The 1980s proved to be the renaissance period for the independent, investment counselling firm in Canada. According to Benefits Canada, there were 29 Canadian investment counselling firms in 1978. Of these, five were the money management divisions of insurance companies and trust companies. In 1978, the institutions accounted for some 78% of the pension assets managed by the largest 40 money managers in Canada.
By 1988, ten years later, per Benefits Canada, there were a total of 75 Canadian companies classified as investment counselling firms – and, of these, 15 were the investment arms of institutions. One other statistic: of the 24 independent investment counsellors in 1978 (excluding the five captive firms of the institutions), just 15 were still around in 1988.
With 60 independent investment counselling firms in 1988, the number had increased by 45 – or triple the number in 1978. As well, the percentage of the assets managed by what I refer to as independents within the Benefits Canada Top 40 increased from 16% to 57% over this ten year period.
This got me thinking about the life cycle of the money management firm in Canada – as of 2013, only 12, or 20%, of the 60 independent money management firms in Canada remained; and three of these had a significant ownership change. Why?
The vast majority of the investment counselling firms that were established in the 1980s were set up as partnerships, typically by individuals who had gained investment experience managing pension and other assets within one of the major institutions. The barrier to entry for the investment counsellors was fairly low as start-up costs were minor and most of these new firms began with one or more of the clients for which they had managed money at the institution they left.
Generally, however, the life of a partnership is finite. I believe the independent money manager partnership goes through four stages in its life cycle.
STAGE I: VISIONARY
In Stage I, if the partners have moved on from one of the institutions, they have met secretly for months to get registered, find a business location, and set the date for departure. Typically, before start-up, the partners have convinced some investors (either pension plans or private wealth clients) to “seed” their operation by providing assets to manage.
The partners have either worked together or have known each other well in one capacity or another. As a result, they have a high degree of trust and respect for each other – so much so that the focus is much more on how the partnership is to be formed rather than on how the partnership should mature or be wound-up. The energy level is high – partners are willing to work long hours to make it work. They know that the rewards can be substantial. The focus is to deliver returns sufficient enough to attract potential clients.
Now in the 1980s, forming a partnership to manage pension fund assets was not that difficult – basically, you, required a Canadian equity team and/or a Canadian fixed income team. And, since most of the assets were managed on a balanced fund basis, you really did not require an economist or asset-shift manager. Having a full complement of three or four professionals was all it took. The Foreign Property Rule introduced in the early 1970s kept money managers focused on the domestic market.
Unless one or two of the partners brought with them a major asset base, the ownership was often equally divided among the three or four founders. This brought a strong sense of partnership and commitment.
The founding partners were, typically, 100% money managers – not marketing or servicing specialists, nor business managers. They would make decisions jointly, which would become a problem later in the evolutionary process. Roles were not well-defined.
The business plan was simple: bring in as many assets as you can, as fast as possible. In the money management field, success is generally measured by the growth and size of assets under management.
STAGE II: ADVERSARIAL
In this stage, all the attributes of the partnership in the Visionary Stage begin to unravel – and it might not even matter if the firm is successful or not. Equality does not last over time. Somewhere between five and 15 years the balance changes. There are two major events that have an impact at this stage: the first represents the equal (or close to equal) sharing of the profits of the firm. As an example, let’s assume the firm has four partners – two on the equity team and two on the fixed income team. After seven years, the asset split between the two teams is 70% managed by the equity team and 30% managed by the fixed income team. However, the split of the profits at the end of the day is a quarter for each partner. This imbalance will typically result in friction over time.
The second event affecting this stage is the impact consultants have had as being “agents of change”, and dismantling the balanced fund approach. In the 1970s and early 1980s, consultants began to separate out the performance of the components of balanced funds and then compare each of these returns to specific indices. As well, consultants also began to create samples for equity-only mandates and bond-only mandates. This put pressure on the internal partnership as monies could be taken away from one of the two teams. Money management firms were forced into taking sides: should they focus on equity investing or fixed income investing?
This created strain on the partnership as focus shifted from managing money to managing the business – not what investment professionals like doing, or have the skills to do.
The culture could become ever more problematic. A long-term business plan was virtually impossible to create. The focus slipped, and participation in meetings was often heated. Here, the “blame-game” was prevalent. If the firm was not successful, it had to be someone’s fault. If the firm was successful, the balance of power shifted and not everyone was an equal partner anymore.
Also in this stage, distractions tend to arise and outside interests become more important. Some partners might want to spend more time with their family, some would like to take more time to spend at the new vacation property that their success allowed them to purchase, and some want to spend more time on their hobbies (e.g., golf, tennis, etc.). This I describe as being distracted by “little shiny objects” – which all have a negative impact on focus. All of a sudden, some partners are still putting in 50- to 60-hour weeks while others are spending a lot less time on investment matters than they did previously – and less than others. Relationships become very strained.
If the partnership were a marriage, we would describe this stage as the “seven-year itch” or a “mid-life crisis”.
STAGE III: STAGNATION
The third stage is the muddle-along stage. The partners have not been able to settle their differences and, therefore, must find a way to co-exist – at least to give the outside world the impression that everything is okay within the new, much larger firm. Anything else will affect their standard of living. By now, there are very few constructive meetings among the partners. And, the firm’s distinct culture may well have split into two or three sub-cultures.
The first stage (Visionary) can, typically, last five to ten years. The second Stage (Adversarial) can cover a further five- to 15-year time span. Now the firm has around a 15- to 20-year history. As a result, the founding partners are in their late 40s to late 50s. At this phase of their lives they are looking to cash out. Coming to work is no longer the fun and challenge it once was. If the next generation cannot afford, or are not willing to buy them out, then, they must look to an outside capital source. Also, in the back of their minds they know if they sell to a third party they will likely have golden handcuffs which will require them to stay on with the firm for anywhere from five to seven years.
Not much gets accomplished at this stage; the firm is adrift.
STAGE IV: SEPARATION
As highlighted in my last article, The Evolution of the Canadian Money Management Industry, there have been over 130 “changes” (e.g., mergers, takeovers, going public, going private, etc.) within the Canadian, money management industry over the past 35 years. I cannot find more than five of these changes which I believe worked out for the acquiring firm and, therefore, it is unlikely that it worked in the clients’ best interest.
Once this stage is reached, a major event has to happen – there needs to be a catalyst for change. However, in the majority of cases, an obvious catalyst never comes. Unfortunately, from the outside looking in it is difficult to recognize that the landscape has changed. It is possible that the firm could be revitalized or re-engineered; however, this is difficult to orchestrate as the partners now have different views (and, likely, timetables) as to what needs to be done. It solves everyone’s problems to sell to an interested party. It is the easiest out.
As history has shown, the life-cycle of an investment management firm rarely lasts more than 25 to 30 years – with many firms having a lot shorter lifespan.
THE TIPPING POINT
So, how do you know when your money management firm is for sale? You can’t find out from your manager as, if “in play”, their company lawyers would have both parties sign a non-disclosure agreement. Since no one would tell me, I created a formula that will, at least, send up a warning flag. The formula goes like this:
As an example, if the total share-ownership of the top five professionals is 60% and the average age of the top five is 55 and the company has been in business for 20 years – I get a total score of 135. Any score above 120 gives me concern. Now, if the firm has been in business for just five years, and share-ownership of the top five partners is 80% and their average age is 45, I am not as concerned. The most important factor here being the age of the firm.
Now, most of the senior partners of money management firms say that they are planning for succession, and will pass down their share-ownership to the next generation and, indeed, most try to do this. However, in practice, I find this seldom to be the case. It is just plain economics. Shares, typically, trade at some formula of book value inside the firm whereas a buyer outside the firm might be willing to pay up to three times book value. There really is not much financial incentive to pass the firm on to the next generation.
In my formula I allow for the rare event when the founding partners’ shares get distributed to others. However, the share ownership of the founding partners must be drawn down at a minimum of three times the rate that their average age is increasing. I feel more comfortable where the combined ownership of the top five falls below 50%.
At the beginning of this article, I stated that there were 45 new, independent, Canadian investment counselling firms which originated between 1978 and 1988. On top of this, there were the 15 firms established before 1978 – bringing the total to 60 Independents in 1988. In 2013, only 12 of these were left standing – an attrition of 80% over this 25-year period.
Now this might seem strange, but I am not a fan of broad share-ownership throughout an investment management firm. Once the number of shareholders exceeds 10, I begin to worry. I understand the concept of wanting to keep and reward top investment professionals and employees. However, when ownership becomes too broad and is distributed across generations, it creates potential conflicts as the goals and objectives of each generation are different. I believe this is a major reason why very few independent money management firms in Canada have built up their own international/global investment expertise. The first generation within the partnership does not want to put out the money, or dilute profits, to build this expertise in-house as the payback period is, typically, beyond the founding partners’ exit date.
So, if not ownership, then what? A well-designed profit-sharing plan will do the job, provided it incents the right behaviour for a sustainable business.
Partnerships, by their nature, create a generational issue. It is very difficult to pass on the reins and culture from one generation to another. The success ratio has not been good. As stated in my previous article, the main reason for plan sponsors to be concerned when their money manager is sold is the cost in every sense and the risk associated when moving assets from one manager to another.
Consultants have, basically, three trigger points for terminating a manager: 1) consistently poor performance that lacks a “style” explanation; 2) departures of key personnel; and 3) ownership changes. All three create noise, disruption and lack of investment focus within a money management organization – and all three are easily tracked. However, by the time this occurs, the damage might already done.
And, in a catch 22, the more successful the firm, the greater the chance it will be sold to an outside party. The prescient plan sponsor should be looking for the organizational warning signs and be prepared to shift even while results alone are still acceptable.
One addendum: as a money management firm goes through their four stages, there is another major event that plan sponsors should be made aware of – and that is the impact of size. A firm that is highly successful in acquiring assets will reach a certain point where value-added created by their specific investment expertise is hindered by the overall size of the assets managed resulting in a significant market impact (i.e., not being able to move in and out of the market as they once could). This constraint will negatively affect value-added returns. As indicated earlier, success can create failure.
J.J. Woolverton, CFA is a partner with AMS Partners Inc.