From the October 2004 issue of Investment Advisor • Subscribe!

October 1, 2004

A Voice in the Wilderness

Are buyers caught up in the booming market for advisory practices paying too much?

At a broker/dealer-sponsored conference where I recently spoke, a long-time financial advisor approached me for a private talk. "I have two things to say to you," he said. "First, as a seller of a practice, I think you are completely off base; second, as a buyer of practices, you couldn't be more right." I was pleased that I had only annoyed half of him.

I've been aware for some time now how my writings and workshops on practice valuation and succession have irritated many in the profession, especially those contemplating their exit from the business.

But I wonder what people are thinking. Professionals who have been trained to critically evaluate their clients' financial circumstances and recommend a course of action often fail to apply the same discipline to their own practices. Like the fat, wheezing doctor or the wigged-out therapist, they forget the adage to "heal thyself."

In financial advisory firms, this quirky thinking may lie in how advisors treat their staff, manage their overhead, or even price their services. If handled well, each of these sound business practices can propel advisors to financial independence; often, however, they do not get the time or attention they deserve. Lately, there has been a particular rash of irrationality in the area of practice acquisition.

Some writers have suggested that Moss Adams's valuation models are outmoded. Some have even said that my view has been debunked by the multiples that are being paid for practices. "It's a new economy," they argue. "If buyers can get these practices at any price, it's still cheaper than getting clients through conventional marketing and the payoff is much quicker."

My premise is that financial advisors are paying too high a price to acquire books of business. By using rules of thumb to value potential acquisitions, they are giving equal value on a relative basis to all practices regardless of the quality of the income, the potential of the client base, and the cost of doing business that is unique to each practice.

I must confess that there are times when this irrational exuberance has made me reexamine my approach to practice valuation because, after all, that's what real buyers are paying real sellers. But even though this is the most active market in the history of practice transitions, I cannot bring myself to accept this marketplace for financial advisory firms as a prudent business environment.

Sometimes I truly feel like a voice in the wilderness. Smart people in and around the advisory profession have been exhorting advisors to use an auction market like FPtransitions to sell their books of business to the highest bidders. "Forget this internal succession planning idea," they say. The market is filled with buyers willing to pay a high multiple of gross revenue. Why go through the pain of planning for an orderly transition, or the expense of a formal valuation, when there are people out there willing to write big checks instead of building their businesses the old- fashioned way?

Sadly, they are right. Expedience in some cases has overtaken economic logic. As with houses in hot markets, there are many advisors who are bidding up prices in order to get access to a client base. I cannot fault the sellers for maximizing value, and I cannot fault FPtransitions for creating an active marketplace for books of business. My issue is with the buyers who I think are overpaying for these assets.

Tulipmania Revisited

According to the writings of David Grau, FPtransitions sees as many as 30 hits on a good listing. One advisor who I talked to about a prospective purchase off this site asked me, "How can I not pay these high multiples? if I don't, somebody else will, and I won't get the client list." Another who purchased a practice off this site told me that he thought he paid too much, but argued that it was important "that I buy the book so one of my competitors in town didn't get it."

I believe these are conditions that existed during Tulipmania and the more recent dot-com boom. We saw similar trends in other industries that have attempted to consolidate over the past couple of decades, including medical practices, funeral homes, real estate brokerages, and CPA firms. In the latter case, buyers were offering 2.5 times annual fees to acquire accounting practices, but now buyers and sellers are telling me the multiple is closer to 1. In the other cases, the markets are virtually non-existent because there is either a low inventory of opportunity or, more likely, potential buyers have come to understand the distressing economic reasons that owners of these firms were willing to sell.

Please be clear about two things:

1) If you can maximize your return by selling your practice, you owe it to yourself to consider this--I'm not an advocate for selling your business below market as long as people are willing and able to pay it.

2) Growth through acquisition is a legitimate and prudent approach to growing one's financial advisory firm. In fact, I think that most advisory firms need to think objectively about determining critical mass, and get to this point fairly quickly if they want to optimize their effectiveness as business owners. This can be done through clearly defining your optimal client and then adding more optimal clients through both mergers and the traditional way of building your business.

But what really bothers me is that people are paying large multiples for books of businesses, with so many of the clients they purchase not in their sweet spot. Moreover, through the bidding process they are establishing premiums for practice purchases that defy economic logic. Sophisticated buyers know this, but volume-driven "producers" do not. Let me break down an example to demonstrate my point.

Let's say we have a practice that generates $500,000 of recurring gross revenue. According to our studies of thousands of advisory practices over the past 10 years, we find the typical practice at this level spends over 40% of its revenues on overhead such as rent, utilities, administrative staff, and other general and administrative expenses. We also find that when establishing fair market compensation for professional staff such as financial planners, portfolio managers, and financial advisors, the typical practice pays out around 40% of its revenues in professional-level compensation, including the owners' compensation for the work they do (their comp for ownership comes outside this direct expense). If advisors manage their practices well, they would typically get an additional distribution out of any leftover profits. In this example, 20%, or $100,000, would be the pretax profit on this business.

Now before I go any further, let me acknowledge that some pundits in the profession vehemently disagree with my notion of recognizing compensation for the owner of a solo practice. Their argument is that owners get paid out of what's left over, and in their mind, that constitutes real cash flow. While true, it's not really relevant from a valuation standpoint. A practice is not a passive investment: Rather, it is one that requires the labor and wisdom and experience of the owner/advisor in order to produce the revenue. There is a direct cost for this. For example, if one were employed by a brokerage house, the firm would pay its broker around 40% of the gross revenues he produces, so I think that is a good benchmark for fair compensation for the owner, or other professionals, generating the revenue in an advisory firm.

Once we've determined the direct costs and expenses, we can evaluate the investment potential of buying the firm. To do this, I suggest we look at how current practice pricing compares to the required rate of return for alternative investments, especially publicly traded common stocks (every investor has choices: buy a practice, buy mutual funds, buy hedge funds, buy individual stocks and bonds, etc.). So for the purpose of this exercise (as seen in the box below), I will use the same foundation of deducting fair professional labor costs and all overhead in order to get to a net profit number. I will also apply a C Corp tax rate to make this analysis truly comparative to alternative investment vehicles.

How Firms Are Valued

% Revenue

Amount
Total Revenue $500,000
Direct Expense

40%

200,000
Gross Profit

60%

300,000
Overhead

35%

200,000
Operating Profit

25%

100,000
Estimated Tax (30,000)
Net After-Tax Profit $70,000

Now if we apply the multiple for fee-based businesses that FPtransitions reports is the current market price --2.1 times revenue--this would get us to a value of $1.05 million.

Divide $1,050,000 by the net profit of $70,000 and you come up with a price/earnings multiple of 15. Divide that P/E multiple into 1, and you get a required rate of return of 6.66%.

By comparison, if you looked at large, well-capitalized, deeply managed investment advisory firms, their current price/earnings ratio (with earnings defined the same way) in the public market is in the same range. So here's the question I struggle with: How can you rationalize a rate of return equivalent to an investment in the equity markets for a book of business completely dependent on the owner, with no systematic marketing and an aging client base that eventually will be depleted? Is it because of the growth potential that the seller could not realize? Is it because this is a cheaper way of procuring clients than traditional marketing?

Also consider this shocking fact--at a capitalization rate of 6.66%, the rate of return is not much greater than a relatively risk-free investment like a long term Treasury bond!

Think Like an Investor

I would challenge you to think in financial terms--like an investor--when you make these decisions. Ramping up takes money, and it's reasonable to pay a strategic premium if your goal is to amass a lot of assets and clients to build your market presence. But you also must temper your enthusiasm for this growth strategy with some common sense on practice pricing.

Even though almost every one of these deals is structured on an earn-out in which the buyer pays the seller a percentage of the gross for a defined period of time, your valuation sets the foundation for the net payments to the seller. Furthermore, with a high value as the foundation, you will find yourself working a lot longer before you realize any meaningful income out of this practice.

Many will argue that you can rationalize the premium when you are not paying the salaries of anybody else and you are buying the book to serve as your own. But at the time you need to add professional staff to service the portfolio of clients you've just acquired, you will need to apply sound economic logic to your valuation model, including defining the direct expenses of professional staff compensation, in order to figure out your net return. What you sacrifice in terms of current compensation could be viewed as an equity investment in the business. So now the question becomes, "What is your return on equity, all things considered?" At what point can you not afford to pay this premium?

Do as You Say

If your client asked you whether she should pay a premium over the market to invest in equities, what would be your advice? If you're the client, what advice would you expect? Or does irrational exuberance not apply to you?

This leads me to conclude that we are in a bubble for practice transitions. If you've been contemplating the sale of your practice, now is the time to get to market before it becomes rational again. But before you do, consider these two caveats:

1) Make sure your buyer can afford the price. If he defaults, you don't want to take the practice back when you were counting on this money to be key to your retirement.

2) Make sure the buyer has the physical capacity to serve all the transferred clients. If they don't, they will likely experience attrition in the client base and the dollars you receive through the earn-out will not be what you were counting on.

As for buyers, beware. There has never been a more active marketplace for the purchase and sale of practices, which makes you vulnerable in your execution of this plan, especially if you've never acquired a practice before.

Mark Tibergien is a nationally recognized specialist in practice management for financial services firms, and partner-in-charge of the Securities & Insurance Niche for Moss Adams LLP, the 10th largest CPA firm in the U.S. You can reach him at mark.tibergien@mossadams.com.

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