As the RIA team at Mercer Capital looks back on 2022 and ahead to next year, we’ve noticed a few themes emerge in discussions with clients that we expect to hear more about in the new year. Don’t think of these as predictions but simply the current state of market behavior—the implications of which will soon be evident.
1. Dynamic Markets Favor Providers of Diversification
After a decade when do-it-yourself investing in a narrow band of large-cap domestic stocks was all you needed to be successful, we see a dramatic shift to dynamic markets which require analysis and judgment. Time will tell if FAANG has gone the way of the Nifty-Fifty, Dot-Coms, and other can’t-lose equity fads. What we know is large-cap U.S. stocks are among the priciest investments available (crypto is another story), and the dollar is punching above its weight. Having lived through the worst year for 60/40 in anyone’s career memory, we now have good opportunities across a broad swath of investment classes. All of a sudden, diversification matters.
We think this bodes well for those who traffic in diversification, whether it’s OCIOs, multi-family offices, wealth managers, independent trust companies, or managers in niche asset classes that play a unique role in portfolio strategies. Anyone who suffered by comparison to the S&P 500 is being set up for vindication and possibly some healthy client inflows.
2. Compensation Plans Are Being Tailored to Business Models
Historically, many RIAs were a variable-revenue, fixed-cost business. That works when markets are steadily rising, but not in times like this. Margin of profitability is also a margin of safety.
Volatile markets have wreaked havoc on industry profitability this year, both because of downward pressure on AUM and because institutional investors are increasingly asking to pay lower base fees plus performance fees. In an effort to match expenses with revenues, RIAs are responding by increasing variable pay: bonus structures and equity compensation that directly share in the profitability of the business. In many firms, leaning more on variable compensation can be a smart risk management tool both for bad markets (mitigating margin impact when revenues sag) as well as good markets (paying to retain key staff when money is plentiful).
3. Borrowing Costs to Affect M&A
For most of this year, we’ve been writing that Fed behavior was going to rein in transaction activity. Like many market prognosticators, so far, we’re “not wrong, just early.” Historically, transaction activity in the RIA space is a lagging indicator, and the steep rise in rates this year is starting to have an impact.
Last week, both Focus Financial and CI Financial announced debt refinancing at higher rates than they’ve had to pay in a long time. Focus closed term financing at SOFR plus 250 bps and SOFR plus 325 bps for maturities between 5 and 5.5 years. If SOFR peaks at 5% or a little higher, Focus will have term borrowing costs on the order of 8%. CI Financial is paying a fixed rate of 7% over the next three years and wants to deleverage. Focus isn’t looking to increase its leverage ratios. Our read on private acquirers aligns with these two publics. We don’t see as much dry powder available to fund M&A in 2023, and that which is available will be deployed more judiciously.
4. Minority Transactions Provide the Opportunity to Wait and See
As M&A slows, minority transactions are being viewed by many as a way to kick the can down the road. Rather than cede control in an atmosphere of lower AUM, revenue, margin, multiples, and—therefore—value, minority sellers can take some money off the table, satisfy a near-term liquidity need, cash out one or a handful of retiring partners, or otherwise satisfy their basic ownership requirements. Key players can stay in the saddle for markets to recover and sell more in a few years.
Regardless of the present conditions, we’ve heard investors in the RIA space make a compelling argument that minority investments work better anyway. Financial buyers don’t want to run RIAs, they just want to own a piece of the success brought about by committed and talented management. If management owns a meaningful stake in the business, outside investors can rest easy. We anticipate an increase in merchant banking over the next few years, especially if markets remain unsettled and interest costs are meaningfully higher.
5. Fortune Favors the Bold…and So Do Earnouts
Just as we see institutional investors wanting pay-for-performance relationships and firms using variable compensation, volatile markets and higher borrowing costs favor pushing more transaction consideration toward contingent payments. It gives buyers comfort and sellers opportunity, and we think the prominence of earnout consideration will only increase.
6. Buy-sell Pricing to Mimic Transaction Behavior
Buy-sell agreements provide ownership structures with a contractual mechanism to determine how ownership interests in closely-held businesses will transact. They are a must-have for RIAs with multiple owners, and in our experience, most have some form of buy-sell agreement in place. Unfortunately, many buy-sells are not well-engineered. We get more work than we should helping disentangle disputes involving internal transactions which were supposed to happen smoothly.
One recurring issue involves buy-sells that price ownership interests using formulas. Formula pricing promises simplicity, but life is rarely simple. It’s common to see formulas using industry multiples derived from rules of thumb, which might work fine under “normal” conditions.
Buy-sells are usually triggered under abnormal conditions, though, when such rules of thumb could dramatically undervalue or overvalue a business. RIAs usually transact with some money paid upfront and the rest contingent on the post-transaction performance of the firm. We wonder why buy-sell pricing isn’t structured the same way.