The Valuation Impact

Are you considering a shift in your fee structure?  Here’s how that might affect the value of your firm.

The Inside Information 2020 Fee Survey uncovered a small but potentially significant trend.  A growing number of advisors are moving away from the AUM revenue model toward flat fees or—more commonly—a combination model where wealthier clients pay AUM and younger, less-wealthy clients pay flat retainer fees.

The move makes sense from a variety of standpoints.  First, flat fees come with fewer conflicts of interest, which might make the firm more attractive to astute clients.  A retainer model makes it possible for advisory firms to collect appropriate fees from clients who have not yet built a significant retirement portfolio, greatly expanding their potential market.  And if we’re building a real profession, well, what other profession do you know has a model where, if the client asks how much you charge, the answer is: ‘I’m not sure.  How much have you got?

This shift has been discussed before, most prominently by the Alliance of Comprehensive Planners.  But there’s one issue that nobody seems to have considered: how would a shift away from the AUM fee model impact the resale value of an advisory firm?  Would a firm that collects flat fees be more or less valuable than a firm whose clients pay by an AUM model?  By what logic would valuation experts make that determination?

To get a better perspective, I talked with executives at four of the planning community’s most prominent valuation firms: Carolyn Armitage, managing director at ECHELON Partners (https://www.echelon-partners.com/, which conducts somewhat more than 200 valuations a year); David DeVoe, founder and principal of DeVoe & Co. (http://www.devoeandcompany.com/; approx. 50 valuations a year); Brad Bueermann, CEO of FP Transitions (https://www.fptransitions.com/; 1,300 a year); and David Grau, Jr., founder and principal at Succession Resource Group (https://www.successionresource.com/; 200-250 a year).  Their answers were enlightening.

Transitioning all clients

Let’s start with a base case: a firm decides to shift all of its clients from AUM fees to some kind of retainer model.  Let’s further suppose that it handles the transition so well that its top-line revenues and EBITDA (earnings before interest, taxes, depreciation and amortization) are the same after the shift as they were before, meaning the same amount of money as before is A) coming in, and B) dropping to the bottom line. 

Would the shift from AUM to retainer, all else being equal, make the firm more or less valuable in today’s M&A marketplace?

“The short answer is that alternate billing models in the RIA space will decrease the value of the enterprise,” says Grau.  “No two ways about it.”

DeVoe agrees.  “In most cases, a shift like that would negatively affect the value of the company,” he says.  “Moving toward a flat fee model across the organization is likely going to compress revenues in the longer term.”

He would also make the assumption that the change would ultimately depress profits.  “Pricing is going to directly affect revenues,” he says, “and for every one percent decrease in revenue, you’re going to have about a four percent decrease in profitability.  We wave big caution flags,” DeVoe continues, “when advisors are contemplating pricing changes in general, specifically going toward a flat fee type of model.”

Even if profitability is the same either way?  Even so.  One reason is that DeVoe doesn’t believe that the flat fee revenues would, each year into the future, increase at the same rate as AUM revenues would.  “Over time markets tend to go up,” he says, “and one of the wonderful things about the AUM model is you have this embedded price increase where, when the markets go up 6% a year, you’re getting a revenue increase.  If you go flat fee, that will be harder to implement,” DeVoe continues.  “ At least, it is less likely to increase at that rate.”

So that means he’s giving more value to the AUM revenue stream than the same flat fee revenues?  “Absolutely,” says DeVoe.

That’s the strong case against making the switch.  But you should know that other valuation firms took a much less absolutist approach.  “If we were looking at a flat fee firm, we would pull back to the business level,” says Bueermann of FP Transitions.  “The first things we want to know are: what’s the revenue, what’s the EBITDA bottom line, and what’s the revenue and bottom line growth?”

Armitage agrees.  “We start with the bottom line,” she says.  “Net-net, you want to have the same profit margin now that you did when you were charging AUM.”  A lower profit margin, of course, would lower the valuation.

Grau says that that many valuation firms will stop there, and give a number based purely on the EBITDA.  “But if you’re doing a deeper valuation of an advisory practice, you have to segment the revenue sources,” he says.

Here’s where the other valuation firms start to agree with DeVoe.  “We take a look at each one of the revenue streams separately,” Armitage explains, “and we will apply different multiples based on the quality of that revenue stream.” 

The mathematics of these multiples are proprietary, but Armitrage and Grau were willing to share the general hierarchy of revenue stream “quality.”  Commissions are at the bottom, because they’re not recurring and therefore hard to project into the future.  Trail commissions are a rung above.  One step up from there is hourly revenue from doing tax returns or project work like creating complex estate plans for wealthier clients.  Roughly at the same rung are fees charged for a new client’s initial planning work, to the extent that they are assessed over and above the yearly fee structure.

On the next rung up the hierarchy you finally arrive at flat fees, and Armitage even suggested that there is a mini-hierarchy within the flat fee model, based on how clients typically pay them.  Flat fees are at least incrementally more valuable if they’re taken directly out of the portfolios or automatically collected from the client’s credit card; less valuable if clients have to pay by check each quarter.

The top of the hierarchy, of course, are AUM fees collected out of the portfolio.

So that basically means that Armitage agrees with DeVoe about the shift from AUM to flat fees, if a bit less stridently?  In fact, she says that ECHELON is willing to put flat fees on a valuation par with AUM if the there is consistency in fees collect.  There are several components to this, including client attrition, the ability of the firm to raise the flat fees commensurate with what they would have gotten from AUM, and no significant fluctuations in revenue year over year.  “If the flat fees are high one year and low the next,” Armitage explains, “then we’re going to discount the quality of that revenue stream, because it’s not as predictable as if the fees are not variable.”

Are there any other ways that a conversion from AUM to flat fees would impact valuations?  Grau and Bueermann agree with DeVoe that flat fees diminish the value to the enterprise—for an entirely different reason. “If your valuation is going to be dependent on a ready and willing market,” says Grau, “there are far fewer folks who have an interest in acquiring a firm with an alternative billing structure.”

Succession Resource Group currently happens to be working with a firm that charges flat fees.  “It probably works out to 60 basis points on the assets,” says Grau.  “But we’re having trouble finding buyers who have an interest in taking them on.  She sold this model to her clients as the most appropriate billing model for the—and it would be very difficult for the acquiring firm to undo that.”

Adds Bueermann: “The acquiring firm is likely to say: I don’t want to acquire a firm that screws up my pricing model in my primary business. If you’re selling to a synergistic buyer [like another advisory firm]; somebody who wants to expand market share,” he says, “they are typically looking for something where your model fits theirs.” 

Currently, fewer than 5% of the valuations conducted by FP Transitions use a fixed-fee model.  “If that’s the universe,” says Bueermann, “then you’ve limited the immediate buyer pool.”

But suppose you’re selling the firm internally, rather than to a strategic buyer?  In that case, says Bueermann, the type of fees you charge would be immaterial.  “In that case,” he says, “you’re just going to look at the profitability and long-term growth.”

Adding a flat fee model

to existing AUM

Let’s move to the second case.  What if, instead of abandoning the AUM structure altogether, the advisory firm adopts different models for different clients.  Let’s suppose it keeps AUM revenues for its wealthier clients, but institutes a flat fee or retainer model so that it can serve the blue ocean of clients who don’t meet its asset minimums. 

How would that affect the valuation appraisal?

“The portion of the revenue that is flat fees would not be as highly-valued,” says Armitage.  “But I do think adding in multiple offerings is appropriate if the firm wants to serve different types of clients.”

Grau says that, with some caveats, adding a flat fee service for younger clients can raise a firm’s enterprise value—provided the appraisal team is willing to look carefully under the hood.  “We just did a valuation last month and went through this exact exercise,” he says.  “They have a very normal set of high-net-worth target clients, but they’ve rolled out a service model for up-and-coming executives or children of the current clients, who have much smaller investment accounts.”

The first cut at this firm’s data was not encouraging.  “As you might guess,” says Grau, “their revenue and assets per client didn’t look great.  Why?  Because they have effectively two different divisions.”  The average client revenues and net worth were pulled down by the younger cohort.

But when they looked more closely, the Succession Resource Group team found that the profit margins were roughly equal for both divisions; the internal costs were lower for the team servicing less-wealthy clients. 

The result?  “That other division ended up being a positive for their valuation,” says Grau.  “It was giving them a chance to build their farm team of advisor staff talent, that would eventually move up to the high-net-worth clients.  And at the same time,” he adds, “the flat fee division gave the firm a younger client demographic, which could be valuable to a firm that might someday buy their future potential.”

The caveats?  Grau says that he looks for scale and discipline when he sees that a firm is serving less-wealthy clients—basically, for the ability to turn a profit with fewer revenues per client.  “If you commit to it, it can work,” he says.  “If you dabble in it, it will not.”

Of the people I talked with, DeVoe was the most skeptical of the segmented fee approach.  “I don’t think the theoretical upside of having more clients will offset the economic impact of taking on new clients who are less profitable than the existing clients,” he says.  “I think it even might cannibalize the current revenue set, as existing clients might decide they want the retainer fee model rather than the AUM model.”

If advisors persist in creating an accommodating model for less-wealthy clients, DeVoe would encourage it to the extent that it would lead those younger clients upstream to the AUM model.  “I think intelligently designed, it could make sense to serve them in a way that, as they grow their net worth, they become more traditional clients of that organization,” he says.

So how should a firm go about adding another client tier without reducing its valuation in the marketplace? “You provide a scaled-down set of services that you can deliver in a cost-effective way,” says DeVoe.  “Ideally,” says DeVoe, “you’re creating an ongoing relationship with high-earning individuals who might be future clients that can eventually move into your traditional fee structure.”

Moving to hourly

Of course, AUM and flat fees are not the only revenue models in the advisor space.  What if that same hypothetical firm decided to shift its model from AUM to hourly fees?

Bueermann says that his firm tends to put a lower value on a firm that uses an hourly model.  “It typically means that your top-line growth will be constrained,” he says.  He adds that, in his experience, there is very little buyer demand for an hourly shop.

Grau and Armitage agree that, from a pure valuation perspective, hourly is the least valuable billing model that an RIA could have.  “Hourly can be a challenge when clients need to write a check separately,” says Armitage.  “Generally the client retention rate is not as high as when fees are pulled directly from the account.  But,” she adds, “if you have consistency and over 95% retention, great.  In that case, hourly fees might still be valued as consistent, predictable future revenue streams.”  In other words, may half a rung higher on the fee value scale.

What if the fees are billed monthly directly from a client’s credit card?  “That helps,” says Armitage, “because it would be more predictable.  It’s a pain in the neck to call up or cancel that automatic subscription, so those usually have a better persistency than clients having to write a check.”

Despite his skepticism toward retainer fees, DeVoe is more skeptical of the alternatives.  “A retainer is more attractive from an economic perspective than hourly work or project work,” he says.  He compares it to a gym membership, where the gym collects recurring revenue whether people use it or not.  “AUM and retainer are stickier relationships,” says DeVoe.  ”If the gym were to charge by the hour to people only when they need it, then they would make a lot less money.”

So what have we learned?  I think the clear conclusion is that any advisory firm that wants to maximize its enterprise value and sell to another advisory firm should be very careful about shifting its client base from AUM to retainer fees—until, at least, retainer-fee structures become more commonplace. 

But if the firm’s intention is an internal sale to successor partners, converting from AUM to flat fees would have less of an impact. In that case, the valuation would be determined primarily by growth, retention and EBITDA calculations.

For advisors who are creating a flat fee model to serve less-wealthy clients, the situation is more complicated, but generally positive.  The firm might follow DeVoe’s advice and carefully segment this offer from their AUM model.  And they would want to take Armitage’s advice and make sure they are serving those clients profitably. 

The valuation experts I talked with seem to be assuming that this retainer-based model would eventually lead to an AUM relationship down the road.  My question is whether those younger clients, raised on retainers, would ever want to switch to a different pricing structure.

Finally, if you’re selling to an outside buyer, an hourly fee structure is least attractive.  But if your clients prefer that you charge that way, or more importantly if YOU prefer it, and plan to sell your firm to successor owners, there is no valuation-related reason not to go that route.