Wealth management M&A: strategies for retention of talent

Farrer & Co’s wealth management M&A practice regularly acts on exits and acquisitions of wealth management and financial advisory businesses, repeatedly encountering similar issues around planning.

The age profile of the financial advisory profession is heavily weighted towards those in the latter stages of their career. FCA data provided to FT Adviser [1] showed that the most common age range for UK financial advisers is 50-59, with many of these planning to retire in the coming decade. This profile closely tracks the growth of the financial advisory sector in the UK since the 1990s.

In this context, our team is seeing buyers and sellers alike grapple with similar issues around incentivising and retaining the next generation of managers, in connection with and in anticipation of M&A transactions.

Rationalising the equity structure

Clearly, wealth management businesses are people businesses at their heart and the incentivisation of employees is a critical component of ongoing success. In our experience, many wealth management businesses have not proactively engaged with considerations around the need to sufficiently incentivise the ‘next generation’ and to include them in the equity structure.

There may be specific reasons for that, but where business owners can engage with these issues ahead of a sale process, so much the better. For a start, positive engagement with the incentivisation of the next generation will help to "lock in" talented individuals, and can potentially make the business being sold a more valuable proposition, as we discuss below. Further, the structural options that are available in terms of equity incentivisation are significantly increased if undertaken before a transaction is in contemplation. And from a tax perspective, thinking about equitisation of your key individuals well before an exit increases the chances of such individuals benefitting from a more favourable tax treatment (under the capital gains tax regime, as opposed to the income tax regime). For example, tax-advantaged incentive schemes and careful structuring of the M&A sales proceeds can drive tax efficiencies for stakeholders. 

Next generation incentivisation as a key buyer concern

Key employee incentivisation will be a focus of any buyer’s diligence and goes directly to value. No well-advised buyer will pay full price to departing business owners if key personnel will need incentivising out of the buyer’s pocket going forward. In our experience, this issue recurs in wealth management M&A, particularly where the equity owners will leave the business in connection with the acquisition. Indeed, it can even be the trigger for the sale itself when it is recognised that a major equity restructuring is required but cannot be achieved with the existing partners’ resources. 

Where this has not been properly addressed prior to completion, incentivisation of key employees is often a focus of negotiation in M&A transactions, with the following mechanics commonly discussed.

Incentivising key employees in connection with an M&A transaction

Earn-out consideration

First, earn-out consideration is used to reduce buy-side risk and to tie the consideration paid to business performance post-completion. 

While earn-outs are typically paid to the sellers rather than key employees (and therefore don’t do anything for key employee incentivisation per se), they are often used to tie equity-selling principals to the business for a transitional period, ahead of their "clean break" becoming effective. This period can serve as a handover period from the departing principals to the next generation of managers, and the structure of the earn-out can be used to encourage the departing principals to facilitate the development of those taking the business forward.

Careful thought should be given to the structure of the earn-out in the context of the buyer’s long-term goals for the business, to ensure that the earn-out is set up to encourage the sellers to assist the buyer’s transitional plans and to ensure that the tax treatment of the earn-out is streamlined.

Retentions from completion proceeds for non-seller incentivisation

As noted above, where buyers consider that the next generation of remaining managers are under-equitised/under-incentivised, there are ways of addressing this mechanically within the transaction structure. 

Clearly, one option is to increase the benefits payable to key employees under their service contracts.  This is often seen as a relatively blunt tool, though, with buyers preferring to link increased key employee remuneration to individual performance/business performance where possible.

Commonly, we see some portion of the money that might have been payable to the sellers as consideration withheld and applied by way of a bonus scheme post-completion. Such bonus schemes typically aim to incentivise the remaining key employees on an ongoing basis post-completion and with reference, say, to successful implementation of a new business plan and growth thereafter. From a tax perspective, such payments will generally be subject to the income tax regime. If buyers do choose to go down this route, careful thought is necessary to ensure that the structuring of such incentivisation is compliant with applicable regulation. Further thought is given to this below.

Long-term incentive plans (LTIPs)/bonus schemes

Even where equity value is not withheld to fund such schemes, buyers will often want to implement new schemes in connection with completion of a transaction, ideally closely tied to the buyer’s vision of success under its new business plan.

A number of UK regulated firms (including the majority of wealth managers and some financial advisory businesses) are subject to one or more “Remuneration Codes”. Depending on the regulatory classification of the relevant firm, these Codes set out rules which govern the payment of remuneration (and in particular, variable remuneration such as retention bonuses) to the staff of the firm and members of its group (if applicable). The Codes can constrain what can be done to incentivise certain key employees.

The Codes provide, for instance, that, in respect of certain senior staff known as "material risk takers", any retention awards should only be paid rarely, only be paid to key staff after a defined event or at a specified point in time and, in certain cases, notified to the FCA. The payment of a retention award may also be made dependent on the individual meeting certain performance criteria that have been defined in advance. Buyers need to be careful therefore to ensure that any post-completion bonus scheme is designed in such a way to meet these detailed regulatory requirements.

Buyers will also likely need to ensure that there are arrangements for "malus and clawback" in place for retention bonuses, meaning that the firm will need to be able to reduce or reclaim such bonus awards in certain circumstances. Retention bonuses (and, by extension, wider incentivisation packages) will need to be designed to ensure that they remain attractive for key employees notwithstanding these regulatory requirements.  

Non-financial incentives

In addition, key employee retention is hugely influenced by cultural fit. Buyers will of course need to consider employee satisfaction in the round. Ensuring proper buy-in by key employees to the business plan and the wider direction of the acquired company will help increase the chances of successful performance in the earn-out period and beyond.

Post-termination restrictions

Finally, in connection with future-proofing the position of key employees post-completion, buyers must think carefully about the appropriateness of existing employment terms, including restrictive covenants.

If there is a wish to further bolster any such restrictions, it may be possible to do this as a quid pro quo for any incentivisation payment being made. Care will, however, need to be taken in the context of any TUPE transfer. This is because under TUPE any variation to a transferring employee’s contractual terms is void if the sole or principal reason for the variation is the transfer (subject to certain limited exceptions). As a result, in a TUPE situation, if any changes to existing restrictive covenants are to be made and are to be valid, they are likely to need to be implemented via settlement agreements with the relevant individuals under which their employment is terminated, and they are then re-engaged under the new terms containing the bolstered restrictions. The settlement agreement can then, at the same time, provide for payment of any relevant incentivisation payment.

Amended service contracts are typically covered as completion deliverables, to put the onus on the selling managers to procure delivery, but thought should also be given as to whether the buyer needs any additional protection in the interim period before signing, to mitigate risks associated with the pre-completion service contracts at a time when the buyer is contractually obliged to purchase the business.

Key takeaways for buyers and sellers in financial services M&A

Employee incentivisation continues to be a key aspect of negotiation between buyers and sellers in financial services M&A. 

Sellers are encouraged to think about this proactively ahead of completion, to increase their structural options in including key employees as sellers to participate in the business upside.

Where buyers feel the need to address retention concerns as part of the transaction process, options can be more limited, and buyers will need to be careful to comply with applicable regulatory restrictions. 

[1] Worry for profession as young adviser numbers plummet -  FT Adviser

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.

© Farrer & Co LLP, July 2024