Barring some extraordinary circumstance, in one week Hillary Clinton will be elected the 44th president of the United States. Her election will mean a lot of different things to a lot of different people, but since this blog is called RIA Valuation Insights, we’ll narrow the focus of this outlook on her upcoming term as president to the possible impact on the investment management community.
A good friend of mine from high school is a Republican lobbyist in Georgia. Charlie’s mood these days oscillates between stoicism and apoplexy, as his party is not only about to lose this presidential election, but also because the G.O.P. is as divided, if not more so, than it was following Barry Goldwater’s bid for the White House. For all of Goldwater’s accolades, his 1964 campaign alienated so many voting blocks in the U.S. that the conservative wing of the G.O.P. was suppressed for 16 years. Indeed, the biggest risk to the investment community may be that Republicans can’t get their act together for several elections to come.
Financial Markets Profit from Divided Government
If there’s one thing the financial markets fear absolutely, it’s one-party rule. The hardest thing for a president to do isn’t working with the opposition party to solve real problems, it’s controlling the demagogues in one’s own party who tend to create problems. George H. W. Bush had to cope with these kinds of distractions in the first half of his term (flag burning amendment), as did Bill Clinton (don’t ask, don’t tell). Republican congressional losses in the midterm election in 1990 plus Iraq invading Kuwait got Bush’s presidency on track, just not enough to overcome the recession. Mid-term losses in 1994 got Clinton refocused on getting legislation through by bargaining with Republicans, arguably turning him into the most conservative president of recent memory – to the delight of financial markets and the chagrin of liberal Democrats. If the G.O.P. is in too much disarray following this year’s dissection-election, Hillary Clinton won’t need to manage her political capital in the same way.
We foresee that financial markets are being set up, in some regard, to be a victim of their own success. ZIRP has inflated valuation multiples and AUM balances across most financial asset classes, and with nowhere to go but down, some external factor could eventually lead markets lower on a sustained basis. We don’t say this based on some elaborate technical analysis other than mean reversion. With low rates and market liquidity, it seems like asset prices can stay up, but it’s difficult to see opportunities for significant topline growth, widening of margins, or multiple expansion. The question of when financial markets falter becomes when, not if. In this environment, the markets feel more vulnerable to politics than usual.
The Warren Administration
Clinton’s election secures the ascendency of Senator Elizabeth Warren, particularly if Democrats gain control of the Senate. Senator Warren is going to be very powerful over the next four years and highly influential on President Clinton – at least as much as Vice President Cheney and the Watergate-era cronies were on President George W. Bush. One helpful thing about Senator Warren is that she makes no secret of her intent; we don’t have to spend a lot of time reconciling what she says in closed door speeches to Goldman Sachs with what she says at political rallies. Warren is convinced that the financial services community profits to the detriment of the rest of the economy, and she has accumulated more than a little evidence from the credit crisis to back that up.
Because of Senator Warren, and the likely new ranking Democratic member of the House committee on Financial Services, Maxine Waters, one theme facing the financial services industry in general, and asset management in particular, is increasing regulation. Wells Fargo’s ex-CEO John Stumpf may be glad he endured his congressional grilling in 2016 instead of 2017. You can expect to see more of the same. There may not be a Basel IV, but we may be in for a creeping reintroduction of some features of Glass-Stegall (ironically repealed under the previous Clinton administration). That said, it’s difficult to deconsolidate an industry with narrow and shrinking margins.
Then there’s the SEC. Senator Warren famously called for the ouster of Mary Jo White as Chair of the Securities and Exchange Commission, in spite of the fact that the SEC’s investigative and enforcement divisions appear to have become considerably more aggressive on her watch. We think fair value marks on illiquid securities held by PE funds, BDCs, and mutual funds will get much more scrutiny. Chairperson White has targeted the PE industry, and any successor is likely to continue this theme.
Tax Rates are Headed Higher
Despite the brouhaha over Donald Trump’s use of net operating loss carryforwards and accelerated depreciation, both are far too esoteric – not to mention economically defensible – to change under the Clinton Administration. The story is different for taxes on carried interest, social security, and estates. An increase in any or all of those tax rates would mean significant changes for the asset management industry – none of them favorable.
In some regards, it’s remarkable that carried interest taxes have been treated at capital gains rates as long as they have. There is some economic rationale for it, of course, and the complexity of explaining performance fees to the average taxpayer has kept the issue from being front page news in most local papers. Unfortunately for the alt asset business, PE fund managers have been a little too visible in their success, such that it has become easier to paint a target on their back. One rare area of agreement between Clinton and Trump is taxing carry at ordinary income tax rates. Assuming tax rates on performance fees change, GPs will be indifferent to being paid through ordinary management fees or carry. If fee pressure continues, managers might be more interested in a “2 and 10” model instead of a “1 and 20”. No word yet on what LPs want.
I read recently that, had the cap on taxable income for purposes of social security been indexed for inflation, it would be about $250 thousand today, or roughly twice what it is. This tax is more difficult to change, because the aggregate benefit paid out of social security is proportionate to the taxes paid in. Nonetheless, the rate may not change, but the cap will likely increase. A logical cap would be the Section 415 limit (currently $265 thousand). This could have a big impact on financial planning models in the wealth management space, but little impact on your typical hedge funder. Many will point out that the least expensive and most logical change for social security would be raising the qualifying retirement age. Nevertheless, we are probably moving into a period where notions of curtailing benefits are unlikely to gain much traction: a Democrat in office, a growing retiree population, and lagging financial markets.
As for estate taxes, under the previous Clinton administration, rates were very high and exclusions were very low, but the law offered lots of leeway for creative estate planning. Lately, the IRS has been trying to limit key estate planning techniques, and they may or may not succeed. Candidate Hillary Clinton has suggested lowering the size of estates excluded from taxes, but there’s probably more than a little uncertainty as to whether President Hillary Clinton will pay much attention to this.
Peak Margins and the Dearth of Growth Opportunities
Earlier this year a portfolio manager at one of our clients explained to us his dislike of investing in “spread businesses” like banking and energy. His argument was simple: because of potentially countervailing forces, businesses that lived by the spread would eventually die by the spread. Unrelenting economic relationships would, over time, arbitrage away margin. Asset management is its own kind of spread business: buying investment management talent and reselling it, at a 40% EBITDA margin, to end users. Spread businesses like banking and energy seem to be more at risk than most in a Clinton presidency. We don’t mean to imply that the asset management industry is at risk of going the way of prime brokerage, but there’s no rationale to suggest the industry, as a whole, will experience margin expansion anytime soon. Expect more consolidation.
One bright spot for the most beleaguered sectors of the RIA world – active management in general and hedge funds in particular – is the likely return of volatility to the asset landscape. The slow unwinding of ZIRP, BREXIT and the collapse of the pound, challenges to the sustainability of the euro, the sustained deflationary impact of technology, global aging and global warming, the oil collapse and destabilization in the Middle East, and the rightward political march of Europe in contrast to the U.S. moving to the left all add up to less asset correlation across the globe. The indexers risk having a huge position in the next Blockbuster Video while missing out on Netflix. All this is happening right on time as The Wall Street Journal and the CFA Institute declare active management dead and buried. We may yet have a moment of schadenfreude for active managers.
The Only Constant
Change is inevitable, of course; and bemoaning change isn’t productive. Several long running trend-lines in the investment management industry seem to be rolling over, and that is anxiety inducing. So I’ll close this blog with some wisdom from an unfortunately departed member of the investment management community, Louis Rukeyser, who said (long before this election):
“Roaming the world as a foreign correspondent for more than a decade, I was able to observe how a variety of vastly different nations organized themselves economically. The inescapable conclusion was that no politician anywhere on the planet has ever actually created a rupee’s worth of prosperity.”
He also said: “The best way to keep money in perspective is to have some.”
God Bless America.