Advisory firm valuations are dropping

Falling markets are cutting firms' revenue tied to AUM at the same time rising interest rates are making it more expensive for buyers to finance deals.

The dramatic increase in the value of wealth management businesses over the past several years has come to an end. Firms aren’t worth what they were even one year ago, and prices may continue to fall in the near term.

There are two main factors causing this.

First, almost all advisory firm revenue is tied to assets under management. When markets go up, so do the revenues derived from the fees that advisers charge clients. Other than the short-lived March 2020 bear market caused by the Covid lockdowns, most asset classes have experienced a steady increase in value over the last decade. Even for firms that weren’t adding new clients, the markets have been a tremendous revenue tailwind.

But over this past year, the markets have experienced declines in virtually every asset class, leaving even the most conservative and highly diversified portfolios with losses. And of course, this has translated into less revenue for advisory firms.

And unlike businesses that get paid based upon transactions, such as selling widgets or mortgages, an adviser’s workload doesn’t decline when revenues ebb. In fact, it’s just the opposite. Financial advice is needed more when markets are down, so the workload increases just as revenues decline, which makes it difficult to contain expenses.

Secondly, the cost of borrowing is much more expensive than it was one year ago.

Many of the consolidators in the wealth management and financial advice business have used debt to pay for the firms they’ve acquired. As a result of the Federal Reserve’s loose monetary policy, it’s been inexpensive to borrow.

This year, the Fed has been raising rates at a rapid clip. Not only has this resulted in higher interest rates on the outstanding loan balances of the consolidators (most of these loans are variable), but the spread due for new debt is much larger than it had been as the credit market for loans has cooled.

This becomes a real challenge both for new buyers coming into the market as well as those established aggregators that want to borrow more money to continue acquisitions. Interest costs are now officially a prohibitive factor.

What we are beginning to see in the acquisitions market is multiple contraction. Firms that may have traded at 14 times EBITDA one year ago may not be able to find that multiple today.

So not only have earnings declined this year, but the multiple of earnings that buyers are willing to pay is coming down as well.

As a result of factors such as the advanced age of many advisory firm principals and the increasingly complex operations responsibilities involved in running a firm, we should continue to see deals being completed. But rather than a transaction with a large up-front check based on last year’s earnings, many deals will be structured with higher rollover equity, along with longer earnouts. The midrange upside to this is that it could allow the selling adviser to achieve a higher valuation should the markets fully rebound.

Scott Hanson is co-founder of Allworth Financial, formerly Hanson McClain Advisors, a fee-based RIA with $15 billion in AUM.