From the December 2011 issue of Investment Advisor • Subscribe!

Buyer’s Remorse

While caveat emptor always applies, sellers usually benefit from helping prospective buyers fully understand the risks of a deal

Much has been written about sellers seeking liquidity or succession solutions, but the real story of the day is the amount of money chasing after a small pool of advisory firms and broker-dealers. According to the “Real Deals Third Quarter 2011 Update” produced by Pershing Advisor Solutions, deals done by private equity firms and serial buyers are increasing.

When we look at the transaction cycle over the last decade, the uptick in advisory firm buyers seems to predict the market: The more money courting advisory firms, the more likely the market will swoon. That’s tongue in cheek, of course, but oddly not entirely off. The bigger implications arise when dollars, especially from passive investors outside of the business, start chasing a small number of potential sellers.

As we all know, demand tends to inflate prices beyond common-sense valuations, making deal structures more aggressive and creating an environment in which more prudent buyers are disadvantaged because potential sellers believe their practices are worth more.

Financial Buyers Emerge

The recently published “Real Deals report, available on Pershing.com, revealed only a slight increase in the number of mergers and acquisitions among retail-oriented financial advisory firms, though these firms were larger on average. The report also showed that after being absent for much of the past year, private equity firms or serial buyers acquired more than 70% of the assets of the firms acquired in the third quarter.

For many years now, we have been hearing of sellers seeking buyers who will pay cash on the barrelhead rather than considering a sale to their own employees, for whom the purchase would have to be financed over time. While that makes financial sense for the seller, it raises the question of whether the business will have the staying power to support the purchase price.

Bigger firms have larger staffs with greater capacity, but if a transition plan is not in place, buyers could find themselves holding the bag with respect to client service after the deal. Smaller firms have the advantage of serving a number of clients that could be assimilated by the buyer, assuming the buyer has a team of professionals able to perform this role.

Buyers considering pouring money into this market should ask several critical due diligence questions and current owners of advisory firms should be prepared to answer them:

How old is the average client? The demographics of the client base are probably the single most important element to evaluate in an advisory firm purchase: Demographics dictate the longevity of a firm. An abundance of older clients in or approaching the withdrawal phase requires the advisory firm to replenish those assets with new clients more proactively and aggressively.

What is the firm’s growth engine?  When most advisory firms get to a certain size they become more passive and responsive to business development opportunities, rather than assertive and creative. When the principals sell out of their stakes they often lose interest in finding new business. While a buyer may include performance targets in the final purchase price, these only work if enough of the purchase price is on the table to be earned by the seller and if the seller still wants to work hard. Whatever the scenario, older advisors usually sell out so they can get some cash and slow down to focus on the things they like to do. Oftentimes, unfortunately, they not only failed to develop younger associates to step up, but also neglected to brand and market the firm to drive new opportunities to the practice.

What role will the selling shareholders have after the deal? Many advisory firms rely heavily on the principals. In fact, often the firm must sell because successors have not been developed. With the transaction completed, are sellers expected to continue working with clients? Is a plan in place to transition those relationships to others in the firm? Does the firm have qualified staff that can actually handle those responsibilities?

How will the younger staff, particularly advisors, feel about the deal?  Forget the culture challenges that come with reporting to passive owners who are more interested in financial returns than client service; we are dealing in an environment where there is an acute talent shortage. This means that quality advisors have options. When the business is sold and the buyers take a preferred distribution of the cash flow, how long will advisors wish to continue working hard to keep and grow clients? Will they be offered an ownership stake, and will the benefits of that stake (dividends, buy-out price, etc.) be enough to induce them to remain with the firm? Or will the sale motivate the firm’s advisors to look for better situations elsewhere or to start their own firms?

How will the clients feel about the deal? While it is unfair to characterize financially motivated buyers as not being interested in having clients served well, there is a risk that a passive financial buyer will make decisions to produce a better return, such as cutting costs, raising fees or changing the service experience. Further, by the nature of the transaction, the buyer may find it necessary to recruit other talent to replace the selling shareholders. These new people will have to connect with clients to keep them in the fold. Typically, serial buyers or private equity firms seek a liquidity event such as an IPO within five years of the first investment. This goal dictates a more intense focus on quarterly earnings, which could force a change in the way the advisors want to work and the clients want to be served.

Consider every angle of a deal and share concerns with the potential buyer. Serial buyers usually aim to consolidate firms quickly. What will create the synergy or common link among those firms? Acquiring a financial advisory business is not quite like buying a manufacturing company or a bunch of muffler shops. Advisory firms depend on professional, credentialed individuals. In the event of defection by the current staff, a limited talent pool exists to draw from. While buyers wish to retain clients and ensure the continuity of the income stream, they need capable staff to serve those clients.

As a prospective seller to private equity investors or consolidators, it is in your best interest to make sure that prospective buyers understand the risks and how they can be mitigated. Once the practice is sold, you never want to take it back (and that happened a number of times in the past few years). The buyer—whether just another advisor or a moneyed firm like a consolidator—must thoroughly understand the challenges. If the deal falters, not only is the amount paid at risk, so too is your reputation with ex-clients whom you respect and regard as friends.

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