This article was originally published by the National Ethics Association and E&O for Less on February 26th, 2016 and written by Harry J. Lew, NEA Chief Content Officer.
Financial advisors typically view compliance as a necessary evil. They don’t always enjoy managing their regulatory obligations, but they do it because they must. And they don’t view compliance as having a future upside unlike the things they really enjoy doing such as marketing, selling, and client advising. That perception can hurt them when they go to sell their firms, according to David Grau, Jr., President and CEO of the Succession Resource Group in Tualatin, Oregon.
Grau’s company helps financial advisors value, grow, and transfer their books to their successor. He says increasing numbers are doing just that as they approach retirement. But unless their firms successfully navigate the due-diligence process, advisors may not achieve their desired selling price. Worse, they may not be able to sell their companies at all.
“Buyers expect a clean compliance record,” says Grau. Lack of attention to ethical business practices and regulatory compliance can seriously derail an advisor’s future retirement plans, he warns.
For most advisors, those plans hinge on how much they can get for their firms. Grau says there are five key value drivers that buyers look for:
- Sources of revenue: how does it split between recurring and non-recurring revenue?
- Growth of the firm: is it experiencing healthy growth or is it stuck on a plateau?
- Client age: where are customers on the asset accumulation/decumulation spectrum?
- The firm’s business model: how strong are client relationships and how delighted are customers with the service they receive.
- The firm’s profitability: is it making money?
“For example, you could have a fee-only practice, with all recurring revenue. It could be growing quickly. It could have young clients. It could also have an amazing service model and be very profitable,” says Grau. “But if it’s had a host of compliance issues over the last few years, it could go from being worth $1 million or $5 million to being totally unsaleable.”
However, if the practice has a clean compliance record, then the advisor might be able to receive on average 2.5 times recurring annual revenue upon the sale of his book, Grau says.
Little Compliance Attention
Which raises a key question. Why do advisors pay so little attention to the role of compliance in succession planning? For one thing, says Grau, many don’t believe their firms have any value. he says they view their client relationships as being intangible and inseparable from them personally. Grau believes advisors should make a paradigm shift and acknowledge that their client relationships are valuable and can be successfully transferred to another advisor.
What’s more, financial advisors are hands-on practitioners. They’re busy with marketing, sales, client fact-finding, annual reviews, customer service, and other day-to-day tasks, not to mention with staying on top of current marketplace trends and completing their continuing-education requirements. In light of these demands, they don’t see how spending time on compliance tasks benefits them long term. “This is a connection advisors don’t make until they get closer to retirement …when they realize they have something of substantial value (to sell),” Grau explains.
When that time arrives, they must be ready for rigorous due diligence. A comprehensive review of an advisor’s licensing/ regulatory history is a key aspect of the sales process, Grau points out. Buyers typically start by Googling the owner and firm in order to uncover damaging events. It also involves tapping the SEC’s Investment Advisor Public Disclosure (IAPD) database as well as checking with a securities broker’s Office of Supervisory Jurisdiction (OSJ). Ferreting out an advisor’s E&O insurance claims history is also important.
But Grau doesn’t stop there. “The financials and the client service model are highly quantifiable,” he says. “It doesn’t take a lot of time to get (this information). What takes more time is going through client files to see how communication has been handled and if there are any red flags we should be concerned about.
“Buyers are going to be working in that business for the next 10 or 20 years,” Grau adds. “So if they (buy a practice) with skeletons, that can be detrimental to their productivity year to year, to the amount of money they make, and to the value of their existing business. We spend a lot of time looking for potential ethical or compliance issues that haven’t been identified yet.”
Grau says unethical practices such as churning or giving unsuitable investment advice don’t always show up on BrokerCheck or on an advisor’s E&O insurance history. But if his client-file review uncovers patterns of self-serving behavior, then he’ll either recommend a discounted price or simply walk away.
What are the most common compliance problems that torpedo deals? Grau says it’s any event that “calls an advisor’s character into question and that has monetary damages associated with it . . . of any amount.” Do frivolous claims have any impact? “In general, these have no impact on the value of the business,” Grau responds. “But if there’s a pattern of those claims, even though denied, which reoccurs every few years from the same client base, then there may be (unethical behavior) going on or the practice may have a litigious client base. Either way, the value of the business will be affected.”
Grau points to several cases over the last 24 months where advisors sold alternative investments. Clients were having concerns, and the advisors were dealing with dozens, if not multiple dozens, of claims relating to the same investment.
When a buyer sees 25 disclosure events related to the same pending claim, that person is going to lose interest. Says Grau, “I’ve had cases where we were still able to get the business sold, but with so many contingencies it might as well not have been sold at all.”
Confounding matters, advisors with black marks either refuse to admit wrongdoing or try to cover them up. Big mistake, Grau says. Instead, they should proactively inform the buyer of compliance issues. “The last thing you want to do is get through due diligence only to have the buyer uncover suitability claims on BrokerCheck,” Grau says.
Ideal Scenarios
But there’s good news. Advisor black marks don’t always kill practice sales. The outcome depends on whether the claims were denied or settled and on the reason for the disputes. For Grau, the ideal scenario has four elements:
- First, advisors should proactively admit their disclosure events.
- Second, they should point to how their broker-dealer, RIA, or insurance company denied or settled the claims independently of them.
- Third, they should be able to provide detailed notes on each event.
- Fourth, they should divest their firm of the problematic clients.
The point, Grau says, is to “encapsulate the risk from the buyer’s perspective.”
What’s Grau’s bottom-line advice for financial advisors looking to sell their businesses? First, recognize the inherent value of their firms. And second, avoid doing anything that jeopardizes that value. Especially important is preventing client suitability claims, bankruptcies, and tax liens or other IRS disputes.
The silver lining for Grau is that advisors who maintain a clean compliance record will not only experience benefits in the short term, but will also add value to their business over the long haul. And not only will they and their families benefit from this extra value, their clients will, too.
“The better their compliance records are, the more likely advisors will be talking to the best candidates in the market (to take over their books of business). So if taking care of their clients is the goal, then maintaining as clean a compliance record as they can in today’s environment will go a long way toward making that happen.”
