The most common methods for valuing an IFA firm are turnover multiples, assets-under-advice multiples, profit multiples and discounted cashflow. I would recommend all four methodologies are applied and checked against one another to achieve a balanced view on value.
Each methodology has its own potential pitfalls and subjective judgement areas however, which need to be handled carefully.
The main problem in focusing solely on the turnover and assets-under-advice multiples is that they both ignore the underlying profitability of the business and its growth prospects. The turnover multiple should, as a minimum, be broken down into multiples of initial commission, trail commission and fees. The market values trail (that is, recurring) commission and fees at a significant premium to initial commission.
Even pre-credit crunch, those banks lending to IFA consolidators struggled to ascribe collateral value to initial income. Given the threat to initial commission posed by the RDR, it would be hard for a buyer today to value, other than at a low level, an IFA largely dependent on initial commissions.
Assets under advice have long been a “rule of thumb” measure for valuing private client and other type of fund managers. Analysts’ reports on Hargreaves Lansdown often comment on its value by reference to the quantum of assets on its platform. In applying this valuation metric, it is important to take into account and adjust for the relative basis points’ revenue earned from such assets.
A further concern with applying this approach is that few IFA firms are able to provide an accurate or audited figure for such assets. We would, therefore, advise any buyer to undertake due diligence to get comfortable with that number. For an IFA business with a transaction model – as opposed to a client relationship/advisory-driven one – an assets-under-advice-based valuation would seem to have little relevance.
I strongly advocate that IFA businesses seeking to create capital value should focus on producing consistently good profit margins. This would suggest that a sensible way of valuing IFAs would be on a multiple of profits.
The multiple should be applied to sustainable profits, which may mean adjusting the reporting profits for one-off items such as profit on disposal of an asset. Adjustments may also be needed for items such as interest income on surplus capital or to normalise salaries of owner-managers.
Critical judgement is also required in determining the right multiple to apply in order to take into account significant differences in business models, profitability, growth rates and adviser productivity. This means a multiple of profit is hard to apply without an element of commercial judgement and a possible adjustment to the profit multiple of a listed IFA or of a recently completed IFA sale to a particular IFA firm.
As IFAs know better than anyone, particularly in the current climate, past performance is no guarantee of future performance. For this reason, I would advise any buyer to do a DCF valuation.
Any DCF is dependent on the quality and robustness of the underlying forecasts which will need to be subject to due diligence. The forecasts should be sensitised for items such as impact on revenue of changes in market outlook, a post-RDR world, different adviser remuneration structures, inflation and interest rates, and future capital expenditure payments.
A buyer should also factor in the potential cost and revenue synergies it expects to generate from the acquisition. Considerable judgement will also be needed to determine the discount rate to apply.
In buying an IFA, there are a number of non-financial factors that are crucial in determining the valuation, the decision as to whether to buy and how to structure the payment of consideration, for example, earn-outs. I will come back to these issues another time.