Larry Raffone must have felt like the belle of the ball.
When the CEO of Financial Engines looked to take his company private in the spring of 2018, he had no shortage of potential suitors. A half-dozen private equity (PE) firms slapped flattering offers on the table.
With a $3.02 billion bid—a roughly 30% premium to the then-current share price—PE titan Hellman & Friedman won the bake-off. The P/E backer moved right away to pair up the 401(k) service provider and robo-advisor with Edelman Financial Services, another of its portfolio holdings, to create a new industry behemoth.
Edelman Financial Engines (as the firm was rechristened) is now the industry’s largest RIA and manages more than $200 billion in client assets. The cash injection from Hellman & Friedman into this newly-merged platform is enabling the firm to keep growing at a rapid clip.
“At the moment, we have more opportunity than capacity,” says Raffone, noting that his firm is on a hiring spree to support an ambitious set of expansion plans.
These days, Raffone is enjoying running his business outside the quarterly scrutiny of the public company spotlight. He appreciates that his PE owners will measure his success over the course of years and not months.
“Private equity backers can more easily invest behind the scenes to fuel innovation,” says Raffone. Carolyn Armitage, managing director at Echelon Partners, adds that for PE buyers, “you can keep your strategic positioning plans private.” Echelon is a Los Angeles-based investment bank and consulting firm focused on the wealth management industry.
But the real driver of cash flooding into the RIA space is playing out for a much more prosaic reason.
“PE buyers know that wealth management can carry very high profit margins,” says Armitage. And profits can be quite steady throughout economic cycles, thanks to the highly sticky nature of client relationships.
Yet right now, the PE spending spree on RIAs isn’t focused on defensive downturn positioning. Instead, by providing fresh capital, PE buyers (along with other strategic investors targeting RIAs nowadays) aim to build out franchises that can further elevate profit margins.
“Once you get to $2-3 billion in assets under management (AUM), you can create scale that allows you to operate more as an enterprise,” says John Langston, an M&A veteran and founder of Republic Capital Group, a provider of deal advisory services.
However, there’s no free lunch. As firms grow in size, they need to build out more specialized staff to handle various part of the business. And adding a lot of six-figure salaries to payroll can pressure profits.
Cerulli Associates found that RIAs with $100 million to $500 million in assets tend to spend around 12%-13% of revenue on infrastructure costs while RIAs managing more than $1 billion spend 21%-22% on overhead. “RIAs need to build an entirely new set of competencies to remain competitive,” the firm’s analysts noted in a 2018 report.
Despite that concern, the trend now is towards building larger practices. This past year, Echelon tallied 181 deals, involving $370 billion in managed assets. In fact, the volume of deals has risen for six straight years. At the current pace, more than 200 deals will be consummated this year.
And few expect the pace to slow any time soon. A recent report by Devoe & Co. noted that “RIA M&A momentum has moved from a ‘spike’ to a ‘surge’ and is now trending toward a possible ‘new normal’ of heightened activity.’”
To be sure, it’s not just private equity that is driving all the action. Wall Street firms, traditional banks, and even the larger RIAs themselves are all pursuing ever-larger deals in a bid to create industry dominators.
But what price glory? As with any industry in the clutches of a feeding frenzy, it’s fair to wonder if buyers are starting to overpay. For example, Goldman Sachs’ recent $750 million purchase of United Capital reflected a lush 17-18 times Ebitda multiple, well above recent industry averages.
Despite that multiple, “Goldman got the steal of the century,” asserts Karl Heckenberg, CEO of Emigrant Partners, “especially when you start to think of all the synergies that can be created between an RIA platform and an investment bank.”
Yet Heckenberg doesn’t think many of the current RIA mergers and buyouts will be easy to justify in hindsight. “The valuations are so bananas. And integrating the deals will entail a lot of complexity,” he says, pointing to some of the larger deals that have been in the $5 billion to $10 billion range.
In contrast, Heckenberg and his team at Emigrant prefer to focus on firms that have $1 billion to $2 billion in AUM, where there are fewer stakeholders involved when negotiating a deal.
Heckenberg says that PE buyers are actively looking for firms in the $2 billion to $3+ billion AUM range. He notes that heavy competition can drive up valuations quickly.
Despite rising valuations, buyers remain undeterred. Snapping up more assets will, in theory, create greater returns longer term. “You need to continually grow if you want to get the fullest valuations,” says Armitage.
Moreover, larger organizations can offer a broader level of wealth management services to clients, as well as attract the industry’s leading advisors, Armitage adds.
Of course, the cycle of ever-higher valuations can create a harsh reality check when the music stops. Indeed, many investors are already questioning the growth-at-any-cost strategy.
Focus Financial has acquired (or merged with) a stunning 30 RIAs through early August of 2019, up from 21 deals in all of 2018. Ruediger (Rudy) Adolf, the founder and CEO of Focus, unapologetically defends the strategy. In a recent interview with RIA Intel, he argues that “If you don’t grow, you die.” But the stepped-up pace of buying has hardly added life to the share price, which is trading at its lowest price since going public, and down 60% from last year's high.
Focus went public last summer with an aim to roll up the industry. Shares were priced at $33 – below the estimated $35 to $39 range. Focus announced late Friday, at the start of the Labor Day weekend, that it had filed a shelf registration.
Why the chilly reception from investors? Focus has yet to demonstrate any real synergies from its massive buying spree of recent years. Analysts at Merrill Lynch predict that the firm will post operating margins of around 15% this year.
A July 2019 RIA benchmarking study by Charles Schwab found that most RIAs have operating margins in the 26% to 30% range.
Recently released second-quarter results revealed clear investor concerns. Operating expense growth of 36% was six percentage points higher than revenue growth. And net debt leverage recently surpassed 4x.
While PE-backed firms having been grabbing many headlines over the past 12 to 18 months, they aren’t the only game in town. Regional RIAs are also driving industry consolidation. And Wall Street is now dipping its toes in as well.
As noted, Goldman Sachs recently made inroads with its buyout of United Capital. Emigrant’s Heckenberg sees Goldman as a logical buyer of more RIAs, in part “because they didn’t have a traditional retail client base.”
Other Wall Street firms such as Merrill Lynch and Morgan Stanley may be more hesitant to pursue outright buyouts to stave off concerns that captive RIAs will end up competing with the large inhouse teams of wirehouse wealth managers already in place under the broker/dealer umbrella.
Heckenberg predicts we’ll see the Wall Street firms instead pursue partnerships that cross-sell various wealth management tools such as custodianship, clearing and cross-border banking services.
What’s the private equity end game?
Ahead of any further push by Wall Street into the RIA business, PE-backed firms remain aggressive industry consolidators. Focus Financial began its roll-up strategy under the auspices of PE firms like KKR, Stone Point and Centerbridge, while other private equity-backed firms, such as HighTower, Mercer, Wealth Enhancement Group, and Allworth, are also racking up deals at a fevered clip.
Still, it’s important to remember that the PE industry is notoriously fickle and has a history of dashing for the exits as soon as sizable profits are in hand.
Echelon’s Armitage notes that P/E buyers typically maintain four- to seven-year holding periods. The clock is already ticking more loudly as we’re several years into the PE industry’s embrace of RIAs.
“We really don’t know what kind of exit plans they have,” she says. The fact that PE firms are benefiting from ultra-low borrowing costs right now means they have ample financial firepower to deploy.
Rising interest rates, in contrast, tend to strain the business models of PE firms, which could lead to a rapid exodus of the RIA investor base.
Memories remain fresh of the insurance industry’s rapid embrace of RIAs in the past decade, only to see those owners subsequently express buyer’s remorse.
While Edelman Financial Engine’s Raffone is grateful to have the strong support of PE firm Hellman & Friedman at the moment, he’s not naïve about the relationship in the longer-term.
“There’s always a chance for another IPO down the road," conceding that “the probable outcome (for Hellman & Friedman) will be to take us public.”
How that plays out in terms of industry valuations remains to be seen. But the withdrawal of any large group of buyers from an industry is rarely a good thing. That may be why so many RIA firms are selling now while the going’s still good.
David Sterman, CFP, is President of New Paltz, NY-based Huguenot Financial Planning