Post by Badger1754 » Mon Feb 26, 2018 12:21 pm

If the VCs expect less than a 30x return

If the VCs operate on an IRR basis and not a cash-on-cash basis

If Wealthfront can command a higher premium on the EBITDA multiplier

If Wealthfront can generate a higher EBITDA margin due to automation, etc.

If further VC investment is required

If Wealthfront is generating 25 bps on a significantly lower portion of its $10B AUM, as certain assets are managed for free

If Wealthfront can generate scalable revenue on something other than bps of AUM

VC = Venture capital. Firm that puts in money into early-stage companies, with the expectation of earning an outsize return on a few home runs -- but also accepting the risk that most of their portfolio will go to zero.

EBITDA = Earnings before interest, taxes, depreciation, and amortization. A decent measure for profitability.

EV = Enterprise value. The formal definition is equity + debt - net cash. It's the "all-in takeover price" to buy a company.

EV/EBITDA. A multiplier that you can use to approximate the takeover value of a company. For example, if a company's EBITDA is $100M, and the EV/EBITDA is 10x, then the takeover price would be 10*100 = $1B.

AUM = Assets under management. This drives Wealthfront's fees.

bps = Basis points. 1/100 of 1%.

2-and-20. A typical hedge fund fee structure. They charge 2% of all assets under management, and then 20% of all gains over a given threshold. The threshold is typically something much lower than the S&P, and the 2% is in place whether ot not the hedge fund makes or loses money.

Last week, we made the difficult decision to pull all of our money out of Wealthfront and transfer it to Vanguard (after being Wealthfront customers since 2013). Part of it was nasrullah's post about the stock-level lock-in . Part of it was the sudden introduction of Risk Parity (and an 8 bps increase in fees). But most of it was math.In short: I believe, under guidance/pressure from its VC investors, Wealthfront is pivoting from a low-fee automated roboadvisor with a distinctively Boglehead-friendly passive investment strategy to a higher-fee active management approach. After all, what is their new Risk Parity or Smart Beta thingy but "active management"? They used Direct Indexing and the opaqueness of your holdings (for example, not informing you of the cost basis) to create stickiness, so as to make it difficult for people to leave. Now, my hat is off to them, because if I were a VC interested in maximizing my returns, I'd do the exact same thing. They offer a slight cost advantage with a heckuva lot more stickiness.For the model below, I used BlackRock as a proxy for Wealthfront's EBITDA margins (rounded up to 50% because I imagine Wealthfront has less legacy overhead), and for its EV/EBITDA multiple (rounded up to 20x for the tech premium and expected growth trajectory). I found the $204.5M in total VC money from Crunchbase . I assume a VC would expect a 30x return on investment.Right now, Wealthfront (with its $10B AUM) is generating a 1.2x return on investment (the light blue highlight).Now, in order to generate a 30x return on investment, Wealthfront has two levers: (1) it can increase its fees from 25 bps, or (2) it can increase its AUM from $10B. I believe its recent moves, such as Risk Parity and its announcement that it will no longer manage the first $10K for free, is a symptom of this fee pressure.The bottom table is a "sensitivity table" showing what it would take at different levels of AUM to justify its VC investment. Where I played with variables is highlighted in yellow.At one end of the spectrum (right now -- at $10B AUM), Wealthfront would have to increase its expenses to 613.5 bps to create a 30x payback. Before you flip out, a 6% expense ratio is actually not that unheard of in the 2-and-20 world of hedge funds once you factor in performance expenses. At the other end of the spectrum, Wealthfront can keep its fees at 25 bps if it manages to increase its AUM to $245B.So the question is, do you believe that Wealthfront can increase its AUM to $245B in the next few years, before the VCs lose patience? (Keep in mind they operate on a 5-7 year investment cycle.) If you don't, then Wealthfront's fees have no place to go but up, and they have created a brilliant product designed to lock customers in.Here is the math:Where I could be wrong:Edited per Taylor Larimore's suggestion to explain some of the abbreviations