by Chas Burkhart
There’s little debate that most participants in today’s markets are focused on the immediate future. Investment horizons in public markets seem shorter and shorter, and M&A is heavily weighted to upfront consideration. Acquisitions are lauded as successful before they even close, and it’s well documented that the majority of strategic M&A is unwound or falls short of buyer expectations. The financial press is often eager to support the cause, heaping praise on dealmakers for strategy, scale and sensational valuations without giving much thought to the future.
It’s all fine when everything is moving “up and to the right.” Rising markets are very forgiving. But what happens when markets roll over, as witnessed in the first half of this year? A short-term trade is fine when the next trade is favorable. But what happens when the future suddenly looks highly uncertain? Or something booked at a high valuation is suddenly worth less? Or an assumed growth rate used to justify a purchase price is increasingly in doubt? My experience dating back to the early 1980s tells me there’s trouble ahead – trouble that could have been avoided with prudent foresight.
The Investment Management Industry and Horizons
The investment management industry comprises countless variations and approaches to the business. Points of view on strategy and tactics vary greatly, from business models to leadership styles to compensation structures, asset allocation, service offerings, etc. There are literally hundreds of different types of investment businesses: lifestyle/boutique/enterprise; wealth management versus institutional money management; private asset-focused versus public market-focused; global client base versus U.S.-centric versus region-specific; 100% employee-owned to 0% employee-owned; 10 bps businesses to 500+ bps (including carry/performance fees); etc. It can be challenging to synthesize all these factors within a single industry.
However, there is one characteristic that runs throughout most of the industry: short-term perspective. We see 1- to 3-year standards for evaluating investment performance, compensation, acquisitions, business planning and more. Ten-year-plus measurements seem irrelevant for making decisions and judging outcomes. Who has the luxury of long-term planning? Who wants to wait around? Incentives—both in positive form such as bonuses and negative forms such as job risk—dictate quick results. So, short-termism pervades.
I’m reminded of a veteran marketing director at one of our former investments, who used to cherry-pick brief investment performance periods that were unquestionably appealing but oddly specific (e.g., look at our 1¾ -year numbers!). We all had a good laugh at the time, but unfortunately, those short-horizon and artificially bookended numbers were often unsustainably good. Conversely, we often see the reverse: good long-term results undermined by recent headwinds. Of course, who relies foremost on longer-term results and isn’t swayed by recent history? Many investment committees suffer recency bias, as do clients. That’s just how it is in a world without patience.
Transaction Activity Speaks Volumes
The phenomenon carries over to deal-making in our industry as well. Valuations paid for wealth management and alternative asset firms over the last few years have grown higher and higher, supported by low interest rates, rising markets, and the greater fool theory. A recent report on wealth management M&A cited an average EV/EBITDA multiple of more than 16x on larger transactions over the past three years (Deutsche Bank US Wealth Management Update, June 2022). While this data is somewhat selective and ignores smaller, typically lower-valued transactions—we’ve seen data suggesting the broad average is 9x—it is corroborated by our own direct observations and demonstrates the high prices buyers are willing to pay. (We also know most of that value is skewed to closing consideration, which shows the risk buyers are willing to take.) The calculus behind return expectations on many of these deals—and there are a lot of them—is remarkable; it requires aggressive compound growth in a relatively tight window. Not impossible, but not exactly likely across a category that has benefited greatly from rising markets for ten-plus years and is now off to its worst start in 50 years and facing a maelstrom of challenges.
Yet true to form, the focus is on the here and now. Sellers receive big paydays at close. Investment bankers are paid at the closing of the transaction. All newsworthy for sure, but no inkling of whether the transaction will survive or flourish.
One long-time industry colleague once said, “beware of anyone who would sell you carry.” The point could be extrapolated to the vast majority of sellers over the last few years. Most are cashing checks at high-water marks in multiples and absolute valuation. Many may have top-ticked pricing, just like the stampede of sellers in 2000—Nicholas Applegate, Bel Air, Fiduciary Trust, J.P. Morgan, Bernstein, U.S. Trust, J O Hambro, United Asset Management, etc. Can you blame them? How many winning offers have exceeded many peoples’ wildest notions of what their firms would ever be worth? If you’re cashing out, why not hit the bid? That’s great for the seller but a catch-as–catch-can for those not receiving big paydays. The better the seller does, the less potential return there is for the buyer, which—when accompanied by underperforming acquisitions—dominoes down to key employees and the next generation of leaders.
And now that 2022 has proven to be a confluence of deteriorating markets, unchecked inflation forces, ever-rising rates and a Ukraine crisis that could well amplify, the assumptions on which most of these transactions have been made are likely to be severely tested in their early years. Five percent, 10%, or even 15% revenue growth assumptions are facing big headwinds now and over the near term. Investors that have paid lofty double-digit EBITDA multiples at close and are seeking to make 20%+ IRRs and 3x+ their money over the next 5-7 years will face enormous pressure and a nearly impossible task. Contrast the frothy M&A environment with the modest single-digit multiples on the world’s largest publicly traded money management firms (7.4x EV/EBITDA in Piper Sandler’s Financial Services Investment Banking Monthly Asset & Wealth Management Report, May 2022). That’s a huge spread between publics/privates and asset/wealth management. T. Rowe Price, Invesco and AMG are all being valued at plus or minus 6x EBITDA currently. What would 6x get you in the private transaction marketplace?
Many of these acquisitions are thoughtfully strategized, but now they need time more than ever. An extended market malaise will create significant misalignment, pressure, and disruption over the short term. Over the next few years, many deals may look horrendous; over the next 10-12 years, many might prove resilient and value-creating. You could say the same thing about any firm on its own, organically driven and uninvolved in any deal-making. Extended poor or mediocre markets will drive decisions that would not have to be made in sunnier times. We would not be surprised to see transaction activity morph to reflect the changes in market conditions. A sensible expectation would be a greater focus on outcomes (usually through deal structure).
What is Success, Really?
Remember Engemann, Rittenhouse, and Brandes – darlings of the wrap business phenomenon of the 1990s? They and the other leaders in this segment had desks and chairs packed into every room, hallway, and closet as they took in tens of billions in assets over a few years. Huge success stories. Within ten years, however, most of the assets evaporated, the furniture was auctioned off, and many of them were marginalized to extinction.
The current market rollover raises interesting questions. What is success? Is it top-ticking a trade, even if the bottom later falls out? Is it achieving stability through volatility, even if dollars are left on the table late in the cycle? Is it better to achieve top-decile annual performance once in a while, even if it’s punctuated by bottom-decile performance rather than consistent second-quartile performance over a longer time period? And whom should we ask? The press favors sensationalism (“Here are the top funds year-to-date!”), but I doubt few believe this actually highlights the best investor or client outcomes. But even among investors—individual and institutional alike—investment performance evaluation has long gravitated to some combination of recent track record and annual performance. Can you imagine an investment world in which five- and ten-year rolling periods were the primary measuring sticks? They are much truer pictures of sustainable success than a year or two, which is essentially the contrast of a few nights of blackjack versus a year of playing every day. Take this chart from J.P.Morgan’s 3Q22 U.S. Guide to the Markets, which shows the wide range of outcomes presented by a one-year horizon and the sharp contrast with the much narrower (and consistently positive) range of outcomes over ten or even 20 years. It’s amazing what a little patience can do.
And what about M&A outcomes…should we judge them on short notice? Can we really discern success from failure at the point of transaction or in the near term? Media headlines and recent pricing structures would suggest we can. History tells us otherwise.
Can you imagine an environment where sellers were measured over the succeeding ten-plus years following their transaction? Where bankers were paid at least a portion of their fees on the long-term success of the deals they oversaw? Where compensation of key executives actually lined up with long-term shareholder gains?
Volatility is a Given, Left-Tail Risk Needn’t Be
Living in the moment has its merits, but it doesn’t lend itself to longevity. Steadily rising markets are nice while they last, but they never last forever. Drawdowns require double the recovery to get back to even. Momentum trades require a sharp sell discipline. Paying heady valuations in a cash-at-close transaction can be painful if the bottom drops out, and the collateral damage can be broad.
There will always be peaks and valleys in our industry: market-fueled growth; hyper success in short increments; washouts of hedge funds and any “current environment” strategies that don’t perform to the satisfaction of the owners, clients, or both over a few years. Whether making deals, launching funds, or setting strategy, you always risk being on the wrong side of a short-term bet. The variable is whether you have the ability to work yourself out of tough times. Long-term committed partnerships should lead to better decision-making and risk management. In his book How the Mighty Fall, management guru Jim Collins discusses the waterline principle: don’t risk blowing a hole in the boat below the waterline. Live to fight another day.
Now is the time to put on the glasses with the longest-term lenses. Solid investors, solid strategies, and solid thinking will endure. The industry’s obsession with short-term fuses and myopia will likely cause great dislocation and put a lot of things on the cutting room floor. The silver lining—for those still standing strong—will be the new opportunities that arise from those ashes.