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M&A Is Here to Stay

Is now the time you should be looking to buy another practice?

David J. Drucker, 08/27/2009

It was recently reported in a weekly news publication that mergers and acquisitions within the financial services industry have taken some interesting twists and turns since the economy fell apart last year.

On average, the article said, prices for advisory firms have fallen about 20%. Likewise, downpayments are down 10% to 15%, earnout periods have increased from an average of five to seven years, and, as a result of all of this (and the effects of the flailing economy), observers expect a 20% increase in the number of firms being sold.

Is this true? And, if so, is it beneficial to you? After all, though many advisors shun the hard work required by acquisitions, they are one of the fastest ways to grow an advisory firm. If the numbers have become this favorable, is this a method of growth you should be seriously considering?

To get answers to these and other questions, I spoke to Dan Inveen, CFA, principal at FA Insight, LLC, and David DeVoe, director of mergers and acquisitions in the Strategic Business Development Group at Schwab Institutional.

Drucker: Dan, would you agree with these figures?

Inveen: In our view, M&A activity peaked in 2007 and dropped in 2008 and 2009. Now it appears to be at 2008 levels. On the buy side, we've got folks confident in their outlook on the future, and, on the sell side, we have a mix of firms that continue to see sale or merger as a strategic fit, and then there are those looking to sell to meet an immediate need...like the founding owner can no longer tolerate the stresses and strains of running the business, or partners aren't getting along. I've heard anecdotally that there are cases of smaller practices with older advisors who have been thinking about getting out of the business. The current economy has exasperated them and they want a quick exit. Some will be looking to fold into a bigger firm that might not allow an immediate exit but at least offers additional resources and the ability to share overhead that will take some of the [cost] pressure off.

Drucker: David?

DeVoe: M&As are continuing to show strength, year to date, in 2009--that is, they're still on track vis-a-vis 2007 and 2008.

Drucker: Where is interest currently coming from in M&A deals?

Inveen: In the last 18 months, the balance of attention has been shifting more toward RIA-type deals compared with the earlier period when consolidators were active and getting lots of attention.

DeVoe: We've seen the same thing. Our research indicates individual advisory firms as buyers have been trending upward steadily since 2006, whereas holding companies as buyers peaked in 2007.

Drucker: To what do you attribute that?

Inveen: A couple of things...advisors are getting more sophisticated about M&A. They're gaining more confidence in being able to conduct deals on their own and they're more motivated to seek scale in this economic climate as they realize that with scale comes cost reductions and a greater ability to provide specialized services based upon a wider range of expertise within the firm. A merger can give a firm more career path opportunities and more marketing muscle--both extremely important due to declining revenues.

DeVoe: I believe advisory firms are exploring transactions where they can optimize the economic structure of their businesses.

Drucker: Where do you both see prices coming in vis-a-vis earlier times?

Inveen: We don't have a lot of hard data, but prices seem lower for smaller firms--$250 million assets and below--while prices for larger firms aren't off that much. Acquisition candidates are heavily sought after but a lot are not willing to sell in this environment. They're finding the need to pay most of their attention to maintaining client service, which has deflected their interest in doing deals.

DeVoe: Yes, pricing has been under compression for the last 12 months or more, which is a natural occurrence when you have a stock market decline that damps growth expectations as well as profit margins. This compression will eventually help close more deals, but with some restructuring of the usual terms. For example, we're encouraging sellers to structure deals so they can capture future increases in valuation or growth; rather than selling everything up-front, they sell maybe 20% now with an agreement they'll sell more as the market returns and valuations move higher.

Drucker: How about deal terms...do you see those changing?

Inveen: In the last couple of years, we've seen an increasing shift of risk to the seller in the form of more earnouts, longer earnout periods, and more requirements that the seller must remain with the firm for some period of time. A couple of years ago it was fairly standard for earnouts to be three years; now they're five or seven. Increasingly, there's less of a cash payment up-front, too. Of course, we could make an argument as to why buyers should want to limit the earnout period; namely, because the buyer won't want to pay for market appreciation if the market turns around soon, forcing up [revenue-based] payments to the seller.

Drucker: How are deals playing out that were negotiated right before the downturn?

Inveen: The motivation behind those deals remains just as solid in 2009, but what's changed is that terms may be out of whack relative to the period when they were put in place. Some buyers may be having trouble making payments and some sellers may not be able to make the deal work from their perspective--for example, if they've sold on the basis of a fixed share of revenues and the revenue pie is shrinking. So we may have cases where people are revisiting their original terms because it's in the interest of both parties to renegotiate--particularly in a merger where the seller and buyer are continuing to work with one another and need to get along.

Drucker: What do you both see for the future of M&A?

Inveen: I wouldn't be surprised if we see a big pickup in activity in the next six to 12 months as financial markets stabilize. There's been no change in the motivations behind deals. The driving factors are still the aging of advisors, the need to make a deal for liquidity or succession purposes, and the growing realization of the importance and benefits of scale--both for achieving efficiencies and providing clients a greater breadth of expertise.

DeVoe: The demographics will continue to drive M&A activity for years to come. The RIA advisor is 55 years old, on average, and 30% are over 60. Another trend fueling M&As is the growing sophistication of RIAs in understanding the basic principles of M&As. Advisors are becoming more strategic about the transactions they do, and the holding companies that buy RIA firms continue to proliferate. Overall, we anticipate the next five years will see strength in the area of M&A; there's a natural consolidation under way.

Drucker: Any last thoughts?

DeVoe: Yes. This market decline has been challenging, but hopefully advisors will look at it as an opportunity--not just to go after wirehouse clients, but to take hard look at their businesses and how they can run them better.

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