rankings culminated in a March Madness style bracket pool, the Trabi would definitely deserve a #1 seed given its two-stroke pollution generator (that maxed out at 18 hp) and lack of basic amenities like turn signals and brake lights. The body was made of a fiberglass-like Duroplast (reinforced with recycled fibers of cotton and wood) and even had some parts manufactured from papier-mâché when the VEB production plant ran low on steel. As the Berlin Wall fell in 1989, thousands of East Germans drove their Trabis across the border as a sign of automotive liberation from the Communist Bloc.Like the Trabant, business divorces can be liberating, but are mostly just ugly and ill-conceived. This is especially true for RIA firms where the founding principals typically serve as Chief Investment Officers or portfolio managers for the larger accounts. As a result, these shareholders (and the RIA itself) have the most to lose when corporate disputes or partner buy-outs arise. Many times, these conflicts are unavoidable and are the natural bi-product of ownership transition and firm evolution. In these instances, a carefully crafted buy-sell agreement (“BSA”) can resolve these disputes in a fair and equitable manner (from a financial point of view) if the valuation process avoids these common pitfalls:Employing a fixed or formulaic valuation methodology. The most commonly used rule of thumb for valuing asset managers is price (or enterprise value) to AUM, which is fraught with all sorts of issues covered by a previous blog post. Even worse are formulas that call for a departing shareholder to be bought out at a pro rata percentage of book value or his/her capital contribution. Such metrics make little sense for RIAs, which often have minimal capital requirements and balance sheets, meaning one-side is likely to get bought out a price that is in no way indicative of fair market value for his or her equity interest. BSAs that call for fixed multiples of earnings or cash flow are less offensive to us, but don’t account for natural variations in cap rates and can be subject to margin manipulation by the managing partners.Delaying a valuation until a triggering event actually takes place. Business owners often have an inflated (and sometimes deflated) view of what their company is worth. Having the business appraised on a regular basis (annually or bi-annually) precludes the inevitable surprise that takes place when a trigger event occurs and allows both sides to gain familiarity with the appraisal process.Employing multiple appraisers and tie-breaker valuations when both sides’ experts inevitably disagree. Besides being costly and time-consuming, this technique can be especially problematic when there’s an outlier valuation or the parties can’t agree on a third appraiser. In any event, the process can be a huge distraction for an RIA’s management team and shareholder group. The problem that we most often see with shareholder agreement disputes is the potential of a forced transaction creating winners and losers. If a departing shareholder is bought out at a premium to the value of the enterprise, that premium comes at the expense of the remaining shareholders. If the shares are bought at a discount, the remaining shareholders reap a windfall. Some buy-sell agreements are intentionally engineered to favor either the selling shareholder or the continuing shareholders, but if so everyone who is a party to the agreement should be aware of that long before the triggering event. At Mercer Capital, we recommend a regular valuation process for buy-sell agreements at investment management firms for a number of reasons:The structure and process, in addition to being defined in the agreement, will be known by all parties to the agreement in advance.The appraiser’s valuation approaches and methodologies are seen firsthand by the parties before any triggering event occurs.The appraiser’s independence and objectivity will be evident in the consistency of methodology utilized over time.Because the appraisal process is exercised on a recurring basis, it should go smoothly when employed at triggering events and be less time-consuming (and expensive) than other alternatives. Our colleague with the Trabi says that one benefit to ownership is that you never know what’s going to happen when you get into the car. Your buy-sell agreement should, on the other hand, be free of surprises. If it’s been a while since you looked under the hood of your shareholder agreement, we recommend you pull it out of the drawer, read it, and then call your legal counsel if you see the potential for any problems down the road. Then call us.

Asset Manager and Mutual Fund Valuations Continue their Decline through Year-end

A quick look at year-end pricing of publicly traded asset managers reveals a continued skid in multiples for traditional RIAs and mutual funds with modest advancement for the alternative managers and trust banks. Earnings multiples are essentially a function of risk and growth, so a decline in cap factors for the traditional managers and mutual funds means one of two things must be happening: either the cost of capital is increasing or the growth outlook for asset managers is stalling. Despite the Fed’s recent actions, WACC’s are generally declining in most industries. There is no reason to assume the cost of capital is now higher in asset management than a year or two ago, so the trend in multiples suggests that the growth outlook for RIA earnings continues to be revised downward. Given that traditional asset managers and mutual funds are so highly levered to market conditions, some consider RIA valuations as a de facto futures contract on the broader indices. If that’s the case, a continued contraction in multiples could portend a pullback or lack of upside for the stock market in general. The market activity on the first trading day of this year tends to confirm this suspicion. Since most of the group is currently trading at a 30% discount to their 52 week high, the market is clearly bearish on the prospects for many of these businesses moving into the new year. Meanwhile, more optimistic investors will view this as a buying opportunity for companies that have gotten a lot cheaper in recent months. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

Asset Manager M&A Continues Ascent Despite Sell-Off

Despite the recent setback in the markets, RIA transaction activity posted solid gains for Q3 and into the month of October. We caution against reading too much into this since transaction value is often not reported, though it is promising that the number of deals has increased fairly consistently over the last year. The fourth quarter looks to continue this trend with Hellman & Friedman’s recent purchase of Edelman Financial (covered in a previous post). The quarter-end multiples for the public RIAs reveals that pricing remains firm but not egregious, a conducive environment for continued transaction activity in the sector. Prospective buyers will also be intrigued by many of these businesses now trading at a 30% discount to their 52 week high. [caption id="attachment_9618" align="aligncenter" width="650"] Source: SNL Financial[/caption] Placing the recent uptick in its larger historical context reveals a lull in deal making after the active 2006 to 2009 period that culminated in BlackRock’s purchase of Barclay’s asset manager business. The sector’s ability to shrug off the most recent correction is a testament to its resiliency in the face of declining management fees and impending regulatory changes. Despite the recent uptick, we believe the backlog for deal making remains fairly robust given the four year pause in transactions from 2009 to 2013 and the aging demographics of many investment management firms. The real threat to deal making would be a longer, more pronounced downturn in the equity markets that would crater AUM levels and investor confidence. We note the decline in transaction activity following the financial crisis of 2008 and 2009 as indicative of what another bear market could do to M&A trends. The outlook for deal making is therefore more nuanced and dependent on market conditions. The market’s stabilization since the last correction has clearly boded well for sector M&A, and the future appears bright – as long as security pricing holds up. Another significant setback would likely curtail the recent momentum and valuation levels.

Many Alternative Asset Managers in Bear Market Territory

A particularly rocky quarter for the equity markets precipitated huge market cap losses for most of the publicly traded hedge funds and PE firms. The lone bright spot and only sector component to generate a positive return over the last year is Blackstone, which benefited from strong performance fees on its portfolio company investments earlier this year. Still, the stock is down over 20% since its peak in May, which shows just how volatile the industry can be, particularly during times of market distress (our recent post discusses the impact of the recent downturn on asset manager shares). With over $300 billion in AUM, Blackstone’s size is both a blessing and a curse. On the one hand, a large AUM base affords it the opportunity to invest in a multitude of asset classes and industries to enhance its risk/return profile with a diverse product offering. But, size can be a drag on performance and cut into carried interest fees if the underlying fund’s stature trumps viable investment opportunities. Still, some of this risk is mitigated by the added stability of higher management fees from a larger asset base. And the market doesn’t seem to mind this trade-off as AUM fees represent a relatively stable source of income to complement unpredictable and often inconsistent returns from carried interest. Stocks of publicly traded PE firms have typically displayed more volatility than traditional money managers, and building larger funds with longer investment horizons may be one way to temper this disparity. Diversifying fund offerings beyond LBOs and into other asset classes such as hedge funds and real estate also helps. Sector analyst Marc Irizarry at Goldman Sachs notes, "All of these firms…have done a lot to diversify their businesses or to position themselves to grow assets on a more sustainable basis." Indeed alt manager shares have outperformed the RIA index as a whole over the last year, albeit by a fairly small margin. Much of the divergence in financial and investment performance within the alternative asset manager sector can be explained by timing. A Bloomberg News piece in Financial Advisor expounds, "buyout firms' earnings rarely follow a linear path because they are driven by the lumpy timing of exits as well as the "mark-to-market" valuations of fund holdings, which are vulnerable to market swings and required each quarter under accounting rules." The economic cycles and gyrations in the stock market since the financial crisis have compounded this volatility as many of the deals that were struck at the last buyout peak of 2005 to 2007 have taken longer to exit at profitable levels, so their shareholders have yet to witness a full fund cycle while these businesses have been publicly traded. Irizarry elaborates, "[alternative asset managers] are still 'show-me' stories in the eyes of the market. There's some reluctance on the part of investors to ascribe higher valuations on these managers until they see how sustainable these businesses really are." Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

Rough Quarter for the RIA Industry

Q3 was an especially bad quarter for asset managers, with the group losing over $40 billion in market capitalization during a six week skid. Given the sector’s run since the last financial crisis, many suggest this was overdue and only pulls RIA valuation levels closer to their historic norms. The multiple contraction reflects lower AUM balances and the anticipation of reduced fees on a more modest asset base. The most recent sell-off brings the industry to the brink of a bear market despite the S&P being down only 10% or so over the last few months. Such underperformance is not surprising for a business tethered to market conditions and investor sentiment. The market is acknowledging that revenue for equity managers is directly tied to index movements and earnings often vary more than management fees due to the presence of fixed costs (as demonstrated in the example below). Combining these dynamics with some multiple contraction reveals the market’s rationale for discounting these businesses in recent weeks. The impact on sector M&A is more nuanced. On the one hand, the lower price tag might entice prospective buyers fearful of overpaying. Yet for others the market’s recent variability could spook potential investors, and sellers may be less inclined to part with their businesses at a lower valuation. Though the third quarter figures aren’t out yet, the recent slide could curtail the deal making momentum we’ve witnessed over the last year-and-a-half. The outlook also remains uncertain and will ultimately be determined by market movements and asset flows. We’re neither smart enough nor dumb enough to predict future market movements and will defer that to the experts. As for asset flows, fee-richer active funds are losing ground to indexes and alternative products despite typically outperforming more passive strategies during market downturns. Overall, asset flows to riskier products (active or passive) are unlikely to improve until the recent volatility declines to more normal levels. [caption id="attachment_9360" align="aligncenter" width="500"] Source: Morningstar[/caption]

Look out below! As capital market valuations apex, so too will RIA margins

Investment returns and the steady upward drift of equity markets are usually kind to investment management firm profits and valuations.This does not seem to be a “usual” period, however, and it serves as a reminder that profit margins are not simply an allocation of returns to equity holders; they also serve as a margin of safety in bear markets.Few industries are as susceptible to market conditions as the typical RIA.With revenues directly tied to stock indexes (in the case of equity managers) and a relatively high percentage of fixed costs, industry margins tend to sway with market variations.While the concept of operating leverage is not new to anyone in the asset management industry, it is easy to forget how easy it is for margins to collapse in a market downturn.It is, of course, striking to notice how RIA margins have recovered to the previous peak of 2007, a potentially ominous warning for equity markets now.Even more striking is how deep profits can fall in a market meltdown.The Qs reflecting the P&L impact from the most recent correction aren’t out yet, but we suspect that profits will be adversely affected for at least the next couple of quarters, depending on the extent of the downturn.Indeed, the market appears to be already anticipating this for most publicly traded asset managers, as they have lost several billion dollars in aggregate market cap over the last six weeks.On the private end of the spectrum, smaller, closely held RIAs tend to be more susceptible to market conditions than their publicly traded counterparts.Private RIAs don’t typically have the AUM and corresponding profit margins to serve as a cushion against a bear market.Anecdotally, we saw many asset managers with under $1 billion in AUM report negative earnings in 2008 and 2009 (at least for a few quarters) while most of the public RIAs stayed in the black.A healthy, larger RIA with 30% to 40% margins in good times can absorb a bear market event without reporting a loss, but many closely held asset managers with half that margin aren’t so resilient.The upward drift in the market from 2009 to 2014 buoyed AUM levels to new highs without the corresponding increase in expenses for many asset managers whose only variable costs tend to be compensation related.As a result, our group of publicly traded asset managers was able to recoup their entire 11% drop in average profit margins in just one year after the financial crisis. Only a few years after 2009, asset manager margins swelled to unprecedented levels; but operating leverage works both ways, and many public RIAs are trading in bear market territory following last month’s correction.The recent downturn should serve as a wake-up call to an industry that hasn’t had much interference in its upward trajectory over the last several years.As valuations drop and revenues contract, more attention must be devoted to expense controls if margins are to be maintained in the short run.Moving forward, this may be a challenge for many industry participants facing higher regulatory costs, a growing complexity of financial products, and personnel expenses that have moved almost in lockstep with revenue since the credit crisis.All of these costs tend to be fairly sticky on the downside. Against a backdrop of increasing fee pressure and robo-advisory competition, this correction may have been long overdue for an industry that’s nearly doubled in size since the Great Recession. Though future market performance remains uncertain, it’s hard to imagine that RIA margin expansion will continue its ascent from the prior six years without another bull market tailwind. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

Simmons First National Acquisition of Ozark Trust and Investment

On April 29th, 2015, Simmons First National Corporation (NASDAQ ticker: SFNC), announced it has entered into an asset-purchase agreement to acquire Ozark Trust and Investment Corporation (OTIC) and its wholly owned subsidiary, the Trust Company of the Ozarks (TCO), a Registered Investment Advisor (RIA) headquartered in Springfield, Missouri. The Trust Company of the Ozarks administers over $1 billion in client assets for over 1,300 clients with a 16% AUM compound annual growth rate. Simmons First National Corporation has agreed to a purchase price of $20.7 million, with a consideration of 75% stock and 25% cash. The deal is to close in quarter 3 of 2015. Unlike most acquisitions of closely held RIAs, the terms of the deal were disclosed via a conference call and investor presentation; the details of which are outlined below. Similar to the Boston Private/Banyan Partners deal late last year, management delineated how the Trust Company of the Ozarks’ attributes met Simmons First’s strategic rationale: Cultural Fit. Simmons understands the importance of cultural fit with any acquisition. Through the due diligence process, Simmons found TCO’s culture to be very compatible to that of its own. TCO is conservatively managed, yet has achieved impressive AUM growth since 2007.Strong Relationship Between TCO and Liberty Bank. Gary Metzger, Chairman & CEO of the former Liberty Bank, served on the TCO board of directors since its inception in 1998. Moreover, Jay Burchfield, TCO Chairman, served as an Advisory Director of Liberty Bancshares, Inc. The respective staffs of TCO and the former Liberty Bank have a strong, long-standing relationship.Market Expansion. Simmons has identified TCO as a high priority acquisition opportunity following the acquisition of Liberty Bank. Simmons believes the acquisition of TCO will provide the needed trust and investment management scale for its increased footprint in Southwest Missouri. TCO is the only independent trust company in Missouri outside of St. Louis or Kansas City. With total AUM of approximately $1 billion, TCO will increase total AUM of Simmons First Trust Company by almost 25%."Sticky" Clients and Assets. TCO has made customer service a focus of its business, which has created a loyal client base. Generally speaking, trust services and AUM do not transfer easily. Moreover, it is hard to replicate TCO’s client service trust and investment management model. TCO’s team has established long-term relationships with all of TCO’s key customers.Strong Experienced Team. TCO’s team has over 200 years of combined experience. TCO’s Senior Management has excellent community relationships. The team has consistently matched or outperformed industry benchmarks. TCO’s team has expressed optimism in being able to grow the business further and take advantage of Simmons’ platform.Reputable Branch Name. TCO is among the region’s most reputable trust companies and is well-known throughout Southwest Missouri. These recent deals are particularly instructive to other industry participants since, of the nearly 11,000 RIAs nationwide, approximately 80 (<1%) transact in a given year, and the terms of these deals are rarely disclosed to the public. Part of this phenomenon is attributable to sheer economics – a new white paper from third-party money manager, CLS Investments, argues that many advisors lose out financially in an outright sale of the business. Another recent publication titled “Advisors: Don’t Sell Your Practice!” in research magazine ThinkAdvisor notes that many principals earn more in salary and bonuses than they would from the consideration they would otherwise receive in an earn-out payment over a period of time, as many of these deals are structured. In other words, returns on labor exceed potential returns on capital for many advisors, particularly for smaller asset managers that typically transact at lower multiples of earnings or cash flow. In these instances, an internal transaction with junior partners might make more sense for purposes of business continuity and maximizing proceeds. For larger RIAs, recent deals suggest that buyers are willing to pay a little more for the size and stability of an advisor with several billion under management.

Banks Interested in Asset Managers and Trust Companies

In a low interest rate environment coupled with rising capital requirements, many banks are turning their attention to asset managers and trust companies to improve ROE and diversify revenue.

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About

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Brooks K. Hamner

CFA, ASA

Senior Vice President

Authored Content

The Silent Risk in Many RIA Succession Plans

What a Cold Snap Teaches Us About Cycles in RIA M&A

Leftovers: RIA Themes from 2025 That Will Carry Into 2026

What to Look for in an Acquisition Target for Your RIA

Private Equity’s Growing Influence on RIA Dealmaking and Valuation Multiples

The Growing Appeal of Independent Trust Companies

You Can’t Spell RIA Without AI

Navigating Valuation Challenges in the Great Wealth Transfer

Webinar Replay: Succession Planning for RIAs

Succession Planning and Its Impact on RIA Valuations

The Impact of Market Volatility on RIA Valuations

Webinar Replay: Understanding RIA Valuations

5 Takeaways from Dimensional Fund Advisors’ Deals & Succession Conference

RIA Valuations and How to Maximize Yours

What Does the RIA Valuation Process Entail?

Are Difficult Partner Discounts Applicable to RIAs?

WHITEPAPER | Purchase Price Allocations for RIAs

How Will Trump’s Second Term Affect the RIA Industry?

RIA Aggregator Investments Trick or Treat

Does This Presidential Election Matter to the RIA Industry?

WHITEPAPER | Valuing Asset Managers

Handling RIA Ownership Disputes

Will Rate Cuts Improve RIA Multiples?

WHITEPAPER | Assessing Earnings Quality in the Investment Management Industry

Why Haven’t Higher Interest Rates and Inflation Derailed RIA Dealmaking Activity?

Are Toxic Cultures the Silent Killers of the Asset Management Industry?

What to Look for in a Quality of Earnings Provider for RIA Transactions

How EBITDA Margins Affect Revenue Multiples

Will RIAs Be Subject to Anti-Money Laundering Rules?

Will Finfluencers Replace Financial Advisors?

Remembering Charlie Munger

Memorable Mungerisms

Munger Games: Charlie Munger’s Legacy

Can Active Management Survive a Bear Market?

5 Takeaways from the Association of Trust Organizations' (ATO) 2023 Annual Meeting

What Can We Make of Goldman’s Brief Foray into the Mass Affluent Space?

Compensation Structures for RIAs

4 Considerations for Your RIA’s Buy-Sell Agreement

Four To-Dos Before You Sell Your Investment Management Firm

Common Valuation Misconceptions about Your RIA

The Relationship Between Revenue Multiples and EBITDA Margins

Whitepaper Release: Compensation Structures for Investment Management Firms

WHITEPAPER | Compensation Structures for Investment Management Firms

Westwood Looks to Replace Lost AUM and Revenue with Salient Partners Acquisition

Rising Interest Rates Will Likely Affect More Than Just RIA Stock Prices

One Step Forward, Two Steps Back: RIA Stocks Finish the Quarter Down 10% after a Fast Start

Five Takeaways from the Association of Trust Organizations (ATO) 2022 Annual Meeting

Far(ther)sighted or Blind Ambition: Tech Platform Nets RIA a Big Price

Pzena Going Private Could Have Larger Implications for the Investment Management Industry

Another Tumultuous Quarter for RIA Stocks Puts the Industry Firmly in Bear Market Territory

Compensation Structures for RIAs: Part II

What Can We Make of All This Turnover in the RIA Space?

What Happens to RIA EBITDA Multiples When Interest Rates Rise?

Alt Managers Best the Market and Other Types of RIAs During a Rocky Twelve Month Stretch for the Industry

What Market Volatility Means for Your RIA

Additional Considerations for Your Buy-Sell Agreement

Alt Managers Best the Market Along with Other Types of RIAs During a Strong Year for Investment Management Firms

Posturing for a Successful Succession

Public Alt Asset Managers Have Nearly Doubled in Value Over the Last Year

Why Is No One Selling in a Seller’s Market?

Strong Quarter Propels Alt Managers to New Highs

To the Moon or Back to Earth?

FAIR … The F-word in RIA M&A: Part 2

Strong Gains in the Wealth Management Industry Propel RIA Aggregators to New Highs

Value Finally Outperforms Growth After Twelve Year Lull

Failing to Plan Is Planning to Fail

RIA Industry Extends Its Bull Run Another Quarter

The Role of Earn-Outs in RIA Transactions (Part One)

What RIAs Need to Know About Current Estate Planning Opportunities

Low Rates and NIM Margins Spur Bank Interest in the Wealth Management Sector

How Growing RIAs Should Structure Their Income Statement (Part II)

Financial Advisors, Tell Your Clients to Gift Now!