It seems straightforward enough: One advisory firm wants to merge with — or outright acquire — another. They come to terms on an agreeable valuation, and the post-transaction integration process begins. If only it were so simple.
A potentially massive yet overlooked blocking point for the two firms is aligning their advisory fee schedules and billing processes. If one charges substantially more or less than the other, or uses a different business model (e.g., an AUM firm acquiring a retainer fee firm), the feasibility of integrating their billing processes can be a major blocking point for an otherwise-well-aligned merger or acquisition.
Consequently, doing detailed due diligence on fee schedules before any kind of merger or purchase occurs is crucial. In particular, advisors should be evaluating any differences in the level of fees charged to clients, the timing of those fees, how those fees are calculated and whether the two firms have fundamentally different approaches to billing altogether. Of course, fee schedules do not need to be identical for firms to successfully navigate these waters, but approaching a merger with a clear understanding of the potential risks and opportunities involved is crucial.
In situations where the buyer charges more than the firm being acquired, most firms eventually pass along those new higher fee schedules to the clients of the acquired firm. In fact, when firms have successfully created a compelling value proposition that allows them to charge above-average advisory fees — and justify them — it can even lead to a willingness to pay a premium in the purchase price to acquire.
For instance, imagine a firm that charges 1.1% on the first $1 million of assets, and they’re buying a firm that simply charges a flat 1% AUM fee. Valuation experts measure the value of the firm being acquired based on their revenue. They charge 1%, and consequently their valuation is based on charging 1%. But if an acquirer charges 1.1%, and expects that clients will transition to the higher fee, that acquirer can actually afford to pay a little bit more for the firm because they recognize the potential to recoup the cost down the line in the form of higher fee revenue.
Some firms will keep the original fee schedule in place for a year or two, just to give clients some stability in the transition and ensure they stick around. Fees are adjusted later, once they’ve had an opportunity to build a real relationship with the newly acquired clients, and demonstrate real value to them that justifies the higher fees.
On the other hand, When the acquirer charges less than the firm being acquired, however, it gets messier. Acquirers that charge less than the firm that they buy typically have to bring the acquired firm’s fee schedule down to their own fee schedule. Which means that the buyer purchases a revenue stream based on a certain price, and then immediately has to cut its newly acquired revenue stream!
Fortunately, this sometimes works out fine, because in general, larger advisory firms tend to acquire smaller firms, and if the larger is significantly more efficient than the smaller, they may more than make up the loss of revenue with cost savings.
For example, suppose a firm being acquired is part of a partnership with $120 million under management that generates about $1.5 million in revenue, and has a 20% profit margin — creating $300,000 in profits. Meanwhile, the acquiring firm is able to cut $100,000 or $200,000 in staffing cost by merging the new firm on their existing infrastructure. Even if the acquiring firm has a lower fee schedule, they can afford to give up some revenue and still maintain profits.
Still, the key point here is that fee schedules are overlooked at everyone’s peril.
Ironically, because so many advisors charge approximately the same fee, around 1% on a $1 million client, advisory fee schedules in practice tend to line up pretty well. Still, though, it’s not just about whether both firms charge the same 1% on $1 million. Rather, it’s the advisory fee all the way up and down the line; if the firm doesn’t align for $500k, and $1M, and $5M clients, then a misalignment of fee schedules can create challenges to raise or lower fees on newly acquired clients.
ADVANCE BILLING VS. ARREARS
The second area that advisors need to watch out for is the billing process — for reasons big and small.
The really big issue is whether the firm bills in advance or in arrears. In other words, when a client starts, is their first quarterly billing for the prior partial quarter that they were with you, or is their first billing in advance for the upcoming quarter (which determines whether, if they decide to terminate the next quarter, you refund them a pro rata portion of their fees)?
Some firms prefer to bill in arrears, believing that no client should be billed until the firm has started doing work on their behalf. Others firms prefer to bill in advance, thereby avoiding any accounts receivable or the need to collect from terminating clients as they leave (for the final partial quarter’s unpaid fee), and simply providing a pro-rata refund for a terminating client instead.
On an ongoing basis, most firms don’t even think about this. They simply bill clients quarterly, whether it’s in arrears or in advance. After the first billing, no one really cares about the timing of billing unless they want to terminate — in which case a firm that bills in advance must determine if it will prorate back a portion of the last fee, while a firm that bills in arrears must collect its final partial-quarter fee.
In a merger or an acquisition, however, these little differences can have outsized impact. If a firm bills in arrears and acquires a firm that bills in advance, then the acquiring firm immediately takes on the liability of refunding any clients who terminate in the quarter right after they’ve been billed. Unless these new clients are immediately converted to arrears billing, then the acquiring firm maintains this potential liability in the future. Yet if the acquirer wants to convert the clients, this gets even messier!
Imagine a firm billing in arrears acquires a firm that bills in advance. We’re in negotiations now, the deal closes in October, shortly after fourth quarter billing has happened at the end of September. So the clients of the firm just purchased paid for Q4 in advance, which means if the buyer wants to bill them in arrears, the next billing isn’t going to happen for five months — until the end of Q1, March 31, when the acquirer can bill them in arrears for the first billing as the acquired firm!
Had the acquirer bought the firm in October, they would not see any revenue at the end of the fourth quarter. And if they don’t bill in advance, they cannot bill for Q1 at the end of the year either. Instead, the acquirer has to wait three more months into Q1. The lesson? A firm has to be cognizant of whether there were gaps between advance versus arrears billing practices, or face substantial billing gaps!
Unfortunately, the situation is not much better in the opposite direction. If the acquiring firm bills in advance and the firm being acquired bills in arrears, then the only way the acquiring firm can true-up clients is to double-bill them. Continuing the earlier example, if the acquired firm in purchased in October and bills in arrears while the acquirer bills in advance, then at the end of Q4, on December 31, the acquirer is going to bill Q4 in arrears because the clients haven’t paid for that yet, and then must bill Q1 in advance because that’s what the acquirer does on an ongoing basis. And so new clients will get hit with two bills to get them on track the first time the acquirer does billing with them!
QuoteIt takes skill to convince clients to stick around when the first thing you’re going to do is double-bill them.
Now, it’s worth noting that clients aren’t being cheated, as it’s not a literal double-charge. Rather, they’re paying the Q4 fees because services were rendered in Q4, and they’re being billed in advance for Q1 because that’s what the acquirer does with all clients. If they don’t like this and terminate, the acquirer would still issue a partial refund. But the bottom line is that the acquirer has to be prepared to communicate to clients that to transition them from an arrears into an advance billing cycle, an initial double-billing must occur.
And to say the least, it takes real skill to convince newly acquired clients to stick around when the first thing an acquiring firm is going to do is double-bill them — right when they’re getting to know their new advisor!
Firms also need to align on the calculation of AUM fees. Do you calculate based on end of quarter balance, or the average daily balance throughout the quarter? On average, these balance out, but not always.
If clients are net savers, end of quarter balances tend to be higher than average daily balances because clients keep contributing — such that the end of quarter tends to be the higher of the two.
But if the firm mostly works with retirees, the inverse is typically true - average daily balances tend to be higher than end of quarter balances, because at the end of the quarter, all the withdrawals have occurred.
And of course, there’s also a risk of big gaps caused by sharp market movements in the closing weeks of a quarter — making an end of quarter balance look very different than an average daily balance.
RETAINER VS. AUM
Even thornier challenges crop up when one advisory firm has an AUM-based fee schedule and the other uses a retainer model. Industry research shows that the majority of advisory firms are still AUM-centric. And in fact, the larger the advisory firm, the more affluent their clients, and the more likely they are to charge AUM fees. This means that generally, acquisitive firms are AUM firms.
But when an AUM acquires a retainer firm, there’s usually a plan to convert the retainer clients over to an AUM fee structure. Which can be difficult, because the firms that use retainer fees — particularly for affluent clients — tend to aggressively sell against AUM fees to convince their clients that the retainer model is superior… and in the process, poison the well for most acquirers.
This is one of the major drawbacks to pivoting from AUM to retainer fees that rarely ever comes up in conversation.
It isn’t necessarily an issue for those who are doing retainer fees for younger clients who don’t have assets, because no AUM buyer is going to acquire a practice filled with clients who don’t have assets — or if they do, they’re going to acquire because they want to actually do the retainer model the way the retainer model is being executed, and/or they help clients will grow into the AUM model later. But if a firm works with affluent clients who have assets and simply charges retainer fees, this makes finding prospective buyers a lot more difficult. AUM buyers want to convert but are afraid of the risk, and there aren’t very many non-AUM buyers. The net result: advisors adopting retainer fee models for affluent clients risk drastically reducing the appeal of the firm to the bulk of prospective buyers.
And in fact, even other retainer firms often have trouble acquiring those who do complexity-based retainer fees, because different firms characterize “complexity” differently. Consequently, even two firms doing annual retainer fees for affluent clients might charge very differently for some of those clients, which makes life messy for the acquirer.
QuoteIndirectly, this is actually one reason why the AUM model works so well.
Indirectly, this is actually one reason why the AUM model work so well. By its nature, it is a very systematized billing model. At worst, a firm may have to change a few rates or break points on its AUM fee schedule, but there’s a standard fee structure for all clients. And that’s often not the case with retainer firms.
The key point: making the billing process much harder to reconcile for an acquiring firm may narrow the number of interested buyers or partners, particularly for firms that move away from AUM fees towards the emerging range of non-traditional fee structure, and in the process limit the potential pool of future buyers who may not offer as competitive of a bid. This obviously is unwelcome news for anyone hoping to sell one day.
At a minimum, though, be certain to deeply and deliberately research fee and billing structures so that everyone — whether the acquirer, the seller or the client — emerges feeling like they won.
So what do you think? Are differences in fee schedules a potential problem when looking at mergers and acquisitions? Have you been in a similar situation? How did you manage the transition from one fee schedule to another? Please share your thoughts in the comments below.