One November day in the late 1970s my dad noticed an ad on the bulletin board at work that caught his attention: someone had a Jensen Healey MkII for sale. The MkII was arguably the best product Jensen Healey ever made: a lightweight two seat convertible with a Lotus four-cylinder double overhead cam engine with dual Stromberg carburetors. The Jensen my dad was looking at was far from perfect – it was covered with a couple of years worth of dust and had a crease running down the middle of the fragile aluminum hood because someone hadn’t been careful closing it. It needed a tune up and who knows what else (British sports cars aren’t known for reliability). But at 2,400 pounds and 140hp, when it ran, it ran fast. Dad brought the Jensen home for the long Thanksgiving weekend and we drove it around Miami (due diligence) to decide whether or not to take the plunge.
Part Two of Our Series on Earn-Outs
Last week, we offered an example, ACME Private Buys Fictional Financial, to shed light on several issues presented by the use of earn-outs in RIA transactions. As explained, gathering comprehensive data on ultimate deal value in investment management transactions is problematic as most post-deal performance doesn’t get reported other than AUM disclosures in public filings. And, if the acquired entity is folded into another RIA, you can’t even judge a deal by that. Sometimes bad deals can be saved by good markets, but hope is not a strategy. Consequently, 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.
As noted above, RIA transactions usually feature earn-out payments as a substantial portion of total consideration because so much of the seller’s value is bound up in post-closing performance. Earn-outs (i.e. contingent consideration) perform the function of incentives for the seller and insurance for the buyer, preserving upside for the former and protecting against potential losses for the latter. In investment manager transactions, earn-outs are both compensation, focusing on the performance of key individuals, and deal consideration, being allocated to the selling shareholders pro rata. And even though earn-out payments are triggered based on meeting performance metrics which are ultimately under the control of staff, they become part of overall deal consideration and frame the transaction value of the enterprise.
For all of these reasons, we view contingent consideration as a hybrid instrument, combining elements of equity consideration and compensation, and binding the future expectations of buyer and seller in a contractual understanding.
Contingent consideration makes deals possible that otherwise would not be. When a seller wants twice what a buyer is willing to pay, one way to mediate that difference in expectations is to pay part of the price upfront (usually equal to the amount a buyer believes can safely be paid) and the remainder based on the post-closing performance of the business. In theory, earn-outs can simultaneously offer a buyer some downside protection in the event that the acquired business doesn’t perform as advertised, and the seller can get paid for some of the upside he or she is foregoing by giving up ownership. While there is no one set of rules for structuring an earn-out, there are a few conceptual issues that can help anchor the negotiation.
Define the Continuing Business Acquired That Will be the Subject of the Earn-Out.
Deciding what business’s performance is to be measured after the closing is easy enough if an RIA is being acquired by, say, a bank that doesn’t currently offer investment management services. In that case, the acquired company will likely be operated as a stand-alone enterprise with division level financial statements that make measuring performance fairly easy.
If an RIA is being rolled into an existing (and similar) investment management platform, then keeping stand-alone records after the transaction closes may be difficult. Overhead allocations, staff additions and subtractions, expansion opportunities, and cross selling will all have some impact on the value of the acquired business to the acquirer. Often these issues are not foreseen or even considered until after the transaction closes. It then comes down to the personalities involved to “work it out” or be “fair.” As a friend’s father used to say: “fair is just another four-letter word.”
Determine the Appropriate Period for the Earn-Out.
We have seen earn-out periods (the term over which performance is measured and the contingent consideration is paid) as short as one year and as long as five years. There is no magic period that fits all situations, but a term based on specific strategic considerations like proving out a business model, defining investment performance objectives, or the decision cycle of key clients are all reasons to develop an earn-out timeframe.
There is no magic period that fits all situations.
The buyer wants the term to be long enough to find out what the true transferred value of the business is, and the seller (who otherwise wants to be paid as quickly as possible) may want the earn-out term to be long enough to generate the performance that will achieve the maximum payment. Generally, buyer-seller relations can become strained during an earn-out measurement period, and when it is over, no one wishes the term had been longer.
We tend to discourage terms for contingent consideration lasting longer than three years. In most cases, three years is plenty to “discover” the value of the acquired firm, organize a merged enterprise, and generate a reliable stream of returns for the buyer. If the measurement period is longer than three years, the “earn-out” starts to look more like bonus compensation, or some other kind of performance incentive to generate run-rate performance at the business. Earn-outs can be interactive with compensation plans for managers at an acquired enterprise, and buyers and sellers are well-advised to consider the entirety of the financial relationship between the parties after the transaction, not just equity payments on a stand-alone basis.
Determine to What Extent the Buyer Will Assist or Impede the Seller’s Performance During the Earn-Out.
Was the seller attracted to the deal by guarantees of improved technology, new product options, back-office support, and marketing? Did the buyer promise the seller the chance to operate their business unit without being micromanaged after the transaction? These are all great reasons for an investment management firm to agree to be absorbed by a larger platform, and they may also help determine whether or not the acquired firm meets performance objectives required to receive contingent consideration.
While bad deals can be saved by good markets, counting on overpromises is not a sound deal strategy. Instead, buyers and sellers should think through their post-close working relationships well in advance of signing a deal, deciding who works for whom, and defining the mutual obligations required to achieve shared success. If things don’t go well after the transaction – and about half the time they don’t – the first person who says “I thought you were going to…” didn’t get the appropriate commitments from his or her counterparty on the front end.
Define What Performance Measurements Will Control the Earn-Out Payments.
It is obvious that you will have to do this, but in our experience buyers and sellers don’t always think through the optimal strategy for measuring post-closing performance.
Buyers ultimately are paying for the future profit contribution from the seller, so a measure of cash flow seems like the obvious performance metric to measure the acquired investment management operation’s success. However, there are at least two problems with using cash flow to benchmark contingent consideration.
Returns from markets don’t determine long-term success nearly as much as returns from marketing.
First, profitability is at the bottom of the P&L and is, therefore, (potentially) subject to manipulation. To generate a dollar of profit at an RIA, you need some measure of client AUM, market performance, a fee schedule, investment management staff, office space, marketing expense, technology and compliance, capital structure considerations, parent overhead allocations, and any number of other items, some of which may be outside of the sellers’ control. Will the sellers accuse the buyer of impeding their success? Can the factors influencing that success be sufficiently isolated and defined in an earn-out agreement? It is often more difficult than it seems.
Second, much of the post-transaction profitability of the acquired business will depend on the returns of the financial markets, over which nobody has control. If a rising tide indeed lifts all boats, should the buyer be required to compensate the seller for beneficial markets? By the same token, if a deal is struck on the eve of another financial crisis, does the seller want to be held accountable for huge market dislocations? In our experience, returns from markets don’t determine long-term success nearly as much as returns from marketing. Consider structuring an earn-out based on net client AUM (assets added net of assets withdrawn), given a certain aggregate fee schedule (so business won’t be given away just to pad AUM).
Name Specific Considerations That Determine Payment Terms.
Is the earn-out capped at a given level of performance or does it have unlimited upside? Can it be earned cumulatively or must each measurement period stand alone? Will there be a clawback if later years underperform an initial year? Will there simply be one bullet payment if a given level of performance is reached? To what extent should the earn-out be based on “best efforts” and “good faith?”
Earn-outs manage uncertainty; they don’t create certainty.
Because these specific considerations are unique to a given transaction between a specific buyer and seller, there are too many to list here. Nevertheless, we have formulated a couple insights about earn-outs over the years: 1) Transaction values implied by earn-out structures are often hard to extrapolate to other transactions. 2) An earn-out can ease the concerns and fulfill the hopes of parties to a transaction about the future – but it cannot guarantee the future. Earn-outs manage uncertainty; they don’t create certainty.
Above all, contingent consideration should be based on the particular needs of buyers and sellers as they pertain to the specific investment management business being transacted. There is no one-size-fits-all earn-out in any industry, much less the RIA community. If an earn-out is truly going to bridge the difference between buyer and seller expectations, then it must be designed with the specific buyer and seller in mind.
Earn-Outs Are Like Warranties
What happened to the Jensen Healey? Over that fall weekend in Miami, we detailed and waxed the car. My dad was able to get the crease out of the aluminum hood by reshaping it with his bare hands. It was a beautiful car and sounded great under power, but even a five-year-old British sports car in the 1970s was cause for concern, and they don’t come with warranties. My dad had lived with an old Jaguar in his 20s and didn’t mind getting grease under his fingernails, but one evening we were diving the Jensen home from dinner and it ran out of gas. The fuel gauge didn’t work; likely one of a string of problems that would lead my father to a level of buyer’s remorse that he had experienced with other cars and didn’t want to deal with again. He didn’t buy it.
Like old sports cars, acquisitions don’t come with warranties, so protecting yourself against buyer’s remorse is critical. Even with escrows and punitive terms, you can’t guarantee that you’ll get what you pay for in an acquisition; but, with a properly structured earn-out, you can at least pay for what you get.