Enjoy the current installment of "Weekend Reading For Financial Planners" – this week's edition kicks off with the big industry news that the SEC has updated the Accredited Investor rules, declining to increase the income and net worth thresholds but expanding the definition of who constitutes a "sophisticated" investor to include financial advisors themselves... allowing anyone with a Series 7, 65, or 82 license to be able to participate in private market investments themselves (though still not necessarily on behalf of their clients, unless their clients still qualify under the more 'traditional' measures).
Also in the news this week is an announcement that insurance companies expanding into the world of fee-based annuities for the no-commission RIA channel are now starting to develop life and disability insurance products for RIAs, as insurance distribution continues to be reinvented, and a study finding that advisors unwittingly tend to engage the men more than the women of their heterosexual couples, resulting in a gender bias that is associated with women not only being more likely to terminate their advisor after a bad experience but being less likely to complain or give the advisor a chance to correct the issue before being fired from the relationship.
From there, we have several interesting investment articles, including a new Morningstar analysis finding that actively managed funds did not actually outperform their passive peers during the recent market volatility (though notably, they didn't underperform either), a look at how market valuation measures aren't very predictive in the short term but that measures like Shiller CAPE are very predictive in the long run (which has significant implications for what return assumptions advisors are using in their retirement planning projections), and a review of SPACs that are suddenly becoming the hot new alternative to IPOs.
We also have a few articles around selling an advisory firm, including what it takes for advisory firms to get a double-digit multiple of earnings for their seller valuation, a look at recent M&A trends for advisory firms that are rebounding quickly after a brief pandemic slowdown, and some guidance on what it takes to sell your advisory firm on the open market (for sellers who have never been through the process before and only get one chance to get it right!).
We wrap up with three interesting articles, all around the theme of building a practice that fits your personal goals (rather than simply one that is solely focused on growth): the first explores the rise of the 'lifestyle' practice as an alternative to the 'traditional' work-hard-play-hard approach (of intensive hours of growing the firm and vacations to recover and then returning to the grind of building again); the second examines one 37-year-old advisor's decision to turn his practice into a lifestyle firm focused on profits and personal time efficiency over growth; and the last explores the 'curse of the overachiever' and how to think about the balancing point and finding the sweet spot between wanting to succeed as a high achiever and when you've got 'enough' to focus your energy elsewhere, instead!
Enjoy the 'light' reading!
SEC Expands Definition Of Accredited Investors... To Include Financial Advisors Themselves! (Melanie Waddell, ThinkAdvisor) - The "Accredited Investor" rules were created to limit the ability of businesses to solicit capital from investors who may not be sophisticated enough to understand the unique risks of small-company less-regulated investment opportunities, but have been increasingly criticized in recent years as fast-growth start-ups have waited longer and longer to become publicly traded, shifting many significant growth opportunities to an investment universe that was limited to all those who couldn't achieve "Accredited Investor" status. The situation was complicated by the fact that it's difficult for regulators to know who is sophisticated enough to evaluate opaque investment opportunities in the first place, and has for decades built the Accredited Investor definitions around having certain minimum levels of income and net worth... notwithstanding the fact that many affluent people still aren't sophisticated investors, and many sophisticated investors aren't necessarily affluent (or at least, not yet!?). But now, the SEC has issued new guidance on the Accredited Investor rules, expanding the Accredited Investor definitions to be based not only on income or net worth, but also on alternative measures of "financial sophistication". Specifically, financial advisors themselves, holding either the Series 7, Series 65, or Series 82 (for offering private securities), will qualify as Accredited Investors, as will Registered Investment Advisers themselves, though notably, it appears RIAs investing with discretion on behalf of their clients will not automatically qualify if their underlying clientele do not meet the Accredited Investor rules (although Family Offices and their clients will). On the other hand, the income and net worth thresholds - earning $200,000/year (or $300,000/year of combined income if married) for at least the last two years, or having a net worth of $1M outside the value of the primary residence - were not altered, nor even updated for inflation (from the limits that were originally set 38 years ago)... which effectively further expands Accredited Investor access (or at least, doesn't narrow it as would have otherwise occurred if the income and net worth limits had been inflation-updated), but has further raised consumer advocacy concerns that the rules are failing to protect a wide swath of 'millionaire-next-door' investors who may meet the financial requirements but may still not meet the financial sophistication measures they're meant to represent.
Fee-Based Insurance Solutions Expand From Annuities To Life And Disability (Michael Thrasher, RIA Intel) - One of the major legacies of the Department of Labor's fiduciary rule is that it spurred a shift towards the development of fee-based annuity products, and while the insurance industry ultimately got the DoL fiduciary rule vacated and ensured that commission-based annuities may remain, the ongoing growth of the RIA channel that cannot accept commissions has led to the continued rollout of fee-based annuity products, and the rise of a new form of intermediary that supports insurance implementation for non-insurance-licensed advisors who can't actually sell the products but still facilitate client recommendations. And now one of those intermediaries - DPL Financial Partners - has announced a new arrangement to facilitate life and disability insurance policies to RIAs as well. Thus far, the life and disability policies offered via DPL are only from mega-insurer Principal Financial Group, though continued adoption of life and disability insurance transactions by the RIA community will likely lead to an expansion of even more life and disability insurance carriers developing new RIA-centric policy offerings. Which raises the question of how, exactly, a new generation of "no-load" life and disability insurance policies may be structured for a more fiduciary-centric advice future?
Wealthy Women Are More Likely To Drop Advisors For Bad Service (Lananh Nguyen, Bloomberg) - In a recent white paper dubbed "Seeing The Unseen: The Role Gender Plays In Wealth Management", Merrill Lynch finds that women are more likely to fire and switch advisors (with 35% who switch after a bad experience, compared to 'only' 30% of men), but are also less likely to complain to their advisors about it before making the switch (whereas men were found to be somewhat more likely to confront their advisor about the problem instead). The problem appears to stem, at least in part, from unconscious gender bias tendencies of advisors, such as defaulting to the male of a heterosexual couple as the financial decision-maker even when he may not be, inferring that couple's finances were merged when they're still held separate, or assuming that women are more risk-averse or less knowledgeable than men. In fact, the study found that when advisors (of both genders) talk to heterosexual couples, the advisor spends more than 60% of the time looking at and communicating primarily with the male of the couple (though overall, in actual conversation-tracking with clients, male advisors were even more likely to make one of the various gender miscues in a conversation with a client couple). The disconnects caused by unintentional gender bias in client communications are especially problematic given that younger generations of women (i.e., Gen Xers and Millennials, who are under age 55) are 4.5X more likely to consider themselves knowledgeable about financial products and services, and are 3X more comfortable making financial decisions on their own, which means the advisor miscues that may have offended Baby Boomer women as clients will be even more likely to lose the business of a Gen X or Millennial woman as a client.
Busting The Myth That Active Funds Do Better In Bear Markets (Ben Johnson, Morningstar) - One of the longstanding claims of those who advocate for active management is that it's hard to beat the indices in a raging bull market (where the investors who are most rewarded are usually the ones who just throw caution to the wind and dial up the risk), but when the bear market comes, prudence and (active) risk management will be rewarded. Which means in theory, the recent pandemic volatility and March/April bear market sell-off should have been a perfect instance for active management to shine. However, in its midyear installment of the Morningstar Active/Passive Barometer report, 51% of active funds that were around at the beginning of the year survived and outperformed their average index peer during the first half of the year... which means active funds were not categorically better than passive funds during the market volatility (though they were not worse, either). Notably, though, there was some variability within fund categories, as only 48% of active U.S. stock funds beat their passive peers, but nearly 60% of foreign stock funds did, yet only 40% of active intermediate core, corporate, and high-yield bond funds managed to do so. On a longer-term 10-year basis - which includes the bull market of the 2010s and the bear market that started the 2020s - the results are generally worse, as even amongst lower-cost funds with only 19% of large-growth funds outperforming (and just 3% of high-cost funds in that category) and 36% of foreign large-stock funds outperforming (and only 19% of high-cost). Although 54% of low-cost emerging markets funds did outperform, along with 60% of low-cost global real estate, and 63% of low-cost high-yield. And ironically, the Morningstar research finds that on average, investors do tend to pick above-average (and lower-cost) fund managers than the rest, but often still end out underperforming passive peers simply because their timing of when they buy active managers is still not good.
The Remarkable Accuracy Of CAPE As A Predictor Of Returns (Michael Finke, Advisor Perspectives) - When deciding what to input as a long-term return for stocks into a financial planning projection, the typical advisor simply uses the long-term historical average, which is an average annual equity return of about 10%/year. However, at times markets can seemingly be so 'cheap' or so 'expensive' that it's difficult to imagine them delivering the long-term average return of the past from that point forward into the future. Yet in practice, trying to adjust market return expectations for measures of market valuation has been a fickle and 'noisy' predictor of returns at best. As it turns out, though, while valuation measures like Shiller CAPE are not a strong predictor of short-term returns, they're actually a remarkably strong predictor of long-term returns. In fact, Finke finds that since 1995, the Shiller CAPE at the beginning of any particular 10-year period was able to successfully predict 90%(!) of the variability in subsequent 10-year returns, and did so despite accounting rules changes and the disruption of the 2008 global financial crisis that occurred during that time period (and has often been cited as a reason to be wary of Shiller CAPE measures). In fact, Finke finds that the predictive value of CAPE has actually been rising since the 1970s, and the standard deviation of the error of Shiller CAPE's predictability was only 1.37% since 1995, which means 2/3rds of the time CAPE predictor returns +/- 1.37%, and 95% of the time it predicted returns within +/- 2.74%. The significance of this predictability is that, with Shiller CAPE currently near 30, the 10-year indication is that returns may 'only' be 5.89% (with a 67% chance of falling between 4.52% and 7.26%), while a long-term historical return of 10% for the next 10 years would have only a 0.3% probability of occurring under Shiller CAPE's predictive measure (implying that advisors really should be reducing current equity return assumptions in clients' retirement projections).
Why SPACs Are The New IPO (Byrne Hobart, Marker) - The traditional approach for a private company 'going public' is to engage in an IPO (Initial Public Offering), with all the fanfare (and potential 'pop' in post-IPO value) that may ensue. However, the path to IPO is time-consuming and expensive for companies, which is challenging both financially (due to the outright cost), and in struggling to capitalize on the timing of when the company is being favored by the markets (e.g., the company that decided at the beginning of the year to IPO in the spring, and by the time the spring came, found itself mired in a pandemic!). Which has led to the rise of the SPAC, short for "Special Purpose Acquisition Company", which effectively raises money itself as a form of 'IPO Blank Check' that then goes and finds an IPO-seeking company to merge with... effectively turning itself into a new publicly traded company, and allowing the private firm seeking to go public to do so in a greatly (SPAC-)expedited process. And with more and more high-flying private companies looking to make a (timely) public market exit - and IPO roadshows slowed by the pandemic that prevents literal roadshows to solicit investors - interest in SPACs has been on the rise, up significantly in the years since 2017 and on track for a record pace of $16.5B of new capital this year alone, bolstered by the recent success of SPAC-public companies like Nikola, DraftKings, and Virgin Galactic. In turn, the popularity of SPACs is even leading to the creation of an ETF version of a SPAC, as more investors seek to participate in the IPO-like opportunities of companies no longer choosing to IPO. However, the reality is that while the IPO process is slower, it does more thoroughly vet companies, and there is some concern that SPACs may be taking on an undue amount of risk by facilitating companies engaging in public exits more quickly (and potentially earlier than they otherwise would have if they had to face the full scrutiny of a public IPO). Still, though, until and unless regulators intervene to limit the growth of SPACs over 'traditional' IPOs, the reality is that the finance industry always finds a way where there's a desire (and in the current markets at least, some companies are clearly finding a desire to expedite the process of going public, and SPACs investors at this point are showing a willingness to help them solve that problem!).
Three Must-Haves For RIAs Seeking A Double-Digit Profits Multiple (Michael Thrasher, RIA Intel) - The outbreak of the coronavirus pandemic in March led – not surprisingly – to a slowdown in mergers and acquisitions of advisory firms, as buyers and sellers were prevented from coming together to close their deals, and the market and revenue volatility made both buyers more wary to buy while revenues were down and sellers more cautious about selling at potentially-depressed values. Yet while the Q2 deal pace for advisory firms was down 34% over the second quarter of 2019, deal activity has been heavily rebounding since May, and the ongoing high demand from large systematic acquirers, in particular, is sustaining the valuations of advisory firms at record-highs despite the pandemic environment. Key factors that are bolstering valuations for the strongest advisory firm sellers include high retention rates (where 90%+ is considered 'table stakes', and the top firms maintain 95%+ retention rates for their >$1M AUM clients); a less concentrated clientele (i.e., not having the bulk of assets or revenue concentrated in just a few big households but instead dispersed more broadly across the client base); advisory firms that have strong leadership beyond the founder/owner (which ensures continuity in the future and can even guide the acquirer about how to succeed in the firm's local market); advisory firms that have stable and rising profits (demonstrating they have effective cost controls and an ability to reinvest in ways that enhance productivity); and advisory firms that have a demonstrated sustaining track record of growth that buyers can anticipate continuing even after the seller has left. For firms that can 'check all the boxes', industry experts report that firms can expect multiples as strong as 10X to 12X their EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Though notably, 'size' in general still commands a premium unto itself, with advisory firms at <$1B of AUM struggling to command an EBITDA multiple higher than (a still rather healthy) 9X.
6 RIA M&A Trends To Watch Now (Carolyn Armitage, ThinkAdvisor) - Despite the volatility of the pandemic, and the disruption of no longer being able to travel (which presents a significant impediment to sales of advisory firms that are often closed with handshakes after a lengthy period of in-person relationship building), mergers and acquisitions of advisory firms were down only slightly in the first half of 2020, and appear well-poised to rebound quickly in the second half of the year. As in practice, it appears that the pandemic may have delayed a number of advisory firm mergers and acquisitions, but it has 'only' delayed them (and isn't causing buyers or sellers to abandon them). In fact, research from Echelon Partners finds that, by and large, advisory firm deal terms are holding steady, as the underlying fundamentals of firms are holding with the fast market rebound sustaining revenue and profits, while low interest rates just provide further 'cheap cash' for buyers looking to acquire. In turn, the accessibility of cash to fund purchases is leading to an uptick in large-firm deals in particular, with 16 of the 35 purchases this year involving firms with >$1B of AUM, though the larger size of firms is also associated with an uptick of buyers taking on minority stakes (13 out of the 35 deals year-to-date), allowing the founder to partially cash out but also to keep on the path of growth with some continued ownership. And with the ongoing growth of "professional" buyers - well-funded RIA aggregators who are serial acquirers - demand, if anything, appears to be picking up, resulting in a relative dearth of sellers and what still remains a strong seller's market.
The Process Of Selling Your Advisory Firm In The Open Market (FP Transitions) - One of the biggest challenges for founding advisory firm owners looking to sell their businesses is that the typical acquirer in today's environment is a serial buyer of multiple firms who has significant experience in how to evaluate and negotiate deals... while the typical seller has never sold a firm before, and only gets one shot at doing it right with the single business they've got that they spent their lifetime building! Accordingly, FP Transitions walks through what Sellers can and should expect from the selling process. The starting point is all about "Finding The Best Match", as the reality is that the end value of an advisory firm is inextricably linked to the acquirer's ability to integrate the staff and retain the clients, which means there must be a reasonable synergy and good match between the firms in the first place. Accordingly, FP Transitions suggests the starting point is to flesh out the essential "Buyer Criteria" - the characteristics that a good-fit buyer would need, whether it's about their investment philosophy, planning philosophy, approach to client service, or something else. From there, the seller may want to obtain a valuation of the firm, to understand what they should be 'listing' the business for as a sale price in the first place, and determine upfront any key aspects of deal terms they want (from how the purchase will be structured, downpayment requirements, expectations for staff retention/transition, etc. Only then should the advisory firm actually announce that the practice is for sale, and begin to vet potential buyers and narrow the field, select finalists, review offers, field counter-offers, and then obtain a 'final offer' (typically presented in the form of a Letter Of Intent [LOI] or Term Sheet). Once the buyer and terms are selected, it's still important to allow for a "Due Diligence" phase, both for the buyer to evaluate the details of the seller (and ensure reality matches with how the firm was held out and marketed for sale), but also for the seller to vet whether the buyer is really the right match, followed by negotiating the finer deal points, and then moving forward to actually drafting transaction documents and closing on the deal.
Transitioning From Work-Hard-Play-Hard Growth To A Lifestyle Approach Instead (David Sterman, RIA Intel) - The traditional approach to advisory firms, like most businesses, is to spend years of intense work to build a business with a significant enterprise value that can someday be sold and allow the business owner to retire, and where any vacations that occur along the way are simply brief respite breaks from the grind of growth. But the profitability potential of advisory firms, especially in an era of AUM, subscription fee, and other recurring revenue models, is such that, at some point, advisors can accumulate enough clients that they can enjoy a high-income practice where it doesn't take as much time to service ongoing clients as it did to get them in the first place, making it possible to 'take your foot off the gas' and enjoy your lifestyle now, while still working, rather than building towards a sale and retirement in the first place. After all, as advisors, we often see clients who focus so much on growth and 'achievement' that their business and finances succeed, but only at the cost of damaged personal relationships (e.g., divorce) and health sacrifices. Yet unfortunately, the idea of a 'lifestyle' practice often has a negative connotation in the world of financial advisors, an industry that historically has glorified 'top producers' and the fastest-growing firms over those that find the most personal happiness and well-being. Still, though, the rise of advisor support platforms, more and more virtual outsourcing providers, and the efficiency of technology to support a limited base of ongoing clients, is resulting in some highly efficient 'lifestyle' practices that generate as much income as partners of larger advisory firms anyway! Which become even more efficient when focused on a particular niche market that allows the advisor to further systematize their expertise into a repeatable planning process!
One RIA's Roadmap To Being Semi-Retired By 37 (Dave Grant, Financial Planning) - Financial planners routinely take clients through a process of trying to effectively articulate their goals, and then helping them to determine the best action steps to take to achieve their goals. Yet Grant notes that in practice, advisors rarely apply the same principles to themselves and their own career and business journey. Which is important, because once an advisory firm hits a certain size and stage of being economically viable and self-sufficient - and approaching client capacity - a decision arises as to whether the business will continue to grow with more clients and more staff... or whether it's time to focus instead on refining the business and the time spent, growing the advisor's free time in the business but not necessarily the business itself. In exploring this journey for himself, Grant realized that he had reached the point in his own firm where he had enough clients and revenue to sustain... and instead of trying to grow, he instituted higher and firmer minimums, let go of non-ideal clients, began to cluster his client meetings into surges in just a few months of the year, and in the end, is earning more than he did before but working with fewer clients and less of an ongoing workload. In other words, at some point, advisory firms generate enough ongoing revenue from a limited subset of clients that it's possible to become 'financially independent' while still running the business but with a limited enough workload to allow for time to do whatever else you want to explore in life also. Which raises interesting questions about what the end goal of building an advisory business should be in the first place - to build a firm that can be sold to generate enough assets to retire or one that is built around the advisor's lifestyle and efficient enough to generate the necessary ongoing income without ever needing to retire anyway?
The Sweet Spot Of Success For Overachievers (Mr. Money Mustache) - The traditional view of success is a combination of "How Much Work You Do", multiplied by "How Much Society Values Your Work", where the intersection of the two makes it possible for some people to earn very high income levels and multiply their financial success further by working longer and harder. Which can be especially challenging to those who find their way to highly-valued (i.e., high-income work), as each incremental hour of additional work (or each incremental client) seems especially financially rewarding. The problem, though, is that if the only measure of success is 'doing more and earning more', it's hard to even figure out when you're gotten "Enough"; instead, there's a very real risk of getting stuck on a never-ending treadmill of success, where someone has more than enough to retire or do 'whatever they want', and yet they still keep trying to work harder, do more, and top their prior work and financial successes. Instead, consider the idea of a "Sweet Spot" - that point in the middle where there's been enough success to get over the initial hump, but the incremental value of 'more' success isn't really worthwhile given the work, health, family, and other sacrifices it may entail to remain on the treadmill. In many other domains, finding the Sweet Spot is more evident - for instance, when physically training for something, it becomes clear that too much training can hurt your body and result in less preparedness than training in moderation. Yet when it comes to business success, achievers in particular often struggle to step back and recognize when they may be 'overachieving', in a manner similar to a runner who overtrains and risks hurting themselves in the process. Which means it's crucial to, from time to time, take a pause and consider what your "Sweet Spot" may be, whether in the domain of health and fitness, parenting and spousal relationships, career success, and financial success. Are there any areas where you may not be giving enough... or where you're actually giving too much and have already passed the "Sweet Spot"?
I hope you enjoyed the reading! Please leave a comment below to share your thoughts, or make a suggestion of any articles you think I should highlight in a future column!
In the meantime, if you're interested in more news and information regarding advisor technology, I'd highly recommend checking out Bill Winterberg's "FPPad" blog on technology for advisors, and Craig Iskowitz's "Wealth Management Today" blog as well.