NFP has no real estate or subprime exposure, but analysts have modestly reduced their 2008 earnings growth projections. While that might seem hardly significant to warrant a 50% plus drop in its market capitalization, this equity market is hardly rational, particularly when it comes to financial services concerns. NFP has also indicated it will seek to acquire firms with $20 million in earnings in 2008, but Eliot Holtz, executive president of marketing, adds the holding company is willing to be opportunistic if more compelling situations present themselves. In addition, NFP's cash flow, $160 million last year, makes its acquisition strategy self-supporting, he adds.
The traditional holding company model calls for acquirers to purchase small businesses at a certain price-typically four or five times operating earnings before interest, taxes, depreciation and amortization (EBITDA) for a significant equity interest in advisory firms. NFP, for example, typically pays five or six times cash flow for 50% of a firm's cash flow, with about 70% of the price paid in cash and the rest in restricted stock. In a few cases, a larger, highly profitable firm might get slightly more. Sources say Boston Private is willing to pay higher multiples for very large high-quality RIA firms.
Then, the holding company bundles more than 50 or even 100 firms together-which is no easy feat-attempts to achieve modest economies of scale, and takes the consolidated company public at a much higher multiple, say, 10, 12 or even 15 times EBITDA. If the stock market is accommodating, this arbitrage creates a win-win for acquirers and acquirees.
When it comes to future acquisitions, holding companies face a new issue thanks to the sinking market for financial services stocks. One year ago before the credit markets collapsed, financial multiples were heading north, with some acquirers saying they might pay eye-popping prices of eight to ten times EBITDA for high-end advisory firms. In light of the market-cap meltdown for financial services stocks in the intervening 12 months, some of this math no longer computes, simply stated. The higher the multiple an acquirer pays for businesses with few brick-and-mortar assets, the longer it takes to amortize the hefty amount of goodwill it takes on with each acquisition.
Both NFP's and Boston Private's public shares now trade at about six or seven times trailing EBITDA, so at least for now, the win-win arbitrage is vastly compressed. This cuts two ways. Today, if you are a target company the low stock price may look attractive. But if you sold your firm several years ago and your restricted shares recently have vested and can be sold, the timing isn't great compared with vesting 12 months ago.
When an inside shareholder can sell usually depends on when they got in, and the private equity firms typically put up the initial capital and get out first. For instance, Apollo Group, which ponied up the seed money for NFP, was able to sell much of its position when the stock's cash flow multiple was in the mid- to high teens.
It's also important to remember that to consider going public in a better IPO environment than the present, a holding company needs to have EBITDA of at least $35 million. Today's punishing markets might be even more demanding. Private equity firms typically commit capital for five to seven years before they seek an exit strategy. So if a holding company can't reach critical mass over that period, advisors could find that a major chunk of their firm has been sold to a new private equity firm-and advisors won't get to pick their new partner. Whoever offers the old private equity firm the most probably will take over.
Moreover, if the few companies that have succeeded as holding company vehicles and actually amassed enough volume to become public entities currently face the prospect of buying advisory firms for prices that are quite close to their own publicly traded shares, it's not a propitious harbinger for the others that are trying to buy advisory businesses right now and go public down the road. For the time being, many traditional exit windows favored by private equity players are boarded up.
In the regional banking world, the problem isn't an exit strategy; it's surviving the current credit crisis. Several bank acquisitions of RIA firms have been spectacular successes, at least from a financial and asset growth viewpoint. Since Harris Bank acquired Sullivan Bruyette Speros & Blayney of McLean, Va., in 2003, assets have nearly tripled from $700 million to $2 billion. The same holds for Miller/Russell & Associates of Phoenix, which experienced a greater than threefold increase in assets from a $500 million level when it was acquired by Western Alliance Bancorp. in 2004. According to several observers, Pacific Capital Bancorp.'s purchase of Morton Capital Management in Calabassas, Calif., was a huge home run for the bank. While the principals reportedly have participated in their firms' growth through earn-outs and profit-sharing, some might well argue they sold too early and too low.
Determining the fair value for small private businesses is a very difficult task. Just look at a transparent industrial giant like General Electric, which traded at 40 times earnings in 2000 and now trades at 13 times earnings after doubling profits in seven years and performing very well. Some say it's as much art as science, so establishing the right price for private, illiquid advisory firms is an even greater crap shoot.