By many measures, mergers and acquisitions (M&A) activity in the investment management space for 2017 is on track to meet or exceed the brisk pace of activity seen in 2016. Whether the desire that drives them is securing access to new investment strategies or achieving economies of scale through consolidation, asset and wealth managers continue to turn to M&A to increase value.
Successful transactions require, among other things, an understanding of the deal terms that are unique to M&A in the industry. This is especially relevant to founders and management of small to midsize firms engaging in transformative M&A involving, in many cases, their lives' work and passion. Whether looking to buy or sell, founders and management can use this Article to gain an understanding of the principal structuring and deal term considerations that arise in investment management M&A.
Asset vs. Equity Deals
A threshold, fundamental consideration that deal teams must address is whether to structure the deal as a purchase of the target's equity or its assets. Sellers typically prefer to structure a transaction as an equity purchase. By selling the entity through which the target's business has operated, the seller is shielded from any ongoing liabilities associated with the business, other than any obligations it has agreed to retain in the purchase agreement.
For similar reasons, buyers typically prefer to purchase the assets of the target's business. An asset purchase enables the buyer to acquire only the desired assets of the target, while leaving behind its liabilities as the seller's responsibility. When buyers and sellers are largely indifferent from a tax perspective, which is generally the case for targets organized as limited liability companies (i.e., a pass through entity for tax purposes), the market has generally moved toward structuring M&A transactions as equity purchases.
In the investment management space, more weight is given to structuring deals as asset purchases. A principal driver for this consideration is the regulated nature of asset and wealth managers, and with it the potential for significant reputational harm associated with SEC or other regulatory actions.
If a buyer purchases the target's equity, any regulatory action — even one based solely on the target's pre-closing acts — is necessarily imported into the buyer's corporate structure. Thus, the buyer's reputation – an immeasurable asset in an industry relying heavily on brand and trust – may be harmed as a result of the target's failure to comply with regulatory requirements. Conversely, in an asset transaction, there is a better chance that only the seller would be the subject of a regulatory investigation or proceeding. As a result, if there is a meaningful risk of regulatory issues associated with the target's business, a buyer will place greater value on structuring the transaction as an asset deal than it otherwise might.
Client Consent Considerations
If the target is providing investment advisory services to its clients, which is usually the case, each advisory client must consent to the assignment of its investment advisory or management agreement to the buyer. For this purpose, an "assignment" occurs when there is either a new manager under the contract (such as a direct assignment of the contract in an asset deal) or a new owner of the target (as would be the case in an equity deal where there is a change of control of the seller). Contacting these clients to inform them of the transaction requires careful consideration, especially for sellers of small to midsize firms, where any actual or perceived change in management may result in clients withdrawing their assets. For this reason, the buyer and seller should establish an integration plan that emphasizes client retention. They should also collaborate on communicating this plan to clients while seeking client consents for the transaction.
Additional complexities often arise when the target's business involves a client base beyond separately managed accounts (SMAs), such as when the target serves as an investment adviser to a private or registered fund. In all cases, some form of consent of the fund's equity holders will typically be required and, in the case of a registered fund, will necessitate an SEC reviewed proxy solicitation. For SMAs and private funds, depending on the language in the applicable contracts (or organizational documents for funds), consents may take the form of "negative" consents where notice of the transaction is provided to the investor and no further action is required if he/she (or the requisite majority of investors in a fund) does not object to the transaction. The negative consent process also requires meaningful notice to the affected investor (both in terms of substantive disclosure and timing) which necessitates collaboration on the part of the buyer and seller. Whether affirmative or negative consent will be utilized requires agreement among the parties. These and other complexities raise additional structuring and regulatory considerations that should be addressed as early in the process as possible.
Conditions to Closing and Purchase Price Adjustments
While a buyer will often insist on being involved with the client consent process, buyers and sellers do not share the risk of negative client responses equally. Whether in an asset deal or an equity deal, a buyer needs assurance that, at closing, it is acquiring the revenue stream on which its purchase price is based. This assurance is typically given through a dual mechanism.
First, closing the transaction will typically be conditioned on securing the consent of clients that represent a certain minimum amount of the target's revenue. This condition can be expressed either based on the level of assets under management or, especially if the buyer would like to compensate for differing asset fee schedules, as a specified revenue run rate attributable to consenting clients.
Second, the purchase price will typically be adjusted if the assets under management or revenue run rate meets the minimum condition for closing, but still falls below a higher specified threshold.
The closing condition and purchase price adjustment typically operate in tandem, and can take a variety of forms. In a common construct, a purchase price adjustment will apply if the assets under management or the revenue run rate falls below a certain level, for example, 95% of the assets under management or the revenue run rate as of the signing of the agreement, with a pro rata price adjustment for every percentage point below the 95% threshold. At the same time, the obligation to close will be conditioned upon the assets under management or the revenue run rate delivered being no less than, for example, 85% of the relevant level at signing. In this construct, the purchase price would be adjusted between the 95% and 85% thresholds, and below that either the buyer, the seller or both would have the right to terminate the transaction.
While these terms provide assurances to the buyer, they introduce risks for the seller. If the seller is unable to obtain the required consents to meet the assets under management or the revenue run rate condition, it may have damaged its relationships with its clients, who may be concerned, even if the transaction does not close, that the seller's management team is not fully committed to its business. As a result, a seller needs to give careful thought to its client base and any potential obstacles to securing the needed consents.
Deal teams may increase the probability of satisfying these closing conditions by ensuring a continuity of management. Assuming the seller's clients are satisfied with the service being provided, they may be more inclined to provide their consent to the transaction when the intent is that the seller's management team will have day-to-day responsibility for managing their assets following completion of the transaction. Buyers who wish to hire and retain the seller's management team will need to give significant consideration to properly incentivizing those individuals, particularly the founders and members of senior management who are receiving proceeds in the transaction. One such mechanism common in the investment management space, the earn-out, is discussed next.
Earn-Outs
To support the business rationale for a strategic acquisition, buyers need to feel comfortable not only that the target's business is intact at closing, but also that it will continue to grow. In order to ensure continuity and growth, the buyer must provide incentives for the management sellers to remain with the business for the long term. As a result, a significant portion of the purchase price is often structured as an earn-out.
Earn-outs are highly negotiated and can take a wide variety of forms, depending in large part on the nature of the business and the strategic plans for the business following the completion of the transaction. For example, earn-outs may be calculated based on the revenue or the EBITDA of the acquired business, and may be contingent on the growth of these metrics. Often the earn-out period is lengthy, with five years or longer being typical.
The earn-out structure addresses concerns of buyers, as well as concerns of sellers' advisory clients, regarding the continuity of management, but it raises a number of issues for sellers who also manage the acquired business.
First, depending on its terms, there may be a risk that a portion of the earn-out to which management is entitled will be taxed at ordinary income rates, as opposed to lower capital gains rates. This differing tax treatment can complicate discussions if there are both management and nonmanagement sellers. In that scenario, at least a portion of the earn-out that management sellers will receive may be taxed at a higher rate relative to the nonmanagement sellers. This factor should be taken into account when establishing the portion of the purchase price structured as an earn-out, the metrics of the earn-out itself, and the ongoing compensation structure of management.
Second, a seller who takes a substantial portion of the purchase price in the form of an earn-out will typically seek to have some control over how the business is operated following the closing. For example, if the earn-out formula is based on the growth of the business, the seller may want specific commitments from the buyer to provide the necessary funding to enable the business to grow. If the earn-out is based on EBITDA, the seller may want control over expense items in the budget. Relinquishing control over the business, however, would be problematic for a buyer who expects to control the strategic direction of the business following the closing.
Adding to the delicacy of these issues, under relevant case law, unless the contract provides otherwise, a buyer may be constrained in operating the business if the ability to achieve the earn-out is adversely affected when, for example, it sets its annual budget or allocates capital expenditures across all of its business segments. As a result, the purchase agreement must address this issue head-on.
The business arrangements regarding the operation of the business post-closing are often among the more challenging issues to resolve. Sellers and buyers are typically able to reach agreement as they gain assurance that their interests are aligned and can craft language consistent with that assurance.
Finally, the parties need to address the circumstances under which the payment of the earn-out may be accelerated. For example, what if the buyer sells the business during the earn-out period? Should the subsequent buyer of the business assume the earn-out, or should all or a portion of the earn-out payments be accelerated? Similarly, what if the buyer terminates, without cause, the employment of some or all of the management sellers during the earn-out period? These are all issues that need to be addressed based on the particulars of the target's business and the parties' circumstances.
Risk Allocation
As noted, since the investment management industry is highly regulated, asset and wealth managers may be subject to substantial liability and reputational harm for regulatory violations. At times, especially if there are historical regulatory issues with the target's business, sellers and buyers will agree to structure transactions as asset sales in order to increase the likelihood that regulatory liability caused by the seller will remain with the seller.
Outside of this structure, the buyer will be left seeking greater protection through alternative means, including more generous indemnification rights (e.g., longer survival periods for the regulatory representations and warranties, stand-alone indemnities and an elevated indemnity cap for regulatory matters). While there is a normative argument for this elevated protection, whether a buyer obtains the enhanced protection is, as with most issues, based on the relative leverage of the parties in the transaction.
Often parties in M&A transactions will bridge this risk allocation gap by using a representations and warranties (R&W) insurance policy. Through the use of an R&W insurance policy, the risk that representations are untrue is shifted to an insurer. However, while the R&W insurance industry has grown significantly over the last several years, insurers have been somewhat reluctant to underwrite policies in the investment management space due to, among other things, the highly regulated nature of the industry. This exacerbates the challenge of reaching an understanding on risk allocation in the purchase agreement. In the authors' experience, deal teams may reach an insurance-based solution through a combination of an R&W insurance policy and comprehensive coverage regarding errors and omissions generally.
The characteristics of the investment management industry make themselves felt throughout the structure and terms of M&A transactions. Buyers and sellers must pay careful attention to these industry characteristics, as well as their specific objectives in a transaction, in order to shape the structure and deal terms to serve their goals.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
