Reasons for advisors to be careful
NOTE: This article was written in late 2003 about a secondary offering then planned (and later pulled) by Clarington Corp. We have neither reviewed nor written about the Clarington IPO completed in March 2005.
Clarington Corporation recently announced its intention to go public. The firm owns Clarington Funds, which is one of the country's fastest growing fund companies which has had strong net sales in an environment where the colour red is commonplace in the industry's monthly net sales reports. An IPO by such a successful firm may seem like a no-brainer investment but advisors should be careful about jumping head first into this puppy.
I admit that I did not read closely enough the initial press release announcing this IPO. Unlike most IPOs, this one clearly differs in a way that should grab the attention of any interested investor.
It states that the IPO is being implemented by way of a secondary offering. The company will not receive any of the proceeds from the IPO though is footing some of the costs to go public. (Clarington will only receive proceeds from the offering if the underwriters exercise their over-allotment option - i.e. if they want to buy more shares than existing shareholders are selling.) In short, this offering is a liquidity vehicle for a number of insiders and other shareholders wanting to cash out. They can only cash out if others are willing to buy. In this case, liquidity is being provided by a number of brokerage firms that, presumably, will look to sell part or all the shares they buy (as underwriters) to retail investors.
Of course it's prudent to diversify one's personal wealth, which presumably is what company insiders are doing. But this isn't necessarily a good deal for advisors and other investors. Think about it, if they're selling - even if it's for diversification purposes - they're unlikely to do so at a low price. For valuation and diversification reasons, advisors would do well to proceed with their eyes wide open.
Clarington's fortunes generally rise and fall with those of Canadian stock market performance - since so much of their assets under management (AUM) are invested therein. This is not unlike the income and business value of many of this country's financial advisors. While advisors tend to invest in what they know best, it's often best to keep actual investments in such sectors quite limited for diversification reasons. See more about this in a past article entitled Big Picture Investing.
Despite Clarington's strong net sales during the worst bear market of our generation, there are fundamental factors of which to be aware before getting overly excited about this offering.
Of every $6 in AUM, $5 are managed by one firm - Halifax based Seamark Asset Management Ltd. While Seamark has posted very strong performance, every manager hits occasional rough patches. Clarington's sales have begun to broaden beyond its Canadian Income fund and other Seamark-managed funds, but the concentration remains. Also, while I'm not one to dump (or stop recommending) a manager just because they hit a very normal slump, history has shown us time and time again that most advisors stop supporting (and often yank money from) managers/funds in such slumps. Trimark in the late 1990s was the most glaring example in memory. Hence, until AUM are sufficiently diversified, this remains a notable risk to the firm's net sales and, in turn, to the company's top and bottom lines.
Judging by recent financials (included in the prospectus) net profit margins are low - i.e. they've been between 2 and 4 percent. Of every $9 in management fees charged to its funds, Clarington keeps about $2. There are two causes.
First, Clarington's financing arrangement with respect to its commission payments to dealers requires them to share a piece of their management fee revenues for a period ranging from two years (for low load funds) to twelve years (for deferred sales charge funds). It has also waived rights to redemption fees on units whose sales commissions were funded by this third party. Over the past few years, this cost has amounted to a little under $3 out of every $9 in gross management fees. Trailers cost them about the same amount.
Second, the firm relies entirely on external money management firms, which is more costly than handling these functions in house. This eats up about $1 of every $9 in management fees.
That leaves relatively little to pay other general and administrative costs. The upside for Clarington is, at the margin, they'll be able to keep a larger chunk of management fees. They will self-finance low load commissions starting next year - increasingly the choice of advisors who sell funds. Plus, fees to subadvisors will shrink slightly as assets pile up.
However, this remains little more than a bulk sale by insiders at a price that meets their satisfaction - and that rarely proves to be a good price for buyers.
Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at firstname.lastname@example.org
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