The outlook for RIA M&A has changed rapidly since 2020 began. Coming off of a record year, DeVoe postulated in January that “RIA M&A could hit over 40 transactions per quarter in 2020” saying that “the pace of deals was a testament to the health of the industry.” Until late February, DeVoe’s estimation seemed feasible as industry experts contemplated what the Franklin/Legg Mason deal and Morgan Stanley’s purchase of E-Trade meant for the industry, and we wrote about Creative Planning’s sale of a minority interest to PE firm General Atlantic.
Today, however, as many of us work from makeshift home-offices, RIA principals have shifted their focus from strategic planning including M&A to ensuring their workforce is safe and healthy, their client service is unwavering, and their firm still exists on the other side of this bear market.
In this post, we look back at RIA transactions that occurred in Q1 2020 and venture what M&A will look like over the rest of the year.
Review of M&A in Q1 2020
According to Fidelity Investments, there were thirteen deals between wealth managers in January totaling $18.9 billion in client assets. The largest of these deals by AUM was Fiduciary Trust Company’s acquisition of Athena Capital, which has $5.8 billion of AUM. This deal pales in comparison to Fiduciary Trust Company’s parent, Franklin Templeton’s, acquisition of Legg Mason (LM), with $1.5 trillion in AUM, for approximately $4.5 billion. These two deals highlight the differing motivations driving transactions in the RIA space.
Partnering with those who already have relationships in a target market is often a faster growth strategy.
Fiduciary Trust Company’s acquisition of Athena allowed the company to strengthen its foothold in New England where it already has about $2 billion in client assets. Many RIAs seeking to grow geographically have turned to acquisitions rather than growing organically. Since wealth management is a relationship-driven business, partnering with those who already have relationships in a target market is often a faster growth strategy than building these relationships in new markets on your own. Additionally, Fiduciary Trust Company’s acquisition expanded its product offerings for high net worth and ultra-high net worth clients.
The Franklin/LM deal highlights one of the biggest drivers of M&A in the investment management space: achieving scale. There is significant operating leverage in the asset management business, and the Franklin/LM combination created a $1.5 trillion money manager poised to take advantage of this. While management of both companies asserted that there would be no personnel changes after the deal was finalized, back office synergies will likely lead to cost savings that will increase returns to investors.
Additionally, in the first quarter of 2020, we continued to see deals driven by RIA consolidators such as Focus Financial and Beacon Pointe who are able to provide scale through back office integration and a solution for ownership succession planning.
Outlook for RIA M&A
By the end of the first quarter, the tone of discussions in the industry had changed. As of March 31, 2020, the S&P 500 had fallen by 20% since the beginning of the year, and publicly traded RIAs suffered their worst quarter since the financial crisis. The outlook for RIAs depends on a number of factors, but the one commonality is that RIAs are all impacted by the market. The decline in the market, and in turn, in RIAs’ revenue has led industry commentators to ponder the likely impact on deal volume and valuations.
Pace of M&A Activity
After thirteen wealth manager deals were announced in January, activity slowed with seven deals in February and three deals in March 2020. Although deals become riskier in volatile and bear markets, they don’t happen overnight. The deals that closed in March were likely being negotiated in November and December of 2019. Given the lag between deal negotiations and the signing/closing of a transaction, it’s likely that the decline in deal volume from January to March doesn’t fully reflect the new market reality.
While we do not expect deals that are in the final stages of negotiations to be canceled, we do expect there to be a slowdown in new deal activity in 2020 as firm principals, RIA consolidators, and outside investors try to conserve capital and project the length of the downturn and the associated impact on RIA revenues and profit.
While financial markets are currently suffering, markets are not down because of blemishes within our financial systems.
Historically, recessions have corresponded with lower deal volume. According to McKinsey, “Since 1980, U.S. recessions have led to steep declines in the value of global M&A activity—typically, of around 50 percent during the first year.” We saw this in 2008 as deal activity slowed at the start of the last recession. However, it is important to recognize the limitations of comparing the current market downturn to the last recession, which was caused in part by excess leverage and a lack of regulation in the financial industry. Credit markets essentially collapsed and funding for M&A was suddenly much harder to come by. While financial markets are currently suffering, markets are not down because of blemishes within our financial systems.
Deal activity in the RIA industry during this market downturn could be propped up by recent expansion of available capital in the space. M&A volume has increased in recent years as RIAs have gained more access to capital, both equity and debt. It is still too early to know if access to capital will decline. A recent article by Financial Planning predicts that PE money will not dry up. Rather, Echelon founder Dan Sievert believes, PE funding is “going to save the industry.” He predicts PE investors will continue to invest in RIAs and “[S]woop up any companies that are falling on hard times.”
There may still be some difficulty finding financing for very large transactions. In 2008, not a single “mega-deal” (value of over $10 billion) was announced. Understanding that “mega-deals” within the RIA space may be defined slightly differently, we still expect there to be a slowdown in larger deals, of which we saw many over the last twelve months. Further, consolidators may reduce the size of their typical transaction as financing for these smaller deals is easier to come by, and a multitude of smaller deals instead of singular larger deals can serve as a means to diversify risk in this volatile operating environment.
You Name the Price, I’ll Name the Terms
While deal multiples may not fall, we do expect deal structures to change.
The RIA Deal Room, published by Advisor Growth Strategies before the COVID-19 pandemic, recently asked if “valuations [were] rising due to better financial results, expanded multiples, or both?” They found that “the data suggest that valuations increased for 90% of RIA firms due to sustained financial performance. […] From 2015 – 2018, the median adjusted EBITDA multiple was 5.1, and there was less than 10% positive or negative variation in the yearly median results.”
We don’t expect multiples to decline drastically, instead we expect that deals will be structured to more evenly distribute risk between the buyer and the seller through the use of earnouts.
A decline in announced deal value in 2020 will likely come as a result of a decline in performance driven by an overall decline in the market, rather than a decline in deal multiples. As Matt Crow explained in a recent podcast, we don’t expect multiples to decline drastically. Instead, we expect that deals will be structured to more evenly distribute risk between the buyer and the seller through the use of earnouts.
More than 70% of RIA transactions in 2019 were structured with some form of an earnout and, on average, sellers paid 30% of total deal proceeds as an earnout. Of those deals structured with an earnout, the payments were typically made over three years or less. Given the new uncertain operating environment for RIAs, we expect that more deals will involve some form of contingent consideration and less of the deal consideration will be paid at closing.
Additionally, given the current volatility, we expect there will be an increase in the number of deals structured as stock deals. In a volatile operating environment, it can be easier to close a stock deal since the price (value of the shares) essentially moves as the market does.
In summary, we expect that deal volume will slow over the next few months, but as Think Advisor recently noted, this slowdown is not necessarily bad news for the industry. During the slowdown “RIAs should take the opportunity to consider how M&A efforts perpetuate the broader objectives of an advisory firm.”
Although we expect activity to slow, M&A activity will not come to a grinding halt. Owners of RIAs who find themselves near retirement and without a succession plan will still consider selling their firm. Additionally, the need for operating leverage that is achievable through scale becomes more pronounced in bear markets.
The less leveraged RIA consolidators are uniquely positioned to partner with RIAs in bear markets as they are able to offer more operating leverage through back-office infrastructure. Additionally, as these consolidators are often PE-backed, they should still be able to find funding in a bear market.