If I’ve never said this before in a blog post, I want to express unequivocally how the RIA team at Mercer Capital really appreciates our clients.  Yes, everyone in professional services appreciates that their clients support their careers.  For us, however, there’s more to it.

We are, after all, analysts.  We could pursue the valuation trade in any number of industries, and some of us (me included) have, at one time or another in our careers, valued everything from deli franchises to propane distributors to medical device manufacturers.

For us, the ultimate client is the one who understands what we do and often knows more about finance than we do.  Our clients are securities analysts, portfolio managers, and trustees who don’t have the luxury we often have of operating in a theoretical world.  We serve smart people whom we greatly respect.  When all goes well, it’s very satisfying.  When it doesn’t, client feedback can be pretty blunt, but—at least—we learn.

In this spirit, the industry news so far this year has been anything but gentle:

• Joe Duran reassigned by Goldman
• Jim Dickson out at Sanctuary
• Liz Nesvold leaving RayJay
• Focus going private

And, of course, the tragic loss of Gavin Spitzner.

A brahmin in the RIA industry once told me that you could never “own” an RIA—at best, you can lease it.  Ultimately, these businesses are a product of the people involved.  You can’t spreadsheet the contributions made by individuals, the dependence equity holders really have on them, and the risk associated with them waking up one day and deciding to do something else or no longer being able to contribute.  It’s all very humbling.

It’s also entirely relevant to valuation.  Money management is labor intensive, whether it’s a population-intensive model like wealth management or an intellect-intensive business like asset management.  The tradeoffs between returns to labor and returns to capital are ever-present.  While there is, undoubtedly, operating leverage with scale, it should be looked at as a limit function that doesn’t extend beyond a reasonable margin.  Financial success is a reward shared with employees and owners, or it tends not to persist.

Our team wonders at industry conundrums for which we have no easy answers.

Why is the RIA industry being fed both by an independence movement and a consolidation movement?

The wirehouse model was based on relegating labor as a distribution channel for products.  Products earn profits for the firm, binding clients and the salesforce to the firm.  As financial products became commoditized, the salesforce didn’t need the wirehouse, and the RIA industry took off.  The RIA consolidation movement is a check on the independence movement, suggesting that scale provides access to offerings that benefit clients and, therefore, advisors.  It’s a real push-pull that is, as of yet, entirely unresolved.

If equity compensation is so important in the RIA space, what is the real margin for third-party ownership?

It’s no surprise to us that some institutional investors favor minority interests in RIAs.  If management is paid based on the business’s profitability, third parties don’t have to spend much time attending to operational issues, attending meetings, approving budgets, and all the other chores of shop-keeping.  Perhaps the real margin of an RIA is net of necessary equity compensation.

If money management is really an owner-operator business, is the sale of an RIA really just factoring compensation?

An owner-operator RIA contemplating a sale is really trading some of their return on involvement (salary and distributions) for a bullet payment.  If the buyer’s cost of capital is lower than the seller, it makes sense to the seller.  Why, then, would it make sense to the buyer?  This probably explains why, for all the headlines about the latest RIA transaction, most industry ownership changes are a product of internal succession.

Is money management truly scalable?

I’m reserving judgment on the pending going-private transaction for Focus Financial.  I’ve never held a position, long or short, in FOCS, but I’ve genuinely enjoyed following their progress over the last five years.  A reporter asked me recently if I thought Focus’s CEO, Rudy Adolf, would stay at the helm if the firm went private.  I’ve never met Adolf, and I have no idea, but I give him and his team credit for spending hundreds of thousands of hours trying to find the best way to square all of the circular issues of scaling an owner-operator business.  Nevertheless, I also wonder if Focus was built on an imperfect premise.  Adolf talks about the lessons he learned from his father scaling an accounting business—something about never making an entrepreneur an employee.  Valuable stuff—no doubt—but accounting is a rigid, impersonal, rules-based, technical endeavor.  FASB has no personality.  Money management is all about personality.

There is no conclusion to my ramble other than an admonition that investment management is a people business and that there are aspects to a people business that do not yield to financial modeling.  It’s kind of frustrating for our team at Mercer Capital, but it also keeps work interesting.