First Class Upgrade to Your Buy-out Using CAPEXChia-Li Chien
Chia-Li Chien, PhD, CFP®, PMP®, Apr. 14, 2019
As a road warrior, I get complimentary flight upgrades to first class from time to time, depending on the airport. In my most recent trips, I noticed that almost half of the passengers in first class were female. By the way that they carry themselves, it is safe to assume that they are in management positions. For trips longer than three hours, the comfort in the spacious first-class seats plus hot meals means a lot to those of us that do not have time to eat before boarding.
Of the 27 million businesses in 2012, 35.8% are women-owned firms, according to the U.S. Census Bureau (U.S. Census Bureau, 2012). In addition to women owners, there are many women executives in the workforce today that are making decisions about the future of their firms, more specifically capital expenditures (CAPEX) investment.
Examples of capital expenditures or investments include expanding to a second headquarters, buying new fleets, hiring a consulting firm to streamline processes, having an M&A project management team to consolidate technologies, and buying a competitor. There are so many factors to determine which projects to invest in and how to measure success when the CAPEX projects are concluded. As we will see in the example below, CAPEX is an excellent process for evaluating acquisition terms.
There are three general steps involved in CAPEX decisions:
Step 1: Determine the weighted average cost of capital or WACC.
Step 2: Determine the projected net cash flow from the investment.
Step 3: Evaluate the project(s).
Let’s walk through an example of CAPEX where a financial service practice (ABC Advisors) is considering acquiring a near-retirement advisor’s practice (Advisor X). ABC Advisors and Advisor X are both in the same independent broker dealer (IBD). ABC Advisors payout ratio is at an average of 71% from 2016 to 2018. Advisor X’s payout ratio is at 50% before selling her practice at 70 years of age.
Step 1: WACC is 13.15% based on ABC’s 2018 balance sheet of 1) $30,000 outstanding long-term debt at 7.5% interest rate, 2) combined federal and state tax at 29.84% (assumed C Corp.), and 3) ABC’s stock was valued at $5 million in 2018.
Step 2: There are two options to consider. Option A is to pay down 20% and to finance the remaining with a 10-year loan at 7.5% interest rate. Option B is to pay Advisor X perpetually 20% of Advisor X’s revenue or Advisor X’s gross dealer concession (GDC) times ABC’s payout ratio. There are a lot of factors (Chien, 2019) that will affect this option. These factors include 1) Advisor X’s life expectancy; 2) Advisor X’s shrinkage of assets under management (AUM) due to aging clients that impact ABC Advisor’s potential future revenue; 3) depreciation methods of the acquiring asset (Advisor X); 4) ABC’s expense ratio (both fixed and variable) based on every Advisor X $1 of revenue; 5) transition project cost, etc.
Step 3: The discounted rate is 18.15% which is WACC plus the risk premium assumed at 5%. The reinvestment rate is assumed at 3.5%.
The net present value (or NPV) for Option A is $69,017.65 compared to Option B of $372,480.37. The modified international rate of return (MIRR) for Option A is 13.27%, and for Option B is 24.22%. The discounted payback period is 5.52 years for Option A compared to Option B of -1.23 years (before buying).
To simplify the CAPEX evaluation without any sensitivity testing, Option B is a better choice for ABC Advisors due to a positive NPV and a shorter discounted payback period.
There were 12,172 SEC-registered investment advisors in 2017 with an average of 46 RIAs per quarter selling to other RIAs (Friedman & Kapusinski, 2018). The majority of financial planning practices are solo practitioners compared to the silo, ensemble, super ensemble, and ensemble enterprise (Tibergien & Dellarocca, 2017). As the fee (revenue) compression continues in the financial service industry to keep pace with growing the practice, many silo and ensemble firms seek to swallow retiring solo practices at an accelerated pace. ABC Advisors is an example of a silo practice.
But if you are a solo practitioner today like Advisor X, using Option B as above is not advantageous. From the seller’s perspective, Option A is far better because you receive $225,000 the day of closing the deal. However, when compared to Option B with net present value of $175,503 of your life expectancy, the difference is a 22% loss in the seller’s equity value.
There were 83,233 CFPs as of Feb 2019 (CFP Board, 2019) and of that 23.15% were women. About 20% of advisors have CFP certificates (Johnson, 2014), translating to 416,165 advisors in the U.S. But 43% of advisors are near retirement (Financial Advisor, 2014). Let’s further assume that 15% of those are solo advisors (26,843) who chose to sell using Option B. That amounts to a loss of seller’s equity value of approximately $1.33 billion.
Although the case study illustrated that the seller is a female advisor, one of the partners of the buyer is also a female advisor. Ideally, both buyer and seller could use the CAPEX process to make the appropriate decision with best options for all parties.
I’ve worked with many owners and executives in helping them to make CAPEX decisions. However, the majority of them are men. I wish more female advisors would consider using the CAPEX process for M&A decisions. With more than half of the U.S. population being women, isn’t it time for female advisors to get an upgrade to a well-deserved equity value pie, just like my observation of the percentage of women passengers in first-class commercial flights?
CFP Board. (2019, Feb 28). CFP® Professional Demographics. Retrieved from CFP Board: https://www.cfp.net/news-events/research-facts-figures/cfp-professional-demographics
Chien, C.-L. (2019). A case study of Succession process in Financial Planning Practice (multiple owners). Working Paper IRB#20181233, California Lutheran University School of Management, Thousand Oaks, CA.
Financial Advisor. (2014, Jan 17). 43% Of Advisors Nearing Retirement, Says Cerulli . Retrieved from Financial Advisor: https://www.fa-mag.com/news/43–of-all-advisors-are-approaching-retirement–says-cerulli-16661.html
Friedman , G., & Kapusinski, S. (2018). The Financial Advisor M&A Guidebook. Cham, Switzerland: Springer International Publishing. Kindle Edition.
Johnson, H. (2014). Getting a CFP is a lot of work. Is it worth it? Retrieved from Chicago Tribune: https://www.chicagotribune.com/news/ct-xpm-2014-04-04-sns-rt-us-yourpractice-integrity-20140404-story.html
Tibergien, M., & Dellarocca, K. (2017). The Enduring Advisory Firm: How to Serve Your Clients More Effectively and Operate More Efficiently (Bloomberg Financial) . Hoboken, New Jersey.: John Wiley & Sons, Inc. Kindle Edition.
U.S. Census Bureau. (2012). QuickFacts United States. Retrieved from U.S. Census Bureau: https://www.census.gov/quickfacts/fact/table/US/PST045217