There was a lot of discussion about regulatory issues at the recent MarketCounsel conference in Las Vegas, which is not surprising since MarketCounsel is a compliance consultant and law firm. But, interestingly, the biggest buzz had nothing to do with legal issues; from the podium, and in the audience, we heard that merger and succession activity has picked up dramatically in the RIA space.
"We have seen it in two contexts," Cory Kupfer, MarketCounsel's director of entrepreneurial services, told the audience. "A growing number of firms are looking to grow through acquisition, and there are a lot of succession deals that are starting to happen after many years of a lot of talk and not a lot happening. The last 12 months has seen the most active interest from our client base in acquiring or being acquired. The market is as hot as I've ever seen it."
Later, he added that the biggest impediment to this trend was "unrealistic expectations and valuations."
A spreadsheet born of necessity
Roger Pine, a principal with Briaud Financial Advisors in College Station, TX, has created a tool that addresses some of these valuation challenges – and it may have come at exactly the right time for the profession. "A lot of times, in these [succession or purchase] negotiations, you find that one side or another anchors on a final number of what the firm is worth," Pine says. "Suddenly, the negotiations become very emotional around that number."
The alternative, he says, is to bring in an investment bank – which not everybody can afford, and which may provide a number without giving both sides a clear understanding of the assumptions behind it. And there are times when the valuation happens to produce the exact number that the firm principal – who is writing the check – believes is correct.
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Pine experienced this dynamic personally when he and his wife Natalie purchased a majority interest in their advisory firm from Natalie's mother, who founded the company. Both sides wanted an objective purchase price that would be fair to both sides, and they were surprised at how poorly the rule-of-thumb metrics (i.e.: 2.1-times recurring revenues or 10-times profits) satisfied either side.
So Pine decided to dig deeper, and ideally analyze the purchase of shares the way he would evaluate any investment that he was recommending to clients. "I'm an engineer by training," Pine says. "So I'm drawn to getting into the numbers."
He put his skills to work and created a spreadsheet with multiple inputs, which is now an open-source document that any advisor can download and apply to his/her succession or acquisition situation. (You can find the spreadsheet here; look for the "Generic Valuation Model" file about halfway down the page.)
The spreadsheet is ideal for a founder and successor to work on together, but it is interesting that the successor can come up with some pretty good revenue numbers even without the help or cooperation of the owner, since most of the inputs don't require the owner to open up his/her books and records. "If you work at the firm, chances are you know the fee structure and how many dollars the firm has under management," says Pine. "You can see most of the revenue side of the equation, and create reasonable ways to project it out based on the firm's past history."
The spreadsheet lists the individual clients, their assets under management, the fee structure (retainer and AUM rate) and their ages. The spreadsheet asks you to make assumptions about the number of new clients that the firm will bring in each year, average assets per new client, average annual investment returns and annual assets lost through client attrition. The total-retainer-revenue-per-year calculations can extend as far into the future as you want, although Pine says that the distant out years don't make a lot of difference to the final valuation. A life expectancy calculation for each client is pulled directly from mortality tables that are included in another page of the spreadsheet, and there are assumptions about when clients will start de-accumulating their assets in retirement.
The numbers can be different for each client, which allows the spreadsheet to account for clients who are grandfathered under old fee structures, or children of clients who may fall under a different pay schedule.
The first output is an estimate of the total annual revenues for the firm going out 25 years (if you want to forecast that far into the future). On the expense side, you can look at the current numbers and extrapolate an annual growth rate.
Of course, when you start digging into the expenses, the selling advisor would have to trust the process enough to open his/her books. The key number here is how much the selling advisor is taking out of the business, which could become a negotiating point when shares are sold and purchased.
Couple the revenues and expenses, and you get the gross profit margin or cash flow for the business projected forward, which is the key metric to creating a valuation. Using that number, you use a discount rate – the annualized return the buyer would ask for on the investment given the risk associated with it – to calculate the present value of the firm. "Given the fact that the ownership shares are illiquid, what kind of yearly return would I want to expect?" says Pine.
The critical assumption
In his own negotiations, Pine found that discount rate is by far the most important input in the model. It was also the hardest to arrive at, since it doesn't come out of the books and records of the advisory firm. "That is the hardest thing you have to negotiate," says Pine. "A little tweak makes a huge difference of hundreds of thousands of dollars, so you have to find an expert who you trust who will give you a number you aren't going to argue over."
In their own case, Roger and Natalie called Mark Hurley of Fiduciary Network and Mark Tibergien of Pershing Advisor Solutions, and asked them for a fair discount rate for buying an established advisory firm. "They said 20% and 25%," says Pine, "so we split it down the middle and used a 22.5% discount rate for the model."
Sellers, of course, will push for a lower discount rate, which leads to a higher valuation. Financial theory, when applied to corporate valuations, argues that the discount rate in excess of the risk-free rate (which is currently near-zero) compensates the buyer for risk. A 22.5% discount rate implies very high risk and extreme uncertainty in the reliability of the projected cash flows, but also recognizes that this may be the dominant investment in the buyer’s “portfolio” for many years to come. A shrewd seller might argue that a more appropriate discount rate would be no higher than that of the lowest-rated high-yield bonds, which would imply a discount rate of less than 10%.
Working through a spreadsheet together offers several advantages for the buyer and seller. For one thing, it makes the negotiating process less emotional. "It's a lot easier to get to an agreement," says Pine, "when you're negotiating around what the inputs should be into the valuation model. Instead of talking about the gross value of the firm, you talk about: What life expectancy do you think we should use in the valuation? What is the average fee that clients pay? How many clients do we expect to bring into the firm each year? What is the attrition rate? What do we expect the average growth rate to be in the markets? What is the average accumulation rate of the clients, and at what age will they start de-accumulating? Many of those numbers come straight out of your records," Pine continues. "So you can move toward a relatively non-emotional discussion that leads you to a final number."
The process also highlights any red flags that might be hidden if an investment banker is plugging numbers into a black box to give a valuation. Are most of the clients paying one-off fees that are lower than the standard fee structure? Are the clients older than expected? Do the new clients coming into the firm tend to be retirees rather than accumulators? Are retired clients de-accumulating their assets at a higher rate than the successor might have anticipated?
Finally, Pine says that the exercise helped him better understand the mechanics of the firm he was buying, which have made him a better owner. "It gives you a lot of information about the business you're going to be investing a big chunk of your life savings in," he says.
For instance? "When we started, we were assuming that we were going to achieve 8% annual growth," he says. "The number looked right and matched up with the company's history. But," Pine adds, "when you break out where that 8% comes from – investment returns, new client acquisitions, new money saved and invested by the accumulating clients minus any decumulation – it turns out that once you reach a certain size, if you are going to get meaningful growth from client acquisition, you have to start bringing in incredible numbers of new clients."
Suppose an advisory firm has $500 million under management, projects 5% asset growth from new clients and the average client has a $1 million portfolio. "Look at the future numbers," says Pine, "and suddenly you have to bring in several clients a month just to stay on the same growth track. It made me rethink some of the growth projections. Once you get to a certain size, unless you bring in more wealthy clients, your growth is going to have to come from the investment returns."
Pine was also surprised to see how low the spend rate for retired clients was, overall. "When we pulled the data, it turned out to be less than 4%," he says. "They are really not de-accumulating at all; they're holding their ground."
Advancing the profession
Ever since Pine made the spreadsheet available to the advisor community as an open-source document, he's gotten requests from advisors who are impatient with the rules-of-thumb, and tell him they are looking for a better valuation model that anybody can use. He has invited advisors to tweak it, improve it, and send him ideas and suggestions.
"On the first page," he says, "I lay out a list of upgrades that are ready to go if someone wants to tackle them." The list includes adding ways to capture hourly fees and figure out how to model them as recurring or one-off; and some way to calculate fees for new clients under a tiered pricing structure. The average age and longevity of new clients is also not yet captured; the spreadsheet assumes that new clients will stay with the firm, on average, for 20 years.
Meanwhile, he is now actively creating an advisory board which will not only provide input into the spreadsheet model, but also take on more complicated tasks, like creating an open-source matchmaker service for potential buyers, sellers and merger partners. "All we have today are proprietary gated ways of identifying those firms," he says. "It seems to me that the associations could offer this service as part of your membership, the way I have a job board for employee candidates.
Not everybody will rely on this tool or other spreadsheet models which may emerge – there will still be a place at the table for the investment bank, funding organization and legal counsel if and when a transaction takes place. But Pine's model offers a way for thousands of advisors and successors to educate themselves about how valuations work, start the negotiation process and along the way get some insights into the future of their firms as the buyer or successor might view it. "Hopefully, we can start some deeper conversations about valuations than what I, personally, have seen so far," says Pine. "A lot of people are starting to get serious about thinking about these issues, and this could be a place for them to start."
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