Eleven years after writing a white paper that rocked the financial advisory profession, Fiduciary Network CEO Mark Hurley has returned with another white paper designed to shock and awe the RIA community. It's called "Creating, Measuring and Unlocking Enterprise Value in a Wealth Manager." (A full copy of the report is available at www.fiduciarynetwork.net.)

Why did he and his staff at Fiduciary Network write the paper? After all, as an investment company that has made stand-alone investments in ten RIA firms, Fiduciary Network has skin in the game. But Hurley revels in the role of provocateur. The firm only plans to invest in another ten to 20 firms, and his goal is simply to pass on information, he says.

What he says he's found, during the last three years as his company has held casual conversations with hundreds of RIA firms, is that misconceptions abound about firm acquisitions. True to form, Hurley begins the paper by claiming that only 200 to 400 firms in America have enterprise value, and the other 19,000 or so have little or none.

How is it that more than 95% of the businesses that populate this profession would be worth bupkus?

Hurley says it's that the profitability at many fee-based firms is contingent on the future sales of financial products since these firms don't have enough recurring revenue to command a respectable valuation. In these cases, the real economic value resides at broker-dealers like LPL Financial, Raymond James and Commonwealth Financial Network.

On the fee-only side of the business, the majority of firms make no money beyond the owner's salary, so in reality owners are subsidizing the business with their labor, in Hurley's view. "Most fee-only firm owners earn market-level wages," he claims, adding they could give up their equity, move to a bigger firm and significantly increase their income.

Moreover, the fact remains that even the largest RIA firms in the business-those with several billion dollars in assets-aren't that big. "They won't appeal to a strategic buyer," Hurley claims, adding that strategic buyers typically are the acquirers who pay the largest premiums. Valuing an advisory firm is also a vexing task. "No one can predict how many clients the firm will add or what the market will do," Hurley explains.

And yet sadly, many advisors labor under the delusion that their firms "are incredibly valuable," the report says. When it comes time to sell their business, most advisors cite some report-often a false one-about the sale of another firm at a stratospheric multiple.

Feeding these delusions of astounding value is a cottage industry of investment bankers who specialize in RIA mergers and encourage advisors to make deals. The actual truth is that very few transactions for RIA firms at remarkable prices have ever occurred.

Equally problematic is the Lake Wobegon mentality afflicting advisors the same way it does active asset managers: Survey after survey reveals that 80% to 90% of active mutual fund managers view their investment prowess as above average, even though most fail to beat their benchmarks.

Advisors Are Overconfident
Many advisors believe their knowledge about investments and financial planning automatically translates into talent in other financial areas, like mergers and acquisitions. It doesn't.

"Advisors are inexperienced and overconfident" when it comes to deal-making, Hurley argues. "M&A is a specialty like wealth management is a specialty."

In contrast to the misplaced hubris among RIAs, most acquirers are sophisticated professionals who do deals for a living and have teams of dexterous lawyers good at wording contracts in subtle ways that dramatically reduce an RIA's options once the transaction closes. "Deals are all about risk allocation," Hurley says. "Doing deals requires a degree in psychology more than a degree in finance. Buyers know this."

That means a minor tweak to the legal language can radically change the range of outcomes. Invariably, the shift in risk and reward favors the acquirer. Some capital structures developed by consolidators transfer all the risk from themselves to the firms they have acquired.

Capital preference structures, commonly used by many consolidators but not by the advisors in their networks, can eat up all of an RIA's remaining equity, leaving the advisors in a financial hole from which they can't escape. Hurley calls this phenomenon "asymmetric dilution." What does that mean? Typically it occurs when consolidators or roll-up vehicles own a different share class, with different shareholder rights, than the advisor in the network. In this scenario, if the consolidator has to recapitalize the firm, its principals may get issued new shares while the advisors' shares get diluted.

But there are other problems. What happens if the consolidator can't do enough deals to reach the critical mass necessary to do an IPO? Then the RIA has a tiny stake in a private company that is worth next to nothing.

Moreover, the consolidator is likely to grow desperate and seek transactions at any cost. This not only continues to dilute the firm, but forces the consolidator to seek deals with lower-quality firms that pollute the others.

If acquirers can't find enough RIAs to reach critical mass, they may start purchasing fee-based advisors, creating the nightmarish possibility of dual regulation by both the SEC and Finra for the entire entity. "You end up having to sleep with everyone they sleep with," Hurley has quipped in the past.

Of course, a consolidator could succeed and make it all the way past the IPO. Both NFP and Boston Private have done so, although they've struggled like many companies in the financial services business over the last two years. Hurley tells advisors they should not only demand transparency from a roll-up firm but also receive the same class of shares as everyone else, including the consolidator. Finally, they should get a prenuptial agreement, outlining how either party can unwind the ownership relationship if it so chooses.

Banks Have Drawbacks
Traditionally, small banks have always been the most aggressive acquirers of advisory firms, though the financial crisis has muted bank activity as many institutions rebuild their balance sheets. Still, it's hard for small bank executives not to see the potential synergies associated with acquiring RIAs.

Small regional banks derive a good part of their business from lending to small family-owned businesses, many of which use RIAs for financial advice, Hurley notes. On the surface, it looks like a win-win for both parties if the bank buys the advisory. When bank acquire them, RIAs get a built-in source of referrals to grow their business, while the bank diversifies and gets a new steady stream of fee income.

Shocking though it may seem, Hurley argues that banks are surprisingly savvy buyers. In particular, they realize that the firm's future success depends far more on the professionals who will run it going forward than on the sellers. The report says that banks often insist that the sellers pay a substantial portion (25% to 33%) of the transaction amount to the professionals who will take over the firm (usually taken from the seller's earn-out payments and paid to the professionals in retention bonuses). This means "reducing the consideration received by the firm's owners," the report states.

Banks typically structure transactions so they can recoup, or self-fund, their investment outlay in a very short period of time. During negotiations with RIAs, banks will typically demand that a high market-level wage for owners must be deducted before arriving at a cash flow figure. They do so for two reasons. First, it lowers the price. Second, it sets more consideration aside for the next generation who will determine the future success of the business.

Then there is the problem of small bank stock valuation. Hurley notes that many small banks are started by entrepreneurs seeking to exploit "temporary dislocations" in the economy and credit markets. Times like the present, when the economy is just emerging from a nasty recession and existing banks are still saddled with bad loans from the last boom, are perfect, since customers are underserved. When these small banks go public, as many do, they can command lofty price-earnings multiples, which they can then use as a currency to make acquisitions.

That's fine for entrepreneurial banks, but it also means the advisor could receive an overvalued stock for his firm. Small bank shares are just as likely as big bank stocks to collapse when the economic cycle turns.

Since these banks are considered small enough to fail, federal bailouts are not happening. "If they go into receivership, you don't get your earn-out, and they still own you," Hurley explains. It may not be fair, but that's the law.

Another problem is the failure of so-called cross-selling synergies to materialize. Advisors are entrepreneurial by nature, and many are inclined to take a dim view of stodgy, bureaucratic bankers, so the relationship required for a successful referral network isn't there. Moreover, bankers' relationship with clients is often transactional, while advisors tend to have more personal connections.

Hurley believes advisors selling their firms to banks should hold onto any profitability from their ownership if they have not been paid in full for it-if they get paid in stages, they should only cede their claim to profits proportionately. Any stock in the bank that they get should be sold immediately. Finally, advisors should demand contractual governance protections for their own autonomy, with earn-out accelerators if the contract is violated.

Internal Transitions
Even if the firm's founders don't want to give up ownership control of their business, they need to spread the equity among key personnel if the firm is to create any sustainable business value. Legal ownership simply doesn't convert into economic ownership even if a control-driven founder might wish it did.

"A buyer isn't buying you [the founder]," Hurley says. "He is buying your successors' services."

While internal transitions are sometimes characterized by pricing disputes and cultural issues, a transition plan allows a firm flexibility, stability for clients and a way to retain key employees. If the other financial metrics were equal, a firm with widely dispersed ownership would have significantly greater value than one with highly concentrated equity.

But a major problem is finding a price that is fair to the founders and doesn't saddle the next generation with decades of debt repayment. Even if everyone can agree on a price, the next challenge is financing the transition. Since many banks don't make such loans, internal transactions "require cross-guarantees from the selling owners and the company."

Selling To Another Wealth Manager
As Hurley states at the start, most fee-based and fee-only firms have little enterprise value by themselves. When several of them merge, they can build an organization with scale and have the capacity to grow at a faster rate.

Furthermore, selling to another advisory entails continuity and certainty for clients, as well as opportunities for successors. The structure of a deal depends on the goals of both the seller and the acquirer. Is the goal to knock out a lot of overhead and increase profits? Or is it to increase capacity to accelerate the top line?

One reason why there have been relatively few of these deals is that potential sellers enter negotiations with unrealistic expectations. Hurley calls them "borderline delusional," not only about price but about the post-closing management of the business. "Reasonable buyers will at least try to be accommodating, but there is a limit to their patience," the report states.

Sellers who demand high salaries after the closing can expect a lower price up front. They also need to understand that a buyer's capacity to pay is a form of counterparty risk, and depends on the buyer's financial strength and access to capital.
Hurley concludes his report by noting the irony that many advisors are devotees of the Fama-French efficient market hypothesis and yet are convinced the theory doesn't pertain to the market for advisory practices. The evidence is they are wrong.