The rise of debt financing in IFA Mergers & Acquisitions
Key Takeaways
A high supply of IFA businesses for sale presents significant growth opportunities through M&A.
Debt financing for IFA acquisitions becoming more accessible, offering cost advantages over equity.
Lenders increasingly recognise the stable, recurring revenue streams of wealth management firms.
Debt-financed acquisitions can be a game-changer for mid-sized firms, enabling rapid growth and competitive advantage.
With about 500 IFAs looking to sell their businesses every year over the next five years, there is hardly any shortage of acquisition targets in this sector in the near future. There are some questions about the quality and cultural fit of the firms that come to the market - not all of them will be very attractive to most acquirers – but there is certainly no shortage in terms of numbers.
The supply of businesses for sale provides a huge opportunity for mid-sized and larger IFA or wealth management firms to grow significantly through M&A activities. The benefits of growing through mergers & acquisitions are clear for the acquirer:
Cost synergies;
Revenue synergies;
Economies of scale, in particular concerning compliance and technology;
“Multiple arbitrage”—larger firms command a higher exit multiple than small firms.
There are also clear benefits for the industry in general: larger firms are more likely to have more standardised processes allowing them to deliver consistent quality to clients.
The big question is how to finance the acquisition of IFA or wealth management firms?
Historically, lenders were reluctant to finance acquisitions of IFAs or wealth management firms through cash flow lending, instead requiring asset-backed security and/or personal guarantees. This was a problem for acquirers--although IFAs or wealth management firms advise their clients on how to invest assets, these firms, like most other professional services firms, usually don’t own any significant assets themselves. In other words, in most cases, there is nothing against which to secure a sizeable loan. If a larger wealth management firm acquires a smaller IFA, it is usually acquiring goodwill, which has no value as security. This has been a barrier for all but the largest acquirers, who are faced with using “free cash” or raising equity to fund purchases. However, the problem with equity is that it is very expensive (according to recent research from Stern School of Business the average cost of equity for wealth management firms is more than twice the cost of debt). Further, finding equity investors is never easy.
Industry experts at Dyer Baade & Company are seeing this landscape changing. Debt providers are slowly but surely starting to understand a key characteristic of IFA and wealth management firms that have been overlooked for many years: the predictability of income and quality of earnings. Most IFAs and wealth management firms tend to generate about 80% of their income as a recurring fee based on Assets under Management (AuM). Further, as a consequence of the diversification of the underlying investment portfolios, recurring income tends to be much more stable than the wider stock market performance. That means that the income streams of wealth management firms tend to be resilient during downturns. In fact, indicative research from Dyer Baade & Company shows that whilst the stock market fell by more than 30% due to the coronavirus crisis and still hadn’t recovered by the end of 2020, most wealth management firms were able to report stable revenues that were in line with the prior year. Finally, IFAs are required to invest modestly in IT and other infrastructure and the result is that profits generated produce high “cash conversion”, which is an attribute prized by lenders.
Against this background and with the help of a corporate finance specialist who has a deep understanding of the wealth management industry, potential acquirers can be presented in a way that makes them very attractive to alternative debt providers, debt funds and challenger banks who are looking for relatively safe and predictable investment opportunities. Dr Daniel Baade, CEO of Corporate Finance firm Dyer Baade commented, “We see a significant increase in appetite from debt providers to finance acquisitions in the wealth management sector. Wealth management and IFA firms generate very predictable earnings with a very high cash conversion. This makes them, in principle, a highly attractive investment case. Assuming the acquiring firm has a sound strategy to generate synergies, does appropriate due diligence and has downside protection in the SPA, acquisition financing is eminently achievable.”
Dr Baade added, “Some of the largest consolidators who are owned by private equity firms are effectively financed by significant amounts of debt. However, we start to see more and more mid-sized firms trying to raise debt to finance acquisitions.”
Raising debt to finance one or a number of acquisitions can be a game changer for a mid-sized firm that is looking to grow fast. It does not only allow them to generate cost and revenue synergies but also to scale the business. Having sufficient firepower gives them also a strong competitive advantage in securing deals with the most attractive acquisition targets.
Editors note: a similar version of this article was published on professionaladviser.com