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 [email protected].)
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.
