Using OPM to Grow AUM

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.