Asset management companies tend to see a drastic drop in their earnings when the United States enters a recession. Historically, investors have diversified away from risky assets such as equities when business activities declined significantly. In addition, many consumers prefer cash over other asset classes during an economic downturn.
All these factors contribute to a decline in assets under management. This, in return, leads to lower management and performance fees for investment managers. However, Lazard Limited (LAZ, Financial), because of its renowned financial advisory business, is in a position to ride the difficult times better than most of its peers and deliver stellar investment returns to investors in the coming months. The market has punished Lazard in the last few weeks, which presents an attractive entry point for long-term oriented investors, in my opinion.
A recession-resilient business model
Lazard primarily focuses on two principal business lines:
- Financial advisory
- Asset management
Under the first segment, the company provides many services, including mergers and acquisition advisory, corporate restructuring and sovereign advisory services. According to company filings, this segment accounted for approximately 53% of total revenue in 2019. The contribution from the advisory business has improved in the last few years, which is a positive sign for investors. As illustrated in the below chart, Lazard successfully grew its operating revenue from this segment during the financial crisis, even though global deals declined.
Source: Company presentation
The performance of this sector during the lows of the financial crisis is an encouraging sign for investors, as a similar uptick in advisory revenue can be expected if the U.S. enters a recession as a result of the Covid-19 pandemic. This is because of a few reasons:
- An economic downturn will punish some companies hard. However, financially strong companies with cash-rich balance sheets will be hunting for bargains to strategically improve their competitive positioning to secure long-term earnings.
- Deals executed right after recessions tend to generate alpha returns, which might prompt industry-leading companies to engage in more deal-making activities in the coming months. According to data from Bain & Company, acquisitions completed during and right after the dotcom bubble generated almost triple the excess returns of deals made during the boom years. In total, 24,000 transactions were analyzed to come up with this conclusion.
- According to data from the Federal Reserve, the total cash on hand and in U.S. banks of American corporations stood at $145 billion at the end of 2019, in comparison to $75 billion at the beginning of 2009. This number does not take short-term liquid investments into account. Evidently, U.S. companies are in a much better position than during the financial crisis to engage in more transactions.
Empirical evidence suggests that the number of deals will initially fall as the global economy enters a recession. However, a quick recovery can be expected once corporate executives decide to double down on the opportunity.
Data from Refinitiv reveals that Lazard was among the top-five distressed debt restructuring advisors in the world in 2019. This is proof that the company is a go-to solutions provider for companies suffering financially.
From a total advisory revenue perspective, Lazard was ranked 4th in 2019. The company generated more revenue than some of the leading financial institutes in the world, highlighting its ability to compete with the best in the world.
Source: Lazard company presentation
Some of the biggest deals facilitated by Lazard during the financial crisis era included the debt restructuring of Charter Communications, the Natixis rights issue, Mitsubishi’s investment in Morgan Stanley and the purchase of Dutch-based insurer Fortis by the Ministry of Finance of the Netherlands. Lazard has built a reputation as an advisor to rely on during trying times, and the company will benefit from this brand image in the next few months or years, depending on how severe the recession turns out to be.
The industry outlook is positive for Lazard’s advisory business
Leading pharmaceutical companies in the world are in a race to find a cure to the spread of Covid-19. Some big names in the industry are partnering with small biotechnology companies to speed up the process of developing a reliable vaccine for the virus. For instance, Vir Biotechnology, Inc. (VIR, Financial) announced a partnership with Shanghai-based WuXi Biologics to test for a treatment. These types of collaborations might open doors for corporate transactions as big names find value in these smaller peers. UBS Group head of mergers and acquisitions for EMEA said, “Health Care is a sector that might have interesting opportunities as a result of this crisis and is one of the sectors that has had the least impact.”
Second, privately-owned companies that show signs of success in finding a treatment for the novel coronavirus might consider listing their securities on stock exchanges. This will prove to be a tailwind for Lazard and other top financial advisors in the world.
Third, companies that are currently considering corporate transactions such as mergers and acquisitions will try to use equity as a funding source to preserve cash for more difficult times. According to data from PwC, transactions funded by cash have soared to new highs in the last decade.
There were two reasons for this phenomenon.
- The Tax Cuts and Jobs Act of 2017 helped (most) companies save billions of dollars, and part of these savings were either distributed to shareholders or used to acquire shares of other companies.
- The strong recovery of the global economy since the fallout of the financial crisis has boosted the operating cash flows of many profitable companies.
The number of deals funded with cash might decline in the coming years, paving the way for Lazard to gain new clients through stock-based transactions as an advisor.
Fourth, the number of companies filing to raise debt will surge in the coming months. Many private companies, including Airbnb, have already started looking for funds in the debt market. This creates an opportunity for Lazard as well because of its reputation as a facilitator of credit to both public and private companies.
Debt restructuring activities might also increase, the same way as during the last recession. All these are positive developments for the leading financial advisory companies in the world.
The asset management business will be hurt, but Lazard can weather the storm
As much as the outlook for the advisory segment is promising, the prospects for the investment management segment are bleak. Historically, market routs have resulted in a severe decline in total assets managed by the industry, which is not an encouraging sign. As investors, it’s important to remain objective and apply a valuation discount to the target price to reflect the troubling times ahead.
Lazard’s offering of exchange-traded products is not as extensive as its rivals such as BlackRock, Inc. (BLK, Financial). However, the company still reported positive net flows between 2014 and 2019. This is one silver lining, as it showcases the ability of Lazard’s fund managers to deliver attractive returns to investors through actively managed products.
Source: Company presentation
It would be difficult for Lazard to generate net inflows in the next few quarters because of the difficult industry conditions, but the long-term outlook is not bleak. When pandemic fears subside, the American markets will stage a recovery. This will prompt investors around the world to embrace risky assets such as equities once again, leading to positive fund flows. However, it might take at least a couple of quarters for this to happen. The good thing is that the advisory business will help Lazard set-off some of the expected losses from the investment management business of the company.
Takeaway: Lazard as a contrarian play
Not all companies are created equal. While many asset management companies will find it difficult to weather the storm, I think Lazard will be helped by its lucrative financial advisory business. This presents an attractive opportunity for contrarian investors who focus on exploiting market anomalies, especially since the price-earnings ratio of the company has contracted to a three-year low.
The future might not be as difficult as some investors believe. An expansion in the multiple can be expected in the latter half of this year. The dividend yield is over 7% at the market price of around $25 on Wednesday, which is an attractive compensation for holding shares until the market recovers.
Disclosure: I do not own any shares mentioned in this article.
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