As one of the more active acquirors in the investment management industry, Focus Financial Partners (Focus) has a broad perspective into the state of the RIA industry and M&A activity. In the article below, we summarize five key takeaways for RIAs based on Focus’ recent Q2 earnings release.

1. Deal Activity Remains Near Record Levels

While deal activity declined for the second consecutive quarter in Q2, the pace of deals remains elevated relative to historical levels despite the macro backdrop (see RIA M&A Update). According to data from Echelon Partners, the total deal count in the first half of the year increased 39.2% relative to the first half of 2021. For its part, Focus closed or announced 14 transactions through August 4, 2022, a slight decrease from 17 transactions during the same period in 2021. Focus CEO Rudy Adolf pointed to succession planning, aging founders, and the need for scale as enduring factors that have helped sustain deal activity even in a down market.

2. Rising Rates Beginning to Impact Some Acquirors

Focus (along with many other aggregators) uses floating rate debt to finance acquisitions, leaving them exposed to higher borrowing costs as rates rise. All of Focus’ ~$2.5 billion in borrowings are tied to either LIBOR or SOFR at spreads ranging from 175 to 250 bps (although Focus has effectively fixed $850 million of its borrowings via hedges at 262 bps). Focus’ net leverage ratio was 3.90x at June 30 (relative to a target range of 3.5x-4.5x), and it’s Q2 interest expense was $19.9 million. The earnings deck includes a sensitivity analysis that indicates that Focus’ pre-tax interest expense would increase by $11.9 million if LIBOR/SOFR were 300 basis points higher.

On an after-tax basis, such an increase works out to about $0.11 per share (Focus’ adjusted net income per share was $0.99 in Q2). Focus’ management doesn’t consider its exposure to increased borrowing costs to be significant relative to the firm’s approximate $2.0 billion in annualized revenue. However, many of the PE-backed aggregators in the industry reportedly run at higher leverage ratios than Focus and have higher borrowing costs, which could lead to financial strain as rates increase and financial performance of the underlying firms takes a hit.

3. Deal Competition Stabilizing

The proliferation of PE-backed aggregators and the professionalization of the buyer market have led to a significant increase in competition for deals in recent years, but that may be normalizing in the current market. Focus’ CEO Rudy Adolf described competition for deals in Q2 as stabilizing relative to the intensely competitive environment seen last year and indicated that there has perhaps been a softening in multiples and that some of the more aggressive buyers during the flurry of deal activity last year may have slowed down the pace of acquisitions given rising borrowing costs and declining fundamentals of prior acquisitions.

4. Margins Are Under Pressure

We wrote earlier this year about the two-front assault on RIA margins (see Hot Inflation and Cold Markets: RIAs Hit With a New Storm Front). Not surprisingly, the Focus earnings call confirms that many of its partner firms have been impacted by declining revenues and rising operating costs, and margins have been squeezed as a result. As firms experience the negative effects of operating leverage, they’re faced with the dilemma of whether to cut costs to preserve margins or maintain expenses in order to take advantage of the upside once the macro environment improves. On the earnings call, Focus’ CEO Rudy Adolf indicated that they’re not pressuring partner firms to cut expenses—at least yet—so that they’ll have the necessary resources to take advantage of the eventual upswing.

5. Contingent Consideration Taking a Hit

Earnouts are frequently implemented in RIA transactions in order to bridge the difference between buyer and seller expectations. It’s not uncommon to see a significant portion of total deal proceeds paid after closing and contingent on future performance, and the deals put together by Focus are no exception. When part of the consideration is contingent, the acquiror records a liability equal to the fair value of the contingent consideration payments, and that liability is later remeasured as the fair value changes over the life of the earnout (see Purchase Price Allocations for Asset and Wealth Manager Transactions). In theory, an increase in the fair value of contingent consideration liabilities is a positive for the acquiror since it means that the acquisition target is performing well and more likely to meet its earnout hurdles. From an accounting perspective, however, the reverse is true: increases in the fair value of contingent consideration liabilities are reported as operating expenses, whereas decreases are reported as deductions to operating expenses.

Echoing the “bad news is good news” macro environment, write-downs of contingent consideration have boosted the earnings of several acquirers, including Focus this year (see Bear Markets Cost RIA Sellers, But Boost Buyers). In the second quarter, Focus reported a decrease in the fair value of contingent consideration of $42.8 million, which in turn boosted earnings by the same amount. This non-cash write down accounted for nearly 90% of Focus’ $49.3 million in GAAP net income for the second quarter.

Also noteworthy is that the total cash that Focus paid for contingent consideration declined from $57.0 million during the six months ending June 30, 2021, to $21.4 million for the same period in 2022. While the timing of earnout payments is subject to the specific terms of each deal, we find it interesting that the cash earnout payments of a firm that’s consistently grown via acquisitions declined by more than half year-over-year. For RIA sellers, the significant decrease in cash paid for contingent consideration along with write downs of contingent consideration reported by Focus (and other acquirors) serve as a stark reminder that headline deal multiples aren’t always what they seem, particularly in down markets.