Time of Reckoning

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 [email protected]).

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.