Mercer Capital’s marketing staff is trained to market valuation services, not perform valuations. Nevertheless, these folks have to read a lot about the practice in reviewing our articles, presentations, blogposts, books, and whitepapers, and I’ve wondered how much they absorb of what we write. I think I got my answer last week, when I showed our marketing director a photograph of an early-1960s Aston Martin DB4 and asked if she knew what kind of car it was.
“Is it a Porsche?”
Incredulously, I had to remind her that Porsche didn’t make GT cars in the 1960s, only rear-engine models like the 911, 356, and 912. The first Porsche with a front engine, grand-touring configuration was the 928, first produced in 1975. The 928 was supposed to be the replacement for the 911, which was expensive to build and difficult to drive (rear engine cars have an unrivaled penchant for oversteer). Porsche enthusiasts (a fandom like none other) balked, and the marque decided to build both the GT and their traditional rear-engine models until giving up on the 928 in 1995.
The 928 was a brilliant car, but it wasn’t a game changer for Porsche. I suspect the jury is still out on the tax bill’s long-term impact on the investment management industry as well. One of the more interesting aspects of the 2017 Tax Cut and Jobs Act (TCJA) that is the bill’s potential impact on mergers & acquisitions. Most of the press assumes that the TCJA is going to be positive for M&A, although it cuts differently across different sectors. For the investment management community, the change in tax law is a mixed bag, and we’ve yet to see a compelling case to suggest that, overall, it will tend to encourage or to discourage transaction activity in RIAs on a net basis.
Keep in mind that much of the TCJA did not apply to investment management firms. The new rules on expensing capital expenditures don’t matter for the asset manager that spends a few hundred thousand dollars (at most) per year on information technology equipment and licenses, plus a conference room table or two. Incentives to re-shore foreign capital doesn’t apply to most RIAs, and the limitations on interest deductibility won’t matter except for the most highly leveraged transactions. There is an argument to be made that the TCJA is bullish for RIA M&A, but there is a counter-argument as well.
Point: New Tax Legislation Encourages RIA Transactions
Most commentators only see positives in the tax bill for M&A activity, and at least some of that extends to investment management firm transactions. We joined in this chorus, noting that rising asset prices have brought many RIAs a surge in AUM, which grows revenues similarly and profits even more, thanks to the magic of operating leverage.
For RIAs structured as C corporations, the TCJA significantly improved after-tax cash flows since most firms pay high effective tax rates. And those higher after-tax cash flows are potentially even more richly rewarded by a market willing to pay higher multiples in a time of mostly bullish sentiment.
All else equal, higher valuations usually encourage sellers to take advantage – which is important fuel to the RIA transaction community in which buyers usually outnumber sellers by a wide margin. And conglomerates with investment management firm divisions may be encouraged to make divestitures in a time when valuations are high and the taxes on gains they make in the sale would be relatively low.
All in all, there are many reasons to believe that the tax act will spur more transaction activity for RIAs. However, there is another side to this story.
Counterpoint: New Tax Legislation Does Nothing for RIA transactions, and Might Even Discourage Them
One drawback of the TCJA is that it does little, if anything, for internal RIA transactions, the most common style of investment management firm transactions. While tax rates for C corporations were slashed, the top tax rate for individuals only declined modestly, from 39.6% to 37%. Most RIAs are structured as some kind of tax pass-through entity, either as an LLC or an S corporation. So taxes on investment management firm earnings are taxed as personal rates rather than corporate rates.
Buyers in internal transactions at RIAs pay for their stock with after-tax cash flow (distributions), and purchasing capacity will be little improved by the TCJA (with a few exceptions). Without an improvement in after-tax distributions, internal buyers can’t pay more for their stock. So the tax bill isn’t really bullish for internal ownership transition. Further, to the extent that sellers now have expectations for higher prices, we may witness a widening of the bid-ask spread, which will discourage ownership transition altogether.
Back to my feature car – the 928 could have wound up on the engineering design floor had Porsche not decided to go ahead and produce it alongside the now (if not then) iconic 911. The legacy of the 928 – always a great GT – was eventually cemented onscreen by Tom Cruise in the 1983 film Risky Business. In the alternative, Porsche could have thumbed their nose at rear-engine aficionados and moved ahead with replacing the 911, but by being non-committal, they hedged their bet and ended up extending the brand. We recommend similar caution in assuming the TCJA is only good for RIA transaction activity. It might be, or it might not be. Risky business indeed.