Bear markets chip away at firm valuations

The current downturn in the financial markets is negatively affecting valuations of advisory firms. The question is, how will this impact the record number of mergers and acquisitions the industry has been experiencing?

Valuations of registered investment advisers, hybrid firms and solo practices have soared in the past several years for three main reasons: the rise of the broad stock market, low interest rates and an increasing number of private equity firms clawing their way into this space.

In a partial turnabout, a reversal of these first two factors is now negatively impacting valuations, while the third continues to provide a tailwind.

Practically all advisory firms receive the bulk of their revenue from fees on assets under management. Typically, as stocks have fallen, bonds and other assets have provided safe havens. That hasn't been the case this year. Just about every asset class has been whacked, which has pushed AUM values lower, resulting in lower fees and lower revenue.

Most firms do their billing on a quarterly basis, so it’s possible that the billing for Q2 wasn’t affected too significantly given that values were relatively high at the end of Q1. But unless there's some dramatic increase in values between now and the end of Q2, revenues will look ugly going into Q3.

One thing that's somewhat unique to our industry is that when our revenues decline, our workload increases. Clients need a lot more reassuring when markets are selling off than they do when the markets are moving higher. (Essentially, that means revenues are in decline while costs either remain fixed or even increase.)

For the past few years, most firms that have sold have marketed their “run rate” earnings, defined as earnings before interest, depreciation, taxes and amortization, or EBITDA; their earnings before owner's comp, or EBOC; or simply their free cash flow. The idea has been that buyers shouldn’t simply look at the previous annual results but should look at the current quarter’s earnings and project that into the future (perhaps with a growth assumption, as well).

What’s happening now is that firms are marketing themselves on historical earnings and are trying to explain away the current declines as market volatility. (This may work if the financial markets quickly recover, but if the markets either stabilize, or worse, decline further, historical performance will be irrelevant.)

Interest rates have risen a bit, but if they spike, as many believe they will, buyers simply won’t be able to pay as much for an advisory practice.

Private equity is still in love with the wealth management space, and I don’t expect that will change going forward. (There are currently more than 30 PE firms that have a stake in an advisory firm and many more want to get into this industry.)

There are other reactive arrows that sellers have in their quivers. If you would like to do some sort of succession deal in the near term, one way to minimize the impact of the financial markets is to accept some equity in an acquiring firm in lieu of cash. Because the acquirer’s valuation will also currently be lower, just like yours, you’ll be participating as the markets recover.

[More: The 4 key drivers of RIA consolidation]

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