Private Equity’s Plan to Beat the Low-Cost Investing Robots

(Bloomberg Businessweek) -- Private equity firms smell money in the financial advice business. Last month, Hellman & Friedman LLC paid $3 billion to buy Financial Engines Inc., an online retirement planning service. Thomas H. Lee Partners LP in October took a stake in HighTower, a Chicago-based wealth adviser with $50 billion under management at the time. And in April 2017, private equity giant KKR & Co. and Stone Point Capital LLC bought a majority share of Focus Financial Partners LLC in a deal that valued the wealth manager at $2 billion.

Private equity buyers tend to swoop into industries when they see an opportunity to make changes and then exit at a profit a few years later. So what’s the attraction to this one? Advisers or wealth managers—the terms are used interchangeably—are intermediaries. They take money from individuals and turn around and invest it with money managers. They also offer help with everything from retirement planning to taxes. On the plus side, it’s an industry with solid profits and the potential for recurring fees. But it’s also a highly fragmented one. About 15,000 independent U.S. advisory firms control about $3 trillion in assets, according to Aite Group LLC, a Boston consulting firm. Many of the businesses are one- or two-person shops, and they’re facing increasing pressure as more individual investors embrace low-cost index funds and online advice.

But a distinct minority of wealth managers are getting bigger, convinced that scale will let them spread costs over a larger base and allow them to spend more on technology, compliance, and marketing. Clients expect fairly sophisticated data, say consultants, as well as data security, neither of which comes cheap. Enter private equity firms. They’re speeding up the dealmaking process, potentially transforming a cottage industry into one dominated by national brands. “Some of the early entrants did quite well, and a number of others are thinking, ‘Hey, we should look at this space, too,’ ” says Elizabeth Nesvold, managing partner at Silver Lane Advisors LLC, a New York investment bank.

Using some of the cash supplied by Thomas H. Lee, HighTower last month acquired Salient Private Client, a wealth manager in Houston with $4.5 billion in assets under management. Salient will change its name to HighTower Private Client. Elliot Weissbluth, HighTower’s chief executive officer, expects more acquisitions to come. “For us to go from $50 billion to hundreds of billions of dollars is a tenable growth plan,” he says. Officials from Lee declined to comment on their relationship with HighTower.

Hellman & Friedman’s purchase of Financial Engines has a different logic. With $169 billion in assets under management, Financial Engines provides investment advice, mostly online, to participants in 401(k) plans at major corporations. It’s part of a group of so-called robo-advisers that have made some people in the industry worry they could be automated out of their jobs. Robo-adviser services offered by large companies such as Charles Schwab Corp. and startups Betterment LLC and Wealthfront Inc. have attracted billions of dollars from investors.

Hellman & Friedman will combine Financial Engines with another company in its portfolio, Edelman Financial Services LLC. Edelman is a more traditional adviser that oversees $21.7 billion. The deal will create a business that can “bring better financial help to millions of investors,” Allen Thorpe, a Hellman & Friedman partner, said in a statement. Both Hellman & Friedman and Financial Engines declined to comment further.

The role technology will ultimately play in the advice business is still hotly debated. “The talk about pressure on fees is blown out of proportion,” says David DeVoe, founder of DeVoe & Co., a San Francisco investment bank that specializes in adviser deals. His take: While charging high fees for basic asset allocation may no longer be possible, advisers who provide more sophisticated services, especially to affluent clients, are still able to make good money. Mark Hurley makes a similar point. His Dallas firm, Fiduciary Network LLC, invests in wealth management firms. “We aren’t seeing fee pressure because the demand for services is going up, not down,” he says. “As people age, their problems get more complex and they need their advisers more.”

DeVoe tracks adviser combinations, and his numbers show the pace is picking up, with a record 47 deals recorded in the first quarter. Merger activity has increased in each of the last four calendar years, according to DeVoe. The average age of the founders of U.S. advice firms is over 60, according to consultants, and many of them may be looking to cash out.

Besides competition from the robos, advisers who get rolled up in private equity deals may face another kind of pressure. Details of financing aren’t public, yet some of the announced deals involve leverage, say bankers familiar with the negotiations. The borrowed money creates the potential for bigger profits for the buyers—or bigger problems should the expected cash flows not materialize.

Weissbluth of HighTower sees more deals, and bigger deals, on the way. “We are just in the early innings of this game,” he says.

©2018 Bloomberg L.P.