The IFA sector has been expected for years to follow the general insurance sector in adopting the consolidator model.
In the GI sector, that model has been a simple story – take a broker receiving, say, 10 per cent commission on its motor and household sales, buy it at one and a half times turnover, and promptly demand 25 per cent commission from the same insurer for the same product. The consolidator’s market power is such that few insurers are able to resist. The buyer ends up paying a fraction of the new turnover and the higher commission is all profit.
Inspired by this example, the IFA market has seen the arrival of a number of consolidator-type models but in recent months most have fallen back, hampered by, among other things, the lack of credit and the fact that early-stage acquisitions have not necessarily performed to plan. Does this mean that the IFA consolidator model is broken?
In IFA businesses, there are no quick wins as there are in GI but the basic theory that underpins consolidation can still hold good, even if the movement to a higher level of commission or earnings can take considerably longer.
Time is a key point and will inhibit the growth of consolidators. In the IFA sector, underlying profits are a key factor. Given the weak trading of the last couple of years, profits have been harder to come by, so consolidators are not acquiring profits on the same scale as they have done in GI. This will inhibit the spread of the model, even though many consolidators do not make underlying profitability a headline issue.
The only fundamentally essential volume factors are profitability and cashflow. Even these can be undermined by a business model skewed in favour of excessive initial commission, a model which will certainly not survive the RDR.
Most of the IFA consolidators that set off down the volume road have fallen by the wayside, unable to generate the profit and therefore the cash, to service the debt used to buy the companies. They have either abandoned the project (temporarily in some cases) or have scaled back to the point of invisibility. Without profits, the volume-driven consolidator model must stumble and it has done.
We look equally hard at recurring income and main- tainable profitability and will only buy businesses with these indicators at sound levels. Even in the present market, there are significant numbers of well run IFA firms with good levels of profitability achieved through good husbandry, for- ward thinking and financial planning – the very virtues that IFAs preach to their clients.
In the present debt market, banks will require transparent serviceability of debt and will not sanction consolidator models that are not based on profits as the key driver.
What does all this mean for IFA firms looking to a consolidator as a potential future exit strategy?
First, all eyes are on the RDR. That means shifting to longer-term earnings’ streams and ensuring clients are fully looked after, not just initially but also in years to come. There is no future in high initial com-mission. If your IFA firm has not begun that move yet, then you have a difficult three years ahead, as the cashflow and profit pain are yet to come. Second, firms need to review their overheads and their mix of trail and initial commission. We have a rule of thumb that overheads should be covered by recurring income and initial income should be largely profit.
It is not surprising that many IFAs have not yet built up significant trail income but what is surprising is how many businesses we see have gone too far the other way – sacrificing almost all initial income and relying on renewal income. Given that most of the cost of a client is the up-front work, this means there will not be enough margin to develop new client activity and the business will stagnate at best or, more likely, go backwards.
Finally, and probably most important, what does the owner of the IFA want from the future? The numerous consolidator models in existence have offered a variety of post-purchase arrangements, from our own totally hands-off, keep-your-brand, systems-and-management model, to those where the firm becomes a branch of a much bigger business, following that business’s model strictly, with no independent strategy at all.
IFAs need to decide whether they will want to stay with the business, whether they will be required or allowed to, and, if so, on what terms and in what capacity. Is there a secondary management level (the marzipan layer) who can run the business if the founder shareholders leave? This can be an issue for the buyer.
Is there equity on offer and does the IFA owner want that or do they want to take a back seat immediately? Potential buyers like to see that some thought has gone into these issues, even though there may be lots of different thoughts at the end of the process.
It is our view that the consol-idator model will get a strong foothold in the IFA sector, particularly as economic conditions and profitability improve. Profitability will always be the issue that separates the good businesses from the weak and we expect the consolidation model, when it re-emerges, to focus on this.