Editor’s note: Stock consideration is rarely discussed in RIA transactions, but it is a common financing feature in other industries. We expect to see more stock-for-stock deals in RIAs for two reasons. As debt financing becomes more expensive (and scarce) and consolidators start to question how much leverage they want to maintain, buyers will be tempted to use equity consideration instead of cash. And if capital gains tax rates rise and sellers can use rollover equity to defer gains, the structure will become more attractive to sellers. How can a seller decide whether or not to accept a suitor’s stock? Jeff Davis has a few thoughts.
M&A activity in North America is slow, judged by no other metric than the periodic headlines from Bloomberg regarding headcount reductions at bulge-bracket investment banks. The culprit is rising interest rates that have tightened, but not yet eviscerated, financial conditions as the ability of firms to tap capital markets requires issuers to accept much higher coupons for debt and lower multiples for equity.
Yet, the factors driving consolidation in the RIA space have not changed—management succession, desire of senior partners to monetize their interest, technology costs, etc. As long-time M&A advisors, we make the not-surprising observation that when the market declines, seller expectations are sticky, focused on precedent transactions from the last bull market.
The recovery rally in equities hasn’t generally extended to public RIAs, leading Focus Financial Partners (NASDAQGS: FOCS) to pursue going private—and it may not be the last. The transaction entailed an enterprise valuation of $7 billion, or ~12x consensus 2023 EBITDA of $592 million. The $53 per share value equated to 11x consensus 2023 EPS, while the one- and 30-day premiums were 15% and 42%. Regardless of how one feels about the multiples, the old Wall Street saw comes to mind: No one goes broke taking a profit. The company went public in mid-2018 at $33 per share.
The acquisition of Focus got us thinking about RIA acquisitions more generally. In addition to increasing contingent consideration, given rocky markets, we expect to see more buyers offering equity to RIA sellers as a portion of their total consideration. Even in the private space, equity rollovers are seen as attractive to buyers, who want to avoid overleveraging and have their acquisition target teams fully on board, and to sellers, who see remaining upside in the RIA space and like the opportunity to defer gains.
Private equity-backed consolidators boast better-than-public valuation multiples based on internal metrics. Those valuations are key to growth. It is easier for a buyer to issue shares to finance an acquisition if they trade at a rich valuation than to issue “cheap” shares.
High multiple stocks can be viewed as strong acquisition currencies for acquisitive companies because fewer shares have to be issued to achieve a targeted dollar value. However, high multiple stocks may represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most of which fall into the genre of “what are the investment merits of the buyer’s shares?” The answer may not be as obvious as it seems, even when the buyer’s shares are actively traded.
Our experience is that some (if not most) board members weighing an acquisition proposal do not have the background to evaluate the buyer’s shares thoroughly. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.”
The vetting process is typically addressed by issuing a fairness opinion that opines the fairness of the consideration to be received by the seller (or paid by the buyer) from a financial point of view.
A fairness opinion is more than a four-page letter; it should be backed by a robust analysis of all relevant factors considered in rendering the opinion, including evaluating the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future but rather to evaluate the investment merits of the shares before and after a transaction is consummated.
Key questions to ask about the buyer’s shares include the following:
- Liquidity of the Shares – What is the capacity to sell the shares issued in the merger aside from whatever 144 restrictions may exist for certain shareholders? SEC registration and even NASDAQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of outstanding shares and shareholders increases.
- Profitability and Revenue Trends – The analysis should consider the buyer’s historical and projected growth in revenues and operating earnings (usually EBITDA or EBITDA less capital expenditures) in addition to EPS. Issues to be vetted include customer concentrations, the source of growth, the source of any margin pressure, and the like. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated.
- Pro Forma Impact – The analysis should consider the impact of a proposed transaction on revenues, EBITDA, margins, EPS, and capital structure. The per-share accretion and dilution analysis of such metrics as earnings, EBITDA, and dividends should consider both the buyer’s and seller’s perspectives.
- Dividends – Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. If the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed? Worse would be if the market expected a dividend cut. These same questions should also be asked in the context of the prospects for further increases.
- Capital Structure – Does the acquirer operate with an appropriate capital structure given industry norms, business cyclicality, and investment needs to sustain operations? Will the proposed acquisition result in an over-leveraged company, which in turn may lead to pressure on the buyer’s shares and/or a rating downgrade if the buyer has rated debt?
- Balance Sheet Flexibility – Related to the capital structure should be a detailed review of the buyer’s balance sheet that examines areas such as liquidity, access to bank credit, and the carrying value of assets such as deferred tax assets.
- Ability to Raise Cash to Close – What is the source buyer’s fund source for the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue? While generally not an issue for RIA consolidation, the government can otherwise block a merger, as appears to be developing in the pending acquisition of Spirit Airlines by JetBlue.
- Consensus Analyst Estimates – If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. diligence process determinations. If Street expectations are too high, the shares may be vulnerable once investors reassess their earnings and growth expectations.
- Valuation – Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently, and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.
- Share Performance – Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.
- Strategic Position – Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers.
- Contingent Liabilities – Contingent liabilities are a standard item on a buyer’s due diligence punch list. Sellers should evaluate contingent liabilities too.
The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential, and risk profile. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over four decades of business.