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Bob Veres adds his bottom line to valuation debate started by Mark Hurley

If you build it, what will they buy it for?

Tuesday, March 15, 2011 – 12:30 PM by Bob Veres, Guest columnist
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Bob Veres: Hurley overlooks a key ingredient: growth.

Elizabeth’s note: RIABiz has compiled the entire Hurley-Veres debate about how to value RIAs on one page. You’ll see how two of the best-regarded thinkers in the business come at this critical issue from two different angles, Hurley suggesting that only a few wealth management firms have the wherewithal to build real value, and Veres saying that the market is prepared to pay for RIAs, and for good reason. Here is the link to the Hurley-Veres Valuation Debate. The exchange is mostly quite civil — but Veres wasn’t shy about pointing out Hurley’s potential conflict-of-interest, and Hurley shot back against that 'concoction.’ The following column is the first volley in their back-and-forth.

While members of the brokerage industry debate the merits of independence and owning their own firm, one of the most important variables in this formula is actively being debated in the independent advisor world.

How much is an independent practice worth when it comes time to sell it?

Before the debate began, the answer would have been a general rule of thumb—two to three times gross revenues, or roughly $20,000 to $30,000 for every $1 million of client assets under management—and then a stern caveat that some firms are more profitable than others, more efficient, more scalable, and therefore more or less valuable. These estimates, however, were more theoretical than experience-based. Statistics compiled by the Schwab Advisor Services show that astonishingly few advisory firms have actually been sold to an outside buyer in recent years; 20 in 2003, 24 in 2004, 52 the following year, 58 in 2006, and then the huge uptick, all the way to 81 in 2007, peaking at 88 in 2008, falling back to 71 last year. This year, we’re on course to break all records, perhaps even approach 100 transactions — out of an estimated 29,000 independent advisory firms.

Upturning conventional wisdom

For a broker who is thinking about going independent, these numbers are worth pausing over. If the rule of thumb is correct, then if you can manage to bring in $10 million of client assets a year under management in your independent advisory firm, that means, in addition to the revenues the firm is generating, you are also building yourself a future enterprise value of $200,000+ additional dollars each year, and the assets and future value of the firm will be growing (assuming competent asset management) somewhat faster than the inflation rate. But if the market for your firm is not as liquid as you were projecting, or not liquid at all, then a big chunk of the annual deferred compensation on your hypothetical balance sheet has just vanished, and the leap to independence looks a bit less attractive.

How likely is this? In a recent white paper, entitled “Creating, Measuring and Unlocking Enterprise Value in a Wealth Manager,” “Mark Hurley argues that only about 400 independent planning firms have any enterprise value at all—meaning they would be attractive to an outside buyer. See: What to make of Mark Hurley’s latest prophecy. Hurley is not totally without an ax to grind; he structures internal succession plans for larger fee-only advisory firms, and helps to fund the purchase by the next generation. But his point is that most advisors are taking, as profits, a little less than they could make if they did the same work for a bank trust department or equity manager. An outside buyer would have to hire somebody to take their place, and wind up with zero cash flow. Hurley asks the reader directly: How much would YOU pay for that kind of investment?

Later, Hurley casts doubt on the idea that advisory firms are scalable; too much of the client-facing work is one-on-one, too much of the investment work and financial planning is one-off. (You can find my own comments on the report in Financial Planning magazine: https://www.financial-planning.com/fp_issues/2010_8/the-equity-problem-2667980-1.html.)

The value of technology

Tim Welsh, writing in RIABiz, begs to differ, and makes a few excellent points, some of which relate to other variables in the “should I stay or go independent” equation. (See: Counterpoint to Mark Hurley study: Wealth management firms are in rapid transition). He concedes that many advisory firms, today, are not well-automated or streamlined, and they lack a scalable infrastructure to support growth. But he notes something that I also talk about in my recent Future of the Profession white paper: the custodians who support independent RIAs have been creating increasingly powerful technology platforms, and — perhaps motivated by margin compression during the recent market downturn — advisors are increasingly setting aside their mistrust of getting too deeply in bed with their custodian, and starting to incorporate these workstations into their practices.

This has created something of an arms race in the custodial world, a virtuous circle where more investment in technology leads to better recruiting for assets, and also helps advisors become more efficient gatherers of assets, which leads to more custodial revenues, and provides incentive to keep investing in helping advisors become more efficient. Welsh says that the newest custodial workstations rival the capabilities of Wall Street, and in fact they may soon move definitively past the brokerage systems. Pershing’s NetX360 platform is moving toward becoming something comparable to Apple’s iPhone “app” store—creating a programming environment for vendors and even advisors to write helpful, time-saving applications that all run on a common, easy-to-adopt interface, potentially unleashing a new round of creativity in the programming community.

The point here is that, well, yes, maybe a lot of advisory firms are currently inefficient and unscaled, but that seems to be changing, and it was always a matter of choice. Choose your technology wisely, think through your systems and procedures, delegate effectively, and understand the difference between profit and a salary, and you should be able to create enterprise value at or very close to the old rules of thumb.

Should you sell to an outside buyer at all?

Or could you? The debate continues on the pages of the Inside Information newsletter, where Roy Ballentine, an advisor in Wolfeboro, N.H., notes that advisors may be systematically getting higher valuation estimates from outside experts than could be justified in the actual marketplace. Ballentine is a member of the esteemed 20/20 Group, a study group whose members are some of the largest, most successful advisors in the country. Recently, he created a two-day presentation on the general subject of succession planning. He brought in two attorneys with expertise in valuation of wealth management firms, shareholder agreements and dispute resolution processes. One of their main points is that all the incentives are behind giving the founding advisor a high valuation number.

To see why, consider the soon-to-retire advisor who plans to sell the firm to his junior partners. He goes to an investment bank. The investment bank takes careful note of who is paying its fee, and who will benefit from a higher figure. If there is an outside transaction, the investment bank will receive a higher fee if the sales price is higher. Is this set of incentives likely to generate a low-ball figure? Ballentine says that tweaking some of the variables—like assuming steady growth when we all know there will be setbacks like the Great Recession, and assuming steady increases in profitability when we all know there will be times when you have to invest in the firm—can make huge differences in the final number.

In a different Inside Information article, Philip Palaveev suggests that the whole idea of selling to an outside buyer may be flawed. Palaveev is the former Moss Adams consulting executive who wrote its annual “Compensation & Staffing” and “Profitability” reports, now president of Fusion Advisor Network, a BD in Elmhurst, N.Y. Based on his consulting experience, he believes a better model can be found at other service firms. Accounting and law firms don’t sell to outside buyers; they build value for their principals when the junior partners buy them out in an endless succession process. Advisory firms, he suggests, should follow the partnership/internal succession model that has worked so well for other service professions.

So what number should you plug into the “stay or go independent” equation? Just because some advisors view their salary as their profit margin, that doesn’t mean you have to make the same mistake. Palaveev and Michael Kitces, publisher of The Kitces Report, both point out that a well-run independent advisory firm should be able to operate at 25% margins — or more — and better technology should allow that number to rise gradually over time. Just because many advisory firms aren’t managed to that level doesn’t mean that you won’t give this issue your full attention.

A new bottom line

Beyond that, there’s the opportunity for growth. This is a key ingredient missing from Hurley’s report, but it should not be overlooked if you’re moving from a declining sector (brokerage) to one that is capable of attracting new business with zero marketing effort. Independent RIAs represent the fastest-growing segment of the financial advice marketplace.

An internal sale at one times revenues means that every $10 million of client assets under management you bring in the door equals an additional $100,000 in the value of your firm (which can be viewed as deferred compensation until retirement). At that price, the buyers would be getting an asset with an annual return of 25%—plus ongoing growth. Based on published multiples, that valuation may ultimately prove to be too conservative.

But until we know more—until there are a few more transactions to set the price, or the debate that Hurley has started is resolved—you’re probably better off being a little skeptical of the hype, and basing your decision on a number that might someday surprise you on the upside.

I welcome your comments. Please post them here on the RIABiz discussion forum and I’ll try to reply.

Bob Veres is publisher of Inside Information, the information service that reliably helps independent advisors become more effective, efficient and successful. His Future of the Profession white paper can be downloaded, at no cost, at: https://www.bobveres.com. He last wrote for RIABiz in this column: Bob Veres’ vision: Scalable, multi-partner RIA firms will be profitable and powerful enough to beat the wirehouses, published last July.

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Roger Hewins

Roger Hewins

March 15, 2011 — 3:31 PM

Bob is making a lot of sense. As we go forward I suspect the much maligned revenue multiple will become respectable again, as we all recognize how volatile EBITDA can be and will probably be.

Two key issues:

1. the internal transfer is a great way to go, and has been overlooked in most of the analyses until recently. It was assumed to be impossible because the price would be too high, but like law firms and CPA firms we can execute gradual transitions over extended periods of time.

2. pricing – a one time sale to the big bank is not really a good comp for internal transfer pricing, when you are selling to the people who are making the business successful. A more conservative price makes this a viable strategy, and you can infer that some part of the “discount” is indirect comp for the people who become your Principals. It is not a gift or a mistake, it is an excellent plan for succession and success.

I will go out on a limb and put some numbers out there. I am interested in what other people are seeing and thinking. Revenue – 1 is too low, 2+ is too high. Perhaps 1.6? EBITDA multiples – 5 too low for a good firm, 10-12 too high for internal transfer. 7.5?

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