Case 080Asset management business and productsWarm up

An asset manager's assets rise 20% but it cuts its fee by 5 basis points. What happens to its profit, and why does it move so much?

The situation

Kosala Asset Management runs Rs 50,000 crore and earns an average fee of 0.55% on it, so revenue is Rs 275.0 crore a year. Its fixed costs, salaries, technology, offices and compliance, are Rs 150 crore. Variable costs, mostly distributor commissions and fund administration, are 10% of revenue.

Next year the board expects assets to rise 20% on market gains and inflows. To win a large pension mandate it will also cut its average fee by 5 basis points, to 0.50%. Fixed costs stay where they are.

Your task

What happens to Kosala's profit, how do you split the change between the two effects, and what does it tell you about the business?

Quick check

Assets rise 20% and the fee falls 5 basis points. What happens to profit?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Profit rises from Rs 97.5 crore to Rs 120.0 crore, about 23%, more than the 20% rise in assets. Revenue grows only 9.1% after the fee cut, but fixed costs of Rs 150 crore stay put, so most of the extra revenue drops to profit. Asset growth adds Rs 49.5 crore and the fee cut takes away Rs 27.0 crore. The same leverage works in reverse: a 20% fall in assets would halve profit.

Step 1Why does profit move more than assets?

Think of a bus route with a fixed cost of driver, fuel and permit whether ten passengers ride or fifty. The first passengers pay for the bus; the later ones are almost pure profit. An asset manager is that bus: most of its costs are fixed, so each extra rupee of fee revenue keeps 90 paise. That is operating leverageThe way a business with high fixed costs sees profit rise or fall by a larger percentage than revenue., and it is the single most important thing to understand about how fund houses earn.

Step 2How do you split the change between the two effects?

Take them one at a time. The asset effect: Rs 10,000 crore of new assets at the old 0.55% fee is Rs 55.0 crore of revenue, Rs 49.5 crore after variable costs. The fee effect: 5 basis points off Rs 60,000 crore is Rs 30.0 crore of revenue, Rs 27.0 crore of profit. Note that the cut applies to the larger asset base, which is why it is bigger than 5 basis points on today's assets.

Kosala's profit moves more than its assets, Rs crore97.5Profittoday+49.5Assets+20%-27.0Fee cut5 bp120.0ProfitafterWhat movedAssets+20.0%Revenue+9.1%Fixed costs0.0%Profit+23.1%Rs 150 cr fixed costs
Kosala's profit rises from Rs 97.5 crore to Rs 120.0 crore: asset growth adds Rs 49.5 crore and the fee cut removes Rs 27.0 crore, a 23.1% rise in profit on a 9.1% rise in revenue, because Rs 150 crore of costs are fixed.
Rs croreTodayNext yearIf assets fall 20%
Assets50,00060,00040,000
Fee0.55%0.50%0.55%
Revenue275.0300.0220.0
Variable costs, 10%(27.5)(30.0)(22.0)
Fixed costs(150)(150)(150)
Profit97.5120.048.0
Change in profit+23.1%-50.8%
The same Rs 150 crore of fixed costs lifts Kosala's profit 23.1% when assets rise 20% with a fee cut, and cuts it 50.8% when assets fall 20% at the old fee.
Step 3What does this tell you about the business?

Read the last column before you celebrate. With a degree of operating leverage of about 2.5, every 1% change in revenue moves profit about 2.5%, in both directions. A 20% market fall, which happens every few years, takes profit from Rs 97.5 crore to Rs 48.0 crore. That is why listed asset managers trade like a leveraged bet on the market, and why the fee cut is a real trade-off: it is small in a rising year and permanent in a falling one.

Say the limit of the model. Fixed costs are fixed only in the short run; in a good year bonuses rise, and in a bad year firms cut staff. The mandate may also bring costs of its own. The structure of the answer still holds: small changes at the top line become large changes at the bottom.

Where candidates lose it

The usual loss is growing profit at the same rate as assets, 20%, or as revenue, about 9%. Both ignore the fixed cost base, which is the whole point of the question.

The second is applying the 5 basis point cut to today's assets rather than next year's larger base, which understates the fee effect by a fifth and makes the split between the two effects wrong.

What the interviewer asks next

  • What asset growth would leave profit unchanged after the fee cut?
  • Why are passive products hard to make profitable for a small asset manager?
  • How would you value an asset manager whose profits swing this much?
  • What costs would you expect to rise if assets grow 20% every year for five years?

Company names and figures are illustrative.