LBOs, Independent Broker-Dealers, and Risks for Advisors

Prior to 2018, there wasn’t much intrusion by private equity (PE) into the independent broker-dealer world apart from growth equity. Broker-dealer purchases were exclusively made using capital from institutional investors that were committed to the PE firm.

That all began to change in 2018 when Genstar purchased Cetera broker-dealers in a leveraged buyout (LBO). Just a year later in August of 2019, Reverence Group followed suit and purchased The Advisor Group. This slow encroachment will likely pick up the pace, a worrisome development for advisors who are affiliated with private equity-owned broker-dealers.

An even more troubling development for these advisors is what we are facing right now. The two worst-case scenarios for private equity-owned broker-dealers are a market correction and declining interest rates, exactly the environment we are in the midst of.

The Problem With LBO Private Equity

LBO Private Equity means the purchase is made with a combination of institutional capital and the sale of junk bonds. This method is used because the PE firm doesn’t have sufficient institutional capital to make such a large purchase so they make up the difference by financing the rest with junk bonds and those junk bonds end up being owned by the acquired company.

This structure allows the PE firm and its investors to kick in a relatively small amount of cash and magnify gains if they sell for a profit. The Advisor Group was purchased for $2.3 billion and of that, $1.6 billion, a staggering 69% was financed through junk bonds which had a B+/Negative S&P rating and debt service payments calculated at around $150 million for the next year.

Private Equity swoops in to buy up these independent broker-dealers. They’re betting that they can buy several, package them up and sell them at a higher multiple. It’s similar to financial advisor businesses. If an advisor has a $1 million practice, they might receive 3 or 3.5 times EBIDTA. If they were part of an entity that owned ten $1 million businesses, they can fetch a 6 to 8 times multiple.

The End Game

So what’s the point of all this? These Private Equity firms are simply trying to play the arbitrage game. They aren’t making any investments in technology or service. The leftover money they have is largely going to recruit more advisors to their newly acquired broker-dealers and to pay them some upfront transition assistance. The whole point is to grow the broker-dealer quickly so they can repackage these firms and sell them.

The only people making money in the midst of all this are the owners of the broker-dealers and the Private Equity firms. The advisors don’t make anything and go through all kinds of disruption.

Advisors that are a part of a firm that is structured this way are putting their businesses at great risk.

Risks For Advisors

There were some stark similarities between the Cetera and The Advisor Group LBO and some stark risks in both cases for advisors. One credit downgrade on Cetera’s junk bonds would mean a Caa1 rating which translates to poor standing and high credit risk. The Advisor Group downgrade would fall to B which along with B+, its current rating which is defined by S&P as “facing major future uncertainty.”

A lot of ink has been spilled over the risk this creates for PE institutional investors but the risk to advisors at broker-dealers that are bought up through LBO PE has not been given nearly as much attention. So we’ll right that wrong for you now.

Service Risk

The broker-dealers at Cetera and The Advisor Group have about half of their cash flow going to servicing the junk bonds they acquired when they were sold. The rest of the money is going to aggressive recruiting packages and buying up more broker-dealers. 

PE firms are using two tactics to cut expenses to the bone; by refusing to grow back-office support when additional money is coming in from the aggressive recruiting of additional advisors and by not only cutting back on tech expenses but also making almost no new investment in tech.

Market Risk

We’re only at the beginning of the Covid 19 pandemic and in recent weeks the Federal Reserve has twice slashed interest rates which are currently sitting at 0-0.25 percent. This is bad news for these PE LBO firms.

They all make money on the cash held at their firms. When rates drop from 2% or 1.8% their profitability is severely reduced or maybe even wiped out. We’re well below that now. Things are going to get very grim.

A long market correction, which looks like where we’re headed, can cut the broker-dealer’s cash flow substantially. If, a big if, currently, the broker-dealer were to realize expected earnings improvements, earnings before interest, taxes, depreciation, and amortization to total debt service would only be around 2x. Such low debt-service coverage will leave the firm’s debt-service capacity exposed.

A firm would have a relatively small amount of money to dedicate to paying staff, hiring additional staff, upgrading tech, and all other expenses. Factor in this scenario and the threat of a ratings downgrade on the bonds will create the perfect storm of risk and uncertainty for the broker-dealer and the advisors they employ.

Technology and Services Investment Risk

Spending money to upgrade tech and services is something non-PE broker-dealers are open about and often even flaunt. One firm spent $150 million on tech in 2018, something LBO PE-owned firms are not likely to do. There is evidence that LBOs result in depressed employee wages and a hefty cut in spending on tech and service while being at a higher risk of bankruptcy. Spending on recruiting, acquisition and compliance are where the spending priorities lie.

Cetera’s B3 rating after its purchase resulted in a thorny operating and regulatory environment for independent broker-dealers. They had to make constant investments in systems and processes in order to maintain compliance. After spending money hand over fist to maintain compliance and a big chunk of cash flow being devoted to servicing its debt, no one is going to be splashing out on tech and services.

Ownership Risk

There are now more than 8,000 PE-backed companies. What does this mean for these firms and the advisors that work for them when the goal of PE is not ownership but offloading risk? A lot of upheavals.

One broker-dealer is on their third PE owner. This can’t go on forever. At some point, the music stops, there are no more buyers and someone is left without a chair. The big groupings of broker-dealers have the option of going public but smaller firms have to find a new buyer.

Both situations can finally expose the cracks left by PE LBO. All of that recruiting often which includes lucrative signing bonuses, not adding back-office staff to keep up, low investment in tech. All of this can cause compliance issues that can last for years. This kind of rapid expansion without corresponding support means these broker-dealers can’t keep up with tracking compliance and overall service, an unforeseen consequence that hits like a tsunami two or three years down the road.

Protect Your Business

Advisors need to understand how to protect their businesses. These PE LBO firms are either going to cease to exist or will have to sell again resulting either in job loss or more chaos. A lot of the risks I described are what happens in the best-case scenario. We are now about as close to a worst-case scenario as it’s possible to imagine. A market drop in a market that seemingly can’t find the bottom reduces advisory fees so the broker-dealers and the advisors working in them will make less money.

The time to get out was yesterday.

?If you’ve been considering enhancing your service and pricing levels or becoming independent the time has never been better. IAA is here to help.