The need for a succession strategy

For a relatively young industry, financial planning can look old in a certain light. The average practitioner is 57 years old. That’s a sure sign that plenty of Australia’s financial advisers, like the baby boomer cohort around which most of them have built their businesses, will soon be putting the finishing touches on their careers, according to Peter Fysh, Financial Planning & Succession principal.

“I still meet principals who say they want to work until they’re 70 but most [experienced advisers] are now waking up to the fact they need to think about succession planning,” Fysh says.

Better late than never, perhaps, but he says the shift into retirement mode would’ve been much less stressful if the exit planning had begun earlier in the process.

“Most principals in the financial planning space don’t really address exit strategies until they need one,” Fysh says, and this can be through ill health, for instance, or the sudden realisation they’re 64 years old.

A couple of factors, too, have been holding back many advisers from heading for the exits over the last few years: the economic damage inflicted on most practices by the global financial crisis, and uncertainty over the potential effects of the Future of Financial Advice (FoFA) reforms on business valuations.

Now with FoFA more or less understood and the value of client investments creeping up above pre-GFC levels, Fysh says previously reluctant practice owners may feel more comfortable about putting their businesses on the block.

Of course, the exact exit route departing advisers choose to take will to a large extent depend on where their businesses have set up shop. Some, for instance, may by relying on buyer-of-last-resort (BOLR) arrangements offered by large institutional dealer groups; others could be pinning their hopes on dealer group-brokered internal succession plans, or perhaps a sellout deal with the most generous cheque-bearing bank. Still other principals might have identified and nurtured a successor (or successors) within their own business.

But whatever exit method advisers have in mind, Fysh says they all want to realise as much value as possible for themselves on the way out while trying to exert at least some influence on “who will manage their [soon-to-be ex-] clients in the future”.

And the most sure-fire way to meet these dual targets, he says, is to put a well-thought-out succession plan in place well in advance, at least three to five years before the ­prospective exit date.

Fysh says key attributes of a good succession plan include:

All staff need to be on contracts, giving comfort to prospective buyers (and the staff as well) that key people will stay after a sale;

Advisers, and other important staff members, should also have an equity stake in the business, again strengthening post-sale continuity;

The business should be profitable on an earnings before interest and tax (EBIT) basis.

He says there is also a growing realisation among principals that having a risk insurance-focused business as well as investment and financial planning income streams can make the practice a more attractive sales prospect.

There is a danger, too, that some financial planning business owners could have become a bit too comfortable with their lot.

“Lots of advisers have grown substantial businesses over the last 10 or 15 years and they’ve become relaxed about growth,” Fysh says. “But the key for any buyer is that they can see growth in the business. If the average age of your client base is too high, then that will probably result in a lower price.”

Terry Bell, head of financial planning ­consultancy firm Business Health, also notes that an ageing client base could diminish the value of a planning ­practice.

Bell says the group’s latest CATScan survey, which aggregates data from thousands of advisory businesses, shows that retirees make up over half the average client base.

“Buyers will factor that in,” he says.

More worryingly, Bell says, over the last couple of years adviser firms appear to have gone backwards in maintaining practice ­standards, cutting back on business fine-tuning activities that could prove decisive come sale time.

For example, a Business Health industry report, due out later this month, has found that only 15 per cent of advisers are surveying their clients, compared to 30 per cent two years ago.

While the lapse might be understandable given the tough economic times advisory firms have been through, Bell says it’s the kind of detail buyers now insist on examining.

“Other things like client segmentation, clearly defined value propositions, pricing methodology and practice benchmarking are becoming more important,” he says. “There’s a new level of sophistication coming in from buyers, they’re much more discerning so advisers need to present their businesses in the best light possible.”

Bob Neill, Seaview Consulting director, is also seeing a more hard-nosed attitude from buyers. Neill says while to some degree it remains a sellers’ market there has been an overall price compression over the last couple of years.

“The average sales transaction has come down from about six-times EBIT to five-times [or from three-times recurring revenue to 2.75-times in old money], that’s a permanent, pervasive change,” he says.

More tellingly, however, Neill says the price differential has spread out considerably as purchasers become fussier about quality. “Three years ago planning businesses traded in a narrow band,” he says.

“Now the gap [between best and worst quality businesses] has widened and is continuing to widen.”

Like Bell, Neill says business qualitative factors, such as data management and ­technology use, are increasingly coming under buyers’ scrutiny. With the FoFA regime about to start, client engagement especially has to meet a high standard to shore up buyer interest.

For example, Neill says if two nearly ­identical practices that generated $100,000 annually in trail income came up for sale, the one with a clearly defined plan to write to ­clients explaining their value proposition would command a higher price.

Business finance

It’s not just prospective buyers who are demanding a higher level of detail from ­advisory firms but also banks that more than ever are involved in funding buyouts.

As Neill notes, the new generation of advisers, unlike the pioneers who built ­businesses from scratch with virtually no capital upfront, are taking on debt to buy into the game. But young advisers aren’t ­necessarily willing, or able, to borrow any amount to buy into a practice.

Tim Lane, partner in the Accru Hobert accountancy business, says practices that generate up to about $200,000 to $400,000 ­revenue a year can be sold “in a heartbeat” as they tend to be a “right-sized transaction”, from the perspective of a debt-fuelled younger adviser.

“But when you get up to levels of $1 million recurring revenue, it’s really only institutions that can afford to buy a practice,” Lane says. “You’re looking at a minimum cost of $3 million.”

Alternatively, retiring advisers could divide up a practice among several successors. In fact, Lane says that most weeks two or three advisory firms will approach him ­asking for advice on exit strategies, with questions about “how to transition equity” usually top of the list.

He says the best answer is to sell down equity “chunks” over time, and to start doing it early.

“My observation of the world is that ­people leave exit planning too late,” Lane says. “They need to think about how to ‘de-risk’ the transaction for incoming owners. If the next generation of adviser can own some equity early on they’re usually happy to be involved [post-sale]. But if a 62-year-old adviser suddenly decides to sell the lot, younger advisers may not want to take on all that debt.”

Despite the transitional challenges for retiring advisers, there is some good news. Lane says compared to, say, accountancy businesses, financial planning practices tend to generate higher cash flows and therefore can exact a higher sale price, in the region of four to six-times EBIT versus a maximum four-times for accountants.

“Even after FoFA comes in, financial planning cash flows should be better than accountants’,” he says. “So there’s no reason why EBIT ­valuations [for financial planning firms] post-FoFA can’t hold up.”

Exit on EBIT street: the new way out

Business valuation experts have for years repeated the mantra that financial planning businesses should be measured by profit rather than revenue.

Until recently, though, the profit-based preachers have been drowned out by a noisy marketplace happily trading on multiples of revenue. If buyers were willing to pay three-times recurring revenue (based on embedded trail income), no questions asked, then vendors were under little pressure to prove the profitability of the underlying enterprise.

But without a doubt the screws are beginning to turn on these long-held rule-of-thumb valuation methods. Firstly, the Future of Financial Advice (FoFA) reforms due to be switched on in July have prompted potential buyers to more closely question the security of advisory ­businesses’ ongoing revenues.

At the same time, the financial services industry is only just emerging from a GFC hangover that has seen costs squeezed across the board, financial advice businesses have not been immune.

In short, the conditions are right for the earnings before interest, tax, depreciation and amortisation (EBITDA, or EBIT as the short form has it) valuation model to flourish in financial planning, as it does in other industries.

If the data collected by the No More Practice Business Valuator is indicative of long-term trends, advisers should welcome the EBIT era.

The No More Practice Business Valuator, produced by Business Health and education provider No More Practice, is an online tool that provides advisers with an estimate of their business’ value based on a number of self-supplied metrics.

As at March this year, about 160 practices had been through the process and the aggregate data indicates an average practice value of 2.8 times revenue while the profit multiple stood at 6.7 on average.

In a statement, Rod Bertino, Business Health principal, says the finding should counter assumptions that a revenue approach will always yield a bigger payout.

“When you multiply the ‘average profit’ by the 6.7, you’re getting a much bigger number than multiplying ‘recurring revenue’ by the 2.8, and that is surprising,” Bertino says. He says the findings should prompt business owners to at least question received wisdom concerning practice valuations.

“If it does speed up the shift from the multiple of recurring revenue basis, practice owners need to understand how well positioned their business is to take full advantage of this, and if they’re not positioned well, what do they need to do?”

In general, Bertino says the EBIT method is an “advance” on ­recurring revenue valuations because it rests on the bottom line of the business and therefore provides “a much more solid basis”.

Bob Neill, Seaview Consulting director, is another EBIT advocate. Neill, who works with a wide range of financial planning firms, says as many advisory businesses have grown significantly over the years, the revenue-valuation model doesn’t hold up.

“With the emergence of scale we’re seeing [acquirers] buying ­portions of the business based on profit,” he says. “While we’ll continue to see small books of business sold based on recurring revenue our view is that planning businesses should focus on EBITDA.”

Tim Lane, partner at the Hobart arm of accountancy and business advisory firm Accru, agrees with Neill’s analysis.

Lane says it is now much less likely that advisers will be able to exit the industry by “selling their book at three-times revenue to the guy down the road”.

“My sense is that people are realising they need to look at return on investment and you need an EBIT methodology for that,” Lane says. “Advisers are realising, too, they can’t rely on growth of funds under management [to justify prices]. There’s a focus on profitability and ­controlling costs.”

He says the industry will inevitably “gravitate away from three-times revenue to EBIT”.

“The quality of a practice will be judged on EBIT margin, where, say, a 40 per cent EBIT margin might be good,” Lane says.

While the transition to a more rigorous, profit-based valuation model won’t be easy for all advisers, he says it could smooth the exit path for many.

“The more profitable a business, the easier any succession process is,” he says.