The private-equity tsunami that's sweeping the investing world isn't exactly inundating the financial advisory industry, but it is making waves. The sector is on pace for a third consecutive year of record-breaking mergers and acquisitions activity, and through late May 38% of the buyers were holding companies (mostly funded by private capital), a jump from 28% two years ago. Holding companies have become the most aggressive acquirers of firms with more than $100 million in assets, says David DeVoe, director of mergers and acquisitions for the strategic-client group at Schwab Institutional.
    The appeal is simple: The financial advice industry is a fragmented, fast-growing market capable of generating annual returns on investment in excess of 20%. Holding companies tap into this space by offering cash and an equity stake to the principals of advisory firms, and ideally provide infrastructure  support, technology or other needed services to help their affiliated firms grow. In return, firms sell a percentage of ongoing future cash flows to the buyers at a higher multiple than possible from a legacy transaction or a sale to a comparably sized outfit. The potential big bang for advisors, however, is the possible payoff that could occur if and when the private entity goes public.
    Generally, the largest holding companies aren't interested in advisory firms with less than $500 million in assets under management. "Larger advisory firms tend to have stronger management teams that can grow a firm after succession," says DeVoe. "The time and energy it takes to do a small deal is about the same as a big deal."
    Jim Reding thinks the private-equity folks are missing out by ignoring smaller firms with potentially dynamic growth prospects. Based in the St. Louis suburb of Des Peres, Mo., Reding, 41, started Financial Advisor Roll-up earlier this year as a vehicle to help smaller players such as his firm boost their valuations by hitching up to the private-equity wagon.
    Reding hopes to aggregate as many as 50 smaller firms under his umbrella to leverage their combined assets, best practices and growth potential to make the collective whole an appealing acquisition to a private-equity buyer. "To get the best deal possible you have to give the private-equity guys what they need," says Reding, principal at Paradigm Wealth Advisors. "And what they need is a time-efficient ramp-up to get to their liquidity event."
    Advisory firms with AUM north of $500 million can fetch multiples of four to five times their annual revenue, says Reding, while smaller firms are often valued at one to two times revenue. He believes that forging a collective group that can deliver the goods to a private-equity buyer will boost the attractiveness and, consequently, the valuations for all of his group's members.
    Reding's premise is twofold: Advisors with AUM between $50 million and $500 million have the capacity to add new clients and grow revenue at double-digit growth rates; conversely, these smaller advisors can benefit from the back-office support that private-equity groups can provide.
Before entering the financial advisory business 11 years ago, Reding worked for Monsanto for seven years and analyzed potential acquisitions during Monsanto's buying spree of seed companies. He says he has carefully studied the private-equity buyout market, and believes he has crafted a win-win package for both Financial Advisor Roll-up-affiliated firms and a potential buyer.
    Under Reding's plan, the private equity firm would purchase 50% of a firm's stock at a multiple of six times earnings before owner compensation (EBOC). Owner's compensation includes such things as salary, health insurance and similar items. One half of this amount is paid in cash and one half in stock in the private-equity company. The private equity firm gets 30% of the advisor's EBOC each year after closing. It's anticipated that the private-equity company will complete an IPO in two to four years.
    Participating firms keep a controlling interest in their business, can maintain the same firm name and keep the same custodian. The expected cash infusion and additional resources available could help boost their assets under management. He has shopped around his concept to various private-equity groups, and says that two undisclosed potential buyers are interested in his idea.
    Reding touts both the back-office help and the expected boost in advisory firm multiples as two immediate benefits to any private-equity deal that might occur, but his holy grail is to cash in on the acquirer's hoped-for IPO. Ditto for some advisors looking at Reding's proposal. "My primary motive to do something like this is to get capital needed to buy other practices," says Dan Davis, a partner at ADK Wealth Advisory Group in St. Louis, a firm with assets of $120 million.
    Davis says his part of the business is about $70 million, with expected revenue this year of $740,000. Selling off half of his business and keeping only part of his cash flow wouldn't give him enough acquisition capital. "I won't participate if I don't think there's a high probability of an IPO," he says.
    To mix metaphors, the IPO home run isn't a slam dunk. For starters, Congress is making noise about changing the favorable tax structure of private-equity groups after the fallout from the Blackstone Group's recent IPO. Rising interest rates could crimp future private equity deal-making, and overall market conditions might turn sour in coming years.
    Furthermore, there isn't much of a track record of IPOs from holding companies with a portfolio of financial firms. Reding cites the IPO for National Financial Partners as his model. NFP is an amalgam of roughly175 financial firms that get commission and fee revenue from life insurance and wealth transfer businesses, corporate and executive benefits companies and financial planning firms.
    NFP was initially bankrolled by the buyout firm Apollo Management; since its IPO in September 2003, its stock had doubled as of mid July and the company's shares were recently valued at 13 times estimated forward earnings.
    Reding reasons that if NFP can fetch that type of valuation with its portfolio of firms selling a bevy of commission-based products, then a holding company stocked with advisory firms more heavily tilted toward recurring fee-based income should warrant a higher multiple. "We will be 67% to 70% fee-based as a group," says Reding. "The private-equity people I'm talking to know that will get a richer multiple when the thing goes public."
    But not everyone subscribes to the notion of an IPO-fueled bonanza. "What's endemic to all of these types of [private-to-public] structures is that you're taking stock of indeterminate value and absolute uncertain liquidity," says Mark Hurley, a co-founder of Fiduciary Network, a private holding company that takes long-term stakes in advisory firms and has no intent to go public. "If you don't get there [with the IPO] you own stock in a company that you don't know how much it's worth or how you will get liquidity from it."
    Hurley cautions against possible unfavorable equity structures upon going public that can include unrestricted shares for initial investors who could bail after an IPO's big pop, leaving advisors holding the bag with restricted shares if the stock tanks.
    "A lot of private-equity guys are vultures," says Reding, who cites his M&A experience at Monsanto as valuable in negotiating deals. "My role is to make sure the advisors don't get screwed." Reding sees his role as that of an investment banker who's trying to negotiate the best deal for the advisors in his roll-up  while streamlining the due diligence process for the private-equity firms. He says he carefully screens each advisor and says they must have at least $50 million AUM, a revenue stream that's at least 50% fee-based and a clean compliance record and they must offer comprehensive wealth management services such as financial and estate planning, in addition to investment planning. Depending on the firm's size, advisors will pay Reding a 5% to 6% fee for his services only if a private-equity deal goes through.
    Reding's firm already has 12 advisors in the fold with assets totaling $1 billion. He says both private-equity groups he's talking to already have $10 billion to $15 billion on their own, and over the course of the next two to three years he aims to provide them with enough advisors and capital to help get them to the $20 billion to $25 billion level he believes is sufficient to support an IPO.
    Various holding companies also have their eyes on potential IPOs. One is Focus Financial Partners, which has ten affiliate companies with $19 billion in assets and is funded by Summit Partners. Focus gravitates toward larger advisory firms, but is willing to look at firms with $300 million AUM. "Clearly, an IPO could be very attractive to our partners," says CEO Rudy Adolf, who believes his company is IPO-ready but offers no time frame for that event.
    United Capital Financial Advisers, funded by Grail Partners, has 15 advisory firms with $1.6 billion in assets. Its sweet spot is firms with assets between $100 million and $400 million, but a huge pending deal at press time could boost assets to $6 billion. They expect an IPO or some other liquidity event within three to five years.
    Many other holding companies are on the scene, but advisors need to realize that such companies expect advisory management teams to aggressively grow their business and to not sit around waiting for the big payday. When it comes to entering a private-equity deal, "advisors should methodically think through their business and personal objectives and not just focus on the valuation," says David DeVoe from Schwab Institutional.