Private Client Adviser Knowledge Base
Issue III
Achieving your Investment Objective - By David Wynn, Investment Director, RMS Bentley Jennison
Hidden Tax Reliefs for Business Owners - By Alison Broadberry, Private Client Partner, Speechly Bircham
Social Media in Financial Services - By Phil Calvert, CEO, IFA Life
Making the Firm your Biggest Asset - By Jasper Berens, Head of UK Retail, J.P. Morgan Asset Management
Achieving your investment objective
David Wynn, Investment Director, RMS Bentley Jennison
Adding together all the column inches written surrounding the ‘credit crunch’ and the collapse of the global economy would probably produce a paper trail that would stretch to the moon and back - and it’s unlikely to be over yet!
During the first nine months of 2009 investment markets have experienced a sharp reversal in trends and sentiment across all asset classes, and those assets that suffered most in 2008, have been the best performers so far this year. Policies enacted by central banks and governments have all but avoided financial meltdown. The 'Crisis' part of this credit crisis has probably past, but many of the issues have not been fixed and could continue to be with us for many years. Sentiment has improved and, for the moment at least, it appears that we are no longer staring into the abyss.
Once economies and markets start to normalise, it is certain that there will be a lot of debate surrounding ‘lessons to be learned’. But are there any lessons that we have learned already?
Riskier assets, such as global equities, have staged a spectacular rally since their March lows but it should however be noted that despite the strong rally most major equity market index levels are not much higher than they were a year ago. It is clear that investors have been shocked by the degree of losses that they have faced and it is apparent that they did not expect the valuation of their investments to be so volatile and behave in the way they have – in a nutshell, they did not fully appreciate the degree of inherent risk.
So, how can we better protect ourselves from the occurrence of these kinds of events in the future and where do we start?
If your objective is not being achieved, it makes sense to go back to the blue-print of your plan. Setting the plan, or investment strategy, is one of the most important investment decisions that investors will make. Whilst setting a robust and appropriate investment strategy is not a ‘panacea’ this approach should significantly increase the probability of the investment objective being achieved.
Setting the appropriate investment strategy
In order to set an appropriate investment strategy we must first identify the investment objective i.e. what do you want your assets to achieve? This calls into question why we invest at all. The simple answer is, we accumulate and invest our assets so that we can pay for a stream of known and unknown costs or liabilities that we expect to arise sometime in the future such as, provision for the beneficiaries of a Trust and financing school fees.
Investment objective
Effectively, the investment objective is determined by the size and incidence of this future stream of expected and unexpected liabilities. It follows that, the better our understanding of this future stream of liabilities is, the easier it should be to set an appropriate and robust investment strategy. For example, if we had one single liability of £10,000 maturing in 1 year’s time we would simply put £9,615 in a bank account that is expected to accrue interest at 4%. In 1 years time the amount of cash in the bank account should be £10,000 which covers our maturing liability in full. If only it were so simple….!
Future liabilities may be known and unknown and comprehensive analysis may prove difficult. The analysis may be further complicated by unforeseen changes in circumstances which may lead to your liabilities maturing earlier than previously expected. Monitoring your liabilities and revising your investment strategy accordingly should ensure that your strategy remains robust.
Understanding risk
Now that we understand the liabilities, we need to consider what further information we require to be able to determine a robust investment strategy?
Firstly, we need to understand the extent of any return or growth that can be achieved from various asset classes but more importantly, it is imperative that we have a clear understanding of what the potential risks of investing in these assets are expected to be.
Forecasts of future anticipated levels of risk and return from investment assets comes from various sources such as global economists and investment strategy teams from fund management companies. The process for forecasting starts with a study of how the assets have behaved historically during the various economic environments we have experienced. It then moves on to consider the expected economic environment in the future and, once this has been determined, anticipated levels of risk and return are calculated on the assumption that the assets are likely to behave similarly during the anticipated economic environment to the way they behaved in the past.
The limitations of forecasting are evident – in effect, forecasts will almost certainly be wrong but unfortunately we do not have a crystal ball! However, it is also evident that forecasts from recognised professional economists should be the next best thing.
How is risk within investments measured?
Risk in investment assets is measured by the degree of volatility in the change of the price or value of the asset.
Standard deviation is an industry recognised measure of the volatility of an investment and is the most common measure of statistical dispersion. Analysing a set of data for a given period of time, the calculation measures how spread out the values in the data set are from the mean or average. The further the spread or dispersion from the average, the higher the measure of standard deviation will be.
Using the example of a cash investment, the data points over the period analysed are all likely to be closer to the average, so the standard deviation is low. If we consider equity type investments, many of the data points over the period may be very different and further dispersed from the average. This results in a higher standard deviation or higher volatility/risk.
In a nutshell, a higher standard deviation equates to a higher degree of volatility which means higher risk.
Forecasts of risk and return
To achieve a market consensus view of the long-term (10 years) outlook for various assets classes it is important to consider the views of a number of forecasters. In our experience, long-term forecasts from a number of providers tend to be reasonably similar. We have detailed below the forecasts that have been very kindly provided by the Cazenove Capital Strategy Team as at December 2008 on a risk/reward chart. Expected volatility or level of risk is plotted on the horizontal axis and expected return on the vertical axis. It should be noted that the forecasts are provided as a long-term, 10 year view and will change over time.
What do these forecasts tell us?
The forecasts tell us that if we want very low levels of risk we must accept low anticipated levels of return (cash) and, vice versa, if we want higher levels of return, we must take on much higher levels of risk (International Equities or Commodities). The eagled eyed amongst you will notice the forecast level of return from cash over the long-term is significantly higher than the current interest rates achievable which indicates the expectation of a return to a normal interest rate environment in the future.
We have already determined that forecasts of expected return may not be borne out, so how do we manage this eventuality? If we consider our simple example used in the section ‘Investment objective’ above and assume that a fall in interest rates has led to a fall in the rate that we can achieve from our bank account to 2%, the value of our investment after 1 year will be £9,808 and will not fully cover our maturing liability of £10,000. In this instance, we would need to find the extra funds from elsewhere.
Regularly monitoring of returns from your investments and revising your investment strategy will help ensure that it remains robust and outcomes, such as the one described in the example above, can be identified early on.
Next steps
Doing nothing should not be an option. You should ensure that the investment strategy you set is the result of a positive decision. This means taking control of the asset allocation i.e. the mix of bonds, equities, property and other growth assets and putting in place a strategy that is a reflection of your anticipated liabilities. This mix must balance the conflicting objectives of risk reduction and higher return.
For example, if you have a liability that is going to mature in the short-term (less than 3 years) you should probably consider backing this with investments that are expected to exhibit low levels of volatility such as cash. In contrast, if your liabilities are not expected to mature for a long time, let’s say 10 years or more, you can afford to consider investing in more risky assets to back these liabilities. The increased time period to maturity means that your assets should have a longer time period to recover from any market falls and you will not be a forced seller of these assets to cover liabilities at inopportune times.
Conclusion
We live in very interesting times and investors are faced with very difficult decisions. It is unlikely that the current difficulties within the global economic environment will go away any time soon and there has never been a more appropriate time to consider the risk inherent in your investment portfolio.
Setting the appropriate investment strategy is very important and the strategy you adopt is probably the single largest determinant of whether your investments will succeed in meeting their objective, i.e. to meet the liabilities as they fall due.
Setting the appropriate strategy appears common sense but the workings behind the scenes such as understanding anticipated risk is complicated. It is therefore critical that you receive investment advice from an appropriately qualified investment professional and that your investment strategy is given sufficient attention and is set in accordance with your investment objective. Finally, it is almost certain that circumstances will change and investment markets will not behave as anticipated, so it is critical that you keep your investment strategy under regular review so that any changes in circumstances can be dealt with accordingly.
Hidden Tax Reliefs for Business Owners
Alison Broadberry, Private Client Partner, Speechly Bircham
Most clients with business interests will know that they can get 100% inheritance tax (IHT) relief on their business assets. But do they know that they can get 100% relief on their non-business assets?
The 100% relief on business assets can also apply to investments in forestry, agricultural land and AIM-listed shares. Not so widely known by business clients is that, with proper planning, IHT on their non-business assets can be reduced or even eliminated.
Take Mr and Mrs Roberts – they jointly own AIM shares and an interest in a family business which provides £800,000 of IHT relief. They also own Ivy House and other assets totalling £1m.
Mr Roberts dies first. They made simple wills leaving everything to each other so there is no IHT to pay and Mrs Roberts inherits Mr Roberts’ transferable tax-free band.
Mrs Roberts dies three years later leaving everything to their children. Her AIM portfolio and business investment qualify for 100% relief, but (assuming current rates) the children have to pay £140,000 on the home and other assets.
Had two steps been taken however, the tax bill could have been avoided altogether.
The first step would have been for Mr Roberts’ will to leave his share of the AIM-listed shares and business to a suitable trust for his family. The second step would have been for the trustees to take an IOU from Mrs Roberts in place of the trust assets.
The result is that no IHT is payable when Mrs Roberts dies. This is because, after allowing for the IOU, Mrs Roberts’ net worth is below the combined total of the Roberts’ tax free bands. In effect, the IHT relief on Mr Roberts’ business assets have been recycled and used again on Mrs Roberts’ death.
What if Mrs Roberts had not survived by two years? Business assets have to be owned for more than two years before they qualify for IHT relief. Mrs Roberts should be advised to take out term life cover and for it to be placed in an appropriate trust.
The moral is that owners of any assets which do or may qualify for 100% IHT relief, would be well advised to review their wills to ensure that 100% tax relief can be turned into 200% relief.
Social Media in Financial Services – hot air or hot stuff?
Phil Calvert, Chief Executive, IFA Life
Just about every newspaper you read and every website you visit is talking about Social Media. It’s the current ‘big thing’ on the Internet and everyone’s getting involved. Except those of us in Financial Services.
You see we’re not quite sure if it has any relevance to us. After all, sites like Facebook are for kids – aren’t they? Well, increasingly not. The business world is piling in and it is enriching the lives of people of all ages. Either way, social networking tools and websites are here to stay, and are giving IFAs and financial brands an exciting new way to interact and engage with customers – plus a powerful new way to re-establish trust and credibility in the industry.
Those financial brands who have discovered social media are eyeing it up keenly because on the surface it looks like an exciting new advertising medium. With many sites having thousands, if not millions of members it seems like a no-brainer as a vehicle to promote financial products and services.
But there’s a problem.
Yes, social media can give your brand incredible exposure – but important to learn best practice and how to use it properly, because members of social networking websites don’t like brands advertising at them. But on the other hand, they do like being engaged with. It’s a subtle but important difference, and one that needs to be learned.
Every week, I have conversations with financial services providers from large insurance and pension companies through to very small IFA firms who work from their garage. Without exception the conversation goes the same way:
“We’ve been looking at social media for the last eighteen months. We think it’s a great idea and something we should be using. But, we haven’t got the time, resource, expertise or money to dedicate our attention to it – but we still think it’s something we should be involved in”.
And that’s fair enough. But to think that just eighteen months ago our industry would be talking about using Facebook, YouTube or Twitter to engage with customers would be thought ridiculous. But as is so often the case with the Internet, these things creep up on us very quickly, until we’re almost too late to benefit.
The fact is that after using a major search engine like Google, the next place consumers go to find information is social networking websites. And unlike Google, when you type in a question, real people respond with answers – and answers that include personal experiences, reviews and recommendations.
In short, consumers are talking about our industry behind our backs. Sometimes positively and sometimes negatively, but either way they are conversations we need to be hearing – if not proactively prompting through social media.
Social media is not just a tool to market your products – it’s a powerful medium to listen to customers, to answer their questions, to engage with them and to add value. So why not join other financial brands at the Social Media in Financial Services conference in January 2010, and discover why the hot air will breath life into your online presence.
Making your firm your biggest asset
Jasper Berens, Head of UK Retail, J.P. Morgan Asset Management
So you’ve worked hard all your life. You’ve built up a profitable advisory business. You have a loyal, high-quality client bank, impeccable financials and a sterling reputation. Now you want to see how all those qualities translate into a saleable asset.
You’re not alone. With the average age of an IFA now estimated to be in the late-50s, plenty of firm principals will be considering how to sell on their business. Faced with the increased demands on independent advisers proposed by the Retail Distribution Review (RDR), many IFAs will be looking for an exit sooner rather than later. Of the 35,000 registered IFAs currently working in the UK, Ernst & Young recently estimated that only 10,000 are likely to be working as fully independent advisers by 2013*.
So faced with competition like this, what can an IFA do to secure the very best price for their business in a buyer’s market? We recently published a report exploring this question.** Working with Ernst & Young to assess recent IFA sales and acquisitions, we discovered there were certain attributes that repeatedly occurred among those firms that had commanded the highest valuations. At the same time there are certain attributes that almost always counted against a firm looking to sell.
We’ve described these attributes as either valuation threats or enhancers – and the impact on valuation can be significant – see Diagram 1 below. So let’s look at a few of these attributes in detail:
Recurring, sustainable income:
This was an extremely strong theme in our research. Repeatedly, acquirers were looking for IFA businesses with a high proportion of earnings based on annual fees and trail commission – to the extent that initial commission business had an almost negligible value because it has to be ‘resold’ each year. Given RDR proposals to outlaw commission among independent advisers, a fee-based business model will command a premium.
Clear proposition:
Acquirers may target a firm for a variety of reasons – for example because it has strong coverage in a particular region, a strong area of expertise, great technology a compelling culture or client servicing approach or because it has cornered the market in a certain type of client. Firms that are able to show buyers that they can offer something that other firms cannot have repeatedly achieved stronger valuations than their peers.
‘Sticky’ client base:
If a principal leaves an IFA firm, chances are the business’s most prized asset – its clients – may leave with him. Acquirers will therefore want signs that clients are embedded in the business – for example, team-based client management, a high level of assets entrusted to the firm, strong net new inflows, longevity of client relationships. Incentives may also be paid for successfully moving clients over to the new firm.
High-quality RIs:
If you are hoping to place a value on advisers who are remaining with the business, they will need to be of a calibre of interest to acquirers post-RDR. This means RIs who have, or are in the process of attaining ‘level 4’ qualifications such as the CII Diploma.
These are just four attributes that if held in combination – our research suggests – will immediately attract the interest of potential acquirers. The big question, of course, then is how much will your business sell for?
Our research suggests there’s no easy answer. During the most recent period of high transaction activity in 2007-2008 (i.e prior to the most serious leg of the credit crisis), IFA firms sold for an average of around 14x EBITDA (earnings before interest, tax, depreciation and amortisation) but prices for reported transactions ranged from anything from 2.2x to 27.8x EBITDA. This is partly because there is no uniformly agreed means of valuing an IFA business (although multiples based on recurring income are increasingly prevalent). Plus, as we have detailed above, valuations can be based on a broad range of qualitative factors – not just bald financials – as well as external factors such as the market environment and the availability of financing and leverage to acquirers.
Also principals should be aware that the ultimate terms of sale may involve significant incentives during the transitional period. For example, the acquiring firm may pay the outgoing principal/s an ‘earn-out’ based on how many clients they successfully transition to the acquirer’s own model.
What is also clear from our findings is that a successful sale takes time. Positioning a firm for sale, researching potential acquirers, agreeing terms and executing a successful transition can all can take three years or more, according to consultants and IFAs who have been through the process. But, say the experts, don’t rush for the exit. This is your one chance to reap the rewards of having built up your own business. Take your time, take expert advice and take heart from the fact that high-quality advisory businesses will find the right buyer eventually.
Selling an IFA – top tips
- Know potential acquirers – try to interest buyers at the right point in their own growth curve;
- Don’t accept the first offer – talk to a number of potential buyers as valuations can vary massively depending on an acquirer’s objectives;
- Time your exit – if you have to sell during a market slump, negotiate the valuation to be based on income over next three to five years to capture any upswing;
- Use specialists – engaging a corporate finance expert to manage the sale can result in a higher price and lets you focus on running the business. An experienced legal team will also attract respect from the acquirer.
- Sell before you need to – Avoid being a forced seller or waiting until there’s no value left in the business.
* 2012 Going for Gold? Preparing for Leadership in the UK life, pensions and savings market, Ernst & Young, Summer 2009
** Reaping Rewards: assessing, optimising and releasing the value of a financial advisory busines, June 2009. For a free copy call Brokerline 0800 727 770 or go to www.jpmorganassetmanagement.co.uk