5 things to know before playing the M&A game

For those who are ever involved in a merger or acquisition, it will probably be the single most important financial transaction of their lives.

For buyers, it can accelerate their growth far beyond what would otherwise be possible. For sellers, it can turn their hard-earned equity into cash to finance the next stage of their lives.

So advisers should ask themselves how prepared they are for a truly life-altering moment for themselves and their families. The answer, unfortunately, is that most advisers probably aren’t well-positioned for merger and acquisition success.

Most research shows that M&A activity has an overall success rate of 50%. That is a coin flip.

Those who do M&A poorly can destroy value in their businesses.

To put the odds in their favor, advisers need to make informed decisions that will maximize rewards while reducing risks.

M&A LANDSCAPE

The registered investment adviser industry is a hotbed for M&A these days.

Last year, there were at least 10 deals involving firms with almost $4 billion or more in assets under management, versus just one in 2014, according to Park Sutton Advisors.

It is little wonder. With 60 being the average age of advisers with more than $50 million in AUM, the opportunity to acquire has never been better.

And with organic growth rates for many advisers slowing and operating costs rising, M&A starts to look appealing. That is especially true for those who are already wealth managers or are looking to enter that area.

The benefits of M&A include the possibility of adding three to five years’ worth of revenue in one transaction; adding key managers and partners or those people needed to maximize value; expanding geographically; eliminating duplicative costs; and achieving critical mass faster.

KNOW HOW IT GOES

To get those benefits, it is important to understand the M&A process. Yes, advisers will probably want to get help, but too often, they hand off control of the deal entirely to a lawyer, investment banker or both.

Although professional advice is invaluable, advisers should remain in the driver’s seat. The way to do that is by having a big-picture view of the entire process.

Here are insights into five key issues about the world of M&A.

1. Get clear about goals. Start with a strategy. Advisers need a vision about what they are looking for in terms of types of clients, the size of the deal, the location and so on or their efforts will be inefficient.

Successfully developing a strategy requires separating personal objectives from business ones. If they are in conflict, business objectives should be prioritized over personal ones.

As for personal goals, advisers should determine what they really want. Explore personal needs for wealth, meaning and achievement and then consider how the business strategy may or may not deliver on these needs.

There are a number of roles available to owners such as board member, chief executive, rainmaker and shareholder.

2. Understand what drives value. For buyers, there are two ways to create value through M&A.

The first is to buy something for less than it is worth. Given the competitive market environment, that is unlikely to happen.

Second, synergies can be created, and these can occur in many ways. For example, perhaps an adviser buys an office nearby and eliminates duplicate overhead.

There are also cross-selling synergies in many cases. Or maybe there is an opportunity to diversify geographically.

To value a small- to medium-size firm, use projected free cash flow, discounted at a risk-adjusted rate of return. This metric will provide the most accurate valuation, though it can be difficult to calculate.

This is an area where an outside adviser can help. At the end of the day, value is created through M&A when the actual rate of return on invested capital exceeds the required rate of return.

Measuring potential value with accuracy is critical to the entire process. Discounted cash flow is derived from projected free cash flow and the rate of return required to attract capital.

Required returns for typical independent advisers are 15% to 25%.

Be wary of using multiples as a valuation method. The best uses for multiples are for quick rule-of-thumb valuations and as a reality check on cash-flow calculations.

3. Build an effective program for sourcing deals. Have a process for finding, organizing and prioritizing opportunities.

Buyers, for example, don’t want to find themselves in an auction. They want to be talking to prospective sellers before they actually put their firms up for sale.

Advisers who get on their radar screens early will find that they tend to reach out to them first.

At its core, think of deal sourcing as an iteration of the client acquisition strategy. Working community connections and tapping the custodian are excellent ways to build a pipeline of potential buyers or sellers.

4. Know the basics of deal structure. When most advisers think of M&A deals, they think about price. But the broader structure of a deal will have a huge impact on the value received from the transaction.

It isn’t just about what advisers pay but how they pay it. Buyers can pay in cash, stock or a mix.

Cash is simpler and cleaner, of course. Stock requires considerable additional effort and cost to both buyer and seller, but stock can be advantageous in certain situations.

And there almost certainly will be some sort of earn-out period. Earn-outs can be very useful in bridging the gap between what the buyer offers and what the seller wants.

By performing well after the deal closes in terms of revenue, pretax profit or other metrics, sellers can get the price they originally desired, and the buyers will be happy to pay, given the good post-close performance.

5. Be prepared for requests and be ready to take action. Get the company set for a successful transaction by having all the financials in order, so that potential interested parties can get the information they need quickly. Disorganization can create doubt in buyers’ minds.

Develop a three-year financial projection so that buyers can easily see where the firm is expected to go.

Also, address any skeletons in the closet early. They will be discovered eventually, so the more transparent the adviser is in raising them, the more likely the deal will close.

Finally, keep an eye on running the business well. While the M&A activity is occurring, the firm still needs to provide great client service and generate strong profits.

Don’t wait to start creating an M&A strategy until one is needed. Advisers should get the ball rolling now -- even if they are years away from an exit -- by understanding needs and goals and by focusing on the transferrable value in the practice.

By making small, steady progress now, advisers will be in the optimal position to maximize their wealth when the time comes to act.

This story is part of a 30-30 series on transitions. It was originally published on April 19.