Are Asset Manager Valuations Headed Higher or Lower in 2016?

Barring Basis Risk, Barron’s is Bullish

Alternative Assets Industry Trends

Despite 195 nations signing onto the Paris Climate Conference commitment to clean energy last week, it looks like Santa will be stuffing most asset managers’ stockings with coal this Christmas. Hopefully it’s at least low-sulfur.

December has been a rough slog for the RIA space. So far it’s mostly been attributed to the cracks in high yield credit. With junk bonds stumbling shortly after Thanksgiving, managers with large high yield offerings are feeling the Grinch. One standout example: WDR. Waddell & Reed’s Ivy High Income Fund has suffered huge outflows this year. Pile outflows with asset devaluation and WDR’s stock has gotten crushed, losing almost a quarter of the company’s equity market cap so far this month (!).

Volatility is inversely related to Value

The hand wringing over illiquidity in the debt market has increased since the spring. In one of those career moments I’ll never forget, a client who started his career in fixed income told me last month “trading Treasuries used to be reasonably lucrative and a lot of fun – but now the only people who trade Treasuries are the government and Blackrock.” With illiquidity, of course, comes basis risk; and in this market, basis risk is not limited to fixed income.

Basis risk is mostly acutely felt (or feared) these days in private equity. The very public write-downs of unicorn investments threaten to tarnish the PE community, and anyone who manages what the FASB considers Level 3 assets along with them. Our blog has written extensively about the Square IPO, and to be polite, I would say the jury is still out on Square, but the LP community is only going to tolerate so many massive write-downs at IPO or sale. The Gilt transaction didn’t help matters. If this continues, the institutional community will want a different fee schedule, and the dominant trade in Greenwich will be long Ford (F), short Ferrari (RACE).

Then there’s the hedge fund community, which Mary Childs reported last week is reeling from another year of underperformance. The 2 and 20 model is losing in an age where even the annual management fee is seen as a reward for performance, and not just a retainer to cover a manager’s expense base. But better 1 and 10 than none and done.

Even diversified active managers are getting squeezed. Affiliated Managers Group is down over 13% this month, and Franklin Resources has lost almost 17% of its share price. With market leadership pretty narrow this year, our guess is that active management won’t have much to brag about, again, once the counting is done. If Vanguard or even Fidelity were public, we would have a great benchmark for pricing passive managers; but even Blackrock, which is into everything (especially iShares), suffered more than we would have expected this month, losing about 11%.

Taylor Swift in heavy rotation on my iPod

2016 may be a year of breakups in the asset management community, as weary investors throw in the towel on exotic and expensive strategies that haven’t worked. Passive strategies and those who deal in them look like the big winners in the near term.   We expect more growth in robo-advisors, but we’re still a long way from them getting meaningful market share.

It’s subtle, but the industry is bleeding fees. AUM growth has masked this so far, but a bear market could get ugly fast in a business where most expenses are either fixed (SG&A) or sticky (compensation). We’ve noted the downward trend in valuation multiples in asset management firms before, but if present trends continue, we’ll look back on 2013 as the perfect year to sell an RIA.

“But it’s on sale!”

Ever the contrarian to the market, Barron’s is viewing last week’s Black Friday special on RIAs as an opportunity to load up the shopping cart. The article’s worth a read, if just to note that there’s no new information in it to back Barron’s sanguine attitude. Yes, market multiples in the RIA space are lower than they have been for a few years, and they are lower than the market in general. Yes, asset management benefits from operating leverage in good times and margin expansion can be quick and phenomenal. Trouble is, operating leverage cuts both ways. In a period of fund outflows, asset devaluation, and potential fee schedule revision, the threats to the industry may well outnumber the opportunities.

Not to be Scrooge – maybe Barron’s is right and the market is wrong, but even if you (want to) agree with Barron’s perspective heading into Christmas, it’s helpful to remember that the market can stay irrational longer than you can stay solvent (or at least sober).