Advisory firms’ value is tied to the market’s value

If you’re an adviser, hopefully you don’t recommend that your clients use leverage to juice returns. (Especially not your older clients.)

Yet many principals of advisory firms are themselves highly leveraged, and most do nothing about reducing that risk, even as they near retirement.

I’m not referring to leverage in the form of debt, but, rather, leverage in the way the value of the business fluctuates with the value of the markets.

Consider some basic math:

A financial adviser runs a registered investment advisory firm (or a practice affiliated with an IBD) with $100 million in assets under management. Assuming an average fee of 1%, the AUM generates $1 million a year in revenue. Let’s assume that expenses are $400,000 and the owner receives an annual salary of $250,000. This leaves the practice with net income of $350,000, or a 35% profit margin.

With the stock market again hitting all-time highs, many practices are reaching new highs in AUM as well. The 10-year bull market and subsequent AUM crest translates into increased fees for the adviser, so the advisory firm may be at a high-water mark for revenues.

Financial advisory firms are selling for top dollar in today’s market, in large part because there’s much more liquidity today than there was 10 years ago. According to a recent article on InvestmentNews.com, 31 registered investment advisers were sold in the first quarter of the year, with private equity a big player and with banks much more willing to finance transactions.

(More: Merger mania: Why consolidation in the RIA space is about to explode)​

In today’s market, the hypothetical $100 million firm referenced above could sell for four to six times its earnings before interest, tax, depreciation and amortization. Based on this example, and using a multiple of five times EBITDA, the value of the firm is roughly $1.75 million.

Where does the leverage enter in? Just consider what the firm might be worth if the stock market fell 30%.

If the firm’s assets are allocated 50% toward equities, this would translate into a 15% drop in AUM. But that 15% drop in AUM could equate to a 43% decline in the value of the practice. Why? The firm’s top-line revenue would decline $150,000, which would reduce its net profit from $350,000 to $200,000. The value of the business would quickly fall from $1.75 million to $1 million.

Conversely, an increase in stock prices could have just as large an impact toward the positive side. Hence, the price of a financial advisory firm is highly leveraged to the market.

For advisers who are near retirement age, prudent financial planning would clearly involve looking for ways to reduce the risk of that leverage.

Fortunately, today’s advisers have options. They can sell a portion of their firm to financial buyers like Focus Financial. They can utilize an internal transition using bank financing. They can sell to strategic buyers like United Capital. They can sell to fully integrated firms like Mercer Advisors, or my own firm, Allworth Financial. Or they can continue doing what they’re doing and hope for the best.

These are boom times for advisory firms. But wise advisers should, at a minimum, run some scenarios with their own numbers to see the impact a market fall could have on the value of their practice.

(More: ‘Retire in place’ doesn’t cut it as a succession plan)​

Scott Hanson is co-founder of Allworth Financial, formerly Hanson McClain Advisors, a fee-based RIA with over $4 billion in AUM.