Investing in Investors – A Look at the Asset Management Industry
At Diamond Hill, our research approach often leads us to gravitate towards businesses that operate with a long-term orientation, owner-operator mindset and a structure that minimizes conflicts of interest. This approach fits well with how we assess investment opportunities within the asset management space.
The asset management industry largely derives its revenues from management fees assessed on assets under management, a measure of client funds managed. For most asset managers, these fees are generally assessed against net asset value, which changes daily based on the overall changes in the underlying asset prices in the market, which introduces revenue volatility. This revenue volatility is further exacerbated by the fact that operating expenses for asset managers are largely fixed. The combination of volatile revenue and high fixed costs means cash flows for the asset management industry are among the most volatile within the financials sector. As such, it’s not uncommon to hear market participants describe investing in this industry as being a bet on the direction of the overall markets. Though this statement is somewhat true over the short term, it does a poor job highlighting the opportunities that can be realized with a long-term investment horizon.
Despite the oft-cited challenges for the asset management industry—market sensitivity (stock price and financials), key person risks, investment performance and capital management—asset managers have many attractive qualities including high revenue visibility, built-in growth via market appreciation, high operating margins and solid cash generation. Generally, the industry has low barriers to entry but high barriers to success, which makes sense considering the inherent near-term conflicts between revenues/cash flow and client outcomes over the longer term.
As long-term investors, we strongly believe delivering excellent client outcomes ultimately drives the amount and sustainability of cash flows in the asset management space, and we believe successful investing in this industry requires an assessment of duration of capital, investment capabilities and alignment of interests amongst stakeholders. We believe each of the three areas directly impacts an asset manager’s ability to deliver attractive client outcomes.
KKR & Co.
Private-market focused asset manager KKR largely makes controlling/illiquid investments in businesses and other private asset classes, seeking to add alpha through optimizing governance, capital allocation, and operational and management changes. We initiated our position in KKR across several strategies in early 2019, believing KKR’s business ranked exceptionally well against each of the three key criteria we look for when investing in asset managers—duration of capital, investment capabilities and alignment of interests.
Duration of Capital
One of the key issues when investing in asset managers is duration of capital—it’s not uncommon to see clients use the daily liquidity feature to opt out of an investment long before the investment thesis can unfold. This frequent turnover by end clients is often the reason for poor realized outcomes.
However, duration of capital is not an issue for KKR as it raises client funds through limited and general partner structures, where clients opt in to explicitly lock up their capital for a multi-year period, often over eight years. These contracts also include what is known as an investment period (typically four years), which allows KKR to hold dry powder until an attractive investment opportunity is identified. KKR’s fund structure protects against frequent turnover and increases flexibility in purchasing and monetizing investments, thus increasing the probability of successful client outcomes. The benefits of this structure were on full display during the pandemic-driven weakness in 2020, when KKR opportunistically deployed nearly $30 billion towards new investments. Today, KKR is taking advantage of the strong recovery in asset prices by monetizing roughly $20 billion of prior investments over the last few quarters. It’s not unreasonable to assume there will be another period of dislocation in the market, and we believe KKR will be well positioned to capitalize on it with its combination of fund structure and nearly $70 billion in dry powder.
Another challenging area in asset management deals with investment capabilities, which largely revolves around the people aspect of the business. There have been countless examples of asset managers who become too focused on profit and cash flows, which ultimately leads to underinvesting in broadening and strengthening investment capabilities. This underinvestment often results in significant underperformance against the goal of delivering on client outcomes. Over the near term, this approach does improve profits, however, it almost always comes at the expense of lower terminal value.
KKR was originally a leveraged buyout-focused private market investor, until the early 2010s when the company commenced a long-term buildout of investment capabilities, which has continued at a brisk pace. Prominent examples of added investment capabilities include infrastructure, real estate, private credit, core private equity (15+ year capital duration), growth-oriented private equity and sector-focused private equity. This buildout has been successful as measured by clients’ realized investment performance. Today, KKR’s growth profile has been recognized by market participants, but what is not well understood is KKR’s strategic broadening of investment capabilities has been 10 years in the making.
Alignment of Interest Among Stakeholders
Most businesses face risks associated with conflicts of interest; however, this risk is particularly high in the asset management industry. Being overly focused on fund shareholders, employees or stock shareholders can lead to an imbalance among stakeholders, which typically reduces the probability of successful investment outcomes for clients.
Consider the following:
- Poorly designed, high employee compensation can lead to excessive investment risk and lower profit margin.
- Excessively low management fees can result in lower margins and sub-optimal investment capabilities.
- Focusing on shareholders through high margins/cash flows can mean management fees are elevated, investment capabilities are neglected and/or terminal value is negatively impacted.
In KKR’s case, we believe the three key stakeholders are well aligned. For instance, KKR’s balance sheet and employees are typically the largest investors in managed funds—directly aligning incentives with fund shareholders. Further, employee incentive compensation is tied to investment performance, meaning employees only receive incentive compensation if investment returns beat a hurdle rate. Lastly, employees of KKR are the largest shareholders of the business. We believe this structure allows each of the three key stakeholders to be treated in an equitable way thus reducing the risks associated with alignment of interests.
As of June 30, 2021, Diamond Hill owned shares of KKR & Co., Inc.
The views expressed are those of the research analyst as of July 2021, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Investing involves risk, including the possible loss of principal.