Gluskin Sheff + Associates Is On The Takeover Radar

Gluskin Sheff + Associates Inc.

US: (OTC:GLUSF)

Canada: (TSX:GS)

Note: Dollar amounts are in Canadian $ unless mentioned otherwise. USD-CAD 1.0514 Price of 1 USD in CAD (November 22th 2013)

Gluskin Sheff + Associates, Inc. (GS, GLUSF.PK) is a Canadian wealth management firm. In Canada GS is in the prestigious business of serving only high net worth individuals, charity foundations and institutional investors. The business model of wealth management is a very simple one - it's about helping people to invest their money in return for a fee. GS only manages portfolios of $3 million or more and often asks for even more from new clients. GS is known for serving the Canadian elites, many of them are the richest and most powerful people in Canada. The highest threshold has an average asset per management (AUM) of $67 million per relationship. GS has built a reputation of high-level client service and high performance. As of September 30th 2013, GS had $6.3 billion AUM.

As of November 19th 2013, following their Q2 2014 results, GS traded at ~$23. When I started my research, the stock was trading around ~$18.5. The recent rise does take some potential upside away. However my research concludes that there is potential left.

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Source: Google Finance

The chart above represents GS's stock price history since the IPO. GS reached its stock price peak in 2007 before the financial crisis. The stock was trading at $30.50 and GS had $5.4 billion in AUM. The indicated performance on the chart can be misleading. The first impression we get from observing the graph is that GS underperformed the TSX in Canada and the S&P in the US. However, the graph's performance does not take into account the dividends and special dividends that GS pays, such as the $1.40 special dividend per share announced last September. Because of the nature of the business, GS returns any excess cash to shareholders and sometimes that amount can be quite large. Usually when a dividend is paid, the price is adjusted downward on ex-dividend date but for most dividends this is not observed amidst the up and down of a normal day's trading. It becomes easily apparent, however, in the case of a larger dividend payout, such as the $1.40 special dividend payment last September, which caused GS's shares to fall from $21.50 to $20.44 (-5.1%). There's an entire section dedicated to GS's dividends below.

Investment Thesis

The principal catalyst for growth is a takeover offer. Historical transactions suggest a 25-30% premium above the market price. At the current price of ~$23, a takeover premium would come in the range of $28.75 and $29.9. The big Canadian banks and insurers are aggressively competing to broaden their distribution channels. Over the last couple years many independents have been bought out by bigger competitors. The consolidation trend is continuing and Gluskin Sheff is certainly on somebody's radar. There's more on the takeover subject below. The other main growth driver is increasing AUM which generates higher fees and increasing profitability. Gluskin Sheff is also known for paying a reasonable dividend of about 5% plus a special dividend related to its performance. I believe these catalysts will continue to command the stock higher.

Brief History

Gluskin Sheff was founded on April 17th 1984 by Ira Gluskin, a former real estate analyst and Gerald Sheff, an architect. According to their corporate website, Mr. Gluskin and Mr. Sheff along with 24 private clients each put $1 million into their first equity portfolio model. Each $1 million investment has since grown to nearly $20 million. From this grew the wealth management firm's focus on the high net worth private client, as well as its philosophy of management and employees investing directly alongside their clients. GS now offers equity, fixed income and alternative investment strategies. David Rosenberg, a well-known personality and respected economist, joined the firm as their Chief Economist and Strategist in 2009. Before joining Gluskin Sheff, Mr. Rosenberg was Chief North American Economist at Bank of America-Merrill Lynch in New York for seven years.

Gluskin became a public company in May 2006 in a $133 million deal. On October 16th 2013, the two founders completed the sale of the majority of their stakes for $122 million. As part of the deal they relinquished control and the pair's stake was reduced from 55% to 2%. Neither of them has had a role in management since 2009.

Business Description

Gluskin Sheff + Associates provide discretionary investment management services to high net worth private clients and institutional investors. The minimum to become a client is at least $3 million. Senior management and employees own at least 25%-30% of the shares. The group collectively makes up the largest shareholders of the company. Restricted share units (RSUs) are also paid out in bonus, ensuring another commitment to the performance of the firm. Management and employees invest in the same portfolios as their clients. These elements ensure that management/employees and shareholders interest are aligned.

GS has been growing their AUM at a good pace. According to their latest annual report, from 1984 to June 2013, their AUM grew at a 20.7% pace.

GS internally manages the following funds:

GS+A Premium Income Portfolio

GS+A U.S. Premium Income Portfolio

GS+A Canadian Equity Portfolio

GS+A U.S. Equity Portfolio

GS+A Growth Portfolio

GS+A Resource Portfolio

GS+A Enhanced Bond Portfolio

The table below provides a summary of their portfolio performance.

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Source: Gluskin Sheff 2013 Annual Report. Page 17.

The GS+A Growth Portfolio Fund is Gluskin Sheff's staple portfolio and is managed by Bill Webb. $1 million invested in the GS+A Growth Portfolio from inception (1984) would have grown to $19.9 million versus $11.5 million for the S&P/TSX over the same time period (net of fees). The results are good and reasonable and pass the test of time. GS use a bottom-up approach based on fundamental analysis. Their approach is to look for companies with a long history of long-term growth and value creation, a proven track record, shareholder-minded management and a share price below their intrinsic value estimate. Their approach sounds like the cut paste format that you find in any prospectus these days. Their short-term performance has been bumpy, but over the long run, they seem to deliver above average returns, so whatever they are doing seems to work.

Management

Gluskin Sheff + Associates have quite a high profile roster with names such as David Rosenberg and Paul Beeston. I have included a brief description of the key people. It was recently announced that Gluskin and Sheff will retire from the board effective as of December 18th.

Summary of some of the key people:

• Mr. Ira Gluskin, now 70, left his CIO post in 2009. He's frequently seen on TV as a commentator.


• Mr. Gerald Sheff, now 72, stepped down as CEO in 2010 and was replaced by Jeremy Freedman, the current CEO.


• Jeremy Freedman, President and CEO, is a lawyer has been with the firm since 2000. Prior to joining GS, Mr. Freedman was a partner and a senior litigation counsel with the renowned law firm of Davies Ward Phillips & Vineberg. He took over the CEO post in 2009.


• Bill Webb - CIO - Registered portfolio manager. CFA. Prior to joining Gluskin Sheff in 1995, Mr. Webb was based in Beijing, China with the Bank Credit Analyst Research Group, analyzing emerging securities markets in China, Taiwan and Hong Kong. He's often sought by the media for comments and investment ideas.


• David Rosenberg - Chief Economist & Strategist - Prior to joining Gluskin Sheff in the spring of 2009, Mr. Rosenberg was Chief North American Economist at Bank of America-Merrill Lynch in New York for seven years, during which he was consistently ranked in the Institutional Investor All-Star analyst rankings. Mr. Rosenberg was the only economist recognized for his accurate economic projections in Fortune Magazine's "Best and Worst of Wall Street 2011," and was ranked most accurate forecaster for 2011 by MSNBC.


• Paul Beeston - Chairman - Current CEO of the Toronto Blue Jays. Former President and COO of MLB. Serves on the Boards of Loblaws and the National Baseball Hall of Fame. Member of the Order of Canada, Canada's highest civilian honor.

Recent Developments

September 4th 2013 - Announcement of a special dividend of $1.40 per share payable on September 23th 2013. Special dividends are based on performance fees of the first 6 months and excess cash. GS also announced that its regular quarterly dividends would increase to $0.80 on an annual basis for fiscal 2014. FY2014 started on July 1st 2013. I have a whole section dedicated to dividends below.

Market-based adjustments in base salaries include a change in the maximum percentage of performance fees allocated to the bonus pool from the current 25% to 40%. The Board also approved an award of RSU, in the aggregate amount of $5 million, to certain senior employees. This was done to further align the long-term interests of key employees with shareholders. If this is the cost it takes to keep a good team together, then I support it. I work in the investment industry and losing excellent personal can be very harmful, especially when your whole business is centered on a few key individuals. These key people have a lot of intangible value attached to them. If you don't pay them for what they are worth somebody will. Unlike machines, some people are irreplaceable.

The founders also announced they are selling 6.4 million shares, eliminating the dual class structure. More details on the deal in a separate section below.

On November 7th, GS announced that Sheff and Gluskin informed the Board of Directors of their intention to retire from the Board effective as of the annual and special meeting of the Company to be held December 18, 2013. They will be goodwill ambassadors of the firm and Mr. Gluskin will continue to manage a portfolio of assets for clients of the firm.

GS also announced that the Board has adopted a shareholder rights plan and amendments to its by-laws. The Board intends to seek shareholder approval of the Rights Plan and by-law amendments at the AGM. The purpose of the Rights Plan is to provide the Board with additional time, in the event of an unsolicited takeover bid, to develop and propose alternatives to the bid and negotiate with the bidder, as well as to ensure equal treatment of shareholders in the context of an acquisition of control, and lessen the pressure on shareholders to tender to a bid. I highly suggest you consult SEDAR for the full documentation.

The Deal

On September 25th 2013, the selling shareholders, Mr. Sheff and Mr. Gluskin entered into a letter agreement to sell off their stakes and to relinquish control. There was already some pressure on Mr. Gluskin and Mr. Sheff to act. According to regulatory filing, their superior voting shares had an expiration date in mid-2016. On October 16th, GS completed their secondary offering of 6.4 million shares at $19 per share for gross proceeds to the founders of approximately $122 million. The deal eliminates the multiple voting shares and leaves the company with one class of shares. Before the deal, Ira and Gerald controlled 55% of the company's multiple voting shares. After the deal, they will each own 300k shares or 2% of the shares outstanding after eliminating the dual share structure. Senior Management and a significant number of employees purchased shares in the offering, representing collectively GS's largest shareholder. After the conversion, GS has about 29.5 million outstanding subordinate voting shares, of which management and employees own 25-30%.

"The closing of the Offering and the elimination of the dual class share structure are important and exciting transitional milestones for our Company, I am delighted that management and a significant number of employees expressed their excitement about the Company's future by purchasing shares in the Offering. This group continues to be, collectively, the Company's largest shareholder." commented Jeremy Freedman, President and CEO.

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Source: Preliminary Short Form Prospectus, October 1st, page 8.

Another positive element is that other owners of multiple voting shares, such as CEO Jeremy Freedman and CIO Bill Webb were willing to convert their multiple voting shares into subordinate voting shares without any compensation for doing so. This act of good faith suggests they have the interest of GS at heart.

According to Scott Chan, an analyst at Canaccord Genuity, the monetization should be a positive development for shareholders because it improves the firm's liquidity, reduces the likelihood the firm will get bought out and could attract institutional shareholders. I agree with that assessment.

Reasoning Behind Acquisitions and Past Transactions

The wealth management industry in Canada is in consolidation and any deal would also extend the trend. It's harder and more complicated to be an independent smaller player in the industry. Smaller independents like Canaccord Genuity and Richardson GMP Ltd. are struggling to turn a profit while the big banks rebounded well from the financial crash and are now swimming in profits. My first job in the investment field was with an independent investment company and we got acquired by a big player. The main reason: Economy of scale. Elements like compliance, internal control, and cost keeps going up. It's a heavy burden for small companies. There is also a trust factor. Some investors are not comfortable investing with a small independent investment boutique. The big Canadian banks and insurance companies are always in search of new avenues to offer their products. The banks are investing heavily in asset management since they have higher margins and this helps combat slower grow in other units. The banks also like their wealth management units because regulators don't require a large capital cushion.

Below are a resume of some of the latest transactions in the industry, as you can tell the bigger players are hungry:

• As recently as September 2013, CI Financials bought 65% of Marret Asset Management. CI Financial expressed interest in the past that it would like to build out its alternative investment product. Scotiabank bought a 38 percent stake in CI Financial in 2008.


• August 2013, Manulife acquired Wellington West from National Bank Financial Group, adding about $900 million in assets. Previously Wellington West was acquired by National Bank of Canada. Manulife also acquired independent Berkshire Financial services in 2007.


• In April 2013, CIBC buys Atlantic Trust Private Wealth Management from Invesco for $210 million. CIBC also acquired a stake in American Century Investments two years ago.


• In December 2012, TD acquired Epoch Investments Partners for approximately $US668 million representing a 28% premium to Epoch's closing price.


• Natcan Investment Management was acquired by Fiera Capital Corp. in 2012. Fiera acquired wealth management Bel Air Investment Advisors business and global asset manager Wilkinson O'Grady. Together, both deals are worth $156.25 million.


• In 2011, Sun Life bought the rest of Mclean Budden Ltd.


• In 2010, Scotiabank scooped up independent Dundee Wealth for $2.3 billion.


• In 2008, Mackenzie Investments finalized the acquisition of Howson Tattersall Investment Counsel.


• In 2009, independents GMP Capital Inc. and Richardson Partner merged to form Richardson GMP Ltd.


• In 2008, RBC acquires Phillips, Hager & North Investment Counsel Inc.

Takeover Rumors

Gluskin Sheff has been the target of takeover rumors for a long time starting in early January 2013 when the founders put the firm up for sale. With the latest deal, the founders don't have the power anymore to block a potential deal. Who would be interested? Without a doubt the five big banks of Canada, insurers and asset managers. The paragraph above has a resume of some of the transactions in the industry.

We know that big banks and insurers love wealth management units because of its predictable fee-based revenues and low capital requirement. The banks and insurers are competing aggressively by acquiring smaller layers and building out distribution channels. Gluskin Sheff is a nice business with a very special class of clients; a class that every bank is aggressively seeking as their next big trophy.

In April 2013, GS confirmed that the company has invited takeover offers. Then they hold off the sale. In September, the founders sold their stake for $19 a share and left GS as a stand-alone company and one class one share. This raises a lot of unanswered questions. Was there a better offer on the table? It's hard to tell. We don't know either if the offer received was only for the founder's stake, a minority stake, or the entire company. We also don't know who the bidders were. Maybe the founders didn't like the structure of the deal proposed (e.g. earn out, share exchange). Maybe the highest bidder wasn't the right match. Maybe management simply believes that they can do better on their own. FY 2012 was a difficult year for GS, so maybe the bidders used it to underbid. So far it's all speculation. Today we know that GS has one class of shares and that management and key employees own at least 25%.

Rising markets have boosted the value of GS's AUM to $6.3 billion as of September 30th. This raises the probability that GS's investment return will meet targets that would trigger performance fees and as a result higher income. Also the miserable year 2008 is exiting from its 5-year performance track record and is replaced by an excellent 2013. These components should help them attract new funds and as a result boost their valuation.

Financial Overview

AUM

The most important metric is asset under management (AUM). In theory, higher AUM should lead to higher revenues. Firms are measured on how much AUM they have. AUM grew 13 per cent year-over-year in the first quarter, despite volatility in global markets. One of GS's main highlights is compounding AUM at an annual growth rate of 20.7% since inception (1984) but that number has been trending downward over the last couple years. Gluskin Sheff loves to bring up this stat but most of that growth was before the 2006 IPO. The chart below indicates the growth in AUM in the last ten years.

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Glusking Sheff went public in 2006 with $3.7 billion AUM. AUM is up approximately 70% since going public. It's a positive trend but not exactly spectacular. If GS adjusted their AUM annual growth rate stat to the IPO year it would not be that impressive. You can see from the curve above that the majority of the growth in AUM was pre IPO years. Basically do not be fooled by a stat GS loves to parade around. In the beginning, a lot of the increase in AUM was from new money, either from existing clients, new clients or institutions. Lately the increase has been performance related. GS endured the financial crisis of 2008 (FY2009) pretty well with only a 20% drop in AUM, much lower than most wealth management firms. According to management, most of the decline in AUM was due to the deterioration in capital markets and GS had a very low redemption level. I believe this is due to the risk profile of high net worth investors and institutions, which are less likely to pull their money out during times of distress. In FY2009, GS declared a dividend increase and a special dividend payout. I suspect that part of the motive of the dividend increase was to attract investors to buy its shares.

As of June 30th 2013, 84% of the AUM was managed on behalf of high net worth private clients, including entrepreneurs, professionals, family trusts, private charitable foundations and estates. The balance of approximately $1.0 billion, or 16% of our AUM, consists of funds managed on behalf of institutions. Below I have a table that displays the distribution of AUM by relationship size. You can see that investors with a net worth of over $50 million are responsible for 25% of the AUM.

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Source: Annual Information Form 2013. Page 8.

Gluskin's greatest source of new business: referral from new clients and word of mouth. If you are a millionaire, what is your friend circle composed of? Other millionaires. It does make sense. If you have a net worth of $10 million, the chances are that you hang out with people of the same social status. They are members of the same golf course and their kids go to the same schools. Gluskin Sheff is also raising their public profile by hiring superstar economist David Rosenberg to act as their mascot. Mr. Rosenberg is often on TV and writes columns in newspapers predicting global trends.

Revenues / Fees

The business model of Gluskin Sheff is a simple one - it's about helping people to invest their money in return for a fee. GS's revenues are derived mainly from Base Management Fees, calculated as a percentage of AUM, and Performance Fees. GS earn Performance Fees only when they exceed pre-specified performance hurdles for their client's investments. Performance Fees are calculated annually on June 30th and December 31st. With the latest positive performance of the market and theirs funds, a lot of investors are piling on the stock with the hope that a big fat special dividend is paid out after December. Performance Fees were $2.1 million for the three months that ended September 30, 2013, compared with $1.1 million in the same quarter a year ago.

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The revenues are pretty volatile with some wonderful years and miserable ones. What I like is GS's ability to rebound after an "off" year such as FY 2009 and FY 2012. In FY 2012, GS was hit with poor investment performance and AUM withdrawal. You can argue that it was a challenging year with the financial markets filled with uncertainty and risk (e.g. Euro debt crisis).

The latest results suggest that the trend is positive. Base Management Fees increased to $20.3 million this quarter versus $18.5 million in the quarter a year ago, as average AUM for the quarter increased to $6.2 billion from $5.6 billion for the same quarter last year. The Base Management Fee Percentage declined to 1.29% from 1.32% for the same period last year. Below I have included a table that demonstrates how Performance fees are calculated on each portfolio. It explains the hurdles and rates and it varies depending on the model/fund.

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Source: Annual Information Form 2013. Page 11.

The following chart shows the Performance Fees as a percentage of Base Management Fees. You can see that they are not consistent and very volatile from year to year.

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Source: Annual Information Form 2013. Page 18.

I have further broken down the fees by segments.

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Just like the table above, the chart clearly tells us that the Performance Fees are very volatile. The Performance Fees are highly dependent on investment performance and swings from one extreme to the other. Since Base Management Fees are not growing at a decent rate, it's up to the Performance Fees to make up the slack. It's certainly not a trend I like. Investors like certainty and stability. If GS could get more assets under management Base Management Performance Fees would be higher and investors wouldn't depend so much on the Performance Fees.

EBITDA / Net Income

For much of 2011 and 2012, Gluskin Sheff's performance was mixed. When the company reported full-year earnings last fall, net income fell to $17 million from $50 million a year prior, and assets under management dipped to $5.4 billion. To keep investors interested, the company had to hike its dividend, as well as pay out a special dividend of six cents per share. Performance rebounded in 2013 with $125 million in revenues and net income of $49 million.

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The following numbers are in line with the other results we have looked at so far, that is they are inconsistent and unpredictable. At the moment, the numbers are on the upswing. Base EBITDA is often used as one of the key valuation metrics. Analysts usually use a multiple of the NTM Base Management Fee EBITDA estimate in a sum-of-the-parts valuation.

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In line with the other numbers, the EPS are up and down. The EPS are a victim of the volatile Performance Fee. Analysts surveyed by Reuters have a consensus of $1.75 for FY 2014 and $1.77 for FY 2015. That number was updated this month and is up from a consensus of $1.58 for FY 2014. The $1.63 in the table is my own calculation. I use more conservative assumptions than most analysts. Sugar coating is not in my personality.

Dividends

GS loves to rewards its shareholders. Last September, GS announced its ninth special dividend and seventh consecutive increase in its regular dividend since becoming a public company. There were two special "performance" dividends alone in 2013, one of $0.65 in February and one of $1.40 in September. Management already announced that their dividend payout for fiscal 2014 is raised to $0.80 annually, up from $0.70.

GS's ability to pay dividends is entirely dependent on their operations and ability to generate fees. And fees are subject to various factors including financial performance and AUM. According to the Dividend Policy, the Board will semi-annually consider the declaration of a special dividend.

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Above is a graph of the dividends declared since the IPO. For FY 2014, I have only included the special dividend declared back in September 2013. It's highly possible that another special dividend is declared after the December results come in. This payout would come in on the top of an already record year for dividend payout.

I love dividends but more importantly, can GS sustain it? Beneath the surface the dividend payout ratio seems sustainable. For normalization purpose, I didn't take into consideration FY 2007 and FY 2012, and I get an average dividend payout ratio of 86%. GS is not a capital intensive business. The regular dividend is about ~40% of the payout ratio. The rest is related to the special performance. The payout might look high but it's sustainable. It's a business model where the excess cash is returned to the shareholders. Therefore the regular dividend is not at risk but the special dividend will fluctuate according to the firm's performance.

The Analysts

On November 8th, BMO Capital Markets, Canaccord Genuity, CIBC World Markets, RBC Capital, TD Securities have all increased their target price. Here's a resume:

• BMO Capital Markets -Market Perform- $23.00


• Canaccord Genuity - Buy - $24.50


• CIBC World Markets -Sector Perform - $22.00


• RBC Capital Markets - Outperform - $27.00


• TD Securities - Hold - $24.00

At the moment, most analysts are bullish on GS. Target prices and recommendations change all the time. That's why I don't put too much weight in their projections and target prices. They change their mind a lot and they also focus too much on the short term. Back in September, most analysts had a hold rating on GS following the sale announcement. To give you an idea, back in 2012, CIBC had a target price of $14 for 2013. Their reports are interesting to read but a reader must keep in mind that their research is for the institutional investors and not for the retail investors.

Growth

I'm not going to start writing a business plan for GS but it can continue to grow if they can successfully execute this following plan:

• Strong investment performance for existing clients. This is clearly the most effective strategy. It's more cost effective to keep a client and to work with them than going out to acquire one. A happy client might also attract new funds by bringing in new money and referrals.


• Expansion of new products. GS can grow by expanding their current portfolio model. Different clients have different needs.


• Expand to new geographic markets. According to GS's 2006 prospectus, 70% of their AUM is from high net worth clients in Ontario and Quebec. There's a lot of wealth in the rest of Canada that GS could aim for, such as oil rich Alberta. GS could also open offices internationally.


• Attract more institutional money. As of June 30th 2013, GS only managed $1 billion on behalf of institution, or 16% of AUM. Historically GS has not sought to compete in this segment of the industry. With the recent positive performance and the new single class shareholder structure puts them in a better position to attract funds.


• Develop a platform for lower net worth individuals. The $3 million minimum bar is pretty high but it's also a sign of prestige. GS used to have a $1 million and a $2 million minimum. GS creates a sense of desire. You want things you can't have. One idea is to have GS develop a line of funds or open a different division that would cater to smaller investors, similar to what Jarislowsky Fraser did in 2012. If successful, the new division would lead to higher AUM.


• Instead of being the investment target, why wouldn't GS start acquiring others asset management companies? That also would increase AUM and potential synergies might be available.

Valuation

What took a bite out of my investment thesis is the 24% rise in the stock price since I started my research. The same situation happened when I was researching NagaCorp. The stock price shot up 16% in the three weeks I was researching it. It looks like a positive curse. Keep in mind that behind GS's current bull ride is investors getting in with the expectation of a big special dividend payout because of the latest positive results. The stock might retreat after that.

However, my valuation is based on a multi-year horizon. Most analysts have a 12-month target price and equity investors are probably discounting at least the next six months.

I have a provided different valuation and assumptions. As explained above, my numbers are slightly more conservative. I calculated $1.63 EPS for FY 2014, below the analyst consensus of $1.75 EPS.

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My table is not that impressive. The only upside is if GS trades at the S&P/TSX 16x multiple, which I doubt will happen. It looks like GS's current market price fully discounted the data for this fiscal year.

The analyst's scenario is more optimistic. The analysts expect $1.75 EPS for FY 2014. At 14x P/E, we are looking at 14.3% return including the dividends. This is a reasonable return for the coming months.

The above scenario is the takeover offer and also the most lucrative short-term scenario. A 25% to 30% premium over the market price is an often used rule of thumb. The latest transactions suggest that the trend is continuing.

The scenario above is simply based on comparables. Sprott and Fiera have approximately the same market cap and CI Financials is much bigger. They are also some of the most mentioned comparables in analyst reports. The comps are trading at higher price to earnings multiple than GS. This can be explained by the lackluster results of GS. Assuming that GS turned the corner on the worst years, we can maybe expect a higher trading multiple. GS's peers have an average of 17.4x forward P/E, with Fiera and CI Financials in the low 20x. I don't think GS will get to that level this year but if it does, it could command a higher valuation.

Based on my valuation, the value of Gluskin Sheff is in the range of $24.6 to $29.9 per share. This represents a 7% upside to a potential 30% in case of a takeover offer. Everything in between is fair too if the market decides that GS deserves a higher valuation multiple.

Positives

• Outstanding long-term track record of strong investment performance.


• Independence. There are not a lot of independent wealth managers in Canada. The majority of them were bought out.


• Senior management and employees are the firm's largest shareholders. Part of their bonus is paid out in RSUs. They also invest in the same portfolios as their clients. I like a company where management interest is aligned with the shareholders.


• The new single class structure might attract more institutional investors.


• GS loves to pay dividends and to return excess cash to their shareholders. Gluskin Sheff has raised its dividend for fiscal 2014 and paid two special dividends in 2013. I'm comfortable with this since they are not a capital intensive business.


• Well positioned to continue to expand in the high net worth private client market, the fastest growing segment of the wealth management industry.


• The deal: this monetization should be a positive development for shareholders because it improves the firm's liquidity, reduces the likelihood the firm will get bought out and could attract institutional shareholders, said Scott Chan, analyst at Canaccord Genuity.


• GS is in a nice market with its prestigious high net worth clientele - a highly sought after segment in the industry. GS has developed an outstanding reputation in the Canadian high net worth private client market.


• Their five year performance will now exclude disastrous 2008 and add exceptional 2013. The better performance track record should help attract funds.


• Wealth management is a low capital requirement business.


• Numerous funds which leads to fee diversification.


• History of dividend growth and special dividend pay out.


• Last year, 94% of the growth in AUM is performance related. The performance crushed the market and should attract more funds.


• I'm not drawing a business plan for them, but if they are desperate for growth they could open a fund for investors under $1 million.

Risks and Negatives

• The biggest risk is a potential drop in AUM. Fees are derived from AUM. A collapse in AUM would lead to a collapse in revenues. GS is linked to changes in securities markets and poor investment performance.


• In 2012, AUM dropped and net income fell to $17 million from $50 million a year prior.


• Original founders sold a majority of their controlling stakes in September 2013. With the founders gone, can management keep the founder's vision?


• Performance fees are subject to performance hurdles that will not be met for some portfolios in the short term and vary significantly year to year due to market uncertainty and volatility.


• While the rich get richer, there are only so many of them. Because of their much selected clientele, it's harder to attract new clients. In Canada, the market for millionaires with $3 million in investments is limited. Gluskin Sheff can only have so many clients. An opportunity is to expand geographically.


• Q1-2014 - AUM experienced a small net withdrawal of $11 million. The net withdrawals resulted from $84 million in net additions from high net worth clients, offset by $95 million in net withdrawals from institutional clients.


• Q1-2014 -The Base Management Fee Percentage declined to 1.29% from 1.32% for the same period last year.


• Loss of key employees. Intellectual capital is extremely important. Any loss of management, or investment professionals could lead to loss of clients and decline in revenues. To retain key employees, GS has implemented an employee stock ownership plan (ESOP), and Restricted Share Units (RSU) and discontinued annual grant of stock options.


• Performance fees allocated to the bonus pool is up to 40% from previous 25%. This means less money for the shareholders. Performance fees were responsible for 36% of the income last year. The fees are now believed to be in line with market rates. Changes were effective July 1, 2013. Performance fees are earned when GS exceeds pre-specified rates of return. As I mentioned earlier, if this is the cost to keep a good team together and to keep performance up, then I am in favor. The compensation is set and reviewed by the Compensation, Nominating, and Governance Committee of the Board. For more information, I invite you to read Gluskin Sheff: New Single Share Class Improves Upside Leverage By Safety In Value.


• Only 6% of the AUM growth in the recent year is from new money. The rest is performance related. There are many ways to read this. First, because of the type of clientele, it's harder to attract capital. On the other hand, a good performance should facilitate them attracting new money.

Catalysts

The recent rise in the stock price from $18 to $24 really took some upside away from my investment thesis. It's possible the recent bull ride is temporary until the next special dividend payout. A lot of people have jumped on the bandwagon after the November 8th results. Clearly the main catalyst is a takeover offer from a big bank or insurer. Past transactions suggest that a 25%-30% premium is common. We know that GS has an open mind because they entertained offers earlier this year. We also know that there's a wave of industry consolidation in the Canadian asset management industry. Higher costs and regulations make it more difficult to operate as an independent. The truth is it's much more cost effective to be part of a big bank with other units to support you. Another important catalyst is increasing their AUM. With a limited supply of multi-millionaires, GS needs to tap more institutional money. Institution only makes up 16% of their total AUM. Their latest positive results and the new single class structure are two factors that might attract new funds to manage. As markets continue to improve, market appreciation is likely to further boost AUM. GS is also well positioned to continue to expand in the high net worth private client market, the fastest growing segment of the wealth management industry.

Conclusion

There's two ways to play this investment. You can have $3 million and invest along them or you can buy the stock and hold it for a long time.

Based on my valuation, the value of Gluskin Sheff is in the range of $24.6 to $29.9 per share. This represents a 7% upside to a potential 30% in case of a takeover offer. Everything in between is fair too if GS keeps up their special dividend payout and the market decides higher valuation multiple is warranted.

At this moment, you might be pondering whether GS is investment worthy. GS's past performance is not really that impressive and lags behind the TSX and S&P500. A lot of my thesis depends on a potential takeover offer. Therefore you need to be aware that there's a certain level of speculation in my investment thesis. The recent industry consolidation suggests a 25% to 30% premium over the open market price. By applying the 25% rule of thumb to an average price of $23, GS would have a market cap of approximately $850 million, or $28.80 per share. GS could fetch such a premium because of the exclusive nice clientele that GS caters to. A big bank would love to have this cream of the crop portfolio of clients and bragging rights. If there's no offer on the table, I believe that you could still have modest return if management succeeds to increase AUM and keeps delivering on the special dividends. The average annual dividend yield is approximately 5% and could realize more with the special dividend. A combination of potential modest growth, dividend and special dividend payout would result in a reasonable 5%-10% annual return. One of GS's key principles is aligning the interest of management with the shareholders by investing a portion of their net worth along with the shareholders and clients. The recent structural changes and performance suggest that GS has turned the corner and is ready to deliver higher returns to shareholders.

Source: Gluskin Sheff + Associates Is On The Takeover Radar

Disclosure: I am long OTC:GLUSF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

Additional disclosure: As with all of my articles the opinions are my own. You should do your homework and make your own best judgments about the company. (I know that this resembles the boilerplate disclosure that you see in every email that you get from your broker but I really mean this and I am not saying it to avoid getting sued.)

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