Despite Market Volatility, Practice Values Increasing at Highest Rate in History

Recently, a number of experts that specialize in RIA M&A have claimed that practice values are reaching their peak and will soon feel the effects of a volatile market and decreased demand for acquisitions. What these experts failed to articulate is that they work within a very narrow segment of the industry, mainly among large consolidation firms. The bulk of the industry is comprised of small and mid-sized practices operating not only under the RIA umbrella, but under IBDs and wirehouses too. This is the sector of the market where most of our work is done and from what we have seen, practice values continue to rise with no sign that they will slow any time soon.

Many contributing factors are coming together to create a perfect storm that is driving up practice values. Though some factors, such as willing buyers with access to capital paying premiums, are a visible force driving up prices, not all factors impacting practice values are obvious. The contributing factors can be categorized into three buckets: the marketplace for practice sales, practice AUM and Revenue growth, and the key practice metrics that influence valuation.

The Marketplace for Practice Sales

For the past 5-7 years, we have waited for the Baby Boomer generation to retire in mass (known as the predicted “age wave”). Instead of retiring, many Baby Boomers have held on to their practice long past the normal retirement age. This created a scenario of low supply of practices for sale in relation to an increasing level of demand for acquisitions, which was fueled by greater access to capital.

This all started to change in 2020, at the start of the pandemic. Since then, we have experienced a sharp increase in practice transition related activity, which we can assume is the front of the age wave. A corresponding assumption had been that the increase in supply of sellers would change the supply and demand dynamic and start to drive prices down. Instead, as the supply has increased it has been met with a greater increase in demand. Demand continues to remain high, due to lower interest rates and greater education and resources for acquisitions and successions. Interest rates are starting to rise, but only time will tell if the demand will curb and level out in relation to supply.

Practice AUM and Revenue Growth

Based on the valuations we track; the current average trailing 12-month revenue growth rate is nearing 25%. To put that into perspective, the highest average we had previously tracked was 15% in 2015. Despite experiencing a volatile stock market, the revenue growth rate is holding steady. Much of the growth we are seeing is largely from net flows (organic growth) and not practice acquisitions (inorganic growth). Advisors who lean more toward formal financial planning often do very well in client acquisition in times of market volatility. We also assume that the increase in Americans retiring in all industries as a result of the pandemic is creating a situation where retirees are rolling over workplace retirement accounts and investing funds from business sales outside of the financial advisor industry.

The Key Practice Metrics That Influence Valuation

The top three practice metrics that have the strongest correlation to a positive valuation result are the recurring revenue ratio, client segmentation and profitability. We have seen an increase among all three of these metrics in recent years. The recurring revenue ratio has improved by approximately 15% in the past 4-5 years, going from an average of 75% to the current average of 90%. In roughly the same time frame, client segmentation (average client size by AUM) has increased from approximately $350k to the current average of $550k. Lastly, while profit margins vary by practice size, we have seen a 5-7% increase in margin across those size ranges. In short, we have seen a meaningful improvement in the three most significant practice metrics that influence valuation. We believe this is due to strong business practices among financial advisors as they shift from serving mainly as practitioners to also serving as business owners and practice leaders.

Again, several factors have been driving practice values up and will continue to do so for the foreseeable future. As practice leaders at all levels become more sophisticated business owners, they will continue to build resilient practices that can weather market volatility and other environmental factors that once had tremendous impact on practice value and revenue. Things can always change, but for now, we don’t see practice values dropping off any time soon.