TSC buys $2.5B manager for Six Times (!)?

Over the Christmas holiday weekend I had the coveted experience of riding in a friend’s recently restored 1970 DeTomaso Mangusta.  I didn’t take him up on the offer to drive the car as the roads were a little damp and Mangustas are notorious for being a little tail-happy, especially in the wet.  The last thing I wanted was to be responsible for putting so much as a scratch on a specimen car that is as rare as hen’s teeth.  DeTomaso built 401 of them before switching production to the much more common Pantera in 1972.  There are maybe 200 Mangustas surviving today.  This particular car was bought by my friend’s dad at an auction in Florida over twenty years ago.  It had been owned by a member of Pablo Escobar’s drug cartel and still had a bullet hole in the fender.  After restoration, it’s probably better today than new – so despite the sordid provenance I wasn’t too keen on sliding it into a bridge abutment.

What’s even more rare than the Mangusta was the announcement earlier this month that Tri-State Capital Holdings, Inc. (traded on the Nasdaq as TSC) bought The Killen Group, a $2.5 billion manager of the Berwyn mutual funds, for about six times EBITDA.  More specifically, TSC paid Killen $15 million cash up front (based on trailing EBITDA of $3.0 million), plus an earn-out paying 7x incremental EBITDA (which could add another $20 million to the transaction price).  So, best case scenario for Killen is for them to deliver about $6 million in EBITDA and get paid $35 million (!).

On the surface, the deal looks awfully cheap.  Reading between the lines, Killen has a (very sustainable) effective average fee of 56 basis points, a normalized EBITDA margin of 35%, and a five-star rating form Morningstar on its largest mutual fund product, the Berwyn Income Fund (BERIX).  All good.  So why didn’t Killen make a killing (extract a double-digit EBITDA multiple from TSC)?  No one expects that kind of an asset manager to sell low.  At first glance, it’s the bookend to the Edelman transaction back in October, which appeared to be priced astronomically high.  In the end, though, the two deals have more in common than not.  In both cases the headline price gives one impression of the deal, while the underlying narrative says something very different.

Much of the valuation work we do in the RIA space is, for one reason or other, performed pursuant to a standard of value known as fair market value.  The standard of value is essentially a framework for the perspective of a given appraisal.  Fair market value is defined by the American Society of Appraisers as:

The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.

When we look at transactions data in preparing fair market value appraisals, one thing we keep in mind is that transactions do not occur at fair market value – or if so only by coincidence.  Transactions involve real buyers and sellers, not hypothetical ones.  They might act at arm’s length in an open and unrestricted market, but usually they have a compelling reason to transact.  It seems like that was the case in the TSC/Killen transaction.

The press release and slide deck that went with the announcement didn’t go into detail, but TSC management alluded to Killen reporting $3.0 million in trailing twelve month EBITDA, which was really about $5.0 million net of a trading error.  A $2.0 million trading error is substantial, but we don’t know much else about it.  What we do know from looking at Killen’s ADV is that they also reported some FINRA compliance issues which appear to be connected with their president and chief compliance officer.

Admittedly, the disclosure is thin and what is disclosed doesn’t sound terribly ominous.  But some consider any “yes” answer to regulatory issues to be a big red flag, especially in connection with a $2.0 million trading error.  Charlie Munger once said that, in the securities industry “integrity is like oxygen, no one thinks about it until it’s gone – then it’s the only thing they think about.”  If the regulatory issue threatened Berwyn’s five-star rating, it could have a huge impact on client behavior.  Put all of this in the context of a small firm (13 employees) with an aging founder who still holds a control position in the stock, and you’ve got what appears to be a motivated seller.

We won’t speculate on what the multiple “could have been” in absence of the factors mentioned above, or what specific role they played in generating the terms of the Killen sale to TSC.  But it appears to be an outlier transaction for outlier reasons, and like the Edelman deal shouldn’t be misinterpreted as signaling anything unusual about valuations in the asset management industry.