When advisors look back on their profession’s evolution five years from now, 2023 is likely to be remembered as the year private firms asserted themselves as controlling owners of many large RIA firms. A combination of factors, ranging from the retirement of some founders to the 2022 bear market, triggered this inevitable change of de facto control at many firms.

Now the question becomes: What do these PE firms want to achieve and how do they plan to accomplish it? When they started to invest gingerly in this space two decades ago, they saw RIAs as unknown quantities—and the feeling was mutual.

It was obvious the advisory business represented a “classic private equity play,” explains Jonathan Stern, a partner in charge of the investment management unit at Berkshire Global. The business was fragmented and characterized by entrepreneurial, non-professional management that lacked expertise in marketing, sales, distribution and technology, he says.

What independent advisors had in their favor was a business model they believed was a better mousetrap and a messianic faith they could deliver superior services. The model resonated with many affluent baby boomers and that was enough to carry firms through some lean times in the early years before the Great Recession.

When the markets boomed in the 2009-2021 period, RIA owners largely pursued one of two paths. A few reinvested in growth, but many chose to “take out” capital and save for their own long-neglected retirements, Stern observes.

The result was that most underinvested in their firms, and that opened the door for PE capital to move in. Then, as the trickle of PE investments turned into a wave five years ago, the new investors realized they were competing against deal-driven first movers, rivals like Focus Financial, Hightower, United Capital and Fiduciary Network, most of which promised to leave advisors’ day-to-day businesses largely alone.

Despite rising markets, some PE-backed aggregators didn’t get the results they wanted, Stern says. Many have now brought new operations-focused management to streamline the organizations, and sought to convert the businesses into integrators. Increasingly, the “acquire anything” strategies are seen as recipes for failure.

Today, the challenge is to sustain growth at a time when the rainmakers who brought in new clients are aging out of the business and younger advisors are taking their place. “A lot of firms are trying to design themselves so clients are clients of the firm, not the advisor,” Stern says.

By treating the clients as constituents of the firm, instead of the rainmakers, the new owners can address so-called “key-man risk,” but it leaves open the question of whether upcoming teams of young advisors can continue to attract scores of new clients the way their predecessors did. Some consultants, like Mark Hurley, the CEO of Digital Privacy & Protection, suggest firms will have to develop client acquisition specialists (see this month’s cover story.)

The worry is that private equity owners are now going to get more directly involved in management, and that older advisors, those who aren’t ready to retire, are unlikely to want to go along with this regime. “Some older advisors are going to go their own way,” Stern predicts, adding these advisors will argue that longtime clients won’t go along with the new regime either.

So what are the risks for PE firms?

Those that bought into the industry early and racked up huge profits would appear to be sitting pretty. But conditions can change fast and the future isn’t so clear, even for the early winners. In the first place, the debt they took on to finance deals has become a problem—i.e., increasingly expensive. At least one consolidator that owns some of the profession’s finest firms was forced to pay 14.5% in pay-in-kind securities.

Also, replacing retiring advisors won’t be easy for these buyers. Hurley and others predict that the battle for talent is likely to intensify and resemble the seamier side of wirehouse broker poaching. In November, Edelman Financial Engines sued Mariner Wealth for allegedly luring advisors with $621 million in client assets.

The rising cost of capital will change expense structures for consolidators and integrators alike. “Companies that are growing as fast as many of those growing through acquisition [are] may require capital to accelerate their growth, and possibly to achieve dominance in certain markets,” says former Pershing Advisor Solutions CEO Mark Tibergien. “I foresee M&A continuing for a number of years yet.”

At the same time, existing PE backers will face a dilemma. Some will want “to roll over their investments every so many years,” Tibergien argues. Indeed, many big acquirers like Mercer Advisors, Edelman Financial Engines and Carson Group have already recapitalized on several occasions, marking up their investments along the way.

But others like Hurley argue that large, integrated RIA enterprises are perfect long-term investments, not only for PE firms but especially for their largest investors, such as sovereign wealth funds and pensions. Already, some of these big institutional investors are putting the screws to private equity funds, demanding direct co-investment rights and effectively squeezing the PE folks to eliminate a big chunk of their management and performance fees.

All three groups of owners—the aggregators, their PE backers and the RIA owners who remain invested in their firms—aren’t likely to want to sell until they have succeeded in “fixing up the business,” Hurley argues. This requires them to find economies of scale and improve profitability, something firms like Mercer, Creative Planning and Mariner Wealth are already doing.

Tibergien thinks this will probably lead to mergers among the larger firms. But if they need capital, will they get it in debt, private equity or public equity?

Debt may be the less expensive option for owners trying to avoid diluting their equity, but additional leverage can place too much risk on the balance sheet and strain the cash flow. Tibergien notes that retained earnings could help build equity, but it probably won’t be at a rate that sustains these firms’ current growth rate.

“Public offerings are kind [of] off the table,” he says, “until some of these firms achieve critical mass and have legitimate branding. It’s not like technology, where someone is buying innovation—more like a retail or institutional service business. But the public markets haven’t responded positively to this idea.”

So a firm’s equity will need to come either from PE firms or from its employees buying in with current shareholders. It was already difficult for younger partners to buy into firms, and it’s getting harder as the firms’ capitalization gets bigger. Logic, Tibergien says, indicates the PE sponsors will continue to be a factor for as long as the returns and growth rates are there.

Stern says there are still PE firms looking to invest in the advisory business. But unless the equity market enjoys another 15 years just like the last, some of these institutional investors are going to find they can’t meet their internal rates of return or hurdle rates.

Others will simply fail at integrating RIAs. Goldman Sachs, which boasted one of Wall Street’s best financial services teams in areas ranging from banking to asset management, saw its acquisition of United Capital end in a humiliating failure this past summer. It won’t be the last.