From the May 2008 issue of Investment Advisor • Subscribe!

Time of Reckoning

In volatile times, the reality of practice valuations is exposed

By definition, "rules of thumb" presume that nothing will change. Real estate values will always go up. Auction rate debt will always be liquid. Advisory firms will always grow at 20% annually.Recent conversations with advisors continue to surprise me. By now, we should know that a "rule of thumb" is not accurate or reliable for every situation. Like many things, the concept is accepted because it is simple, does not require any thought, and is talked about with confidence by many even when they are wrong.

There is an often-cited rule of thumb for valuing advisory firms at 2.1 x revenue, and advisors have been taking liberties with this data for their own benefit. In fact, not only do some still apply 2.1 to recurring revenue--many liberally apply it to all revenue--regardless of whether it falls within a commission practice, 401(k) plan business, insurance agency, or hourly consulting work.

So what's wrong with this? Inflated perceptions of value create distortion for sellers and problems for buyers. Let's look around us:

House values are down in most places. The redemption of preferred shares in closed-end funds that hold auction debt was frozen early this year. And advisor practices are having a harder time supporting such an extraordinarily high valuation with available cash flow. The pursuit of simplicity ultimately makes the lives of many complicated.

The market, by any measure, is down significantly. More and more practices derive their revenues from fees for assets under management. The cause and effect is clear unless, of course, advisors have put their clients into all-cash portfolios. In that extreme and unlikely scenario, their assets under management and therefore their revenues would not increase at the same rate as in the past because money market rates are low, certainly lower than the returns their clients have come to expect or that advisors had projected.

Costs are rising faster than revenues, driven by increases in costs for compliance, labor, insurance, benefits, and technology. Meanwhile, troubled times mean advisors must devote more effort to holding hands and less to developing new business. Combined with the fact that many advisory firms do not have the physical capacity to serve all of their clients well in normal times, their ability to grow is now hampered by the intense pressure to give more service.

Is the past going to repeat any time soon? It might, in the form of a prolonged bear market. Therefore, valuations determined by a rule of thumb are especially dangerous for buyers, sellers, and the people who finance them.

Reasonable Pricing

Sellers and buyers must remember that value is a function of the future. Wise advisors know never to place clients into investments based solely on historical performance (in fact, they are warned about this in every prospectus). Likewise, investors in practices should not presume that the 20% CAGR of the average advisory firm for the past five years is a likely trend for the near term.

A simple method of calculating business value divides cash flow by a required rate of return, also known as the capitalization rate. The capitalization rate consists of a measure of risk and an assumption about long-term growth: [V = CF ?? (R -- G)]. The capitalization method has its warts because the model assumes that cash flow will continue to grow at a normalized and predictable rate in perpetuity. The risk rate used in the formula tends to temper any optimism about growth by assigning a probability to how likely that is to occur.

A more refined approach to determining value is a discounted cash flow (DCF) model that forecasts cash flow for specific, discrete years based on specific assumptions about what will drive the business. In the DCF method, one can project forward three to five years and incorporate more direct assumptions into the calculations before capitalizing the terminal year. While valuation is still more art than science, this more disciplined process forces buyers and sellers to make more realistic assumptions about the foreseeable future.

Other factors come into play in a real deal as well, including the motivations of the buyer and seller; the potential for synergy; market prices for comparable businesses; tax considerations; and the quality, demographics, and earnings potential of the client base. (Pershing Advisor Solutions has detailed many of these different transactions in a report entitled Real Deals: Definitive Information on Mergers and Acquisitions for Advisors, and will be producing a sequel later this year. For a copy of the Pershing sponsored report "Real Deals," please e-mail etsikkos@pershing.com).

Another rule-of-thumb presumption is that all firms are equal. In reality, each firm has a different capacity to grow, a different market, a different approach to client service and advice, and, therefore, a different profit model. From this perspective, the values determined by applying rules of thumb are chimerical visions not supported by fact. But that has not stopped people from looking at advisory firms as a homogenous group from a valuation perspective.

A Likely Scenario

Amy acquired a practice from her former boss in the middle of last year. Assume that the practice generated $1 million of revenues off of $100 million of assets and 300 clients. Also assume that due to underperformance and market pressures that the practice is on a new annual run rate of $900,000 in revenues. Out of this amount, the buyer has to pay her staff, cover other overhead costs, fund substantial payments to the seller or the bank, plus generate enough cash flow to pay herself enough to live on. On the surface, $900,000 may seem sufficient.

But a typical practice like this would be spending around $400,000 on overhead costs such as rent, utilities, compliance, and administrative staff--before paying the salaries and benefits of any professional staff and the owner. Assume that a practice of this size has two professional staff members earning a total of $200,000 plus benefits. This leaves less than $300,000 for the buyer of the practice to pay down the purchase price and take out any money to live on and invest for her own future.

Meanwhile, on top of the normal planning, investment strategy, and service she and her staff provide, she has to spend an extraordinary amount of time tending to existing clients because the market is in distress (and so, consequently, are many of her clients).

Assuming Amy acquired the practice at the rule-of-thumb price of 2.1 x revenue, she agreed to a purchase price of $2.1 million for a practice that now produces $300,000 of cash flow before owner's compensation. For the sake of simplicity, let's assume she put $100,000 down on the purchase price and agreed to amortize the balance over five years. Not including interest, her annual obligation would be $400,000!

As we can see, this scenario would be hard to rationalize even before the market downturn because there still wasn't sufficient cash flow to amortize the purchase price over a reasonable period of time. Further, just to meet her debt to the seller, Amy would have to work several years without any personal take-home income, unless she decided to fire the staff and handle all the planning, client service, and advisory work herself. Such actions have additional and obvious ramifications.

Amy could negotiate a longer term of payment, but if the seller is doing the financing, the burden of risk shifts onto him and away from the buyer. If a bank funded the deal--generally a difficult source of capital for such transactions--they would have strict limits on amortization, payments, interest, collateral, and personal guarantees and might only be willing to finance 50% of the purchase price.

This scenario is not only possible, it is today's reality.

Now What?

I do recall some nasty columns and speeches by others who thought my view of practice valuation was outdated, old-fashioned, and in light of the wonders of this business, disrespectful of what advisors have built. But while an emphasis on analysis may have been laughable when the market was going up and thronged with buyers, many acquirers are anguished over how to make future payments now that their cash flow has decreased.

Current events also appear to be causing some potential sellers to come to grips with their timing: They hung on through the bull rush, but may be more willing to walk away rather than work so hard to make less in the coming years. This could change the dynamic to a buyer's market.

Like lightning and floods, market movements both destroy and promote growth. They clean up our environment naturally. As much as we would love the consistency and predictability to rely on rules of thumb, old wives' tales, and "absolute truths," volatility and change are a constant in our business. A new reality calls for a sober reckoning of the value at which advisory firms should change hands.

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