Let’s Make a Deal

It's good to own (or work for) a registered investment advisory (RIA) these days. As you may have heard, the CDO debacle is helping RIAs to steal Wall Street firms' clients and their assets. Two-thirds of the 200 RIAs recently surveyed by Citigroup Global Markets said their net new assets were “primarily” coming from full-service brokers.

Indeed, the RIA model — independent, fiduciary advice, usually on a fee-only basis — is in high demand. Retail clients are flocking to RIAs: According to Citigroup's RIA survey published in early October, Schwab Institutional's “5,000 RIAs bring in more assets than Merrill's 16,700 brokers.” The survey also reports that from first quarter of 2007 through the second quarter of 2008, “Schwab RIAs have brought in $100 billion of new client assets,” compared to Merrill's $80 billion. Of course, Merrill has $1.5 trillion alone in client assets, whereas the same study estimates that industry wide, there are 10,000 to 15,000 RIAs that manage about $2.4 trillion in client assets.

And then there are the dealmakers: Despite the larger credit crunch, 2008 will likely become another record year for RIA M&A activity. The cash-hoarding regional banks and private banking companies that used to lead the deal-making charge have been forced to the sidelines. But other RIAs have taken their place, buying or merging with fellow RIAs to ensure future growth. Some of the deals are driven by an RIA principal's desire to retire in, say, three to five years.

But growth is the key driver. About one-third of RIAs want to buy another RIA over the next 12 months, according to the Citi survey. The problem: Only 2 percent wanted to sell, making an 18-to-one “massive demand/supply imbalance.” The survey's authors reckoned, “It's a seller's market … In our view, sellers can command a higher price while this imbalance persists.”

According to the 2008 Moss Adams “Financial Performance Study of Advisory Firms,” 53 percent of the responding 700 RIAs either bought or considered purchasing another advisory firm as a growth or succession strategy. “RIAs buying RIAs is always going to be an active market. As RIAs get bigger and more sophisticated, I think they become more legitimate buyers in their own right,” says Dan Inveen, a consultant with Moss Adams.

While acquisitions by holding companies and private banks have dropped this year, the number of RIAs buying other RIAs has shot up. In 2007, RIAs acquired 35 percent of RIAs assets compared to 55 percent this year. “That's indicative of the growing sophistication of RIAs,” says David Devoe, director of M&A at Schwab Institutional.

One of the most significant M&A deals in the “RIA buying RIA” group came when Kochis Fitz, of San Francisco, and Quintile Wealth Management, a multi-family office in Los Angeles, merged to create one of the largest RIAs in the country, with over $5 billion in client assets, making it number 12 on Registered Rep.'s “Top 100 RIA” list.

Upfront Cash Payers On Sidelines

Nevertheless, industry participants say there has been downward pressure on valuations. The equity market's plunge since Labor Day alone has taken a double-digit-percent toll on AUMs. And, the other big piece of the buyer's market, the traditional buyers — regional banks, private banks and private-equity backed holding companies — are, in general, taking a break due to dramatically lower share prices and cash constraints. Their deals often included cash. Banks, according to a Moss Adams/Pershing study from this past summer, were often paying higher valuations and 70 percent in upfront cash with 30 percent in company stock.

Regional banks bought only about 3 percent of all RIA assets acquired in the first three quarters of 2008. That's down from 20 percent in 2005. National banks have pulled back, too. In 2008, national banks purchased about 1 percent to 2 percent of RIA assets acquired, versus 20 percent in 2005 and 40 percent in 2004.

Holding companies backed by private equity firms — such as Wealth Trust and Focus Financial Partners — say their M&A activity has slowed down, too. A year ago, holding companies were responsible for 45 percent of the total assets acquired in RIA deals worth more than $100 million. This year, that number has dropped to 30 percent.

The decline comes as no surprise given that liquidity has tightened, and the value of most financial firms has tanked. (See table at left.) Firm valuations have dropped, which causes “downward pressure on [deal] valuations,” says Devoe. On top of that, “Market volatility distracts advisors from focusing on making deals, and also affects equity-based deals.”

Holding companies created to acquire stakes in RIAs, will likely do fewer deals in 2009 — unless you count their “sub-deals.” That is, when acquired partners make their own acquisitions. Between 10 and 15 holding companies are active in this space, says Moss Adams. These firms are changing the way they do deals due to market turmoil.

For one, they are inclined to pay less. Rusty Benton, CEO of WealthTrust, a holding company based in Nashville, says he is willing to pay about five times cash flow versus seven times cash flow (defined as money left over after the firm's overhead and compensation has been paid out) in the recent past. WealthTrust is currently invested in 12 RIAs with about $8 billion in client assets and, like most other holding companies, is backed by a private equity firm. (WealthTrust is backed by New York-based Circle Peak Capital.)

Benton says 2009 will likely be a very slow year for RIA acquisitions for his firm. In September, WealthTrust terminated plans to open a New York office and let go of Mark Rogozinski, the firm's senior vp of corporate development, whom it had just hired in March. Instead of focusing all efforts on recruiting current RIAs, Benton's team will be seeking wirehouse brokers interested in going independent, also known as breakaway brokers. (He says they'll still have to be primarily fee-based.)

Another successful holding company doing deals in a new way is Focus Financial Partners in New York (16 partner RIAs with over $29 billion in client assets). Of its five acquisitions in 2008, two were based in Europe. A typical deal involves Focus buying 40 percent to 70 percent of a company's future cash flow. Focus pays in cash and stock with two earn-out payments based on the acquired firm's growth rate (one after three years and one after six years). Earn out payments are also combinations of cash and stock.

Rudy Adolf, founder and CEO of Focus, says his firm is focusing on subdeals. Of the five acquisitions Focus made this year, two were sub-acquisitions. That's to say Focus' partner RIAs purchased other advisory firms on their own. For example, just four months after it was acquired by Focus Financial, Greystone, of the U.K., used Focus' capital to make an acquisition of its own. In April, Focus' San Francisco-based partner, HoyleCohen, added Cullington Hill Advisors to its team. Lead by Elisabeth Cullington, the firm brought $100 million to HoyleCohen. The deal was financed by Focus. Adolf says, “For our partners, sub-acquisitions of smaller firms are the next logical step.”

WALL FLOWERS

As they deal with plunging stock prices, banks and private banks that were once RIA acquirers have slowed their efforts on the M&A front.

MAKING HISTORY

The roll-up/consolidation phenomenon was pioneered in the 1990s and has been growing.