Jennifer Kreischer, Director, Audit & Accounting and a member of Kreischer Miller’s Investment Industry Group, is a frequent speaker on the key levers that investment firms can use to drive value in their businesses. Here is a summary of a recent presentation she gave on this topic.
Investment News Research, together with SkyView Partners and Live Oak Bank, recently conducted a survey of 554 investment firms about their intentions regarding M&A transactions. According to the survey, 72 percent said they “have either completed a transaction in the last two years or are contemplating one in the coming two.”
With so many potential transactions on the horizon, planning for the purchase or sale of an investment firm is smart – especially since many sales come from unsolicited offers. It also has the advantage of highlighting areas where the business could add value before any potential transaction.
Knowing the firm’s value is crucial to both planning a transaction and increasing value. Formally evaluating the business protects the interests of the owners and allows a new investor – either a new owner or source of capital – to assess the opportunity versus other uses of their funds. For example, when an internal partner is promoted and looking to buy shares of the firm, he or she may need to borrow money from the bank to buy in. Knowing the value of the firm will help the new partner evaluate how long it may take to see a return on their investment.
As noted above, the valuation process also provides an opportunity to measure the impact of growth initiatives by seeing how they impact the valuation model in a sensitivity analysis. Drilling down further, it can be used to incentivize the firm’s employees to act in ways that add the most value.
Valuation is an art and a science. One valuation approach is to use all of the firm’s revenue and expenses, forecasted to a number of years, and discounted back to present value. This is known as the Discounted Cash Flow (DCF) method. More often, the Multiple Model is used as a proxy for DCF. A multiple of revenue or earnings (typically earnings before interest, taxes, and depreciation & amortization, or EBITDA) is used with a multiple intended to represent the average for peer transactions. This is a simpler exercise, but the real art is selecting the multiple, as multiples always fall in ranges.
How does a firm increase its value? First, value increases as earnings increase. Assume a multiple range of 4 to 6 times EBITDA. A company with $75,000 in EBITDA is worth $300,000 at the low end of the multiple range. Earning $100,000 would increase the value to $400,000 at the low end of the range.
What if the business could also work up to higher end of the earnings range? At $100,000, it would be valued at $600,000. We might call this increase in value the multiplier effect. Value grows as earnings grow, but that effect is multiplied as the qualitative factors are improved, meriting a higher multiple.
It’s clear that the multiplier effect works to improve value in a transaction, whether sale or financing, but does it matter if your business is not planning for a transaction? The answer is yes. Actions that move the multiple up the range tend to be those that produce a more sustainable business. In other words, it not only produces more income in the current period but also increases the likelihood of producing the same income or more in the future. A long track record is evidence of a sustainable business. It is beneficial to make your business both qualitatively and quantitatively better.
Which key drivers should be considered in valuations? These data points often line up with industry key performance indicators (KPIs). Revenue-related drivers often include client base (such as concentrations, turnover, and age), revenue growth compared to market movements and attribution of actual impact, services offered (which can be basic or fully integrated with clients), and fee basis/percentages. Expense-related drivers often include compensation and expenses, talent pipeline, and technology support.
When evaluating the revenue drivers for a closely-held and organically-grown wealth management firm, we start by understanding the current revenue base, breaking down client segments and evaluating service fees and length of the relationships. This helps identify profit and growth drivers. Similarly, evaluating various asset classes and the amount of R&D time invested in each can help identify opportunities for new investment products. This analysis should be repeatable to allow for comparison from one year to the next, and aligning your key drivers with your regular reporting structure is a good idea.
Always be on the lookout for new trends that may impact future growth (such as outsourcing), be vigilant about your barriers to growth, and implement a plan to track your growth trajectory.
Keep in mind that growth investments don’t necessarily increase your valuation unless you can convince the valuer that they will contribute to future earnings. It is easier to prove with actual examples of how similar initiatives have positively impacted your earnings, demonstrating your ability to grow and address market changes.
If you have any questions about this information or would like to discuss your firm’s valuation needs, please contact Jennifer Kreischer, Director, Audit & Accounting, at email@example.com.