RIA Succession Planning Options: 8 Things to Know

Both situations will generally result in dissatisfying outcomes, the Mercer Capital experts warned, but there’s good news. Growing a firm’s valuation, like establishing an effective succession plan, is “very possible.” Like estate planning, though, it takes time and a clear set of goals and expectations.

At the end of the day, Crow and Hamner said, all advisors will benefit from learning more about the nuts and bolts of succession planning and the closely linked valuation and transaction process, starting with the following list of key topics and considerations.

1. Internal transitions are often preferred, but can be challenging.

As the Mercer Capital experts discussed, internal transitions of ownership are the most common type of transaction for investment management firms. Many RIA owners prefer working for themselves, and their clients prefer working with an independent advisor.

On the positive side, internal transitions allow RIAs to maintain independence over the long term and provide clients with a sense of continuity and comfort that their advisor’s interests are economically aligned. This option typically requires the most preparation and patience, according to Crow and Hamner, but it allows the founding shareholders to handpick their successors and future leadership.

On the negative side, the high valuations of well-run RIA businesses often mean that the next generation is simply priced out of deals to buy them outright.

2. Mind the pricing conundrum.

As noted, a common roadblock when planning for internal succession is pricing. Establishing a valuation is straightforward enough, Crow and Hamner noted, but the big question is how will the next generation pay?

A deal can be seller financed, of course, but that requires the retiring shareholder to maintain significant business risk at the same time they give up control over the business. In the expert's experience, external debt or equity financing are options that can mitigate some of the drawbacks to seller financing.

3. Debt financing has pros and cons.

As the experts detailed, debt financing has become a readily available option for RIA principals working on succession planning, especially as more specialty lenders have entered the market.

Notably, debt financing increases the remaining shareholders’ personal risk, since it comes with an obligation to repay borrowed funds. This is unlike equity financing, which typically does not require repayment.

Debt financing for RIAs also typically includes a personal guarantee, which many borrowers are opposed to. Finally, borrowers are also more exposed to their own business by using leverage to purchase an equity stake. While traditional lenders look for tangible assets to use as collateral, RIA lenders focus on cash flow.

Prior to the proliferation of cash-flow based lenders, most RIAs had to turn to local banks, who generally aren’t comfortable with the asset-light balance sheets and fee-based structure of RIA firms.

4. Terms shouldn’t be discussed in isolation.

The terms for loans made to RIAs vary significantly depending on the risk profile of the firm.

Additionally, according to the Mercer Capital experts, the terms interact with each other and are difficult to discuss in isolation. For example, a higher origination fee could reduce the need for a prepayment penalty.

5. Sales to consolidators are promising.

RIA consolidators have emerged over the last decade as a promising means for ownership transition, according to Mercer Capital.

Most well-known RIA consolidators have grown their assets under management at double-digit rates over the last five years, and acquisitions by consolidators represent an increasing portion of overall deal volume in the sector.

For RIA principals who are looking for an exit plan, sale to a consolidator typically provides the selling partners with substantial liquidity at close, an ongoing interest in the economics of the firm, and a mechanism to transfer the sellers’ continued interest to the next generation of management.

Still, there are several considerations when considering a sale to an RIA consolidator. Price is the big one, according to Crow and Hamner, but after the deal closes, the selling shareholders will typically have to stick around for several years. This means RIAs must be selective about their new home, otherwise the experience post-sale can result in substantial friction and dissatisfaction.

6. Post-deal conditions can vary significantly.

At one extreme, there are consolidators that standardize only the minimum level of business processes across their acquired firms, which typically include back-office tasks such as compliance and accounting.

This “stay as you are” model has minimal impact on how the firm is run, according to the experts, and it theoretically maintains the selling partners’ sense of entrepreneurship. Acquired firms can retain their own branding and client-facing processes after the deal closes, and there is usually little or no impact from the perspective of the firm’s clients.

At the other extreme, there are consolidators that unify the branding of acquired firms and present a homogenous wealth management platform to clients. Under this model, most functions of the acquired RIA moved under the corporate umbrella. Sellers have much less control after the deal closes.

Some sellers may see this as gaining freedom from the day-to-day management of their firms, the experts explained, but others may be reluctant to relinquish that much control.

7. Private equity is in the spotlight.

As the experts discussed, private equity is increasingly being used to “cash out” founding partners of successful RIAs. PE is drawn to the industry’s typically high margins, low capital expenditure needs, and recurring revenue model.

Private equity can provide a relatively straightforward path to diversification for existing RIA principals, but it also comes with some potential pitfalls. Chief among them: RIA principals will have to weigh the benefits of diversification and instant liquidity with the costs of losing full or partial control to outside ownership.

8. Majority vs. minority investment makes a big difference.

It is common to see some equity retained by the seller to ensure their incentives align with the PE firm's. Earnouts based on specific financial metrics or milestones can also serve this purpose, according to Crow and Hamner.

PE firms frequently purchase a majority interest to assume control over future operations. Such a sale creates a larger liquidity event for the sellers, but at the cost of relinquishing control. Minority financial investments, alternatively, can allow departing owners to realize liquidity while allowing remaining owners to maintain control and an ongoing interest in the firm’s economics.

Often, a change of control is thought to occur when greater than 50% of the equity changes hands. But, as the experts warned, the notion of “control” can be more complicated with RIAs from a regulatory and reporting perspective.

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