How financial advisors can avoid bad private equity deals

Private equity investors’ pitches to financial advisors often feature tempting bid prices and promises for the future, but these enticing offers may also carry the risk of golden handcuffs.

The PE deals driving high volume and valuations in industry M&A have helped many advisors reach succession planning and expansion goals — although not every deal is successful, according to experts. 

The worst-case scenario could lock advisory practice founders who have spent decades serving their clients and building businesses into a litigious PE-backed parent firm that has taken over their customer bases, employees and professional legacies.

Cross-Search

Registered investment advisory firm owners and other potential sellers must vet any acquirers’ offers carefully, including by speaking with other advisors who have previously joined the firm and by engaging dealmakers or consultants who can assist with the due diligence process, the experts said. PE-backed firms and other buyers protect their investments through employee contracts and deal terms with nonsolicit or noncompete clauses that limit sellers’ subsequent options if they don’t like their new setup, said Jodie Papike, CEO of independent advisor and executive recruiting firm Cross-Search.

READ MORE: How financial advisor compensation is crucial to succession and M&A

Grass isn’t always greener with private equity

While it’s difficult to paint all PE-backed firms with a broad brush, a lot of them “are now looking more like a wirehouse than an independent RIA,” and some advisors who make deals with them then must operate under an ownership team pushing “their decisions through and through” on service models, branding and control of the client base, Papike said. A poor choice of buyer in a private equity deal can lead to contractual entanglements that pose the prospect of a “really, really difficult thing to navigate for an advisor” and a challenge to the profession’s cherished but hotly debated notions of independence, she said.

“Anytime you’re an employee of a firm, you should expect there to be more restrictions if you were to ever leave,” Papike said. “Obviously, if a firm is going to offer you more money to join them, typically there are more restrictions involved in the back end of your contract.”

Even executives with firms that have received substantial PE investments toward their growth argue that advisors must weigh their choices thoughtfully and look at more than just the financial or monetary offer.  These deal valuations can run to high multiples —  sometimes 10 or even 20 times an RIA’s annual earnings. But whether the parties are ultimately a good fit often proves more important than an eye-popping price tag or a payoff to the founder, according to Abby Salameh, the chief growth officer of Birmingham, Alabama-based registered investment advisory firm RFG Advisory.

“I have definitely seen ‘deals’ that did not translate into the outcomes expected by the sellers or the buyers,” Salameh said in an email. “I won’t say who or what firm, but, on the advisors’ side, they were told they would maintain control of how they ran their business, the software they used and their own brand name — and only after a year or so, they were told they needed to completely change all of those to drive operational efficiency and scale. On the buyers’ side, I have seen abysmal growth from firms that were purchased at super-high valuations, leaving little to no room to drive organic growth because the due diligence was probably not done well to know that the clients were all retired and in decumulation mode.”

READ MORE: How consolidation is testing fiduciary duty in RIAs

From the macro to the micro — private equity trends and individual deals

To be fair, some of these concerns could arise with any type of capital financing or ownership changes that take place outside of advisors’ control, whether through a PE deal or a publicly traded firm’s acquisition that suddenly alters their business overnight. And the doomsday “vulture” story of a PE firm that loads up its acquired company with debt leverage, strips out its valuable assets then leaves that firm to die simply hasn’t played out in the reliably profitable industry that is wealth management.

In fact, many of those perceptions of PE firms, also known as leveraged buyout companies, represent a caricature of their investment intentions, said Steven Kaplan, a professor at The University of Chicago Booth School of Business who is faculty director of the Polsky Center for Entrepreneurship and Innovation.

“They are about value creation,” Kaplan said at the CFA Institute LIVE conference in Chicago earlier this month. “When you survey them, they say that what they really try to do is make their companies grow more, and so they’re not the cost-cutters that you read about in popular books or if you listen to some politicians. They really want to grow these businesses.”

On the other hand, advisors seeking a succession plan with a PE deal must go into the negotiations with clear eyes, Lisa A.K. Kirchenbauer, the president and founding partner of Arlington, Virginia-based Omega Wealth Management, said in a presentation about the firm’s multigenerational succession and client retention plans at the Financial Planning Association Retreat in Oak Brook, Illinois, last month. First of all, the prospective PE-backed buyers “will put discounts on your value” based on an RIA’s marketing, staffing levels and technology, with a judgment that “you should have made those investments if you didn’t,” she said.

“No. 2 is that, in many cases, you are now buying in,” Kirchenbauer said. “You’re not getting cash for everything. You’re getting equity in this other business, which you have no control over. So it’s really worth getting past the allure of the multiple to understand the terms. And the terms might be great for you, given your circumstances, but you have to look beyond the multiple.”

READ MORE: Firms that can and can’t fetch 20-times EBITDA with private equity

There’s no one-size-fits-all approach for private equity deals

She and Salameh pointed out that advisors’ goals for a PE-backed transaction look much different, depending on the stage of their careers. In addition, past research Salameh has conducted into the motivations of RIA sellers has suggested that they are searching primarily for compatibility, honesty, autonomy and a strong business plan for the future, alongside similar passions for client service, personalities among the parties and the drive for success.

RFG Advisory

“The surprising thing was that the results were less about the monetary value of what they were receiving and more about feeling like it was a ‘good fit,'” Salameh said. “You will notice that these factors are not at all about the valuation (if all things are equal) and much more about the ‘right fit.'”

The many circumstances involved in PE deals on either side of the equation explain why “the most important” task for advisors is to invest “a significant amount of time on the due diligence phase and understand exactly what the structure will look like for you as the advisor but also what it will look like for your clients,” Papike said.

For advisors who “want to keep everything the same” after they depart the business, they may find their best result in a deal with a peer who shares the same approach to the profession, so that “they have that peace of mind that, if they are going to sell to that advisor, their clients are going to have a similar experience with minimal change,” she noted.

Others could find their home with one of the many PE-backed suitors courting advisors these days. But they have more choices than ever, including selling a minority stake without relinquishing the full equity.

“The outcome, a lot of times, I think is dependent on how much control you give up or how much you sell of your business,” Papike said. “They do need to expect that there are going to be some changes. It doesn’t necessarily mean that all of those changes are going to be bad. … They need to be at the point of time in their business or career that they’re comfortable with that and ready for that.”