Boutiques’ backup plans amid Covid crisis

One of the early myths about the new coronavirus was that it was a great leveler, that it affected everyone equally. It does not. Those in society with little or no safety net are feeling the pain of the economic shutdown more acutely than those with greater funds to fall back on. The same is true for businesses. Smaller firms, with smaller margins and fewer resources, are existentially threatened in a way that larger businesses are not. And boutique asset managers are no exceptions. With fewer assets under management, the combination of steep market declines and heavy outflows can put pressure on smaller shops in a way that larger rivals don’t feel, which raises questions from gatekeepers about these firms’ viability.

‘You’re probably going to have some fallout, and I think that’s going to largely be driven by the under performers and those that have had a difficult time,’ said Greg Trinks, head of investment manager research at UBS Global Wealth Management. ‘From a stability standpoint and from an asset flow standpoint, if [boutiques] were under pressure [before], that’s probably going to be exacerbated through this.’

Lisa Erickson, head of traditional investments at US Bank Wealth Management, agreed. ‘This environment is increasing the pressure on some of the boutiques and the smaller shops simply because they don’t have the same financial resources as a larger firm. Maybe diversification across product types at a larger firm makes an easier ride in a tough environment,’ she said.

According to data from Door, an online due diligence service for fund analysts, there has been a spike in inquiries about firms’ disaster recovery and business continuity plans, as well as their use of outsourced services and the depth of portfolio management teams.

‘With most investment staff at home, regular processes for research and making investment decisions don’t apply. The first course of action for manager research analysts are to figure out if asset managers have a backup plan for managing portfolios and if they can deploy it efficiently,’ Door co-founder Roland Meerdter said. ‘Understanding an asset manager’s business continuity and disaster recovery plan is key – importantly, those plans should have been made and tested before a crisis like Covid-19 hits, and manager research analysts shouldn’t have to hunt for the information at such a critical time.’

While the questions submitted to Door were not aimed at smaller shops specifically, they reflect analysts’ priorities at this time and are issues that present more of a challenge to smaller firms with fewer resources and less time to spend on functions beyond running money.

One manager researcher told Citywire that they had drawn up a list of every manager on their platform with less than $5bn in assets, and were monitoring each one closely.

The gatekeeper, who spoke on the condition of anonymity, said they wanted to know if firms had sufficient resources to stay in business for a number of quarters, on the basis that economic activity could be subdued for a long time, even after lockdown measures are lifted.

They are not alone in having such concerns. Speaking on a recent Citywire virtual roundtable, Gene Goldman, chief investment officer, and director of research at broker-dealer group Cetera, said his team had begun moving away from smaller shops for this reason.

‘We’ve really moved to have a bias to larger firms on our recommended list, because we do think the environment is changing, we do think markets are changing, and you need vast amounts of resources, big analyst teams, to really find those hidden gems,’ he said. ‘It’s going to be a very different world – not just everything moving up in the same direction. We do think that there will be winners and losers, and the winners will be those larger firms that can navigate this.’

On the same roundtable, Tom Thornton, who oversees manager research and discretionary model portfolios at Raymond James, did not go as far as Goldman but did acknowledge that the recent selloff would make life difficult for some smaller shops. ‘I definitely agree that the smaller managers, who are trying to grow, all of a sudden their assets are down from the market and probably flows too, so pressure is on them,’ he said.

James McGrath, co-chief investment officer of Forbes Family Trust, expressed a similar concern. He added that gatekeepers were also under pressure in the current climate and may have less time to devote to discovering smaller
managers.

‘There are just a lot more distractions right now. We may not have enough bandwidth to forage for mushrooms. I think that, in the short term [boutiques] may take a hit, but I don’t think that’s permanent,’ McGrath said. ‘It’s harder for smaller managers to get out of the gate.’

Data from Flowspring, which specializes in analyzing asset management flow data, shows that the 627 US asset managers with $5bn or less at the end of January saw their assets decline by 20% on average from then until April 3. This was largely in line with market falls – the S&P 500 declined 22.8% over that period.

The mutual fund and ETF AUM of the largest 10 asset managers in the US dropped by an average of 14% from the end of January to the end of March, according to data from Morningstar Direct. While still bad, at the end of March, these 10 firms still accounted for nearly two-thirds of the mutual fund and ETF market. According to Flowspring, the largest 1% of asset management firm now manage 219 times the assets of the smallest 50% of asset managers.

‘A number of firms are struggling with flows and deflating asset values right now. This immediately drops their revenue, and for the smallest firms, which may have razor-thin margins, this can put them in serious financial trouble,’ Warren Miller, founder and CEO of Flowspring, said.

However, Miller echoed Trinks’s point, and said that not all small firms were alike and that their fates depended on their strengths and weaknesses going into the crisis.

‘Firms with a strong track record or differentiated products may find solace in the arms of a larger firm looking to acquire them. This allows the larger firm to realize some scale advantages after the transaction,’ he said. ‘Weaker asset managers with no suitors may have to shut down if they can’t find a pathway to profitability. Finally, there are the firms that will cut costs to remain profitable but may end up cutting too deep – hurting their ability to generate investment performance that meets their investors’ expectations, ultimately dooming them to “zombie” status – never growing to a truly successful level.’

It is worth pointing out that there are a number of small firms that will, of course, be just fine as they are. About one in 10 of the 627 firms with $5bn or less in assets finished the period from January 31 to April 3 with assets up thanks to market appreciation and/or inflows. About one-third of firms took in money during this time, even if their overall AUM declined.

While larger firms are better positioned, they are not immune from these same pressures and their cost base can count against them.

‘Even if you’re larger and you have more scale, your business is still dropping, but at a similar rate to the smaller ones. So, you’re having to look at your own cost structure. You may be able to survive longer but you still have relative business management issues within your own shop,’ said Erickson. When the $5bn AUM figure is raised to as much as $20bn, Flowspring data shows a number of well-known boutiques took in a lot of money during the period, including WCM Investment Management ($1.5bn), Polen Capital ($879m), Brown Advisory ($540m) and GQG Partners ($529m).

While manager research teams are understandably putting a greater focus on firms’ contingency and continuity plans, many are still enthusiastic about the prospects for boutique managers. Trinks, in particular, said he thinks boutiques may be more flexible amid market volatility than their larger counterparts.

‘One thing we have to keep in mind is that a large battleship, while it may have thicker armor, can also take a lot longer to turn around and be nimble,’ he said. ‘You may find that a lot of [boutiques] already worked from home when they could, that they had different work-life balances and different cultures in the boutiques, than what you might see in a large asset manager, so the need to turn the battleship so quickly may not even be there.’

‘Are you going to have smaller boutique managers that are going to struggle? Yeah, you are. But you have the other side of this, where you have boutique managers that have no problem raising assets, [that] have strong performance,’ he added. ‘It’s not so much a large asset manager versus small. It’s more so about consistency, repeatability and process.’

Erickson also maintained that her team’s process would not change when it comes to boutiques, but she admits such firms do face additional pressure at the moment.

‘We really do focus on the best investment opportunity, but to have the best investment opportunity, you have to have a good firm structure,’ Erickson said. ‘You have to have a strong sense that it’s a viable firm, but recognize again that they can be a little bit more stress-tested in unusual Black Swan environments like this one.’

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