From the June 2007 issue of Investment Advisor • Subscribe!

June 1, 2007

The Art of the Deal

Advisors who don't understand where those astronomical practice values are coming from are doomed to get what they deserve

Let's start with an easy one: How would you rate the following deal? An independent advisor is the sole owner of a wealth management practice that generates $2 million a year from asset management fees, growing at 20% annually. His total operating expenses are running at about $600,000, so he's pocketing a cool $1.4 million a year.

While he's not ready to retire yet, our advisor decides it's time for a strategy to make his exit in the next few years, and hopefully get a few bucks for his practice. Enter a rollup firm, offering to buy 100% of his practice, but just 50% of the owner's $1.4 million annual comp, for $3.5 million (half in cash, half in non-but hopefully-soon-to-be-trading stock).

If the firm continues to grow at 20% a year for the next three years, he gets a $1.75 million bonus, bringing his take to $5.25 million. Moreover, because the firm hit its targets each year, he gets to collect half of the earnings growth, which totals another $3.5 million over the three years. Altogether he's collected $8.8 million, and he still owns a portion of the pre-comp earnings, which he can sell to a successor: not as valuable as real equity, but at a multiple of four, it's worth maybe $5 million, bringing the total value of the sale to $13.8 million.

What Do You Think of That Deal?

A) He's my hero

B) About what I'd expect

C) If he liked that deal, I've got an ostrich farm...

If you didn't pick the ostrich farm, you might want to think about going back to selling annuities. Here's why: While our owner was making his $13.8 million over three years, his firm generated $8.7 million in revenues, which would have put his owner's take, had he not sold the firm, somewhere around $7 million. That means he actually sold his firm for about $6.8 million, half of which is bet on the rollup stock.

How much was the firm really worth? By the third year, the firm is netting just over $2.8 million before owners comp. If you figure our advisor's working comp should be somewhere around $500,000, that puts $2.3 million on the bottom line. In today's market, a growth rate of 20% a year should put the earnings multiple conservatively at 8, so the practice was worth in the neighborhood of $18.4 million. Our "savvy" advisor just took an $11 million haircut--his firm's growing cash flow was used to buy him out and give the buyer an eight-figure cap gain. The good news is that the stock half of his payout should do pretty well, if this is an indication of the kinds of deals the rollup firm is making.

Welcome to the new M&A world of advisory practices. In case you didn't guess already, the above deal terms are similar to those offered by National Financial Partners. Combined with insurance and other "products" and services NFP offers its affiliates to boost their revenues and profitability, it's no wonder the rollup firm's stock has climbed from its IPO price of $23 to a high of around $46 at the time of this writing. I wouldn't want to sell them a practice, but I'm thinking about buying some NFP stock for my retirement portfolio.

What's Going On?

Two trends have combined to boost practice values beyond anything we could imagine only a few years ago, yet create pitfalls (such as the above deal) which promise to separate more than a few unwary practice owners from much of their firm's skyrocketing value: A seller's market for practices that can continue to grow after their founder(s) exits, and push earnings ratios out of the value-stock range and into the growth-stock stratosphere. At the same time, most of the largest advisory firms have already been sold, turning the institutional M&A eye toward firms well below $500 million in AUM.

Last fall, Philip Palaveev of Moss Adams, unveiled a study conducted for Pershing Advisor Solutions titled "Real Deals: Definitive Information on the Mergers and Acquisitions for Registered Investment Advisors," which offers considerable insight into the changes in the booming market for advisory firms over the past five years.

The market for successful practices is, indeed, booming. Some industry watchers estimate as many as 35 institutional buyers are currently looking for acquisitions, as are a growing number of advisory firms themselves, accounting for more than a quarter of the deals involving larger firms with revenues of greater than $1 million. Consolidators such as NFP and Focus Financial make up about another 10% of that market, while, historically, banks have led the pack with roughly half the acquisitions of big firms.

The Moss Adams Study shows that the median price for larger firms over the past five years was a healthy 2.75 times revenues, (which puts the average earnings multiple somewhere between 9 and 11). But Palaveev is quick to point out that in the vast majority of these deals (74%), collecting those princely sums is conditional on future growth performance (known as earnouts), often over a number of years. "For firms that do not reach their targets," he writes, "realized total payments can be as low as 50% of the deal's potential value."

Different Terms, Different Outcomes

Savvy advisors also need to know the significant differences between the terms and the outcomes of various types of buyers. For instance, banks tend to buy 90% of a practice with the purchase price split between 63% cash and 27% bank stock, which is restricted for three to five years, and they take an option on the other 10%. Not surprisingly, this lack of incentives for principals and possibly other advisors translates into rather dismal 9.9% post-transaction profit margins.

The exception to this love-'em-and-leave-'em strategy for banks, according to investment banker John Temple, managing director at Cambridge International in New York, are community banks. These smaller, local institutions are interested in boosting their low industry earnings multiples with more high-powered asset management. Their home-grown corporate cultures are also far more compatible with leaving some ownership in the hands of advisory principals and their successors, and aggressively cross marketing to bank clients.

Consolidators, on the other hand, typically buy 100%, with the ultimate goal of creating one very large, publicly traded advisory company. Consequently, their acquisitions tend to look very much like the NFP deals, with powerful incentives built in for principals to not only stay but to continue to grow their practices.

What's more, these rollup firms have considerable interest in helping their firms grow as well. According to Elliot Holtz, executive VP for marketing and firm operations at NFP, his company offers its advisory practices services that "combine the best of independent B/Ds, wirehouses, and custodians, including due diligence and research on alternative investments, state-of-the-art technology, practice management support, low cost E&O insurance, estate planning and risk management tools and products, and financing to expand through acquisition of other practices."

Palaveev reports that these incentives are working, with firms acquired by consolidators averaging 25% operating profits, and strong growth, including a 38% revenue increase for 2005. Professionals at these firms are also among the most productive in the advisory industry, averaging $493,000 in revenue per professional, 24% higher than the industry average of $396,000.

Trouble in Consolidator Paradise?

Yet all isn't going swimmingly at practices in the consolidator fold. "At the same time," Palaveev continues, "one of the key rationales for consolidation--efficiency--is not materializing." Specifically, overhead at these firms is running at 49%, quite a bit more than the 41% industry average, not to mention Moss Adams's optimum target margin of 35%. "Perhaps there has not been enough time for the necessary changes to be made and to take effect," he writes, "as the firms studied were acquired only in the last two years." Or perhaps the value-adding programs offered by rollup firms are skewed toward growing revenues through volume sales rather than increasing operating efficiencies.

It also seems that long-term stability might be a concern with consolidation firms. Once the high earnings and growth rates acquired in their favorable acquisitions can be quantified, it's not hard to imagine rollup founders cashing in on the value they've created by selling out to a much larger company. How else could they maximize the considerable value of their buying acumen?

Finally, perhaps the most important theme that Palaveev uncovered is that the largest firms had been culled from the herd by the end of 2004, with deals since then involving smaller and smaller practices. The Moss Adams data shows the percentage of target firms with more than $500 million in AUM falling dramatically, with the void filled by a dramatic increases in the number of transactions involving firms with $100 million to $300 million in AUM, and even those with less than $100 million. In 2004, for instance, fully 80% of transactions involved firms with more than $500 million in AUM--and 58% involved firms with assets in excess of $1 billion. By 2006, deals with $1 billion firms fell to only 21%, while firms with under $500 million now comprise half of all transactions.

Value Proposition

While advisory firm values have been creeping up and selling firms have been trending smaller, the world of practice M&A made a quantum shift the day Mark Hurley announced the acquisition program of his Fiduciary Network, LLC in Dallas, Texas. (See "Walkin' the Walk," April 2007 on Hurley's plan.)

"We have two advantages over other acquisition firms," Hurley explains. "Through Emigrant Bank, we have access to lower cost capital, and because we're closely held, we have investment horizons out past 20 years." This longer view, he says, enables Hurley to look at practice acquisitions as long-term investments, and to value firms based on the present value of their growing earnings streams--the way fund mangers value growth stocks.

Consider how much a practice is worth today if viewed as a growth stock earning $2.3 million a year, and growing at just 10%, for the next 20 years: at a 15% discount rate for risk, the present value is $27 million. Quite a bit more than NFP's $13.8 million (and that firm was growing at 20%), or anyone else is offering these days. Yet, through a Byzantine deal structure involving multiple classes of stock, multiple payout dates at various earnings multiples for each principal, a capital pool to buy equity for junior partners, and a minority non-voting interest retained by Fiduciary Network, Hurley offers sellers of growing firms up to 14 times free cashflow, while handing the majority of their firms off to the next generation of professionals: "In a large firm with solid growth," he says, "the owners could end up with $30 million."

There are two essential elements to Hurley's deals, and they are the two factors that are transforming the independent advisory industry: Growth, and successors. Hurley's financing model uses each firm's own growing earnings to fund the buyout of the older partners by the younger partners, with temporary cash flow wrinkles covered by Fiduciary Network's financing. As we've seen, growing earnings over a long time horizon creates a pool of capital that can make everyone involved, well, rich.

Growth, and Junior Partners

So, in Fiduciary Network transactions, firms need to continue growing to create a windfall for present owners, and the junior partners who will buy them out with some risk, but little of their own capital. They also need the junior partners. Hurley heavily emphasizes that the real key to his deals is the quality of the successor partners. "In our due diligence, we spend more time with the junior partners than with the selling owners," he says. "Because they are the future we're buying into."

That is the proverbial handwriting on the wall. Independent advisory practices large and small can be worth more money than anyone ever imagined if, and only if, they are growing, and if they have the next tier of partners who can step into leadership roles and continue that growth. Without high-quality junior partners, retiring advisors only have their clients to sell--which are currently valued on FP Transitions' myriad Web sites at 2.1 times annual fee revenues, paid over four years. Sure, you might find a bank that hasn't figured this out yet to pay a higher multiple, but if you want to attract the truly big bucks, and keep your practice independent in the bargain, you have to have successors you can sell.

Which begs the unavoidable question of why advisory firms need to sell to consolidators, banks, or even enlightened financiers such as Mark Hurley? If the growing cash flow of the practices themselves is covertly financing all these buyouts, which are really just transfers to the next generation of advisors, what do you need all these middlemen for?

The current conventional answer is that the younger advisors can't afford to pay anywhere near the values that banks, let alone Fiduciary Network, are offering. Of course they can't. Neither can the banks nor even Hurley. It's the growth of the practices that's underwriting all the transactions--but over a long time.

Planner, Heal Thyself

So the real answer to the question of why selling advisors need these facilitating firms is, ironically, that they didn't plan far enough ahead to sell their firms to their junior partners in bite-size pieces. This isn't really rocket science (Okay, maybe Hurley's deals are rocket science). But every day, small to mid-size businesses in many other industries sell themselves to young successors, one piece at time. Law firms, accounting firms, even mutual fund companies have ownership tracks where the firms internally finance young professionals to buy equity, and pay back the loans out of the growing distributions of their ownership shares.

The key, of course, is adding young partners who will contribute to the growth of the firm. Sound familiar? Moreover, the time horizon doesn't have to be that long: in ten years, a couple of motivated and talented young advisors could buy out a practice's sole older principal at multiples equal even to Hurley's golden eggs. That won't happen, however, in the two to three-year time horizon in which advisors today typically start thinking about executing their exit strategy.

These days, virtually every older advisor you talk to says they want to sell internally, if only they could make it work. To make such an internal succession work, the older generation of successful advisors has to come to grips with the notion that selling equity in the firms they founded is not a hit to their pocketbooks, it's the path to their own prosperity. Compensating, motivating, and retaining junior partners will help these principals take the firm a quantum leap beyond what they could have done by themselves. They'll have a decreasingly smaller piece of a rapidly expanding pie. If you don't grasp that, maybe you should go back to selling annuities.


Bob Clark, former editor of this magazine, surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at rclark7000@aol.com.
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