In the 1970s, Ferdinand Porsche surmised that his eponymous sports car company had developed its iconic model, the 911, as far as it could go.  Buyers seemed to want a more powerful and refined car, and a new incarnation of their rear-engine, rear-wheel drive products wouldn’t fit that bill.

To get there, they introduced the 928, the company’s first grand touring layout, first V-8 engine, and first water-cooled radiator.  The 928 received great reviews, starred in “Risky Business” (alongside Rebecca De Mornay), out-tracked the 911, and was a complete flop in the showroom.

Porsche wanted the 928 to replace the 911 as its premier offering, but the newcomer never outsold the classic.  In 1995, after 61 thousand units over 18 years, Porsche threw in the towel on the 928.  But that’s not the end of the story.

ZIRP Models in a Post-ZIRP World

The much-ballyhooed consolidation trend in the RIA space is in a state of transition.  Public buyers like Focus and CI Financial are mostly sidelined by internal issues, and the private equity community has nearly exhausted the supply of cheap financing.  This seems like a good time to take a step back from the consolidation models that have led the effort over the past five years or so and consider what we can learn from their successes and failures.

The current circumstance is borne from the unique combination of zero interest rates and a bull market.  In a post-ZIRP market, normalization is painful.

Going Public to Access Cheaper Capital

I’ll admit to being blindsided by CI Financial’s announcement that their U.S. wealth management operation sold $1 billion in convertible preferred securities to a Bain-led consortium just to reduce parent company leverage ratios.  Most industry followers are well acquainted with the manner in which CI grew its RIA holdings rapidly in a couple of years by outbidding the competition.  Then the bill came due.

CI’s acquisition binge left it overleveraged, and—with a 14.5% PIK—the cure may prove worse than the disease.  Replacing high single-digit debt with double-digit equity creep is no solution.  CI hopes to complete an IPO within the foreseeable future to redeem the convertible preferred before the PIK owns the whole company, leaving the parent with nothing more than some residual debt.

Price borrows the money, but value services the debt

How did this happen?  CI reset the market for RIA pricing and then paid it.  Price is what you pay, but value is what you get.  On leveraged transactions, price borrows the money, but value services the debt.  I know many private credit managers still feel good about their RIA acquisition loans because market valuations haven’t fully adjusted to the rate environment.  That feeling may not be durable.

Is an IPO credible? It’s been a long time since the IPO window was open for mature, cash-flowing industries with high single-digit growth rates like RIAs.

I’m old enough to remember when the crowning moment for a successful private company was an initial public offering.  Good times.  The dot-com bust, Enron, WorldCom, Sarbanes Oxley, and many other regulatory and market factors conspired to make it more difficult and less rewarding to be a public company.  In twenty years, the number of listed companies in the U.S. was cut in half, and the private equity industry grew by more than ten-fold.

Going Private to Access Cheaper Capital

While CI is looking to public markets for cheaper capital, Focus Financial is going private—partly because management feels public markets undervalue them.

There are many comparisons and contrasts to be drawn between CI and Focus.  Focus used its first-mover advantage to cast a broad net (every RIA I know met with them—some multiple times) and maintain discipline in acquisition pricing, while CI burst onto the scene and played catchup by offering big multiples.  Focus didn’t pay dividends or have a share buyback program; CI had both.  Focus didn’t buy the management rights to affiliate RIAs and didn’t try to create an integrated brand.  CI pursued full integration.  CI mainly went after large wealth management franchises.  Focus would do big deals, but mostly did lots of small ones. Focus’s CEO, Rudy Adolf, complained openly about CI’s aggressive practices. CI’s CEO, Kurt MacAlpine, remained circumspect.

In the end, though, both CI and Focus took advantage of cheap debt financing and occasionally cooperative equity pricing to garner market share in the wealth management space pursuant to the same premise: that industry consolidation was as profitable as it was inevitable.

The inevitable is always certain, it is not always punctual

Unfortunately, while the inevitable is always certain, it is not always punctual.  Just as CI’s model didn’t age well, Focus seems to have run out of momentum.  Their last and final earnings call was brief and peculiar—packing disappointing results and pride in their accomplishments into a few minutes and then taking no questions from the analyst community.

Focus’s new owners at Clayton, Dubilier, & Rice have to at least be considering trying to restructure the management agreements.  As a quick refresher, Focus doesn’t own RIAs; it owns a preference claim to a portion (usually about half) of earnings before partner compensation.  As part of the Focus transactions, a management company is set up, and the leadership of the partner firm retains control.

Rudy Adolf frequently cites his father as the inspiration for this unique organizational framework.  His dad was an accountant who consolidated firms but was careful to “never turn an entrepreneur into an employee.” Adolf made a similar vow.

Maybe the analogy was a false premise for Focus.  Accounting is a rules-based discipline where you recruit a bunch of smart twenty-somethings, give half of them a copy of GAAP, the other half a copy of the tax code, and tell them to go count.  Wealth management is a dynamic trade involving principles like prudence and fiduciary duty, and it’s fueled by personality.  If you don’t believe me, think about how you know the first names of the two men who branded one of the largest money managers in the U.S., Franklin Templeton.  Now tell me the first name of the founder of the largest accounting firm in the world, Deloitte.  See my point?

Entanglement is not a substitute for structure.  In accounting, firm structure comes from the regulatory structure underlying the practice.  In money management, it takes ownership and leadership to bind a firm together.  If CD&R can get control of the management companies at the Focus affiliates, they have a shot at creating a sustainable enterprise that pays off for them.  It negates one of the founding precepts of Focus, but I can’t see it any other way.

Markets Make Opinions

A tempting indictment of this post is that it’s easy to look backward and see the faults in popular RIA consolidation models.  Maybe so, but a wonderful thing about financial markets is that we seem to always be stepping on the same rake.  Looking back is a way to look forward.

Beware of diseconomies of scale dressed up as critical mass

The primary justification for consolidation is economies of scale.  If scale is a panacea, why is Franklin Resources such a basket case?  Franklin just agreed to buy Putnam Investments for about a third of what it sold for just a few years ago, and markets yawned, with BEN basically tracking the S&P.  The Legg Mason acquisition didn’t fare any better, and one wonders if simply smashing together ailing firms is a reasonable strategy for success. We’ll probably see that attempted with a couple of private RIA consolidators before the end of 2024.  Beware of diseconomies of scale dressed up as critical mass.

Then there’s Alvarium Tiedemann, which is much more interesting to me than it has been, so far, to public markets (disclaimer: I don’t invest long or short in any of these names. I’m just an analyst who reads things and notices stuff).  AlTi went public through a SPAC, so maybe the stock is still working through the market’s general distaste for SPACs. It’s also possible that AlTi will never garner much notice and will end up going private in a few years.  Public markets haven’t figured out what to do with the RIA space—there doesn’t seem to be much of an investor constituency.

The AlTi experience may also be signaling that markets are tired of the rollup narrative. I’ve heard as much from family offices.  Both Focus and CI experienced market enthusiasm that AlTi has failed to generate.  I don’t think it’s character, just timing.  All narratives, including consolidation, are sometimes true—but it’s usually reflected in the price.

Declaring Victory

The big exception to all this underperformance is Victory Capital.  Victory has a lot supposedly going against it.  It has only made a few very large, strategic acquisitions rather than spreading bets over a multitude of opportunities.  It is a mixture of wealth and asset management, and supposedly investors like pure plays.  Victory may be the most under-reported investment management firm in the space.

Price-to-press-release isn’t the best valuation metric for RIAs

Victory’s success proves that price-to-press-release isn’t the best valuation metric for RIAs, after all.  Victory trades at three times its IPO price from five years ago, easily besting Focus, CI, and AlTi.  And Victory even pays a dividend.  It appears the Victory story may be more about execution than acquisition, but I’ll save that for a later blog post.

All Models Are Wrong, Some Are Useful

In 1976, a British statistician named George Box penned the famous line, “All models are wrong, some are useful.” His point was that we should focus more on whether something can be applied to everyday life in a useful manner rather than debating endlessly if an answer is correct in all cases.

Porsche’s iconic rear-engine layout wasn’t capable of every mission, so Porsche tried a GT layout in the 928—for 18 years.  The 928 wasn’t successful in and of itself, but it got Porsche’s customer base accustomed to seeing the automaker as capable of something other than the 911.  This set Porsche up for success with other formats, like SUVs and sedans, which now outsell their 911 model (in its eighth generation).

In the post-ZIRP environment, many RIA models are hitting a wall of market resistance, opening up space for new ideas.  Some of those ideas will look a lot like the same wine in more presentable bottles—some will genuinely be new.