Much to my chagrin, most financial analysts aren’t very interested in cars.  Every once in a while, I find a colleague who is as fascinated by carburetors and bias-ply tires as I am, but it’s rare.  Jim, who retired from Mercer Capital many years ago, was just such a person.

Jim loved old British cars like Jensen Healeys and Triumphs, and, as is the case with such devotion, his love was unrequited.  Jim’s last classic was a Series III Jaguar XKE coupe — a 2+2 with one of the big V-12s.  Some classic sports cars are considered “exotic;” old Jaguars are better described as “mysterious” — because you never really know what’s wrong with them — but something always is.   Jim thought his E-type was a “nice twenty-footer,” meaning a car that looks great from about twenty feet away — just don’t look too closely.

It’s easy to fall in love with an old sports car for the looks (despite missing pieces of trim), the sound (of a rusted exhaust), or even the smell (of transmission fluid on your garage floor).  People routinely spend illogical amounts of money on objects which no longer have any practical value.

There’s no such analogue for buying an RIA, where value hinges on one factor: earnings.  Maybe it’s the accretion to the buyer’s earnings, maybe it’s an expectation of growth in earnings, maybe it’s the sustainability of earnings. Whatever the case, it’s all about earnings.  So, it’s worth taking time to thoroughly assess earnings quality to help you avoid buying a nice twenty-footer.

Assessment of Earnings Quality

Quality of earnings assessments were birthed over a decade ago in accounting firms as a component of buy-side due diligence.  Today, they are generally recognized as being more of a finance exercise than an accounting document and are as or more useful to sellers than they are to buyers.

As implied by the name, QofE projects look at aspects of profitability that go well beyond audited results.  They include detailed analysis of revenue and expenses and derive a measure of normalized earnings more meaningful than simple reported results, even if the presentation of those results is accurate.

Industry Knowledge Is Critical to Assessing QofE

While a quality of earnings assessment often follows a familiar pattern, it is not a rules-based exercise.  There are no specific standards or regulations about what goes into a QofE project.  Instead, it’s a principles-based endeavor that requires an analytical team to look beyond “what” earnings a company produces and instead explore “why” a company is profitable.  The why tells not only the likelihood that a given level of results is sustainable but also which variable(s) influence sustainability.

Consequently, QofE work requires a considerable depth of industry knowledge.  The 15,000 or so RIAs in the United States follow a variety of business models, and it would be a mistake to view them as a homogenous group.

Readers of this blog know there are major differences in the models underlying asset management, wealth management, OCIO, or hybrid RIA-BD, to name a few.  And within the major categories are many, many iterations of strategy and structure.  Firms that follow a relationship model with retail clients behave differently than institutional models where performance relative to benchmark determines success.  There are models that are labor intensive by the number of staff and others that are labor intensive by the quality of staff.  Some sectors of money management are fiercely competitive, while others are much less so.

A well-prepared QofE model in the RIA industry understands the uniqueness of a given firm’s model and evaluates the good and the bad of prospective profits resulting from that model.

Revenue, Unpacked

Put simply, earnings are the product of revenue and expenses.  A quality of earnings assessment looks carefully at what causes a firm to generate revenue.

An RIA’s revenue base is deceptively simple: the product of managed assets and realized fees.  But that doesn’t really explain the genesis of revenue, its sustainability, and the prospect for growth in revenue.  A QofE analysis looks beyond the level of managed assets and fees, considering, among other things, the following:

• Nature of AUM — What sorts of assets does the RIA manage? One sector of highly volatile securities or a balanced portfolio of equity and debt instruments?  What is the likelihood that market dynamics will significantly impact AUM in the foreseeable future, and is there a good way to hedge that risk in the terms of a transaction?
• History of AUM — What are the “flows” that produced the current AUM? Does the RIA have a compelling track record of true organic growth (new customer assets net of withdrawals and terminations)?  Or has AUM growth been mostly the product of market tailwinds?  Is AUM growth tied to a streak of outperformance because of a favorable market climate (that both grew existing accounts and attracted new ones)?
• Customer dynamics — Who are the RIA’s clients? How long have they been with the firm?  What is the historical attrition rate for the client base?  Is a disproportionate amount of the firm’s business (considered by AUM and recurring revenue) the consequence of a handful of clients, and are those clients likely to have a similar decision timeline?  What is the firm’s performance relative to benchmarks while key clients have been associated with the firm?
• Fees relative to market — An RIA’s fees relative to market may reveal important variables in the business. Above market fees may indicate a vulnerability to revenue over time but may also suggest pricing power based on performance, reputation, uniqueness, etc.  Below market fees may indicate model efficiency, if margins and compensation are still within norms.  Below market fees may also represent an opportunity to improve profitability or possibly market competitiveness, but the specific meaning of relative fee levels is usually found in conjunction with other key operational aspects of the firm.
• Fees realized as compared to fee schedules — If the RIA sticks to its fee schedule, it may underscore its pricing power within the industry or indicate a rigidity that impedes growth. Fee negotiations are more normal within some sectors of money management than others and are usually a barometer of competitive pressures that speak to revenue sustainability.
• Fee history — How have the firm’s realized fees (actual fees as a percentage of AUM) changed over the past few years? If realized fees are declining, it may be due to competitive pressures or changes in the client mix to larger clients who typically pay fewer basis points per dollar managed.

Cost Structure

Quality of earnings doesn’t just depend on revenue dynamics.  The expense base of an RIA is ideally designed to attract and develop revenue streams at a reasonable margin.

The primary expense for any RIA is, of course, compensation.  Compensation schemes in RIAs are as varied as the businesses themselves.  Some are heavy on salary; some are heavy on incentives.  Some incentive compensation is tied to firm performance, and some is tied to individual performance.  Some compensation schemes offer the firm flexibility with different market circumstances, and some lean heavily on profitability to support compensation in challenging times.

Compensation doesn’t operate in a vacuum.  A firm with seemingly appropriate compensation expense relative to revenue could be far off-market if the fee schedule that forms the revenue base is also off-market.  For example, if compensation expense is reported at, say, 65% of revenue, but realized fees are 20% above market, then compensation expense is 80% of normalized revenue — probably not a sustainable level.

The impact compensation has on quality of earnings revolves around how the compensation plan supports the business model over time, how it is stressed and supported by different market circumstances, and how it has responded to bull and bear markets in the past.

Other Considerations

Earnings quality doesn’t depend on any one factor in isolation.  A business model is ultimately a series of interrelationships that harness workforce intangibles, branding, product and service positioning, and strategy to organize talent to serve a market.  Some of these factors are on the P&L, and others are not.

One thing that is often forgotten when evaluating earnings quality is ownership.  An RIA is ultimately a professional service firm, and for millennia, professional service firms have been owner-operator businesses.  The consolidation efforts within the investment management space have thrown more than a few curve balls at this tradition in recent years, and some have pushed back at attempts to separate returns to labor and returns to capital.  Ultimately, the best ownership model is the one that supports operations, which, in turn, produces a higher quality of earnings.

In the collector car world, the condition of cars available for sale can vary anywhere from “fully restored” — basically good as new — to “project cars” — meaning vehicles that need major mechanical refurbishment.  Old Jaguars can be both good as new and project cars because that’s essentially how they came from the factory.  That shouldn’t be the case in an RIA transaction, which is why simply kicking the tires isn’t adequate due diligence.

A thorough quality of earnings assessment can go a long way to understanding why a given firm is profitable and how likely it is to remain so after a transaction.