Did you hear a tornado alarm in May? That might have been the sound of Goldman Sachs invading your industry.

The investment bank’s purchase of United Capital for $750 million has likely changed the game in a space already giddy with M&A activity. The consolidation in the RIA world is happening at a rapid pace and shows no signs of stopping—it’s happening for a number of reasons, not only financial ones, but amid a backdrop of demographic trends that cut to the heart of the U.S. economy.

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As the baby boom generation joins the AARP crowd, the advisory industry does so apace: People are retiring and wanting to turn their assets over—to people who are also retiring. Who is going to get that money? Goldman, a white shoe firm catering to the ultra-wealthy, obviously saw a good thing in United Capital, a firm known for its intense national branding, Jenny Craig-like holistic card systems and access to people at the lower end of the wealth rainbow. “Access” was a key word in Goldman’s press releases heralding the purchase at an estimated 18 times cash flow.

Overheated Market?
Because the market is good, advisors are likely thinking the best deals for their firms are to be found now. The demographic changes are also putting clients in play.

“We have had clients who’ve come from firms where the advisors were the same age as them,” says Jason Ozur of Lido Advisors in Los Angeles. “What they didn’t want was a situation where they were 75 and their advisor was 75 years old.” Because sellers likely have high expectations, he says, buyers have to look at the composition of the portfolios they’re getting. “How did they do in the fourth quarter of last year? The markets were down 14% or 15%, and the portfolio being managed by the company we’re going to acquire is down 12%. Do those clients fit in with the way we manage money?”

Parties always end. The bull market will stop too. 2018 offered another glimpse of somber times after trade disputes and uncertain Fed moves sent cold shivers through the markets. The S&P 500 caught the cold, tumbling 13%-14% in the fourth quarter, and 6.59% for the year (with dividends included, it was a negative 4.75%). “The challenge everybody has in the space when the market’s down is that the revenue is down at the same time the workload is up,” says Scott Hanson, co-founder of Allworth Financial in Sacramento, Calif.

The RIA firms that Financial Advisor spoke with didn’t change any plans or lose much sleep over the December slide, however. The markets came roaring back in the first quarter of this year and plans continued apace. But the foreshadowing of less friendly market conditions can’t be ignored.

In any case, Jeff Maurer, the founder and CEO of high-net-worth wealth manager Evercore Wealth Management, says, “It’s very hard to grow a firm at a double-digit rate based on a bull market. You have to go do it in hand-to-hand combat—finding new clients, having existing clients choose you as their sole advisors. Adding talent with assets. Sitting back and waiting for the market to grow your revenues is a recipe for disaster.”

Hanson (whose firm, the former Hanson McClain, was rechristened Allworth in April) began acquiring for the first time last year after growing organically for years before that. “We’ve had more changes in the last year than in the history of our firm,” he says. Acquiring clients, assets and partners became the new growth strategy, and to that end Allworth acquired four other firms (it also gave up its well-polished West Coast brand name in a nod to new partners).

He says the giddy merger activity is echoing that of the insurance and brokerage giants 10 years ago. He says those companies are now 10 times the size of advisory firms, and believes the same will happen to the RIA space. Bear markets notwithstanding, he sees a lot of consolidation going forward.

“When you watch this Goldman Sachs-United Capital deal,” he adds, “Goldman Sachs is a kind of marquee investment bank that is getting into the wealth management space. I think there are other banks that are going to follow suit. … I think it’s a bit of an alarm bell.”

The key drivers for firms to sell are to achieve scale and have a succession plan, says David DeVoe of M&A consulting firm and investment bank DeVoe & Co. in San Francisco. “We see firms that have $100 million or less that are excited to join a firm that is maybe half a billion. We see half-billion-dollar firms looking for scale, we see multi-billion firms that are seeking scale.” He believes that there are going to emerge a dozen or so megafirms that operate differently than smaller firms and serve clients differently. But he thinks smaller firms will continue to thrive since there are low barriers to entry and it’s a relationship business.

Clients might want more services, not just wealth management, investment management and retirement planning but tax planning, estate planning—even banking, checking and mortgage services. “These are all variations of scale,” says DeVoe. There are buyers who will pay premiums to have a CPA or law firm attached, he adds.

Tech Wars
Rising markets can make a balance sheet happy, but the tech arms race can burden it all the same. Carson and Hanson say the tech race is one of the biggest drags on a firm’s profitability and revenue. But such build-outs have been crucial, too, Hanson adds: “Three years ago, we had three people on our technology team. Today we have 14.”

Robert DiMeo of Chicago-headquartered DiMeo Schneider & Associates says his firm is rolling out a new CRM and portfolio accounting system, and it added a new website in the first quarter. Ozur says Lido is implementing a new CRM system and a technology that will assist advisors in the field with digital signatures.

“I don’t think advisors are becoming technology firms,” says Ozur. “But some of the best technologies [at RIA firms] are developed out of necessity.” He uses as an example a software template Lido has created to track thousands of mutual funds and predict how they will perform daily to check their drift from style mandates. 

DiMeo says firms as large as his have a harder time getting out-of-the-box things like CRM systems to do the job they need. “We’re as much like a law firm or an engineering firm as we are an RIA … so we really had to go down our own path with things like CRMs and such,” he says.

“A private client is not just an investor,” DiMeo says. “They are a consumer of all sorts of things, using Amazon … and Uber. So in some way shape or form we have to be on that continuum.”

War For Talent
DiMeo Schneider came up with an aggressive five-year growth plan a couple of years back that included a bold plan to increase revenue and staff (boosting the latter from 75 to 110 or so).

DiMeo says there’s a war for talent. “If you can’t attract and professionally stimulate and retain the right type of talent, I just can’t imagine that not being the primary challenge or one of the top challenges for any advisory or professional services firm today.” Last year the firm hired a full-time director of HR for the first time and it has also beefed up compliance resources.

A decade ago, an investor with $10 million or so in assets looking for an advisor would ask a neighbor for a referral. Now those investors might actually put out a request for proposal just like a pension would, DiMeo says. “They want to understand how many CFAs are on staff and how do you go about researching alternatives versus traditional investments.”

Deb Wetherby, CEO of her own namesake firm in New York that manages a little over $5 billion, also said that costs are rising because of the need for RIAs to attract and reward talent. (She’s got about 75 people on staff.) “We do feel like in order to do that we have to continue to grow at some pace, and not growth for growth’s sake but growth to give opportunity to people coming up through the ranks and growth to be able to reward our people now.”

The firm is feeling this more than any short-term S&P indigestion. She adds that one of the industry’s problems is that the founders of firms have tended to hoard ownership and have no succession plans.

Ozur of Lido Advisors says his firm has recently turned to tuck-in acquisitions to help fill the talent gap. The Carson Group has done several acquisitions this year, many of which were about getting talent, Ron Carson says.

“It’s really hard to find really good people,” says Carson. “Just look at the age of the industry.” He points to CFP Board stats counting more advisors over the age of 70 than under the age of 30. “I think we have an advantage in Omaha. We have some really good talent pools. We’ve got Orion. We’ve got Securities America. TD Ameritrade is here.” The Carson Group has 220 people on staff after adding 68 or so last year, and it just broke ground on a new 200,000 square foot campus. Carson wants the staff numbers to reach 400 by the end of 2020.

How To Stand Out
“We’re not experiencing fee pressure per se, but we are experiencing clients wanting a broader offering at the same price, which is its own kind of fee pressure,” Wetherby says. Her firm’s expertise in impact investing over the last decade has helped it differentiate itself with clients, she says, adding that at least a third of her new business inquiry has some interest in impact investing, which is especially important to next-gen investors (the firm added a full-time director of impact investing, Justina Lai, in 2015). Demand for financial education to multi-generation families is also an area where Wetherby tries to stand out. The firm comprises a staff half made up of women, which also draws a certain clientele, she says.

“We’re not just trying to gather assets,” says Wetherby, who says that there’s a sweet spot for midsize firms such as hers. “We’re trying to grow at a pace that’s digestible. … We don’t want to be too big.”

“Geographically we need to be everywhere,” says Ron Carson. His firm is building out services. It recently added retail banking with “Carson Cash,” which allows clients to withdraw and deposit money on its dashboard. The accounts will be FDIC insured, he says. He says he tried to get out of the tax business a few years ago, but clients were so upset he brought it back. “That’s when I learned; you’ve got to look at the relationship and the totality. If we’re not providing that service, now we’ve got CPA firms getting into our business. Banks are getting into our business. Law firms are getting into our business. The client wants a simple experience that has a lot of depth to the expertise. So banking, taxes is an attempt to have a single pane of glass experience.” He compares the experience with that of using Amazon. People will even pay more for the single trip, and that’s how he looks at the build-out of services.

Allworth, as Hanson McClain, has always been focused on the “middle-class millionaire”—good savers moving into retirement. “We believe the firm should be responsible for business development, not the advisor,” Hanson says. “So all of our advisors have always been on a salary model with us.” The M&A idea is to partner with firms that have been stagnant in growth and turn on Allworth’s marketing engine for them, he says. That drives new clients, which drives new revenue. Most firms aren’t good at business development, he says, and rely on referrals from their custodians. He also does a radio show, but digital channels like Facebook have become crucial for spreading educational materials to people who might not be financial junkies.

Growth Challenges
Ozur says that historically from the year 2000 to the end of 2018, Lido’s growth has been organic, through referrals from clients. This year, however, the firm did its first tuck-in of advisor Ken Stern with $400 million, “which brought in 13 really strong bodies,” Ozur says. The firm also beefed up compliance and added analysts and three new advisors to help handle new clients. Lido wants to do a few more of those in 2019 as well as continue to grow organically. “Our budget this year is to bring in three-quarters to a billion in new assets.” (It currently has $3.75 billion). 

Lido has also developed expertise in alternative investments like bridge lending in real estate to help clients who need steadier income (retirees or entertainers, perhaps); buying, rehabbing and flipping homes; and single-stock hedging with options to help, say, tech execs with concentrated stock positions. Those alternatives keep clients hedged as well when the market runs into problems, he says, such as December when stocks fell and bonds ran up against a more aggressive Fed. In that environment, the typical stock/bond split was no salve on a wounded market.

Valuation For The Rich And Tired
There are a lot of simplistic ways that firms value themselves, says Ozur. “One and a half times revenue to three times revenue. … Let’s say there’s $2 million of revenue. Let’s say they have $1.2 million of expenses. So let’s say they have $800,000 of [earnings before owner’s compensation], which means the owner of the company is taking home $800,000 a year. The problem is if you were to merge that individual’s firm into the mix, and if that guy was to still [take] $800,000 a year, what’s the value of the firm? Zero. Cause there’s no EBITDA. So you have got to impute a salary for the owner to figure out the EBITDA, and then what’s the multiple on EBITDA, and EBITDAs can range anywhere from 4 to 12 times depending on the size.” You then have to value the EBITDA relative to the mother company. The selling owner is likely going to want to keep making that $800,000, he says, but it could be she or he needs to take it in stock ownership and back into that number in other ways.

Carson says that patience will be rewarded for buyers. He calls the owners of many firms the “rich and the tired.” Many of them are well off financially, but won’t have the energy to reinvent themselves, and their firms will come down in price when the market goes south.

DeVoe says there were 97 total M&A transactions in 2018, “more than this industry has ever seen.” There also were 31 transactions in this year’s first quarter. But the transaction sizes have compressed, he says. Until 2016, the average size punched through the $1 billion mark, but it’s declined since then, and fallen precipitously more recently to close to $600 million. One key reason is that smaller sub-acquisitions are becoming a bigger part of the numbers.

In many cases, advisors have an inflated value of their own firms, especially in this market. “I’ll talk to an advisor who at the beginning of the conversation discusses how they’d be curious about acquiring firms,” says DeVoe, who works with buyers. “They’d be willing to pay three to four times cash flow for a firm. Ten minutes later I ask them, they talk about the value of their firm, and they think they are worth three to four times revenue. … In the same conversation they’ve used a similar metric but one that’s literally four times the other.”