On the same day it missed its earnings forecast, Focus Financial saw its debt downgraded by both Moody’s Investors Service and Standard & Poor’s Global Ratings yesterday. The downgrades follow Focus Financial’s announcement in February that it will be taken private in a leveraged buyout by private equity firm Clayton, Dubilier & Rice.
That deal saddles the company with additional debt that’s going to increase the firm’s leverage ratios—while at the same time Focus faces a dog-eat-dog acquisition environment competing against other big players racing to buy up registered investment advisory firms (and taking on more debt in the process). The downgrade highlights the issues confronting Focus and other RIA aggregators like Hightower, Mariner and CI Financial as leverage in a rising interest rate environment becomes a growing concern for the entire aggregator and consolidator space.
Focus is issuing a $500 million term loan as part of the take-private deal. The downgrades, coupled with ongoing turbulence in the financial services sector (notably among regional banks), raised the question of whether Clayton Dubilier might try to lower the $53 per share price it is offering to take Focus private.
Several investment banking sources said that Clayton Dubilier, like most private equity firms, almost certainly has a material adverse change clause in its agreement with Focus. Such clauses typically allow the acquirer to alter or even withdraw a proposed offer in the event of a material in market conditions or the business itself.
"The big picture is the go-private deal terms have been set," said Dan Seivert, CEO of M&A advisor Echelon Partners, in an email to Financial Advisor. "But almost all deals have mechanisms in place that allow the buyer to walk or reprice if the target experiences material changes in their financials."
For their part, the ratings agencies are concerned about Focus assuming more debt. “The wealth management industry has been consolidating rapidly in recent years, a trend that we expect to continue,” said S&P Global Ratings in its downgrade. “As competition for RIA acquisitions and all-in purchase price multiples have increased, [Focus’s] peers such as Hightower, Mariner and CI Financial have employed greater leverage to scale quickly. Focus's leverage has also increased in recent years with heightened acquisitions, though to a lesser extent than peers. We expect that as a private company, Focus will continue its aggressive acquisition strategy and operate with higher leverage than the 3.5x-4.5x range it had committed to as a public company.”
S&P lowered its long-term issuer credit rating on Focus to “B+” from “BB-” and slapped a “B+” rating on the $500 million term loan.
Moody's Investors Service, meanwhile, slashed Focus’s corporate family rating and senior secured debt ratings to “B1” from “Ba3.” It assigned a "B1" rating to the proposed term loan.
Both S&P’s and Moody’s said the outlook on Focus is stable.
S&P said it expects Focus to operate with an average debt to EBITDA ratio of 5x to 7x for the next 12 months while it continues its acquisition spree.
Moody’s, meanwhile, said its downgrade “reflects the impact the new LBO-related debt will have on Focus's leverage ratio (debt to EBITDA, including Moody's standard adjustments), which will rise to 6x from its current level of 5.1x as of year-end 2022.”
Moody's said it thinks Focus’s leverage ratio will remain higher over the next couple of quarters as the revenue at its partner firms slows down in the face of choppy markets and a tighter financial environment. That should also crimp affect Focus’s ability to pull off acquisitions, Moody’s said.
“The rating action also incorporates our view that the LBO transaction increases governance risk because the company's ownership will be highly concentrated among two private equity firms and will have limited representation of independent directors on its board. Moody's also expects private equity ownership will increase Focus' tolerance for financial risk and debt leverage.”
Focus is a partnership of independent fiduciary wealth management firms. Its stockholders were set to receive $53 per share as part of the deal to go private. Another player is Stone Point Capital, which is holding on to an investment in Focus and providing financing for the transaction. Focus said in February that it would be an all-cash transaction and that the firm’s enterprise was more than $7 billion.
Zacks said yesterday that Focus had missed its first quarter earnings, logging only 86 cents a share against 96 cent consensus estimates, a 7.29% disappointment. Revenues of $557.51 million for the quarter missed the Zacks guidance by 1.29%, the company said. The company had beat consensus revenue estimates three times over the last four quarters.
Rudy Adolf, the company’s founder and CEO and chairman, conceded in an earnings call yesterday that market conditions are unsettled. But he also said the firm had 16 closed transactions for new firms year to date in 2023.
The firm’s CFO, Jim Shanahan, said on the call that the missed guidance was due partly to lower non-market correlated revenues.
One question remains: What effect will tighter credit market have on massive RIA aggregators like Focus doing rampant acquiring?
"It really depends on three key things," said Seivert. "One: Is their current debt at fixed or variable rates? Two: How much 'dry powder' or raised capital do they have? And three: How quickly are they deploying it?"