Advisory firm owners have unrealistic expectations about what their firms are worth.
Sales of RIA firms usually are done based on a multiple of cash flow, but owners and founders often overestimate their free cash by forgetting to factor in the cost of their replacement, according to a white paper released today by the Alliance for RIAs.
“Smaller entities have to take into account the replacement cost of the owner,” said John Furey, founder of Advisor Growth Strategies LLC and a consultant to aRIA.
And unrealistic price expectations by a seller “may ultimately turn into a deal killer,” the paper said.
Owners of advisory firms also can be misled by reports of large transactions, such as the purchase last year by First Republic Bank of Luminous Capital Holdings LLC for $125 million in upfront cash, Mr. Furey said.
The all-cash deal for the $5.5 billion-in-assets Luminous led to speculation about the apparent large multiple, Mr. Furey said.
But advisers need to “look underneath the hood to see what really drives value,” which in the Luminous case was its growth rate, he said. Luminous reached $5.5 billion in assets, from $1.5 billion, in four years.
Size also matters when it comes to valuations, the white paper argued, because larger firms have more services and a deeper talent pool with which to retain clients after a sale.
The paper warned about the tendency to make back-of-the-envelope valuation estimates. Nevertheless, values are generally three to 10 times EBITDA (earnings before interest, taxes, depreciation and amortization), or earnings before owner's compensation.
Buyers tend to apply a big discount rate — 20% or more — on their calculations of the present value of future cash flows because advisory firms' revenue is linked to the vagaries of market performance, client needs and the ability to manage expenses in good times and bad, the paper says.
The illiquid nature of an RIA firm, and the fact that its value is all goodwill, contributes to large discounts, Mr. Furey added.
Advisers can maximize the value of their businesses by increasing profitability, growing faster and reducing risk to future cash flows, the paper said.
Risks to future profits can be reduced by having more diverse sources of revenue, such as family office services or tax preparation, as well has having more staff who can retain client relationships, Mr. Furey said.
The alliance is a group of top advisory firms that study practice management issues with a focus on succession planning. Its founders all are on the acquisition trail and believe smaller advisers need to merge with larger firms to create enterprise value.