April is the cruellest month, breeding
Lilacs out of the dead land, mixing
Memory and desire, stirring
Dull roots with spring rain.

Opening lines from T.S. Eliot’s “The Wasteland”

Following a comparatively placid first quarter, this month hasn’t been kind to anyone working in investment management.  You can tell the amount of client “feedback” that advisors have been getting by the amount of reassuring charts and tables that wealth managers are posting on LinkedIn.  “I know this concerns you…we’ve been here before…it always gets better…don’t lock in your losses…this is only the fifteenth worst week since 1897…”

Just when clients get comfortable with the fact that bear markets have historically led to double-digit returns, the media starts talking about the end of American exceptionalism and the dollar losing its status as the world’s reserve currency, and the phones start lighting up again.  The Bloomberg headline I just saw while writing this was, literally, “Get out while you can.”  Comforting.

Never mind that money managers are, themselves, human.  Stomach-churning volatility doesn’t just bother clients.  Investment managers have their own investible net worth at stake, not to mention their ownership in their firms.  If RIA values are a function of RIA profits (which they are), and RIA profits are levered to RIA revenues (which they are), and RIA revenues are levered to market behavior (which they are), that means RIA valuations are to the VIX what Selena Gomez explained CDO-squared securities were to the housing market in The Big Short.

Readers of this blog may be wondering what impact current market conditions have on the value of their firms.  Specifically, given the current macro environment, is the value of your RIA impaired?

The answer probably depends on who you ask and, more importantly, why you’re asking.

Strictly speaking, market drawdowns create a gravitational pull on RIA valuations.  A unique feature of RIAs is that, on any given trading day, you can revalue a firm.  Just sum up the assets under management, apply the effective fee schedule, and calculate annualized revenue.  Then, walk the halls and calculate annual compensation expense, rent, IT spending, marketing, compliance, and other costs associated with the business.  With those numbers in hand, you quickly get to run-rate annualized EBITDA.  Apply an appropriate multiple and, voila, you get an estimate of the current value of an RIA.

A unique feature of RIAs is that, on any given trading day, you can revalue a firm.

If your accountants are looking at the carrying value of your firm on a parent company’s balance sheet, they might be just that prescriptive in their determination that your fair value is impaired.

But impairment is a non-cash charge — which is probably the least of your concerns these days.  The question on the industry’s mind is whether the intrinsic value of their investment management firm is down and, if so, how much.  The answer to that query is more nuanced.

Consider the value of an RIA when viewed as a basket of intangibles: brand and reputation, customer relationships, and a pool of talented people skilled at working together for a common goal.  In that regard, market conditions have little to do with the value of the firm — they only represent a filter through which the merits of an RIA’s intangible assets are expressed.  Profit rises and falls through bull markets and bear markets, but if the firm maintains and enhances these key attributes, the intrinsic value of the firm is maintained and grown.

This analytically abstract view through an academic’s rose-colored glasses only works when one ignores time, of course.  Intangibles may manifest their value eventually, but in the long run, we’re all dead.  Even the perfect firm is challenged when it hits the buzz saw of a bad market, and this month is no exception.  Check the month-to-date market performance of any publicly traded RIA and the impact of market volatility on the value of investment management businesses is indeed tangible.

Assuming this bear market, however deep it gets, will eventually be succeeded by happier times, profits will recover.

Yet it’s not as simple as today’s annualized profitability times a multiple, is it?  Practitioners usually focus on valuing RIAs using DCF models to avoid overstating the impact of any particular moment in the market.  Just as we wouldn’t extrapolate a quick 25% increase in AUM into perpetuity, so too would we eschew assuming that the current level of trauma on the P&Ls of our clients presents an indefinite circumstance.  Markets come and go.  Assuming this bear market, however deep it gets, will eventually be succeeded by happier times, profits will recover.  Pain will be followed by gain.  And the present value of all those cash flows, however impacted by the drawdown, will still reveal a valuable business.

For this reason, we think market conditions may not have a major impact on deal flow in the RIA space — unless the sources of acquisition capital dry up.  Transactions may have more levers for contingencies built into their terms, however.

Times like this are an important reminder of building resilience into your firm’s financial management.  Margin of profitability is also a margin for error, and firms with fatter margins have partners getting better sleep these days.  Variable compensation is another important shock absorber for rough markets.  “Excess” working capital is a plus, and is not looking so excessive at the moment.

So, take heart and focus on your intangibles.  One advantage of times like this is that bear markets for finance create bull markets for advice.  Client relationships are strengthened when advisors help them avoid financial self-harm, as no doubt many want to do.  Client neediness is not a threat to the value of your RIA; it is evidence of the value of your RIA.