The price of advisory firms is about to go up-big time
Advisors who want to sell or buy a firm now have a
host of financial heavyweights lining up to assist them. Sending
shockwaves through the profession in May was the news that
Houston-based Sanders Morris Harris Group, which is headed by former
Prudential Securities chairman George Ball, agreed to buy Edelman
Financial Services of Fairfax, Va., in a multi-tiered transition that
could reach $128 million.
But it wasn't the only big deal that has been consummated in the last 12 months. During that period, Wachovia Wealth Management purchased Tanager Financial Services, a firm that manages $2 billion in Waltham, Mass., and Compass Bancshares acquired Houston-based Stavis Margolis, which oversees $500 million. Mellon Bank seems to keep acquiring several portfolio management-oriented firms every year, while concerns like Boston Private Financial Holdings, Lydian Trust Company and Focus Financial, an affiliate of Summit Financial Group, reportedly are scouring the business. Some reports even claim that The Pottruck Group, a private equity firm formed by Charles Schwab & Co.'s ex-CEO, David Pottruck, is looking at the advisory business.
Bigger advisory firms like Edelman's may be commanding most of the attention and the big multiples, but they aren't the only ones being romanced. At virtually every level, size and scale of the business, an owner can find many prospective buyers for their firm, practice or book of business.
There is both good and bad news for firms on this cusp, depending on how they position themselves, says David Grau, president of Portland, Ore.-based Business Transitions LLC, whose firm helped advisors sell 183 businesses last year. The best news is that there has been desirable price improvement for advisory firms. The average sales prices for small shops (less than $3 million in revenues) rose in 2004 after slipping in 2003, Grau says. As a result, the average small practice sold for $426,000 in 2004, a 35% increase over the average sales price of $315,000 in 2003. Several experts expect those prices to keep rising.
Edelman told Financial Advisor he had more than 40 firms interested in buying his business. Even a solo practitioner with a more modest book of business can expect that 15 or 20 suitors will at least want to kick the tires.
The bad news is that all but the very large and profitable firms are being sold at prices that are far more attractive for the buyer than the seller, which partially explains why the number of potential buyers dwarfs the number of sellers. But over time, the market dynamics are likely to change in favor of sellers.
Mark Hurley, a senior advisor with Denver-based investment bank Headwaters AB, and a consultant with JP Morgan Asset Management, describes this phenomenon as adverse selection. "Right now you have a market that's not clearing," he told attendees at a JP Morgan conference in May. "There is a big gap between the bid and the ask price." In early July, Hurley and Sharon Weinberg, managing director in charge of JP Morgan's advisory business, will issue a report on the state of the industry.
There is such a "yawning chasm" between what most sellers and buyers think is a fair price that few deals get completed. Although Business Transitions assisted in consummating 183 transactions last year, most experts believe fewer than half of all proposed deals get done. And while giant corporate mergers are often negotiated in a few weeks-the Time Warner-AOL deal took three weeks-selling an advisory firm can take from six months to two years.
Rebecca Pomering, a principal of Moss Adams in Seattle and a consultant for many mergers of advisory firms, says that even when negotiations reach the due diligence stage, about two out of five deals fall apart. There are three primary reasons: 1) the economics of the deal wasn't what the seller thought was represented; 2) the seller can't provide adequate information about the future potential of the client base; 3) the longer the transaction is discussed, the more likely differences of opinion about valuation are likely to surface.
Like Hurley, Pomering thinks that valuations for successful firms are likely to appreciate over the next five years. But there's an ironic twist here. "We tell people considering the sale of their firm, and asking how to increase value, to build a business that doesn't have to be sold," she says. "It's the firms that have a strategy and vision in place, that don't have to be sold [because of the principals' ages], that are the ones that will get high multiples."
Hurley believes that valuations for the best advisory firms will climb significantly from the current level of five times EBIT (earnings before interest and taxes) and that many advisory can double their EBIT by 2010. Do the math and that means the value of a firm could triple in the next five years. And at that point their value should start to more closely approximate that of the enterprise. "A large public entity like National Financial Partners, which has insurance agents, third-party benefits providers and financial planners, trades at 14 times EBIT," he notes, adding that the investment advisory business is probably a more attractive business than the others thanks to the recurring character of fee revenue. "Once an advisory firm gets to a certain size, it doesn't lose a lot of clients and it has a very predictable cash flow, like a mutual fund company. That's very valuable."
One reason why prices remain modest is that few strategic buyers have yet to appear on the scene. Indeed, Sanders Morris Harris, the firm that bought Edelman Group, is a strategic acquirer with a clear-cut vision, which helps why they are willing to pay more than a legacy buyer (the firm's employees), the typical financial advisor seeking to grow by purchasing rivals' clients or a financial buyer trying to find an arbitraging opportunity between the private and public markets. "Even if the multiples go from five to seven or eight times EBIT, there's still a siginificant arbitrage," Hurley says.
He argues that most strategic buyers have avoided the advisory business because they are convinced that most advisory firms are not big enough to bother with. "At some point they are going to realize just how hard it is to build an advisory firm," he adds.
Strategic buyers typically have a different psychology and a vision of the business that goes far beyond economic calculus. "Big multiples will also go to firms that have their own strategic vision," particularly if it dovetails with the strategic buyer's or puts a new weapon in their arsenal, Pomering says. In the case of Edelman, it was able to bring Sanders Morris Harris into the mass affluent market, where before it had a greater presence in the high-net-worth arena.
Over time, it is quite possible that the advisory profession will start to be dominated by 150 to 200 larger firms that control over slightly half the entire industry's assets under management, in much the same way that drug store chains control over half of all prescription sales in a market once dominated by independent pharmacies.
But size alone won't determine the value of a firm. The quality of the client is just as important. "What would you rather buy: A firm with 40 clients averaging about 40 years old with $80 million under management or a firm with 200 clients averaging about 75 years old with $80 million in assets?" Pomering asks. "That's why it's meaningless to talk about average multiples like 2.1 times revenues. Some client bases are depleted oil wells. Value is a function of the future. What is this business worth going forward."
Eventually, barriers to entry to this business are likely to rise. Geography is likely to become a driving force behind many deals. That means a small firm with an established position in a mid-sized market, say southwestern Oregon or Winston-Salem, N.C. half way between Charlotte and Raleigh, could become a lot more valuable than a firm of similar size with much more competition in southern California. "Even some firms with profits south of $1 million could be worth a lot because they are in good markets and they can be re-engineered."
Restructuring a firm means examining how it operates, how it's managed and how it can be run more efficiently. "The biggest obstacle to making most financial planning firms is getting the owner out of the way," one consultant argues.
Sadly, owners of many smaller firms probably would be much better off financially if they were employees of larger firms. But that requires the proprietor to engage in a considerable reckoning with his or her own ego. "It's great to be king, even if it's Liechtenstein," remarks Hurley, who sold his own nascent mutual fund company to JP Morgan in early 2004.
But even owners of large firms face a conundrum when contemplating the sale of their firm. Take Edelman's case. He received $12.5 million to sell a 51% interest in his business and could get as much as $128 million if the business hits certain targets over the next four years.
The potential variance in the total amount of this deal may be unusual but the structure is not. After all, this is a business where the firm's largest assets walk out the door every night.
Virtually all acquirers purchase financial planning firms in several stages, both to protect themselves and to provide the principals of the acquired firm with adequate incentives to remain as productive as possible. And it's not unique to financial advisory businesses. When Allianz bought Pimco Funds several years ago, there were published reports that Allianz gave star bond fund manager Bill Gross the opportunity to earn several hundred million in bonuses if he stayed at Pimco and maintained a predetermined level of performance.
For financial advisors, this so-called "earn-out" component of any deal makes selling a firm a serious gamble, since more than half the total payout may come after the firm is sold. This is particularly true if the acquirer is a financial buyer. To date, only one acquirer, Jessica Bibliowicz's National Financial Partners, has succeeded in acquiring enough firms to go public, and she has focused more of NFP's efforts on estate and insurance planning firms and benefits administrators than on financial advisory shops.
From all reports, owners of firms that were bought by NFP are quite happy, but an advisor talking with another financial acquirer should be well aware of the risks involved. First, there is no guarantee that the acquirer will reach the levels of profitability and critical revenue mass to do an initial public offering (IPO). Second, a seller must hope that the equity markets will be receptive to financial services IPOs when they do reach those levels.
In many instances, a financial buyer tries to acquire a firm by purchasing a controlling interest of, say 60%, in the business in return for cumulative convertible preferred stock. This can mean, among other things, that if the profits of a firm making $1 million a year when the deal is signed dip below $600,000, the buyer has a claim to their $600,000 a year before the advisor sees a nickel.
The biggest risk for advisors is that the financial buyer is unable to go public and they are forced to sell to another financial buyer who uses the situation to dilute all the prior acquirees. "Buyers know advisors are getting older and they are selling comfort and liquidity for a very high price," Hurley says. "But unlike strategic acquirers with a vision, financial buyers add no value and they are hardly immune to market risk."
Financial buyers, usually private equity firms, are hardly stupid. But they are playing the game with someone else's money, not their own. Consequently, their downside risk often is a lot lower and their pain threshold is frequently much higher than an advisor who has spent 30 years building a firm, which represents their largest single asset.
Strategic buyers, like financial buyers, don't want to run your business, but they do have a vested interest in its strategic direction and how it can be integrated into the rest of their firm. As a result, they are willing to overpay, particularly for a deal that can enhance an IPO's marketability beyond simply contributing to additional mass.
Over the next five years, the most common transaction will be the legacy acquisition, in which younger partners and employees buy out the firm's founders. Experts expect these deals to be characterized by lower risks and lower multiples, since sellers can structure transfer of control on more favorable terms in and the buyer knows all the firm's strengths and weaknesses. In many instances, the founders may be able negotiate an ongoing part-time role for themselves that provides a source of both income and fulfillment well into their golden years. Many people didn't go into this profession for money, and they won't get out for it, either.
"D" Shannon thought he was in love. He'd found
Craig-the perfect buyer for his Warrenton, Va., advisory firm,
Stonewall Asset Management LLC. Then along came a new suitor with both
a bigger wallet and bigger promises. But I'm getting ahead of myself.
Who is D Shannon? He's just another guy who bounced around our industry looking for a way to make a living. After stints as a less-than-successful fee-only planner and then a hugely successful life insurance salesman, Shannon finally settled down as a fee-based advisor with Securities America. He built a very saleable business grossing between $450K and $600K a year-depending on the amount of effort he cared to expend. In mid-2003, that's exactly what he decided to do ... sell his business. Shannon needed to make time for his next career: speaking and writing.
Initially, he tried finding a buyer on his own. "First, I tried selling to Brian, an advisor with a fledgling practice who I met at Dan Sullivan's Strategic Coach program."
Both advisors moved to a common broker-dealer to make the merger go more smoothly. "Brian then came to me to learn how I did marketing," says Shannon. "I had prepared a Gantt chart showing what and when he needed to do things." The day after Brian left Shannon's office, he didn't call Shannon, but sent a fax saying, "I'm not doing this. I don't want to move forward." Says Shannon, "He saw all the hard work it would take to build the business and he backed out."
While all of this was going on, Shannon had brought in a CFP named John to run things day to day so he could focus on negotiations with Brian and beginning a writing and speaking career. When things fell through with Brian, Shannon offered the business to John. "He knew many of the clients, and I was only asking $300K, but John said he didn't want to buy." In retrospect, Shannon realized this was probably for the best, as John proved to have an excellent employee mentality but doubtful entrepreneurial skills.
Shannon knew he'd seen an ad or article somewhere about a group facilitating practice sales. "I turned to Mary, my assistant, and asked, "Who was that Business Transitions person we heard about?" Shannon contacted David Grau at Business Transitions LLC in Portland, Ore., to see what he needed to do to prepare his business for sale.
"It was April, and Grau said it would take about three months to find a buyer and consummate a sale. So I decided to give myself a mid-July deadline by which I'd show up at an NSA [National Speakers Association] meeting and announce that I was a full-time speaker/writer," adds Shannon. He put together all of the paperwork describing his practice in a "due-diligence notebook," sent a copy to Grau (who loved it, saying it was the best he'd seen) and Stonewall Asset Management was listed for sale on April 14, 2004.
As Grau expected, Shannon got some inquiries the same day he listed and, ultimately, received a total of 32. In the first week of May, Shannon started culling down his list. "Jeanie at Business Transitions would make the calls to the lesser-qualified saying 'forget it ... no hard feelings' while I eyed each prospective buyer using the referability rules I learned in Strategic Coach: Do what you say you're going to do, say please and thank you, finish what you start and show up on time," says Shannon. These simple rules helped him separate the casual from the serious, like the young man who was to have met with him at 11 a.m. one morning, only to call in at 2:30 p.m. to say he was stuck in traffic.
"I wanted people to know this was a business serving real people in a rural setting. A litmus test would be if the prospective buyer were uncomfortable not wearing a coat and tie," says Shannon. He found the right person in the form of Craig. "Craig grew up an hour away from me in Waynesville, Va., went to William and Mary, where he studied personal finance, and had run a $2 billion money market fund. Plus, he was a good guy."
Craig offered nearly what Shannon was asking for Stonewall: A down payment of 35%, a short-term earnout, and close to Shannon's full price of $600,000. "He said that if I sold to him, he'd even throw in his Porsche Boxster," says Shannon, who's own classic Mustang and Woody weren't getting driven enough as it was.
In addition to Craig, two other particularly excellent buyer prospects came out of the woodwork, although Craig was still the favorite. Just when it looked like Craig was the winner, one more came along: we'll call him Ernest. "I was all ready to shut down the auction and sell the firm to Craig when I suddenly got an offer from this Harvard-type in Beantown. He said he'd be down tomorrow and he came as announced. I showed him around, answered all kinds of questions and then took him back to his hotel," says Shannon.
Ernest soon returned to Shannon's farm, where Stonewall is located in a building separate from Shannon's residence, and said "What would it take to turn this auction to red?" which is Business Transitions lingo meaning get it off the market-close the deal.
Says Shannon, "I knew I had Craig's offer to fall back on, so I asked for the most aggressive terms I could think of: full price, a 50% down payment, and a promissory note for the remainder. Ernest called back and said 'done.'" And that's when all the fun started.
If you ask Shannon what ultimately went wrong with this deal, he'd say two things. First, "Having a deadline by which I wanted to be out was useful for organizing my thinking, but it created an inflated sense of urgency for me to accept an offer," says Shannon. Second, his and Ernest's personalities couldn't have been more different, as he was soon to find out.
What's the big deal with personalities? Ernest's money was as green as the next guy's, right? Herein is a little-understood fact about buying and selling advisory practices: You don't just sign the papers and walk away. If you're the seller and you want to maximize client retention, you plan on working closely with your buyer for at least a year.
Now, the more discerning reader will say, "Yes, but Shannon was getting a promissory note from this guy; he didn't really have to stick around." True, but he still had a contract that stipulated when and how he'd get paid on the note. What if Ernest perceived, accurately or not, departures from the contract by Shannon? Might he withhold payment? He might and he did.
But I'm getting ahead of myself again. Closing didn't take place when it was supposed to. "We got to the middle of June, I hadn't received the purchase documents I had expected some time earlier, and then they came on the morning of the revised closing date. By this time, he'd violated my rule of 'do what you say you're going to do,' and he was well on the way to violating the rest."
What Shannon received were the legal documents provided by Business Transitions ordinarily needing only minor customization, but which Ernest's attorney (a trust and estate man) had completely reworked. "I called Grau and said I couldn't make sense of the revised documents," says Shannon. He then called Ernest and said he couldn't sign the documents because he didn't understand them. Yet, Shannon finally gave in and negotiated off Ernest's revised documents when, he now acknowledges, he should have insisted on doing the deal from Grau's original documents or not doing it at all.
The personality issues really surfaced when Shannon and Ernest decided to have a "meet the new partner" party for Shannon's clients. It took the form of a luau held on Shannon's farm. "It was like a wedding where the in-laws hate each other but everyone has a @!%$-eating grin on his face," says Shannon. "I wanted to grip and grin and catch up with clients about their latest vacations. Ernest wanted to talk to them about mutual fund expense ratios."
At any rate, the party was held, the crowd finally dispersed, and Shannon prepared to get down to the business of transitioning clients. Ernest had other ideas. "I talked with Ernest about hitting the ground running, but weeks went by and I heard nothing. Then I got an e-mail from him saying he was in Connecticut playing golf every day and studying for his Series 7. This went on for five weeks. And just when I thought he was done vacationing and ready to get down to business, I found out he was in Hawaii."
During this time, Ernest's first check to Shannon bounced. "When I brought it up to him, he said, 'No big deal, I'll put the funds in my account.'" Ernest didn't make good on the check until the end of August, according to Shannon. Future payments were delayed when Ernest balked at meeting certain expense-sharing requirements of the contract. "For example," says Shannon, "he didn't want to pay the bank charge for the check he'd bounced."
Business Transitions counseled Shannon to take the high road. "I was getting nickeled and dimed," says Shannon, "and finally said to Grau, 'If he wants to fight a paperclip war, tell him to pack a lunch.'" Shannon told his assistant to do the best she could responding to Ernest's demands for expense data; he was going to get started writing a book and no longer wanted to be bothered with Ernest.
Perhaps the real losers in this whole scenario, though, were Shannon's clients. He still gets calls from old clients saying things like, "Ernest is pushy, impolite and arrogant. I don't get a good feeling from him. I want to work with you. If I can't work with you and don't want to work with him, is that going to cost you money?"
Says Shannon, "I'm always going to regret turning my clients over to someone with so little desire to maintain and nurture client relationships."
Final lessons from Shannon? He's got three: "I got a great deal on paper, but the big print giveth and the small print taketh away. Just because you're selling doesn't mean you won't be involved. And when in doubt, don't!"
David J. Drucker, MBA, CFP, a financial advisor since 1981, sold his practice 20 years later to write, speak and consult with other advisors. Learn more about his books at www.daviddrucker.com.
As members of the first generation of
financial planners retire from their practices, they are looking for
ways to transfer their firms in a way that suits them best. Fortunately
they have many choices, both inside and outside their firm.
They can sell to a fellow partner or an ambitious employee. They can even open up the field and take advantage of a thriving open marketplace to find the best-qualified person or firm. Many employees want to step into the role of business owners themselves, but in a crowded field of suitors, they must look for ways to stand out so that they will be competitive when the time comes.
Being ready at the right time requires smart choices and preparation along the way-actually, many years in advance, like five years or more. Think of it as a long-term plan that sets up the conditions for success. Although luck can play a role in helping things along, making the right decisions and investing in your own intellectual and financial resources can create the right conditions for luck to flourish.
Pick The Right Employer
It all starts here. Suppose you have made good grades in school, have effective and efficient work habits, understand every nuance of investment theory and customer service, and yet still have no chance of buying your employer's business. Where is the fairness in that? There is none, but you have to face that prospect and not flounder when it happens to you.
The problem may be not with you or your employer per se, but rather with your employer's perception of the potential match between you and their clients. In the end, it comes down to economics. If they do not see you as a good fit, or not capable of being their equal, they will think that their clients, and any future payments they would receive, will evaporate as soon as they leave. Considering that about two-thirds or more of the value they will receive from the sale will come from payments after closing, you never will be seen as a viable buyer as long as your employer holds that view. The risk could appear even greater for the employer if the employee cannot come up with the competitive one-third down that a partner or an outside buyer can produce.
Of course, their perception could be completely wrong. Employers have been known to make a mistake from time to time, but that perception is everything in this circumstance. So here is the first major decision you will make. Do you spend the time and effort changing the employer's perception of you, or do you move on?
If you decide to stay, be prepared to move toward the qualities that your employer thinks are essential for the client match. In short, be prepared to emulate your boss. If that is beyond your ability or your endurance level, it is time to look elsewhere. Every minute you stay past that realization will a complete waste of your time, unless you are learning something valuable that you can use later.
Many people are disheartened when they realize they are in a dead-end job. Don't be. Just consider it a test of your resolve. Instead, spend that time finding a better professional match for your personality and skill set.
Be one of the few employees who attends broker-dealer, custodian or professional organization meetings and conventions-spend your own money on it if you have to. The attendees are virtually all business owners. Take your vacation time, if necessary, because it is a wonderful opportunity to choose your employer instead of the other way around. By being proactive, the momentum is going in your direction as you meet them in a neutral setting; assess their style and their likelihood of selling in your timeframe. If nothing else, you will learn more about what it takes to own a practice just by listening to and engaging in the conversations around you.
Practice Owning Your Own Practice
If you were to ask many employers how or when they got their first clients, you will find out there is always a good story there. Frankly, many got them while they were working for someone else. There is no better training than to own and handle every aspect of the client relationship. From the initial prospecting to the nuances of the relationship, including the late-night panic calls about the drop in investments, the experience will teach you more about owning your own practice than will any textbook.
Owning your own clients is also a good test to see if you really want to do it. Someone once said that the best thing about being self-employed is that you can work any 18 hours of the day you want. This is hardly an exaggeration when you are truly committed to the course. But the level of satisfaction that comes from the accomplishment can hardly be exaggerated, too.
Some employers may not like the idea that you have your own clients. They may tell you that you cannot do that and still work for them. If they do, find another employer not threatened or intimidated by this, because that firm will be a better match for you in the end. If you want your employer to sell his or her practice to you, he or she must perceive you as an equal or at least a potential equal. Saying, "I have already created my own client base," implies that you can handle theirs, too.
Employers are also more likely to sell at least a portion of their own book to someone who has already shown the ability to handle their own-no matter how small it is. Few things will enhance your confidence in yourself, and your stature in your employer's eyes, than this one thing. If things do not work out with your employer, this confidence can take you places of your own choosing.
Getting The Down Payment
Down payments for practices selling in the open marketplace typically run in the range of 30% to 40% or more. For example, a practice selling for $250,000 will command a down payment of $75,000 to $100,000. It may be very difficult, to impossible, for an employee to come up with that much money. You may still have student loans that you are paying off, or you may also be trying to save for a house.
The money only goes so far. If you can, do not spend the money you earn on your own clients, and just live on your salary. This additional amount of capital could make you very competitive just when you need to be.
In spite of this considerable hurdle, you can leverage your insider relationship with the employer to give you the edge over the outside buyer. After all, the employer knows you and your abilities, and you have many years' head start over an outsider. They may perceive that client retention will be better with the inside sale, thus lowering their risk in the deal. Employers may even overlook their own economic self-interest and agree to sell to you with a lower down payment or a longer payout because they may see it as their personal duty to mentor the next generation.
Either way, it could work to your advantage. But do not rely on it or think you have an entitlement to it. Nothing will kill a deal quicker from an employer's point of view than to see an employee with their hand out and their nose in the air.
Have a backup plan that will raise as much capital for the down payment as possible. After all, you do not want the reverse going on, where the employer thinks you must be forever indebted to him or her. Be frugal with your money and keep your eye on your long-term plan. Know how credit works, and then maximize your access to it.
Here is an example of a simple technique that can help you increase your ability to come up with the cash and do a bootstrap deal when you need it. Take cash advances on various credit cards and pay the service fees for the advance. It is a small but necessary price to pay for what it can do for you later. Take all of that cash and put it in a bank for a month or two.
Go ahead and make the minimum payments during that time, and then turn around and pay off the credit cards after a few billing cycles. Repeat this periodically to build up a record of accomplishment. This kind of transaction velocity will improve your score and raise your credit limits. If you implement strategies such as this consistently, you be able to raise the capital you need when the time comes to buy.
The right employer, the experience and confidence you get from your own client base, and solid access to capital are the three most important tools you will need to realize your dream of owning your own practice. Do not rely on sitting back and thinking you will just inherit your employer's practice, because it may not happen. Take an active role in your future and you will increase your chances for success. Just as you tell your clients about A shares, if you make your payment up front, you will get more in the end.
And once you have been successful, the rewards of ownership will be well worth the effort. This next generation of financial advisors is better educated in the technical aspects of money management and investment theory. On paper, they are bigger, better and faster.
Still, it is important to remember that schooling is only one component for success. Grit and gumption are still at the heart of making the American Dream come true. The pioneers of the industry are looking to reward those who understand the true cost of the dream. The rest is up to you.
William Grable, CPA, is president of
Business Transitions Publishing Inc. and consults with financial
advisors on internal succession and external transition strategies for
their practices. Please visit www.businesstrans.com or call (800)
934-3303 for more information.