Value Drivers in an Advisory Practice

Friday, May 21, 2010 15:15
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Value Drivers in an Advisory Practice

One of the most important changes over the past two years in this industry, prompted by the Great Recession, is that practice value, or equity, has grown into the single largest, most valuable asset most advisors own. At the same time, our studies show that most advisors do not understand what they’ve built or, how to transfer it, value it, or protect it.  It’s time for that to change.  Let’s continue our discussion of practice value and valuation methods.

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What creates value in a financial advisory practice? 

 

At its most basic level, the value of a practice lies in its client relationships. In the earliest phases of the open market for financial service professionals, most, if not all, of the value rested in the client base and their ensuing revenue, and nothing more. Even the language of the day referenced this characteristic, referring to the sale of an advisor’s “book,” rather than as a sale of a business or the practice itself. In this context, the supporting structure of services and staff, as well as other licensed professionals, were considered of secondary importance to the cumulative assets under management waiting to be transferred to another caretaker.

 

Valuation techniques have now evolved to the point of assessing the cash flow potential of a practice’s client base, as well as the risk elements in transitioning that client base to another advisor or business. But new valuation techniques factor in more than just the clients and their revenue, adding infrastructure to the equation – the number of licensed employees who remain through a transition, the nature of the referral channels, and the degree of technology in the practice. In other words, current valuation methods explore the business elements as well as the details of the client base to ascertain a value.

 

This approach mirrors exactly what is now happening in the evolving financial services marketplace. Astute and experienced buyers are seeking out advisory practices that have evolved business structures – and are paying a higher multiple for these businesses.  The buyer-to-seller ratio at the end of the first quarter of 2010 was approximately 48:1.   (It is a very competitive marketplace, but still more akin to eHarmony for financial advisors than eBay – I’ve never seen an auction on our site for a seller’s practice.  It is always about the “best match.”)

 

This market behavior points to a subtle, but important, distinction that is emerging with regard to what is being valued. Previously, it has been assumed that, for small-to mid-size financial service practices, the value was closely tied to the clients. But the higher multiples being paid for more sophisticated business platforms suggests that certain operational elements, such as licensed employees, strong branding, a market niche, and office systems, are of increasing value in the market.

 

This is no surprise for larger well-established wealth advisory firms. The market has always paid handsomely for these businesses. Now it appears that small businesses that mirror the durable and robust organizational structures of their larger brethren may also enjoy values that are significantly higher than the value received for simply transferring clients.

 

Recent expansion of the prices paid for small-to mid-size financial service practices (those with less than $2,000,000 in annual GDC) have drawn concern from some industry observers, who have expressed the opinion that the values being paid may be a “bubble” and that values may not be sustainable, particularly in a market downturn.  But multiples paid for practices with an established and strong business structure have proven to be quite durable in the face of the most recent market turmoil. In addition, buyer activity, as measured by the number of inquires on these larger practice, listings has shown a steady increase when these practices are listed on an open-market basis.

 

This suggests an alternate explanation for the higher prices being paid. The next generation of investment professionals, as buyers, is beginning to recognize the additional value of having an established operational structure – a real business rather than just a list of clients.  These higher values may reflect that buyers are valuing and coveting practices, which they believe are better structured to thrive and grow and increase in value in the young, but rapidly evolving, independent financial services industry.  If these buyers are right, it creates some profound implications for financial practice owners, as well as their broker-dealers and custodians.

 

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