Preparing for the Unknown Unknowns

The Importance of Sell-Side Due Diligence

Industry Trends Transactions

1949 Packard Super Deluxe Eight Victoria Convertible Coupe (

Last weekend I had a chance to join my dad for the annual Concours on Amelia Island, a fantastic gathering of car collectors and interesting automobiles of all kinds and eras.  Coinciding with the weekend’s events were collector car auctions from all the major houses.  A cursory review of results from those auctions (prices paid and sell-through rates) suggests that there’s not much of a recessionary cloud hanging over the economy yet—at least not the economy inhabited by classic car buyers.  Duesenbergs and Ferraris routinely fetched seven figures, and Lancias and Porsches brought big money.

One car that caught my attention last weekend sold for a comparatively modest sum.  The beautiful 1949 Packard convertible pictured above and featured at the RM Sotheby’s auction brought just under $45,000.  If you’re younger than 65, you can be forgiven for not knowing Packard, as the marque was discontinued in the late 1950s.  Bad markets and a bad transaction got the best of a great automaker, a cautionary tale for anyone planning the future of their business.

From Great to Gone in Ten Years

Packard was a leading automaker before World War II.  It wasn’t a limited issue brand like Rolls Royce or Delahaye, but as production cars go, Packard was one of the most respected luxury manufacturers in the U.S., arguably more so than Cadillac.  Unfortunately, the end of WW2 saw a diminished Packard Corporation that couldn’t compete as an independent against the Big Three from Detroit.

Starved for capital, engineering talent, and distribution, Packard merged with Studebaker in 1953, part of a longer-term strategy to sell to the much larger American Motor Company.  Fully assembled, the three independent automakers would have been the third largest in the U.S.—a great opportunity to prosper in the ultimate scale business.

The deal that you think will save you could be the deal that sinks you

Unfortunately, the post-merger revelations about Studebaker’s financial problems created distrust among executives, scuttled the merger with AMC, and ultimately resulted in the cessation of Packard.

The post-mortem on Packard: the deal that you think will save you could be the deal that sinks you.

Due Diligence on Your Buyer

Lessons from the consolidation of the automobile industry have merit in the RIA space.  Even if a deal isn’t technically considered a “merger,” the sale of an RIA is often more about selling up than selling out, with target company shareholders taking at least some equity in the surviving enterprise.  The resulting arrangement could be structured as a consolidated business, as is the case with most RIA aggregators, or as a sort of co-parenting arrangement, as is the case with Focus Financial.  However, the end result is the same.

If you’re not being offered a “cash and dash” transaction, you are not just selling your RIA; you are investing in your buyer.  And it’s a significant investment.  The buyer might only be expending a few percentage points of their capital to acquire your firm, but you’re giving up your entire firm in exchange for some cash and rollover consideration in your buyer—a business you don’t really know.

It’s strange, then, that sellers rarely do as much due diligence on their acquirers as acquirers do on their targets.

Strategic Planning for Sellers

Former Secretary of Defense Donald Rumsfeld once famously riffed off of a psychoanalytical framework called the Johari Window.  When answering a question about Iraq supplying terrorist groups with weapons of mass destruction, he said:

Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know.  We also know there are known unknowns; that is to say we know there are some things we do not know.  But there are also unknown unknowns—the ones we don’t know we don’t know.  And if one looks throughout the history of our country and other free countries, it is the latter category that tends to be the difficult ones.

Parsing one’s circumstance into known knowns, known unknowns, and unknown unknowns is a strategy technique useful for contemplating a sale in which the seller becomes an owner or is otherwise partnered with the acquirer.

Known knowns in an RIA transaction include the business model of the combined enterprise, fee schedule, cost structure, compensation, growth trajectory, margin, relationship expectations, and so forth.  Known knowns are all the items that are routinely covered in due diligence.

Known unknowns in an RIA transaction include obvious exogenous factors that will affect the outcome of a transaction.  Will clients agree to stay with the new enterprise?  Will market performance increase or decrease the likelihood of contingent payments?  Will employees want to remain or seek other opportunities?  Known unknowns also include soft issues like corporate culture that contribute to or undermine the success of a transaction.

Unknown unknowns, of course, can’t be listed—that’s what makes them unknown.  Other than a black swan event, many unknown unknowns will probably be the secondary or tertiary effects of known unknowns.

When Unknown Unknowns Become Known

Partner firms of Focus Financial will soon have a new partner as the company goes private under the care of Clayton, Dubilier & Rice.  This was, I think, completely unexpected for partner firms—an unknown unknown.

Assuming that Focus’s leadership is doing their fiduciary duty to all their stakeholders, partner firms must be wondering if they’ve got the deal they signed up for.  Focus had a distinct business model, culture, and plan not just to grow but to help their partners grow.  Given the volume of transactions and the history of Focus, those items were codified as known knowns.  Now, they are known unknowns.

I marvel at the speculation that CD&R plans to make money on Focus by breaking it up

A big known unknown is the plans of CD&R, a storied PE firm with a long and successful track record.  I marvel at the speculation that CD&R plans to make money on Focus by breaking it up and selling off its partner firms.  Quick reminder to my fellow armchair quarterbacks that Focus doesn’t own its partner firms.  Focus owns pieces of paper that entitle it to preferred interests in partner firms’ earnings before partner compensation (EBPC).  It’s unclear if Focus could resell these preferred interests and, if so, to whom.  Maybe the partner firms want to raise capital to buy back Focus’s claim on their earnings—we’ll see.

But if CD&R doesn’t plan to try to scrap out Focus, what is their plan?  Is it to go private for a few years, wait for a better market, and then take it public again?  Focus was richly priced when it first went public, but now that it’s a known quantity, it’s hard to imagine that performance is repeatable.

Another big known unknown is the perspective of the partner firms.  If they want to reclaim their independence, can they?  Are these partnership agreements a Hotel California: RIAs can check out anytime they like, but they can never leave?  Do the agreements survive a change in control of Focus?  Are the partner firm agreements even all the same, or are there nuances that put some in a different position than others?

Whatever the case, we’ll probably continue to learn more about the business of RIA aggregation through the experience of Focus Financial.  The model was intended to maintain the entrepreneurial spirit of the heads of the partner firms, but in a situation like this, one wonders if entanglement was an adequate substitute for structure.

Known but Debatable

I do not think it’s fair to say Focus’s foray into the public space was a failure.  Over the years, I’ve blogged that the IPO was richly priced (it was).  I thought some of their disclosures on things like organic growth were less than helpful (they were not).  I wondered if they were overleveraged (and I wasn’t the only one).  I noted that they had lots of competition in the acquisition space (as time went on, they did).  It’s absolutely true that most of the total return on Focus was earned on the initial day of trading and the speculation over going private.

Nevertheless, Focus survived almost five years of trading activity, a global pandemic, huge market swings, and quarterly analyst calls.  Focus management engineered a successful acquisition brand and grew to be a massive enterprise.  To what end, well, that’s a known unknown.

Focus’s biggest challenge was, in many ways, beyond their control.  Equity markets haven’t developed an investor constituency for public RIAs.  Focus’s alter-ego, CI Financial, is facing similar unknowns, even though they’ve conducted their consolidation plan 180 degrees differently than Focus.

Relative to other vehicles sold last weekend, I thought Packard went cheap.  But the car investor community isn’t any more interested in post-war Packards than investors are in public investment management firms.  It may not make sense, but the market is what it is.  That much is known.

My dad at the Amelia Concours. Happily, he didn’t spill scotch into that pristine, race-prepped 914/6.