EXTERNAL FINANCING TRAJECTORY FOR ADVISOR ACQUISITION LOANS
Over the last few years, over 60% of acquisitions in our industry have been financed through bank loans. External financing options from lenders offering SBA, conventional and Tri-party loans has become an established, cottage niche industry within advisor M&A.
The increased accessibility to external financing and acquisition loan options have fundamentally changed the financial services advisor M&A industry. With the growth trajectory of bank financing utilization, external financing will continue to influence and shape advisor acquisition structure and strategy.
For those of us who have a decade of direct experience in advisor M&A buy-side and sell side consulting, matchmaking, and/or deal construction, the trajectory and influence of external financing is even more profound.
Advisor Acquisition Loans Growth Trajectory
Over the last 5 years, external financing for advisor acquisitions went from virtual non-existence to commonplace. In 2013 only about 5% of advisor acquisitions had external financing and in 2017 external financing was used for 65% of acquisitions.*
For the last 3 straight years (2015, 2016, 2017) external financing has been used in 60% to 65% of the acquisition deals completed in the industry.*
When AdvisorLoans launched our Loan Advisor model in 2015 it took us a while to complete our first $10 million in loans. Now, that’s just what a normal month looks like for us. Over 80% of the loans we assist advisors with are acquisition loans.
I believe in 2018 external financing will grow to 70% of acquisition deals and will represent 75% of how acquisitions are financed by 2020.
10 Primary Factors:
CONTRIBUTING TO ADVISOR M&A EXTERNAL FINANCING GROWTH
There are a myriad of factors playing into the external financing growth for acquisition loans. This Insight Article focuses on what I see as the primary factors.
1. Advisor Demographics
A major driver of external financing volume and growth trajectory is the correlation with the M&A activity trajectory expected over the next decade.
Fidelity recently released a report on their perspectives of the State of the Wealth Management Industry 2017: The New Value Drivers.** It showed that 37,684 advisors plan on retiring with the next five years and another 72,653 advisors plan on retiring in 6-10 years. With about one-third of advisors retiring within 10 years, the spotlight on the acquisition financing component of the transition of the industry’s retiring advisors to the growth advisors, widens and increases intensity.
The sheer quantity of acquisition opportunities becoming available is the biggest factor that will drive external financing growth.
2. Buyer Awareness
Just a few years ago, most of the advisors I spoke with didn’t know they had external financing readily available, or just had a vague understanding that a lender or two was focusing on advisor acquisition lending. Now when I consult with advisors, virtually all know they have financing available and have multiple options.
Over the last few years many custodians, independent broker-dealers, and firms have gone from not providing their advisors with information on external financing resources to providing one SBA lender resource to today where most now provide their advisors with a list of three or more resources for their advisors to call.
We have seen a substantial increase in platform providers and firms move from having no real strategy for the M&A external financing needs of their affiliated advisors, to integrating external financing as a key factor in their asset retention and growth strategies.
Acquiring Advisors are also exposed to the external financing options through internet searches, industry and firm conferences, media articles, and through word of mouth from the advisors who have gone through it. AdvisorLoans used to get most of our business from advisors finding us from a Google search for “advisor loans” or similar word search. Now, most of our business comes from referrals.
3. Seller Awareness
Seller awareness is one of the biggest contributors to a continued external financing growth trajectory. Most sellers now know financing is readily available.
In just a handful of years we have gone from sellers not typically having an issue with seller financing typically 70% to 75% of the deal, to today where many sellers now think that all acquisitions can now be done with 100% external financing and wanting 100% (or close to it) in an upfront payment (with a retention clause).
While 100% external financing acquisition loans still represent a minority of the loans done, the key point takeaway is that acquisition financing has flipped from mostly seller financing to mostly external financing.
In five short years, the advisor M&A industry has gone from buyers not even having to make a call to a lender about an acquisition loan, to buyers who aren’t pre-qualified with a lender for acquisition financing being in a competitive disadvantage in today’s acquisition marketplace.
4. Increasing Lender Options
The increased external financing options and lenders available will continue to push acquisition bank loans trajectory growth.
While there used to be one primary SBA lender with a focus on advisor lending, now there are several, and more getting into the space each year. Because SBA lenders have their own bank qualification and underwriting criteria in addition to that required by the SBA program itself, a lot of advisors didn’t qualify for one bank’s SBA loan even though they met all of the SBA requirements.
For example, SBA has a minimum 1.15 DSCR but an SBA lender may require up to a 1.75 DSCR, about 50% more cash flow needed than what the SBA actually requires. Now, there are enough SBA lenders with varying qualifying criteria that if an advisor meets SBA minimums AdvisorLoans has SBA lenders that will do the loan.
While there is still a significant lending gap to meet all acquisition structure types and other financing purpose needs advisors have, it is becoming smaller every year. AdvisorLoans continues to proactively add loan purpose and structure options, as well as new lenders to the industry for SBA, conventional and Tri-party acquisition loans.
5. New SBA Acquisition Equity Injection Rules
The new SBA equity injection rules that went into place January 1st, 2018 will also fuel more SBA loans by making 100% financing easier for most deals.
The new rules also make it easier for principals to sell to their associate or junior advisors without sacrificing on price, or upfront payment received. The new SBA rules will increase M& A deals from the convenience of sellers not having to wait and find the right external buyer when the advisors already working with them can now more easily get qualified for 95% to 100% financing.
With SBA loans still being the primary lending program utilized for advisor acquisitions, I believe this factor alone will propel 100% financing structures from currently just over a quarter of the deals, to as much as 1/3 of the deals in 2018. The more sellers have 100% upfront payments, or even 90% plus, the more sellers will be insisting their buyers get external financing if they want to be the buyer the seller selects.
6. Wirehouse Dynamics
Sunsetting will increasingly give way to selling into independence.
The current and foreseeable wirehouse dynamics will also play a role in increased acquisition financing. As W-2 employees, wirehouse advisors do not technically own their book, and as such have fewer succession options. There are also significantly more negative consequences to sunsetting arrangements for both the wirehouse advisor “seller” and “buyer.”
When a retiring advisor sunsets their practice to another wirehouse advisor they are essentially selling their practice for pennies on the dollar for what they would receive if they broke away to the independent channel and sold their practice (often simultaneously with breaking away). Sunsetting puts the retiring advisor in a position of selling their practice at not only a deep discount from what they could sell into independence for, but also substantially less upfront down payment, and is taxed as regular income instead of capital gains.
The wirehouse “buyer” advisor pays steep consequences as well. When a wirehouse advisor acquires clients from another advisor the wirehouse makes sure that a non-compete and non-solicit provision is included in the agreement. The wirehouse internal succession non-solicit provisions do not fall under protocol rules and are so heavy-handed in their agreement language that it makes it almost certain that clients obtained in this way won’t be able to come with an advisor that leaves the wirehouse in the future.
I believe these two dynamics will be a bigger factor with each passing year in pushing both retiring wirehouse advisors and those who want to grow through client acquisitions into the independent channel, adding external financing growth from the wirehouses where external financing for acquisitions is non-existent.
7. Platform Provider Retention and Growth Strategies
Custodians and broker dealers view the unprecedented wave of retiring advisors as both a crisis and an opportunity.
The firms who establish internal succession external financing options and programs will be able to retain more of their retiring advisor’s clients, assets and revenues by making it easy for the retiring advisor to sell to another advisor at the same platform provider.
The firms proactively helping their growth advisors with external financing options will excel in external acquisitions as well, adding new clients, assets, and revenues to their firm while simultaneously reducing that of their competitors.
The corporate retention and inorganic growth goals and strategies will be a major factor influencing acquisitions and the external financing needed to facilitate both.
8. Decreasing Appetite for Broker Dealer to Advisor Financing
While external financing is in full growth mode, both options and appetite for broker dealer direct acquisition loans are on the decline. For many of the broker dealers who have the financial strength to offer acquisition financing to their advisors, have for the most part viewed financing their advisors’ acquisitions as a “necessary evil.”
As external financing has become commonplace I believe there will be diminished interest by both broker dealers and advisors for broker dealer acquisition loans. In fact, AdvisorLoans is regularly refinancing exisiting broker dealer notes advisors previously took out and rolling them into new acquisition loans.
Broker dealer loans usually cap out at 50% of the acquisition sales price, have rates generally higher than what is available with lenders, and are often limited to external acquisitions that generate net new assets and revenue to the broker dealer.
As factors including skyrocketing compliance and regulatory costs continue to impact broker dealer margins, fewer IBDs will be willing, or able to afford, to offer acquisition loans to their advisors direct. I see broker dealer acquisition loans to advisors decreasing, adding another component to the external financing growth trajectory.
9. The Increasing Importance of Scale
Independent practices have many more factors causing margin compression than even just a few years ago. There is industry competition that is decreasing margins such as robo-advisory and competition from other advisors. The increased regulatory costs burden for independent advisors is increasing and will so all the more as the SEC and FINRA have made the independent channel regulatory supervision a priority.
Consolidation and scale in the independent world is moving from preferable, to a necessity for advisors to counter the margin compression they are under from lower fees and higher costs.
10. Organic Growth Not Enough
Advisors know just how hard sustainable year over year growth rates are to maintain. In the same Fidelity** study referred to earlier, Fidelity found that in 2016 assets withdrawn from existing clients now outpace new assets from existing clients.
If this is the case during a bull market essentially ten years running, we all know what happens to organic net growth during a bear market when the Wall Street bear does awake from its long hibernation.
Organic growth obviously has to be a priority for most every advisor to not only grow but to just stay even with the assets lost each year. While single digit net growth is appealing, a 50%, 100% and even 200% or more growth in one year through an acquisition is very appealing.
I see the continued pressure on sustainable organic growth to cause more and more advisors to seek out inorganic growth acquisition solutions.
*SRG 2018 Advisor M&A Review. https://www.successionresource.com/2018-advisor-ma-review/
**State of the Wealth Management Industry 2017: The New Value Drivers. https://clearingcustody.fidelity.com/app/proxy/content?literatureURL=/9882162.PDF