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M&A rainmakers hedge their bets on how deep COVID-19 will drive cuts to RIA sale prices, although first quarter market has been stable.
April 10, 2020 — 1:50 AM by Oisin Breen
Brooke's Note: Selling an RIA was never about the money. The discussions about the amount of money that an RIA owner gets for her/his practice were largely dignified ways to put off addressing when post-work life begins. So it's maybe not ironic at all that the best way to get sellers to sell isn't to make them an offer they can't refuse. The better strategy is maybe to offer senior advisors much less but -- by introducing a community health disaster of Biblical proportions. COVID is a vivid reminder that arbitraging those assets to a post-work life is a great trade that might otherwise expire and become worthless.
The COVID-19 pandemic sweeping the world took RIA valuations back to 2017 in about seven days. In the process, it may also have clarified for aging RIA owners why the time to think about retirement has finally come.
But there is still too much uncertainty in the market to determine how it will affect valuations, or which direction the M&A market may turn.
"Advisors had an easy run for the last 10 years. The market has been extraordinarily favorable. But when it gets harder ... [when] market struggles make things [tough], that accelerates people on the fence," says Jeff Concepcion, founder and CEO of Stratos Wealth Partners, a $14.5 billion AUA Beachwood, Ohio-based RIA and roll-up. It just sold a stake to Emigrant Partners to fund M&A.
"If things stayed easy, they'd stay another two or three years, but now they're saying, 'I don't want to go through another cycle like this.'"
Even during the most liquid practice markets, only about 4% of SEC-registered RIAs did deals at all, according to RIA M&A experts. See: Dan Seivert and Mark Tibergien karate chop private equity investors.
"This could be the inflection point," agrees Scott Wetzel, CEO of Wayzata, Minn.-based RIA lender SkyView Partners. "Robust demand from buyers may finally be met with more supply."
Between 2018 and 2019, RIA sales leapt 31% to 132 from 102; in 2013 just 36 deals crossed the dotted finish line.
Early reports from the first quarter of 2020 note that M&A remained stable, with an estimated 34 transactions completed. RIAs and roll-ups were roughly equal in the number of deals closed.
Slow train coming?
Industry observers and M&A executives are split over whether the Covid-19 crash is likely to put the brakes on M&A, or if it will kick it into overdrive as sellers scramble for the exits.
It's stick or twist, says Ari Sonneberg, partner and chief marketing officer at Boston-based Wagner Law Group, via email. "Deals [will be] approached with increased caution, and a recognition by some that this also creates opportunity for bargain hunting."
Private equity firms that have relied on debt to fuel an RIA shopping spree will also reign in the spending, says Matt Crow, president of Mercer Capital in Memphis, Tenn. "They’ve now got portfolios packed with overpriced deals and their access to credit isn’t what it was."
"This is a giant reset."
The problem is that you can't accurately measure risk when you don't know the extent of the problem, Crow continues.
"There's just too many unknowns; it would be very difficult to complete due diligence.You're trying to verify the durability of client relationships, the size of revenues, the quality of earnings ... how do you predict that in an environment where clients are super edgy ... [and open] to lower cost products? You have no idea what the value is."
Scott Slater, Fidelity's vice president for practice management and consulting, however, thinks "firms will likely take time to assess market direction."
"The key drivers that fueled a record year for M&A in 2019 still exist today, including extensive private capital interest ... Because those drivers continue to be central, we expect M&A will continue to be active in the long-term," he says, via email.
That said, if recent M&A interest at SkyView is a barometer, even Slater's long-view optimism may be too cautious. M&A may even speed up, but at a discount.
In the week beginning Mar. 9, for instance, loan applications at the RIA lender surged three-fold to a total of $26 million, up from a weekly average of $8 million. Of those, 57% of applicants ($14.8 million) requested refinancing -- up from an average of 14% ($1.1 million) -- rather than M&A backing.
Losing the grey dollar
Most of the M&A rainmakers consulted for this article hedged their bets when pressed to say when cuts to RIA valuations will hit. Typically such hedging comes with a wink and a nod to the trailing twelve-month revenue (TTM) model typically used to determine RIA prices, as well as a V-shaped recovery.
But there was unanimous agreement over who will be hit hardest by the Covid-19 crash: older advisors close to retirement who hung on in the hope of a higher payday when they finally sold their businesses.
The kicker, however, is that even if older advisors do sell, they'll still have to stick around to ensure any transaction meets potentially stringent targets for a full payout.
Revenue growth, client retention and asset appreciation will be key metrics in determining how much of the headline price they'll receive.
Moreover, growing revenues is difficult when your client base -- like you -- is older and probably drawing down on their investments, says Annie Tronoski, managing director of New York-based investment bank, Park Sutton Advisors.
"It’s not just the advisor but the assets that are ageing … if you’re 70 and you’re thinking about your assets [and] actively growing your client base … we have a hard time making the numbers work that you're better off [selling] five years from now."
But there's a third option, that solves both problems, says Wetzel. "The senior advisor can sell whatever percentage he or she likes to a junior advisor … [and] advisors can recognize the benefit of having a junior through periods like today,” he explains.
"In 2019, 65% of our M&A transactions were partial sales, compared to 18% in 2018."
A mid-sized RIA with $500 million in AUM on Feb. 20--once worth about $13 million--is now worth approximately $11.5 million. Factor in more complex valuation metrics, and this sum could plunge as low as $9.8 million -- a 34% haircut.
As of Apr. 7, the Covid-19 crash has stripped an estimated 11.2% from the average RIA's assets under management (AUM). As a consequence, revenues, cash-flow and valuations have fallen in lock-step.
This sharp decline assumes a 60-40 split between equities and bonds in an RIA's overall portfolio, using the S&P 500 and the Vanguard Total Bond Market Index as benchmarks, as of Apr. 7.
For many firms, that means the market has erased much of the value accrued during the past few years, although many firms' values are self-adjusting by earn outs.
Conversely, the TTM-based valuations process means those RIAs already under the hammer will not be hit the hardest -- if they lose out at all.
"The current crisis may hasten some advisors to say, 'I’m ready, get me out; I don’t want to go through this again,'" says Carolyn Armitage, managing director of Los Angeles-based investment bank and valuation services firm Echelon Partners, via email.
The effect on advisors in their 60s and 70s is to see the glass as suddenly half-empty as they weigh slogging through another major downturn or beating a path to the beach, the golf course or the place where they'll write their memoirs.
"They can’t wait forever, so they’ve got to do a deal … with a market that might not conform to their timetable," says Crow. "[Circumstance] doesn’t stop the march of time."
Shortened sales cycle
Damage at most senior-owned RIAs is not nearly as severe as the broader securities markets, says Wetzel. "More senior advisor portfolios with more senior clients are more conservatively allocated … [so a] higher percentage in bonds resulted in more muted portfolio decline and [therefore] RIA revenue decline."
"[Nevertheless] It’s going to accelerate activity in the second half of the year and dislodge those people who were content and complacent to do something," says Concepcion.
"They're [now] saying, 'Gosh, did we miss the window?' ... [No but] it's going to have some effect ... it will shorten the sale cycle."
Even sellers who have long since signed on the dotted line could take a shellacking, says Crow.
"If you closed a transaction 12 months ago and part of the consideration was a three-year earn-out, some of those earn-out payments aren't going to be made [and] that's effectively cut the valuation on deals that have already closed."
Before Covid-19 threw the market into a spiral, sellers' tails were up and phrases like "all-time high" commonplace. Record deal numbers became "the expectation," according to reports authored by San Francisco investment bank DeVoe & Co. in its fourth quarter 2019 deal book.
If the last six years can be characterized as a sellers market, RIAs may now find they have to do some wooing of their own.
Indeed, in a late January report, M&A Valuation and Deal Structure, Boston-based custodian and broker-dealer Fidelity Investments concluded that sellers faced a reality check. "Sellers may have inflated expectations of the multiples they can realistically receive," the report noted.
Now that wake-up call has hit home, says Slater
"In the months ahead, buyers may be in a stronger position to negotiate and be selective, while sellers will need to articulate their value clearly to potential buyers."
Just don't call it a buyer's market -- yet, adds Crow. "If profitability is [hit] on a permanent basis, then it will bring more sellers to the table, tipping the scales."
Although valuations will have to take into account changed market conditions, it is unlikely that buyers will press sellers too hard for a heavy discount, says Bill Singer, attorney and writer of the Broke and Broker blog, via email.
"The old squeeze ain't what it used to be … [although] you always have idiots who think that times like these are an invitation to play hardball."
"Not only does it tend to trouble the clients but it sends a [bad] message ... [and] whatever advantage they may have gained when they first rolled out their myopic squeeze play, they lost millions in future revenue and AUM because [advisors] looking to relocate heard about the firm's culture."
Time to sell?
That said, RIA roll-ups will likely use fear to grease the wheels of potential deals, says Wetzel.
"Roll-ups and PE firms will message that valuations are substantially declining to motivate sellers to liquidate at less attractive multiples. The narrative is very self-serving."
Indeed, in recent weeks Raleigh, N.C. RIA buyer CAPTRUST has sent out a number of emails encouraging RIAs to sell.
"There is no doubt that 'may you live in interesting times' is meant to be a curse, and this is certainly true today for literally EVERYONE," writes David Wahlen, the firm's senior associate for recruiting and acquisitions, in an email dated Mar. 31.
We have ample capital resources, and our strategy of geographic expansion has not wavered." wrote Wahlen, who declined a request for comment.
Do the math
A back-of-an-envelope process for valuing an RIA applies a three-fold multiple to fee-based revenues and a 1-fold multiple to commission-based earnings. Typically this produces a revenue-to-valuation multiple of 2.6.
More complex analyses, including assessments of growth, risk and profitability can then drive valuations up or down by a very rough figure of 15%, according to Nick Arellano, managing partner at Hermosa Beach, Calif. valuation and consulting firm Your Legacy Partners.
"There are three ways to value RIAs: One, a revenue multiple; Two, a cash-flow multiple and three, an income-based approach. But in our valuations, we only put revenue weighting at 10% and the cash-flow multiple at 20% ... Everything comes down to growth, risk and profit, and in this industry, those can be drastically different," he explains.
"There's a bell curve, and in all our valuations, we show plus or minus 15% ... as a ballpark."
It's simple arithmetic, says Terry Mullen, CEO of Wellesley, Mass. RIA business intelligence consultancy Truelytics, via email.
"If AUM is higher then future revenue is higher and the price is higher. If the AUM is lower then future revenue is lower and the price is lower," he explains.
"Currently we're not seeing that. What we're seeing is a deal structure that defers a portion or percentage of the payment to protect the downside ...If we see a quick recovery, the impact could be minimal."
In other words, say goodbye to 100% up-front payouts, adds Wetzel. "We're recommending increased use of escrow accounts over two-to-three-year time periods to allow for potential repricing."
Before Covid-19 bulldozed the global economy, buyers increasingly front-loaded deals with a hefty pay out to the seller. Over 40% of acquirers paid more than 50% up front last year, according to Fidelity data.
The devil, the detail, the oxymoron
Mullen's forecast, where RIA valuations might emerge unscathed by the most significant crash in recent US history, depends on two factors.
First, the RIA-sector must continue to weather the Covid-19 storm better than most other domestic markets. Thus far, it has. The current 11.2% revenue drop for RIAs is paltry in comparison to the total shutdown of the travel industry, for instance.
Banks will not only continue to lend, they'll ramp up the cash they put in the hands of acquirers, says an investment banking source. At least one bank known to this source recently bolstered its RIA M&A lending facility by a factor of eight to $200 million from $25 million.
Secondly, the economy must recover sooner, rather than later, bouncing back swiftly in a V-shaped recovery. This, however, looks increasingly unlikely.
Economists, including Nobel laureate Joseph Stiglitz, Citigroup Chief Economist Catherine Mann and Moody's Analytics Chief Economist Mark Zandi predict a longer, potentially U-shaped recession, according to Bloomberg.
As a result, AUM and consequently RIA revenues won't return to pre-March levels for some time.
The oxymoron in play is that a large number of RIA acquirers, the lenders they tap and the valuations firms they employ continue to rely on TTM revenue models as their cardinal means to assess valuations.
TTM is as grindingly slow in acknowledging a downturn as it is in recognizing its conclusion.
"Twelve-month revenue multiples are the most common process to use, and I think it's potentially very harmful to the industry -- buyers and sellers -- because it can be wildly inaccurate. But unfortunately, people do use it because it's simple," says Arellano.
In a V-shaped recovery, TTM means RIA sale values dip -- but 50% less than revenues do -- as one or two quarters of slumping AUM are factored in against the tail-end of a bull market, and the start of another.
In a U-shaped recovery, AUM remains in the doldrums for at least a year, meaning there are a minimum of eight quarters where valuations suffer under the TTM model. This could lead to a firm being valued at up to 34% less when green-shoots abound compared to when the crash first hit.
Focus on the facts
One roll-up that might keep its powder dry is Focus Financial Partners, says Crow.
"[It] has substantial credit facilities to do deals, but at the same time they’re already highly leveraged, and [debt] ratios are going to shoot up … How much does their cash-flow get impacted by [Covid-19]? Can they service their debt? Probably, [but] it's going to be really tight."
"Are they really going to be gun slinging doing acquisitions? I doubt it," he adds. "Boy there are going to be so many questions on the analyst’s call."
Going public was great during the bull market, but it's going to be painful in the downturn, adds Armitage.
"Focus, being public, is at the whim of the market whiplash with full disclosure and transparency ... Thus the large preference [for] private ownership ... [among] wealth management firms."
New York-based Focus floated in late July 2018, and its share price soared to $47.65 by Sept. 21. Since then the firm has struggled to reach such heights. It hit a Covid-19 inspired low of $17.13 on Mar. 20, and now trades at $20.34.
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