The credit crisis has spoiled the RIA M&A party-if only for a while
These days everyone is suffering. The media has been all over the story of the credit bust, the drop in housing values, the stock market's dive since Labor Day and how these events have wiped out the American Dream. Financial advisors and other employees of the large publicly traded firms have also seen their retirement savings wiped out as their firms' stock prices plummeted — all that has been well documented in news stories, too. But there is another group of people suffering as well, albeit very quietly lest they attract unwanted attention: registered investment advisors (RIAs). As their clients' assets plummet, so do the revenues of their firms. That's not surprising, of course, but the problem is that many RIAs who sold stakes to “roll up” or “consolidator” firms are now scrambling to pay quarterly disbursements to these firms that they can no longer afford.
“It is difficult to estimate what percentage of the industry is suffering from some form of financial stress since the affected firms are not prone to disclosing the issue,” says Philip Palaveev, who has advised scores and scores of financial advisors over the years as a consultant with Moss Adams, an accounting firm. “If I had to venture an estimate, I would say that at least 30 percent of all advisors are facing personal financial issues that require them to significantly change their lifestyles or borrow money to maintain [them].” Palaveev is now CEO of Fusion Advisor Network, an independent financial planning group.
The problem is worst among the advisors who are in their 30s and 40s and have not had enough time to accumulate personal capital outside of the practice, Palaveev says. “To make matters worse, these are usually the practices that are growing the fastest and investing in staffing and infrastructure. I would estimate that at least 10 percent of all practices will have to lay off staff in an attempt to cut back expenses and maintain some level of profitability.”
Some RIAs, who should know better, thought their recent growth was permanent. Deals to sell a piece of future cash flow were priced — and locked in with preferred shares, in some cases — based on the assumption of continuing double-digit growth. For one of the country's premier advisory firms, 25 percent-plus yearly growth has become an expectation. And a reasonable one, too: Since selling itself three years ago to one of the industry's many RIA “aggregator,” “consolidator” or “roll-up” outfits (as they're called), the firm has used the cash infusion to add offices, expand services and hire new personnel. Not surprisingly, that growth expectation has been shorn back dramatically as revenue and assets across the financial services industry have generally followed the steep downward trajectory of the major market indices. But “Dave” (as we'll call him), one of a handful of principals at this firm, is relieved to point out that net income through the past three quarters is up 10 percent year over year — a remarkable fact that he attributes largely to two things: a steady stream of new clients and a particularly lucky third-quarter billing date, when the Dow Jones Industrial Average was still above 10,000. Unless a rally occurs, the fourth quarter, by contrast, will likely make for an “ugly” year-end financial statement, he says.
Nonetheless, the fact is that Dave and his partners are comparatively well off. Not that it's been a bed of roses. They were forced to trim the budget, including letting some non-core personnel go. Dave and his partners also did something else no doubt many others wish they'd done: Since the sale of his firm, they've sold as much of the vested stock portion of their buyout (50 percent of the price) as legally possible — much of it last year at bubble-busting valuations — avoiding serious damage to their net worth. To gauge the importance of that divestiture, one need only look at the stock prices of public “consolidators,” companies such as NFP or Boston Private; they have tanked by about 40 percent to 95 percent in the past 18 months.
The relatively good fortune of Dave's firm doesn't end there. Since the firm experienced three years of solid growth before this year, the preferred share of earnings owed to the acquirer isn't so significant as to force the principals to pay it back out of their own pockets. Unfortunately, for many of Dave's peers at other RIAs acquired more recently, this isn't the case. Not only has the stock they accepted as part of the payment not been sold as rapidly (or at all), but the lack of time and/or favorable market conditions have not allowed these firms to reach their growth targets. As a result, some may be left with little or no income to pay principals after paying the buyers their preferred share of earnings.
“The deal structure [selling a portion of cash flows] was very attractive to many advisory firms since it allowed the firm to preserve almost full control of operations and finances,” says Palaveev. “The price for that independence, however, was that the acquirers will be first in line for dividends, before the selling advisors can receive profit distributions or even compensation.” Palaveev adds that the deals were good, but necessarily came with some risk: “The combination of independence, high valuation and a big check would not have been possible without this risk. Unfortunately, no one was thinking about a 20 percent decline in revenues when they signed the contract.”
JUST LIKE YOUR RETAIL CLIENTS
Even financial advisors, apparently, get overly optimistic in valuing businesses. One can see why: The Dow averaged 13 percent compound annual growth between September 2002 and October 2007. This helped stoke a bull market in which both individual RIAs' looking to sell part (or all) of their books and the growing number of buyers dangling handsome multiples for their share of the RIAs profit margins (up to 50 percent or more) were both counting on one thing: The market would continue its upward march. But markets have crashed 52 percent from the October 2007 peak to trough (November 20, 2008) — the largest such drop since 1937, according to investment manager The Leuthold Group. Now, many of the deals that were made based on expectations of future earnings growth — and guaranteed distributions of that future growth — are causing great stress in the industry for both buyers and sellers.
Among the most distressed is National Financial Partners and its 180 acquired firms that provide life insurance, executive benefits and wealth management (or some mix of the three). The first “roll-up” firm to go public in September 2003, NFP stock opened at just over $24 and more than doubled over the next four years. But in its quest to acquire firms, it apparently took on more debt than it could handle. At the time of this writing, NFP had renegotiated its debt-to-equity ratio with its creditors and thus avoided default. But many of its acquired firms are also facing the preferred earnings squeeze outlined by Palaveev. According to its third-quarter earnings report, 20 percent of NFP's acquired firms are in “base deficit,” meaning some firms may end the year with no income for themselves because of an obligation to pay NFP its cut of earnings. (NFP typically takes a "base" of 50 percent of acquired firms' earnings, so a base deficit means the firm is not even earning that 50 percent.) When the Meanwhile, NFP stock — which many of the firms accepted as 50 percent of their buyout consideration — is trading near $3.30, down from a high of $56 just over a year ago.
“This business doesn't work,” said Off Wall Street research analyst Mark Roberts in a Barron's story from March. (Registered Rep. could not get a copy of the research, and Roberts was unavailable for further comment.) But NFP and its affiliated firms are hardly alone. Similar situations are playing out at other RIA holding companies and rollup firms. While it may be nearly impossible to verify at private companies that don't disclose their financials, the same set of facts exist: AUMs are down by 20 percent to 40 percent or more, therefore, revenues are in similar decline. At firms where deal structures require the selling RIA to pay a preferred share of earnings to the consolidator, some principals are being forced to cut staff and/or dip into their own pockets to pay the buyer. And as these RIAs get squeezed, what has become the favored succession model for larger RIAs is being called into question.
The nascent RIA industry isn't used to bad news. It has been hailed for years now for the independent conflict-free nature of the advice it provides. More recently, of course, the RIA industry's players have used the balance sheet mismanagement of their wirehouse rivals to increase the flow of talented advisors and wealthy clients to their model. Unfortunately, some of them (it is hard to estimate, since the data is largely private) have made their own credit-related mistakes. NFP, as mentioned, let its debt-to-equity ratio get out of hand, though it has since negotiated with lenders to amend the terms of its credit agreement. (The new agreement raises its allowable debt-to-equity ratio to 3.5 to 1 over the next year. After that, it goes back to 2.5 to 1.) Boston Private was forced to accept $150 million from the government's TARP program. And that's just what can be seen at public firms that invest in RIAs. At private firms — including Focus Financial, which has 16 firms and $28 billion in assets, and WealthTrust, which has 16 firms and $7 billion in assets — acquisitions continue to get done. But these firms aren't immune to the markets either.
“All of these firms are highly leveraged,” says a disgruntled principal at an RIA that sold to one of the “consolidator” firms in 2007. “The whole pyramid is built on cash flows based on incremental growth and hugely optimistic projections of that growth,” he says. “Just ask one of them to show you their financials — they're horrendous.” Is he concerned? “Absolutely.”
For one, fixed costs (rent, office equipment, compensation of staff) are eating up this year's almost non-existent profits. He wouldn't disclose the terms of his deal, but clearly getting back on track with the earnings and growth targets he agreed to in the sale is a distant reality. “We'll be okay, but we're not getting back to where we were or anywhere near those projections. For that we'd have to see 39 percent returns — and that's not happening in your wildest dreams,” he says.
Focus Financial Partners' CEO Rudy Adolph would not discuss specifics of the deals he does with RIA firms, or his own firm's financials — it is, after all, a private firm. But he did say that Focus more than doubled its EBITDA in 2008, and added $3 billion in net new client assets in addition to buying five new partner firms. In an email he added that the firms “continue to perform well … have experienced almost no client attrition and have in fact gained many new clients who have been disappointed with the level of service they received at their previous institution — usually the wirehouse.”
But even when the holding companies are financially sound, the RIAs they partner with may face trouble. According to market participants, a typical deal looks like this: An acquirer buys 40 percent (or sometimes as much as 50 percent, as was often the case at NFP) of an advisory firm that has $2 million in profitability. The $800,000 dividend paid to the acquirer (40 percent times $2 million) is guaranteed in the sense that the buyer is first in line and the contract stipulates that that dividend will not decline below the acquisition level. So, if profitability of the firm declines to, say, $1.5 million, the acquirer still receives its $800,000 distribution, but the selling advisors are now making less ($700,000 in this hypothetical example), bearing the burden of the declining market. Of course, on the upside, the buyer rewards the RIA with bonuses for earnings above the target earnings — alas, a possibility few firms will realize this year.
“Why do people sell?” asks Pershing Advisor Solutions CEO Mark Tibergien. “Generally for three reasons: to retire, to be part of a larger organization or because you need resources to grow.” What RIA sellers — their alleged sophistication notwithstanding — often don't realize is the risk they take on when they sell. “If you sell to a consolidator, part of the currency will be stock; so you have to have confidence the company will remain stable and continue to grow,” he says. Tibergien suggests potential sellers ask themselves, “If you weren't part of the deal, would you still buy the stock of the acquiring company on the open market?” For “Dave,” the principal at the RIA mentioned at the start, selling the acquirer's stock was “our first priority,” he says. “My income and my ownership give me the tiny exposure I want to this business. If you're an asset allocator for your clients, you should be shot for owning your own stock,” he says.