For financial advisors and RIAs acquiring a book of business or clients, there is inherently risk involved in the transaction. In any one of these situations, it is important to understand the type of risk involved - both from a buyer and a seller's perspective - and how to mitigate these risks. For scenarios in which the purchasing advisor is utilizing bank financing, there is an added component of risk to the bank providing the financing. Let's examine some of the factors that impact risk in an acquisition scenario, and who is ultimately impacted by that risk.
Years of Industry Experience
A purchasing advisor's years of industry experience in the business impacts risk as it can help show a proven track record or history of skills in the industry. Consider two scenarios, one in which a purchasing advisor has 30 years experience and another in which the purchasing advisor has 2 years of experience. The advisor with 30 years worth of experience has certainly been through more tumultuous market conditions and will have more experience navigating difficult conditions than the lesser experienced advisor. As the acquisition unfolds, they may be more likely to spot potential issues and remedy these issues before a negative impact is felt.
From a seller's perspective, they will want to sell their business to a strong individual that is able to carry on their legacy. While a lesser experienced advisor may be able to do so successfully, often a proven history of industry experience is preferred because it gives the selling advisor peace of mind that their clients will be appropriately taken care of post-acquisition.
Practice Size
When it comes to practice size, one of the considerations looking at risk is the size of the practices involved. Is this a case of big fish acquiring small fish, or small fish acquiring big fish? Does the purchasing advisor have the capacity to take on additional clients and manage their accounts, or will new staff have to be brought on? Generally, from a bank's perspective, a larger practice may have a greater ability to absorb a smaller practice versus the opposite scenario. For example, consider if a purchasing advisor has $500 million in Assets Under Management, and is buying a practice with $50 million in AUM. Absorbing the smaller amount in AUM will be an easier transition than if a smaller purchasing advisor with $50 million in AUM is purchasing a firm with $500 million in AUM.
Revenue
When it comes to revenue, the primary risk factor being examined is whether a firm's revenue is advisory revenue (fee-based) or brokerage (transactional). Fee-based revenue is revenue that comes in the door every quarter, whereas brokerage revenue is only earned when transactions are conducted. Advisory revenue is considered to be less risky as it is not transactional in nature.
Personal Financial Strength
A combination of factors are considered when evaluating risk while looking at a purchasing advisor's personal financial strength. These will include an individual's credit score, debt service coverage ratio, and examining their liquidity and net worth. While banks may not always require an individual to utilize and employ their own capital in a transaction, it is beneficial to see that purchasing advisor's have built up their own personal assets and minimized liabilities. As with any scenario in which an individual borrows money, the less debt you have the less risky a transaction is deemed to be. A strong personal balance sheet and personal financial strength are an indication of reduced risk to the bank lending an individual money.
Practice Strength
The strength of a practice and risk of the practice include a combination of factors. Some of these will include (like mentioned previously) the revenue of a firm and what percentage of revenue is advisory, the average tenure of clients with the firm, and the asset concentration of the firm. For a practice being acquired, if the average client has only been with the current advisor for a year, they may be more likely to leave a new advisor than if the clients have a long-standing 30 year relationship with the advisor and trust that they have hand-picked their successor.
Deal Structure
How an acquisition is structured, including the percent of the purchase price financed, if claw-back provisions are included, and what the selling advisor's transition period and duties entail, will impact the acquisition risk to all parties. Here, let's look at the transition period from a risk perspective. To the acquiring advisor, if the selling advisor agrees to conduct initial client transition meetings with all clients and then remain on in the business as a consultant for 24 months, this can help aid the transition of clients. The purchasing advisor will be able to rely on the selling advisor for advice and guidance should any unique scenarios occur, and clients have peace of mind that there is a strong relationship between selling and acquiring advisor. Conversely, suppose the selling advisor merely sells their book of business and immediately exits the business. In that case, there can be a greater chance for clients to ultimately leave the purchasing advisor, which impacts the risk of the acquisition.
Commonly, to mitigate risk for the purchasing advisor - especially in times of tumultuous markets - we see advisors utilizing claw back provisions that require a certain threshold of revenue or assets under management to be retained after an agreed-upon period of time. Having these provisions in place lessens the risk to the purchasing advisor, as ultimately the purchase price is reduced if these thresholds are not met.
Collateral
When obtaining conventional financing for financial advisor loans through Advisor Financing, our typical collateral includes a first lien position on the business and an assignment of life insurance in the loan amount. This collateral reduces the risk from the bank's perspective as should something happen to the purchasing advisor, the bank can still be paid off the amount they are owed. For example: let's look at a sample scenario in which absolutely no collateral is involved, and the acquiring advisor passes away, leaving their business (and the debt from the acquisition) to their spouse, that has been a stay-at-home parent for twenty years. The spouse is then left to make some major decisions that they likely have no qualifications for, and doing this in a time of turmoil while dealing with grief. Having collateral such as life insurance allows for these worst-case scenarios to be handled as smoothly as possible with the best interests of all parties in mind.
Internal versus External Transition
When speaking of internal or external transitions for acquisitions, this is a question of whether the purchasing advisor is within your same firm, broker-dealer, or moving entirely. How much work is involved for the clients to change advisors: is it one quick piece of paper with an electronic signature, or does it require a significant amount of work? The risk in these scenarios is that at times, the more work required for clients, the less likely they may be to move to the purchasing advisor instead of moving to another advisor altogether.
Interest Rate term
The term on the interest rate for financing is a factor that impacts primarily the purchasing advisor and the bank. However, in a small way it also impacts the selling advisor. If the financing features a variable interest rate, the purchasing advisor risks the chance that interest rates will rise and thus their cost of capital increases. Conversely, with variable interest rates the bank risks the chance that interest rates will fall, and thus may not be as profitable on their financing. For fixed interest rate terms, the longer the term is, the longer both the purchasing advisor and the bank are locked in to that specific interest rate, regardless of whether interest rates in the market are increasing or decreasing. Finally, you might wonder how the interest rate and term impact the selling advisor. Ultimately, if interest rates are high enough that purchasing advisors are not willing or able to obtain financing, there may be deals that are left on the table. Fortunately, we have not seen this happen and do not anticipate this. Even if interest rates are rising and may be slightly higher today than they were a year ago, at the end of the day a strong acquisition opportunity is still going to be a strong acquisition opportunity with significant upside for the purchasing advisor.
Relationship to Seller
The relationship with the seller is a risk factor in which we consider if there is a strong positive relationship or if there is no relationship at all. With a strong positive relationship in which information is freely shared, there is less transition risk for client and asset retention than if there is no relationship or information shared.
Relationship with Bank
Finally, the relationship with the bank is another risk factor for advisors obtaining capital. Banks often prefer a business banking relationship with advisors and may also have periodic reporting requirements. When banks have a strong relationship with the advisor they are lending money to, they are better able to see the day to day operations of the business and if there are any potential threats that may impact the performance of the acquisition.
In conclusion, there are many factors that impact risk in acquisition transactions where one advisor is selling their practice to another advisor. While this is not a comprehensive list, it starts to lay the foundation for thinking about what risk factors may appear and whether the risk is to the selling advisor, purchasing advisor, or the bank involved in the transaction.
