Some allocators believe that owning an equity stake in an asset manager delivers a leveraged exposure to market beta. And with most allocators seeking to reduce their portfolio’s correlation to risk markets (such as equities or credit) it is not surprising that some allocators assume that asset management equity stakes offer little utility for their portfolio. However, we would contend that this assumption is at best simplistic and, arguably, completely inaccurate.
Firstly, let us consider the basis for this belief by examining a simplified hypothetical asset manager, which we will call “TradCo Capital”. TradCo earns a 0.5% average management fee investing in a risk market. After expenses, it earns $10m profit at a healthy but not unusual profit margin of 40%.
If the market declines by 20%, our calculations suggest TradCo profits will slump by 50%! Conversely, a 20% market return boosts TradCo’s profits by 50%. That’s a nice outcome in a rising market (which history tells us will be the most typical market environment) but, ouch, the negative returns in a declining market will hurt most investors which hold this asset. Even worse, our calculations suggest all of TradCo’s profits will be wiped out should their risk market drop by 40%.
But when we look back to 2009, the average asset managers’ profit margin declined by only 6%, from 34% to 28%1. Why didn’t profit margins decline more when the S&P 500 suffered a peak to trough decline of 48%?
Sharing the pain
Most asset managers pay a percentage of their profits to employees in the form of variable compensation, such as cash bonuses and long-term incentive plans. How much is paid varies from firm to firm, but a pay-out ratio of 33% of pre-tax pre-incentive profits is not atypical.
With the addition of variable compensation, TradCo’s employees share in the pain (and the gains) of the market movement, helping to mitigate the impact on TradCo’s profitability.
Sell, Sell, Sell!
In bear markets, retail investors often head for the hills, selling at the bottom. Alderwood Capital does not invest in retail asset managers; we focus on institutional managers. This provides some additional help. To keep things simple, let us assume that TradCo’s institutional clients target a strategic asset allocation of 60% to assets like TradCo’s and 40% to other assets which have a correlation of 0.2.
So in our market decline scenario, TradCo’s clients respond by rebalancing into TradCo’s strategy. When our risk market is performing well, the clients withdraw some of their gains to allocate to other assets. How does this affect TradCo?
So the combination of variable compensation structures and client rebalancing now means that the impact on TradCo’s profits, down 23%, is similar to the negative 20% market return (and in sharp contrast to the 50% reduction in profits shown in Figure 1). The simplistic belief that the impact would be some leveraged multiple of the market movement is debunked.
Can We Do Better?
Our hypothetical TradCo example is a useful illustration of what you might expect from owning shares in a large generalist asset manager listed on the stock market. Here at Alderwood Capital, our investment universe is very different from a TradCo – we focus instead on private equity stakes in specialist boutique asset managers. Our target investment differs from TradCo in a number of important ways:
1. Investment processes designed to protect in down markets.
2. Lower fixed costs and higher profit margins.
3. Often with performance fee structures.
Let us look at an illustrative hypothetical boutique, which we will call “BoutiqueCo”:
Our BoutiqueCo’s investment process outperforms in the bear market. This alpha may partially offset the negative impact on BoutiqueCo’s AUM from the market decline, mitigating the negative impact on management fee revenue. Subject to the details of the fee structure, the relative outperformance may also trigger significant performance fee revenues2.
BoutiqueCo’s relative outperformance means it is well positioned to win new accounts from other allocators who are rebalancing back to their strategic asset allocations or who are replacing existing managers who failed to protect their clients’ capital. With the combination of rebalancing, net flows and performance fees, the net impact of the bear market is to boost BoutiqueCo’s profitability.
We would expect BoutiqueCo to struggle for alpha when markets are racing ahead. As long as their clients understand their process and have bought into their philosophy, clients should tolerate periods of underperformance and be retained. The bull market still helps boost profitability, but the impact is mitigated by clients rebalancing
An Endowment Model Outcome, with Down-side Protection
Once fully deployed, Alderwood’s portfolio will include investments in managers of investment strategies which span multiple asset classes, and we will actively seek out equity investments in managers of uncorrelated asset classes. The overall underlying asset class exposures should be not dissimilar to an endowment portfolio.
The benefit of accessing these exposures indirectly via equity stakes in the asset managers (alongside a portfolio which invests directly in these asset classes) is that the combined impact of variable compensation, client rebalancing, performance fees and institutional net flows all serve to protect the portfolio in bear markets for risk assets. As a result, if we do our job well, Alderwood’s investors will benefit from cash flows driven by exposures similar to a broadly diversified multi-asset portfolio but with enhanced downside protection.
However, this is not a free lunch. It requires Alderwood to identify actionable deal flow via our intermediary and proprietary origination networks. Our team’s ability to assess whether those targets have developed an investment process, team and culture capable of delivering sustainable alpha will be tested once again. Even if we have successfully identified and executed investments in quality firms which fit our criteria, those firms may be challenged by events such as changes in their clients’ investment policies, turnover of key personnel and regime shifts in markets. Diversifying our portfolio mitigates but can not eliminate these risks.
At our prior firm, Northill Capital, roughly half of our investee managers’ combined AUM was invested in alternative assets and private markets such as infrastructure, private credit, insurance linked securities and multi-asset portfolio solutions with large exposures to hedge funds and private equity. The remaining half was invested in managers of “traditional” asset classes such as concentrated, benchmark unaware listed equity portfolios and sub-investment grade credit.
We only regret that our tenure from 2010 – 2018 didn’t include a proper bear market. We’re looking forward to the next one.
1Source: BCG / Piper Sandler. 100 manager sample representing $52bn AUM.
2The illustration in Figure 5 assumes BoutiqueCo earns performance fees for outperformance of their benchmark, which is typical for long only or long biased public equity managers. A hedge fund manager managing a market neutral or low beta strategy would typically need to generate a positive absolute return above any prior high-water marks before crystalising a performance fee.
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