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.”