#FASuccess Ep 395: The Rise Of Bank Financing To Fund Independent Advisor Acquisitions And Succession Plans, With Dustin Mangone

Resources Featured In This Episode:

• Dustin Mangone
• PPC Loan
• PPC LOAN 2024 M&A Lending Report
• SBA Loans

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Full Transcript:

Michael: Welcome, Dustin Mangone, to the "Financial Advisor Success" Podcast.

Dustin: Hey, Michael. Thanks. Thank you so much for having me.

Michael: I really appreciate you joining us today to talk a little about this kind of change over the past 10 years in our industry, where banks finally showed up and figured out how to lend money to advisory firms, which then has catalyzed all sorts of changes around how much happens at mergers and acquisitions, and kind of the safety of sellers that don't always have to take back seller-financed notes and impacts on succession planning.

And it's a fascinating thing to me because as advisors, we're quite aware of how strong and financially stable our advisory firms are. We run these, and particularly with the rise of the AUM [Assets Under Management] model, these recurring revenue businesses with mid- to high-90% retention rates, a natural growth in revenue that comes from markets, at least under the AUM model. Like, these are really robust cashflow businesses.

And for years and years, advisory firms would try to then borrow from banks to finance acquisitions or internal successions, the banks would be like, "Oh, that sounds like a great business, tell me about your physical assets we could repossess as collateral…" and the answer is like, "Well, I run an advisory firm. I have furniture in my conference room, but I don't really have physical assets. My business is that my clients trust me, and pay me ongoing fees every year." And the banks would say, "Yeah, we can't really lend against that, it's not secured," and would walk away. And that has really changed over really the past 10 years, and I think it's had all sorts of fascinating ripple effects in the business far and wide.

And today, I think I'm excited both just to talk about how all that stuff actually works, because I think for a lot of us as advisors, the only time we've ever actually dealt with a bank in a lending scenario is a mortgage on our home, and residential mortgage lending is a little bit different than business lending. So looking forward to both just the digging into how do these loans actually work in the advisory firm context? And even a little broadly, what's changing in the industry now that bank financing is a thing?

The Origins Of PPC Loan's Advisory Firm Lending Business [05:41]

Dustin: Sure. And I think the comparison between mortgage lending, and the availability of capital for advisors who lack tangible assets is a regular discussion we have, and probably a good place to start this conversation is kind of looking back at the beginning of how we uncovered this market. Because as a company, our founding partners in the late '90s started identifying dentists as a market that really lacked traditional bank financing, and it was a similar scenario where the business itself lacked tangible assets that were of any value to a bank in terms of recourse...

Michael: Right. You can get the X-ray machine and the dental chair.

Dustin: Yeah, used dental equipment, not a great market.

Michael: Yeah, yeah. Not so much.

Dustin: But they were working inside a bank up in Chicago with some dentists, but really kept running into limitations, and saw an opportunity that was untouched. I'd say PPC, when it was established was one of the first movers in that industry, but the company was founded and focused on lending to service sector cash flow-based businesses. So they broke away, formed PPC, and started lending to dentists for M&A needs. And over time, we expanded into other industries, but one thing I always credit our founders for was continuing to look at what other markets, what other niches can we serve, and our first look into the advisory space was really specific to RIAs.

And in 2005, one of our partners started researching and writing a white paper on the space, and spent a couple years doing so, kind of really understanding the industry, doing due diligence, learning about RIAs, broker-dealers, registered reps, IARs. And I always find it funny because when we rolled out, or when we kind of put the program together, it was very limited. It was, okay, we want to target registered investment advisors because they are 100% fee-based. They had that recurring revenue streams that was really important to what we found to be a successful repayment of our loans. And at that time, in looking through the industry, there was no options.

And this was late '07 when we rolled this program out, so we had quite the head start on any other specialty lenders in this space. But we always take more of a crawl, walk, run approach to any industry we enter, and in doing so we said, okay, in looking at transactions being done, we've got advisors who have no options for traditional debt. Private equity really wasn't a thing, maybe they had the ability to self-fund some of the transaction, but in most cases, cash upfront considerations were limited, 10%, 20%, 30% probably at the highest level.

So we looked at the market and said how can we come in and add value without taking too much risk? Because we're stepping into a new niche, we never know what to expect, and as a lender, you want to limit your losses so that you can stick around long-term.

Michael: Right.

Dustin: Well, in doing so, we set our lendable limits at the lesser of 60% of a purchase price for 1X fee-only revenues, which was, for RIAs, 100% of their revenues. So even in structuring our program so conservatively, it really was an immediate change to, one, the availability of capital for the buyers to provide the sellers, but also leveled the playing field somewhat in a sense that it was a more balanced shift of risk when you think about buyer and seller. If a seller is going to sell their business, and you look back 10, 15 years ago, I mean even 15 years ago, closer to the 2008 timeline, in valuations, maybe they were, just for discussion purposes, using revenue multiples, let's call it 1.5–2X.

For the firms, and we talk about...and when we look at advisors, their firms, the profitability, there are so many that are successful. These aren't businesses that run tight margins like a restaurant. We know broker-dealers have tighter margins. But the advisors, their books, their firms, you have good margins. And even with the availability of these new capital options, it's still less of a hesitation, because if a seller is generating $1 million in revenue, and is taking home $400,000 or $500,000/year, a lot of them were still a little hesitant to say, yes, give me 10%, 15%, 20% down, I'll transition my distributions and my profits to you, and get paid out over maybe 5–7 years on the seller note, when they could likely earn just as much by maintaining or retaining the business for another 3 or 4 years.

Michael: Right. That was always kind of the challenge in seller-financed transactions, I find, in the early days of RIAs, is if you were a selling firm owner, it's like, "Let me get this straight, I'm going to sell my firm to you, I need to finance it over 7 years so that the annual payments are low enough to be manageable with the profits of the firm, and then you'll use the profits of the firm to pay off my note. Which essentially means I'm going to get the same profits I was already getting, but I don't own the equity anymore, and you're just giving me the profits I already owned to walk away from the rest of my equity." It kind of felt weird. You didn't really want to do it unless you literally couldn't work in the business anymore, and you were about to walk away with nothing. It's like, well, if this person wants to continue the business, and then use some of the profits to pay me back, I guess it's like getting a trail off my business, it's better than nothing.

But it always seemed really strange, or at least I heard a lot of advisors that really struggled with this idea of "I'm going to sell my business in a seller-financed note that's all going to be paid by the profits that I would have had if I just kept my own business in the first place."

Dustin: Yeah, and I think that's the funny thing about that discussion, or that mindset makes perfect sense, because that die-at-the-desk approach, you can't kind of fault them for wanting to go that route, and not risk "What happens if this is a bad buyer? What happens if they default on repaying me? How do I take over the business? How have I impacted the relationship with my clients?" So with that new option of having...or with us offering an option for buyers to borrow money, and provide more cash at closing, I think it did start to stimulate the discussions, as well as the desires for sellers to consider retiring, and selling the business, and maybe staying on in some capacity.

But again, it kind of gave them an alternative that was less risky to say, "Yes, I am willing to sell my business, because I can put some cash to work now, and get the value out of time-value of money, and not have to seller finance to some market…or I'd call it a lower than market rate is what most sellers do offer, and it's likely what they were offering 15, 20 years ago, if that was their only option. But it did kind of shift that balance so that there was a little more shared risk in the transaction between the buyer and seller, and not just the seller shouldering almost 100% of the risk, and hoping that they get paid back in a timely manner.

Because most sellers I'd say, at that point in their careers too, they've probably got their business somewhat on cruise control. "Hey, I've got $100 million in assets, $200 million in assets, $50 million in assets…" any number, but a lot of them have reached the point where they're not actively pursuing new clients, they're not necessarily looking to put forth the effort in growing the business and have probably reduced their schedule down to just a few days per week. So as you mentioned, it's not only you repaying me with my profits, but there could potentially be the desire on behalf of the buyer to have them more involved, and all of a sudden working more, and assisting in transitioning the business, and kind of interrupting that comfortable lifestyle.

How The Availability Of Bank Loans Changes The Calculus For Firm Owners Considering A Sale [15:05]

Michael: So I want to come back for a moment to the lending limits you were talking about, and where you guys started offering a structure. And we're going to try to go through these for the conversation today, I'm going to try to bring these back to sort of concrete number examples, because I think for some of us that aren't as used to talking about terms and numbers, it's hard to think about them in the abstraction.

So, if I imagine some $200-plus million AUM firm that has $2 million of revenue, if this business is getting sold, probably back then at maybe 2x revenue, so $4 million of enterprise value, instead of saying, I'm selling my $2 million revenue of business for $4 million of enterprise value in a seller-financed note over 7 years at some market rate, PPC was willing to come in and say, hey, we'll lend up to 1x of the fee revenue, so we'll lend $2 million into this transaction. So now either the buyer has to come up with the other $2 million as a down payment, or the seller, maybe seller finances the other $2 million if they want to. But from the seller end, if the bank's coming to the table with $2 million of cash, the seller gets $2 million of cash at closing. So this isn't just, "Seller-financed note, I'll get my payments for the next 7 years," it's, "I get 50% of my cash when we sign this deal, and then maybe the other 50% of compensation comes over time." Am I thinking about that, and framing that right in terms of the numbers, and how that worked?

Dustin: Yep, you're spot on. And that kind of goes back to the discussion around shared risk. It gave the sellers a little more incentive to sell, or consider buyer options because they weren't required just to take a note. Hey, if I can advance some of my payout today, take that cash off the table, take that risk off the table, they were more willing to consider the sale I think at an earlier date. Versus, "Hey, I'm going to reach 65, 70, I'd love to retire, but I'm not really interested in seller financing, I'm not having to spend 40 to 60 hours a week running this business, I may just be better off doing what I'm doing. It gives me something to keep myself busy a few days a week, and then I'll supplement that with golf and travel and spending time with the family." But now, all of a sudden, that cash option I think really started to change the mindset.

Michael: Right. If I think about that in dollars, if I'm running this $2 million practice and I've got some 30% profit margin on it, I'm netting $600,000 from the practice. So then seller financing it for 7 or 8 years to get a $600,000–$700,000 note payment is like, well, I could have just gotten the $600,000/year by keeping my earnings. It shows up a little bit differently when, "Well, I'm going to sell my practice, and instead of getting my $600,000 a year of profits while I run my business, I get a $2 million cash check at closing, okay? Now that'll put more money in my pocket fast, and I'll get the rest over the next 7 years," or whatever it's going to be financed over.

But now it feels different. It's not just, "I'm going to take the profits I was getting, and now I'll get them in the form of a note, it's a really giant 7-figure check in my bank account when we close on this deal." This now starts to feel different from the seller end.

Dustin: Yeah, and it does. It makes a huge difference for somebody, as you mentioned, who's not wanting to get repaid with their own profits. And I think the other thing it fed into was probably the desire for many selling advisors to reach a point in their career where they're not necessarily ready to retire, but they might be interested in unloading the ownership responsibilities of running a firm. And even as a solo practitioner, working under a broker-dealer, or a single-owner RIA firm, as you mentioned, doing $2 million in revenue, the next gen may not be in place at that point in time, probably not a huge talking point as it is today.

But for those who saw an opportunity to say we'd love to continue working but also sell the business, I think it opened up the door for a variety of options, because now you can have a serious conversation with someone who is buying the business, and one, you're getting more cash at closing, two, if you are interested in working back for 2, 3, 4, 5 years, for us as a lender, we love that idea because it minimized at that time what we'd consider the transition risk in moving clients. But what happens if they're not interested in moving over? If we're dealing with a seller who's trying to exit the business in 3, 6, 12 months, and simply provide transitional assistance, how does their absence after that transition period impact their willingness to continue working with the buyer? Because a lot of times there might only be a 6, 12 month look-back on the transaction, so beyond that, the buyer shoulders all the risk if clients start to walk out the door.

So I think that opened up the doors for sellers who did, again, want to continue working in some capacity, but not necessarily as an owner. So it created kind of a new option. It wasn't continue working or retire, it's what if I could do both? I could somewhat retire, help service these clients, be a familiar face for the buyer, minimize transition risk, maximize the amount I'm going to get. It just really changed the dynamics of the industry.

As we entered the market, taking one step back, we rolled out our original program in late '07, early '08, and at that time, my focus was in different markets for PPC. I was working with dentists, I was working with veterinarians. So one of our founding partners and another employee at the firm rolled the program out, we did a handful of loans, the Financial Crisis hit in '08, and we took a step back.

Well, it took us another 4 or 5 years to convince the banks that this is a viable market. There is a lot of opportunity here, and these are low-risk transactions.

PPC Loan's Role In The Lending And Loan Servicing Process [22:00]

Michael: And help us understand just for a moment the structure here of I guess what your firm does, or where they sit in the process. Because you're talking about needing to convince the banks to get comfortable with this kind of lending, so it sounds like your firm is not actually the bank, the lender of money, you're an intermediary in between?

Dustin: Correct. And that's probably a good place to kind of take one step back, before we hit the evolution. But that's one of the unique things about PPC, is while we're not a bank, we don't operate like a traditional broker. And what I mean by that is, let's use mortgage lenders for example. They're there to work with you typically on the front end, help you get your loan in place, get some terms on paper, you move into the title company to close things out, and you may never hear or talk to that person again. You go to buy another home, you might find another broker.

But at the end of the day, the focus on the mortgage side is rate and fee. Everything else is pretty standardized. I mean, I would even say costs and things like that are pretty similar when you look at buying down rates. But there wasn't a lot of variation in rates either across the board. Slight variation, and important variations, but nothing material.

Michael: Most banks have fairly similar cost of capital sources at the end of the day, so...

Dustin: Correct. So the one unique thing about how PPC operates is we don't just manage or work with the client on the front end. And there are some options in the market today for advisors that are just traditional loan brokers. They're there to find you a bank, get you a term sheet, and likely hand you off to the bank once you decide that that's the offer you move forward with. PPC actually operates as a contracted partner with our partner banks, and serves as more of an outsourced lending department. So PPC has an underwriting team, we have a closing team, and we have a servicing team. And we, from the first phone call until the loan is paid in full, we manage the client relationship. So our customers work with us through the entire process until the loan funds. If there's reporting requirements, they're dealing with us, we're collecting the annual financials. If there's a modification to the loan, we're handling that. If there's a new need, we're handling that.

So any customer needs are handled by PPC, and what that's allowed us to do is control the client experience, and fine-tune that over time. Which I think is one of the differentiators, because being a first mover in this space, I'd say we didn't have to worry a lot about competition in the way of rates and fees and things of that sort, but as time progressed, new competitors come into the market, people catch up with you. And there's a lot of good options I'd say with comparable terms today, but again, the biggest difference is how we work with our clients, because anybody who's ever worked with a bank, and borrowed money knows it's not the most enjoyable experience. And you mentioned local banks, it's even worse. Because if you're approaching them for a business loan, where your business will serve as collateral yet it has no tangible assets, they might have some interest in learning, but it's probably not enough time to learn the business and get you funded in time to close your transaction.

So our understanding of the space really kind of changed that dynamic. But that's one of the unique things about PPC that differentiates us is while we work with partner banks, again, we control the client experience. And to add to that, we're not shopping loans to our partner banks. We've created a program, and this has been the same in all industries we've served, where when we have a partner bank, and we bring a new partner bank on, they are adopting our program and our product. Not vice versa where, "Hey, I've established an advisory program with 1 bank that I rolled out in 2013, and if we brought on a 2nd, a 3rd, a 4th partner bank, it wasn't under the agreement that we'd be offering different terms, different covenants, or different lendable limits."

Michael: So kind of functionally, you've set up, "Look, here's how we do loans to RIAs. We set these terms, we have these deal covenants, we finance at these limits. Here's the profile of the risk." I guess now you've got like, "Here's our track record of what's defaulted and what's paid through." If you're a bank, and these terms sound like a place that you want to deploy some of your money because you need to loan off your balance sheet because that's how banking works, we've got a place for you to deploy some of the dollars that you need to put into loans.

Dustin: Exactly. Banks looking to diversify into different C&I [Commercial and Industrial] loans, they are lending from their balance sheet. So the loans do stay on our partner bank balance sheets, and ultimately they have a right to reach out to the client should they choose, but typically they go through us for any needs. And a lot of times when clients might call the bank, outside of a basic payment question, or something about the loan, 95% of the time they refer you back to us. But in most cases, we've established how the relationship will work, and clients know PPC is the point of contact that we need to reach out to with questions.

Michael: Okay, so that helps in the structuring. So you started in '07, '08, a couple of things happened, then the Financial Crisis happened, then no one wanted to lend into financial services for 5 years.

Dustin: Yep.

Michael: So it comes back in 2013 with this 60% of purchase price, or 1x fee revenues lending portion, which lets you at least kind of cover roughly half of it, and everybody sorts out how they're going to do the other half. So help us understand more of what's changed since, and what financing structures look when advisors are trying to explore bank financing options.

Dustin: When we rolled out the program in 2013, we obviously structured in a manner that would allow us to approach the market conservatively, and not absorb too much risk. But as we continued to lend, and really learn about the market...and this is what I was tasked with in 2013. The company kind of dropped it on my shoulders and said, "Dustin, we've got a new project for you. We're going to take this back to market, and we're going to go to our partner banks, and see who's willing to move forward." And our primary partner bank that we'd been working with since 2003 jumped on board in '13, and they were the ones who funded the handful of loans in late '07, early '08, before the Financial Crisis.

But finally got them off the sidelines, started lending again in '13, and as we started to really learn the market, we started to see that just independence, or independent advisors were much more widespread, and not just under the RIA umbrella. I think it was just naturally assumed that, without looking under the hood, that certain advisors, and certain broker-dealers, or those that might have been around for 20, 30 years at that time might still be focused on the commission side of the business, and maybe some stock picking. But really, there was far less focus on fee-based revenue outside of the RIA industry, RIA space, and as the years went on, we started to expand to not only offer our program, which already had its structure to RIAs, but really accommodate and provide capital to all independent advisors. And today, that really involves RIAs, registered reps under broker-dealers, IARs has become a more popular option for independence...

Michael: Meaning because I'm an IAR under some corporate RIA where it's "my clients and my practice," but I don't literally have my own entity structure because I'm under someone else's RIA platform.

Dustin: Yes. And we were seeing more of that, a new way for just different people within the industry, firms to offer those operating structures. But yes, the IARs that own their book… We've seen RIAs who have grown, they have their own client bases, and realize, hey, we can kind of add another ancillary service or product to our business by offering other independent advisors who don't necessarily want to form their own RIA, and maybe not be big enough to go SEC registered, a $100 million or more, but they want to be independent. They want to be entrepreneurs, and they just need kind of a little bit of support, not zero support maybe as an RIA who's going to go out and need to hire or outsource all the various positions within the firm. Versus the wire houses, where they're taking care of everything, and you're focused on just providing service to your clients. So that IAR platform model has really grown in popularity over the last probably 3 to 5 years, from what we've seen in the market.

But the independent space, all of those areas we serve today, and have even worked with specific broker-dealers on transitioning advisors from their employee to their independent channels as a way to retain advisors who see more opportunity in the independent space. Or those that are in a W-2 position might want to look at going independent, and leaving the firm, they've offered these transitional opportunities internally so that they can retain advisors and assets.

How Bank Loans To Advisors Are Structured Today [32:17]

Michael: So help us understand just what loans look like today, and what are the terms, what is the structure, what are the rates? What is the marketplace today for RIA debt financing?

Dustin: Over the last 10 years, what's evolved is our willingness to lend more and more and more to advisors. So starting at the lesser of 1X recurring, or 60% of revenues, we've grown to now lend up to 100% of a purchase price. And in its most simplistic approach, I'd say 2X the combined recurring revenues of buyer and seller, which in a lot of cases kind of backs into a similar figure that might be a 70% or 75% LTV in a lot of cases. Maybe it's a little less in some cases, maybe it's a little more.

But as we grew our program, what we wanted to rely on is our underwriting, and not outside valuations. So in the early years, and even today, for most of the smaller loans we do, we don't require valuations. But that was the evolution in the program where we just continued to get, I wouldn't say more aggressive, but more comfortable in lending to this space. We started to see the value in the cash flows. And one of the biggest differences in the advisory space versus others is the fact that a lot of the buyers in this space are established business owners, unless they're doing an internal succession plan. When we worked with dentists, vets, insurance agents, CPAs, you name it, a lot of it was financing a first-time business owner. So they weren't bringing an additional business to the table as added collateral and added cash flow support. So as we started to really realize the differences, it gave us the comfort in increasing our lendable limits to, as mentioned, 100% financing as an option, as well as a much higher lendable limit when you think about loan-to-value.

So today when we talk about 100% financing, that is not just 100% to the seller at closing. I think that gets kind of lost in the weeds sometimes, with some of the reports that hit the market from other firms, consultants, service providers. But we've structured transactions with this 100% financing in a way that accommodates the seller who wants to leave in 6–12 months. When you look under the umbrella of a broker-dealer, you think about some of the smaller advisors, let's call them sub-$150, $200 million in assets that might be solo practitioners, don't have the next gen, a lot of them do wake up and say, "Hey, I'm just...I'm done. I'm ready to retire, I'm fine to stick around for 6–12 months, but after that, I'd really prefer to exit the business, and not be involved, and not have a payout through seller financing."

So we've actually structured, and you asked about the evolution of the products and what we're lending, that 100% financing option allows us to finance 100% of purchase prices, and disburse funds over time. And usually it's some percentage at closing, and some percentage 12 months later, based on a look-back or clawback provision.

Michael: So I want to come back to some maybe number examples, just to try to make sure I'm processing this well in common terms. So if I go back to my $2 million revenue practice before, if I'm getting the sort of the proverbial, the traditional 2x revenue valuation, it's a $4 million practice, then you could get financing for the whole $4 million.

Dustin: Correct.

Michael: If, or as valuations have expanded, if I'm getting 2.5X revenue, so my $2 million practice is getting sold for $5 million now, the bank will still only finance the same $4 million, which means now I'm financing $4 of the $5 million of purchase price, so essentially I can finance 80% of this, the buyer still has to solve for the other 20%. Am I thinking about, and framing those numbers up well?

Dustin: Close.

Michael: Okay. What am I missing?

Dustin: So the biggest difference... Yep, and I'm glad you went back to your original example.

Michael: Yeah.

Dustin: So looking at a 2.5 multiple, as you mentioned, or a $5 million purchase price on $2 million in recurring revenues, what we also give consideration to is who is our buyer, and what does their existing business look like? And what they bring to the table is lendable equity. So if I have another $2 million firm that says, "I've identified an acquisition opportunity, a retiring advisor who is doing $2 million in fees, selling for $5 million, and we also generate $2 million in fees," in simple math, we're looking at the combined recurring revenues of buyer and seller.

Michael: Right, right.

Dustin: So now I have $4 million in combined recurring revenues, an $8 million lendable limit, and I would now consider financing 100% of that $5 million purchase price.

Michael: So in some internal succession, as a simplified example, there's no other revenue, enterprise value coming to the table, I may be capped at financing $4 million of this $5 million.

Dustin: Exactly.

Michael: But if this is my cross-town merger, hey, I'm going to merge my $2 million firm into your $2 million firm because you're retiring, and I want to finish with a $4 million combined enterprise that values at $8 to $10 million, you would give me an $8 million lending limit 2x our combined enterprise, and getting 2x our combined enterprise, or $8 million is more than enough for me to cover the entire $5 million it takes to to do the purchase part. Which essentially means you're not just underwriting this loan based on the revenue that comes from the purchase, you're underwriting based on the revenue I've got in my acquiring firm, plus the revenue that I'm taking on board. Which means if I'm a bigger firm acquiring a smaller firm, this gets pretty easy to get to 100% covered.

Dustin: Exactly. Exactly. And that's where we evolved as a company, in gaining more comfort in who we were lending to. Because it wasn't just reliant on the seller's cash flow to not only service debt, but also compensate our buyer with a living wage, you know? If we're looking at a financing candidate who's buying a business for the first time, and has no established cash flow, not only do we want to see that the business can afford to pay the debt, but we want to know it can afford to pay our owner at least a sufficient wage to cover their day-to-day living expenses and annual liabilities. So that established cash flow from those existing business owners has been really the catalyst for getting more aggressive, and growing to 100% financing.

But when we say 100% financing, it's important to note that that is not paid at closing. We've structured, and we've got a unique structure that most lenders don't offer, but if you think about that $5 million purchase price, there's still downside protections for the buyers, typically with the form of a clawback provision, and maybe a 5% to 10% attrition allowance. So what we'll do is, based on the buyer and seller, is disperse 50%, 60%, 70%, 80% at closing, let's call it 60% to 80% on average, and the remainder at the end of 12 months...

Michael: And so I only pay and accrue interest on the portion I've drawn? It's kind of like construction loan-style, I only pay interest on what I've actually pulled out as the borrower?

Dustin: Yep. And that's one of the unique things that not all banks are willing to offer. It's been something that we do offer the market today through what we call our bank holdback option. And a lot of times sellers aren't necessarily, if they're structuring a deal and they say, okay, I'm selling for $5 million, we've agreed on that price, I'm going to get paid out over 12 months, they might decide that hey, I'd like 50% today, and 50% in one year for tax purposes.

Michael: Right.

Dustin: One way or the other, we're holding back some percentage of the price to be funded down the road, but I like the idea of spacing that out over tax years. And when you think about $2.5 million, or principal and interest on $2.5 million versus $5 million, it is a material difference in your cash flows during those first 12 months post-closing, and while you're transitioning clients, and maybe while you're working to bring billings back up in line with, or generating revenues from those clients you purchased. So that feature has been so well received, but again, not all of our partner banks are willing to offer that, too.

The Role Of Clawback Provisions In Helping To Protect Advisory Firm Buyers [42:02]

Michael: Now, you mentioned in the middle there, when you were talking about how maybe I'm paying only 80% or 90% up front, and the remainder after 12 months subject to clawback provisions and attrition allowances. So for those who aren't familiar, what are clawback provisions, and how do they work? And what are attrition allowances, and how do they work.

Dustin: So clawback provision is the downside protection in a contract to basically keep the seller honest, is how I like to describe it. They know that once the business sells, the seller still has an obligation to work with the buyer, and transition those clients because these transitions, in some cases it happens, it's not the norm, but once the deal closes, typically the buyer has not been introduced to the clients, and obviously, to transition that relationship successfully, it's necessary for the seller to step in, typically sit in on meetings in some capacity, and help kind of transition those clients slowly over that usually one-year period following the sale.

So with that clawback provision, it gives the buyer comfort knowing, one, I can buy this business today, but if the seller doesn't live up to the contract and help transition those clients, that could result in a lot of those clients leaving. And now all of a sudden you went from, "Hey, I'm buying $2 million in revenue, to I've only got $1 million in revenue because 50% of the clients or assets walked out the door." So it's a downside protectionary measure for the buyer, but there's typically a 5% to 10% attrition allowance worked into deals that we see, especially on acquisition deals.

And one thing I would highlight is...

Michael: Which essentially means you can...if I do the deal, and 95% of the clients stay, I'm not going to claw anything back on the purchase price that was within the allowance. But if 93% of the clients stay, then there's going to be a price adjustment.

Dustin: Correct.

Michael: And do I price adjust because you're 2% off from the 95% threshold? Or do I get my whole 7% back if you are more than 5%, and trigger the threshold?

Dustin: We see it vary from deal to deal.

Michael: Okay.

Dustin: At the end of the day, we're the buyer's advocate. We work with the buyer, we want to make sure they're in a position for success. So if it were up to us...

Michael: So you'll tend to argue for sort of the more stringent, if you violate the threshold, it's like a markdown from the original?

Dustin: And In most cases, I would say it's the opposite of that, where if there's a 5% attrition allowance, 7% walk out the door, it's a 2% adjustment to the price.

Michael: Okay. Okay.

Dustin: That's more common, because naturally, there are just some clients who I think it's just par for the course with any transaction, who may or may not...

Michael: Yeah.

Dustin: You know, they could be walking out the door the next day, despite there being a sale one way or the other.

Michael: Right.

Dustin: So it's just natural levels, but we have seen those transitions. In the disbursements we do, I would probably tell you that 85%, maybe even 90% of the holdbacks are paid out at 100% of what's being held back, there is no adjustment to the price. So we have seen a high level of success.

Michael: 85% to 90% of the holdbacks end up being paid at 100%, which means the attrition allowance thresholds that are commonly negotiated are not violated, and we're not triggering other clawback provisions, commonly.

Dustin: Correct.

Michael: And I've got to presume again, if it's like...if we've reached the 5% allowance because you had 7% attrition, and you're marking down 2%, that is important to sort of true up the deal, as it were. But I'm sort of reading by inference then, when you get to the 10% to 15% where the holdbacks are not paid at 100%, they might still be paid at something close to 100%. Like, we're not seeing a lot where the hold, if you don't get 100% of the holdback, it's because it got written down to zero.

Dustin: Correct. Yeah, I don't think we've, honestly, ever had one of those situations where we've written a holdback to zero. It's usually a minor adjustment, 10%, 20% on the high end.

Michael: Oh, right, because this might only be 10% of the purchase price. So if you were holding the last 10%, and the 5% allowance was violated because it was 7% attrition, and there's a markdown of 2%, if I'm going to mark 2% of the 10% of purchase price holdback, 2% of 10% is like we're pulling...we're knocking off 20% of the holdback, but that was only 2% of the original deal. Am I looking at that right?

Dustin: Yes. Yeah, that's correct. And that's another interesting aspect of those clauses, is some might be limited in a sense that if the deal is structured with 80% at closing, and 20% being held back, some transactions might say only the 20% being held back is available towards an adjustment to the price. The 80% is paid, there's nothing that can be clawed back there. But it's not uncommon to see the opposite. Even though we paid 80% upfront to the seller, if there were a scenario where the purchase price was adjusted down by 25%, it could fall back on the seller owing the buyer funds. We have not seen that happen in the last 11 years of lending to this space, but you do see that variation in contracts.

Michael: Okay. Well, I guess so that's when you get into is it a 10% holdback, is it a 20% holdback? Because I'm leaving myself more room, because I'm concerned there might be more problems when I get in there on this deal. So ideally, if I'm evaluating it well as a buyer, I'm assessing the risk to figure out how much of a holdback to stick around so I'm at less risk for this. With obviously the flip scenario for the seller, which is I want as much cash up front, and as little holdback as possible so that either my risk isn't on the table, or at the least you're going to have to decide how hard you want to come after me for it if it's already been paid.

Dustin: Exactly. The beauty of this space, I've always said, is as a lender, we're evaluating all the various aspects of a transaction. Who is our borrower? What do they represent as a financing candidate? Looking at their business, the seller's business, what's the relationship? What's staff, clients, and who's sticking around? And while we have a significant amount of due diligence to do on each transaction, what we've also learned is sellers in this space are typically exiting the business later in life, in their 60s, 70s, some in their 80s, they're not selling in their 40s or 50s because they're looking for a career change, and this is their life's work.

Michael: Yep.

Dustin: And they themselves are a layer of due diligence on our buyers. It's rare we see someone...and it happens, but in the largest percentage of cases, a seller's probably not selling to someone who's got a practice that's much smaller. They're looking for someone to take over their life's work, they're probably looking for someone who's been in the business for longer than 5 or 10 years. Usually, they've been around 10, 15, 20, 25 years, a lot of them, when they're doing these acquisitions, and they themselves, the buyers own a business, a practice of equal or greater size. So they've kind of vetted and identified a qualified buyer from all the various metrics they look for, and who that individual is, how they're going to help run the practice, and we can kind of come in, do a little more digging behind the scenes in terms of their credit quality, personal financial strength.

But it's really created I would say some efficiencies in our program versus what we might see in other industries, where, again, you have a buyer coming in who has no existing business, has never been a business owner, and is looking to step into the business as an owner for the first time in their career.

The Core Terms Of Bank Loans To RIAs [50:47]

Michael: So beyond sort of this general borrowing limit of up to 2X the combined recurring revenues of buyer and seller, just how do the core terms work?

Dustin: So we offer conventional loans, and really you have 2 different options, conventional and SBA loans, SBA being government-backed loans that provide capital to a variety of different markets. But under those programs, they can serve all different industries, but they all land under the same criteria, so it can make things a little more difficult, a little more complicated, and maybe much less flexible, is what I like to say.

With our conventional loans in our program designed around the advisor's need, it does allow for some flexibility, but we are financing transactions on 10-year terms, they are fully amortizing loans. Occasionally, some will have a 7-year balloon payment, but that's typically loans that are north of $5 million. Everything under $5 million, most of our stuff is 10-year terms, 10-year amortizations. We do offer fixed rates currently in the 8%s. I have occasionally offered some fixed rates in the mid to upper-7%s these days for high-quality transactions.

And what I mean by that is a lot of times it's what our buyer represents. If I'm lending to a solo practitioner, with really no other advisors in the firm, and they're doing another acquisition of a firm and they're going to need staff, and that staff's coming over with the seller, that's going to be a little riskier. Versus, hey, I've got a 4-partner RIA doing $700 or $800 million in assets, and if they're buying a $200 million firm, I'm going to have multiple guarantors typically who look much better with regards to their personal financial strength, because they've been business owners, they're debt-free, our loan-to-value is much, much lower, or our leverage compared to the overall market value of those combined firms.

So looking at those factors, that all feeds our pricing model. We don't price everyone at the same level, because not every candidate has the overall financial strength, or some lack the financial strength needed to borrow $3, $4, $5 million. They might be in a position to borrow $1 million or $2 million, but it might be a little more difficult for someone with a half million dollar net worth, let's say, versus somebody with a $10 million net worth.

Michael: So quick note, just for folks who are listening, so we're recording this in late June of 2024. So as we talk about rates currently in the 8%s, I just feel compelled to acknowledge your mileage may vary depending on what the interest rate environment is by the time you're listening to this, either when the episode goes live, or months or years later. Because I know many people come back to listen as time goes on.

Dustin: Yeah, and I'd probably have had a different opinion maybe several months ago, that maybe there's more likelihood we see some lower rates at the end of the year, but that's seeming less likely right now. But that doesn't mean things won't change over the next 12–24 months.

Michael: So I'm trying to math this a little, and just like, plugging numbers into my good old-fashioned financial calculator, because I'm an HP 12C guy...I can't let it go. So if I go back to our original example, like my $2 million practice, so if I'm selling it for 2X revenue, and it's a $4 million purchase, and I'm financing at 8% over 10 years, I'm getting a loan payment almost $600,000 a year, like $596,000 a year. So if I was running a $2 million practice at 30% margins, I really am right back in the realm where my note payment is almost exactly the same as my profits. It doesn't line up perfectly because my profits are taxable, and my loan payment is not fully deductible, so I'll have some tax slippage.

Dustin: Yep.

Michael: But it seems like I'm pretty close if I'm paying 2.5X revenue, and it's a $5 million purchase price. Now my note payment's not $600,000, it's just shy of $750,000. And so if I'm running 30% margins, I'm a little bit in the whole [for] cash flow year 1. I need my practice to start growing for this to turn cash flow-positive for me. Or if I've got some money to put a down payment, and borrow less, then obviously it works a little better.

But does that kind of sound right for what you see? We're kind of in this realm where you finance over 10 years, and you're pretty close to cash flowing? Maybe you're a little bit negative in the first year or 2 because valuations have drifted a bit higher, and that's kind of where terms land right now?

Dustin: You're spot on. And that's where that lendable equity with a buyer's firm is so important.

Michael: Right.

Dustin: Because under that scenario that you just outlined, and this kind of shifts us into a different discussion, and we can address that at some point, but you start to get into the inside buyers internal succession plans, and the affordability issue of those trying to buy 100% of the firm all at once, versus doing it in a phased approach.

But when a lender is looking at a transaction, and to your point, if 30% margins on $2 million in revenue leads to $600,000 in profits to service $600,000 in debt, that break-even figure, just a simplistic discussion, not getting into amortization, depreciation, interest deductions, that results in what we consider a debt service coverage ratio of 1-to-1, there's $1 of profit to service $1 of debt.

Michael: Okay.

Dustin: And I don't know of any lenders who have a debt service coverage minimum of 1.0-to-1. Most are going to run on the lowest of ends probably 1.2-to-1, up to maybe 1.3, 1.4-to-1. So what we're looking for is a little bit of cushion there, especially in the advisory space, knowing that tomorrow could lead to a market correction, or the next few months, it ultimately puts this underwater pretty significantly.

Michael: So the reliance on the internal transaction, right, where there's not other enterprise value, cash flow equity at play, this makes you nervous as a lender, if they've got exactly $1 of profits to cover $1 of debt, because that math adds up but just barely, and then you give me a market pullback, and now I have to worry as a lender about whether they're going to have a problem with the payment at the end of the year.

Dustin: Yes. And that's...looking to the numbers you referenced, 2X multiple seemed kind of right there, and then you get into the 2.5, 3X figures, and sometimes even higher, and it makes it almost impossible for an inside buyer to complete a transaction at least of 100% of the firm, because it would require a significant amount of seller financing, probably, because there's lendable limits, or loan-to-value limits, there is cashflow or debt service coverage minimums. So shifting debt from bank to seller doesn't solve debt service coverage problems. What solves that? Cash injections, potentially deferred seller notes. And typically, from an inside buyer, they're not likely, if they don't have any equity in the firm, sitting on a significant level of cash in terms of their ability to inject that amount towards the purchase price so that the bank loan is approved based on debt service coverage minimums.

Bank Lending For (Partial) Internal Successions [59:26]

Michael: So let me ask this a little bit further maybe in the context of internal succession. So let's kind of run with my same practice, right? This $2 million practice selling for $4 to $5 million valuation, depending on what our multiple is. But my internal successor doesn't want to buy the whole thing, or isn't ready to buy the whole thing, they just want to buy 10%. So I'm trying to buy 10% of this firm, which basically means I could just lop a zero off of all these, right? My 10% stake costs $400,000 to $500,000, my 10% note is going to cost me somewhere between $60,000 to $75,000, and my profit distribution on a 10% ownership is $60,000. So I've got the same relative numbers, but I've just taken a zero off of everything.

Now when I think about it in that context, and I'm thinking about my internal successor who presumably is already an advisor that's working in the firm, that has a lot of clients, that probably makes some decent income, if I've got an internal buyer who's an advisor who's also making $150,000, or $200,000, or $250,000, is there some point where the bank then comes in and says, okay, from a pure balance sheet of the practice perspective, I don't love that you're buying a stake that has a $75,000 note payment, and you only get $60,000 of profits. That's not a great debt service coverage ratio. But you make $200,000. If I'm otherwise comfortable that you're really in for this transaction, assuming your lifestyle is not too high, you should be able to cover the $15,000 or $20,000 delta. Your income should be able to cover this delta if we're only doing a 10% transaction.

Is that a valid way to think about it? Is that actually how it shows up when you try to underwrite a not 100% internal transaction, but some smaller tranche?

Dustin: It's very common. And you've kind of hit the nail on the head when you look at the numbers, because with today's valuations, that does...the affordability issue of internal succession plan, it gets talked about a lot, but not everyone is interested in selling externally. I'd say we run into probably more that would prefer to sell internally, when they have the people in place, and they understand they might be leaving some chips on the table. But there is a balance between external prices and internal prices, but for that inside buyer, we are having that discussion.

As a lender, I think it's important for people to note, is making sure that the lender's kind of working to support your best interest, too. We've seen transactions that were far more underwater than the example you just gave. It could be you've got $60,000 in profits and $90,000 in debt payments, you're really going to be...

Michael: Okay. That would be stressful a little, yeah.

Dustin: Yeah, so you're going to start to cannibalize that kind of base wage. So let's say they were making $150,000, and that wasn't going to change. Well, how comfortable are you living on $120,000 a year?

Michael: Right.

Dustin: Well, if we grow at this pace over the next 4 or 5 years, I should finally get into the green, should be in a cash flow-positive situation, but again, all dependent on certain levels of growth, and not considering the what-if scenarios tied to the market. But with that, it's easy for a lender to come in and say, "Hey, if we're doing this, the business is collateral. So I'm lending $400,000 to a business worth $4 million." A very easy loan because if you default, the business is responsible for the payment. And then...

Michael: I guess assuming, as the 100% owner going down to 90% owner, that I'm willing to have the business shares that I effectively own collateralize the financing of my internal successor, right? I do have to at least be comfortable that the profits from my shares will collateralize the purchase of his or her shares.

Dustin: Correct.

Michael: Okay.

Dustin: So we go in and we have these discussions with our borrowers, just to make sure we're all on the same page. Hey, make sure I'm seeing these numbers right, okay? $60,000 a year, $60,000 in debt, 1-to-1 [profit to debt service], as a buyer into a business or as a business owner, there's risk-reward. That seems like a fair and balanced situation. As they get more and more underwater, it's not that we would necessarily immediately pass because they might be slightly underwater when looking at distributions versus debt payments, but we also want to...we don't want to just make a loan and put someone in a bad situation, because we know, hey, worst case scenario, the business is going to be responsible for this payment.

Michael: Right. But these aren't exactly the kinds of businesses you want to foreclose on and run, as a bank.

Dustin: No.

Michael: Not so much.

Dustin: And this all kind of falls under... So we were talking about acquisitions, mergers, things of that sort. That falls under our growth loans, which is acquisitions and mergers, and then we have our next gen loan program for these types of transactions, buy-ins, what I call internal equity purchases, so an owner with equity buying more equity, and then buyouts, but ultimately internal succession plans. And when you look at a structure that you just outlined, us doing this in tranches starts to grow the inside buyer's ability to acquire larger pieces.

Michael: Right, right. I buy 10%, it's a little bit underwater, but 3 or 4 years from now, our practice is growing. So now I've got $100,000-plus of free cash flow to make my $60,000 to $75,000 note payments, which means I'm actually revenue-positive, so now when I want to go do the next purchase, the numbers finance most of it, and my free cash flow from the first tranche makes it easier to make the note payments on the second tranche, and I can layer myself up if I just buy another slice every 3 years over the span of 6, 9, 12 years.

Dustin: Yes, and that's what creates...that allows the borrower to also start to establish wealth, and grow their position, or grow their overall financial position and financial strength to better qualify for larger amounts. Because you might get, as you mentioned, the firm's growing, cash flow's growing, but also, so with your income growing, you're starting to probably put more away in terms of your personal liquidity, your retirement savings, your equity ownership interest. That 10% that you bought for $400,000 might now be worth $600,000, but your loan balance is $300,000 in a few years.

Michael: Right.

Dustin: So all these things start to better position these buyers to potentially acquire larger chunks. I mean, I just spoke to a $1.4 billion firm a few days ago, 5 people looking to buy in, and the question they ask is, would we be better off buying if we could 1% each, 2% each, 5% each today, and maybe a little bit over time to divest the owners of 75% over the next 4 or 5 years? Or should we just wait?

I would not ever recommend waiting because the ability to acquire equity, start paying down that debt, start growing your personal financial strength, is going to open up the doors for you to acquire a larger interest in the firm. Because you may have a seller who says, I'd love to sell 50% in 10% tranches over the next 5 years, and maybe the following year or a couple years later, I'm just going to divest of all of my equity. And therefore, a lot of buyers would be positioned at that point in time to borrow 100% of the buyout price for that owner's 50% interest. So it's building that debt-free equity position, that excess cash flow to meet the lending requirements, or what we consider our debt service coverage ratios.

Michael: And so again, where are those limits? So I guess the loan-to-value limit is essentially up to 2X of the combined revenues of buyer and seller, so 2X the revenues in internal succession, 2X the combined with an external transaction. What are the actual debt service coverage limits? If folks are thinking about this, and trying to math some of their own deals in their head a little, where do you hit real limits on this?

Dustin: 1.25, or 1.3-to-1 I think would be a good number to work off of.

Michael: And which is the 1.3, and which is the 1? I need $130,000 of profits to cover $100,000 of debt?

Dustin: $130,000 of profit to cover $100,000 in debt payments.

Michael: Okay. Okay.

Dustin: Now, if we're talking about an equity purchase, or a buy-in, using that 10% example, we are looking at global cash flow. So we're looking at not only the individual's cash flow, but we're approving based on the global cash flow of the firm, because it's ultimately collateral. So if I've got that $2 million firm with $600,000 in profits, that can easily support those debt payments on a $400,000 loan as a backstop.

So we want to have that discussion with the buyer about, "We know this is your cash flow," and that's where I say some lenders might come in and say, "Well, we know if he's underwater $30,000 a year, no big deal. The loan as a percentage of the total value of the firm is well within our lendable limits, and it easily cash flows."

Michael: But I guess both from a risk, and a getting comfortable perspective, your frame from the bank end is the practice is big enough to support this, so we're going to require the practice to cover it, and we know we're covered. If I'm the seller, I'm basically looking at this and saying, y'all are going to use the profits from the 90% I still own to backstop the 10% that I'm selling. And I, as the seller, have to decide if I think at the end of the day, my buyer can handle the debt payments from either the profits or their salary, and whatever I pay them in the advisory firm. I've got to make my own sort of internal evaluation of how much of a lending risk this really is or not, to let my successor buy in with some combination of profits, and maybe a little bit of their salary.

Dustin: Yeah, exactly. And here's probably the easiest way to describe that. When you think about an acquisition loan, you think the buyer is typically the business. So let's assume it's an RIA buying another RIA. In that case, we're lending to the business, and the guarantors are the owners of the firm, or maybe those with a 20% ownership interest or greater. So you have borrower as the business, and guarantors as the owners. That's under the growth loans program.

You can flip-flop the borrowers and guarantors under our next gen loans. So our buyer is now an individual.

Michael: Okay.

Dustin: They are buying 10%. Our guarantor is a corporate guarantee from the RIA.

Michael: Okay. Not necessarily like a personal guarantee from...

Dustin: Correct.

Michael: ...who is the founder or owner, just from the business?

Dustin: Correct. And I always tell my buyers, when you go back, the one question that's most commonly asked by the seller is, aren't I inadvertently responsible for that payment? If you default and the firm is a corporate guarantor, the firm's responsible for the payment, I own 90%, you're not paying it, so it probably falls on me. Yes, you are inadvertently responsible, but you do not have a personal guarantee.

And what we typically recommend or see is through a buy-sell arrangement, they can build in protectionary measures. And it could be if you default, in addition to death and disability in the buy-sell arrangement or buy-sell agreement that might be tied to market value, a selling advisor, the primary owner, 90% owner could say we're going to add a default clause to this buy-sell agreement. And in the event of default, I have the ability to force a buyback of those shares or that equity at a 10%, 20%, 30% discount to market value, I can withhold distributions to make that payment so that my income is not impacted, they can really iron out a few different ways to really incentivize that buyer to not default. Knowing that, hey, you're going to be impacted by defaulting potentially on this.

So through risk reward, yes, you might be eating into a little bit of your base compensation in a down year, or maybe when profits are compressed. But it does give the seller some peace of mind, knowing that even though I don't have a personal guarantee, it also limits the exposure they have to a default situation.

Small Business Administration Loans For Advisor Borrowers [1:13:21]

Michael: Okay. So stepping back a moment into just loan types, you had mentioned earlier that these are not SBA [Small Business Administration] loans. What is, for those just who are not familiar, what are SBA loans? How are they different? And where do they work?

Dustin: So SBA loans are a good resource, but an SBA loan, or Small Business Administration, provides capital to all types of markets throughout the country,

So the biggest difference is, one, the SBA requires that a seller sells 100% of their interest, and exits the business within 12 months. So buy-ins and internal equity purchases do not qualify for SBA financing because if I own 100%, I need to sell 100%. If I own 50%, I need to sell 50%. I can't sell 5%, 10%, 15%, 20%, and my buyer can't go get an SBA loan.

Michael: Right. Okay.

Dustin: In an acquisition, it could suffice, but a lot of times it's not uncommon to see a seller wanting to stay on for 3, 4, 5 years, or the buyer wanting them to stay around. In some cases, they do exit within 12 months, but again, not uncommon to see them sticking around for longer than 12 months, which is problematic for an SBA loan.

Additionally, SBA loans will look for additional forms of collateral, primarily a lien on personal real estate. I think any advisor probably falls under this same recommendation, hey, if you can keep your business and personal assets separate, do so.

Michael: Right, right.

Dustin: And that doesn't do that. So flexibility is probably one of the biggest differences in SBA and conventional financing.

Michael: And in a world where... This is a government program, that the government, I'm presuming, sort of supports on the underwriting end, does that mean if I actually do fit the SBA cookie cutter, I end up with a slightly better interest rate or payment period because I do fit the SBA structure?

Dustin: No. And that's another area where you find pretty big differences between SBA and conventional loans. Most SBA that I know of, they do offer 10-year fully amortizing loans. So the loan term itself is the same, but rates and costs vary greatly. Historically, it wasn't uncommon to see prime-plus-1, prime-plus-2, which would put you at 9.5 to 10.5 today, and that could be a floating rate. And we actually saw a lot of refinance requests over the last few years of people looking to get out from under SBA loans.

Michael: Because they were floating rate, and our rates went way up.

Dustin: Yep. But again, looking for a long-term relationship, if you have ongoing needs, the SBA limit is also $5 million. Our limits or loan amounts run from $200,000 to $25 million. So if you are a firm or an advisor with ongoing active needs, you could quickly run out of runway with the SBA option.

And what helps, what also helps on the conventional side is the ability to support all the ongoing needs. So we've structured our program over time to include all these various additional lending options, the next gen loans, refinances, working capital, lines of credit, so that we can be a long-term partner. Because we might start with somebody today who says I've got an acquisition need, but in 12, 18 months I'm also going to be looking to sell 10% or 20% of the business.

Michael: Right.

Dustin: And then you need to find a partner who can accommodate all those ongoing needs so you're not forced to pay off when a new need comes up.

Recent Trends In Advisory Firm Valuations [1:17:16]

Michael: So I have to presume that just the sheer volume of loans you do, you see just lots of transactions, and the terms and the pricing that they get done at, that they close at. So I'm really curious if you guys have data or perspective on what are going rates for advisory firms at this point from your end? I guess I don't even know if you look at them as multiples of revenue or multiples of EBITDA [Earnings Before Interest, Taxes, Depreciation, and Amortization]. Where do you see pricing and valuations landing these days?

Dustin: Very interesting question, because I'll kind of revert to revenue multiples, and the reason why is we work with firms and advisors of all sizes. So a lot of times if you're doing an acquisition, and the seller has $50, $100 million in assets, operating under a broker-dealer, and so is the buyer under the same broker-dealer, for the buyer it might be a revenue purchase. There might not be any additional overhead they're taking on.

Michael: Right.

Dustin: And they're probably not going to want to apply an 8X EBITDA multiple to a business where the seller is taking home 70%. They could be the sole employee in that business.

Michael: Right.

Dustin: So you see revenue multiples kind of applied and used in valuations on those smaller practices. But we did do an analysis of our portfolio, and we've done so for many years and finally put out our M&A lending report, because I think it provides a different perspective on the industry versus what you might see from a DeVoe or Echelon or Fidelity, who's really focused on the large RIA transactions that are...there's 200 or 300 of them a year. What's not being reported on is what we fund, what our competition funds, and it's hundreds of other transactions that go unreported.

But what we typically see is 2.5–3X on recurring revenues, is kind of the average recurring revenue multiple. And a lot of times, even if you're thinking about an EBITDA multiple, it's not far off from that revenue multiple. So using your example, if I say I've got a $2 million seller who's priced at $5 million, or 2.5X revenue with 30% net, well, they're actually getting a pretty hefty multiple if you're talking about EBITDA. I mean, $5 million, or 2.5X revenue on...$600,000, yeah.

Michael: Well, they'd be at $600,000 on profits, so you're just over 8X EBITDA at that point?

Dustin: Correct. So it kind of lines up in those cases. And if you're 40%, it's a little lower on the multiple side. But it's not uncommon to see that 2.5–3X revenue range, even when they're pricing off of an EBITDA multiple, and you can kind of back into that revenue figure.

So I'd say 2.5–3X, we always look at gross revenue. And I point that out because in the numbers we report, gross revenue, that's the only figure with an RIA, but with a broker-dealer, you might have a net revenue figure, which accounts for the broker-dealer override, but we're always looking at gross production so it's an even playing field. So whether it's an RIA, a broker-dealer, advisor, an IAR, we are looking at their gross production, not net of any overrides or haircuts from a broker-dealer or a platform.

Michael: Okay. So you look at multiples, like in RIAs it is the gross, at a BD, we're not talking off your grid payout, we're talking your gross, like your GDC, your original top line.

Dustin: Correct. Yeah, if you're generating $1 million in GDC [Gross Dealer Concession], and the broker-dealer has a 15 basis point override, and your payout is $850,000, the multiples that feed our statistics are tied to that $1 million in GDC.

Michael: Okay. Okay. And is there I guess a size skew when you look at it this way? Are the multiples smaller for smaller firms, and larger for larger firms? Do you see that in the deals that you do?

Dustin: Generally speaking, but it's not consistent. And I say that because when you look at broker-dealers, take RIAs out of the equation, advisors, buyers and sellers under the same broker-dealer can get pretty aggressive. And I say that because a lot of times, going back to that solo practitioner, you might have a broker-dealer advisor who says, I'm buying $50 million in assets that's generating $500,000 in GDC for $1.5 million. It's like, wow, that seems a little bit higher than what I'm used to, based on averages, based on what we're seeing, that larger firms getting higher multiples, but for the buyer, it's hey, this is a pure revenue play. I am buying these clients, I have the capacity, I don't need to retain any expenses. Or maybe the seller has no expenses, it's just...

Michael: Right. It's then like your classic small-book purchase.

Dustin: Yep. And I think that kind of skews those figures, where it's not consistently as they get bigger, they're always priced higher, because you might have a lower quality book. Just because it's larger doesn't mean it's as high quality as something that's smaller. The larger books could have demographic issues, a much older client base, it could have asset concentration issues, a few clients that generate 50% of revenues. So all these variables kind of feed into those prices at the end of the day.

Michael: So as I get larger, or I get just more normalized expenses, I kind of threw around these numbers before of 2.5 revenue, with a 30% multiple...a 30% margin, which basically puts you a little over 8X EBITDA, 8X earnings, when you get to the firms that actually measure in terms of earnings, is that where the numbers tend to show up, if you look at these as EBITDA multiples? Or do you see higher or lower ones? Because ultimately it's going to show up in your debt service limits indirectly anyways.

Dustin: Correct. And it does tend to show up in those kind of standardized numbers. Now, I would say when you're looking at the reports and the headlines about the larger transactions that might be...let's call it 12X EBITDA and larger, [at] those prices, there's a select few buyers that can afford to pay those prices. And that's just the reality. And that's why I always like to talk about the headlines versus actually what's happening in 90% of the other businesses. I think you even probably put it, what, closer to 3% earlier, when you mentioned the aggregators. They have a different business plan, they have a different business model, they have a different MO.

And as a lender, offering traditional debt as an option for M&A, most of the firms I'd say we work with, 90% are going to be sub-$1 billion, just because as firms get larger, one, they're either...they might have the ability to self-fund these transactions, they might have a minority partner who's providing capital, a private equity partner. So those things do lead and contribute towards some of the higher multiples paid. But all these transactions that we're financing, that some of our competition is financing, those aren't showing up in those numbers, and those aren't showing up on any of the M&A reports. So that 2.5–3X is somewhat common, and it still remains at a level that I think provides a good multiple to the seller for an exit, but also stays within a range that can be feasible for an internal transaction.

Michael: I guess with the caveat, unless you're not actually running a firm with terribly healthy margins, right? If you're trying to sell for 2.5 revenue, and you're only running 18% profit margins, this deal is going to fail because everybody's going to end out with debt coverage that's like where the note payment is radically higher than the profits because you don't actually have that much profits, and at that point, you're basically trying to sell your practice for 15X earnings, and the math just won't work.

Dustin: I mean, exactly. You know, a lot of our discussion does operate around kind of the general...and we probably see on average 30% to 50%. I mean, it's not uncommon for even some of these larger RIAs...

Michael: 30% to 50% margins?

Dustin: Yeah.

Michael: Okay.

Dustin: And not all RIAs, but this is taking into consideration all the clients that we work with, across all independent spectrums. So broker-dealers and IARs, there's a lot of advisors and firms we work with that are in the $100 million to $500 million range, for instance, that would like to leverage traditional debt for growth to reach higher levels of production, to reach higher multiples that maybe some of the aggregators are willing to pay. And I always tell people we're your bridge to that sale. If you want to grow, we can be that partner. We're not taking an equity interest. And then, when you reach the point of you getting the offer you're hoping for, or looking to exit the business, you can pay us off, and we'll go our separate ways.

Michael: Right. And for folks who are listening, this is Episode 395. And so if you go to Kitces.com/395, we'll actually have a link out to the report that Dustin's firm put together, of what they're seeing for numbers and transactions. They've put out a lovely report, so we're trying to mention some numbers from it, but you can read the full report in the show notes.

Surprises That Arise For Buyers And Sellers During Loan Transactions [1:27:45]

Michael: So Dustin, as you go through firms that do this, where do you find advisors tend to get surprised, I guess between expectations versus reality, when you're calling up for a loan to do a transaction, and then find out how it works? Where do advisors tend to get surprised?

Dustin: I feel like more of the surprises come from sellers. And I say that because a lot of times it might be just unrealistic expectations on what they can get when it comes to price and cash, and how quickly. Even as firms grow, larger transactions in terms of the dollar amounts, there does potentially need to be seller financing. We talk about 100% financing, but I'd say most of the prices sub-$5 million would qualify for that. Not that the larger ones don't, but the larger deals that do end up in the $5, $10, $15, $20 million price range typically have buyers who do want some level of seller financing, and some protection.

So it seems that the sellers run into that issue a little more often than what I see buyers, because for a lot of buyers who are going in to negotiate a deal, especially first time, I always recommend calling us early in the process.

Michael: Right.

Dustin: Don't go negotiate a deal with a seller...

Michael: And then see if you can get it financed, yeah.

Dustin: It just burns so much goodwill.

Michael: Right, right.

Dustin: It was hard enough to reach the point of them saying, I am ready to sell to you, now let's talk numbers. And buyers I think are cognizant of that potential hurdle, and they will reach out because traditional debt is available. There are a handful of us who do it nationally, who know the industry, and I think them leaning on us helps them avoid those pitfalls. So I'd say a lot of it I see on the seller side where buyers come and say, we've started the discussions, it feels like there's some unrealistic expectations, what can we expect from you? And I think that can help avoid those pitfalls.

The Low Point For PPC Loan In Their Advisor Lending Business [1:30:04]

Michael: So have there been any speed bumps or low points for you guys as you've been trying to do these transactions, and work with firms over the past 10 years? I think in the past 10 years, obviously, because the Financial Crisis was not an ideal time to have been rolling this out originally. But as you look over the past decade, where have the hiccups and speed bumps come as financing has expanded?

Dustin: For us, it's probably in the banking partners. The desire to continue providing capital to this space...I mean, we are well capitalized, ready to go. But I think even with 10 years of funding these transactions, 10 years, or 11 years now of lending money since 2013 without a missed payment, no defaults, no missed payments, you would kind of expect just banks in general to start to gain a little more comfort in these transactions. And they have, but banks operate under strict regulatory requirements, just like advisors, and sometimes they just can't get out of their own way. It could be, hey, this is an exception to credit, we live within this box, this is our credit criteria. Well, that doesn't necessarily mean the deal inside the box is better than the deal outside the box.

So that would be kind of, I would say, the pitfalls we as a company, we as a lender have run into, and I think the business model helps us avoid that when you talk about our ability to serve the market. By having multiple banks, some may be bought and sold and exit the industry, others may change course in terms of their business model, and not look to lend to advisors, and allows us to continue to serve the market without having any pauses in our operation.

But you know, even with our track record, having banks approach us about potentially leveraging what we offer, getting into a new market, there's always hesitation there on their behalf when it comes to lending to businesses with no tangible collateral.

What Dustin Wishes He Had Known Earlier About Advisor Lending [1:32:08]

Michael: So what else do you know now about lending, and working in the independent advisor marketplace, you wish that you knew 10 years ago when you guys were starting this program?

Dustin: I wish I knew about the quality of the transactions, and the quality of the buyers and borrowers who have approached us for funding. It was an unknown. There wasn't a lot of statistics, as I mentioned. But I feel, in looking, if I had to go back, I would definitely say let's be more aggressive. Because having a borrower, especially whether it's an internal or an external transaction, internal transactions are great, we love them, the banks love them because there's little to no transition risk. A lot of times the ownership team's not changing, if there's a buyout of a founding partner, that person's probably not sitting down with the clients, if the firm is that size. They're not actively involved, a lot of them have slowed down. So doing internal transactions, in the eyes of the clients, there are no changes. It's behind the scenes, to the cap table.

Michael: Right.

Dustin: External transactions, most of the time the buyer is of equal or greater size, so that added collateral and cash flow they bring to the table, and also how that's impacted their personal financial strength makes these loans overall pretty easy to do.

So that would be an area, of knowing and kind of realizing that this is somewhat, or a lot different than the markets we've served. And the quality of those candidates, the buyers, the firms, everybody we work with, I would have loved to have been a lot more aggressive right out of the gate.

Dustin's Advice For Next-Gen Successors Navigating The Path Towards Acquisition [1:33:48]

Michael: Right. So any advice you would give the G2 successors that are trying to figure out how to navigate their path towards acquisition when there is more concern these days around affordability in terms?

Dustin: I think the one thing I would recommend is go after the opportunity as soon as you can. If it's been discussed, if the seller's interested in selling internally, start evaluating your options. Because realistically, where prices are at, and when a firm has the ability to transition internally, it's because they've grown to a certain size, and they have larger teams, but they have the candidates who are in a position to buy. Unless you have a seller who is so flexible that they're willing to take a lesser price, take seller financing with no payments and still get that higher multiple, the only feasible, or not the only feasible way, but doing a sale, doing it in tranches over time can really change the dynamics of what's doable for an internal succession plan.

And I think it's just one of those unsexy headlines that doesn't get talked about. Nobody wants to say, hey, let's go do a press release. We successfully did an internal transition over a 10-year period, and the seller got all cash at every tranche, without having to seller finance a dollar of it. So there are options out there.

And I think for that next gen, it's do your homework, get out there, talk to people like ourselves, and valuation experts, consultants, any other service providers that can help give you some insight on how deals have been structured, what worked, what didn't work. Because I think we talk to so many next gen advisors, and sometimes these conversations stretch out for years, where we thought we were buying equity, there's been a discussion around an internal sale, and now we're 3 or 4 years down the road and nothing's happened. And I think either sometimes they lack the desire, or the aggressive nature to provide a solution. Sometimes I think the sellers are dangling that carrot in hopes that they step up and have that discussion, maybe make an offer, or go out and research what options are available. But for those that are relying on the seller to be the lead, if you're working the 2 or 3 days a week, and you've got a good team in the place, and the firm's growing, the income's great, there's not a lot of desire to sell sometimes, even though they know there's a need to start doing so, and transitioning the firm internally.

So that would be my advice to the next gen, is take that opportunity and run with it. See what you can do to put an offer on the table, rather than waiting on the seller to structure a deal and just hand it to you.

What Success Means To Dustin [1:36:45]

Michael: Interesting. So as we come to the end here, this is a podcast about success, and just one of the themes that comes up is the word "success" means different things to different people. And so you've spent much of the past 10 years building out this successful division that's doing lending in the advisory space, but how do you define success for yourself?

Dustin: For me, it's, I mean, really progress and probably growth. As an individual, a father, a spouse, a business owner, I fortunately had the opportunity to buy equity in my company in 2017, went through a second round of an equity purchase in 2020. And we can look at the growth of the program, and we can look at the growth of the company, and it's not a year-over-year upward trend. Things happen, as a business owner. But I think when I look back, I'm always looking at it's how have I progressed and grown in all capacities of life? As a business owner, how am I working with my staff? How am I bettering them? And the same goes on the individual side. So I've always looked at it as at least being able to look back, and seeing that I'm progressing and growing as an individual and business owner.

Michael: I love it. I love it. Well, thank you, Dustin, for joining us on the "Financial Advisor Success" Podcast.

Dustin: Thanks so much for having me, Michael. I've really enjoyed it.

Michael: Likewise. Thank you.