TRANSITION TALK

Impact of Consolidation

Posted by David Grau Sr., JD on May 8, 2019 1:09:44 PM

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There has been a fair amount of talk over the past decades about consolidation in the financial services industry. Most of the white papers and articles addressing this concept have presented it in a negative light as though it signals the end of the lifestyle practices that dot the landscape in this profession. Industry regulation, growth, technology, fee compression, competition, and aging advisors forced smaller practices to consolidate just to survive. At least that was the working theory.

As the original organizers of the open marketplace for independent advisors seeking to sell or to acquire, we have a slightly different perspective on consolidation; we view it in a very positive light. Consolidation looks very different than what the prognosticators laid out decades ago. From our vantage point of working with businesses below $2 billion in AUM, we’ve observed the industry is indeed experiencing some consolidation, but not only due to acquisitions or roll-ups by companies like Focus Financial, United Capital, or Dynasty. The consolidation that we see every day is owners of stronger, sustainable enterprises acquiring smaller, one-generational books and practices.

Viewed in this light, how better to look after 250 clients or households when a single-owner advisory practice nears retirement than to find a very similarly structured business that can step in, take over, and provide for the staff members as well? This process works for the buyers, the sellers, and, most importantly, the clients.

As the financial advisory profession matures, practice owners have been compelled to grow and improve—a very natural part of facing competition head on. But eventually, time and energy begin to wane. As retirement, or even simply slowing down, begins to appear on the horizon for single-owner books and practices, advisors are faced with three choices:

  • Maintain the practice as long as possible while gradually working fewer hours and thereby winding it down;
  • Invest the time, money, and resources to grow and strengthen the business and transition to an internal successor team; or
  • Sell to or merge with a third party.

Many advisors tell us that they don’t want to sell to a third party—ever. The problem is that these same advisors haven’t built a sustainable enterprise of their own, which leaves them with few options, including attrition. Letting a practice wind down slowly as the founding advisor retires on the job, stops taking on new clients, and stops serving the small ones is an attractive option for many advisors, as it preserves the cash flow and practice for an additional five to perhaps ten years. If there is a health event during that time frame, the business is not particularly salable since the owner has been scaling back. In time, there is nothing left to sell. Building a sustainable business, however, is the best option if the founding owner starts soon enough (at least ten years prior to retirement) and has the energy and acumen to turn his or her one-generational book or practice into an enterprise.

In our work, we see some very natural divisions in the construction and ownership of independent financial professionals—divisions that help to explain the choices that advisors have as they consider their transition options. The ownership structures utilized by independent financial advisors or service providers fall into three distinct categories: book, practice, and enterprise.

BOOK

A book is the traditional ownership structure, best described as a single advisor, usually in a sole proprietorship arrangement. While there may be multiple advisors sharing an office and splitting the revenue to cover expenses and to pay for office space, phones, support staff, and basic services, each advisor is a single book owner. A book is all about production. About 70% of advisors own a book.

PRACTICE

A practice is not only larger and stronger than a book, but its owner will have invested in office space, at least a small support staff, and basic infrastructure. Practice owners also have set up a formal entity structure, either an LLC or a corporation, even though there is only one owner. Practices are larger than books in terms of cash flow and value. About 20% to 25% of advisors own a practice. Note that books and practices are, by definition, one-generational.

ENTERPRISE

An enterprise is not only larger and stronger than a practice, but it is more sophisticated in that it will utilize a professional compensation system that supports a strong bottom line. Profitability is key to differentiating this level. Profit distributions are used to augment the compensation system and to reward and empower next-generation advisors who invest in ownership and create an internal successor team. Sustainability is the main idea here. Enterprises have already—or are actively working to—established a multi-owner, multi-generational structure. Less than 10% of independent advisors own an enterprise.

The key differences between financial advisory businesses do not center on size or the amount of AUM, or even value. The differences lie in the structural elements of organization, entity, compensation, and profitability. Book owners simply don’t have the same choices that enterprise owners enjoy.

One clear trend in transactions that we’ve seen over the years is that larger buys smaller; stronger acquires weaker. Consolidation is the natural maturation of an industry whose entire value is derived from professional abilities and personal relationships. If an advisor doesn’t choose to—or isn’t able to—build a strong, sustainable enterprise, then he or she can join someone who has already done so. The result is that an advisor who still wants to work for only three to five more years can still ensure his or her clients and staff members are taken care of beyond that time. Selling to a third-party buyer who is a mirror image of the seller’s practice, but operates a larger, stronger business that can take on 100% of the seller’s clients and staff, looks like a much more palatable alternative.

We often use the term “micro-consolidation” to describe smaller, sustainable enterprises acquiring small books and practices. Sellers in this case are looking for buyers no more than double their size. For example, a business with $150 million in AUM would likely be looking for a buyer with $250 million to $300 million in AUM. When we see these matches it is often because similar deals with larger consolidators and banks look good on paper and are tempting, but the cultural differences and the expectations placed on the seller post-closing are often a bridge too far. As a result of these “micro-consolidation” matches, the interactions between new advisors and the acquired clients are not drastically different from what the clients are used to. Micro-consolidation allows smaller but sustainable businesses to provide a compelling value proposition to a seller in terms of both their financial needs and client concerns. The acquisition success of smaller enterprises illustrates that the opportunity is growing for buyers and sellers across the market.

Along with the trend of micro-consolidation, we are also seeing more diversity in size between buyers and sellers. Regional enterprises are making competitive offers to onboard both the clients and the advising talent of small and mid-size practices. Larger boutique firms are pursuing smaller books that fall within their niche. The defining feature for many successful acquirers (of any size) is an enduring structure and a strong match for the seller’s clients. Consolidation is not a homogeneous trend and it signifies a maturing industry. The value, scale, and efficiency consolidation creates can be a good thing for both practitioners and clients.

If you fall into the general definition of a book or practice owner, consider your options and decide at least ten years before your estimated retirement date or goal which path you want to be on when that time comes. Are you poised to be acquired or to be the acquirer? Are you in a position to develop and invest resources in an internal succession team? Does attrition make sense after carefully analyzing the other options?

As a book or practice owner, start your planning process by doing one thing—a formal, third-party valuation of what you’ve built. Through that process, you’ll learn a lot more than just what an appraiser thinks your value is. You’ll also learn what drives value and what you can focus on to make the most improvement. You’ll also likely come to discover what most of our valuation clients have learned: your business is the largest, most valuable asset you own.

This article is an excerpt our 2019 forthcoming Trends in Transactions and Valuation Study. You can learn more + order your copy of this comprehensive report here.

ORDER Our 2019 Trends in Transactions and Valuation Study

Topics: Multi-Generational Ownership, Organizational Structure, Business Growth, M&A, Sustainability, Trends in Transactions Study

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