In every deal there's a sucker and if you can't figure out who the sucker is, there is a very good chance it's you. These days, many supposedly shrewd executives at the big Wall Street firms that were making billions slicing and dicing dubious mortgages and selling the pieces to institutions around the globe are finding that this favorite aphorism of Warren Buffett is hitting a little too close to home.

Ever since the subprime tsunami reared its hydra-like head late in July 2007, the financial advisor community has found reason to thank the powers that be for allowing most of the mortgage-related problems to sidestep their clients and their businesses. But as the credit crisis keeps metastasizing from one fixed-income sector to the next, one of the hottest trends in this business in 2007, advisory firms' own merger and acquisition activity, is suddenly becoming a victim of fixed-income market paralysis.

Of course, uncertainty in the financial markets and instability in the credit markets have triggered a dramatic slowdown in M&A activity across a wide range of industries. When Wall Street investment banks suddenly fail to sell six-month asset-backed commercial paper and auction-rate municipal securities that reset their interest rates every seven to 35 days, the notion of financing highly leveraged acquisition transactions over a period of several years appears fanciful. Add to that the swooning prices of equities in financial services companies and the financial alternatives grow even slimmer.

Registered investment advisors (RIAs) "have no subprime exposure but merger activity is going to be affected by what happens in the overall marketplace," says David DeVoe, strategic director of M&A at Schwab Institutional. Moreover, subprime problems have damaged the debt and private equity markets acutely and both are major sources of acquisition financing.

Frothy valuations of RIA firms-like most other businesses-are disappearing for the most part. "The cost of capital has gone up for everything" from homes to businesses, DeVoe adds. Debt financing, which frequently can play an important role in many advisor transactions, is in increasingly scarce supply as lenders focus on shoring up their balance sheets.

A weak equity market also is prompting many acquirers to view lofty valuations for RIA firms as dubious. Like it or not, many advisory firms' revenue streams is highly correlated to their assets under management (AUM). "It seems that the [equity] market will be flat to declining for the near term and perhaps for one or two years," DeVoe says. Take that steady annual market appreciation factor of 6% to 8% out of the equation, and whopping valuations become harder to justify.

Virtually every single breed of advisory firm acquirer-ranging from consolidators and roll-up artists to regional banks to larger RIA firms-is wrestling with its own set of financial issues these days. The two biggest publicly traded consolidators, National Financial Partners (NFP) and Boston Private Financial Holdings, have seen their market capitalizations cut in half over the last 12 months, albeit for very different reasons. But the net effect is that the value of their stock as acquisition currency has lost some of its luster-and most regional bank shares are in a similar position.

None of these developments mean that the economics of advisory firms have experienced a permanent, intrinsic loss of value. Indeed, the basic fundamental attractions underlying the advisory business remain as compelling as ever. But as the shine temporarily dims for financial assets of all stripes, RIA firms and others are feeling some of the ill winds.

Both NFP and Boston Private have managed to achieve something other consolidators have yet to do; they have taken their firms from private equity-backed acquisition vehicles into full-fledged public companies. Founded in the late 1990s, NFP acquired more than 200 insurance/estate planning firms, benefits provider businesses and financial planning firms and went public in 2003. Boston Private is an older business and was established as a hybrid regional bank/wealth management firm.

In its latest fiscal quarter, Boston Private, which traditionally paid top-dollar prices for high-quality advisory businesses, recorded financial results that were impaired by significant real estate loan writedowns, much of it on land loans in Florida and California. As with most real estate-related problems, the equity market clearly is wondering if Boston Private has adequately reserved against potential losses.

NFP has no real estate or subprime exposure, but analysts have modestly reduced their 2008 earnings growth projections. While that might seem hardly significant to warrant a 50% plus drop in its market capitalization, this equity market is hardly rational, particularly when it comes to financial services concerns. NFP has also indicated it will seek to acquire firms with $20 million in earnings in 2008, but Eliot Holtz, executive president of marketing, adds the holding company is willing to be opportunistic if more compelling situations present themselves. In addition, NFP's cash flow, $160 million last year, makes its acquisition strategy self-supporting, he adds.

The traditional holding company model calls for acquirers to purchase small businesses at a certain price-typically four or five times operating earnings before interest, taxes, depreciation and amortization (EBITDA) for a significant equity interest in advisory firms. NFP, for example, typically pays five or six times cash flow for 50% of a firm's cash flow, with about 70% of the price paid in cash and the rest in restricted stock. In a few cases, a larger, highly profitable firm might get slightly more. Sources say Boston Private is willing to pay higher multiples for very large high-quality RIA firms.

Then, the holding company bundles more than 50 or even 100 firms together-which is no easy feat-attempts to achieve modest economies of scale, and takes the consolidated company public at a much higher multiple, say, 10, 12 or even 15 times EBITDA. If the stock market is accommodating, this arbitrage creates a win-win for acquirers and acquirees.

When it comes to future acquisitions, holding companies face a new issue thanks to the sinking market for financial services stocks. One year ago before the credit markets collapsed, financial multiples were heading north, with some acquirers saying they might pay eye-popping prices of eight to ten times EBITDA for high-end advisory firms. In light of the market-cap meltdown for financial services stocks in the intervening 12 months, some of this math no longer computes, simply stated. The higher the multiple an acquirer pays for businesses with few brick-and-mortar assets, the longer it takes to amortize the hefty amount of goodwill it takes on with each acquisition.

Both NFP's and Boston Private's public shares now trade at about six or seven times trailing EBITDA, so at least for now, the win-win arbitrage is vastly compressed. This cuts two ways. Today, if you are a target company the low stock price may look attractive. But if you sold your firm several years ago and your restricted shares recently have vested and can be sold, the timing isn't great compared with vesting 12 months ago.

When an inside shareholder can sell usually depends on when they got in, and the private equity firms typically put up the initial capital and get out first. For instance, Apollo Group, which ponied up the seed money for NFP, was able to sell much of its position when the stock's cash flow multiple was in the mid- to high teens.

It's also important to remember that to consider going public in a better IPO environment than the present, a holding company needs to have EBITDA of at least $35 million. Today's punishing markets might be even more demanding. Private equity firms typically commit capital for five to seven years before they seek an exit strategy. So if a holding company can't reach critical mass over that period, advisors could find that a major chunk of their firm has been sold to a new private equity firm-and advisors won't get to pick their new partner. Whoever offers the old private equity firm the most probably will take over.

Moreover, if the few companies that have succeeded as holding company vehicles and actually amassed enough volume to become public entities currently face the prospect of buying advisory firms for prices that are quite close to their own publicly traded shares, it's not a propitious harbinger for the others that are trying to buy advisory businesses right now and go public down the road. For the time being, many traditional exit windows favored by private equity players are boarded up.

In the regional banking world, the problem isn't an exit strategy; it's surviving the current credit crisis. Several bank acquisitions of RIA firms have been spectacular successes, at least from a financial and asset growth viewpoint. Since Harris Bank acquired Sullivan Bruyette Speros & Blayney of McLean, Va., in 2003, assets have nearly tripled from $700 million to $2 billion. The same holds for Miller/Russell & Associates of Phoenix, which experienced a greater than threefold increase in assets from a $500 million level when it was acquired by Western Alliance Bancorp. in 2004. According to several observers, Pacific Capital Bancorp.'s purchase of Morton Capital Management in Calabassas, Calif., was a huge home run for the bank. While the principals reportedly have participated in their firms' growth through earn-outs and profit-sharing, some might well argue they sold too early and too low.

Determining the fair value for small private businesses is a very difficult task. Just look at a transparent industrial giant like General Electric, which traded at 40 times earnings in 2000 and now trades at 13 times earnings after doubling profits in seven years and performing very well. Some say it's as much art as science, so establishing the right price for private, illiquid advisory firms is an even greater crap shoot.

To say many of the banks have gotten great deals might be an overstatement. Each individual case is different, and if a parent bank provides a large and steady stream of referrals and new business, the post-acquisition growth some bank-owned RIAs have enjoyed might not have been replicated if they had remained independent. But as Schwab Institutional's DeVoe explains, deal activity from regional banks has slowed noticeably and many top bank managements' attention is focused on survival for the moment.

The proliferation of holding companies seeking to buy advisory firms ultimately is beneficial for the business, DeVoe says, because it creates more options for firms to consider. "Having competition has been good for us," NFP's Holtz says, because it increases advisor awareness of their choices.
Firms like United Capital in Newport Beach, Calif., and Mesa in Minneapolis are focusing on firms with assets in the $100 million to $500 million range, while Wealth Trust and Fiduciary Network are looking at firms with over $500 million. "More specialization among holding companies will help create value," DeVoe predicts. "Several of the holding companies are doing a lot of the right things. They don't tell advisors how to run their businesses and enable junior people to buy into the business which they couldn't do otherwise."

Fiduciary Network CEO Mark Hurley maintains his firm, which has done four deals in the last year, is still willing to pay high single-digit multiples, and he argues the wobbly stock market is good for the high-end, fee-only firms he is targeting. He bases that statement on the examination of the 2002 results of over 50 firms he has talked with.

"Among 50 firms, I have not found a firm where net revenues did not go up in 2002 because they were so busy adding new clients," Hurley declares.     "These firms are diversified value investors, and even if the average portfolio was down 6% new assets [made the top line] positive. So 2003 was a spectacular year for them. Their worst year was 1999, a bad year for value investors." His first two acquisitions, Regent Atlantic and Evensky & Katz, both experienced revenue growth of 25% or higher in 2007.

Fiduciary Network initially buys only 8% or 9% of a firm's equity and makes sure the younger partners have plenty of skin in the game so they have incentives to grow the business. Over time, the holding company may increase its stake.

Practically every acquirer from NFP to United Capital to Fiduciary Network will tell you they offer transition and succession planning opportunities, not exit strategies. Only one big firm, which shall remain nameless, offers RIA principals two times revenues and typically shuts the firm down and lays off all employees three months after the deal is completed. That's probably the quickest exit strategy out there.

Academic studies of mergers and acquisitions among large public companies frequently conclude that most are failures. So far the record for financial advisory businesses looks somewhat better. Part of the reason is that the deals take six months or more of negotiations, which often fall through. Fiduciary Network's experience of talking with 50 firms, negotiating with more than 20, and closing four or five deals illustrates this. With no pressing need to sell, Fiduciary Network's deals took more than a year to negotiate, but acquirees emerged with high comfort levels.

NFP's record in this area is illuminating. Prior to 2008, the firm completed 249 deals, of which 35 were sub-acquisitions where an NFP-affiliated firm bought another firm or a block of business, Holtz says. Additionally, there have been seven internal consolidations, largely takeovers, mergers or succession transactions. Indeed, more holding companies are encouraging successful affiliates to entertain sub-acquisitions.

Only 21 of NFP's 249 transactions, or 8.4% of the total, have resulted in what Holtz calls "dispositions," where a firm typically is sold back to the principals or folded. In these cases, "we have parted ways. Typically, it's sold back," he explains.
If the failure rate is relatively low at NFP, throughout the industry the success rate probably varies widely, with some deals far more successful than others. Holtz calls "succession planning a process, not an event," and maintains a group of staffers who focus on this. "Our deal doesn't work for someone who wants to get out quickly," he says, but "people in their mid-forties aren't looking at a five-year exit."

From his perch at Schwab Institutional, DeVoe believes most acquirers prefer principals to plan a phased exit over at least five years. "When the principals at a large organization are seeking to leave in six to nine months, it's not very attractive [to acquirers]," he says. But that doesn't mean principals have to keep working 60-hour weeks.

What if an acquisition by a holding company isn't appealing for an advisor? DeVoe suggests talking with a friendly competitor about a merger of equals. The success of some mergers, like Balasa, Dinverno & Foltz, has been detailed in this magazine on several occasions.
The merger between Kochis Fitz and First Quintile, completed earlier this year, is another example. The deal resulted in a highly profitable firm with $5 billion in assets, and some would estimate about $30 million in annual revenues. For firms of this scale, it's not clear that partners need any exit strategy or liquidity event.

"It creates a succession plan for Tim Kochis and others, opens avenues for younger people and brings together complementary skill sets," DeVoe says. "As a result, one plus one equals three. Until a year ago, we saw about one merger of equals a year. Last year we saw five."