--- FOR IMMEDIATE RELEASE ---

Transcription

1 --- FOR IMMEDIATE RELEASE --- TIBURON RELEASES UPDATED RESEARCH REPORT ON TRENDS IN SUCCESSION PLANNING, FIRM VALUATIONS, & THE GROWING ACQUISITION MARKET FOR FINANCIAL ADVISORS -- Report addresses the different valuation methods, declares discounted cash flows to be the best method, and introduces key value drivers which impact the valuation of an advisory firm -- TIBURON, CA, August 2, Tiburon Strategic Advisors, a research-based strategic consulting firm serving the brokerage and investment management industry, recently released an updated version of its research report on Trends in Succession Planning, Firm Valuations, & the Growing Acquisition Market for Financial Advisors. In this report, Tiburon details transactions that have taken place and offers analysis on how and why certain mergers and acquisitions succeed. In this particular release, Tiburon addresses the issue of valuations, always a favorite discussion topic and often a transaction stumbling block. In short, valuations go beyond financial statements; sellers should not focus solely on the price generated by multiples, as there are many other value drivers (e.g., revenue composition, corporate structure) that can cause a valuation to fluctuate. In any case though the average valuation for an advisory firm is $650,000, with a median that is closer to $450,000. Discounted cash flows is the best model to value a firm; multiples of cash flows are the next best model (the average cash flow multiple is 3-8x); revenue multiples are appropriate if only the clients are being bought; and a percentage of assets multiple is really never appropriate. While knowing how to value the firm is very important, equally important is positioning your business for sale. Long ahead of time, sellers should institutionalize their processes and benchmark their operations. Sellers need to put together a very clear, concise picture of their client base the assets, the fees, past client communications, and a description of each client. Also sellers should anticipate the buyers questions and they should paint the house before the sale. Average Valuations One study claims that the average advisory firm sold was sold for $650,000. This number has actually been on the rise. At the end of 2000, the average valuation was at $500,000, while by the first quarter of 2001 this number rose to $650,000. This is reported to vary by region, with firms in the Northeast selling for the highest prices at $674,000 while the average practice in the Midwest and in the North Central part of the United States sells for about $100,000 less, only receiving about $575,000. This divergence is quite substantial. Higher values in the Northeast and the Southeast appear to be due to the concentration of highly populated areas in which many of these practices are located. One Study Claims That the Average Advisory Firm is Now Worth $650,000 $500 Average Value of an Advisory Business ($ Thousands) 4/23/01 Investment News (Business Transitions); Tiburon Research & Analysis $650 4Q/00 1Q/01

2 Despite the market correction, the market for advisory firms remains strong. While values may be off 1-10%, this is not substantial given the run up in values over the past decade. Also, some believe that now is a better time for buyers, since sellers revenues are down and the possible client attrition has happened. Furthermore, some advisors are less excited about the business now than they were which again provides businesses for sale. Another source argued that the recent market correction has had a dramatic but surprising effect on the value of advisory practices. The recession is not pushing values down across the board as you might expect but rather reversing a fifteen year trend by eroding the relative value of fee-only practices; this is supported by an FP Transitions report which shows that fee-only practices fell in value to 1.9x revenues at the 3Q/01, while values of commission only (1.1x) and fee-based (1.7x) practice values were substantially unchanged. Some believe that buyers, acting out of a combination of ignorance and confusion, may be paying too much to acquire firms while others believe deals don t make sense for sellers. Those who argue that the buyers are the losers in transactions claim that sellers will always want to use rules of thumb because these guidelines tend to inflate the purchase price, and do not tend to recognize volatility, attrition in the book of business, and the future economics of the practice. Those who argue that sellers are the losers claim that potential sellers may be figuring out that they are the losers and not selling but instead just scaling back their businesses. Valuation Methods There are several different valuation methods used in buying and selling financial advisory practices. We strongly believe that some methods are clearly better than others but we will describe all of these in some detail. There are three different multiples that can be used to value a financial advisory practice: multiples of assets, revenues, and cash flows. Also a discounted cash flow analysis can be used as a way to value a business; Tiburon believes that this is the most appropriate way to value a practice. Two other conceivable valuation methods are book value and return on investment, though neither is really used in this industry segment. Revenue Multiples Unfortunately, many still like using a multiple of revenues. One study we found, showed that still more than a third, 36%, of firms used multiples of revenues to value a practice. 17% of firms used a percent of assets and 15% used a multiple of discounted cash flows. Another 14% used book value and 9% used ROI to the buyer. This seems to imply that many of the buyers are still fairly uneducated about how to value practices. Unfortunately Many Still Like Using A Multiple Of Revenues ROI to Buyer 9% Book Value 14% Methods Used to Value Firm (Percent) Other 9% Multiples of Revenues 36% Our own telephone research showed that multiples based on revenues are the most common way advisors buy practices. Of the advisors we interviewed, all utilized a multiple of revenues to value the practices Multiple of DCF 15% Percent of AUM 17% 2/6/02 HD Vest Conversation (Klein); 5/99 Financial Advisory Practice (Downer & Co.); Tiburon Research & Analysis they bought or sold. While under normal circumstances this is generally not an advisable way to buy a practice, the one exception is when the only aspect of the practice being purchased is the clients. In this case, all you need to evaluate is the revenues since you will not assume the costs of the seller s business. As far as most practitioners we interviewed, they were in this situation where they were 2

3 only acquiring a book of business. In fact, 70% of buyers buy the book of business, not the business itself. Using this revenue multiple methodology, two-thirds of advisory businesses are sold for one-to-two times revenues. One study broke down the revenue multiples of transactions that have taken place. This study showed that 15% of firms sold for 1.0x revenues, about two-thirds sold for between 1.0 and 2.0x revenues and the remaining 20% of firms sold for over 2.0x revenues, with some firms selling for more than 4.0x revenues. The most telling factor in the price a practice commands is the manner in which it derives revenues. It is important to compare commission-only advisors, feebased advisors, and fee-only financial advisors and their revenue multiples. These firms, on average sold for 1.1x, 1.7x, and 1.9x revenues respectively. This distinction clearly points to the fact that building a fee-oriented business is at least one way to drive up the valuation of a firm, though we will discuss other ways to increase firm valuations later in this release. We believe that fee-based practices will continue to be the most profitable model. Revenue multiples are concerning if one plans to absorb the business. As we pointed out, it is very important to look beyond assets and revenues when evaluating a firm s worth. To illustrate this point, we have profiled two $50 million AUM firms side by side to show the impact of focusing on assets or revenues versus cash flows. Notice that both of these firms have $50 million in AUM and $500,000 in revenues. If one were to use a percentage of assets or a multiple based on revenues, one would have valued both firms equally. In one case, this would have been a big mistake. It is obvious that practice number two is the more attractive firm to buy and should be valued higher for several important reasons. Practice number two has less personnel expense (smaller staff), This May Not be So Bad Because About 70% of Buyers Buy the Book of Business, Not the Business Using This Revenue Multiple Methodology, Two-Thirds of Advisory Businesses are Sold for One-to-Two Times Revenues The Most Telling Factor in the Price a Practice Commands is the Manner in Which it Derives Revenues 3/01 Financial Planning; 1/01 Practice Transitions Report (FP Transitions); Tiburon Research & Analysis 1.1x Buy Business 30% Com m ission- Only FAs Business Transaction Types In the case of acquiring the book as opposed to the business, a case can be made that the expenses (and hence cash flows) of a business are less relevant than the revenues 10/01 Bloomberg Wealth Manager; Tiburon Research & Analysis Average Revenue Multiples (Percent) x 12% x 20% Above 4.0x 4% x 5% x 8% Average Revenue Multiples by Firm Fee Source 1.7x Buy Book of Business 70% Up to 1.Ox 15% x 12% Fee-Based FAs x Revenues 24% 1.9x Fee-Only FAs These are listing numbers but FP Transitions reported that each practice attracts an average 22 qualified buyers Fee-based practices were those with 70%+ of revenues generated by fees We believe that fee-based practices will continue to be the most profitable model based on their flexibility to add services to bring additional value ot the client and avoid having to reduce fees 2/22/02 FP Transitions Letter (Goad); 1/02 Financial Planning (FP Transitions); 10/01 Bloomberg Wealth Manager (FP Transitions); 9/01 Financial Planning; 4/23/01 Investment News (Business Transitions); 3/01 Financial Planning; 1/01 Practice Transitions Report (FP Transitions); Tiburon Research & Analysis 3

4 no debt, and as a result, income of $250,000 versus the $75,000 of practice number one. At the same time, the clients of practice number two are upwardly mobile professionals still in their earning years. The clients of practice number one are retirees on fixed incomes with an average portfolio value of $50,000, which is likely to stop there given their stage in life. Hopefully, this example makes the point that two firms, which seem to look alike with $50 million in AUM and $500,000 in revenues, can have dramatically different valuations. Cash Flow Multiples Cash flow multiples are 3-8x and more solid than asset or revenue multiples. Again the previous illustration should point to the fact that using asset or revenue multiples could be quite costly for an uninformed buyer, whereas using free cash flow multiples will give a buyer a much stronger foundation on which to make a decision because under this valuation method the buyer is actually evaluating what the firm is showing on its bottom line. Valuations can be easily estimated with simple cash flow multiples. The following chart uses free cash flow multiples of 4x, 5x, and 6x, respectively, to estimate the value of three different size firms, $50, $100, and $250 million in assets under management. In the valuation profession, there is a technical definition of free cash flows that refers to what is available to the owner after taking into account all necessary expenses. In the case of financial advisors, the firms are almost always private and may have personal expenses for which adjustments need to be made. This adjustment is called an expense normalization. We will cover this in more detail in a moment. In our example, we have used some fairly simple ratios to determine revenues, expenses, and cash flows. Revenues are assumed to be 1% of AUM, expenses at 50% of revenues, and therefore making cash flows also 50% of revenues. We then But Revenue Multiples are Concerning if One Plans to Absorb the Business 11/01 Personal Financial Planning Monthly; 11/19/99 Moss Adams Conversation (Tibergien); 9/99 Financial Advisory Practice; Tiburon Research & Analysis Cash Flow Multiples are 3-8x and More Solid Than Asset or Revenue Multiples Valuations Can Be Easily Estimated With a Simple Cash Flow Multiple Case Example of Two Similar But Different Practices Practice #1 Practice #2 $50,000,000 $500, ,000 $50,000 Retirees with fixed incomes and an average portfolio value of $75,000 $75,000 Multiples 0.5%-2.5% AUM 1.0x-3.0x Gross Revenue 3.0x-8.0x Net Free Cash Flows AUM Gross Revenues Staff Number of Clients Average Client Size Clients Income On a recent tour of the FP Transitions site, prices varied widely; one business was offered at below gross revenues while another was at almost five times gross The businesses that are designated as no longer available but still listed on the FP Transitions site supported multiples as high as three times gross revenues There is a substantial small firm discount relative to the multiplies at which money managers sell 1/1/02 Journal of Financial Planning; 1/1/02 Financial Advisor; 10/01 Bloomberg Wealth Manager; 8/1/01 ivalue Program Brochure; 8/01 Senior Consultant; 8/01 Registered Rep; 3/30/01 American Banker; 9/15/00 Moss Adams Presentation (Tibergien)11/19/99 John W. Rafal & Associates Conversation (Rafal); 11/19/99 Moss Adams Conversation (Tibergien); 11/18/99 Timber Ridge Financial Advisors Conversation (Flinn); 11/18/99 Wetherby Asset Management Conversation (Wetherby); 11/16/99 VAM Conversation (Minella); 11/16/99 IAG Conversion (Kelly); 10/99 Stavis, Margolis Advisory Services, Inc.; 7/26/99 Accounting Today; 3/22/99 Investment News; 1/18/99 Investment News; 9/98 Senior Consultant Tiburon Research & Analysis Simple Valuation Model $50,000,000 $500, $500,000 Upwardly mobile professionals years of age with growing portfolios $250,000 Examples (AUM) $50 million $100 million $250 million Gross Revenues 1%) $500,000 $1,000,000 $2,500,000 Less Expenses 50%) $250,000 $500,000 $1,250,000 Pre-Partner Cash Flows $250,000 $500,000 $1,250,000 Less Principa l Compensation & Expense Normalization $200,000 $200,000 $200,000 Free Cash Flows $50,000 $300,000 $1,050,000 Assumed Mulitple Estimated Valuation $200,000 $1,500,000 $6,300,000 11/01 Personal Financial Planning Monthly; 10/25/99 Assante Conversation Presentation (Bowen); 9/99 Financial Advisory Practice; 7/99 Registered Representative; 2/99 Senior Consultant; Tiburon Research & Analysis 4

5 subtract out principal compensation and add back any expense normalization adjustments. In our example, we have used a net figure of $200,000 for these two adjustments. We then arrive at the cash flow amounts of $50,000, $300,000, and $1,050,000 for the $50 million, $100 million, and $250 million firms respectively. Working from this cash flow amount we can now apply the multiples. We assume multiples of 4x, 5x, and 6x respectively on the three practices, suggesting that there is a size premium. This means that the larger firm, $250 million, gets the higher multiple of 6x cash flows, the $100 million firm gets 5x cash flows, and the smaller firm, $50 million, gets 4x cash flows. The result of these numbers is that a $50 million firm would have an estimated value of $200,000, a $100 million firm would have an estimated value of $1.5 million, and a $250 million would have an estimated value of $6.3 million. Notice that the valuation grows exponentially. This is due to the size premium as well as the decreasing impact of the principal compensation adjustment. Discounted Cash Flows A discounted cash flows model is the correct way to value any business. Percentages of assets and multiples of revenues are only rules of thumb; they don t mean much unless they turn into free cash flows. Even a multiple of cash flows is only an estimate of the value of future cash flows. Specifically, Tiburon believes there to be three key drivers of values: current free cash flows, expected growth in cash flows (e.g., what is the true potential for the business), and the appropriate discount rate (e.g., what is the true business risk). Agreeing to a definition of free cash flows may not be as easy as you d expect. To begin our calculations, we have to start by subtracting business expense from the total firm revenues to arrive at our pre-tax operating profit. Then we must subtract the cost of replacing the principal, which can be between $100,000 to $250,000. Once this basic framework is established, we need to introduce several concepts and definitions. The first concept is expense normalization adjustments. The idea behind expense normalization adjustments is to accurately reflect what someone else would have to spend if they were to run your business. Expense normalization adjustments can include a wide variety of items, such as an excessive salary or bonus paid to the owner, excessive rent paid to owners (or lack thereof), excessive fringe benefits (e.g., country clubs, cars, vacation house), excessive T&E costs, and excessive staff (or lack thereof). Typically, the expense normalization is added back to pre-tax operating profits because these expenses would not continue to be carried by a new owner. Second is the adjustment for principal compensation. This is the amount of compensation that would be required to replace the current principal. In most advisory firms, the principal compensation is distributed out of net profits, so it is not included in the costs of operating the business. A new owner would have to incur that cost if they were going to continue running the business. Therefore, the amount of principal compensation is subtracted from pre-tax operating profit. Thirdly, there are non-cash expenses that need to be accounted for if any exist. Non-cash expenses include depreciation, amortization, and balance sheet changes, which are added back to pre-tax operating profits. While the calculation of free cash flows seems very straight forward, you will find that this is often an area for a lot of negotiations. The most common definitional problem occurs when financial advisors minimize profits in their business or run certain personal expenses through their business. This may be legal, but it tends to camouflage economic reality. It is usually appropriate to make adjustments to the expenses to come up with an accurate measure of free cash flows. Another key decision to be made when building a valuation model is selecting a capitalization or discount rate. The capitalization or discount rate is the measurement used to quantify the future growth and unique risks of a firm, or the uncertainty of the income continuing. For example, fee businesses are perceived to have less risk and faster growth than commission businesses because fees are considered a source of recurring revenues. The discount rate should be calculated as the risk free T-bill rate plus some equity risk premium, small company risk premium, and subject company risk premium. Ibbotson suggests that the expected rate of return on public small cap stocks is 17%. 5

6 For most advisory firms, using the rate of return on a private, micro-cap stock (20% or even more) is, in Tiburon s eyes, the most realistic number. Hence, 20% is most likely the right number to use for the discount rate and is what we use in our examples to follow. Some experts quote even higher rates of 20-50%, with less transferable entities at the high-end of the scale. Other factors to consider when determining a capitalization rate are the returns available on alternative investments, volatility or stability of income, amount and quality of competition, size of the practice, condition of the local economy, and the quality and nature of the book of business. High risk and discount rates lead to lower valuations. Value Drivers Value drivers are numerous. There is a whole series of value drivers that help buyers and sellers to determine where within the previously described ranges their firms might be valued. The first value driver is the firm size; the larger the assets, revenues, and most importantly profits, the greater the valuation will be. Demographics of clients, such as the average client size, average client tenure, and age of clients are all important in knowing what the growth potential of the business is and how expensive it will be to serve the clients. Also, knowing the age and stability of the business is another important value driver, as is the reputation of the business and which market niches the firm serves. Also, the dependency on the owner and institutionalization of processes is an important value driver since it can help the buyer determine how difficult or easy the transition process will be. Finally, the professional and administrative staff should be evaluated as they will also be key in the transition process and there might be some other firm-specific issues that buyers should consider. Advisors planning to sell their practices should build them along the way to get the most value. Firms should work to institutionalize processes long before the founder wants to retire. For instance, principals should assign multiple relationship people to each client. On the investments side, there should be regular investment committee meetings to develop a firm strategy. Marketing strategies should not be dependent on one person and the branding should be on the firm not specific individuals. These steps all allow for a new principal to come in and take over the business without having to fear that all the clients will leave since their primary contact at the firm is no longer there. Finally, benchmarking can be a very useful process. We suggest all buyers and sellers utilize Tiburon s free benchmarking tools to measure the relative success of any potential acquisition candidate. Tiburon Strategic Advisors Tiburon Strategic Advisors, based in Tiburon, CA, was formed in 1998 to offer research-based strategic consulting and other related services to financial institutions and investment managers. The firm has served over 175 corporate clients and completed over 375 research and strategic planning projects in that period. The firm s knowledge base ranges from mutual fund distribution, to wrap programs, alternative investments, online financial services, the fee-only financial advisor market, and bank/broker mergers. CONTACT: Krista Jenssen at Tiburon Strategic Advisors at KJenssen@TiburonAdvisors.com or (415) If you are still receiving Tiburon releases by regular mail, please drop us a line with your address and we will get these out to you 5-7 days earlier and more conveniently. 6