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.