Like to hear a bit of good news? Try this: Despite the drab equity markets, resulting in lagging revenue and smaller client portfolios for advisors, you can probably get more for your practice today, more quickly, and for more cash up front than at any time in the past four years.
How can that be? The most recent data compiled at FP Transitions, the facilitator of advisory practice transactions based in Portland, Oregon, reveals a surprising and encouraging trend. During periods when the securities markets are down, the value of advisory practices rises because advisors want to replace lost revenues by acquiring another practice; this drives up price-to-revenue multiples and down payments, while shortening the time involved to complete a transaction. During bull markets, the values of practices are pushed up by institutional and financial buyers paying prices no advisor would consider, while during bear markets, advisors themselves support practice values.
Ironically, due to the equity market turbulence and its consequences, many would-be sellers hesitate out of fear of selling too low, while just the opposite is far more likely to be the case. Since the revenues of most practices will probably increase from their currently depressed levels over the next three to four years (the average time for a current earn-out transaction), today’s higher multiples have a very good chance of translating into a larger total payment for your practice. As a seller today, you’re essentially trading your practice for a future revenue stream at the bottom of the cycle, rather than the top–the equivalent of selling high and buying low.
The Numbers, Please
Here are the economics. The number of buyers is up dramatically from the data for year-end 2001 published in FPTransitions’ annual Practice Transition Report: from 1,500 to 1,900 (see chart 1, page 75), while the number of active sellers has increased modestly: 346 to 383 (see chart 2, page 75). This increased demand is directly visible in the ratio of selling price to gross revenues, the average selling price, the average number of inquiries per listed seller, the size of down payments, and the length of earn-out periods. Even our closing ratio, the number of seller listings that result in a transaction, is up, from 78% to 90%, reflecting both the level of interest and the earnestness of buyers today. The average selling price of those transactions has also risen, from $611,000 to $641,000 (see chart 3 on page 76), although this may be as much a reflection of our own focus on larger practices as it may be the increased demand for them.
The multiples of selling prices to revenues are up from our year-end numbers, albeit modestly. Today, 92% of all transactions (up from 87% in 2001) occur at ratios between one and three times revenues: fee-only multiples increased from 2.00 to 2.10, and ratios at fee-based firms (which derive at least 70% of their revenues from fees) rose from 1.70 to 1.74, while commission-based firms remained constant at 1.1.
Moreover, this slight increase in selling multiples takes on an added significance considering that it represents the first such increase in more than two years. It’s the first indication we’ve seen that demand from financial advisors themselves, looking to replace falling revenues in their own practices, is just as capable of creating the same levels of support for practice values as institutional and financial buyers attracted by the equity bull markets of past years.
The increase in buyers over the past six months has raised by 21% the average number of inquiries sellers receive within the first 30 days of listing their practice, from an average 19 to 23 inquiries per firm. Interest in commission firms rose 14.3%, fee-based firms held steady at 25 inquiries, and interest in fee-only firms skyrocketed 55% to 28 inquiries per listing. These queries directly translate into quicker transactions: the number of firms in our system that sell within nine months of first listing has increased from 70% to 78%.
The scramble to buy revenues (i.e., practices) is also evident in the higher down payments being made, as well as by falling earn-out periods. The average down payment has risen across the board, compared to the figures from year-end 2000. For commission firms, it’s up 15.4%, to 21.65% of the selling price; fee-based firms now receive an average of 26.70%, an increase of 8.5%, and the up-front money for fee-only transactions jumped 38.0%, from 24.2% to 33.4%.
Simply put, down payments are up because the competition to acquire firms today is fierce. Fee-only sellers in metropolitan areas, especially in a warm or desirable climate like Phoenix or Atlanta, can easily receive over 40 inquiries from serious, capable buyers. Buyers today are very optimistic about the future of the equity markets and their ability to guide clients through these tough times. Buyers also realize that they are probably buying at or near a low point in the equity markets, and consequently are willing to pay more because they can buy the same practice today for less than was possible 18 months ago. It’s interesting to note, however, that with three- to four-year earn-out periods often tied to revenues, the total price that today’s sellers receive may turn out to be higher than prices paid during the recent boom years, when prices were high but subsequent revenues declined.
Just as higher down payments reflect today’s buyers’ willingness to take more risk, so does the decline in the average earn-out period. The earn-out period (the time sellers have to wait to receive the balance of their selling price, usually dependent on factors such as client retention and revenue targets) declined from 4.2 years to 3.4 years for fee-only firms. For fee-based firms the average period declined from 3.9 years to 3.7 years. Reflecting a softening in the market for commission-based firms, the earn-out period for those firms has increased slightly (2.5%) from 3.9 years to 4.0 years. While part of the overall decrease in the financing period can be attributed to optimism by buyers, with down payments up, there is also less balance to be paid out, and therefore less time required to pay it.
Advisors Are Doing the Buying
Driving this dramatic demand for advisory practices are almost exclusively advisors themselves (see chart 4 on page 76): 47% of buyers are affiliated with independent broker/dealers, 14% with custodial firms, 7% with insurance B/Ds, and 5% with national wirehouses. Today’s buyers have excess capacity since most have lost some clients, and all have lost some income, while most have kept the same overhead and staffing from better times.
At the same time, practices no longer enjoy the luxury of growing with little or no marketing, through referrals or just by an appreciation of assets. These traditional marketing strategies tend to bring clients in slowly, and often fail to yield the kind of clients targeted by a particular practice. Advisors who don’t want to wait for word-of-mouth to restock their client and asset base have, based on our data, turned to acquisitions as their marketing plan.
We hear from buyers frequently on the issue of client quality. It is expensive and labor-intensive to care for 300 clients, when the same income and asset base can be built with only 60 or so wealthy, more sophisticated clients. It would take most planners five to 10 years, in a strong economy, to reach $30 million or more in assets under management from only 50 to 60 clients under a fee-based or fee-only business model. But with an acquisition, this plateau can be reached in 90 days or less.
On the other side of these transactions, sellers today tend to feel overworked and underpaid thanks to the bear equity markets, making them more prone to leave the industry or at least strongly consider the thought for the first time in their careers. The number of seller listings we received over the past 12 weeks increased sharply after market rebounds, signaling a certain amount of shell-shocked opportunism. In this rush to “get out on a market uptick,” there’s a danger that sellers will negotiate overly risky deals, which they could end up paying for out of their income stream over the years to come. Fortunately, a well-prepared seller can take many steps to reduce the risks that come with a contingent payoff structure. The following measures are highly recommended:
Place restrictions on the buyer
Virtually all deals these days use either an earn-out payment period of three to four years or an adjustable promissory note tied to the future cash flow of the practice. Both of these are forms of “seller financing,” and as a result the seller can and should attach some controls to the buyer’s handling of the acquired client base and income stream, particularly concerning actions that could hurt future revenues. For instance, sellers can add provisions to the Asset Purchase Agreement that restrict a buyer’s ability to convert the seller’s former clients into a different business model or to significantly raise the fees the clients have been paying.
Other requirements might include the need for an annual audit or performance evaluation by a neutral third party, and making sure the buyer is the primary advisor to the clients.
Select the proper buyer
The skills and reputation of the buyer provide a level of assurance to the seller. Sellers should interview and select their buyer from a group of qualified applicants. They should always check the references of a buyer with industry peers and with the buyer’s clients, and also obtain a copy of the buyer’s credit report. If a buyer has previously acquired a practice, that experience can be very revealing in evaluating the future success of the proposed transaction. A seller should find a buyer that he or she would trust to manage their own money. After all, if the seller doesn’t trust a buyer, why should the seller’s clients?
Introduce the buyer to your key clients
Sellers (and buyers) should also explore through due diligence any concentrations of assets in a buyer’s existing practice. For example, if 40% of the assets or cash flow of a practice comes from one family or company, the risk of that business might also increase the risk of a successful transition. Many sellers will insist on being introduced to the decision-maker responsible for this concentrated group of assets or revenues prior to finalizing the deal.
Require an adequate down payment
While the transition period motivates a seller to help move the clients over to the buyer, many sellers overlook the importance of having a motivated buyer. Buyers are ultimately the ones who must convince the seller’s clients to transfer their portfolios to the buyer’s care and expertise. Thus, sellers should rarely rely only on an earn-out payment structure. Rather, they should require a nonrefundable down payment to the seller of between 10% to 40% of the estimated closing value, or employ a promissory note for a sum certain in the deal. This will help a seller determine which buyers are serious and capable and which are not, and will help to reduce the seller’s risk.
Demand separate books
Sellers should insist that buyers maintain separate books and records for the acquired client base for the duration of the earn-out period. The seller, or the seller’s accountant, upon reasonable notice should make these books and records available for review. In certain situations, it may be appropriate to require an audit of the revenue portion of the financial statements during the earn-out period. In most cases, the seller retains the right to perform a surprise audit on these records at his or her expense, unless a discrepancy is discovered above a certain level, such as $500, in which case the buyer pays the cost of the audit.
Keep the seller managing the practice
A seller can require that he or she be retained by the buyer under an employment or consulting agreement for a fixed period or until a certain percentage of the purchase price has been paid. To avoid tax complications, it is important that the compensation for services rendered during the earn-out period be reasonable and reflect the actual fair market value of the services provided. We highly recommend buyers and sellers have all documents reviewed by their own accountants.
Buy life insurance
Both buyers and sellers should consider obtaining life insurance policies on the other party for additional protection, at least during the earn-out period.
Include conditions on the subsequent sale of the practice during the earn-out period. The buyer and seller should also determine whether the acquired client base, or a portion thereof, may be sold to a third party during the earn-out period, and the effect of such a sale should it take place. Most sellers will insist that the third party be obligated to pay off the entire purchase price at the time of the second sale.
Establish a dispute resolution procedure
As in any business agreement, disputes regarding future payments are possible, and both parties should consider in advance the appropriate form of resolution should a problem arise. Many deal structures require binding arbitration of disagreements. Mediation can also be very helpful to quickly and economically resolve disputes.
As you may have noticed in some of the preceding data, the continuing bear equity market and buyers’ increased concerns over reducing risk have resulted in a reemergence of the dominance of fee-only practices. The data clearly show that fee-only practices are the most popular and most valuable practices on the market today. Fee-only practices are also the most expensive to acquire in terms of cash outlays, demanding and obtaining cash down payments up to 50% of the selling price and earn-outs not exceeding three years. Nonetheless, we have sold or have received full-price offers on every fee-only practice we have ever listed. Inquiries are increasing rapidly for fee-only practices as well–they are up 55.6% in our most recent data. This increase may be as much an indication of acquisition as a growth tool, or the sudden discovery that there is a marketplace for these businesses, as it is the success of FP Transitions.