Asset Management – Valuation (Part 2 of 4)

Characteristics of Asset Management Firms

Most major asset managers are conservative with their use of 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 as profits fall and they collect a smaller fee from their profit participation agreements.
• Asset managers like to have flexibility via risk management and speculative solutions provided by the trading floors of investment banks. In order to have the most market risk line capacity available for them to engage in interest rate and currency swaps, they need to be creditworthy counterparties.

As such, given the low leverage position – and accordingly 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 grows, 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

1. Price/Earnings, EV/EBITDA and EV/AUM

Asset managers are usually valued on a P/E, 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.

• P/E is the most pure and takes into account the leverage of the company. P/E 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. The type of client that the firm services will also affect this metric – a firm that deals primarily with retail clients will charge much larger fees on their AUM than a firm that deals with institutional clients. This metric is more widely used by the financial institutions group (FIG), 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.

However, the quality of AUM growth is even more important. AUM can grow organically because:

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
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, 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. Companies that continuously get higher inflows will be rewarded with 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.

We have prepared a Brief Guide to Asset Management, you can download it now.

Jason Oh is a management consultant at Novantas with expertise in scaling profitability for retail banks (consumer / commercial finance) and diversified financial service firms (credit card / asset management / direct bank).

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