While readily working with standard private equity firms focused on growth capital, we made the decision over a year ago to not work with those private investment firms that rely on high levels of debt on the part of portfolio companies to goose returns—namely, leveraged buyout private equity fund managers.
In anticipation of difficult markets, we focused on lower debt-to-net capital ratios, while avoiding broker/dealers whose ratios started to push to four times or higher. Similar issues arise with leveraged buyout funds.
Debt-to-equity ratios of LBO-backed firms can run up to two times higher than that of a similar publicly traded firm. The motive behind leveraged buyout investments, of course, is that higher levels of debt can promote a better equity return than a less indebted business. But private equity is notorious for having the openness of a closed society, much like the Amish. One of the few ways to get any information on what is going on in the LBO-backed firms is through the ratings agencies, like Moody’s, which track their financials and rate their non-investment-grade bond holdings for investors.
It's not particularly timely information. For three of the largest independent broker/dealers tied to LBO private equity, including The Advisor Group, Cetera and Kestra, the only recent Moody’s report available is from Aug. 4, and it focuses on The Advisor Group. There are reports on Cetera and Kestra that date back to 2021.
The Moody’s report for Advisor Group had encouraging news, with an upgrade on its outlook for the firm’s senior secured notes from “stable” to “positive.” Advisor Group had a debt-to-EBITDA ratio of 10.5 times as of Dec. 31, 2020, brought down to seven times as of August, with Moody’s anticipating the leverage ratio falling to 6.5 to 7 times EBITDA by the end of 2022. A major factor helping all broker/dealers, including those backed by LBO funds, is higher interest rates, which boost money market returns from cash sweep accounts.
In the 2021 book, The Myth of Private Equity, author Jeffrey C. Hooke goes into detail on the history and inner workings of private equity. Hooke, a former private equity executive and investment banker, and currently a senior lecturer in finance at Johns Hopkins Carey Business School, says that, historically, private equity has avoided cyclical industries like financial services.
When I asked him about the expansion into the broker/dealer space, Hooke said “Broker/dealers tend to be more cyclical than most industries, so it is not the optimal candidate for LBO PE. IBD representatives can walk out the door anytime. However, since the PE industry has bought most available firms that fit the low-tech, low-cyclical profitable categories, the PE funds are now branching out to less obvious candidates.” He concluded, “As long as the lenders play ball, what is to stop them?”
I asked Hooke what he saw as the risks to the leveraged private equity investments in the IBD industry if there was an equity market downturn of some 40% to 50%. “In market declines, the AUM falls, thus lowering the b/d income. Lower income and high debt raise the possibility of bankruptcy. If the broker/dealer is in the business of taking on lots of stock or bond inventory, which most do not, market declines present additional risks. In the worst-case situation of bankruptcy, most of the big LBO PE funds have 10 to 15 LBOs in the portfolio, with a diverse mix of industries. If one goes bankrupt, like a broker/dealer, so what, they have 14 others to rely on. Statistically, about 25% to 30% of LBO PE deals default on their loans,” he said.
In his book, Hooke writes: “The best a fund can hope for are marginal improvements to boost earnings and add-on acquisitions to push revenue growth. The basic math shows the LBO cannot spend much on renovating a portfolio company’s operations.”
As we have seen in the IBD channel, LBO private equity has been aggressive, with cutting costs through consolidation, closing back offices and reducing staff, while at the same time spending above the industry average on acquisitions of broker/dealers, and issuing generous forgivable notes to entice advisors to join.
Spending less on those already with the firm but more to get new assets in the door works in the short term but can cause broker/dealers to struggle in the longer term and experience low retention of advisors, given a lack of costly technology improvements and lackluster service from marginal staffing levels—all exasperating factors to advisors.
LBO private equity firms aspire to add assets and control costs as much as possible until they gain enough revenue growth to sell or take the company public. With the potential of a protracted recession on the horizon, will these LBO private equity managers hold on to their investments longer than they usually do?
“Most PE firms have a six- to seven-year hold time, and the final liquidation, when all is sold, often stretches out to 12 to 14 years,” Hook said. “The PE funds need to get permission to go past 10 years and the investors usually rubber-stamp extensions. I can see that hold time for financial services PE deals lengthening, particularly if a recession hits and the financial firms’ earnings drop, making them harder to sell to another buyer.”
With The Advisor Group and Cetera making overtures of selling equity to the public, ultimately the markets will dictate the timing. LPL had originally desired to go public around 2008 but needed to defer to 2010 due to the market upheaval following the global financial crisis. An extended bear market could equally delay the intensions of larger LBO-backed firms’ timing or, depending on the skills of the managers, possibly derail those plans altogether.
Jon Henschen is the founder of the recruiting firm Henschen & Associates. Since 1999, Henschen & Associates has focused on recruiting financial advisors to independent broker/dealers and RIAs throughout the United States.