Morningstar has begun coverage of financial services umbrella firm Pinnacle Investment Management, attributing it a narrow moat, and a high uncertainty rating.

Morningstar analyst Shaun Ler has set a fair value estimate of $11. On Tuesday, the company was trading at about $10.30, which puts it in the three-star range or fairly valued.

It carries an exemplary capital allocation rating because in Ler’s view it has a sound balance sheet and is “making the right investments”.

Pinnacle has a dividend yield of 1.96 per cent, slightly down on its five-year average of 2.19 per cent. It paid a dividend of 11.7 cents in March.

Pinnacle’s affiliate model: strong brand, switching costs

Pinnacle provides seed and working capital, marketing and distribution services, business support and responsible entity services to a network of boutique managers—which it terms as "affiliates."

Apart from charging fees for its services, Pinnacle also earns a share of profits from its affiliates via holding equity interests in them. As of 30 April 2020, Pinnacle has 16 affiliates under its network with $84.9 billion in funds under management.

The key characteristics that determine its narrow moat—or ten-year competitive advantage —are its strong brand and switching costs. Pinnacle typically caters to smaller-scale boutiques and access to the club allows entrants to unlock capital, investment infrastructure, and distribution capabilities that are usually the preserve of larger firms.

The club of 16 includes select strategies of Hyperion, Solaris, Resolution, Antipodes, and Firetrail—who collectively manage 64 per cent of FUM, are assigned medallists by Morningstar Manager Research.

Ler says the outlook for earnings is positive as Pinnacle acts as an “incubator for growth”. Ninety percent of affiliate strategies and products (with a track record exceeding five years) have outperformed benchmarks over the five years to 30 April 2021.

“We see the appeal in Pinnacle’s business proposition,” Ler says. “Amid an increasingly competitive funds management landscape, scale, bargaining power and resourcing depth are key success factors.”

“Affiliates which are backed by Pinnacle are free from administrative burden and can focus on managing money, thereby having greater potential to achieve better returns. Affiliate managers continue to own equity in their own businesses, ensuring alignment with clients.”

Affiliate FUM has grown at a compound annual growth rate of 32 per cent to $70.5 billion as of December 2020, from $23.3 billion in December 2016.

Over this time the number of affiliates has more than doubled from seven to 16.  

Ler expects the firm’s growth trajectory to continue. He forecasts aggregate FUM to grow by close to 25 per cent a year to border $170 billion by fiscal 2025—consisting of retail FUM of $42 billion and institutional FUM of $127 billion—versus growth of roughly 60 per cent a year from fiscal 2017-2020.

Pinnacle Investment Management (PNI) v Morningstar Australia Index, growth of $10k

A chart comparing the 10k growth of Pinnacle v the Morningstar Australia Index - MAX

Source: Morningstar Premium

What are the risks?

A few key factors explain the high uncertainty rating Ler has attached to Pinnacle. A range of controllable and non-controllable events may cause it to experience stronger than expected outflows, market losses and/or margin compression.

The covid sell-off for instance led to a 7.5 per cent fall in FUM over the five months to 31 May 2020. As Ler notes, “sharp market declines could quickly leave smaller boutiques unprofitable.”

Secondly, subpar performance heightens the risk of competition. Competitors include narrow moat money managers Perpetual (ASX: PPT), and Magellan Financial Group (ASX: MFG) as well as no-moat Platinum Asset Management (ASX: PTM).

Third, once an affiliate grows in scale and becomes self-sustaining it may choose to leave the Pinnacle stable. Likewise, the risk of redemptions—notably by super and pension funds—could leave smaller boutiques unviable too.

Pinnacle seeks to counter these risks holding a stake in any departing affiliates, and by diversifying its clientele and selling to retail investors once an affiliate amasses a credible track record.

A tick for capital allocation

Pinnacle is making what Ler sees as the right investments and has a sound balance sheet, which should help it navigate future downturns.

Together these account for Pinnacle’s exemplary capital allocation rating.

“By providing a range of integrated services, Pinnacle frees up its affiliates to do what they do best—investing and managing money,” Ler says.

“It has so far backed the right horses, and execution on getting boutiques up to scale has been top-notch. Cash is used to grow distribution and seed new products, as well as acquire stakes in its affiliates.”