The unquenchable thirst for wealth management

With $5 billion in assets under management and nine acquisitions under its belt, some might assume Merit Financial Advisors is hitting all the right notes for building scale in the modern wealth management industry.

In reality, the 22-year-old advisory firm has reached the level at which the deep-pocketed world of private equity capital and expertise steps in to rocket enterprises like Merit to the stars.

“Last year we made it a mission to find a capital partner because we knew we needed to bring in some additional expertise as well as the capital backing,” said Kay Lynn Mayhue, Merit’s president.

Less than a month after selling a minority ownership stake to private investor Wealth Partners Capital Group and private equity firm HGGC, Mayhue is anticipating “six to nine deals this year.”

That is a bold statement coming from an RIA that didn’t make its first acquisition until 2012 and peaked at three deals in 2017. But this is in many respects the epitome of the wealth management industry feeding the hungry herds of private equity investors.

“Private equity continues to vote for the independent wealth management model with their pocketbook,” said David DeVoe, chief executive of DeVoe & Co.

“We are at a stage when PE is not only very attracted to the industry, but their investments will actually strengthen it,” DeVoe said. “The capital they provide is funding increasingly bolder moves by management teams, and ultimately the strategies and innovation that achieve success eventually trickle down to other smaller firms in the industry.”

Mergers and acquisitions in the RIA space have been setting records for the better part of a decade, and when even a global pandemic can’t derail the pace of consolidation, the focus turns naturally to the seemingly irreversible influence of private equity money.

“Either you’re all in and getting better at what you’re doing, or you might as well sell your wealth management business,” said Alois Pirker, research director at Aite Group.

The pursuit of what the wealth management industry commonly sums up as scale makes perfect sense up and down the food chain, but especially for the private equity investors homing in on the space as if they only recently discovered its golden goose potential.

Ganesh Rao, head of the financial services sector at private equity firm Thomas H. Lee Partners, said the consolidation in wealth management is only in its “second or third inning.”

Rao said his firm started paying serious attention to the wealth management space a few years before taking a majority ownership stake in Hightower in 2018.

“As a firm we spend a lot of time trying to figure out and identify sector opportunities,” he said. “One of the impetuses was the fiduciary rule being rolled out, which we saw as another thing that would push the RIA space.”

Talk to any PE firm long enough and the conversation inevitably turns to the appeal of the fee-based business model enjoyed by most RIAs, which has been one of the few areas in financial services that remains immune to significant fee compression.

“I can’t speak to what all firms are looking for but to us it’s really a function of team cohesiveness, a high-quality offering to clients and growth,” said Gaurav Bhandari, managing partner at the private equity firm Long Arc Capital.

“The client relationships are sticky and long-standing, and that’s attractive to us,” he said.

Long Arc Capital was founded in 2016 and acquired a majority interest in Robertson Stephens two years later.

In three years of private equity ownership, Robertson Stephens’ assets under management quintupled to $2 billion.

“We saw a brand at Robertson Stephens, and we had confidence in our ability to grow the business,” Bhandari said.

Just as references to sticky assets and predictable income streams represent the universal appeal of wealth management, growth is the universal objective. And no matter how that objective is tailored or polished, it is never hidden.

BENEFITS OF SCALE

At Hightower, for example, the PE ownership has engineered 20 deals since 2018, boosting total assets under administration to more than $100 billion, a 230% increase in less than four years.

Those kinds of results for an industry that is constantly banging the drum about the benefits of scale seem to tamp down any debate about whether private equity is good for the wealth management industry.

“We do not at all feel pressure to grow through acquisitions,” said Bob Oros, who took over as chief executive of Hightower a year after Thomas H. Lee made its investment in the aggregator.

On the matter of growth, Oros said, “It’s part of our strategy, but it’s really about the right-fit firms, high-quality firms, and it has to be at a price that makes sense.”

One of the most aggressive buyers in 2020, Hightower charged into 2021 by announcing three acquisitions before the end of January.

If it seems as if private equity investors are relative newcomers to the wealth management space, it’s not because anything dramatic has changed about either wealth management or private equity. The answer lies in the kind of scale emerging across the advisory business that private equity is now playing a major part in building.

“With private equity sometimes it comes down to the size of their minimum investments that they have to make in a firm, and 10 years ago you didn’t have that many RIAs with $10 billion-plus under management,” said Mark Bruno, managing director at Echelon Partners.

“These days, private equity is supporting a lot of aggregators and consolidators,” Bruno added.

Steve Young, president and co-founder of HGGC, described the PE firm’s initial foray into the wealth management space as no different from its work in any other business or industry that could benefit from a leg up.

“We are buy-and-build partnership experts, and we’ve seen this movie before,” said Young, who is best known as the Hall of Fame quarterback who led the San Francisco 49ers to three Super Bowl victories. Young called Merit Financial Advisors a “great platform with great leadership. And we have operational resources and capital markets expertise.”

Regarding the timing of the move into wealth management, HGGC partner Neil White said it came down to size.

“It took time to find platforms with the scale to support a private equity investment,” White said. “We look for situations where you have attractive industry dynamics, and a partnership element where you can bring the right people together.” 

But as Young acknowledged, private equity relationships are often short-term in nature, which is something the wealth management industry will have to accept.

“Private equity has a fuse, and that can sometimes be one of its shortcomings,” he said. “But at HGGC, we want to focus on leaving businesses in a better place. We are building something that we hope is attractive to other wealth management firms to come join us.”

CASHING OUT

Not all the private capital finding its way into the wealth management space is in the form of a private equity fund, but when it is private equity, the original investors are typically looking to cash out within three to five years. That usually means an equity sale to another set of private equity investors.

In Merit’s case, for example, outside investor Wealth Partners Capital Group established a limited liability corporation to invest in Merit and HGGC provided most of the capital.

At Hightower, the initial 2018 investment by Thomas H. Lee was recapitalized in December to provide liquidity to some investors by creating a separate PE fund with Hightower as the lone investment.

Jim Dilworth, co-founder of Entwood Holdings, distinguishes his 2-year-old private investment company from classic private equity funds by stressing his longer-term commitment.

“The next generation of advisers are not looking for a quick liquidity event; they want a long-term runway to build their own business,” he said. “There’s nothing wrong with private equity, but there’s so much capital chasing these RIAs, it’s inflating valuations and putting pressure on owners to sell, and that creates a challenge for the younger next generation.”

Sam Ryder, vice president at the private equity firm LLR Partners, acknowledged the reality of short-term partnerships when it comes to private equity.

“When we think about investing, we view our underwriting from a five-year investment horizon,” he said. “We’ve held two or three years, and we’ve held investments for seven-plus years, but the average shakes out around five.”

But the ownership transitions, he added, are rarely abrupt or a surprise to anyone.

“As far as successful exits, over time our portfolio companies are developing relationships with some of the larger buyers,” he said.

OUTSIDER IMPLICATIONS

Once an RIA attracts the attention of a private equity investor, it has typically already grown into a formally structured business. But Oros of Hightower said it is still important to understand what it means to partner with outside investors.

“You have to be ready for a partner, whether it’s with private equity or some other capital partner,” he said. “I can promise you I have accountability with my partners, and you have to ask yourself if you’re ready for that. Don’t take someone’s money if you’re not ready to do what you say you’re ready to do.”

Meanwhile, there remains a persistent debate over spiking advisory firm valuations as private capital continues to fuel M&A activity.

QUALITY OVER QUANTITY

Tim Bello, co-founder of Merchant Investment Management, said his 4-year-old firm has 26 minority stakes in the wealth management industry and maintains no specific target on the number of firms it will buy or a dollar amount.

“There’s a massive addressable market and that causes us to hurry very slowly,” he said. “We want quality over quantity, and we want to make sure the firm wants to grow and can grow.”

As a representative of a company pumping money into the wealth management space, Bello justifies it in many ways, including arguing that selling pieces of a privately owned advisory firm produces a measurable valuation.

“Every one of these firms deserves a mark to market,” he said. “They deserve a line item on their balance sheet that reflects their life’s work.”

On the issue of whether that valuation is being inflated by the same process that makes valuations necessary, Bello believes private capital might be a party to it, but not solely responsible.

“The desire to enter the wealth management space is totally justifiable and understandable, but that’s not the only thing driving up the numbers,” he said. “The [wealth management] market is overvalued, but so is the stock market.”