Earn-outs are as common to investment management firm transactions as they are misunderstood. Despite the relatively high level of financial sophistication among RIA buyers and sellers, and broad knowledge that substantial portions of value transacted depends on rewarding post-closing performance, contingent consideration remains a mystery to many industry participants. Yet understanding earn-outs and the role they play in RIA deals is fundamental to understanding the value of these businesses, as well as how to represent oneself as a buyer or seller in a transaction.
Contingent consideration remains a mystery to many industry participants
This blog series is not offered as transaction advice or a legal primer on contingent consideration. The former is unique to individual needs in particular transactions, and the latter is beyond our expertise as financial advisors to the investment management industry. Instead, we offer these posts to explore the basic economics of contingent consideration and the role it plays in negotiating RIA transactions.
Earn-Outs Are Fundamental to RIA Transactions
As the saying goes (which has been attributed to at least a dozen famous figures): “It’s difficult to make predictions, especially about the future.” This reality is the single most difficult part of negotiating a transaction in the investment management industry. The value of an RIA acquisition target is subject not only to a large number of variables but also a wide range of possible outcomes:
- Performance of financial markets (standard deviation varies)
- Skill of the investment management staff (difficult to measure)
- Sustainability of the acquired firm’s fee schedule (not as much a given as in the past)
- Retention of key staff at the acquired firm (absolutely necessary)
- Retention of key staff at the acquiring firm (absolutely necessary)
- Motivation of key staff (absolutely necessary)
- Retention of client assets (depends on third party behavior)
- Marketing strength of the merged enterprise (tough to predict)
Without faith in the upward drift of financial markets, favorable margins in investment management, and the attractiveness of the recurring revenue model, no one would ascribe material value to an RIA. But actually, buying an investment management firm is making a bet on all of the above, and most people don’t have the stomach.
Only by way of an earn-out can most investment management firm transactions overcome so much uncertainty
Readers of this blog understand that only by way of an earn-out can most investment management firm transactions overcome so much uncertainty. Nevertheless, in our experience, few industry executives have more than an elementary grasp of the role contingent consideration plays in an RIA transaction, the design of an earn-out agreement, and ultimately the impact that these pay-for-performance structures have on valuation.
If nothing else, earn-outs make for great stories. Some of them go well, and others go like this.
From Earn-Out to Burn-Out: ACME Private Buys Fictional Financial
On January 1, 20xx, ACME Private Capital announces it has agreed to purchase Fictional Financial, a wealth management firm with 50 advisors and $4.0 billion in AUM. Word gets out that ACME paid over $100 million for Fictional, including contingent consideration. The RIA community dives into the deal, figures Fictional earns a 25% to 30% margin on a fee schedule that is close to but not quite 100 basis points of AUM, and declares that ACME paid at least 10x EBITDA. A double-digit multiple brings other potential deals to ACME, and crowns the sellers at Fictional as “shrewd.” Headlines are divided as to whether Fictional was “well sold” or that ACME was showing “real commitment” to the wealth management space, but either way the deal is lauded. The rest of the investment management world assume their firm is at least as good as Fictional, so they’re probably worth 12x EBITDA. To the outside world, everybody associated with the deal is happy.
The reality is not quite so sanguine. ACME structures the deal to pay half of the transaction value up front with the rest to be paid based on profit growth at Fictional Financial in a three year earn-out. Disagreements after the deal closes cause a group of advisors to leave Fictional, and a market downturn further cuts into AUM. The inherent operating leverage of an investment management firm causes profits to sink faster than revenue, and only one third of the earn-out is ultimately paid. In the end, Fictional Financial sold for about 6.5x EBITDA, much less than what the selling partners wanted for the business. Other potential acquisition targets are disappointed when ACME, stung with disappointment from the Fictional transaction, is not willing to offer them a double-digit multiple. ACME thought they had a platform opportunity in Fictional, but it turns out to be more of an investment cul-de-sac.
The market doesn’t realize what went wrong, and ACME doesn’t publish Fictional’s financial performance. Ironically, the deal announcement sets the precedent for interpretation of the transaction, and industry observers and valuation analysts build an expectation that wealth management practices are worth about 10x EBITDA, because that’s what they believe ACME paid for Fictional Financial.
This example highlights the difference in headline deal values (total consideration) and what actually gets paid after the earn-out payment. Sometimes they’re the same but often only a portion of the contingent consideration is realized, which makes total consideration multiples difficult to interpret. We’ll touch on this a bit more in next week’s post on transaction strategies and earn-out parameters.