So you are thinking about buying a book of business. But before you do, consider what you are really buying. Or, if you are one of the many advisors who plan to sell their businesses, think about what you are selling.

It is accepted wisdom that advisors need large books in order to operate profitably. It is also accepted wisdom that buying a book of business is a quick way to get there. True enough. In Advisor Impact Inc. ’s Practice Update: 2005 survey of 965 advisors, the
38% of advisors who have bought books of business had $6 million more in assets under management on average and their books grew by an average 24% from 2003 to
2004, vs 18% for those who haven’t bought books.

That’s good news, suggesting that there will be a market for the 66% of advisors who are building their businesses with the explicit goal of selling for a profit. The research, sponsored by Investment Executive and AIM Trimark Investments, surveyed advisors who work for both Mutual Fund Dealers Association and Investment Dealers
Association of Canada firms. If the data were split by channel, some of the numbers (e.g., assets under management) would differ; however, the research focused on margins and trends, and these were consistent across channels.

Although the actual process used by advisors in buying or selling a business is less than scientific, buyers and sellers alike seem to agree on how businesses are valued: according to AUM, gross revenue and, to a lesser extent, percentage of recurring revenue. So, what is the problem?

The problem is summed up in the old adage: buyer beware. The fact is that advisors who have bought books of business may have bigger businesses but they are not necessarily more profitable, which means they are running larger and more complicated businesses but generating roughly the same profit (or income) as those who did not buy books.

This has an obvious knock-on effect for sellers. If buyers begin to focus on different drivers of value, sellers will need to focus on those same drivers as they build their businesses for sale.

The problem isn’t with book acquisition as a strategy. If properly managed, purchasing a book is a valid form of growth. The problem is that advisors are buying books of business without sufficient due diligence. They are buying for the top line, not the bottom line — and, as a result, the bottom line is suffering.

What does the research tell us? First, we have found that there are both good and bad ways to grow a business. Advisors who have bought books of businesses have, on average, $6 million more in assets than those who have not. However, although that translates into books (AUM) that are about 14% larger than the average, these same advisors have about 34% more clients.

This suggests that advisors who have bought books of business were buying large numbers of smaller clients. Assets per client for the average advisor is $150,000; for those who have bought books of business, that number slides to $127,000.

Second, we have found that there are substantial costs to managing larger client bases.
Because advisors who have bought books are working with larger numbers of smaller clients, their expenses are higher. So, while average gross revenue for bought books was 8%, expenses were 27% higher.

Although the average cost per client was only slightly higher for those who bought books, a high number of smaller clients increases overall costs substantially. Also, by using this simplistic analysis, we cannot begin to assess the time cost of client management, which has significant negative impact on the bottom lines of advisors who have bought books.

Finally, I suggest that these two issues will have an impact on practice stability.
Although profit margins remain consistent for those who have bought books and those who have not, it is valid to question how easy it is to manage a client base that is 34% larger, when the additional costs are not fully supported by increased revenue.

The real question is whether $11,600 in operating profit is worth the time and effort required to manage an additional 102 clients, each generating marginal profit of about $116 a year?

Despite these facts, advisors remain confident that they will sell their practices for a solid return when they retire. Thirty per cent of advisors expect to sell their practices for $1 million or more, and another 21% for between $500,000 and $1 million. There is something to be learned, however, from those who have already travelled that road.
Virtually every advisor whom we interviewed on this topic said he or she would do things differently the next time around. Although both buyers and sellers tended to agree on the price, three areas were identified as weaknesses in valuing based on assets or revenue only.

@page_break@> The quality of the clients. Advisors who have bought books said that in the future they would spend much more time analysing clients, focusing both on their profiles today and their potential. Some advisors also said they would look more carefully at the completeness of the files.

> Stickiness of the clients. Advisors who have bought books of business indicated they would want to understand how satisfied clients are with the selling advisor, recognizing that hidden problems might lead to attrition at the time of transition. Attrition would result from big discrepancies between investment styles of the advisors, so this was also raised as an area requiring more discussion and analysis.

> The transition plan. Advisors who have bought books of business said unanimously that in the future they would create a clearer transition plan, detailing both the process of transition and the length of time in which the selling advisor would be involved in the business.

But let’s return to one of the original points — that client acquisition can be an effective growth strategy. Acquisition makes sense if you know what you want (clear target client), know what you are buying (client analysis), look at all risk factors (satisfaction, investment profile, age, needs) and have a clear transition plan.

Although by no means a comprehensive list, here are some things to consider when buying a book of business:

> demographic profile of clients (i.e., age and stage);

> clients’ satisfaction with the current advisor and the extent to which the relationship is dependent on that individual;

> potential for cross-selling, multi-generational planning, etc.;

> investment style of new clients and the extent to which that matches the style of the buying advisor;

> detailed evaluation of clients’ current investments and scope of changes that may be necessary;

> scope and quality of information tracked on clients;

> process to inform clients of the transition and extent to which that issue has been broached in the past;

> timeline of transition, or how long the selling advisor will be available to work with clients;

> the specific responsibilities of the selling advisor.

Just as the quality of the client base affects the long-term return on the investment, so does the quality of the business. The value of any business increases if there are processes, people and systems in place that allow purchasing advisors to improve efficiencies in the combined business. They need synergies that will reduce costs, increase revenue or do both.

What does this mean for valuation models? Today, buyers are valuing based on the top line — and the results have been less than impressive. As buyers increasingly consider what the return on their investment will be, I believe that they will become more diligent in assessing the value of the assets they are buying and that this will have a knock-on effect in terms of how their businesses are managed. The focus will be on quality, retention and efficiency.

And, in the end, this focus will be beneficial to advisors and clients alike. A well-run business is not only more valuable, it also provides its clients with a better level of service. IE

Julie Littlechild is president of Toronto-based Advisor Impact Inc., which provides research and training for financial advisors and accountants in Canada, the U.S. and Britain. For more information, visit www.advisorimpact.com. Also in this issue, see the Practice Update: 2005 “Practice and Profitability” booklet.