If Focus Financial goes ahead with an IPO, it will be a landmark for the financial advisory business. Although Focus isn't an RIA, it owns part of 50 firms and would be the closest representation the industry has yet had to a public company.
But Focus, which filed an S-1 form with the SEC last month to get the IPO process started and is backed by two leading private equity firms, KKR and Stone Point Capital, will face serious scrutiny from potential investors.
An analysis of the Focus filing by Matthew Crow, president of research and valuation firm Mercer Capital, identifies five hard questions Focus will have to answer:
1. What exactly is Focus Financial?
Focus is an aggregation of RIA cash-flow streams, contingent rights and responsibilities, according to its S1 filing. The Focus model is to acquire between 40% and 60% of an existing RIA’s earnings before partner compensation, or EBPC, which post-acquisition is referred to as “target” earnings.
The remaining EBPC is retained by a management company formed by the affiliate firm as a wage pool for selling partners. Focus takes a preferred position in the affiliate firms’ EBPC; the selling partners are responsible for delivering at least the dollar portion of EBPC sold to Focus, termed the “base” earnings.
"Any excess above target earnings is split pro rata," Crow says. "This asymmetric payoff dampens the downside volatility for Focus, but obviously also raises it for selling partners."
2. How will a bear market impact this business model?
At some point we're going to find out.
"Because we haven’t experienced a sustained bear market since Focus completed most of their acquisitions, the downside implications of this arrangement on selling partner groups (and, in turn, on Focus) aren’t yet fully known," Crow writes.
"The disproportionate risk borne by the partners of affiliate firms is, presumably, known to them," he continues, "although knowledge and experience sometimes yield different outcomes. We wonder how selling partner groups would behave in a market environment in which their compensation was severely restricted, remembering that retained EBPC is effectively wages for the continuing efforts of affiliate firm leadership."
3. How will Focus be valued?
For starters, a value to the company's stock "will no longer be assigned," Crow notes. "It will now be determined by the market."
At present, Focus' valuation is "somewhat complicated, and we are very interested to see how the market treats them," Crow writes.
In 2017, Focus reported a net loss of $48.4 million on sales of $663 million. But the firm also recorded an adjusted EBITDA for the same period of $145.2 million. While adjustments to EBIDTA aren't particularly unusual, Crow says, "they sometimes involve judgement and, in this case, some folks may not agree with all of management’s adjustments."
So if Focus is worth a multiple of EBITDA, "the question is how much is EBITDA?" Crow says. "My guess is that they are hoping to show a forward outlook of adjusted EBITDA of $200 million per year to get to a $2 billion to $2.5 billion valuation.
"But if they have to get to adjusted EBITDA using addbacks that the market doesn’t agree with," he adds, "then the base amount of EBITDA to capitalize will be lower and so will the Focus valuation."
4. What needs to happen after Focus goes public?
Focus will have to transition from an acquisition platform to an operating platform, according to the Mercer analysis.
"Focus will eventually have to be more than an acquisition machine," Crow said in response to questions by email. "They’ll have to show they can improve their partner firm profits. Operation services will become more important to fueling growth."
If they can improve partner firm profits more than they would have without being part of Focus, "then the holding company really is adding value to the partner firms and the model is a two plus two equals five kind of idea," he continued. "They know this, and I’m sure that’s what they’re going for. But the S-1 is very heavy in talking about the acquisition model and light on talking about the operating model."
Investors want to know that Focus will pay a reasonable price for good partner firms and be successful in helping to operate and enhance the RIAs after the acquisition, Crow adds.
"If they are good at deal-making and good at operating, then this will be very successful," he concluded. "Markets will come and go and provide them with headwinds and tailwinds. The question is whether the model will work consistently in different market environments and provide investors with a way to own a wealth management enterprise."
5. What else should concern investors?
- Organic revenue growth. Last year organic revenue (essentially same-store sales) at Focus firms grew 13.4% over the previous year. The prior two years, Focus reported mid-single digit organic growth.
"Whether or not those organic growth rates best industry averages depends on whom you ask," Crow writes. "We think this will be a closely studied metric for Focus as it matures."
- Operating leverage. "This is where you get a disproportionate level of profit out of more revenue," Crow says. "Investment management firms usually have a lot of operating leverage, because you can manage an extra, say, $500 million in assets with about the same number of people, office space and back-office systems. So most of the revenue from the extra AUM falls to the bottom line."
Crow points out that when Focus had $382 million in revenue in 2015, they had an adjusted EBITDA margin of just under 20%. Two years later, the company added another $280 million in revenues, but its profit margin represented by adjusted EBITDA only increased to just under 22%.
"Not much of an increase, so not much operating leverage," Crow says. "But to be fair, it may be too early to tell."
- Next generation executives. The management teams who sold out to Focus shared in profit increases and had an incentive to help the organization grow. After a firm is acquired, Focus takes a pro rata piece of that increase in profitability, and while the selling generation of partners gets compensated for this in the form of earn-out payments, successive generations will not, Crow notes.
"It will be interesting to see how second-generation partner firm leadership behaves," he says. "Will succeeding generation leadership at partner firms be sufficiently incented to continue the growth that first made them attractive as acquisition candidates to Focus? The selling partners of affiliate firms have a relationship with Focus that younger members do not share."
Why does all this matter?
"In going to market, Focus management is committing to prove viability in public filings, conference calls and daily trading," Crow says. "It is a major undertaking for any company, but even more so for the one who goes first. If Focus Financial is successful as a public company, no doubt HighTower Advisors and United Capital will consider following their lead."