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What is a practice worth?

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Practice principals who are set to retire and are looking to offload their business can find the process of determining a sale price daunting. The impact of the global financial crisis has not made the process any easier. 

If it were possible to rank valuations of financial planning practices by degree of difficulty, then surely determining the value of Storm Financial's client book after its collapse would feature on top of the list. It seems to be impossible to sell a business that is leaking clients left, right and centre, let alone to get a decent price for it. But when Kenyon Prendeville director Steve Prendeville, who advised on the sale of the client book, is asked how you sell the unsaleable, he stoically replies: "Nothing is 'un-sellable'.

"There are still thousands of clients there, there is still recurring revenue and there is still a need for those clients to receive quality advice. Even a distressed asset like Storm, which is a fraction of what it previously was worth, still has an implicit value."

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Unsurprisingly, the Storm client book had to be offered for a price well below the market average. "It was a distressed asset and, therefore, it was cheap. But it did have value," Prendeville says.

Yet, a low price was not the only factor in ensuring a successful transaction. The way in which the payment was structured was just as important, he says. "With a business that is losing clients very quickly you need to structure how much is paid upfront, how much is deferred and over what time frame."

In the end, it was a subsidiary of financial planning group Financial Index Australia that bought Storm's book of about 10,000 clients. The price paid has not been disclosed, and Prendeville is not about to change that.

Pricing problems
Storm might be an exceptional case, but valuing a financial planning practice is often a tricky business, especially for practices that cannot rely on the elaborate processes and extensive experience of large institutions. But as the average age of principals is edging closer to 60, more advisers will have to deal with this issue and start preparing their exit.

Yet, many practitioners will delay planning their succession until the very last moment. This traditional lack of enthusiasm in planning succession is caused by a hotchpotch of emotional and practical obstacles. Valuation is certainly one of the challenges in this process.

Professional services businesses in general are hard to value, because often much depends on the client relationships the principal has built up over the years. How to price these relationships in the light of this key person exiting the practice is complex to say the least.

Then there are also uncertainties about determining how much a client book has been 'worked' - if there are still opportunities to extract new revenues from existing clients by offering them different services.

These issues combined with the tendency to delay planning for succession until the last moment have led to the use of valuation methods that are sometimes a little ad hoc.

Refuge in revenues
Financial planning practices attract relatively higher prices than other professional services businesses because a large part of their revenues is fixed - this part is known as recurring revenue. Because of this stable income stream, the risks attached to acquiring the business are perceived as fairly low.

The price paid for a practice is often based on the recurring revenue and expressed as a multiple. This is particularly a common practice in transactions between practices with revenues of less than $500,000, Centurion Market Makers director Chris Wrightson says. "Those financial advisers tend to use a valuation approach that is best described as market-based or peer-based. They look at what they observe in the market and the multiples of recurring revenues being paid based on publicly available information. They will then turn around and offer a price for something that reflects that information and how badly they want that particular asset. It is far from sophisticated," Wrightson says.

Publicly-listed group Snowball is an active acquirer of planning and accounting businesses, and chief executive Tony McDonald agrees many sellers and purchasers of planning businesses do not always apply the best due diligence in transactions. "Two years ago you would have people saying: '$2 million revenue times 3.5, and you pay 80 per cent upfront and 20 per cent later'. Now that is not how other industries value their businesses. Recurring revenue is a really good summary of where you end up, but only after having established a price," McDonald says.

Revenue multiples have in recent years hovered around an average of 3.5. This figure is partly based on the buyer of last resort (BOLR) clauses that many dealer groups have in place with their practices, Wrightson says. "For small and middle-sized practices the existing buyer of last resort facility provides a base line valuation for practices," he says.

"Most [BOLR clauses] are built around recurring revenue and most of them have a deferred payment system. So you get a third of your money today, and another third in a year's time, that is going to be based on that year of recurring revenue. Usually, compared to market transactions, they are not structured very generously."

Axa-owned dealer group Hillross has such arrangements in place for its practices, but they are not intended to reflect market prices, Hillross head of growth, mergers and acquisitions Ray Djani says. "The intent with our buyback [arrangements] is not to reflect the maximum price a practice could receive in the market. It reflects more a reasonable floor price valuation, which in some respects provides the owner principals with a minimum value and some peace of mind in the event that a buyback is appropriate," Djani says.

Crisis changes the terms
As a result of the way BOLR clauses are structured, most practice sales have taken place in the open market and use the multiples stated in their clauses as a guideline to determine a price. But as the financial crisis wiped out at least a third of practices' funds under management (FUM), potential buyers have become more discerning about risks to revenues. They now carefully scrutinise where funds are invested and in particular whether there is any exposure to hard hit areas such as the listed property market or agricultural managed investment schemes.

"We have seen an increase in realism among people. Some people wished they applied some more science to [valuation], especially where debt is used. Banks are not as cuddly anymore," McDonald says.

Not only have revenues dropped, but the average multiple on which the price of a business is based has also started to decrease, he says.

"Multiples have come down: multiples of EBIT (earnings before interest and tax), recurring revenue and as a percentage of funds under advice. Everyone is pricing risk more realistically these days," he says.

Financial Planning Services Australia (FPSA) chief executive Mark Ryan agrees with McDonald. Ryan says until recently average recurring revenue multiples of around 3.2 and 3.5 were common. "You're now seeing a lot of people talking 2.8. I think the variance at the top level and bottom level has become a lot larger. It used to be quite a narrow trading range," he says.

But in many cases where lower multiples are being discussed, transactions do not go ahead, Kenyon Prendeville director Alan Kenyon says. "All we can say is that across our transactions recurring revenue averages are around 3.3 and EBIT at six to seven times. Everyone's profits are down, but multiples are not. It's a sellers market and that is what has been lost in the gobbledegook that has recently been published in the press," Kenyon says.

He says a few weeks ago the firm advised on the sale of a practice that fetched a multiple of 3.78. "We had 20 enquiries, six interviews, we had four indicative offers, two did due diligence and we accepted one offer," he says.

This practice was particularly attractive because it was still growing in the current market environment, but overall the demand for planning practices is still strong, he says.

Many planners look to regain the revenue they have lost during the financial crisis by buying out competitors. "There is a greater need for people to buy," Prendeville says.

"In the absence of organic growth, people look at in-organic strategies to get a better utilisation of their team, to keep free cash flow and keep the team they have in place."

The average financial planning business previously had a gross revenue of about $500,000, of which $400,000 was made up by recurring revenues and $100,000 consisted of new business. "Now, there is no new business being written, so there goes $100,000. The market has fallen 20 to 30 per cent, and so their recurring revenue has fallen. The profits disappear immediately. To keep their people in place, they now have to buy businesses to get their free cash flow back," Prendeville says.

Pricing factors
Making a proper assessment of the value of a planning practice is an elaborate process. Institutions almost uniformly use the discounted cash flow (DCF) model - a method that involves complex mathematical and financial modelling. This method projects a series of future cash flows or earnings and then adjusts the outcome using a company's weighted average cost of capital over a period of five to 10 years. The sum of all future adjusted flows represents a company's present value.

"The process is to determine whether an acquisition would be accretive or not. You look at whether you can offer the customer a new proposition. That is what drives institutional thinking in this space," Centurion director Wayne Marsh says.

The DCF model has been described more than once as a form of financial black art, and is beyond the skills and resources of an average planning practice. But there are a number of factors advisers can take into consideration to get a better overview of the advantages and risks embedded in a planning business. Not all of those are purely financial. Kenyon Prendeville uses an extensive check list in establishing a price for a business.

"I suppose it is a belief system that Alan and I have that you can't determine value purely on the financial metrics. They are important, but you also need to take into account market position, brand, quality of staff, marketing, client age and FUM," Prendeville says.

When looking at FUM, one should not only look at size, but also where funds are invested. "At the moment the FUM is really important: what exposure is there to Timbercorp or underperforming closed assets?" Prendeville says.

"You can't take an accountant's view of 'this is the recurring revenue' or 'this is the EBIT' and then put a multiple to it. What determines that multiple is what risk is resident within that business. That's why we have to do a full business diagnostic to get a real understanding of what is behind those numbers."

Ease of migration is another factor in assessing the attractiveness of a business and this is largely dependent on the platform a practice uses. "The more mainstream a platform is, the larger the market and the more buyers there will be. If you use niche platforms, then there will be fewer buyers because you have to migrate that FUM to a preferred platform," Kenyon says.

In some cases it is nearly impossible to migrate clients' funds to a firm's preferred platform. "There are some first generation master funds which are extremely hard to transfer because there is a trustee relationship in place," Kenyon says.

Still, the biggest stumbling block for many advisers in valuing their business is the determination of the goodwill of a planning practice, and the central question here is about client retention. The most common way of addressing this issue is paying for an acquisition in instalments over time. If many clients leave the business, the final price paid for a practice will come down too.

As the awareness of risk has grown in recent months, the slice of payments that is deferred has become larger. "Over the previous five years, much of our payments were done over 12 months, with 70 to 80 per cent paid upfront. But now with vendors hoping to recapture some of the lost value, we are seeing periods of two years and it may be 60 per cent upfront, 20 per cent paid in 12 months and another 20 per cent paid in 24 months," Prendeville says.

But this structure also works the other way and gives the vendor the potential to get a higher price for the practices over time. As the market recovers, so does the value of the client book, and as a result the payments are higher in dollar terms. "It means that they can do a deal today and they can get on with doing business today," Kenyon says.

Vendors do not have to wait until their FUM is at levels at which it is attractive to sell the business.

"One business that we sold in November - this is at the height of the crisis - we actually created a five-year push-and-pull option for the deferred consideration. Up to five years' time, the vendor has the option of calling in value at that time, and the purchaser as well. We created a floor price," Kenyon says.

The benefit for the purchaser under this construct is that financing the acquisition is much easier because there is no full payment within a 12-month time frame. "What we have seen is a lot more terms and conditions, and a lot more flexibility to find that middle ground for buyer and seller," Kenyon says.

Compliance scrutinised
Like Snowball, FPSA has also been an active acquirer of practices in the past two years and Ryan says he has seen much more attention being paid to compliance by practices. "The big fear of anyone buying a practice is that they buy a practice with an absolute nightmare in the drawers. In the past the focus has been on validating revenues. It is now on validating the quality of compliance: how clean and well kept are the files of the practice?" he says.

"Companies with great record keeping, great documentation process, great software and good organisation, they are properly going to be higher valued than any other [company]."

Compliance is an important feature of FPSA's 52-step check list for determining practice value. The dealer group has just hired three more compliance staff to find all the needles in the haystack.

"We have a process that includes examining the statements of advice, looking at the last compliance check, looking at references in the industry, because every practice we bring on can be a threat to our group and we have an obligation to our existing businesses to not only protect our licence, but also their business," Ryan says.

Hillross launched a new mergers and acquisitions program in late December 2008, and in the past six months seven advisory firms have joined its network. "We also have other opportunities in the pipeline at the moment. A number of our advisory firms want access to more clients to increase their revenues, improve their capability and know-how in particular client segments, or expand into new territories and regions as well as plan for succession," Djani says.

Djani indicates that sustainability of revenues and the profit are still the most important factors in determining the value of a practice, but there are other factors that could see a practice attract a premium. "Value is viewed differently depending on the buyer and what their strategy is for that business. For example, a larger corporatised financial planning business with good systems and processes may be prepared to pay a slight premium for a business, because they may be able to strip out some costs and absorb that business and convert the operations and service delivery into their own, gaining further synergies," he says.

Practice value can also be affected by the level of communication advisers maintain with their clients, he says. "Like in any pressure test environment, client service offers get tested, the people delivering the advice get tested, and clients start to look more closely at what they are paying for services," he says.

"Those financial planning businesses that have strong and valued service propositions and who have stayed in regular and close contact with their clients are more likely to be able to demonstrate the value of their services. Those who might have relied on the growing equity markets and positioned their proposition at delivering better than market return will find it much harder to extract higher value."

Pricing without commissions
The proposed move away from commission-based remuneration systems by the FPA could have a dramatic impact on the way businesses are valued. Although the finer details of the preferred remuneration process are not yet clear, chances are that the recurring part of revenues will decrease.

"If commissions stop, there is a range of possible outcomes. One of them is that all commissions are stopped at a future point. Another is that all commissions are stopped from that point on, in other words, grand-fathering all the existing commissions. If we get to 2012 and they say no more commissions from that day forward, but all the other stuff is grand-fathered then it is going to be quite a long time for that to take effect," Wrightson says.

His colleague Marsh says: "There is a school of thought that says if practices move towards a no-commission and a fee based on assets going forward, that more and more will be valued as professional services businesses."

The implication of this is that prices could fall, but Marsh does not believe it will go that far. "I think when you compare a financial planning practice with, say, an accounting practice or a legal practice, there are differentiating characteristics. One is the greater certainty of income under the advice model. There is an underlying growth of both the market and systems. With that profile, I think they continue to attract a premium over traditional professional services businesses."

Djani agrees a move to fee-for-service does not necessarily mean revenues will decline or recurring revenue is any more difficult to determine. "A number of firms have agreed fees with their clients, often set and agreed in advance, for a range of services that will be delivered. While these fees may be reviewed annually, if the adviser can continue to demonstrate the delivery of valued services, there is no reason why those fees cannot be sustained," he says.

Kenyon says: "We're not yet seeing any impact on valuation."

He argues the same discussion about a potential fall in prices flared up when the Financial Services Reform Act was introduced in 2002, but it did not cause a mass exodus at the time, and neither will the move away from commissions. "I think the fee-for-service debate has been going on for some time. I think some people have already engineered ways to move to fee-for-service," he says.

But businesses that have already moved to fee-for-service have found their business has held up much better, and, therefore, have been able to limit the devaluation seen at most other practices. "What we have seen is that those businesses that had fixed fees have come through the last 12 months without any changes because they haven't had FUM-linked business," Prendeville says.

"They have been rewarded for being better businesses because they have reduced market risk to their revenue."

And that is worth something.

 

 

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