28 Aug 2023
Succession planning for independent financial advisor (IFA) firms is one of the topics that frequently triggers lively debate and commentary at industry events.
Over the years, the debate has centered on which succession model is the best, the need for consolidation of smaller IFA firms facing cost pressures, practical considerations for different succession models and the always-thorny issue of valuing an IFA firm.
The COVID-19 pandemic brought new energy to these debates, as even end-clients of smaller advice practices started questioning what would happen if the primary advisor passed away. The Financial Sector Conduct Authority has also expressed a keen interest in advisor succession and requires advisors to have a formal succession plan to ensure continuity of services to the firm’s clients.
As a firm who deals with most of the country’s top IFA firms, and an unashamed supporter of independent financial advisors, we believe that solving the succession problem is critical to the well-being of the IFA market in South Africa.
In this article, we share some of the most common themes in our discussions with South African advisors about succession planning.
Our first learning is that a discussion about mergers and acquisitions (M&A) of advice firms is in essence a succession planning conversation. In fact, we often use the following graphic to illustrate this point:
Figure 1: Summary of succession options
Source: Ninety One Investment Platform.
In talking to advisors about these succession options, the learning was that they represent some type of M&A transaction in their business, as all succession plans eventually result in a change of ownership in the IFA firm. Even in the case of organic succession, the internal junior advisor taking over the firm must eventually buy out the founder.
The next key takeaway is that two main factors drive the different succession options, as highlighted in Figure 1:
Many advisors who have been through the process of implementing one of these succession models admit to underestimating one of these two factors. They either underestimated how long it would take to implement the plan, or they underestimated the extent to which they would lose control over many aspects of their own business post the transaction. We unpack some of the issues around control later in the article.
A second topic that often causes strain post implementation of a succession plan is when financial advisors really retire. Figure 2, which provides a summary of around 3 200 active independent financial advisors dealing with the Ninety One Investment Platform, is a good starting point.
Figure 2: Age distribution of independent advisors using our platform
Source: Ninety One Investment Platform.
There are many interesting conclusions you can draw from Figure 2. (For example, there are almost no investment advisors younger than 25!) However, for the purposes of this article, we want to focus on the older age cohorts.
It is clear that most advisors remain active up to at least age 65, maintaining a sizeable client load. Furthermore, a significant proportion of advisors continue working beyond age 65. It is only at age 75 that most advisors appear to give up practicing.
The key conclusion here is that those involved in crafting succession plans should make provision for the selling advisor to work until at least age 65. There is a good chance that the selling advisor will continue working beyond age 65 but with a reduced client load. Many a well-intentioned succession plan experiences strain because the selling advisor wants to continue working post their intended retirement date, whereas the buyer would like to see them retire.
It might seem strange that a financial planner neglects their own personal retirement plan, but it happens more frequently than you would expect. Quite often, a founder advisor ends up at age 60 with limited financial provision outside of their advice practice.
These succession plans are notoriously tricky to pull off as the selling advisor needs a very high valuation on the deal to fund their own retirement. This has been the experience of several advisors looking to sell their firms to fund their retirement. We estimate that an advisor can only replace 50% of the earnings from running their own advice practice if they sell the practice for cash and live off the proceeds (based on a typical sale valuation – outlined in the next section). Normally, this is not enough, and advisors who find themselves in this position are often forced to continue working for the buying firm after the acquisition. This has big implications for the buyer of the practice.
When engaging with advisors on their succession plan, the conversation invariably leads to a discussion on what an advice business is worth. Entire articles have been written about valuing an advice business. This is especially the case in markets like the US and the UK which have seen aggressive consolidation of advice firms by private equity-funded consolidator networks.
Resisting the temptation to fall down the rabbit hole of discounted cash-flow valuation models, we would like to make the following broad observations based on recent engagements with many buying and selling advisors in the SA market:
When an advisor sells their investment advice firm to another advisor for cash, and the firm is managed very similarly (with similar services and revenue lines) before and after the sale, the valuation generally ends up being in the range of 2.25 to 2.5 times the annual gross revenue of the business.
If the practice is sold to a larger financial group, where the objective is to convert the clients of the selling firm into the buyers’ own financial products (generating additional revenue for the buyer), the valuation is generally higher. In these cases, it can exceed 3 times the annual gross revenue of the business.
If the objective of the transaction is to facilitate an organic succession plan, where a younger successor in the practice acquires their first meaningful stake in the business, the valuations are generally lower. In these cases, valuations can be anywhere from 1 to 2 times annual gross revenue.
The key takeaway here is that there is no single ‘correct’ valuation of an advice practice, and the price varies significantly depending on the objectives of the participants.
Our final theme covers ‘softer’ issues such as unhappiness with the culture of the new entity after an acquisition. The challenge of a cultural mismatch is often mentioned in IFA mergers and acquisitions in markets like the UK and the US (markets with high advisor M&A activity). There are several articles providing firsthand accounts of actual cases where deals failed a few years after conclusion.
For those interested to read more about these international experiences, a good reference point is an article recently published on kitces.com by US-based blogger Bob Veres.1
In this instructive article, Veres relays the experiences of various advisor M&A transactions, where the deal created tension for reasons other than money. Many of these experiences resonate with what we hear from SA advisors.
Consider the following tips to avoid some of these unfortunate outcomes in your succession transaction:
Advisor succession and M&A – its Siamese twin – are critically important discussions for the SA IFA market. A successful succession/M&A deal requires structured planning and negotiation – and most importantly, an advisor needs to devote sufficient time to prudently navigate this multi-layered process.
We trust that the themes we have outlined give you some structure when thinking about your own succession plan. We are always interested in your comments and keen to engage with you on these issues.