Last month, I wrote about Mark Hurley’s newly released third (and in my view, best) white paper on the future of the independent advisory industry: “The Brave New World of Wealth Management.” The paper is a “‘30,000 foot view’ of the current state of the industry and, given the forces confronting the industry today, how we expect the structure and the economics of the business to evolve over the next decade.”
Having spent the past five years evaluating hundreds of independent firms as CEO of Fiduciary Network LLC, a private banking enterprise he launched in 2007 that provides succession liquidity to independent firms, Hurley and his team have gained unique and invaluable insights into the advisory business. For this paper, they reviewed data about past transactions and talked to many of the participants in those deals, as well as a host of industry experts and observers of these transitions.
As I wrote last month, there’s too much insightful and useful information in Hurley’s 84-page study to report on in these pages, so my last column focused on Hurley’s assessment of the present state of the advisory industry and its implications for the future of independent advice. Equally interesting—and probably more useful—is the Fiduciary Network team’s evaluation of the current state of the transactions between buyers and sellers of advisory firms, and their suggestions for conducting these deals more successfully. As the baby boom generation of owner-advisors shifts into high-gear about selling their firms—internally or externally—they’ll be well-advised to study Hurley’s insightful analysis of what has worked, what hasn’t and why.
Hurley’s section on mergers and acquisitions starts out with a rather pessimistic (and colorful) assessment of advisory firm M&A: “Notwithstanding the compelling economics of acquisitions within the wealth management industry, we are expecting to see a relatively limited number of transactions because of the inexperience of firm owners with M&A transactions. When two extremely inexperienced parties try to merge together, the process is somewhat analogous to virgin porcupines trying to mate—there are more than a few obstacles and risks in the way of a successful outcome.”
The M&A activity that Hurley addresses in the paper is between what he calls “evolving businesses,” which are firms that manage more than $1 billion in client assets, and so called “tweeners,” which are firms with between $2 million or so and $1 billion in annual revenue. However, his analysis of the current business climate for acquisitions and the challenges involved can be applied to the transitions of firms of all sizes, and even to internal succession.
First, he addresses the pervasive problem of the quality of the existing client firms in many of today’s boomer-owned firms: “One factor limiting the number of transactions is that many tweener firms—the most obvious acquisition candidates for evolving businesses—have unattractive client bases due to either or both concentration risk (the revenue of many tweeners is dominated by a handful of client relationships) or demographics (many tweener client bases tend to be quite old).”
As any good M&A consultant will tell you, the value of any independent advisory firm is largely dependent on the value of its current client base, which includes both its overall age and how quickly it’s depleting its AUM. Hurley then addresses the big issue in any advisory transition: “Wealth management deals are premised (and valued) on the ability to transition to the buyer the goodwill built up over many years between the seller and its clients. In other words, all of the value is contained within the very human relationship between the seller and its clients. Consequently, psychology—navigating human preferences, emotions and biases—becomes far more important than economics in successfully consummating a deal.”
This section of the paper goes on to expand on the idea of the importance of “non-economic” factors in advisory M&A, listing four distinct challenges to advisory firm mergers and sales, and provides a detailed analysis of each one.
Sellers have unrealistic expectations. “Driving this lack of realism is an absurdly optimistic expectation of their firm’s likely future profitability as a stand-alone enterprise, despite all the changes that are sweeping through the industry.” Those changes are aging client bases, a decrease in the number of millionaires (thanks to the 2008–2009 meltdown and the subsequent sluggish economy), and the aging of the owner-advisors themselves (putting them in an unfavorable need-to-sell position). Hurley rightly points out that these factors combine not only to lower the value of many firms, but also to reduce the bargaining power of many of today’s sellers. The result is that fewer deals close than might have done with more realistic owner’s valuations.
Buyers have unrealistic expectations. While the above seller expectations have been well-documented by other industry M&A gurus, this is a new, and rather insightful, observation: “Many firms with a stated goal of acquiring other wealth managers are only willing to consider a seller that would be a ‘perfect fit’—in other words, a seller with high growth potential, a client base that resembles their own, top-tier professional employees, similar corporate culture and, of course, an identical investment philosophy. In short, typical buyers believe that they should not be troubled to change any of their own operations in connection with an acquisition.” As Hurley points out, the sudden increase in the client base of any firm by 75% or 100% (or even 50%) is bound to dramatically change the buying firm. Again, it’s the Fiduciary Network team’s observation that as transition deals advance toward closing and it becomes clear that the buyers will indeed undergo change, they often get cold feet.
All material acquisitions require material amounts of capital. “Few (if any) wealth managers—or their owners—have the means to finance an acquisition without the assistance of an outside capital provider. Unfortunately, even fewer wealth managers have any experience in raising capital. Consequently, owners of wealth managers tend to be downright delusional when it comes to raising capital to fund an acquisition.” This is a problem that I’ve puzzled over for more than a decade. Even in the rare occasions when buyers and sellers get past their unrealistic expectations, a lack of financing often kills the deals. When will custodians and indie BDs realize they’ll have to provide financing for their affiliated firms to be buyers or face the prospect that many of their advisors will be acquired by their competitors?
Buyers and sellers underestimate the degree to which wealth management deals are “three-handed.” Hurley writes, “Both buyers and sellers typically fail to recognize the relevance of a third party to the transaction—the successor professionals of the seller.” This may be the most important (and the most overlooked) point in the entire paper. As mentioned earlier, the key to any advisory acquisition is the retention of the clients. So, ask yourself which is easier and more likely: the transition of clients to an advisor they’ve never met or sufficiently exposing a firm’s clients to a junior advisor so that they view him or her as “their advisor,” and consequently see the sale as “their advisor moving to another firm” rather than the firm being sold? By underestimating the value of their junior advisors to the buyer, Hurley points out that many owner-advisors fail to allow for them to participate in the proceeds from the sale. When the owners realize the sale won’t go through without the junior advisors’ buy-in, it’s a rude awaking that often kills the deal.
Taken together, Hurley’s expositions of why many advisory firm acquisitions don’t get done provide the best road map that I’ve seen for how to actually get one of these deals done. At a time when historical numbers of advisory firms are poised to come up for sale, “The Brave New World of Wealth Management” is exactly the right paper at exactly the right time.