Rising Capital Costs, And The Low-Down On RIA Lending

Stubbornly High Interest Rates And Other Forces Have Reshaped RIA Deal Financing
Janeesa Hollingshead, Contributing Editor, Wealth Solutions Report
Janeesa Hollingshead, Contributing Editor, Wealth Solutions Report

Navigating the M&A financing landscape since 2022 – against the backdrop of stubbornly higher interest rates – has been a challenge for all but the most financially flush wealth management businesses.

A steep rise in the cost of capital, industry demographic trends creating a succession planning crisis and private equity-backed consolidation moves driving higher valuations have combined to significantly alter the playing field.

The result? Increased scrutiny among buyers, a supply and demand ecosystem that heavily favors larger businesses with strong balance sheets as well as ongoing fragmentation, to some extent, at the small to mid-sized end of the dealmaking spectrum.

RIA Segment: Costly To Compete

The RIA segment has been among the fastest-growing areas in wealth management, driven by the appeal of its recurring revenue business model, combined with the rising trend of successful wirehouse advisors making the leap to independence.

But competing in such an environment with strategic goals such as growth or succession planning-based M&A, new RIA launches or other initiatives to create rapid scale can be very costly from a funding perspective.

To better gauge current RIA lending trends and the outlook going forward, WSR recently connected with three industry experts that each bring an industry insider’s view to this critically important arena of strategic growth across wealth management:

  • Dustin Mangone, Managing Partner, Director of Investment Advisor Services at PPC LOAN, a specialty lender for investment advisory firms that provides conventional business loans for acquisitions, equity purchases, debt restructuring, refinancing and other capital needs
  • James Hughes, SVP, Head of Investment Advisory Lending at Live Oak Bank, a cloud-based digital bank primarily focused on small business banking and one of the top SBA lenders in the U.S.
  • Derek Bruton, Senior Managing Director at Gladstone Group, a provider of M&A advisory solutions to RIAs, encompassing wealth managers and asset managers

WSR: What types of succession planning loans are in demand right now, and what segments of the independent financial advisor industry most actively seek such loans? How have higher interest rates driven changes in demand, if at all?

Dustin Mangone, Managing Partner, Director of Investment Advisor Services, PPC LOAN
Dustin Mangone, Managing Partner, Director of Investment Advisor Services, PPC LOAN

Mangone: Investment advisors across the industry increasingly rely on traditional debt to address various needs, particularly for inorganic growth and succession planning. Over the past decade, demand for succession planning loans, both internal and external, has grown exponentially as sellers move away from self-financing transactions in favor of bank financing. The availability of capital and specialized loan programs tailored to these needs has enabled sellers to expedite their liquidity event and cash out more efficiently.

These loans are crucial across all segments of the independent space, encompassing RIAs, IARs and broker-dealer advisors. Solo practitioners typically opt for external sales as they often lack a successor, while larger firms and those with multiple partners have the option to transition internally if they have capable successors ready to take over.

Next Gen loans, specifically designed for internal successions, have gained in popularity across the industry. They cover needs like equity stake purchases, internal buy-ins and partner buy-outs. Notably, conventional loans are the only option for equity stake purchases or internal buy-ins, as SBA loans are not applicable. Both conventional and SBA loans can fund partner buy-outs if the seller exits the business within 12 months.

Affordability remains a significant hurdle for internal transitions despite valuations reaching all-time highs. While external sales may yield a premium, many firms still pursue internal transitions as their desired option. However, recent increases in interest rates have raised the costs of equity purchases, particularly for first-time buyers.

Despite these challenges, succession planning loans play a pivotal role in supporting advisors and firms during ownership transitions, ensuring the continuity and longevity of their businesses. Given the aging advisor force, the demand for such loans is anticipated to remain robust, underscoring their ongoing importance in the industry.

WSR: Given the significant rise in loan interest rates over the last two years, how has demand for succession planning or M&A-related loans reacted?

James Hughes, SVP, Head of Investment Advisory Lending, Live Oak Bank
James Hughes, SVP, Head of Investment Advisory Lending, Live Oak Bank

Hughes: Live Oak Bank has seen the demand for M&A-related loans increase steadily year-over-year. Recently, the cost of capital has been seen as a deterrent for borrowers. However, our loan volume remains quite healthy.

The main shift in the market we are seeing is the need for more complex financing structures, which we are accommodating.

We are serving the market with access to quick working capital loans (starting at $10,000), large growth facilities loans up to $100,000,000, or more, and everything in between. We still see lots of potential from a lending perspective. We are focused on working with firms with a long-term view on a banking partner.

Also, we are building products specific to our customers, whether for succession planning, M&A, recruiting, commercial real estate or something else. We remain optimistic about the industry and our position to serve it.

WSR: How has the interest-rate environment driven changes to the financial strategy and funding process for buyers looking at new acquisitions?

Derek Bruton, Senior Managing Director, Gladstone Group
Derek Bruton, Senior Managing Director, Gladstone Group

Bruton: The elevated borrowing costs resulting from high interest rates are impacting the financing aspects of RIA acquisitions, leading buyers to scrutinize every facet of a deal to ensure optimal returns. At Gladstone, we’ve noticed buyers intensifying their Quality of Earnings (QofE) evaluations, meticulously reviewing financial statements to ensure the long-term health of the business post-acquisition. Sellers, cognizant of buyers’ scrutiny, are paying close attention to the elements shaping the offers they receive.

Moreover, EBITDA, or earnings before interest, taxes, depreciation and amortization, adjustments have emerged as a critical area of focus during this process. While EBITDA is a key metric, adjustments can significantly influence valuation and negotiations. Buyers are carefully examining these adjustments to uncover discrepancies that could distort true profitability and value.

For instance, some sellers agree to reduce salaries to inflate EBITDA and subsequently enhance the firm’s valuation. However, buyers are weighing the potential future replacement costs against any short-term gains, being mindful of preserving future earnings.

This intensified focus on EBITDA adjustments is part of a broader trend of rigorous due diligence within the RIA M&A space. Buyers are delving deep into various aspects of a firm, including financial health, regulatory compliance, client retention and growth prospects, to mitigate risks in an uncertain market.

Despite the challenges posed by high interest rates, the RIA M&A sector remains buoyant, driven by predictable, recurring revenues, loyal client bases and the growing demand for fee-based financial advice among American investors.

By adapting deal structures and intensifying scrutiny around EBITDA adjustments, strong buyers and sellers with reasonable expectations (and sound M&A guidance) are still able to successfully close deals while simultaneously managing risks in an evolving market.

Janeesa Hollingshead, Contributing Editor at Wealth Solutions Report, can be reached at editor@wealthsolutionsreport.com.

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