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.