Advisory businesses deploy two types of leverage to accelerate their growth: operating leverage, which builds off infrastructure, technology, and other people’s labor (OPL); and financial leverage, which builds off other people’s money (OPM).
In recent years, larger firms with multiple tiers of staff have emerged out of an industry that was mostly small-practice based. A new study sponsored by Pershing Advisor Solutions and produced by Moss Adams LLP reveals that advisors who build capacity and leverage a larger infrastructure can grow faster and more profitably than their smaller counterparts. According to the study, to be published this fall, firms with multiple owners are growing almost 25% faster than the average firm.
How to access the resources to achieve this growth? While operating leverage is a proven model, we have not seen widespread use of financial leverage–where the practice owners borrow money or seek equity from passive investors for technology, acquisitions, or recruiting. More managers of advisory firms are considering this opportunity, however. The current low cost of money, distress being experienced by competitors, and high consumer demand for advice from independent providers make growth through other people’s money tempting.
Other People’s Money
At a recent seminar on succession sponsored by Dimensional Fund Advisors (DFA), I was asked by an audience member why custodians don’t provide the funding to help advisors finance their transition plans or make acquisitions. He argued that firms like Schwab, Fidelity, and Pershing have a vested interest in the advisor’s growth and continuity, and tend to have the deepest pockets in the relationship. The reality is that Pershing does provide such funding under the right circumstances, as I presume the other custodians do, but the deal usually has some hair on it.
First, there cannot be any explicit tie between the loan and the decision to custody at a firm–this conflicts with the fiduciary standards of both the custodian and the advisor. The advisor has to make the custody decision on the merits of the platform, which may include assistance in more effectively serving their clients. Broker-dealers have increased flexibility around this issue as is demonstrated by the upfront checks that are often paid to retain or recruit reps–but the money usually takes the form of a forgivable loan tied to production and retention for a much longer term.
Second, and most important, the borrower has to demonstrate a sound business purpose for the loan and an understanding of how he or she will pay it back within a reasonable period of time. In the broker-dealer environment, the BDs are indifferent as to how the advisor spends the money as long as they continue to practice in an ethical and prudent manner. The RIA world is a business-to-business environment, however, not a supervisory environment, so the source of the capital views the transaction much like a conventional bank views a commercial relationship.
Consequently, advisors must develop a business plan that includes how the money will be used to fund their growth, a forecasted income statement and balance sheet quantifying the impact, and a cashflow projection that shows when it will be repaid. The cashflow projection should include all the ins and outs of cash month-to-month over the first year, then year-to-year over the life of the loan.
This valuable exercise helps an advisory firm create a plan for the loan and its repayment. If the numbers don’t work in terms of being able to pay back the loan, the firm learns that their plans are too ambitious, the purchase price for an acquisition is too high, or they failed to anticipate costs such as new furniture and fixtures, equipment, salaries, and rent.
That’s the point of creating a plan, however. If advisors can project both the positive and negative impact of growth on their cash flow, balance sheet and income statement, then they can make an informed decision as to how the growth should be funded.
There are three basic types of funding for an advisory business:
- o Short-term working capital
- o Long-term debt financing
- o Equity
First, remember the financing principle that funding should match the useful life of the asset. That’s why you don’t see a one-year mortgage on a home or a 30-year car loan.
Short-term working capital implies a loan that will be repaid in 12 months or fewer. On the balance sheet, then, that funding should be applied to the cash flow needs caused by increases in accounts receivable and other current assets. It could be applied to an upfront payment to a new advisor, or an acquisition–providing you expect the event to pay off in the first year.
If that doesn’t occur, then the advisory firm will need to seek either long-term debt or equity, which are typically used to fund long-term needs (greater than one year). These would likely include an acquisition of another advisory firm or an investment in leasehold improvements for the office and related assets like desks and computers. Lenders prefer to keep the payment terms tight, requiring a borrower to repay the obligation within three to five years. When evaluating this option, the advisory firm should be conservative and reasonable in estimating the revenue and expense impact of whatever they are spending the money on. Even advisors can get consumed by irrational exuberance when it comes to faith in their own abilities.
The other alternative is to fund growth through equity. Equity comes from two sources: retained earnings, meaning profits left in the business; and new capital, either from the existing owners or from outside investors (see Friends in Need? sidebar for examples of two such outside investors).
Are There Risks?
Equity is the most expensive form of financing. When the current owners give up a stake, they are also giving up future appreciation in that stake, and often the dividends or profit distributions that typically are paid to the active shareholders in the business. The best way to evaluate which financing option makes the most financial sense is to project a reasonable or expected rate of growth in the business after receiving the capital, then calculate how much will be paid to the source of the funds over the life of the relationship. A loan usually has a defined term; an equity investment is forever, in a sense, or at least for as long as you are still involved in the business. You must also consider how much you received for your stock.
Loans are not without risks either. Small business owners generally must sign a personal guaranty. And if they default, they will need to disclose this on their ADV form if an RIA, and possibly on their U4 if a registered rep. Backup collateral is not at all persuasive to lenders, especially if that collateral is illiquid. If it gets to the point where the lender has to grab your assets in order to get paid, nobody will be happy with this relationship.
Using other people’s money to fund the growth of an advisory firm is an intriguing management decision that often has merits. But remember–when another entity has capital at risk, a new tension and a new dynamic will only intensify the need for your business to perform.