June 12, 2020
Managing Through Uncertainty and Disconnect…
Good Prep is Good Practice
The investment industry is in a precarious position of late, as markets have risen and appear to have run right through a wall of economic worry this quarter (yesterday notwithstanding). Secular change and pressure have been building steadily among asset owners, managers, and intermediaries in recent years, and are now being exacerbated by the 2020 forces acting on our industry. Waning demand for active management, pockets of continued fee pressure, demand for more holistic, solutions-based services, the arms race in technology platforms, rising regulation, disintermediation, size and scale objectives: these issues are but headliners in a long and growing list.
The late-cycle emergence of the COVID-19 virus and ensuing social distancing shutdowns across the world rattled markets in March, but right up until yesterday major indices had regained much of the lost ground despite clear economic stress. In fact, despite massive unemployment and a number of industries operating at a fraction of capacity, earlier this week the S&P 500 was just 5% off its all-time high! Rapid and historic fiscal and monetary response have provided a significant economic backstop, and it seems the market expected the virus to run its course, other risks to abate, and the world to normalize. The full impact of shutdowns on corporate profits won’t be known for some time and could take years to fully recover. On top of that, long-simmering civil unrest and the approach of what’s sure to be a fiercely debated Presidential election in the US have created even further turmoil and uncertainty. Most equity markets surged in the last month or so as the confluence of the pandemic, national protests, and the battered economy have put the country in a precarious position not soon to be reconciled. How is it that such widespread pain is marrying up with such a swift market recovery? Perhaps yesterday the reckoning began.
We’ve given a lot of thought to what all this means for investment management organizations. We would not be surprised to see the short-term recovery turn out to be a bit of a mirage and providers face an extended period of meaningfully lower revenue, which would in turn pressure income statements, balance sheets and even capital structures. And even if the markets do not roll over for some duration—as we all would prefer—mounting secular pressures won’t abate. There are tough issues all organizations should address to improve their odds of near- and long-term sustainability and their competitive positioning.
We recently co-hosted a webinar titled “Will the Industry Need More than PPE?” in which we discussed potential implications for all investment organizations should COVID-19 and/or other catalysts generate a protracted downturn. Our focus was on three key topics: leadership, economics (especially compensation and expenses), and external ownership. We think these three topics are fundamental business issues for everyone in our industry.
- Leadership. Clearly, firms with strong, decisive leadership will be advantaged in an extended downturn. Now is the time to be assessing leadership capabilities, learning from other well-run organizations, contemplating the implications of a lengthy setback and gearing up to make hard decisions. As investors, we here at Rosemont have witnessed a direct correlation between leadership and outcomes. Our experience—both through our 31 investments and countless other observations—clearly shows that poor leadership, absenteeism, acts of commission or omission, unwillingness to make unpopular decisions, personal greed, etc., are key determining factors behind the least successful businesses and investments. Intuitively, the most successful ones have been run by extraordinary leaders.
- Economics. In a downturn, a decline in asset balances would likely lead to a similar decline in revenue and a much greater decline in profits. Of course, top-line pressure may be exacerbated or mitigated by factors such as billing structures, performance fees, net flows, etc., and the need to cut costs and/or restructure would depend on the specific business’ overall level of profitability and cost structure. For example, managers operating at 25% or lower net income margins are in jeopardy, as a significant decline could erase all margin and force unwanted action. It’s a valuable exercise to consider—prospectively—what actions might be required, how they would be implemented, and what consequences might result. For example, what level of compensation reduction would employees tolerate, and in what sequence might comp reductions be implemented? In which functional area would you first reduce headcount if necessary?
- External Ownership. M&A is likely beginning a period of unprecedented activity. Most parented organizations—that is, those with over 50% held by an outside entity/entities—will face additional pressure in a downturn as their parents grapple with their own challenges. This may manifest as less financial support, a greater focus on cost cutting, or even outright divestment. We’ve started to see numerous instances of this already within just a few months of the March pullback. All parented firms should be having frank conversations with their outside owners and seeking to better control their destinies before stress levels ratchet up.
We are strong believers that companies should be getting their houses in order, modeling the potential impact of lower assets and revenues and considering what adjustments might be made to costs and what pivots need to be made to strengthen the organization competitively. If we experience a meaningful and protracted downturn, the strongest will thrive, the mediocre will limp along and the weakest will be merged, shut down, or fade away. And if we don’t see a downturn, everyone will be better off for the planning.
Respectfully,
Brad & Chas
About Rosemont
Rosemont Investment Group is a private investor in asset and wealth management companies, backed by permanent capital. Over the past 20 years we have been minority equity partners in dozens of firms, in all cases majority-held by employees. We serve in a non-controlling advisory role, providing solicited guidance on issues ranging from high-level strategy to functional decisions and assist in business and corporate development. www.rosemontinv.com
March 27, 2020
Implications of the COVID-19 Crisis
An issue that affects everyone in the investment management ecosystem—whether managers, intermediaries, or allocators, etc.—is the effect of revenue declines on cost structures. A number of articles have touched on the viability of boutiques through the crisis (for example, “Restaurants Are Being Destroyed. Money Managers Should be Scared” and “The RIA Profit Margin to Weather a Pandemic’s Recession“). Cost cutting/restructuring—whether at smaller boutiques or larger enterprises—has material implications.
- Q1 revenue impact is a bit of a wildcard, though first-quarter billings are only days away for most. Even more unclear is Q2. Managements are trying to scenario-model what the top line might look like to understand bottom line impact and thus the implications for forward spending, reinvestment, bonus pools, etc.
- Firms with 40-50%-plus cash flow margins can obviously tolerate revenue declines much better than their poorer margined peers. However, the owners’ perspective on where that impact will be felt most ranges from incredibly self-centered to company-first attitudes. At least they have the flexibility to take margin hit and protect the status quo. Firms with narrower margins and more revenue sensitivity are being forced to act, and it’s going to be hectic and divisive for many. Net inflows or outflows will mitigate or exacerbate this problem.
- Specific cost-cutting measures are varying. Travel spending has obviously evaporated, but this is typically only a fractional % of costs. Other discretionary line items may be tweaked, but comp—as the biggest line item, by far, for every single manager—is a likely area of action. This will play out in four ways…(1) reduced profit distributions, (2) comp cuts for senior execs, (3) comp cuts across the board (bonuses, even salaries), or (4) layoffs.
- We’ve heard a range of responses thus far, from full speed ahead to indefinite termination of all hiring activity, and layoffs. Anecdotally, public managers have been the most aggressive thus far, with a spate of hiring freezes (e.g., BlackRock and JPM, in contrast with privately held Capital Group). Many companies will use the downturn as cover for contemplated personnel changes. And if the downturn extends and margin impact worsens, we will see far more layoffs. A few large companies have, for now, offered assurances there will be no short-term layoffs (e.g., Morgan Stanley, Citigroup, Deutsche Bank).
- Distribution is often an early target for layoffs, as new business activity slows, less productive members can be trimmed, and these aren’t seen as harmful to clients. Does not apply to client service/relationship management, which is more important than ever. Trimming investment talent is tricky, as the most “expendable” tend to be the least expensive.
- Implications for future operating structures abound. Remote working is likely to be seen in a better light going forward; certainly many are getting more comfortable with video conferencing. This may translate into reduced physical footprints, more hoteling, etc. Also, firms may reconsider their commitment to (or adoption of) open office space as workspace proximity and lack of barriers elevate contagion risk.
- Parented managers are perhaps most in the crosshairs. Revenue contribution, allocated expense, and relevance are coming under the microscope. Look for shuttered/merged units, spinouts, and more battle lines drawn between management units and their parent company owners.
Despite the massive volatility and shockwaves of the last few weeks, we need to remember it’s early in this saga. Many chapters are still to be written, just as the effects of 2008 manifested themselves over many years after the sub-prime crisis. Duration is in some ways more important than magnitude. Allocators and gatekeepers are watching closely to see how managers respond… how responsibly they manage their businesses, what they prioritize, etc. Some allocators will use this as a catalyst to make change, others will form deeper loyalties. This crisis is going to be very revealing.
Respectfully,
Brad & Chas
About Rosemont
Rosemont Investment Group is a private investor in asset and wealth management companies, backed by permanent capital. Over the past 20 years we have been minority equity partners in dozens of firms, in all cases majority-held by employees. We serve in a non-controlling advisory role, providing solicited guidance on issues ranging from high-level strategy to functional decisions and assist in business and corporate development. www.rosemontinv.com
March 18, 2020
Where are the modern day Oaktrees, Silvercrests, Silchesters, Champlains, Magellans, Mawers, GMOs, etc.?
As advisors and/or funders to a number of commercial-grade investment management startups—including several of the names above—the subject matter has been a preoccupation of ours for over 30 years. But over the last decade, risk appetites for starting commercial investment businesses have noticeably dried up. Why?
Compensation and ownership perspectives are the primary ingredients. Personal and competitive compensation “requirements” have become far more important than the prospect of creating substantial value and sharing fairly in it. Industry pay has proved attractive and resilient for even mediocre PMs, relationship managers and operators. Successful professionals are rarely considering both taking significant pay cuts and helping fund a new entity. The founders of each of the above firms did so, as did countless others in the 1970s-2000. Equity among the boutique set has come to be viewed much more as a compensation enhancer and entitlement, not a foundational orientation and/or risk proposition.
There are multiple other factors at work. Oversupply across most asset classes and widespread pressure on allocators and intermediaries have made it much harder to start at dollar zero or de minimis AUM. Emerging managers more often submerge than emerge, and often such firms get out of the gates with fragile infrastructure and limited functional expertise, relying on a key person or two. And it’s an even harder proposition for the preferred return/high watermark business model, where getting behind the eight ball early or often spells doom. Startups of significant personal means can fall back on their own capital; those with little means face daunting odds and the Shark Tank quandary from backers and allocators (i.e., are they willing to give up what it will take to get a deal done). Non-solicit agreements are ubiquitous and daunting. Meanwhile, recruiters are constantly seeking quality professionals for their clients. And what if early performance is soft, or worse? Staying power is hard. Challenging markets, personal tragedies, etc. all can add up to unlucky outcomes -and timing is always a big part of the equation.
And yet our discussions with gatekeepers and allocators across the global investment industry make it clear there is keen interest in uncovering modern-day startups who really have what it takes – and are built to absorb multi-year business risk. What GQG and DoubleLine have accomplished over the last five to ten years is remarkable and rare.
To be clear, commercially sustainable startups face a high bar. The vast majority of startups are lifestyle pursuits with little or no long range planning. Their success correlates strongly to the founder’s (or founders’) abilities and timeline. Commercial grade startups launch with clear leadership, functional excellence across the board, a tenured pedigree, significant client loyalty, a distinctive investment engine, and alignment across all constituents.
For most startups over the last 50 years, business risk was a simpler and more intellectual consideration than the stomach-churning reality it is today. And yet for many owners of investment businesses – financial institutions, outside investors, clients – their priorities will shift and their patience/timeline will prove finite as markets fall and pressures build. Size, scale and relevance will be under the microscope.
This market dislocation should be a springboard. The backdrop includes ample financing, a sea of mediocrity in which to stand out, material wealth creation over the last decade, and allocators seeking excellence. Business stress is likely to shine a light on diverging interests and priorities, creating an opportunity for ambitious, capable, entrepreneurial leaders to emerge.
Even in the current market carnage, opportunities are germinating. Perhaps a new generation of commercial-grade startups are on the way.
Rosemont Investment Group is a private investor in asset and wealth management companies, backed by permanent capital. Over the past 20 years we have been minority equity partners in dozens of firms, in all cases majority-held by employees. We serve in a non-controlling advisory role, providing solicited guidance on issues ranging from high-level strategy to functional decisions and assist in business and corporate development. www.rosemontinv.com
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