Given all their in-house talent, they should be much better at this.
Asset management businesses should have a deep understanding of capital allocation. It is literally their day job.
We know from investing in companies that management teams who are good capital allocators create considerable value, whereas poor capital allocators can reduce great businesses to mediocrity.
But are asset managers themselves great businesses? How well have they allocated capital? Do they walk the talk?
Large asset managers certainly have the potential to be great businesses. They generate free cash flow because they don’t require much capex, hold no inventory and suffer no bad debts. On top of that, a large component of the cost base is variable in the shape of bonuses.
Yes, there’s pricing pressure from passives but most businesses face similar problems. One positive from the intense focus on fees is that it creates higher barriers to entry for competing startups.
Another advantage is that rising markets over the long term should also help offset some pricing pressure, even if assets under management (AUM) do nothing but match the index.
Let’s do the data
We can test how good these companies are at capital allocation by looking at the returns of publicly-quoted asset management businesses – there are around 30 in Europe and the US.
Using Bloomberg data, I analysed 16 of the largest listed asset managers responsible for some $20tn in AUM, assessing each one’s total return (price performance + dividends reinvested in the company’s shares) and their capital allocation since June 2017. We could go back further but corporate activity before then reduces the sample size.
The MSCI World Index produced a total return of 112% over that period, equivalent to 11.2% a year. I think this is a fair benchmark despite the different bond/equity components among the managers.
The results? Not so good. Just four of the 16 asset managers beat that index – Alliance Bernstein, Cohen & Steers, BlackRock and Man Group.
On top of that:
- Seven generated returns of less than half the performance of the World Index.
- Five returned negative total returns in dollar terms: Schroders, Franklin Resources, Invesco, Abrdn (TAMFKA Aberdeen) and Jupiter.
What went right?
What did the winners do so well?
The five companies that beat the market on average, returned all their cash flow to shareholders through dividends and buybacks.
The top two – Alliance Bernstein (+179%) and Cohen & Steers (+165%) – paid all cash flow to shareholders as dividends and did no buybacks. They also spent no cash on acquiring other asset managers.
The list of negative returners (Schroders, Franklin, Invesco, Abrdn and Jupiter) paid on average 63% of their cash flow to shareholders as dividends.
The two US managers there are notable for such poor performance despite being so much closer to the hot US equities market. Franklin Resources returned -22% and Invesco -34%, despite the latter being the manager of the mighty $297bn QQQ technology fund, the world’s fifth largest ETF.
Bad value
Bottom of the pile is Abrdn at -37%. It is no coincidence that 2017 was the year the business was created in its present form through the merger of Standard Life and Aberdeen Asset Management – a deal widely seen as the poster boy for value-destroying M&A deals in the industry.
Shredding shareholder value through terrible M&A deals is the honeytrap that asset managers can’t resist.
In 2020, Franklin bought Legg Mason for $5.9bn (gross of cash), a company that had barely grown revenue in five years and only made $300m a year – a price of 20 times earnings for a mature business. It puzzled me why they would want to use half their cash balance and burden the balance sheet with debt, to invest at only 5% return.
What else could they have done?
Well, at the time, Franklin was valued at $12bn and trading at 8 times earnings. They could have bought back half of their own company, effectively investing at a 12% return, and suffered zero integration costs.
Instead, they acquired Legg Mason and other businesses costing $6.5bn in cash and spent a further $1bn on integration costs over the years. Last year, their staff cost per employee was also 27% above the average of their peers – an eyewatering $380k. Unsurprisingly, return on assets has fallen from 11% in 2016 to 3% last year – which tells me all I need to know about the quality of their capital allocation.
How to do it right
So based on this analysis, what would I do if I were running a large, listed asset manager?
First, I’d commit to paying out all operating cash flow to shareholders as dividends and avoid large-scale acquisitions. If Jupiter did this, they’d in theory yield more than 20%.
I’d then move on to cutting employee costs – we cannot justify paying ourselves almost 10 times the national wage without adding value. And any unhappy employees are welcome to leave – but they’ll need fair winds and following seas to start an actively managed fund from scratch today.
One final note. Where there has been value destruction, there is sometimes value – but it often requires a new management team or takeover bid to be unlocked.
The Ranmore Global Equity fund currently holds shares in both Jupiter and Aberdeen. Yes, their total returns were the worst on my list over the past seven years. But as recent shareholders, we have not suffered from that value destruction.
It’s high time that asset managers ‘walk the talk’ and allocate capital to create value.