Over the last two winters, more partners at large RIA firms have found themselves bumping into each other at tony Florida enclaves near Naples and Palm Beach than in previous years. An escape from cold weather and the pandemic was only part of their motivation.

Suddenly, many have experienced the type of liquidity events they once thought were reserved only for their biggest clients. This prompted some advisors with second homes in the Sunshine state to prolong their Florida stays for six months in order to become residents and avoid state income and capital gains taxes on a once-in-a-lifetime windfall.

What's interesting is that many advisors went into the RIA business not to make a fortune but to create a business model they imagined would resonate with clients, often successful people who lacked financial sophistication. In the last five years, Wall Street and the investment world finally fell for the model.

The proliferation of private equity firms allocating “growth capital” to the advisory space has mushroomed, resulting in dramatic consolidation rivaling that of other industries like HMOs and independent pharmacies in previous generations, only at a much faster pace and larger scale. The ramifications of this changing ownership structure of the advisory business have yet to play out.

But whose business is it anyway? Each private equity investor has its own unique investment model and exit strategy. Some demand a controlling interest while others prefer a minority stake.

For the present, a buoyant equity market and unprecedented debt market have combined to produce favorable conditions for both buyers and sellers, creating an environment conducive to friendly transactions and warm relations between RIAs and their new investors—at least for now. To gain a better perspective on what’s taken place in the profession over the last two crazy years, Financial Advisor talked to someone who knows the business as well as anyone, Mark Tibergien, former CEO of Pershing Advisor Solutions.

“Control” can be an elusive concept in a human-capital driven, professional services business, Tibergien explains. Private equity investors understand that an advisory firm “owns” the client relationship, so they tend to be more deferential than they might be with management in other industries.

Sources Of ‘Growth Capital’?
Private equity firms in earlier incarnations earned a reputation as asset strippers. That image may have been justified when they were investing in old smokestack industries, but today they are portraying themselves as sources of growth capital.

Is that justified? Tibergien, who spent two decades as the advisory industry’s leading valuation expert before joining Pershing, thinks it’s partially accurate, but not in the way it is perceived. Most RIAs are “quite profitable” and don’t need growth capital unless they are contemplating an acquisition or buyout of major partners.

Until recently, the financial management of most RIA firms was somewhat primitive. As Tibergien notes, their balance sheets basically served as a “cover page” to their income statements.

But a balance sheet also reveals a business’s ability to pay its bills and withstand adversity. Most advisors didn’t need external capital if they wanted to bring on a new partner, promote one internally or open an office in an adjacent market. Today, however, those marginal strategic initiatives don’t really move the needle for billion-dollar advisory firms. The hard reality, in Tibergien’s view, is that while RIAs may be growing faster than most brokerage firms, asset management complexes and insurance companies, their growth rates have slowed considerably.

Mergers and acquisitions have emerged as the most viable avenue for advisors to grow. “Most RIAs lack scale and capacity to grow and usually are limited by their geographic market and by a talent shortage,” he explains.

That’s a major reason private equity has seized an opportunity the profession itself appears unable or unwilling to meet. These transactions also are solving the liquidity dilemma faced by founders.

A longtime critic of many advisors’ failure to nurture successors, Tibergien believes the advisory business is conflating the term “succession planning” with what really is “ownership transition.” “Most RIAs have not groomed their next generation of business managers and lead advisors to take over the business in an orderly fashion,” he argues.

While the first generation of advisors ran their businesses like sole proprietorships with nominal balance sheets, today’s larger firms don’t have that luxury. Profits and capital are required to make serious investments in technology, as well as recruiting and developing new talent, Tibergien says.

If the first generation and their private equity backers underestimate that challenge and think the primary reason for outside capital is simply to acquire other RIAs, both could be in for a disappointment. The only difference is that many in the first generation of advisors have cashed out the lion’s share of their equity.

When The Music Stops
As private equity firms have transitioned from investing in the smokestack industries to service-oriented businesses with stronger growth prospects, they’ve displayed a willingness to pay premium prices. Some of this can be attributed to private equity’s own unique set of challenges—they have a surfeit of capital and don’t get paid anything if they don’t deploy their funds.

This helps explain why these institutional investors may be paying lofty multiples for RIAs even though most firms are not exhibiting the level of organic growth private equity firms typically justify paying big premiums for. Tibergien cites a “solid floor” of other factors, including market fragmentation, secular growth from aging client demographics, a high degree of recurring revenue, strong cash flow, cheap debt and stock market performance that all compensate for most RIAs’ inability to achieve high-single-digit new client growth.

But the aging demographics driving today’s retirement boom is a double-edged sword. As millions of clients enter the decumulation phase and draw down their assets while demanding more services, RIAs’ margins will inevitably be squeezed. At that point, the happy marriage between advisors and their outside investors might not remain so rosy.

In the last two years, some private equity firms have paid an eye-popping 18 to 20 times cash flow for RIAs. Tibergien turns these multiples upside down and translates it into a suggested 5% rate of return.

That’s a big difference from just a few years ago when the multiples were closer to 10 and the implied rate of return was about 10%. The private equity firms that came to the party early in the last decade are now sitting on handsome gains, luring in many latecomers.

Take the case of the Carson Group in Omaha, Neb. In 2016, Long Ridge Partners purchased a 29% stake in the firm for $35 million. Last July, Long Ridge sold that interest to Bain Capital for $290 million, or more than seven times its original investment, valuing Carson at about $1 billion.

Those are the type of returns private equity firms dream about. But the reality is likely to be quite different for new institutional investors and the firms they invest in. Tibergien’s view is that “the business is going to have to row fast in earnings and value.”

What happens if financial markets stop providing a tailwind to the gravy train? The second quarter of 2020 provided a glimpse of what could happen, Tibergien says. Deals temporarily dried up because “no one wants to be a seller in a down market.” Markets recovered with alacrity, and deals came roaring back. The prospect of higher capital gains tax rates following President Biden’s election only accelerated the M&A boom.

Meanwhile, the fundamentals of the RIA business model remain sound. There are simply too few advisors and too many Americans seeking advice. The best advisors were always in the business to help clients with difficult choices, not to hit some jackpot.