After nearly a decade, Focus Financial Partners’ long-awaited is initial public offering (IPO) is finally coming to market.

A reading of its S-1 filing by several people reveals some very interesting characteristics about the financial realities of one of the advisory world’s leading aggregators. Of particular significance is the use of a new financial metric, "adjusted" EBITDA (Earnings Before Interest And Tax Plus Depreciation And Amortization). In the filing, the company clearly acknowledges that the concept, which adds back certain non-cash charges into cash flow, is not recognized under traditional GAAP accounting methods.

Other aggregators are keenly rooting for the Focus IPO to be a success. Financial Engines and Edelman Financial Services just merged and went private at 19 times traditional EBITDA so private equity investors are clearly willing to pay up for certain RIA companies. If public investors, a different breed, line up to buy Focus shares and the firm performs well financially in its first year as a public company, other aggregators like United Capital and HighTower would feel compelled to at least consider their own IPOs.

But a look at the financial results Focus has posted to date raise several questions at the very least.

Organic Growth
IPO investors typically base their decisions on how they think a company will perform going forward. The recent past is often seen as a good predictive indicator of the future until it isn't.

One interesing  piece of information about the Focus filing is its organic revenue growth. Rivals at various other aggregators have long argued that the Focus model, in which it purchases equity stakes of 40 percent to 60 percent in the acquired firms, generates little incentives for the advisors to grow their business after they’ve cashed out most of their equity.

Data from the S-1 filing appear to support that conclusion. One part of the filing says that organic revenue growth in 2017 was 13.4 percent, but that includes growth related to acquisitions of other firms and customer relationships by partner firms and mergers among Focus firms.

Total revenues at its existing firms, not those acquired, is closer to 8.3 percent in 2017 from about $485 million in 2016, according to one expert who tried to strip some of the above-mentioned factors. Revenues in 2017 were $663 million for Focus, but the lion’s share of growth came from acquisitions.

It’s worth remembering that 2017 was a year when the S&P 500 was up more than 19 percent. Furthermore, the U.S. benchmark underperformed most other global equity indexes, so a globally diversified portfolio could have even bested the S&P. Even assuming Focus advisors had older clients with larger fixed-income allocations than most RIA firms, the numbers would appear to indicate that, on average, Focus firms are shrinking, or at least not growing significantly.

There are several possible explanations. Firms affiliated with Focus could have an older client base and these clients could be consuming their capital. Or they could simply be losing more clients than they are onboarding.

Whatever the case, several other aggregators enjoyed organic growth in the 15 percent to 20 percent area in 2017. For its part, Focus appears to be addressing the issue of stagnant new client growth or even attrition. Earlier this week, it announced it had led a $28 million funding round for Smart Asset, a lead-generation data service for advisors.

Then there is the issue of revenue composition. The S-1 says the entire partnership is operating under the fiduciary model, but just under 10 percent of its revenues come from transactions and other non-recurring sources of business. Whether investors will assign the same multiple to non-recurring revenues is an open question. In the private market, buyers typically don’t.

Intriguing Accounting Concepts
Then there is the concept of adjusted EBITDA (Earnings Before Interest And Tax Plus Depreciation And Amortization). That is the lens through which Focus is asking investors to view its business model. The S-1 states that adjusted EBITDA is not defined under GAAP and does not purport to be net income or cash flow.

It entails adding back non-cash equity compensation expenses and non-cash changes on fair value of estimated contingent consideration. What that means exactly isn’t clear.

One financial expert who has examined the S-1 believes that Focus may be setting targets for certain affiliated firms. If they exceed those targets, they receive additional equity if this observer is accurate. But whether that is the case or not, one thing is clear—the non-cash equity compensation expense is dilutive to existing shareholders.

Who could be getting this non-cash equity compensation? One possibility is that Focus acquires firms in the middle of the year and promises an earn-out if business remains strong. That’s a common practice in the M&A world.

It also is widely believed that a handful of top-performing Focus firms, including Buckingham Asset Management, G.W. Wade, Coastal Bridge Advisors, The Colony Group and Joel Isaacson & Co., are generating an outsized share of the company’s top-line growth and some have wondered how Focus treats them compared to the slow growers. The filing doesn’t say whether this is a way of rewarding certain firms that exceed their targets.

One analysis concludes that under traditional cash flow analysis Focus has about $85 million to $95 million in in 2017 EBITDA. The adjusted EBITDA concept it is employing raises that figure to about $145 million, a huge increase in terms of how the aggregator is valued.

Whether IPO investors buy into the adjusted EBITDA concept could be critical in deciding whether the offering is a success or a flop.

Capital Structure And Valuation

Convincing investors that Focus deserves a reasonably high multiple will also be pivotal. When Financial Engines and Edelman merged and went private, the private equity investors paid 19 times traditional EBITDA. But Financial Engines is the nation’s first robo-advisor, with a huge footprint in the 401(k) market. Like Edelman, it specializes in serving middle-class America, a market considered attractive because most of the financial advice industry has shunned it.

Focus’s revenue grew 36.6 percent in 2017. However, regardless of what metric one assigns to organic growth, most of the topline gain comes from acquisitions. To keep these transactions coming requires continuous financing and as Focus gets bigger, it will need to do more acquisitions every year to sustain its growth rate .

That brings up the issue of Focus’s capital structure, which includes $1.1 billion in debt and $680 in convertible preferred shares. If the market buys into Focus’s adjusted EBITDA concept and gives the aggregator a multiple of 15, that translates into an equity valuation of about $2.175 billion. Were that to happen, the IPO would be a success.

But if investors want to rely on the traditional EBITDA metric and assign a 15 multiple to $95 million, the equity turns out to be $1.425 billion, enough to cover the debt but not the convertible preferred. It’s not clear whether Focus and its underwriters, Goldman Sachs  and KKR, would pull the IPO or resort to creative financial engineering maneuvers if that happened. KKR also happens to be one of Focus’s two major private equity shareholders.

Where Are Advisors’ Yachts?

KKR and Stone Point, another private equity firm, own 70 percent of Focus with the rest divvied up among management and advisors. Most advisors will receive restricted class B shares that they can swap into saleable Class A shares over a three-year period at the rate of one-twelfth per quarter. Thus if the stock pops in the months immediately after the IPO, advisors will be limited in their ability to get liquidity.

The Long Term

The S-1 filing says Focus has 55 partner firms so, depending on which EBITDA metric one uses, the average firm is throwing off between $2 million and $3 million annually. They represent major small businesses for three to five private advisor/owners but look puny to Wall Street.

When ownership and cash flows are divided with an aggregator like Focus, they look even smaller. How Wall Street looks upon this type of business model remains to be seen.

However, as mentioned previously, analysts who have examined Focus’s results believe it displays many of the traits of an aging advisor network with an even older client base. Other aggregators have been established to help finance the ownership transition of RIA firms from their founding partners to the next generation.

All the aggregators are talking about the importance of achieving scale. It would appear Focus is already trying to consolidate the firms within its own network. The S-1 mentions that Focus currently has 55 partner firms and also lists more than 95 acquisitions during its history. 

Were Focus to continue merging smaller affiliated firms run by advisors looking to retire into larger ones, it might ultimately be able to transform dozens of small independent RIAs into a lean, mean network of 20 or 25 billion-dollar RIAs with impressive positions in their respective markets. At present, St. Louis-based Buckingham appears to be the one to watch.

All this is down the road. First, it has to convince Wall Street that the concept of adjusted EBITDA is a reasonable one.