M and A

Why “Headline” M&A Multiples May Be Deceiving

Charles Paikert US Correspondent New York April 29, 2024

Why “Headline” M&A Multiples May Be Deceiving

High figures for earnings before interest, taxation, depreciation and amortization (EBITDA) can draw attention, but all is not what it seems, according to those who track mergers and acquisitions in the wealth sector.

Those double digit EBITDA valuation multiples for acquired RIAs sure look impressive, don’t they? 

In fact, they “can be highly misleading,” according to Allen Darby, CEO of Alaris, a five-year-old firm that represents advisory firms looking to sell.

The high multiples often include “earn out” provisions, specifying growth metrics sellers must achieve in a certain period of time to receive the remainder of the money set out in the deal terms.

The problem is that all too often earn outs are based on “really aggressive assumptions” of gaining net new assets that “far exceed past growth,” Darby said. “No one ever hears whether those post-acquisition incentives are actually achieved.”

Or, as veteran investment banker Peter Nesvold, partner at Republic Capital Group, puts it: “An earn out with unusually high growth requirements that the seller is unlikely to achieve is really just a form of window dressing for the headline multiple.”

Indeed, the RIA industry’s “lackluster organic growth rate” of approximately just 3 per cent has started to become “a paramount focus” of M&A valuations, according to Fidelity Investment’s M&A Review for the year’s first quarter.

“Without a significant uptick in organic growth, EBITDA multiples and overall firm valuations may start to tick down, all other conditions being equal,” the Fidelity report stated.

Earn outs can be a “significant component” of the headline multiple, according to a recent Alaris white paper. An offer of 12 times EBITDA might actually be eight times a firm’s existing business, with a multiple of four “tied to an aggressive projection” making the “real offer” a multiple of eight, not 12.

As a result, Alaris urged RIA sellers to separate earn outs from the valuation of their existing business to “fully understand, evaluate and compare offers.” A lower multiple with better deal terms, the report noted, may be more attractive that a higher one with unrealistic earn out expectations.

This year’s strong market performance to date has boosted organic growth expectations, including market appreciation, to around 6 per cent to 8 per cent, Nesvold estimates.

But significant organic growth excluding market appreciation and acquisitions has been notoriously difficult for many firms to achieve.

Many advisors spend too much time on operations, too little on client-facing activities and marketing, Darby said. What’s more, a number of firms with a comfortable lifestyle business simply don’t have a growth mindset, he added.

Nesvold cited demographics as the main culprit. 

“For many firms, the average age of the clients are about 10 years younger than the average age of the advisors” he said. “If the firm has not invested in a strong second generation of business developers, organic growth starts to slow as the principals hit a certain age.”

Laura Delaney, Fidelity’s vice president of practice management and consulting, agreed, adding that too many RIAs are still “dependent on the founders to bring in new business.”  Even though many RIAs doubled down on onboarding new clients in 2022, most acquired only smaller clients, according to a Fidelity report released last year.  

Firms seeking to improve their growth metrics to attain a higher valuation for a sale can certainly address issues internally.

Organic growth is often “the single most important metric in the valuation of an RIA” because it distills a substantial amount of information into a single data point, according to Nesvold. Key determining factors include being located in a geographic market with strong wealth creation, institutionalized business practices and processes and cultivating a strong second generation of business developers, he said.

Another option is relaying on the resources of the buyer to boost growth, said Alaris.

An experienced and well capitalized buyer with economies of scale and expertise can unlock organic growth and free up capacity with additional services, more sophisticated marketing and centralizing operations and back office functions, he explained. 

Critically, sellers need to consider how much they receive from the post-acquisition share of growth economics, Darby said. While current valuation is important, “consider how the post deal revenue sharing will affect you in years to come,” he cautioned.

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