‘No profit doesn’t mean no value’: Scale key to advice firm viability

In its 2024 market commentary, Forte Asset Solutions said that smaller advice firms are expected to see a significant number of merger and acquisition (M&A) activity in order to reduce costs and reap the benefits of scale.

According to the report, businesses with less than $500,000 in annual revenue are making up 45 per cent of the total advisory marketplace. Forte stated that this sector “exposed the vulnerability of the industry”.

With the rise of smaller advice practices, more businesses are now reliant on a single person to ensure their success. For example, 70 per cent of all Australian advice firms have a single principal, and 76 per cent reported they did not have a succession plan or successor agreement in place.

Furthermore, one in two owners reported that their business could not operate efficiently if they were not working there, and 89 per cent said their business could not develop or grow without them.

Clients have also become heavily reliant on a single person within businesses, as such, 64 per cent stated they would not be comfortable dealing with anyone in the practice other than their current adviser.

Despite the challenges, even practices operating under the $500,000 revenue threshold can be worth more than $1 million in asset value, assuming revenue is greater than $330,000 and a three times multiple.

Forte explained that, while a business may have little to no profit, it does not automatically mean it has no value, and that if the “business is acquired and ‘tucked in’ to an existing infrastructure, it may immediately become profitable”.

VBP’s 2024 Advice Operations Research Report released in June revealed that, despite the challenges facing firms under the $500,000 revenue threshold, those in the $501,000 to $1 million annual revenue bracket were the ones in the “danger zone”.

The report revealed that these firms had the lowest average earnings before interest and tax (EBIT) with just 16.60 per cent, explaining that this could be the result of “challenges in scaling operations” as firms look to grow beyond the $500,000 mark.

“Revenue is growing but so, too, are costs, that business likely has capacity challenges in that there are not enough ‘hands and heads’ to prepare and provide advice leading to a significant time deficit,” the report said.

In an attempt to cut costs, Forte said that “like-minded businesses” have begun to enter service agreements, reducing operating costs by sharing office accommodations and staff.

As the cost to run an advice business continues to rise, the firm added, scale has become “key to the financial viability of financial services practices”.

The M&A space has remained relatively consistent over the last 18 months with a high demand but low supply. The firm explained that the high demand for M&As is due to “increasing costs and the subsequent need for size and scale”, while minimal legislative risk feeds buyer and seller confidence.

As the talent pool in the advice profession remains slim, businesses are also using M&A as a means to increase their number of staff, thus providing greater opportunities for scale.

The low supply, according to Forte, is a result of business owners needing to re-engineer their businesses in recent years as they navigate new legislation, rising costs, and changes to technology, service standards, and fees.

As a result of this, business owners were holding off on selling until they could be confident that their clients and revenue were secure.

“No seller wants to come to market with an underdeveloped value proposition or a business in transition,” the firm said.

Valuation of clients

According to Forte’s actual 12-month performance, general financial advice firms are being valued at 2.5 to 3 times their recurring revenue, while high-net-worth firms are reaching a 2.75 to 3.3 times multiple. Large advice businesses are sitting in the 5.5 to 7 times EBIT range.

The age and location of clients is having a slightly negative impact on valuation, garnering a 2.5 to 2.8 recurring revenue multiple for firms with more than 30 per cent aged or regional clients, while risk advice is seeing less demand and less supply resulting in a 2 to 2.5 times multiple.

While it is common practice to value a financial advice business either by their profit margin or by multiplying the recurring revenue, Forte explained that there is a direct correlation between the two, stating: “The higher the profit, the higher recurring revenue multiple achieved.”

It further explained that there is an “elasticity” between the two, in that if one is substantially higher than the other, the lowest valuation will have a drag effect on the higher.

Forte further explained that to achieve “price convergence” – an average of three times recurring revenue and six times EBIT – the business needs to be operating at 40 per cent EBIT.

A trend has also emerged of different fee structures leading to different valuation with buyers paying market value for client fees valued over $5,000, but those sitting around $3,500 being discounted for the buyer, and those under $2,500 being discounted even more.

However, Forte stated: “Irrespective of the fee structure, all clients can still be profitable, but it depends on the service offer and the level of technology-assisted advice”.