BATTEN DOWN THE HATCHES
Managing Through Uncertainty and Disconnect…
Good Prep is Good Practice
June 12, 2020
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.
Brad & Chas
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