It has long been a seller’s market for advisory practices. In the late 1990s, sales were motivated by greed as institutions pursued a mostly flawed rollup strategy that enticed them to pay vastly inflated prices. In the last three years or so, sales were motivated by fear that the advisory business had taken a turn for the unprofitable, that it was no longer fulfilling, or that the retirement nest egg that an advisor had built into the value of her practice was gradually eroding. Now, however, the pendulum is swinging back to inflated perceptions. In their zeal to replace lost revenues and utilize excess capacity, advisors are inflating demand to acquire other practices to new heights. But today’s buyers should beware.
We have recently received increased numbers of inquiries from advisors interested in unraveling deals they committed to over the past couple of years. Most have assumed a substantial book of clients who do not fit their target market but whom they now feel obligated to serve. Others have found there is insufficient cash flow from the practice to both support the terms of the buyout and pay themselves adequately. The causes of these developments are legion, but the biggest may be a failure to understand how businesses are valued and what the economic drivers are in advisory firms.
The problems we see typically fall into five categories:
1) There is not enough potential future income per client. Many practices, especially commission-dependent ones, have consumed the lion’s share of the income in the form of front-end loads and insurance commissions. Fee-based ones may not have much of a future income stream if clients need to begin withdrawing principal.
2) Clients are too old. Some practices are like depleted oil wells. There may be a little bit left at the bottom, but the buyer will be investing in a practice that has a short life. This can be a very expensive purchase, even on an earn-out, since these formulas generally assume high growth in perpetuity.
3) The original price was based on rules of thumb. It’s not uncommon for sellers to cite recent publications that encourage transactions by pumping up the price multiples. But by definition, a rule of thumb relies on the past, not the future. In other words, the rule implies the business will continue at least at the same level it has in the past. If I were a seller, I would rely on “rules of thumb,” because these will be the highest values available. If I were a buyer, I would dismiss these rules, since most small practices are sold on an earn-out, and it is impossible to know what multiples of gross practices sold for until the earn-out is complete.
4) There is insufficient cash flow to support the purchase. There is a tendency to focus on gross rather than net revenues in an acquisition. According to the most recent FPA Study on Financial Performance of Financial Advisory Practices, the average operating costs of a practice have risen to 45% of gross revenue. If you add to that the cost of labor for yourself and any other professional involved in the practice, the margins get very tight. At your current run rate, when will you break even on the purchase?
5) There is a lack of capacity. One of the great surprises for many practitioners is the time it takes to transfer these relationships. It can be done by adding staff, improving technology, or working ungodly hours. Or it can be done by accepting a certain level of attrition for clients who are not economically practical to service. This raises a moral issue for the seller, however: Did you do justice to your low-end clients by selling them to somebody who won’t take care of them?
First, Ask These Questions