What to Do When Independence Becomes Unprofitable

How RIAs Can Revive Their Struggling Bottom Line

The business of running an independent wealth management firm is an expensive one—and it is only going to become more expensive. With the changing regulatory environment, increased competition from an ever-expanding pool of RIAs and employee advisors, the rise of the robo, and fee compression, the need for scale has never been greater. Unfortunately, there are way too many barely profitable firms and as the principals of these firms look at their horizons, the smart ones will realize the need to align themselves with larger firms that already have scale, professional management, business development infrastructure, a succession plan and an equity structure that extends beyond a single founder/principal. An unprofitable firm that hitches its wagon to a more profitable one becomes the embodiment of the quote: “A rising tide lifts all boats.”

Unfortunately, the market for unprofitable firms – even ones that are in growth mode – is slim…and it will get slimmer as the M&A market heats up. In any scenario, the more motivated and flexible all parties are to a deal, the more likely it is to get done. But in the case of an unprofitable firm, managed expectations on the part of the seller is mission critical.

Here are some things to keep in mind:

Most acquisitions are valued on a multiple of EBITDA. Obviously, in the case of an unprofitable or barely profitable seller, applying a multiple to zero wouldn’t work. If a buyer is motivated to acquire an unprofitable firm because it is attracted to what that seller can add to its value proposition, then a multiple of post-acquisition EBITDA is usually used. (This takes into account elimination of redundant expenses, raising of fees and growth, then looks at the kind of profitability the selling firm would generate in a combined scenario.)

Because the seller is currently unprofitable, the majority of the deal will be weighted on growth hurdles, earn outs and back-end bonuses.

The seller of an unprofitable firm doesn’t have a whole lot of leverage even if he has a firm with solid growth potential and asset base.

If the seller values the ability to gain scale , a succession plan and accelerated growth more than he values up front cash and the most aggressive multiple, then he is much more likely to get a deal done (i.e., eliminating the pain points is more important than short term upside).

While most industry thought leaders agree that standalone firms that lack scale and profitability will find it harder to thrive in today’s environment , sellers who believe their profitability will increase in the natural order of things – by raising client fees, decreasing expenses and organic growth – should certainly stay the course until they can create more meaningful EBITDA.

Take “Bob”, who is the principal of a $500mm fee-only RIA that generates approximately $4mm in annual revenues. The cost of doing business for an investment management firm with a 12-person research and analytical staff is exorbitant and as such, Bob’s EBITDA is only $350,000. While Bob’s low EBITDA is dragging down his enterprise value, he has built a great firm that services 150 high net worth clients. After years of trying to positively impact his profitability, he has decided to actively pursue a search for the right buyer that would generate meaningful cost and revenue synergies and offer a mechanism to accelerate growth. In the final analysis, Bob is deciding between two offers: one from a bank looking to grow its wealth management unit; the other from a larger and more profitable RIA that deploys a similar investment approach. While neither deal offers him much liquidity up front – and both will require Bob to grow and reduce expenses considerably before he sees any real benefits – he knows that monetizing in the short run is of much less importance at this stage than improving profitability. And he knows that the deal he consummates today will allow him to capture much greater enterprise value in the long run—rather than continuing down a path that is likely to become even more difficult and less profitable.

While many wealth management firm principals embarked on the journey to independence for freedom, flexibility and control, they also expected a modicum of profitability to follow.

Yet the landscape has become far more difficult terrain for many to traverse alone. Remapping your future with a mind open to M&A can take stress off the day-to-day and allow you to get back to running the business you envisioned—with freedom, flexibility, control and greater profitability.