Tip the Scale - Why Valuation, Security, and Certainty Require Scale

There has been a large amount of talk and a fairly good amount written about the importance of size or more precisely scale in the wealth advisory business. What is scale and why is it so important? Essentially think of scale as having size relative to others in your industry/business that allows you to spread costs over a larger revenue base and generate outsized free cash flow.

Speaking with a well known head of one of the asset custodians on this topic not too long ago, we asked him what he considered true scale in the independent RIA business? His response was fairly consistent with what I have heard tossed about in the industry news, conferences etc. He said that for practical purposes today, scale is probably around the $1 billion level. He then commented on how just about 15 years ago many RIAs, and those who served them, viewed scale at just $100 million in assets. 10 years from now scale may be $10 billion or more depending how things evolve in our space. While many will adjust and thrive, my opinion is that a greater number of advisors will face severe head winds in the future if they do not grow to a size that allows them to compete.

Here are some reasons why scale is critical in the RIA business, regardless of whether your ultimate plan is to sell your business. Since a business sale is the obvious direction the conversation goes when talking scale, let’s hit that first. Bigger firms, growing faster generally have larger valuation multiples. Ask any M&A practitioner or industry consultant and they will confirm this point. There are dynamics of supply and demand at work, and currently there is only a relatively small number of $1 billion plus firms and very few with assets greater than $5 billion. Larger firms with scale produce more free cash flow and that makes them the primary targets for larger buyers. Since deep pocketed buyers need deals to be material and “move the needle” to justify the time and resources spent, they will seek out those larger firms thus driving up valuations. So, the outsized free cash flows from spreading costs across the larger revenue base and the laws of supply and demand are two main drivers that contribute to firms who have achieved scale, which makes them able to realize greater valuation multiples.

Now, to more practical thinking for those that have no interest in seeking a buyer for their business. Scale is critical in an RIA business because it is critical to the long term best interests of your clients and your employees. Many advisors create a nice lifestyle practice of anywhere from $75 million to $250 million and then decide, whether consciously or not, to shift to harvest mode and not invest in their business, people, and technology to build scale. All of the free cash in the business is taken out for lifestyle and very little remains to build a true enterprise with scale. Part of investing in the business is being able to recruit and retain great people to best serve clients. Without growth and scale, the business is unable to generate the free cash flow to invest in and compensate great people or provide the resources necessary to keep them. As a younger advisor matures and looks to best serve clients, they may explore other firms that are more competitive in the marketplace. So, growing to scale and having the cash beyond the needs of the owners to invest back in the business is critical. Great people and great systems will be critical over the next 10 years and beyond.

Clients too will become more aware of the value an advisory firm should be bringing to table for their benefit. If a client perceives that their current advisor is not investing in the business and proactively growing and adding capabilities, yet another advisor in the same market is, the client may make a change. Also, as baby boomers age and next gen clients earn and inherit more wealth, they will be met by a myriad of technological advances and wealth management solutions. If an advisor does not grow his business to a sufficient scale to generate substantial economies, they may suffer severe margin compression and in the most extreme cases extinction. Information is cheap, in most cases free. It is a certainty that the client of the very near future will know which advisors have invested in their business to best serve clients and those who have not.

A final thought on why growing and achieving scale is important is succession planning. As stated above, the valuation multiple applied to your business will almost certainly be larger if you can achieve true scale. It is also true that the likelihood of finding a buyer should be greater if you are greater in size and creating tremendous free cash flow. But also consider this: your successor in the business is probably more excited about buying into a thriving business with a more certain future due to the fact that your business is an enterprise. It has the scale and the free cash flow to invest in the business to serve clients, making the clients less likely to leave or find another advisor. It’s more valuable to your successor and it’s more exciting to your successor. He or she has the resources to best serve clients and to combat the natural market forces of fee compression, competition, and down market disruptions. They are buying into or perhaps buying all of a business that’s going to be around until they are ready to sell to their successor.

While having a nice small lifestyle practice may seem like the perfect fit for you and your goals, it make sense to consider how getting to scale will better benefit you, your family, your employees and your clients. If you are unable to grow to scale on your own, there are plenty of opportunities to partner with firms that have already achieved scale and thus most effectively short cut the process. Its a simple case of how to best manage the equity in your business. This can be done without sacrificing all of the great things that come with being an independent RIA!

Important Disclosure: This content is for informational purposes only. Opinions expressed herein are subject to change without notice. Beacon Pointe has exercised all reasonable professional care in preparing this information. Some information may have been obtained from third-party sources we believe to be reliable; however, Beacon Pointe has not independently verified, or attested to, the accuracy or authenticity of the information. Nothing contained herein should be construed or relied upon as investment, legal or tax advice. Only private legal counsel may recommend the application of this general information to any particular situation or prepare an instrument chosen to implement the design discussed herein. An investor should consult with their financial professional before making any investment decisions.

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