Creating, Measuring and Unlocking Enterprise Value in a Wealth Manager June 2010

Transcription

1 Creating, Measuring and Unlocking Enterprise Value in a Wealth Manager June 2010 Mark P. Hurley Benjamin J. Robins Yvonne N. Kanner Steven E. Cortez Shehzad Sippy Jonathan Yu

2 Fiduciary Network, LLC Mark P. Hurley is President and CEO of Fiduciary Network, LLC. Benjamin J. Robins is General Counsel. Yvonne N. Kanner is Executive Vice President and COO, and Steven E. Cortez is Executive Vice President. Shehzad Sippy is an Associate, and Jonathan Yu is an Analyst. Copyright Fiduciary Network, LLC, 2010 This material is for your private information, and we are not soliciting any action based upon it. Opinions expressed are our current views only, at the time of writing. The material enclosed is based upon information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such.

3 Contents Introduction... 1 I. Executive Summary... 4 II. Sources of Enterprise Value in Wealth Management Businesses Wealth Management Firm Example III. Measuring Enterprise Value IV. Alternatives for Unlocking Enterprise Value Alternative #1 Participating in a roll-up...63 Alternative #2 Selling to a small bank...77 Alternative #3 Internal transitions...91 Alternative #4 Sell to another wealth manager i

4 Index of Exhibits Chapter II 2.1 Present Value of Fees from a Single Client Relationship is Extremely Large The Wealth Management Industry Has a Substantial Generation Gap; 60% of Advisors Older Than 50 Years Non-Owner Compensation Rose Much Faster Than Revenues at the Largest Firms...33 Wealth Management Firm Example Acme Wealth Management...48 Chapter III 3.1 NPV of Future Profitability with No Reallocation of Economics to Successor Professionals NPV of Future Profitability Almost 20% Less with Reallocation of Economics to Successor Professionals...54 Chapter IV 4.1 Calculation of Value of Roll-up Holding Company Common Equity Apparent Economics of a Roll-up Transaction Example of Roll-up Holding Company Valuation Calculation of Value of Roll-up Holding Company Common Equity Effect of Roll-up Capital Structure on Seller Outcomes Apparent Economics of Selling to a Small Bank Economics of Selling to a Small Bank with Portion of Consideration Paid to Successor Professionals Self-Funding Nature of Bank Transactions Apparent Economics of Internal Transition Priced at Implied Value, First Tranche of Equity Will Not Be Repaid for More Than 12 Years Repayment Matrix with Different Multiples of EBITDA and Rate of Revenue Growth Internal Transitions Even Those at a Discounted Price Require Many Successor Professionals Amortization Schedules Are Not Problematic Provided the Wealth Manager Meets Its Projected Growth Targets Without Earnings Growth, Required Out-of-Pocket Payments of Principal are Enormous Low Prices for Equity Make Amortization Schedules Less Problematic Providing Seller Financing Substantially Lowers the Value Selling Owners Achieve Implied Value of Acme Wealth Management is More Than $17.4 mm Revenue Factoring is an Expensive Form of Capital Immediate Accretion Equals Revenue Minus Transferred Costs and Owner Compensation Accretion After Selling Owners Depart is Discounted at a High Rate Selling Owners Receive a Portion of Present Value of the Accretion ii

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7 Introduction This is a very narrow analysis: we examine the issue of enterprise value and nothing else This paper looks at a limited and relatively esoteric topic: enterprise value in a wealth manager. In other words, it examines the economic value that someone receives from owning the equity of a wealth management business. Our goal is to answer three questions: What exactly is enterprise value and how might it be created in a wealth manager? How would one measure it in this kind of enterprise? What are the alternatives currently available for unlocking this value? It is important to emphasize that this is a very narrow analysis; we examine only the issue of enterprise value and nothing else. This paper does not even attempt to address topics such as the viability of any individual wealth management firm, succession planning, or even the future of the industry (as some of the co-authors earlier studies have considered). Additionally, the authors recognize that wealth managers provide value to their clients and communities in many ways that are totally separate and apart from (and much more important than) the purely economic matters addressed here. Wealth managers are incredible businesses that help their clients solve their most complex and vexing problems and materially improve many people s lives. Why write this paper? An obvious question is: Why undertake all of the work and effort necessary to produce this study? We have several motivations. Most owners of wealth managers do not understand the intricacies of mergers and acquisitions transactions We must confess upfront that we have a conflict of interest in that our company Fiduciary Network ( FN ) is an investor in wealth managers and to date has completed nine transactions. However, FN s structure is extremely specialized and likely would be of interest and/or appropriate for only about thirty or so wealth managers or only about.15% of the industry s participants. And we have carefully avoided discussing what FN does in any detail so as to not detract from the usefulness of this report. Thus, while the study may be an educational tool that we can use with a small group of prospective investment targets, we would not have invested so much of our time and resources in writing it without a much broader purpose in mind. Owners of wealth managers have little experience and knowledge about mergers and acquisitions One of the most surprising things that we have learned over the four years since we started our company is how little most owners of wealth managers know and understand about the intricacies of mergers and acquisitions transactions. Although they are extremely sophisticated investors, the first transaction in which most of the owners of these businesses will ever materially participate will be the sale of their firm. Consequently, they rarely understand what investors actually look for in a wealth manager and the analysis that investors employ to value these enterprises. More importantly, many prospective sellers have little insight 1

8 into the techniques used by investors to subtly alter the risk and therefore, the likely outcomes in a deal structure. Further, the sale of one s business is an all-consuming, emotionallycharged process that is exhausting. Buyers fully understand this and the other aspects of the psychology of deals. And they use their knowledge to manipulate unsuspecting sellers. Unfortunately, owners who wait until they try to sell their businesses to become knowledgeable about mergers and acquisitions transactions are potentially easy prey. There are simply too many moving parts to any transaction. No one has the ability to learn about all of them on the fly while trying to successfully negotiate with a sophisticated buyer. The time to acquire knowledge is long before considering selling your business Thus, another purpose for this study is to provide an educational tool for the owners of wealth managers. It provides a detailed analysis of the actual mechanics and structures of different types of transactions as well as the benefits and tradeoffs involved. Knowledge is Good As we say repeatedly throughout this report, there is no one choice that is appropriate for every firm. But in the words of the motto of Faber College from the epic motion picture Animal House: Knowledge Is Good. And the time to acquire this knowledge is long before ever considering selling your firm. We also recognize that not dissimilar from several of the studies that some of the co-authors have previously published many parts of this paper will be viewed as controversial. While more than a few people will likely disagree with our conclusions, our hope is that readers will view them in the spirit in which they are written. Our goal is to be as candid as possible and provide owners of wealth managers with a realistic view as to what their options are and the steps that they need to take if their goal is to capture material enterprise value for their businesses. We also hope that this report leads to more scrutiny of a series of issues that could stand a little more sunlight and attention. Thanking our sources and colleagues At this point in the introduction to our previous papers we have listed the many industry participants who shared their time and expertise in helping us prepare the report. Similar to our prior efforts, this report could not have been written without the help of countless owners of advisory firms of all sizes. However, because of the sensitivity of the topic, most of our sources have shared information with us on a confidential basis. Consequently, we have decided not to identify anyone by name, be they individuals who provided us with confidential information or not. Regardless, we would like to thank everyone who has helped us with this study. You were extremely generous and gracious with your time and 2

9 information. We hope that you will view what we have produced as a useful tool that is worthy of your input. In addition to the many industry participants who contributed to this study, two of our colleagues, Adam Bartkoski and Kelly Mills, provided invaluable assistance through their review and editing of its drafts. Finally, three of the authors of this study have had the good fortune of working with the wealth management industry for nearly fourteen years. It has provided us a great livelihood. It has also been a privilege and an honor to work with so many individuals who care so much for their clients. This report is a small way of showing our appreciation. Mark P. Hurley Benjamin J. Robins Yvonne N. Kanner Steven E. Cortez Shehzad Sippy Jonathan Yu

10 I. Executive Summary Few topics have recently generated more intense debate and speculation within the wealth management industry than enterprise value. More specifically, do wealth managers have any value as businesses and if so how do you measure it and potentially unlock it? For some owners, what they receive for their firms will determine the quality of their retirement lifestyles Driving this discussion is the graying of the owners of many wealth management firms. What began two decades ago as a group of young entrepreneurs striking out on their own to launch new companies that would pioneer a new way of providing financial advice has evolved into an industry dominated by small and mid-sized businesses owned by people in their late 50 s and early 60 s. For some but clearly not all of these owners, finding the means to sell their companies for material remuneration is quite important. After years of working hard and reinvesting in their firms, they understandably would like to capture a return on their efforts. Additionally, the recent financial market correction has adversely affected their retirement savings as well as their firms ability to replenish those savings. Consequently, for some firm owners, the consideration that they receive for their companies will be a material determinant of the quality of their retirement lifestyles. Other firm owners have a different perspective. They have a passionate interest in using their firms to build a legacy that will survive them and, at the same time, ensure that their clients are cared for after the founders have departed. But as rational businesspeople, they recognize that the only enterprises that survive their founders are those that create material economic opportunity for their successors. Thus, while those owners who fall into this group may be less concerned with the economic consideration that they may capture from a sale, they recognize that they need to build sustainable value in their enterprises for their companies to continue to exist over the long term. Even the largest wealth managers are relatively small businesses and the ranking of the industry s largest firms is analogous to a biggest jockey contest Similar to other important topics within the industry, there is far from unanimous agreement as to whether wealth managers have any enterprise value. The relationships that the best firms have cultivated with their clients are extremely personal and may not be transferable to their successors. Additionally, owners also recognize that even the largest independent wealth management firms are not that big when compared to companies in other industries, making the annual ranking of its largest participants somewhat analogous to a biggest jockey contest. Further, the overwhelming majority of the remainder of industry participants are unprofitable lifestyle practices that is, their owners are paid less than they would as employees of another wealth management firm and, therefore, are subsidizing their businesses with their labor. However, there are also several reasonable arguments as to why wealth management firms could have enterprise value. First, they generate exceptionally stable revenue streams. The annual client turnover rates of only 1% to 3% at the best fee-only firms suggest that the average tenure of their client relationships will range between 33 and 99 years. These organizations collect an annual fee for every year that their clients remain at the firm and the aggregate fee stream generated over the life of a single relationship is staggeringly large. 4

11 Enterprise value in a wealth manager is its future profits Additionally, the industry has also been besieged by banks and roll-up firms interested in acquiring wealth managers. Although due to the recent financial market correction their demand for acquisitions has abated somewhat, banks did acquire dozens of firms over the last decade. It also seems that a week does not pass by without the launching of yet another private equity-backed wealth management roll-up firm. If so many sophisticated buyers are interested in acquiring firms, how could they not have great enterprise value? A. What is enterprise value and what are the steps necessary to create it? The first step in settling this debate is to consider what the term enterprise value actually means: It is the economic value that an investor captures from owning the equity of a company. Because wealth management firms have virtually no tangible assets, their only enterprise value is their future (in particular, after their current owners have departed) profits either as standalone businesses or as part of another entity. A careful analysis of the industry suggests that only about 200 to 400 of its participants either have or possess the potential to build material enterprise value. The remaining 18,000 to 19,000 firms currently have no enterprise value and are very unlikely to build any in the future as standalone businesses. More specifically, the vast preponderance of industry participants rely on an economic model fee based that hinders the creation of enterprise value. 1 Fee-based firms both sell investment products to clients and collect fees. They effectively front-end load the compensation that a client pays for advice. Absent the sale of additional products each year, fee-based organizations are unprofitable. 2 Fee-based model hinders the creation of enterprise value Unfortunately, there is no empirical evidence to suggest that, because one generation of employees at a wealth management firm is able to sell products to a particular group of clients, their successors will be able to sell additional products to the same clients, or to other new ones. Rather, the ability of the individual involved is the key determinant of such success and not any pre-existing relationship the client might have had with the firm. Consequently, fee-based firms have no transferable goodwill, the intangible asset that reflects enterprise value. 3 In contrast, the other economic model employed by wealth management firms fee-only does create the potential to build enterprise value. Feeonly firms sell a service (comprehensive financial advice) for a relatively small annual fee. It is paid directly by the client to the adviser and is not tied to the sale of any investment products or the particular implementation of the investment plan. 1 As we describe in great detail in Chapter II, there are a wide variety of fee-based firms. Some of these organizations are far along in their evolution to fee-only businesses and do not require the sale of additional products in order to be profitable. These firms should be evaluated from an economic standpoint in the same manner as fee-only. 2 As noted earlier, the term unprofitable refers only to whether the business makes money after paying its owner-employees a market level wage. 3 It is important to note that although the fee-based model hinders creation of enterprise value in a wealth manager, firms employing the fee-based approach do build great enterprise value in the brokerages that support them. 5

12 Most fee-only wealth managers are too small to build enterprise value on a standalone basis The Achilles heel of every wealth manager trying to build enterprise value is its dependence on professional staff Provided that clients are satisfied with both the quality of the service and the individuals who deliver it, they will likely continue to pay advisory fees indefinitely. Thus, so long as a fee-only firm can sustain the quality of its service and its people, the firm could potentially have transferable goodwill and, therefore, enterprise value. Most fee-only firms are unprofitable To be sure, being fee-only does not ensure that a business either is profitable today or will be in the future. In fact, most fee-only firms (typically managing less than $300 million of assets and generating less than $3 million of annual revenues) currently do not earn any profits as standalone businesses and lack the ability to build sustainable profitability as independent entities. To put it another way, after deducting their operating costs, they are unable to pay their owners market level salaries much less produce sufficient free cash flow for reinvestment required to evolve into mature companies with sustainable profitability. Further, while many larger fee-only wealth managers have the potential to build significant enterprise value, they must first surmount several substantial obstacles. First, the fee-only economic model relies heavily on one input professional labor that is in short supply. The Achilles heel of every wealth manager is that it has limited scalability and ultimately its ability to grow is dependent upon recruiting and retaining professional staff. Unfortunately, a chronic shortage of quality wealth management professionals is rapidly driving up the cost of labor a threat to the operating margins (and thus, the future profitability) of every firm. Consequently, wealth managers that want to build enterprise value must grow their revenues at a rate that is faster than the rate by which their costs are rising. Doing so, however, requires evolving into a more mature business. Seven steps to building enterprise value Transitioning from a small to mid-sized company into a large, highly profitable wealth manager is challenging. Only a small number of those firms that try will succeed. Those that do will undertake the same seven steps: 1. Recruit and retain a next generation of professionals who are capable of and are interested in continuing the business after the founders have departed. The number and quality of the successor professionals that a firm is able to recruit and retain will be the single largest determinant of the organization s success in building enterprise value. But a precondition to a firm being able to attract and retain these individuals will be providing them with an opportunity to participate in the firm s ownership and offering clearly defined career paths. 2. Institutionalize the firm s client relationships. Having transferable client relationships is a precondition to building enterprise value in a wealth manager. But client relationships are only transferrable if the client views his or her relationship as being with the firm 6

13 rather than with one or two of its employees. Thus, wealth managers that aspire to build material enterprise value employ a variety of approaches (client relationship teams; disaggregation of the production and delivery of intellectual capital; etc.) that encourage a perception among clients that their relationship with the firm as a whole is far more important than any relationship that they may have with individual employees. 3. Build a base of clients that is profitable, demographically diverse and not overly concentrated. Not all client relationships are profitable for a wealth manager. An essential element to creating enterprise value is to build a demographically diverse client base appropriate to the firm s economic model that is not too concentrated in a small number of relationships. 4. Institutionalize the firm s marketing capabilities and brand. Wealth managers will have to evolve from absolute monarchies into enlightened despotisms into oligarchies Because growth is an essential element to sustaining profitability, wealth managers must be able to continue to recruit substantial volumes of new clients after the founders have departed. They must also evolve their brand away from the reputation of the founders to that of the capabilities of the larger organization so that clients will still be attracted to these firms after their generational transition is completed. 5. Evolve the company s management and governance structure. If wealth managers are to become large profitable enterprises they need management teams that are qualified and experienced in managing businesses (talent in financial planning and investments is not enough). Consequently, professionals outside of the organization will need to be recruited and the founders will have to play more limited roles in the day-to-day operational matters of their companies. Additionally, as these organizations broaden their ownership, their governance structures will have to change. They will have to evolve over time from absolute monarchies into enlightened despotisms and eventually into oligarchies that value input from all of their shareholders. 6. Create a robust culture of compliance. A compliance failure which can expose a wealth manager to regulatory scrutiny (including enforcement actions), civil litigation and material brand damage poses the single greatest threat to enterprise value. While heightened attention to processes and controls can mitigate the risk, only those firms that adopt an organization-wide attitude that all employees (including owners) bear the responsibility for compliance will have the best chance of avoiding compliance disasters. 7. Reinvest in the business. Nearly all of the aforementioned steps will be costly. Funding them will require a firm s owners to either forego a substantial portion of the firm s ongoing profitability or solicit an investment of outside capital. 7

14 Complex and emotionally wrenching evolution From the perspective of many owners, the potential reward for building enterprise value is not worth the aggravation involved In sum, building enterprise value will require that a wealth manager undergo a complex and emotionally wrenching evolution. Its culture will change. It will have new management and the roles of the founders and its successor professionals will be quite different in the future than they are today. From the (understandable) perspective of many owners, all of this is very unattractive and fraught with risk. They earn a good living. They are very comfortable. They also reign supreme over their companies. And they have very little interest of changing any of these aspects of their lives or companies, regardless of the potential opportunity for large amounts of consideration. Consequently, of the 200 to 400 firms that could potentially build substantial enterprise value, it is likely that only a small portion will attempt to do so. Given the complexity of the challenge involved, it is also likely that only a fraction of those that do try will succeed. B. How is enterprise value in a wealth manager measured? Investment bankers have more rules of thumb than they have thumbs Investors value wealth managers by considering a series of binary and qualitative factors Measuring the degree to which a firm has been successful in accomplishing these steps and therefore, its level of enterprise value is (understandably) a complicated and subjective analysis that does not lend itself to simple metrics. Investors measure value by building a risk-adjusted projection of a firm s future profitability, an analysis that is unique to each individual business. Many industry participants, however, have been encouraged (largely by investment bankers seeking sell-side mandates) to value their companies using rules of thumb: a multiple of revenues; a percentage of assets; a multiple of EBITDA, etc. Such rules of thumb are mostly marketing tools designed to encourage owners to believe that their firms can be sold for large amounts of consideration; provided, of course, that they retain the investment banker as their adviser. In reality, investors run extremely detailed due diligence processes, examining a series of binary and qualitative factors. On the binary side, investors closely look at (i) whether a firm has institutionalized its client relationships; (ii) whether it has institutionalized its brand and marketing programs and (iii) whether a firm has created a strong culture of compliance. If the answer to any of these three questions is no, the firm likely has little current enterprise value, a conclusion that would lead most investors to condition any consideration on the firm s future performance. Assuming a firm has met these three preconditions, investors will then undertake a qualitative analysis. Their objective is to determine the degree to which the organization has successfully taken the remaining steps on the road to building enterprise value. Three interdependent variables result from the investors analyses: (i) a projection of future profitability; (ii) a discount rate that reflects the risk the projected profitability might not materialize; and (iii) a deal structure that allocates this risk between seller and buyer. 8

15 Forecasting the future profitability of a wealth manager is more art than science Investors will assume that a substantial portion of future profits will have to be paid to successor professionals Developing an accurate forecast of the future profitability of a wealth manager is much more art than science because future revenues and future costs are hard to predict. Revenue is tied to a firm s ability to attract new clients and the performance of the financial markets, two things which no one has ever been able to accurately forecast. Additionally, the rapidly rising cost of professional labor makes predicting the future costs of a wealth manager extremely challenging. Further, for firms in which the overwhelming majority of the ownership is held by the selling owners, investors will make an additional adjustment to their projections of future profitability. Rational investors understand that a level of legal ownership in a firm s equity may not translate precisely to the same level of economic ownership. More specifically, after the founders of a firm have departed, the bargaining power of the successor professionals increases, providing them with the ability to demand more of the firm s overall economics. Consequently, investors adjust their valuation models to reflect the incremental portion of the firm s projected future profitability that will have to be allocated to the retention and motivation of the organization s successor professionals. Sellers and buyers bridge the gap in how to value a firm by allocating risk in a deal structure Determining an appropriate discount rate is extremely subjective As subjective as it might be to forecast a firm s future profitability, determining the appropriate rate at which to discount these future cash flows is even more so. The range of rates used in wealth management transactions (15% to 25%) vary widely. Owners (understandably) argue for as low a rate as possible so as to maximize the valuation. At the same time, buyers often see far more risk than sellers that the wealth manager s future profitability might never materialize, leading them to argue for a much higher discount rate. Reasonable parties can bridge this gap by using the deal structure to allocate risk between seller and buyer. For example, buyers structure transactions in which they only gradually acquire risk from the sellers by paying a substantial portion of the aggregate consideration in the form of an earn-out. The better that the business performs during the earn-out period, the greater the level of consideration paid to the seller. Sellers unwilling to retain risk are signaling that they lack confidence in their businesses A seller s position on the allocation of risk in a transaction (in particular, should the seller appear to have an urgent desire to transfer risk to the buyer) plays a substantial role in how (and even whether) a buyer is willing to acquire a firm. From the perspective of buyers, sellers who are reluctant to retain a substantial amount of risk for a reasonable period of time (i.e., those who are focused on maximizing the amount paid at closing) lack confidence in the quality of their businesses and the likelihood of sustainable future profitability. Consequently, buyers will often heavily penalize (in the form of a much lower valuation) those sellers who seek as much near term consideration as 9

16 possible. At the same time, however, buyers are willing to pay substantially higher prices for those firms with owners who are interested in only gradually selling their businesses and shifting risk to the buyers. Owners who build great enterprise value will be richly rewarded Finally, it is important to emphasize that the three outputs of the buyers valuation analysis (profitability forecast, discount rate and risk allocation) are linked to each other. Any change that a selling owner wants made to one variable triggers changes to the other two. C. What are the alternatives for unlocking enterprise value? Although completing the steps required build a large, highly profitable wealth management firm are challenging (and perhaps even unpleasant), we believe those firms that manage to do so will be richly rewarded for their efforts. Numerous large financial services companies have concluded that participating in the wealth management business is critical to their longterm strategies. These organizations also have learned just how hard it is to organically build a substantial firm and that it is almost impossible to do so quickly. Consequently, many believe that acquisitions are the only way to meet this important strategic objective in a reasonable time period. The investment management industry experienced a similar phenomenon in the mid- to late-1990s as numerous large financial services companies and banks determined that it was strategically important to have a substantial presence in the money management business. Similar to wealth management, building a large investment management company takes many years, far longer than any of these financial services companies and banks were prepared to wait. Consequently, they became aggressive acquirers of large independent money managers. But at that point in time, there were only a relatively small number (about 25) of potential sellers. Given that the interested buyers dramatically outnumbered the potential sellers, the acquirers paid immense premiums, making billionaires out of many investment management firm founders. No independent wealth manager today is material to a strategic acquirer It is likely that some current owners of wealth managers will be similarly fortunate, provided their firms can become much larger and more profitable businesses. Strategic acquirers are only interested in material acquisitions Strategic acquirers are only interested in acquisitions that are material that is, acquisitions that increase their EBITDA by at least 15% to 20%. 4 Even mid-sized strategic acquirers (such as regional banks) have EBITDA of $250 million to $300 million. Thus, a wealth management firm would need to generate $40 million to $50 million of EBITDA (net of market-level owner compensation) to be 4 It is important to differentiate between a strategic acquisition of a wealth manager and those that were made by several banks over the last decade. A strategic acquisition either provides the acquirer with an immediate and substantial presence in an industry in which it believes it needs to participate or immediately and materially enhances its profitability. In contrast (and as we will discuss further) the wealth management firms involved in small bank transactions were small companies (EBITDA net of owner compensation <$10 million). Consequently, the sellers did not receive the premium pricing (as compared to their implied value) found in the large investment management deals described above. 10

17 Overwhelming majority of owners fantasize about finding a slow deer buyer In reality, sellers are largely limited to only four alternatives for unlocking enterprise value a compelling acquisition candidate to such a buyer. Given that even the largest firms currently generate less than $10 million of EBITDA annually, we are likely many years away from seeing a series of strategic acquisitions in the wealth management industry that can rival those completed in the investment management industry. Dreaming of a slow deer Although it is highly unlikely that any strategic acquirer would currently view any independent wealth manager as an attractive target much less be willing to pay a premium price for one we find that the overwhelming majority of firm owners cling to the same fantasy. In this shared dream, they are able to run their firms any way that they want to extracting as much current profitability as possible and doing as little as possible to evolve their businesses into mature enterprises. However, at the exact point that they want to retire, a strategic acquirer (perhaps a large, dumb public company, a.k.a., the slow deer ) will appear out of nowhere. The acquirer s management will be both unsophisticated and desperate to buy a wealth manager. Consequently, the buyer, ignoring (or unable to identify) that the firm s profitability is unsustainable, will offer to pay the selling owners substantial consideration with few conditions attached. The proliferation of this fantasy has been fueled by a series of urban legends of other wealth managers that were somehow able to execute the strategy. While no one has first hand knowledge of a transaction with such an outcome, invariably every owner we have met knows another owner who knows of some other owners who claim such knowledge. Unfortunately, we were unable to identify any slow deer buyers. In reality, the choices currently available to owners of wealth management firms for unlocking their companies enterprise value are relatively proscribed. They can sell their firms to either: (i) a roll-up; (ii) a small bank; (iii) the firm s successor professionals; or (iv) a larger wealth management firm. Each alternative has attractive attributes but also involves tradeoffs that create potential pitfalls for sellers. Alternative #1 Participating in a roll-up An astounding number of wealth manager roll-ups have been launched over the last five years. 5 Backed by private equity firms, these organizations target all kinds of providers of financial advice, including fee-only and feebased wealth managers, insurance agencies and brokers who are leaving wirehouses. From a basic economic perspective, roll-ups are cooperatives. Owners of wealth managers contribute their companies to a holding company in exchange for a small amount of cash and shares in the larger enterprise. 5 Although legions of new roll-up firms have been launched, only a relatively small number of them have actually consummated any transactions. 11

18 A team selected by the private equity sponsor manages the roll-up, though each underlying member firm operates largely autonomously. 6 Roll-ups are designed to provide the benefits of scale unavailable to small, individual firms The theory underpinning such cooperatives is that they should be able to provide benefits to their member firms that would be unavailable to these organizations as individual, small private businesses. In particular, sponsors pitch participation in their roll-ups as a potential opportunity for firm owners to capture robust consideration while at the same time allowing their firms to capitalize on the substantial scale of the resulting enterprise. By combining numerous wealth management firms to form a single larger entity, a roll-up could potentially access the public capital markets at a valuation that would be far greater than what the private markets would pay in the aggregate for the individual member firms. Those owners who sold their firms to the roll-up in exchange for stock in the entity should, in theory, participate in this public to private arbitrage. Additionally, the member firms also could potentially benefit from a roll-up s greater scale in several other ways. Low value-added functions could be centralized. Intellectual capital could be shared across member firms. And the roll-up s size, national presence and brand could benefit the marketing efforts of its member firms. Tradeoffs and potential pitfalls of roll-ups Like every other alternative for unlocking the enterprise value of a wealth manager, there are potential pitfalls involved in participating roll-ups. To be sure, every roll-up is different and not all of these tradeoffs are part of every such enterprise. However, participating owners should fully understand what they may have to agree to in connection with their participation. More specifically: 1. Completion risk. Most of the economic benefits from participation in a roll-up are predicated on the enterprise achieving scale that is sufficient to access the public equity markets in a timely manner (e.g., five to seven years from inception of the enterprise.) 7 Unless the firm is able to complete a public offering, the owners of member firms have effectively traded the shares of their companies for illiquid equity of indeterminate value that does not cash flow. Few, if any, wealth manager roll-ups will ever achieve sufficient scale to go public However, the bar for completing a successful public equity offering has historically been set fairly high; the holding company of the roll-up (and not the member firms individually) must own about $35 million of EBITDA. Given the relatively small size of even mid-sized wealth managers, a roll-up must complete 60 to 70 acquisitions to have sufficient scale to go public a massive number of transactions that few if any roll-ups are likely to ever consummate, much less in only five to seven years. 6 It is important to note that while member firms are generally allowed to operate autonomously, the rollup takes voting control of the firm and has the right to replace its management. 7 For reasons that we will explain further below, should the roll-up take longer than five to seven years from the launch of the roll-up to complete a public offering, the outcomes for participants in the enterprise often deteriorate quickly. 12

19 2. Altered incentives destroy value. Roll-ups often buy too much of their member firms, adversely altering the incentives for selling owners For the sponsors and management of roll-ups, the urgency to achieve sufficient scale for a public offering is paramount as it is the primary means by which they make money from their participation in the enterprise. Consequently, to more quickly achieve scale, they often acquire the preponderance of the economics of their member firms. Unfortunately, the purchase of so much of a wealth manager s ongoing profitability has an unintended side effect: it destroys the incentives for the current and successor management to continue to build the company. By taking stock in the roll-up in exchange for one s firm, a participating owner is effectively investing in all of the firms in the enterprise. Thus, should the roll-up adversely alter the incentives for the management of member firms, it simultaneously destroys the value that participating owners can capture. 3. Potential conflicts between incentives of roll-up sponsors and participants and resulting outcomes. Should a roll-up fail to achieve sufficient scale to complete a public offering, its private equity sponsor will likely lose its entire investment The inability of a roll-up to achieve scale that is sufficient to complete a public offering is also potentially disastrous for the entity s private equity sponsor. Private equity firms invest millions of dollars funding the acquisition of member firms as well as the operations of the holding company an investment that is typically leveraged substantially. Consequently, should the roll-up fail to complete a public offering in a timely manner, it is likely that the sponsor will lose its entire investment. The potential loss of capital creates a series of incentives for the sponsors of roll-ups to take steps that are not necessarily in the best interests of their member firms. For example, to achieve sufficient scale, the sponsor may lower its standards for acquiring partner firms even exceptionally poor quality firms that have been the targets of regulatory enforcement actions and substantial civil litigation may not be disqualified. The sponsors also may direct the roll-ups to agree to one-off transactions that provide unusually favorable terms to a handful of sellers, not because the targets are outstanding but rather simply to provide more immediate scale to the roll-up. Just as adversely altering the incentives of member firm management reduces the value achieved by those member firm owners who participated earlier in the enterprise, the steps taken by a roll-up s sponsor to get scale at any cost likewise diminishes the value of the roll-up equity issued to those member firms at the closing of their transactions. 4. Potential asymmetric dilution. Should a roll-up fail to achieve sufficient scale to complete a public offering in a timely manner, the enterprise may be forced to raise additional capital, often under draconian terms that severely dilute the company s existing shareholders. The private equity sponsors and roll-up management teams, however, often hold a class of equity with anti-dilution protections. Consequently, should the roll-up require additional capital, the value of the shares held by the owners of member firms could be obliterated. 13

20 5. Impact of capital structure on the allocation of the roll-up s economics. Preferences owed to a rollup s sponsor and management consume most of the economics of the enterprise Even in the case that a roll-up is able to complete a public offering, capital structure issues pose a threat to the value that the owners of their member firms will achieve for their shares in the enterprise. More specifically, the sponsors of roll-ups typically substantially leverage these entities so as to boost the returns on their capital. The sponsors and management also are often entitled to the return of their capital plus a significant return on that capital prior to any of the shares held by the owners of member firms receiving any value. Unfortunately, in such roll-ups, repayment of the debt and payment of the capital preferences may consume the vast preponderance of the economic value achieved through a successful public offering. Consequently, although the roll-up may have significant enterprise value, very little of it is captured by the owners of member firms. 6. Unequal restrictions on the sale of stock. A second potential pitfall that could await those owners of wealth managers who participate in roll-ups that are able to successfully complete a public offering is tied to the restrictions on the sale of stock. More specifically, the shares held by the owners of member firms are often restricted for several years following the IPO and, in the interim, can only be sold in small amounts through company-wide secondary stock offerings. However, the shares held by the roll-up s sponsor and management are often not subject to the same restrictions. Consequently, these two groups will often begin to unload their shares prior to the end of the restricted period on the shares held by the owners of member firms, leaving them in the unfortunate position of being the last man out. Steps for avoiding the potential pitfalls of selling to a roll-up For many firms, participating in a roll-up may be the only alternative available for unlocking enterprise value. However, by taking the following four steps they can mitigate or avoid the pitfalls described above: Owners should demand complete disclosure from a roll-up both prior to participating and on an ongoing basis 1. Demand complete transparency. As noted earlier, participating in a roll-up in exchange for equity in its holding company is economically analogous to investing in every firm that participates in the enterprise. Additionally, at closing, selling owners forfeit voting control of their firms. Any competent wealth manager would carefully investigate investing only a portion of their clients assets in a private company. However, for many owners, the shares that they receive from participating in a roll-up constitute a substantial portion of their personal net worth. Thus, before entering into such a transaction, an owner must fully understand all of the economics and governance of the entity as well as the financial condition of all of the other participating wealth managers. Achieving this level of understanding requires that the roll-up provide the seller with complete transparency and full i.e., financial, legal, etc. 14

21 disclosure prior to the transaction. The owners should also conduct detailed due diligence on each of the other participating firms as they will effectively be investors in each if they elect to participate in the venture. Finally, the selling owners must have a contractual right to access all of the books and records of the roll-up on an ongoing basis and be regularly provided with complete and accurate financial statements for the enterprise. 2. Insist on protections from the roll-up deciding to lower its standards for acquisitions. No roll-up will provide its participants with a blanket veto over its subsequent acquisitions. However, because the value achieved by the owners of firms that participate earlier in the enterprise is directly affected by the quality of subsequent acquisitions, it is reasonable that they receive some minimal protections concerning the quality of subsequent acquisitions. Selling owners must be protected against sub-standard acquisitions and be able to repurchase their firms More specifically, participants with a fee-only model (and thus, potentially having enterprise value) should insist that the roll-up agree not to acquire fee-based firms (which have only de minimis enterprise value). Selling owners also should insist that all future acquisitions meet a threshold test for size and profitability. Finally, the roll-up should be barred from acquiring firms that do not have a clean compliance history; firms that have been the subject of material regulatory enforcement actions or substantial civil litigation should be disqualified. 3. Include in the transaction a prenuptial agreement. As noted earlier, if a roll-up fails to achieve sufficient scale to complete a successful public equity offering, the owners of the participating wealth managers who received equity in the roll-up holding company are unlikely to be able to extract any value. Consequently, they should demand that they have an option to repurchase their companies (using a pre-determined valuation formula) should the roll-up fail to complete a public offering by a specific date. 4. Stock held by a roll-up s management and its sponsor should be subject to same restrictions on sale as that held by owners of participating firms. Finally, should the roll-up succeed in completing a public offering, it is unfair (and economically irrational) that the owners of participating firms be restricted from selling their shares while the sponsor and/or the roll-up s management are not similarly constrained. Thus, as a condition of their participation, the selling owners should require contractual protections that all of the shares held by the three groups (member firm owners, roll-up sponsor and its management) be subject to identical restrictions on their sale. Alternative #2 Selling to a small bank Prior to the recent financial correction, small banks regularly acquired wealth managers, in particular fee-only firms. The stable, recurring fees of fee-only firms provide some diversification to bank revenues dominated by spread lending. 15

22 Wealth managers can take advantage of a bank s infrastructure Although very few small bank acquisitions of wealth managers have been consummated in the last year, we expect to see many more in the future. However, because banks typically acquire additional lines of business whenever their equity is trading at a premium (measured in terms of a multiple of EBITDA) to its historical levels, we may be waiting for a few years. Many owners of wealth managers viewed selling to a small bank as an attractive opportunity for several reasons. First, banks, as public companies, possess the ability to pay potentially substantial consideration for a wealth manager. Banks also have the potential to generate wealth management client referrals from their other lines of business. Finally, the selling wealth manager can take advantage of the acquirer s existing infrastructure (office space, information technology, HR department, etc.) both reducing its operating costs and its required level of ongoing reinvestment. Bank-wealth manager transactions in which the selling owners were paid in cash typically have been structured so that most of the consideration is deferred and paid through an earn-out. The selling owners received a payment at closing and a subsequent payment three to five years later. The size of the post-closing payment was formulaic and tied to the performance of the wealth manager during the earn-out period. In many bank acquisitions of wealth managers, however, the selling owners were paid with the bank s stock. Although the sellers typically received most of the consideration upfront, they were restricted from selling the stock for two to four years. Tradeoffs and potential pitfalls of selling to a small bank Many owners of wealth managers will find that selling to a small bank will offer the best opportunity for unlocking the enterprise value in their firms. However, bank transactions have their own set of potential tradeoffs; again, not every transaction has all of these but we have identified six features of prior transactions that have the potential to be problematic: Most bank-wealth manager cash transactions were self-funding and the buyer took little risk 1. Substantial portion of consideration paid to owners must be allocated to successor professionals. A key tradeoff in every bank acquisition that we researched in which the selling owners were paid cash consideration is that the acquirer conditioned the transaction on a substantial portion (25% to 33%) of the aggregate consideration being paid to the successor professionals. Typically a large portion of the earn-out payment would be set aside to fund future retention bonuses for the successors. 2. Cash transactions can be designed so as to be self-funding and to shift the preponderance of risk to the seller. Many bank acquisitions over the last decade in which the selling owners were paid cash consideration were structured so that the deal was largely self-funding and, thus, the acquiring bank took little risk. More specifically, the bank acquired 100% of the wealth manager s equity at closing in exchange for a payment at closing and a subsequent earn-out payment 16