Beyond Comp: What Makes Advisory M&A Deals Stick

When it comes to setting up a successful long-term relationship with top advisers, firms still generally rely on sticks instead of carrots.

Art by Anja Susanj

 


When an independent retirement advisory is acquired, there is plenty of negotiation around the purchase price, says Peter Campagna, a partner with M&A advisory firm Wise Rhino Group. But when it comes to the employment agreement—including non-solicitation clauses and deferred compensation deals—there’s usually little room to maneuver.

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“These agreements are usually heavy, and they are heavy no matter who the buyer is, and they are often non-negotiable,” Campagna says. “The [acquirer] is paying tens of millions of dollars and is folding you into a larger corporate policy structure, and at the end of the day, the seller doesn’t have to do it—it’s their choice. It’s just something that I often have to coach sellers on that they’ll need to capitulate.”

Campagna, who specializes in the valuation, selling and buying of advisory firms, says in the end, the price tag is what drives most dealmaking, and things like noncompete and non-solicitation contracts usually don’t hold up deals. Over time, however, they can matter when it comes to an acquiring firm wanting to ensure a new adviser or team doesn’t walk away with clients. In this instance, there are few executive compensation plans, vesting schedules or other bells and whistles that can ensure a long-term relationship.

“When it comes to things like deferred compensation plans, that’s generally a minor hook,” Campagna says. “A lot of these people are independent and have built their own business, and now they’re joining a bigger firm. … It’s usually the bigger legacy places—the wirehouses and retirement consultancies—that have big deferred-comp programs in place.”

This generally means there will be an employment deal in which an adviser will take a monetary hit if they should leave for a competitor or poach clients they had with the larger firm. Since noncompetes are already banned in some states, non-solicitation agreements tend to be the vehicle of choice, Campagna says.

“Where there is teeth is the non-solicit,” Campagna says. “They are not going to pay for an acquisition if the person can walk away the next day with the clients. [The client relationship] is truly what is being purchased, and that is the great concern of the purchasing firms.”

Earlier this year, the Federal Trade Commission forwarded a proposal to ban noncompete clauses in all 50 states. The proposal, which experts say will likely get a great deal of industry feedback and revision, is more targeted at the broader workforce, not financial advisers. Even so, as noncompetes cool as a method of keeping top talent, areas such as non-solicitation and ownership packages will continue to be key focus areas, according to recruiters in the space.

Rank & File

Stiff employment contracts have been common practice in recent years across the financial advisory space as consolidation and deal-making has been rampant, says Bill Willis, president and CEO of Willis Consulting, a financial adviser recruiting firm with offices in Los Angeles and Scottsdale, Arizona.

The potentially harder part of the agreement, Willis says, is ensuring that everyone on a team—not just the head honchos—are incentivized to stay, generally with fear of a monetary hit if they leave.

“If there’s a dollar amounted associated with a noncompete or non-solicitation contract, it gives it more legal teeth so someone won’t go the other way,” Willis says.

Sometimes, advisers will buy themselves out of a noncompete contract either with funds from their next employer or a bank financing, Willis says. But those kinds of moves are generally less common if the independent advisers are not managing the client money, but instead are relying on a central source for that management.

“If Johnny the adviser is doing his own thing, parking the money in his practice, it’s a lot harder to control and a bit more like herding cats,” Willis says. “If the money is centrally managed, then it’s harder for them to move the client away.”

Willis notes that laws differ by state when it comes to working with customers after leaving an employer. In California, it’s hard to enforce a non-solicitation agreement, whereas in New York it’s relatively easy to enforce. Willis says knowing local regulations is essential when engaging in an M&A transaction.

Carrots

“The legal contracts are the strongest and most compelling way that firms keep advisers and consultants in play,” says Louis Diamond, president of financial adviser recruiting firm Diamond Consultants. “But to me, that is almost a negative way of approaching it—I don’t want to keep people just because their contract says they need to stay, but because they want to stay.”

Diamond says a key selling point is showing top advisers a path to growth with the new firm—and how they can benefit from that growth. This can be done through post-acquisition equity in the firm, which usually has a vesting scheduled tied to how long an adviser stays. Perhaps more important, he notes, is that it “gives people a sense of belonging and sense that they are part owner of the firm.”

Private equity firms, which have been key players in the adviser acquisition space, often use shared equity packages, Diamond notes.

Another, related strategy is to show advisers how joining the new firm will aid in growing their business and client list, whether through lead generation mechanisms, retirement plan participant access or custodial services.

“Pretty much every adviser wants to grow, so if a firm can help them grow their business, they are more likely to stay,” he says.

Still, Diamond says, non-solicitation contracts will continue to be key as a way of retaining advisers.

“What any of these firms is buying are the people,” he says. “The people in the firm and their underlying relationships is the key element. … It makes them less marketable to other firms and protects them a little bit from leaving.”

Time Will Tell

Recruiter Willis says he is not personally in favor of noncompete contracts, as he believes the customer should decide who to work with. Realistically, however, it takes monetary incentives along with potential penalty to get people to stay.

“I’ve seen deals done with no such barriers, and it doesn’t go well,” Willis says. “People are living and learning as the RIA M&A progresses and people learn from the failures and successes.”

As all the advisory M&A that has taken place over the past decade matures, it’s inevitable that some advisers may start to look for their next move or hang up their practice.

That’s when a deal that incentivizes staying three, four or five years may come into play, says Campagna of Wise Rhino. It’s also when stock ownership can play an important part in keeping people invested and wanting to realize the growth of the firm.

But in Campagna’s experience, many of the successful advisers who are acquired tend to be hard-working people who love their job and like working with their clients.

“I work with a lot of people who are still super-motivated to work hard,” he says. “They’re just wired that way.”

Inching Forward

Managed accounts remain a rare QDIA.

Art by Alex Eben Meyer


Managed accounts haven’t made much headway as a qualified default investment alternative.

Just 4.3% of plans utilize a professionally managed account as the default investment for automatic enrollment, compared to 75.9% of plans that use target-date funds, according to the PLANSPONSOR 2023 Defined Contribution Plan Benchmarking Report. But 29% of plan sponsors surveyed say their plan includes a professionally managed account service as an investment option for plan participants.

“If participants are educated consumers (on fees and the need to engage) and they feel it’s in their best interests to go into a managed account, we’re fine with including managed accounts as an option on the menu,” says Matthew Compton, managing director of retirement solutions at New York-based Brio Benefit Consulting. “If a plan has an engaged population and some of them choose a managed account program, good for them. But for folks who are just defaulted into a plan’s QDIA, it doesn’t make a ton of sense.”

“Set It and Forget It” Mentality

Among plans that have a consultant or adviser, 52% utilize managed accounts in some capacity, according to Cerulli Associates’ U.S. Defined Contribution Distribution 2022 report, which surveyed consultants and advisers. Of that 52%, 44% of plans include managed accounts as an option on the investment menu. Only 3% incorporate managed accounts as the plan’s QDIA, with another 5% utilizing a dynamic QDIA, which defaults an automatically enrolled participant into a target-date fund and then, at a pre-determined point nearing retirement, transfers the participant into a managed account.

The usage of managed accounts as a default investment “has ticked upward slightly over the last few years,” says Shawn O’Brien, associate director and leader of the U.S. retirement research practice at Boston-based Cerulli. “Still, our data suggests only a mid-single-digit percentage of 401(k) plans offer managed accounts as the QDIA.”

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O’Brien attributes that mostly to the larger fees that managed accounts tend to have, compared to target-date funds. “For sure, the higher cost has got to be the most prohibitive factor for plan sponsors,” he says. “If you’re a fiduciary, you are going to be very conscious of the fees, particularly for a plan’s default investment. Within the context of cost, I think there’s also a concern that if participants are not engaging with the managed account, they aren’t going to get the most out of it.” To get a more customized allocation, he adds, a participant needs to engage enough to provide information such as his or her risk tolerance and outside assets.

Asked why managed accounts far more frequently appear as a menu option rather than as a default investment, O’Brien says, “It’s safer from a fiduciary perspective,” since a participant would make an active choice to invest in a managed account. “There is an argument to be made for managed accounts as an option that is mainly geared toward participants who are a little older and more affluent and who have a more complicated financial situation,” he says. “So a lot of plan sponsors think of managed accounts as having a strong value there.”

Brio Benefit Consulting does not currently have any plan clients utilizing managed accounts as a default investment, Compton says. “We’re not a believer in them as a QDIA,” he explains. “When we compare these types of programs to target-date funds, we think that, especially with the younger participant demographic—who are going to, in many cases, leave their money in the plan for decades—there is not a strong-enough reward for the extra fee.”

Compton also sees an issue with the typical lack of engagement by automatically enrolled participants placed in a default investment, which limits the customization abilities and other guidance that a managed account service can provide.

“Many participants in a default investment are looking for a ‘set it and forget it’ mentality,” he says. “If they go into a managed account program as the default and are paying an extra 25 to 50 basis points a year (compared to target-date funds), we don’t think it’s worth it. The additional expense is actually going to take away from their ultimate retirement readiness.”

Northbrook, Illinois-based Bjork Asset Management currently has no plan clients with a managed account QDIA, President Sean Bjork says. “We’ve done a lot of thinking about, ‘Hey, is this a better mousetrap?’” he says. “But we’ve yet to find any robust data set that says, ‘Yes, this is a better default investment.’”

Bjork sees a lot of promise in the customized investment allocations and personalized guidance a managed account service can provide. But he also sees considerable uncertainty in how to gauge the value of managed accounts as a QDIA, particularly in terms of ultimate outcomes such as a projected retirement income replacement.

“If we could see some well-validated research, I would be all in,” Bjork adds. “But we’re not there yet. To get there, I would need to see an outcomes study with a statistically significant data set along the lines of, ‘This is a group of 3,000 participants defaulted into a managed account solution, and here are 3,000 participants who fit the same cohort–demographics of income level, age, etc.—but they were defaulted into target-date funds. And we can quantifiably show that the folks in the managed accounts are better off by some measurable outcome, enough to make up for any higher fee structure and then some.’”

Helping Sponsors Consider It

Bjork is asked how he would respond if a sponsor came to him expressing interest in potentially switching from target-date funds to managed accounts as their plan’s default investment.

“The first thing I’d do is ask, ‘Why?’” he responds. “That would be revealing, in terms of what the sponsor is trying to accomplish. Then we can talk about, ‘What are the different ways to accomplish that goal, using the currently available tool set?’ And we’d talk about how managed accounts are one option.”

If a plan sponsor approached him about considering a possible move to managed accounts as the default investment, Compton says he would first want to make sure that the sponsor understood how managed account programs work, their fees and the participant engagement needed to optimize a managed account’s value. He would also talk with the sponsor about that organization’s employee demographics, its plan participants’ patterns of engagement versus disengagement and recent feedback about the plan the sponsor has gotten from participants.

“In some situations, an employer may have an employee demographic that is very much engaged and regularly looking for more tools and knowledge,” he says. “So maybe it makes sense to incorporate managed accounts as an option.”

Cerulli has been expecting for a few years to see managed accounts become more commonly used as a QDIA, but there has not been a significant increase in adoption yet, O’Brien says.

“Like anything else in this (retirement plan) market, that will take quite a bit of time,” he says. “But I think what we’re going to see is a noticeable increase in the use of dynamic QDIAs. Do I think that dynamic QDIAs will overtake traditional target-date funds in the next five years? Absolutely not. But I do think we’ll see a higher rate of adoption.”

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