Most of us have a "soapbox" issue that evokes an emotional response and provokes a vociferous argument. For PETA activists, it's protection for animals. For libertarians, it's small government. For Green Bay Packers fans, it's their loving or loathing of
Brett Favre. For NAPFA members, it's the purity of fee-only advice.
Personally, I have many such issues--but high among them is the folly of "rules of thumb." Few things get under my skin more than when people who normally show good critical thinking seek a one-size-fits-all answer to a complex question.
One particularly irksome query these days: "What are advisory practices selling for?" Offering a rule-of-thumb answer would be like a financial planner telling a client how much money she needs to retire without knowing what she has or how she consumes. When presented with the question, I must quell my first instinct to respond sarcastically. Then, after biting my tongue and counting to ten, I artfully build the argument as to why relying on cocktail conversation about rules of thumb for buying or selling an advisory firm is imprudent even in the best of times. Imprudent, that is, unless you are a seller persuading a na?ve buyer that while the price may seem high, this is what everybody else is paying, so it must be right!
According to a recently completed white paper written for Pershing Advisor Solutions by FA Insight on mergers and acquisitions among larger (over $100 million in AUM) advisory firms, just 31 transactions have been recorded since January 1, 2009, which is a 30% drop from 2007. Serial buyers--those who strategically acquire firms as a consolidation play--dropped to just 26% of all deals reported. According to the authors of the white paper, Real Deals 2009: Definitive Information on Mergers and Acquisitions for Advisors, "capital constraints, economic uncertainty and increased levels of caution characterize the current marketplace." (For a copy of this white paper, please e-mail me at firstname.lastname@example.org.)
The Real Deals study posits that serial buyers are narrowing the scope of what they regard as a desirable acquisition. Instead of just focusing on the financial reward that might come with cash distributions or a liquidity event, professional buyers are looking at strategic fit as well. Reduced cash flow and a less exuberant market naturally dictate a lower valuation because of the negative impact on future returns.
M&A activity has obviously been on the wane as advisors focus on retaining clients and managing their businesses. Plus, firm owners who intuitively know the worth of their practices are not enthralled with the idea of selling at a fire-sale price. The emotional state of buyers and sellers aside, real economics drive deals. These economics revolve around three key elements of business valuation:
1) Future cash flow (potential);
2) Risk, or uncertainty about the firm achieving its projected cash flow;
3) Growth--the elements that will ensure the enterprise is sustainable.
Future Cash Flow
Value, by definition, is based on assumptions about the future. Prudent investors do not make decisions based on what a business has done, but rather what it is expected to do. When evaluating an advisory firm, it is important to know what will impact the future cash flow of that specific firm. For example, what is happening to its expense structure? Is there a systematic business development plan in place or is the practice totally dependent on referrals to the lead advisor? What would happen to those referrals if she were to die, become disabled or retire? Will real fees be reduced because a large proportion of clients have moved into the withdrawal phase?
A fact often ignored by one-time buyers and sellers is that acquisitions are funded out of the cash flow of the business. The only circumstance where this may not be true is when a buyer intends to "flip" the business to another buyer, much like homes were flipped during the real estate boom. But operating enterprises--particularly professional service businesses that are dependent on their owners to function--do not lend themselves to this treatment.
Of course, roll-up firms often hope to recoup the price they paid and then some by going public or selling the consolidated enterprise. However, every deal that I have seen involving a consolidator required those who remain in the business to make preferred cash payments to the consolidator on a very regular basis. Payments are usually made before the financial advisor pays himself and covers his operating expenses.
Cash is king in every transaction, and the advisory business is no exception.
One of the most disturbing elements of rule-of-thumb valuations is the assumption that all practices are equal: equal in terms of their business economics, their capacity to grow and attract business, and risk. Risk can be evaluated in several ways: market risk, management risk, financial risk, compliance risk, general business risk. Relevant risk factors should have an impact on the required rate of return to acquire a business.
Let's compare two firms. The first is run by a solo practitioner and one administrative staff member. Their average client is in his late 60s and retired, and the owner has virtually no time to add new clients because she is at capacity with 150 active client relationships. How much confidence would you have in the future cash flow of this business? Conversely, the other practice has three partners, three associate planners, three administrative staff, plus an office manager. Their clients are typically business owners and executives between the ages of 40 and 60, and 20 new clients are added each year. What is this practice's future cash flow potential? Importantly, should both of these firms be priced at the same multiple?
When attempting to build value in a practice, it is critical to evaluate weaknesses. You must know what is "broken" in order to focus on what to fix or fortify. If the lion's share of your client base is old and not adding to assets, can you begin replacing them with a different type of client? If you as an advisor are not adding clients, can you hire others who will start rebuilding the business again?
If you have no inclination to do either, and if the margins continue to get squeezed, procedures continue to be ignored and clients continue to be underserviced, then it is not reasonable to expect a valuation model that rates you at the same level as an elite advisory firm.
One of the easiest ways to think about a business acquisition is to compare it to investing in an equity. The premise is that buyers wish to realize some form of capital appreciation. While dividends would be nice if the enterprise is growing, it is necessary for the business to retain capital to fund its growth and pay the employees well in order to keep them focused on objectives. This is especially true in a service business like an advisory firm.
The keys to growth in an advisory firm are:
o sufficient capacity to take on more clients
o a systematic method of business development
o and a command-and-control structure that ensures the business is managed prudently, the work is done correctly, and rules and regulations are adhered to.
In this business another key element of growth is how the markets are expected to perform, as much of the new growth in revenue comes from appreciation in the assets under management.
Without the capacity to grow, a practice would look more like a bond from which investors receive income but not appreciation. Evaluated in this context, would you price the investment differently?
The point of my argument is that as much as we would like to view this business as predictable and all firms as equal, the variability from one advisory firm to the next is extreme. Each has a different economic structure, each has a different capacity to grow and flourish, and each has risk characteristics that should cause you to price them uniquely.