Cold enough for ya?
Back in early December when the temperature was unusually high and the VIX was unusually low, many of our clients were calmly contemplating 2016 while they developed their budgets for the year ahead. Six weeks later, the debate over whether or not weakness in high yield would spread has been settled — and most of the eastern U.S. is covered in snow.
Boxer Mike Tyson once said, “Everybody has a plan – ‘til they get hit in the face.” With equity markets and most debt markets draining AUM from client portfolios lately, many asset managers and wealth managers are reeling. Between watching firm revenues tail off with all the red on the screen, plus fielding phone calls from anxious and sometimes angry clients, it’s easy to feel out of control, if not helpless. But out of control and helplessness are two different things.
I once read an interview with a veteran airline pilot who said that, when confronted with a crisis, the first thing to do was order coffee. In other words, step away from the crisis, get control of your own thinking, and consider your options from there. In that spirit, take a moment to step away from Bloomberg, grab some coffee, and think about the business of your investment management firm.
Here are some brief thoughts about five topics, posed as questions, that can make or break the value of RIAs. These topics have longer term and more strategic implications than the day-to-day fluctuations in capital markets, and while equity research may be more fun, these are more reliably lucrative.
1. Do the Right People Own the Right Amount of Your Firm?
Ownership is a sticky wicket, and indeed can be the most distracting issue for an otherwise successful shop — all the more reason to focus on ownership now, rather than kicking the can down the road another quarter. Any ownership program has benefits and tradeoffs. Usually that tradeoff involves rewards to the builders and producers of the firm versus the sustainers and future leadership.
We have some clients with dynamic ownership programs that get tweaked every year. This willingness to be flexible can allow RIAs to ensure that the ownership is supporting the long term strategy of the firm. But doing that means giving up some of the “permanence” that is usually associated with ownership, and can make equity participation walk and talk a lot more like a compensation plan.
Others have a hard time getting shares moved from generation to generation, usually because the spread between the bid and the ask is just too wide. A frequent internal quip at Mercer Capital is that RIAs are worth so much that no one can afford to own them. Some try to solve this with interesting terms or creative financing, but we usually discourage clients from trying to cure price with terms.
2. Are Your Corporate Documents Updated and in Order?
Specifically, think about your buy-sell agreement and whether or not it supports the long term continuity of leadership at your firm. What is the pricing mechanism in your ownership agreement? What happens if someone dies? What if the partner group has a member who is no longer productive to work with – can you fire them and buy them out?
It won’t surprise anyone to learn that we recommend calling for an independent appraisal to establish pricing at the time of a transaction. Not that we know more about what your firm is worth than you do, but our experience is that, when a valuation dispute arises (often when an owner is kicked out), the bid/ask spread can be huge. With an independent valuation opinion resulting from a structured process, the matter can be resolved by someone with no skin in the game other than their professional reputation.
Of course, the best way to avoid confrontations over valuation is to get a regular valuation analysis prepared by an outsider. It sets the stage for ownership transitions, and while there is still usually some spread between expectations and reality, at least the spread is much more narrow.
3. Do Your Client Demographics Support your Business Model?
Just like ownership, the client base of every RIA evolves. The question is: are you managing that evolution for the long term strategic benefit of your firm?
We did expert testimony work a few years ago for a partner in a firm managing $6 billion for 14 institutional clients. Needless to say, that’s an efficient and highly profitable way to run an RIA – until you post too many periods of negative alpha.
Most client concentrations aren’t that extreme, but it’s always worth thinking about whether you have the optimal client composition. If you run an independent trust company or wealth management firm, you probably have mostly high net worth clients. What do they have in common? Did they make their money from the same industry? Are they geographically concentrated? How old are they? How are their kids involved in the family wealth? Is that money being managed for this generation or the next?
We sat down recently with an asset manager who has, over time, managed their client base very deliberately. They are a straightforward long-only manager, but they have investors via mutual funds, wrap programs with wire-house firms, direct relationships with high net worth clients, direct institutional relationships, and institutional relationships they handle through consultants. They explained that, because their investment style goes in and out of favor with trends in the market, they wanted clients with a diversity of pressure points and decision timelines. If their performance dips because of market conditions, not everyone heads for the exit at once. If they outperform, they don’t immediately slam up against their capacity with a lot of hot money that will leave just as quickly.
4. Is Your Firm Growing Because of Markets, or Because of Marketing?
As a follow-on to the commentary about customer demographics, it’s important to think about what you’re selling. Investment performance waxes and wanes, so just selling alpha in good times can really burn a shop when the market turns. Having a message that resonates about what you do that is unique can attract clients when you are outperforming and when you are underperforming, and it is a more reliable way to accumulate AUM than the steady upward drift of the capital markets.
Also, don’t forget to market to (educate) your existing clients. If they are educated about why you do what you do, they’re less likely to leave when the market doesn’t favor your style. A dollar of AUM retained is worth just as much as a dollar of AUM gained – maybe more.
5. Do You Have a Series of Products Available to Grow Beyond the Capacity of Your Current Offerings?
In scarcely a generation, the investment management profession has gone from offering relatively straightforward buy-low-sell-high services to ETFs to ESG. Clients still want their investment managers to buy low and sell high (or least buy high and sell higher), but the “buckets” have changed some and will continue to change.
It’s an obvious statement that you have to be offering products that clients want to buy. But if you were starting your RIA fresh today, what would your product offering be? From where you are today, is there a logical progression of product offerings to capitalize on your firm’s strengths and grow your client base and AUM base for decades to come?
It’s difficult to know what kinds of products clients will want in the future, but it’s certain that clients will want investment management products in the future, and will probably be willing to pay about 100 basis points for products that are sufficiently differentiated such that clients can see the value.
Improving the Value of Your Practice Regardless of Market Dynamics
Happiness is expectations netted against reality. Unless you came into this year massively overweight cash, or with a big short position on energy, you’re not too happy and neither are your clients. However, it’s a good time to keep your eye on the practice management ball, because it will give you a competitive advantage in a year where most RIA managers can’t get their minds off the ticker.
If you can improve the fundamentals of your practice in 2016, the markets will eventually take care of themselves, and you’ll be in a better position to profit when the bears go back into hibernation. It has been our consistent experience that good practice management builds value in an RIA, and in turn building value in an investment management practice reinforces the better aspects of the business model.
In that vein, Brooks Hamner and I will be at the Arizona Biltmore in Scottsdale next week to speak to Bank Director’s Acquire or Be Acquired conference about how banks can build the value of their trust and wealth management franchises. This happens to coincide with several important collector car auctions, not to mention 75 degrees and sunshine. Yes, I can hardly contain my excitement. We’ll post the slide deck, and hopefully photos of some premium iron, next week.