Can I Afford to Take Out a Loan to Acquire Another Practice?

How cash flows and indebtedness on the business and personal front can impact the calculus of growing through loans

ThinkAdvisor.com - As interest among independent financial advisors in growing through acquisitions continues to grow, one question that has increasingly been asked is, “Can I afford to take out a loan to purchase another independent wealth management practice?”

When it comes to making acquisitions with bank financing, the ability of advisors to scale borrowing to buy one, two, three or more practices depends on the acquirer’s practice and personal cash flow, all of which can be improved meaningfully by targeting cash-flow rich acquisitions.

Overleveraging Is Uncommon

First, some background: Traditionally, financing extended to advisors for the purpose of acquiring other independent practices has been minimal at best, and most lenders remain skittish overall on the independent wealth management space. Consequently, lending capacity remains untapped.

For example, we recently worked with a prospective seller of a successful independent advisory practice who approached us to determine how much bank financing was available for prospective buyers of her practice, based solely on her practice’s financials. Until that point, she had not collateralized the practice, which had robust free cash flows.

Initially, this advisor had planned on listing her practice for $2.5 million. Our cash flow analysis supported a $3 million valuation, especially factoring in a further increase in cash flows that could be expected after a sale, with the departure of the owner and her corresponding compensation.

The advisor increased her asking price, and was able to negotiate a $2.8 million sale via bank financing.

Although the seller’s practice supported the sale price, the funding bank also collateralized the transaction with the purchaser’s practice. The aggregate free cash flows and substantial enterprise value from both practices assuaged reluctant bankers, enabling deal financing — and the transaction — to happen smoothly.

Maximize Borrowing Scale

Having established that independent advisors can afford to take out loans to make acquisitions when purchasing cash-flow rich practices, the question becomes: How can advisors maximize borrowing scale to accelerate a growth acquisition strategy?

The commercial real estate (CRE) developer provides an excellent example of maximizing borrowing scale. Real estate developers are speculating that the value of the underlying property they acquire will increase over time, much like advisors with the value of their practice.

CRE obligations commonly are constructed on a five-year term with a lengthy amortization schedule, reducing their annual payments significantly. The combination of longer amortization periods and speculated property growth yields ever-increasing cash flow.

The CRE borrower example underscores that cash flow is king, and extending amortization periods over longer time horizons will maximize future free cash flow from an advisor’s practice, an outcome that directly supports the advisor’s ability to make future acquisitions.

Think Twice About Seller Notes

The CRE borrower example also suggests caution with respect to seller notes — financing facilitated by the seller — as counterproductive when attempting to scale borrowing. This is because seller notes normally mature over a three- to four-year time horizon, requiring the buyer to make large monthly or quarterly payments that settle an obligation rapidly but can weigh heavily on the cash flow for a newly purchased practice.

Indeed, prospective practice buyers with existing seller note obligations may find it difficult to substantiate free cash flow required to support other acquisitions. However, bank financing can provide a reprieve by enabling the refinancing of seller notes into a new bank note that extends the amortization period, freeing up cash flow to promote borrowing scale.

Personal Debt Impact

Underwriting all wealth management practice acquisitions requires a global cash flow analysis. As the term suggests, a global cash flow analysis looks at all cash flows and related indebtedness of the practice and the financial advisor, including on a personal basis.

Successful financial advisors often amass considerable illiquid net worth from their practice and supplement personal asset growth by maximizing available credit. But for independent advisors seeking bank financing to buy books of business, high personal leverage levels can thwart their growth ambitions by restraining their ability to maximize borrowing for acquisitions.

Today’s enterprising independent and registered investment advisor has an unprecedented opportunity to grow their practice through M&A activity facilitated by a burgeoning bank financing marketplace.

But when it comes to maximizing borrowing scale for these transactions, the most successful acquirers will be those who think about their total cash flow and indebtedness on both a business and personal level.

For many advisors, whether they can afford to take out a loan to acquire another practice may require pressing the pause button on personal big ticket items that involve significant new borrowings, such as a second residence or a luxury yacht. Doing so to successfully execute on growth acquisition opportunities could be a strong investment in the future.

To view the original article featured in ThinkAdvisor, please visit:

https://www.thinkadvisor.com/2018/11/19/can-i-afford-to-take-out-a-loan-to-acquire-another/