Key Takeaways
Strong margins are desirable, but maximizing current distributions can come at the expense of investing in the people and capabilities that drive long-term growth.
Because investments in talent, business development, and succession planning are expensed rather than capitalized, RIAs can underestimate their importance.
The most valuable firms balance current returns to ownership with sustained investment in future enterprise value.
In the 1980s, Porsche built one of the most advanced production cars in the world. The Porsche 959 was fast, technologically sophisticated, and enormously expensive to develop. Although Porsche sold the 959 for the then-eye-watering price of nearly $250 thousand in the late 1980s, the company reportedly lost a similar amount of money on each of the 337 units it delivered.
Fortunately for Porsche, management wasn't evaluating the project solely on its current profitability. The company viewed the 959 as a platform for developing technologies and capabilities that would benefit future generations of vehicles. The accounting statements captured the costs associated with the project, but the long-term value of those investments would emerge gradually over many years.
Investment management firms face a similar challenge. Most businesses make investments that are easy to identify. Manufacturers build factories. Railroads lay track. Utilities construct power plants. Those expenditures appear on the balance sheet and are recognized over time. In investment management, the assets that matter most are considerably less tangible.
The main productive asset of an RIA is, of course, its workforce. Advisors, client service professionals, compliance personnel, marketers, portfolio managers, and future leaders collectively generate the cash flow that ultimately determines the value of the enterprise. Yet investments in these assets generally pass through the income statement immediately. Recruiting a future advisor reduces current earnings. Expanding a business development effort reduces current earnings. Building succession depth reduces current earnings. Accounting rules treat these expenditures as expenses, even though management may rightly view them as investments in future growth.
That distinction creates an interesting challenge for ownership groups.
The Distribution Trap
One of the attractive features of the RIA business model is its ability to generate substantial distributable cash flow. Investment management firms require relatively little capital to operate, and successful firms often produce more cash than is needed to support day-to-day operations. Once compensation, occupancy, technology, compliance, and other expenses are covered, ownership has considerable discretion regarding what happens to the remaining profits.
Those profits can be distributed, or they can be reinvested.
Neither choice is inherently right or wrong. The challenge is that the benefits of each option are evaluated differently. Distributions are immediate and certain. Reinvestment opportunities are neither. Owners know exactly what they receive when profits are distributed. The return on investments in recruiting, training, marketing, succession planning, or new service offerings can only be estimated.
As a result, many firms gradually drift toward prioritizing current profitability. The process is rarely intentional. A year of strong markets leads to higher distributions. Another year follows. Margins become an important benchmark of success. Before long, maximizing profitability becomes an objective in its own right rather than a byproduct of a successful business model.
We worked with an investment management firm several years ago that illustrated the point. The firm was owned primarily by outside investors, and the board's focus was straightforward: maintain strong margins and maximize distributions to shareholders. For a time, the strategy appeared successful. Profitability improved, distributions increased, and there was little reason to question the approach.
Meanwhile, conditions in the firm's market were changing. The local cost of living had increased meaningfully, competition for talent intensified, and compensation practices failed to keep pace. Employee turnover began to rise. Recruiting became more difficult. Future leaders left for opportunities elsewhere. The firm's operating results remained respectable, which made the underlying issues easy to overlook, but the organization's ability to sustain growth was gradually deteriorating.
Eventually, management found itself confronting a tradeoff that had been deferred for years. The firm could continue prioritizing distributions, or it could reinvest in compensation, recruiting, and talent retention. The board ultimately chose a third path and sold the firm.
The lesson is not that distributions are bad. Successful businesses should reward their owners. The lesson is that distributions and reinvestment compete for the same pool of capital. When one objective consistently dominates the other, consequences tend to follow.
What Are You Building?
This issue surfaces frequently in valuation work because buyers rarely focus on current profitability in isolation. Strong margins are attractive, but informed buyers are generally more interested in understanding how those margins were achieved and whether they can be sustained. A firm generating a 35% EBITDA margin because it has developed scale, operating leverage, and a durable client base presents a different opportunity than a firm generating the same margin by limiting investment in personnel and growth initiatives.
Earlier this year, we wrote about the tradeoff between growth and margin and observed that the most valuable firms tend to exhibit strong levels of both. That observation still holds. The best business models are not necessarily the ones producing the highest margins at a particular moment. Rather, they are the ones capable of generating attractive profitability while continuing to invest in and exhibit growth.
The challenge for RIA owners is that many of the investments supporting future value are difficult to measure. Financial statements capture compensation expense but not stronger client relationships. They capture recruiting costs but not the future revenue generated by successful hires. They capture the cost of training future leaders but not the stability that succession planning can provide. The most important assets in many investment management firms never appear on the balance sheet at all.
Priorities = Tradeoffs
This is why ownership priorities matter. Firms that consistently distribute every available dollar may achieve impressive current returns while quietly reducing future opportunities. Firms that reinvest every available dollar may create growth but fail to generate an appropriate return for ownership. The objective is not maximizing one at the expense of the other. The objective is finding the balance that supports both.
Porsche could have abandoned the 959 program and reported better earnings. Instead, management accepted lower profitability in the present to build capabilities that would benefit the enterprise for years to come. Purchasers of the 959 ultimately reaped a benefit from Porsche’s investment; today those cars typically sell for between $2 million and $3 million. Investment management firms face similar decisions every year. Some portion of current profitability must eventually be consumed, and some portion must be invested. The difficult part is deciding where that line belongs.
About Mercer Capital
Mercer Capital is a valuation and advisory firm organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to asset managers, wealth managers, independent trust companies, broker-dealers, private equity firms, and alternative asset managers.
If your firm is evaluating ownership transitions, compensation structures, growth initiatives, or valuation matters, we would be glad to help.