For more than a decade, the growth strategy for large independent broker-dealers has been simple. First, sell to a private equity manager with plenty of cash. Next, lever up and take on a mountain of debt. Then go on a buying binge, picking off broker-dealers one, two or even three at a time. Even better, acquire a network of brokerage firms that an insurance company no longer wants to own, because advisers don’t like to sell proprietary products.
LPL Financial and Cetera Financial Group are perhaps the poster children of this strategy. Since 2005, when two private equity managers took a majority stake in LPL Financial, that firm has acquired at least 11 firms. And since 2010, when what eventually became Cetera was spun off from Dutch insurer ING Groep and bought by Lightyear Capital, the network has done at least a dozen such deals.
“Bulk up and do it fast” has been the game plan for independent broker-dealers, until now. Consolidation in the independent broker-dealer industry will look a lot different in the 2020s than it did in the 2010s. Growth from snatching up decent-sized individual firms, say those with 200 to 1,000 reps or advisers, for the most part is over because most firms of any decent size have already been bought. Further, anxiety about the risks of the debt-laden strategy has started to raise its head, as the danger of easy money and high valuations concern financial advisers.
“We get calls almost every week from private equity firms trying to get into this business,” said Carolyn Armitage, managing director at the investment bank Echelon Partners. “Over the next decade, the IBD industry is poised for continued consolidation and making the business more professional.”
“Around the industry there are certainly fewer large firms to acquire,” said James Poer, president and CEO of Kestra Financial Inc. “But there are a fair number of firms out there of $50 million to $150 million” as ranked by total revenues, he noted.
Now, for IBDs to see real growth, megamergers will have to happen. A handful of such deals occurred last year. In February, private equity manager Warburg Pincus said it was buying from another private equity manager Kestra Financial Inc., an independent broker-dealer platform that serves over 2,000 advisers and $92 billion in client assets. According to investment bank Echelon Partners, the estimated transaction value was $600 million to $800 million, nine to 12 times EBITDA, or earnings before interest, taxes depreciation and amortization.
And, over the summer, Reverence Capital Partners bought Advisor Group, an independent broker-dealer network that serves over 7,000 advisers and $268 billion in client assets under administration. The estimated transaction value was $2.3 billion, or a 12 to 15 times EBITDA multiple, according to Echelon.
“The transaction is part of a growing theme in private equity consolidating the broker-dealer landscape,” according to a report by Echelon. “In fact, Advisor Group announced a prospective merger with Ladenburg Thalmann only months later, which would create a megaplatform serving approximately 11,500 advisers and boost assets to more than $450 billion.”
And those megadeals were overshadowed by perhaps the greatest grab for scale the financial advice industry has ever seen. While not directly involving independent broker-dealers, Charles Schwab’s acquisition of TD Ameritrade affects thousands of advisers registered with IBDs who use those two custodians to run separate but related registered investment adviser businesses.
That means private equity buyers, as they acquire and sell more firms, will only have an even greater impact on financial advisers who work at independent broker-dealers or registered investment advisers over the next five to 10 years, executives said.
“The firms are getting bigger to be better, and focusing on more specialized services to advisers, as opposed to getting bigger to be bigger,” said Ms. Armitage, who worked previously with LPL and a predecessor Cetera firm. “Private equity to private equity sales [of broker-dealers] will happen, for sure.”
Perhaps the biggest difference in the independent broker-dealer industry is that it is entering this decade from a position of strength. Ten years ago, that wasn’t the case, as the industry was reeling from market losses and product failures of the credit crisis. Now, firms are generating record revenues from all-time highs in the stock market and corporate tax cuts that have fattened profits.
In the past 10 to 15 years, private equity money has descended on the IBD and RIA industries like a giant cloud of locusts, gobbling up every type of firm it can. The problem is, of the top 25 independent broker-dealers, as ranked by InvestmentNews — meaning those with $220 million or more in total revenue in 2018 — there is almost nothing substantial left to buy.
That could change, however, if one of the remaining seven large insurance company-owned firms is put on the block, but insurance brokers are unattractive and notorious for being among the lowest producing advisers when it comes to generating securities commissions and fees. Ten of the InvestmentNews top 25, or 40%, are already, or soon to be, owned by two giant broker-dealer networks owned by a private equity manager — the previously mentioned Cetera Financial Group and Advisor Group.
Three more, Commonwealth Financial Network, Cambridge Investment Research Inc. and Lincoln Investment Planning, are closely held private companies, and ownership of Commonwealth and Cambridge have consistently been adamant about having no desire to sell. Four more — LPL, Ameriprise Financial Services Inc., Raymond James Financial Services Inc. and Waddell & Reed Financial Advisors — are essential businesses for large, publicly traded companies.
“There are a lot of smaller, niche firms that are really great organizations, profitable, and have advisers with good profiles,” said Mr. Poer, “and there are some that are not. We don’t view the world as needing to get big. We look at the industry through a lens of the quality of advisers, not quantity.”
With larger deals, valuations for independent broker-dealers are high, some have noted, raising questions about the amounts of debt used to finance the deals. Genstar Capital, a private equity manager that focuses on midsized companies, brought the issue to the fore when it said in 2018 it planned to finance a majority of its $1.7 billion acquisition of Cetera Financial Group through the sale of $1 billion in below investment-grade debt.
And when Reverence Capital, in August, completed its purchase of Advisor Group, it issued $1.6 billion in junk bonds to finance the deal. After Advisor Group said in November it was acquiring Ladenburg Thalmann, S&P Global Ratings placed the company’s debt on a “negative” credit outlook, or CreditWatch, meaning its B+ rating could be lowered.
“The CreditWatch placement reflects our expectation that Advisor Group’s mostly debt-financed acquisition of Ladenburg Thalmann could potentially weaken the company’s credit metrics, particularly its debt service capability,” according to S&P Global Ratings.
Advisor Group is not sweating its current debt levels.
“We are extremely comfortable with our capital structure,” wrote its CEO, Jamie Price, in an email. He added that the firm’s expectation is that the combined Advisor Group and Ladenburg organization, on a pro forma basis, will have lower leverage levels compared to the close of the network’s most recent financing in August.
Financial advisers need to keep a careful eye on the amount of debt private equity managers use to buy broker-dealers, according to executives and analysts. All they must do is think back to the example of Nicholas Schorsch’s RCS Capital Corp., which spent $1.1 billion in mostly borrowed cash, in 2014, to buy Cetera. When Mr. Schorsch’s nontraded real estate investment trust business fell apart, his brokerage network slid into bankruptcy because the cash flow wasn’t available to cover the debt payments. Advisers who bought stock in the company saw their investments wiped out.
But rewards for private equity investors can be substantial. For evidence of that, all they have to do is look to the history of LPL Financial.
After a majority of LPL was acquired by two private equity managers in 2005, LPL had its initial public offering in late 2010 at $30 per share. Last Thursday, LPL shares closed at $97.05 per share, an increase of more than 300% in a little less than 10 years.
Frothy valuations of broker-dealers should concern advisers, particularly if the broad stock market takes a turn for the worse, noted Steven Chubak, senior analyst, diversified banks & brokers, Wolfe Research.
Firms with lower levels of debt to EBITDA could take advantage of the move to megamergers, Mr. Chubak noted.
“For example, LPL is going to grow organically and also benefit from IBD mergers and acquisitions by recruiting out of those firms,” he said. “That has been a good recipe of success for such firms.”
Meanwhile, if megamergers falter this year, that means 2020 will turn into a recruiting knife fight among IBDs looking for growth, with rising costs to pay brokers and advisers to leave one firm to work at another.
“There will be a lot of hand-to-hand combat from a recruiting standpoint, and it’s hard to grow if equity markets are choppy,” said Larry Roth, managing partner of RLR Strategic Partners, a consultant and investment banking boutique. Mr. Roth has run both of the predecessor organizations of Advisor Group and Cetera Financial. “It’s going to be difficult [for broker-dealers] to grow. Picking up 200 to 1,000 advisers will be very tough because there’s not much for sale.”
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