Most business owners look to grow their companies on a continual basis. The idea of creating economies of scale as a way to increase profits is a common business strategy. And perhaps no part of the financial advice industry has taken that belief to heart as much as registered investment advisers.
Fueled by mergers and acquisitions and a bull market, the size of RIAs as measured by assets under management has exploded. The number of RIAs with $1 billion or more in client assets has grown 54% in the last five years, from 216 firms in 2014 to 338 firms in 2019, according to SEC filings.
The growth of firms in the $5 billion category, so-called megafirms, has been even faster. Five years ago, just 28 firms were in that category; now there are 52, an 86% increase.
Growth driven by M&A
Organic growth certainly accounts for a percentage of that, with the S&P 500 posting total returns of close to 51% from September 2014 to the start of this month. It's tough, however, for a mature RIA to see substantial organic growth of AUM, and M&A accounts for the lion's share of the increase in asset size, industry executives, consultants and bankers said.
"Growth on your own is hard," said David DeVoe, managing director of DeVoe & Co., a consultant and investment bank for the wealth management industry. "So that has left many firms to explore M&A and acquisitions."
The number of RIA transactions has more than doubled in the past five years, with 97 deals recorded last year compared with 41 such deals in 2014, according to DeVoe & Co.
Planning for more acquisitions
And there are no signs that the trend will be slowing down, with more than half of RIAs expecting to buy another firm in the next two years, according to DeVoe & Co. research.
In fact, the boom in the growth of megafirms may just be getting started, one analyst noted. The number of firms with $5 billion in AUM could easily double over the next five years, depending on conditions like the stability of the broad stock market and whether there continues to be a steady supply of advisers willing to sell their businesses.
"Could there be 100 firms with $5 billion or more in client assets?" asked Marina Shtyrkov, a research analyst in wealth management at Cerulli Associates. "Yes. Given the rate of consolidation today, we can see that, but the path there is largely through inorganic growth, meaning acquisitions."
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Fueled by private equity funds looking for the heady returns that RIAs kick off — profit margins of 25% to 35% are typical and in some instances they're higher — megafirms have been making acquisitions over the past five years with abandon.
And while roll-up firms that have been making headlines in the trade press for more than a decade, such as Focus Financial Partners and HighTower Advisors, have been busy making deals, many others, such as Mercer Advisors and Mariner Wealth Advisors, have also grown through a strategy of acquisition.
"Private equity investors see the opportunity because the RIA market is so fragmented," Ms. Shtyrkov said. "Billion-dollar RIAs only account for 5% of firms, but control 64% of the assets. It's fragmented but there is also a concentration of assets."
Headaches and hassles
But building assets to between $1 billion and $5 billion, a target for many advisers who see greater profitability through scale, is filled with numerous challenges and pitfalls that many will not be able to overcome.
First there have to be enough smaller RIA owners willing to sell to sustain the M&A market.
And while the demographics would seem to suggest there should be a steady supply of sellers simply because many owners are reaching retirement age, the number of deals would seem to suggest otherwise.
"Many advisers are moving to an age when they have to sell," Mr. DeVoe said. And yet he said too many are not pulling the trigger.
"We'll see 100 deals this year, but really [we] should be seeing 200 to 300 in an industry with more than 10,000 RIAs," he said.
The result of a lack of supply is that prices are going up for RIA acquirers. It's a seller's market, and some advisers are asking for unrealistic premiums on their practices from some potential buyers, according to industry executives.
Other potential problems: finding the right cultural fit between a buyer and a seller, and managing growth. If an RIA grows too fast, it runs the risk of having too few advisers managing client accounts and potentially alienating customers who seek high levels of services.
Overhanging those concerns are advisers' anxieties about the broad stock market. Will it continue to climb, adding to the value of RIAs, or will stocks plummet suddenly as they did in the credit crisis of 2008, potentially decimating the value of an RIA business just acquired?
"There are always roadblocks with deals, but the No. 1 issue is an RIA's valuation," said David Barton, vice chairman and head of M&A at Mercer Advisors. "This isn't a red-hot market, it's a white-hot, seller's market, and they know it. That means they are demanding unreasonable prices when it doesn't make economic sense for the buyer."
Mercer Advisors has done a slew of acquisitions in the past few years — more than two dozen since 2015, when private equity manager Genstar Capital acquired a majority stake in the firm. Five more acquisitions are close to being completed, and Mercer has grown its AUM from about $7 billion in 2016 to almost $17 billion today.
"Every buyer has this issue, particularly smaller RIAs with one shareholder," Mr. Barton said. "I have to come in and say, you are getting two forms of compensation. The first is reasonable pay as an adviser, and the second is everything that's left over, [or] profit."
"But advisers commingle those two things," he said. "I have to separate those out and risk getting into a dispute about reasonable compensation for the adviser and replacement costs. That's a landmine."
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Mercer itself was the target of a partial acquisition just two weeks ago when Oak Hill Capital bought an equity stake in the company from Genstar and another private equity firm, Lovell Minnick Partners.
"The big headache has been finding advisers who are a cultural fit," said Brett Davis, partner and CEO of True Private Wealth Advisors, which has grown from roughly $240 million in 2012 to $1.1 billion today, completing seven deals in that span. Started by four advisers who left Merrill Lynch in 2012, the RIA does not buy the firms that join its platform but charges advisers a fee for its various services, including setting up a new office once the adviser cuts ties with his or her former firm.
"There are seven different groups, so we have seven different opinions about trading platforms, CRM, everything," Mr. Davis said. "It's a trade-off between flexibility and running the business to scale. Finding that balance is a process."
"One of the main difficulties in any deal is the clash of CEO personalities," said Carolyn Armitage, managing director at the investment bank Echelon Partners. "They are not necessarily used to reporting to somebody or being accountable to someone. We've had folks who wanted to break deals, in one instance because of a dispute over a midlevel employee someone wanted terminated. The other CEO wouldn't do that, so the deal fell apart."
Big firms leading the way
Right now, the large RIAs are driving the market, meaning there will be steady growth in the mega, $5 billion firm category. Seventy-five percent of RIAs with $1.5 billion in AUM expect to buy another firm in the next 24 months, according to DeVoe & Co. research.
Can firms get too big?
"I don't think a firm can get too big, but the real danger is growing too fast," Mr. DeVoe said. "Firms that grow quickly face the challenge of [getting] the firm up to speed, and those firms need to make hires well in advance," he said. "The industry average is to have 80 clients per adviser. Say a firm does a bunch of deals and that average jumps to 105 clients per advisers. At that point, things are starting to fall through cracks and that adviser can't keep up. That can undermine a firm."
While private equity funds will continue to drive deals, they will also make bids that price an RIA out of reach, said Marty Bicknell, CEO of Mariner Wealth Advisors, which is on track to completing close to a dozen acquisitions this year and has north of $30 billion in AUM.
While large enterprises have been sold for off-the-chart multiples, those valuations had not reached the marketplace for an RIA with $500 million to $2 billion in AUM, Mr. Bicknell said.
Those firms were being sold for six to eight times EBITDA — earnings before interest, taxes, depreciation and amortization, he said. But in recent potential transactions, the asking price shot up to 9.5 times to 11 times a firm's EBITDA, he said.
"We've been outbid in the last couple of deals by significant amounts," Mr. Bicknell said. "I'm using my own capital and not going to chase a deal at that multiple. It's impossible for me to justify that."
"Those RIAs are still phenomenal businesses, but at those prices it extends the breakeven point and risk factors," he said.