If you are even involved in a merger or acquisition, it will probably be the single most important financial transaction in your life.
If you’re a buyer, it can accelerate your growth far beyond what would otherwise be possible. If you’re a seller, it can turn your hard-earned equity into cash to finance the next stage of your life.
So ask yourself: How prepared are you for a truly life-altering moment for yourself and your family? The answer, unfortunately, is that you’re probably not well-positioned for M&A success. Most research shows that M&A activity has an overall success rate of 50%. That’s a coin flip. If you do M&A poorly, you can destroy value in your business.
To put the odds in your favor, you need to make informed decisions that will maximize your rewards while reducing your risks.
THE M&A LANDSCAPE
The RIA space is a hotbed for mergers and acquisitions these days. In 2015, there were at least 10 deals involving firms with almost $4 billion or more AUM, versus just one in 2014, according to Park Sutton Advisors.
It’s little wonder. With 60 being the average age of advisors with more than $50 million in AUM, the opportunity to acquire has never been better. And with organic growth rates for many advisors slowing and operating costs rising, M&A starts to look appealing. That’s especially true if you are already a wealth manager or are looking to enter that space.
The benefits of M&A are many:
1. You can add three to five years’ worth of revenue in one transaction.
2. You can add key managers and partners — people you need to maximize value.
3. You can expand geographically.
4. You can eliminate duplicative costs.
5. You can achieve critical mass faster.
KNOW HOW IT GOES
To get those benefits, you need to understand the M&A process. Yes, you will probably want to get help. But too often, we see advisors hand off control of the deal entirely to a lawyer, investment banker or both.
While professional advice is invaluable, you want to remain in the driver’s seat. The way to do that is by having a big-picture view of the entire process. Here are insights into five key issues about the world of M&A.
1. Get clear about your goals. Start with a strategy. You need a vision about what you are looking for in terms of types of clients, the size of the deal, the location and so on. Otherwise, your efforts will be inefficient.
Successfully developing a strategy requires you to separate your personal objectives from your business objectives. If you find they are in conflict, prioritize your business objectives over your personal ones.
As for your personal goals, determine what you really want. Explore your personal needs for wealth, meaning and achievement and then consider how your business strategy may or may not deliver on these needs. There are a number of roles available to you as an owner: shareholder, board member, CEO, rainmaker and others.
2. Understand what drives value. If you are a buyer, there are two ways to create value through M&A:
- You buy something for less than it is worth. Given the competitive market environment, it’s unlikely this will happen.
- You create synergies. These can occur in many ways. For example, perhaps you buy an office nearby and eliminate duplicate overhead. There are also cross-selling synergies in many cases. Or maybe there’s an opportunity to diversify geographically.
To value a small- to medium-sized firm, use projected free cash flow (discounted at a risk-adjusted rate of return). This metric will provide the most accurate valuation, although it can be difficult to calculate.
This is an area where an outside advisor can help. At the end of the day, value is created through M&A when the actual rate of return on invested capital exceeds the required rate of return.
Measuring potential value with accuracy is critical to the entire process. Discounted cash flow is derived from projected free cash flow and the rate of return required to attract capital. Required returns for typical independent advisors are 15% to 25%.
Be wary of using multiples as a valuation method. The best uses for multiples are for quick rule-of-thumb valuations and as a reality check on cash-flow calculations.
3. Build an effective program for sourcing deals. You should have a process for finding, organizing and prioritizing opportunities. If you’re a buyer, for example, you don’t want to find yourself in an auction. You want to be talking to prospective sellers before they actually put their firms up for sale. If you get on their radar screens early, they will tend to reach out to you first.
At its core, think of deal sourcing as an iteration of your client acquisition strategy. Working your community connections and tapping your custodian are excellent ways to build a pipeline of potential buyers or sellers.
4. Know the basics of deal structure. When most advisors think of M&A deals, they think about price. But the broader structure of a deal will have a huge impact on the value you get from the transaction.
It’s not just about what you pay but how you pay it. Buyers can pay in cash, stock or a mix. Cash is simpler and cleaner, of course. Stock requires considerable additional effort and cost to both buyer and seller, but stock can be advantageous in certain situations.
And there almost certainly will be some sort of earn-out period. Earnouts can be very useful in bridging the gap between what the buyer offers and what the seller wants. By performing well after the deal closes (in terms of revenue, pretax profit or other metrics), sellers can get the price they originally desired, and the buyers will be happy to pay, given the good post-close performance.
5. Be prepared for requests and be ready to take action. Get your company set for a successful transaction by having all your financials in order, so potential interested parties can get the information they need quickly. Disorganization can create doubt in buyers’ minds. Develop a three-year financial projection so buyers can easily see where you expect to be heading.
Also, address any skeletons in your closet early. They will be discovered eventually, so the more transparent you are in raising them, the more likely the deal will close.
Finally, keep your eye on running the business well. While the M&A activity is occurring, you still need to provide great client service and generate strong profits.
Don’t wait to start creating an M&A strategy until you need one. Get the ball rolling now — even if you are years away from an exit — by understanding your needs and goals, and by focusing on the transferrable value in your practice. By making small, steady progress now, you will be in the optimal position to maximize your wealth when the time comes to act.
John J. Bowen Jr., a Financial Planning columnist, is founder and CEO of CEG Worldwide, a global training, research and consulting firm for advisors in San Martin, Calif.