M&A: Recording
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AN INSIDE LOOK:
M&A AND PRIVATE EQUITY INVESTMENTS IN THE ASSET MANAGEMENT INDUSTRY
Marilyn: Hello. I’d like to thank all of you for joining SunStar Strategic for an inside look at M&A and private equity investments in the asset management industry. Today, we’ll be hearing from three experts in the financial industry who’ve actively participated in numerous M&A deals. With us today are Brad Hearsh, a senior advisor for UBS Investment Bank; Brett Gallagher, director of research and acquisition, and a partner at Nile Capital Group, and Neil Hennessey, Chief Executive Officer of Hennessey Advisors.
Following the presentation, our panelists will be happy to address your questions. You can type a question into the question box on your screen anytime during the webinar. We will wait to answer them until the end. I’d like to turn the presentation over to our first panelist, Brad Hearsh. Brad is a senior advisor at UBS Investment Bank’s global financial institutions group. He advises senior management and boards of directors on asset management companies on mergers and acquisitions and private placements. Brad has been with UBS for 31 years, and has a law degree from the University of Virginia. Brad?
Brad Hearsh:
Thanks, Marilyn. Thanks to all of you for joining today. The asset management M&A topic is a broad one, so I’ll certainly not give it justice in ten minutes, but happy to have a conversation offline following the webinar, if anybody would like. I’d like to touch briefly on four topics today. One, first, valuation. Second, the nature of transaction activity in today’s market. Third, some comments about the buyer landscape, and then, fourth and last, highlight a couple of transaction considerations.
Valuations
Starting with slide one. This slide addresses the valuation topic, and the graph tracks forward P/E multiples for both the larger US and UK traditional asset managers, as well as the alternative asset manager universe. And as you can see, the P/E multiple for the US traditional asset managers are tracking generally in line with their long-term historical averages. Of course these longer-term averages are now almost all post-crisis. If you were to look at the longer-term averages prior to the financial crisis, they would be on average more like 17-18 times forward P/E.
Having said that, private M&A valuations, though, have been holding up reasonably well, even moving up a bit here in the last year or two, particularly for the more attractive asset classes like global equities, global fixed income, real assets like real estate and infrastructure, private credit, and others. Growing concerns with those attractive characteristics have been trading recently in the 10-12 times EBITA range, 10-12 times cash flow. Alternatively, asset classes that have been under more pressure from passives, and indexing, and ETFs and the like, such as US large cap equities, probably would struggle to get more than maybe eight times EBITA in today’s market.
Now, these multiples are reflective of growing concerns and mature P&Ls to the extent that a transaction involves simply the sale of mutual fund AUM. Valuation would be more of a function of a multiple of revenue or multiple of management fees on the order of two times to maybe four times revenue. It depends largely on the nature of the fund, the track record of the funds involved, the size of the funds involved, their asset class, and the like. Moving to slide two.
Asset Management M&A – Notable Recent Transactions
With respect to activity in the marketplace today, my first comment would be that the level of activity and conversation is reasonably robust. As you can tell across a range of both large transactions and more middle market asset management acquisitions. Across a pretty wide spectrum of asset classes and client types, although I would say there have been fewer deals around pure US equity firms than maybe there have been in the past.
Second, I’d be remiss if I didn’t touch briefly on a couple of the very large transaction announcements here in the last year, like a Janice Henderson or a Standard Life Aberdeen. It’s raised the question - are these transactions a sign of things to come? I will say based on our more recent conversations with some of the larger traditional mutual funds platforms, there is, by their own omission, arguably, these firms representing melting ice cubes. In many cases, large melting ice cubes, and slowly melting ice cubes.
These firms, to a large degree are still quite profitable, but melting ice cubes, nonetheless. And I do think there is the potential to see larger organizations use M&A to try to pivot their strategies, and to try to achieve cost synergies through the use of M&A in larger business combinations. My third comment would be that another driving force for M&A has been the increasing interest on the part of private equity, particularly since the financial crisis. Not only as a source of additional liquidity for asset management firms, but as the P/E investments mature over time, they’ll be exit transactions for the P/E firms that will generate transaction activity both big and small, as well. Moving on to slide three.
Buyer Landscape for Asset Managers
This slide depicts, broadly speaking, the buyer landscape, and it’s by no means all-inclusive. But the landscape, as you can tell, is quite broad geographically and buyer-type wise. It continues to broaden. Although broad, I would say a strategic interest, and financial interest for that matter, is not as deep as it might have been a few years ago. And what I mean by that is that buyers/investors today are considerably more picky and selective. They are risk adverse, and their interests tend to be more specific and more narrowly defined than they might have been maybe ten years ago. Turning to the last slide, slide four.
Transactions Considerations
This slide highlights some of the transaction considerations that come in asset management M&A. Clearly, the most important driver of M&A transactions is the desire for owners to liquefy and monetize their stakes. I would say in addition to that, expanding distribution and gaining access to growth capital can also be important. When you have the presence of both of those factors, often times the stars align in such a way as to produce an M&A transaction.
From the buyer’s perspective, I would say the interest comes from a desire for AUM scale, or the appeal of investment capabilities, and/or niche distribution represented by the target firm. In terms of transaction approach, I would say strategic buyers are typically looking for majority ownership, or at least a path to majority. The more integration and consolidation that is involved in a combination, the more likely it will be majority, if not 100 percent ownership. I would say financial buyers, including private equity have been more open to majority and minority stakes.
And in some cases, financial buyers are willing to consider acquiring revenue shares, which keeps them out of the sort of budgeting and expense discussions going forward. In terms of the form and consideration, certainly deferred consideration is quite common, but it can vary widely depending on the circumstances. In my experience, typically, you would see at least something on the order of half the consideration being paid upfront, but it can be a little bit more certainly, or a little bit less.
The deferred consideration can be structured as earnouts or retained equity stakes, with the metrics being based on retention or growth in AUM revenues, or EBITA, or a combination of retention and growth. Typically, the future consideration is based on a hardwiring of mechanics upfront. Occasionally deals are structured where they will be a third-party evaluation in the future to determine the size of the deferred consideration. But more often than not, the mechanics for the payout are well-thought out, and hardwired at the outset of the relationship.
Earnouts generally run anywhere from a couple of years to five years, while retained equity liquidity tends to be a little bit longer. It tends to be in the five to seven-year range. Cash is more often used as consideration, but stock is occasionally used, and sometimes used to facilitate deferred tax taxes. Lastly, with respect to culture, I think most targets can expect reasonable autonomy with respect to investment process and security selection. It’s rarely otherwise, unless the transaction simply involves the merger of mutual funds or the acquisition of AUM. In many cases, it’s possible to retain a good bit of day-to-day independence.
Multi-boutique models have become more popular for some buyers, although the more integrated and consolidated the transaction is, that naturally allows for less autonomy. In terms of compensation plans, generally speaking, buyers will allow the continuation of the existing compensation plans that exist inside the selling company, at least for a period of time. But again, for more integrated approaches to transaction, there’s likely to be a migration more to the buyer’s approach to compensation.
Last, I just have a comment about the legal and regulatory front. Typically, these transactions do involve employment agreements for key individuals, including non-competes, which generally are in place for, say, three to seven years. Where there’s been a deemed change in control, i.e., an exchange in more than 25 percent of the ownership of firm, that would typically require client consents. And of course messaging to clients is important in order to obtain those consents successfully. So maybe I can leave it there, and, Marilyn, turn it back to you and the rest of our panel.
Marilyn:
Super. Thank you so much, Brad. That was terrific. I would like to now introduce Brett Gallagher. Brett is a 28-year veteran in the asset management industry. His career includes serving as the deputy CIO at Artio Global Investors/Julius Baer Investment Management, as well as head of investment management for J.P. Morgan Singapore, and head of global equity for Bankers Trust International Private Bank. Brett is currently a partner with Nile Capital Group, where he is the director of research and acquisition. Brett?
Brett Gallagher:
Thanks, Marilyn, and thank you all for joining the call today. Just quickly, since Nile is not a household name, I’ll let you know that we are a sector-focused private equity shop, that sector obviously being asset management. And we tend to seek out stakes in talented, but emerging asset managers, and then help them scale. So, we’re operating in a little bit of a different segment of the market than a lot of other people.
Asset Management Deals by the Numbers
The market is big and robust. We’ve had more than a thousand transactions in the last five years. That may overstate the number slightly because if it’s a deal we’ve done in two parts it does get counted twice. The median target valuation was about 65 million dollars. The average skewed by a few large transactions, closer to 570 million. In terms of the manager AUM, the median again, four billion, the average a little under 18 billion.
Our focus with Nile, we would actually be below median, so we’re looking at firms below that four-billion-dollar market. The overall industry continues to grow. Sixty-eight trillion today globally. It should be 100 trillion, according to PricewaterhouseCoopers, by 2020. And why we think asset management is a great industry for the private equity industry, is that it tends to be consistently the most profitable of all the S&P industry groups, more so than technology or healthcare, or any of the others that normally come up. It is where public plans tend to spend the bulk of their money. Almost 80 percent of their budget goes to asset management fees, yet, currently, less one percent of their private equity allocations are going to asset management. On the next slide is a concept that really got Nile off the ground, and the mutualization of asset management.
Potential Mutualization of Asset Management
What we mean by that, is that we believe increasingly, the providers of the capital, the investors, the plan sponsors, will look to become, or should look to become, owners of the managers in which they invest.
So you’re not only receiving the underlying stream of assets, but you’re participating in the growth that you helped create, and that you’ve helped influence as you go along. Looking at the industry again, the upper left-hand chart is showing that it truly is a private industry. Eighty-three percent of the assets that are managed are managed by companies that are privately-held. Only 17 percent of the assets are managed by publicly-traded firms, and if we float adjust it, it falls to 13 percent.
The chart in the upper right shows the typical budget for the ten largest public plans. Eighty-eight percent of their fees going to asset management, far outweighs anything else they’re doing. So certainly they’re familiar with the industry. They see managers in and out of their office all day. They invest across the broad spectrum of asset classes, why shouldn’t they invest in those underlying companies?
On the next slide we see the view of those other industries in terms of the public/private split.
Public vs. Private Ownership
We’re looking at revenues, whether it be software, hardware, technology, food, beverage, tobacco, healthcare, or energy. It really doesn’t matter. The bulk of the revenues that are generated in these industries are already being generated by publicly-traded companies. So our argument is if you need exposure to any one of these segments, you can probably get a broader exposure in the public markets. There really isn’t as much opportunity in the private markets. Asset management, again, being the inverse or the flipside of all this. Moving to slide 13, we see another way of looking at valuation.
Valuation | Historic Deal Multiples
Brad was talking about forward P/Es. We like to use percent of assets under management as one of our go-to metrics. And the reason for that is it tends to be more consistent across the lifecycle of an investment manager. If you’re smaller and emerging, the kind of firms that we’re looking at, you’re not generating a lot of cash flow - you’re probably operating in the red. To try to get around that, we use assets under management as a shorthand.
There are some differences here. That gold line at the bottom is actually the median valuation of transactions that have taken place for firms who do not have a mutual fund complex. These are mainly large separate account mandates that they’re running. That’s been fairly stable between one and a half and two and a half percent of assets for a fairly long period of time. Even if we extended this chart back, that would not change that much. Once a firm does have that mutual fund complex in place, you get a valuation bump.
The mutual fund fees tend to be a little higher. The money may be a little stickier. Those firms tend to trade between two and a half and four percent of assets under management, so part of our strategy is to buy along that bottom line, implement mutual funds and comingle vehicles for the manager. By the time we come to exit, we’re hopefully being valued off of that upper line. I would say that the private equity firms that have entered the market in the last few years, they tend to be the larger firms, and they’re focusing on the larger end of the asset management spectrum.
They probably are using more of the EBITA multiple band than anything else, and that really relates back to the fact that they’re private equity firms. Whether they’re looking at consumer companies, or energy companies, that’s their go-to metric and they’re looking to apply it to the asset management industry as well. But, again, why I like this percent of assets under management is just the consistency over time, and the consistency irrespective of where a company is in its life cycle, whether it’s emerging, or whether it’s a very mature firm.
Moving on to my last slide - this is taking a look at one of the value drivers in the industry.
Asset Growth vs. Performance
Most people believe that if you perform, assets will come. That is partly true, but not necessarily totally the case. This an excerpt looking at international equity funds. This is from our first research report that we did back in early 2014. That top chart is looking at the top 20 international equity funds in terms of their ability to bring in new assets, and comparing that to their performance rank.
You can see that the performance of managers’ pre-crisis was typically in the 30th to 40th percentile. So good, but not great. You didn’t have to be great to gather assets. You had to do all those other things well. Since the crisis, that’s become even more the case. The performance of the top assets gatherers has actually deteriorated, and you can see that it’s more like median or better is good enough now. The bottom chart, I just flipped that on its head, and I want to look at the top 20 performing funds, the best performers, and how they fared as far as ability to gather assets.
Here again you see pre-crisis, they had to be somewhere in the top third of the peer group. That was typically what it took to be a top 20 asset gatherer. Since the crisis other things have come into play, and being somewhere around 40 percent or better is good enough. Now, one caveat before I finish - if you’re in an asset category, let’s say US large cap growth, which is being challenged by passive and index-like products, in an asset class that is shrinking, generally your performance has to be in the top 15 percent of your peer group on average for you to see positive inflows.
If we’re an asset class like this, like international equity that’s stable or expanding, we generally consider the top 40 percent good enough. So the hurdle is a little bit easier if you’re in a little bit more of an exotic asset class. And with that, I’ll pass it back to you, Marilyn.
Marilyn:
Thank you, Brett. Those were great insights, and we appreciate all of what you were able to share with us. I’d like now to introduce Neil Hennessy. Neil is the CEO for Hennessy Advisors. He opened a broker dealer firm in 1989, and founded Hennessy Advisors in 1996. The firm has successfully managed eight transactions to acquire 25 mutual funds totally three billion dollars. These have grown to 6.5 billion. Barron’s has ranked Neil among the top 100 mutual fund managers. Neil?
Neil Hennessy:
Well, good morning or afternoon to everybody. First, Brad and Brett went over the industry and how the acquisitions go together, and what they cost, or some ranges in there. What I want to do is give you a 30,000-foot view of the mutual fund industry as I see it today in the headwinds that the mutual fund industry is facing. First and foremost is the Department of Labor - the new ruling coming out.
DOL
To start with the Department of Labor, it doesn’t matter, in my opinion, if they put it through, or they don’t put it through because the concept behind it was very simple. The DOL did not have an enforcement arm to really enforce this rule. So they were, from the beginning, going to rely on the plaintiff’s bar which is going to say “look, why did you charge this individual this amount, but you charged this to a retirement account? What’s the difference?” So, essentially, we’re facing the headwinds no matter what’s going to happen.
Let’s look at the next slide -
Passive vs. Active
I’ve been in this business for 38 years. I’ve seen this movie before. I’ve seen the actors. I don’t need to wait to see the clips at the end. But, essentially, passive vs. active is not a new concept. Theoretically, if you look at it, if everybody went passive, how are you ever going to raise capital, and how is anybody ever going to get ahead? So it doesn’t make any sense. Right now, there is fee pressure in the industry, and it’s going to be there for a while.
When I look at these two headwinds, and I look at fee pressure, we have passive vs. active. We have the DOL. What’s that look like to our industry going forward? Well passive vs. active, this will be around for another year, year and a half, and then it’ll go away just like it has in the past. But, essentially, in our game, and the way we look at it from Hennessy Funds, is that organic growth is going to be very difficult to achieve in the next year to a year and a half.
But as difficult as that is, it also opens up opportunities, and the opportunity is on the acquisition side. So it’s my belief in the next year to year and a half, there’s going to be a lot more M&A activity simply because you’re either going to grow through acquisitions, or you’re going to get acquired. As we all know in the front of our lobes as money managers, we certainly don’t want to go back to March of ’09. But whenever we get a scare in the market, we’re no different than anybody else going, oh god, if we’re going back to March of ’09, am I going to lose my net worth, or what’s going to happen here? So I think that it’s going to feed on itself as we go forward. Next slide, please.
Outlook
So when I look at the outlook, and I tell people when they call me, I said the biggest part of M&A activity is obviously learning it. So don’t hesitate to make an outgoing phone call. Everybody doesn’t want to make an outgoing phone call to a company like mine, or Brad’s, or Brett’s, for fear that you’re going to lose your negotiating power. You’re not going to lose it simply because we all know what the numbers are. We all know what the bottom line is. We all know, okay, well, this is what it should be valued at, and this is how much money I can make, and this is how you get money off the table.
M&A
So essentially in the M&A business, and you’re looking at it, it’s the same as the mutual fund business, which is essentially everybody thinks we’re in the money management business. The reality of the situation is we’re in the fee business. And that’s what these acquisitions are looking at. We’re trying to get more and more fees to come through the door. If we can get economies of scale, all the better, so it drops to the bottom line. When I look at people saying, well, I’m not going to make an outgoing phone call, that’s crazy because in my opinion, I try and tell my wife this all the time when she’s at Nordstrom’s. No is a full sentence.
So you don’t have to agree to the deal, but you can find out a lot of information, talk to a lot of people, and find out what your business is worth, and should you look and say, well, maybe I sell a piece of it, or I sell it all and sub advise that. But the difference is do not be scared to make that outgoing phone call. With that said, it’s going to be a little rough in here for the mutual fund industry, but this is like a kidney stone. It’s going to be painful for a year, a year and a half, but it will pass. And the next thing you know, those will be off to the races. With that, I’ll turn it back to Marilyn for questions and answers.
Q&A
Marilyn: Great. Thank you, Neil. I really appreciate it. And we appreciate everybody’s insights this morning. Right now, I would like to open the session up to questions. So our participants, if you have a question, you can type them into the box that should be on the right side of your GoToWebinar screen. We do have our first question. And it is:
IS M&A IN THE ASSET MANAGEMENT SPACE HEATING UP THESE DAYS, AND IF SO, WHAT’S DRIVING THAT?
Brad Hearsh:
This is Brad Hearsh, I’m happy to start. I’m sure Brett and Neil will have a point of view as well. I don’t think there’s any question that continued consolidation in the industry is – I mean it’s going to continue, if not intensify. In fact, some of the comments that Neil made about the pressures in the short-term, about the pressures on fees, I think particularly in the retail business, which is becoming more expensive to operate from both the marketing and the distribution perspective, but also from the standpoint of what it takes from a regulatory perspective to keep up and to grow a firm adequately, I think is suggesting that there will be continued consolidation on the retail side for sure.
But I also think there’s going to be consolidation among institutional money managers as well. You know, the industry is very evergreen in nature, and you sort of can’t take it with you. As the senior managements of even boutique institutional firms, you know, move up in age. At some point there, will be an ownership transition. That’s constantly taking place. There’s always going to be an ongoing need for liquidity in the marketplace. Given some of the broad challenges, the near-term challenges that firms that are up against ETFs and passes, for example, not just retail firms, but institutional firms as well, are going to have to find other ways to grow.
They’re either going to have to diversify. They’re going to have to get better distribution by partnering with somebody. So I think all of these factors suggest that the level of consolidation and M&A activity is going to continue to increase, and going to be with us for quite a long time.
Neil Hennessy:
If I could just add to that, and this is Neil, we’re seeing a lot more deals. But what I’m seeing out there is that a lot of money managers, especially in the mutual fund arena, decided to either cut their management fees, or waive their management fees for a certain period of time. On the acquisition side, if I go in and try and acquire that, I can’t waive those fees away. I can’t put them into a higher expense ratio mutual fund for at least two years. The SEC is going to look at it and say, well, why are you going from, you know, .101 to 126? We’re not going to allow that.
So what could happen is I look at the deals, and if I want to merge it into one of my other funds, that means I have to lower my management fees on all the assets. What I’m saying is a lot of mutual fund companies, getting the concept or the idea that if they cut their fees, they’ll attract more money. And that’s not going to happen. So, essentially, we can’t even bid on it because we can’t make any money. And that’s a big problem. So as I say, keep your margins where they are, if you can, but don’t go into this fee cost cutting business because we’re never going to meet or beat Vanguard.
Brett Gallagher:
This is Brett. I’ll just add one other thing. From a private equity perspective, we’re definitely seeing much more interest. I think that as a lot of other industries have fairly matured, and multiples are basically close to record highs, leverage has been applied in record amounts. Asset management remains sort of one of those untapped industries even though there has been a lot of activity. Because the companies aren’t levered, because they’re highly profitable, and because once you hit that tipping point.
Once you’ve covered your fixed costs, as Neil mentioned earlier, every dollar flows through to the bottom line so they are very cash flow generative. In fact, we expect to make at least one time the multiple from cash flows typically within about four years after an acquisition. So it’s just a great industry for private equity. I think even what’s happening elsewhere in the private equity world, firms are beginning to look more and more at asset management.
Marilyn: Thank you, Brett. We have several more questions. Here’s one:
BESIDES NOT AGREEING ON VALUATION, WHAT ARE OTHER REASONS THAT MAKE A DEAL NOT HAPPEN?
Brett Gallagher:
This is Brett. I can give you one. And this is a firm that we had acquired in December of 2015. We actually were not the highest bidder on the deal, but we were the one who gave the most leeway to the incumbent management team. A lot of people, the reason for setting up their own asset management business, is because they don’t like working in a large bank, and they don’t like the bureaucracy, or they want their name on the door.
Those are the kinds of things that we look to preserve. We try to focus on the non-financial items as much, or more, than the actual dollar amount. Obviously, it’s got to be close, but I think a lot of people just want to retain the control that they’ve come to have, unless they’re cashing out.
Brad Hearsh:
Yes, Brett, I would just add to that. It is a sector, frankly, that I think is difficult to transact in because of the non-financial issues involved. I mean the P&Ls for a lot of these companies, whether retail or institutional, are relatively straightforward. It’s not a balance sheet business, so you don’t have to go through what you go through to value a banker or insurance company. But the cultural issues, the issues around compensation, the issues around what impact on the organization a buyer is going to have in terms of people’s roles, to the extent that there is differed consideration.
What kinds of risks will be involved in the combined company that may make that deferred consideration less achievable? There are very significant risks and range of issues that I think Brett was alluding to that sometimes are indeed more important than simply the highest valuation or the highest price. So it’s a good question, but it’s a complicated one because there are a lot of non-financial issues, depending on the circumstances that will come into play.
Neil Hennessy:
And I’ll just add, depending on how the deal goes together, are you merging it into an existing fund at – for example, using my own my firm for ease - are we going to merge that mutual fund into one of our funds? Okay. So the portfolio manager goes away. Or, are we going to acquire the management contracts to an asset purchase agreement, and sub-advise it back to the management? Most RIA firms aren’t – they have either institutional and private individual accounts and some mutual funds. We just happen to be only a mutual fund company. I don’t like to have it complicated.
A lot of times, a manager can get money off the table by selling their asset management agreements to somebody like us, or Brett, or something, and then sub-advise it back. Now, that comes down to two things. It’s going to come down to attitude and personality, and if you can work within the framework of the new firm, and are you willing to obviously look incentive-wise to continue to build the funds so that everybody makes more money. But for us, it’s either you’re merging in, or it’s going to be attitude and personality that would blow up a deal.
Brett Gallagher:
One thing I’d like to add, we actually have an advisory board member who’s an executive coach, and her background is in the entertainment industry – it’s not finance. She’s the only non-financial person on the team. But we determined early on that the only industry, potentially, with egos as big as the entertainment industry is asset management. And she has worked with those people -producers, directors - her entire career. And she now works. We’ll pay the first six months of her retainer every time we acquire a firm to go in and work with existing management because of those non-financial issues.
Brad Hearsh:
I think what you’re hearing from all three of us is how important it is for the two sides to have a common vision about what they really want. To Neil’s point, if somebody is looking just to sell their fund, and to merge into another fund, they obviously should come in with the expectation it’s not going to involve the transfer of people, and it’s a much more sort of simple cultural matter. If that’s not the case, then it’s obviously a somewhat more complicated picture. But the key is really to make sure that both sides are in it for a common vision.
Marilyn: Let me jump in here. We have two related questions. “Why a private equity is interested in the asset management space versus other financial services firms?” And then related to that: “Are you seeing an interest from private equity in investment advisory firms?”
Brett Gallagher:
I think it comes back to just the attributes, some of which we had mentioned earlier. Number one, the profitability of the industry once you do hit scale. The fact that it is an asset light business, you don’t have to expand. You don’t have to go out and put a factory up, buy new equipment. Once you get to scale, you can add a body here or there, but it’s very, very easy to scale, and the cash flow just falls to that bottom line. So for a private equity firm, that is probably the key thing.
ARE YOU SEEING AN INTEREST FROM PRIVATE EQUITY IN INVESTMENT ADVISORY FIRMS?
Brett Gallagher:
We have seen some of that. We are not specifically focused on that part of the industry, Brad might have better mapping of that. But we do see some of the people that we regard as competitors who are a little broader. They have tended to be targeting that area more frequently from my perspective.
Brad Hearsh:
I certainly agree with Brett’s comments on the first question. I think the fact that it’s a capital light industry, strong cash flow, and where margins can expand pretty dramatically if you can generate good performance and properly grow assets under management, the returns can be quite exciting. To the second question, we are seeing a lot more interest on the part of private equity in the RIA and wealth management areas of the business.
Historically, the wealth management high net worth business has been a very, very fragmented place with not a lot of firms of six and scale, and that is rapidly changing. And that has begun to attract the attention of the private equity community. I think Brett and Neil’s earlier point about the increasing size of valuations in the asset management space, as it becomes a little bit more expensive, some of the big private equity firms frankly have pivoted more to wealth management, and decided it’s a little bit more competitive, and hard to compete in the asset space.
So we are seeing increased interest in wealth management, both on the part of bigger private equity firms, in some of the rollups in larger organizations, but also smaller private equity firms looking at more midsized RIAs and the like.
Neil Hennessy:
There’s a difference between an RIA firm and a mutual fund firm. So if I look at, for instance, our company, we’re purely mutual funds. So everything is publicly acknowledged, all the filings, everything is out there. If you buy an RIA, and this is why we don’t do it, if you buy an RIA, you are taking on the unforeseen liabilities. Yes, you’re buying the clientele.
Most likely, the clientele is going to stay. But at the same time, you have to be aware that there’s unforeseen liabilities that if the market takes a big hit, and the next thing you know, you get sued for an unsuitable investment. And that’s a risk that I’m not willing to take, but that’s why it’s a good and bad business just being an RIA in my opinion.
Marilyn: All right. Great. Thanks. Great discussion around that point. Now, we’re going to move to closed end funds.
WHAT PRICE MULTIPLE WOULD YOU EXPECT TO SEE ON DOMESTIC CLOSED-END FUND MANDATES? HAS THE RISE IN ACTIVISM HURT VALUATION?
Brad Hearsh:
That’s a great question. Historically, the multiple management fees paid for closed end funds has always been higher than open-end funds. You know, since the money is captive, and you don’t have redemptions, they trade instead on a public exchange. And so the permanency of the capital has always meant that if open-end funds, depending on the asset class and their characteristics, and so forth, are trading at two, or three, or four, or maybe even slightly higher times management fees.
I would say closed-end funds historically traded in the sort of four to six times range. Again, because of their permanency. Now the increase in shareholder activism has certainly made it more difficult for closed-end funds that are trading at a discount to get shareholder approval. So, obviously, the transfer of closed-end fund contracts is a little bit trickier, but to the extent that the funds are trading at or around NAV, you know, that obviously suggests that there’s less likely to be an activist factor.
A lot depends obviously on the size of the investment, and what the entire shareholder base looks like. But, again, for a fund that’s trading at a deep discount, it’s potentially an issue. For a fund that’s trading a little bit closer to NAV, it should not be an issue.
Marilyn: Let’s take our last question here. Again, we’re going to take a little bit of an around the corner bend here:
CAN YOU TALK ABOUT VALUATIONS FOR ETF SHOPS, AND ARE THEY CONSISTENT WITH TRADITIONAL MUTUAL FUND SHOPS?
Brad Hearsh:
I’m happy to maybe comment on that as well. I would say, for the most part, yes, the valuations for ETF businesses have been high relative to traditional mutual fund businesses. I’m not convinced that that’s likely to stay the same. It’s partly because until recently, there haven’t been, and there are not as many ETF businesses. They’re a bit of a scarcity value out there. The one publicly-traded firm in the ETF space is Wisdom Tree, which does trade at a slight premium, maybe more than a slight premium to the traditional…
Neil Hennessy:
A little more.
Brad Hearsh:
A little more. I was understating. It’s sort of in the mid-twenties kind of P/E. So a kind of significant premium. But they are the only sort of public play in ETFs, which I think also helps their stock price, and their stock price is all about the potential growth that people perceive to be in their product offering and the like. So I think the answer is yes. I think ETFs have been trading at higher multiple of fees, and higher multiples of earnings, and so forth.
In the case of Wisdom Tree, it’s partly a function of the fact that they’re not as profitable. And so there are multiples and prices on top of a fairly low level of profitability today. But I’m not convinced that is going to continue to be the case because we could get to a place where the ETF part of the sector is a lot more mature.
Brett Gallagher:
I would agree with that. I think a lot of the premium is that growth premium. You know, we’re now at a point in the US, where about 35 percent of the assets are passively managed. And I’d argue there’s probably another decent chunk of closet indexers out there. Those are the managers who we see continue to be redeemed, and where the assets go passive. But I think we’re getting toward that point, where you’re up around 50 percent. I believe active management is going to come back. You’ve gotta be truly active, but I do believe active management is going to come back. And I believe that as the growth slows, the multiples on the ETFs will also compress.
Neil Hennessy:
The only thing I’d add on the ETF market because we’ve looked at it, right now, it’s controlled by the big boys and girls, and essentially, they continue to cut their fees. They’re cutting their fees, and I would not be shocked to see Vanguard go to zero on a fee. People think I’m crazy when I say that, but the reality of the situation is they’re just trying to garner as much cash and as much money as they can so down the road, they can market to them a higher margined product that’s in their portfolio mix.
This is the same concept we saw, and Brad and Brett, you guys will remember, the same concept when we opened up money market funds in the late seventies and early eighties. There was no commission to open. It was a checking account. You got a higher interest rate. You get your money out. It was liquid. People would open up. In fact, when I was a rookie, I got paid $10.00 to open up a money market account with no commission. But that’s what the firm paid me.
And somebody would put $50,000.00 dollars in there, or $100,000.00, and six months later, I would call them up and say, you know, I sort of like Bank of America here. Would you be interested in purchasing a hundred shares for $700.00 or $1,000.00, or whatever it was, and they go, well, I got $50,000.00, what’s the big deal? I started that relationship with that person. If it worked out, we did more and more and more business.
But it was given away at the beginning, and then we got them in the higher margin products later if you were good at investing. But at the same concept that Vanguard and all the big boys were working off, we’ll just get the capital, and then we’ll get them in the higher margin products later on. That’s my view from Novato, California on the ETF business.
Marilyn: Terrific. That was our last question. We’d like to, again, thank our presenters and our participants I think it was a great webinar. I’m happy that all of you were able to participate. We will be transcribing everything that’s been said today, as well as making a recording available on the SunStar’s Strategic website. If you have any additional questions, you can use the contact us form on the SunStar Strategic website, and we’ll forward those to our presenters. I’d also like to invite everyone who’s been here today to join us in June for our next inside look. At that time, we’re going to discuss best practices for outreach for advisors. Thank you again, and have a great afternoon.