These are interesting times for financial advisory firms: There is an oversupply of capital chasing an undersupply of sellers. The last time this scenario existed was just before the millennium market crash, when we counted over 30 institutional buyers who were trying to roll up advisory firms. It makes me wonder if this is a technical indicator of another market downturn, or simply recognition that this is a wonderful business.
This was one of the questions that we at Moss Adams LLP tried to answer in a white paper for Pershing Advisor Solutions titled "Real Deals: Definitive Information on Mergers & Acquisitions for Advisors." (For a copy of this report, e-mail email@example.com). We were able to identify 228 publicly announced transactions of individual financial advisory firms with more than $100 million of assets under management (AUM) that took place between January 2000 and June 2006. Through our direct consulting, we were also aware of scores of internal transactions between owners and employees, or between parents and children.
When you look at who is buying larger firms, those with roughly more than $100 million in AUM, it becomes apparent that the buyers are taking a look at all aspects of financial planning, wealth management, and investment management in order to capitalize on other assets in oversupply--wealthy and retiring individuals.
The five main categories of buyers of larger firms were:
- Trust companies;
- CPA firms;
- Other RIAs.
Each of them has different motives. In the case of the banks and trust companies, they are attempting to round out their offering by dealing with both sides of a client's balance sheet. In the case of the trust companies and CPA firms, they are seeking synergistic fits with their traditional businesses. With other RIAs, they are seeking scale and market presence, while the consolidators are looking for a financial play that they hope will come with a roll-up of a group of these firms.
Let the Seller Beware
From a seller's standpoint, each buyer offers a different level of appeal.
Banks, for example, represented half of all deals in 2005, and 43% in 2006. They generally pay the highest price and largest upfront payments, which is very appealing for sellers seeking to take some chips off the table. The strategic value of acquiring an existing large firm is embedded in the idea that the banks don't have to create such a firm from scratch. The biggest challenge banks have, though, is successfully integrating such firms into their cultures. In some of the post mortems of such deals, we found the sellers chafed under the bureaucracy and lack of integration or coherent strategy for wealth management in a credit/deposit environment.
Trust companies have been less successful of late in making acquisitions. Their hope is to establish a presence in key metropolitan markets, and as a result, they seek large firms with well-established reputations. Unfortunately for the trust companies, these are the same firms every other institutional buyer wants, so the price competition makes the acquisition difficult to justify from a return-on-investment perspective since they don't have a natural feeder system for new clients in markets where they don't yet exist.
Consolidators like Focus Financial Partners (led by Rudy Adolph) are picking up steam since 2005 when roll-up firms accounted for only 21% of the publicly announced deals. The challenge for consolidators is that in order to be successful, they have to satisfy both their financial backers and the owners of the firms they acquire, who have taken a substantial portion of the proceeds in stock in the acquiring company. Both want to see value increase and expect a liquidity event within a reasonably short period of time, say within five years. This means that consolidators have to get to critical mass quickly.
Many investment bankers believe that in order to get institutional coverage in the stock market, a firm needs a capitalization of around $1 billion, minimum. So another pressure consolidators have is the need to add new firms in time to satisfy the liquidity deadline. But if National Financial Partners (NFP) is a good example of how to do it right, the reward can be substantial for those firms who sell to a consolidator because of the 'lift' they get in the multiple upon the public offering, which could be double what they would get in a straight-up transaction on their own.
CPA firms have had mixed success in acquisitions. They didn't account for any of the larger deals in 2005 but have been picking up smaller firms here and there over the past five years. One of the biggest challenges we see with accountants in this business is the same cultural disconnect that advisors have with banks. However, they can be tremendous feeder systems for advisors who are still interested in growing. On paper, the acquisition of wealth management and financial planning firms by accountants seems like a natural, synergistic fit. The risk in these deals is that if the integration doesn't occur quickly enough, or if the major advocate for the acquisition inside the accounting firm leaves for any reason, there is a possibility this business will eventually be jettisoned by the other partners, who may not be committed to the enterprise.
Advisory firms themselves represent the most intriguing group of buyers. While they generally are not as well capitalized as other institutional buyers, they may offer the most appealing cultural fit of all of the other entities combined. These transactions frequently occur as mergers rather than acquisitions, but there usually is a triggering mechanism for the owners of the firm to sell their positions at some future date while building value in their ownership of a larger enterprise. Organizations like Boston Private represent a more sophisticated brand of this type of buyer in that they are well capitalized and do try to preserve the integrity and culture of the individual firms.
Buyers of Another Kind
Since our research was completed, some new acquirers have emerged more forcefully, such as StanCorp Financial Group and Fiduciary Network LLC.
StanCorp is an Oregon-based insurance company that is driven by the strategic appeal of expanding their service offering. Unlike the other institutional buyers, they are not interested in having sellers remain around for a long time because it is their intent to staff these practices with professional advisors whom they will recruit once a deal is consummated. This presents an interesting career opportunity for young and somewhat experienced advisors.
Fiduciary Network, which is led by Mark Hurley, is taking equity positions--at this point, only minority stakes--in larger firms ($1 million of net cash flow). Fiduciary Network has an interesting motivation. Rather than seeking a liquidity event such as an IPO, as other consolidators do, the investors in this enterprise are viewing this as a long-term investment on which they will receive preferred distributions of income. That is a powerful statement about their belief in the future of this business.
There are several common threads in most of these acquisitions:
The buyers generally expect the owners as lead advisors to stay with the firm for some reasonable period of time, perhaps as many as five years;
Almost all the buyers position the acquisition as a growth strategy, not a solution to bail somebody out of a failed internal succession plan;
After the transaction, all of them needed to address the management and client succession issues for the older advisors who sell;
Except for a few select consolidators like United Capital Financial Partners and StanCorp, institutional buyers all seem to be focused on firms with more than $500 million of AUM, though many will look at "tuck in" mergers of smaller firms if they already have a presence in their market.
The rosy picture for sellers leads to the big question for firm owners: "If everybody wants in, why do you want out?"
That in fact may be the reason why there have been so few sellers. Principals of these firms realize that the multiple and amount of up-front payment would have to be pretty substantial to replace their earning power from continuing to own the business independently. They also have this strong, burning desire to remain independent, and are torn by a sense of responsibility to employees and clients that selling the firm might be a betrayal to them.
We are experiencing an uptick in the number of firms at least kicking the tires on these possible deals. But prospective sellers keep coming back to the same questions:
Is this a window that will close quickly?
How much would I leave on the table if I keep growing at this rate?
If the buyer wants me to stay after I sell, why should I share the growth?
Lastly, there's a twist on the Groucho Marx line that he would "refuse to join a club that would want [him] as a member." In some consolidations and mergers, the combined entity is only as strong as its weakest firm, which is a good reason to conduct due diligence on the buyer.
But reality usually catches up to those who negotiate in earnest with prospective buyers. Many see the need to sell to a larger firm in order to create a better magnet for good talent and create career opportunities for their staff. They see such sales as a way to leverage their current operations and gain efficiencies, especially since the cost of compliance and other squeezes on margin are diminishing the opportunity for remaining independent.
Age is also their partner in this decision. A variety of studies conducted by Schwab Institutional and Moss Adams place the average age of advisory firm owners in the mid-50s. While this is not old by current mortality standards, it is the point when most business owners are contemplating the next phase of their lives outside of their current careers.
From our point of view, there are several key industry trends that will likely influence the merger and acquisition market for advisory firms, though these same trends may have a more negative impact on multiples over time:
The acute shortage of talent is forcing firms to admit more partners to their business, thus diluting their equity and income;
Control of the firms is also being diluted as the owner groups expand--with less individual control, the willingness to sell will increase, especially for second-generation shareholders;
Internal buy-ins will increase in frequency, but their valuations will be low relative to the external market. This will happen because these buyers have fewer resources and will not be interested in paying a premium to hold onto their jobs when they themselves are marketable.
As buy-sell agreements ripen, many firms will have to sell to find the human and financial capital to grow. The new generation of owners is less risk tolerant and has a stronger preference for balancing life and work. This is not a "Gen-X" phenomenon but a fact of life when entrepreneurs recruit people with an employee mindset.
All of these issues have implications for buyers. The premiums that acquirers are paying are not cash on the barrelhead, but rather incentives tied to future growth. In most cases, if the current leaders of the practice can't sustain an annual growth rate of at least 20%, they are not likely to get the highest multiple. In many cases, deals are structured in a defensive way for buyers who fear attrition and no growth when they acquire a financial advisory business. So if these firms are already at physical capacity, and if their lead advisors are older and less energetic, and if no systematic marketing and sales effort is in place, it's possible buyers will be overpaying for practices that are not sustainable for the long term.
Even though there are many willing, well-capitalized buyers, and an increasing number of motivated sellers, the problem that doesn't go away for most of these firms is they will have to create a well-structured internal succession program for both the management of their firms and the servicing and procurement of clients. Without these conditions in place, buyers run the risk of acquiring a depleted oil well, and sellers run the risk of getting less than they had hoped.