I’m sure it sounded like a great idea during the planning stage.

Last month, I was walking through the historic “South of Broad” area in Charleston, South Carolina, when I noticed a bright orange McLaren 570S turning onto the cobblestone street (photo above). I’ve driven a 570S, with over 550 horsepower and a naught-to-125 mph time of less than ten seconds, on a track before and am familiar with its tremendous capabilities. Smoothing out rough terrain at 5 mph is not, however, one of them.

When I pulled out my phone to take a few pictures, the passenger window rolled down. There, inside, was a bride and groom, fresh from their ceremony, making a conspicuously awkward getaway. The groom was gingerly piloting the McLaren to avoid scraping carbon fiber aero bits off the chassis. He looked nervous. The bride, gossamer veil pressed against the low headliner, billowy wedding dress crammed into the bucket seat, unforgiving suspension transcribing the precise dimension and shape of every paver to her backside, grimaced face suggesting she now understood the full extent of what “I do” means, leaned out and yelled, “Worst Idea Ever!” I assume she meant the car.

Next time, when the wedding planner suggests a Bentley, go with that. Or…walk.

For Richer and for Poorer

If you’ve been offered rollover equity as part of a sale of your investment management firm, this post should offer a few things to consider on your road to riches. Rollover equity has become a standard feature of deal consideration in the RIA industry. At one time, sellers were typically offered cash plus an earnout to sell their firm. Both of these forms of payment are still prominent, although cash consideration has waned. We expect rollover equity to remain a prominent feature of deal consideration for the foreseeable future.

The concept of rollover equity is relatively simple. Sellers agree to exchange some or all of their firm’s stock for stock in the buyer. The exchange is made on a relative value basis, and if the stock of the acquiring firm carries a higher valuation (say, higher EBITDA multiple) than the selling firm, the transaction is considered accretive to the buyer.

Rollover equity has become common

Rollover equity has become common as 1) more of the buyer community includes aggregators trying to build an operating ownership base invested in the future of the consolidated enterprise, and 2) buyers are trying to satisfy seller expectations on pricing while protecting their downside.

Investment Management Is an Owner-Operator Business

Buyers have a number of reasons to offer a significant amount of rollover equity as part of their payment to RIA sellers.

Investment management is a labor-intensive business and cannot rely on an assemblage of hard assets, like a manufacturer, to serve as a store of value. The value lies in the knowledge, skill, AND interaction of the persons working at the RIA. This is not an uncommon circumstance in professional services firms, but even more so when the qualities of the professionals are unique and, thus, hard to replace.

RIAs are suited to be owner-operator businesses, and owner-operator businesses are difficult to fully transact. A wise old lion of the RIA consolidation movement once told me, “You can rent an RIA, but you can never really own one.” Consolidators have tried various schemes to thread the needle between returns to capital and returns to labor.

Before it went private, Focus Financial’s acquisition model was to securitize a portion of earnings before owner compensation (or EBOC), leaving some behind in an operating entity to compensate for the continuing efforts of the selling partners. The portion purchased gave Focus a preference return, backed by the selling partners. As such, Focus could not consolidate ADVs and ended up being largely a basket of non-traded preference stakes in wealth management firms. Whether or not this was successful is a matter of opinion, but the post-going-private Focus seems to be working on restructuring these agreements.

There are other methods such as revenue share and minority stakes that attempt to maintain leadership continuity but allow for outside investment — and these all can accommodate the needs of some consolidators.

Buyer Motivations for Rollover Equity

For others, though, growing a large RIA presence through inorganic transactions means building not just a business base, but a partner base. With rollover equity, the buyer gains both a business and a base of investors. Rollover equity allows buyers to entice sellers to become partners in the larger enterprise. And, by growing the partner/investor base through acquisition, consolidators conserve and leverage cash to grow more than they could given their capital base.

With rollover equity, the buyer gains both a business and a base of investors

Rollover equity also offers buyers much-needed downside protection in a transaction environment that is living in the past. RIA valuations trended upward, along with transaction volume, until interest rates started rising two years ago. The cost of capital has risen since then, and RIA valuation multiples have, correspondingly, fallen — all else equal. What isn’t equal is that RIA sellers still want the multiples from two years ago.

Buyers have had to get creative to meet seller expectations. One way is with longer earnouts that have higher hurdles to get paid. Another is to grant them equity in a parent company that is valued at a higher multiple. If the market for RIAs cools further, the buyer still won’t have overpaid for the target company to the extent they exchanged their own shares at a higher relative valuation. That’s the beauty of multiple arbitrage. I’ll get to the ugly side of this in a moment.

Finally, rollover equity is an attractive way to enhance deal pricing. Do the math, and it’s tough to make 15x EBITDA pencil out if you’re paying cash. If a third of the deal consideration is in an earnout such that the earnout payments are paid for by future performance, that helps. If another third of the deal consideration issued by the parent is in paper, it’s magic. If you’ve ever dreamt of being able to print money, the closest thing is buying other people’s businesses with your own stock.

Seller Considerations

For sellers, rollover equity has several attractive features and a few caveats. Many sellers would like to stay in the game after relinquishing control of their firm. Rollover equity not only gives them that option but puts them on the cap table for a larger and potentially prosperous enterprise. This assumes, however, that the RIA “seller” is prepared to become an investor, or buyer, of a stake in the acquiring firm.

A major advantage of rollover equity is tax treatment. Usually, the seller can roll over the tax basis in their stock to the new shares and defer having to recognize the gain. So long as capital gains rates are at current levels or lower — and/or the time value of money improves the economics of the tax deferral via a long holding period — this is a boon for the seller. The seller might relocate to a state with lower capital gains taxes (if any) before the sale of the buyer. Or it might get a step up in basis at the time of their demise, etc. Deferring the recognition of gains opens possibilities to selling shareholders that they wouldn’t otherwise have.

Obviously, this tax treatment can work against sellers if they get dragged along in a sale of their buyer at an inopportune moment — higher rates, bad pricing, distressed terms, etc.

We see the bigger risk in establishing the relative value of the shares received

We see the bigger risk in establishing the relative value of the shares received from the buyer in exchange for the seller’s shares. If a buyer values the target company’s stock at, say, 10x earnings but values their own stock at, say, 20x earnings, then the seller is receiving 50% as much earnings yield and 50% as large a claim on earnings as what they are giving up. If the buyer has the model, growth, and plan for liquidity such that they are genuinely worth it, maybe that’s okay. If not, an accretive deal for the buyer is, symmetrically, a dilutive deal for the seller.

Further, many of the consolidation models are predicated on a successful exit. If the IPO market remains unreceptive to new RIA rollups, or if PE interest in the space fades, it will be hard for today’s sellers to realize the valuation supposedly received for rollover equity.

This brings us to a final point: liquidity. If you accept rollover equity and later regret your decision, can you get out? Having a “put” provision in your agreement to accept rollover equity is prudent if you one day decide you don’t like the direction of the acquiring firm or if, for some reason, you need the money.

Happily Ever After?

We didn’t see many instances of rollover equity in offers for RIAs until a few years ago. Now, they are common enough to warrant this blog post and probably for us to formalize our advice in a whitepaper.

Rollover equity is neither inherently good nor bad. It makes pricing a deal a little more challenging, and it requires sellers (i.e., investors in the rollover equity) to do considerable due diligence on prospective buyers — not something we see everyone doing. Like choosing a car to leave one’s wedding, sometimes the option that looks attractive ahead of time can ultimately lead to some discomfort. If someone offers you their equity in exchange for yours, give us a call. Make sure you don’t opt for the “worst idea ever.”