February was a record month for headline transactions in the RIA industry. Peter Mallouk sold a substantial stake in Creative Planning to PE firm General Atlantic on February 12. Less than a week later, Franklin Templeton agreed to buy rival asset manager Legg Mason for $6.5 billion, and Morgan Stanley purchased online broker E-Trade for $13 billion just a few days ago.
Interestingly enough, the smallest and least heralded deal, General Atlantic’s minority interest purchase of Creative Planning, is probably the most notable from our perspective since our clients are typically more similar to CP than Franklin, E-Trade, and LM in terms of size and product offering.
Still, we can’t dismiss the implications of these larger transactions and what they say about two sectors of the investment management industry that many analysts believe are dying – active management and discount brokerage. The Franklin / Legg deal was touted as being more about “offense not defense” according to Franklin chief Jenny Johnson, who said the acquisition was about building “an all-weather product line-up and world-class distribution platform.” While that may be the case, the reality is that both firms had suffered significant outflows and increased competition from passive funds. Combining both firms is expected to generate $200 million in cost savings and stem the tide of waning profit margins.
Morgan Stanley’s purchase of E-Trade was likely also a defensive maneuver anticipated to yield approximately $400 million in expense reductions for the Wall Street giant. It may have also been Morgan Stanley’s counter to Goldman’s purchase of United Capital last Spring in their bid to enter the mass affluent space. E-Trade’s recent financial woes are primarily attributable to falling commission revenue, which, like active management fees, have been in free fall for quite some time.
Both E-Trade’s and LM’s stock price rose over 20% upon announcement, and it naturally leads us to wonder if smaller active managers or broker businesses can expect such a windfall from a prospective acquirer. Scale still matters for most asset management firms, so consolidation rationales are always going to be there especially for an industry looking to cut costs. Brokerage firms’ commission revenue is less proportional to client assets, so bulking up just for the sake of it doesn’t make a whole lot of sense. Many of these businesses are already transitioning to an asset-based revenue model anyways, so we’re seeing fewer acquisitions of brokerage firms in general.
Even with asset manager deal-making holding up, the sector’s recent uptick in M&A activity is largely attributable to a growing interest in wealth management firms. The driving force behind this increase is strong demand from RIA consolidators, PE firms, and strategic acquirers that are drawn to the sector’s recurring revenue model and sticky clientele base. The lack of internal succession planning is another catalyst as founding partners look to outside buyers to cash out.
Despite this uptick, there are still numerous challenges to sustaining this level of M&A growth for the RIA industry. Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task. The risks include cultural incompatibility, lack of management incentive, and size-impeding alpha generation. Minority interest acquisitions (à la Creative Planning) sidestep some of these challenges, but the risks are harder to avoid in control acquisitions. Well-structured deals and effective integration strategies can help mitigate risks and align interests, but only to an extent.
And yet, with over 12,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back-office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression. An aging ownership base is another impetus.
The performance of the broader market will also be a key consideration for both buyers and sellers in the coming year. The current downturn from the Coronavirus could curtail the recent momentum or spur buyers to negotiate lower pricing. We’ll let you know how it all shakes out.