Originally published in Financial Advisor

By Mark Hurley

Editor’s note: This is the fourth in a series of interviews with thought leaders on the future of the wealth management industry. 

Elizabeth Nesvold, The Deal Maker
Liz Nesvold has been one of the leading merger bankers for the wealth management industry for decades. Over the last 24 years, she has completed more than 150 advisory engagements involving trust companies, wealth managers, financial planners, banks and other financial services firms. An entrepreneur, Nesvold founded Silver Lane Advisors, where she and her five partners have advised on many of the industry’s largest deals. Liz shares her thoughts on how she believes the industry will evolve over the next 10 years and the role mergers and acquisitions will play in shaping it.

Hurley: Looking out at the industry 10 years from now, how many winners will there be and what will be their profile? And what happens to the other firms?

Nesvold: It’s easier to start with the second-tier firms. Many will hit terminal velocity; unless the principals are prepared to reinvest heavily to evolve their firms, they will find it difficult to grow their business, attract top talent and transition ownership.

Hurley: Jeff Thomasson’s “barbershops”?

Nesvold: Exactly.

Hurley: And the winners?

Nesvold: More sizable platforms. The big winners may have $150 million of revenue, whereas midsized winners perhaps $40 million to $50 million.

Hurley: Do you see any small winners?

Nesvold: Of course. It’s such a fragmented industry that there will always be successful firms operating at a smaller scale. They will likely be more specialized with at least $8 million to $10 million of revenue.

Hurley: How many of each size?

Nesvold: There were fewer than 10 firms with more than $5 billion of assets in 2007, and today there are nearly 40. My guess is that number will double again over the next decade. In terms of revenue, there might be seven to 10 firms with at least $150 million and perhaps as many as 50 firms in the $40 million-plus range.

Hurley: And the smaller winners?

Nesvold: Although there will be thousands of small firms, fewer than 200 will have any material enterprise value.

Hurley: What will be the profile of the big winners?

Nesvold: Firms that can attract people, grow organically and grow by acquisition.

Hurley: Can a firm get to that size without an acquisition?

Nesvold: It is possible, but not probable. The math is daunting.

Also, this is not about assets or even revenue. It’s about profitability. Many firms aggregate a fair amount of assets but surprisingly little profitability. It might be understandable if a firm is reinvesting heavily in the business. However, eventually those investments need to start paying off. Moreover, some firms have had to cut fees to scale. The old “we’ll-make-it-up-in-volume” philosophy doesn’t work in wealth management.

Hurley: How many of the firms with more than $1 billion of managed assets today would you estimate do not make much money?

Nesvold: About two-thirds.

Hurley: Wow!

Nesvold: It’s shocking. Some work with ultra-affluent families who have banded together to get Walmart pricing, even though the management of their 25 trusts and 100 accounts is complicated work that requires expensive human capital. Far too often wealth managers underprice their services because they don’t know their own costs.

Hurley: So, what are the future winners going to look like?

Nesvold: Strong regional players with trust capabilities, generational planning and other ancillary services all under one roof. But there are not many firms that can afford to build that kind of infrastructure, and putting all of this together is easier said than done. Even some larger institutions have trouble delivering a holistic service offering profitably.

Hurley: But what about the profile of winners that work with the “millionaires next door”?

Nesvold: To achieve critical mass with a $1 million to $10 million clientele, you’re likely doing it on a super-regional or national basis. It’s hard to gather that many assets in one geography because of competition.

Hurley: These firms will have to run a business in more than one location?

Nesvold: Most likely, which isn’t easy.

Hurley: How many firms today can conceive of doing this?

Nesvold: A handful.

Hurley: An element of self-selection?

Nesvold: It is. It’s often challenging for founders to accept that, while they are great at sourcing clients and are the chief architects of the strategy, there are roles that they are incapable of doing well that require outside talent.

Hurley: Let’s switch to robo-advisors. Your recent white paper was not too bullish on their futures.

Nesvold: It was not bullish on the independent robo-advisor. Companies like Schwab, Vanguard and Fidelity should do quite well. But the market will ultimately look similar to that of the original Internet banks. When billion-dollar brands jump in to offer a similar technology as a bolt-on capability to their traditional offering, it’s a game-changer. Many of the independent robos will invariably be unable to sustain their [cash] burn to profitability.

Hurley: But how will robo-advisors affect wealth managers that service $1 million-to-$20 million clients?

Nesvold: For that segment, not much. Probably those competing in the under $1 million category will feel some competitive pinch.

Hurley: What will operating margins look like 10 years from now?

Nesvold: It depends on how well firms are able to leverage solutions that are available in the market. Part of the profile of the winners is that they will be very good technology adopters as opposed to developers or legacy systems users. They will increasingly focus on their core value added and outsource the rest.

Hurley: What about those firms that have outsourced their asset gathering?

Nesvold: At some point, the pricing [of outsourced asset gathering] will change. So while it can be additive to a business, advisors who are incapable of developing business organically will see their profitability growth slow and eventually even shrink over time.

Hurley: Have most wealth managers figured this out?

Nesvold: Silver Lane’s clients have! We show them the quantitative impacts to franchise value. It’s important for the advisor to recognize that it has to build [its own] value and cannot be entirely dependent on any single source of distribution. Buyers are fairly sophisticated when it comes to assessing these business factors.

Hurley: What drives owners to sell?

Nesvold: For many wealth management deals, it’s demographics. But the savviest of clients often consider transacting long before they have only five years left in the business. They’re thinking about the future, and partnership decisions are more about growth and evolution than about near-term succession planning and monetization. Don’t get me wrong, though, invariably everyone wants some type of liquidity event.

Hurley: How does the age of client bases affect pricing?

Nesvold: It’s a bell curve. Buyers want to see a nice distribution of client aging in terms of revenue. The top of the curve should ideally average out to clients in the late 50s to early 60s.

Not too long ago, we looked at a firm on behalf of a buyer that had both an average partner and client age in the late 60s. Essentially, the clients were aging out along with their advisors. There clearly was value to the business, but the disconnect was on pricing—the sellers wanted to be paid as if they had been reinvesting in the firm and buyers viewed it as more of an annuity that would fluctuate with the market over time.

Hurley: This suggests that acquisitions are more about growth than cost savings.

Nesvold: Unlike bank transactions, wealth manager deals in the $500 million to $2 billion range are more about enhancing growth opportunities than cost savings. It’s about creating more collective value on the revenue side. Invariably, there will be some cost efficiencies in advisor-to-advisor transactions. But you’re not doing the deal because of the efficiencies; you’re doing the deal to enhance the growth trajectory.

Hurley: It also argues that the quality of successors is important and that they have some bargaining power.

Nesvold: No question. Unless the seller has a long lead time in the business, allocating value between owners and successors who do not own equity can be the most difficult part of a transaction.

Hurley: What happens if a wealth manager drops dead and the estate sells the firm?

Nesvold: I have been in that situation three times in my career. It’s at least a 30% discount to where the franchise would have traded, and that’s assuming there’s at least one other client-facing partner and a client servicing team. But in one transaction there was a 70% defection of value because [the successors] held up the estate of the prior sole owner of the business. Hurley: By our count, there are more deals in the market right now than there were in the previous four years combined.

Nesvold: There are. The deals also are getting bigger. But fewer than 50% of the “unbanked” deals will actually get done. Sellers’ expectations can sometimes be unrealistically high, particularly if they are using implied pricing from much bigger deals to value a smaller practice, so pricing and form of currency become stumbling blocks. Others have unreasonable demands about integration and post-closing roles and control.

Hurley: So how do you figure out whom to represent?

Nesvold: After nearly 25 years in the business, I can figure out in about five minutes if the market will have an appetite for a particular firm. Often, it depends on whether a business has invested in quality human capital and infrastructure; if it has been selective on its clients, if it has a good P&L and a great local reputation.

That much said, part of our job is to prep the client and put the right buyers in front of them, but invariably they have to sell the vision. And if the client can’t stand up to the level of scrutiny that I know someone like [Fiduciary Network] is going to bring to the table, that’s probably not a good client.

Hurley: What about client psychology?

Nesvold: We do a lot of work up front and have developed an online tool that gets to client psychology early in the process. It really helps clients think about the elements of a deal, the partnership and the post-closing environment that will be most comfortable, while enabling us to understand their motivations.

Hurley: You also published a paper looking at banks buying wealth managers.

Nesvold: We did. In the early part of my career, banks were the most acquisitive buyers; today, we are seeing a lot more advisor-to-advisor transactions and a host of others who have bellied up to the bar.

There seems to be a shared fantasy among wealth management firm owners that right before they want to step down some big unsophisticated bank will show up and offer to write them a giant check, with few strings attached. I would disabuse anyone of that notion.

Hurley: Will bank acquirers lean more towards teams coming out of wirehouses then acquiring traditional independent wealth managers?

Nesvold: Some will, because [the people] have to be comfortable in a bigger environment. In other instances, a bank would prefer to own something that is independent of the trust company or bank charter. Nearly half of the deals that get done today involve a wealth manager as the acquirer; about a third of the transactions involve a bank. Those who find comfort with a bank buyer are often former employees of big companies that went out on their own years prior.

Hurley: What about the roll-ups?

Nesvold: I prefer the term “holding companies.” Their success is often tied to the post-acquisition organic growth [of the firms they acquire.] Their acquisitions are either growing organically or the parent may hit terminal velocity. Growth lowers the effective cost of any individual deal. Without solid organic growth, any promised multiple expansion on [the holding company’s] currency won’t be fully realized.

Hurley: What about cash versus stock deals?

Nesvold: In most cases, cash is king. Otherwise, you are trading an illiquid currency that you control for one that you do not control. If you are taking mostly stock, you had better ensure that the acquirer is growing organically, is profitable and is run by professional management.

Hurley: And you ultimately need liquidity.

Nesvold: You have to have liquidity. If I’m 60, and I have a three- to five-year time horizon, why would I swap out of my own currency to somebody else’s? It doesn’t mean you have to take 100% cash, but there has to be some cash element to the transaction. If I’m 45, and I’m transacting to change the growth trajectory or to take some hats off, that’s a totally different ball game.

Hurley: In terms of wealth managers, it seems that everyone is a buyer.

Nesvold: Every one of my clients is a buyer until they’re not.

Hurley: I talked to a 74-year-old the other day who is a buyer.

Nesvold: Of course he is.

Hurley: What is the profile of those with the greatest likelihood of being successful buyers?

Nesvold: Because there are more buyers than ever, you have to bring some value-add to the seller beyond price. There has to be an alignment of vision, a plan for how you’re going to integrate and evolve the business. The transaction has to be good for both parties and not just the selling owners.

Also, the pricing depends on qualitative and quantitative factors and the allocation of risk. If you can tell me how [a seller] will perform over the next five years, I’ll tell you what price somebody is going to pay for it.

Hurley: What are the other attributes of smart buyers?

Nesvold: They are thoughtful about the changes that they would make and are collaborative about discussing those changes. They think about integration from a “best practices” approach.

Hurley: How important is it to have had prior experience, either successful or unsuccessful, in acquisitions?

Nesvold: Well, you need to have your misses to know what you really want.

Hurley: How many firms today with at least $300 million of assets do you believe will be sold over the next decade?

Nesvold: Probably 300. My guess is half will be sold to other wealth managers.

Hurley: And the successful acquirers are more likely to wind up in the mid-to-large size range?

Nesvold: No question. There are firms that can get to $5 billion organically, but it’s hard to continue that trajectory because of the law of large numbers.

But there is a big difference between material deals and a strategy of tuck-ins. It’s so much harder to get a smaller deal done than it is a midsize deal. Every nickel, every line item in the definitive agreement means more. It comes back to the psychology, too. Every change, every discussion, is amplified.

Hurley: If you owned a wealth management firm, what would be keeping you up at night?

Nesvold: How do we keep up the pace of organic growth, and how do we attract good talent? The talent necessary to source and cater to high-net-worth individuals requires people who have certain genes.

Hurley: What thing has most surprised you in the industry over the last 10 years?

Nesvold: The shift to ETF solutions for clients. I don’t think I envisioned that so much of the money management skill sets would be commoditized.

Hurley: What do you hope is the most pleasant surprise you’ll see over the next 10 years?

Nesvold: That people have been more thoughtful about their business models. Too little time is spent on thinking about what [firms] want to be. As Wayne Gretzky’s father said, you need to skate to where the puck is headed. It would be wonderful if firms started to practice what they preach and do their own planning well in advance of any event that may occur.

Hurley: Thank you very much.

Nesvold: Thank you.

Mark Hurley is founder and chief executive of Fiduciary Network, a private bank specializing in the wealth management industry.

Effie Guo contributed to this article.