There is a proverb that “the seeds of destruction are sown in good times.” And these have been some good times for the advisory industry.
In 2021, the average firm grew its assets under management by 22% according to a survey by the Ensemble Practice. Over the last six years, the typical firm has doubled in size (between the start of 2016 and the end of 2021). The average owner income has grown over the same period by 46%.
Because our entire industry has been so successful, we have started to make some dangerous assumptions—and it’s important to remember that they are just assumptions. This often happens in my home city of Seattle. During the summer, it is easy to forget that we get 10 months of rain (requiring antidepressants and oversized gutters). The skies are so blue and the clouds such a distant memory. Still, as those of us who have been here for a while can tell you, taking that good weather for granted would be a mistake.
Since we’re still in the glow of these halcyon days, it is perhaps a good time to review our business models and take a hard look at our assumptions and examine some of the clouds gathering on the horizon.
Low Interest Rates And The High Availability Of Credit
Low interest rates have had a profound impact on our society and have tremendously benefited advisory firms. I will leave the macroeconomic effects to more qualified individuals and instead focus on some of the overlooked effects on the industry.
Low interest rates allow the buyers of advisories to borrow more, pay less and use the additional capital to purchase more ownership. The same effect that is driving up the price of homes throughout the country is also driving up the valuation of advisory firms. Both internal and external buyers have been able to borrow a lot to make purchases of equity, and the result has been valuations higher than ever before. Low interest rates are a bit like beer goggles: Everything looks attractive past a certain point of inebriation.
Unfortunately, the effect can be reversed. When rates go up, existing borrowers may find their loans difficult to service, and some may default. New buyers may be discouraged from purchasing or purchase less. Demand may suddenly shrink, and as we know from Adam Smith, that tends to lower prices.
The biggest beneficiaries of low interest rates have not been the internal advisory buyers scooping up 5% or 6% of their firms, nor are they the small buyers who purchased a book of business or two. No, the biggest winners are the private equity firms. The vast majority of transactions reported and most of the upward pressure on valuations come from private equity-financed entities. And if you looked under the hood of the acquirers very actively consolidating our industry, you would find that 90 cents of every dollar invested in firm purchases has been borrowed.
This is where the biggest danger for valuation lies. An increase in interest rates could severely cramp private equity’s appetite for purchases, and simultaneously squeeze those firms already bought to generate the cash flow required to service existing loans.
What’s more, rising interest rates typically cause the market to correct or even worse. The cost of capital for publicly owned companies grows and the appeal of bonds and other fixed-income instruments increases. Imagine for a moment that the equity markets were to decline by 15% as interest rates go up and loan payments rise as a result. The relationship between acquirers and their portfolio firms could change in tone dramatically, as we witnessed in 2008.
To make it worse, many ultra-large institutional investors have over the years seemingly beefed up their private equity allocations because fixed-income instruments aren’t generating as much income. This was certainly the case in the years before 2008, when banks were buying risky mortgage-backed securities, partly because they couldn’t get the old 5% from government bonds. If interest rates increase, we may see a contraction in the money allocated to private equity, and as a result, less capital available to acquire advisory firms.