Warren Buffett likes to say that in every deal there's a sucker, and if you can't figure out who the sucker is, there's a very good chance it's you. Over the last few years, a growing cadre of successful independent RIAs have sold equity stakes in their businesses to private equity firms with an eye toward succession planning and a potentially lucrative payday should the roll-up entity achieve critical mass and go public.

But some unfortunate things are happening to a number of advisory firms on the road to their big paydays. Most of these firms rely on assets-under-management (AUM) revenue models. After the dramatic declines in their AUM last year, they experienced commensurate declines in revenues and operating income.

Unfortunately, many private equity firms structure deals in ways that protect themselves in the event of a major revenue downturn and leave the advisors holding the bag. Take capital preference shares. Not all private equity firms use them, but a number of the bigger players in the business do.

The Art Of A Deal
Here's how some typical deals might work. Firm A is worth $10 million and its owners sell 60% to roll-up Firm B for $6 million. Firm A owners get $2.5 million in cash and $3.5 million in Firm B's stock.

In exchange, roll-up Firm B gets 60% of Firm A's operating cash flow or gets an amount equal to 60% of Firm A's operating cash flow the year when the deal was closed-whichever is greater. And that's the kicker: Even if operating cash flow declines in subsequent years, roll-up Firm B must be paid a much larger amount of money-equal to 60% of cash flow at the time of the deal. So if advisory Firm A had cash flow of $2 million in year one when contracts were signed, but this year earns only $1 million, it still owes Firm B $1.2 million.

Moreover, a private equity firm typically funds a roll-up and its shares outrank others. So to continue our example, Firm A's shares in Firm B are subordinate to the shares of private equity Firm C, which invested $30 million in Firm B and its management. Firm C is entitled to 100% of Firm B's capital plus 12.5% on its $30 million investment. Since $6 million was invested in Firm A, it gets a 12.5% return on that amount that Firm A must pay. That amounts to another $720,000 that Firm A owes, bringing the grand total to almost $1.3 million that it now owes roll-up firm B and private equity firm C.

This game of three-card monte gets even worse. After the 12.5% is paid to the private equity Firm C, its managers could be entitled to a return on their personal shares that end up being extracted from Firm A before the advisor sees a dime of the money his firm is earning. These compounding preferences are problematic, especially if roll-up Firm B takes longer than originally anticipated to get to a payday, such as by going public.

The financial advisors who agreed to give up control of their firms are supposed to be intelligent business owners with far more financial sophistication than business owners in other industries witnessing major consolidation, like car dealerships and trash collection operations. But the sad truth is that, when compared to Wall Street lawyers, most advisors might as well be bumpkins who fell off their turnip trucks.

The upshot is that the one-sided legal terms of certain contracts are triggering a series of sagebrush rebellions-or on-the-job retirements-at some advisory firms. Since the private equity roll-up firms rely heavily on debt, the financial crisis of the past year has put them on the hot seat with lenders. As they bump up against debt covenants or violate them on occasion, executives at the holding companies are exerting much greater control over advisors' business operations.

This confluence of events is spawning unconfirmed reports of advisors skipping their long, hot summers in the office and instead going on tours of Europe and extended golf or fishing vacations. It's hard, though, to get people to talk about it openly. A number of officials at private-equity consolidators were unavailable for comment for this article, while several advisors who have entered transactions with roll-up firms would not speak about it, at least not on the record.

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