Comparing Private Equity to Traditional Debt for Financial Advisory Practices
As the advisor industry has matured and grown, it has garnered interest from a number of sectors looking to tap into the opportunities that are available. Most recently private equity investors who normally pursue investment opportunities in firms like technology startups and manufacturing have turned their sights to the financial advisor industry. This has provided many financial advisory practices with a new source of capital for acquisitions and other growth initiatives. Just like any other source of capital, private equity comes with its own advantages and drawbacks, which advisors should consider before making a commitment.
Pros and Cons of Private Equity
One of the most prominent advantages of private equity is that the investor is equally committed to the success of the practice. This is because they share in the risk, as well as the reward, and are motivated to help the practice succeed. Also, private equity firms tend to have deep pockets, giving advisors access to tremendous amounts of capital often larger than that of traditional debt resources. Additionally, private equity firms are more likely to accommodate an aggressive acquisition growth strategy whereas a bank will likely be more conservative and selective in the type and quantity of deals they will finance.
On the other hand, that shared risk often comes with shared ownership and loss of some level of control over the practice. Often the private equity firm holds significant decision-making powers, limiting the advisor’s ability to make decisions about the practice. Buying back that control is often very costly and laden with challenges. Also, instead of paying back the loaned capital at a set rate, private equity firm arrangements often include profit sharing, which can dip into the returns of the practice and the individual advisor. Private equity firms also have expectations about how quickly those returns should happen and when they are paid, which creates additional pressure on the practice to deliver results, sometimes at the sake of compliance or quality.
Lastly, private equity is not an available option for everyone. Private equity firms are typically pursuing an investment in larger advisory firms that are at least $1 billion in AUM eliminating this as an option for the largest percentage of advisors and firms.
Pros and Cons of Traditional Debt
Luckily, the same factors that have attracted private equity to the financial advisory market have also led many specialty lenders to enter the field. Just like private equity, traditional debt comes with its own advantages and disadvantages. On the plus side, with traditional debt the practice principals retain ownership and all control over their practice. Retained ownership also means that all profit goes to the owners to distribute or use as they see fit. As with most loans there is personal liability involved for the practice owners, but the cost of securing capital through traditional lenders is cheaper than private equity. It also comes with fixed terms providing a steady, predictable payment schedule for cash-flow purposes. Of course, if revenue and/or
profit declines, payment is still due to the lender which can impact cash flow in hard times. On the other hand, the interest paid on that loan is tax deductible, which may help reduce your tax burden during the term of the loan.
Advisors Have Options
In either case, the good news is that advisors have options. The fact that private equity has become a viable capital solution demonstrates the sophistication and business acumen of the advisor industry as a whole. It will also help to continue to shine a light on all the good work the industry does for its clients and the positive impact it has on the economy. This can only create more opportunities for advisors in the future.