Is it going wrong for the consolidators?

Historically low interest rates begat historically high asset prices. Those made the business models of advice and wealth management very attractive, as most charge ad valorem fees, so their revenues rise as markets rise, without costs doing the same. 

So this is achieved by buying a bunch of firms, each charging fees in that way, and then removing some of the costs to increase the proportion of the revenue that turns into profit.

Alongside that, consolidation created consolidators, as advice and wealth management firms combining meant new fund providers were finding it harder to gain traction because as advice and wealth management firms become larger, so their minimum investment sizes grow, and they may be forced to exclude smaller funds. 

That left a tail of sub-scale funds and fund houses, with pools of assets to be scooped up by others.  

But the spreadsheets that glowed with green ink for most of the past decade are turning a darker hue as rates rise and asset prices fall.  

In the advice market space, those benign conditions also led to higher valuations being paid for firms.

The traditional model is to pay a percentage of the assets under management of a firm to buy it. This multiple is often in the range of 1 per cent to 2 per cent, but amid the flurry of private equity cash in recent years at least one advice firm consolidator began paying 8 per cent of AUM. 

But in rising markets, those numbers can be rendered meaningless pretty quickly; for example, if markets are buoyant then AUM will rise quickly, driving revenue higher.

But if rates rise markets usually fall, and that would be expected to drive down the AUM, and so change the calculations underpinning the purchase by the consolidator in the first place.  

The same general principles apply within the asset management space, and a real world example of how this can go wrong is the recent announcement from AssetCo that its chief executive Campbell Fleming is leaving, amid a 40 per cent decrease in the share price this year to date.

Fleming’s role was to boost the distribution capacity of the collection of boutique asset management acquired by the business, which is chaired by Martin Gilbert. 

Fleming described the six months to the end of March 2023 as, “one of the toughest on record for active equities businesses with a backdrop of relentless outflows across the industry”.

That period coincides with the beginning of the rate-tightening cycle in the US, and the downturn in equity and bond markets around the world. 

And in such periods the sales skills and strategies of even a veteran operator are going to struggle against the headwinds of rates rising at a pace not seen for decades. 

But the story runs deeper than that. Many of the products run by the boutiques were sub-scale when acquired by AssetCo, or concentrated in areas such as UK equities or global equities where demand is either muted for the asset class or where well established incumbents have large funds.

And while consolidation is itself a cure for the problem of sub-scale funds as funds can be merged, time seems to have caught up with AssetCo, as they were not able to create the scale prior to markets turning against them.

Paying the piper 

The second complication is that many of the consolidators in the advice market raised at least some of the capital to buy up firms by taking on debt. 

And again, in the era of loose monetary policy, the calculation was intuitive, with rising asset prices meaning the AUM of firms could reasonably be expected to rise by more than the cost of repaying the interest on the debt.

But rising rates create a double whammy, with the cost of refinancing the debt rising at the same time as the revenue streams are declining. 

And the key here is that just as mortgage holders are presently worried about the costs when their refinancing rolls around – an impact that is spread over many years as each individual is different – so the same scenario faces the consolidators, with a steady stream of refinancing negotiations facing the companies in the years ahead. 

While macro events determine the performance of most asset classes over short-time periods, the decade that may become known to history as the quantitative easing era extended the normal business cycle. 

But such cycles always reassert themselves and force those whose business models were built on the basis of the “old normal” to adjust to the brave new world, and there will likely be casualties along the way.

David Thorpe is investment editor of FTAdviser