We are now in the 11th straight year of a record economic expansion cycle that began in the ashes of the Great Recession. While registered investment advisor firms have benefited from rising fees derived from growing equity markets, there are two questions that increasingly emerge among RIA owners:
How much longer can the good times roll? And if we enter a recession in the near future, won’t that depress the lofty valuations—based on multiples of asset management fees—that selling RIAs have enjoyed in recent years?
Look Beyond AUM Fees
Many high-visibility economists are starting to predict a recessionary cycle could be around the corner. And conventional wisdom holds that such a recession would diminish RIA fees on assets under management and, thereby, weigh down RIA valuations in the event of a sale.
This makes sense, at least in theory. Yet the rumors of the pending demise of RIA valuations—even in the event of a near-term economic recession—are greatly exaggerated.
RIA firms can’t stop a prolonged or deep market downturn from happening, but there are factors beyond AUM fees that make RIAs attractive targets for acquisition—recurring cash flows and growing investor interest in receiving more holistic financial advice, to name two. Regardless of whether markets are in a peak or valley, RIAs remain a fundamentally strong model.
Creative Transaction Structures
Moreover, there are a few distinct approaches that sellers can take in a down market to maximize the multiples they ultimately get for their RIA firms. It may mean stretching out transactions to better mitigate risk for buyers, but in the end the headline valuation is what matters. The reason: Any M&A deal will have contingency conditions that chip away at the total outlay that the buyer makes to the seller for a business, but the valuation that both parties agree on when the transaction is finalized generally sets the ceiling for what the seller can possibly get. The higher that ceiling is, the better off the seller is.
Here are three specific ways for RIA owners to structure sale transactions to maintain high valuations, even in a recession:
- Staged transition of stakes: Sellers and buyers can structure transactions so that a minority stake in the RIA is sold initially, when markets are down, with additional stakes transferred in subsequent, scheduled tranches. This approach allows more time for the value of the firm to recover as markets rebound, thus justifying higher upfront valuations. The caveat, of course, is that it should be timed to coincide with a market upswing.
- Longer earnout periods: Once all agreed-upon equity has been transferred, there typically is an earnout period that helps mitigate financial risk for the buyer. Though it behooves the seller to have shorter earnout times—one or two years rather than four or five—one way he can assuage the concerns of the buyer is to stretch out the time period over which the earnout occurs. As with the staged transition of stakes, this approach allows more time for markets to recover and can potentially help to justify a higher upfront valuation.
- Structure the earnout to align with performance benchmarks: By structuring the earnout by some combination of time and performance metrics—asset growth, cash flow or profits, for example—sellers can offer buyers a valuable concession to insulate against down markets while still achieving a high valuation.
In the end, each deal is unique because every buyer and seller is unique in terms of what either party prioritizes most in the deal and what they are willing to accept to get the best possible version of it.
Some sellers may look at the approaches above and think they would never make such concessions in a million years. This attitude fits well in an environment in which it seems as though equity markets will never fall. But when they do—as they inevitably will someday—RIA sellers should be willing to be creative with deals to ensure they can still get top-dollar valuations for their firms.
Larry Roth is founder and managing partner of RLR Strategic Partners (www.rlrstrategicpartners.com), an affiliate of Berkshire Global Advisors, the international investment bank. He is the former CEO of Advisor Group and Cetera Financial Group.