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Don’t bet on an aggregator deal

Owners of independent advisory firms have been hearing lots of talk of aggregators — firms that include Fiduciary…

Owners of independent advisory firms have been hearing lots of talk of aggregators — firms that include Fiduciary Network LLC, Focus Financial Partners and United Capital Financial Advisers LLC — that are scooping up top registered investment adviser firms for top dollar.

The deals are the envy of the industry. Acquired firms can receive as much as five to eight times free cash flow, with the largest deals sporting even higher multiples depending on back-end targets over a three- or five-year period.

Acquirers are backed by cash-rich private-equity and venture capital firms that fuel the deal making. Focus Financial, for example, boasts financing from the VC firms Polaris Venture Partners and Summit Partners, which have put up $35 million and $15 million, respectively, for acquisitions.

So what does it take for an advisory firm to be a contender for one of these aggregator-financed deals at potentially superior multiples?

There are five hurdles that typically must be met:

Size. Typically, an independent firm must manage at least $400 million in assets to attract the interest of private-equity investors. The PE firm must do deals of size in order to get a big-enough bang for their buck.

This criterion alone rules out the vast majority of advisory firms. Just 8% of advisory firm registered with the Securities and Exchange Commission manage $1 billion or more in assets, and 41.3% manage less than $100 million.

By contrast, a recent report from Pershing Advisor Solutions found that the median deal involving private-equity-backed firms in the RIA business involved a firm that had $1.35 billion in assets under management.

Given the deal track record, AUM size is a knockout factor for most advisory firms. Insiders guess that well under 20% of advisory firms are even big enough to qualify.

Business organization. This factor is also AUM-related. Most aggregators prefer to acquire firms that have institutionalized their business. That is, they want firms in which clients’ accounts are handled by a team and clients view their relationship as with an organization, not just an individual. Aggregators are willing to pay top dollar for these firms.

Although tuck-in opportunities exist for small, one-man-band practices, the deal multiples are much lower. Tuck-ins are arrangements in which sellers with fewer assets under management attach themselves to larger practices that ultimately acquire their assets.

One aggregator told me that he routinely walks away from deals in which prospective sellers boast about how indispensable they are to their firms. He is astounded by their glaringly illogical sales pitch: “My clients love me, and this place can’t run without me, so how much will you give me after I step out?”

Relative attractiveness. There are only a handful of aggregators, and each does just a few deals each year. That means a firm must be just what the aggregator is looking for to be worth the time and effort expended.

Why aren’t there more aggregators? First, aggregation is a complex business model with lots of moving parts, demanding proficiency in difficult mathematical calculations with many variables. Aggregators regularly juggle issues such as the dilution of the current owner’s shares as new acquisitions come on board and as principals of existing firms cash out.

Second, as the industry has matured, aggregators have learned from their mistakes. Some of their acquisitions have been disappointing. Unless a prospective firm fits precisely with their business model, aggregators are inclined to pass on a deal.

Desired business model. Some aggregators are interested only in firms that have a particular business model. United Capital, for example, takes on only those firms that are willing to adopt its financial planning model and are willing to take its name.

Personality. It goes without saying that buyers must have confidence in the integrity and skill of their future business partners. As well, prima donnas or combative, scorched-earth street fighters need not apply.

Given all the above knockout factors, the 7% to 9% acceptance rate of Ivy League schools starts to look like a comparative piece of cake.

Those who want to join an aggregator and haven’t yet been able to pull it off should take heart. As more private-equity money seeks high-return investment opportunities, it is likely that more of these well-financed serial acquirers will enter the independent marketplace.

Mark Elzweig ([email protected]) is an executive search consultant who advises independents and registered investment advisers on succession planning.