by Rogan LaBier
Mergers and acquisitions in the small, privately held broker dealer space can appear downright mysterious. They occur behind closed doors, and frequently details are not publicly disclosed. There is no standardized procedure for reporting these transactions, and few people have firsthand experience with them. It is almost as if they donâ€™t exist, but clearly they do: Every owner of every broker dealer has a friend who has sold his firm, or bought the assets of another. Itâ€™s just that when the time comes to contemplate selling oneâ€™s own practice, there are very few places to turn â€” and fewer knowledgeable professionals.
But there is hope. There are at least two types of companies that make a business of affecting these transactions, and, as a matter of course, track these transactions. One operates primarily in the broker dealer vertical, whereas the other focuses on transitions in the individual practice space â€” catering not only to financial-planning pros, but also insurance pros and CPA practices. Both types of firms publish qualitative reports on the industry.
Now would be the time to tell you the self-serving part of this story. I run one of the two types of companies mentioned above. Far from being in the dark regarding mergers and acquisitions (M&As), I see them on a daily basis â€” matching buyers and sellers of broker dealers is my companyâ€™s only business. Rest assured, in this punishing regulatory environment it is a solid business. And Iâ€™m something of an evangelist too, insofar as getting the word out: Yes, there is a vibrant market for buyers and sellers of broker dealers and books of business; and yes, there are generally accepted accounting principals that inform the transactions and valuations; and yes, we track these transactions on an active basis, analyzing the trends, and making the data public, for anyone who is interested. Whereas many of the intermediaries in this space are former real estate brokers, general business brokers, or attorneys, my background is in broker dealer operations, and as a former sales trader and prop trader. I was even a principal at one of the largest electronic brokerages during â€œthe bubble days.â€ I understand what owners go through every day. It is troubling that so few owners of small broker dealers understand the metrics involved in selling their practices.
The so-called â€œsmall broker dealerâ€ space, defined by the NASD as broker dealers with fewer than 150 employees, trades nearly in a vacuum. The major financial press has little interest in tracking this space. Most trade publications fail to service the â€œsmallâ€ broker dealer vertical. And yet the fact remains that nearly 80 percent of all broker dealers not only qualify as â€œsmall firmsâ€ but are in fact much, much smaller than the designation would suggest. Indeed, almost 80 percent of all broker dealers have fewer than 10 registered reps â€” and so are bona fide mom-and-pop shops.
Mom-and-Pop Get No Respect
Mom-and-pop shops are the broker dealer industry in this country. Small firms are the true face of the industry. Yet you rarely see their needs catered to. Itâ€™s not that the major financial publications donâ€™t care about this space, they do, but it is extremely difficult to find out about transactions in this space. And of course, major news media is dependent upon huge advertising accounts, and small firms just donâ€™t advertise like major wirehouses do. But there really is interest from the major media providers; my company has been asked, for example, by one of the largest financial media companies, to provide an index based on our qualitative understanding of the space. Though our database is arguably the deepest in the business, we still do not feel we have enough hard data. It is our goal that all the mom-and-pop shops in the country will eventually be up-to-date and knowledgeable about value in this space â€” and that the major media will orient their coverage to model the actual industry, rather than the few major firms alone.
Small Broker Dealer M&A, 2005
The following report summarizes and analyzes transactions in the small, closely held broker dealer space from January through December 2005. Data is based on quarterly reports published by The Broker Dealer Exchange, LLC.
How we track this data
The transactions on which this data is based comes from a combination of transactions facilitated in-house or by our consultants, transactions facilitated by external consultants, and data shared by legitimate competitors, securities consultants, securities attorneys, public media, and certain regulatory authorities. Much of the data is provided by trusted sources on a confidential, anonymous basis. We tend to wait for corroboration from independent sources before including data into our matrix.
Nuts and Bolts
Overall M&A activity in the closely held, non-public broker dealer space has remained steady with slight growth during the second half of 2005. However, there has been a significant up tick in overall interest in doing deals, both among prospective buyers and sellers in the second half of 2005 â€” but the number of actual deals consummated in the fourth quarter was not significantly higher than the third.
The main change weâ€™ve seen in the second half of 2005, starting in the third quarter, is a new and somewhat concerning trend among buyers â€” a switch from the simple desire to increase business by acquisition to one more oriented towards consolidation of back-office functionality. Make no mistake, the regulatory environment is punishing firms today, and small firm owners are feeling the pain. Consolidation is the name of the game in todayâ€™s market. Surprisingly, the desire to achieve economies of scale with regard to compliance systems seems to be taking precedence over the desire to drive growth. Significantly, many more owners of firms, including owners of large firms in the NASDâ€™s â€œsmall firmâ€ vertical (the NASD defines a â€œsmall firmâ€ as one having fewer than 150 RRs; interestingly, 80% of all firms are just that â€” mom-n-pop firms), are expressing an interest in mergers and/or exit strategies. Some of the larger firms in the â€œsmall firmâ€ vertical are suddenly expressing a desire for acquisition or even merger. The keen desire to lessen the regulatory burden is prompting a heightened interest in doing something right now.
Whatâ€™s happening at firms
Gross revenues at most firms are up, but transactional volume has been disappointing. The exceptions were firms that had strong institutional mortgage trading desks. These departments have outperformed others. During the summer of 2005, a traditionally slow time transaction-wise, short-term prospects were looking dismal, and firms began voicing the desire to consolidate and combine with others for the back-office synergies. Many firms had cut costs to the bone over the previous year, and in that unpleasant environment were looking outwards to bring in additional economies of scale. Word at the retail broker level during the summer was that clients continued to sit out the lackluster stock market, preferring to shovel cash and credit into the housing market. Third quarter 2005 seemed to bring an improvement, yet the idea of merging for back-office economies stuck. At least now the expansion of the real estate bubble is arguably slowing down, and the worst fears of the doom-and-gloom crowd (hyperinflation, depression, etc.) havenâ€™t been realized, and weâ€™ve almost made it through winter. This bodes well for an extended soft landing, and a resurgence of investment into the stock markets. As the Dow passes 11,000, we should see commensurate transaction volume rises.
There continues to be a rise in the number of small firms offering proprietary product, who, lacking developed distribution channels, are looking to acquire assets involving a significant numbers of reps with large books of business. Still, groups of reps with large books of business are hard to come by, particularly when faced with the prospect of having a limited proprietary product line. At the same time, weâ€™ve seen groups of reps reaching out to leave their firms because of the firmsâ€™ strict policies of only offering certain limited proprietary private equity product. These firms would do well to get sensitive to their reps in a hurry â€” or risk losing top producers. Having tracked a number of acquisitions done with the goal of achieving a distribution network for some proprietary product, it is my position that those deals wonâ€™t work, and we generally recommend against them. Particularly in this market, where commission dollars are down, and the perceived ability to sell alternative investment products is becoming a hot issue for RRs, it would be wise for firms to take into account RRâ€™s feelings on these issues.
Pricing remained more or less static over the last half of 2005. The anticipated prices (larger transactions tend to take place over time, with the double-edged sword of future potential to the up- and downside, making it impossible to know what price the deal will ultimately generate) have seemed to be a bit lower, particularly with respect to heavy annuity business, as well as high turnover solicited transactional business. â€œDirect accessâ€ accounts â€” not to be confused with â€œdirect application businessâ€ â€” have come in lower than expected as well. Note that the regulatory environment is probably casting a shadow on these asset classes.
Demand for transaction-based assets has remained strong, with the exception of deals involving companies with serious regulatory issues or super-high turnover rates. Pricing over the last quarter remains stable at approximately
1.9 times recast, adjusted EBITDA, on average. There is a large distribution in the price curve, however, and key factors are transferability and predictability of the revenue stream, as well as the size of the total account values.
On the very low side of the multiple are highly non-transferable assets. For example, a one-man shop in a very rural area, where the owner has known his clients for 30 years and is prominent in the community. These types of businesses often see huge attrition when bought by an outsider, and transaction prices tend to reflect this risk.
Most sought after asset class (but not the highest price yielding asset class) could still be described as â€œtransaction based assets, being run conservatively by reps whose practice is more oriented toward fiduciary than salesmen.â€ Particularly if these firms offer larger books of business with total client account values exceeding 100MM. These financial planning flavor firms typically have a much lower revenue and net than firms doing an active solicited business.
However, they also tend to sell for prices more based on the size of the book of business than on the revenue stream. Itâ€™s easy to see why: If your firm had a strategic goal of half a billion in total client account values, and your plans called for getting there by strategic acquisition, you would rather do this in as few deals as possible. Integration issues are always an important factor, not to mention due diligence and related legal costs. So, relatively large books tend to achieve a premium at sale, relative to small books. For my tracking purposes, we consider books with less than 20MM to be â€œsmallâ€ books, and these typically trade at a discount relative to large books. The good news is that first time buyers â€” who should really be testing the water, rather than taking on the world (at least initially) â€” may test the waters with small books, often at a relative discount.
Transaction structures have remained consistent. Across the board, transactions typically take place in the following way: An overall price is agreed upon (weâ€™ll call this the â€œanticipated yieldâ€) and then a percentage is paid upfront, with a structured payment schedule covering the rest. Frequently, the upfront portion is 30 to 50 percent, and the structured portion has some variable points, so that there is potential upside and downside for buyer and seller. It is possible to achieve a much higher price than anticipated through clever bargaining in the structured payout part of the deal. However, it is well to note the double-edged-sword nature of the structured portion â€” it is also possible to create an overall smaller yield if things go wrong. Transactions for tiny books of business typically close within days of the assets transfer to the new owners. But as deals grow in size, where there are many employees, revenue streams, etc., the timing can be stretched out to 24 months or more. Suffice it to say that all sellers want cash on the barrel head, and no earn out, and all buyers want nothing down and a five-year earn out. Neither scenario is practical, and it is in the details where these deals become accretive.
Small books of business often trade for one percent of assets, and are typically paid with some small amount down, with the remainder to be paid in full upon confirmation of transfer of the accounts. Owners who agree to stay on and assist in the transfer process have a better chance of seeing the maximum value from their book sale; and buyers typically protect themselves by only paying for what is actually received.
Roll-ups are certainly being attempted, but there are few firms who are executing on this track successfully. Gone are the days when firms just wanted to acquire anything under the sun, and particularly distressed assets. The regulatory problems that come along with fire-sale acquisitions make those acquisitions, in my eyes, not worth the candle. More firms seem to be realizing this, and the number of requests for â€œfire saleâ€ type assets has been dwindling. Weâ€™re thankful for this, because we donâ€™t do those types of deals â€” thereâ€™s too much of a chance that they will end in tears. However, the regulatory environment is poisonous, and so owners at many firms are dreaming of greater economies from mergers, rather than simple growth.
Large RIAs are showing an increased interest in acquiring traditional retail brokerage businesses, and vice versa. Synergy is the name of the game, and these companies typically look to expand a particular line of business with strategic buys of boutique businesses that complement their strategic plans â€” adding a very specific value. For example, if the broker dealer is running a trade desk, and has a very specific niche business catering to high net worth clientele, there may be synergies at the holding company level. Letâ€™s say the holding company acquires the broker dealer. Now the RIA can send all execution business to the BD, and recapture those lost revenues at the holding company level. And the BD can now offer value-added services of its affiliate to its high net worth clientele, and add that business on the RIA side, recapturing it as it flows to the holding company. It is important to note that this increase in interest may simply be due to more owners hearing about the possibilities for the first time, rather than being based on heightened production, particularly in this current low transaction environment.
Rogan LaBier, President, Broker Dealer Exchange, LLC, www.bdexchange.com.