The M&A market remains extremely active, but not every potential seller may be able to command the price they would like — or even find a quality buyer.
Maintaining a lean, independent team can be attractive to founders, as RIAs generate steady cash flows and can be extraordinarily profitable. However, these smaller firms, more akin to practices, may be vulnerable when it comes time to sell.
They have far less annuity revenue certainty than more institutionalized RIAs because they have often not implemented the proper - and costly - structure to ensure the long-term success of the business. This includes hiring professional management, implementing the latest technology, or organizing a disciplined and consistent business development strategy.
When the time comes to take chips off the table, practices will be valued at a discount compared to their more properly institutionalized peers.
GAP IN MULTIPLES
An institutionalized business is a larger, more efficient organization with more potential value in the event of a transaction. Smaller practices are vulnerable in this low investment return environment given widespread competition, as well as fee pressure from robo advisers and other low-cost index offerings.
This vulnerability creates a significant delta, or gap, in the multiples offered for advisory businesses.
A smaller practice of $100 to $300 million in AUM may be worth 4 to 6 times normalized run-rate EBITDA, the standard valuation metric. But larger institutionalized businesses of $500 million to $2 billion in assets are more likely to see valuation multiples in the range of 7 to 10 times normalized run-rate EBITDA.
Smaller practices are vulnerable in this low investment return environment.
When considering acquisition targets, and especially if succession is the catalyst for a transaction, buyers want to see firms that are positioned for long-term success even after the departure of a founder.
A critical component of supporting this success lies within the capital investments made in the business over the years in the areas of technology, marketing, and administration. These investments increase the scalability of the business and reduce the disruption that will occur in the event founders or other key people depart.
REVENUE MUST BE DIVERSIFIED
Another hallmark of a practice is the smaller number of employees. While the firm itself may be quite profitable, it is untenable to expect a buyer to pay a premium if client revenue has not been diversified across advisers.
Practices employ limited staff, both in terms of junior advisers and people in supporting roles. The lack of human capital, especially when it comes to next-generation talent ready to step up and assume the place of retiring advisers, is a huge factor in discounted valuations.
Larger firms have the luxury of creating more touch points with the client. The ability to devote a team of advisers to foster a relationship increases the “stickiness” of the client, which is critical if and when a senior adviser departs.
The notion of creating a business with real long-term value should be top of mind for advisers.
ACHIEVING ENTERPRISE VALUE
Firms with enterprise value can be valued long-term, regardless of who is at the helm, whereas the value of a practice is linked directly to the existence of a few key people. For advisers with a long time horizon and means to invest in their business, they should consider deploying the capital necessary to create and preserve value.
It is untenable to expect a buyer to pay a premium if client revenue has not been diversified.
However, for those advisers with shorter time horizons, it is likely too late to institutionalize their businesses without outside help. It may be prudent to consider partnering with a larger firm who will recognize the potential for real value creation, and support growth with the necessary investments.
Not only may this be a means of creating security for shareholders, it also may create stability for clients as they will not need to shuffle their assets around upon the loss of their adviser.
Clients also may benefit from a more developed investment process and service offering at the larger firm. The trade-off for practice owners is that they cede all or a portion of their ownership stake in their practice.
However, if partnered with the right firm, the owners can likely benefit by becoming a partial owner in an organization with material long-term enterprise value. Upon retirement, they may be better able to fully realize the value of what they built.
