What RIAs need to know about debt financing
In the bad old days, RIAs seeking debt financing were largely confined to onerous SBA loans (if they could get one) and burdensome seller-financed notes for internal buy-outs.
Live Oak Bank began to revolutionize the marketplace in late 2012 when it introduced deal terms much more conducive to the independent advisory business.
But advisory firm owners are still largely unfamiliar with the cornucopia of debt offering now at their disposal. “We’ve seen that advisors are surprised when they start the process to discover the number of options available,” says DeVoe managing director Brad Grubb.
What’s more, a surprising number of RIAs, even larger enterprises with over $1 billion in AUM, “haven’t really thought about debt financing,” according to Scott Slater, vice president of practice management and consulting for Fidelity Clearing & Custody Solutions.
For owners still on the learning curve, lending executives answer some frequently asked questions:
What’s the first thing a lender looks at when considering an RIA loan?
- “The debt service coverage ratio — the amount of free cash flow a firm has to pay its debt,” says Scott Wetzel, who founded SkyView Partners in suburban Minneapolis in late 2018. Generally, the ratio should be north of 1.3, he recommends. “In other words, a firm should have at least $1.30 coming in for every dollar obligated to service the debt.”
- “The first thing a lender looks at is the cash flow of the business,” Mike McGinley, executive vice president for Live Oak, says, particularly since RIA’s are made up of mostly intangible assets. It must be predictable and sustainable, he says, adding that “It has to be able to cover the annual debt service of the loan with a buffer for any market movement.”
- The personal financial strength of RIA ownership and the profitability of the RIA — both for buyer and seller if the loan is for an acquisition — is the “first thing we look at,” says Dustin Mangone, director of PPC Loan’s Investment Advisor Program. When PPC examines profitability, “cash-flow is king considering we have no tangible collateral,” he notes.
- “We look at the quality of the book of business, the quality of the advisors as people and business leaders and the liquid net worth of the guarantors,” says Ed Swenson, COO of Dynasty Financial Partners.
- “We underwrite the cash flow and durability of the business and the entrepreneur’s ability to execute the business plan,” says Rick D’Amico, managing partner of Merchant Credit Partners.
What should RIAs have in order when beginning the process of applying for a loan?
- “A three-year financial statement, AUM, compliance history, records of recurring versus non-recurring revenue and legal formation documents,” D’Amico says.
- Wetzel recommends showing a lender that RIAs have a pre-existing relationship with a local bank. “It’s a little like showing that your parents were alumni of the college you want to attend,” he says. “It makes the application process a lot easier.”
- The ability to show increasing revenue and profitability trends, Mangone says. These trends “provide a lender comfort in knowing that an RIA can absorb a substantial market decline of 30% to 40% if not more,” he explains.
- An advisory firm needs to have “a thoughtful understanding of how much capital is needed, what it will be used for, the needed duration on the loan and the investment case for taking the loan,” says Dynasty’s Swenson. “The investment case, or use of capital, should be additive to the enterprise value of the underlying practice,” he adds.
What are the biggest red flags for a lender looking at an RIA?
- “Multiple significant regulatory disclosures,” says D’Amico.
- “Over-levered personal balance sheets,” warns Swenson.
- “The biggest red flag is when proposed transaction terms aren't sound,” says Grubb.
- “A bankruptcy in the last seven years and client concentration risk,” Wetzel says, offering the example of one RIA which had 57% of its revenue concentrated among five clients. Other red flags include: Portfolio concentration risk, not enough recurring revenues and the risk of losing key employees in the event of a merger or acquisition, he adds.
- “Below average levels of profitability or declining profitability, concentration issues and an aging customer base at the firm level,” says Mangone. “From a personal financial standpoint, it would be adverse credit, tax issues, weak personal finances, and a large number of FINRA disputes,” he adds.
What about intangibles?
Most lenders want a personal guarantee, that is, a borrower’s legal promise to repay credit issued to a business for which they serve as an executive or partner. But for RIA lenders, a personal guarantee is usually unsecured. “It’s mostly psychological,” says SkyView managing partner Wetzel.
The personal character of the borrower is the most important intangible for lenders, lending company executives agreed.
- “Character is hard to quantify, but we look at regulatory history and take time to interact with advisors and make on-site visits,” says D’Amico. “RIAs have an advantage here because they have to act as fiduciaries.”
- PPC is able to get a perspective on a borrower’s character by observing how they communicate via phone and email and their response to difficult questions or adversity, according to Mangone. “We also look for things such as bankruptcies, late payments, and customer disputes on their FINRA report,” he adds.
- “Past SEC or FINRA issues and arrests certainly give us pause,” says McGinley.