Those in the know understand that both qualitative and quantitative factors must be evaluated when estimating enterprise value. The list of appraisal considerations is too long to address in any one discussion. Suffice it to say that one should understand, measure and benchmark multiple facets of an organization’s business such as production processes, distribution channels, sales infrastructure and customer service. A clarity about the industry in which a business operates is likewise essential. Who are the competitors? What regulations prevail and how is the industry responding to new mandates? Are industry sales sensitive to changes in global or local economic conditions? Is the industry poised for growth or fast reaching its apex?
Turning the microscope to narrowly focus on a single company, it would be remiss to ignore the economics of its brands and reputation. An organization’s customer base can reward shareholders if net sales grow and add to free cash flow. On the other hand, disgruntled buyers can decide to go elsewhere or seek redress in a court of law. Both outcomes are costly and can lower share value. Notably, the damage associated with a lost sale can vary depending on how long it takes to recover, if possible at all. For example, a money manager that loses a large institutional client will be reinvesting a much smaller pool of capital over the ensuing months. Should other long-term consumers like peer pension plans get wind of bad news, they too may exit, causing the asset manager’s portfolio to plummet further.
It’s not remarkable then that new research concludes that “high firm and product awareness – or together, brand awareness – could lead to greater retained assets and new inflows.” Nevertheless, the message is one that bears repeating given the significance. While its 2016 survey affirmed the link between reputation and financial wellbeing, eVestment uncovered some startling trends too. They are summarized below:
For details, read “Why Asset Manager Reputation Matters” (Chief Investment Officer, May 19, 2016) or download the white paper entitled “Importance of Brand Awareness” from the eVestment website. As Warren Buffett declared, “It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”
If you get a chance to view “The Man Who Knew Infinity,” go for it. Award-winning actors abound in this tale of math wits at Cambridge University who contributed dozens of important ideas that are still being used in business and science. Dev Patel, stars as the self-taught math genius, Srinivasa Ramanujan, who rose from poverty to team with world-renowned scholars such as Bertrand Russell and John Edensor Littlewood. Based on a book of the same name by Robert Kanigel, this biographical tale of talent writ large examines the unlikely friendship between Mr. Ramanujan and his mentor, Professor G. H. Hardy (played wonderfully by Jeremy Irons), the uncertainties of a war torn England and the dire loneliness of the young man who left his home in India to share his insights about numbers.
Sadly, Mr. Ramanujan died in his thirties, leaving a legacy of path-breaking equations that have since been proven right. According to a 2012 article in Business Insider, his work is used by physicists to compute “the entropy, or level of disorder, of black holes.” Last month, the founder and CEO of Wolfram Research, Stephen Wolfram, reviewed Hollywood’s take on this band of merry mathematicians and pondered how they could have saved countless hours had they had access to his Mathematica product that is used by many Wall Street quants. His admiration for this driven wunderkind is obvious, as is his hope “that many more people will take advantage of the tools we have today to follow Ramanujan’s lead and make great discoveries in experimental mathematics – whether they announce them in unexpected letters or not.”
Popcorn aside, The Man Who Knew Infinity is captivating and well worth a trip to the cinema.
When I was a university professor and gave written homework, I frequently found myself in the position of having to remind students that reliance on a spell checker may not always produce good results. “I through the ball” is grammatically incorrect but would not reveal itself as an error. Someone would have to know that “threw” is the appropriate choice. Inevitably, a few individuals would counter that they plan to employ staff to write memos, carry out financial analyses and undertake research. I would then ask how one can adequately evaluate a potential hire, let alone review the quality of that person’s work (if hired) if he or she is lacking sufficient knowledge to recruit and oversee thereafter.
Outside the classroom, selecting and monitoring is no less important, whether it’s an investment security or a service provider. During a recent workshop I was invited to lead about service provider due diligence and the U.S. Department of Labor (“DOL”) Fiduciary Rule, I shared a matrix I created with other investment industry professionals. It showcases some of the many qualitative and quantitative elements that could be used as part of a selection and monitoring endeavor. Big picture categories include, but are not limited to, the following: Client Capabilities, Compliance, Credit Worthiness, Funding Sources and Operational Integrity. See slide 24 of the presentation entitled “Fiduciary Considerations” by Dr. Susan Mangiero.
With its early April 2016 debut, it’s too early to tell how the DOL’s new mandate will influence hiring and subsequent performance reviews. Attorneys emphasize that the bar is set higher than before so it will be important to track how Requests for Proposals (“RFPs”) and vendor interviews proceed. Firms seeking to use a “Hire Me” exemption to avoid being tagged as a fiduciary may not be able to provide sufficiently granular and plan-specific information to ERISA buyers in order for those fiduciaries to carry out their duties. When this question arose during an April compliance conference I attended, several of the presenting attorneys acknowledged that there could be an information gap, adding that buyers and sellers would have to figure out a mutually beneficial path forward. I will defer to the legal professionals to address this issue.
As an aside, the “Fiduciary Considerations” slide deck prepared by Dr. Susan Mangiero includes material produced by others. Efforts were made to attribute the original source. Those seeking to use any or all of this slide deck need to contact the copyright owners of each slide.
The news in pension land is sobering to say the least. Sadly, there are too many examples to cover in one blog post but taxpayers, participants, creditors and regulators are trying to understand the nature of the money trail that has, for some plans, led to trouble writ large. Consider what’s going on in Puerto Rico right now.
In addition to a just missed payment of more than $400 million, Governor Padilla told C-Span viewers on May 6 there is no money to pay roughly $800 million due on July 1 2016 to senior bondholders. As he explains, debt service has gone up faster than what he calls revenue inflows. Elsewhere, Nick Brown of Reuters writes at length about gross underfunding of the municipal pension plans in “Puerto Rico’s other crisis: impoverished pensions” (April 7, 2016). Despite multiple reforms introduced in 2013, funding remains perilously low. Keith Brainard, head of research for the National Association of State Retirement Administrators, is quoted as saying: “With about $1.8 billion in assets to pay $45 billion in liabilities, the 96 percent combined shortfall is among the biggest of any U.S. state pension this century, and probably the biggest ever for pensions ‘of this size and scale’.”
Bad economics is more than a numerical exercise. Real people are impacted. Plan participants, taxpayers and investors all have a stake in what happens next. As I wrote on March 19 in “Puerto Rico: Pensioners Versus Bondholders,” many individuals who own debt issued by this U.S. territory are themselves retirees or saving for retirement.
Should contagion occur, the cost of capital for other municipal borrowers will almost surely increase as frightened investors demand higher yields. Worse yet, some lenders may say “no” to certain new debt, leading to possible tax hikes at the local level. There is a trickle down effect when credit risk heads upward. See “Muni Market Shrugs at Puerto Rico Default, but Next Time Could Be Different” by Bernice Napach (Think Advisor, May 2, 2016).
Whatever you think of the Puerto Rico situation and proposed solutions, the clock is ticking for many cities, counties, states and countries that have not adequately funded their pension plans. Capital markets are paying attention. There is a lot at stake.
Whenever the topic of performance measurement comes up in conversation, I think back to a story someone told me about a woman who took the number two spot in a race. Proud of her accomplishment, she telephoned friends and family with the news. Here’s the catch. Only one other runner competed. Technically, her statement was correct but probably a stretch. A typical listener would likely interpret her claims to mean second best out of a large group of athletes.
When it comes to investing, context is likewise critical. A classic fallacy is to describe a security as riskier based on its standard deviation alone and ignore rates of return. If it turns out that the “riskier” security realized large enough gains compared to a second security, the resulting coefficient of variation (“CV”) would flip the ranking. (Ignore for now the notion that relying on a single statistic alone is ill-advised.)
It’s not always easy to construct an appropriate investment benchmark but the exercise is nevertheless vital since performance monitoring drives other decisions. The topic continues to receive focus from practitioners and scholars alike. A deep dive about construction and review is left for another day but the urgency may accelerate sooner than later.
As I listened to a series of compliance Q&A sessions this week about the Fiduciary Rule, I kept pondering how asset allocations are likely to change over the next year. Revised business models, the use of algorithms via robo-advisors and modified sales compensation arrangements will almost surely result in portfolio composition shifts for some investors. Should that occur, it will be incumbent upon a service provider to craft an appropriate benchmark that reflects the new regime and then explain its rationale to each investor. Otherwise, an individual or a plan sponsor may question why the performance of a post-Fiduciary Rule collection of assets is being graded against a stale benchmark.
This issue of dynamic performance evaluation is not new. However, given the regulatory focus on numerous factors that influence asset allocation, one can readily conclude that benchmarks will be part of the Fiduciary Rule implementation agenda in the months to come.
Like most people who work in the financial services arena, I hastily downloaded the long anticipated “Fiduciary Rule” when it was released by the U.S. Department of Labor (“DOL”) on April 6, 2016 and am busy tackling this final version. With more than two hundred pages, it’s going to take longer than a lunch break but is nevertheless vital reading. DOL’s Fact Sheet is a good start. No doubt there will be a flurry of articles and webinars about details and implications. I am attending two events early this week alone.
As with any new regulation, a cadre of professionals will be involved to discuss how best to comply. Ideally, an organization will coalesce its brain trust from Legal, Operations, Sales, Public Relations and Accounting at a minimum. In deference to industry concerns about how long it would take to make necessary changes, implementation will be phased in with a final adherence date of January 1, 2018. Other sought after modifications survived and are expected to make it easier for financial service firms to inform their clients in the aggregate about regulatory mandates.
The elephant in the room is the uncertainty about how post-mandate behavior could veer from the goals of the regulators and who might get hurt as a result. Free market economists refer to the Law of Unintended Consequences when they decry an event that distorts the invisible hand that optimizes demand and supply. Realists will counter that the financial services industry is already regulated and therefore does not operate on the basis of unfettered buy and sell signals. Nevertheless, history has repeated itself many times, demonstrating the acuity of those in search of profitable loopholes.
According to “Beware the Fiduciary Rule’s Unintended Consequences” by Christopher Robbins (Financial Advisor Magazine, April 6, 2016), many industry executives expect smaller firms to wither away “when some of their revenue streams dry up.” A related view is that tiny client accounts will be jettisoned by the remaining service providers and left with few choices other than “computers or robots,” despite the stated purpose of this initiative being to help all retirement investors. Keep in mind that the U.S. Securities and Exchange Commission (“SEC”) seems poised to challenge whether a robo-advisor can serve as a fiduciary. If the answer is “no,” does that preclude these algorithm-based providers from serving retirement customers?
Some attorneys exclaim that this conflicts of interest mandate will open the door wide to added ERISA lawsuits. In “Why Plaintiff Firms Will Love DOL’s New Fiduciary Rules,” Skadden Arps partner Seth Schwartz is quoted as saying that “As night follows the day, there will be more litigation.” In “Fiduciary Rule Less Complex, but Questions Linger,” reporter Sean Forbes (Pension & Benefits Daily, April 7, 2016) interviews a handful of attorneys who express concerns about (a) private rights of action to bring a lawsuit (b) a definition of a fiduciary that “goes way beyond common law” and (c) questions about the enforceability of the Best Interest Contract Exemption (“BICE”).
One big upside of the Fiduciary Rule is that the topic of fiduciary duty is being mainstreamed as never before. Transparency can be a good thing as long as investors pay attention.
Not everyone is convinced that more information will translate into better decisions made at the individual level. During a quick call last week with an in-house benefits attorney, I got his message loud and clear. An employer can only do so much if a participant remains reluctant or unable to engage. Wall Street Journal pundit Jason Zweig echoed this view in his April 8, 2016 column entitled “You Are Responsible For Your Retirement Savings.” His central point is that the DOL Fiduciary Rule is not a panacea that can fully eliminate investment product risk or prevent an individual from working with an ethics-challenged advisor or broker.
Stay tuned for subsequent posts about the DOL Fiduciary Rule.
Once a company has identified the categories of customers it wants to attract and retain, most people would agree that providing effective service is important. After all, it is hard to expand enterprise value without a healthy growth in cash flow. While this is a truism for nearly all industries, financial advisory executives are thinking hard about this topic right now as the operating environment is poised to significantly change.
According to “DOL Fiduciary Rule Set To Shake Up Retirement Marketplace” (LifeHealthPro, February 24, 2016), “Experts say that the rule will be approved soon and many of the changes will be implemented by year’s end…” If true, some organizations could exit certain activities or otherwise alter the way they do business. This means that an existing customer may be forced to go elsewhere. Some suggest that compliance costs incurred by financial service companies will be passed along to the end-user. Whether that happens will depend on a variety of factors, including the bargaining power of the consumer and the “stickiness” of the buyer-seller relationship.
Technology is another consideration. Robo-advisors are predicted to gain a slice of the “estimated $250 billion to $600 billion of IRA assets” up for grabs should full service firms decide to jettison clients with low account balances. See “Who Wins, Who Loses With New DOL Rule? $3 Trillion in Play” (ThinkAdvisor, December 31, 2015.) Even before talk about a possible passage of the Conflict of Interest Rule, larger firms were hungry acquirers of financial technology companies. Michael Kitces describes a flurry of these recent deals in “Top Financial Advisor Issue For 2016 – The Department of Labor Fiduciary Rule and the Best Interests Contract Exemption” (Nerd’s Eye View blog, January 4, 2016).
Greek philosopher Heraclitus supposedly said “There is nothing permanent except change.” Given what is going on now in financial advisory land, this is indeed true – not just for service providers but possibly for their customers as well.