We’ve written extensively about the challenges facing smaller asset managers and boutique mutual fund firms – the growing tide of passive investing, negative fund flows and fee pressures – making it more expensive to operate from a marketing, distribution and regulatory perspective. It is becoming increasingly difficult for firms to achieve the growth they need to get to the next level, let alone survive.

By any measure, these challenges are not about to subside anytime soon. Firms are either going to have to diversify or access distribution by partnering with another firm. For many, a merger or an adoption as a subadvisor by a larger firm may be a growth strategy to consider. M&A activity among asset managers has been at its highest level ever in the last few years, prompting many firms to take a closer look at their valuations so they can know what to expect should something come their way. On the other side of the deal, many firms have incorporated acquiring and adopting managers as part of their growth strategy.

What should you expect in an M&A today? We reached out to our friend Brad Hearsh, a senior advisor for UBS Investment Bank, for his insights into the consolidation in asset management and what’s driving valuations. Having successfully managed more than 25 asset management transactions since 2010, Brad is a treasure trove of valuable information, so we’re pleased he took the time to talk with us.

What’s happening with mutual fund M&A and what’s driving valuations for small firms?

There are a number of ways to think about M&A in the mutual fund world. There are companies that have mature P&Ls and are generating pre-tax earnings or EBITDA. Many of the large fund companies have reasonable profit margins, even as they struggle to maintain net flows. While they may not be growing as rapidly as in the past, they are still going concerns.

The valuations of these companies in the public markets are based on a multiple of the earnings they generate on a standalone basis and are largely dependent on their anticipated growth over the next 12-24 months.  In a competitive M&A situation, however, these valuations could also include consideration of the earnings created by the elimination of redundant costs in a transaction with another mutual fund platform.

All of that is fine for larger, more mature companies that have significant earnings. But, when you move to smaller firms, they don’t always have a strong P&L. There are just not enough earnings to be valued as a growing concern.  But they have funds or groups of funds that are generating management fees, which are appealing to a larger company. So, you can expect to see valuations that are based on a multiple of revenues from those fees.

We represented a company earlier this year that managed less than $5 billion in AUM spread over more than a dozen funds. They had built a very significant infrastructure which was difficult to operate profitably. So, the company decided it was time to exit the mutual fund business and focus on another part of asset management. Ultimately, a large, global asset manager offered to pay a multiple of revenue, which was close to a multiple of EBITDA because the buyer took on relatively few of the costs associated with managing the funds. They took over a couple of the key individuals, but no other costs. The funds traded at close to 5X management fees because the valuation represented essentially only 6-7x EBITDA to the buyer.

Is 5X revenue typical?

That’s probably on the higher end. The reason for the attractive valuation in that case was because a number of the funds were closed-end funds that invested in attractive, faster growing asset classes.  The risk in the transfer of open-end funds is greater since clients can simply redeem shares at any time.

Many of these transactions involving smaller mutual fund platforms are viewed as an opportunity to pay 5-7x EBITDA, which is like 2-4x revenues. So, relatively low earnings multiples for the buyer but a fairly clean transaction for the seller at a multiple of revenues that reflects a high multiple of earnings of the seller’s business standalone.

What about firms that don’t necessarily want to get out of managing money but don’t want the headache of administering and distributing funds?

That’s the other wrinkle in all of this – where there is an opportunity to sell a fund contract but take back the management of the fund in the form of a sub-advisory arrangement. These transactions are often referred to as “fund adoptions”.  A small number of companies among the bigger firms are open to that approach and work with sellers as sub-advisors. The economics are different because you are going to get less consideration up front. Instead of selling 100% of the management fee, you are selling a portion, say half, and keeping half because you are still running the money.

You have to believe that the multiple of the management fees you are selling to the adopter of the fund combined with what you are going to make on the management fees longer term equals something you find appealing. If you think the buyer can help sell your fund better than you can on your own, there is probably upside in that management fee that you hold on to. I think the valuation is roughly the same in terms of the multiple of management fees being sold, but what is different is you have to come to grips with whether selling only a portion of the management fees is an attractive proposition. Participating in the growth from a stronger brand and distribution can make sense for many smaller firms.

How do you make yourself look better to the market whether you are selling funds or pursuing an adoption?

Where you come out in terms of valuation is dependent on several factors. The most important for smaller firms is probably their investment track record. If the investment performance is strong, the buyer is going to believe it can market/sell the funds and grow the AUM. A buyer in that situation would be more open to do the sub-advisory adoption structure because the manager has an investment team that is responsible for the performance track record.

Asset class is also an important factor.  Some asset classes are currently viewed as currently having more growth potential, such as real estate, infrastructure, private credit, global equities and global fixed income, quant strategies, passives and ETFs and solutions businesses.  Opportunities in these areas will be viewed more favorably from a valuation perspective.  And the revenue from permanent capital vehicles, like listed closed-end funds, will also attract better valuation multiples.

Selling agreements and positions on platforms can be important. If you’re selling to a major mutual fund company, selling agreements aren’t going to matter much since the larger firm will likely have these agreements with virtually everybody already. However, a buyer that is not well-represented or positioned in the intermediary distribution channels might consider selling agreements as a positive.

Another factor – to the extent the seller is willing to part with all the distribution and administrative aspects of the business, either by selling the contracts outright with no ongoing involvement, or with a pure investment management sub-advisory relationship, that means there are more costs to take out of the business. The easier it is for the buyer to map over the funds, the better off the seller is from a valuation standpoint.

Finally, AUM size can be important, too.  A fund or family of funds that have $3-5+ billion of AUM is likely to attract more interest than one of less than $1 billion.

What else do boutique firms need to know about buying or selling?

It’s certainly important for firms to understand their objectives for pursuing a transaction.  Firms with good investment track records that see upside in their strategies may put a higher priority on the distribution strength of a potential buyer—and designing a transaction that allows participation in the future growth of the funds–while other firms may simply want to maximize upfront price.

In addition, the process from committing to a strategic partner to close takes time. The time varies depending on the party, the size of the organization, the level of urgency and the like. Sometimes you spend a couple months thinking through who the right buyers are and what kind transaction process and structure makes the most sense. You also want to invest time thinking about the best way to position the opportunity to the market to generate the maximum amount of enthusiasm, fit and price.

You can then spend another few months in discussions with potential buyers, narrowing the field of interest and ultimately negotiating final documentation with the best party.  From start to signing and announcing a deal, companies can assume it will at least take 3-4 months.

Finally, companies considering a sale or partnership are well served to work with an experienced investment banker to organize an appropriate process for the situation and assist in obtaining best terms from the market.  The same is true for working with experienced legal counsel who will understand the intricacies of the documentation and what protections are consistent with market.

Dan Sondhelm is CEO of Sondhelm Partners, a firm that helps asset managers, mutual funds, ETFs, wealth managers and fintech companies grow through marketing, public relations and sales programs. Click to read Dan’s latest Insight articles and to schedule a complimentary consultation.