As individual wealth in the U.S. began to proliferate during the latter half of the 20th century, so too did the need for objective and comprehensive wealth management services. This ultimately led to the emergence of an independent wealth management industry, whose founders’ interests were closely aligned with the interests of their clients, and whose advice was unconflicted by product sales. Forty years later, there are 15,000 independently owned firms that make up the fastest growing segment of the financial services industry.
Today, many founders of the independent RIA industry have reached retirement age and face choices about how best to transition their businesses. This has created a multi-dimensional “succession planning puzzle” for our industry, as founders must piece together such issues as maintaining excellent client service, ensuring the business is in capable hands and planning for their own successful retirement. Among the key questions confronting RIA founders are:
How do owners capture the value of their organization without compromising the very core values that created it in the first place?
How do these businesses maintain the alignment of interests, independence and objectivity that is core to their value proposition through the transition?
As owners wrestle with these fundamental questions, they must consider five key criteria of the succession puzzle: client alignment and employee alignment, selling price, management succession and seller risk/diversification.
Just as wealth managers advise clients to set goals and keep them firmly in view, the same is true for our own transition planning. Succession is not something you figure out at the end of the journey; it is never too early to have a plan as it is an essential part of client service.
Alignment of Client and Employee Interests
Given that the alignment of interests of wealth managers and their clients is the foundation of the RIA industry, any succession plan must take this factor into account. A viable succession plan must maintain the alignment of interests between the owners of a business and those that benefit from the activities of the business, or the clients. In the RIA industry today, client alignment occurs on several levels. Those who own the business also work in the business, so the success of the business and the satisfaction of its employees are closely aligned. Those who own the business also are responsible for delivering the service, so the decision makers are essentially the same people who are serving the clients. The largest asset on the balance sheet of the RIA owner is typically the stock in the RIA, and the client’s largest asset on their balance sheet is typically the asset managed by the RIA, so their success is tied together in a meaningful way.
Client alignment, however, is not the only factor to consider in maintaining the values of an RIA firm. It is also critical to align the interests between owners of the business and those who work in the business--the employees. Employee alignment occurs on several levels. Those key advisor-employees who work in the business to serve clients are typically the owners of the business and benefit from their efforts in the form of ownership. Those advisors who are developing and learning the trade have future opportunities for advancement and equity participation. Importantly, the more concentrated the employee ownership, the less alignment exists.
With the above issues in mind, let us examine four different potential pathways for succession, and some key advantages and challenges of each:
- Sale to a Financial Buyer
- Sale to a Strategic Buyer
- Internal Succession
- Institutionalized Internal Succession
It is also important to point out that there are two primary components to succession: succession of ownership, and succession of management. While management succession is certainly deserving of a separate discussion, we are primarily focused here on the issue of ownership succession.
Sale to Financial Buyer
A financial buyer is typically a pure investor that is primarily interested in cash flow and price appreciation. These include public companies, private equity firms and permanent capital investors.
Typical Structure
- Most always cash transactions
- Investment horizon of ~7 years
- Typically majority interest, fewer minority
- Focus and management incentives shifted to financial success of business
Advantages
- Maximizes price
- Reduces risk for seller
- Can aid with management succession
Challenges
- Client alignment: owner agenda not as clearly aligned with clients
- Employee alignment: opportunity for future equity participation diminished
Sale to Strategic Buyer
A strategic buyer is typically an organization primarily interested in the strategic benefits of acquiring the business for gained synergies in the areas of enhanced profits, service support, cross sale opportunities, accelerated growth, etc. This can be a bank, trust company, or another RIA (typically owned by a financial buyer). These tend to be larger competitors that see benefits to combining firms.
Typical Structure
- Mostly cash, but some stock transactions
- Long term investment
- Typically 100% purchase
- Focus and management incentives shifted to financial success of business and capturing synergies
Advantages
- Maximizes price
- Reduces risk for seller
- Can aid with management succession
Challenges
- Client alignment: owner agenda not as clearly aligned with clients
- Employee alignment: opportunity for future equity participation diminished
Small Firm Internal Sale
A small firm internal sale (AUM under $5 billion) involves the sale of stock to existing employees. This is the most typical way smaller RIA firms are transitioned in the industry.
Typical Structure
- Sale limited to employees only
- Structures are idiosyncratic (non-standardized, specific to the individual business)
- Mixture of some or all of cash, notes, earn-outs and compensation
- Stock is sold piecemeal and over a long period of time
- Lower buy in price point is part of compensation and retention
- Long term investment
- Focus is typically on continued service and core values of the organization
Advantages
- Client alignment: independent ownership and objectivity maintained
- Employee Alignment: employee retains equity upside and client alignment
Challenges
- Price can be as low as one-third the level of a sale to financial or strategic buyer
- Typically increases risk for seller: Takes longer and typically involves a note
- Management succession not always easy, especially for smaller firms
Large Firm Institutionalized Internal Sale
This path typically involves the merger of your organization into a larger organization that has “institutionalized” or engineered an internal succession model. Essentially, this is simply an extension of the Small Firm Internal Sale only you are transitioning your clients and people into a larger firm before exiting the business. In the institutionalized version the organization is large enough (AUM over $5 billion) to move away from an idiosyncratic succession and toward a formal engineered succession model, hire professional management, establish sophisticated governance, and work toward optimizing all five criteria of the succession puzzle: client alignment and employee alignment, price, management succession and risk/diversification. These organizations are harder to find.
Typical Structure
- First, a non-taxable merger of firms (transition smaller firm into larger firm)
- Later, the shareholder/founder’s retirement triggers sale
- Employee-owners have rights to buy
- Purchase for cash
- Institutionalized bank financing established
- Long-term investment by each employee
- Stock is sold consistently, retiring generation after generation of advisors and talent
Advantages
- Client alignment: firm continues to be owned 100% by employees, and as such, independent ownership and objectivity remains with owner-agenda remaining aligned with clients.
- Employee alignment: 100% employee-ownership directly aligns the interests of decision-makers (owners) with that of clients, allows those who are responsible for delivering service to benefit from their efforts as owners, and provides future opportunities for advancement and equity participation of developing advisors.
- Provides a multi-generational solution to multi-generational families
- Price optimized: price is optimized relative to seller values, client and employee alignment
- Risk for seller manageable (relative to values, client and employee alignment)
- Management succession
Challenges
- Complexity: two-step process of merging, successfully transitioning business to new organization, then retiring, adds complexity to the transaction.
Final Thoughts
Each potential pathway above is a reasonable approach to succession, and it would be tough to argue that one is the “right” path over all others as there are examples of success for each one in our industry. The challenge is figuring out which one appropriately addresses all the key considerations (price, client well-being, employee well-being, service, etc.) you are trying to “optimize.”
Owners who are attempting to solve the succession planning puzzle may wish to consider the following advice:
- Having a solid succession plan starts by figuring out what you want and committing to it. Sellers should decide what their objectives are and prioritize them before beginning to meet with potential suitors.
- Having clarity around your ultimate exit strategy, whatever it is, will help you manage your business more effectively today.
- Succession is important, but not urgent, which means it is easy to put it off. But, it is also complicated, takes time, and is an important part of taking care of your clients and employees, so prioritize it as such today.
Interestingly, the decisions that owners make with respect to their pathway to succession will not only determine the future of their own firms, but also will likely shape the next chapter of an industry that in many ways is still in its infancy.
Rob Francais is Chief Executive Officer of Aspiriant. For information, visit www.aspiriant.com.