Have valuations for RIA firms risen too much?

Hot, hot, hot. That’s an apt description not just of the blazing summer weather in much of the country but the current demand for registered investment advisory firms. As Bruce Kelly noted in his recent cover story, valuations of RIA firms have leapt to double or triple what they were a decade ago. There seems to be a feverish race among private equity firms and other deep-pocketed investors to grab a stake in what have become the brightest stars in the wealth management firmament. 

Is the intensity of demand for RIA firms a sign of excess? Is the buyers’ love affair, to quote the song, too hot not to cool down?

One industry executive quoted by Kelly contends that buyers are convinced they are acquiring businesses that are well-positioned to grow organically over the next several decades no matter what happens in the economy or markets. There are no peak valuations or bubbles here, says the expert.

To be sure, investing bubbles usually involve widespread public involvement. Whether it was the Dutch tulip mania of the 17th century or the dot-com craze at the end of the 20th, a bubble grabs everyone’s fancy because it’s such a sure thing — until it isn’t. Today’s hot RIA market fails that bubble test because it is simply too small and too institutionally driven. Even if today’s prices were deemed to be bubble-like after some future price drop, relatively few mom-and-pop investors would even be aware of what had happened, let alone be harmed.

But don’t discount the possibility of so-called “smart money” behaving not so smartly. In the real estate bubble of the early 2000s, for example, supposedly savvy institutions were as frenzied in their appetite for mortgage-backed securities as the buyers who snapped up houses with zero-down mortgages. In their quest for yield, institutional investors seemed willing to believe that a credit-rating agency’s imprimatur could be the magic that turned junk into highly-rated credits.

Private equity investors engaged in today’s gold-rush-like hunt for RIA firms are under similar pressure to produce results. As they sit on tons of dry powder that must be employed to earn the returns investors expect, forking over a little or a lot more to get in on the action may be a price PE firms are willing to pay to employ that idle cash, especially if their peers are doing the same.

As John Bogle once said, “Never confuse genius with luck and a bull market.” Much of the attractiveness of RIA firms reflects the rising value of the assets they manage rather than organic growth, which is tough to accomplish. A bear market would likely lead to less rosy RIA firm results, lowering valuations and making today’s investments at lofty prices look less than desirable. Professional investors should know that better than anyone.

But since even they aren’t immune to emotion or infallible market timers, for now the RIA sizzle appears likely to continue.