In his book “Freakonomics,” University of Chicago economist Steven Levitt and journalist Stephen J. Dubner explain the economics of residential real estate transactions, which may come as a surprise.
Because most real estate agents who work with sellers are paid a percentage of a house purchase price, most sellers believe those agents have an incentive to sell their houses for the highest price they can get.
But Levitt explains that because most seller’s commissions are a small portion of the selling price — typically 3-4% — the increase in an agent’s commission on a higher sale is relatively small, and therefore doesn’t provide much incentive.
Knowing what I know about building incentive and compensation structures and also human behavior, I believe he’s right. Levitt says agents get a much larger jump in earnings when they sell more houses. Therefore, selling agents’ real incentive is to sell houses as fast as they can, which usually translates into selling them for less rather than more.
Levitt’s book had an impact on me because it offered this and many other examples of how economics affects financial transactions in unexpected ways. I thought of this book recently as I was analyzing the current market for independent advisory firms.
Market for Advisors
Conventional wisdom is that the buying and selling of advisory firms is slowing down. But from what I can see, it’s actually speeding up .
The transactions are being handled in a different way, though, which means they fly under the radar of those collecting this type of data.
The experts who keep tabs on M&A activity in the independent advisory space are either M&A brokers or industry players who get their information from these brokers. And like real estate agents in Levitt’s research, M&A brokers can make more money by selling firms quickly, so they can move on to the next sale.
Yet wouldn’t a quick sale be best for the selling advisor(s), too? Not really, because advisory firms sell most quickly when you sell them to one buyer.
But how else would you sell an advisory firm?
Over the fast few years, firm owners (along with their objective consultants) have made an interesting discovery: Many prospective buyers don’t want all of the advisory firm’s clients. That is, most buyers are interested in high-net- worth clients with a lot of assets under management and relatively few other complications.
While they may take a selling firm’s other clients, they usually don’t value them as highly and want to pay less money for them.
However, an increasing number of savvy business owners have started to rebel against this “second class” client system and have sold their businesses a different way.
That is, they are dividing up their client bases on the front end into groupings of large clients (typically over $2.5 million in AUM), middle-market clients ($350,000 to $2.5 million) and small clients (under $350,000).
They also can separate out specific “niches” that certain buyers have an interest in: doctors, engineers, corporate executives, young clients, clients close to retirement, clients in retirement, etc. This way they can bundle their similar clients together and sell them as a group to a buying firm that does value them.
It’s a clever strategy that seems to be flying under the radar so far.
In fact, many firms that are selling their clients in segments are finding that the sum of the parts is greater than the whole. That is, when you add the different segments up, they are selling their firms for more — often a lot more — than they would have received from selling their firm as a whole.
The firm owners who have pioneered this strategy have eliminated the inefficiency in the market that sells all firms and all clients as if they are the same. Owners also can work directly with buyers and eliminate the broker fees.
It’s a grassroots system that Steven Levitt might be proud of.