Mercer Capital's RIA Valuation Insights


Why Earn-outs Matter in Asset Management M&A

bmw-i8

Betting on the Future: BMW chose a relatively conservative approach to investing in new engine technology: the i8 (bmwblog.com).

Pity the senior auto executive these days: their product is bearing much of the blame for killing the planet, but gas is so cheap they can’t even sell boring fuel efficient cars to the local chapter president of the Sierra Club.  The Economist ran a cover story last week calling the internal combustion engine “Roadkill,” and repeated the estimate that car emissions kill more Americans every year than traffic accidents – yet the political climate in America doesn’t suggest that regulatory standards for burning fossil fuels of any kind will be tightening soon.

Predicting what kinds of cars people will want to buy next year, let alone five years from now, has never been easy.  Today, there are too many options.  Will car buyers want all-wheel-drive pickups with huge internal combustion engines, or battery-powered autonomous-driving cars?  Will people even own cars in 20 years or will we all be driven around by some Uber-like service, making car ownership, parking lots, and garages obsolete?  Do you test the market with an expensive, limited production high-performance car like the BMW i8, or do you make a more affordable, mass market car like the Toyota Prius?  If you invest heavily in technology, will the market shower you with orders like it did for the Tesla Model 3, or spurn you like the doomed Fisker Karma?

M&A in the RIA Community Wouldn’t be Possible Without Earn-outs

As the saying goes (which has been attributed to at least a dozen famous figures), it’s difficult to make predictions, especially about the future.  This reality is the single most difficult part of negotiating a transaction in the investment management industry.  The value of an RIA acquisition target is subject not only to a large number of variables, but also a wide range of possible outcomes:

  1. The performance of financial markets (standard deviation varies)
  2. The skill of the investment management staff (difficult to measure)
  3. The sustainability of the acquired firm’s fee schedule (not as much a given as in the past)
  4. The retention of key staff at the acquired firm (absolutely necessary)
  5. The retention of key staff at the acquiring firm (absolutely necessary)
  6. The motivation of key staff (absolutely necessary)
  7. The retention of client assets (depends entirely on third party behavior)
  8. The marketing strength of the merged enterprise (tough to predict)

Without faith in the upward drift of financial markets, favorable margins in investment management, and the attractiveness of the recurring revenue model, no one would ascribe equity value to an RIA.  But actually buying an asset manager is making a bet on all of the above, and most people don’t have the stomach.

Readers of this blog understand that only by way of an earn-out can most investment management firm transactions overcome so much uncertainty.  Nevertheless, in our experience, few industry executives have more than an elementary grasp of the role of contingent consideration in an RIA transaction, the design of an earn-out agreement, and ultimately the impact that these pay-for-performance structures have on valuation.

This blog kicks off a series which we’ll ultimately condense into a whitepaper to explore and maybe demystify some of the issues surrounding earn-outs in RIA transactions.  If nothing else, earn-outs make for great stories.  Some of them go well, and some wind up like this:

From Earn-out to Burn-out: ACME Private Buys Fictional Financial

On January 1, 20xx, ACME Private Capital announces it has agreed to purchase Fictional Financial, a wealth management firm with 50 advisors and $4.0 billion AUM.  Word gets out that ACME paid over $100 million for Fictional, including contingent consideration.  The RIA community dives into the deal, figures Fictional earns a 25% to 30% margin on a fee schedule that is close to but not quite 1.0% of AUM, and declares that ACME paid at least 10x EBITDA.  A double-digit multiple brings other potential deals to ACME, and crowns the sellers at Fictional as “shrewd.”  The rest of the investment management world assume their firm is at least as good as Fictional, so they’re probably worth 12x EBITDA.  To the outside world, everybody associated with the deal is happy.

The reality is not quite so sanguine.  ACME structures the deal to pay half of the transaction value up front with the rest to be paid based on profit growth at Fictional Financial in a three-year earn-out.  Disagreements after the deal closes cause a group of twelve advisors to leave Fictional, and a market downturn further cuts into AUM.  The inherent operating leverage of investment management causes profits to sink faster than revenue, and only one-third of the earn-out was paid.

In the end, Fictional Financial sold for about 6.5x EBITDA, much less than the selling partners wanted for the business.  Other potential acquisition targets are ultimately disappointed when ACME, stung with disappointment from the Fictional transaction, is not willing to offer them a double-digit multiple.  ACME thought they had a platform opportunity in Fictional, but it turns out to be more of an investment cul-de-sac.

The market doesn’t realize what went wrong, and ACME doesn’t publish Fictional’s financial performance.  Ironically, the deal announcement sets the precedent for interpretation of the transaction, and industry observers and valuation analysts build an expectation that wealth management practices are worth about 10x EBITDA, because that’s what they believe ACME paid for Fictional Financial.

Earn-outs and Transaction Strategy

Most post-deal performance doesn’t get reported, other than AUM disclosures in public filings.  If the acquired entity is folded into another RIA, you can’t even judge a deal by that.  Thus, we don’t have comprehensive data on ultimate deal value in many investment management firm transactions.  One example we have reported previously was the disastrous post-transaction performance of Killen Group after it was acquired by Tri-State Capital.  Killen missed by so much that it cut the total consideration paid by almost half and reduced the effective EBITDA multiple paid from nearly 11x to around 6x.  Which multiple represents the real value of Killen?  No doubt the buyer in this case, as in most others, would rather see the kind of performance that would justify paying the full earn-out, and the seller would prefer that as well.

Conclusion

Sometimes bad deals can be saved by good markets, but that’s not much of an acquisition strategy.  As a consequence, earn-outs are the norm in RIA transactions, and anyone expecting to be on the buy-side or sell-side of a deal needs to have a better than working knowledge of them.  We’ll talk more next week about the structure of contingent consideration in investment management firm deals, but drop us a line in the meantime if you’d rather not wait.


Mercer Capital’s RIA Valuation Insights Blog

The RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.