M&A deals involving registered investment advisors broke another record in 2022, marking the ninth successive year of record activity, according to DeVoe & Co. While consolidation in the RIA space is expected to continue in 2023, the buyer profile is set to dramatically change as economic headwinds and the rising cost of debt force many RIA-only firms backed by institutional capital to take a back seat after years of dominating the deal flow. Look for independent broker-dealers flush with interest-rate revenue to emerge as credible challengers to aggregators who have dominated the M&A status quo.
There's been a flood of institutional capital from private equity, large family offices and other sources of private growth capital into the wealth management industry in recent years. Much of this investment has gone into the independent RIA segment specifically. These firms were ripe for institutional investment because they typically had clean capital tables and presented fewer legacy operating and technology issues than IBDs. And until recent regulatory harmonization, they were comparatively lightly regulated, reducing the perception of compliance risks and costs. Flush with capital and access to debt, IBDs have become able to pay higher multiples and deliver on more seller-friendly terms.
RIA aggregator firms backed by institutional capital grew exponentially by leveraging their earnings before interest, taxes and amortization, or EBITA, and using that debt to acquire more RIAs. It was a virtuous cycle that worked for years. The model remained highly successful as long as two conditions were met:
Last year may have changed all of that. With markets entering an extended period of extreme volatility, EBITA has been negatively impacted as assets under management and resulting fee-based revenue tumbled across the RIA space. At the same time, interest rates saw an unprecedented one-year rise as the Federal Reserve increased its target federal funds rate by 425 basis points. Corporate debt is now harder to obtain, with the cost of capital being much higher than it has been over the past decade, when interest rates were near zero. This means lower valuations for RIAs across the board.
Private equity-backed RIA firms that were leveraging EBITA to grow are having a challenging time making their model work in this environment. This will further drive down demand for acquisitions of RIA firms and further diminish valuations. These issues will fundamentally transform what had been core assumptions about drivers of wealth management M&A growth this year.
In 2023, RIA M&A will likely come from two primary sources: wealth management firms with established broker-dealer platforms and the aggregation of RIA aggregators.
Wealth management firms that have IBD platforms with well-run cash sweep programs are in an enviable position. The dramatic rise in interest rates has generated passive income for independent broker-dealers for the first time in years. Cash-sweep programs tend to create significant cash that accrues directly to IBDs’ bottom lines. This has been an unexpected windfall for these firms thanks to the rapid increase in rates, as broker-dealers tend to be solid businesses with recurring revenue and little to no debt.
With the cash flows from their sweep programs, IBDs of all capital structures and ownerships are in a perfect position to change the power dynamics in the industry. RIA aggregators will be forced to curtail their activities because, being privately backed, they've already used their firepower. When seller expectations fall in line with this new buyer reality, expect IBDs to be ready to pounce. While interest rates remain elevated, independent broker-dealers can take advantage of their scale and fill the M&A void by using their renewed source of revenue directly for acquisitions or leveraging it to roll up high-quality RIAs.
In this new paradigm, expect a proliferation of aggregation-of-aggregator deals. With their typical M&A deals drying up, look for RIA aggregators that have already reached a certain size to seek out friendly mergers with similar firms. Large aggregators that recognize they can no longer get the financing to acquire their way to becoming national firms may decide that a merger of equals is the best way to still get there.
This isn't the end of RIA consolidation — there are too many economic and demographic reasons fueling the trend — but it does mark a shift in who's leading M&A. Independent broker-dealers are not just in the game but sliding into the driver's seat.
Neil Turner is co-founder and co-CEO of NewEdge Advisors of New Orleans, an RIA and IBD.
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