After a record year for mergers and acquisitions in 2019 and a strong start in 2020, the COVID-19 pandemic has created several challenges for advisory firms looking outside their organizations for growth.
For one, lenders and potential deal partners may look askance at advisors who took loans under the Paycheck Protection Program, two executives say.
Three experts on RIA M&As explored some of those challenges on Wednesday, including risks both old and new, that advisory firms should keep in mind as they pursue growth opportunities and succession planning this year and beyond.
Potential PPP Problems
Advisory firms that participated in the PPP may face potential new risks as a result of that decision.
When the pandemic started, several advisory firms likely spoke with their attorneys and accountants and concluded it was “prudent to take the money,” Rick Dennen, CEO and president of specialty lending firm Oak Street Funding, said during the TD Ameritrade Institutional webcast “M&A and Succession in a Pandemic World.”
His firm had a couple of RIA customers who took part in the program and “I’m not going to take it or hold anything against them,” he said. When his firm underwrites a loan, it looks at the firm’s balance sheet and, a year from now or six months from now, if the loans are forgiven, the balance sheets will be enhanced, he noted.
However, the PPP money is probably “not going to enhance the value of the business” and, perhaps more importantly, some will look at a firm taking a PPP loan as a sign that it’s “in distress and we can’t give them credit,” Dennen said.
Like Dennen, David Barton, vice chairman, M&A leader at RIA Mercer Advisors, would not personally “sit in judgment of anybody that’s taken a PPP loan — that’s a business decision,” he said.
However, when firms certify they need that PPP capital to survive, it is “quite a statement that you’re making and you do have to disclose that on your Form ADV” that advisors must submit to the Securities and Exchange Commission, Barton said.
Firms should also keep in mind that, as a result of taking that PPP money, “you’re essentially telling your own clients that ‘we’re in financial distress and we need to take a loan to keep the doors open,’” Barton said. It is “waters under the bridge at this point, but I’d be very careful about the decision to do that and then also … make sure you’re making the appropriate disclosures if you are doing that,” he advised.
Tough Market for M&A Funding
In any case, some firms may find it tougher to get funding right now, Dennen said.
“If you just look overall, it’s probably tougher from a commercial perspective for anybody walking in,” he said.
“Banks are going to look at more current information” from firms looking for funding, he pointed out, explaining: “Maybe in a typical world, they might have been, at this point in time … looking at year-end audits and maybe some quarterly updates through March. Whereas, in today’s world, we’re going to be looking for information through May: April and May results if it’s a May deal.”
The lending situation has “certainly changed a little bit,” he said, predicting that among “lenders that don’t have a good understanding” of the advisory firm sector, “you’ll start to see a pullback.”
Although his firm has been seeing a lot of M&A activity in the second quarter, he said: “We’ve seen some of the smaller deals that might have been used for working capital, I would say, kind of got put on hold, I’m guessing, because of” the PPP. The Small Business Administration stimulus program has “probably resolved some of the working capital issues” for some advisory firms, he said.
The most recent M&A “deal flow that we’ve seen is coming from larger deals, and those are typically well-capitalized transactions,” he added.
Planning, Planning, Planning
Advisory firms should also make sure they have a business continuity plan in place because “a failure to plan is a plan for failure,” Barton said, adding: “They should also have a disaster recovery plan.” Both plans are recommended by the SEC and are “germane now in a COVID-19 world,” he stressed.
Pandemic or not, firms should make sure that a merger or acquisition is worth the huge amount of time that will be involved in a deal, Barton also suggested.
After all, he said, when “completing a transaction start to finish from negotiations to letter of intent to completing the purchase agreement, from completing all the schedules to that purchase agreement to doing the consent letter to doing the closing and the work in between, you’re talking months of labor.”
And it’s ‘very sophisticated, complex work, and it’s easy to mess it up,” he warned, adding: “So be careful about what you undertake. If you’re thinking you’re going to buy the assets or the stock of a company, a firm that has $20 [million] or $30 million in AUM, that’s a pretty low revenue stream to invest that kind of time and energy.”
One potential alternative when a firm is pursuing a small company that could make more sense is to consider making a “lateral hire” type of deal rather than an acquisition, he said. A firm can conceivably offer to pay a portion of the other company’s book of business, with additional money, and “reward them for the transfer of assets” from one RIA to the other, he explained, adding: It’s “a lot less work.”
Barton has not “seen any waning of interest” in advisory firm M&As since the pandemic started, he also said, adding: “In fact, I’ve actually seen the opposite. I’m seeing more firms coming to market and the velocity of deal flow increasing.”
However, Scott Collins, managing director, sales consulting at TD Ameritrade Institutional, said he heard from partners that “there was a little bit of a lull” in deal-making when the pandemic started, although that has “definitely picked back up” at the firm.
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