Navigating Small Firm M&A: Key Valuation and Deal Insights

Valuation factors, deal structure, and the merger & acquisition process for small firm transactions

It’s unclear when $1 billion became a survival line for our business, but this whispered number is one all small investment managers understand.  The placement of an arbitrary Asset under management (“AUM”) minimum leaves smaller, and often more nimble managers, on the sidelines while behemoths gain more control of distribution channels and rake in an overwhelming percentage of asset flows.  With new distribution channel doors closed and few options for expansion and growth, the investment management industry has been pressed into a consolidation phase.

How managers react to the consolidation phase depends on their own personal situations. Some believe the best way forward for their strategies is to be part of a larger firm with substantially more resources to aid in marketing and sales.  Questions like, “What will I do,” “What happens to my team,” And “How do we get from here to there” are complicated and unique to the needs of buyers and sellers.  I am writing to share what I’ve seen and heard over the past few years to help leaders frame a strategy for the way forward.

In this article, I want to talk about valuation factors, deal structure, and the merger/acquisition process for small firm transactions.  As we watch private equity capital drive valuations of wealth management firms higher, one is left to wonder where investment managers stand. Providing color and perspective might help you navigate the best path forward for you and your firm.

Valuation: AUM, EBITDA and Revenue

A quick review of public markets demonstrates that the valuation multiples for US managers have remained steady for several years.  Let’s start with the three primary valuation multiples tracked in the marketplace. These are multiples of AUM, multiples of EBITDA, and multiples of Revenue.  My perspective is that multiples of AUM are the least helpful.  AUM with a revenue yield of 50 basis points is simply more valuable to a buyer than AUM with a revenue yield of 25 basis points, all else equal.  Revenue multiples provide more color but might mislead owners of under-scaled firms about valuation.  Take the example of two firms with $3 million in revenue: one is losing $300,000/year and the other has $1 million in EBITDA. A revenue multiple will imply the businesses are worth the same, which makes little sense.

So, this brings us to EBITDA multiples, and this is where I believe the focus should be.  You’re effectively selling your company’s ability to generate profits so this is where the buyer will be focused.  We’ve provided a snapshot of average and median multipliers for publicly traded US asset managers dating back to 2018 taken from Bloomberg at the end of each quarter.  There is some noise in these numbers but they generally follow a consistent trend.  First, you’ll note that the averages always out-pace the medians.  This is because the numbers are skewed by a few companies trading at significantly higher multiples because of their growth, market dominance, and product mix.

Unless a seller meets these standards, one can’t expect their valuation to be impacted by others who do.  Gilbert Dychiao, who serves as Co-head of Investment Banking and Head of Financial Institutions Group for Oppenheimer contributes, “Valuation multiples will vary based on the target’s performance and positioning in the broader investment management landscape. Traditional asset managers generally transact in the range of 6-12x EBITDA. All else equal, firms positioned in differentiated, higher-growth product categories or strategies are likely to shake out at the higher end of that range.”  Said another way, if you’re running a rapidly expanding ETF shop and have a dominant position, you’re going to get paid more.  If you’re running a Large Cap value portfolio with high expenses, you’re likely going to find yourself at the bottom of that range.

Managing Director of CTH Advisors, Jack MacDonald, has a slightly different market view.  His focus is on buyers and sellers under $5 Billion in AUM, and he sees the valuation range in his markets a bit lower.  “In terms of valuation multiples, you might see EBITDA multiples in the range of 5-8x, depending heavily on investment style and historical growth, taking into consideration both client retention and profitability.”  Jack points out another important detail,  “A transaction will typically involve an upfront cash payment in the range of 30% to 50%, followed by deferred payments over 1-3 years.  These deferred payments are typically tied to client retention.”  There is always asymmetric information about the customer base, and a buyer’s way of protecting themselves is by paying out over a longer period. Further, if a seller asks the buyer to take all the risk on the assets sticking around, they should expect a significant discount in the offered valuation.

Factors impacting deal structure

The major factors that impact deal structure are “asset purchase” or “stock purchase,” percent of up-front cash, and the term of the earn out.  An asset purchase means that the buyer buys and pays for specific assets and liabilities of the seller, and these will be listed in the purchase agreement.  Typical assets include the management agreements, computers, client files, performance track records and supporting data.  Examples of liabilities may include an office lease, Bloomberg and Factset terminals, and data subscriptions. An acquisition of the company stock is much less common because a buyer can’t know what lurks beneath, and the perceived risk will be great enough that it will impact valuation. Jack McDonald reports that a very small minority of deals are done this way.  Smaller firms simply don’t have the resources for diligence necessary to do take on the risks.  So a seller should expect a buyer to seal off any unknown liabilities through an asset purchase.

Cash paid up front in a transaction varies but should be expected to range from 30% up to 50% for a profitable firm.  If a business is not profitable or has other issues, lower percentages will likely apply.  Keep in mind that more is good, but it isn’t always better for the seller.  A seller that pushes hard for cash up front may be inadvertently communicating uncertainty about the quality of the client base. Similarly, a seller who is willing to take a longer earnout may get paid a higher multiple of EBITDA. Sellers that demand short-term earn outs will likely find themselves lower in the range of potential EBITDA multiples than they otherwise might have received.  Ultimately, the easier you make it for the buyer, the easier it is for them to justify a higher price. Sellers with great margins, performance track records and interesting products will do better on both metrics.

Transaction Process

The process for a transaction can vary widely from company to company. Firms can get introduced any variety of ways, including through a personal network, auditor, lawyer, or through a banker who is familiar with a wide range of industry participants. It’s important to get to know how well a buyer might fit with your plans. An NDA should be put in place early on, and it should have balanced language to protect both parties.  One-sided NDA agreements are a red flag, as they might be the first indication of how a buyer will approach the rest of the relationship.  Once the NDA is in place, you should expect a robust exchange of information about the firms, your culture, and goals and objectives.  In five years, what outcome would you be most happy with?  Financials, capital structure, investment process, distribution and marketing efforts, regulatory history, HR and compensation are examples of information you should be ready to provide. Spend time with the other parties in person.  Zoom is helpful and can eliminate some options, but it is no substitute for spending time together.

A Letter of Intent is the next step.  This document effectively communicates the terms of the deal you have agreed to, and is subject to final diligence. Most of the provisions are non-binding because the buyer will need to conduct more detailed reviews of your firm.  This typically takes place over 30 to 60 days. While these are (mostly) non-binding agreements, the intent is to agree to the terms before the time and expense are invested in final diligence.  At the end of this period, assuming all goes well, the parties will sign a definitive agreement.  The definitive agreement is a much more detailed version of the letter of intent.  Once this is signed, client solicitations begin, and the deal closes when the management assignments are signed.

Final Thoughts

Navigating the merger and acquisition landscape for small firms can be a complex and daunting task. Understanding the key valuation factors, deal structures, and the transaction process is crucial for making informed decisions. By focusing on EBITDA multiples, considering the impact of asset purchases versus stock purchases, and preparing for a thorough transaction process, small investment managers can better position themselves for successful outcomes.  Finally, small differences in valuation won’t matter in the long run, but small differences in culture can be incredibly destructive.  My two cents is to always pick the best culture fit.

As you contemplate the future of your firm, it’s essential to stay informed and prepared. The insights shared by industry experts like Gilbert Dychiao and Jack MacDonald highlight the importance of understanding market dynamics and positioning your firm strategically.