With a constant stream of headlines about M&A and near-daily inquiries from prospective acquirers, it’s easy for RIA owners to get the impression that external transactions are the norm.  Indeed, they have become far more common in recent years, and the depth and breadth of external acquirer models is greater than ever.  But the deluge of M&A hype belies the fact that external transactions are still relatively rare: Fidelity’s wealth management M&A report listed about 230 transactions in 2023, relative to a universe of about 15,000 RIAs—a number that continues to trend up.  For every RIA you hear about that sold to an external acquirer, there’s a far greater number of RIAs that haven’t sold.

Internal transactions don’t generate headlines, and prospective buyers (next-gen management) likely aren’t beating your door down to close a deal. While they may be less conspicuous, internal transactions are a viable avenue for succession planning and one that many RIAs accomplish successfully.

Internal Transactions Can Be an Attractive Option

RIAs are owner-operator businesses and, as such, are well suited to internal transactions.  Many RIA owners prefer working for themselves, and their clients prefer working with an independent advisor.  Internal transitions allow RIAs to maintain independence over the long term and provide clients with a sense of continuity and comfort that their advisor’s interests are economically aligned.  They also afford an opportunity to hand-pick successors and transition ownership at an intentional pace.

Internal transitions allow RIAs to maintain independence over the long term

Contrast that with an external transaction.  When you sell to an external acquiror, you introduce a new party to your firm’s operations.  You can try to diligence cultural alignment before the deal closes, but it’s hard to prove it exists until you’re actually working with the new party.  And then there’s the uncertainty related to how external transactions are structured.  More often than not, a sale to an external acquirer involves taking consideration in the form of earnouts and rollover equity.

When you sell your RIA and take rollover equity, you’re trading a controlling interest position in your firm for a non-controlling interest in the acquiring firm.  The influence that you have over the future performance and ultimate exit of the acquirer is likely less relative to the influence you have now.  In other words, you’re along for the ride.  That may be a good thing if the acquirer you’ve sold to continues to grow and ultimately reaches some sort of favorable exit.  But you’re making a big bet on the acquirer, and there are a number of risks that are introduced.  For example, there could be future dilution.  The business model you thought you bought into might change.  Or there might be multiple changes of control at the acquirer.

Internal Transactions Take Planning

Internal transactions avoid many of these uncertainties, but they require an intentional focus over a long time horizon to execute effectively.  While it’s likely that an external transaction can be accomplished in a matter of months, successfully executing an internal transition plan requires advanced planning over years or even decades.

For internal transactions to be feasible, it’s necessary to develop and retain the right staff internally to take over the management of the business and its clients over time.  Compensation structures are a critical element of this, allowing you the tools to incentivize and retain talent that you develop internally.  Firms that cannot retain the right people and develop staff internally often develop a “barbell” of staff experience—where constant turnover in the lower ranks of an organization and an aging partner base results in a widening gulf between experience levels in the organization.  The absence of a strong “middle” of the barbell is a common obstacle to the internal transition of management and client service responsibilities and firm ownership.

Getting compensation structure right is helpful not just for retaining staff but also for supporting an internal market

Getting compensation structure right is helpful not just for retaining staff but also for supporting an internal market that will facilitate a gradual transfer of ownership from the founding partners to next-generation management.  For such a market to function effectively, it’s helpful to delineate between “returns to labor” and “returns to capital,” such that it’s clear what the prospective buyer is acquiring and what the current ownership is giving up, as they become less involved in the day to day management of the business.

Another common hurdle to internal transactions relates to negotiating valuation and transaction terms with next-gen management—a process further complicated by the industry’s M&A boom.  Internal transactions don’t occur in a vacuum, and the same factors driving consolidation and M&A activity have influenced valuations in internal transactions.   Given the rapid changes in RIA valuations, it’s increasingly important for RIA owners to understand the current market dynamics even if they’re not contemplating an external sale.

Rising valuations have created challenges for internal transactions, as buyers (next-gen management) often lack the ability to purchase a substantial portion of the business outright. With proper structuring, however, internal transactions are still feasible, and buyer capacity is not the gating issue it once was, given the growing number of external capital providers who will finance internal transactions.

Is all that time and effort worth it?  Building a firm with an eye to transition internally isn’t the quick liquidity event of an external transaction, but it’s often the best strategy for building long-term value.  A gradual transition of responsibilities and ownership to the next generation creates incentives and an alignment of interests for employees, which supports the growth of the firm to everyone’s benefit.

It’s worth noting here that building a firm capable of transitioning internally doesn’t preclude a future external transaction or hybrid option like a minority transaction.  Most actions required to create a firm with the prerequisites to transition internally make good business sense anyway.  The elements you need to have in place to affect an internal transition—next-gen leadership in place and incentivized, a compensation model that works, client relationships that are “owned” by the firm and not a particular advisor—those are all things that enhance value in the eyes of a prospective acquirer.  Building your firm in such a way gives you options and leverage, regardless of the ultimate exit strategy.

About Mercer Capital

We are a valuation firm that is organized according to industry specialization.  Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.