Executive Summary
With recent advisor surveys suggesting that as many as 1-in-5 financial advisors could leave the industry in the wake of the DoL fiduciary rule, the potential arises that there will soon be a wave of advisory firms looking to sell. For those who are thinking about selling, this suggests there may be a race to get out the door first, before the glut of sellers causes advisory firm valuations to crash. And woe to the advisor who was "coincidentally" planning to sell and retire in the coming years.
In this week’s #OfficeHours with @MichaelKitces, my Tuesday 1PM EST broadcast via Periscope, I explore the potential consequences of financial advisors leaving the industry after the DoL fiduciary rule takes effect, and how the transition to a fiduciary world could actually lead to an increase in advisory firm valuations, not a crash.
The reason is that despite the fiduciary fears, RIA firms that operate as fiduciaries - typically operating as a level fee fiduciary with an AUM fee structure - actually already sell for an average price around two times revenue, while the traditional commission-based firm only sells for around one times trailing revenue. In other words, despite all the fiduciary fears, the reality for the past decade is that fiduciary AUM firms already sell for double the typical valuation of a commission-based firm!
In addition, the reality is that there's such a massive number of buyers for every sellers, that even a big uptick in sellers may do little to impact the current seller's market. Because not only is there an estimated 50:1 ratio of buyers to sellers, but most buyers are large firms looking to buy several others, while most of the sellers are solo or "smaller" multi-advisor firms. Which means the ratio of the amount of capital to buy advisory firms, compared to the value available to sell, could be more like 100:1 or 200:1 or more... which is ample pent up demand to absorb a DoL fiduciary seller's wave.
Of course, the reality is that selling a commission-based firm in the face of DoL fiduciary will still have limited value, simply because commission-based firms don't sell for as much in the first place, and may be even less appealing as the DoL rules make them harder to operate. And the push for more commission-based firms to shift to the AUM model as level fee fiduciaries, and then provide ongoing financial planning to justify their valuation, could accentuate the crisis of differentiation and push firms to reinvest even more in their advisors and services to compete (which can compress profit margins and ultimately bring valuations down slightly).
Nonetheless, the reality is that the marketplace has actually already judged level fee fiduciary AUM firms to be more valuable than commission-based firms, and if 20% of financial advisors really do leave after DoL fiduciary, that just makes more clients available for those who remain behind. Which means in the long run, not only may DoL fiduciary not impair advisory firm valuation multiples, it could leave the fiduciary survivors with an even larger business than they ever had before!
(Michael’s Note: The video below was recorded using Periscope, and announced via Twitter. If you want to participate in the next #OfficeHours live, please download the Periscope app on your mobile device, and follow @MichaelKitces on Twitter, so you get the announcement when the broadcast is starting, at/around 1PM EST every Tuesday! You can also submit your question in advance through our Contact page!)
#OfficeHours with @MichaelKitces Video Transcript
Welcome, everyone! Welcome to Office Hours with Michael Kitces!
I want to talk today about the valuations of advisory firms, because I'm hearing a lot of buzz about DoL fiduciary... specifically, some advisors suggesting that they might soon be throwing in the towel and selling, for fear of what the fiduciary rule will do to valuations of advisory firms.
It is true that we had a recent study from Fidelity recently suggesting that as many as 20% of advisors could leave once the DoL fiduciary rule hits. And Ric Edelman has said he thinks as many as half of the advisors could leave over the next 10 years, driven in large part by DoL fiduciary.
This possibility of a big wave of advisors leaving the industry has generated fear that there's going to be a wave of firm owners selling, and that all of this selling activity could drive down valuations for advisory firms. It makes intuitive sense, right? As advisors are all trained in the mechanics of markets: when too many people are trying to sell an asset at the same time, sellers overwhelm the buyers, and it drives the price down.
But I'm not convinced that DoL fiduciary and its aftermath is actually a serious threat to advisory firm valuations. In fact, I suspect what we're going to find are a lot of advisory firms actually get more valuable after DoL fiduciary, not less! Here's why...
Valuation Multiples For Fee Vs Commission-Based Businesses [Time - 1:27]
One of the driving forces of the DoL fiduciary rule is that it puts pressure on any kind of upfront compensation - i.e., commissions - that potentially leads to conflicted recommendations. That's the whole focus of the Best Interest Contract. If you want to still get conflicted commission compensation, it's still permitted, but the firm needs to conform to the best interest contract exemption and then implement all the required policies, procedures, and compliance obligations to validate that they're still giving best interest advice for reasonable compensation, without any misleading statements.
The alternative (the "easy button") that the Department of Labor gave for regulatory purposes, is that you can become a Level Lee Fiduciary, shift away from commissions altogether, and just focus on level AUM fees or retainer fees. Doing this will significantly reduce your compliance obligations while moving forward under DoL fiduciary.
Most RIAs are choosing to become level fee fiduciaries. But as I predicted in discussions earlier this year, we're seeing broker-dealers actually split. Some like LPL are choosing the full best interest contract route and will still have commission-based retirement accounts. Others like Commonwealth and even Merrill Lynch are shifting to become level fee fiduciaries and just doing assets under management for all retirement accounts.
Given the DoL fiduciary pressure on commissions, those in the commission-based business have expressed a lot of nervousness about this forced switch from commissions to level fees and the pressure that it puts on their businesses.
But here's the irony of the fear. When you actually look at the transaction prices for AUM fee businesses versus commission-based businesses, advisory firms built around AUM fees are worth more – a lot more!
The going rate for an AUM firm is about two times trailing gross revenue. Larger firms that are highly profitable sometimes get even more. By contrast, the typical commission-based firm struggles to get even one times trailing revenue. In many cases, larger firms (sometimes including broker-dealer entities themselves) can't even get that much. Many broker-dealers would be happy to actually get one times trailing revenue! They're just hoping to get 0.7 or 0.8 times revenue!
Which means if a commission-based firm can shift its revenue from commissions to recurring AUM fees and just make the exact same revenue, then on average, the business is twice as valuable. That's not a DoL fiduciary valuation disaster... that's a DoL fiduciary valuation gift! That's regulators forcing advisors into businesses that are actually more valuable in the long run!
Making The Transition From Commissions To Fees? [Time - 3:47]
The caveat here is that making the transition from getting all compensation upfront to one that has levelized compensation with AUM fees, can be a tough transition if you do it all at once.
For instance, if you're an advisor that has been bringing in $10 million in new business every year and earning 5% commissions, that used to pay you $500,000 of gross revenue. With a 1% AUM fee on that same business, it's $100,000 in revenue instead of $500,000.
Cumulatively, over a decade, the 1% fee may generate more revenue (it has the potential to grow as the portfolio grows, and you don't have to go back to clients and sell them new things to generate more revenue). But still, from an annual revenue perspective, it does mean there's a near-term hit.
That's the reality of converting from commissions to fees. You have to take a hit in revenue for a period of time, as you go through and convert clients. Eventually, you've cumulatively added so many AUM clients that it adds up to more revenue in the long run, but there is real work associated with shifting to become more fee-based or to go entirely level fee fiduciary.
I'm sure that's part of why a lot of advisors are saying that they're going to leave. If you were approaching retirement already and you don't have 5- to 10-years left in your career, it may not be that desirable to go through a rebuilding process and complete this transition. And if you don't have CFP marks or some training to give valuable ongoing advice, you may even have trouble converting your clients to an AUM or retainer model because they're going to ask what advice you are giving to earn an ongoing fee. If you don't have a good answer to that question, then that may be a tough transition!
I suspect that's why those who are most oriented towards pure sales and the least oriented towards advice are the most likely to leave. That's what we see in other countries as well. When the UK shifted to what is called RDR regulations (retail distribution review) and eliminated commissions, they saw about 25 percent of their advisors leave, though it appears to have mostly been the most sales-oriented folks that weren't really giving that much advice. Australia seems to have go through a similar result when they banned commissions about three years ago.
So if you're extremely sales-oriented, you may decide it's easier to sell the business, walk away, and go sell some other product in another industry, rather than try to be a salesperson running a business that no longer has upfront sales commissions. Even though the regulations are forcing advisors towards a more valuable business model, I get that not everyone is going to make the transition. That means there probably will be some uptick in advisors that are selling their practices. Some may even feel inclined to just walk away (though ideally you still want to sell your business).
Will We Shift From A Sellers To A Buyers Market For Advisory Firms? [Time - 6:21]
The fact that there's a potential uptick of advisory firms sellers brings us back to the question of whether we can have a near term glut of sellers that depress valuations, even if AUM firms are ultimately more valuable. Could there be a near term wave of selling that drives down valuation multiples? I still don't see that as likely to happen.
The reason I don't is because I think we still underestimate how much pent up buying demand there is for advisory firms. The popular statistic from FP Transitions (which is a marketplace that matches advisory firm buyers and sellers) is that they're finding there are about 50 buyers for every seller right now, a massive imbalance of way more advisors who want to buy firms than those who want to sell.
But when you dig in the numbers, it turns out not just that there's a 50-to-1 buyer to seller ratio, but also that buyers tend to be larger established firms, many of which are serial acquirers with the capital to do multiple transactions every year, while the bulk of the selling firms are solo firms (or at the most are "smaller" independent firms with just a couple of advisors). Of course that may well be a very valuable business worth a couple of million dollars, but still much smaller than the ones that are worth tens of millions of dollars that are doing multiple serial acquisitions.
Here's why that matters: If the number of buyers to sellers is 50-to-1 and the buyers are all ready to buy 5 apiece, then the actual imbalance (based on the capital to buy versus the number of firms to sell) could be off 100-to-1, 250-to-1, or more. There are some very deep pockets out there still looking to buy advisory firms!
In fact, there's so much capital currently coming into the advisory industry to buy firms that it's leading to an uptick in large RIA selling as well. It's leading to new private capital coming in just to buy large RIAs. And the capital is having so much trouble buying RIAs, that they're giving money to large RIAs to buy smaller RIAs in what's now called the "sub-acquisition" market! In other words, there's so much capital out there to buy advisory firms, that the people with the capital need other advisory firms to help them use their money to buy more advisory firms!
That much buying power pushing through the advisory industry right now means that even if there's a big increase in the number of sellers, there is likely more than enough buying capacity to handle the transition into DoL fiduciary. Which means there just isn't much risk of a seller glut driving down valuation multiples.
It is still important to recognize that selling a largely commission-based firm in the face of the DoL fiduciary rules is not going to get a great valuation. But that's not because of the wave of sellers... that's because you're running a commission-based model that struggles to sell for one times revenue already... and that one times revenue pricing is going to be even less valuable when DoL fiduciary is making it harder to execute the old commission-based business model! In fact, I suspect one of the primary buyers of commission-based businesses in the coming few years will be AUM firms that are hoping to buy clients up at commission-based valuation multiples and double their money by converting those clients over to AUM fees, doing what the seller didn't want to go through the pain of doing themselves!
Margin Compression Could Squeeze Valuations A Bit? [Time - 9:20]
It is worth nothing that there is one aspect of DoL fiduciary that may ultimately compress valuation a bit (though it's more of an indirect effect of the DoL fiduciary). It's the fact that when so many advisors all get forced towards the AUM model all at once, it's going to exacerbate what I call our "crisis of differentiation" - where it seems like we're all doing the same holistic financial planning and wealth management with AUM model, such that it's hard to differentiate from other advisors.
And if you thought it was bad before because so many advisors were doing the same thing, it's about to get a whole lot worse! Because soon there may be another 100,000 advisors forced to do what you do as a fee-based advisor! Or, if you're a commission-based advisor and you're about to do this transition, good luck differentiating your new level fee fiduciary service from all the other RIAs out there that have been doing it for years!
I think we're seeing part of the effect of this already. It's driving firms to reinvest more into what they do, up the ante with the quality and education of their advisors, and deepen their services. We're seeing this already in the benchmarking studies: all of the reinvestments that firms have to make are causing a reduction in profits.
Over the past couple of years there has been a lot of discussion about whether robo advisors are going to compress AUM fees, but what we're actually seeing is that AUM fees have been steady while profits are getting squeezed because firms are putting more money back into the firm in order to do more for their clients and justify their AUM fees. This margin compression could ultimately bring down valuations of firms a bit.
Because while the industry likes to throw around the "two times revenue" valuation number, the truth is that any competent buyer doesn't value businesses based on revenue alone, particularly if it's a sizable advisory firm. They value it based on profits and cash flows.
Now when most advisory firms have similar profits and cash flows off of the same revenue, then the rule of thumb multiple of revenue happens to be a pretty decent estimate. But since valuations are ultimately based on profits and cash flows, and it's possible profits and cash flows could get squeezed by the competitive landscape where AUM advisors struggle to differentiate themselves and successful advisory firms won't run 25 to 30 percent profit margins, but they'll run 20 to 25 percent profit margins instead... that may cause valuations to come in a bit, at least as a multiple of revenue.
Still, that's really not actually caused by DoL fiduciary. That's caused by competition. That's caused by too many advisors trying to use the same AUM model for the same wealthy clients while providing the same services. Maybe DoL fiduciary is a catalyst for that because it's going to drive even more advisors towards the same model at the same time. But it's not the cause.
Nonetheless, in response to the broader question of whether DoL fiduciary is going to cause advisory firm valuation multiples to crash... I just don't see it.
If you're in a commission-based business you're not going to get a great multiple if you sell at this point, but you weren't going to get a great multiple before either.
If you convert to an AUM fee model and you can actually make the transition, then you can expand and improve the valuation of your business! It may mean a few lean years in the transition, but it's actually way more valuable (potentially twice as valuable as a multiple of revenue!) on the other end.
For those advisors who do want to sell, there's still way more buying capacity than potential sellers. This is even true if there is a wave of sellers, because it's not just a 50-to-1 buyer to seller ratio – the differential is probably more like 200-to-1 in terms of buying capital to available value of firms selling! There is a huge amount of buying potential out there.
As a result, I just don't see this valuation crash coming. There may be some pressure on margins in the long run (because we're a maturing industry with growing larger firms), but that will only squeeze valuations a bit.
And, on the flip side, if 20% of advisors leave (or more if Ric Edelman is right), that means more clients available for those of us who survive (and thrive!) which means our businesses may be so much larger by then that you won't actually care if the valuation multiples are slightly compressed! Your firm may outgrow any valuation decrease when you're a survivor that serves your clients well!
So I hope that gives some helpful food for thought around the future of advisory firm valuations, and where things are likely going in the next couple of years. This is Office Hours with Michael Kitces, Tuesdays, 1:00 p.m. East Coast time. Thanks for hanging out everyone. Have a great day!
So what do you think? Will the DoL fiduciary rule really cause a wave of advisors who sell their firms? Will that overwhelm the buyer demand, or just be absorbed by all the available capital? Are you excited to make the transition, or fearful of the challenge? Please share your thoughts in the comments below!
Michael, thank you for the timely and thorough article. I hear the stat of 50 to 1 and the variations you listed above. What exactly does a buyer to seller ratio mean though? I have purchased one RIA lifestyle practice and am also a part of FP transitions EMS program so I am probably a “buyer” in their studies. The thing is though, out of all of the practice owners that are considering a sale, there are only a few that I would consider buying. Likewise there are many sellers that really couldn’t consider me to purchase their firm for various reasons (geographic location, capital, etc) but I am still a “buyer”. Another thought I have is If I am an adviser who is looking to sell my practice for 1-2 times revenue, why don’t I keep working for another two years and re-consider? The incentive for an owner to sell is much less once a firm is established and has people and processes in place to keep the ship going. Not to mention that they are probably getting referrals and new clients without much effort just by the nature of having more clients.
I think there is a risk of current AUM firms losing value over the next ten years (not necessarily in the short term) for these three reasons:
1. Fee compression – whether in the form of Robo competition or as the AUM model gets challenged by regulators and our clients.
2. Costs are increasing – Talent, Compliance, Technology, all of it is costing more and more in the form of salaries and subscriptions that will only stop when your business does. Sure you can get everything you need via subscription but you have to take all of those expenses and use it to get new business or you end up with a really efficient infrastructure with proverbial cobwebs gathering on it because you don’t have the business to justify it.
3. Accountability – the barriers to entry have never been higher because the skill set that it takes to manage an advisory firm successfully is getting increasingly more demanding. Then there is the DOL which my understanding is that clients will hold advisers accountable through the court system. We will have case law and transparency. Both of which are complex and expensive.
In summary, my opinion is that practices are expensive right now which is okay as long as the money and talent is there to buy them. Should either the profitability of RIA’s go down, or the demands of running them get more, then the amount of money buyers are willing to spend will decrease in the future.