Without the bull market to inflate and support business valuations, planners looking to sell or put succession plans in place are in for a rough ride. Kristen Paech reports.
The subprime maelstrom and the havoc it’s wreaked on global equity markets is a wakeup call for financial planning practice principals across Australia. For years planning firms have been sitting pretty, riding the bull and watching valuations charge ever upwards.
But the time for complacency is over. The bull has fled the arena, forcing business owners to stand on their own two feet or risk being trampled by the incoming bear. Profitability is now a matter of survival, and succession planning has never been more crucial. Regrettably though, it’s an area that often falls by the wayside. Recent research by Axa found business owners can get so caught up in the day-to-day management of their practice that they forget about the bigger picture. This indolence could cost them dearly.
The 2008 Axa succession report revealed financial advice businesses with profitability below the industry average of 20 per cent in a bull market will struggle to realise their full value if the market becomes bearish. If current market conditions are any indication, retiring principals are in for a rough ride. Price/earnings (PE) ratios for some prominent listed financial planning and related services companies have contracted significantly between June 8, 2007 and March 14, 2008. Count Financial saw its PE ratio fall from a high of 36.6 times to a low of 19.0 times during the period, while Prime Financial Group witnessed a low of 7.3 times after enjoying a high of 21.5 times just months before, according to estimates from Austock.
DKN Financial Group realised a PE ratio high of 27.9 times and a low of 11.3 times, while Snowball Group hit a high of 18.1 times and a low of 12.2 times. Chris Dionne, principal at Shirlaws, says many planners didn’t see the need for a strategic approach to succession planning in a bull market.
“Equally when the market’s down, clients are doing it tough, money’s tight and interest rates have gone up, they’re going to potentially feel like they haven’t got the money to invest in their business,” he says.
But rather than sit back and just hope for the best, Dionne says now is the time for business owners to spend money and back their belief in being able to recoup the costs when they come to sell the business.
Ian Knox, managing director of Paragem, suspects principals were frightened to sell up while the markets kept rising, in fear of missing out on any upside.
“We started to see multiples becoming quite giddy and reports were made of valuations above 3.5 [times recurring income],” he says.
“Since November last year there’s been a dramatic fall in funds under advice because of the market falls, and as a consequence the revenues have dropped in most practices, one would imagine, by a minimum of 20 per cent. If that’s the case, valuations should also have fallen by a minimum of 20 per cent if you’re using an annualised forecast on revenue.”
Knox says practices were attempting to annualise forward earnings – dangerous conditions for a buyer – at a time when the market was reaching record highs.
“If we enter into a prolonged bear market, revenue from practices will remain flat to negative relative to 2007 earnings, so I think you’ll find practices being valued at more sensible levels,” he says.
Quality businesses tend to hold their value regardless of market conditions, but for those planning firms that do not have the luxury of a top poll position the runaway bull will certainly test their mettle. There is no doubt that the option to list has become less attractive because of the credit crunch, particularly for middle- to upper-sized financial planning firms.
Getting the process underway is costly and distracting for a business, and when you add market turmoil and nervous investors to the mix, most firms are likely to think long and hard before going down this path.
Storm Financial blamed market volatility for its decision to scrap its initial public offering (IPO) late last year. The company was due to float on December 12.
Steven Davidson, head of the acquisitions and succession team at Axa, says: “What we’ve seen in the last 18 months is a number of cases where practices are coming together to do an IPO, which can potentially pay off when the firm lists, but in reality Storm failed to list last year prior to the market going askew and a number of other potential IPOs have been deferred.
“One could read into it that this model doesn’t attract investors.”
It remains to be seen whether Best Advice Project (BAP), the group that counts 12 planning firms as members, will float later this year.
The group, which is on the verge of rebranding as Shadforth Financial Group, plans to transition all firms across to a new dealership, Shadforth Dealer Services.
BAP has been considering the move on the back of the merger, but chief executive Tony Fen- ning says while it remains an option, the group is not committed to listing.
The benefits, he says, would be the ability to offer staff equity in the business, and increased liquidity, which enables the older planners to sell down their equity so the younger advisers can take up the baton.
“One of the things that we think would give us a competitive advantage is the ability to offer people ownership in the business,” Fenning says.
“That’s almost impossible to do at a small firm, whereas a listed vehicle enhances your ability to do that. It also frees up the capital of the firm to be more widely spread and for more people to participate in the future growth of the business.”
Current market conditions lend weight to the case for building multiple succession options into a business.
Firms that take a broad, strategic approach to succession planning have the ability to carry out an internal succession sale or an external sale, rather than rely on the now absent bull to carry them into retirement. Such an approach means having the right business structures in place and ensuring the advisory offering is both clearly articulated and easily transferable to the wider market.
These structures include relevant reporting, functionality, documented work practices and business procedures, and a strong compliance track record.
Tony McDonald, managing director at Snowball Group, says with tight market conditions putting pressure on margins, the need for practices to “corporatise” is paramount.
“There is a relentless drive for succession and in this tougher financial market environment, how are you going to get that profitability?” he says.
“Corporatisation is about better customer service and higher profitability. I think there’ll be much greater focus on that going forward.”
De-risking the business from any key person dependency is also critical. Davidson says a successful handover starts with the client.
“If the relationship is to one adviser then it’s not a corporatised business,” he says.
“If there’s a meaningful proposition for the client and they’re willing to pay for it, it’s going to be sustainable.”
McDonald expects to see more activity in the mergers and acquisitions (M&A) space as a result of the change in market dynamics.
Some 60 per cent of practice principals are over 55 and considering exiting financial planning in the next five years, according to Business Health’s Future Ready II white paper.
“There’ll be some agonising going forward about listing and I think what you’ll see in the listed market, just like the private market, is more thought being given to mergers and acquisitions,” McDonald says.
“We’ll see more discerning structures put in place where effectively the reward for the vendor will come on their ability to deliver appropriate growth in the practice.”
Indeed it appears a good time for a buyer to sit down and negotiate a sensible price with the seller.
Now that there are less people bidding at the auction, so to speak, aspiring business owners have more chance of nabbing a planning firm for a song.
On the flipside, while valuations have come down, the seller can still obtain a good price for their firm if they act smartly.
By negotiating a deal where the equity holder transitions out of the business and sells down over a period of years, they can participate in any market recovery that takes place.
However, Davidson says it is rare for principals to sell their business in its entirety.
“Our research shows that 85 per cent of the transactions that take place are the sale of a client base, so only 15 per cent of principals are selling their business as a going concern,” he says.
This is partly because few of them have a fully-funded, agreed and documented succession plan in place, according to Business Health.
Davidson says Axa is seeing more off-market sales, where the firm looks for a buyer that’s compatible from both a cultural and operational perspective, and more brokers willing to represent a trade sale.
But activity will ultimately be driven by access to capital, he adds.
“What we’ve seen to date is larger businesses, those owned by baby boomers, buying up other baby boomer businesses; the question is who will buy their business down the track?” he says.
“We should assume the next generation will be the ones buying the practices and they will need to find the money from somewhere.”
The cost of debt has risen substantially on the back of the credit squeeze. However, innovation around cash flow lending solutions is making the dream of owning a business more attainable for many young planners and aiding principals as they move into the “third age”.
Until a few years ago, there were few borrowing options for planners wanting to buy into a practice unless they were willing to mortgage their personal assets, such as their home, to provide the collateral for the loan.
With Australian real estate markets booming, and mortgage debt levels also soaring, many didn’t have enough equity in their house to borrow the necessary cash, and in some cases were forced to take out finance with the vendor and pay it back over a number of years.
Now, though, the major banks are offering products that allow the planner buying the equity stake to borrow against the recurring income of the practice.
“They suddenly have an alternative where they can buy into a business and use the business equity they’re acquiring as security for the borrowing, so it’s opened up a new avenue for them,” says Malcolm Arnold, national manager, financial planner banking, at NAB.
“This appeals to the business owner and the young adviser, because they might not have much equity, or perhaps want to keep their house and their personal assets separate from their business operations.”
Arnold says that five years ago, around 75 per cent of transactions of this nature that were carried out through NAB were for the purpose of growth, where a planning firm that was looking to acquire another firm to enhance their reach and grow their business would come to the bank for funding.
But wariness over leverage – given the cost of debt, rising interest rates and market volatility – has led principals to think more about managing their own succession rather than the growth of their business.
Internal and generational succession is increasingly being seen as a sound business strategy for retiring principals.
“In the last year or so a lot more principals have started to plan for succession and a lot of the finance we’ve been writing has been for young planners wanting to buy some equity in a business,” Arnold says.
“So it’s moving towards succession planning transactions. It’s probably 50/50 now – half is succession planning and half is business growth. Because they don’t have as much confidence in the value that will be achieved for their businesses, and there aren’t enough people looking to buy the businesses, many financial planners have come to the realisation that if you have a young planner in your practice who has been working for you long term, they are potentially the best successor.”
Matt Taylor, business development manager at BankWest, says although it costs the planner more to borrow against the practice, there are tangible benefits in doing so.
“They’ll generally pay between 50 and 100 basis points on top of what they’d pay if they had bricks and mortar security, but it can create a more equitable situation for the partners of the practice,” he says.
“If two financial planners are working together, sometimes one has his property on the line and the other doesn’t, which makes it a bit unfair. If the practice is the only underlying security the bank is relying on, the risk is aligned equally to the partners of the business.”
It also makes it easier to bring another partner into the practice, Taylor says.
“If they’ve got a good employee in the practice, they might want to offer a smaller stake -10 or 20 per cent – as a starting point to their succession plan,” he says.
“They can do it on a staged basis, so we can look to fund them in on a smaller scale, and then over time if their shareholding in the practice grows they can continually leverage off that [practice’s growth] to buy more shares in the business.”
So the benefits for principals are twofold: not only does internal succession make good business sense, it can also act as a staff retention tool.
Rewarding employee loyalty with equity can motivate younger staff to work hard and take comfort in the fact that they are reaping the benefits through a share in the profits of the practice.
The lending terms available to planners vary among the different players. However, NAB typically lends on a 10-year term based on the recurring income of the business.
BankWest, on the other hand, offers a 15-year term and values practices around earnings before interest and tax (EBIT), using recurring income as a secondary rather than primary valuation model.
Loan-to-valuation ratios range from about 60 per cent to 75 per cent, but in the current market environment, Arnold says firms don’t want to gear themselves too far.
He admits the credit crunch has had an impact on activity levels, but says good businesses with strong profiles are still pursuing all avenues available to them.
“You have to add another 2 per cent on [to] the interest rate that you got in July last year, so there’s no doubt that’s having an impact on young planners taking up the opportunity to buy in, or existing businesses buying another one, because the cost has risen,” Arnold says.
“[But] we’re still seeing a lot of activity. The businesses that are succeeding now are those that have got the core fundamentals right.”