Both the stock and bond markets have been on a tear the past several weeks. While this has buoyed the value of clients’ portfolios, it has also propped up the value of wealth management firms.
With the exceptions of this year (2023) and last, the volume of M&A in the advisory space has rapidly increased over the past decade. But the decline of both the stock and bond markets in 2022, along with a tremendous spike in interest rates, caused a slight pullback in the number of deals completed over the last couple of years.
Because even a modest increase in the stock and bond markets can have a dramatic effect on the price of an advisory firm, it is my opinion that the recent spike in stocks and bonds will cause M&A to reaccelerate.
But specifically, how? Let us assume a firm manages $250 million and operates on a 35% profit margin. If we also assume a 1% management fee, that firm produces $2.5 million in revenue with a 35% margin, for expenses of $1,625,000 and a profit of $875,000.
A 10% drop in the value of AUM will reduce the revenue from $2.5 million to $2.25 million. With expenses remaining the same, the profit for the firm falls from $875,000 to $625,000.
On the flipside, a 10% increase in AUM will bump up revenue to $2.75 million. With no increases in costs to manage the business, the profit increases from $875,000 to $1,125,000. That 10% increase in assets managed results in an increase in profits of almost 30%.
Because one of the main drivers of business valuation is net profit, and profits are much higher than they were a few months ago, it is realistic to assume that the value of many advisory firms have risen 20%, or more.
We have had hundreds of conversations with owners of wealth management firms over the past couple of years and many would-be sellers had paused any transaction discussions due to the decline in the markets. Now that that we have experienced a solid recovery, many of these firms are open to discussions once again.
Another factor that has contributed to the slowdown in M&A has been high interest rates. Most, if not all, of the main consolidators in this space use some debt as a means of financing transactions. Interest rates have certainly had an impact on cashflow as many firms have found that their debt service is eating up all their free cash flow.
The good news on the interest rate front is that the Fed appears to be through raising interest rates. They are even now forecasting cuts next year. Whether or not a rate cut materializes, there is certainly a renewed sense of optimism for many firms involved with M&A.
Other tailwinds that have driven M&A are not going away. Advisers are getting older and closer to retirement. The business is becoming more complex. Clients expect more.
We are approaching a perfect storm, and my prediction is that M&A in the wealth space will set a record in 2024.
Scott Hanson is co-founder of Allworth Financial, formerly Hanson McClain Advisors, a fee-based RIA with approximately $16 billion in AUM.
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