Perhaps one should avoid the temptation to use house metaphors when describing something like an RIA business. And yet.
Like your house, your advisory firm has likely got a lot of your personal stake and stamp in it—it’s a product of sweat equity and the value of the relationships you’ve built. Like your house, your business is lately getting covetous looks from house flippers who’ve decided that they like what you’ve done with the fancy lights, landscaping, pool, sunken living room and expanded garage. They might want to buy it from you, dress it up and sell it up the food chain to bigger developers.
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As with your house, you’re likely facing a conflict: wondering whether to sell it for the maximum value—the loftiest dollar amount for all you’ve put into it—or instead turn it over to the kids, the next generation, people who might do more to protect your legacy and the spiritual value of what you’ve created but who are going to give you less value for it. It’s likely been a nice annuity for you, too, something that keeps paying dividends to you while you slowly wind down into retirement.
And there are also blocks and blocks of other houses like yours, a lot of which have suddenly gotten quite big. Some have started putting up “for sale” signs as their owners consider the next phases of their lives. And as their prices have gone up in value, so has yours when you’re all in such a great location. That’s probably got you thinking the same thing—that you could take advantage of all this equity, find a buyer now—when private equity firms have to put their money to use—and cash out.
Hard to imagine all this, but as the registered investment advisory industry has morphed over the last 20 years, a billion-dollar firm is no longer as unique as it used to be. Instead, firms have evolved from mom and pop shops into something more corporate, more professional, its cubicles graced by specialists rather than one or two advisors wearing all the hats.
Brent Brodeski, the chief executive officer at Savant Wealth Management in Rockford, Ill., remembers 30 years ago when his firm was just him and one other person doing everything, including taking out the garbage. Back then, he said, “You told your employees to go on your wife’s [healthcare] plan.” Now he’s got 583 employees, including a new artificial intelligence expert trying to tame the firm’s swelling data lakes. The emergence of corporate structures (and boards to report to) has not only created health plans but also more defined career paths.
Marty Bicknell, the CEO and president of the voracious aggregator Mariner Wealth Advisors, headquartered in Overland Park, Kan., has seen the changing attitudes toward his space, too. “Even three years ago we had a hard time at Mariner getting a line of credit from a traditional lending source. Banks did not understand our business. They couldn’t find an asset to underwrite because it’s a cash-flow business. Over the last three years, there’s been dozens and dozens. When we did our last debt round, just a few weeks ago, we had 40 lenders offering to loan us money. Forty.”
Dick Pfister, the CEO of San Diego-based AlphaCore, says that private equity has had something to do with that loosening of the purse strings. PE firms foster a culture of more quarterly reporting, since there’s now an investor class for RIA chiefs to answer to, and more normal reporting leads to more confident bankers, Pfister says.
There’s a downside. Brodeski says leverage ratios are ticking up and that all the money flowing into the space at a time of higher interest rates means there’s a temptation to borrow, lever up—and possibly buy firms that are overpriced. “PE-controlled firms are playing with OPM—other people’s money,” he says. When the market turns down, that could leave a lot of firms exposed, he adds, if they have too much debt and the market is no longer growing and pumping up those revenues to cover interest expense.
Still, according to Steve Gaven, the chief growth officer at SageView, based in Newport Beach, Calif., intelligent use of leverage is always going to be important in acquisitions, and lenders like what they see in the wealth management space: recurring revenue streams and sticky client relationships where there’s not a lot of client turnover. And the markets go up over the long term, something attractive for borrowers because there’s growth embedded in the market, no matter what organic growth is doing (and the stock market is, in fact, hitting new records).
Still, why is organic growth (in terms of new client acquisition) so sluggish? There are many theories about that. One is that a new generation of advisors, people who came directly out of university financial planning departments with a monastic fiduciary mission, disdain sales culture and haven’t learned business development chops.
Alan Moore, the co-founder of the XY Planning Network, a network of young advisors who’ve created their own startups, says this notion of business development failure is comically wrong. The problem, in his view, lies with senior management.
“There are very real structural barriers that founders have put into place,” he says about the organic growth problem. “When the founder was starting their firm, they worked with anyone that had $50,000 (or less) in their investment account. Those clients grew over time, so they started raising their minimums. Now they are hiring younger advisors and saying, ‘Go find new clients with $1 million or more.’ And that’s just not a reasonable ask. If someone has that kind of pipeline, they will just start their own firm.”
He adds it’s for that reason younger firms have bigger growth rates. He claims the organic growth rate of XYPN firms, many of which have lower or no minimums and target the emerging affluent, is much larger than the industry average. Recent research from Ensemble Group confirms that RIAs with younger partners sport higher growth rates. (See story in this issue of FA.)
Those firms that can grow organically are likely to see more buyer interest, but even here, as valuations stay lofty, buyers are going to look under the hood. For example, if your main referral sources are custodians, some advisors might view the fee-sharing arrangement as a marketing expense. An acquirer might not.
“Not all organic growth is created equally,” says Larry Miles, the CEO at Chicago firm Choreo. “I’ve heard a lot of questions being asked of those firms whose sole or overwhelmingly primary growth channel is a custodial referral program. Because in many respects, you don’t really own those clients. You’re kind of renting them. And rent is expensive. I think the discerning [acquirer] is asking not just what is your organic growth but specifically where is it coming from. Is it repeatable? Is it something you own and control? And something we can invest in and take you from doing well to really well?”
Peter Mallouk, the president and CEO at Creative Planning in Overland Park, Kan., says saturation has had something to do with the lack of organic growth. Whereas it used to be easy in the industry’s early evolution to take clients from brokerages and mutual fund companies, now RIAs are increasingly having to take clients from one another.
Will A Talent War Get Legal?
That’s made people wonder whether the war for talent might spill over into more legal proceedings. In the wirehouse world, lawsuits against departing advisors are common (ask J.P. Morgan), especially since the breakdown of the famous “Broker Protocol,” which has led to a battle royale in federal courts over teams that make off with clients and assets. While that hasn’t happened as often in the RIA world, Edelman Financial Engines served a stark reminder that it could when it sued Mariner Wealth in November … accusing the acquirer of poaching 10 advisors and making off with some $621 million in Edelman assets. (Bicknell said he couldn’t comment on this directly.)
The desire to hold clients and advisors through legal handcuffs, however, might be ultimately problematic. Young advisors are in high demand and have a lot of power to negotiate their contracts, perhaps by demanding that their firms take the fetters off, says Stephen Galletto, an attorney at Stark & Stark who works with advisory firms and helps them come to market.
In April, the Federal Trade Commission issued a rule banning noncompete agreements. The tamer nonsolicit agreements might remain in force, but young advisors still likely have room to negotiate terms, Galletto says, perhaps by limiting the number of months a nonsolicit applies or removing even more restrictive language. “Something to be careful about is a non-service clause, which would prevent you from even servicing a client that sought you out,” he says.
Mike LaMena, the CEO of New York-based Wealthspire Advisors, says he does see more instances where talent is moving from one RIA to another. “If you’re relying on [restrictive covenants] to retain talent, you’re going to lose the game,” LaMena says. “You have to have an incredibly attractive environment where people are thriving for people to want to stay. If you’re not creating that ecosystem where they can collaborate, where they have all the resources they need … [then] restrictive covenants and things like that, they’re not going to be what keeps people at firms.”
Add Services?
One big question firms have is whether they should add services that might have lower margins, like tax prep, even though clients, many with increasing wealth complexities, want them. For large firms aiming to be full-service—attempting to replicate multi-family offices with estate planning, cybersecurity and concierge services, there’s increasingly no question.
Josh Harris, the managing director of corporate development at Coldstream Wealth Management, based in Bellevue, Wash., says things like tax services are going to be incredibly valuable to clients. “It’s absolutely wrong for a wealth management firm to say that it’s just an add-on [or] it’s going to be a loss leader.” With clients finding it difficult to get new CPAs, “the talent shortage with tax is really difficult,” he adds.
The desire for more services at the same price point is going to put pressure on firms, it’s been said. There’s even been talk that firms might abandon AUM and go to different fee arrangements. Harris says it’s unlikely. “I’ve witnessed firms who have taken on flat fees and whatnot. They spend a lot of time each year renegotiating fees with their clients.”
Larry Miles, the CEO at Choreo, has made sure that clients understand all the services it provides. They might not know they need or want something or that the firm can meet a need, whether it’s estate planning or tax help, and that’s a good opportunity for a competitor to swoop in and make their own case. “We want to make sure we are constantly reminding them of the different ways we can be of service.”
What’s In It For the Young?
Some young advisors are no longer waiting for promises of equity. According to Moore, “XYPN has almost 1,900 advisors and many (if not most) were part of a promised succession plan that fell apart. One big reason is the valuation issue. The valuation spike has driven many to starting their own firms, which is why you’re seeing a boom of solo and small RIAs being started.”
Indeed, the number of SEC-registered advisors hit a record 15,396, according to the Investment Adviser Association in a recent industry snapshot. New firms are being created faster than they can be consolidated.
Meanwhile, the private equity money awash in the space has helped advance the industry’s corporatization and professionalism, so that firms can offer better career tracks to people with different specialties. That could help solve a problem that younger advisors have had in the past where they are mostly forced to work for an aging entrepreneur, wear many hats, help grow a firm—and then find it’s too expensive to buy into.
Ken Stern, the president of Lido Advisors in Los Angeles, says that his firm now has its biggest intern group ever. “We didn’t even have an intern class five years ago. … Now we have interns ranging from being in the financial planning school, to computer scientists and people that are specializing in data programming. We have interns in so many different modalities. Could I have handled something like this, or many firms, four or five years ago? There’s no way.”
John Furey, a managing partner and consultant with Advisor Growth Strategies says that when he got into the business 20 years ago, the feeling among founders was that they wanted to max out the value of their equity for themselves. But those firms that want to survive a generational shift are going to get equity into the hands of their younger advisors earlier. “You have to equitize your team far sooner than you think.” He says that he’s not a fan of seller financing, but he says some firms have developed smart relationships with local banks to help their younger advisors buy in. There are also firms with more sophisticated buy-sell agreements that open up opportunities for young staffers to buy equity every year.
Tom Manning, the president and CEO of F.L. Putnam, headquartered in Wellesley, Mass., says that his firm’s parent holding company (which has been around since the 1920s) owned 100% of the firm up until a few years ago. “We’ve been buying the stock from the parent and distributing to employees as part of compensation now since 2015. We’ve got wide distribution of ownership at this point. The mechanism by which we acquired the shares was to pay cash to the parent company. They give us the stock, we distribute it to employees.”
Valuations Still Strong
The consensus among M&A consultants is that valuations for firms have plateaued but are still strong and in the best cases can be 20 times earnings.
Laura Delaney, the vice president of practice management and consulting at Fidelity and an M&A expert, says that the structures of acquisitions have changed, where all-cash deals are falling by the wayside while mixtures of equity and cash are becoming more the norm as interest rates rise and capital becomes more expensive. “Equity is becoming more of a currency,” she says. “For smaller firms who are being acquired by a larger firm, if a smaller firm is going for eight or nine times their EBITDA and the larger firm’s worth 20, well now the [acquired] firm’s worth 20. I think the smaller firm would like an equity stake in that combined firm.”
For acquirers buying firms at earnings multiples around 13 to 17 times EBITDA, the deals are being split into more equity up front followed by a retention payment followed by about three years of earn-outs. About 98% of clients typically stay on after the deal is done, says Delaney, taking the number from a 2023 Fidelity study.
“Beauty is in the eye of the beholder,” she says, “But there are things we have identified that either add to value or detract from a firm’s value. It is about looking under a firm’s hood.”
Some firms might get a lower valuation because they have some commission business, but she says sometimes commission business is good. “What generally adds to value or subtracts from value is do we have client concentration risk? Do we have a next generation of investors identified? Or the next generation of leaders identified?”
Furey says it’s no longer a slam dunk for RIA firms to come to market and think they’re going to be flooded with offers when cash is no longer cheap. “Because of the cost of capital being higher … there’s less cash at closing because debt is more expensive. There’s more equity in deals because equity is expensive, too, but what buyers will do, if their multiple is higher than the seller’s multiple, there’s arbitrage there, they get accretion, so they’re putting more equity in deals.” He also sees more earn-out requirements, so the seller has to keep growing the business.
Some big acquirers have learned their lessons after getting into trouble by structuring deals so that management cashes out and effectively retires on the job. Furey asks: Why would an owner who sold and got all the cash up front have any motivation to work hard to keep clients around?
“I like today’s environment more because there’s more risk-sharing,” he says.