From the July 2017 issue of Investment Advisor • Subscribe!

When Debt Is Good

Financial leverage can play a useful role — when deployed prudently

When 'debt' is called 'leverage,' business owners see opportunities. When 'debt' is called 'leverage,' business owners see opportunities.

The word “debt” is rarely expressed as a positive notion. Financial advisors coach clients to reduce financial liabilities. Politicians push to eliminate the federal deficit. College graduates bemoan daunting student bank loans. Debt is a four-letter word. That is both an absolute fact and a matter of perception.

When the same concept is called “leverage,” wealthy people and business executives see potential. Using other people's money for the purpose of acquiring an asset or funding business growth can be an effective financial management tool for those who can afford the risk and are able to repay the obligation.

(Related: 6 Ways Business ‘Gurus’ Can Lead Advisors Astray)

Let's go over a few key principles to financing:

  1. Funding should be matched to the useful life of an asset.

  2. Debt is a prudent way to fund an appreciating asset, but a dangerous way to finance a depreciating asset.

  3. Equity is the most expensive form of financing.

As an advisory firm starts to operate more like a business, owners must learn how to use and manage the balance sheet. This helpful tool provides great insight.

The balance sheet tells you what you own (assets) and how you fund it (debt and equity). It organizes your assets top down, from the most liquid to the least liquid. It illustrates how you are financing your business from short-term commitments to the most permanent. When transformed into key ratios, the balance sheet informs you of your ability to pay your bills and your ability to withstand adversity.

Key Balance Sheet Ratios:

  • Current Ratio = Current Assets ÷ Current Liabilities (The higher the ratio, the more liquid the company.)

  • Debt/Equity Ratio = Total Liabilities ÷ Total Equity (The higher the ratio, the more at risk the business.)

Managing the Balance Sheet

Important dynamics within advisory firms make balance sheet management critical.

As advisory firms grow, a gap can occur between when services are rendered and when fees are paid. Advisors typically receive payment in advance when they assess the client's portfolio; a fee based on assets under management. This fee covers one quarter of service and must last until the next billing cycle.

The firm must pay its staff, plus cover rent, utilities, marketing and other overhead. When recording transactions on the balance sheet, prepayments appear as “cash” on the asset side of the balance sheet. Much of the same payment also appears as a liability because it represents an obligation to provide advisory services for the quarter to come.

The prepayment is drawn down throughout the quarter as expenses become due. Then the cycle begins all over again the next quarter. If the cash on hand is not sufficient to meet the firm's obligations during a quarter, the advisor likely borrows from a line of credit, thus increasing the short-term (current) liability. Without careful management, current liabilities could exceed current assets, diminishing the working capital of the business.

The working capital challenge is exacerbated when a business uses short-term debt to fund long-term needs. A common principle in financing holds that funding should match the useful life of an asset.

Advisors have been trained to stay out of debt, so using a short-term line of credit makes them feel that they will get out of hock more quickly. They fail to appreciate — especially when the business is growing — that using short-term capital to fund a long-term asset puts stress on their cash flow and possibly sets the stage for refinancing or seeking new funding.

Financing Growth

The balance sheet works better when advisory firms contemplate mergers and acquisitions. Some private equity firms are attracted to the financial advice business as a way to generate a return for their investors. Private investors are also steering millions of dollars into digital startups in hopes of capturing the generational shift to robo solutions.

Firm owners seeking private equity to fund their growth or to help them break away from a bank or wirehouse often find it compelling to use equity instead of debt. The bubble over their head says that working with an equity backer minimizes their risk. Typically they sell an ownership stake to private investors, thus monetizing their own investment in the businesses. These new shareholders are often regarded as “passive” investors in the advisory firm. In a sense that is true, unless the firm underperforms or fails to fulfill the purpose of the new equity investment. Depending on how dire the circumstances, this may result in a leadership change, a modification of partners’ compensation or, in some cases, a forced sale of the business.

Even if the advisory firm grows according to plan, the private equity investors usually demand some form of return on their investment, such as dividends. This payment lasts forever unless the investor sells to another buyer. Such investors usually enjoy a preferred position, receiving their investment return before those working inside the firm are paid. The amount, the preferences and the duration of the payments reveal why equity is the most expensive form of financing.

Understanding this fact helps advisors contemplate the trade-off between debt and equity. Because of their own financial strength — or lack of it — some may be forced to find an equity backer in order to execute on their strategic growth plans.

This may be especially true if the advisor lacks the financial strength and collateral required for bank funding. Only a few financial institutions in the country, such as Live Oak Bank, truly understand what makes advisory firms tick. Traditional banks are reluctant to lend to small service businesses with insufficient assets to use as collateral. Banks expect to have their loans repaid through the generation of cash flow, and they usually want a backup plan. If the firm can't liquidate assets to repay the loan, the bank will seek a personal guarantee from the firm owners. These factors elevate the perceived risk of bank financing.

(Related: How Live Oak Is Solving RIAs’ Succession Problem)

This risk is real if owners overpay for the acquisition of another firm. While advisory firms are commonly believed to be worth some “multiple of revenues,” this approach tends to inflate the purchase price and make it difficult to pay off the debt used to buy the practice, or to produce an acceptable return for the equity investors who funded the transaction.

For example, imagine you applied a 2x multiple to revenue to acquire an advisory firm that generates $1 million of annual revenues and $100,000 of earnings before interest, taxes, depreciation and amortization (EBITDA) (this is a good proxy for cash flow in an advisory firm). Also imagine that this practice primarily serves clients who are retired, thus limiting the future growth of this practice.

Assuming that 100% of the clients transferred assets and there was no downward adjustment in the market that would impact asset values and revenue, how long would it take you to repay the loan needed to purchase the practice?

Alternatively, if you accepted a private equity investment to make this purchase, what rate of return would the investor realize based on this structure?

Finally, will the transaction result in you building value in your own business or producing a return to you that offsets the risk you took in making the deal?

As the advisory business evolves, it has become critical to look beyond the profit and loss statement and understand the balance sheet. The balance sheet measures liquidity and safety in a business. Advisors must make informed decisions about how to finance growth and how to structure transactions with lenders and equity investors in order to manage their risk and leverage what they have already created.

--- Read How to Make Technology Part of Your M&A Strategy on ThinkAdvisor.

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