How will a capital gains tax hike affect red-hot RIA M&A market?

Many RIA sellers who were already contemplating an exit in the near- to mid-term are likely to see the handwriting on the wall and scramble to complete their sales before the tax increase takes effect.

Deal flow in the registered investment advisory space is continuing to heat up, and there’s much speculation that it’ll get even hotter as President Biden’s plans to raise capital gains taxes inch closer to fruition.

In the latest development, the president has proposed raising the top tax rate on capital gains from 20% to 39.6% on families with income over $1 million. The change, which is part of his budget plan for next year, would be retroactive to April 28.

The budget is still subject to negotiation, and parts of it will almost certainly change before it is enacted. Regardless of the final version, it’s yet another sign that President Biden is serious about capital gains taxes.

Many RIA sellers who were already contemplating an exit in the near- to mid-term are likely to see the handwriting on the wall and scramble to complete their sales before the increase takes effect and Uncle Sam takes a bigger chunk out of their proceeds.

Yet in the very near term, until we know where capital gains taxes will settle, the full effect on the RIA M&A market is unclear. With the glut of sellers, will buyers continue to gobble up practices as they have, or will the market hit a ceiling for demand? And will valuations for practices go down, stay the same or go up?

[More: Why the M&A clock is ticking faster than ever]

Depending on how it all shakes out, we could see a realignment at the top of the RIA space. Here’s how the buyers and sellers should think about the proposed tax increases:

WHERE IS THE CEILING?

For sellers, it’s unclear where the ceiling is in terms of the current demand for acquisitions. If the demand for practices, driven by voracious PE-backed acquirers, continues to exceed supply even with the additional sellers driven into the market by tax hikes, the status quo is likely to continue with respect to RIA valuations. It has been a seller’s market in recent years for RIAs, and it’ll likely remain so, in which case we’ll continue to see strong valuations.

Sellers won’t like the other scenario. If the influx of selling RIAs exceeds the market’s demand, there will be sellers hunting for buyers, rather than the other way around, which could depress valuations.

MORE DEALS TO BE HAD

Clearly, pricing dynamics in the market will be a prominent driver of how acquirers will respond to a potential increase in sellers in the market. The broader question, however, is whether buyers will step up their acquisition pace simply because there are more deals to be had.

In other words, there will be some buyers that maintain their discipline amid an increase in supply of RIA sellers in the market. They will stick their investment theses and only take swings at firms that fall right into their strike zone.

Alternatively, there will be buyers who will be more acquisitive simply because there are more deals to be had, regardless of the price. They may be less selective than before and risk taking on a crowd of underperforming assets. However, to extend the baseball analogy, they’ll accept the risk of some strikeouts, pop-ups and groundouts for the chance to hit a home run.

BE READY TO ACT

It remains to be seen what effect the potential capital gains tax hike will have on the RIA market. One thing is clear, however: The market is so dynamic that it could swing either way in response to even a hint of a significant change to the rules of the M&A road.

Whether you’re a buyer or seller, it’ll benefit you in the long term to pay attention to what happens next — and be ready to act.

[More: Navigating the blurring lines between M&A and recruiting]

Jeff Nash is founder and CEO of BridgeMark Strategies, a transitions firm for the independent wealth management space, and partner and co-founder of Ignition Point Partners.