- 1 Asset Management Industry Primer
- 2 Asset Management Business Model
- 3 Valuation of Asset Management Firms
- 4 Client Segmentation in Wealth Management
- 5 Related Reading for Asset Management
Asset Management Industry Primer
We define asset managers as institutions that take a fee for managing money via investing it for a beneficiary. Asset managers will take care of client funds via a variety of products and asset classes. These asset classes include public equities/stocks, fixed income/bonds, money markets, commodities, infrastructure, real estate and alternative strategies – including hedge funds, private equity and venture capital.
The asset management industry involves being a steward for the money of individuals and institutions and managing them in order to meet the unique return objectives of the client. The asset manager can be compensated in a variety of ways, including fixed fees, pay for performance and as a percentage of assets under management (AUM).
Due to the steady nature of the business (taking a percentage of assets under management per year), asset managers have a business valued more like a basic corporate than financial institutions such as banks and insurers.
Asset management can be broadly divided into retail and institutional asset managers depending on what kind of money they handle. However, the largest firms can cover both – the best example being Blackrock. Clients can be subsegmented into general retail, high net worth, ultra high net worth, institutional, pension, and corporate.
Different asset managers may specialize in different asset classes – for instance, Fidelity is known for being a public equity mutual fund shop while Brookfield is an alternative asset manager that has historically focused on hard assets such as infrastructure, power and real estate. However, there are no set rules and asset managers will often dip outside of their historical expertise, poaching star portfolio managers from other firms to start their own funds in different asset classes.
As a rule of thumb, the higher the average return of the asset class, the higher the management fee. Management expense ratios for equity funds are higher than those of fixed income, which are in turn higher than that of money markets.
Major traditional asset managers include Blackrock, Vanguard, Fidelity, PIMCO, Invesco, Franklin Resources, Affiliated Managers, T Rowe Price, Eaton Vance, Legg Mason, Janus Capital, Aberdeen Asset Management and Federated Investors.
Asset Management Business Model
Asset Management Fees
Revenue is a function of assets under management or administration and the fee charged on these fees. Retail asset managers will offer a variety of products including mutual funds, index funds and specialized pools. Some asset managers are merely acting as a temporary custodian, in which case the fee is mostly administrative. When the mandate of the asset manager is to grow the capital, the fee will be higher. The more advanced the strategy and the more expertise required, the larger the fee will be (for instance, a specialized high yield bond manager specializing in oil and gas). For most investors, they will see this in the fund prospectus and marketing materials as the management expense ratio (MER) and any administrative fee.
For alternative asset managers, fees can be substantially higher than the 2% management fees that are the mutual fund standard. Hedge funds may have a 20% profit participation in addition to the 2% of AUM management fee. Private equity firms will have carried interest provisions where the fund that achieve a similar payout (with some jurisdictions offering tax benefits).
When the stock market is performing well, most asset managers that are equity or stock focused will have higher assets under management at the end of the year. Higher assets under management will of course equal higher fees. As such, asset manager performance tends to be correlated with stock market performance. A good asset management will see assets grow even when the broader market is flat or falling. Especially with stocks having run up continuously since the financial crisis, there is a growing demand for asset managers who are able to generate consistent returns uncorrelated with the market and asset classes that fulfill this mandate (real estate and infrastructure).
Larger index funds may also use their funds for securities lending for short sellers. This may generate additional revenue.
Expenses in Asset Management
Once the assets under management have yielded their fees, asset managers must pay salaries (the most expensive of which being the portfolio managers for the respective funds – if the PM is seen as a driver of AUM, whether through sales or performance, he can command a much higher share of the proceeds than a PM who does not). The actual sale of mutual funds is often done by third parties to the asset management firm, so trailer fees will have to be distributed to the respective salesperson. These two will constitute the largest expenses.
Trailer Fees and Distribution Channels
Selling through third party channels is a direct cost of sales – as third party and independent distribution channels will take cuts of the MER via trailer fees. As a starting point, trailer fees are 50% of the MER, but depending on buyer or seller power, this can go 60-40 either way. For instance, if a mid sized asset manager is selling its mutual funds via a small bank, the bank may only get 40% of the MER. Conversely, if the asset manager has a distribution agreement with HSBC, they can expect HSBC to get 60%.
The administrative fee is separate, but if it is included in the total MER structure, it ends up being 40-40-20 (the 20 being for covering administrative expenses).
Asset managers may also outsource other asset managers for specific mandates that they do not satisfy for some portfolios – they will skim a margin off the top or negotiate a split for the MER.
Portfolio Manager Salaries
Star portfolio managers are what drive people to put money into asset manager funds. If a PM has a high yield bond fund that outperforms over a long period of time, when he moves the funds have significant flight risk as well – these stars need to be compensated to not move. Compensation may be as a % of AUM, based on performance or a combination thereof.
Large asset managers will have a large supporting analyst team for their PMs, with some PMs having their own investment teams where analysts are paid handsomely. Analysts will conduct investment research, organise meetings with investable firm universe names and perform other miscellaneous tasks.
These teams will have to pay for data services and intelligence via Bloomberg and equity research. All in all, these can add up.
Operating Margin in Asset Managers
After other selling, general and administrative expenses – including large scale marketing efforts from the ads you may see in the financial district – we can get to the operating profit of the asset manager. Asset managers are rarely highly levered, so net income is fairly easy to get to after tax (although asset managers may have holdings in other asset managers, complicating the consolidation).
Operating margin is a very important metric for asset managers as it reflects how much of the fees generated are kept by the company. This is a major reason for asset manager M&A as there are large economies of scale from cutting general and administrative expenses as well as increasing selling power to third party channels and distributors. As a general rule, higher AUM given a similar operation (retail vs institutional, active vs passive) means a better operating margin for traditional asset managers.
Some expenses are more redundant than others. Commissions are less likely to be reduced via consolidation as payments to third party salespeople are often fixed.
Characteristics of Asset Management Firms
Most major asset managers are conservative with leverage. There are a couple of reasons for this:
- Asset managers can see cash flow and earnings fluctuate wildly with markets. For instance, with an AUM of $100 billion and average fees of 1%, the asset manager has $1 billion in fee revenue. If there is a financial crisis, the stock market falls by half and the asset manager’s performance is in line with the stock market, they now make $500 million. This will have a pronounced effect on leverage and coverage metrics. For alternative asset managers such as hedge funds, their cash flows may be cut by more than half because they do not have torque from their profit participation agreements.
- Asset managers like to have flexibility via risk management and speculative solutions with the trading floors of investment banks – in order to have the most market risk line capacity available for them to engage in swaps for interest rates and currencies, they need to be creditworthy counterparties.
As such, given the low leverage position – and accordingly relatively lower interest payments – and consistent fee based model, asset managers tend to generate strong free cash flow, which is spent on return of capital initiatives such as dividend hikes and share repurchases. As AUM growth goes, dividends will be slowly increased as well, but not to a level where they may become unsustainable if the market tanks. For very good periods of performance that management feels may not continue, they may choose to park cash opportunistically or repurchase shares.
Valuation of Asset Management Firms
Price/Earnings, EV/EBITDA and EV/Assets Under Management
Asset managers are usually valued on a Price/Earnings, EV/EBITDA and EV/AUM basis. As a secondary metric, large asset managers with diversified businesses may also be looked at from a free cash flow yield perspective.
Price/earnings is the most pure and takes into account the leverage of the company. Price/Earnings is a good representation of what flows through to the shareholder.
EV/EBITDA is pre-leverage and is also considered by most equity analysts – but it needs to be adjusted for timing for deferred commissions and sales charges as they are real costs to the firm despite possibly not showing up in the current valuation period. As such, analysts will smooth these data.
EV/AUM is nice in theory, but can only be used to compare against close peers in practice. As an illustration, a passive asset manager may have a very large AUM, but the fees that they earn on their product may be 10x lower than that of an equity mutual fund firm. The type of client that the firm services will also affect this metric – a firm that deals primarily with retail clients will be charge much larger fees on their AUM than a firm that deals with institutional clients. This metric is more widely used by financial institutions group investment bankers or the corporate development teams of banks for precedent transactions analysis.
Asset management valuation primarily focuses on Assets Under Management (AUM). A larger AUM means a larger fee base which means more revenues while incremental expenses do not scale as much. Accordingly, AUM growth is imperative for share price appreciation. Declining AUM is negative for financial stocks.
However, the quality of AUM growth is even more important. AUM can grow organically because of 1) rising markets boosting the value of the assets managed – which can be looked at as beta exposure; 2) the outperformance of the asset manager versus its benchmark – which can be looked at as alpha generated and 3) net inflows via more investors giving the asset manager their money.
If AUM rises with the markets, this is not high quality growth – especially if the asset manager’s funds are not beating their peers or benchmark. From a valuation standpoint, financial stock investors will give less credit for AUM growth in a rising market in earnings and cash flow multiples. Returns are also not dependable or consistent, so analysts tend to discount them more heavily.
If AUM rises because of net inflows (or conversely, declines due to net outflows), this means that the sales team is doing a good job of marketing the product – something that is made much easier by having funds that beat their peers on a regular basis (so as to justify the fees). Companies that continuously get higher inflows will be rewarded by higher multiples as best-in-class firms.
AUM can also grow inorganically via mergers and acquisitions. M&A makes increasingly more sense in today’s investment environment because of the cost synergies and reluctance of investors to shop around. When purchasing a declining firm, a quality acquirer can try to salvage outflows but there is an expectation that not all of the AUM will be captured – however, the NPV savings from cost cutting and possible cross selling from an augmented distribution channel will also be considered.
The strength of the distribution channels will also be considered. Firms that have a large network of internal and third party distributors are much more likely to win new client business and valuations should reflect this.
Current Valuations for Asset Managers
Valuations right now are mixed. A major positive catalyst for the industry right now is the current bull market. Stocks are seeing multiple expansion and earnings are rising as investor sentiment is high. This means higher AUMs which translates to more revenue under a larger fee base.
However, the flows are changing, as investors – especially millennials – lack confidence in the legacy financial establishment due to active management having underperformed passive management (just buying an index) and greater transparency towards the fees that they pay. This means lower AUM for active managers who have seen mediocre performance.
Also, retail investors are going more global and have better choice. Today, the world’s markets are becoming increasingly accessible via several ETF platforms and discount brokerages. Investing is no longer a rich man’s hobby and people do not have to go through their banks.
Retail asset managers are seeing the greatest dispersion between winners and losers.
Independent, traditional asset mangers that do not have scale, prestige or good performance have languished. Fees for the industry on the whole are falling, so this means significant margin compression on the assets that they do manage – assets that are dwindling as there are net redemptions from their funds. This is during a bull market as well, so any downturn can cause an accelerated fall in share price.
As such, asset managers that have historically traded at a premium to other sectors in the market are now well below market and historical peer multiples for Price/Earnings and EV/EBITDA.
However, alternative asset managers such as Blackstone and high volume, best in class firms have soared. Blackrock is up 15% YTD as of January 2018.
What this means for smaller firms is that there is a view to consolidate. Asset management is an industry that scales well – higher inflows and better performance leading to a higher fee base (AUM) means a pronounced increase in assets, but without a commensurate increase in costs. The number of people hired for administration, legal and accounting does not change much with more money. Conversely, it does not change much when there is less money either. There are obvious cost synergies with asset manager mergers in terms of eliminating redundancies for administration.
Client Segmentation in Wealth Management
Retail Wealth Management
Retail investors are everyday investors without much buyer power. Generally, retail investors are individual investors without liquid investable assets of USD 1 million – although the allure of a more bespoke investment counsel is not compelling until USD 5 million.
The retail business will come with the highest fees, so at least on a gross fee basis, this offers the highest return on AUM. Retail investors largely invest in mutual funds or segregated funds, although there is increasingly a flow into ETFs for passive investing – sometimes via automated platforms such as roboadvisers for millennials.
Usually, the firms that have bee the most effective in getting retail clients historically are those with cross-sell opportunities and distribution channels. Large mutual fund companies have strong relationships with banks, where they are able to pay a trailer fee to bank investment advisors to market their product. Mutual funds may also go through independent broker channels to sell on a pure commission basis, although upfront fees (loads and deferred service charges/DSC) are disappearing amidst investor knowledge and ethical concerns.
In countries with concentrated banking sectors, the banks will have enough scale and cross-sell opportunities to have their own major asset management divisions and the accessibility to banking clients. For instance, if a client goes to meet a financial advisor to talk about opening a savings account, the topic of mutual funds can be brought up. It should also be noted that in a concentrated banking market such as Canada with 5 main domestic banks, management expense ratios will be much higher than that in a fragmented market such as the US.
For passive investing, Blackrock and Vanguard are able to get costs very low due to their scale and skill in replicating a benchmark index. However, they will also make money via securities lending when other market participants want to borrow against their stocks for shorting.
Roboadvisors such as Wealthfront and Betterment will charge fees based on money managed – the roboadvisors will automatically rebalance portfolios which are constructed with low fee ETFs. Investing through roboadvisors means that investors still have to pay the fees on the ETFs in addition to the rebalancing/administrative fees. For these firms, the margin is very low for the AUM, so the way to profitability is via scale.
Firms that retail investors look at include Fidelity, Franklin Templeton Investments, Invesco, Aberdeen Asset Management, T Rowe Price and Legg Mason for active investing and Blackrock and the Vanguard Group for passive ETF investing. Millennials are increasingly looking at roboadvisor firms such as Wealthfront or Betterment.
High Net Worth Wealth Management
High net worth clients are classified differently according to the jurisdiction and the relative prestige of the firm. At regional banks, the threshold for HNW usually falls around USD 1 million. At global institutions, the threshold will be closer to USD 5 million.
Although this technically gets investors access to tailored investment solutions in addition to alternative or private funds that are not available to retail investors, this does not necessarily constitute a benefit in terms of investment performance (nor are fees substantially lower at the $1 million dollar level). The attractiveness of this platform, in addition to the larger suite of products, is the bundling of services such as tax and estate planning.
At this level, asset managers also collect fees via the selling of mutual funds, but may also provide tailored investing via constructing a portfolio for the client and charging an annual fee (essentially a private mutual fund) or a % charge based on assets under management for administration. Once assets are large enough, fees will fall for the investor, but not to as low as what institutional investors can get.
Between retail and HNW is usually an “economy plus” option for clients with assets over the equivalent of USD 100,000 in their country. What this means is a dedicated financial advisor that will also be available to recommend a variety of mortgages and loans, but is merely a semi-enhanced version of what most people qualify for. Ultra High Net Worth (UHNW) with liquid, investable assets above USD 25 million qualify for private banking.
As a standalone product, HNW asset management is not that attractive – what makes it attractive is the bundling of services in a one-size fits all solution that can help finance a yacht, get a commercial mortgage and help their children get floor seats to the latest Taylor Swift concert.
The firms that sell to high net worth individuals are large the same as the retail platform, but under a different Series of funds which means increasingly lower fees once certain investment thresholds are met. Someone with $10 million in Fidelity will be paying much less per dollar of AUM than someone with $1 million.
Institutional Asset Management
Institutions that have money managed include pensions – state, public and private, insurers, other financials – managed via a third party where fees are split, non-profit organizations (Red Cross, World Vision), endowments (Harvard/Yale/Princeton) and corporates. The same dynamic applies – the larger the client, the lower fees can be negotiated down.
The largest funds tend to be state investment funds/sovereign wealth funds and pensions. These funds have a mandate to ensure their beneficiaries will be able to receive fixed payments over a certain time period.
Although many of the largest funds can hire the best and the brightest to work for them and are good stewards of capital that outperform their benchmarks, they will also allocate monies to third party alternative investments via external hedge funds and private equity managers. Examples will include the Canada Pension Plan Investment Board (CPPIB).
Large unions and smaller state or provincial actors will tend to go to third parties, still making considerable assets the prize for various institutional managers.
Just from the sheer scale of the assets, asset managers will aggressively pitch for the opportunity to manage pension money by cutting fees or having high watermarks to ensure returns. State funds are tax exempt, making low fees able to drive low returning funds that would not clear private investor hurdles into acceptable profitability. To put into perspective, pensions are able to pay very competitive fees compared to retail investors.
As choosing the right fund manager means a difference of billions of dollars, pension consulting and manager selection is a lucrative business. The institution that looks to outsource asset management will work with consultants to find an appropriate manager based on factors such as performance, risk profile, fees and management tenor – with a preference for longstanding portfolio managers.
Recently, private pensions have become a dwindling source of funds for asset managers as employers continue to switch to defined contribution payments for staff where they are not responsible for a guaranteed sum after retirement as opposed to the defined benefit pension where they are. However, for more egalitarian countries such as Canada, state pension funds such as CPPIB have been given a mandate to expand.
Related Reading for Asset Management