One of the most glorious places on earth to eat is La Colombe d’Or in Saint-Paul de Vence, France – just above Nice. Known as much for its art collection as for its food, just inside the garden entrance at the restaurant is a giant marble thumb, carved by the artist Cesar, to greet you as you enter. The placement appears inspired to give guests the “thumbs-up” on their arrival or departure from the restaurant, setting up the right mood for a tremendous calorie fest (and corresponding tab). It’s impressive, at least until you notice the collection of Legers, Picassos, Calders, and Miros that “Cesar’s Thumb” has to compete with.
The shorthand method of valuation in many industries has long been some kind of “rule of thumb”, usually a multiple of some measure of gross scale or activity.
Twenty years ago, money managers were often thought of as being worth something on the order of 2% of assets under management. Even today, transactions in RIAs often disclose only the transaction value, which when compared to the latest AUM measure in the firm’s ADV filling, yields something of a transaction value as a percentage of AUM. Because this is often the only valuation metric available from an RIA transaction, it still receives a lot of press – more than it deserves.
A not very close look at the transactions data belies the use of price-to-AUM as a standalone indication of value. While some recent RIAs have transacted at a value that was at or near 2% of AUM, others are very different. And publicly traded asset managers might command 4% of AUM or more.
So, obviously, there’s more to the story than a measure of central tendency with regard to AUM. The 11,000 plus RIAs in the U.S. come in all shapes and sizes, and the value of any business is typically some conversion from a measure of expected future cash flow, not simply activity.
Imagine an RIA with $1.0 billion under management. The old 2% of AUM rule would value it at $20.0 million. Why might that be? In the (good old) days when RIAs typically garnered on the order of 100 basis points to manage equities, that $1.0 billion would generate $20 million in revenue. After staff costs, office space, research charges and other expenses of doing business, such a manager might generate a 25% EBITDA margin (close to distributable cash flow in a manager organized as an S-corporation), or $2.5 million per year. If firms were transacting at a multiple of 8 times EBITDA, the value of the firm would be $20.0 million, or 2% of AUM.
The reality, today, can vary widely. If that same RIA is a fixed income manager, the fee schedule on managing debt instruments might only yield 30 basis points, or $3.0 million on $1.0 billion in AUM. Running a fixed income shop of that size might require fewer people than an equity manager, and the cost per employee might be lower. Still, if the EBITDA margin were lower, say 20%, then distributable cash flow might be more on the order of $600 thousand for the fixed income manager, or less than a quarter of that in the first example. Again, if the prevailing multiple of EBITDA is 8x, then the implied valuation, or $4.8 million, is less than half of one percent of AUM, and a quarter of the value implied by the rule of thumb.
So what do rules of thumb tell us? To the extent that businesses transact with certain measures of value in mind, they become self-fulfilling prophecy and are instructive as to value. Asset managers are usually pretty savvy with regard to ROI, though, so profitability matters. Fee schedules (realized, not just published) influence the return off a given dollar amount of AUM, as do cost structures. And this is before we talk about concentration risks, growth trends, and overall sustainability of the business model. And it’s before we talk about how sought after asset management is today as a sustainable source of profitable returns. Fee schedules may be down. Margins may be all over the place. Risks vary wildly. And multiples may be higher.
So the next time someone suggests a rule of thumb to value your RIA, don’t hesitate to ask: whose thumb?