How Fee De­tails Can Make or Break a Takeover

If an ac­quir­ing ad­vi­sory firm doesn’t ad­e­quately con­sider the nuts and bolts of a seller’s fee struc­ture and billing pro­cesses, headaches are guar­an­teed.

Financial Planning - - CONTENT - By Michael Kitces

If an ac­quir­ing ad­vi­sory firm doesn’t ad­e­quately con­sider the nuts and bolts of a seller’s fee struc­ture and billing pro­cesses, headaches are guar­an­teed.

It seems straight­for­ward enough: One ad­vi­sory firm wants to merge with an­other — or ac­quire it out­right. They agree on a 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 (as when an AUM firm ac­quires a re­tainer-fee firm), the fea­si­bil­ity of in­te­grat­ing their billing pro­cesses can be a ma­jor block­ing point for a merger or ac­qui­si­tion.

DUE DILI­GENCE

Con­se­quently, it is cru­cial to do de­tailed due dili­gence on fee sched­ules be­fore a merger or pur­chase oc­curs. In par­tic­u­lar, ad­vi­sors should be eval­u­at­ing any dif­fer­ences in the level of fees charged to clients, the tim­ing of those fees and the meth­ods for cal­cu­lat­ing fees.

Of course, fee sched­ules do not need to be iden­ti­cal for firms to suc­cess­fully nav­i­gate these wa­ters, but ap­proach­ing a merger with a clear-eyed un­der­stand­ing of the po­ten­tial risks is cru­cial.

In sit­u­a­tions where the buyer charges higher fees 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 aboveav­er­age ad­vi­sory fees — and jus­tify them — it can even lead to a will­ing­ness to pay a premium in the pur­chase price.

AD­JUST­ING FEES

For in­stance, imag­ine a firm that charges 1.1% on the first $1 mil­lion of as­sets and is seek­ing to buy a firm that charges a flat 1% AUM fee.

Val­u­a­tion ex­perts mea­sure the value of the firm be­ing ac­quired based on its rev­enue. If the tar­get firm charges 1%, the val­u­a­tion is based on that fee. But if an ac­quirer charges 1.1% and ex­pects ac­quired clients to tran­si­tion to the higher fee, it can af­ford to pay a lit­tle bit more for the firm be­cause of the po­ten­tial to re­coup the cost down the line in 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 once the new own­ers have an op­por­tu­nity to build a real re­la­tion­ship with the newly ac­quired clients and demon­strate real value to them that jus­ti­fies the

higher fees.

But when the ac­quirer charges lower fees than the firm be­ing ac­quired, it gets messier. In such a sit­u­a­tion, ac­quir­ers have to bring the ac­quired firm’s fee sched­ule down to their own fee sched­ule. This means that the buyer will be cut­ting 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, it 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 into the ex­ist­ing in­fra­struc­ture. Even if the ac­quir­ing firm has a lower fee sched­ule, it 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, it’s not just about whether both firms charge the same 1% on $1 mil­lion. Rather, it’s the struc­ture of the ad­vi­sory fees all the way up and down the line; if the firm doesn’t align for $500,000, $1 mil­lion and $5 mil­lion 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.

The re­ally big is­sue here is whether the firm bills in ad­vance or in ar­rears. In other words, when a client starts, is the 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, 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

When an ac­quirer faces a de­crease in rev­enue be­cause of lower fees, it some­times can off­set part of the de­cline through cost sav­ings from in­creased ef­fi­ciency.

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 that a firm billing in ar­rears ac­quires a firm that bills in ad­vance. We’re in ne­go­ti­a­tions now, the deal closes in Oc­to­ber, and shortly af­ter Q4 billing has hap­pened at the end of Septem­ber. So the clients of the firm just pur­chased have al­ready paid for Q4. This means that if the buyer wants to bill them in ar­rears, the next billing isn’t go­ing to hap­pen for five months — at the end of Q1.

If the ac­quirer bought the firm in Oc­to­ber, it would not see any rev­enue at the end of the fourth quar­ter. And if it doesn’t bill in ad­vance, it can­not bill for Q1 at the end of the year ei­ther. In­stead, the ac­quirer has to wait three more months into Q1.

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

It takes skill to per­suade clients to stick around when you’re im­me­di­ately go­ing to dou­ble-bill them.

the ac­quir­ing firm can true up clients is to dou­ble-bill them. Con­tin­u­ing the ear­lier ex­am­ple, if the ac­quired firm is pur­chased in Oc­to­ber and bills in ar­rears while the ac­quirer bills in ad­vance, then at the end of Q4, on Dec. 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 be hit with two bills to get them on track the first time the ac­quirer does billing.

Now, it is worth not­ing that clients are not be­ing cheated, as it is not a lit­eral dou­blecharge. Rather, they are pay­ing the fourthquar­ter fees be­cause ser­vices were ren­dered in the fourth quar­ter, and they are be­ing billed in ad­vance for the first quar­ter be­cause that is 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. At the least, it takes real skill to per­suade newly ac­quired clients to stay 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. This 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. In the process, they poi­son the well for most ac­quir­ers.

This is one of the ma­jor draw­backs to piv­ot­ing from AUM to re­tainer fees.

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, or they help clients grow into the AUM model later.

THE RISK

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 for af­flu­ent clients risk dras­ti­cally re­duc­ing the ap­peal of the firm for most prospec­tive buy­ers.

In fact, even other re­tainer firms of­ten have trou­ble ac­quir­ing those that 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.

In­di­rectly, this is ac­tu­ally one rea­son 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, par­tic­u­larly for firms that move away from AUM fees to­ward the emerg­ing range of non­tra­di­tional fee struc­ture. This is ob­vi­ously 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 that they won.

Thorny chal­lenges crop up when one ad­vi­sory firm has an Aum-based fee sched­ule and the other uses a re­tainer model.

Newspapers in English

Newspapers from USA

© PressReader. All rights reserved.