The Company leases office space to support its reportable segments. NFP’s corporate headquarters is located at 340 Madison Avenue, New York, New York, where NFP leases three floors. In November 2009, NFP subleased one floor to a third party. NFP and certain of its businesses occupy the remaining two floors. NFPISI and NFPSI occupy office space at 1250 Capital of Texas Highway South, Austin, Texas, where NFPISI leases six floors. NFPISI has subleased a portion of this space to various third parties. Additionally, the Company’s businesses lease properties for use as offices throughout the United States and Canada.
You should read the selected consolidated financial data set forth below in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the Consolidated Financial Statements and the related notes contained in this report. The Company derived the following selected financial information (excluding Other Data) as of December 31, 2011 and 2010 and for each of the three years in the period ended December 31, 2011 from the Company’s audited Consolidated Financial Statements and the related notes contained in this report. The Company derived the selected financial information (excluding Other Data) as of December 31, 2009, 2008, and 2007 from the Company’s audited Consolidated Financial Statements and the related notes not contained in this report.
a) Prior to January 1, 2010, the Company calculated the internal growth rate of the revenue of its businesses as a measure of financial performance. This calculation compared the change in revenue of a comparable group of businesses for the same time period in successive years. The Company included businesses in this calculation at the beginning of the first fiscal quarter that began one year after acquisition, unless a business internally consolidated with another owned business, made a sub-acquisition that represented more than 25% of the base earnings of the acquiring business, or a significant portion of the business’ assets were sold. With respect to two owned businesses that consolidated, the consolidated business was excluded from the calculation from the time of the consolidation until the first fiscal quarter that began one year after acquisition of the most recently acquired firm participating in the consolidation. However, if both firms involved in a consolidation were included in the internal growth rate calculation at the time of the consolidation, the combined firm continued to be included in the calculation after the consolidation. With respect to sub-acquisitions, to the extent the sub-acquired firm did not separately report financial statements to NFP, the acquiring firm was excluded from the calculation from the time of the sub-acquisition until the first fiscal quarter beginning one year following the sub-acquisition. Sub-acquisitions that represent less than 25% of the base earnings of the acquiring business were considered internal growth. With respect to situations where a significant portion of a business’s assets were sold, the surviving entity was excluded from the internal growth rate calculation from the time of the sale until one year following the sale. With respect to dispositions, the Company included businesses up to the time of disposition and excluded such businesses for all periods after the disposition.
NFP and its benefits, insurance and wealth management businesses provide a full range of advisory and brokerage services to the Company’s clients. NFP serves corporate and high net worth individual clients throughout the United States and in Canada, with a focus on the middle market and entrepreneurs.
NFP enhances its competitive position by offering its clients a broad array of insurance and financial solutions. NFP’s continued investments in marketing, compliance and product support provide its independent advisors with the resources to deliver strong client service. NFP believes its operating structure allows its businesses to effectively and objectively serve clients at the local level while having access to the resources of a national company. NFP’s senior management team is composed of experienced insurance and financial services leaders. The Company’s principals and employees who manage the day-to-day operations of NFP’s businesses are professionals who are well positioned to understand client needs.
The economic environment remains challenging, and many economic indicators continue to point to a slow and uneven recovery. This uncertain environment has reduced the demand for the Company’s services and the products the Company distributes, particularly in the life insurance market. 2010’s temporary estate tax laws have also had a continuing impact on the high net worth life insurance market by increasing the value of the estate that is exempt from federal estate tax and thereby decreasing the size of the target market.
The Company earns revenue that consists primarily of commissions and fees earned from the sale of financial products and services to their clients. The Company also incurs commissions and fees expense and compensation and non-compensation expense in the course of earning revenue. The Company refers to revenue earned by the Company’s businesses less the operating expenses of its businesses and allocated shared expenses associated with shared corporate resources as income (loss) from operations. The Company’s operating expenses include commissions and fees, compensation expense-employees, fees to principals, non-compensation expense, amortization of intangibles, depreciation, impairment of goodwill and intangible assets, (gain) loss on sale of businesses, net, and change in estimated acquisition earn-out payables. Prior to this Annual Report on Form 10-K, NFP referred to “compensation expense-employees” as “compensation expense” and referred to “fees to principals” as “management fees.”
Information with respect to all sources of revenue and income (loss) from operations and Adjusted EBITDA by reportable segment for the years ended December 31, 2011, 2010 and 2009 is presented below (in millions).
performance (in an individual business line, segment, and consolidated basis); for planning purposes, including the preparation of budgets and forecasts; as the basis for allocating resources to enhance the performance of the Company’s businesses; to evaluate the effectiveness of its business strategies; as a factor in shaping the Company’s acquisition activity; and as a factor in determining compensation and incentives to employees.
The Company believes that the use of Adjusted EBITDA provides an additional meaningful method of evaluating certain aspects of the Company’s operating performance from period to period on a basis that may not be otherwise apparent under GAAP when used in addition to, and not in lieu of, GAAP measures.
During the year ended December 31, 2010, revenue increased $33.6 million, or 3.5%, as compared to the year ended December 31, 2009. The revenue increase was driven by revenue increases within the ASG and CCG of $44.2 million and $7.9 million, respectively, and offset by a revenue decrease of $18.5 million within the ICG. Existing firms within all segments contributed to an overall revenue increase of $72.8 million, offset by a $39.2 million decline in revenue from disposed firms. After the impact from divested businesses of $13.6 million, revenue in the CCG increased by $21.5 million driven by new clients and product sales, strength in certain specialty benefits, and medical inflation, which leads to increases in health insurance premiums and the commissions earned from them. ICG revenue was negatively impacted by dispositions, changing product offerings at carriers and uncertainty around estate tax exemption levels that were only resolved in December 2010. Results in the ASG were driven by general improvements in the financial markets and increased investor confidence from 2009. Assets under management for the ASG increased 18.6% to $9.3 billion for the year ended December 31, 2010 compared to $7.9 billion for the year ended December 31, 2009.
Adjusted EBITDA for the year ended December 31, 2010 was $116.8 million, compared to $110.3 million in the last year, an increase of 5.9%. The Adjusted EBITDA margin was 11.9% compared to 11.6% in the last year. CCG Adjusted EBITDA increased by $5.2 million driven by the absence of the 2009 allocation of the sublease cost for NFP’s New York corporate headquarters and revenue growth. ICG Adjusted EBITDA also benefited from the absence of the 2009 allocation of sublease cost, but decreased overall by $4.3 million, as a result of the weaker sales environment for life insurance products. Due to expansion efforts, ASG Adjusted EBITDA grew by $5.6 million.
Advisor Services Group. The ASG earns fees for providing the platform for financial advisors to offer financial advice and execute financial planning strategies. These fees are based on a percentage of assets under management and are generally paid quarterly. The ASG may also earn fees for the development of a financial plan or annual fees for advising clients on asset allocation. The ASG also earns commissions related to the sale of securities and certain investment-related insurance products. Such commission income and related expenses are recorded on a trade date basis. Transaction-based fees, including incentive fees, are recognized when all contractual obligations have been satisfied. Most NFP-owned businesses and members of NFP’s marketing and wholesale organizations conduct securities or wealth management business through NFPSI.
Wholly-owned businesses that utilize the Company’s marketing organization, wholesale life brokerage businesses and NFPSI receive commissions and fees that are eliminated in consolidation, having no effect on the Company’s net income.
Fees to principals. NFP pays fees to principals to the principals and/or certain entities they own based on the financial performance of the business they manage. From a cash perspective NFP may advance monthly fees to principals that have not yet been earned due to the seasonality of the earnings of certain subsidiaries, particularly in the life insurance businesses in the ICG. NFP typically pays a portion of the fees to principals monthly in advance. Once NFP receives its cumulative preferred earnings, or base earnings, the principals and/or entity the principals own will earn fees to principals equal to earnings above base earnings up to target earnings. Additional fees to principals are paid in respect of earnings in excess of target earnings based on the ratio of base earnings to target earnings. For example, if base earnings equal 40% of target earnings, NFP receives 40% of earnings in excess of target earnings and the principals and/or the entities they own receives 60%. As the Company moves towards a more integrated business model, where the former owners of the acquired business become employees instead of principals, such ratios of base to target earnings will be proportionately impacted and become less meaningful.
Since the ASG is primarily comprised of NFPSI, NFP’s registered broker-dealer and investment advisor, no fees to principals are paid in this segment.
Non-compensation expense. The Company’s businesses incur operating expenses related to occupancy, professional fees, insurance, promotional, travel and entertainment, telecommunication, technology, legal, internal audit, certain compliance costs and other general expenses. In addition, NFP allocates non-compensation expense associated with NFP’s corporate shared services to NFP’s three reportable segments largely based on performance of the segments and other reasonable assumptions and estimates as it relates to the corporate shared services support of the operating segments.
Amortization of intangibles. The Company incurs amortization expense related to the amortization of certain identifiable intangible assets.
Impairment of goodwill and intangible assets. The Company evaluates its amortizing (long-lived assets) and non-amortizing intangible assets for impairment in accordance with GAAP. See “Note 2-Summary of Significant Accounting Policies” and “Note 15-Goodwill and Other Intangible Assets” to the Company’s Consolidated Financial Statements contained in this report.
Change in estimated acquisition earn-out payables. The recorded purchase price for all acquisitions consummated after January 1, 2009 includes an estimation of the fair value of liabilities associated with any potential earn-out provisions. Subsequent changes in the fair value of these estimated earn-out obligations are recorded in the consolidated statements of operations in each reporting period.
As of December 31, 2011, NFP maintained two incentive plans for principals and certain employees of its businesses, the PIP and the RTIP, each of which is discussed below. Certain employees participate in employee-specific bonus programs that are earned on specified growth thresholds.
The PIP is designed to reward the annual performance of a business based on the business’s earnings growth. For the initial 12-month performance period of October 1, 2009 through September 30, 2010, a cash incentive payment was made to the extent a business’s earnings exceeded its PIP Performance Target (as defined below). The PIP was established such that the greater a business’s earnings growth rate exceeded its PIP Performance Target rate for the 12-month performance period, the higher the percentage of the business’s earnings growth the Company would pay the principal under the PIP. NFP calculates and includes a PIP accrual in fees to principals expense. The Company paid $10.7 million, which was included within fees to principals expense relating to the initial 12-month performance period in the fourth quarter of 2010. For this initial 12-month performance period, the incentive target (the “PIP Performance Target”) for each business participating in the PIP was generally set at the lower of (a) such business’s earnings for the 12 months ended September 30, 2009 or (b) such business’s incentive target under the ongoing incentive plan as of September 30, 2009. The initial 12-month performance period used performance targets that rewarded principals for advancing certain corporate goals and initiatives related to the Company’s reorganization and also took the difficult economic environment during the initial 12-month performance period into account. NFP’s Executive Management Committee, in its sole discretion, was able to adjust any PIP Performance Target as necessary to account for changed business circumstances, including, without limitation, sub-acquisitions.
A PIP was in place for the 15-month performance period of October 1, 2010 through December 31, 2011 (the “Second PIP”). Management migrated to an incentive program that rewards only incremental growth but still maintained potential for material incentive payments. The Second PIP will be payable in cash beginning in the first quarter of 2012 and, similar to the initial PIP, was based on specific performance criteria for each business. Incentive targets (“Second PIP Performance Targets”) were set based on the earnings of each business during the last PIP incentive period, with the fourth quarter of 2009 counted twice. The calculation of a business’s Second PIP Performance Target is based on a 15-month period and reflects the fact that the Second PIP will include two fourth quarter periods. The 15-month performance period was selected in order to align the plan with the calendar year. NFP’s Executive Management Committee, in its sole discretion, may adjust any Second PIP Performance Target as necessary to account for changed business circumstances, including, without limitation,
sub-acquisitions. The Second PIP accrual in fees to principals expense is based on the business’s earnings growth rate above its Second PIP Performance Target. To measure growth, the target is allocated on a seasonally adjusted basis, using the seasonal earnings pattern by quarter for the past two years. NFP calculates the business’s Second PIP accrual amount and earnings growth rate on a cumulative basis. Overall, the Company has accrued $7.9 million within fees to principals expense relating to the Second PIP from October 1, 2010 through December 31, 2011, for payment in the first quarter of 2012. For the twelve months ended December 31, 2011, the Company’s accrual was $4.6 million.
A new PIP is in place for the 12-month performance period of January 1, 2012 through December 31, 2012, the terms of which are materially consistent with the Second PIP. It is envisioned that future plans will be 12 months, consistent with calendar years.
Commissions and fees. Commissions and fees revenue for the year ended December 31, 2011 increased $24.3 million, of which approximately $15.2 million represented commissions and fees revenue from acquisitions that had no comparable operations in 2010. Excluding the impact of dispositions of $4.4 million, overall revenue in the CCG increased by $13.5 million due to growth at existing firms, driven by new clients and product sales.
Non-compensation expense. Non-compensation expense decreased $0.7 million for the year ended December 31, 2011 compared with the last year. The non-compensation expense ratio was 18.1% for the year ended December 31, 2011 compared with 19.4% in 2010. Excluding dispositions of $1.4 million, non-compensation expense remained relatively flat.
Impairment of goodwill and intangible assets. Impairment of goodwill and intangible assets decreased $0.7 million. The impairment in 2011 related to a management contract buyout anticipated to occur in the first quarter of 2012.
Fees to principals. Fees to principals increased $10.3 million in 2010, as compared with 2009. Included in CCG fees to principals for the year ended December 31, 2010 was stock-based compensation expense of $7.4 million related to the accelerated vesting of certain RSUs and an amortization expense of $2.8 million for those RSUs outstanding prior to the acceleration. The total compensation expense ratio was 54.4% for the year ended December 31, 2010 compared with 53.4% in 2009. Excluding the impact of this accelerated vesting, fees to principals increased, and the total compensation expense ratio slightly declined.
Non-compensation expense. Non-compensation expense decreased $0.6 million for the year ended December 31, 2010 as compared with the prior year. Non-compensation expense decreased primarily due to the recognition in the fourth quarter of 2009 of a $4.8 million allocated loss and related expenses recognized on the sublet of one of the floors of the Company’s New York corporate headquarters in the fourth quarter of 2009. The decrease was partially offset by a $1.9 million loss and related expenses recognized in 2010 on the sublet of office space for one of the CCG’s executive benefits businesses, as well as an increase in promotional expenses.
Impairment of goodwill and intangible assets. Impairment of goodwill and intangible assets decreased $352.5 million to $1.9 million in 2010, as compared with 2009. The decline in impairments was driven by the significant impairment in the first quarter of 2009 as compared with the year ended December 31, 2010. The impairment taken for the year ended December 31, 2009 reflected the incorporation of market data, including NFP’s market value which had remained below net book value for a sustained period, the performance of the Company in the economic environment in the prior year period, and discount rates that were risk adjusted to reflect both company-specific and market-based credit spreads and other relevant market data. Among other significant factors, the market value in the prior year period reflected the stressed macroeconomic environment and its impact on the Company’s sales.
Income from operations. Income from operations decreased $1.0 million for 2011 as compared to 2010. The decrease in income from operations is due to a decrease in revenue and an increase in impairment of goodwill and intangible assets, partially offset by a decrease in commissions and fees expense, fees to principals, and non-compensation expense.
revenue and an increase in fees to principals, due to the accelerated vesting of certain RSUs issued under the EIP of $6.0 million, amortization expense of $2.0 million for those RSUs outstanding prior to the acceleration, and an increase in commissions and fees expense, all of which was offset by decreases in compensation expense-employees, non-compensation expense, amortization, and depreciation. Dispositions were a significant driver in the variances mentioned above within the ICG’s retail life and wealth management business lines as revenue from disposed firms contributed a decline of $25.6 million to the overall revenue decline. Disposed entities also contributed to declines in commissions and fees expense, compensation expense-employees and non-compensation expense in amounts of $4.0 million, $11.5 million, and $7.6 million, respectively.
Commissions and fees. Commissions and fees revenue decreased $18.5 million in 2010 as compared with 2009. The decline was driven by $25.6 million of dispositions, offset by increases in revenue generated by existing firms.
Compensation expense-employees. Compensation expense-employees decreased $9.3 million in 2010 compared with 2009. The total compensation expense ratio was 50.6% for the year ended December 31, 2010 compared with 49.2% in 2009. The overall decline in compensation expense-employees was primarily driven by the decline in compensation expense-employees from disposed businesses of $11.5 million.
Amortization of intangibles. Amortization expense declined $2.0 million in the year ended December 31, 2010 compared with the year ended December 31, 2009. Amortization expense declined as a result of a 10.9% decrease in amortizing intangible assets resulting primarily from dispositions and impairments.
Commissions and fees. Commissions and fees revenue increased $34.6 million for 2011 as compared to 2010. Results in the ASG were driven by an increase in sales of certain variable annuity products and a slight increase in assets under management. Assets under management for the ASG increased 3.7% to $9.7 billion as of December 31, 2011 compared to $9.3 billion as of December 31, 2010.
Non-compensation expense. Non-compensation expense increased $2.4 million for 2011 as compared to 2010. The non-compensation expense ratio was 6.4% for the year ended December 31, 2011 compared with 6.4% in 2010. The increase primarily related to increases in professional fees and regulatory-related fees.
Commissions and fees. Commissions and fees revenue increased $44.2 million in the year ended December 31, 2010 compared with the year ended December 31, 2009. Results in the ASG were driven by general improvements in the financial markets and increased investor confidence from 2009. Assets under management for the ASG increased 18.6% to $9.3 billion as of December 31, 2010 compared to $7.9 billion as of December 31, 2009.
Commissions and fees. Commissions and fees expense increased $32.1 million in the year ended December 31, 2010 compared with 2009. The commission expense ratio was 82.4% in the year ended December 31, 2010 compared with 84.9% in the last year. The increase in commissions and fees expense was largely attributable to the increase in revenue. The decrease of the commission expense ratio was driven by lower revenue in 2009 as fees for assets under management declined with declining market values during 2009.
Non-compensation expense. Non-compensation expense increased $7.2 million in 2010 compared with 2009. The non-compensation expense ratio was 6.4% for the year ended December 31, 2010, compared with 3.8% in 2009. Non-compensation expense increased, in part, due to costs associated with enhancements in services and technology offerings provided to advisors.
Other, net. Other, net, which primarily consists of income from equity method investments, rental income, and net expenses relating to the settlement or reserving of legal matters, decreased $1.9 million for the year ended December 31, 2011 as compared to the year ended December 31, 2010. The decrease is the result of the Company recording a provision on a loss contingency of $2.5 million, offset by an increase in rental income of $0.6 million.
Income tax expense (benefit). Income tax expense was $28.4 million in 2011 compared with income tax expense of $26.5 million in the prior year. The effective tax rate for the year ended December 31, 2011 was
43.5%. This compared with an effective tax rate of 38.4% for the year ended December 31, 2010. The effective tax rate for the year ended December 31, 2010 was lower than the effective tax rate for the year ended December 31, 2011, primarily due to tax deductions relating to dispositions during 2010, a reduction in unrecognized tax benefits due to settlements with tax authorities during 2010, and an increase in 2011 in deferred taxes for future repatriation of foreign earnings. The estimated effective tax rate may be affected by future impairments, restructurings, state tax changes and, as a result, may impact income tax expense both in terms of absolute dollars and as a percentage of income before income taxes.
Year ended December 31, 2010 compared with the year ended December 31,
Interest expense. Interest expense decreased $2.1 million in the year ended December 31, 2010 compared with the year ended December 31, 2009. The decrease was due primarily to the repurchase of the 2007 Notes and repayment of outstanding amounts under the 2006 Credit Facility, offset by the issuance of the 2010 Notes and NFP’s entry into the 2010 Credit Facility. See “Note 7-Borrowings” to the Company’s Consolidated Financial Statements contained in this report for further details.
Other, net. Other, net decreased $3.3 million in the year ended December 31, 2010 compared with the year ended December 31, 2009. The decline was largely the result of key-person life insurance proceeds of $5.5 million and the receipt of $1.9 million in proceeds from the settlement of an NFP owned key-person life insurance policy on a principal for the year ended December 31, 2009. For the year ended December 31, 2010 other income was comprised of $5.8 million of rental income for the sublet of the Company’s former headquarters, and $1.8 million for the Company’s ownership interest in its joint ventures.
The Company has historically experienced its highest cash usage during the first quarter of each year as balances due to principals and/or certain entities they own for earned fees to principals above target earnings in the prior calendar year are calculated and paid out, more acquisitions are completed and the Company experiences the seasonal revenue and earnings decline at the beginning of the year. In many prior years this has led to borrowings on NFP’s applicable credit facility in the first quarter. The borrowed amounts are then typically repaid as the year progresses, when operating cash flow typically increases as earnings increase.
However, this borrowing pattern did not occur in 2011, because cash flow was sufficient to fund fees to principals to principals of firms that performed in excess of target earnings, and acquisitions occurred primarily in the third quarter. In addition, the cash balance on hand at the beginning of the year was higher than it had been in the previous several years. The borrowing pattern could change to the extent acquisitions or sub-acquisitions increase, or as capital is deployed for other uses.
NFP periodically assesses the impact of market developments, including reviewing access to liquidity in the capital and credit markets. Given NFP’s recapitalization transactions, which took place in 2010, the Company anticipates that short/medium-term liquidity and capital needs have currently been addressed, although such needs may change in the future. Further, the Company’s ability to access capital is subject to the restrictions in the 2010 Credit Facility; see “Risk Factors-The Company’s business may be adversely affected by restrictions and limitations under its credit facility. Changes in the Company’s ability to access capital could adversely affect the Company’s operations.” To the extent that financing needs change due to changing business needs, or to the extent the general economic environment changes, an evaluation of access to the credit markets and capital will be performed. Continuing uncertain conditions in these markets may adversely affect the Company.
On April 28, 2011, NFP’s Board authorized the repurchase of up to $50.0 million of NFP’s common stock on the open market, at times and in such amounts as management deems appropriate. This repurchase authorization was completed in the first quarter of 2012. The timing and actual number of shares repurchased was dependent on a variety of factors, including the limitations under the 2010 Credit Facility, capital availability, share price and market conditions. The restricted payments covenant of the 2010 Credit Facility allowed the Company to repurchase up to an aggregate of $50.0 million of its capital stock during any four consecutive fiscal quarters (the “Stock Repurchases”), so long as: (A) both before and after any repurchase, no default or event of default shall have occurred and be continuing, (B) both before and after any repurchase, on a pro forma basis, the leverage ratio for the most recently completed period of four consecutive fiscal quarters does not exceed 2.25 to 1.0 and (C) after any repurchase, minimum liquidity (as defined in the 2010 Credit Facility) shall not be less than $50.0 million. As of December 31, 2011, 3,452,293 shares were repurchased under this program at an average cost of $12.10 per share and a total cost of approximately $41.8 million. See also “Note 10-Stockholders’ Equity” to the Consolidated Financial Statements contained in this report.
During the year ended December 31, 2010, cash provided by operating activities was approximately $119.4 million compared with $123.8 million for the year ended December 31, 2009. The decrease was largely due to a decrease in net income adjusted for non-cash charges to $101.6 million for the year ended December 31, 2010 from $109.7 million for the year ended December 31, 2009. Included in net income for the year ended December 31, 2009 was $5.5 million of cash received for key man life proceeds and $1.9 million in proceeds from the settlement of an NFP-owned key man life insurance policy. During the third quarter of 2010, the Company accelerated the vesting of approximately 1.5 million RSUs granted to certain principals primarily through the EIP, of which 40% was paid out in cash in the amount of $7.4 million.
During the year ended December 31, 2011, cash used in financing activities was approximately $55.8 million, while cash used in financing activities was $36.9 million during the prior year period. During the year ended December 31, 2011, the primary uses of cash were the purchase of common stock of approximately $41.8 million, as well as repayments of $12.5 million under the 2010 Credit Facility.
During the year ended December 31, 2010, cash provided by financing activities consisted mainly of $120.3 million in net proceeds from the issuance of the 2010 Notes, $21.0 million in proceeds from the sale of warrants entered into concurrently with NFP’s offering of 2010 Notes, and $125.0 million in proceeds from the issuance of long-term debt under the 2010 Credit Facility, offset by the purchase of convertible note hedges of $33.9 million, the purchase of the 2007 Notes of $219.7 million, and repayment of outstanding amounts under the 2006 Credit Facility of $40.0 million.
For a detailed discussion of NFP’s recapitalization transactions, which took place in 2010, see “Note 7-Borrowings” to the Company’s Consolidated Financial Statements contained in this report.
As of December 31, 2011 the Company’s future contractual payments, commercial commitments, and other long-term liabilities were as follows:
Of its significant accounting policies (see “Note 2-Summary of Significant Accounting Policies” to the Company’s Consolidated Financial Statements contained in this report), the Company believes that the following critical accounting policies may involve a higher degree of judgment and complexity.
The Company has acquired significant intangible assets through business acquisitions. These assets consist of book of business, management contracts, institutional customer relationships, non-compete agreements, trade name, and the excess of purchase price over the fair value of identifiable net assets acquired (goodwill). The determination of estimated useful lives and the allocation of the purchase price to the intangible assets requires significant judgment and affects the amount of future amortization and possible impairment charges.
Book of Business: The Company refers to a book of business as the acquired firm’s existing customer relationships that provide a significant source of income through recurring revenue over the course of the economic life of the relationships. NFP assumes the useful life of a book of business to be typically 10 years.
Management Contract: The management contract secures the services of the principal(s) and encourages growth of the business through the terms of the agreement. The compensation terms are generally such that the principals receive 100 percent of the differential between base earnings and target earnings, as previously described under “Business-Acquisitions-Acquisition Model-Management Contract.” The management contracts generally include three year non-compete agreements which become effective upon termination of the contract and therefore discourage the possibility of competition against NFP. NFP views the value of the management contract as being based on the future expectation of the principals’ ability to replace the diminishing acquired book of business, such that base earnings is maintained on an ongoing basis. NFP assumes the useful life of a management contract to be 25 years, based on an assumed average service life of the principals.
Goodwill: Goodwill is the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed. In the case of NFP’s businesses, goodwill is expected to represent the value associated with workforce, management expertise, the value of future cash flow generated beyond the useful lives of the existing books of businesses and the management contract. If contingent consideration is recorded, such liability would be an offset to an increase in goodwill.
Goodwill and intangible assets not subject to amortization are tested at least annually for impairment, and are tested for impairment more frequently if events or changes in circumstances indicate that the intangible asset might be impaired. Indicators at the business line level, which is considered a reporting unit for this analysis, include, but are not limited to, a significant deterioration in its operating cash flow compared to the reportable segment’s financial plan or prior year performance, loss of key personnel, a decrease in NFP’s market capitalization below its book value, and an expectation that a reporting unit will be sold or otherwise disposed of. If one or more indicators of impairment exist, NFP performs an evaluation to identify potential impairments. If an impairment is identified, NFP measures and records the amount of impairment loss.
If the fair value of the reporting unit exceeds the carrying value of the net assets assigned to that reporting unit, goodwill is not impaired and NFP is not required to perform further testing. If the carrying value of the net assets assigned to the reporting unit exceeds the fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second step of the goodwill impairment test
compares the implied fair value of the reporting unit’s goodwill with the carrying value of the goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined in a manner that is consistent with the amount of goodwill recognized in a business combination. That is, the fair value of the reporting unit is allocated to all of the assets and liabilities of that unit as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the purchase price paid to acquire the reporting unit.
See “Note 15-Goodwill and other intangible assets” to the Company’s Consolidated Financial Statements contained in this report.
For acquisitions effective prior to January 1, 2009, contingent consideration is considered to be additional purchase consideration and is accounted for as part of the purchase price of the Company’s acquired businesses when the outcome of the contingency is determined beyond a reasonable doubt.
For acquisitions completed after January 1, 2009, earn-out payables are recorded at fair value at the acquisition date and are included on that basis in the purchase price consideration at the time of the acquisition, with subsequent changes recorded in the consolidated statements of operations, based on current estimates. The fair value of earn-out payables are based on the present value of the expected future payments to be made to the sellers of the acquired businesses in accordance with the provisions outlined in the respective purchase agreements. The fair value of the earn-out payables are allocated to goodwill. In determining fair value, the acquired business’s future performance is estimated using financial projections developed by management for the acquired business and the volatility of market participant assumptions regarding revenue growth. The expected future contingent consideration payments are estimated on the basis of the earn-out formula and performance targets specified in each purchase agreement compared to the associated financial projections. The fair value of the Company’s earn-out payables were valued using a Monte Carlo simulation, whereby future applicable earnings are simulated using a Geometric Brownian Motion, over the term of the earn-out period. For each simulation path, the earn-out payments are calculated and then discounted to the valuation date. The value of the earn-out is then estimated to be the arithmetic average of all paths. The model is calibrated to management’s forecasted earnings, and the valuation is performed in a risk-neutral framework.
See “Note 4-Commitments and Contingencies” to the Company’s Consolidated Financial Statements contained in this report.
As of December 31, 2011, the Company is subject to U.S. federal income tax examinations for the tax years 2008 through 2010, and to various state and local income tax examinations for the tax years 2001 through 2010.
Stock-based awards issued to the Company’s employees are classified as equity awards. The Company accounts for equity classified stock-based awards issued to its employees based on the fair value of the award on the date of grant and recorded as an expense as part of compensation expense-employees in the consolidated statements of operations. The expense is recorded ratably over the service period, which is generally the vesting period. The offsetting entry is to additional paid in capital in stockholders’ equity.