From the March 2013 issue of Investment Advisor • Subscribe!

High Flyin’: Revisiting the Hybrid Model With HighTower

HighTower’s acquisition structure is as innovative as its business model

A few years ago, I did some publishing consulting work for Elliot Weissbluth, the CEO of HighTower Advisors in Chicago. After learning about his firm, as I subsequently wrote in these pages, I came to believe that HighTower’s “hybrid” merger of independent client-centered advice with sophisticated financial solutions and products—traditionally found in brokerage firms and private banks—represents the future of financial advice. Recently, I realized that while I had learned a lot about HighTower’s products and services, I didn’t know much about how the firm structures the relationships with its affiliated advisors. To fill this gap, I caught up with Weissbluth recently, and he was more than happy to further my education. What I learned is that HighTower is as innovative with its advisory firms as it is with its product line, and I was even more impressed with the power of HighTower’s business model to provide competitive advantages for its advisors.

I’ve been fascinated with firm valuations since I stumbled across fledgling FP Transitions (now Business Transitions) more than a decade ago. FP Transitions was a pioneer in providing listings that matched firms for sale with potential buyers, as well as sophisticated valuation services based on the going market prices for similar firms.

Initially, that is to say 10 years ago, FP Transitions found that most firm transactions were valued at around two times gross revenues. In those early days, the idea of selling an advisory firm was a novelty: Independent advisors had only been managing client assets for a fee for little more than a decade. Consequently, there was considerable debate over what the value of those assets might be, if any. I remember many conversations with Mark Tibergien, then head of consultant Moss Adams Advisory Services (now CEO of Pershing Advisor Solutions), in which he fervently maintained that the market overvalued advisory practices and that most firms, when valued on profitability, were barely worth the equivalent of 1.5 times revenues, depending on their overhead.

However, David Grau at FP Transitions was steadfastly reporting that advisors were buying firms for multiples of two times revenues or higher. And, of course, we all heard rumors of institutions such as banks paying far higher multiples for larger firms, but those numbers were hard to verify. Grau realized that the key issue in acquisition was the retention of the clients, and his firm created a program to facilitate the transition of clients from the old advisor to a new one with astonishingly high success rates (over 90%).

FP Transitions’ revenue-based valuation model always made sense to me and still does for acquisitions by other advisors. If one advisory firm is simply buying the clients of another firm to be absorbed into their business model, then the efficiency or inefficiency of the operations of the seller are irrelevant: The buyer knows what its margins are and structures its valuation accordingly. Aside from particularly high-maintenance clients, the only issue is successfully transferring the clients to the buyer.

Over the years, Mark Hurley, CEO of Fiduciary Network, a Dallas-based financier of succession-oriented advisory firm buyouts, has consistently maintained that the market has woefully undervalued the AUM at independent firms when the growth of those revenue streams over the next 10 or 20 years are considered. The market for advisory firms seems to have borne out both Grau and Hurley: Grau recently told me that independent firm acquisition prices have pushed well past three times revenues.

While the structure of Fiduciary Network’s deals are confidential, FP Transitions’ acquisition structures have always been an open book. Typically, the acquiring firms pay one-third of the value of the selling firm in cash up front; one-third in a promissory note; and one-third is contingent on successfully transferring the clients to the new owner. Grau has found that the shared risk of the client transfer by the seller creates significant motivation to actively participate in a smooth transition.

In contrast with advisor-to-advisor transitions, HighTower has a stake in the profitability of the firms it acquires. While the HighTower model can be used for the succession from one generation of advisors to the next, that transition is facilitated over nearly a decade. The model is based on using HighTower’s considerable collective negotiating and buying power to reduce the overhead costs of the firms it acquires and split the remaining net revenues evenly between the firms’ principal advisors and parent company. HighTower increases these economies of scale by working with multiple product, services, technology and custody providers (for instance, it has relationships with all four major custodians: Schwab, Fidelity, TD Ameritrade and Pershing), and soliciting competitive bids for best pricing. This structure creates incentives for principal advisors to maximize revenues and minimize costs, while motivating the HighTower home office to reduce the collective costs and to help its advisors grow their firms.

Due to its sensitivity to the cost structures of its advisory firms, HighTower bases its firm valuations on net rather than gross revenues. According to Weissbluth, HighTower values the firms it acquires at five times the revenues it is buying (or about 3.5 times gross revenues), net of overhead projected to include the HighTower savings. “We see many firms with 40% to 50% expense ratios,” he said. “With our buying leverage, our goal is to get that overhead down to 30%. We’re almost always successful.” As mentioned above, the 70% net revenues then are split between the firm principles and HighTower. It should be noted that those expenses do not include principle compensation or the compensation of support advisors. “If firm principals want to leverage themselves to increase revenues with support advisors,” said Weissbluth, “that’s fine; but the increased cost comes out of their portion of the net revenues.”

The structure of these buyouts is half the cash up front with the other half vesting over nine years. The selling advisors also sign a nine-year note to pay back the cash should they leave the firm, which is proportionately forgiven for each year they vest. What’s more, the selling advisors also get an ownership stake in HighTower, which entitles all the advisors collectively to 25% of the firm’s annual profits and equity.

Notice that nowhere in these calculations do advisory assets under management factor into the equation. “Assets can be misleading,” said Weissbluth. “What was the firm’s overhead? And more importantly, what is the quality of those assets? If you see a firm with $200 million in AUM and $2 million in revenues, those aren’t very high-quality assets. We like to see clients paying between 50 and 60 basis points: Then we know they are high-net-worth investors or institutions.”

To date, HighTower has used this formula (exactly this formula: “We don’t want any of our advisors to feel someone else got a better deal,” said Weissbluth) to acquire 38 firms, which include more than 80 advisors, that are now organized into 25 offices around the country. While the firm doesn’t disclose its total AUM, a reasonable estimate would put that figure in the $204 billion to $255 billion range. “We are the only independent firm to have more than $1 billion with each of the four major RIA custodians. That means they listen to us,” Weissbluth said. “And one thing we’ve worked with each of them on is increasing the sophistication of their products and their technology. Today, the independent platforms are vastly superior to their Wall Street counterparts with technology and with more products at a better price. We’re very proud of that.”

From a valuation perspective, HighTower confirms FP Transitions’ (and others’) figures of around 3.5 times revenues for high-quality, transferable assets. Its deal structure creates incentives for firm principles to both grow their businesses and manage their costs. It’s motivated HighTower to help move the independent world into at least parity with the large brokerage firms. At the risk of repeating myself, these are just a couple of reasons why HighTower and its business model are likely to be the future of independent advice.

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