EY’s Asset Management Transaction Advisory Services professionals are in demand as asset managers, including hedge funds, have been embracing robust levels of corporate activity. The Hedge Fund Journal asked Principal, Simon Western, what is driving the increased level of transactions, and explored the diversity of buyers, sellers and deal structures.
Western, a ‘Green Card Brit’ who loves living in the US, has been an investment banker covering asset management for EY since 2012, having previously held positions at Merrill Lynch, Goldman Sachs, Bank of America and Nomura. His group maintains a top-level strategic dialogue with C-suite executives, typically the CEO or CFO but sometimes a Head of Corporate Development where the role exists. The breadth of the practice’s client base – ranging from traditional asset managers running trillions to niche alternative asset managers, including hedge funds – gives EY a panoramic perspective on what Western views as “unprecedented change impacting the asset management industry”. Additionally, EY’s transactions practice can garner some insights from its affiliated audit, tax and consulting practice (with information barriers applying where appropriate).
The past five years has seen more transaction activity across the alternative asset management industry than in any other five year period (or indeed longer periods) in Western’s career. Thus 2015 saw 42 deals by hedge fund managers together running $252 billion, and making up around 8% of the $3 trillion industry by assets, according to Madison Street Capital. “Most transactions are driven by a founder or owner who wants to get some level of liquidity. The other recurring theme is a business with good investment capabilities but without access to strong distribution capabilities,” Western sees. Very few deals are defensively motivated, as net redemptions and challenging periods for performance seen by some managers tend to be shorter term factors that ebb and flow with market moods. EY’s discussions with key decision makers have identified six secular, multi-year, trends impacting the industry.
The search for yield
Developed world interest rates have been very low for nine years and Western is of the opinion that rates may remain lower for longer. Seven trillion dollars of sovereign debt has negative yields. “This presents an obvious challenge in delivering income to investors, and particularly retirees,” says Western. In certain countries the problem is exacerbated by demographic change in the form of ageing populations, particularly in China and Western Europe. Indeed, the United Nations World Population Ageing: 1950-2050 report says “population ageing is without parallel in human history” and finds that no country has a population that is getting younger! As predictable, defined benefit pensions outside the public sector are nearly all closed to new members, and in most countries, retirees need products and strategies that can generate income in a low rate world.
Shift from active to passive
Another force for change is the relentless growth of passive investment at the expense of active, and principally fundamental active, investing. “Active management has been called into question as performance after fees in large cap equities has often lagged indices,” says Western. Investors are increasingly using passive investments for their core book. Fundamental, active equity saw net 2015 outflows of $207.3 billion while index funds gathered $413.8 billion, according to Morningstar. This understates the growth of passive flows as futures are also seeing strong growth: CME Group reported e-mini S&P 500 volumes up 31% year on year in the first quarter of 2016. Similar trends can be seen in fixed income with active flows turning negative in 2015, says Morningstar. It is palpably harder for traditional asset managers to raise funds.
Alternatives and multi-asset class investing
Partly as a consequence of the aforementioned two trends, allocations to alternatives are increasing: from circa $1 trillion in 1999 to circa $7 trillion in 2014, according to a World Economic Forum report on alternatives. Foundations and endowments in the US always had relatively high, double digit percentage allocations to alternative strategies. Now other institutional allocators, such as pension funds and insurance companies, inside and outside the US are designating strategic buckets for alternatives, including hedge funds. Hence alternatives are seeing faster growth than traditional assets, with liquid alternatives a way of wrapping them into regulated open or closed end fund structures. UCITS hedge funds have latterly shown particularly strong growth, advancing assets by 30% in 2015 according to Lyxor Asset Management.
The search for better risk adjusted returns also lies behind a move towards multi-asset class investing, which often has a high degree of overlap with alternatives. This might involve equity alongside credit or some less liquid alternatives to capture illiquidity premiums. In summary: “Hedge funds that were once perceived as a source of outsized returns for high net worth individuals, are now more likely to be viewed as a source of diversification for both individuals and institutions,” says Western. McKinsey forecasts that by 2020 alternatives will make up 15% of industry assets but 40% of industry revenues, as fees are on average higher than for traditional management.
Search for ‘solutions’
‘Solutions’ is becoming a ubiquitous term, which may be over-used, “but there is a demand for products fulfilling specific investor needs,” Western notes. Target date retirement funds with an in-built dynamic glide path between asset classes, designed to generate a specific payoff at a particular maturity, are one example often marketed to individuals. Liability-Driven Investment (LDI) is another ‘solution’ aimed largely at institutions such as pensions and insurance companies.
Individuals displacing institutions
EY also sees individuals growing their relative share of assets vis a vis institutions. “The maturity of the institutional marketplace makes this inevitable to some degree as does the wholesale shift from defined benefit to defined contribution pension plans,” observes Western. Defined contribution plans and individual retirement accounts nearly doubled assets from $7.3 trillion in 2008 to $14.2 trillion in 2014, while defined benefit assets grew only from $7 trillion to $10.4 trillion over the same period, according to the Investment Company Institute. This means that many firms want to access individual investors and need to decide whether to do so directly or partner through vertically integrating with a distribution partner.
EM growth trajectory intact
The final trend that EY identifies may surprise some readers but illustrates the long term perspective of EY and its asset management clients. Though emerging markets have been out of favour for the past few years, taking a multi-decade view EY identifies “higher economic growth and capital formation, combined with new regulations for retirement saving, as boding well for growth of assets,” as Western explains.
Growing breadth of buyers
Heeding this new landscape, buyers including public and private firms, financial and strategic, active and passive are expressing views on which firms and combinations thereof are best positioned. Some buyers are purely financial and hands-off, some are mainly strategic and others can involve a varying balance of each. “Some financial buyers have raised third party capital, in limited life private equity style funds, which often have intended maturities of 10 years or more – and might become permanent if the sponsors choose to eventually list them,” Western sees. But if capital is returned to investors in these vehicles, then stakes may need to be divested.
Other buyers, including some publicly listed ones, are housing the stakes on their own balance sheets and could therefore have a theoretically perpetual time horizon. Some acquirers are completely passive while others have substantial resources to support targets. “Some buyers have teams of 10 or more staff offering a whole host of services, helping targets with seeding, capital introductions, talent management and operational advice on the back office and mid office side – if the target chooses to use them,” Western observes. The hand-holding is not obligatory and if targets do not want any interference they will not get any.
Among strategic buyers are publicly traded alternative asset management firms that want to diversify revenue streams and grow earnings. Having perhaps started with a private equity business they may be moving into other areas, e.g. real estate, hedge funds, or illiquid credit – to generate other streams, and patterns, of management and performance fee income. These buyers want full control to wed targets together into a single entity. “Publicly listed alternative asset managers need to demonstrate their continuing growth prowess, and may be particularly interested in increasing their share of management fee income relative to performance fee income,” Western observes.
“Companies need to position themselves strategically for success,” stresses Western. Where firms have gaps in their product suite or skillset, an acquisition may seem swifter and simpler than developing expertise organically from scratch. For instance: “Traditional asset managers that have found themselves with outdated, out of fashion or commoditised products and capabilities,” may want to plug gaps in their line up by adding hedge funds, real estate, infrastructure or private equity. Traditional life insurance companies with long term sticky money are an example.
There is even speculation that a technology giant might enter the asset management business and Western is willing to entertain this possibility. “Technology firms have a huge user base and huge trust between users and the firm, so this could make sense, but a legacy asset manager with legacy systems might not match their culture.” Instead, Western wonders if a tech firm might acquire one of the new firms in the small, but rapidly growing, marketplace of digital advice.
Considerations for sellers
Western sees no sign of the momentum abating in corporate activity as the drivers are real and compelling. “Costs are going up, investor demand for products is changing substantially, distribution is getting more expensive, and this all increases pressure on the industry to do transactions”. One factor pushing up costs is “new regulations for asset managers that were hitherto less regulated than insurers or banks,” says Western. More compliance, lawyers, monitoring systems, technologies and human capital are needed to monitor it all. Another reason for amalgamations is that “larger institutional investors are becoming more sophisticated and want to work with a smaller number of broader asset management partners, so they need scale, product breadth and high quality performance”.
But the most obvious motive for selling part or all of a hedge fund management business is monetising a part or all of the wealth created. Some founders also want to leave a lasting legacy before they retire and/or pass the baton on to successors. Other deals have more strategic rationales, which include accessing distribution channels, raising seed or acceleration capital, or kick-starting new product launches, sometimes in new asset classes or strategies.
Deals have nearly always been private transactions (we know of only one asset manager IPO in 2015) for the simple reason that not many sellers are willing to be a public company. Currently public capital markets are not generally offering alternative asset managers compelling valuations, and the public market is highly selective in what it is willing to support.
But multiple factors affect valuations of asset managers and Western sets out the important nuances. “There are differences between public and private market valuations; between traditional and alternative asset managers; between controlling and minority stakes, and between management and performance fee income”.
A further distinction is that valuation metrics differ between private and public markets, with EBITDA multiples applying to the former while PE multiples or post-tax earnings multiples apply to the latter. Private valuations of asset manager corporate transactions are disclosed in a minority of instances and Western cautions against extrapolating generalised valuation metrics from this subset of deals. Valuations can vary with asset classes, strategies, fee levels, and the quality of the company, but in broad brush terms Western sees “control transactions are often taking place at 7-9 times management fee EBITDA plus a discounted multiple of typically 3-4 times performance fee EBITDA”.
Lumpy and unpredictable performance fee income is being ascribed a modest single digit EBITDA valuation multiple at best, and no value at worst, according to Western. In public markets the implied valuation placed on performance fee income is inferred by applying a typical 7-9 times EBITDA multiple to management fee EBITDA and subtracting this valuation from the overall enterprise value. Though this is less than the 8 to 11 times EBITDA range that Western saw a few years ago, it is still more than public company valuations based on different measures of earnings – and occasionally higher quality targets can command still higher premiums over depressed stock-market multiples. Indeed, if publicly listed alternative asset managers continue to languish at low valuations for an extended period, Western would not be shocked to start seeing one or more go-private transactions.
Clearly at the right point of the cycle alternative asset managers’ performance fee income can be multiples of their management fee EBITDA. This is one reason why sellers sometimes do have a more robust view of the growth and valuation prospects of their firms than do buyers. Valuation multiples for controlling stakes can be greater if the transaction is structured with an earn-out so that the total price is not cut and dried on the day of the deal. Where there are differences of opinion over valuation, “you can sometimes bridge the difference with an earn-out that involves the buyer paying a portion of the consideration up front at the time of closing with potential to earn a further consideration over the next 3-5 years if certain growth hurdles are hit,” Western explains. Earn-outs are in fact typical of private deals, he finds. They have the added benefit of aligning incentives between sellers and buyers by rewarding the buyer for attaining growth targets agreed to in advance.
Minority stakes can involve somewhat lower valuations, because there is no need to offer the seller a control premium, with “financial buyers often paying 5-7x blended EBITDA including performance fees,” Western observes.
Conceptually, earn-outs acknowledge that it may take time to find out how strong the synergies between two businesses are or for the management team of the seller to prove out asset retention and growth post deal. Additionally they are a bridge between the growth rate a seller believes it can achieve and what a buyer is willing to pay up front. And with or without any earn out, “the best deals tend to involve a courtship period to find a good cultural fit,” Western explains. He counsels that sellers should be mindful that “they are giving up control and modifications to corporate governance mean that new partners may want seats on the board or management committee. Teams also need to be kept happy as do investors most importantly of all”.
A lack of cultural fit is one reason why banks have not always been the best stewards of asset managers. For instance, banks are not always comfortable offering competitive compensation to portfolio managers, and there can be conflicts of interest between banking and asset management. Suboptimal corporate combinations can lead to pressure for demergers, which EY also advises on.
Whither the asset management industry?
Western has been advising asset managers for nearly 20 years and has some inkling of what the industry may look like in another 20 years. One scenario is that the industry becomes bifurcated between behemoths and boutiques, with the middle ground hollowed out. The behemoths “could combine traditional fund management, quantitative ETFs, and illiquid private market strategies such as commercial real estate, credit, or infrastructure, all under one roof,” and one of the giants is already a role model for this.
Alongside these dominant players Western sees space for “a swathe of small niche focused firms with very narrow product focus who can show they consistently deliver”. Western is of the opinion that “unless regulatory costs escalate massively we will still see a tremendous number of hedge funds”. Despite higher barriers to entry he still expects to see hundreds of them, albeit with a smaller group of larger scale players at the top, and thinks fees are sustainable if hedge funds can deliver strong risk-adjusted performance net of fees, in addition to lower correlations to mainstream financial markets.