We’re always perplexed by the lack of transactions in the RIA industry. Sure, there are some out there, but a typical year reports less than a hundred deals in a space with almost 12,000 federally registered advisors. This means that less than 1% of industry participants transact in a given year. How could that be in an aging profession with a highly scalable business model? We offer a few explanations in this week’s post.
1. Most RIAs are not big enough to be consistently profitable
According to the Investment Adviser Association, the “typical” SEC-Registered Investment Adviser has $317 million in AUM, between 26 and 100 accounts, nine employees, and is headquartered in New York, California, Florida, Illinois, or Texas. It’s hard to envision that a business of this size would generate enough revenue to cover overhead and professional staff expenses (likely in an expensive market) and yield much profitability, particularly during a market downturn, especially if you consider that many believe $500 million in AUM to be the breakeven point for many asset managers to generate consistent levels of profitability (depending on size, headcount, location, client type, etc.). If valuation is based on earnings, then the average RIA may not have much to sell.
2. Many asset managers don’t have sustainable enterprise value beyond their owner(s)
A lot of RIA principals have not taken the necessary steps to transition their client relationships, investing acumen, business development capabilities, and/or managerial responsibilities to other staff or the next generation of firm leadership. To a prospective buyer, this means there is significant risk that the RIA’s accounts and firm viability will not outlive its owners. This is part of the reason why so many asset manager transactions are structured as earn-outs – to protect the buyer against future declines in fees or earnings associated with a principal’s departure or reduced activity levels in the business after the deal.
3. Asset managers are (currently) expensive
Despite what you’ve been reading about industry headwinds (fee pressure, competition from passive products, etc.), most RIAs are more valuable than ever. Since the market is trading at an all-time high, many asset managers’ AUM balances are as well, which means higher fees, earnings, and valuations. Such a high price tag makes them less appealing to prospective buyers looking to maximize ROI.
4. Many RIAs have distinct cultures that don’t necessarily jive with prospective buyers
This is probably the case with many industries but seems especially true for asset managers. The business and its reputation have come a long way from the Wolf of Wall Street broker culture of the late 80s and early 90s. Still, these businesses tend to have unique attributes and identities that aren’t necessarily conducive to firms in different (or even the same) industries. Banks, for example, have recently taken an interest in the business for its high margins and low capital requirements. In our experience, though, bank and RIA cultures often don’t mesh; this can be an unforeseen hurdle in a deal that may make a lot of sense on paper.
5. Asset managers value independence and often prefer to transition the business internally
Most RIAs are employee-owned, and that’s by design. To keep the company’s culture and investment/client relations teams intact, many principals looking to exit the business will often look to the next generation of firm leadership as prospective buyers for their interest. They do this to avoid outside influence and appease institutional investors who often seek independent RIAs wholly controlled by the firm’s principals. Buy-sell or shareholders’ agreements that allow younger principals to buy in at a discount to fair market value are not uncommon for asset managers looking to encourage employee ownership and remain independent.
Conclusion
On balance, though, we think the outlook for asset manager M&A is promising. The industry is still fragmented and ripe for further consolidation. An aging ownership base is another impetus, and the recent market gains might induce prospective sellers to finally pull the trigger. Fee compression could also lead to more transactions if RIAs look to create synergies and cost efficiencies to maintain their profit margin. We haven’t come across much of this yet but are seeing more clients and prospects ask about succession planning and exit strategies. Perhaps this is a sign of more to come, which isn’t saying a whole lot.
