There has been a notable drop in mergers and acquisitions involving registered investment advisors; we ask a firm tracking trends in the space whether this is the start of a bigger trend or a temporary halt to what has been a busy period.
Is the sharp decline in RIA M&A activity the beginning of an extended trough or just a short-term speed bump?
Advisory firm transactions fell sharply over the past month and a half, down 35 per cent from the average monthly volume of the year to date, according to the most recent DeVoe RIA Deal Book.
The steep fourth quarter decline “marks a possible turning point” in M&A activity, according to David DeVoe, CEO of his eponymous firm, which tracks deal volume and provides valuation, consulting and investment banking services.
“High interest rates, a declining stock market and a challenging economic environment typically drive down M&A,” DeVoe said. “It remains to be seen if these pressure points are creating a short-term lumpiness of volume or a sustained downturn.”
Rate increases and market declines have caused some private equity-backed buyers to “reassess their interest” in buying advisory firms, according to Charlie Ruffel, chairman of Kudu Investment Management, which specializes in taking minority stakes in advisory firms. “That has manifested itself in less frenzy for investment bank-led RIA processes and lower multiples.”
Pause for integration?
Much of the deal volume slowdown can be attributed to “major market participants taking a pause to integrate acquisitions made over the past few years,” according to investment banker Brian Lauzon, managing director of InCap Group. “This is a healthy and natural outcome to the secular M&A trend we’re experiencing.”
While a heightened interest rate environment could temper activity among larger, leveraged acquirers, Lauzon said, those conditions “could also make room for some new entrants and spur merger activity among some large aggregators as the macro trends driving industry consolidation continue unabated.”
Cost of capital repercussions
Financing costs are rising at the same time RIA revenues are falling as result of the percentage of AUM business model tied to a volatile stock market. Potential acquirers now find themselves looking at shrinking margins, falling valuations and increasingly apprehensive lenders eyeing growing non-performing loans and in turn placing more restrictive covenants on new loans. What’s more, not only are future borrowing costs rising for buyers, so is the cost of servicing their current debt.
M&A activity is often a lagging indicator, valuation specialists Mercer Capital noted in a recent report, as deals can take months or even years to close after their announcement.
“The adverse effects of rising interest rates, higher inflation and lower earnings also impact closely held RIAs [who are] vulnerable to reduced valuations and transaction multiples as prospective buyers anticipate lower cash flows on a diminished AUM base,” Mercer vice president Brooks Hamner and analyst Koby Allen stated.
Revised deal structures
These new market conditions have led to changes in deal structures.
Wealth managers are increasingly selling less than 100% of their business, holding back the balance for several years hoping the market will bounce back. Deals are also increasingly relying on earn-out provisions where sellers must meet specified benchmarks in areas such as client retention and revenue growth over a period of time.
Even if the bloom is off the M&A rose as 2022 winds down, optimism is not in short supply.
Brett Bernstein, CEO of XML Financial Group, a Focus Financial partner firm, said he is currently negotiating to buy two RIAs and is finding more interest from sellers than ever.
“A lot of firms are tired of doing everything themselves and need help in areas like compliance,” Bernstein said. “Yes, there are headwinds now, but we’re asking firms how we can help them navigate those headwinds. The opportunities in the market are still massive.”
The same factors that drove the M&A market to record highs over the past five years “are still very much in evidence,” Ruffel maintained. “Scale and brand matter, and mid-sized RIAs recognize that. And the actual value proposition of best-in-class RIAs resounds more in uncertain markets. The best RIAs are going to do phenomenally well in the decade ahead. It’s no bad thing that the froth has left the market, in my view.”