Many small and mid-size investment managers face the challenge of trying to build a diverse and resilient business within a limited operating and investment platform. Competitive pressures may lead investment managers to develop product offerings that require additional resources beyond their existing platform. This product expansion should be critically evaluated to determine if the required AUM targets can be achieved to yield the necessary operating margin.
Scale is the holy grail of the investment management business
Growth in AUM is often considered the litmus test for success in the investment management business, and for good reason. The common view is that scale derives directly from asset growth. However, scale requires two critical components,
i) fee earning assets, and
ii) stable and consistent operational and client service delivery models.
Simply put, scale is achieved when the cost of servicing additional assets remains steady as the volume and related fee income of those assets grow. When the cost structure over operations and client service is comprised substantially of fixed costs, managers can then take full advantage of operating leverage through growth in AUM to deliver higher operating margins.
Competitive fee pressures can lead to commoditization of investment products
Investment management fees are typically constrained within a range of prevailing fee rates set by competitors. Many investors, particularly institutional investors, are quick to use fees as a differentiator among managers in the selection process, which serves to further commoditize investment management products. This creates a recurring cycle where competitors are compelled to agree to artificially depressed pricing or risk loss of business, and the duration of the mandates can make it difficult to correct long-standing pricing mistakes.
Although certain pockets may be able to extract premium pricing arrangements, these situations are limited to those with proven performance in specialist mandates or others that may be capacity constrained. These fee pressures only heighten the need for investment managers to maintain cost discipline in order to preserve or increase operating margins.
Product proliferation is not product diversification
Demand for investment products run in cycles that are driven by any number of factors that may or may not be within the control of the investment manager. Products may suffer from periods of underperformance that render the product uncompetitive, or a product may fall out of favor due to market conditions or investor attitudes. A diversified product book is the most effective way to insulate from these threats. In building a diversified product book, it is critical to consider the operating and investment platform that will be used to service these products. There is an element of risk associated with adding disparate products since proliferation of products will create a support model that can’t be maintained, which runs counter to achieving scale. Diversified strategies build from synergies while proliferation creates costly redundancies.
Cost discipline supports strategic product offerings
Cost discipline is less about slashing costs of an existing platform than it is about managing a cost structure that delivers a targeted level of operations and service that have been built to support an existing platform. A cost structure will typically be driven by two components:
i) the volume of services that are needed to be offered to clients or consumed within the investment manager’s operations, and
ii) the rate charged for these services by either a third-party provider or incurred internally.
Cost discipline requires that each of these components be managed in a way that supports the goal of achieving scale. To be successful, cost discipline should be applied on a continuing basis rather than appear as a function of an annual exercise, such as budget setting. Setting the volume of services to match the target level of product support is typically the starting point. This volume will consider the number, size, and type of clients being supported. Managing the rate charged for these services can be undertaken through oversight and measurement of outsourced vendor services. Together, these components comprise the aggregate spending level and will be a factor in the determination of scale. Adjustments to aggregate cost can then be made through a combination of service level and rate changes.
An important factor in setting service levels relates to the earlier discussion on product diversification vs proliferation. Proliferation will broaden the expense base to the point where the risk of overextending the service model can create product silos with high AUM hurdles to achieve profitability.
Leveraging platform synergies helps offset pricing threats
The emphasis of this discussion relates to managing the product range in a way that leverages existing operating and investment platform synergies. This is the cornerstone of building scale and will provide the ability to withstand the impact of pricing threats to the product book.