By James E
By James E. Abbott, a partner in the Wall Street law firm Carter, Ledyard & Milburn whose practice includes the representation of investment managers and acquirers of investment management firms.
Consolidation in the investment management industry has been under way for many years. It is only more recently that the wave of deal making has reached hedge fund managers and alternative investment firms, with consolidators like Asset Alliance Corporation attracted by the entrepreneurial energy and higher management and incentive fees that characterize this part of the industry. Some buyers are only interested in acquiring the whole firm; others prefer to own only a majority interest, a 50% even split or in some cases a minority investment is possible. Purchasing only part ownership serves the buyer's purpose of keeping management incentivized to work hard for the continuing success of the business. Retaining an ownership interest will suit a manager whose objective is to continue active involvement with the firm, while diversifying the risk of having so much personal wealth tied up in one, illiquid investment. Another benefit of a deal may be the support for the management firm which is available from the buyer and its business contacts. This may include resources to market the firm and accelerate the growth of assets under management; assistance with the development of new products or the launching of new funds; cost reduction opportunities through the sharing of space, equipment, personnel, benefit and insurance arrangements or other overheads; and the availability of better financing terms for the working capital and capital expenditure needs of the business.
The appropriate valuation for a management firm is frequently stated by reference to a multiple of revenues, or EBITDA or assets under management. Valuations can vary widely based on a number of factors which make future results more predictable or indicate a pattern of future growth. Recent deals for hedge fund managers with $200 to $500 million of assets under management have been completed in a range that values the entire firm from three to six times trailing annualized revenues. Some transactions have been done at somewhat higher multiples (up to eight and a half times) where the selling manager has successfully negotiated for a valuation based more on expected future revenue growth than on historical results. The purchase price variation results from factors like the length and volatility of the manager's investment track record, the growth rate of assets under management, the management and incentive fees charged by the manager, the stability and contractual commitments of the manager's clients, and synergies that could be realized by combining or coordinating the manager's business with the buyer's other operations.
Form of consideration
The consideration paid by a buyer can be any combination of cash, common or preferred stock of the buyer or stock purchase options or warrants, promissory notes representing future payment obligations, convertible debt and, in some cases, contractual "earn-out" provisions requiring future payments to be made upon the attainment of targeted future results. An "earn-out" is sometimes used to bridge the gap when agreement cannot be reached on a fair purchase price, but this often leaves a significant risk of future disputes over the contingent payments.
The use of equity securities of the buyer provides incentives for the selling manager to perform in a manner consistent with the buyer's interests, and the use of non-cash consideration allows the buyer to leverage the cash it is using for the acquisition to obtain a better relative return on its investment in the management firm. A selling manager will usually want to receive at least enough cash to pay any tax on the gain realized from the transaction, unless a tax-free deal can be structured. With a proper deal structure, non-cash consideration may permit the selling manger to defer paying tax on the non-cash portion of the payments received, and allows an opportunity for the manager to participate in the buyer's equity appreciation and the greater liquidity and business diversification afforded by investing in the buying parent company.
An important issue where non-cash consideration is included is how to value these securities. If the transaction is not registered for securities law purposes, a discount may be appropriate since liquidity may be limited until stock sales are permitted under Securities Act Rule 144. To address this, registration rights may be negotiated to commit the buyer to register resales of the securities with the SEC.
Another negotiated issue may be a "lock up" request from the buyer to prohibit the selling manager from transfers of all (or an agreed portion) of the manager's buyer stock for some agreed period of time (up to one year usually) to keep the stock out of the market. A "lock up" is particularly appropriate where the selling manager will receive a large enough block of buyer stock that heavy selling by the manager could negatively impact the market trading price for buyer stock.
Post-deal firm management
Often the most difficult part of the discussions concerns management control of the firm after completion of the deal. In most cases, the buyer is only interested in the firm if the investment managers responsible for its past success agree to stay on board after the deal. Thus, there is usually little change in responsibility for investment management decisions. How business management decisions of the firm are made is another matter, with each buyer wanting a greater or lesser role in decisions that will affect its investment in the management firm. The threshold issue is the composition of the Board of Directors, Board of Managers or other supervisory authority. But the real details are found in a stockholders agreement, operating agreement or other document that spells out specifically which decisions can be made by management, which decisions require Board approval (or in some cases a super-majority of the Board), and which decisions must be approved by stockholders or by the buyer alone. These allocations of responsibility vary widely based on the relative interests of the parties; with day-to-day ordinary course of business decisions (like the hiring and firing of employees) frequently left to management; the Board having control of more fundamental or expensive decisions (like launching new products, making large capital expenditures, or approving an annual budget for the firm proposed by management); and stockholder or buyer approval being required for extraordinary transactions like a sale of the business. Pages and pages of contractual details on firm management procedures and responsibilities are the norm to document this critical "pre-nuptial" understanding of the parties.
Employment and incentives
Key employees of the management firm (whether or not they are the selling owners of the firm) will usually be required to sign employment agreements and non-competition agreements to protect the buyer's investment in what is primarily a people business. Heavily negotiated points include (i) the length and scope of non-competition covenants (including specific restrictions on solicitation of the firm's clients and employees), (ii) the length of any employment agreements (anywhere from one to five years), and (iii) the definition of "cause" for which employment can be terminated. The length of non-competition covenants may be three to five years after completion of the deal and, if longer, as much as a year or two after the manager's employment terminates. Restrictions on soliciting or advising firm clients after departing from the firm are sometimes documented in great detail, including specific lists of clients that are either off limits or that are recognized as being the manager's personal contacts and therefore outside the scope of the restrictions. These provisions will seem terribly burdensome to the manager, but are important to the buyer to protect its investment. A manager can take some comfort from the knowledge that these restrictions are not always strictly enforced by buyers and their legal enforceability may be subject to challenge if the length or scope of the restrictions is excessive. Nevertheless, negotiation of these career restrictions is rarely easy unless the selling manager is planning to retire.
Buyers will usually also need to install appropriate management incentive programs, which may range from bonuses (either discretionary or based on attainment of targeted results) to stock options or other equity participation schemes.
Representations, indemnification and consent requirements
Like other corporate investment transactions, a buyer will seek representations from the selling manager concerning the financial statements of the firm and the completeness of disclosures concerning its business. If the representations are not accurate, the selling manager will be expected to indemnify the buyer for the losses it incurs as a result of the misleading information supplied. As a business matter, the buyer may be constrained to forego making indemnification claims against the selling manager (unless losses are very substantial) for fear of ruining relations with an important executive responsible for the ongoing success of the acquired firm, but this usually doesn't make it any easier to reach agreement on the heavily negotiated liability risk allocations covered by representations and indemnification provisions.
One precondition to completing most hedge fund acquisition transactions will be the receipt of consents to the transaction from important clients and other third parties to the extent required by the management firm's contracts. If the firm is a registered investment advisor, applicable provisions of the federal Investment Advisors Act or corresponding state regulations will require customer consent to continuation of investment advisory contracts after any change in ownership control of the management firm.
The sale of a hedge fund management firm has all of the issues that arise in an average M&A transaction, along with the more delicate issues that result from the fact that terms for an ongoing business relationship are usually being negotiated at the same time as the buy/sell deal terms. The "marriage" portion of the transaction requires that negotiations be conducted without an unduly adversarial tone, and it may be wise for compromises of contentious issues to be more quickly proposed in order to keep discussions from breaking down or relationships from being damaged. Selling managers may become frustrated with the time required to negotiate details, complete documentation and obtain necessary third party consents. To protect the selling manager's interests in the broad range of areas that are touched on in this article, experienced legal and tax advisors should be consulted to facilitate the transaction. Selling managers must trust and work with their advisors and, more importantly, must pick a buyer with whom a relationship of trust and longer-term partnership can be forged to live beyond the bargaining process. u