We start the new year with an industry-focused piece, sharing a recent article from our Investment Management blog, RIA Valuation Insights. The industry focus is intentional because we have provided family law valuation and forensic services to numerous owners (and spouses of owners) of RIAs/wealth management firms. In addition, the broader topic of understanding the role of a firm’s margin in valuation is important for family law attorneys as well as other parties to a divorce.
An RIA’s margin is a simple, easily observable figure that condenses a range of underlying considerations about a firm that are more difficult to measure. As much as a single metric can, margins reflect the health of a firm—indicating whether a firm has the right people in the right roles, whether it’s charging enough for services, whether it has enough (but not too much) overhead, and much more. But when assessing your firm’s margins, it’s important to consider the context of the firm’s ownership and compensation structure and also the tradeoffs associated with margins that are too high or too low.
Consider the typical cost structure in the industry: For most RIAs, costs other than compensation (things like rent, data services, professional services, tech vendors, insurance, etc.) might total 20% or less of revenue. The remaining 80% (or more) remains with the firm’s stakeholders, either going to employees in the form of compensation or shareholders in the form of distributions. The line between compensation and distributions can often blur because of the overlap between employees and shareholders. To add to the confusion, the primary input to investment management is talent—something that’s hard to quantify and certainly isn’t a commodity; benchmarking services can provide perspective, but no compensation database can tell you precisely how much a particular individual “should” make.
Margins can be a convenient shorthand for the firm’s operational success, but the nature of the industry’s cost structure lends to significant discretion in how to split pre-compensation profits between returns to labor (in the form of compensation) and returns to capital (in the form of distributions). With that discretion comes tradeoffs. Striking the right balance between margin and compensation is an important aspect of building a sustainable and growing enterprise.
If margins are too low, the economic benefits from the firm’s operations flow primarily to employees, not shareholders. The result is that there’s little incentive for ownership, which can make internal transactions difficult from a cash flow and valuation perspective. On the other hand, if margins are too high, employee retention may suffer, and it may be difficult to replace employees in the event of turnover. Spending less on employees is also a tradeoff with growth. Firms that limit investment in employees may be trading margin now for growth opportunities later. All of these considerations can be exacerbated if outside shareholders are present or if ownership by employee shareholders is disproportionate to their contribution to the firm.
From a valuation perspective, high margins are desirable, but buyers are particularly mindful of the durability of those margins and the firm’s future growth prospects. A high-margin firm isn’t necessarily a firm that commands a high multiple—and in fact, the reverse may be true if buyers expect the firm’s margins to contract. Similarly, a low-margin firm growing rapidly and with a cost structure in place such that margins can be reasonably expected to expand over time may command a higher multiple of current profitability.
Another factor to consider is how a firm’s current margin is achieved in the first place. If a firm runs with an above-peer margin, is it because they’ve grown rapidly but efficiently, taking advantage of operating leverage and scale, or have they slashed necessary overhead costs and skimped on compensation? The former might be worth a premium; the latter might be viewed as unsustainable, or the lack of employee incentives might be viewed as compromising future growth opportunities. Margin that comes from revenue growth and scale rather than cost cutting is likely to be viewed more favorably from a valuation perspective.
How does all of this relate back to compensation decisions? In our experience, the most successful (and valuable) firms tend to have a few things in common that help them navigate the “margin vs compensation” dilemma. One commonality is broad-based employee ownership, which mitigates many issues that can otherwise arise in determining returns to capital versus returns to labor. Another commonality is that such firms typically have significant variable compensation programs that align incentives between employees and shareholders and serve as a “shock absorber” that keeps the firm’s margin within a reasonable, sustainable range in both upside and downside scenarios.
The presence of such incentive compensation mechanisms can dramatically impact growth: According to Schwab’s 2022 RIA Compensation Report, firms using performance-based incentive pay saw growth in net asset flows 34% greater than firms that did not use such incentives over a five-year period. While these firms likely sacrificed some margin in the form of higher incentive compensation to achieve this growth, sustained organic growth is a far better builder of long-term shareholder value than sustained margin without growth.
In the investment management world, evaluating a firm’s margin isn’t as simple as “more is better.” For RIAs, margin reflects efficiency, but it also reflects the firm’s tradeoffs with compensation. Investment management is a talent business, and striking the right balance between margin and employee compensation that allows the firm to attract, retain, and incentivize talent is critical to an RIA’s success.
We are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.
