So much for transitory: February’s CPI growth came in at 7.9% year-over-year (the highest level in recent memory), and the ongoing Ukraine conflict portends further supply chain challenges that could drive prices even higher. The front-end of the yield curve has shifted higher as market participants reason that rising inflation will force the Fed to raise rates sooner and by a greater magnitude than had been previously anticipated.
Historically, a flattening yield curve has signaled an end to a growth cycle, and so far in 2022 that certainly seems plausible. Markets are down and valuation multiples have declined significantly, particularly in high-flying tech stocks. So, what does all of that mean for the RIA industry?
Revenue Impact on RIAs
Almost all wealth management and asset management firms employ a revenue model where fees are based on a percentage of AUM. Such a model is unique in that it’s not directly linked to the cost of doing business. In many other industries, there is a far more direct link between pricing and the cost of doing business. If a widget manufacturer’s cost of making a widget goes up, it raises prices to compensate. If a bank’s cost of borrowing goes up, it raises interest rates. And so on.
For RIAs, revenue changes with the value of client assets, not the cost of doing business. While larger accounts are often more complicated (and costly) to manage than smaller accounts, the relationship between the cost to manage an account and the value of an account is not linear. If, for example, a $20 million account decreases to $10 million, the cost of managing that account is unlikely to drop by half. The consequence is margin pressure.
The percentage of AUM revenue model works well for the RIA industry because it aligns interests between clients and advisors (fees increase when the value of a client’s assets increases). In times of rising markets, the percentage of AUM revenue model is an enviable one: market growth can drive revenue growth that is largely decoupled from the cost of doing business, which has allowed significant margin expansion and profit growth in the industry.
This operating leverage is the secret sauce of RIA margin expansion. In recent years, market growth alone has contributed to 10-15% annual revenue growth at many firms—far outpacing formerly modest inflation effects. Even many firms with negative organic growth have seen growing revenues and profitability as market growth has more than offset client outflows.
Current market conditions, however, demonstrate the downside of the “percentage of AUM” revenue model. Through March 8th, the Russell 3000 index was down over 14% year-to-date. For all but the most rapidly growing RIAs, organic growth will have done little to offset the market decline this year. Tiered fee structures may help mitigate the impact (the first dollar of AUM lost is often at a lower fee rate than the firm’s overall rate), but run-rate revenue for many RIAs has likely still taken a significant hit so far this year. RIAs often bill on a quarterly schedule, so the impact of the current market downturn may not have been felt yet, but it will soon absent a significant turnaround. Operating leverage works both ways.
While RIAs have little control over market movement, they do have control over their fee schedules and fee discipline. If there were ever a time to increase fees, now would (theoretically) be the time. Everyone is experiencing rising costs across nearly every aspect of their lives, so price increases are to be expected. But RIAs are in an awkward spot when seeking to raise their fees—the whole point of the “percentage of AUM” revenue model is that the fees paid scale with the value of the account.
Informing clients of increasing fee schedules at a time when their account value is down significantly is unlikely to be well received despite the familiarity of price increases elsewhere. When you combine that with the secular trend of declining fees in the investment management industry, we think that the ability of firms to raise their fee schedules is somewhat limited. For new clients, there may be more flexibility to remain disciplined on stated fee schedules in order to more closely align the price of investment advice with the cost of delivering it.
Cost Structure Impact
At the same time that revenue is declining, the fixed cost base for RIAs is facing significant upward pressure. Tech and software vendors, landlords, professional service firms, and the like are all raising prices at the fastest pace in decades to reflect their own higher costs of doing business and strong demand. While it takes time for these price increases to make their way to an RIA’s P&L, rising costs seem unavoidable for many RIAs unless inflation retreats significantly. With rising costs and declining revenue, the potential for margin compression if the current environment continues is very real.
Most significantly, compensation costs (the largest component of an RIA’s cost structure) are under pressure given the extremely tight labor market and record turnover. RIAs will need to balance increasing compensation costs in order to retain key employees with firm profitability. We’ve said it often in the past, but compensation mechanisms that directly link employee pay to firm profitability (e.g., through a variable bonus pool or equity compensation) not only help to attract and retain key employees, but also help to preserve margins when revenue declines. How to best structure compensation packages to weather environments like today’s is a topic for another blog post, but it suffices to say here that we see firms with well-structured compensation packages that balance short term (salary), medium term (bonus), and long term (equity) incentives as having a competitive advantage in tight labor markets and volatile financial markets alike.
M&A and Deal Activity
M&A activity and consolidation in the RIA industry is driven largely by long-term, secular trends like aging founders, lack of succession planning, and gaining access to the benefits of scale and broader service capabilities. As such, the longer-term trends in deal activity are likely to continue. In the short run, however, we could see an impact on M&A deal volume and pricing depending on the duration of continued inflation and the current market downturn. If revenue declines and margin contraction persists, we may see sellers delay going to market in order to wait for performance to rebound. For deals that do occur, multiples at the top-end of the current range may come under pressure without the backdrop of a market updrift to rationalize premium pricing.
Further, there is the potential for RIA aggregator models (which account for a significant portion of total industry deal activity) to come under pressure if the current market environment continues. These firms typically rely on floating rate debt and high leverage to acquire RIAs, leaving them particularly exposed if the performance of the underlying firms deteriorates or if interest rates increase.
So far, we haven’t seen any downturn in deal activity. Fidelity’s monthly Wealth Management M&A Transaction Report listed 13 transactions in February, a record level for the month. But, as we saw in 2020, there can be a lag between market activity and a noticeable impact on deal volume due to the multi-month process between deal negotiations, signing, and close. Recent market pricing of public RIA aggregators isn’t terribly encouraging; their cost of capital is going up rapidly – but that too is a topic for another post.
There’s still much uncertainty about the duration of the current market environment and the ultimate impact it will have on RIA performance. The upshot to all of this is that revenue growth in recent years has far outpaced the cost of doing business for most firms, allowing margins to expand to healthy levels. As a result, many firms today are well positioned for a potential downturn given their robust margins and ample cushion to absorb possible revenue declines while remaining profitable.