Missing the Point?
How Private Equity Investment in Wealth Management Could Be Bad for Clients
For the past two years, the financial press has been breathlessly reporting a surge in merger and acquisition activity in the wealth management industry.
Hellman and Friedman paid $3 billion to buy pioneering digital advisor Financial Engines. Goldman Sachs paid $750 million to acquire United Capital. Reverence Capital Partners paid an estimated $2.3 billion for Advisor Group and Tucker Anthony Associates picked up Wealth Enhancement Group, which itself had executed 13 independent advisory practice acquisitions since 2013 – just to name a few.
All this activity has certainly been good for financial industry investment bankers. But I question whether it is a good thing for the wealth management industry or, more importantly, for our clients.
Why Wealth Managers May Sell
There are legitimate reasons for the boom in wealth management M&A activity, most of them having to do with a confluence of factors making it harder and harder to operate smaller broker-dealers or registered investment advisers (RIAs), including:
- Sharply increasing regulatory burdens and compliance costs
- Fee compression driven by large-scale index fund and ETF sponsors like Vanguard, Schwab and Blackrock
- The need to keep up with and invest in technology platform innovation
- Changing client experience expectations as to the range of available products and services, quality of reporting, service levels and ease of use
- Aging principals looking to monetize the businesses they have built, along with
- Rising valuation multiples, which are making it harder for successor employees to buy their partners out
As a result, many of the deals getting done are consolidation strategies – small firms selling to aggregators, plugging their subscale businesses into larger platforms that have the resources to invest in technology, keep up with regulatory requirements and offer a broad, up-to-date product platform in an era of continuous innovation.
What's Wrong With This Picture?
This trend could be problematic for a number of reasons. First, much of the M&A activity in wealth management is being driven by private equity firms, which have accumulated larger and larger pools of investor capital – so-called "dry powder" that needs to be put to work. These private equity players have raised capital from limited partners attracted by the opportunity to make money servicing the increasingly complex and challenging needs of baby boomers entering and navigating their way through retirement.
The problem with this dynamic is that private equity firms and the wealth management industry have entirely different time horizons. The promise private equity firms make is that they will invest their limited partners' capital over three years, improve the returns of the wealth management business they invest in by consolidating them and/or operating them more efficiently, and then "harvest" those investments in five to seven years.
That short-term time horizon can be seen in deals where one private equity firm sells to another. Lightyear Capital, for example, recently sold two of its investments: Wealth Enhancement Group, to TA Associates, and Advisor Group, to Reverence Capital Partners. Why? I haven't asked Lightyear founder Don Marron. But Lightyear Capital had been the majority owner of Wealth Enhancement Group since 2015, and purchased Advisor Group in 2016 with PSP Investments. My guess is the time had come to "harvest."
Effective wealth management, by contrast, is best delivered (some might say can only be delivered) over long time horizons. A few years ago, I posted a blog on my LinkedIn Influencer site titled "The Long Haul." It features a financial advisor having dinner with a long-time client whose retirement home was built with the proceeds of an investment portfolio carefully stewarded over 40 years.
A private equity fund with a five-to seven-year holding period is unlikely to be the best steward of a wealth management business whose value proposition to clients requires continuity in advice and execution, or where results are measured over decades.
That "horizon mismatch" has the potential to lead to suboptimal outcomes.
The second problem is that a number of private equity-driven deals have used leverage. To finance its acquisition of Advisor Group, Reverence Capital is using $1.6 billion in below-investment-grade bonds. They are able to do that because wealth management businesses have the kind of recurring revenue streams that are attractive to lenders. But what happens when the market, now at historical highs and well into the teeth of a decade-long bull market, turns down?
The third cause for concern is that the principal objective of private equity firms is to generate returns for their limited partners and, in the process, for their general partnership. Wealth management just happens to be a fruitful area in which to accomplish that. There is nothing "purpose-driven" about the investments private equity funds are making in wealth management. It's all about returns.
If Not Private Equity, Then Who?
I would argue the best owner and manager of a wealth management business is an organization committed to wealth management for the right reasons – one that wants to make a positive difference in the lives of their clients.
It's an organization that has both a long-term horizon and enough scale to invest in their platform and compete effectively.
Most importantly, it's a firm that is employee-owned. Because aligning the interests of clients with those of the advisors helping them to manage their wealth has always been a critical ingredient for effective wealth management.
Those kinds of firms exist. The firm I work for is one of them. But they are not owned by private equity funds – and never will be.