Prognosticating on practice values

A variety of complex factors, including aging sellers and choosier buyers, will affect asking prices

May 27, 2012 @ 12:01 am

By Joni Youngwirth

Where are practice values headed? That's a key question for advisers who are considering the purchase or sale of a practice. According to an article on InvestmentNews.com (“Good time to sell your firm, study shows,” Feb. 24), values continue to rise, albeit modestly. The average price for a practice sold in 2011 rose to 2.33 times recurring fee revenue, from 2.31 in 2010, according to FP Transitions LLP.

Of course, the multiple is just an initial estimate of value. The terms of the deal have as much or more of an effect on buyers and sellers as the multiple. Indeed, the 9% average earn-out arrangement cited in the article is a significant shift from 2010's 21% average, representing larger down payments and less risk to sellers.

While the overall climate seems promising, certain industry movements and trends are likely to shape practice values in the years to come. Let's examine a few of those factors.

AGING SELLERS AND CLIENTS

Clearly, advisers in their 60s are more likely sellers than those in their 40s. But 60-somethings are becoming notorious procrastinators when it comes to executing a sale. Take the adviser who has been talking for a decade about wanting to sell his practice. When he finally gets serious about it in his mid-70s, his clients have aged, as well. Multiples aside, he can't find a buyer because no one wants a book of 90-year-old clients.

As Mark Hurley, chief executive of Fiduciary Network LLC, warned in a 2010 story in InvestmentNews, the business is now “dominated by geezers,” with more than 60% of industry participants over 50 and the average age of an owner rapidly approaching 60. Cerulli Associates Inc. reported that the U.S. industry has shrunk from 314,000 advisers to 310,000.

We can only hypothesize how these facts will affect practice valuations. What will the likely imbalance between those exiting the industry and those entering it mean? How will the “pig in the python” baby boomer scenario play out in the financial planning field?

One theory is that buyers will become more selective, with more individualized criteria.

Some buyers will pay a premium to purchase a fine-tuned financial planning practice — one that has clear producers, investment models, defined roles and responsibilities for personnel, and so on. Such practices would be particularly interesting to advisers who hadn't developed an internal infrastructure themselves. Other buyers won't want to pay for infrastructure if they have their own.

Recurring revenue is valued higher using the multiples approach and typically is attractive to buyers. Some buyers would rather purchase nonrecurring revenue at a lower value and convert to asset management fees and recurring revenue.

Less discussed to date is the effect potential tax changes, such as an increase in the capital gains rate, might have. Could looming tax hikes prompt buyers and sellers to close deals sooner rather than later, or perhaps lead to bigger down payments?

SMARTER BUYERS

Here's one thing sellers can safely assume: Potential buyers are getting smarter. They will seek hard data about the firm and its clients. Above and beyond the percentage of recurring revenue versus commission-based revenue, they'll want to know the specific ages of households and the percentage of households with multiple generations as clients. Whether you're striking a deal now or plan to in the future, it's wise to start assembling the precise quantitative data that buyers will want.

Keep an eye on other trends, such as increased regulatory oversight, new business models and greater emphasis on managing a practice as a business. Add that to an increase in mergers and acquisitions, which has led to a higher percentage of multiadviser firms.

And even greater change may be on the horizon: According to some, technology will replace financial advisers in the not-so-distant future.

What will these factors mean for practice values? As Winston Churchill said, “It's always wise to look ahead, but difficult to look further than you can see.” Currently, we can see just a short window, perhaps three years. Practice values have been fairly stable, but there's no crystal ball for what the future may hold. While we can play “what if” indefinitely, the only sure thing is that regardless of age, every adviser needs an exit strategy.

Joni Youngwirth (jyoungwirth @commonwealth.com) is the managing principal of practice management at Commonwealth Financial Network.

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