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Fundamentals Remain Supportive of an Active RIA M&A Market

Four key trends help explain the increased M&A activity in the RIA space over the past few years and will continue to propel deal-making moving forward.

The wealth management industry continues to evolve in lockstep with new client expectations and demands. Increased client demand for impartial and independent investment advice has led to a proliferation of RIAs across the United States. The RIA channel continues to grow faster than any other wealth management segment, as firms of all sizes saw strong organic growth over the past five years.

Through the first three months of the year, 23 M&A deals closed, representing just under $30 billion in client assets, a 35% increase over 2019 Q1 AUM totals. The majority of these deals, however, were completed in January and February, with only three closing in March due to the COVID-19 pandemic.

Although the outbreak of COVID-19 slowed deal-making in recent months, fundamentals remain supportive of an active market coming out of the crisis. Four key trends help explain the increased M&A activity in the RIA space over the last few years and will continue to propel deal-making moving forward.

1. An Influx of External Capital

Today, few RIAs execute growth strategies by relying solely on existing cash flow. Instead, firms are drawing on available capital from three main sources: lenders, passive investors and private equity firms. Each source of capital provides unique trade-offs around autonomy, business support and growth rate. An RIA’s size, desire for autonomy and strategic growth goals will help determine the right partner and subsequent deal terms.

On one end of the spectrum, debt financing allows firms to retain their autonomy and expand their businesses, as creditors generally do not take any active ownership in the company. Passive investors fall in the middle of the autonomy spectrum, with different types skewing toward being less active and more active in the underlying business. On the active end, private equity firms participate in large-scale deals with aggressive growth targets, typically taking seats on portfolio companies’ boards to effectively steer decision-making.

2. Increased Operating Costs

The RIA channel is the fastest-growing segment of the wealth management industry, with roughly 1,500 firms entering the space yearly. The industry currently comprises over 14,000 firms managing nearly $5 trillion in client assets. RIAs account for 25% of wealth management AUM, a number expected to grow to 30% by 2023.

Increased competition is putting additional pressure on advisors to provide clients with more robust service offerings for the same or lower fees. As a result, smaller firms are struggling, as many cannot afford table stakes technology, top-end advisor talent, innovative marketing campaigns, growing compliance overhead and increasing staff. Moreover, many advisors prefer to spend their time servicing clients, rather than dealing with the operational complexities of running a business.

Smaller firms are folding into larger firms, which can handle the industry’s growing technological, operational and regulatory requirements. The increased scale large firms obtain through the acquisition of smaller RIAs helps to offset rising overhead and increase firmwide productivity.

3. Succession Challenge

Roughly 44% of financial advisors in the U.S. are over the age of 55. As many advisors draw closer to retirement, they must figure out viable exit strategies for their businesses.

Succession planning is a unique value-add that buyers can offer sellers looking to wind down their careers. According to a recent Fidelity survey, 43% of sellers identified a lack of a viable succession plan as a key driver for seeking out M&A.

Both buyers and sellers have a strong incentive to ensure a smooth and seamless transition of the business. Client retention is of utmost importance to buyers, while knowing their clients are in good hands is critical to sellers. The design and execution of a well-thought-out succession plan are paramount to achieving these goals.

4. Highly Fragmented Market With Top Heavy Segment

While the RIA channel has experienced high levels of M&A over the past few years, the industry remains highly fragmented, with a few large firms controlling the lion’s share of industry assets. According to a recent report from Cerulli, 87% of RIAs manage less than $250 million in client assets, accounting for only 14.4% of total AUM market share.

While smaller shops account for the majority of firms operating in the RIA space, a small contingent of firms manages the majority of industry AUM. Firms managing above $1 billion in client assets represent 3.6% of the RIA segment but account for 64.4% of AUM market share. What’s more, 63 firms, representing 0.5% of the total market, manage 34% of all industry assets.

Larger, growth-oriented firms will look to build scale through the acquisition of smaller firms executing succession plans, experiencing growth challenges, needing stronger technology and those looking to offload the operational burden of running a stand-alone firm.

What to Expect Moving Forward

While 2020 may not be a record-breaking year, the M&A market should remain active. Firms with equity capital at their disposal are in a position to be active buyers in the market. On the other hand, firms relying on debt to finance deals will likely have more trouble deal-making, as creditors, such as banks, have less of an appetite to finance speculative deals in the current environment.

Most firms, especially those with revenue tied to the market, will experience margin compression, as revenues fall while client servicing volume increases. As a result, firms, particularly those with weak balance sheets, may be more inclined to sell, as the current environment could prove too difficult to navigate alone.

In an effort to de-risk acquisitions, buyers are likely to insist that up-front cash payout percentages decrease, with more of the payouts being allocated along a performance-based runway. Not only will this structure protect the buyer from another market downturn, but it will benefit the seller, as he or she will be able to participate in the market recovery, which will likely translate to a higher valuation.

Moreover, advisor revelations triggered by the crisis may increase the number of sellers in the market, once valuations recover. Thousands of advisors starting firms during the recent bull market will likely reassess the costs and benefits of running a stand-alone business, as many have now dealt with their first recession as a business owner. The increase in client servicing demands, coupled with the technical and operational burdens of running a firm remotely, will likely bring more advisors to the M&A market.

Nicholas Bamberger is a consultant at Capco.

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