RIA M&A: What Can Possibly Go Wrong?

A Very Incomplete List of What Not to Do in Transactions


As business combinations go, it’s hard to imagine a better press release:

Ferrari, the most storied and most successful name in Formula One racing history and the only team to compete in every world championship ever held, boasting a top 16 Constructors’ Championships and 15 Drivers’ Championships…

…signs Lewis Hamilton, the most recognizable and winningest driver in Formula One, tied with Michael Schumacher for the most Drivers’ Championships, who serves as a global ambassador for Formula One, built McLaren’s reputation and cemented Mercedes’s, and was knighted by Queen Elizabeth.

Ferrari brings unparalleled intellectual property and commitment to racing, capital from a robust market valuation, and a history of being on top.  Hamilton brings unparalleled driving skills, a following among not just fans but also mechanics and builders, and a history of being on top.

What Could Possibly Go Wrong?

I’ll get back to the Ferrari/Hamilton deal later.  In the RIA community, nothing gets people’s blood flowing like a transaction.  Big mergers are fantastic, but even deals involving a few hundred million of AUM are widely reported.  For all the hype, making M&A successful requires minding Ps and Qs, and is as much, if not more, about attention to detail and being realistic as it is about sweeping vision and uplifting pronouncements.

I’ve written in the past about the perils of focusing on the volume of press releases instead of the volume of earnings.  Today, I thought it would be worthwhile to discuss what can go wrong in an RIA deal and how to protect yourself from it.

Here’s a partial list of mistakes we’ve seen (some from buyers, some from sellers) in no particular order.

Failing to Get an Independent Quality of Earnings Assessment

A Quality of Earnings assessment is like a SWOT analysis of your financial statements, looking at all of the risks and opportunities inherent in your revenue, expenses, and earnings.

Is this a seller issue or a buyer issue?  Both.

The Quality of Earnings analysis is designed to show you how a buyer would look at you

If you are a seller, a Q of E assessment can alert you to issues that will be exhumed during due diligence and held against you by the buyer in negotiations.  If you have real opportunities for earnings enhancement, it will help you get paid for those opportunities.  The Quality of Earnings analysis is designed to show you how a buyer would look at you so you’re realistic about what you bring to the table and ready to negotiate the best deal for you.  Whatever you do, don’t hire the Q of E firm that does regular work for the buyer — they have an inherent conflict of interest, and they will find things that the buyer can use against you in the due diligence process to whittle down the offer price to help create a “gain on purchase” (to buy you for less than you’re worth).

If you are a buyer, a Q of E analysis is a deep dive into a range of qualitative and quantitative issues that protect you from simply trusting seller representations.  If the seller presents you with their own Q of E, get that analysis in its native format (usually Excel) and hire someone to review and critique it.  It’s not unusual to see adjustments to reported results that are realistic.  Others might just be possible.  Others might be fantasy.

Failing to Meet with Multiple Generations of Leadership

If a selling firm has two owners of retirement age and a half dozen senior managers below them in their forties and fifties, who will ultimately be tasked with making the transaction successful?  I know this sounds obvious, but we’ve seen multiple deals in which the buyer didn’t meet with anyone other than the owner selling the firm so they can retire in the foreseeable future.

On signing day, the buyer is introduced to the staff, who are presented with employment agreements.  This may be a tough announcement if the next-gen was expecting to buy out their owners and take over themselves.  And if their existing employment agreements aren’t pretty good, this could be the scene in which the proverbial assets get on the elevator, go home, and don’t come back.  Yes, this has happened.

Whether you are a buyer or a seller, it’s important to involve all the relevant stakeholders in preparing for a transaction to ensure continuity of operations after closing.  It’s not always easy, but it’s always necessary.

Misunderstanding the Economics of the Transaction Structure

Pop quiz: if deal consideration is five times EBITDA in cash, five times EBITDA in rollover equity, and five times EBITDA in earnout payments, what is the deal multiple?  If you guessed 15 times EBITDA, you’d make a typical trade journalist, but you would also, very likely, be wrong.

Cash consideration is easy enough to understand, but precious few RIA deals are “cash for keys.”

Rollover equity is complicated because it’s based on the relative value of the buyer’s equity.  Buyers naturally want accretive transactions in which they are picking up more dollars of earnings per share than they make themselves.  But if the deal is accretive to the buyer, it’s symmetrically dilutive to the seller.  And if the acquiring firm sells one day for a lower multiple than it was valued at the date of your transaction, it will be even more dilutive.  We are always surprised when RIA acquirers boast about the high multiples at which they are valued (by firms they hire to value them…); savvy sellers will know those high valuations work against them.

As for contingent consideration, the question revolves around how realistic the earnout targets are and whether those payments will be made in cash or stock.  And then there’s the time value of money.  Our advice is to be realistic about risk adjusting contingent payments and then discount them.  It doesn’t take much to turn a 5x EBITDA headline earnout into 3x on an economic basis.

So, what’s our hypothetical five-plus-five-plus-five deal worth?  Probably less than 15 times EBITDA.

Unrealistic Compensation Expectations

Compensation can be highly idiosyncratic, especially for founder partners.  You might only “pay” yourself $100 thousand per year because you get distributions on 40% of your firm’s earnings.  That’s fine as an independent enterprise, but a buyer isn’t going to pay a multiple for your compensation just because you characterize it as earnings.

Occasionally, you’ll meet an unsophisticated buyer who is willing to pay a multiple on what would be part of a normal compensation package.  This never ends well.  A selling partner with eight figures in sale proceeds usually won’t exert himself or herself at the same level for comparatively de minimis pay.

Conversely, don’t leave money on the table.  If you are a selling partner and take out more in wages than it would reasonably take to replace you, make that adjustment and get paid a multiple on the difference.

Consider what a realistic, market-based compensation package is for the partners

In any event, prior to going to market, consider what a realistic, market-based compensation package is for the partners.  That may increase or decrease earnings, but it will probably bend the margin toward something a buyer would consider “normal” or at least sustainable.  Negotiating deal pricing over partner compensation is unnecessary.  Pick a reasonable balance between returns to capital and returns to labor, and craft your transaction accordingly.

Viewing a Merger as a Sale

In a typical RIA transaction, the “seller” is making a bigger investment in their “acquirer” than the other way around.  Why?  Because, outside of the initial cash consideration, the seller is accepting rollover equity and earnout payments in exchange for their company.

Rollover equity is essentially an investment in the acquirer, with what might be an indefinite holding period and an uncertain ultimate liquidity event.  Earnout payments, also known as contingent consideration, mean the selling principals are actually going to be partners with the acquirer in their firm until such time as those earnout payments are, well, earned (or not).

Also, remember that the scale of economics between seller and buyer is disproportionate.  The seller is handing over their life’s work, often in exchange for a small percentage of the acquirer’s enterprise.  The deal’s success matters to everyone, but it matters far more to the seller.

Not Considering Post-Transaction Reality

This one could be titled “Viewing a Sale as a Merger.”

For sellers, it’s important to remember that selling your firm, even part of it, is giving up control.  There is no such thing as a no-touch acquirer.

There are ways to minimize the invasiveness of a new owner with revenue-sharing arrangements and employment agreements.  But we’ve seen supposed financial buyers taking minority stakes who find clauses in their agreement that allow them to exert as much pressure as they think they need after the ink dries.  The subsidiary leadership’s only leverage is that they generate the revenue and can leave.

For buyers, remember that you are hiring entrepreneurs, and entrepreneurs are often that way because they don’t want (can’t live with) a boss.  The great irony of the consolidation movement in the RIA space is that the RIA space formed in the first place because ambitious people at wirehouse firms and bank trust departments decided they could do better if they left the mothership and headed out on their own.  Consolidation negates much of that spirit, but to the extent it involves second and third-generation leadership at RIAs, those folks may be more accustomed to having a boss and will be more adaptable to working for a parent organization.

Press Releases Don’t Build Businesses

Getting back to the dream combination of Ferrari/Hamilton: What could possibly go wrong? Lots.

Ferrari hasn’t won a Constructors’ Championship in sixteen years.  Not since before the GFC.  Translated to our world, that’s a lot of negative alpha.  Enzo Ferrari sold road cars to fund his racing ambitions; now, his company is public, a global branding house that races to sell cars, media, and lifestyle accoutrements.  If you’ve seen the excellent movie Ford versus Ferrari, you know that Ford tried to buy Ferrari in the 1960s.  Today, Ferrari’s buyer would more likely be LVMH.

Hamilton. Is. Old.  At 225 miles per hour, age isn’t just a number.  This is my unvarnished opinion and the subject of much debate in the F1 community, but Lewis Hamilton turned 39 last month, and his last Drivers’ Championship was four years ago.  In the past fifty years, only one driver as old as Hamilton has managed to win the F1 season.  Even if he’s the greatest F1 driver in history, Hamilton’s instincts, eyesight, reaction time, and nerves are off-peak in a ridiculously competitive field.

So, a little due diligence suggests that pairing an also-ran team with an aging icon won’t produce many podiums.  But it will garner millions, if not billions, of dollars of free publicity for both Ferrari and Hamilton.  If that is their actual ambition, the deal will be wildly successful.  For RIAs, unfortunately, press releases don’t build firms.