Transaction Advisory, Investment Management

August 21, 2017

Five Considerations for Structuring Earn-Outs in RIA Transactions

As covered in last week’s post, 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.  Just as the financial press never writes about periods of “heightened certainty,” so too buyers of RIAs are justifiably concerned about the ongoing performance of their acquisition target after the ink dries on the purchase agreement.

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 downside for the latter.  In asset manager transactions, they 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 seller and buyer in a contractual understanding.

Twenty years ago, Toyota considered whether the future of automobiles would involve gasoline or batteries and developed a similar middle way, the hybrid engine.  A hybrid motor uses regenerative braking to charge batteries that recapture power to augment or substitute for the car’s conventional internal combustion engine.  Similar technology has been deployed in supercars like the Porsche 918 Spyder, but the Prius is responsible for helping shape the future of automotive transportation by making hybrid technology prevalent.

As hybrids go, though, earn-outs are even more prevalent in asset manager transactions than Priuses are in Whole Foods parking lots, and it’s easy to understand why.

Earn-Out Parameters

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 up front (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.

1. 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 a 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 determining success or lack thereof fairly easy.

If a 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, how additions and losses to staff will be treated, 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 my neighbor’s father used to say: “fair is just another four letter word.”

2. Determine the appropriate period for the earn-out

We have seen earn-out periods (the term over which performance is measured and over which 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, defined investment performance objectives, or the decision cycle of key clients are all reasons to develop an earn-out timeframe.

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 speaking, buyer-seller relations can get very strained during an earn-out measurement period, and after they’re done 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.

3. Determine to what extent the buyer will assist or impede the seller’s performance during the earn-out

Did the buyer lure the seller in with promises of technology, products, back-office support, and marketing?  Did the buyer promise the seller that they would be able to operate their business unit independently and 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 to get contingent consideration.

We have seen bad deals saved by good markets, but counting on false confirmation is not a sound deal strategy.  Instead, buyer and seller should think through their post-close working relationships well in advance of signing a deal, deciding who works for whom, under what circumstances, and what the particulars are of their mutual obligations to shared success look like.  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 their counterparty on the front end.

4. 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, want to see profit contributions from the seller, and so some measure of cash flow is a natural way to pay for the kind of desired performance from an acquired investment management operation.  There are at least two problems with this, however, which suggest maybe another performance metric would be more effective for the buyer (and the seller).

First, profitability is at the bottom of the P&L, and is therefore subject to lots of manipulation.  To generate a dollar of profit at a 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 all be sufficiently isolated and defined in an earn-out agreement?  It’s more difficult than it looks.

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 the 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 success, over time, 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 nobody’s giving the business away just to pad AUM).

5. 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 in the earn-out term 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”?

Because these specific considerations are usually unique to a given transaction between a given buyer and a given seller, there are too many to list here.  I have two quick thoughts on that: 1) transaction values implied by earn-out structures are often hard to extrapolate to other parties to other transactions.  2) The earn-out can address many of the concerns and hopes of the parties to a transaction about the future – but it cannot create the future.  Earn-outs manage uncertainty; they don’t create certainty.

Conclusion

Above all, we would emphasize that a plan for contingent consideration 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 based on buyer and seller considerations.  A bridge that doesn’t successfully link two points is not a bridge, it’s a pier.  A pier will eventually leave either buyer or seller in deep water.

We’ll talk more next week about the structuring of earn-outs for RIAs, but drop us a line in the meantime if you’d rather not wait.

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Eagle Ford – 2017/2018 Acquisition & Divestiture Commentary (1)
Eagle Ford – 2017/2018 Acquisition & Divestiture Commentary
Transaction activity in the Eagle Ford Shale has been fairly steady over the past 12 months, with the majority of transactions in the $100-300 million range.  The seller’s rationale has most often been about balance sheet management and re-allocation to other plays, usually the Permian Basin.  However, the Eagle Ford area has some quality economics of its own, which has been attractive to buyers.  Many argue it has the best shale production economics in the U.S. next to the Permian Basin.  These differing strategy based swaps have been at the heart of transaction flow.  This has also led to consideration that Devon may sell its Eagle Ford division in search of returns elsewhere.  The chart below, drawn from Mercer Capital’s newsletter, shows some details in regards to the transactions including some comparative valuation metrics.Magnolia – Blank Check Company forms a New South Texas ProducerThe largest transaction in the past year was the recent announcement of a special purpose acquisition entity (“SPAC”) coming to an agreement with certain Enervest controlled funds.  The result of the merger is the creation of a pure play Eagle Ford and Austin Chalk company with 360,000 net acres in South Texas.   The majority of that acreage is in what is known as the Giddings field which is an oil play in the Austin Chalk (mostly held by production).Break-evens are claimed to be in the low $30’s per barrel with one year (or less) paybacks in Karnes and Giddings field.  Magnolia1 is led by a former Occidental Petroleum executive, Steve Chazen, who has both short and long-term optimism for the opportunity.  Estimated EBITDA for 2018 is projected at $513 million including approximately $240 million of cash flow after capital expenditures.Highest and Best EconomicsDenver-based Sundance Energy Australia Ltd. struck a deal with Pioneer Natural Resource Co. to buy almost 22,000 acres and 1,800 boe/d of production in the Eagle Ford Shale, bolting on to an existing leasehold in South Texas.The pure-play Eagle Ford player agreed to pay $221.5 million for the leasehold, which runs through McMullen, Atascosa, LaSalle and Live Oak counties. The transaction would give Sundance 56,600 total acres in the play, with an inventory of 716 gross undrilled locations.Meanwhile, Pioneer was exiting to focus on the Permian Basin.  Pioneer announced in February it would put most of its resources going forward into the Permian and planned to sell nearly all “non-Permian” projects, including in the Eagle Ford, Raton Basin, and West Texas Panhandle.  The table below demonstrates why its desire to focus on the Permian was warranted.  However, one thing to note is that purchasing acreage in the Permian is much more expensive than the Eagle Ford, so drilling most likely needs to be based on existing acreage positions. Overall, the Eagle Ford’s economics are improving (Venado – a KKR backed Austin firm, made a $765 million purchase from Cabot that was based on this optimism). About 61,500 net acres of the Venado position, which is located primarily in Frio and Atascosa counties in South Texas, is operated and about 9,400 net acres are non-operated. Production from the properties during third-quarter 2017 was 15,656 barrels of oil equivalent per day. An interesting discussion on this acquisition can be found in this video: ?? Have a great week! Endnote1 In case one was wondering - Chip and Joanna Gaines are not involved.
Bankruptcy: An Overview Part 3 (1)
Bankruptcy: An Overview Part 3
From January through May of this year, 39 E&P companies and 31 oilfield services companies had to file for bankruptcy. This post is the last in a series of three aimed at helping those companies, and any others who may face bankruptcy in the future, to understand the valuation-related aspects of Chapter 11 restructuring. In the first post we highlighted two reorganization requirements tied to valuation. First, the plan should demonstrate that the economic outcomes for the consenting stakeholders are superior under the Chapter 11 proceeding compared to a Chapter 7 proceeding. Second, upon confirmation by the bankruptcy court, the plan must not be likely to result in liquidation or further reorganization. In the second post we explored in depth the consequences of the first requirement. Here we examine the importance of the second requirement.Cash-Flow TestFor a company that has followed the steps explained in the previous post, this second requirement represents the last valuation hurdle to successfully emerging from Chapter 11 restructuring. Even if a company shows that the restructuring plan will benefit stakeholders more than liquidation will, the court will still reject the plan if it is likely to lead to liquidation or further restructuring in the foreseeable future. To satisfy the court, a cash-flow test is used to analyze whether the restructured company would generate enough cash to consistently pay its debts. This cash-flow test can be broken into three parts.The first step in conducting the cash-flow test is to identify the cash-flows that the restructured company will generate. These cash-flows are available to service all the obligations of the emerging entity. Remember the discussion in the second post—a stream of cash-flows is developed using the DCF method in order to determine the reorganization value. Thus, in practice, establishing the appropriate stream of cash-flows for the cash-flow test is often a straightforward matter of using these projected cash-flows in the new model.Once the fundamental cash-flow projections are incorporated, analysts then model the negotiated or litigated terms attributable to the creditors of the emerging entity. This involves projecting interest and principal payments to the creditors, including any amounts due to providers of short term, working capital facilities. These are the payments for each period that the cash-flow generated up to that point must be able to cover in order for the company to avoid another bankruptcy.The cash-flows of the company will not be used only to pay debts, and so the third and final step in the cash-flow test is documenting the impact of the net cash-flows on the entire balance sheet of the emerging entity. This entails modeling changes in the company’s asset base as portions of the expected cash-flows are invested in working capital and capital equipment; and modeling changes in the debt obligations of and equity interests in the company as the remaining cash-flows are disbursed to the capital providers. A reorganization plan is generally considered viable if such a detailed cash-flow model indicates solvent operations for the foreseeable future.ConclusionAlthough the Chapter 11 process can seem like no more than a burden, a rigorous assessment of cash-flows and a company’s capital structure can help the company as it tries to develop a plan for years of future success. We hope that these past three posts explaining the key valuation-related steps of a Chapter 11 restructuring help managers realize this potential.However, we also understand that executives of oil and gas companies going through a Chapter 11 restructuring process need to juggle an extraordinary set of additional responsibilities—evaluating alternate strategies, implementing new and difficult business plans, and negotiating with various stakeholders. Given executives’ multitude of other responsibilities, they often decide that it is best to seek help from outside, third party specialists. Valuation specialists can relieve some of the burden from executives by developing the valuation and financial analysis necessary to satisfy the requirements for a reorganization plan to be confirmed by a bankruptcy court. Specialists can also provide useful advice and perspective during the negotiation of the reorganization plan to help the company emerge with the best chance of success. With years of experience in both oil and gas, and in bankruptcy, at Mercer Capital, we are well positioned to help in both of these roles. For a confidential conversation about bankruptcy proceedings and how we can help, please contact a Mercer Capital professional.
Does AI Spending Increase an RIA’s Value-or Just Reduce Its EBITDA?
Does AI Spending Increase an RIA’s Value - or Just Reduce Its EBITDA?
AI investment can create value for RIAs by improving capacity, growth, efficiency, and risk management, but the benefits must ultimately translate into stronger cash flow or reduced risk. Recurring AI costs generally remain operating expenses, making measurable adoption and returns critical to valuation.

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