A Match Made in Equity

A 20-year rep, Chmielewski had plodded along as an affiliate of Royal Alliance Associates. He knew he could do better and, at 43, was looking for a way to build up his practice, maximize its value and eventually sell it to fund his retirement. United Capital offered a deal that appealed to Chmielewski. It would buy his practice (paying 30 percent in cash and 70 percent in United Capital stock in return

A 20-year rep, Chmielewski had plodded along as an affiliate of Royal Alliance Associates. He knew he could do better and, at 43, was looking for a way to build up his practice, maximize its value and eventually sell it to fund his retirement.

United Capital offered a deal that appealed to Chmielewski. It would buy his practice (paying 30 percent in cash and 70 percent in United Capital stock in return for a set percentage of the practice's cash flow and a requirement that the revenues hit certain growth targets). United also agreed to guide Chmielewski through the difficult transition from commission-based rep to fee-based registered investment advisor — a switch that he had been trying to make on his own, but without much success. He also wanted to ensure his practice would survive even if he were no longer in charge. “It's hard for firms like mine that are smaller with five or six employees, and where I'm the main person. If I'm not here, does firm stop operating?” he says. United Capital says this deal structure is pretty standard: It will not pay more than 30 percent in cash for any of the practices it buys, but reps can decide to take the balance of the purchase price in any combination of United stock or five-year notes.

An Old Idea Comes of Age

While the idea of rolling up individual financial-advisory practices is not new — a wave of roll-ups hit the industry more than a decade ago — this time, companies like United Capital are popping up to take advantage of some converging trends. Reps are looking for a setup that will give them immediate benefits as well as a clear exit strategy. Equally important is the quest by private equity investors to find acquisitions that will provide strong, predictable and potentially expanding cash flows.

This wave of private equity-backed roll-ups began in 1999, when Leon Black's Apollo Management pumped $125 million into National Financial Partners, a start-up launched by Jessica Bibliowicz. According to data compiled by Schwab Institutional Strategic Client Group, private equity-backed holding companies acquired 22 percent of the RIAs that were sold in 2006 — double the number acquired in 2005. That includes the 10 practices snapped up by United Capital, which is capitalized with a $20 million investment from Grail Partners, a Boston-based private equity firm. David DeVoe, director of mergers and acquisitions at Schwab Institutional, predicts more of the same for this year. “Private equity-backed holding companies are well positioned to accelerate their momentum in 2007,” he says.

Although financial-advisory practices don't have hard assets, they are an attractive target for private equity funds because of their cash flow and consolidation potential. “Financial advisors are generally profitable and there are lots of them,” notes Eric Fitzwater, an analyst for SNL Financial. “The financial-advisory sector is very fragmented, so there may be opportunities to consolidate the industry while effectively maintaining the client relationships.”

Some 20 roll-up firms are now competing to acquire financial-advisory practices. According to a recent Moss Adams study, 35 percent of the RIA firms with more than $5 million in revenue have already been acquired. The latest entry into the roll-up field is Global Wealth Management Partners, a new outfit in Purchase, N.Y., founded by former Charles Schwab CEO David Pottruck and Alan Weber, his former No. 2. The pair has nailed down private equity backing and is expected to start making acquisitions this spring. A spokesman says they are not yet ready to discuss their strategy, however.

Last year, Rudy Adolf, a former American Express executive and partner at McKinsey & Co., launched Focus Financial Partners with $35 million in backing from Summit Partners, a private equity/venture capital firm that has backed companies such as office-supply retail chain Staples and Chicago-based optionsXpress, an online brokerage firm. Focus has acquired six RIAs so far and has about $4.5 billion in assets under management. Focus plans on acquiring 30 to 40 practices in the next five years. Unlike United Capital, Focus does not help reps rehab their practices — it's looking for well-established RIA groups with at least $500 million in assets, says Adolf.

Another roll-up outfit is WealthTrust in Nashville, Tenn., which has been in the business since the late 1990s. In November, it was spun out of Morgan Keegan after the Memphis-based regional brokerage decided that the unit did not fit its long-term strategy, according to WealthTrust CEO Rusty Benton.

Benton met with 36 different private equity players, including Summit Partners. In the end, Morgan Keegan sold WealthTrust to Circle Peak Capital, and the firm is now on its way to increase its current $6.5 billion assets under management to about $20 billion in the next four to five years.

The current wave of roll-ups may do better than the 30 companies that sprang up to consolidate the advisory business in the late 1990s, says Mark Tibergien, partner at the Seattle-based consulting firm Moss Adams. Most of those outfits failed because of a flawed business model. They offered reps low multiples, 1 to 1.5 times revenue. The big payoff was supposed to come from the IPO of the holding companies, which never occurred.

This time the holding companies are more aggressive in their pursuit of potential acquisitions thanks to private equity dollars. “The offers are not getting stale like they used to,” which made people question the deal, Tibergien says. And, he adds, they have another factor in their favor: The target reps have aged at least five years — the median age for a financial advisor is 51. Creating a smooth plan to retirement motivates more advisors to consider selling out to a roll-up firm.

Rules of the Roll-Up

Tibergien advised Chmielewski on the merits of his buyout deal. He says the deals are great for “growth-minded firms who are trying to take some chips off the table but still feel they can build value and income.” It's not a good idea for people who cherish independence. Nor is a roll-up the way to go if you are looking to sell and retire immediately. Typically, the deals depend on several years of growth to make the numbers work for the buyers. “Unless you think you can grow at 20 percent, it's probably not that great of a deal,” Tibergien says.

If a business is able to generate that kind of growth, why do they need to join a roll-up? Well, for one thing, a sale provides a rep with an exit strategy when he's ready to retire. Mark Feldman, CEO of Phoenix-based Inlign Wealth Management, an RIA with $1.6 billion in AUM, says he turned down overtures from Focus Financial Partners because he doesn't need a parent company to keep his two-year-old RIA practice on a rapid growth path. “We are new and not mature enough to be looking for an exit,” he says.

For owners who are ready to sell, holding companies typically pay a multiple of EBOC (earnings before owner's compensation). The multiple is usually 3 to 5 times EBOC. (See table.) The rep decides how much current cash flow he wants to retain and how much he wants to build up in deferred compensation in the form of equity in the holding company. The EBOC multiple depends on the nature of the practice. Buyers pay more for practices that have a proven and predictable pattern of annual fees. United Capital says it considers the quality of an advisor's clients (age, their investable assets, etc.) as well but to a lesser degree. The terms can also include growth incentives that give the seller agreed upon percentages of new business.

Duran, CEO of United Capital, says that the typical purchase deal gives the seller one-third in cash, stock and notes. Chmielewski says that his multiple was lower than most because his practice was still 75 percent commission-based. He declines to provide details about his buyout, but says he tried to maximize the amount of United Capital stock in the deal.

Duran says the financial details are easy to iron out once United Capital determines that the practice is a good fit. “There's a cultural assessment involved to make sure we both have common values,” he says. If the business is heavily commission-based, like Chmielewski's, the seller must be motivated to change his business model. United Capital will identify shortcomings of the acquired firm and subsequently make adjustments that help increase revenue. At the very least, new partners will see changes in hiring practices, technology and payroll. And independents must also be prepared to surrender some autonomy. For every prospective deal, United Capital sends Matt Brinker, vice president of acquisitions, and Todd Pack, senior vice president of operations, to the firm to generate a report about client segmentation, culture and economics. A team of two certified financial advisors and two certified financial accountants, who review the practice and outline a business plan to improve performance, assess the report. At this point, many reps balk because they “think they have it right,” Duran says.

United Capital requires the makeover because its business plan relies on boosting annual revenues of acquired practices by 30 percent to 40 percent. Mostly this is accomplished through the transition to a fee-based business model and training the owners to provide fee-for-service planning advice. “We will not do an acquisition of a firm if we don't think we can improve it,” Duran says.

The newly acquired firm becomes a division of United Capital but retains its individual identity — that means no name change. The holding company provides administrative, accounting, compliance support, as well as practice-management consulting and training in financial and estate planning and investment management. The practices are also encouraged to look for other practices to acquire to build their businesses. United Capital provides all the financing for such “tuck-in” deals. This option appeals to sellers like Chmielewski, who says he always wanted to expand through acquisition but didn't have the time or capital to make it happen.

That ambition made Chmielewski an ideal candidate for United. He knew he could do better and even knew how — by providing more financial-planning services. The problem was that even as he advised clients on financial-planning issues, he continued to rely on commissions for most of his compensation. In effect, he was giving the planning away and getting nothing in return.

Since joining United Capital, Chmielewski's Port Richey, Fla.-based practice has done a near 180 — his business has gone from 25 percent fee-based/75 percent commission-based to a 68/32 split. United Capital provided two weeks of training at Chmielewski's seven-person office. One of the major shifts was to transform the approach from “personality-based” to “process-based,” he says.

The team was trained to create scenarios and model portfolios for clients using Monte Carlo simulations. As he began to use the new discipline with clients, Chmielewski learned that they had more assets with other advisors than he had suspected. The new comprehensive-planning approach, he says, helped him grab some of those assets. Since joining United Capital in September 2005, Chmielewski has gained $20 million in assets from existing clients, bringing his total assets to $135 million.

Ultimately, Chmielewski's payoff will come when United Capital has its “liquidity event” — as all private equity investors demand. (And there's also his piece of mind about retirement, which he says will be something to appreciate down the line.) Duran says the company would like to have a public share offering when it has at least one subsidiary in every state and at least $10 billion in assets under management.

Focus Financial is planning on acquiring 30 to 50 more practices in the next three to five years. Then, it too expects to float an IPO.

Apollo Partners, which backed National Financial Partners with $125 million in 1999 made out handsomely. It took NFP public in 2003 and raised $239 million through the offering. In its first day of trading, NFP stock closed at $26.25, up 14 percent. Apollo, which still has a 10 percent stake, has seen NFP shares more than double since the IPO.

Elliot Holtz, executive vice president of marketing and operations at NFP expects the consolidation trend to continue due to the industry's fragmented nature and because “it's hard for product manufacturers to reach independent firms.” Bringing the firms together, he says, adds value to their practices.

NFP's successful transition to a publicly held company has, Tibergien says, encouraged other private equity firms to back financial-advisory roll-ups. “Everyone has the NFP model to look at,” he notes. “People say, ‘Maybe it's possible’.”

Tibergien says its possible that at least one of these private equity-backed roll-ups will evolve into a national advisory firm. “At this point, there's not anyone who has enough momentum or that has tried to persuade their firms to develop a national brand. But it might just be a natural evolution,” he says.

An Offer You Can't Refuse?

Here is how one acquisition of a firm with $1.5 million in earnings before owner's compensation could play out. The example assumes the holding company will acquire 50 percent of the advisor's ongoing profit but 100 percent of the equity.

Earnings capitalized (EBOC) $1.5 million
EBOC multiple 5x
Valuation of the Firm $7.5 million
50% earnings capitalized $3.750 million
Cash (50%) $1.875 million
Consolidator stock (50%) $1.875 million
Possible additional payments for growth $0.75 million to $2.25 million
Guaranteed (cash) $1.875 (1 × revenue)
Best case scenario $13.125 (5 × revenue)
Source: Moss Adams/Pershing

WE GOT YOUR BACK

Holding companies are making a come back after a flawed model forced them out of the market in the late 1990s. Now, new players have emerged and this time they're relying on private equity firms to help keep them in the game.

Holding Company AUM (billions) Private Equity Firm Capital Invested (millions)
Focus Financial Partners
New York
$4.5 Summit Partners
Boston
$35
United Capital Financial Advisers
Newport Beach, Calif.
$1.2 Grail Partners
Boston
$15
WealthTrust
Nashville, Tenn.
$6.5 Circle Peak Capital
New York
$75
Source: Company reports
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