Further rises to US interest rates, and the drama around Silicon Valley Bank and other lenders such as Credit Suisse, raise questions about what the macroeconomic story means for the M&A market among financial advisory firms.

Rising interest rates haven’t torpedoed the RIA merger and acquisition market to date, but how long the industry can continue to dodge that bullet remains unclear.

The US Federal Reserve Board’s quarter-point rate hike last week [March 22] and accompanying forecast of an additional increase possibly as soon as May has put interest rates squarely in the M&A spotlight. The Fed’s most recent 25 basis point increase has been taken in stride “because markets tend to absorb telegraphed changes well,” said veteran dealmaker M&A veteran Peter Nesvold, partner at Republic Capital Group. “It’s surprise moves that disrupt the indices.”

The anticipated rate increase in May has also already been priced in deals, said Brooks Hamner, vice president at valuation firm Mercer Capital. But additional escalations could have “an adverse effect on market conditions,” Hamner warned.

Beyond May, rate increases “may start to slow activity more than the limited drop we’ve seen,” agreed Dustin Mangone, director of investment advisor services for PPC Loan, a major lender to RIAs.

Even though interest rates have risen steadily for over a year from near zero to a range of 4.75 per cent to 5 per cent, they “haven’t had a material impact to the portion of the market where most deals happen,” Nesvold said. 

Deal activity slowing
“Some of the very largest RIAs that took substantial debt loads have some capital structure work to do,” he added, “which could slow some of the deal flow. But at this time, there are plenty of buyers picking up any slack.”

Nearly three months into the year, however, the registered investment advisor M&A market has been “choppy,” with deal volume down approximately 10 per cent, according to David DeVoe, principal of San Francisco-based RIA consultancy DeVoe & Co. 

Large aggregators backed by private equity are still willing to pay up for quality firms, DeVoe said, but smaller acquirers appear to be pulling back from M&A activity “because of lending costs and greater challenges to raise capital.”

Indeed, nearly two-fifths of RIA transactions through February involved sellers with greater than $1 billion in AuM, compared with only 16 per cent in last year’s fourth quarter and 29 per cent in the same period last year.
 

Impact on valuations
The impact of rising rates on valuations and deal terms is less clear.

“Deal multiples have remained flat and deal structures have seen no material change,” according to Mangone. But the investment banking firm InCap Group has “certainly seen valuations and deal terms moderate,” said managing director Brian Lauzon.

A high interest rate environment ultimately means that RIA sellers “will have to offer lower prices to satisfy a buyer’s need for increased return, and equity values and multiples will fall accordingly,” argued valuation specialist Hamner. “A stock’s price is a function of its earnings and a multiple – the P/E ratio – and both have fallen for most businesses over the last year-and-a-half.”

In fact, the multiple for one major RIA deal that is currently pending has been reduced by approximately one-third from last summer, according to an executive with knowledge of the terms.

Role of bank loans
Although the steady drumbeat of rate hikes makes M&A financing more expensive, a borrowing cap on bank loans may be a mitigating factor.

“Banks will only lend up to four times of EBITDA,” Dan Seivert, CEO of ECHELON Partners told an M&A panel at the Financial Services Institute’s OneVoice conference earlier this year. “If you buy a firm for 12 times EBITDA, you can only borrow four times, or one-third the amount. If it were a situation where you could borrow 12 times, that would mean the higher price of the debt would be a bigger deal to the borrower and the buyer.”

Today the ceiling on bank loans “has lowered to perhaps two or three turns of EBITDA,” Nesvold said. “Non-bank lenders were north of eight times at one point, but are probably closer to four times now. These types of loans are generally only available to RIAs with at least $10 million of EBITDA.”

The loan limitation is based on how much debt the business can support while meeting the cash-flow requirements for an approval, according to PPC’s Mangone.  

“Other lenders may focus on lendable limits tied to a multiple of revenues or perhaps a percentage of a valuation,” he added, “but cash-flow support will ultimately be the deciding factor.”

What next?
What other factors do industry executives see shaping the M&A market through the summer?

“Smaller firms are more likely to feel ill-equipped in a choppy market to go it alone,” Nesvold said. “I see continued consolidation in the sub-$1 billion market – possibly even among themselves.”

Lauzon foresees “the emergence of a new cadre of serial acquirers – some may be PE backed, some will be self-financed. I think that we will soon have our first mega-merger between two of the top consolidators. If this happens, one of the firms will likely be one with a good bit of leverage on their books.”

Valuations will slide downward if rates “remain where they are now,” Hamner said. “With that said, the macro trends and tailwinds are so positive, any retracement should be modest.”

The influx of private equity investment, perhaps the single most important development in the RIA industry over the past decade, will continue, DeVoe said. “These firms rightly believe that the independent RIA model is the single best model for US investors and expect it will continue to grow for years to come.”

An economic slowdown or a prolonged recession would put “downward pressure” on RIAs' revenues and profits “which could affect valuations,” Mangone said. “But recent history would tell you this likely won’t have much of an impact on multiples; deals will just involve more shared risk between buyer and seller and more creative structures.”