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Capital idea

The capital strength of financial services companies is a hot topic. Providers are struggling to adhere to the various strictures coming from the regulator and from Europe at the same time as coping with the ravages of the stockmarkets.

IFAs are not immune from this either. Everyone agrees that the industry is in flux and for businesses to survive periods of fundamental change, they have to have a secure financial base. Traditionally, IFA firms have been small practices averaging fewer than four RIs and with little capital reserves. One response to possible changes to the polarisation regime and the impact of Government-imposed low-margin products has been consolidation but, increasingly, the capitalisation of IFAs has also been mooted.

Aifa director general Paul Smee says the lack of capitalisation has been a persistent problem for IFAs. He says: “The problem for IFAs has been that when there have been problems, there has not been the capital there to help. Also, when the time comes to sell the business or retire, undercapitalised IFA firms have been very difficult to value. After all, what is the value of an address book?”

Some of the major providers have also voiced concern about the capitalisation of IFAs and have been tentatively suggesting schemes whereby they could collectively inject capital into the IFA sector.

There is also strong anecdotal evidence of life companies knocking on the doors of IFAs wanting to take minority stakes in their businesses.But, given the FSA&#39s recent indication that multi-ties are not on the immediate horizon, the providers will have to explore a variety of ways of injecting capital into IFAs.

Future regulatory requirements on capital are not yet clear. When the FSA assumes its full powers at the end of November, a fundamental difference will be a move from the PIA “belt and braces” practice to the FSA&#39s much trumpeted risk-based approach. The ext-ent to which this will affect IFAs is debatable. In any case, the industry is waiting for the outcome of the regulator&#39s consultation on this approach.

However, EU legislation is thought likely over the long term to lead to greater capital adequacy requirements across the board.

Traditionally, compulsory professional indemnity insurance has filled the void of capital for IFAs. But the regulator is consulting on whether this should remain the case. As Smee points out, there is a payoff between PI and capital reserves.

Kangley Financial Planning managing director Geoff Kangley says the meagre capitalisation of IFAs has come about for solid financial planning reasons.

He says: “For a limited liability company such as mine, there is no benefit in holding large capital reserves as it is simply inefficient and liable for corporation tax. Sole traders and partnerships will also not want to subject themselves to 40 per cent tax on it. Money in a company is a depreciating asset.”

As a consequence, the profits of the business go into the pension or dividends.

A few years ago, the need to computerise had IFAs looking for additional capital. Kangley questions whether the average small IFA would need to attract development finance into their business unless they were looking to expand. He says the majority would not wish to expand and incur the extra cost of, for instance, having to employ a full-time compliance officer.

But Aegon corporate development director Laurie Edm-ans provides a radically different perspective. He refers to the Australian model in which the vast majority of IFAs are owned by providers.

Edmans says the industry has long been tarnished by a reliance on front-end charges and commission. Apart from leading to a mismatching of the interests of the consumer and IFA, he says the reliance on indemnity commission has left IFAs vulnerable to any changes in the regime.

He says any move away from up-front commission would leave IFAs financially exposed during the transition period and this will need to be financed. “You can only afford to change if you have enough fat to live off in the meantime,” he says.

Edmans points to Australia, where IFAs are remunerated according to funds under management and the valuation of an IFA is some 8-10 times annual income.

In this country the recent prices paid for IFAs suggest a valuation equivalent to only one year&#39s commission.

Clerical Medical head of strategic marketing David Shelton agrees on the need for financing a transition to a different remuneration structure for IFAs. Apart from this, he is concerned that under-capitalisation could inhibit the growth of the IFA sector in the future.

He says capital is needed for improvements to infrastructure such as updating IT equipment but, most important, to grow and take adv-antage of the growing market for advice.

As Kangley points out, many IFAs prize their independence, which many fear could be eroded if there is financial backing from third parties. The traditional source of security has been to join a network or national.

The options for an IFA wishing to attract backing are those open to anyone else. They can approach venture capitalists or business angels, the banks, or private individuals. However, IFA expansion has tradition-ally been achieved by merger, rather than by buyout. And those who have attracted backing are understandably reticent about sharing the details.

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