Practice Acquisitions - Business Management for Financial Advisers

To pump up volume quickly, many advisory firms acquire books of business from other advisers. Practice acquisitions are a great way to go, providing you don’t overpay. Sellers will almost always rely on a rule of thumb—a multiple they read in the trade press or hear at a cocktail party. Your responsibility is to define the economics of the target practice-with charges to both fair compensation for the owner as well as all overhead expenses.

In financial terms, value is measured by projecting cash flow and discounting it at an appropriate risk rate (or required rate of return). To simplify this process, you can apply a capitalization rate to current free cash flow to come up with a value. For a buyer, this would be the most conservative way to measure value. Each year, we receive inquiries from advisers interested in unraveling deals they committed to several years before.

Most of these dissatisfied owners have assumed a substantial book of clients who do not fit their target market but whom they now feel obligated to serve; others find there is insufficient cash flow from the practice to support the terms of the buyout and still have enough left over to pay themselves adequately for their time invested. Clearly, the “greater fool theory,” which says that there will always be a buyer regardless of price, lives large in the advisory world.

The causes are legion, but the biggest reason may be the lack of understanding of how businesses are valued and what the economic drivers for advisory firms are. The problems we see with practice acquisitions typically fall into five categories:

  1. Not enough potential future income per client. Many practices, especially those that depend on commissions, have already consumed the lion’s share of the income in the form of front-end loads and insurance commissions. Even those that are fee-based may not have much life left in future income if the clients need to begin withdrawing principal. The question is not how much revenue the client base has generated in the past but rather how much it’s likely to generate in the future.
  2. Clients who are too old. Other practices are like depleted oil wells. There may be a little bit of the good stuff left at the bottom, but the buyer will be investing in a practice that has a short life. If so, this can turn out to be a very expensive purchase, even on an earnout, because these formulas generally assume high growth in perpetuity.
  3. Price based on rules of thumb. It’s not uncommon for advisers selling practices to cite recent publications and articles in the trade press that encourage transactions by pumping up the price multiples. But a rule of thumb, by definition, relies on the past, not the future. In other words, the rule implies that the business will continue at least at the same level it has maintained in the past. If I were a seller, I would always rely on rules of thumb because these values will be the highest available. If I were a buyer, I would dismiss these rules for one simple reason: most small practices are sold on an earnout, and it’s impossible to know what multiples of gross revenue a practice has sold for until the earnout period is over. To our knowledge, no studies have yet been published that revisit the price realized through the term of the earnout. The prices agreed to when the deals are consummated, which form the basis for the published rules of thumb, are rarely the prices the sellers actually realize through the earnout.
  4. Insufficient cash flow to support the purchase. Sellers tend to focus on gross revenue rather than net income or cash flow in an acquisition. According to both the 2001 and 2003 FPA Financial Performance Study, the average operating costs of a practice hover around 45 percent of gross revenue. If you add to that the cost of administrative and professional labor—including the seller’s, which you have to consider no matter what—the margins get very tight. So the question is, at the current rate of income, at what point can you expect to break even on the purchase?
  5. Lack of capacity. One of the great surprises for many practitioners is the time it takes to transfer these client relationships. You can do it by adding staff, improving technology, or working ungodly hours. Or you can do it by accepting a certain level of attrition among clients who are not economically practical to serve. This brings up a moral question for the seller, however: Are you doing your low-end clients justice by selling them to somebody who does not want to take care of them?

So, is buying a practice a bad idea? Not necessarily. In spite of the risks, growth through acquisition still presents a viable opportunity for advisers to expand their practices quickly, but they must apply the same common sense to acquiring a practice as they do to counseling their clients. Investing in due diligence and critical analysis, including financial analysis, is essential before signing on the dotted line. Before buying a practice, every buyer should consider at least these six questions:

  1. How independent is the source of the deal, whether broker, investment banker, or other source? Independence has been a professional battle cry for many advisers, but they often seem to value it less when engaging help for their businesses. Advisory firms commonly use intermediaries or business brokers—including online services—that represent both sides of a transaction. For the sake of expediency, advisers would rather have one person facilitate the deal; that way they can share the cost. That choice comes with a risk: the broker’s goal is to see that the deal gets done, not to advocate for one side or the other. Obviously this can be good or bad, but you may never know. That’s why it’s prudent always to have an independent set of eyes—such as your attorney, your CPA, or an experienced merger-and-acquisition adviser—review the deal before you execute. What’s more, many issues are complex and tricky and require a professional opinion from an expert on matters related to tax, liability, noncompetition agreements, and other terms in the deal.
  2. Can the practice reward me for both my labor and my risk? In conventional valuation theory, analysts make adjustments for things like personal expenses, compensation, and the true cost of doing business before they apply a multiple or capitalization rate to the free cash flow of the enterprise. Because so many advisers do not differentiate between their compensation and their revenue minus expenses, this concept is often difficult for them to grasp. But one of the real costs of running an advisory practice is professional labor.
    In other words, if you were an employee of the business (which in fact you are), what would your labor be worth? In assessing the value of a practice, add dollars to reflect this cost and deduct it from the revenues along with all other expenses in the business to come up with a bottom-line number. The bottom line will be the business’s operating profit, or the return for your risk of buying and owning the business. That’s the number that should be capitalized, not thegross. We have seen far too many practices that have a large gross but cannot afford to pay their owners fairly and produce a profit or a return on ownership.
  3. Is there a more effective way to deploy my resources? You have a finite amount of time, money, and energy. Is buying an overvalued practice with limited growth potential the best deployment of those resources? For example, if the seller is asking $400,000, might you be better off investing those same dollars—or even a fraction of those dollars—into your own marketing, your own reputation, and your own efforts? This question is especially important to consider if you’re not already part of the practice and therefore are uncertain whether the clients will continue with you. Could you achieve your net-return goal just as quickly, and for less money, without this acquisition?
  4. Is the acquisition a good cultural fit? The excitement of consummating a deal often causes people to bypass the most basic question: Will this relationship work? Before you acquire a practice, be sure to understand the philosophy, the processes, and the reasons for the outgoing adviser’s recommendations to his or her clients. If your approach—or your target clientele—conflicts with the seller’s, the potential for attrition is very high. This may sound obvious, but we have seen far too many buyers who think they can change the way acquired clients buy products and services from their adviser. Ask yourself how you will do this. Trashing the approach used by the outgoing adviser is not usually a formula for success.
  5. Do I have the capacity to serve this client base? You may be tempted to skim off the top clients and ignore the others—a choice that could make it easier to manage the capacity problem of taking on all of the new business. That’s your call. But recognize that especially in the early years, you will need to expend an extraordinary effort to keep these clients in the fold, to make them feel valued, and to provide them with the kind of service that they’ve come to expect or that they truly desire. You should put together an operating plan for how you will serve these clients and with what frequency, then determine if there are enough hours in the day for you to handle them in addition to your current client base.
  6. Have I evaluated all of the hidden risks? Every acquisition has the potential for risks that are not apparent at the outset. These problems could involve compliance or client satisfaction, or they could take the form of past recommendations made by the firm that are now time bombs ready to explode. In the ideal world, you would have the opportunity to do a client satisfaction survey before you acquire the practice; several good and relatively inexpensive tools in the market are available for this. At a minimum, you will want to engage an independent compliance consultant to perform due diligence on the seller’s practices and procedures before you commit. Both of these steps can be covered in your letter of intent, which is normally the prelude to the purchase agreement. Any reluctance on the seller’s part to these kinds of evaluations raises a big red flag.

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