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How do sell side analysts assign valuations to asset management firms?
While there is no pre-existing information to fully answer your question, we've used the available data to pull together key findings: The methods used to valuate an asset management firm vary greatly, depending on the size of the firm and the information available to the person conducting the valuation. An old rule of thumb is that a firm is worth about 2% of the total assets under management (AUM), though industry experts recognize that this method is built on too many outdated assumptions to be relevant in today's market. The larger investment corporations like Goldman Sachs, Morgan Stanley, and JP Morgan do not discuss their own methodologies, and the articles that we found written by smaller investment firms discuss only the pros and cons of various methods.
Below you'll find an outline of our research methodology to better understand why information you've requested is publicly unavailable, as well as a deep dive into our findings.
METHODOLOGY
A thorough search of the websites, white papers, and other articles published by the larger investment banks such as Goldman Sachs, Morgan Stanley, and JP Morgan did not uncover any publicly-published articles detailing their valuation process for asset management firms. We expanded our search to secondary sources, and while we found several that discussed the valuation methods used in this sector, none had special reference to any of the large investment banks. As we will show below, while there are some widely-used "back of the envelope" calculations for reasonably triangulating a asset manager's value, there is no single, widely-accepted calculation used to definitively fix the value of an asset management firm. In fact, the best explanation of the various methods used to value an asset manager came from a series of blog posts and a white paper from Mercer Capital. We supplemented this with an excellent white paper by VRC which helped to clarify many of the details. While discussing the various valuation methods in detail, none of these gave a definitive answer as to Mercer's own methodology. We hypothesize that Mercer's methodology depends greatly on the circumstances (e.g., what data they have on the asset manager in question) and/or that Mercer simply chooses not to disclose the details of its own "best practices." Either or both explanations would also explain the lack of definitive information about the valuation methodology of Goldman Sachs, et al.
With these limitations in the public record in mind, we were able to find detailed articles discussing how asset management firms are valuated in a general sense. Below we have provided short summaries of these methods.
THE 2% RULE OF THUMB
Until relatively recently, the rule-of-thumb for valuating asset managers (whether individuals or firms) was that they were worth about 2% of the total assets under management (AUM). So, for example, an asset manager with a total of $1 billion in AUM would be valued at $20 million ($1 billion * 0.02). The necessity of such a rule-of-thumb was created by the fact the actual transactional value of those assets is frequently unreported. Where the value of a given transaction by a given asset manager is disclosed, it is "often the only valuation metric available from an RIA transaction." (An RIA is a registered investment advisor, i.e., an asset manager or firm registered with the Securities and Exchange Commission (SEC) or state securities authorities transaction.) This round number was based on the expectation that asset managers garner 100 basis points (i.e., 1%) per transaction, transact about eight times per year, and operate at a EBITDA (earnings before interest, taxes, depreciation and amortization) of about 25%.
However, that assumption quite obviously does not hold in all cases, and is grossly oversimplified. Other approaches to valuating an asset manager include valuing its own assets (in the case of an RIA, this mostly means its employees), its own income, and looking at the market data. We detail each of these below.
THE ASSET APPROACH
This is less a single approach and more a spectrum of various methodologies which "involve some market valuation of a subject company’s assets net of its liabilities." In the case of an RIA, the primary assets are its staff, though "the worth of a company’s trade name, assembled workforce, customer list, or other intangible assets" are all considered in the calculation. The value of many of these is very subjective, and consequently Mercer notes that the income and/or market approaches are usually better when evaluating asset management firms.
THE INCOME APPROACH
This approach usually uses one of two methodologies:
"Single period capitalization models generally involve estimating an ongoing level of profitability which is then capitalized using an appropriate multiple based on the subject company’s risk profile and growth prospects." In other words, the one doing the valuation attempts to find a period of cash flow which can be taken as representative of the asset manager's "normalized financial performance" and extrapolate the managing firm's valuation from there.
"The discounted cash flow methodology (or DCF) requires projecting the expected profitability of a company over some term and then 'pricing' that profitability using an expected rate of return, or discount rate." This method is best used when "the future direction of the firm is expected to vary from the historical results."
Naturally, these methods require significant insight into the company's balance sheet, and "the income approach requires a thorough analysis of the risks and opportunities attendant." This level of information is typically only revealed during the merger & acquisition process after the signing of a non-disclosure agreement (NDA).
THE MARKET APPROACH
The market approach may use one or more of several methodologies, depending on the nature of the asset manager in question. It is most often "applicable to valuing small- to medium-sized, closely-held wealth management firms." Publicly traded companies can be valuated by observing their trading activity or their market capitalization in comparison to their AUM. However, while there may be a large amount of public data available for these publicly-traded companies, there can also be significant differences due to their varied sizes, different influences on their real value, and the fact that large, public companies tend to be significantly more diversified than closely-held, smaller firms. Therefore, this method must be used with caution.
Alternatively, a company's approximate value may be determined by studying the details of similar companies, especially the details which become public when such companies are sold. This approach "may be the most compelling due to the high availability of pricing data." However, it is also "often the most misused." It is easy to find companies that are similar to the asset manager in question without properly appreciating and evaluating their differences. Likewise, examining public transaction data may fail to reveal "potential synergies" unique to the buyer and seller which affected the price of those transactions.
KEY DRIVERS OF VALUE
As the above makes apparent, there cannot be a complete, one-size-fits-all approach to determining the value of asset management firms because the "best practices" methodology depends on the size of the firm, whether it is publicly traded, and what information is available at the time the valuation takes place. However, VRC offers the following as a reasonably complete list of the key data that valuation should focus on:
However, while offering a pair of case studies showing how these data points may be weighed, VRC does not disclose a formula for weighing these factors.
CONCLUSION
Despite limited visibility into the internal methodologies employed by the largest investment banks, we were able to uncover the following from multiple other sources: There is no single methodology which can provide an accurate valuation of all asset management firms due to the fact that complete information about said firms is rarely available outside of the due diligence process of a merger or acquisition, there are several methods that investment firms use to valuate potential allies, rivals, and acquisitions depending on what information is available, as we have detailed above. We could find no evidence that the largest investment banks like Goldman Sachs, Morgan Stanley, and JP Morgan use significantly different methodologies than those employed by smaller firms like Mercer Capital and VRC and judge it likely that there is no qualitative difference in the methods employed.