Biden tax plan to ‘light a fire’ under red-hot market for RIA industry

April 30, 2021

The acquisition frenzy for independent advisory firms may be about to get even hotter.

That’s the thinking of some industry dealmakers, who predict that President Biden’s proposal for tax increases on the wealthy will pour fuel onto the already-hot market of deals to acquire RIAs.

For advisors who are nearing retirement, or who are younger, growing quickly and in need of fresh capital, the Biden administration’s plan, announced Wednesday, provides three reasons to make deals sooner rather than later. With historically low individual rates, a long-standing benefit for investment profits and a perk for inherited assets all potentially headed toward the exit, locking in tax savings now has emerged as top of mind.

“Advisors that are wanting to sell not only because of the robust market but because they think it’s the right time to find that strategic partner want to lock in this year’s capital gains rate,” says Carolyn Armitage, a managing director of Echelon Partners, an investment bank in Manhattan Beach, California, that is focused on financial advisory firms. “Everyone is expressing an interest in closing by year-end.”

President Biden unveiled his sweeping tax-hikes plan in his first address to a joint session of Congress on April 28, 2021.

President Biden unveiled his sweeping tax-hikes plan in his first address to a joint session of Congress on April 28, 2021.

Bloomberg News

Bankers have, of course, a bottom-line interest in saying they want more transactions to happen. But not just the formal matchmakers are predicting an even bigger wave of RIA deals, which topped record levels last year and is set to grow further. The proposed tax hikes have “lit a fire” on the deal-making front, says Louis Diamond, the president of Diamond Consultants, a financial advisor recruiting and M&A advisory firm in Morristown, New Jersey.

Biden would help pay for his sweeping $1.8 trillion American Families Plan, centered upon child care, paid leave, education and healthcare, with $1.5 trillion in tax hikes on the wealthiest Americans. His proposal calls for a higher capital gains tax rate of 39.6% for those making $1 million or more. That’s also the rate to which he would raise the current top 37% individual rate for those making at least $400,000. The hike would nearly double the current long-term capital gains rate of 23.8%, which includes the 3.8% Obamacare levy. Long-term capital gains tax is levied on profits when an asset or investment is sold after being held for at least one year.

Biden would also eliminate a lucrative, long-standing loophole called “step up in basis” that wipes away capital gains taxes on inherited assets, and would leave heirs to pay tax on the assets’ appreciation since they were originally bought. The administration has said there would be protections for farms and “family-owned” businesses if given to heirs who continue to run them, and no tax owed if inherited gains go toward charitable contributions.

The giant tax proposal faces a tough fight in Congress, which could scale back its provisions. Goldman Sachs analysts predicted the capital gains rate may be likely to go only as high as 28%, not 39.6%, once a bill is passed and sent to Biden for signature.

Another wild card is whether the tax plan might make the capital gains hike retroactive to the start of 2021, and not 2020, to capture the outsize profits that markets have handed investors so far this year. On a run for 11 years now, stocks have risen 10% since Biden’s inauguration on Jan. 20, the most for a presidential start since the Great Depression.

Either way, lawyer, CFA and CPA Peter Nesvold, the founder and managing director of Nesvold Capital Partners, a minority investor in RIAs and other financial services firms, says that “clients are calling and asking, ‘Are you able to close before 12/31’? If you’re thinking about transacting or raising capital, it makes a lot of sense to transact this year.”

Acquisitions of RIAs, on a steep upswing for eight years running, reached a record-high last year, with 205 deals, including 69 in the last quarter, a high mark, according to Echelon. So far this year, Armitage says, there have been “well over” 90 deals, including 76 transactions in the first quarter. She predicts 255 total deals by year’s end, a nearly 25% increase on last year’s record level.

Many acquisitions have been fueled by private equity firms — the same money-makers who stand to get slammed by the elimination of the preferential capital gains tax break. Private equity, hedge fund and real estate firms make their money via so-called carried interest, which is an investor’s share of a fund or investment’s profits.

Deals by Wall Street and private-equity firms to snap up RIAs are likely to increase amid proposals for tax hikes on the wealthy.

Deals by Wall Street and private-equity firms to snap up RIAs are likely to increase amid proposals for tax hikes on the wealthy.

Bloomberg News

So how might deal-making for RIAs grow under Biden’s proposal?

Nesvold says that two groups of advisors are now showing the most interest in making a deal: those who are in their 60s and near retirement, and those in their 40s: “Some older advisors who might have three to five years left in the business are deciding that it’s the right time to transition the book out. Then you have much younger advisors, in their early 40s, that are growing so quickly that they need outside capital.”

Harris Baltch, the head of M&A and capital strategies at Dynasty Financial Partners, a wealth management company for RIAs that's based in St. Petersburg, Florida, says that a higher capital gains rate will make deals involving the sale of a RIA’s revenues, rather than its equity, more popular. The reason: it’s not hit by capital gains tax. “You don’t give them a piece of your equity, but a piece of the top line revenue” — up to 10%— “in exchange for capital,” he says of Dynasty’s signature “revenue participation interest” structure. “There are certain ways you can be creative in monetizing your business.”

Armitage cites several different deal structures that may grow in popularity. One involves a seller giving up a chunk of equity. That can work well for advisors nearing retirement, who can “offload the day-to-day” elements of their practice while still retaining a degree of ownership. While such deals don’t put cash immediately into a seller’s hand, they leave them with an equity stake that can potentially grow faster, due to the infusion of a new partner in the business. While the structure has a trade off — “most advisors feel more comfortable when they have complete control” — it “has the potential to become more common” amid looming tax hikes.

For advisors contemplating deals with a private equity firm in which they sell a chunk of their practice but stay at their advisory practice, she says, a deal can potentially be structured so that a seller’s income falls below the $1 million threshold.

Say an advisor wants to make $1 million a year but crafts a deal to sell part of their practice and accepts only $300,000 a year, because they’re already wealthy and don’t need the additional income.

The forgone $700,000 of compensation would go into the practice’s earnings before interest, taxes, depreciation and amortization (EBITDA), a common measure of profitability. For a RIA that sells for seven times’ EBITDA, for example, the extra $700,000 transmutes into an additional $4.9 million of value that can be factored into the equity that the seller swaps with the buyer. Harris predicts that advisory firms will do more deals to sell a minority stake, rather than the whole shebang. “That gives you a strategic partner to provide
capital to monetize a portion of the business today, and a portion tomorrow,” he says.

Bob Oros, the chairman and CEO of Hightower, a Chicago-based wealth management firm that invests in RIAs, says that "the reality is, regardless of the tax environment, sellers prefer cash." But he added that "it’s entirely situational, as firms selling to a larger, high-value entity may seek equity with their eye on higher valuations in the future.”

On another front, Armitage says, aging advisors with health issues may just decide to throw in the towel, cash out and deal with a higher capital gains rate.