Book valuation multiples are useless when buying a book of business if the portfolio up for sale is of poor quality. Yet quality is often in the eye of the beholder.
Valuators never rely on only one multiple to compute the value of a book of business. Some buyers focus on asset size, others on renewal commissions. Valuators argue that whatever the evaluation multiple retained, qualitative aspects of the book count the most. They determine its choice and scope.
PPI Solutions CEO Jim Virtue says that valuations confined to quantitative criteria like book size is too simplistic. “There are several qualitative factors that need to be considered. An advisor’s practice with $40 million in assets under management (AUM) could have a lower value than a $20 million AUM book because of the composition of the clientele, the number of clients, the age of the clients, and the type of products,” he explains.
A book of 1,000 clients with AUM of $40 million may be worth less than a block of 100 clients with assets of $20 million, Virtue says, because advisors may be overwhelmed by looking after so many clients. “In addition, the average account in the first book would be $40,000 per client, while in the second it would be $200,000 per client, which has greater potential,” he says.
Several payment structures
These qualitative factors can make a huge difference in book valuation, Virtue adds. “Similarly, if a practice is exclusively insurance with no investment products and the clients are all doctors, it will likely sell at higher multiples since there are good opportunities to expand the investment business.”
Financial Horizons Group, president, Quebec Region, James McMahon says that in mutual funds, valuation based on assets alone would also be risky because compensation may vary for the same volume of assets under management. “Funds now offer several different payment structures, fee-based management, reduced costs, buyback costs over three years instead of seven…These days, taking a multiple of assets is meaningless,” McMahon says.
Quality affects multiples
Christian Laroche, CEO, of Pro Vie Assurances, stresses the importance of the makeup of an insurance portfolio. Quality may affect the multiples. For example, he would pay a higher renewal multiple in disability insurance than in life insurance. “These products include renewal commissions for life. It’s rare to get your hands on a book of business like that,” he says.
In contrast, Laroche finds investment fund books less attractive. “These books are generally less stable. We have no control over the business. There may be many transfers. I would tend to pay slightly less for them.”
Stéphane Dulude, president and general manager of SFL, Partner of Desjardins Financial Security, president and CEO of SFL Investments and president and CEO of Desjardins Financial Security Investments Inc., believes the methods sellers have established to stem instability as crucial. “In terms of the multiple used, we do not differentiate between large and small mutual fund books. We mainly look at how the block is served. A book with assets under management of $40 million may be worth less than another of $30 million if, for example, the advisor serves the clientele without an assistant or service plan, and with no customer management system or segmentation. The value may also vary if the makeup of each book is fundamentally different,” he explains.
Mutual fund books
Dulude echoes McMahon’s stance on payment structure being pivotal to valuing a mutual fund book. “You will get distortion if you use only an asset multiple to value a mutual fund portfolio,” he says.
In an example he shared with The Insurance and Investment Journal, he pointed out significant gaps between valuation based on the percentage of assets and that based on revenues (commissions). Valuations based on revenues will vary according to the makeup of the book of business, he explains.
The examples show a comparative valuation of three portfolios of $5 million in mutual fund assets. The portfolio with compensation based on front-end fees is worth double that with back-end fees. A fee-based portfolio of the same size is valued similarly to a front-end load portfolio. “These are obviously ‘extreme’ examples because few advisors are likely to have 100% of their assets in back-end load (DSC) funds, or 100% in fee-based,” Dulude says.
He sees the front-end load payment formula gaining ground in mutual funds. “It’s a major trend with us, which has a large impact on books of business,” Dulude continues.
The trend raises the price of books, he adds. “Representatives with lots of experience are increasingly turning to compensation based on front-end loads (we see lots with no-load) and are propelling the portfolio price upward. It is too early to conclude that the same trend will surface in fee-based management,” Dulude says. He explains that zero-load funds let advisors balance clients’ portfolios more easily, without incurring exit fees, for example.
The pay structure for back-end load funds is still predominant in many portfolios, he adds. “This type of fee will be more appropriate for younger clients, for example. They will have no fees to pay when they buy their funds and they probably will not pay them when they withdraw the money.”
LFS also distributes life insurance. The network plays two roles during transactions: it values books and provides financing. “We tend to prioritize quantitative criteria over qualitative criteria. If an advisor pays five times the renewals for an insurance portfolio, this will be truly exceptional! That’s the premium that the advisor would be willing to pay for a portfolio of physicians or contractors with disability insurance,” Dulude explains.
Desjardins Financial Security Independent Network (DFSIN), has over 1,600 representatives across Canada, including 800 in Quebec, Stéphane Dulude points out. “Year after year we recruit 200 to 300.”
Sources of revenue like renewal and trailing commissions are not the only factors to consider when valuing a book of business. You also have to keep in mind that the seller will incur an expense for the business when he leaves, according to George Hartman, author of Exit is Not a Four Letter Word and CEO of Market Logics.
Hartman told The Insurance and Investment Journal that advisors who sell their books create an expense for the buyer. When sellers leave, their activities must be taken over by someone else, he explains. “It is appropriate to assign a cost to the business for those duties when calculating the value of a book of business, in the same way you would consider the cost of other staff members.”
First-year commissions
Nor should buyers be blinded by first-year life insurance commissions. “The FYC disappears when the founding advisor sells, leaving only a small amount of renewals to create value for a purchaser. Consequently, smaller practices generating, for example, $100,000 of total revenue might have only $10,000 of recurring revenue. For this reason, advisors looking to buy insurance practices will typically look for larger businesses that generate $500,000 or more of total revenue,” he explains.
Hartman adds that some buyers may be interested in a practice with low revenue. For example, a practice in life insurance exclusively may appeal to a buyer who sells only mutual funds because of the potential business opportunities.
