Unlock your independence

A Credible M&A Strategy

Welcome back to another episode of the Independence Playbook. In today’s episode, John is joined by Harris Baltch, Head of M&A and Capital Strategies, to talk about how advisors can prepare for M&A pre-launch, prepare for M&A post-launch, and create a credible and repeatable M&A strategy.

Podcast Transcript

JOHN SULLIVAN: Hello. I’m John Sullivan and I head up business development for Dynasty Financial Partners. I’m hosting this podcast series called the “Independence Playbook.” We’ve covered a few episodes as it relates to advisors transitioning to the fully independent model and on this episode, we’re going to focus on M&A.


Today, I’m joined by Harris Baltch, who’s the head of Dynasty’s M&A and Capital Strategies group. — I’m pleased to have you here today, Harris. I think we’re going to jump right in.


HARRIS BALTCH: Thanks, John. Great to be here.


JOHN: Well, Harris, we’re talking to a lot of advisors, obviously, and one of the themes that’s been coming up as these advisors are coming through the process and thinking about what it’s going to look like once they’re out is the whole concept around M&A. When this comes up with advisors, what do you tell them? How do you approach it in terms of educating them?


HARRIS: Yeah, it’s becoming more and more a common theme, John. Especially advisors that are, you know, coming through the pipeline, they want to know more about M&A even before they launch their own firm.


And so what we try to do is kind of bifurcate the conversation really into three separate conversations, right? The first is, how can you prepare for M&A pre-launch? How can you prepare for M&A post-launch? And then as you continue to grow and scale your business in independence, how can you create a credible and repeatable M&A strategy to attract advisors or other RIAs in order to grow and scale your business inorganically?


You know, we have checklists and playbooks for all of this stuff but when it comes to a pre-launch conversation, some of the main items that we want to cover with advisors are really around three main things.


[00:02:00] The first and foremost, and this may seem, you know, simple to some but complex to others, is what should your entity look like? A lot of advisors can structure their businesses as S Corps or LLCs or C Corps.


And depending on what their M&A strategy is or how they want to design their business — are they a sole proprietor looking to just go into independence on their own or do they have a bigger team where they want to succeed ownership over time or prepare for M&A — you know, could lead to other types of structures. And so our goal is to help guide them in partnership with good legal and tax counsel along the way.


And when you kind of decide what your entity formation is, you got to think a little bit more deeply about what your operating agreement needs to look like because that really defines what your business looks like from a legal standpoint after you are out of the gate.


And having a really strong operating agreement when you launch is really going to help define your M&A strategy post-launch. And so some of the common questions that we ask advisors when they’re thinking about coming together and putting pen to paper on an operating agreement are, “How do the owners want to interact with each other? What do they want to accomplish as business owners? What are the types of things that they want to accommodate each other on if, God forbid, something happened and their health was compromised or if somebody died or… Are they allowed to succeed part of their ownership outside of the RIA?”


And so having the operating agreement address all of these things at launch is really important. It’s difficult to address every combination and permutation that may happen after you launch your business.


And so it is quite common for advisors to make certain amendments to their operating agreement to accommodate a situation or to accommodate M&A. [00:04:00] But it’s important to consider as much as you possibly can. And we try to leverage all of our experience in order to help, you know, RIAs.


The other thing that we speak with advisors about, and this ties into the operating agreement review, is share classes. A lot of advisors, you know, come to the table and think, “Well, maybe just one common share class is really all we need.” But if you want to do M&A, it’s a prudent thing to think about different types of share classes.


So one very common share class that most advisors have when they launch their firm are founder shares. And this could include things like having access to economic profits, upside and capital appreciation, and then ultimately, control over key decisions of the firm.


But as the firm grows and scales and business owners want to succeed a portion of the ownership of the firm to others to accommodate second gen, third gen advisors or even potentially support staff that have been committed to the business, is when you really need to think about granting advisor shares and having even profit interests to help support and bring the team together around common ownership of the RIA.


So we try to advice on striking the right balance. You don’t want to be too complicated out of the gate. But having a simple operating agreement that addresses some of these common themes are really important so that advisors can, you know, interact with each other and also transact with confidence when they’re approached with their first M&A opportunity.


JOHN: That’s excellent, Harris. So a lot of sort of on the technical side, guidance and support around legal structure, different share classes like you guided

us through there. But as the date draws near and the team is getting ready to launch the firm, what are some of the common questions, the more practical… their questions they’re asking about M&A and what are some of the answers that you give them?


HARRIS: [00:06:00] Yeah. Well, you know, we try to encourage advisors who want to do M&A, try not to get over your skis before you even launch your business. But common questions come up. What are they thinking in terms of… or what do we know about M&A valuations? How can, you know, you accommodate an M&A strategy that’s repeatable over time?


And so when you put kind of the operating agreement and the share class discussion aside, you know, the proverbial investment banking answer around M&A valuations, it really depends. It depends because M&A valuations can vary based on how you’re approaching growth.


In certain instances, there could be an advisor who comes to the RIA that wants to tuck in. And that tuck-in can be a combination of things to the firm. It could be an advisor that just wants to, you know, surround themself with other like-minded folks get access to better technology — doesn’t necessarily want access to equity.


And so the most important thing to a simple tuck-in would be a defensible payout, right? So something that makes them, you know, at or better than where they currently are in addition to upgrades in technology and of course, culture. But, you know, that probably scratches the surface in terms of where M&A begins because from then on end, it can get incredibly more complicated with what advisors want. Some advisors will sacrifice payout for equity. Other advisors will sacrifice, you know, equity for growth. And so, you know, striking that right balance between different types of considerations ultimately leads to what valuations are in the market.


[00:08:00] As you kind of go more uphill, more upstream with respect to complexities, there could be teams that are looking to depart a wirehouse and move into another RIA. And so what’s the right balance between down payments of capital in need to support things like deferred notes, transition bonuses or things like that come into play?


And for advisors or teams that want access to equity, you know, how can advisor either be granted equity in a very tax-friendly way when they join an existing RIA or potentially earn into that equity over time with a specific performance milestone or the types of things that we talk about, which, again, play into valuation?


At the end of the day, it should be no surprise to everyone listening on the line that larger firms are, hopefully, more scalable, more durable but ultimately, more profitable. So you definitely see a correlation out there between size and valuations. But, you know, post-deal expectations play into all different types of combinations that lead to valuation outcomes.


And you also see, just to add to that, John, structure can play a significant component. I touched on it before. But, you know, advisors are used to receiving payouts and capital when they move amongst different wirehouses.


And by moving to independent owning equity in a firm to align with other partners at the firm, really give you the ability to participate in the upside. But, you know, for better or for worse, we’ve seen a lot of deals happen where advisors aren’t necessarily granted the full amount of equity at launch. [00:10:00] What’s more common is to establish fundamental milestones, whether they’re based on a transitionable revenue or growth targets in order to trigger additional equity for teams that are joining existing RIAs.


And then, you know, for RIAs that are transacting either with other RIAs or aggregators or integrators or whatever their strategic objective is, you see a more professional investor approach the market with capital, with structure. And the structure could not only be built into what the outcomes are based on growth but also in terms of, you know, the type of equity that’s actually granted to advisors as part of the transaction.


At the end of the day, you know, culture is most important. And so you can think of all different ways to value firms and what the, you know, headline multiple is versus what the realized multiple is or what the discounted multiple is. But if you don’t have a sound culture where an existing advisor feels like they can flourish, none of this really matters.


And so when we’re working with advisors, particularly on the sales side, you know, we want to make sure that they are having conversations and moving ahead with other like-minded advisors where they think they can grow their business.


JOHN: So as we come through this process and the team, obviously… You’re right. You can’t get out over your skis. We always talk about day one, which is really to establish the initial RIA, get that up and running so that it’s sort of a viable enterprise. And you actually have advisors. You can recruit advisors to, you know, a very strong platform. But what about capital needs? So the advisors are going to say, “Do I need capital at the ready as soon as I launch? Is it something that I worry about after the fact?” How do you address sort of the capital question at launch?


HARRIS: Yeah. Well, look. If you’re looking for capital at launch, you got to have a valid use case, right? And so some of the valid use cases that we see are firms that want “Sleep at night” money. [00:12:00] You’re starting a brand new business. If a platform is offering you capital and it’s a reasonable cost and it has a reasonable payback mechanism, why wouldn’t you take it?


And so we encourage firms to take capital when they’re looking to launch into independence because you don’t know what’s going to happen. And firms that don’t necessarily have a very strong liquidity profile when they launch, you know, value capital, especially if it has fair payback terms.


But it can extend well beyond that, John. I mean, firms that want to have a robust M&A strategy are looking as a move into independence as a potential de-risking event for some of the senior principles of the firm that are using the transition to independence as a means for creating succession amongst next gen advisors also look for capital. And so how do you come up with an effective way to introduce capital into an RIA, allowing senior advisors to take capital out of the business at launch and potentially succeed ownership to second gen advisors? You know, capital plays an integral part of the equation.


Some of the capital solutions that we’ve seen really kind of run the gamut in terms of, you know, the types of solutions that are out there. I mean, broadly speaking, the market has really warmed up to the wealth management industry, the independence movement. And so there are a lot of different flavors of capital out there.

So firms that are moving into independent certainly need to be prudent with their selection of who is going to be their capital provider. But on the simplest side, you know, we see term debt and bank debt being available for advisors.


[00:14:00] I think because the industry is warmed up to these unsecured businesses being incredibly sticky with clients and cash flows, banks are becoming much more comfortable with underwriting these types of businesses especially, you know, even ones that are launching onto a platform because of how sticky these relationships are.


And so while some advisors are adverse to leverage, we encourage firms that are looking for some startup capital or “Sleep at night” money to take some term debt especially if the terms of the capital have, you know, fair prepayment terms.


But, you know, for firms that are looking for a more significant chunk of capital, term debt or bank debt may not get you there. And so there are alternative ways to access capital. Some of the types of things that we’ve seen are revenue purchases.


So the opportunity for an investor to come in instead of underwriting the business from a bottom line standpoint, underwriting the top line or revenues in exchange for capital is something that’s very common as well as almost institutionalizing your business out of the gate when you launch your firm with an outside minority equity owner.


A lot of times, having an institutional investor come in, whether it’s a platform or a family office or just a third party that has a relationship with the senior management team is a great way to institutionalize your business from the get-go. We’ve seen all of those scenarios play out very well.


And if you think about it, for a firm that is looking to institutionalize their business, thinking ahead around M&A and inorganic growth, having an institutional investor invest in your business out of the gate is a great way to really validate your business model, validate the management team and at the same time, also provide institutionalized backstop support when you’re going to get additional debt capital to support your first M&A trade.


[00:16:00] So there is a little bit of circularity there, John. What we’ve seen is an influx of capital participants in the space. And, you know, we try to work with advisors to optimize their balance sheet to deploy capital effectively.


JOHN: A lot of good information there, Harris, especially as it relates to some of the technical aspects of launching the new firm — the different capital capabilities that are out there. And clearly, you know, depending on where the advisor is coming from, they’re going to need a lot of technical and legal advice on some of those particular strategies.


So let’s kind of switch gears here as we wind it up, Harris. You know, when you talk to advisors, there’s a lot of thoughts and a lot of information in the marketplace. What are some of the common misperceptions that advisors have about M&A in general?


HARRIS: Yeah, it’s kind of crazy out there right now, John. It’s been crazy for a long time. I mean, despite the deal activity you read about, it feels like deals are getting done every week. And they are because our industry is incredibly fragmented.


And just to lay out some anecdotes, I mean, using round numbers, if there are 20,000 RIAs out there… And I think we all know that the number is a little higher than that. There are only 365 days in a year. [00:18:00] So that means it would take 55 years to consolidate the industry. But at the same time, there are new RIAs being created every week.


You think about that, John. I can’t. I can’t. I don’t know how many years it would take to consolidate. But the reality is, it’s just a very robust market right now. The fact that you have a high degree of fragmentation, you know, strong recurring cash flows, an aging advisor base looking for some type of succession creates a tremendous opportunity.


And you see it with respect to how much buyer demand there is out there, whether it’s RIAs, integrators, aggregators, professional investors, U.S. firms, non-U.S. firms. You know, it’s clearly an industry that’s ripe for consolidation. It reminds me a lot of what the banking industry looked like in the early ‘90s.


And recently, I was talking with a private equity professional. He was telling me that the only other industry he’s seen as fragmented as the RIA space is the HVAC industry, which I thought was kind of interesting.


But, you know, getting back to your question around misperceptions, M&A doesn’t happen overnight. It takes time, you know.


And sometimes, deals that look good on paper might not work if the culture isn’t there or the terms evolve or potentially, you could be working on a transaction and some type of press release hits about the buyer or about the seller that you weren’t expecting, and it calls off the deal. So you have to have a lot of patience with M&A.


And deals that, you know, warm up may not get done for quite some time because of an extenuating circumstance that’s just out of your control. [00:20:00] And so it’s really important for firms that want to do M&A to be patient, to be disciplined and to have access to capital so that when you’re ready to move forward down the process because you can’t find the capital partner because, you know, in my opinion, inertia kills M&A deals.


And so you need to be able to come up with a repeatable process that makes sense for your business. You stay disciplined to that process. And you have a capital partner by your side that understands your process and believes in the management team. And last but not least, you know, a lot of the advisors that we speak to sometimes try to do too much, right?


You’re in independence. You’re doing it yourself. Maybe you’re working with a variety of different partners to help support and grow your firm, organically. But it’s really hard to do M&A on your own.


And maybe I’m being a little selfish here, John, but it’s important to hire an investment banker to help you. Whether you’re considering an acquisition or an ultimate exit, investment bankers are incredibly skilled at deal-making which may include modeling, valuation, negotiation, structuring. And they know the buyer and seller landscape incredibly well, which can hopefully give any CEO an incredible amount of leverage through educating them on the dos and don’ts and, and also closing with confidence.


JOHN: A lot of great information today, Harris. I really appreciate your time. That’s all we have for today. So, you know, again, thanks for joining me.

HARRIS: Thanks John.

Sign Up and Stay Up to Date

Receive updates about Dynasty and our Community of Network Partners.