Interest rate increases could decrease the value of advisor practices in the same way they reduce the value of homes, Greg Gessert, LPL vice president of strategic business solutions, said at the company's Focus conference.
“My personal feeling is that values are at their peak,” he said.
He offered advice on how to best do a valuation and made observations on the deals LPL is seeing.
Gessert also gave reasons for why advisor practice values may go down:
Interest rates – Rate hikes often reduce the value of homes. As the price of borrowing goes up, Gessert believes the prices of practices will also go down.
Supply And Demand – With the increase in seller supply from the large wave of advisors that will be exiting the industry in the coming years, it can increase competition and ultimately lead to discounts in overall valuations.
Lower Client Lifetime Value – “As clients age, you will expect the value to go down,” said Gessert. To counter this realization, advisors need to recruit the children of clients and make them clients.
DOL Ruling – There will be a likely shifting of the incentive base. If compensation is being pushed forward in a "level load" manner, it pushes out the revenue, which lowers the present-day value. Gessert explained, if you take money that you think you were going to make today and push it out three or four years, the discounted rate will lower the current day value. For some, the potential changes might even eliminate types of revenue.
Lower Velocity – As advisors get comfortable with their financial situation and phase into retirement, the value of their practice naturally declines. “Typically, some of the older advisors would use A shares," he said. "Younger advisors have a higher return on assets because they more likely invest in fee-based programs. It is good to know you are continuing to invest in your business.”
John Napolitano, chairman and CEO of U.S. Wealth Management, one of the fastest growing LPL firms, believes valuations are changing right in front of our eyes. His opinion is that there are too many advisors ignoring the important task of finding a successor, even if it is only a contingent successor.
These same advisors are blindly walking around thinking that their practices are worth ‘X’ times revenue, he said. They also feel that there are throngs of advisors lined up to bid up the price under any conditions. That is not the case, he said.
Do Not Rely Only On Multiples To Get A Value
“No business is exactly the same, so you have to look at things that drive cash flow,” Gessert said. For that reason, he does not love the multiple approach to valuations. However, of the 140 closed transactions that LPL has assisted with over the past 36 months, they are averaging 1.6 times trailing 12-month revenue, which includes every revenue mix there is.
Multiples, like price-to-sales and price-to-cash flow, or comparable sales (akin to comparing a home value to other house sales in similar neighborhoods) should really only be used as a starting point.
Gessert gave the example of Facebook and LPL Financial having the same revenue, but Facebook having margins that are five or six times as high. Nobody would expect them to sell for the same value.
Absolute Vvaluation Methods Are Better To Use
Gessert talked about “cost to develop,” where one looks at the comparable cost to develop the same revenue stream. However, he noted that the “discounted cash flow (DCF)” is their method of choice.
Because of the time value of money, the future revenue needs to be discounted to what it is worth today. Gessert suggested asking, “What does each dollar of revenue in the future equal today?”
This approach starts by discounting the treasury yield (2.6 percent), the equity risk premium (6.7 percent) and small business premium (11.6 percent). In other words, the starting discount rate is about 21 percent. Then cash flow quality and transition risks get factored in.
Revenue and cash flow quality are levers that can also play a role in determining the value. For example, recurring revenue is going to sell at a premium. Client demographics also need to be looked at, as older clients will have to be discounted. Gessert said the typical range of clients ages has been between 50 to 70 years old in the deals he sees. Finally, expense structure and historical and projected growth have to be factored in.
Transition risk is also something to be considered. For example, client tenure can matter. Deal structure and terms make a difference, just as if the sale is being done internally or externally. If it is the same broker-dealer or custodian, that can make things easier, although LPL will sometimes provide incentives in the form of a forgivable note to bring on new relationships that can possibly help pay for the entire down payment. Lastly, client concentration risk and post-closing assistance from the seller can help with the valuations.
Other Advice And Observations
Most of the deals LPL has seen are sold as an asset sale (generally a sale of a client list.) The reason they are not sold as a business or entity is because the long-term buyer can be open to liability risk.
Retention rates are good, he said. “Thankfully we haven’t seen many below 90 percent. At the low end we saw 60 percent. We saw one at 150 percent retention. That advisor found client accounts in other places. We usually see 95 percent within the broker-dealer, from advisor to another, because in most cases it is a block transfer of accounts or a one-page amendment of an advisory agreement, so it is really not a repapering of the account.”
It can most likely improve retention if the existing advisor stays out. This “sell and support” approach separates the business ownership and the business involvement, and reduces the retention rate risk.
Of the 140 closed transactions that LPL has assisted with over 36 months, the average GDC is $357,000, with an average sale price of $570,000.
Also, 25 percent of the deals were all cash, where because the money was up front, the buyer got a cash discount. Thirty-three percent of buyers made a down payment of the total deal price in the form of a cash payment, while two thirds financed.
Looking To Find A Firm To Do A Deal With?
Gessert recommended pulling up all the reps in your neighborhood. He said he is seeing only a third of advisors with succession plans, stressing that everyone should have one.
LPL has three teams that all play a role in helping advisors with these issues: acquisitions, succession planning and strategic business solutions. “We see 200 to 300 valuation requests a year,” Gessert said. He encouraged the advisors in the room to take them up on the service as it is free of charge for LPL advisors.
Mike Byrnes is a national speaker and owner of Byrnes Consulting LLC. His firm provides consulting services to help advisors become even more successful. Need help with business planning, marketing strategy, business development, client service and management effectiveness? Read more at ByrnesConsulting.com and follow @ByrnesConsultin.