Introduction

The economy continues to be underpinned by the services sector.  In the last 12 months we have been instructed on several sales and purchases of successful financial services and software support businesses. It is increasingly important for prospective purchasers and their advisors to be alive to the specific factors which impact on the valuation of a business whose assets predominantly comprise goodwill and other intangibles, such as brand, client relationships, intellectual property and trade secrets.  In this paper, we examine recent developments relevant to valuation methodology and price negotiations for IFA businesses.

State of the market

Notwithstanding the consolidation prompted by the Retail Distribution Review, the APFA 2015 report “The Financial Adviser Market: in Numbers” indicated stability in the number of advice firms.  Time will tell whether ongoing pressure from direct to consumer offerings and higher FSCS levies will prompt increasing numbers of IFAs to seek an exit.

Some commentators predict a shift from the traditional valuation principles for IFA firms, based on a multiple of recurring income, to valuations by reference to net profit.  Those lifestyle firms with significant recurring income but a narrow profit margin may well encounter increasing difficulties in finding an exit route which matches their expectations, perhaps suggesting a likely flurry of deals in the short term.  Vendors who wish to retain an ongoing role in their business should, however, be wary of profit-based earn-out structures, given the potential focus on driving down costs at the expense of client and staff satisfaction.

Valuation methodology

Whilst we have seen a wide variation of valuation metrics, the most common is based on a multiple of an appropriate indicator.  On the evidence of recent transactions, valuations by reference to a multiple of around 1.5% of recurring income are still widely used.  A proportion of the purchase price is usually deferred over a 2 to 3 year period and adjusted by reference to a multiple of recurring income earned during that period.

The valuation multiple is, however, merely one element of a complex price adjustment mechanism.  Below, we consider particular factors which have significantly affected recent deal values.

Key valuation drivers

RDR

In addition to being a catalyst for deal activity, as the transition to advisor charges and higher regulatory capital requirements prompt IFAs to consider the financial viability of their businesses, the Retail Distribution Review also has a direct impact on valuation criteria.

The definition of “recurring” income for the purpose of the valuation multiple is of paramount importance.  Definitions of recurring income employed in recent transactions have generally excluded:

(i)         legacy income attributable to cash rebates passed on by platform providers which were due to be switched off pursuant to the FCA’s so-called “sunset clause” with effect from April 2016; and

(ii)        legacy commission from group personal pension schemes, also banned from 2016.

Purchasers and their advisers should be aware of other regulatory developments which will continue to have a direct bearing on the value of a target IFA.  For example, any target net asset threshold for an IFA practice should take into account the FCA’s regulatory capital requirement, which will with effect from 30 June 2016 be calculated based on the income of the target business.

Revenue Synergies

An investment manager with a financial planning arm will often seek to take advantage of the potential to migrate the client book of a target IFA to its own investment products.

Valuation of the target should not necessarily assume, however, that such revenue synergies are guaranteed, and a purchaser should exercise caution.

Any incentivisation of financial advisors to move clients to different products should be carefully considered, given the inherent risk of regulatory infringement.  The purchaser must ensure that the duty to act in the best interests of the client prevails over any strategy to increase investment management fees, and that this is supported by advice records.

Custodian exit charges serve as an obvious disincentive for advisory clients to move their investments, and the level of such charges should therefore be investigated.  The parties may well decide to bear such charges in agreed proportions, given the potentially significant impact on the buyer’s revenue forecasts, and any such arrangements should be negotiated and agreed at an early stage.

Assuming that an asset purchase structure has been agreed, the paperwork required to novate existing agencies with product providers, in order to enable the purchaser to benefit from provider paid fee arrangements, can vary considerably between providers.  The management time likely to be incurred in collating and procuring the signature of such documents should be figured into the estimated costs of achieving the required revenue growth. 

Client demographic

It is important to analyse the demographic of the client base, not least in order to ascertain whether relocation of the business is likely to affect client relationships, particularly if the IFA is situated in a comparatively remote area.  Assuming that relocation of the business to the purchaser’s existing branches, either on or after completion, is commercially viable, the cost of such an exercise (including redundancies and dilapidations liabilities on termination of office leases) and the question of who should bear these costs, will need to form part of price discussions.

The standard of the target’s client management software will often dictate the quality of the information on which a purchaser can base its valuation decision.  The purchaser should ideally seek to obtain a full breakdown of client income and assets under management by reference to product and advisory proposition, in order to facilitate transparent discussions on the exclusion of more vulnerable income streams.

Regulatory compliance

A full review of the target’s compliance history, including conflict of interest reports, complaints registers and Gabriel compliance reports, will often identify issues which impact on deal values.  For example, historic advice on financial products which are or have been on the FCA radar, such as keydata, may well complicate or delay FCA registrations; any such protracted delay could impact significantly on the business handover and client communication process.

Incentivisation

As human capital is perhaps the most important valuation driver for any service sector business, a purchaser should from the outset strive to minimise client attrition by identifying those financial advisers with key relationships and ensure that they are subject to appropriate restrictive covenants, and sufficiently incentivised to grow the business.  An equity incentive is often the most effective way of tying individuals into the business for the long term.  Purchasers should, however, be aware of the tax implications of equity incentives, for example HMRC rules on disguised salary for fixed share partners. 

ROLE OF THE LEGAL ADVISOR

It is essential for the legal advisor to a prospective purchaser of an FCA regulated business to have a detailed knowledge of those factors specific to the financial services industry which significantly affect the commercial terms of the deal, for example:

• The definition of “recurring income” on which the price has been calculated will need to be reflected in the sale agreement; a holistic understanding of the accounting and regulatory criteria which determine whether income is recurring will ensure that the drafting of the purchase price mechanism accurately reflects the commercial agreement between the parties.

• Negotiations over earn-out and net asset adjustment mechanisms can become unnecessarily complex; a confident advisor aware of the underlying commercial objectives and regulatory factors may well be able to suggest a simpler solution.

• Legal, financial, tax and compliance due diligence are usually carried out in tandem, but unless an adviser with transaction management experience is proactive in drawing together the different workflows it is easy for pertinent findings to be overlooked.

George Green LLP has extensive experience of transactions in the financial services sector, from advising nationally renowned investment managers to local IFAs and insurance broker groups.  For more detailed information on our financial services transaction team, please call or e-mail us using the contact details below.