Common sense says that advisors are too busy with client concerns and trying to stay afloat during the recent COVID-19 shut-down to be pursuing M&A for their businesses; however, that sensibility would be misplaced.

Deal activity during the last 90 days continues to be robust, barely missing a beat from the record volumes pre-pandemic; and my team remains at fever pitch managing our acquisition pipeline. After inking our fourth deal this year, and 34 over the last four years, our initial thought going into the crisis was that we might get a breather in terms of M&A volumes; however, it truly has been the opposite. Here are my learnings during these unprecedented times.

The COVID-19 Wave Washed Away Profitability For Many Smaller RIAs
When the COVID-19 tsunami reached our shores, the profit of smaller solo founder-operator RIAs retreated with that insidious tide. These advisors wear multiple hats inside their business, jacks-of-all-trades. Indeed, in stripping it down to just client-facing work, small RIA advisors typically spend only 46% of their time on revenue-producing client work (Source: Cerulli). Within this context, smaller RIAs often report their financial statements on an “EBOC” basis, earnings before owner compensation. That is, “pay all the bills and what is left over is mine.” In an 11-year bull market that worked just fine. However, when the COVID-19 tsunami hit the world’s shores, economic markets worldwide roiled.

While these smaller RIAs managed to pay their bills, they didn’t pay much else, because their bottom line disappeared. For the first time since 2008, solo founder-operators felt vulnerable. Worse yet, many lacked the human capital and resources to respond to their clients’ increasing demand for information and guidance. They had no one to lean on and no corporate support at any level. Fortunately, for clients and the industry the markets have largely rebounded in recent weeks, but this shouldn’t mask an important lesson for these firms. With the vivid memory of the impact of sharp market declines on their businesses, many smaller RIAs have now realized they needed a platform partner, a fully institutionalized large RIA to backstop them in times of need.

The industry-wide procrastination of a succession plan and business continuity plan has led to a wakeup call. This group is coming to market now and trying to take advantage of a seller’s market before that too disappears like their EBOC. 

Mid-Size RIAs’ Temperatures Rose As COVID-19 Took Its Toll
Perhaps in the most precarious position were those mid-size RIAs who had invested in partial infrastructure, made growth investments, and employed 10-12 staff but hadn’t yet reached scale. While they had more resources at their disposal to respond to the escalating pandemic, they also had more costs. The classic “V” curve (profit goes down before it goes up). Stuck in between making those investments for growth versus receiving the benefits of those growth investments but undercut by the COVID riptide of declining revenues—the dreaded double whammy. 

Worse yet, and to avoid staff layoffs, some of these firms took PPP loans to stave off disaster.  Unfortunately, few realized they had to disclose this fact to their clients in their Form ADV and are now dealing with questions about whether they should have taken the loans and whether they were used to protect jobs or to protect themselves. Most clients don’t want to hear that their financial planner needed to borrow money to keep the doors open—not comforting news coming from the firm charting their financial future. The coup de gras is these firms lacked the ability to organically grow their way out of the V deficit with net organic growth hovering at about 1.8% excluding market. Stated differently, the profit margin for mid-size firms is often lower in normal times as smaller RIAs because of their increased cost structure; bigger but not better.       

Mid-size firms had gone too far to turn back, and it was not an option to lay off highly compensated employees as that human capital was needed to service the larger clientele. As for fixed costs, well, they are fixed.  For them, the decision was to build scale or join scale. Building scale requires expertise, money, time, and involves risk of failure. Joining scale is a decision and has some risk associated with it but mostly de-risks shareholder exposure. Most mid-size firms chose the latter option and this group is coming to market in mass. Like smaller RIAs, mid-size firms understand this is a seller’s market, but like our bull market that ended so abruptly in Q1, that too can change as buyers become more cautious in an uncertain and changing world.   

Size Doesn’t Matter—Sellers Want The Same Four Things
Assuming high cultural alignment (assuming otherwise presumes failure), every seller has four selling criteria. First, the deal partner must be a great fit for their clients. Second, the deal partner must be right for their staff and offer them career development opportunities beyond what they could provide. Third, the deal economics must be suitable to the seller; this includes a fair purchase price (not necessarily the best purchase price), but also a reasonable deal structure. Fourth, sellers want to join platform RIAs with strong organic growth. Decumulation is real, with 48% of RIA clients 60 years of age or older (Source: Cerulli), and over 20% over 70 years of age (Source: Dimensional). Unless the RIA owner is planting new tree seedlings to replace the old timber (net organic growth), they will soon find themselves in a revenue death spiral as 30% of advisor clients are in active decumulation. With seven baby boomers turning 65 every minute, the clock is ticking. Strong organic growth is the Holy Grail of our industry, and RIAs treading water want to drink from that wellspring.    

David Barton is vice chairman at Mercer Advisors.

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