From the August 2011 issue of Investment Advisor • Subscribe!

Doing It Right

A new solution to the decade-old problem of internal succession

David Grau's been a friend of mine since 2001, when I worked with him and his newly formed FP Transitions for a few years to brand their expertise in helping independent advisors realize the value in their practices. David recently set aside a few hours to tell me about a new program that he and his team have created which he believes—and now, I do, too—will solve one of the most vexing challenges facing advisors today.

Despite the very substantial revenues that many advisory firms generate, most independent advisors went independent to better serve their clients. In fact, it's only been within the past decade or so that a broad spectrum of independent advisors have had the potential to earn incomes that rival—or even exceed—what comparably experienced brokers take home. Of course, this relatively new-found advisor earning potential is the direct result of the industry's transition to managing compounding client assets for ongoing fees during the past two decades. The most valuable aspect of this changing advisory business model has been the apparently unexpected increase in the value of advisory firms: from close to zero in the case of the transactional-based practices of yesteryear to tens of millions of dollars for some of today's most successful fee-based firms. Yet, due to the newness of this unexpected windfall, few advisors have done any planning for getting this value out of their firms when they retire.

By now, we're all well aware that with us baby boomers beginning our transitions into some sort of retirement, the independent advisory industry is poised to transfer the management of trillions of dollars of managed client assets—I've seen estimates as high as $4 trillion—over the next 10 or so years. That's a pretty good chunk of change (even by Congressional standards). Consequently, over the past decade we've seen this eventuality dawn on the institutions that serve independent advisors, with many of them offering various "solutions" designed to bring the AUMs of "their" advisors within the fold, and possibly capture some of those assets away from their competitors.

Here's the problem: To the extent that aging baby-boom advisors have done any thinking at all about what they'll do with their firms at retirement, almost all of them have a vague vision of transitioning the firm to "junior advisors" who are either currently employed by their firms, or whom they intend to hire for that purpose "sometime soon." Let's set aside the "who" issue for a moment, and explore the more quantifiable "how much."

Many independent advisory owners today have found their firms to be worth vastly more than ever expected or planned for—and far more then their "junior" successors can afford to pay. To their everlasting credit, a surprising number of these advisors choose to forgo the market value of their firms, selling their practices at the end of their career to their junior partners at a price they can afford.

In addition to the potential tax ramifications of transferring undervalued assets, these commendable acts of altruism come with another downside. A few years after the acquisition of a firm by the junior partners, a large institution or roll-up firm offers the actual market value for the firm, or even substantially more than that, based on the suitor's real or imagined projections of increased efficiencies or business synergies, and the junior partners end up reaping the original owner/advisor's windfall.

The solution, of course, would be for someone to come along with a financing formula for junior partners to buy out senior partners at market valuations, but under terms that young advisors can afford. By some accounts (including his own), Mark Hurley at Fiduciary Network has created just such an acquisition program. However, Hurley is only interested in working with the largest of advisory firms.

To bring a succession solution to the rest of the independent advisory industry, FP Transitions recently launched its Equity Management System (EMS). "As the name implies, our new system enables advisors to manage the equity they are building in their practices," Grau told me. "Managing equity is not about retiring, at least in the traditional sense. It's about controlling your end game strategy and protecting what is, for most advisors, their largest and most valuable asset."

The FP Transitions EMS is a complex system borne out of Grau's background as a securities attorney, his past partner Bill Grable's background as an acquisitions accountant, and current partner Brad Bueerman's background in international M&A, plus over a dozen years helping thousands of independent advisors sell, buy or build value in advisory firms. His on-the-ground, practical experience with how practice transitions actually work—and what strategies work better than others—is one of the things that impressed me about Grau from the day I met him. FP Transitions' EMS program is full of features derived from a working knowledge of how advisors actually sell their practices, as well as protections against possibilities that most people would never think of.

For instance, in addition to the desire to sell their firms to junior successors, Grau and his team (which now includes David Jr. and a staff of 20) realized that most advisors don't want to simply sell their firms and ride off into the sunset—that's a dream that many advisors enjoy, but rarely choose. More often, they want to gradually scale back their workload, turn things over to the next generation, and continue to receive their current substantial compensation well into the future. Sound like having your cake and eating it, too? Well, it is. Yet, Grau realized that what most advisors want is the way many law firms have worked for over 100 years.

So, he and Bueermann put their heads together to create a formula that amounts to an annuity that pays the owner/advisors essentially their current total compensation over a minimum number of years no matter what happens. It's a very sophisticated program that involves the gradual transition of small amounts of firm equity to junior partners, financed in part by the firm itself and partly with profit distributions. "It's important that junior partners have skin in the game," says Grau. "But, due to our structure, their contributions are pre-tax, greatly increasing their bang for the buck, especially as firm values compound over time." An essential element of the FP Transitions formula is annual evaluations of the firm's value—so the junior partners, and their spouses, regularly can see the tangible benefits of their investment.

Grau's long experience with advisory transitions also revealed a flaw in the traditional succession plans that I've never heard anyone even talk about, much less solve. "When they finally get around to transitioning their practices," he says, "most advisors simply start transferring portions of the equity to a single junior advisor each year. But, just because someone is a good advisor, doesn't mean they're cut out to be an owner. Usually by the time the founding owner realizes he or she has made a mistake, they have a real problem."

Consequently, FP Transition's system includes several safeguards, starting with very gradual transfers of small amounts of equity in the early years, combined with quick-exit formulas should things not work out as planned. But, the simplest safety measure has perhaps the greatest value. Even when a junior advisor demonstrates he or she has what it takes to be an owner, it's not unusual for an owner/advisor's sole heir-apparent to leave the firm. That means the owner has to start the succession over from scratch and can set the transition, and his or her retirement, back by years.

Again, Grau took a page out of the law firm manual, advising firm owners to have more than one potential successor on staff. They can reasonably assume that one of them will leave; and if they don't, a buyout by multiple junior partners works even better than just one.

The one problem Grau's formula won't solve is when advisors want to transition in the next two or three years; they'll need at least seven years to make this work, and longer would be better. But there's no excuse for procrastination any longer: If you want to pick your successor to run your firm, the tools are now available to make it work for both of you.

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