Before the coronavirus gave the market a cold, consultants say that advisory firm valuations had reached nosebleed levels.

Andrew Altfest, whose firm Altfest Personal Wealth Management has been tentatively seeking merger targets, said that in many cases the firms he was looking at were often too rich for his blood. “It has to be a fair rate of return to buyers to compensate for the amount of time and investments, and I think some of the valuations were high.”

But now the calculus has changed with the coronavirus, the market downturn, self-quarantines and the shutdown of much of the economy. Those RIA firm valuations are going to come down.

“I believe this sudden and aggressive down move in the markets exposes the vulnerabilities of most RIAs, particularly smaller RIAs,” said Matt Cooper, the president of Beacon Pointe Advisors, a Newport Beach, Calif., firm that’s in acquisition mode. “Most [firms] bill as a percentage of AUM, and with asset prices falling across the board, RIAs are [going to see] an almost certain drop in revenues. Because a large percentage—my guess is well more than 50%—bill quarterly in advance, we are a week away from pegging values for [second quarter] billings and revenues.” (Cooper made the comments last week, as April 1 loomed.)

The owners paying advisors a fixed salary “are shouldering all the risk of the reduced revenues,” he said.

But just as the stock market decline itself leads to opportunities (if you are in the position to buy), so too do reduced valuations for RIA firms. One silver lining: Junior staffers are now in a better position to buy into the firms they have helped build, say consultants, because lower revenue means lowered valuations.

“A second silver lining is that the loans for these purchases—the interest rates are going to be better, that’s another benefit,” said David DeVoe, whose firm DeVoe & Co. consults with advisors on M&A activity. “The third thing is the shock to the system will hopefully jolt many advisors into putting these plans in place. We’re still an industry that has 70% of advisors that do not have a written succession plan.”

But consultants say the process must be thought out carefully. DeVoe said he recommends separating equity from compensation. There’s a reward for labor and there should be different rewards for being shareholders.

Philip Palaveev, a consultant with the Ensemble Practice, said in mid-March that a healthy firm that’s profitable with good teams won’t have trouble going through the crisis, especially if they hold onto relationships with clients. Firms with little debt, good capital reserves and 25% profit margins are going to be in better stead to get through the crisis, he said, as they got through the crisis of 2008. But he said advisors very often don’t look at their own P&L sheets and that’s going to make it hard when revenues decline.  

Palaveev said it would be tempting, but a mistake, to use the capital cushion if times get tight for advisories trying to pay their bills. However, he said it is a more defensible use of capital reserves to help partners who are buying in by making disproportionate distributions or to make a second loan to them.

“Many of you are exactly in that position where you have borrowed money to buy the equity of the firms … and if that’s the case you’re looking at a difficult personal situation,” Palaveev said in a webinar on March 18. “The partners who have borrowed money to be owners of this business are very often your top contributors, your rising stars. … And we can’t really let them suffer too much. … We can’t ask them to spend every dollar and every cent trying to hold on to an equity position. It won’t work very well for them and it may create a disastrous situation between the firm and its owners.”

DeVoe said that after the financial crisis, valuations for RIA firms fell from their pre-crisis highs and took a few years to come back. “Multiples of cash flow had expanded into double digits for large firms,” he said. But cash flows are likely to compress and nobody’s sure how long that will last. For those advisors who were hoping to sell, deal structure, including the down payment, is going to be more important than valuation. “Rather than wait around for two or three years … let’s structure the deal so that you’re able to grow and grow even faster, run a better business within the shelter of [an acquirer’s] tent.” If you’re selling to a sophisticated buyer, he said, one that has calculated the ways it can help you grow, those firms will pay for a higher valuation than a neighbor firm down the street.

Cooper said that even though lower valuations can help junior staffers buy in, it’s a difficult call to make.

“In general, founders do not want to buy themselves out, at a discount, with their own money," he said. "This means they don’t want to carry the note, take a significant discount on the price because it’s a minority purchase or the buyer claims their ‘sweat equity’ is what helped create the value, then have the note serviced by the cash flows attributable to the equity purchased, which they would have collected anyway. The icing on the ‘I don’t like this deal cake’ is if the founder is forced to carry the note, they are doing all the above and carrying 100% of business risk they carried before the transaction.”

He also said that junior staffers are not likely the risk-takers that founders are and may not want to go out to get a loan to buy a minority stake in a risky business. The pandemic has shone a light on firms that aren’t actually growing, he said.

“Most small firms weren’t growing beyond the market for the last several years anyway," he said. "This market pullback has the potential to expose a lot of firms that weren’t adding new clients and weren’t adding new AUM attributable to new clients.”