Wealth management firms are brimming with talent, brain power, energy and most importantly, revenue-generating capacity. These firms come in many shapes and sizes, and vary widely in terms of the key components that drive value. As such, the valuations of wealth management firms present a number of special considerations.
Tangible assets are negligible among wealth management firms. The major driver of value is a “two legged” asset that goes home every night, the human capital. Business is typically based on close personal contacts, mutual trust and the collective reputation of the firm and its key professionals. The longevity and predictability of those assets are difficult to ascertain – and, in many cases, firms do not have legal rights to those assets except for those cases in which employment agreements have been signed.
Approaches to Valuation for Wealth Management Firms
Within the valuation industry, the three approaches to valuing a business are: the asset, income and market approaches. The asset approach is typically best suited to value tangible asset-rich businesses or non-operating type entities. Wealth management is human capital driven, which is measured through the financial operating results of the business. Thus, the income and market approaches are best relied upon in valuing a wealth management firm. The remainder of this article will focus on elements of the income approach and the market approach and their applicability in valuing wealth management firms.
Income Approach – Use of Historical Financial Information or Forecasts
The two primary methodologies within the income approach are the capitalization of cash flow (“CapCF”) and the discounted cash flow (“DCF”) methodologies. The CapCF measures and determines value, based on capitalizing a normalized cash flow amount that is viewed as representative of normalized financial performance. To the extent that the business is mature and the past is deemed to be a predictor of the future, a valuation professional may find the CapCF the best method to employ. Often times, however, the future direction of the firm is expected to vary from the historical results. This situation is best addressed through use of the DCF methodology. The build out of forecasts often can be a daunting task.
Revenues of wealth management firms are a function of price and quantity. Price is usually stated in terms of basis points earned on Assets Under Management (“AUM”) and quantity reflects the asset base, or AUM. Revenues for wealth management firms are not secured by long-term contracts and can provide challenges to building (or relying on) defensible forecasts beyond one year (much less, two years.) Current operating data may be relied upon when there is a high level of client retention and when fee structure is predictable. In some cases, there can be shifts in revenue (due to unpredictable swings in market performance) or cost drivers, or the business is not at a mature state (earlier stage companies.) All of these factors make the use of current operating data tenuous. In the case where there is a reliable track record or there are several likely scenarios on the horizon, VRC has successfully worked with its clients to create sophisticated expected cash flow models based on various scenarios, which consider all operating characteristics and pertinent drivers of value.
As forecasts are subject to market expectations and are tied to shifting business dynamics, valuation professionals are dependent on management to prepare forecasts based on a soft set of assumptions. When the underlying forecast assumptions provided by the client are deemed to depart significantly from historical results with no supportable rationale based on the valuation professional’s independent examination of the business and/or the company financials, or are subject to attack, a valuation professional will lean more heavily on industry knowledge, market data trends and drivers, coupled with the client’s input, in building defensible, well-reasoned forecasts.
Forecast risk for smaller wealth management firms tends to be higher than for larger firms, due to higher dependencies on both key personnel and client concentration issues. The loss of either of these could significantly change the projected path of the firm. This risk is mitigated in medium- to large-sized firms as they have deeper benches of seasoned professionals with a larger pool of intellectual capital. Additionally, the intangible assets of a larger wealth management firm tend to be embodied in the collective knowledge of the firm’s culture, which is largely recognized as “corporate branding.” A wealth management firm that has built a reputation of consistently delivering a superior product, backed by a strong track record, and delivered by high-quality professionals, has created distinctive branding, which enhances value.
In general, higher value developed using the income approach will be attributed to wealth management firms with the following characteristics: larger size, longevity, depth of personnel, increased brand awareness, diverse client base, and differentiation/sophistication of services. This translates into value to the extent that an investor would attribute lower company-specific risk, in the form of a “required rate of return” for investing in the company, when determining value via an income-based approach, or a higher multiple when determining value via a market approach. All other things held equal, holding the average AUM fee constant, the lower the risk attributes then the higher the firm value.
Use of the Market Approach to Value Wealth Management Firms
In addition to the income approach, the market approach is often applicable to valuing small- to medium-sized, closely-held wealth management firms. While there is a plethora of pricing data available, valuation professionals must be cautious to not blindly apply the observed market data. There are two primary methods to employ the market approach – by developing valuation multiples implied by outright sales of similar businesses (the “Transaction Multiple Method” or “TMM”), or by obtaining the trading activity and valuation multiples in shares of publicly held companies (the “Guideline Public Company Method” or “GPCM”.)
Due to the size, diversity and differences between most publicly-traded wealth management firms versus small- to mid-sized, privately held firms, we tend to focus on the TMM as opposed to the GPCM. The TMM provides data on similar sized private companies, which may have a similar operating platform to small- to mid-sized wealth management firms. While there may be a plethora of data for the GPCM, there are typically significant differences due to: the size of these companies, the fact that they are public companies subject to differing influences of value, and that these public companies may be significantly more diversified than closely-held wealth management firms.
In the end, a valuation professional must simply recognize the strengths and weaknesses of each data set (for either the TMM or the GPCM) when applying one of these methods in performing the market approach. Based on the quality and quantity of market data, the valuation professional may apply the TMM or the GPCM as either a determinant of value or a check to the results set forth in the income approach, depending on the market data available. It is not uncommon for market data to call into question the credibility of client-driven forecasts, which form the basis of the income approach.
Another relevant point regarding market data is that small- to medium-sized wealth management firms often contemplate the implied value, as a multiple of revenues, often in lieu of focusing on value as a multiple of earnings1. The rationale is that the operating structure, practices, and expense structure could vary widely amongst firms, especially when it comes to partner compensation and employee bonuses. In addition, many small- to mid-size wealth management firms are not encumbered with external third-party financing, and therefore are not required to have audited financial statements. Thus, the financial statements are often not reviewed and/or audited by an accounting firm, increasing the skepticism by acquiring firms of the expenses represented on the income statement. For these reasons, a buyer will often focus on the revenue-generating capacity of the firm. They will determine value, in relation to the level of expected continuing revenues, and will institute their own practices and expense structure in generating future revenue. The multiple that is considered applicable to a given company is largely determined by an analysis of many of the items previously discussed in this article.
Industry data from Mergerstat and Capital IQ databases support the wide range of multiples applied to wealth management firms. Average revenue multiples based on a search for wealth management firms range from 0.25x revenue multiple up to a 6.26x revenue multiple, with a median multiple of 1.73x revenue. Due to this wide range of multiples, a valuation professional needs to appreciate how the qualitative factors of the wealth management firm business would be impacted if they are on the low or high range of the stated revenue multiples.
Key Drivers of Value
The key data that a valuation professional should focus on in valuing wealth management firms are:
- Recurring client base – characterized by the amount of repeat business
- Revenue growth – segregate organic versus market growth
- Revenue source – commission-based or fee-based
- Size of wealth management firm – scale matters
- Client demographics – client concentrations, client tenure, new client ratio, client age
- Compensation and expenses of management
- Life stage of company – start-up, expansion phase, mature life cycle
- Sophistication and quality of services – generally the more differentiated and sophisticated the services provided, the higher the management fees for services rendered (thus the higher the profitability)
- Understanding of business model – is the wealth management firm offering integrated advice, such as financial planning or risk management, with higher margins in addition to traditional asset management services
- Alliances to generate new business – does the wealth management firm have an alliance with a broker-dealer, which enables the firm to offer additional products while continuing to remain independent
- Longevity – in general, the longer the wealth management firm has been in business, the more stable the revenue base and the stronger the corporate brand in the marketplace
- Employee demographics – number of employees, tenure, relationship with clients. These factors will provide insight into the collective knowledge, reputation and branding of a company
Case Example of Two Wealth Management Firms
VRC has valued many wealth management firms over the past several years. Below is a case study of two wealth management firms that operate similar business platforms but differ significantly in key characteristics. Table 1 illustrates the variety one can encounter when valuing two companies operating in the same industry.
Wealth Management Firm 1
The purpose of the valuation of wealth management firm 1 was for shareholder buy-ins and buy-outs. These valuations were completed annually by VRC in order to set equity value for the purpose of the buy-in/buy-out related to shareholder transactions.
The primary valuation approach VRC relied on was the income approach. Specifically, VRC performed a five-year discounted cash flow analysis, with a relatively low discount rate (due to the perceived low forecast risk for this company.) VRC also considered a significant sample size of transactions in the marketplace, and used the market approach to compare how the implied market multiples, developed from the income approach, compared to market multiples from private transactions in the marketplace.
Wealth Management Firm 2
The purpose of the valuation of wealth management firm 2 was for stock equity compensation. VRC was hired to determine the base price of the company, in order to determine growth in value in subsequent years for the existing shareholder base.
The primary valuation approach VRC relied on was the income approach. Unlike wealth management firm 1, VRC could not rely on a single point DCF due to the risk patterns shown in the facts (see Table 1) as well as the myriad of possible paths in the near future for wealth management firm 2. In this case, with significant input from management, VRC prepared a probability-weighted cash flow scenario, considering four different scenarios. This included using a 25 percent weight in a scenario that the company would be out of business and dissolved in three years and consistent with the fallout of the potential loss of its founding and largest client. The preparation of each set of these cash flows considered the following: (i) compensation schemes, (ii) changes in significant value drivers, (iii) differing market expectations and (iv) risk characteristics.
Although both of these wealth management firms have highly talented personnel providing sophisticated services to their respective client base, there are significant differences in the fact pattern between the two companies. It should be of no surprise that the value results of wealth management firm 2 were much lower in terms of a concluded value and implied valuation multiple than wealth management firm 1.
Wealth management firms are sensitive to many assumptions, which need to be carefully contemplated in the valuation process. If significant value-driving factors and potential risks for a company are not identified, or are mischaracterized, the results may be illogical in relation to the underlying fact pattern. A deep understanding of any wealth management firm and analysis of meaningful documentation and facts in each case could be the difference between a supportable value conclusion and one that can be easily challenged by a third party.
For more information, contact your VRC professional.
1It is noted that the valuation of larger wealth management firms will typically also incorporate the reliance on a multiple of “adjusted earnings.” This may be more applicable when reviewed and/or audited financials are available and when adjusted earnings can be computed.