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Vonnegut: The Math and Meta Questions of Going Independent
The decision should start and end with clients
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For some advisers, going independent can pay off big. PHOTO:
ISTOCKPHOTO |
By
Norb Vonnegut
Oct. 15, 2015 7:00 a.m. ET
Let’s make a deal.
I’ll assume your
three-person team manages $1.5 billion in total assets at a wirehouse,
generates $10 million in annual revenue and splits compensation
equally. You’re sick of the mothership and want out.
Door No. 1 is a “3x”
deal from another wirehouse, potentially giving you three times your
annual revenue. You sign a nine-year employee forgivable loan and your
team gets $15 million up front. If you hit your numbers, you get
another $15 million. After income taxes of 40%, your deal could be
worth $18 million in total.
Door No. 2 is an “RIA in
a box.” You dig into your pockets and start a registered investment
advisory company. The payoff here is more uncertain—but it may add up
to a lot more. I assume revenue is flat and your team sells the new
firm after five years for 10 times pretax earnings. In this case, your
team splits $35.7 million after tax.
What’s your vote?
Before I explain my
hypothetical example in more detail, let me say flatly: Compensation
is the wrong way to make your decision. The decision starts and ends
with clients, as highlighted in these four questions you should be
prepared to answer:
Will
clients follow you to a startup?
About 75% to 90% of
clients move with their financial advisers, estimates John Straus,
chairman and chief executive of FallLine Securities, which provides
transition services, a broker-dealer, and a technology and services
platform for independent advisers. Breakaway advisers “design the
client experience” and improve it, says Mr. Straus, explaining the
high retention rates.
By contrast, wirehouse
systems sometimes force advisers to “shoehorn a client into a client
experience that the client doesn’t always want,” says Mr. Straus, who
previously ran the wealth-management units at UBS Group, J.P. Morgan
Chase and
Morgan Stanley.
Can you
grow your business?
As much as we love to
hate wirehouses, their banking operations create wealth and,
consequently, opportunities for financial advisers. There’s nothing
like referrals from investment bankers to grow assets—if you can get
them.
On the independent side,
meanwhile, there is potential consolidation with other practices,
particularly as financial advisers get older. “About 75% of RIAs in
the United States have less than $100 million in total assets under
management, and many of these firms lack a succession plan or the
ability to recruit a successor,” says Jay Hummel, a senior vice
president at
Envestnet
which provides wealth-management services and software to financial
advisers.
Talk about the range of
possibilities. If you have significant relationships with
private-equity managers, you might be able to join forces, roll up
smaller RIAs and align your interests in a way that would never fly at
the wirehouses. And when’s the last time you picked up $100 million in
assets?
Does
your team have the right stuff to go independent?
Some firms help advisers
break away with as little as $50 million in client assets, says Mr.
Straus. But he adds, “$400 million to $500 million is necessary to
deliver a tailored client experience.”
Mr. Hummel concurs with
those numbers but recommends advisers have a plan for getting to $1
billion after going independent.
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For a hypothetical
brokerage team, here are potential annual costs and financial
benefits of launching a new firm and selling it after five
years.
ANNUAL REVENUE:
$10,000,000
Platform fee:
$1,900,000
Staff
compensation and benefits:
$920,000
Adviser
benefits:
$300,000
Rent/research/office expenses:
$304,480
Business
development and marketing:
$200,000
Legal/accounting/insurance:
$190,000
TOTAL EXPENSES
BEFORE ADVISER DRAW: $3,814,480
ADVISER DRAW:
$1,500,000
EARNINGS BEFORE
INTEREST, TAXES, DEPRECIATION AND AMORTIZATION: $4,685,520
Hypothetical
equity value (10 times Ebitda): $46,855,200
Capital-gains
tax (at 23.8%):
$11,151,538
AFTER-TAX
PROCEEDS: $35,703,662
Source: Norb
Vonnegut, with assistance from FallLine Securities
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Both men say teams
should expect to invest $75,000 to $300,000 before they can open their
doors for business—with real-estate decisions being a big part of the
swing. Importantly, this range doesn’t include “leave behinds” like
deferred compensation or employee forgivable loans. Yikes. Not them
again.
Figure that it takes
roughly six months for teams to build the infrastructure necessary to
break away. And that’s once you decide to go for it, says Mr. Hummel,
who notes that teams generally first spend a year thinking about it.
‘Why are
you doing this?’
This is the one question
that all clients ask, says Jack Petersen, the managing partner at
Summit Trail Advisors. His firm opened for business in New York,
Chicago and San Francisco in July and worked with Dynasty Financial
Partners to structure the move.
According to Mr.
Petersen, advisers who go independent must start with the mind-set
that “I’m in this for the client.” They must be driven by a personal
need to improve the client experience, which is possible he says,
because “when you start brand new, you can leverage the latest
technology.”
Now, back to my math for
going independent.
To adjust for risk, I
projected flat revenue at the RIA. What happens if you break away, the
market crashes 37% (shades of 2008) and it takes five years to recover
at the shop you create?
I created a scenario for
a team serving ultra-high-net-worth clients. The head count includes
three advisers, four support staff, a compliance officer and a chief
operating officer.
Importantly, adviser
compensation at an RIA equals the adviser draw (shown as $1.5 million
in the table) plus whatever profits are distributed. Adviser draw,
therefore, shouldn’t be compared with, say, 45% payouts from
wirehouses.
In the year of the sale,
the buyer and seller are likely to negotiate the adviser-draw number
hard, with advisers pushing for the lowest number possible to maximize
the enterprise value of their firm. Conversely, the buyer will argue,
“We need to compensate somebody for the valuable services you provide
clients, either you or your replacements.”
The numbers and scenario
are mine, although I drew extensively on my discussions with Mr.
Straus of FallLine Securities. I would also note that expenses vary
according to capabilities, assets under management and target client
niches.
My take: For whatever
reason—risk profile, overhang of EFLs, the state of your career—the
RIA route isn’t right for everyone. But given the potential to create
better client experiences unencumbered by legacy technology, I think
financial advisers owe it their clients to investigate the pros and
cons of going independent.
“I’ll take Door No. 2,
please.”
Norb Vonnegut built his
wealth-management career in New York and now writes thrillers about
financial malfeasance. Email him at
norbert.vonnegut@dowjones.com.
Twitter: @NorbVonnegut
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