Last week my colleague, Brooks Hamner, took us down the rabbit hole of the impact of higher interest rates on valuation in the RIA space. With the expansion of acquisition multiples over the past few years, it’s a healthy reminder that very low interest rates helped fuel those higher prices, and that cheap debt is a two-way street.
There’s more to the story, but, unlike most things in finance, the other economic factors that accompany higher interest rates exacerbate the negative impact on RIAs, rather than mitigating them. The Fed is raising rates, after all, because inflation is higher. Investment management is a labor-intensive business and has an expense base that is, therefore, highly sensitive to inflation. Further, higher interest rates don’t just hit RIA valuation multiples – they also impact the valuations of the very securities that RIAs charge fees against to derive revenue.
If you haven’t already (I imagine many of you have), this is an excellent time to stress-test your financial condition to see what impact weakened markets, higher inflation, and rising interest rates will have on your firm.
Base Case: Successful Wealth Manager
Assume a successful wealth management firm with $5 billion in AUM that generates fee revenue at a blended rate of 75 basis points. On the expense side, salaries run about $15 million which, at 40% of revenue, is within norms. Variable – or bonus – compensation runs 20% of pre-bonus EBITDA, after consideration of non-personnel related expenses which total 20% of revenue. The net result of this is an EBITDA margin of 32% – very healthy for the sector. With strong margins and a variable compensation structure that buffers some of the impact of changes in profitability, this is the profile of a firm designed to weather most RIA operating environments.
Base Case Plus Debt
Now, let’s take our sample firm case one step further, and assume that part of this wealth manager’s business was acquired in recent years in leveraged purchases using covenant-light financing from a non-bank lender. Acquisition debt outstanding is $30 million, amortizing over 15 years at a base rate plus 550 basis points, or (until recently) 5.75%. This computes to annual debt service of about $3.0 million.
Under the circumstances described in our base case, debt is well within conventional covenants, with debt to EBITDA of 2.5x and debt service coverage (EBITDA to debt service) of nearly 4x.
Threat 1: Impact of Bear Market
As I write this, major U.S. equity indices are down between 15% and 25%. Normally, a wealth manager could expect falling equity markets to be offset by a flight to quality. That market rotation would increase bond prices, or at enable help them to hold steady and offset the impact on AUM from falling stocks. As we all know too well, debt markets haven’t offered any shelter from the equity storm this year, such that it’s difficult to assume much help from fixed income to mitigate the downturn in equity markets. Higher rates appear to be repricing different classes in such a way that we’re seeing more correlation than usual – certainly more than we would prefer.
A 20% drawdown in AUM has a corresponding impact on our sample firm’s revenue, but the only expense offset is to bonus compensation. With this one change, our sample firm’s EBITDA margin declines to 17.5%, and the leverage ratio doubles.
Threat 2: Inflation
Interest rates are rising because inflation is well above the Fed’s target. Lots of expenses borne by RIAs are subject to inflation. The biggest expense for a wealth manager is, of course, labor – and especially so in this market because talent is scarce. The RIA industry may actually be experiencing negative unemployment, as the demand for skilled staff from client-facing to compliance positions exceeds the number of people employed in the industry. Peruse your LinkedIn and you’ll see investment management talent playing musical chairs, all of which threatens to increase costs for everyone at something exceeding inflation. In major markets, non-staff costs like rent are back on the rise, and other costs from tech to insurance are at least keeping pace.
If we increase fixed costs at 10%, overall expenses grow considerably. Again, because of the hit to profitability, bonus compensation drops – at least in theory. Cuts in variable comp may prompt staff to look elsewhere, increasing talent replenishment costs and reducing the function of profit-sharing schemes in cushioning the blow of lower margins.
Couple inflation with the drawdown in markets, and the EBITDA margin is cut even further. At this point, leverage ratios are beyond compliance levels even for non-bank lenders, and our sample company is at risk of not being able to service its debt.
Threat 3: Higher Interest Rates
If EBITDA drops when interest rates are increasing, what does that do to our sample firm’s ability to service their debt. Well…it doesn’t help. If interest rates increase by 300 basis points, which seems to increasingly be the consensus, our highly diminished EBITDA barely covers principal and interest payments.
Efforts to stave off default mostly include restructuring debt into longer amortization terms and cutting owner compensation. My stepfather often told me that you can always tell which one of a banker’s eyes is glass: it’s the one that shows sympathy.
What About You?
This illustration is overly simplistic, but useful nonetheless. Consider what this means for your own firm. If you’re interested, shoot me an email and I’ll send you the excel file behind this post that you can use to build your own stress test. Or hire us and we’ll do a more elegant version using your particular circumstances.
I was reminded this week of a few comforting words from noted British economist Elroy Dimson: “Risk means more things can happen than will happen.” Given the possibilities I’ve presented here of things that can happen, we can all hope that other things will happen. Dimson probably didn’t intend to be quoted on this matter in the spirit of optimism, but right now it sounds better than President Jimmy Carter’s description of similar times: malaise.