Financing A Financial Advisor Acquisition Or Succession Plan With Live Oak Bank

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#OfficeHours with @MichaelKitces Video Transcript

Welcome, everyone! Welcome to Office Hours with Michael Kitces!

I'm here today with Jason Carroll. Jason is a Managing Director with Live Oak Bank.

For those of you who aren't familiar, Live Oak Bank does loan financing for financial advisor succesion plans and mergers and acquisitions. So when you're buying or selling a practice, and that question always comes up, "But how can you finance the deal to pay for it?" This is the guy who answers how you pay for it!

An Introduction to Live Oak Bank and Jason Carroll [Time - 0:35]

For regular Office Hours viewers on Periscope, you may notice that this is a new format, since I'm usually talking to you directly. But honestly this is a space that I actually have not spent a ton of time on, so I wanted to get someone here who can really talk about it. So, here is Jason Carroll!

Jason, can you give like a little bit of background of Live Oak Bank and where you guys come from? I mean no offense, but I don't feel like you're a household name in the banking world that advisors would know, so some background might help.

Jason: Yeah, so at a high level, we're an FDIC insured, national footprint bank. We're a specialty lender. Right now we only lend to 10 industries, veterinarians, dentists, doctors, things like that and......

Michael: So lending to professional services firms is your niche in banking?

Jason: Yes, professional services typically. Unlike other banks, our lending focuses on very cash flow heavy businesses, such as advisor businesses, where there's not a lot of collateral, inventory...

Michael: Right, and that's always been historically why it's hard to get lending for advisors. For advisory firms, you go to a bank and say "I'd like to borrow a couple million dollars." They say, "Awesome. Tell us about your collateral." And we respond, "Umm... my clients like me a lot?"

Jason: Right. "My clients are very sticky," is what you hear. But as the bank, we're not buying them. And that's a good point to highlight because technically Live Oak Bank was founded in '07, we got our FDIC charter in 2008, and what's important about it is our charter's specifically written to allow for collateral shortfalls when we lend.

Michael: Okay, so you don't have to have hard asset collateral, and that's okay.

Jason: Yep. So we're not lending to John Deere and putting a lien on a bunch of tractors. We lien on the business cash flows... we're cash flow lenders and depend on the goodwill relationship that advisors have with their clients. And we can only lend on the independent side of the advisor business, so that's another differentiator.

Independent Advisor Loan Financing Based On Client Cash Flows [Time - 2:24]

Michael: So independent RIAs, and advisors at independent broker-dealers, is who you work with. Functionally I guess the key issue is that you have to actually own your business, you have to actually own the cash flow. If you're an employee advisor, technically you don't own the cash flows, so you can't borrow money against them.

Jason: Right. So not Morgan, not Merrill, they're definitely two employee firms, so not that side of the world. But we do lend for RIAs, registered reps, and hybrids, all on the independent side.

I started the group in 2012 when I joined the firm. I left Charles Schwab, where I managed all the institutional lending platforms at Schwab. And now a few years later, at the time that we're having this conversation, we just crossed over $300 million in lending to advisors.

Michael: Wow. In under 4 years.

Jason: We did our first loan in February of '13, so give or take...

Michael: So you're living a part of the uptick in advisor M&A activity. The growing trend we're seeing in industry studies of merger and acquisitions, you're at the center of that.

Jason: Yep. So 65% of that number, $300 million, is advisor succession and acquisition, as for us successions are a type of acquisition anyway...

Michael: Okay, so basically either internal succession plans or external succession plans.

Jason: Yeah, and internal succession plans could be employees purchasing from the owner, or one advisor purchasing from another on the same platform, like Ameriprise buying Ameriprise. To us that would be an internal acquisition.

Michael: Okay, so internal within the broker-dealer too. If you're at Ameriprise or LPL for instance, and you want to buy other advisors on the platform, Live Oak Bank is a loan financing option.

Jason: Right. Or for external deals. That could be Ameriprise buying Cetera for example, or RIA X buying RIA Y. We do a lot in recruiting and recruiting growth.

Another example might be the wirehouse advisor that wants to transition and start their RIA, but has to navigate a forgivable note, and says to us "Can you help me with that?" We can.

Financing Out Of Forgivable Loan Retention Incentives [Time - 4:07]

Michael: How interesting. So if I want to break away, but my problem is that I've got a forgivable loan from a retention deal from a couple of years ago and I don't want to pay the lump all at once, or I may not even have liquidity to pay the lump all at once, you'll finance the repayment of my forgivable loan against my own future client cash flows from my breakaway?

Jason: Yes, but a couple different ways it happens...

Michael: No offense, I would imagine there are some broker-dealers that created forgivable loans for retention who are not actually thrilled that you're making it easier for that transition?

Jason: Well, I'm not thrilled that there's other banks in the country...

Michael: True, competition is what it is!

Jason: Competition is what it is.

So we do that on a smaller scale. Mostly what we get is the advisor that wants to transition. I'm not picking on wirehouses, so maybe it's a wirehouse, or moving from LPL to another platform.

In addition, as they move, it's going to take three to six months to transition their clients, and they're not going to have money under management during the transition to bill on, or may not be set up yet with the new custodian they're going to bill it through. So we will capitalize their new business.

Michael: Ahh, because just literally there's no cash flows coming in while your clients are transferring.

Jason: Right. We'll capitalize their business so they can afford to initially operate their business, whether that's on the forgivable loan side or not. Though someone typically is not going to take a seven year note as a forgivable and call us six months into it and say, "Hey, can you buy me out?" They're not...

Michael: Right. But, if you had a seven year forgivable and you've just got three years to go, and you want to transition, and you don't want to wait until the end of the three years, but you don't want to write the repaycheck check all at once. That kind of the scenario?

Jason: Yeah, so we work with a lot of advisors in motion in general. Whether that's forgivables, or operating capital, or working capital. Or recruiting as a tuck in, where it's "I'm XYZ RIA, and I custody with Pershing. And I'm going to recruit someone from a broker-dealer, or from a wirehouse, or from another RIA."

This is also where we get into more of the succession planning. How are you going to find and fund generation two that's going to run a sustainable business for you? Maybe he has a small book of business. The advisor says "I'm going to bring them as a tuck in under me, and that's how I'm going to start to execute on my succession plan."

Advisor Financing Loan Terms And Interest Rates [Time - 6:12]

Michael: So can we talk numbers a little bit? What does a financing deal really look like? I'm going presume you still require some skin in the game from the advisor, and that you won't finance 100% of the deal. There's probably some kind of down payment. So what does that look like, in terms of down payments, and interest rates, and loan durations?

Jason: We'll just talk about acquisition and succession. Typical 10 year term fully amortizing loan...

Michael: Okay, so no balloon payments. You are going to make full payments over time.

Jason: P(rincipal) and I(nterest) over time, paid monthly. Down payment percentages vary, from 25% to where we can do up to 100% financing.

So you'd probably say, "Well, that seems like a wide range," and it is.

If you and I just met to start talking and you say "I want to sell you my business and I need the bank," Live Oak Bank is going to fund more on towards the 25% range, because of attrition risk.

Michael: Right, right. You're concerned with collaterizing against cash flows that may or may not successfully transition at the end of the day.

Jason: Right, and the clients don't know that new advisor. There's attrition risk, so we try to mitigate our risk exposure.

That's compared to daughter buying dad's practice, who's been there for 20 years, he's out on the golf course, she's running the office, very small attrition risk. I could go up to 100% financing.

So it really depends on risk mitigation on either side of the transaction.

Michael: So in practice with advisor M&A, your primary underwriting risk is client retention, so that's what you underwrite against. How good is your goodwill, really, because that's what we're borrowing against.

Jason: Yeah, and that's what we want to understand. We say, "How long have you been working together? Have you met that top-tier list of clients? Is there a similar investment philosophy, culture," things like that. If it's no, we just met at the bus stop last night, there's a little more risk for us as the lender. And our buyers don't want to take on that risk either.

So we really work very consultatively with advisors and say, "You're exposing yourself to risk here."

I think one difference here on Live Oak as well, everyone on the team only does investment advisory loans, so we're not financing a pizza parlor one day, a laundromat the next, and trying to figure out...

Michael: Right. You live advisory businesses and how they work.

Jason: Yeah, so we become consultative in nature, because that's all that we do.

Michael: And so I guess from the advisor perspective, the advisor's strength of relationship with the clients and the confidence in transitioning them in a deal now gets reflected twice in the deal, because of course those are the core factors for valuation in the first place.

Jason: Right.

Michael: And then expected client retention it affects the underwriting of the financing as well in terms of both down payment. Does that impact the interest rate that you charge as well?

Jason: No, we're not a risk-based pricer.

Michael: Okay, so everybody gets the same rate?

Jason: Yeah, it's roughly prime plus 2% to 2.5%. The Prime Rate is 3.5%, so the total interest rate is about 6% to 6.5%.

And remember, it's a business loan. Even if it's a registered rep, it's a business loan, because their business entity is as a sole proprietor. So you're writing that interest off as a part of your taxes every year.

Michael: Right. It's tax-deductible financing, so the 6.5% rate is pre-tax, and then subtract the value of the tax deduction.

Jason: And from a down payment perspective, we like to see equity. But if I'm buying your shop, I have $100M in AUM, you have $100M in AUM, I'm already bringing my equity to the table, right? Versus if it's a junior buying out the senior, where the junior brings no equity to the table, so we might say "You have to put 10% down. We'll fund up to the remaining 40%, and then the rest is on a seller note." Although ultimately it's not often done like that. Typically these deals are structured that what we don't finance, are financed entirely with a seller note.

Michael: So it's not uncommon to end out with basically a blended financing. The seller will seller-finance some, and then Live Oak Bank finances the rest.

So who's who in claims order there? Of course, hopefully nobody's transaction goes south, but were it to hypothetically go south, who stacks up where?

Jason: The bank's always first.

Michael: Of course, naturally! That's why you're a good banker, because the banker goes first!

Jason: We're always first in any position. But the point of why a seller note? Well, a seller note is because they want some extended upside potential in their pocket. That's fine, I'm getting paid back.

Michael: So the seller may take an earn-out or something like that?

Jason: Performance based, that's what it is...

Michael: Okay, so the seller takes a seller note. The bad news is they're secondary, the good news is they may be on an earn-out basis or performance basis, so they've got upside skin in the game as well?

Jason: Yeah, we have guys that say, "I want to sell my business but I don't want to exit." "Okay, so sell. Have a liquidity event where it makes sense, but seller-finance some with an earn-out to still participate if the value of your firm's still going up." Especially if the advisor wants to stay involved. Maybe to help out during heavy times in tax season. Maybe the advisor still wants to get paid for referring business to the firm. Maybe the advisor wants to be paid as an employee at will. At this point, just give up your ownership.

Michael: So basically, those "I want to hang around, but give up the ownership. You finance the transaction, I'll have my liquidity event."

So getting really rough on numbers, my profits off of the business I buy is probably more than enough to finance a note if I'm actually spreading this note out over 10 years? For the buyer, my deal is typically cash flow positive from day one? Though probably not by a huge margin once we take some taxes out of it?

Are There Advisor Loan Requirements And Covenants? [Time - 11:58]

Jason: We encourage advisors to work with attorneys around the tax implications to the sellers. But we really just want to make sure that risk overall is mitigated. It's a shared risk between the buyer and seller.

And then there's performance measures, mostly from an attrition perspective. How many clients are still with the firm versus having left the firm?

Michael: And are there consequences for me as the buyer that did financing with you if we're not hitting some of the attrition metrics?

Jason: Not with me.

Michael: Not with you, so just with the seller?

Jason: Yeah, we don't have covenants. So our $200M combined, I'm not going to call the loan if you drop below $180M. Can't do it, don't want to do it, not in there. Now, if my $100M that you just bought for me drops down to $80M, drops down to $70M, there's high attrition factors, those attrition factors are in these buy-sell agreements when we do them. (But it primarily impacts the seller.)

Valuation Of Financial Advisory Firms [Time - 12:57]

Michael: Do you do the valuations as well? If I'm going to sell a firm, I need financing, which means I need a clear valuation. Because you're obviously going to want to validate the valuation as a part of underwriting of the risk. So...

Jason: So we have a short list of valuation companies that specialize in the industry. I don't want to say them because if I say them, it looks like I'm partial to one versus another...

Michael: Sure, well I guess we could at least point out that right here next to us is FP Transitions.

Jason: Good partners with them.

Michael: I'll guess that would be one of the partners. Obviously there's a couple other folks out there that do valuations.

Jason: We do want firms that are qualified and that have a focus on the financial services industry. We get, "Well, my brother's a CPA. He's going to help us out." We don't like that.

Michael: Okay, so you don't want it outsiders doing valuations. But FP Transitions, Gladstone, DeVoe, SRG, there's a bunch out there that do valuations that know how to price advisory firms in the industry.

Jason: Yeah, everyone you mentioned is on our short list.

Michael: And then you take their valuation as gospel? If they say, "This is the valuation" then that's the valuation you're financing against? And then you do your risk-based assessment of what percentage in total you'll lend against that number?

Jason: Yeah, typically these valuations come back in a range. So we can lend within that range. We do have buyers that say, "We want to buy above that range," but it's just like you buying a house. I'm the bank, I'm not giving you more than what the house is worth. But if you want to do that, that's your choice...

Michael: If the buyer wants to do that, the buyer can ask for a seller note, and you two of them work that out?

Jason: Yeah, that's exactly right.

Michael: But it's not your problem, because you're not financing 105% of appraised value.

Jason: The most important factor in these deals is the discounted cash flow, because that's what pays back your investment. A valuation is done at a point in time, not a future looking, which is how a buyer's looking and say, "Well, how long is it going to take to pay back my investment?" That's what they're more interested in, and that's what I'm more interested in. That's why we want a strategy in place of how you're going to make sure the clients move from one platform to another. Are we re-papering? Are we changing investment philosophies? All those things that cause ripples in the water, we want to mitigate as much as we can.

Typical Live Oak Bank Advisor Deal Size? [Time - 15:00]

Michael: Typical deal sizes? How small do you go? How big do you go?

Jason: Our average size right now is right about $900,000.

Michael: Value of the practice?

Jason: No, our financing.

Michael: Oh, your financing portion, okay.

Jason: Yeah, my financing. So let's say that that equates to, as you said, a $1.8M deal. We're financing $900,000. So $900's our average.

Michael: Which I guess is roughly...well 50% of a $90 million AUM practice, give or take a little.

Jason: There you go. Yeah. We don't really have a cap though. We leverage a few different platforms. We are a publicly traded bank.

Michael: Okay, so I can look up Live Oak Bank on the stock exchange?

Jason: Live Oak Bank, LOB on NASDAQ. Went public July 23rd. So what's that mean? Well, we leveraged the SBA platform...

Michael: Okay, Small Business Administration.

Jason: Small Business Administration 7(a) program. Live Oak Bank is the second largest SBA lender in the country behind Wells Fargo. That said, we don't have to because we're a publicly traded bank and have a bunch of conventional capital.

Michael: From the advisor end, do I care at the end of the day about whether you go through SBA or not? Does that change the terms to me, or is it just you're a bank, you work out your capital sources, I just care that I get my 10 year note at prime plus 2.5%?

Jason: Mostly that's just my problem. For example, with succession, a partial buy-in is something that the industry really wants and needs. But the SBA rules don't allow partial buy-in for the juniors to buy out the senior, where they want to buy just 10% in the first year.

Michael: So those staged succession deals which are so common for internals, rarely is it all at once...

Jason: Yep, can't do that with the SBA, so that's where I would come in conventionally and give those slugs of capital.

Michael: And you guys literally hold the loans in your own portfolio?

Jason: Yeah, we service the loans. It has to do with the SBA kind of platform, but we do own and service all the loans. We get 90 day financials from all of our clients.

And we're preferred and designated by the SBA, so we make all our decisions in house.

But again, that's one platform that we lend on. We can lend conventionally as well. That has to do with me as a banker and our risk-weighted capital. Whatever makes the most sense, where are we at risk? With the FDIC and now the SEC looking at us and everybody else, we have to make good, sound judgements.

Michael: How big can you get on the upside?

Jason: The SBA program has a $5 million cap. But if it was a $10 million deal, there's nothing to say we couldn't do $5 million SBA and $5 million conventionally.

Michael: So you're getting up in the multibillion dollar RIAs at that point. And still, you might not finance 100% of that anyway.

Jason: Let me go back to that, because that's a good point. Our target is not a $10 billion RIA. It's about a $75M in assets versus up to maybe a $1.5B or $2B. So really, if you look at a triangle, it's not the way bottom number of, "I have $10M in AUM," nor is it the top. We address that big middle.

Michael: $75M to $1.5B AUM, so basically you're talking about firms that are probably valuations from a little north of a million up to maybe $15 or $20 million top end. Not that you're financing all the $20 million deal, anyway, and that may not be done all at once anyways if you're doing succession deals to junior buyers in tranches over time.

Jason: Yeah, and we've done...I'd want to say the largest we've done is about a $2.8 billion AUM shop that we financed... I believe they did the full max on $5 million on SBA. But they didn't care.

We're a very technology and marketing driven bank, so our technology platform enables a very fast and efficient process that gets answers very quickly. We are a bank, we're not a broker, so we make our decision, and we write our own checks.

Timing The Loan Financing For Advisor Acquisition Deals [Time - 18:58]

Michael: Last question: what does the timeline typically look like? If I'm an advisor who's interested, and I'm talking to another advisor and we're hammering out a deal and getting close... at what point do I need to call you, so that I don't like screw up the timing of my deal because I didn't call you early enough?

Jason: Well, our average is 38 days from when you give me your information, to where we wire money out.

Michael: Wow, that's actually pretty fast.

Jason: It's fast.

Michael: So if I'm really 38 days out from needing to wire the money, I've probably done most of the deal at that point, right?

Jason: Yeah. But you want to know a couple things to finish a deal. Are you approved? When do you get your money?

The "Are you approved" part actually comes in about 10 days after you've applied. That's the bank underwriting. You're approved, you have a legal and binding letter that has your name on it.

Then about 15, 20 days later, that's when the money comes down. In the meantime, that's when you're doing your valuation, that's when you're doing your buy-sell agreement; all that goes into an average of 38 days. Some are shorter, some are longer because we're waiting on other external details.

Michael: I know plenty of succession deals and transactions that got delayed for a long list of other reasons, so I'm sure some of those speed bumps come up too.

Jason: To get back to your specific question, when do you call? Call early.

Michael: You'd rather be on the radar screen for the discussion early, just so that they don't do it too late or mess something else up along the way?

Jason: Yeah, don't mess something up along the way, don't put themselves in a risky situation.

Michael: Awesome. And they find you at Live Oak Bank, liveoakbank.com? That's pretty straightforward.

Jason: Yeah, liveoakbank.com/advisor.

We have a new resource center that we're putting out on the website, that has an interactive video that talks specifically about tax implications, valuation, and how deals are getting done. That's going to be out live within the next two to three weeks. And it has a bunch of white papers, along with shorter one-pagers on how to get things done if you're an advisor in motion.

Michael: All right, awesome. Thanks for joining us!

Jason: Thank you much. Good seeing you.

Michael: And thanks to everyone who's listening, for joining us for Office Hours with Michael Kitces. Normally 1 p.m. East Coast time. I was running a little bit late today, but Jason was kind enough to visit with us anyways! Hope this was helpful food for thought, and thanks, everyone, have a good day!

So what do you think? Have you ever looked at a deal to buy an advisory firm and found that loan financing was a challenge? Does the availability of financing for advisor succession plans or acquisitions change your own views or desires to do or be part of a succession plan?