What Exactly Is M&A?
The term "mergers and acquisitions" (M&A) broadly refers to the process of one company combining with another; however, the method and legality of how these terms are processed are slightly different.
Mergers occur when two organizations join together, and both parties remain active and involved on an ongoing basis. This can be done by subsequently forming a new legal entity under a single corporate name, or more simply by an existing advisor joining forces with a peer and contributing his or her book of business in exchange for a proportional share of value in the receiving party's business. In many cases, mergers occur between two entities of approximately the same size. This allows the two organizations to combine forces and market share instead of directly competing against each other. For instance, in 2015 H.J. Heinz Company and Kraft Foods merged together to establish themselves as one of the largest food and drink companies in the world. After merging, their new business entity was named The Kraft Heinz Company. While this is obviously a much larger transaction, it is indicative of why many advisors consider merging.
Acquisitions, on the other hand, are when one company purchases another entity outright and establishes itself as the new owner. This can come in the form of buying another advisor's book of business (an asset purchase) or alternatively, buying the exiting advisor's equity in their business. Legally, the target advisor that was acquired no longer exists, but its brand (name, website, logo, phone number, etc.) may still remain post-sale to ensure the retention of clients. An example of this is when Morgan Stanley MS acquired E*TRADE Financial this year in an all-stock deal worth $13 billion. This effectively solidified Morgan Stanley amongst the leaders in the wealth management industry and gave them more technology assets, customers, and recurring revenue streams.
There are a multitude of transaction structures for mergers and acquisitions. A merger may provide each advisor with partial ownership and control of the newly merged organization. Compare that with an acquisition, which results in the selling advisor being retained for a period, but usually as an employee or contractor of the acquiring firm. The lines between merger and acquisition terminology are often blurred in public-facing communications because the goal is to ensure there is a seamless transition from the client's perspective.
Who Deals With Mergers and Acquisitions?
The responsibility of who manages the merger and acquisition process may vary depending on the size of the companies involved and their experience with such activities. But, it is a good idea to ensure you have a neutral intermediary, or buy and sell-side representation to usher the deal towards close and ensure all the moving pieces are being managed and discussed. It is also common to have the assistance of external counsel, such as lawyers and accountants, to conduct a final review of the transaction and documents. It is important to ensure that as the owner buying, selling, or merging, that you actively manage your external professional counsel and set clear expectations. This is critical to ensure you don't spend weeks working with an intermediary and craft a well thought out strategy, only to have your counsel review and begin renegotiating on your behalf, resulting in you losing a deal. Attorneys and CPAs are tremendous resources, but it is most effective to ensure you have a knowledgeable industry expert who works with mergers and acquisitions daily to help the parties make fully informed decisions and avoid reinventing the wheel.
Why Do Advisors Merge and Buy/Sell?
The reasons for companies pursuing mergers or acquisitions will vary, but most are motivated by improving long-term prospects and potential for their business. Factors to consider when pursuing a merger or acquisition may include the ability to create a competitive advantage, diversify the customer base, expand service offerings, reduce operating costs, expand to new geographies, increase capabilities and assets, and more. In many cases, the reason to move forward with a deal would be a combination of several factors. Here are some of the most common motivations for moving forward with a merger or acquisition:
- Growth: Mergers and acquisitions can be a shortcut of sorts, allowing a business to expand its operations effectively overnight. Whether looking to merge or acquire strategically (expanding new service offerings for example through a merger or purchase) or economically (merging or acquiring a firm that will add more of the same type of revenue), mergers and acquisitions can quickly increase market share.
- Eliminate Competition: By merging with or acquiring a target company that is a competitor in an industry, a business can effectively increase their market share and potential customer base.
- Synergies: Mergers or acquisitions of a complementary business allows companies to combine their strengths, business activities, and differentiators to bolster their offerings and potentially lower costs.
How Long Does an Acquisition Take?
The acquisition process is detailed and complex; it requires many steps along the way. While each deal is different, acquisitions can often take anywhere from a few weeks (in a best-case scenario) to several months to complete. Much of the timing relies on how well both parties are aligned and how efficiently they are able to work together to move the process along. There are several factors that can impact the timeline of any given acquisition:
- Decisiveness: The decision-making process can take time. Each owner involved in the transaction wants to have full confidence that this is the best move to make, that the deal is fairly priced, and that there are no better options available. If there is hesitation on either side of the deal, more time and research will likely be needed to help it progress.
- Complexity: The transaction timeline can be impacted depending on if the target company is generally similar or different to the acquiring company, and also the level of complexity in the business structure of the company being acquired.
- Management: Willingness for management teams to cooperate can impact the timeline. For instance, if managers in the acquired company are not willing to work for the purchasing company or if they are unwilling to change the way they work, the purchasing company would have to find a solution to make the transition as seamless as possible.
- Due Diligence Phase: If the seller is slow in retrieving and providing information during this phase, it can extend the transaction timeline.
What Is an M&A Strategy?
A mergers and acquisitions strategy allows a business to set a group of parameters to consider to help determine the appeal or viability of any potential deal. A company's key business-drivers should be fully understood in order for them to be able to focus on deals that align accordingly. Before pursuing an M&A deal, it is important for a business to understand what they are looking for and how it will help them reach their ultimate goals. For instance, a strategy may be centered around finding a target company that addresses a perceived area of need, such as increasing market share, improving weak points within their company, or improving efficiencies and lowering operating costs.
A solid strategy comes with a deep understanding of the industry, its competitors, and the market share within the industry. Having a pulse on the market landscape through the lens of anticipated opportunities, trends, and customer feedback can play an important role in any M&A strategy. A complete strategy should also take into account the integration process (including restructuring plans) - how will clients be onboarded and serviced to ensure a high retention rate. The typical M&A process combines both qualitative and quantitative elements, including a review of the compatibility of the firms/owners, understanding the value of the practice(s), a pro forma cash flow analysis, evaluation of the deal structure and tax strategies, financing considerations, and finally — the contracts.
What Is a Pro Forma and Why Is it Needed?
Prior to an acquisition or merger, a pro forma cash flow model (or financial model) will be used to analyze the combination of the two organizations in the proposed deal and help recast what the combined business will look like. This comprehensive analysis of each business' financial health and how they may work in conjunction is a great resource to aid in the decision-making process. A financial model can map out a variety of tested M&A scenarios to predict success and outcomes, and ensure each party understands all of its options. This information can help inform whether or not to proceed with a merger or acquisition, or if it is necessary to get more creative. Most financial models will include financial statements, a forecast projection, estimation of the tax liability for each party, and additional analysis to help evaluate the most meaningful data for the potential merger or acquisition.
Financial modeling is not a foolproof science, however. Many assumptions and estimations about future performance must be made here, which can greatly influence the potential valuation of a company and the viability of a deal. Here are the primary steps for building out a cash flow model, which will be more involved in a merger than an acquisition:
- Baseline Inputs: To help determine a viable range for the value/purchase price, creating an operating forecast for the combined business is necessary. This will take some assumptions to build-out, including the value, projected revenue and expenses, possible synergies, debt service (if applicable), compensation for the future partners (in a merger) or compensation for the retiring owner (in an acquisition), tax considerations, and more.
- Projections: Using the available financial data for each business a financial projection for the combined business will be generated. This model then serves as a tool to run “best-case” and “worst-case” scenarios to ensure the viability of the combined businesses.
What Is Involved in M&A Due Diligence?
Before any deal closes, the buyer and seller must go through a process called "due diligence" to confirm each party's relevant information. This is likely to include the seller's financials, contracts, clients, client service model, investment choices, liabilities, compliance, technology stack, and anything else that is pertinent to the deal and its valuation. This verification process should ensure that buyer and seller are fully informed on all of the necessary aspects of each other's organization and help the buyer confirm that they are making an educated decision if they are to move forward with the transaction.
It is up to the seller to provide due diligence information to the buyer, so a motivated seller should begin putting together these resources as soon as they decide to begin marketing their business for sale. The amount of time this will take is largely dependent on the complexity of the seller's business, the availability to have a dedicated resource on the task, and how motivated they are to compile this information in short order. Depending on the size of the business, due diligence can take as little as a week but sometimes may stretch over a period of two to three months.
Informal due diligence will be conducted by all parties up to the point of closing, but the official due diligence process should begin once a letter of intent is signed by both parties. In an ideal world, the due diligence information would already be prepared at this point and be ready to hand off to the buyers for review. Realistically, sellers may have yet to begin compiling this information and be unprepared at this moment; however, this is an integral part of the M&A process — a deal should not move forward until due diligence information has been provided and thoroughly reviewed. If a deal were to proceed without due diligence, the buyer would be taking on a significant amount of unnecessary risk.
Elements of M&A Support
While most deals are internally managed by the owner(s), there are a number of other resources needed to support the parties during the M&A process. This may include specialized consultants, industry experts, lawyers, accountants, banks, investment banks, and private equity firms. While not all of these roles will be needed for every M&A transaction, it is likely that assistance from outside of the buyer and seller organizations will be necessary to facilitate a seamless and well-informed transaction. Third-party support can also help transactions stay objective and void of personal bias, helping to maintain a foundation of trust between both the buyer and seller entities.
Specialists and support teams can provide help at nearly every stage of the M&A process, and are highly common during the valuation, business modeling, due diligence, and post-merger integration phases. M&A support can ensure that a transaction is receiving the appropriate attention to detail and is backed by accurate data. By having as much information at hand as possible, potential issues or red flags can be identified (and hopefully remedied) prior to finalizing any M&A transaction.
How Are Valuations Determined?
A valuation (or how much a company is worth) is an important starting point for M&A negotiations for buyers and sellers alike. It is important to note that valuations can fluctuate or be impacted by market conditions as demands shift in response to any number of factors. But how is this valuation determined? There is not a single standard approach for all businesses, but rather a customized assessment based on the nature of the organization being analyzed. For instance, a smaller advisory firm with less than $2 million in revenue would need a different valuation process than a larger advisory firm with $10m+ in revenue.
Still, there are a number of valuation methodologies that are common and will likely be considered within a company's financial assessment, including income-based valuation methods for larger firms, and market-based valuation methods for smaller firms with readily available data.
- EBITDA or EBOC Multiples: Also known as "Earnings Before Interest, Tax, Depreciation, and Amortization" — or "Earnings Before Owner's Compensation" — EBITDA or EBOC applies a multiple to a company's bottom-line. This formula determines how much profit a company makes with its current assets and operations and provides an indication of cash flow and expected value.
- Discounted Cash Flow (DCF): A DCF valuation method is used to estimate the value of a company based on projections of how much money it will generate in the future. This approach may highlight the potential for positive returns if the DCF is above the current cost of the investment; however, since this method relies on estimates, it can come with more risk.
- Revenue Multiple: The revenue multiple (or times-revenue) method is perhaps the simplest form of valuation. This method uses a multiple of current revenues to determine the maximum value of a particular business. For advisory businesses specifically, it is most common to use two revenue multiples, one for recurring revenue and the other for commission revenue since they are valued differently by buyers.
Given that every business and industry is different, it is highly likely that a company's value may be assessed with the use of more than one method. By crafting informed valuations based on a variety of different factors and scenarios, they should be able to arrive at a reasonable valuation estimate off of the varied figures available to work with. For most M&A transactions, it is necessary to work with an unbiased industry expert to determine the value of any given company. When hiring a valuation expert, look for a firm that has the following criteria at a minimum:
- Unbiased and Free of Conflicts: Ensure the firm you are hiring to conduct the valuation does not have any disclosed or undisclosed conflicts, and that you know the firm you are hiring. Many savvy buyers or larger institutions that recruit advisors will masquerade as a valuation resource, but lack objectivity. It is also common that a broker-dealer, TAMP, or other coaching organization may offer an opinion of value as a “value add” - but in reality, these extra services have the potential to create unreasonable expectations and sometimes disastrous results.
- Appropriate Credentials: Look for a firm that has the generally accepted valuation credentials, such as the CVA or ABV, but also ensure your valuation team has a CPA as well. The CVA and ABV designations are relatively simple designations to obtain and enforcement of their standards are virtually non-existent. The CPA designation has significantly more training and higher standards that must be upheld to protect buyer and seller.
- Industry Knowledge: Find a valuation team that has experience and knowledge of the financial services industry. Some firms will have limited industry knowledge of one broker-dealer for example, but lack context for the industry as a whole.
It is also important to note that a valuation is a starting place for negotiating the deal, and it is common to see buyer and seller deviate from the valuation as the terms, tax strategy, and other factors are negotiated. However, if leveraging bank financing, most lenders will only lend up to the appraised value.
What Are the Current M&A Trends?
Given the economic impact of COVID-19 across the world, many M&A trends have taken a dramatic shift in 2020. Small business and local economies have been affected greatly, whole industries have come to a halt, and global financial markets have been in turmoil. While M&A activity slowed significantly during March through June, it is fully expected to pick back up once the virus dissipates and things begin to normalize again. Through Q3 of 2020, deal volume, values paid, and financing terms have all returned to pre-COVID conditions.
For businesses that have thrived over the past decade of economic prosperity, they may find themselves emerging from this global pandemic in an advantageous position. If a company does not have a defined M&A strategy, now may be a good time to develop one. Companies should know what targets or types of businesses will fit within their strategic agenda. It is entirely possible that opportunities that would be highly unlikely in standard conditions could present themselves, so it is important to be prepared.
This is a ripe time for many advisors to be thinking forward about how they can execute their acquisitions and mergers strategy. If the right moves are made, some businesses will be able to substantially accelerate their growth while so many other buyers remain on the "sidelines."
Mergers and acquisitions are complex business transactions that have the potential to realign the trajectory and potential growth for the parties involved. They can provide an opportunity for businesses to combine their resources and strengths to achieve far greater business outcomes in much less time, to increase efficiencies, or to reduce competition. Still, there can be high levels of uncertainty on the anticipated synergies between two companies, or even the accurate and fair valuation of companies within any given deal.
Getting mergers and acquisitions across the finish line is no easy task. They require high levels of collaboration, financial expertise, negotiation, and business acumen. Some companies are substantial enough to have their own corporate development teams to handle these important tasks. For those that do not (or those that need additional assistance), there are many firms that specialize in the execution of mergers and acquisition deals for advisors. They can help both target companies and the acquiring company with the full mergers and acquisitions life-cycle, providing a turnkey solution.