Fund manager M&A deals will fail ‘unless you dive deeper’

This essay appeared in Citywire Selector on April 13, 2011. 

To weigh the opportunities and risks in buying a fund managed by BlueBay, Thames River or other investment managers, a research analyst must perform extensive research and due diligence.

It follows then that, in contemplating the acquisition of an entire company such as BlueBay or Thames River, which were recently bought by RBC and F&C respectively, research and due diligence of a much greater magnitude and expanse is required.

But are participants in mergers and acquisitions really doing all of their homework before taking the plunge? Surprisingly, not as well as we might think.

My comments in this article are not specific to either RBC or F&C – these two companies are mentioned only as recent examples of prominent transactions. Acquiring an entire company is a complicated and time intensive undertaking. Because of the dependence upon human capital, innovation and complex distribution relationships, asset management is a particularly challenging industry in which to conduct a transaction.

Long before a deal closes, a potential buyer must get input from experts who provide opinions and advice on critical aspects of a target company. In the traditional approach to assessing a manager for M&A purposes, a buyer gains insight from lawyers, investment bankers and business/operational consultants into the principal businesses, financial structure, operational platform, contractual relationships, and legal obligations of the company. Little is done by way of a deep dive into evaluation investment capabilities, product platforms and distribution relationships.

Clearly, a great deal of insight is gained through the due diligence process executed in the lead up to a deal. Yet its standard format often does not explore driving factors unique to the asset management industry. In order to get a full view of the company considered for acquisition, a buyer needs to take into consideration the sophisticated clients who, through their buying of investment products, are ultimately responsible for the success or failure of a company. Given their experience and position, professional buyers of investment management products have an incomparable perspective on the industry.

Here’s why. Asset managers are valued on metrics associated with either earnings and revenue generation – earnings before interest, taxes, depreciation, and amortisation (ebitda) is commonly used – or as a multiple to assets under management. To derive either of these two figures and to project their growth with confidence, one must understand their source.

In the contemplation of many M&A transactions, the quality of a product and its underlying managers is too readily equated with performance track records, current AUM and recent flows. Further, though valuable and an important consideration, a strong brand name can give a target a lustre (and premium valuation) that is not truly reflective of the quality of an asset manager’s product offering and future potential. Prospective buyers are prone to ‘starry-eyed syndrome’.

As research analysts recognise in their daily work, history is a fickle indicator for what can reasonably be expected in the future. Investment performance is subject to cyclicality, alpha decay and luck masked as talent. Like the ever present warnings to end investors, acquirers of asset managers should heed the warning that past performance is not necessarily indicative of future results.

In my research, I have found that there can be a wide analysis gap between the work done by buyers of asset management products and buyers of asset management companies. In taking a broad approach to analysis and valuation, buyers of companies often fail to look deeply enough into the investment capabilities and products that ultimately drive financial success of a company. It should also be noted that fund selectors can learn from the extensive due diligence executed by M&A specialists – particularly with regard to the assessment of operational and firm level risks.

It is commonly recognised that flows follow performance of investment products. The question then for the buyers of an asset management company is: ‘How can we be confident that the performance (and flows) will continue or will improve?’ This is the same question that fund selectors ask themselves everyday when analysing managers.

The qualitative elements that are so important in assessing the sustainability of performance for a manager running a fund are applicable to understanding the entirety of that manager’s company. What typically appears as a single line of revenue generated by management and/or performance fees is in fact reflective of an aggregated approach. While the traditional approach to M&A due diligence starts from the top down, fund selectors begin with a bottom up analysis of individual products and work their way up.

In reality, the top line revenues of an asset manager consist of a variety of revenue streams by way of multiple investment strategies, vehicles and client commitments. An in-depth evaluation of the most important revenue streams provides the basis to identify weaknesses and stress-test certain assumptions about a target’s ability to continue to grow AUM and produce strong results. The evaluation provides key information needed to truly understand the value of the business and to clearly articulate risks.

Combining product research into a sum of the parts approach through analysis of the particular components of the investment engine identifies risks lurking beneath the surface. Significant and potentially unsustainable drivers of performance (and AUM) or concentration risks are identified. Large explicit or implicit bets in an industry or sector across multiple portfolios may be present and can have unforeseen implications. Investment processes may be unrepeatable or weakly articulated. Investment decision making may be unrepeatable and/or dependent upon an unstable individual or team.

Over the past couple of years, I have had extensive discussions about past and ongoing deals with investment bankers and asset management executives involved in M&A transactions. Having been previously on the other side as a fund selector and key client of asset managers, I have taken great interest in discussing how deals get done. While there are many organisations that do take an in-depth level view of capabilities, there are a significantly high number that don’t. When metrics and value managers are discussed, it is odd how some of the most basic things that fund selectors focus on get overlooked. In my unscientific surveying, those deals which have proven successful use an approach that includes important criteria used by sophisticated fund research analysts in selecting funds.

Indeed, the success of an asset manager is also dependant upon the areas typically evaluated during the execution of due diligence; strong legal, operational and financial platforms are critical for the viability of any company. But, particularly as the asset management industry and products evolve and becomes more complex, getting to the core of the business is crucial.

Furthermore, while the experts traditionally tasked with executing due diligence will be focused on the industry, the analytical methods they apply are unlikely to resemble the rigour of a sophisticated investor. Lacking the tools and experience, the due diligence review will not reach into the most important areas of a target. To do so requires knowing where and how to look.

This article originally appeared in the April 2011 issue of Citywire Global magazine.