Fidelity Warns Advisers to Get Smart on Firm Value

A new cut of the Fidelity RIA Benchmarking Study shows many in firm leadership positions struggle to understand and articulate practice value. 

Each time it is updated, the Fidelity RIA Benchmarking Study serves as a lasting source of insight into practice management trends and what challenges should be top-of-mind for advisory firm owners, explains David Canter, executive vice president for practice management and consulting, Fidelity Clearing & Custody Solutions.

The 2015 edition of the study is no exception. A fresh cut of the data published today by Fidelity shows that, despite widespread optimism among advisers about future profitability and growth, there are some real emerging threats to firm value. These include a lack of human capital and troubling client age demographics, over which advisers might not have complete control in the end—but there are also factors, such as “the serious lack of understanding regarding what drives firm valuations,” on which advisers could and should clearly be doing better.

According to the new data, just 38% of firms have a strong grasp of what can drive firm valuations when a practice is actually put up on the selling block. “In addition, the study identified several challenges to optimizing firm value,” Canter explains, “the top one being that many firms simply don’t make it a priority.” This can potentially result in a lower than anticipated price for the firm when it comes time to sell, merge or transition the business to internal successors, according to study results.

“A firm’s value is dependent on many factors—some of them, such as size and revenue, are widely known,” Canter adds. “Other valuation drivers, such as client demographics, may not be so obvious, but firms still need to consider them in order to get a clear picture of their worth. The demographics of their clients—which can shed light on whether those accounts may grow or depreciate over time—can indicate a lot about a firm’s current stability and its ability to grow revenue in the future.”

NEXT: What the high-performers do

The RIA study also identifies a group of high-performing firms in the areas of growth, productivity and profitability, outlining some of their best practices when it comes to understanding firm valuation.

Not a surprise, a higher percentage of high-performing firms have an “advanced understanding of what can drive business value” (48% vs. 40%), and more high-performing firms have established an “agreed-upon mechanism for determining firm value in the event of an internal transition” (75% vs. 61%). Perhaps as a result of their deeper business intelligence, high-performing firms are apparently more confident in their people, Fidelity says. In fact, a strong majority (63%) of high-performing firms agree with the statement that, “Our people have all the skills and training for us to achieve our strategic goals.” This compares with less than half (49%) of all other firms.

“The biggest takeaway here for RIAs is that knowledge is power,” Canter concludes. “In order to realize the full potential value of your firm, you need to know what can drive that value first. Then, make the important decisions that may ultimately help you achieve those long-term goals.”

Fidelity’s report concludes with four key considerations to help firms maximize their value:

1. Consider a third-party valuation. If a firm owner is considering taking specific actions that are related to the value of the firm (e.g., issuing equity), getting a third-party valuation can provide them with meaningful insights from an outside opinion on the firm’s business value. Most third-party appraisers write an opinion letter that provides an independent perspective on the value drivers within a firm.

2. Invest the time to strategically manage the firm. Firm owners should commit to long-range strategic planning that includes five- to 10-year goals. Further, use key performance indicators (KPIs) to help manage the fundamentals of the business. Using KPIs can help quantify a firm owner’s goals, manage the firm to these metrics, and foster a culture of accountability throughout the organization.

3. Invest in the firm’s team members, including future leaders. RIAs may want to consider the following two-pronged approach to investing in human capital. First, commit to developing talent. Identify the skills the team needs to develop, and provide a combination of additional professional experiences and training to help them reach their potential. Next, identify and create next-generation owners who have the requisite skills to contribute to the growth of the firm. If a firm owner is planning to pursue an internal succession, they should begin identifying and grooming next-generation owners at least five to seven years before their planned exit. They may also want to develop equity compensation plans to retain key talent, including potential next-generation owners. And they should consider providing employees with opportunities to buy firm equity at a discount to fair market value and consider offering seller financing.

4. Position the firm to capture intergenerational wealth transfer. Firm owners may want to consider a multi-faceted approach that includes the following. First, engage the adult children of existing clients. Identify client relationships that have the potential to expand to younger generations and build engagement strategies that not only deepen these relationships, but also encompass these clients’ adult children, and potentially even grandchildren, where applicable. Also, focus business development activities on younger investors. When pursuing the next generation of clients, cultivate relationships with younger investors who meet the firm’s account minimum, or who have a combination of high income and strong saving habits that may eventually result in their meeting the account minimum.

Fidelity Clearing & Custody Solutions is the division of Fidelity Investments that provides clearing and custody to registered investment advisors (RIAs), retirement recordkeepers, broker-dealer firms, banks and insurance companies. Addition information on the RIA Benchmarking report is here.