Whether or not the road tests and sales figures confirm it, the new Corvette is already a success.  It’s only been two weeks since the car debuted, and I can’t remember another new model launch that generated as much conversation.  Last Thursday I had complete strangers asking me what I thought about it on the elevator ride up to the office in the morning and down that afternoon.  One told me he had already put down a deposit.

Unlike previous iterations, the eighth generation Corvette sports a mid-engine configuration, and if you squint it looks like a Ferrari 488.  The Stingray is no Prancing Horse, however.  With a 6.2 liter normally-aspirated (no turbo) V-8 generating 495 hp, GM is eschewing the high compression engines favored by European manufacturers (the Ferrari produces more than twice as many horsepower per liter).  Corvette faithful will appreciate the old-school iron under the hood, if they can accept the “hood” being behind them, an automatic transmission, and a dizzying number of character lines in the bodywork.

Focus Got People Talking, and Moving

It’s been a year since the Focus Financial IPO generated a similar level of conversation in the RIA community – and the transaction dominos have been falling ever since.  In that same year, Victory Capital pulled off a major acquisition, Affiliated Managers Group got back into the acquisition game following a two-year hiatus, United Capital was acquired by Goldman Sachs, and Mercer Advisors is soliciting bids.

I was thinking about all of this on a road trip across the southeast last week, in-between blasting Tom Petty on satellite radio and dropping in on a few clients.  At one of my first stops, a client asked if I saw a lot of M&A activity in the RIA space.  Yes, I replied, but I see even more headlines about it.  Plenty has changed in the RIA community in the last twelve months, but even more has not.

The Focus IPO was a Watershed Moment

The Focus management team is to be congratulated for surviving their first year as a listed company.  Serving private equity masters is no walk in the park, but public company life means enduring the unexplained ups and downs of daily trading activity, the tedium of analyst calls, and half-informed commentary from armchair quarterbacks such as myself.  It must weigh on Rudy Adolf and his colleagues, but they made it this far.  Their share price has been volatile but mostly resilient, and the analyst calls are becoming routine.  The question is: now what?

The Voting Machine and the Weighing Machine

Benjamin Graham developed the metaphor for the stock market acting, in the short run, like a voting machine (a popularity contest) and in the long run, like a weighing machine (based on sustainable profitability).  It’s a useful way to look at Focus, as well as the overall RIA consolidation movement.  Headline activity attracts capital and acquisition opportunities, and headlines begat headlines as others rush to join a crowded trade.  At least for now.  Eventually, all of these consolidators will have to demonstrate they can do something productive with their acquired businesses, and that’s when the robustness, or lack thereof, of the different rollup models will show.

Benjamin Graham developed the metaphor for the stock market acting, in the short run, like a voting machine and in the long run, like a weighing machine.

The IPO gave Focus an edge in vying for attention among RIA sellers.  As a quick reminder, Focus Financial is not an RIA.  It is a leveraged investment enterprise that accumulates preferred stakes in RIAs, encouraging their growth with best-practices coaching and sub-acquisition financing.  It is not unlike the European Union: financial bonds without much consolidated governance.  Nevertheless, Focus is viewed as a bellwether for acquisition behavior in the RIA community, and rightfully so.

United Capital and Mercer Advisors are more typical consolidation models: national platforms with cohesive branding, marketing, management structure, compliance, and investment products.  Focus’s de-consolidated model probably guarantees independence.  Goldman Sachs, which recently acquired United Capital, could never have fit Focus into their framework.

Now that Mercer Advisors has put a for-sale sign in the yard, it will be interesting to see who wants their franchise.  One would expect Goldman to consider the possibility of rolling Mercer into their United Capital unit, which could be awkward because Goldman is running the book, but it could happen anyway.  Goldman also led the Focus IPO, and anyone who doubts David Solomon’s commitment to building an investment management franchise hasn’t been paying attention.  My contacts within the Goldman partner network say 1) Solomon is committed to transforming Goldman Sachs and 2) they are impressed with what he’s doing – a powerful endorsement from a tough audience.

For Now, It’s a Land Grab

In the near term, Focus will be judged as an acquisition model, which is much more difficult than it sounds.  Acquisition activity is difficult to sustain.   Focus announced eight transactions in the second quarter.  Skimming the ADVs of the acquired entities, these eight firms came with just under $10 billion in AUM and 83 employees.  That’s not insubstantial, although nearly half of that workforce and 70% of that AUM came from one deal.  The other seven transactions averaged about $400 million in AUM and six employees.

When you’re the size of Focus Financial ($100+ billion in partner firm AUM and thousands of partner firm employees), it’s tough to move the needle with small deals.  Focus claims thousands of potential acquisition targets, but a realistic assessment is far fewer.  Their model won’t appeal to every would-be seller, and firms that work much outside of the advice and planning space won’t suit Focus.

As Focus grows, the pressure will build to do larger transactions.  The rise of competing acquisition platforms will drive up the competition and the multiples, and limit the opportunities for arbitraging the cost of capital.  Deals will still be accretive in the future, but less so than in the past.  All of the consolidators will face this.

How Will Things Look in Ten Years?

In the longer term, Focus will be judged as an operating model.  Since Focus allows their partner firms to run independently, they have limited opportunities to widen margins with scale.  Monitoring marketing and compliance activities may become more labor-intensive.  Seeing hundreds of firms through succession issues could prove daunting.  Ultimately, the parent organization will have to justify its considerable overhead by helping partner firms grow faster (organically) or become more profitable (than they would be independently) – otherwise the whole will be worth less than the sum of its parts.

As for the more integrated consolidation models, the future of Goldman Sachs’s mass-affluent wealth management practice would be easier to forecast if Joe Duran’s acquisition chief, Matt Brinker, had stayed.  Brinker left on the eve of the Goldman deal closing, perhaps to avoid a non-compete.  While he hasn’t said so, it’s hard not to imagine Brinker resurfacing in a similar role elsewhere.  With Brinker out, will Goldman try to grow this platform organically, or draw on other internal resources to hunt for acquisitions?  We’ll know more when Mercer Advisors announces their acquirer.  If Mercer flips to another PE firm, we’ll see more of the same from them.  Word is strategic acquirers are looking at the deal.  In any event, RIA sellers will have several acquisition models from which to choose.

Who’s Paying for All of This?

The equity multiples being bandied about for RIA consolidators are dizzying.  We know Focus went public at a high-teens multiple of adjusted EBITDA.  Similar multiples were rumored (and remain unconfirmed) for the Goldman/United transaction, and many have suggested the ask for Mercer Advisors is just as high.  RIAs cannot sustain those valuations, so either the pricing is overstated, the pro forma adjustments are substantial, the expected growth is steep, or these really are the end times.

One of the earliest lessons I learned in finance was that labor-intensive businesses don’t handle debt well because all they can really mortgage is future compensation.

We can only speculate about much of this.  However, much of this activity is financed with borrowed capital rather than equity, and because leverage is more formulaic, the behavior surrounding it is more transparent.  To that end, we’re puzzled about Focus’s debt burden.  In their Q1 2019 filings, Focus reported term debt of almost $800 million and another $290 million on their revolver.  Management reported that this represented a bit less than 4.0x a defined measure of cash flow.  Focus recently announced consolidating $300 million of revolver debt under the term loan, and then quietly filed an 8-K on Friday that upped that amount to $350 million.

Term debt is generally more expensive, but freeing up the acquisition line offers flexibility.  With a $650 million revolver in place, Focus could expand their indebtedness considerably – in sharp contrast to what we’re accustomed to seeing.

Most RIAs have unremarkable balance sheets.  One of the earliest lessons I learned in finance was that labor-intensive businesses (such as professional service firms) don’t handle debt well because all they can really mortgage is future compensation.  When leverage ratios get stretched and operating conditions dim, the analyst community becomes agitated.  Until then, with a sympathetic Federal Reserve on tap and a land-grab strategy to execute, it’s going to be tempting for Focus management to lever up.  We expect to hear more about this during the earnings call next week.

As For Everyone Else

At one-quarter the price of a new Ferrari, the new Corvette will attract a lot of buyers for Chevrolet.  GM would probably be satisfied with a lot of lookers.  The Corvette is what is known as a “halo-car,” designed to showcase what the automaker can do and get people into the showrooms to look at all of their models (less than 5% of Chevy sales in 2018 were Corvettes).  Attention drives activity.

I haven’t touched on Hightower or Victory or Captrust or Fiduciary Network or any of the other consolidation platforms.  And I haven’t talked about the PE platforms like Kudu Investment Management that are making headway in the RIA space.  It’s been an active year since the Focus IPO, and the domino effect that comes from transactions completed at seller-friendly pricing and terms sends ripples throughout the industry.  Whether you plan to jump into the fray in the foreseeable future or not, the marketplace around your firm is caught up in it, and it affects you.