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Consolidate with destiny

The reasons behind the FSA’s desire for IFA businesses to be better capitalised, for advisers to be better qualified and for initial commission to be consigned to history have already been commented on widely in the press. Implementation of these measures, in line with last year’s retail distribution review, will undoubtedly help to professionalise and raise the esteem of the IFA industry.

IFAs are, however, now facing the challenge of how to implement the changes to their business model and capital base in order to meet the FSA’s requirements. These changes need to start being made at a time when advisers are trying to maintain their income levels, which is proving difficult during an economic recession. If things were not difficult enough, most shareholders now have to accept that the value of the IFA businesses in which they are invested is probably at least 50 per cent less than it was 18 months ago when the market peaked – at around the time of the sale of Bestinvest.

As a corporate finance partner in KPMG who has advised on around 30 IFA M&A transactions over the past 10 years, I believe those IFA firms which implement these afore-mentioned changes will improve the long-term value of their business.

This seems to be borne out when looking at the business models of three well-known firms which all attracted high valuations, namely, the sale of Chase de Vere Investments to Bank of Ireland in 2000, the IPO of Hargreaves Lansdown in 2007 and the sale of Bestinvest to 3i.

These firms broke the mould in terms of valuation multiples and, in my view, this is due to the differentiation of their business models which were developed by inspirational founders whose ideas were undoubtedly ahead of their time and whose leadership served their shareholders well as they patiently built up their businesses to the point of sale/IPO.

I would recommend that any chief executive of an IFA firm seeking to increase shareholder value while at the same time implementing the RDR’s proposals could learn from the successes of these three firms, each of which had a business model focused on maximising profit margins and increasing profit year on year. Such profit focus was at the expense of top-line growth.

The days of value being generated by bulking up the number of advisers with scant regard for profit or cash flow are long gone as, indeed, are those businesses which flourished for a while with such a model.

In the current market when looking for value, an investor or purchaser will focus on profitability but will also want to understand adviser productivity levels and the proportion of income earned from by charging clients fees (hourly or by reference to assets under influence) or trail commission.

High profit margins seem to be generated by firms able to utilise technology such as call centres, internet, fund supermarkets or wrap platforms, etc, to improve the client experience and to raise efficiency levels to ensure that minimal and expensive face-to-face adviser time is spent on back-office administration.

The biggest proportion of an IFA firm’s cost base is staff costs and here I see the greatest opportunity to reinvent the business model in line with the RDR prompted abolition of initial commission.

Higher long-term profitability will stem from aligning advisers’ income to client retention. Unsurprisingly, those businesses paying away very high rates of commission struggle to make a profit even in benign market conditions.

This reinvention may involve a massive cultural change for many in the IFA industry, not least those employed and self-employed advisers who thrive as commission- driven salesmen.

Furthermore, I acknowledge that the transition may involve a painful and in some cases fatal strain on cashflow and short-term profitability for some firms. However, this change is being forced on to IFA firms by the RDR.

Chief executives who are able to make the change will have a sustainably profitable firm and will, in the process, build up a culture of loyalty to the employer and profess- ionalism, enhanced by higher qualifications, when dealing with clients. This, in turn, should make clients more accepting of a new fee-based relationship with their adviser.

Any management team able to implement these changes in their business models, especially in tough trading conditions, will be well regarded and this may well be the single most differentiating factor between IFAs that successfully command a high value and those that do not. The history of M&A deals done in the sector over the past 10 years would seem to support that view.

There will be many firms that are unable to meet the challenge and this could present a number of attractive consolidation opportunities for ambitious, scalable firms that have changed their business models accordingly.

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