Bear Markets Cost RIA Sellers, But Boost Buyers
A Public Service Message That Earn-outs Aren’t Always Earned
The history of the auto industry is full of products that were more hype than reality, but maybe none more than the Fisker Karma. The Karma was the luxury hybrid offspring of legendary automotive designer Henrik Fisker. It was supposed to be the future of four-wheel transport: elegant, comfortable, and efficient. It photographed awfully well, and consequently, Fisker got plenty of free publicity in the automotive press. Unfortunately, the product didn’t live up to the promise, as the Karma was cramped for space, not terribly fuel efficient, and very expensive. Battery problems prompted a recall that ultimately killed the company, after selling less than 2,000 units. As we say in the south, Karma’s a biscuit.
Earn-outs and Valuation
We’ve written before about how earn-outs are a key provision in most RIA transactions and recent earnings results from public companies in the space bear that out. What some might have characterized as overpayment for past deals has resolved itself via contingent consideration, resulting in right-sized transaction consideration. This lamentable situation for sellers also represents an earnings cushion for buyers. Consequently, we find that RIA valuations in transactions didn’t get as stretched as they might, to many, have appeared.
One impediment to getting deals done in the investment management community is the undercurrent that other sellers have received astronomical multiples for their businesses. Indeed, some nosebleed pricing was achieved in many instances in 2021, prompting Focus Financial’s CEO Rudy Adolf to bewail “drunken sailors” who overpaid for acquisitions. The impact of a few irrational players does more than compete away deals from “disciplined” buyers, it also resets expectations for sellers to stay put unless someone is willing to give them a similar deal. Nobody wants nine times when their industry nemesis got fifteen.
Earn-outs Resolve Differences in Expectations
The gap between buyer and seller expectations can be thought of as a bid-ask spread, and one which often can’t be resolved simply by splitting the difference.
The most common way to bridge the bid-ask spread is by way of contingent consideration, also known as an earn-out, in which the buyer agrees to pay something in addition to upfront consideration if the acquired business achieves certain performance metrics after the deal closes. Earn-outs are commonly tied to:
- Retention: if the acquired RIA retains, say, 95% of AUM as measured at the closing date for a certain period after the transaction. Such a provision guards against the uncertainty of relationship transitions – especially in smaller wealth management practices – as new advisors take over accounts from sellers transitioning out of the business.
- Growth: if the acquired RIA increases AUM, revenue, EBITDA, or some other key performance metric in the years following a transaction, buyers might pay more to cover some of the increase in value brought about by post-transaction performance improvement. To the extent that sellers can influence the outcome, growth after the close ensures they get paid for some of the upside in their enterprise, while buyers end up with a stronger franchise and often a lower valuation multiple than if the business underperforms.
- Margin: to the extent that transaction negotiations involve some debate over cost structure, the maintenance or enhancement of profit margins after the close ultimately prove out, or prove wrong, what operating leverage is inherent in the acquired entity.
Earn-outs can be structured any number of ways, but ultimately they resolve something of the differences of opinion about the performance that naturally come up between risk-averse buyers and sellers who don’t want to leave money on the table.
Earn-outs Resolve Emotional Differences
Earn-outs also perform an important psychological function in dealmaking. Buyers can report back to their boards and shareholders that they’re only committed to paying for proven performance. If the deal turns out to be less than advertised, the amount they ultimately paid for the target stays fixed – often much lower than it would have taken to close the transaction with entirely upfront consideration. Sellers get bragging rights, as they often anticipate that they will “easily” achieve the projected performance needed to get earn-out payments.
Earn-outs help buyers get over the fear of the unknown, as indeed most post-close surprises are negative. For sellers, earn-outs help them get past what is often called endowment effect, or the syndrome that an asset is usually more dear to its holder than it is to someone else.
From an M&A marketing perspective, earn-outs fuel interest in deal activity. Sellers tell their friends they got paid X-teen times, a multiple in which the numerator commonly includes contingent consideration as if it had been paid, in full, at close. Buyers don’t mind this, as it attracts other sellers to their brand. And investment bankers love it because it supports deal flow.
When Bad News Is Good News, or #FASBknowsbest
Recent activity in public RIAs show the impact of earn-outs on ultimate deal consideration, and why sellers shouldn’t confuse contingent consideration with upfront consideration. Several public RIAs, including Focus Financial Partners, Silvercrest Asset Management Group, and CI Financial, reported writing-down contingent consideration in recent quarters on prior transactions.
This write-down activity is a peculiar aspect of GAAP (Generally Accepted Accounting Principles), in which the expectation of the payment of earn-outs is made at the time of the acquisition in what is known as the purchase price allocation.
By way of example, consider a deal that includes upfront consideration of $25 million and contingent consideration of an additional $15 million, paid over several years and subject to the performance of the target RIA. The transaction isn’t simply booked at the total potential payments, or $40 million. The contingent consideration is risk-adjusted and present-valued. In this example, the $15 million in earn-out payments might be fair valued at only $10 million, such that the transaction is booked at $35 million (upfront consideration plus the fair value of earn-out payments).
Over the term of the earn-out, the value of the transaction is effectively remeasured. If the entire earn-out payment of $15 million is earned, the cost of the transaction is $5 million higher than was estimated at close, and the additional payment is recognized as an expense on the income statement. This has a negative impact on the earnings of the buyer.
If, on the other hand, the acquired company underperforms, GAAP prescribes that the contingent consideration is remeasured – for public companies on a quarterly basis – in the form of a write-down. In our example, if none of the $15 million in contingent consideration is ultimately paid, then the $10 million fair value of the earn-out would be written off entirely. That write-off flows through the income statement as an offset to expenses; it is money that was to be paid but instead was not paid. Thus, if a target company underperforms expectations, it can – somewhat perversely – increase GAAP earnings of the acquirer.
The impact of these write-downs can be material. Focus Financial announced GAAP pre-tax net income in the second quarter of 2022 of $81.5 million. Of this, more than half, or $42.8 million, was a result of a decrease in expected earn-out payments. At CI Financial, about 25% of their GAAP EBITDA in the most recent quarter was a result of writing down contingent consideration ($75 million of $295 million). And at Silvercrest, a similar adjustment to expected earn-out payments constituted nearly half of GAAP pre-tax net income. Of note, the financial disclosures of each of these companies makes the impact of this adjustment very clear, and each eliminates the impact of changes in earn-out consideration from their adjusted (non-GAAP) EBITDA.
Earn-out Support Deal Activity in Bear Markets
On paper, this is how it’s supposed to work. One reason deal activity can remain strong in tough financial markets is that buyers can use earn-outs to control what they pay for deals, offering more money in the event that markets recover and justify higher valuations, and managing their outlays if performance lags. Recent earnings calls allude to this, subtly, with Jay Horgen from AMG noting “constructive pricing and structure” that “insures to the benefit of our shareholders.” Victory Capital’s David Brown noted “some of the way to deal with the difference between buyer and seller expectation is restructuring and timing of payments and partnering in the future of growth.” As a consequence, Focus Financial’s Rudy Adolf noted “overall industry activity is going to remain high. Competition is kind of…normal.”
For sellers, the relevant consideration is bear markets may tank a big part of their expected deal consideration, well beyond their control. A falling tide may not simply work to the detriment of sellers, but also hand buyers a bargain purchase when markets improve. Earn-outs align interests in the near term, but can provide asymmetric benefits in years ahead.
Westwood Holdings’s recently announced acquisition of Salient Partners is nearly half earn-out consideration: $25 million on total possible consideration of $60 million. 35 to 60 is a pretty tremendous bid-ask spread, although not uncommon in the RIA space. We don’t know what the exact KPIs are that Salient will have to produce to receive full payment. What we do know is that it’s another example of the prominence of contingent consideration in RIA transactions, a situation that we expect to persist.