FCA and PRA regulated entities in a variety of sectors use consolidation to drive growth, promote innovation or take advantage of cost synergies. Scale and diversification are key drivers in the wealth management sector, and acquisitions can be very helpful in expanding access to specific asset classes, geographical locations, clients, and the expertise of key managers.
In this article, the first in a series, we look at a range of aspects in M&A transactions which can affect value, for buyer or seller, and propose ways of addressing these in the commercial terms. Subsequent articles will look at structuring transactions, the regulatory considerations in M&A, retention and incentivisation of key personnel, and business integration post-completion.
Price is clearly a critical element of the structure of a transaction. There are a number of different bases of valuation, including a multiple of EBITDA, percentage of AUM, discounted cash flow or other suitable metrics. Different methodologies will suit different situations, and there may be good reasons to pay a premium (where the target is of greater strategic importance) or offer a discount (for opportunistic acquisitions or where there are commercial or regulatory risks associated with the business). Specific valuation advice should be sought in each case, as the starting point of any transaction is a detailed review of the financial information of the target.
Price is one thing, but how and when it is paid is another. It is crucial that at the same time as agreeing price, the wider costs and strategic aims of the parties are thought through and factored into the price and the deal structure. For example, post-deal integration and client and asset retention are often cited as key risks in M&A, and if these are considered early the pricing structure can be used to apportion the risk.
Structuring consideration payments in wealth management acquisitions can be complex, especially where value for the buyer is dependent on successful completion of client transfers and ongoing client retention.
A key protection for buyers involves structuring the price using deferred consideration or an earn-out, where the price paid is contingent on certain milestones of the target business following completion. This helps de-risk the overall price (and reduce the up-front consideration) by allowing a proportion of value to be conditional upon certain post-completion metrics being achieved.
Deferred consideration can therefore be based on the AUM / clients which actually transfer to the buyer’s control but also which remain as clients for a particular period following the acquisition. This structure is usually defensive, to ensure retention of existing clients, but can also be accretive, by reference to additional new clients and AUM post-completion. This may reflect the seller’s own business plans and projections, especially if these form part of the buyer’s rationale for making the acquisition. There is a great deal of flexibility in structuring these arrangements, but at their core they are often aimed at providing a financial incentive to ensure that the value of the acquired business remains post-deal, and to mitigate risk and the wider costs of the transaction.
These “earn-out” arrangements can also be attractive to buyers where cash is tight, as the target business can effectively be used to fund future consideration payments. However, earn-outs must be carefully structured in financial services transactions, as common metrics of valuation are often highly exposed to market volatility. By way of example, an earn-out linked to AUM could be heavily distorted by market factors outside of the “core” performance of the business. A seller may feel that they have little ability to influence business performance after the sale and may therefore seek contractual controls following completion.
Focused on realisation of value and a “clean break”, sellers will typically push for a larger guaranteed payment. In order to achieve this, they may be willing to agree to more onerous assistance undertakings, both prior to and following completion, to assure buyers of the likelihood of deal success.
Transactions will often require regulatory consent, and therefore the time from agreeing the heads of terms (and price) to completion can be significant. Given this unavoidable time lag, the pricing structure should reflect this. “Collars” (setting a minimum price for the transaction) and “caps” (setting a maximum price) are used to provide greater certainty to buyers and sellers alike. For example, where the deal is a percentage of AUM, this may well increase or decrease over the period and pose an issue for buyer and seller as the final position will not be known when the deal is struck. The buyer may not want to buy at all if the AUM drops below a certain value, or the deal may not have the same strategic value if the business is smaller (and therefore the buyer may still want to proceed but not on the same price structure). The seller will want to receive the benefit of any additional AUM up until completion, but there may be a critical point, if AUM falls, where the deal ceases to be attractive to them. Caps or collars, in combination with appropriate conditionality, can help mitigate these issues.
Linking value to key assets
Certain transactions will require active client consent in order to transfer to the buyer. Even if this is not required, in many transactions there is a large administrative burden on the buyer, such as onboarding the new clients and moving them onto the buyer’s standard terms. Recognising these practical points, it is possible to link them to price to de-risk the position:
- By adjusting the price on a sliding scale if AUM / revenue is less or more than a specified minimum level of the value agreed at the start. This can be used both to calculate the price at completion but also as a factor of any deferred consideration, so that client retention for, say, 12 months after completion becomes a seller risk.
- By not paying full value for those clients that do not promptly (before or after completion) agree to move over to the buyer’s terms and conditions. This will encourage the seller (who has the main contact with these clients) to help with this process and reduce internal costs and time for the buyer (and therefore risk).
It will often be useful to set out the basis of calculating the price and the other core expectations in the term sheet at the start. This allows the parties to focus on the core areas of value in the subsequent stages of the transaction, and also sets out softer expectations which can be used as the basis for any future re-negotiations if circumstances change.
There may be other deal-specific reasons for reviewing the upfront price, and a buyer will want to keep in mind the overall rationale for the deal. If certain key clients (or types of client) are central to the rationale for the transaction, their failure to transfer could affect the commerciality of the deal, which might be reflected in a price adjustment. Such matters might even become conditions to completion of the deal if they are sufficiently significant to the overall rationale of the buyer.
Proper identification and understanding of any significant liabilities is crucial. A well-run due diligence process should focus on areas of significant risk which could go to value. Where liabilities are identified, the buyer has various structural options to mitigate the liabilities it will take on, including deal structure, price and contractual protections.
Where liabilities are defined and non-contingent, a price adjustment may be appropriate. Alternatively, retentions can be considered for specific liabilities, such that the buyer retains an amount of the completion proceeds as surety for the crystallisation of a defined liability.
Warranties and indemnities serve to apportion risk between buyers and sellers, whether identified at the time of exchange or not. Indemnities will be key in allocating liability for legacy product risks. In this context, the position of the seller following completion is a key consideration for the buyer – to ensure that the buyer has an entity of substance giving the warranties and indemnities, which can stand behind any future claim.
A due diligence exercise concerning a regulated M&A transaction would typically cover (amongst other matters):
- Corporate and constitutional issues;
- Regulatory compliance matters, including any complaints made to or investigations by the FCA and other regulators, a review of the seller business’ standard terms of business with clients, and any pensions advice issues;
- Key commercial contracts, including IT contracts for investment platforms, etc;
- Data protection issues concerning client personal data; and
- Employment and remuneration issues for key staff, including pensions liabilities.
Historic liabilities in a highly regulated sector can be a real issue, whether relating to structured products, DB pensions or otherwise, and the diligence will need to focus on these in particular. Remediation can be costly and management time-intensive, and may bring reputational risk. These issues may ultimately affect price or even whether the deal proceeds, and thought will need to be given to whether it is possible to structure around them.
Warranty and indemnity insurance can be a helpful tool for both buyers and sellers and is increasingly prevalent in financial services transactions. Buyers may have concerns about the substance of the seller post-completion, and it can be reassuring to know that an insurance policy stands behind the seller’s warranties and indemnities. Alternatively, the seller might wish to achieve a clean exit with limited continuing liability – and be willing to pay for, or contribute to, the cost of the W&I policy. A seller may also want to structure this so that the buyer takes out the W&I policy and the seller’s liability is limited to a nominal sum. W&I insurance can be particularly helpful in the regulated sphere where liabilities can quickly become very financially significant.
In this context, W&I insurance merits consideration by both parties and the costs addressed at an early stage. While W&I insurance may not cover all relevant risks, including significant known risks thrown up in due diligence, it can give useful assurance to buyers and help to limit ongoing claims for sellers. Note that taking out a W&I policy is not a substitute for proper due diligence, and indeed the insurer will require that a full due diligence process is carried out.
Pre-completion undertakings should be provided in the purchase agreement to govern the way that the target is run in the interim period and to prevent the management of the target from doing anything outside of the ordinary course of business. It is also worth re-assessing the basis of the calculation of the price.
A material adverse change clause could also be sought by the buyer to ensure that the business acquired on completion is not materially different to the business agreed to be purchased at exchange. However, these provisions are unlikely to be easily accepted by sellers, particularly where the transaction is made public at an early stage. It can be difficult to define what is material in this context, and there are often fairly protracted negotiations around the risk allocation brought about by these clauses.
Pricing structure will be a heavily negotiated element of any deal, and the outcome will likely reflect a commercial compromise. Valuation will need to be considered in the round, taking account of the apportionment of liabilities and the potential effect of any identified or suspected risks on the value of the deal.
In all cases, pricing and the rationale for the transaction should be closely aligned. Judicious use of deferred valuation can help align pricing with the key deal drivers. Caps and collars can be used to give additional certainty to deferred consideration structures.
If you require further information about anything covered in this article, please contact Anthony Turner, Andy Peterkin, Charlie Court, Edward Twigger or your usual contact at the firm on +44 (0)20 3375 7000.
This publication is a general summary of the law as at the date of publication. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, March 2023