Some of the revenue your firm generates may not be worth much in an acquisition. Certain revenue, in fact, may actually reduce your valuation. If you’re thinking about selling or merging at any point in the future, you need to be sure you’re generating the “right” kind of revenue and you may even want to rethink the business lines that create the “wrong” kind.
It’s all about risk. The M&A market loves revenues that are both recurring and stable because the risk of those revenues continuing (or not) is easy to measure. At the same time, the market severely discounts non-recurring revenues because of the unpredictability of the future cash flows. And the market clearly despises revenue from sources that shade client trust and fiduciary relationships due to regulatory and litigation risks.
Here’s a short guide to “good”, “bad”, and “ugly” revenues in the wealth management business:
Good Revenue
The “Fee-Only” model – in which advisors are compensated directly and exclusively by their clients – continues to produce the gold standard in wealth management revenues. And, advisory fees tied to the level of assets under management command the highest valuations in the M&A market. Why? The fees are recurring, they automatically increase as the market goes up or clients deposit more assets and history has shown that Fee-Only firms with this type of billing arrangement have almost stunningly low rates of client departure.
In fact, whenever you hear a story of a buyer paying an extremely high multiple of cash flow for a wealth manager, rest assured that the seller was “Fee-Only” and had lots of AUM-based fees.
Other revenues that are likewise recurring and somewhat stable but not quite as attractive include:
• Retainer Fees – Single negotiated fees for a full range of services (investment management, financial planning, tax, etc.).
• Family Office Services Fees – In addition to AUM-based investment management fees, some firms also charge for services like bill payment, property management, various concierge services, etc.
Bad Revenue
1. Trading or Product-Based Commissions – Some firms call themselves "fee-based" to describe (or euphemize) a hybrid of trading and sales commissions with AUM fees. It’s a model most often used by brokers or advisers who are affiliated with a B-D.
Commissions are the economic equivalent of a “sugar high” for wealth managers in that the near term cash flow may generate an immediate rush of pleasure but the long-term negative impact on valuation is likely to leave you feeling irritable. From an acquirer’s perspective, commissions are pretty close to worthless, in part because they are non-recurring and in part because they create a structural conflict of interest between advisor and client that jeopardizes the future stability of client relationships.
2. Trailers – Some mutual fund share classes charge investors ongoing 12b-1 fees for shareholder services, which in many cases clients don't even know they are paying. While the fees are perfectly legal (though available only to those with a B-D affiliation), they are non-recurring. As soon as a client sells a fund with 12b-1 fees, the advisor loses the related revenue stream. Furthermore, trailers create a structural conflict of interest by giving advisers an economic incentive to favor certain mutual funds or share classes over others.
Ugly Revenue
While buyers place little or no value on non-recurring revenues, any business activities that are not clearly in the best interests of an advisor’s clients will LOWER the price a buyer will pay and even may scare buyers off. Examples include:
1. Shareholder Servicing Fees – Recently, we have come across a new scam in which some “Fee-Only” firms have found a back door method to skim fees off of their clients’ mutual funds – in some cases, as much as 0.25% of client assets invested in "no transaction fee" funds.
Ostensibly the payments are made in exchange for shareholder support services provided by the RIA. But in reality, the advisor is doing nothing but getting paid more at the expense of its clients. The arrangement is deceptive and creates an awful conflict of interest (it gives the RIA economic incentives to invest more client assets in funds paying the kickback).
Advisors may hide behind the technical “legality” of the payments. However, it’s a regulatory time bomb and at some point the SEC is going to catch on. Furthermore, even if the arrangement is legal, good luck convincing a buyer that you always act in your clients’ best interests if you claim to be “Fee-Only” but also receive product-based fees.
2. Double-Dipping on Asset Management or In-House Products -- Many wealth managers try to boost their revenues by getting into the business of creating their own in-house investment products (mutual funds, limited partnerships, hedge funds, private equity vehicles, and so on). Ignoring whether wealth managers are genuinely qualified to create these products (generally not, we’d observe, as it’s a completely different business with completely different competencies), in-house products create unavoidable conflicts of interest if advisors either:
• Double-dip on the asset management fees (i.e. charging an AUM fee on all assets under the advisor's discretion and also charging a second fee on the portion of the client's assets invested in the in-house product will bias an advisor in favor of using the in-house product in lieu of a third-party manager), or
• Charge a higher fee on the in-house product (i.e. charging "2 and 20" on a hedge fund product gives the advisor a strong incentive to continue to move more and more of its clients' assets out of the standard portfolios, on which the advisor likely charges 1% or less, and into the hedge fund).
A wealth manager may be able to fool some of its clients with these revenue boosting product strategies some of the time. Buyers, however, know that at some point many of a seller’s clients will figure out they are getting shafted and, inevitably, head for the exit.
Think Like A Buyer
If these conclusions sound extreme, put yourself in a potential buyer’s shoes. In an M&A transaction, buyers try to measure future earnings only; what you might have made in the past is completely irrelevant. Again, the analysis is all about risk. Stick to your business lines generating stable, predictable cash flows and abandon those that are responsible for non-recurring fees or otherwise create conflicts with your clients.
Ben Robins & Steve Cortez are partners at Fiduciary Network, which provides funding for financial advisory firm transfers.