As noted in our most recent M&A update, RIA dealmaking remains fairly robust, with a near-record year in 2023 and a significant uptick in year-over-year total transacted AUM during the first quarter of 2024.  In this environment, adequate due diligence is critical since the cost of corporate M&A failures is high for both buyers and sellers:

• For RIA buyers, overpaying for a target can hamper returns (particularly in a down market) and crowd out more attractive investment opportunities for years to come.
• Sellers only get one chance to sell their business. Failing to maximize proceeds or structuring a deal properly represents a missed opportunity they can never get back.

These high stakes mean that thorough and high-quality due diligence is critical.  A Quality of Earnings (or QofE) analysis is an essential component of transaction diligence for both buyers and sellers.  Optimizing your transaction diligence requires assembling the right team.

In this post, we discuss five things RIA buyers and sellers should look for when evaluating potential QofE providers.

1. Industry Experience

Dealmaking in the RIA industry has its own nuances that a generalist QofE provider would likely not appreciate.  The emphasis on run-rate or ongoing profitability over the latest twelve-month earnings and the prevalence of earn-outs and other forms of contingent consideration are two critical aspects of this sector’s typical deal terms that could get overlooked by a QofE analyst with little or no industry experience.

There are also ~15,000 RIAs in this country that follow various business models, and it would be a mistake to view them as a homogenous group.  Firms that follow a relationship model with retail clients behave differently than institutional models where performance relative to benchmark determines success.  Some models are labor intensive by the number of staff, and others are labor intensive by the quality of staff.  Understanding a QofE provider’s experience with RIAs will help ensure the deal is structured properly and due diligence is focused on what actually matters to industry participants.

• Is the QofE provider a generalist or dedicated to a particular industry?
• Has the QofE provider worked with firms in the RIA space?
• What kinds of RIAs or investment management firms have the QofE provider previously worked with?

 2. Valuation Perspective

A quality of earnings analysis is not a valuation.  However, every valuation includes an assessment of earnings quality.  A QofE provider that brings a valuation perspective to the engagement is more likely to identify insights that matter to the proposed transaction price (i.e., valuation).  Because of the close connection between a QofE analysis and valuation, you should inquire as to a potential provider’s valuation perspective.

• Does the QofE provider have an active valuation practice?
• Do any of the QofE provider’s team members hold recognized valuation credentials?
• Do the members of the QofE provider’s team undertake continuing professional education
  in valuation topics?

 3. Transaction Experience

Don’t view your QofE analysis as a mere “check the box” exercise on your diligence list.  A QofE report should provide genuine insight into the target before you reach the closing table.  While a QofE analysis can, in some respects, feel like an audit, it is not one.  Instead, it is a component of transaction diligence, so you should inquire about a potential provider’s transaction experience.

• Has the QofE provider represented buyers or sellers in transactions?
• Has the QofE provider advised buyers on M&A strategy?
• Has the QofE provider rendered fairness or solvency opinions?

4. Technical Expertise

A quality of earnings analysis requires attention to detail, a thorough understanding of generally accepted accounting principles, and familiarity with the practical elements of accounting practice.  Certified public accountants with audit experience are likely to possess each of these attributes.

• Does the QofE provider’s team include one or more experienced CPAs?
• Does the QofE provider’s team include members with audit experience or a background in accounting?

5. A Deep Bench

Transactions don’t wait.  When it is time to move on a deal, you can’t waste time waiting for your QofE provider to catch up.  When evaluating QofE service providers, you should inquire about the depth of resources they can bring to your assignment.

• Does the QofE provider have multiple engagement leaders capable of overseeing your
  engagement?
• Does the QofE provider have a pool of qualified staff capable of executing the engagement on your timetable?

Conclusion

Successful RIA buyers and sellers take Quality of Earnings analyses seriously.  This requires selecting a QofE provider who can be a valuable member of your transaction diligence team.  The best QofE providers generate relevant insights before you close your transaction — those insights are most likely to come from a team with a broad and deep technical skill set, transactional experience with RIA firms, and a valuation perspective.

About Mercer Capital

We are a valuation firm that is organized according to industry specialization.  Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.

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Special thanks to Travis Harms and Nick Heinz for much of the content in this blog post.