Five Questions to Ask Your P&L
A Great Start to 2019 is a Thorough Lookback at 2018
Earlier this month, the RIA group at Mercer Capital took some time to outline our points of focus for the year ahead. Group consensus is that the investment management industry is facing an unprecedented number of cross-currents, making the vision for 2019 anything but 20/20. Last year was kind of a “meh” year for investment management, with a couple of interesting IPOs and an impressive level of M&A activity, but also generally unhelpful financial markets and pronounced multiple contraction across the space. Add to that a surplus of economic uncertainty and a deficit of political stability, and we see ample ground to speculate as to the future of the RIA community. But indulging in guessing games gives you little reason to follow this blog, so we’ve decided to spend more time this year giving perspective as to what money managers can control.
A Not-So-Random Walk Through Your Income Statement
Now that January is almost over, we know that many of you have wrapped up quarterly investor communications and can now take a moment to think about your firm’s operations, direction, and other practice management issues. A useful place to begin your plan for 2019 is doing some fundamental research on your own business, starting with the P&L. It’s easy to take internal financials for granted, but if you take a step back and consider your results from operations as if you were an outsider doing due diligence, you’ll give yourself the opportunity to gain an insight or two that is directly relevant to the outlook for your RIA. Here are five questions to organize a review of your financial statements. Simple enough, but these five questions lead to about five hundred more.
1) What Do Your Revenue Trends Tell You About the Overall Health of Your Business?
One of the more unique characteristics of investment management firms is that, for the most part, run rate revenue can be calculated on any particular day, given closing AUM and a realized fee schedule. But revenue is a flow rather than a stock, and the trends in what generate revenue for an RIA say plenty about the overall health of the firm. This diagnostic works best at a granular level.
Breaking down trends in revenue into trends in AUM and realized fees is revealing. In fact, one of the first things we do when researching a new client is to develop a quantitative history of their revenue to evaluate the success of their marketing plan, investment management skills, client retention, and value to the marketplace.
You may be a $2 billion manager today, but what about five years ago, and how did you get here from there? Retracing your steps can be a revealing exercise, regardless of what sort of investment management firm you operate.
You may be a $2 billion manager today, but what about five years ago, and how did you get here from there? Retracing your steps can be a revealing exercise.
Regarding trends in assets under management, we’ve noticed over the years that wealth management firms tend to focus on net inflows, and asset management firms pay more attention to investment performance. We recommend you look at both. New clients gained net of terminations has implications for the effectiveness of your marketing and client service models, as do new contributions from existing clients net of withdrawals. Keep in mind that this latter measure may also be indicative of the demographics of your client base, especially if you have more retail clients (as opposed to institutional). Wealth management firms pay less attention to investment performance, but we sense those days are changing. We learned last year that the CFA Institute is studying ways to extend GIPS (Global Investment Performance Standards) to wealth management firms, and while this may still be years away, you should start thinking about being ahead of the trend. The most successful firms won’t hesitate to study their firm’s performance from as many perspectives as possible, looking for ways to improve.
As for fees, it has been widely reported that the industry is coming to terms with what investment management services are worth to different types of clients. Early warnings of an army of robo-advisors turned out to be hype, but there is clearly fee pressure (or at least fee consciousness) in every sector of the industry. What matters to you is your fee schedule. What are you earning today versus last year, and can you trace that by the product or service you offer over time? Are changes in your realized fees earned a product of changes in client composition or product offerings, or are you having to price existing products to existing clients more competitively to gain or retain business?
2) What Are Your Labor Costs Relative to Market?
Whether you’re part of an asset manager, wealth manager, trust company, or any other sort of investment consultant, your biggest cost is labor. Twenty years ago, RIAs could afford mostly to ignore labor costs because the growth of the industry, heady fees, and favorable markets offered operating leverage that would reliably outrun any margin pressure from overpaying people. Those days are gone, however, and what we hear regularly is clients looking for ways to become more disciplined about compensation. Unfortunately, that isn’t easy to do.
Although there are several significant compensation studies performed regularly in the investment management industry, the data isn’t very useful to actually set compensation levels for staff or owners. Data is usually given in ranges, which can be very broad, and it’s difficult to compare positions across firms since even titles like “portfolio manager” can mean different things in different offices. In addition, perceptions of what is necessary to recruit and retain staff can vary. We’ve had some clients in secondary markets report that labor costs were lower there than in gateway cities. Others report that it takes more money to recruit talent to secondary markets because qualified talent wants to live in New York and San Francisco. This issue becomes more acute the more specific a skillset is needed on an asset management team.
We think it’s more useful to think about labor costs holistically. How does your compensation program relate to your overall business model? Is the plan scalable? Does the plan create an appropriate tradeoff between returns to labor and returns to capital (distributions), or are you disguising senior talent compensation as a benefit to ownership? There is no one answer. Wealth management firms necessarily look more at individual production as it relates to compensation, although in ensemble practices it may be more appropriate to consider sharing in firmwide profitability. Asset managers lean more toward paying for strategy performance, although doing so can be difficult in persistently unfavorable markets.
Labor costs are the biggest tradeoff to margin, and at some level speak to the scale and efficiency of the RIA. That said, one has to expect margins to vary based on the type of investment management business. An institutional manager with a concentrated strategy benefits from extraordinary operating leverage as compared to most wealth managers. But margins, and the trend in margins, can tell a story about your business model, and how you are staffing it.
3) Is Your Technology Spending Appropriate for Your Business Model?
Robo-advisors may not have made a dent in the industry yet, and indeed may never, but technology is becoming more essential to the RIA community anyway, and that trend isn’t going to abate. The challenge, at this point, is to identify what tech spending is worthwhile, and what is just spending for its own sake. Technology is a big bucket and means different opportunities to different people.
We see a great deal of spending on IT across the investment management firm spectrum, but it seems like the jury is still out in many cases as to whether or not firms are seeing a real payoff from it. Is your technology spending focused on marketing (like Salesforce) or compliance? Are you trying to fuel growth, reduce costs, or improve client service?
Do your tech spending habits suggest that you have a real technology strategy, or are mostly reactive? And have you made a conscious decision to have your firm be on the leading edge of tech for asset management (sometimes the bleeding edge), or are you content with being on the trailing edge. Tech is such a challenge for the industry that many firms have dedicated a position in the organization to follow this area of practice management. At the very least, others are making it part of the job qualification for a chief operating officer.
4) Are Your Marketing Dollars Actually Growing Your Business?
When the investment management industry was growing steadily because of new investors and market tailwinds, marketing and distribution were concepts that RIAs could take for granted. Mixed markets and mature investment allocations have changed all of that, and firm leadership who got into the business because they liked picking stocks have been slowly waking up to the reality that they’re in sales.
When the investment management industry was growing steadily because of new investors and market tailwinds, marketing and distribution were concepts that RIAs could take for granted.
One value to disaggregating changes in revenue, as discussed above, is seeing the effectiveness (or lack thereof) of your firm’s marketing plan. Taking a hard look at how much you spend on marketing and where it’s being spent is another worthwhile use of your time. Performance matters to clients, but alpha alone won’t attract new clients or retain as many of your existing assets as you might like.
We heard an excellent presentation on differentiating your marketing message last fall, led by Megan Carpenter at Fi Comm Partners. The upshot of the presentation is that financial services are, from a client’s perspective, generic. Developing a unique way to differentiate and communicate your service offering keeps you from becoming a commodity and having to auction yourself to your clients.
We’re not a marketing consulting firm, but we notice firms having a difficult time connecting their spending on growth initiatives, like marketing, with the actual growth of the firm. You may not be able to develop a measurable, one-to-one relationship between your spending on distribution and the growth of your business, but if you can’t articulate – even to yourself – the relationship between your monetary commitment to growth and your client asset acquisition rate, then it might be time to find a way to do that.
5) Is Your Profit Margin Threatened by Ownership Issues?
The profitability of an RIA speaks to more than just the results from operations. Often, where profits go is more telling than where they came from.
Is your firm fully distributing? That is, are you able to pay out all, or mostly all, of your profits as distributions? If so, then you must be funding most of your growth initiatives, in terms of human capital development and marketing, within your normal expense structure. Will this remain the case, or will you be required to use profits to fund partner buyouts or firm acquisitions? Is your ownership on board with those reallocations of distributable cash flow? Just like compensation tends to be sticky in downturns, most RIA partners don’t like the feeling of reductions in distributions – even if they understand it intellectually.
Are your distributions an investment in future leadership, a payment for current key partners, or a royalty for founders? Depending on how you structure ownership, you can utilize distributions for any one or all of these, but it’s likely your RIA did this without even realizing it. Part of the wisdom that comes from interrogating your financial statements is making what was accidental intentional, and in the process developing some greater degree of control over your firm’s destiny.
Are your distributions an investment in future leadership, a payment for current key partners, or a royalty for founders?
How sustainable is your profit margin? If markets took a sustained 20% hit, would that wipe out your profitability? Is your buy-sell agreement up to date or could an ownership dispute derail your business? What is the trend in the margin (growing, shrinking, stable) and why?
For a professional service firm, distributions can be an effective way to reinvest in the business – given that the business is one of human capital rather than machinery and equipment. The question to consider is whether or not you’re using distributions as a way to grow, sustain, or monetize your business model.
If Your Financial Statements Told a Story, How Would it End?
The investment management industry has been transitioning from one where a rising tide lifted all boats to one of winners and losers. Issues that could once be overlooked by clients, like performance and pricing, no longer are. As a consequence of client behavior, issues that could once be overlooked by RIA leadership, like staffing and ownership transition need serious attention. We seem to be entering a period where there will be a premium on intentionality and accountability, and the financial results of your operations for last year are an informative source of objective commentary on how you’re doing.
If a picture is worth a thousand words, then a detailed P&L is worth several thousand. Just make sure that your financial statements tell the same story about your business that you tell yourself. If you’re not allocating resources to support the business you think you’re running, make a New Year’s resolution to seek greater alignment.