Adopting the Right Playbook for Asset Management M&A
Asset management M&A activity is at a record high, with deal volume and value in the first two quarters of 2019 exceeding the total for the previous year. Industry and market pressures are largely responsible for this robust M&A activity. In an increasingly competitive industry, many firms are turning to acquisitions in order to quickly grow and leverage escalating fixed costs over a larger revenue base. Meanwhile, incumbents continue to fight numerous cost-pressures and threats from consumer preferences for passive funds. In order to successfully close on the right deals, companies considering an asset management acquisition must adopt the right playbook for evaluating and integrating target companies.
Here are four things companies should consider when contemplating an asset management acquisition.
1. Consider assets under management and sources of revenue growth
The total market value of assets a firm has in its portfolio, commonly known as assets under management (AUM), directly affects its revenue. This is because fee rates are typically derived from a percentage of managed AUM. Rather than simply evaluating AUM as a whole, buyers should look deeper to analyze causality and disaggregation of AUM trends. Is the company’s AUM growing simply as a result of market conditions, or is its success truly sustainable? Evaluating the performance of a company’s sales team, brand, and other functions can also provide crucial insight as buyers look to understand AUM trends.
As part of an evaluation process, companies’ financial models should analyze fee rates and potential fee compression to assess risk. Overall revenue growth may obscure declining fee rates as the industry gets more competitive and faces threats from passively managed funds. Scrutinizing current and future fee rates minimizes the risk of post-deal surprises, and ensures that valuations do not over-estimate future growth.
2. Don’t underestimate distribution and sales strategies
Buyers should ensure they thoroughly understand the target firm’s distribution channels, which will help determine where synergies may exist and where additional sales resources may be required. For example, it is important to know how the target company sells its products to new clients and distributes its fund offerings. Buyers should make sure that any potential cuts to distribution channels or sales personnel take into account any potential revenue impact from the loss of new sales. At the same time, it is important to remain skeptical of any significant reductions in sales personnel that factor in other business impacts—such as future AUM growth rates or potential client attrition.
3. Understand performance fees and potential clawback provisions
Whereas traditional wealth management firms and mutual fund complexes typically earn fees based solely on AUM, hedge fund managers may also earn fees based on performance. Performance fees are payments made to asset managers for generating positive returns and are typically based on a percentage of investment profits earned, regardless of whether these are realized. Since performance fees are based on both realized and unrealized gains, asset management companies face the risk of returning previously recorded profits if a fund’s performance deteriorates in the future—often called “clawback” risk. Buyers should carefully analyze any performance fee components of earnings and understand clawback provisions. To the extent material clawback risk exists, buyers should carefully understand this exposure in order to avoid having to return previously collected performance fees (e.g. through an escrow account or an indemnification provision).
4. Adopt a strong integration plan and carefully assess synergies
If a majority of the value proposition or investment thesis is attributable to rationalizing systems, back-office, or other functions, care should be given to ensure that a proper integration plan and resources are in place following the close of the transaction. Beginning this process early will help to minimize execution risk and ensure efficiency and effectiveness of the integration. Buyers should also understand where “negative” synergies may occur—such as with the loss of key customers—and confirm that their financial models take into account both the potential upside and downside.
Asset management M&A activity is expected to remain strong in 2020 as small firms succumb to fee compression and cost pressures. With the temptation for firms to overpay for M&A targets in order to scale and offset market pressures, buyers must be thoughtful and deliberate in executing their M&A playbooks during the diligence and integration phases of deals in order to maximize deal value.