Recent studies have shown that volatility and risk aversion in the financial and investment markets over the past year have slowed the pace of M&A activity in the Registered Investment Advisor (RIA) sector. Although the momentum that led to more than 70 deals in 2007 has clearly slowed, the current dislocation provides strong businesses with opportunities to capitalize and enhance the value of their brand. In taking advantage of these opportunities, however, businesses will face the challenge of obtaining access to the right kind of capital.

Historically, owners of privately held asset management firms have had a limited number of options available to them when attempting to capitalize the value embedded in their businesses. As a result, the owners (often the firm’s managing principals) have typically resorted to third parties to provide liquidity, most frequently in exchange for some portion of the firm’s equity.

This path, however, introduces a new set of challenges. Among other considerations, it erodes or eliminates independence entirely while diluting embedded value. The lack of meaningful economic participation for key talent can contribute to employee turnover, which may negatively affect investment performance or client services and slow the gathering of new-business mandates. 

Historically, if an organization wanted to remain independent and sell equity internally to members of the firm, the founding principals frequently took a significant discount to fair value by subsidizing or self-financing the purchase. If bank debt was used, it frequently burdened the business or its principals with a host of onerous restrictions and requirements. 

Most asset management firms lack the capital base and physical assets to provide the needed security for lenders to make bank debt, when available, an efficient source of capital. In contrast to other industries that regularly use leverage in the normal course of business, asset management firms often lack the appropriate banking relationships. As a result, lenders frequently impose burdensome financial covenants on the business, including the requirement of personal recourse to the firm’s principals, in order to provide credit. For these and other reasons, bank financing is not usually a desirable alternative. In today’s environment, given the level of distress in the banking sector, it may not even be an option for many organizations.

Although private-equity investors may be somewhat flexible as to the amount of equity they purchase or the terms of the arrangement, they will typically attempt to impose some degree of governance control over the business. This control may include voting rights, compensation limits, and consent requirements. Beyond a characteristic desire to influence the operations of the firm, private-equity investors might also seek to influence the long-term economics associated with their investment and expose the enterprise or other owners to greater risk in the process. Among other measures, this effort may include a put option to sell back their equity stake at guaranteed minimum return levels following a certain period of time. 
The principal drawback to raising equity capital, however, is of a more straightforward nature: Equity capital is dilutive in perpetuity and consequently reduces the economic value available to firm principals or other owners for the life of the business.

If the owners of an asset management firm are intent on maximizing the current capital value of their business, they might sell to a strategic partner that will typically offer enhanced economics based on its view of perceived synergies and the associated long-term growth potential. Moreover, with a more diversified capital base, a strategic acquirer might also require lower rates of return than an investor financed entirely with equity capital and thus further enhance valuations. This approach often provides substantial capital to the sellers. But as with private equity, it usually comes at a high economic cost, particularly for growing organizations. Further, depending on the size of the investment or the nature of the partnership, it may also place severe limitations on the organization’s independence.

The financing challenge historically faced by independent asset management firms has been met with varying degrees of success by a number of innovators. Consolidators commonly purchase majority equity stakes across a broad spectrum of asset management firms and provide distribution and back-office centralization. Other, more recent industry players vary in their combination of equity ownership with the degree of passive or more hands-on participation in the business. Compared with private- or strategic-equity capital, many of these solutions offer greater flexibility and autonomy. As with traditional sources of equity capital, however, many are economically dilutive in perpetuity.

For independent asset managers wanting to remain independent, traditional resources are clearly an imperfect solution to the capitalization problem. When available, debt capital frequently imposes onerous terms, and equity capital typically limits independence and dilutes the economic benefits available to principals and other shareholders. In sum, the value-proposition for traditional resources is severely challenged.

In contrast, revenue sharing arrangements can provide less restrictive capital and preserve independence and autonomy for owners of asset management firms who are unwilling to sell equity. In the past, revenue sharing referred to a perpetual arrangement between owner and subsidiary. More recently, it has been detached from equity ownership and has become solely a capital vehicle. This approach provides the firm principals with up-front capital in return for a fixed-percentage interest in the top-line revenues of the firm for a limited term. With this approach, sometimes called a Revenue Share Interest (RSI), owners enjoy the benefits of increased profitability as businesses gain efficiency with scale. Because the RSI is self-amortizing and survives only for a limited term, the revenue interest reverts to the owners upon expiration. This structure, therefore, allows for the possibility of additional investments, should future capital needs arise.

By using RSIs, which are passive in nature, the owners of asset management firms can both access significant capital and maintain the business structure and culture that enabled the firm to become successful. With zero fixed liability, limited covenants, a fixed term, and limited economic participation, RSI investments provide asset managers with a superior source of capital for growing and managing their business.

RSI investment represents a new, efficient, and sustainable capital resource for the asset management industry. It provides wealth managers with access to significant risk-sharing capital without sacrificing autonomy or ownership and, as a result, leaves businesses free to pursue their strategic goals. As the marketplace evolves, asset managers can avoid many of the disruptions and pitfalls that traditionally accompany a search for liquidity and can focus on investment performance, relationship management, and building brand value.

Alexander G. von York is Vice President of Asset Management Finance.