Cash flow is king in evaluating a practice

The traditional rule of thumb for valuating financial advisory firms may be about as useful as a butcher’s thumb on a scale, panelists at an InvestmentNews round table on succession planning contended last month.

“I want to make emphatically clear that the 2.1 times [gross revenue] multiple should not be relied upon,” declared Mark Tibergien, chief executive of Jersey City, N.J.-based Pershing Advisor Solutions LLC, a subsidiary of Bank of New York Mellon Corp. “It’s bogus, it is wrong and it is not relevant to most practices. The ultimate test of value is whether the business generates sufficient cash flow and what is the reasonable rate of return to get access to that.”

The traditional rule of thumb “ignores how profitable one’s firm is,” said Kristofor Behn, a Boston-based certified financial planner and president and founder of The Fieldstone Financial Management Group LLC. “Greater revenue does not guarantee greater profit. It all depends on efficiency.”

CASH FLOW IS KING

When it comes to valuating firms, cash flow is king, Mr. Behn said.

“There are two ways to value a firm: cash in hand and potential cash in hand,” he said.

A more accurate gauge of a company’s worth, Mr. Behn argued, is a multiple of a firm’s net operating profit.

“That’s what Wall Street uses,” he said.

“If you looked at the future earnings of a business after fair compensation and overhead expenses and you applied a 2.1 times multiple,” Mr. Tibergien asserted, “you could buy a bond for a better rate of return. So there is absolutely no logic to pay that kind of premium for a business that has a finite life and whose client base is old.”

“The real issue for the buyer is whether the cash flow hurts the purchase price,” he concluded. “If the cash doesn’t flow, the deal doesn’t go.”

However, one panelist noted that a traditional valuation was satisfactory when she sold her advisory business in New Jersey in late 2005.

“I sold at 2.2 times gross revenue,” said Diane MacPhee, who is now a consultant heading Manahawkin, N.J.-based DMac Consulting Services LLC. “My transaction was very friendly, back of the envelope. When we talked about structuring the deal, I was comfortable with one-third lump sum, one-third promissory note, one-third earnings.”

And Vern Hayden, president of Westport, Conn.-based Hayden Wealth Management Group, said he also incorporated the traditional gross revenue multiple — but didn’t rely upon it — when he was calculating a sale price of his advisory firm to a bank last year.

Another formula Mr. Hayden used, he said, was 1% of his firm’s assets under management plus seven times net revenue plus three times gross revenue, divided by three. He then added a 30% premium for his staying on with the firm after the sale.

That number, Mr. Hayden said, approximated the traditional rule of thumb calculation, and was non-negotiable.

As it happened, before he re-ceived inquiries from NorthEast Community Bancorp Inc. in White Plains, N.Y., his firm had done a five-year projection of anticipated revenue growth, Mr. Hayden said.

He presented those projections to Kenneth Martinek, NorthEast’s president, chairman and chief executive, along with his sale price.

When Mr. Martinek asked him if he believed in the projections, Mr. Hayden said he replied “Yes, I didn’t do them for you, I did them for us.”

After examining the projections and Mr. Hayden’s sale price, Mr. Martinek accepted Mr. Hayden’s proposal.

“I assume he calculated that the bank would receive a favorable return on its investment,” he said.

But registered investment advisers shouldn’t expect many offers from banks this year, according to David DeVoe, senior director of mergers and acquisitions for Schwab Institutional in San Francisco.

M&A SLOWDOWN

Continuing turmoil in the financial markets is slowing down mergers and acquisitions for RIAs, he reported.

Speaking to advisers at a breakfast presentation in New York last month, Mr. DeVoe said large national banks will be preoccupied with credit availability and the subprime mortgage crisis.

“Acquiring RIAs is not what they’re thinking about,” he said. [InvestmentNews, March 31].

There were only 10 M&A deals tracked by Schwab research analysts from Jan. 1 through March 20, compared with 19 for the comparable period in 2007, and Mr. DeVoe said it was unlikely that last year’s record high of 80 transactions would be equaled.

Firms with less than $500 million in assets under management have been most affected, he added.

Round-table panelists also debated the impact of current market conditions.

“We are dealing in an environment where the market is getting stoned, and the income generator for many advisory practices is getting hurt,” said Mr. Tibergien.

Before joining Pershing last year, Mr. Tibergien spent 13 years at Moss Adams LLP of Seattle, where he was the partner in charge of the business consulting and business valuation groups, as well as chairman of the financial services group. He is also the author of “How to Value, Buy and Sell a Financial Advisory Practice,” (2006, Moss Adams LLP).

Mr. Behn did not think the credit crunch would have much of an effect on transactions.

The credit markets are “a very limited source of capital” for buyers, he said. “You’re drawing on personal reserves and revenue from the practice to pay for it. So in terms of the current situation, I don’t think it’s going to have a great impact. The demand is going to continue.”

Demand among buyers this year will continue to be driven by holding companies, such as Focus Financial Partners LLC and National Financial Partners Corp., both of New York, and Nashville, Tenn.-based WealthTrust Inc., Mr. DeVoe said in his presentation to advisers.

There are at least 15 such companies looking to acquire advisory firms, he said, pointing out that they all have different business models, “This is good news for advisers,” Mr. DeVoe argued, “because it’s giving them more options than ever.”

Mr. Tibergien made the same point about these buyers at the round table.

“They all have different profiles of the optimal firm, different deal structures and different objectives,” he said.

For sellers, making a deal with a consolidator is, “in many cases, a pretty appealing option,” Mr. Tibergien declared.

CULTURAL FIT IS CRITICAL

No matter to whom advisers agree to sell, the round-table panelists agreed that it was critical to make sure the buyer is a good cultural fit with the firm and its clients.

“Price was not my number one issue,” said Ms. MacPhee. “It was more about the culture and the compatibility.”

Mr. Behn recommended Financial DNA, from Atlanta-based Financial DNA Resources, as an excellent tool to help determine compatibility.

He also credited Financial DNA with inspiring Succession Registry, a Mansfield, Mass.-based firm he co-founded in January that is an online service matching advisers and prospective buyers, employees, partners or potential successors.

Mr. Behn is also a founder of Practice Lifecycle, an Internet practice management portal for advisers.

Another way of establishing a good fit with a buyer, said Mr. Hayden, is “establishing relationships far in advance of selling a business.”

The point, he explained, was to “find an institution that parallels the way you think, so you’re not selling the business as a commodity, but as a service — because you’re interested in existing clients and staff” who will not only stay with the firm but also help it grow.

E-mail Charles Paikert at [email protected]

To view an edited transcript of the round-table discussion, go to investmentnews.com/successiontranscript.