You gotta respect a man who puts his money where is mouth is. Mark Hurley has received considerable publicity over the past ten years for a series of studies about the economic future of the independent advisory industry (most recently with JP Morgan Asset Management in 2005). I've taken exception in these pages to some of
Mark's conclusions, most notably that because the financial markets value future cash flow more than advisors do themselves, eventually we'll see the industry consolidate into 50 or so large, presumably public, advisory firms. I've felt that applying financial metrics to advisory practices where profits and even free cashflow can be easily understated leads to vastly underestimating the financial strength of many practices and, in my view, some pretty silly conclusions.
Much to his credit, Mark hasn't been content to merely espouse his theories every few years: He's recently launched a company designed to take advantage of the financial opportunities that he's been talking about. Even more impressive, his new firm--Fiduciary Network, LLC in Dallas--isn't structured to create one of the predicted mega-advisory firms that I and many others find so distasteful. Rather he's offering an alternative to advisory firms that don't want to be consolidated. Of course, as I've written before, in the sale of any advisory firm, the devil is in the deal terms. As one advisor put it to me: "Mark is a very smart guy and, shall we say, a real capitalist. There's no doubt he and his partners will make money on these deals. The question is, where is that money coming from?"
That's just what I've been trying to figure out. The problem for which Mark Hurley offers a solution comes from the immaturity of the independent advisory industry. Still less than 40 years old, independent advisors have yet to solve the succession issue. In established professions such as law or accounting, firms are structured so that junior professionals can gradually buy out the senior partners. By all accounts, the vast majority of advisors want to do this, too. The problem is that advisors have yet to come up with a structure in which younger professionals can afford to pay current owners anywhere near what their practices are worth. Consequently, most advisors who are ready to transition their practices end up selling to their employees for far less than market value, or selling to an outside advisor. That's not the only option--a growing number of top firms sell out to banks or rollup firms.
According to Hurley, the problem stems as much from the high value of advisory firms as from the ironic failure of many planners to start thinking about succession until they are within five years of retirement. Unlike law or accounting firms, where the client relationships tend to be with specific professionals and are accordingly valued at around one times revenues, the steady stream of revenues from managed assets are worth much higher multiples to financial investors.
The caveat here, which Mark is quick to point out, is that those AUM revenues have to be generated by an advisory firm that is truly a business: with workable multigenerational systems to replace lost assets, work with clients' children, capture trust assets, and attract, train, retain the next generation of advisors--and most importantly, grow those revenues in the future. For firms such as these (which undoubtedly number far fewer than 1,000), Mark says financial investors will pay substantially in excess of even the three or four times annual revenues that banks currently offer.
The Hurley-Milstein Approach
Who would pay that much? Enter Fiduciary Network, LLC--a partnership funded with a $600 million line of credit from Howard Milstein's Emigrant Savings Bank in New York. Hurley's strategy is to use Emigrant's financing to enable junior advisors to buy out senior partners at some of the industry's top firms: the senior partners sell shares at three specified future dates, for lump sums tied to future growth rates paid by the bank, and junior partners pay the loans back out of the future earnings of their ownership interests. Fiduciary Network participates in the growth of the firm though a minority stake of non-voting stock. "We want the junior advisors to buy as much of the stock as they can," says Hurley. "That way, they have increased incentive to grow their firms. We just want to share in a small piece of that growth."
Because the senior partners are selling their interest in the firm over time and that interest is valued at a multiple of earnings at the time of sale, they continue to have a stake in growing the firm. "It's the future growth that's financing the whole deal," says Hurley. "If a firm has $2 million in cash flow that's growing at 15% or 20% a year, what's the present value of that 30-year income stream?"
The answer, of course, is a lot. A present value of $2 million a year growing at 10% for 30 years, discounted at 15%, is $32.9 million. And the selling partners continue to get profit distributions on the shares they haven't sold yet. Hurley confirms these numbers: "We'll start paying the selling owners around 8 times free cash flow, and if the firm keeps growing that could go up to as high as 14 times. In a large firm with solid growth, they could end up with $30 million."
Junior Partners, Beware
So who's really picking up the substantial tab on these deals? The structures are complex and getting specific details is difficult, in part, because, as Hurley says, the program is sufficiently flexible to tailor each transaction to meet the specific needs of each buyer and seller. But I think we can be reasonably confident that it isn't Mark Hurley and his partners: My guess is that they'll end up doing all right. Moreover, it doesn't seem to be the selling owners: even with the 15% of their selling price they are required to set aside to help their employees finance the buyout, they'll still get more than other buyers are paying today.
As the old saying goes: "If you're sitting at a poker table and you don't know who the patsy is..." The only ones left are the buyers: the junior partners buying equity of their senior colleagues. As the new owners of the firm, the growth that is "financing the transaction" is their growth--the future revenues that as owners they would be entitled to. There are two questions they have to ask themselves: What are they getting in return for that growth, and are they paying a fair price for it?
What they are getting is, indeed, an unprecedented opportunity. Without Fiduciary Network's underwriting, the owners of these practices would undoubtedly have to sell to a financial institution (probably a bank). It's safe to say that the junior associates who now find themselves working for a bank have far less control and a smaller financial stake than the senior partners did before they sold out.
Hurley is offering these junior advisors an opportunity to become one of the senior partners in a large financial advisory firm. Will they have the same financial prospects as the firm's founders had? On a percentage basis, probably not. Yet a smaller piece of a much larger pie can be worth more. Ask anyone who's received stock options in a Fortune 500 company.
What's more, they will continue to have their independence. Well, sort of. Emigrant is, after all, a bank. But a minority stake by a financier is significantly better than being owned outright. What the junior advisors can only answer for themselves is whether being a senior partner in a major firm is worth giving up some future up side and having Fiduciary Network as a partner.
So far, two firms have accepted Hurley's overtures. Evensky & Katz in Coral Gables, Florida, has received much of the publicity due to the high industry profile of principals Harold Evensky and Deena Katz. But the real gem is clearly Regent Atlantic Capital in Chatham, New Jersey. With $1.6 billion under management, senior partner David Bugen's firm is one of the preeminent practices in the industry. "We wanted to keep the firm independent," says Bugen. "And we were willing to take the 15% haircut off the market price to make it work. We still believe we got a very fair deal." To be sure they did, Bugen and his partners retained investment banker John Temple at Cambridge International Partners to look after their interests. Together they decided Fiduciary Network was the best alternative.
I'd suggest the junior partners in all these deals do the same. If cutting a complex deal with former Goldman Sachs investment banker Hurley and real estate developer Milstein isn't reason enough, knowing that ultimately they're going to pay everyone involved should be. What they are getting has great value: but it can't hurt to have a firm grasp of what they're giving up to get it.
Bob Clark, former editor of this magazine, surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at email@example.com.