10 Pros and Cons of Taking On a Minority-Stake Investor

At a glance, the benefits of taking on a minority equity investor seem promising but there are some disadvantages as well, so RIAs should choose partners carefully.

Here are 10 pearls and pitfalls that RIAs should consider before taking on a minority investor.

Pros

An RIA may seek capital from an outside equity investor for a variety of reasons, which may include:

• Downside risk protection: In many cases, an RIA may seek outside equity investors because the existing principals cannot, or do not wish to, commit additional capital to the business. This often is the case in closely held RIAs that are financed and managed by a small number of principals and next-generation managers with relatively limited financial resources. In these scenarios, the RIA issues new equity to outside sources and the capital is paid directly into the company.

• Liquidity, diversification: The equity of a closely held RIA often represents the vast majority of the wealth of the firm’s owner(s). These owner(s) may seek partial liquidity to diversify a portion of their personal wealth. In these cases, the company does not issue new equity, but rather the existing owner(s) sell equity directly to outside sources and no new capital flows into the firm.

• Succession planning: The existing owners may wish to transfer equity to next-generation managers, but the next gen may not have sufficient capital to acquire the equity at the requested valuation.

  One option would be to sell equity at a discount to next-gen investors, followed some time thereafter by a sale of additional equity at a near-market valuation to an outside investor. The blended valuation between the two sales may be closer to the seller’s expectations.

• No client consent process: An RIA that sells a material amount of equity to an outside party typically must obtain the consent of clients before the transaction closes. The time and cost of this process can serve as a detractor to the actual transaction. However, the RIA generally will not have to go through this process if the investment represents less than 25% of the firm’s equity. In this way, minority transactions are simpler than majority sales.

• Minimal loss of control: In the scenario in which the existing principals sell less than 50% to an outside capital source, such principals maintain legal control of the firm. Understandably, the outside investor will insist upon selected minority-owner protections such as limitations on major asset sales or diversion of business away from the RIA. However, owners are comforted that they will continue to control the business.

• Expertise: In some cases, existing RIA owners will seek a strategic or financial investor to gain access to industry expertise or as a step toward an eventual public offering. The target may gain access to capital and selected other benefits from the outside investor — e.g., marketing expertise, improved technology, acquisition experience, etc. By opening up its equity to outside interests, the RIA seeks to incentivize the outside investors to maximize the target’s equity value — i.e., aligning all parties’ interests.

• Prelude to an acquisition: The equity investment also may serve as a prelude to an outright acquisition of the RIA by the outside investor. For instance, the minority investment might be coupled with an option to acquire additional amounts of equity in the future, yielding an eventual pathway to a control transaction at a later date.

Cons

Depending on how the investment is structured, some of the biggest disadvantages include:

• Permanency: Equity investments are generally permanent transactions and can involve illiquid holdings that are difficult to unwind — a stark contrast to other forms of funding such as debt financing.

  Over the long term, the RIA may be encumbered with a nonactive owner that limits its strategic flexibility. Likewise, business history is replete with examples of acrimonious shareholder battles. Suggestion: consider potential exit scenarios for minority equity investors, such as a five-year distribution provision that forces some future action.

• Equity dilution: Equity financing is commonly referred to as the most “expensive” form of financing. In the scenario that an RIA issues new equity to the outside investor, the transaction dilutes the ownership of the RIA’s existing principals. Here again, debt financing has an advantage because such funding usually does not involve issuing new equity.

• Divergent interests: From a practice perspective, outside equity investors may have an explicit or implicit divergence in interests from the existing principals. For example, where the equity financing is provided by a strategic corporate investor, the investment may limit the RIA’s ability to 1) enter into markets that are (or perceived to be) competitive with the investor, or 2) consummate a merger or acquisition with a competitor of the investor.

  When the capital is provided by a financial investor (e.g., private equity), the outside owner also may have an incentive to sacrifice long-term minded decisions for shorter-term financial returns.

Peter Nesvold is the founder of Nesvold Capital Partners, a merchant bank that specializes in the asset and wealth management industries. He can be reached at [email protected].