Transaction Advisory

Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. The industry’s demographics suggest that increased attention to succession planning is well warranted: a majority of RIAs are still led by their founders, and only about a quarter of them have non-founding shareholders. While there is growing recognition of the importance of succession planning, it often lags far behind other strategic initiatives with more immediate benefits like new client and staff growth1. In the long run, however, firms with a well-developed succession plan have a distinct competitive advantage over those without. Fortunately, many viable options exist for RIA principals looking to solve succession planning issues. In this post, we review several of the more common options.Internal transition to the next generation of firm leadership. Internal transitions of ownership are the most common type of transaction for investment management firms and for good reason. Many RIA owners prefer working for themselves, and their clients prefer working with an independent advisor.Internal transitions allow RIAs to maintain independence over the long term and provide clients with a sense of continuity and comfort that their advisor’s interests are economically aligned. A gradual transition of responsibilities and ownership to the next generation is usually one of the best ways to align your employees’ interests and grow the firm to everyone’s benefit. While this option typically requires the most preparation and patience, it allows the founding shareholders to handpick their successors and future leadership.Debt financing. Debt financing has become a readily available option for RIAs in recent years as the number of specialty lenders focusing on the sector has increased. External debt financing is often used to finance internal transactions as an alternative to seller financing. Such arrangements avoid introducing a new outside equity partner and can work well when the scope of succession issues to solve is limited to financing the transaction.There are potential drawbacks, however. For example, debt financing for RIAs typically requires a personal guarantee, which many borrowers oppose. Borrowers are also more exposed to their own business by levering up to purchase an equity stake.Sale to a consolidator or roll-up firm. RIA consolidators have emerged, promising a means for ownership transition, back-office efficiencies, and best practices coaching. The consolidator model has been gaining traction in the industry in recent years. Most well-known RIA consolidators have grown their AUM at double-digit growth rates over the last five years, and acquisitions by consolidators represent an increasing portion of overall deal volume in the sector.For RIA principals looking for an exit plan, a sale to a consolidator typically provides the selling partners with substantial liquidity at closing, an ongoing interest in the firm’s economics, and a mechanism to transfer the sellers’ continued interest to the next generation of management. There’s a wide spectrum of consolidator models, and they can vary significantly in terms of their effect on the day-to-day operations of the acquired RIA. RIA owners considering selling to a consolidator should think carefully about which aspects of their business they feel strongly about and how those aspects of the business will change after the deal closes.Sale to a private equity firm. Drawn to the industry’s typically high margins, low capital expenditure needs, and recurring revenue model, private equity managers have sharpened their focus on investment management firms in recent years. Private equity can be used to buy out a retiring partner, but it is not typically a permanent solution. While PE firms provide upfront cash, remaining principals must sacrifice most of their control and potentially some of their ownership at closing.Minority financial investment. Minority financial investments can provide existing ownership with liquidity while allowing remaining shareholders to maintain control and an ongoing interest in the firm’s Minority investors typically do not intrude on the firm’s operations as much as other equity options, but they will seek deal terms that adequately protect their interest in future cash flows.Sale to a strategic buyer. A strategic buyer is likely another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal. On paper, this scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees, clients, or the company’s identity.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides valuation, transaction, litigation, and consulting services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.1 See https://content.schwab.com/web/retail/public/about-schwab/2024-Charles-Schwab-RIA-Benchmarking-Study.pdf

Strong performance of U.S. equity markets in 2024 combined with narrowing credit spreads in the high yield bond, leverage loan and private credit markets are powerful stimulants for M&A activity. According to the Boston Consulting Group, U.S. M&A activity based upon deal values rose 21% though September 30 compared to the same period in 2023 after Fed rate hikes during 2022 and 1H23 weighed on deal activity.Deal activity measured by the number of announced deals is less compelling as deal activity has been dominated by a number of large transactions in the energy, technology and consumer sectors.While large company M&A may continue, the broadening rally in the equity markets (Russell 2000 +13% YTD through October 16; S&P 400 Midcap Index +14%) suggests that deal activity by “strategic” buyers may increase. If so, deals where publicly-traded acquirers issue shares to the target will increase, too, because M&A activity and multiples have a propensity to increase as the buyers’ shares trend higher.It is important for sellers to keep in mind that negotiations with acquirers where the consideration will consist of the buyer’s common shares are about the exchange ratio rather than price, which is the product of the exchange ratio and buyer’s share price.When sellers are solely focused on price, it is easier all else equal for strategic acquirers to ink a deal when their shares trade at a high multiple. However, high multiple stocks represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be obvious even when the buyer’s shares are actively traded.Our experience is that some if not most members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.”A fairness opinion is more than a three- or four-page letter that opines as to fairness of the consideration from a financial point of a contemplated transaction. The opinion should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.Key questions to ask about the buyer’s shares include the following:Liquidity of the Shares.What is the capacity to sell the shares issued in the merger? SEC registration and NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. OTC traded shares should be heavily scrutinized, especially if the acquirer is not an SEC registrant. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.Profitability and Revenue Trends. The analysis should consider the buyer’s historical growth and projected growth in revenues, EBITDA and net income as well as trends and comparisons with peers of profitability ratios.Reported vs Core Earnings. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated (preferably over the last five years and last five quarters) with particular sensitivity to a preponderance of adjustments that increase core earnings.Pro Forma Impact. The analysis should consider the impact of a proposed transaction on the pro forma balance sheet, income statement and capital structure in addition to dilution or accretion in EBITDA per share, earnings per share and tangible book value per share both from the seller’s and buyer’s perspective.Shareholder Dividends. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. Sellers should examine the sustainability of current dividends and the prospect for increases (or decreases). Also, if the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed?Share Repurchases. Does the acquirer allocate some portion of cash flow for repurchases? If not, why not assuming adequate cash flow to do so?Capex Requirements. An analysis of capex requirements should focus on whether the business plan will necessitate a step-up in spending vs history and if so implications for shareholder distributions.Capital Stack.Sellers should have a full understanding of the buyer’s capital structure and the amount of cash flow that must be dedicated to debt service before considering capex and shareholder distributions.Revenue Concentrations. Does the buyer have any revenue or supplier concentrations? If so, what would be the impact if lost and how is the concentration reflected in the buyer’s current valuation.Ability to Raise Cash to Close.What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?Consensus Analyst Estimates.If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.Valuation. Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.Share Performance.Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Strategic Position. Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?Contingent Liabilities. Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too.The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business.

Earnings are a crucial reference point in determining transaction prices negotiated by buyers and sellers of RIA firms. However, reported earnings, even when audited and presented in accordance with Generally Accepted Accounting Principles (GAAP), have limitations. GAAP earnings are backward-looking, reflecting how a business has performed under specific rules in the past. While these historical earnings have their uses, buyers in the RIA industry focus more on the future—what’s visible through the windshield, not the rearview mirror.In this whitepaper, we illustrate how buyers and sellers benefit from a quality of earnings report that extracts a company’s sustainable earning power from the thicket of historical GAAP earnings. We review the most common earnings adjustments applied in QofE analyses and review the role of working capital and capital expenditures as the links between EBITDA and cash flow available to buyers.

Apart from a number of headline deals, M&A activity was sidelined for much of 2022 and 2023. But needing to replenish a depleting asset base with quality mineral acreage, stabilizing interest rates, and pent-up M&A demand are expected to compel buyers and sellers to renew their efforts in 2024 and beyond.As deal activity recovers, sellers need to be prepared to present their value proposition in a compelling manner.  For many sellers, an independent Quality of Earnings (“QofE”) analysis and report are vital to advancing and defending their asset’s value in the marketplace.  And it can be critical to the ensuing due diligence processes buyers apply to targets.The scope of a QofE engagement can be tailored to the needs of the seller.  Functionally, a QofE provider examines and assesses the relevant historical and prospective performance of a business.  The process can encompass both the financial and operational attributes of the business model.In this article, we review five reasons sellers benefit from a QofE report when responding to an acquisition offer or preparing to take their businesses or assets to market.1. Maximize value by revealing adjusted and future sustainable profitability.Sellers should leave no stone unturned when it comes to identifying the maximum achievable cash flow and profitability of their assets.  Every dollar affirmed brings value to sellers at the market multiple.  Few investments yield as handsomely and as quickly as a thorough QofE report.  A lack of preparation or confused responses to a buyer’s due diligence will assuredly compromise the outcome of a transaction.  The QofE process includes examining the relevant historical period (say two or three years) to adjust for discretionary and non-recurring income and expense events, as well as depicting the future (pro forma) financial potential from the perspective of likely buyers.  The QofE process addresses the questions of why, when, and how future cash flow can benefit sellers and buyers.  Sellers need this vital information for clear decision-making, fostering transparency, and instilling trust and credibility with their prospective buyers.2. Promote command and control of transaction negotiations and deal terms.Sellers who understand their objective historical performance and future prospects are better prepared to communicate and achieve their expectations during the transaction process.  A robust QofE analysis can filter out bottom-dwelling opportunists while establishing the readiness of the seller to engage in efficient, meaningful negotiations on pricing and terms with qualified buyers.  After core pricing is determined, other features of the transaction, such as working capital, assumption of asset retirement obligations, thresholds for contingent consideration, and other important deal parameters, are established.  These seemingly lower-priority details can have a meaningful effect on closing cash and escrow requirements.  The QofE process assists sellers and their advisors in building the high road and keeping the deal within its guardrails.3. Cover the bases for board members, owners, and the advisory team and optimize their ability to contribute to the best outcome.The financial and fiduciary risk of being underinformed in the transaction process is difficult to overcome and can have real consequences.  Businesses can be lovingly nurtured with operating excellence, sometimes over generations of ownership, only to suffer from a lack of preparation, underperformance from stakeholders who lack transactional expertise, and underrepresentation when it most matters.  The QofE process is like training camp for athletes — it measures in realistic terms what the numbers and the key metrics are and helps sellers amplify strengths and mitigate weaknesses.  Without proper preparation, sellers can falter when countering an offer, placing the optimal outcome at risk.  In short, a QofE report helps position the seller’s board members, managers, and external advisors to achieve the best outcome for shareholders.4. Financial statements and tax returns are insufficient for sophisticated buyers.Time and timing matter.  A QofE report improves the efficiency of the transaction process for buyers and sellers.  It provides a transparent platform for defining and addressing significant reporting and compliance issues.  There is no better way to build a data set for all advisors and prospective buyers than the process of a properly administered QofE engagement.  This can be particularly important for sellers whose level of financial reporting has been lacking, changing, outmoded due to growth, or contains intricacies that are easily misunderstood.For sellers content to work their own deals with their neighbors and friendly rivals, a QofE engagement can provide some of the disciplines and organization typically delivered by a side-side representative.  While we hesitate to promote a DIY process in this increasingly complicated world, a QofE process can touch on many of the points that are required to negotiate a deal.  Sellers who are busy running their businesses rarely have the turnkey skills to conduct an optimum exit process.  A QofE engagement can be a powerful supporting tool.5. In one form or another, buyers are going to conduct a QofE process – what about sellers?Buyers are remarkably efficient at finding cracks in the financial facades of targets.  Most QofE work is performed as part of the buy-side due diligence process and is often used by buyers to adjust their offering price (post-LOI) and design their terms.  It is also used to facilitate their financing and satisfy the scrutiny of underlying financial and strategic investors.  In the increasing arms race of the transaction environment, sellers need to equip themselves with a counteroffensive tool to stake their claim and defend their ground.  If a buyer’s LOI is “non-binding” and subject to change upon the completion of due diligence, sellers need to equip themselves with information to advance and hold their position.ConclusionThe stakes are high in the transaction arena.  Whether embarking on a sale process or responding to an unsolicited inquiry, sellers have precious few opportunities to set the tone.  A QofE process equips sellers with the confidence of understanding their own position while engaging the buy-side with awareness and transparency that promotes a more efficient negotiating process and the best opportunity for a favorable outcome.  If you are considering a sale, give one of our senior professionals a call to discuss how our QofE team can help maximize your results.

M&A deal flow was sidelined for much of 2022 and 2023, but the economy’s soft landing, stabilizing interest rates, and pent-up M&A demand are expected to compel buyers and sellers to renew their efforts in 2024 and beyond.As deal activity recovers, sellers need to be prepared to present their value proposition in a compelling manner. For many sellers, an independent Quality of Earnings (“QofE”) analysis and report are vital to advancing and defending their asset’s value in the marketplace. And it can be critical to the ensuing due diligence processes buyers apply to targets.The scope of a QofE engagement can be tailored to the needs of the seller. Functionally, a QofE provider examines and assesses the relevant historical and prospective performance of a business. The process can encompass both the financial and operational attributes of the business.In this article, we review five reasons sellers benefit from a QofE report when responding to an acquisition offer or preparing to take their businesses to market.1. Maximize value by revealing adjusted and future sustainable profitability.Sellers should leave no stone unturned when it comes to identifying the maximum achievable cash flow and profitability of their businesses. Every dollar affirmed brings value to sellers at the market multiple. Few investments yield as handsomely and as quickly as a thorough QofE report. A lack of preparation or confused responses to a buyer’s due diligence will assuredly compromise the outcome of a transaction. The QofE process includes examining the relevant historical period (say two or three years) to adjust for discretionary and non-recurring income and expense events, as well as depicting the future (pro forma) financial potential from the perspective of likely buyers. The QofE process addresses the questions of why, when, and how future cash flow can benefit sellers and buyers. Sellers need this vital information for clear decision-making, fostering transparency, and instilling trust and credibility with their prospective buyers.2. Promote command and control of transaction negotiations and deal terms.Sellers who understand their objective historical performance and future prospects are better prepared to communicate and achieve their expectations during the transaction process. A robust QofE analysis can filter out bottom-dwelling opportunists while establishing the readiness of the seller to engage in efficient, meaningful negotiations on pricing and terms with qualified buyers. After core pricing is determined, other features of the transaction, such as working capital, frameworks for roll-over ownership, thresholds for contingent consideration, and other important deal parameters, are established. These seemingly lower-priority details can have a meaningful effect on closing cash and escrow requirements. The QofE process assists sellers and their advisors in building the high road and keeping the deal within its guardrails.3. Cover the bases for board members, owners, and the advisory team and optimize their ability to contribute to the best outcome.The financial and fiduciary risk of being underinformed in the transaction process is difficult to overcome and can have real consequences. Businesses can be lovingly nurtured with operating excellence, sometimes over generations of ownership, only to suffer from a lack of preparation, underperformance from stakeholders who lack transactional expertise, and underrepresentation when it most matters. The QofE process is like training camp for athletes — it measures in realistic terms what the numbers and the key metrics are and helps sellers amplify strengths and mitigate weaknesses. Without proper preparation, sellers can falter when countering an offer, placing the optimal outcome at risk. In short, a QofE report helps position the seller’s board members, managers, and external advisors to achieve the best outcome for shareholders.4. Financial statements and tax returns are insufficient for sophisticated buyers.Time and timing matter. A QofE report improves the efficiency of the transaction process for buyers and sellers. It provides a transparent platform for defining and addressing significant reporting and compliance issues. There is no better way to build a data set for all advisors and prospective buyers than the process of a properly administered QofE engagement. This can be particularly important for sellers whose level of financial reporting has been lacking, changing, outmoded due to growth, or contains intricacies that are easily misunderstood.For sellers content to work their own deals with their neighbors and friendly rivals, a QofE engagement can provide some of the disciplines and organization typically delivered by a side-side representative. While we hesitate to promote a DIY process in this increasingly complicated world, a QofE process can touch on many of the points that are required to negotiate a deal. Sellers who are busy running their businesses rarely have the turnkey skills to conduct an optimum exit process. A QofE engagement can be a powerful supporting tool.5. In one form or another, buyers are going to conduct a QofE process – what about sellers?Buyers are remarkably efficient at finding cracks in the financial facades of targets. Most QofE work is performed as part of the buy-side due diligence process and is often used by buyers to adjust their offering price (post-LOI) and design their terms. It is also used to facilitate their financing and satisfy the scrutiny of underlying financial and strategic investors. In the increasing arms race of the transaction environment, sellers need to equip themselves with a counteroffensive tool to stake their claim and defend their ground. If a buyer’s LOI is “non-binding” and subject to change upon the completion of due diligence, sellers need to equip themselves with information to advance and hold their position.ConclusionThe stakes are high in the transaction arena. Whether embarking on a sale process or responding to an unsolicited inquiry, sellers have precious few opportunities to set the tone. A QofE process equips sellers with the confidence of understanding their own position while engaging the buy-side with awareness and transparency that promotes a more efficient negotiating process and the best opportunity for a favorable outcome. If you are considering a sale, give one of our senior professionals a call to discuss how our QofE team can help maximize your results.WHITEPAPERQuality of Earnings AnalysisDownload Whitepaper For buyers and sellers, the stakes in a transaction are high. A QofE report is an essential step in getting the transaction right.

After sitting on the sidelines for much of 2022 and 2023, the prospect of Fed rate cuts may lure buyers back onto the field in 2024.And when deal activity heats back up, due diligence will be as critical to buyers as ever. For many buyers, a quality of earnings (“QofE”) report is a cornerstone of their broader diligence efforts.For family businesses, an acquisition that goes sour can negatively affect family wealth for decades to come. Obtaining a thorough QofE report as part of deal diligence can help family business directors avoid such a misstep. In this week’s post, we review five reasons family business directors need a QofE report before approving an acquisition.1. Avoid overpaying for earnings that aren’t sustainable.Audited financial statements provide assurance that the past performance of the target company is faithfully represented. However, successful acquirers are focused on the future, not the past. A thorough QofE report helps buyers extract what truly sustainable performance is from the welter of the target’s historical earnings. Paying for historical earnings that don’t materialize in the future is a recipe for sinking returns on invested capital. QofE reports analyze historical earnings for adjustments that convert historical earnings to the pro forma run rate earnings that make an acquisition worthwhile.2. Identify opportunities for cost savings in the target’s expense base.The detailed analysis of cost of sales and operating expenses in a QofE report can uncover opportunities for acquirers to boost margins at the target through cost-saving initiatives. By observing trends in headcount by function, occupancy, and other components of operating expense, buyers can identify redundancies and develop strategies for enhancing post-acquisition cash flow from the target.3. Find revenue synergies with your existing business.A thorough QofE report is not just about expenses. Observing revenue trends by product and business segment, coupled with analysis of customer churn data, can help buyers better understand how the target “fits” with the existing business of the buyer, which can open up strategies for fueling revenue growth in excess of what either company could accomplish on a standalone basis. Armed with a better understanding of opportunities for revenue synergies, buyers can move to the closing table more confident of the upside to be unlocked through the transaction.4. Clarify working capital needs of the target.Incremental working capital investment is the silent killer of transaction return on investment. A thorough QofE report will move beyond the income statement to evaluate seasonal trends in the core components of net working capital. Doing so helps buyers plan adequately for the ongoing working capital requirements they will need to fund out of post-acquisition earnings. Working capital analysis in the QofE report also helps buyers negotiate appropriate working capital targets in the final purchase agreement.5. Assess capital expenditure needs at the target.Not every dollar of EBITDA is equal. EBITDA multiples are a function of risk, growth, and capital intensity. Buyers cannot afford to overlook capital intensity when evaluating targets. A thorough QofE report examines historical trends in capital expenditures and fixed asset turnover to help buyers better discern the prospective capital expenditure needs of the target and how those needs influence the transaction price and prospective returns. For family businesses contemplating an acquisition, the stakes are high. You can’t eliminate risk from an M&A transaction but obtaining a thorough QofE report on the target can help directors avoid mistakes and increase the odds of a successful deal. If you are considering an acquisition in 2024, give one of our senior professionals a call to discuss how our QofE team can generate Insights That Matter for your diligence team.WHITEPAPERQuality of Earnings AnalysisDownload WhitepaperFor buyers and sellers, the stakes in a transaction are high. A QofE report is an essential step in getting the transaction right.

What Buyers and Sellers Need to Know About Quality of Earnings ReportsFor buyers and sellers, the stakes in a transaction are high. You only get one chance to do it right.Commissioning a quality of earnings report is an essential step in getting the transaction right.In this whitepaper, we illustrate how buyers and sellers benefit from a quality of earnings report that extracts a company’s sustainable earning power from the thicket of historical GAAP earnings. We review the most common earnings adjustments applied in QofE analyses and review the role of working capital and capital expenditures as the links between EBITDA and cash flow available to buyers.Leverage the experience of our QofE team to generate Insights That Matter in support of your next transaction.

Through November 2021, there were three M&A deals in the Marcellus and Utica shales.  Compared to the 16 deals in the same period in 2020, companies looking to get into or out of the Appalachian basins effectively did so in 2020.   The following table summarizes transaction activity in the Marcellus and Utica shales in 2021:Click here to expand the image aboveAs shown in the following table, M&A activity picked up in 2022 year-to-date, with twice as many transactions announced.Click here to expand the image aboveWhat has caused the slight rebound in M&A activity in the Marcellus and Utica shales?  Companies are focusing on asset quality, strong balance sheets, prudent capital structures, and free cash flow growth.  Below we examine the two largest transactions that occurred in but were not limited to the Marcellus and Utica shales in 2022.Sitio Royalties and Brigham Minerals, Inc. Merge to Create the Largest Public Minerals OwnerOn September 6, Sitio Royalties Corp. (NYSE: STR) (“Sitio”) and Brigham Minerals, Inc. (NYSE: MNRL) (“Brigham”) announced a definitive agreement to combine in an all-stock merger, with an aggregate enterprise value of approximately $4.8 billion based on the closing share prices of Sitio and Brigham on September 2, 2022.  The combination brings together two of the largest public companies in the oil and gas mineral and royalty sector.  Upon completion of the merger, the combined entity will retain the name Sitio Royalties Corp.Under the merger agreement's terms, Brigham shareholders will receive a fixed exchange ratio of 1.133 shares of common stock in the combined company for each share of Brigham common stock owned.  Sitio’s shareholders will receive one share of common stock in the combined company for each share of Sitio common stock, based on ownership on the closing date.   Brigham’s and Sitio’s Class A shareholders will receive shares of Class A common stock in the combined company, and Brigham’s Class B and Sitio’s Class C shareholders will receive shares of Class C common stock in the combined company.  Upon completion of the transaction, the former Sitio shareholders will own approximately 54%, and the former Brigham shareholders will own about 46% of the combined entity on a fully diluted basis.Robert Rosa, CEO of Brigham, commented,“Our merger with Sitio creates the industry-leading powerhouse in the minerals space … with approximately 100 rigs running across all of our operating basins and greater than 50 activity wells to continue to drive production and cash flow growth.”The Sitio-Brigham deal press release discusses operational cash cost synergies, a balanced capital allocation framework that aligns with shareholder interests to drive long-term returns, enhanced margins, and increased access to capital.  But, as a recent Forbes article points out, despite Kimmeridge Energy, which owns approximately 43.5% of Sitio, being a heavy promoter of ESG in the shale business, the press release has only a slight mention of ESG.  The only direct mention of ESG is in the last bullet point of the strategic rationale behind the deal.EQT Corporation Continues to Add to Core Marcellus Asset BaseOn September 8, EQT Corporation (NYSE: EQT) (“EQT”) announced that it entered into a purchase agreement with THQ Appalachia I, LLC (“Tug Hill”) and THQ-XcL Holdings I, LLC (“XcL Midstream”) whereby EQT agreed to acquire Tug Hill’s upstream assets and XcL Midstream’s gathering and processing assets for total consideration of $5.2 billion.  The purchase price consists of cash of $2.6 billion and 55 million shares of EQT common stock worth $2.6 billion.  The transaction is expected to close in the fourth quarter of 2022, with an effective date of July 1, 2022.  Transaction highlights include:~90,000 core net mineral acres offsetting EQT’s existing core leasehold in West Virginia95 miles of owned and operated midstream gathering systems connected to every major long-haul interstate pipeline in southwest AppalachiaCombined upstream and midstream assets at 2.7x next-twelve-month (“NTM”) EBITDAUpstream-only valuation of 2.3x NTM EBITDA300 untapped drilling locations in the Marcellus and Utica shales The deal is the largest U.S. upstream deal since Conoco Phillips purchased Shell’s Permian Basin assets for $9.5 billion in September 2021. EQT President and CEO Toby Rice commented, “The acquisition of Tug Hill and XcL Midstream checks all the boxes of our guiding principles around M&A, including accretion on free cash flow per share, NAV per share, lowering our cost structure and reducing business risk, while maintaining an investment grade balance sheet.” The Tug Hill/XcL Midstream transaction piggybacks EQT’s May 2021 $2.93 billion acquisition of all of the membership interests in Alta Resources Development, LLC’s (“Alta’) upstream and midstream subsidiaries.  Consistent with his comments on the Tug Hill/Xcl Midstream deal, Mr. Rice commented that the Alta deal would provide attractive free cash flow per share accretion to EQT shareholders. As with the Sitio-Brigham deal, Forbes points out that the EQT-Tug Hill-XcL Midstream press release provides only a token reference to ESG in a quote by the CEO of Quantum Energy Partners, the private equity backers of Tug Hill and XcL Midstream.ConclusionM&A transaction activity in the Marcellus & Utica shales increased in 2022 relative to 2021, with large industry players motivated by free cash flow growth and creating shareholder value and less motivated by championing the ESG cause.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We can leverage our historical valuation and investment banking experience to help you navigate a critical transaction in the oil and gas industry, providing timely, accurate, and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

A few weeks ago, I sat down with Kevin Nill of Haig Partners to discuss the current state of the M&A market and other timely trends in the auto dealer industry. Specifically, I wanted to discuss some of the movements in Blue Sky multiples for various franchises and interpret the range of multiples that Haig Partners recently published with the release of their Second Quarter 2022 Haig Report (subscription required).What is the current state of the M&A market for auto dealerships? Any signs of transactions slowing down? Are you seeing earnings or multiples start to plateau or revert?Kevin: The market continues to be quite active, with a nice balance of buyers focused on strategic growth opportunities and sellers who see valuations still at or near peak levels. The pandemic accelerated the need for scale to effectively compete in a changing retail environment—consumers are ever more focused on a seamless buying experience and are embracing a digital world for researching, negotiating, and transacting the retail purchase. Couple that with the benefits of marketing a broad and large selection of inventory and dealers recognize they need more franchises and locations to effectively compete.Our analysis indicates there may be over 8 million units of pent-up demand in the marketplaceNADA has suspended the publication of data on the performance of the total dealer body, but public company financial results do indicate we may have seen a plateau in earnings. Based on our analysis, the average public dealership earned $7.0M through the Last Twelve Months (LTM) ended 2Q 2022, down just slightly from $7.1M for the quarter ended 1Q 2022. However, that’s still up approximately $5M from 2019’s average of $2.1M!! From the data and research we are seeing, inventory constraints should continue for the next several years and ensure the dealer enjoys strong gross margins for some time. Our analysis indicates there may be over 8 million units of pent-up demand in the marketplace. Additionally, the high gross F&I and service departments continue to see an upward trajectory in results.As for multiples, our firm tracks this very closely by monitoring transactions we represent alongside ongoing discussions with industry leaders in finance, accounting, and the legal communities. In summary, multiples overall have changed little since the pandemic: it’s the underlying earnings that have contributed to the elevated valuations. That said, some franchises are gaining traction and are more appealing to buyers. These include Toyota, Hyundai/Kia, and Stellantis.Scott: With NADA’s suspension of dealership performance data, Mercer Capital has also pivoted to supplying information and trends from public companies in our recently published Mid-Year 2022 newsletter. Despite positive revenue growth in the last twelve and six months, revenue growth in the more recent period is less in all six public companies showing signs of slowing down. Additionally, public companies have continued to enjoy heightened gross profit from new and used vehicle departments compared to historical averages.Any new trends in buy/sell negotiations in the last few months? Any sticking points?Kevin: There really haven’t been any “new” issues that have arisen in buy/sell negotiations, but one trend we are seeing both in the industry and our practice is a willingness of sellers to entertain either a sale of just some of their dealerships or a minority/majority ownership stake in the entire enterprise.The willingness of sellers to entertain either a sale of just some of their dealerships or a minority/majority ownership stake in the entire enterprise is a recent trendSellers are seeing these alternatives as additional strategic options for their families and organizations. In some cases, a seller may choose to take some proverbial chips off the table by exiting a market or selling a couple of stores. Further, as outside capital investors continue to target auto retail due to strong and consistent returns, some dealers are selling a percentage of the business, which allows them to stay on and operate the business. Our recent publications have gone into greater detail on this subject if readers want to know more about this trend.Scott: The trend for dealers to sell a small minority stake in their entire group (or perhaps only divest of a rooftop or two) seems to be a new and interesting phenomenon. This trend appears to be a shift from dealers selling the entire enterprise or a majority stake in the dealership holdings. Auto dealers clearly value maintaining control and not having to answer to a family office group, private equity holders, or a third-party controlling stakeholder.Operating an auto dealership is very much a day-to-day and month-to-month business. Auto dealers are usually heavily invested in their communities and care deeply about their legacies.Selling a minority interest gives the auto dealer some liquidity. While dealerships have become very valuable and have generated record profits, often those profits are reinvested in the business or are leveraged against other assets, while the heightened value of the dealership only represents value on paper until a transaction or liquidation event occurs.Mercer Capital provides estate planning valuation services that may benefit owners who take some chips off the table once a firm like Haig Partners has helped them negotiate a minority investment.The latest Haig Report mentions Toyota is the most desirable brand. Is there any reason it would not obtain the same multiple as luxury brands?Kevin: It’s no surprise to anyone active in the auto retail space that Toyota dealerships are in high demand. Manufacturer relations are best in class, and the underlying product continues to resonate with consumers. Our firm has sold 33 Toyota dealerships, including the 2nd highest-valued dealership ever in August 2022 (John Elway’s Crown Toyota). Buyer interest is always substantial. In most cases, Toyota stores will bring better multiples than some of the smaller luxury makes like Jaguar, Land Rover, and Audi. But in general, the high-profile luxury nameplates still command a higher multiple. There are a number of reasons, but the most impactful cause is there are far fewer Lexus, Mercedes-Benz, or BMW dealerships in the market and even fewer for sale. So “Economics 101” is in play—limited supply and high demand bring higher multiples. Scott: Kevin’s comparison of a Toyota dealership investment to a luxury brand is equivalent to the allure of owning a professional sports franchise. Interested investors in luxury brands covet the exclusivity and market appeal of owning one of these franchises. There may only be a few luxury brands in each market, and if one becomes available, it may be a long time until another luxury franchise becomes available. To Kevin’s point, the approximate number of Toyota and various luxury brand franchises in the United States are as follows: Will the shift for Cadillac, Infiniti, and Lincoln blue sky from a dollar amount to a multiple materially shift the value of these franchises?Kevin: Over the past several years, several weaker franchises traded for a hard dollar amount rather than a multiple of earnings, given the lack of repeatable earnings. Buyers placed a value on the “shingle” and looked at used cars and fixed operations as their way to make money from these stores. However, as some of these brands have seen a resurgence in performance, partially from the post-pandemic bump but also from developing more appealing products, we have seen buyers take a more bullish approach. So, yes, these franchises have definitely seen an improvement in value. Nissan is another brand we have seen improve in the eyes of buyers. The franchise still has a way to go, but many believe the worst is behind Nissan — their products are solid, and the OEM has learned from its “volume at all costs” approach.Are there any new threats to the auto industry?Kevin: Open any automotive periodical, and you will see discussions about the potential impact of EVs. One consequence of the forecasted shift away from ICE to EV is the desire of some OEMs to modify their retail strategies. Tesla and other EV startups have gone the direct selling route, foregoing the traditional franchise model, and some major manufacturers are eyeing this strategy with jealousy. All despite historically failed attempts to replicate the proven ability of the franchise retailer to best serve the consumer’s needs. Ford, Hyundai, Mercedes-Benz, Volvo, and Polestar are examples of manufacturers who are overtly or quietly trying to change the retail model more toward the agency model seen in Europe. Haig Partners encourages dealers to be active participants with their state dealer associations to ensure franchise laws remain robust and protective of retailers. Scott: Despite the news and headlines dominated by EVs, the implications of EVs can vary drastically by brand. In other words, some OEMs are further along in producing EV models, while others do not anticipate producing EVs before 2024 and 2025. Additionally, the requirements of the various OEMs to auto dealers are also quite different. Some brands do not require any additional dealer commitments, while others, such as Ford, are forcing auto dealers to declare at what level they want to opt-in for selling EVs. Ford’s financial requirements can range from $0 for dealers that do not opt-in to selling EVs (only selling ICE vehicles) to $1,200,000 for dealers that opt-in to selling EVs at the premium level.What are the typical adjustments seen in negotiations for buy/sells?Kevin: One of the most important aspects of representing a seller is ensuring the buyer has a solid understanding of the historic and expected cash flows generated by the dealership. Just looking at the dealership’s financial statement doesn’t accurately depict the earnings opportunity of the store.Just looking at the dealership financial statement doesn’t accurately depict the earnings opportunity of the storeWe extensively analyze the dealership to understand what add-backs and deducts should be applied to reflect recurring cash flow. Some are non-cash entries; others are one-time expenses or income that should be adjusted.Some common add-backs are LIFO expenses, owner’s compensation (if excessive and/or not to be recurring for a future owner), owner’s perks that run through the statement (travel, airplane, etc.), and F&I over-remits/mailbox money that is generated outside the dealer statement.Deductions to earnings include PPP funds and one-time settlement funds or gains from asset sales.Scott: Similarly, Mercer Capital reviews the balance sheets of auto dealers for potential adjustments to inventories, fixed assets, working capital, goodwill, non-operating assets, and owner accounts receivable. Some typical areas for potential adjustments on the income statement include inventories, owner compensation, rent, other income, owner perquisites, and remittance, to which Kevin refers.Remittance is related to the service contract and other warranty-related products the dealership offers in connection with the purchase of a vehicle. A dealer can act as an agent in this process by offering products from multiple third-party vendors or acting as the principal, whereby they own a reinsurance company that offers those products to their customers. In either case, the dealership retains a portion of the service contract or warranty product and remits the other portion to the obligor or administrator of the contract. In an example where a vehicle service contract is $800, the dealership might retain $400, report that as income, and remit $400 to the obligor/administrator.In some cases, the dealer may have an “overpayment” arrangement in place with the third-party administrator or their reinsurance company, whereby the dealer might retain $250 in the previous example and then remit $550 to the obligor/administrator. The “overpayment” arrangement allows the dealership to determine the amount of the overpayment and designate a beneficiary outside the dealership to receive the overpayment amount. These arrangements effectively reduce or shift income out of the dealership. The presence and amounts of overpayments or over remittances should be considered as potential normalization adjustments to earnings when determining the value of a dealership.We thank Kevin Nill and Haig Partners for their insightful perspectives on the auto dealer industry. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.

For this week’s post, we take a look at recent trends in middle market M&A. Despite turbulent economic and geopolitical conditions in the first half of the year, valuations in the middle market continued to hold their ground.Still, whether looking to buy or sell, family business owners would be wise to act sooner rather than later, as declines in volume and value thus far in 2022 suggest tightening conditions in the middle market.Overall deal activity in the second quarter of 2022 fell from levels seen in the first quarter of the year and the second quarter of 2021. In aggregate, deal activity in the first half of 2022 also fell from aggregate deal activity in the first half of 2021.Despite the decline in U.S. deal value and volume, multiples on deals completed in the first half of the year remained in line with levels observed in 2020 and 2021, suggesting a potential “flight to quality” in the middle market in the first half of the year.U.S. Deal Value and Volume: Q1-2020 to Q2-20222U.S. Deal Volume by Industry: Q1-2020 to Q2-2022Click here to expand the image aboveBroader economic conditions in the U.S. negatively influenced deal value and volume in the first half of 2022 but did not stifle overall deal activity. In the second quarter of 2022, U.S. GDP declined for the second straight quarter, and annual and monthly inflation measures continued to hit record levels.In response to the rampant inflation in the U.S. economy, the Fed executed two sizable rate increases in the second quarter, including enacting the largest rate increase since 1994 at its June meeting. While the U.S. economy has not yet officially fallen into a recession (despite the two straight quarters of decline in GDP), most Fed watchers agree that Jay Powell and the FOMC won’t relent in their fight to bring down inflation even if it does cause a recession. In short, the Fed appears to be willing to take a cool down in inflation in exchange for a weaker short-term outlook in terms of GDP and overall economic growth.TEV/EBITDA Multiples: Financial BuyersYet despite these challenging macroeconomic conditions, deal activity did not come to a screeching halt in the first half of 2022, as seen in the middle of 2020. We believe this is a good sign for the overall health of the middle market, particularly when coupled with the fact that multiples on PE deals were relatively unchanged in the second quarter, as seen in the chart above. The prolonged “sellers’ market” of the past several years appears to be holding up to this point in 2022, as buyers continue to be willing to pay elevated multiples for well-positioned businesses coming to market. Deals in the $50-$100 million tranche of the middle market realized multiple expansions in the second quarter, growing from an average multiple of 8.5x to 9.2x. Multiples in other tranches were either unchanged or slightly down.EBITDA Multiples by Buyer Type: 2020 to 1H 2022Number of Deals by Buyer Type: Q1-2020 to Q2-2022Click here to expand the image aboveDebt multiples on PE deals fell in the second quarter of 2022. The drop in debt utilization in deal activity is likely a sign that rising interest rates are beginning to weigh on deal activity and financing terms. Rising interest rates equate to an increased cost of borrowing and overall cost of capital for businesses, increasing the discount rates used in buyers’ valuations of potential targets. While elevated discount rates, in theory, should lead to valuations (and hence multiples) coming down from levels seen over the past several years, corporate balance sheets and PE firms still appear to be flush with cash. We believe there is still a great deal of readily deployable capital on the sidelines that should continue to support elevated multiples and valuations in the middle market in the foreseeable future.Debt Multiples: Financial BuyersIn conclusion, while deal volume was down in the second quarter of 2022 (and in the first half of the year in general), activity did not come to a screeching halt despite a challenging economic environment in the U.S. and geopolitical strife abroad.In our opinion, there has been a “flight to quality” in the middle market, which has supported valuations and multiples despite reduced deal volume. This has created heavy competition among strategic and financial buyers for well-positioned businesses coming to market and, in the process, has helped maintain the elevated multiples and deal values seen in the middle market over the past year or so.While observed multiples remain elevated, owners looking to transact their business would be advised to begin the process sooner rather than later, given the prospects of further interest rate hikes, continued volatility in the public markets, ongoing geopolitical tensions globally, and the upcoming midterm elections.While the state of the middle market remained relatively placid in the first half of 2022, these and other factors will likely hamper deal activity in the middle market in the coming quarters and years.

Year-to-date RIA M&A activity has surpassed last year’s record levels in 2022, even as macro headwinds for the industry continue to mount. Fidelity’s August 2022 Wealth Management M&A Transaction Report listed 155 deals through August of 2022, up from 112 during the same period in 2021. These transactions represented $212 billion in AUM, up 16% from 2021 levels. The continued strength of RIA M&A activity amidst the current environment dominated by inflation, rising interest rates, and a tight labor market is noteworthy, given that all these factors could strain the supply and demand dynamics that have driven deal activity in recent years. Rising costs and interest rates coupled with a declining fee base will put pressure on highly leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. But despite these pressures, the market has proven robust (at least so far). Demand for RIAs has remained strong, with professionalization of the buyer market continuing to be a theme driving M&A activity. Serial acquirers and aggregators increasingly drive deal volume with dedicated deal teams and access to capital. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the first eight months of the year. While the current market environment has prompted some serial acquirers to temper their pace of acquisition activity (CI Financial’s CEO Kurt McAlpine remarked on the company’s first-quarter earnings call that their pace of acquisitions has “absolutely slowed down”), we’ve not yet seen that borne out in reported deal volume. Multiples in the industry remain high, although the upward trend in multiples has reportedly leveled off. On the supply side, the current market environment is likely to have a mixed impact on bringing sellers to market. On one hand, some sellers may be reluctant to sell when the markets (and their firm’s financial performance) are down significantly from their peak. On the other hand, a concern that multiples may decline if the current market environment persists may prompt some sellers to seek an exit while multiples remain relatively robust.The current market environment is likely to have a mixed impact on bringing sellers to marketWhile market conditions play a role in exit timing, the motives for sellers often encompass more than purely financial considerations. Sellers are often looking to solve for succession issues, improve quality of life, and access organic growth strategies. Such deal rationales are not sensitive to the market environment and will likely continue to fuel the M&A pipeline even in a downturn. And despite years of record-setting M&A activity, the number of RIAs continues to grow—which suggests the uptick in M&A activity is far from played out.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has trended upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquirer models will likely continue to support higher multiples than the industry has in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions. For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions, as in most transactions. But how the deal is financed is often a crucial secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and, in some instances, may still be the best option). Still, there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs. If you are an RIA considering selling: Whatever the market conditions when you go to sell, it is essential to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a broad spectrum of buyer profiles has emerged to accommodate different seller motivations and allow for varying levels of autonomy post-transaction. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision that can significantly impact personal and career satisfaction after the transaction closes.

For this week's post, we republish a prior post on the subject of Fairness Opinions. It's proven to be one of the most popular posts on the blog. If you missed it the first time, we hope you find it informative and helpful.What Is a Fairness Opinion?A Fairness Opinion involves a comprehensive review of a transaction from a financial point of view and is typically provided by an independent financial advisor to the board of directors of the buyer or seller.  The financial advisor must look at pricing, terms, and consideration received in the context of the market for similar companies. The advisor then opines that the transaction is fair, from a financial point of view and from the perspective of the seller’s minority shareholders. In cases where the transaction is considered to be material for the acquiring company, a second Fairness Opinion from a separate financial advisor on behalf of the buyer may be pursued.Why Is a Fairness Opinion Important?Why is a Fairness Opinion important?  There are no specific guidelines as to when to obtain a Fairness Opinion, yet it is important to recognize that the board of directors is endeavoring to demonstrate that it is acting in the best interest of all the shareholders by seeking outside assurance that its actions are prudent.One answer to this question is that good intention(s) without proper diligence may still give rise to potential liability.  In its ruling in the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985), the Delaware Supreme Court effectively made the issuance of Fairness Opinions de rigueur in M&A and other significant corporate transactions.  The backstory to this case is the Trans Union board approved an LBO that was engineered by the CEO without hiring a financial advisor to vet a transaction that was presented to them without any supporting materials.  Regardless of any specific factors that may have led the Trans Union board to approve the transaction without extensive review, the Delaware Supreme Court found that the board was grossly negligent in approving the offer despite acting in good faith.  Good intentions, but lack of proper diligence.The facts and circumstances of any particular transaction can lead reasonable (or unreasonable) parties to conclude that a number of perhaps preferable alternatives are present. A Fairness Opinion from a qualified financial advisor can minimize the risks of disagreement among shareholders and misunderstandings about a deal. They can also serve to limit the possibilities of litigation which could kill the deal. Perhaps just as important as being qualified, a Fairness Opinion may be further fortified if conducted by a financial advisor who is independent of the transaction.  In other words, a financial advisor hired solely to evaluate the transaction, as opposed to the banker who is paid a success fee in addition to receiving a fee for issuing a Fairness Opinion.When Should You Obtain a Fairness Opinion?While the following is not a complete list, consideration should be given to obtaining a Fairness Opinion if one or more of these situations are present:Competing bids have been received that are different in price or structure, leading to potential disagreements in the adequacy and/or interpretation of the terms being offered, and which offer may be “best.” Conversely, when there is only one bid for the company, and competing bids have not been solicited.The offer is hostile or unsolicited.Insiders or other affiliated parties are involved in the transaction, giving rise to potential or perceived conflicts of interest.There is concern that the shareholders fully understand that considerable efforts were expended to assure fairness to all parties.What Does a Fairness Opinion Cover?A Fairness Opinion involves a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed in reaching a decision to consummate a transaction.  The financial advisor must look at pricing, terms, and consideration received in the context of the market.  The advisor then opines that the consideration to be received (sell-side) or paid (buy-side) is fair from a financial point of view of shareholders, especially minority shareholders in particular, provided the advisor’s analysis leads to such a conclusion.While the Fairness Opinion itself may be conveyed in a short document, most typically as a simple letter, the supporting work behind the Fairness Opinion letter is substantial.  This analysis may be provided and presented in a separate fairness memorandum or equivalent document.A well-developed Fairness Opinion will be based upon the following considerations that are expounded upon in the accompanying opinion memorandum:A review of the proposed transaction, including terms and price and the process the board followed to reach an agreement.The subject company’s capital table/structure.Financial performance and factors impacting earnings.Management’s current year budget and multi-year forecast.Valuation analysis that considers multiple methods that provide the basis to develop a range of value to compare with the proposed transaction price.The investment characteristics of the shares to be received (or issued), including the pro-forma impact on the buyer’s capital structure, regulatory capital ratios, earnings capacity, and the accretion/dilution to earnings per share, tangible book value per share, dividends per share, or other pertinent value metrics.Address the source of funds for the buyer.What Is Not Covered in a Fairness Opinion?It is important to note what a Fairness Opinion does not prescribe, including:The highest obtainable price.The advisability of the action the board is taking versus an alternative.Where a company’s shares may trade in the future.How shareholders should vote a proxy.The reasonableness of compensation that may be paid to executives as a result of the transaction. Due diligence work is crucial to the development of the Fairness Opinion because there is no bright-line test that consideration to be received or paid is fair or not.  The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling stock).ConclusionThe Professionals at Mercer Capital may not be able to predict the future, but we have four decades of experience in helping boards assess transactions as qualified and independent financial advisors.  Sometimes paths and fairness from a financial point of view seem clear; other times they do not.Please give us a call if we can assist your company in evaluating a transaction.

This is the eighth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. Directors are periodically asked to make tough decisions about the strategic direction of a company. Major acquisitions are usually one of the toughest calls boards are required to make. A board’s fiduciary duty to shareholders is encapsulated by three mandates:Act in good faith;Duty of care (informed decision making); andDuty of loyalty (no self-dealing; conflicts disclosed). Directors are generally shielded from courts second guessing their decisions by the business judgment rule provided there is no breach of duty to shareholders. The presumption is that non-conflicted directors made an informed decision in good faith. As a result, the burden of proof that a transaction is not fair and/or there was a breach of duty resides with the plaintiffs. An independent fairness opinion helps demonstrate that the directors of an acquiring corporation are fulfilling their fiduciary duties of making an informed decision. Fairness opinions seek to answer the question whether the consideration to be paid (or received from a seller’s perspective) is fair to a company’s shareholders from a financial point of view. Occasionally, a board will request a broader opinion (e.g., the transaction is fair). A fairness opinion does not predict where the buyer’s shares may trade in the future. Nor does a fairness opinion approve or disapprove a board’s course of action. The opinion, backed by a rigorous valuation analysis and review of the process that led to the transaction, is just that: an opinion of fairness from a financial point of view.Delaware, the SEC and FairnessFairness opinions are not required under Delaware law or federal securities law, but they have become de rigueur in corporate M&A ever since the Delaware Supreme Court ruled in 1985 that directors of TransUnion were grossly negligent because they approved a merger without adequate inquiry and expert advice. The court did not specifically mandate the opinion be obtained but stated it would have helped the board carryout its duty of care had it obtained a fairness opinion regarding the firm’s value and the fairness of the proposal.The SEC has weighed in, too, in an oblique fashion via comments that were published in the Federal Register in 2007 (Vol. 72, No. 202, October 19, 2007) when FINRA proposed rule 2290 (now 5150) regarding disclosures and procedures for the issuance of fairness opinions by broker-dealers. The SEC noted that the opinions served a variety of purposes, including as indicia of the exercise of care by the board in a corporate control transaction and to supplement information available to shareholders through a proxy.Dow’s Sour PickleBuy-side fairness opinions have a unique place in corporate affairs because the corporate acquirer has to live with the transaction. What seems fair today but is deemed foul tomorrow, may create a liability for directors and executive officers. This can be especially true if the economy and/or industry conditions deteriorate after consummation of a transaction.For instance, The Dow Chemical Company (“Dow”), a subsidiary of Dow Inc. (NYSE: DOW), agreed to buy Rohm and Haas (“RH”) for $15.4 billion in cash on July 10, 2008. The $78 per share purchase price represented a 75% premium to RH’s prior day close. The ensuing global market rout and the failure of a planned joint venture with a Kuwait petrochemical company led Dow to seek to terminate the deal in January 2009 and to cut the dividend for the first time in the then 97 years the dividend had been paid.Ultimately, the parties settled litigation and Dow closed the acquisition on April 1, 2009 after obtaining an investment from Berkshire Hathaway (NYSE: BRK.A) and seller financing via the sale of preferred stock to RH’s two largest shareholders.Dow was well represented and obtained multiple fairness opinions from its advisors (Citigroup, Merrill Lynch and Morgan Stanley). One can question how the advisors concluded a 75% one-day premium was fair to Dow’s shareholders (fairness is a mosaic and maybe RH’s shares were severely depressed in the 2008 bear market). Nonetheless, the affair illustrates how vulnerable Dow’s Board of Directors or any board would have been absent the fairness opinions.Fairness and ElonBefore Elon Musk reneged on his planned acquisition of Twitter, Inc. (NYSE: TWTR) on July 8, 2022, one of the most recent contentious corporate acquisitions was the 2016 acquisition of SolarCity Corporation by Tesla Inc. (NASDAQGS: TSLA). Plaintiffs sought up to $13 billion of damages, arguing that (a) the Tesla Board of Directors breached its duty of loyalty, (b) Musk was unjustly enriched (Musk owned ~22% of both companies and was Chairman of both); and (c) the acquisition constituted waste.Delaware Court of Chancery Judge Joseph Slights ruled in favor of Tesla on April 27, 2022. Slights noted courts are sometimes skeptical of fairness opinions; however, he was not skeptical of Evercore’s opinion, noting extensive diligence, the immediate alerting of the Tesla Board about SolarCity’s liquidity situation and the absence of prior work by Evercore for Tesla. Tesla Walks the Entirely FairLine with SolarCityDownload Presentation

Year-to-date RIA M&A activity has surpassed last year’s record levels so far in 2022 even as macro headwinds for the industry continue to mount. Fidelity’s May 2022 Wealth Management M&A Transaction Report listed 93 deals through May of 2022, up from 72 during the same period in 2021. These transactions represented $135 billion in AUM, up 12% from 2021 levels.The continued strength of RIA M&A activity amidst the current environment dominated by inflation, rising interest rates, and a tight labor market is noteworthy given that all of these factors could put a strain on the supply and demand dynamics that have driven deal activity in recent years. Rising costs and interest rates coupled with a declining fee base will put pressure on highly-leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. Despite these pressures, the market has proven robust (at least so far). Demand for RIAs has remained strong, with the professionalization of the buyer market continuing to be a theme driving M&A activity. Deal volume is increasingly driven by serial acquirers and aggregators with dedicated deal teams and access to capital. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the first five months of the year. This group of companies, along with other strategic acquirers and consolidators, have continued to increase their share of industry deal volume and now account for about half of all deals. In addition to driving overall industry deal volume, the proliferation of strategic acquirers and aggregator models has led to increased competition for deals throughout the industry. This has contributed to multiple expansions and shifts to more favorable deal terms for sellers in recent years. While there are some signs that deal activity from these acquirers may slow down (CI Financial’s CEO Kurt MacAlpine remarked on the company’s first quarter earnings call that their pace of acquisitions has “absolutely slowed down”), we’ve not yet seen that borne out in the reported deal volume.On the supply side, the motives for sellers often encompass more than purely financial considerations. Sellers are often looking to solve succession issues, improve quality of life, and access organic growth strategies. Such deal rationales are not sensitive to the market environment, and will likely continue to fuel the M&A pipeline even in a downturn. And despite years of record setting M&A activity, the number of RIAs continues to grow—which suggests the uptick in M&A activity is far from played out.Whatever net impact the current market conditions have on RIA M&A, it may take several months before the impact becomes apparent in reported deal volume given the often multi-month lag between deal negotiation, signing, and closing. But at least through May, transaction activity has remained steady or even surpassed last year.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has continued to trend upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquiror models will likely continue to support higher multiples than the industry has been accustomed to in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions.For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions as they are in most transactions. But how the deal is financed is often an important secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs.If you are an RIA considering selling: After years of steadily increasing multiples and fundamental performance, RIA valuations are now at or near all-time highs. But whatever the market conditions when you go to sell, it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a wide spectrum of buyer profiles has emerged to accommodate different seller motivations and allow for different levels of autonomy post transaction. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision, and one which can have a significant impact on personal and career satisfaction after the transaction closes.

This week, we welcome Jay D. Wilson, Jr., CFA, ASA, CBA to the Energy Valuation Insights blog. Jay is a Senior Vice President at Mercer Capital and a member of the firm’s Financial Institutions and Transaction Advisory teams. The post below originally appeared as part of an ongoing series from Mercer Capital’s Transaction Advisory team regarding the importance of quality of earnings studies in transactions for middle market companies.Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

This week, we welcome Jay D. Wilson, Jr., CFA, ASA, CBA to the Family Business Director blog. Jay is a Senior Vice President at Mercer Capital and a member of the firm’s Financial Institutions and Transaction Advisory teams. The post below originally appeared as part of an ongoing series from Mercer Capital’s Transaction Advisory team regarding the importance of quality of earnings studies in transactions for middle market companies.Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

Transaction activity in the Permian Basin cooled off this past year, with the transaction count decreasing to 21 deals over the past 12 months, a decline of 6 transactions, or 22%, from the 27 deals that occurred over the prior 12-month period. This level is in line with the 22 transactions that occurred in the 12-month period ended mid-June 2020. It is difficult to interpret the significance with any certainty. On one hand, it could indicate increased trepidation regarding production prospects in the basin. On the other hand, it could simply be a sign that regional E&P operators have started to "right-size" their inventories in the West Texas and Southeast New Mexico basin. Based on the evolving economics of the region, as we will examine further below, the latter case may be closer to the truth.A table detailing E&P transaction activity in the Permian over the last twelve months is shown below. Relative to 2020-2021, the median deal size nearly was $387 million, just 4% lower than the median deal size of $405 million in the prior 12-month period. However, the median acreage purchased over the past year was 21,000 net acres, just over 42% lower than the 36,250 acres among the deals in the previous year. Given the concurrent decrease in acquired acreage and relatively unchanged median transaction price, the median price per net acre was up 16% period-over-period. Looking at acquired production, the median production among transactions over the past year was 5,500 barrel-oil-equivalent per day ("Boepd"), a 39% decrease from the 8,950 Boepd metric from the prior year.Given the relatively unchanged level in the median transaction value in conjunction with a lower median production level, the median transaction value per Boepd, unsurprisingly, jumped 54% from $31,886 in the prior 12-month period to $49,143 in the latest 12-month period. This willingness to pay over 50% more per acre and/or per Boepd suggests that these targets' underlying economics have been, and remain, supportive. However, the marginal costs of these acquisitions may be approaching the perceived marginal returns projected for these properties, as evidenced by the decrease in the transaction count relative to last year.Click here to expand the image above. The approach to the marginal "equilibrium" appears to have been a pretty short runway to land on. Of the 21 transactions completed, 14 occurred from June to December, with the remaining 7 occurring from January 2022 to the present. One metric we analyzed, based on the deal value per production (annualized) per acre, indicates a sharp decline in the "bang for the buck" exhibited by the transactions before and after year-end 2021. As presented below, the median cost per production acre for the 14 transactions from June to December 2021 was $1.072. In contrast, the median metric for the seven transactions from January to June 2022 was $10.762, indicating a 10.0x increase in the cost per production acre.A deeper dive into the details of each transaction would be needed to discern any common causes for this movement, but this could indicate a shift in focus from proven reserves towards unproven acreages. In other words, acquirers may be putting increased value on the potential optionality for greater-but-yet-proven production presented by these targets.Click here to expand the image above.Despite the upward trend in energy prices over the past year, what we are seeing is a likely slowdown in M&A activity in what is generally considered to be the most economical oil and gas basin in the U.S.  If the Permian is a bellwether of U.S. production in general, are we likely to see a slowdown in M&A activity in other basins soon? I would venture to say "yes."Earthstone Energy Acquires Bighorn's Permian PortfolioIn late January 2022, Earthstone Energy announced its agreement with Bighorn Permian Resources to acquire its Midland Basins assets for a total consideration of $639 million in cash and 5.7 million shares of Earthstone's Class A common stock (the "Bighorn Acquisition"). The effective date of the Bighorn Acquisition was January 1, 2022, and the deal closed on April 18, 2022. The Bighorn Acquisition included 110,600 net acres (98% operated, 93% WI, 99% HBP), primarily in Reagan and Irion counties, with an estimated production of 42,400 Boepd (57% liquids, 25% oil), and proved reserves of 106 MMBoe (20% oil, 34% NGL, 46% natural gas).Robert Anderson, President, and CEO of Earthstone Energy, commented, "The transformation of Earthstone continues with the announcement of the significant and highly-accretive Bighorn Acquisition. Combining the Bighorn Acquisition with the four acquisitions completed in 2021 and the pending Chisholm Acquisition, we will have more than quadrupled our daily production rate, greatly expanded our Permian Basin acreage footprint and increased our Free Cash Flow generating capacity by many multiples since year-end 2020. The proximity of the Bighorn assets to existing Earthstone operations positions us to create further value by applying our proven operating approach to these assets, primarily in the form of reducing operating costs. The addition of the high cash flow producing assets from Bighorn to the strong drilling inventory of Earthstone, including the Chisholm Acquisition, furthers Earthstone's transformation into a larger scaled, low-cost producer with lower reinvestment in order to maintain combined production levels."Earthstone Energy Acquires Midland Basin Assets from Foreland InvestmentsIn early November 2021, Earthstone Energy announced the completion of its acquisition of privately held operating assets located in the Midland Basin from Foreland Investments LP ("Foreland") and from BCC-Foreland LLC, which held well-bore interests in certain of the producing wells operated by Foreland (collectively, the "Foreland Acquisition"). The aggregate purchase price of the Foreland Acquisition was $73.2 million at signing, consisting of $49.2 million in cash and 2.6 million shares of Earthstone's Class A common stock valued at $24.0 million based on a closing share price of $9.20 on September 30, 2021. The Foreland Acquisition included approximately 10,000 net acres with an estimated production of 4,400 Boepd (26% oil, 52% liquids), and PDP reserves of approximately 13.3 MMBoe (11% oil, 31% NGL, 58% natural gas).Mr. Robert Anderson, President and CEO of Earthstone, commented, "This transaction will be our fourth acquisition this year as we continue to advance our consolidation strategy and enhance our Midland Basin footprint with additional scale. The acquisition of these low operating cost, high margin, producing assets at an attractive valuation is a nice addition to our production and cash flow base. The Bolt-On Acquisition also includes approximately ~10,000 net acres (100% operated; 67% held by production) in Irion County. We expect to benefit from additional operating synergies when production operations are combined with other assets in the area. As we have done in prior acquisitions, we look forward to applying our operating approach to these assets in order to reduce costs and maximize production and cash flows."ConclusionM&A transaction activity in the Permian declined at an increasing rate over the past year, with two-thirds of the 21 transactions occurring in 2021, and the remaining third transpiring in the YTD period ended in mid-June. But the overall upward trend in deal cost per unit (be it per-production level, acreage, or production-acre) indicates buyers' willingness to pay more to achieve their desired asset base. The overall story is one of the companies right-sizing their presence in the basin.We have assisted many clients with various valuation needs in the oil and gas industry in North America and globally. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

As we’ve been writing in recent blog posts, consolidation efforts in the RIA space are facing multiple headwinds. Among them, market conditions and inflation are motivating buyers to scrutinize profit estimates more than ever. In that light, we thought our readers would appreciate this guest post by our colleague, Jay D. Wilson, Jr., CFA, ASA, CBA, who works with banks and FinTechs. We’re getting more requests for QoE assessments from both the buy-side and sell-side (the latter wanting to buttress their CIMs).Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

As we’ve been writing in recent blog posts, consolidation efforts in the RIA space are facing multiple headwinds.  Among them, market conditions and inflation are motivating buyers to scrutinize profit estimates more than ever.  In that light, we thought our readers would appreciate this guest post by our colleague, Jay D. Wilson, Jr., CFA, ASA, CBA, who works with banks and FinTechs. We’re getting more requests for QoE assessments from both the buy-side and sell-side (the latter wanting to buttress their CIMs).Acquirers of companies can learn a valuable lesson from the same approach that pro sports teams take in evaluating players. Prior to draft night, teams have events called combines where they put prospective players through tests to more accurately assess their potential. In this scenario, the team is akin to the acquirer or investor and the player is the seller. While a player may have strong statistics in college, this may not translate to their future performance at the next level. So it’s important for the team to dig deeper and analyze thoroughly to reduce the potential for a draft bust and increase the potential for drafting a future all-star.A similar process should take place when acquirers examine acquisition targets. Historical financial statements may provide little insight into the future growth and earnings potential for the underlying company. One way that acquirers can better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE).What Is a Quality of Earnings Study?A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer. The QoE can help the acquirer assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors.Ongoing earning power is a key component of valuationOngoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long-term growth can be expected. This estimate of earning power typically considers an assessment of the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness, growth potential, and potential volatility of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. Historical EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-backs; (2) Non-recurring items; (3) Pro-forma adjustments/synergies.Customer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysis.Business and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring. The prior areas noted are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisCustomer AnalysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth companies in certain industries such as technology, where valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit. These unit economics provide a foundation from which to forecast and/or test the reasonableness of projections.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers' perception of the company and its products.The QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situationsThe QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to utilize the QoE study to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers.Leveraging our valuation and advisory experience, our quality of earnings analyses identify and assess the cash flow, growth, and risk factors that impact value. By providing our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows of a potential target, we help them to increase the likelihood of a successful transaction, similar to those teams and players that are prepared for draft night success.Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers and reach out to us to discuss your needs in confidence.

This is the fourth article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. When considering a buy-side transaction to expand, many middle market companies may not consider a merger transaction as an option compared to an outright acquisition. Mergers are often seen as transactions for big conglomerate-type companies on Wall Street, but they can be effective for middle-market businesses as well. A merger is a combination of two companies on generally equal terms in which the transaction is structured as a share exchange although sometimes a modest amount of cash may be included, too. There are many questions that must be addressed. The key economic question involves the exchange ratio to establish the ownership percentages based upon the value of each company and the relative contribution of sales, EBITDA and other measures to the combined company. Corporate governance and social issues are important factors to consider also. Because the “target” shareholders are not cashed out, a significant amount of time early in the process should be spent exploring the compatibility of directors, executive management and shareholders.Why a Merger?A basic premise from a shareholder perspective is that a merger will increase value through enhanced profitability, growth prospects and perhaps from the perspective of an acquirer of the combined company.Stated differently, both shareholders should own shares in a company that will be more valuable than the interest in each independent company.Assuming the parties are comfortable with governance and social issues, a merger can be an excellent means to grow the business when one of two conditions exist:Neither ownership group wants to truly exit; and/orNeither company has enough capital to fund a buy-out acquisition. In the first situation, it may be that certain market, business or personal life cycle dynamics will keep one or both parties from wanting to sell the business. There is too much opportunity in the existing business to forego and owning a smaller percentage of a large pie is not an insurmountable hurdle. A merger gives both sets of ownership the value enhancements related to the expansion without forcing either group to exit their ownership position. Mergers also have another very practical element. Cash is conserved because all or most of the consideration consists of shares issued by the surviving corporation to the shareholders of the company that will be merged into the surviving corporation. Some cash will be expended for professional fees, but the funds usually are nominal relative to the value of the combined companies. Importantly, existing excess liquidity and/or the borrowing capacity of the combined company can be used for expansion.Relative ValueIn a merger transaction, there is a two-sided valuation question. While in an acquisition, the buying party is typically bringing cash to the transaction (cash being easy to value), the merger parties are effectively both paying for the transaction with stock. The value of both companies must be set to determine the relative value percentages. If Company A (valued at $110 million) merges with Company B (valued at $90 million), the relative value percentages are 55%/45%. Following the merger, the former Company A shareholders should have 55% of the equity ownership in the merged entity, with the former Company B shareholders holding the remaining 45%.In addition to considering the stand-alone valuation of each company, a contribution analysis should be constructed based upon sales, EBITDA, equity and other financial metrics. The valuations and contribution analysis then provides a range of exchange ratios (or ownership percentages) to conduct negotiations.While the valuation and contribution math may be straightforward (or not at all), negotiating merger transactions can be complicated since one party is not paid to go away. Mercer Capital is often hired on a joint basis by entities seeking to negotiate a merger transaction.While the final decision to go through with the merger remains with our clients in this situation, we serve as an independent advisor to both sides of the merger to establish the relative value parameters. An independent assessment of the relative values can help tremendously in building confidence with shareholders and boards that the terms of the merger are reasonable for both sides.True-UpsAs with most deals, merger transactions usually include certain post-transaction “true-ups” to ensure that each entity delivers adequate levels of working capital (or other assets) at closing. A typical structure is for the parties to create escrow accounts funded with cash in amounts proportional to the post-merger ownership percentages. These escrow accounts serve as a mechanism to adjust for any shortfall at one entity.If needed, a portion of the escrow cash is contributed into the merged entity, serving to make-up for any shortfall at closing. This keeps the ownership percentages at the agreed-upon relative value percentages. The excess cash left in the escrow accounts after these adjustments is distributed to the shareholders of the former (now merged) entities.In our experience, shareholders and boards do not like the uncertainty of shifting ownership percentages – this escrow structure prevents the percentages from changing based on post-closing adjustments.Who Is in Charge?As with any acquisition, an organized post-transaction integration is critical to the success of a merger.No matter how compelling the economics of a combination may be, the cultural fit of the two businesses will be a key element in determining the eventual success of the transaction. From the initial stages of the transaction, issues related to the cultural fit should be discussed and strategies should be implemented to increase the probability of a successful integration.A basic question to be addressed early in the process is who will run the combined company. Public companies sometimes use co-CEOs, but not often for good reason. There should not be any question who is in charge, the responsibilities of subordinates, and the chain of command and accountability.A comprehensive agreement on overall governance structures (including regional management, board construction, etc.) can provide some comfort for the side that might see themselves as being on the losing end of the potentially more political question of chief executive.Shareholder control is another issue that has to be dealt with explicitly. If both entities consist of a large number of shareholders with no shareholder in direct control, the control issue is moot because there will be no controlling shareholder in the merged entity. Such prospective mergers are easier to negotiate because one shareholder (or voting block) does not have to give up control.However, when one or both entities has a controlling shareholder (which could be represented by a single individual or a family block of stock), loss of control in a combined company may trump compelling economics. Both parties need to examine this issue closely and provide for conflict resolution mechanisms through the corporation’s by-laws and buy-sell agreements. Like marriages, getting out of a transaction is a lot harder and more expensive than entering into it.Concluding ThoughtsWe think mergers are a viable strategy to expand a business when the economics and social aspects are compelling for many small and middle market companies. Reasonable valuations and a detailed contribution analysis are the initial building blocks to quantify the economics. Mercer Capital is an active transaction advisor. While we most often are retained by one party, some of our most successful and rewarding projects have been those where we were jointly retained by both parties to advise on the transaction structure. If you are considering a merger (or in the middle of a current transaction), please call one of our Transaction Advisory Group professionals to assist.

RIA M&A activity and multiples have trended upwards for more than a decade now, culminating in new high watermarks for both activity and multiples set late last year. Deal momentum continued strong into the first quarter, but we sense at least initial signs of slowing as the macroeconomic backdrop has deteriorated.What Does the Future Hold for RIA M&A?On CI Financial’s first quarter earnings call last week, CEO Kurt MacAlpine remarked that the company’s acquisition pace has “absolutely slowed down” relative to 2021 as they focus on integrating existing firms and delivering.  We suspect that other serial acquirers will follow a similar path as CI this year, particularly in light of rising interest rates and declining fundamentals for existing firms.  Add to that the challenges of negotiating a deal when equity markets are swinging as wildly as they have been, and it’s easy to imagine at least a temporary slowdown in the pace of M&A in the coming months.The driving force in recent years has been strong demand and low supply for investment management firmsWill we look back at 2021 as the year RIA transactions peaked, or is the current slowdown merely a blip on the radar amidst a longer-term trend of consolidation and rising valuations?  To look forward, it’s helpful to first consider what shaped the RIA transactions landscape over the last decade.  In short, the driving force in recent years has been strong demand and low supply for investment management firms.  On the demand side, the amount of capital and number of acquirer models has increased rapidly in recent years as investors have sought out the high margins, strong growth profile, and low capital intensity that the fee-based business model offers.At the same time, the number of RIAs in the market for a third party acquirer has remained limited, despite the industry’s often cited lack of succession planning.  As the ratio of buyers to sellers has increased, so too have multiples and transaction activity.We don’t see those long-term supply and demand dynamics changing with the current market environment.  Certainly, some buyers (like CI) will be sidelined temporarily, but they’re still around.  When markets eventually stabilize, it’s more than plausible that transaction activity will return to the long-term trendline.What About Multiples?Supply and demand dynamics have certainly played a role in the rising multiples we’ve seen over the last decade, but the macroeconomic backdrop has added fuel to the fire as well.  The era of extremely low interest rates lowered the cost of capital for acquirors and enabled consolidators to finance RIA acquisitions with cheap debt.  And a persistent bull market has made it easy for buyers to justify projections that look like something out of a SPAC deck.A persistent bull market has made it easy for buyers to justify projections that look like something out of a SPAC deckSo far this year, margins for RIAs have been attacked on two fronts: falling equity markets eroded the fee base, while high inflation and a tight labor market threatened to drive up personnel costs and other overhead.  There’s a lot that goes in to pricing, but it’s safe to say that on many recent transactions, the buyer’s projection model likely looked very different than what’s actually transpired so far this year.  While many of these deals may work out in the long term, chances are there are sellers out there who feel they timed things perfectly, and some buyers that feel they’ve been left holding the bag.With the cost of capital for aggregators rising rapidly and the growth outlook for RIAs declining, we expect to see some multiple contraction relative to the high watermarks seen last year.  And while private transactions for wealth management firms have historically been priced very differently than public asset/wealth management firms, it’s equally likely that at least some of the decline we’ve seen in the public firms will translate to the private markets.There’s still much uncertainty about the duration of the current market environment and the ultimate impact it will have on RIA performance and transaction activity.  As it stands, a near-term slowdown in transaction activity and multiples seems likely, but so too does a return to normal once markets stabilize.

RIA M&A activity continued to trend upward through the first quarter of 2022 even as potential macro headwinds for the industry emerged. Fidelity’s March 2022 Wealth Management M&A Transaction Report listed 58 deals in the first quarter, up 26% from the first quarter of 2021. These transactions represented $89.2 billion in AUM, down 2% from the prior year quarter.Deal volume continues to be led by serial acquirers and aggregators. Mariner, CAPTRUST, Beacon Pointe, Mercer Advisors, Creative Planning, Wealth Enhancement Group, Focus Financial, and CI Financial all completed multiple deals during the quarter. This group of companies, along with other strategic acquirers and consolidators, have continued to increase their share of industry deal volume and now account for about half of all deals. In addition to driving overall industry deal volume, the proliferation of strategic acquiror and aggregator models has led to increased competition for deals throughout the industry, which has contributed to multiple expansion and shifts to more favorable deal terms for sellers in recent years. While deal activity remained robust, the first quarter this year was dominated by macro headlines like inflation, rising interest rates, tight labor markets, and multiple contraction in equity markets—all of which are factors that have potential to impact RIA performance and M&A activity. Rising costs and interest rates coupled with a declining fee base could lead to strain on highly-leveraged consolidator models, and a potential downturn in performance could put some sellers on the sidelines until fundamentals improve. While the duration and extent to which these trends will ultimately impact RIA M&A are still uncertain, recent pricing trends for publicly traded consolidators suggest that investors aren’t particularly optimistic about these models in the current environment. On the other side of the equation, historically tight labor markets and rising costs could amplify certain acquisition rationales like talent acquisition and back-office synergies. Structural trends continue to support M&A activity as well: the RIA industry remains highly fragmented and growing with over 13,000 registered firms and more money managers and advisors who are capable of setting up independent shops. As advisors age, succession needs will likely continue to bring sellers to market. Whatever net impact the current market conditions have on RIA M&A, it may take several months before the impact becomes apparent in reported deal volume given the often multi-month lag between deal negotiation, signing, and closing. But at least through March, transaction activity has remained steady. The Fidelity report lists 19 deals in March, a record level for the month and in line with the levels reported in January and February.What Does This Mean for Your RIA?For RIAs planning to grow through strategic acquisitions: Pricing for RIAs has continued to trend upwards in recent years, leaving you more exposed to underperformance. While the impact of current macro conditions on RIA deal volume and multiples remains to be fully seen, structural developments in the industry and the proliferation of capital availability and acquiror models will likely continue to support higher multiples than the industry has been accustomed to in the past. That said, a long-term investment horizon is the greatest hedge against valuation risks. Short-term volatility aside, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions. For RIAs considering internal transactions: We’re often engaged to address valuation issues in internal transaction scenarios. Naturally, valuation considerations are front of mind in internal transactions as they are in most transactions. But how the deal is financed is often an important secondary consideration in internal transactions where buyers (usually next-gen management) lack the ability or willingness to purchase a substantial portion of the business outright. As the RIA industry has grown, so too has the number of external capital providers who will finance internal transactions. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but there are also an increasing number of bank financing and other external capital options that can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs. If you are an RIA considering selling: After years of steadily increasing multiples and fundamental performance, RIA valuations are now at or near all-time highs. But whatever the market conditions when you go to sell, it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. As the RIA industry has grown, a wide spectrum of buyer profiles has emerged to accommodate different seller motivations. A strategic buyer will likely be interested in acquiring a controlling position in your firm and integrating a significant portion of the business to create scale. At the other end of the spectrum, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Given the wide range of buyer models out there, picking the right buyer type to align with your goals and motivations is a critical decision, and one which can have a significant impact on personal and career satisfaction after the transaction closes.

This is the second article in a series on buy-side considerations. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here. Business is good for many middle market operators and investment capital is generally plentiful. Are you an investor whose capital is industry agnostic, or does your capital need to be targeted at add-on investments that build on a pre existing business platform? All business investors are “financial” investors - the real question is how “strategic” is their ability to leverage the assets of the target. Providing practical guidance on approaching a business target and conducting initial due diligence depends on the investor’s criterion, competencies, and execution bandwidth. In this article we assume you have identified a target or group of targets and you are attempting to learn enough about the target to determine whether to proceed with developing a meaningful indication of interest. Of course, an active seller is likely prepared for the sale process and represented by an advisor who is postured to provide the financial and operating information necessary for investors to quickly determine the suitability of a deal (i.e., a pitchbook and defined protocols for communication and information access). However, many desirable targets may not be seeking a sale because business conditions are favorable, and their businesses have been managed to provide options to the owners regarding continued independence and turn-key ownership and management succession. If the former, you, as a prospective buyer may have already pinged on the radar of the seller, and if the later, you have mined for target opportunities and are ready for the next step to accomplish an acquisition. Our focus here is to summarize some practical considerations for approaching and vetting an identified target.First ContactM&A is not easy. For every transaction that is announced a very long list of items for both the buyer and seller were satisfactorily addressed before two parties entered into a merger or purchase agreement. For the acquirers, first impressions matter a lot. There are no second chances to make a good first impression.How a target is contacted can be pivotal to achieving receptivity and obtaining a critical mass of information. In cases where market familiarity or professional collegiality already exist, it can make sense for an investor’s senior leadership to make direct contact with the target’s senior management and/or owners.In cases where the target is not familiar to the investor, then following a respectful and empathic set of protocols is key. Investors using professional advisors and/or who involve their senior decision makers are likely to be taken seriously by the target. Peer-to-peer contacts too far down the chain of command are more likely to be dismissed.Owners and senior managers are keen to prevent the rumor mill from derailing business momentum and disturbing internal calm. A mindful and considerate process of first contact and initial discussions that is highly sensitive to the discrete nature of exploratory discussions will increase the probability that initial discussions and diligence can proceed to the next phase as a relationship based on trust develops.In our experience, contacting a target through a financial advisor has an important signal function that the potential acquirer is serious and has initiated a process to prioritize and vet targets. Diligence procedures will be thorough and well organized; deal consideration and terms will be professionally scrutinized. Alternatively, some business owners and investors who initiate a process may be perceived as canvassing to see what sticks to the proverbial wall. This can inadvertently serve to inflate seller requirements and expectations assuming the initial inquiry is successful.Initial Due DiligenceOnce the initial contact is established, it is important to follow-up immediately with an actionable agenda. Actions and processes include:Non-disclosure agreement;Information request list;Clear set of communication protocols involving specified individuals;A centrally controlled and managed information gateway;Establishment time frames and target dates for investigative due diligence, IOI, LOI, pre-closing due diligence, deal documentation, and ultimately closing. Organization begets pace and that pace culminates in a go or no-go decision.Preliminary ValuationProcedurally, our buy-side clients typically request that we perform a valuation of the target using a variety of considerations including the standalone value of the target and potentially the value of the target inclusive of expected synergies and efficiencies.A properly administered valuation process facilitates an understanding of the target’s business model, its tangible attributes, its intangible value, its operating capacity, its competitive and industry correlations, and many other considerations that investors use not only for the assessment of target feasibility but as an inward-looking exercise to assess the pre-existing business platform.For first-time buy-side clients, our services may also include building leverageable templates and processes for future M&A projects. Additionally, our processes may also be critical to the buyer’s Board consents, the buyer’s financing arrangements, and other managerial and operating arrangements required to promote target integration.Concluding ThoughtsConducting target searches, establishing contact, and performing initial due diligence are critical aspects of successful buy-side outcomes. In general, there are as many (if not more) consequential considerations for buyers as there are for sellers.Some buyers covet the conquest and go it alone without buy-side advisory representation. Conversely, even seasoned investors can benefit from third-party buy-side processes. Unseasoned acquirers may find their first forays into the M&A buy-side world untenable without proper guidance and bench strength.As providers of litigation support services, we have seen deals that have gone terribly wrong as if predestined by inadequate buy-side investigation. As providers of valuation services, we have valued thousands of enterprises for compliance purposes and strategic needs. As transaction advisors, we have rendered fairness opinions, conducted buy- and sell-side engagements and advised buyers concerning a wide variety of deal structures and financings. If you plan to take a walk on the buy-side, let Mercer Capital’s 40 years of advisory excellence guide and inform you.

RIA group-think has been pro-consolidation for the past decade, and increasingly so. You've read the headlines about the pace of deals reaching a fever pitch last year and continuing into this year. We've been skeptical of the believed necessity for RIA consolidation in this blog in the past, and have yet to be dissuaded from our position. But opinions are only opinions, and facts are facts. This seems like an opportune moment to check our feelings against reality. How is RIA consolidation performing so far? The verdict from the public markets isn't very encouraging. We look at three publicly traded consolidators of wealth management businesses, Silvercrest, CI Financial, and Focus. Over the past five years, Silvercrest Asset Management Group (SAMG) showed cumulative share price appreciation of less than 65%, underperforming the Russell 3000 by over 2200 basis points. To be fair, SAMG pays a reasonable dividend, and its wealth management clients are probably not 100% invested in equities. Nevertheless, we think of RIA returns as being leveraged to the market, and in an era of strong markets a wealth management firm with organic growth plus an acquisition strategy should – in theory - be able to outperform broad indices. SAMG didn't beat the market, but it outperformed a couple of rivals. Focus Financial Partners trades less than 25% above its IPO price from the summer of 2018, in spite of a tremendous number of acquisitions and sub-acquisitions. Focus doesn't pay a dividend so 22% cumulative return is the total return for FOCS shareholders since going public. CI Financial has fared even worse, as the Canadian shop revered for its willingness to pay top dollar hasn't posted a positive return over the past five years, even if you count dividends. Keep in mind, all of the above happened in an era of strong equity markets and low interest rates – what should be optimal conditions to consolidate the RIA space.Obligatory Car StoryThe business climate of the late 1990s was one in which consolidation was rife in nearly every industry. Rollup IPOs were the SPACs of the day, newly minted dot-coms were trading their highly inflated equity currency for other companies' highly inflated equity currencies, and old economy manufacturers were teaming up to share branding, technology, and overhead. Sometimes this worked very well, and sometimes it didn't.It's often said that most M&A results in failure. The free-wheeling, mass-market managers at Chrysler could never agree on expectations with the hierarchical, engineering-led team at Daimler-Benz. The loveless marriage resulted in unfortunate offspring like the Pacifica crossover and the R-class. Less than a decade after the 1998 merger, Daimler unloaded Chrysler to Cerberus for about 25% of the $36 billion it had originally paid.At the same time, a more unlikely pairing actually worked. The 1998 sale of Lamborghini to Volkswagen's Audi division turned out to be wildly successful. Italian styling and German build quality make a good combination, and today Lamborghini sells almost fifty times as many cars annually as it did before Audi bought it. It hasn't caught up with Ferrari yet, but it's close enough to make the guys in Modena pay attention.Investment ThesisLooking back on the two auto industry transactions sheds some light on the expected performance of RIA deals. One way to compare Daimler-Chrysler and Audi-Lamborghini is to consider why they happened in the first place.Daimler-Chrysler was a bulking-up, bigger-is-better, merger-of-equals. The logic was driven by internally-focused economies of scale, and it wasn't clear who was in charge. That left an environment that was unusually hospitable to culture clashes that undermined opportunities, synergies, and (ultimately) sales.Audi-Lamborghini was product-focused, and it was clear from the beginning who acquired who. Huge increases in Lambo sales and the opportunity to equal or surpass their old rival with the Prancing Horse kept internal dissent at bay.Which transaction looks most like the typical RIA deal? The investment thesis for investing in RIAs (whether asset management or wealth management) is straightforward: sticky revenue and operating leverage produce a sustainable coupon with market tailwinds. In an era of ultra-low yields, it's the best growth-and-income trade available, and it's become a crowded trade with a diverse array of institutional investors and family offices. As we've said many, many times in this blog, it's easy to see why one would invest in investment management.Consolidation ThesisInvesting in RIAs is one thing; consolidating them is quite another. Still, the themes that drive industry consolidation are equally well-rehearsed:Scale. With 15,000 or so RIAs in the United States alone, solving for fragmentation seems like an obvious play. Consolidation wonks tout the financial leverage that comes with economies of scale, enhancing margins, distributions, and value.Access. Larger firms theoretically are able to source more sophisticated investment products, technology stacks, and marketing programs.Problem Solving. Sellers have to have an impetus to give up control over their own destiny, and consolidation is often seen as the solution for aging leadership (or at least aging ownership) without a compelling succession path.Financial Engineering with Debt. Covenant-light debt at low rates has made capital widely available for public and private acquirers alike. Banks will typically lend at 3x and non-bank lenders at as much as 6x. With Libor near zero, even premiums on the order of 500 to 600 basis points make LBOs compelling.Financial Engineering with Equity. Multiple arbitrages has been the handmaid of cheap debt. At one point, it was "buy at five to six times, sell at eight to nine times." Then the spread was 9 to 12. Then it was 12 to 15. Then it went further. The whisper numbers usually outpace reality, but the logic is the same. All the above is widely accepted in the industry, and it's easy to see why. But if Fed activity stalls equity, while at the same time raising the cost of borrowing, things could change abruptly. This wouldn't just threaten industry consolidation for financial reasons, it might also expose some flaws in the consolidation thesis.Diseconomies of ScaleIf you put ten RIAs together that each makes $5 million in EBITDA, your combined operation will make $50 million in EBITDA. Your holding and management operation, however, will probably need an executive team with a C-suite, an accounting department, a marketing department, legal, compliance, investor relations, and a couple of pilots for your jet. They'll all need office space in a nice building, even if they mostly work from home. The subsidiary level profitability will inevitably be eroded by monitoring costs.Some of this expense may be replacing functions that would previously have happened at the subsidiary RIA level, but not all of them. Is there enough expense synergy in consolidation to cover the overhead costs of a consolidator? I doubt it.In the asset management space, there is an argument that AUM can be added faster than overhead, and margins can expand almost infinitely (we've seen some big ones). In wealth management, it's a tough slough. When Focus Financial went public, we thought that, even with massive growth, it would be hard to get their adjusted EBITDA margin above 25% - the level we're very accustomed to seeing on a reported basis at wealth management firms of more modest proportions. A publicly traded consolidator might have more than 100 souls on board at the management company level. That's a lot of payroll to cover with subsidiary-level synergies.AccessibilityAre small firms disadvantaged when it comes to necessary products and services? With custodians eager to accommodate all manner of investment products, outsourced compliance, subscription-based tech, and scalable marketing, it's easier than it has ever been to compete as a sub-billion dollar RIA. Scale enables firms to have positions to manage these functions, but it doesn't provide the functions themselves. We aren't experts in RIA operations, but we haven't yet seen a small firm struggle because it couldn't get what it needed (or wanted).Exit and SuccessionConsolidators offer exit capital for RIA founders. In that regard, they can resolve the standoff between generations of leadership and pay senior members a price that next-gen staff either cannot or will not pay. But a cheaper source of capital (or greater appetite for risk) is not a surrogate for succession.Since most of the consolidators in the industry are relatively new, we don't know a lot about whether these models are sustainable. RIAs are not capital intensive, but they are highly dependent on staff to manage both money and relationships. Often the staff who will generate returns for the consolidator in the future don't get a lot of equity consideration in the transaction. And will the founding generation work as hard for their new boss as they did for themselves?These conundrums have led many consolidators to structure earnouts or develop hybrid ownership models that share equity returns in some form or other with subsidiary RIAs. One touts promising to never turn "an entrepreneur into an employee" – which sounds reasonable. Ultimately, though, the staff at subsidiary operations are sharing equity returns with the parent company, and the principal/agent dilemma is less a dichotomy and more of a spectrum.As such, the consolidator will be paying for a firm run by highly motivated founders and getting a firm that will ultimately be run by differently motivated successors. RIA consolidation is the act of simultaneously acquiring the operating asset and accepting the succession liability.Financial De-EngineeringMost RIAs, by far, operate on a debt-free basis. Usually, this is for the obvious reason that there isn't much of an asset base to finance, so why bother. Consolidators, on the other hand, frequently rely on debt financing and, as deal prices have increased, so have leverage ratios. Financing a cash flow stream that is in many ways leveraged to Fed activity works very well in the era of declining and low interest rates – as we have seen.Rising rates and falling (or stagnant) markets lead to higher debt burdens and lower cash flows to service that debt. Add to that the threat of inflation increasing payroll burden. In normal times, there would be enough equity cushion to protect against default. With higher deal multiples – based on highly adjusted EBITDA measures - and the massive leverage available from non-bank financing, we could be in for some nasty surprises.If coverage starts tightening, deal activity will fall off, and multiples will drop. If multiples drop, acquirers won't be able to exit on satisfactory terms. Without equity compensation as a carrot, producers will find an exit for themselves. The unfortunate reality of leveraged RIAs is that their assets get on the elevator, but the liabilities never leave.Climate ChangeI'm not calling it the end of the RIA consolidation trend. For many reasons, it could continue for years to come. But the performance of publicly traded consolidators has been lackluster, in spite of very favorable conditions in which those business models should thrive. Now that we have the prospect of RIA stagflation, it could become very difficult to maintain a land-grab mentality that operates as if the acquirer is valued on the basis of price-per-press-release.

Deal activity in the Eagle Ford increased over the past year as energy prices recovered from a tumultuous 2020. As we noted in June of last year, production in the Eagle Ford remained relatively flat over the prior year despite 146% growth in the regional rig count, suggesting the significant increase in drilling activity was just enough to offset the decline in already-producing wells, but not economical enough to spur production growth meaningfully. This may also have signaled to potential buyers that the time was right to increase their footprint in southern Texas while conversely providing for an exit for sellers who could either capitalize on the prospect of a continued upswing in energy prices or redeploy capital elsewhere. Whatever the exact incentives may have been that drove the M&A activity, the result was ten deals closed in the Eagle Ford over the past four quarters, up from eight transactions closed in the prior four quarters.Recent Transactions in the Eagle FordA table detailing E&P transaction activity in the Eagle Ford over the last twelve months is shown below. The median deal value in the past four quarters ($370 million) was approximately $282 million higher than the median deal value from Q2 2020 to Q1 2021, excluding Chevron’s acquisition of Noble Energy in July 2020. The average deal value over the past year ($573 million) was more than double the average value ($274 million) over the prior year (excluding the Chevron-Noble Energy deal). Also notable, larger positions were transacted over the past year, with a median size of 45,000 net acres as compared to 26,500 net acres in the prior year (excluding Chevron-Noble Energy), and an average deal acreage of nearly 80,000 net acres this past year which was more than double the average of 34,775 net acres in the prior year.SilverBow Resources Builds Up Its Eagle Ford AssetsOn October 4, 2021, SilverBow Resources announced the closing of its purchase to acquire oil and gas assets in the Eagle Ford from an undisclosed seller in an all-stock transaction. The aggregate purchase price for these assets was $33 million, with the transaction consisting of approximately 1.5 million shares of SilverBow’s common stock. In late November 2021, SilverBow announced another transaction closed with its purchase of oil and gas assets from an undisclosed seller for $75 million, including $45 million in cash and approximately 1.35 million shares of SilverBow’s common stock.Of this second transaction, Sean Woolverton, CEO of SilverBow, commented, “This is the third acquisition we have closed in the second half of this year. This transaction represents SilverBow’s largest to date. As we look to 2022, the Company is set to grow production by double digits in part from the incremental development locations and a full year’s worth of contribution from the acquired assets. With greater cash flow and liquidity, SilverBow remains well-positioned for strategic M&A and further de-levering.”Callon Petroleum Divests Non-Core Eagle Ford AssetsOn October 5, 2021, Callon Petroleum – one of the upstream companies we follow regularly in our quarterly review of earnings call themes from E&P operators – announced it had entered into an agreement to sell non-core acreage in the Eagle Ford as part of its acquisition of leasehold interests and related oil, gas, and infrastructure assets in the Permian basin from Primexx Energy Partners. Total cash proceeds from the divestiture were approximately $100 million. The Eagle Ford properties included approximately 22,000 net acres in northern LaSalle and Frio counties. Net daily production from the properties was approximately 1,900 Boe/d (66% oil) on average in the third quarter through month-end August. Callon noted in its press release that the sale would eliminate approximately $50 million in capital expenditures related to continuous drilling obligations over the next two years, allowing for redeployment of capital to higher return projects.ConclusionM&A activity in the Eagle Ford has picked up over the past year in terms of both deal count and the amount of acreage involved. The ten deals noted over the past year were split evenly between property/asset acquisitions and corporate transactions, such as the Desert Peak Minerals-Falcon Minerals Corporation merger announced in mid-January of this year. This signals a notable increase in corporate-level activity as only one of the eight transactions in the prior year involved a corporate transaction, possibly foreshadowing greater industry consolidation in the Eagle Ford moving forward.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world. In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions. We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results. Contact a Mercer Capital professional to discuss your needs in confidence.

Many observers predict that the market is ripe for an unprecedented period of M&A activity, as the aging of the current generation of senior leadership and ownership pushes many middle-market companies to seek an outright sale or some other form of liquidity.Obviously, not all companies are in this position. For those positioned for continued ownership, an acquisition strategy could be a key component of long-term growth. For most middle-market companies, especially those that have not been acquisitive in the past, executing on a single acquisition (much less a broader acquisition strategy) can be fraught with risk. There are many elements, from finding the right targets, to pricing the deal correctly, to successfully integrating the acquired business that could derail efforts to build shareholder value through acquisition.This article is the first in a series on buy-side considerations that we will share over the next few months. In this series, we will cover buy-side topics from the perspective of middle-market companies looking to enter the acquisition market. If you wish to read the rest of the series, click here.Our first topic starts at the beginning – identifying and assessing acquisition targets.Identifying Acquisition Targets and Assessing Strategic FitWith aggregate M&A activity setting records in 2021 and continuing a strong pace in 2022, many businesses are exhibiting a thirst for growth or conversely their shareholders are eyeing an exit at favorable valuations.With labor tightness, supply chain disruptions for capital goods, and financing costs fluctuating in real time, buyers and sellers are increasingly strategic in their mindset. Inflation and interest rates represent potential headwinds, but pent-up demand and plentiful war chests are likely to fuel elevated M&A activity in the foreseeable future. More than a few baby boomers have held on to their business assets making ownership succession and liquidity significant concerns.Additionally, many middle market business assets are churned by financial investors with defined holding periods. Large corporate players and private equity buy-out groups generally have their own corporate development teams. However, small and mid-market companies, occupied with day-to-day operations, often find themselves with limited bandwidth and a lack of financial advisory resource to identify, vet, and develop a well-crafted strategic M&A rationale and then execute it.This article provides touch points and practicalities for identifying viable merger and acquisition targets and assessing strategic fit.Motivation and ObjectivesA rejuvenated appreciation for optimal capital structures and fine-tuned operations has largely debunked the oversimplified notion that bigger is always better. However, right-sizing is about achieving a proper, often larger scale at the proper time for a supportable price. A classic question in strategizing to achieve the right size is that of "buy" versus "build."Many acquisitions are as much about securing scarce or unavailable hard assets and labor resources as they are about expanding one’s market space.Whether your investment mandate is to alleviate scarcities or to achieve vertical or horizontal diversification and expansion, tuning your investment criterion and financial tolerance to motivations and objectives is key.These collective questions, among others, help address the who and the what of recognizing potential targets and assessing the pricing and structural feasibility of a business combination in whatever form that may take (outright purchase or merger in some form).Given our experiences from years of advising clients, we have learned that the most obvious or simple solution is generally best. Many buyers already know the preferable target candidates but lack the ability to assess and the capacity to engage those targets. Additionally, many well-capitalized buyers lack the financial discipline to score, rank, and sequence their target opportunities with the expertise employed by large, active corporate developers and private equity investors.Understanding the magnitude and timing of the returns resulting from your investment options is critical. Constructing financial models to study the options of now-versus-later and the interactive nature of deal pricing, terms, and financing is vital to the process. These technical and practical needs must be addressed competently to grant buyers the freedom of mind and energy to critically assess deal intangibles that often influence the overall decision to move forward with a target or not. Cultural fit, command and control for successful integration, brand and product synergies, and many other factors ultimately manifest in an investment’s total return on investment.Scoring opportunities by way of traditional corporate finance disciplines using NPV and IRR modeling as well as using various frameworks such as SWOT Analysis or Porter's Five Forces is highly recommended. However, blind ambition and soulless math may not result in the best choice of targets.One common sense and often overlooked assessment is how a seller’s motivations may have a bearing on the risk assessment of the buyer. A seller today may be alerting today’s buyer about future realities the buyer may experience. In some cases, sellers are motivated by a deficit of ownership and management succession. In other cases, a seller’s motive may be the result of industry dynamics and disruption that may one day be the concern of today’s consolidators. Get informed, get objective and be rational when assessing a target. If you cannot do that with in-house resources, get help. If you have in-house resources, have your mandates reviewed and your target analysis checked by an experienced advisor with the right balance of valuation and transaction awareness.Take a Walk in the Seller’s ShoesWe know that sellers often fear opening-up their financials and operations to certain logical strategic buyers. This may stem from generations of fierce competition or from a concern that not selling means the seller has revealed sensitive information that will compromise their competitive position or devalue the business in a future deal. Many sellers are extremely sensitive to retaining their staff and keeping faith with suppliers and customers. Buyers should understand that sellers require comfort and assurance regarding confidentiality.Being proactive with non-disclosure agreements and even better using a third party such as Mercer Capital to establish contact may facilitate a process of mutual assessment that is initially a no-go for many tentative sellers. Buyers that demonstrate empathy for the seller’s position and who employ a well-conceived process to initiate exchange are more likely to gain access to essential information.It is common for the seller’s initial market outreach to set the hurdle price for the winning buyer. That may occur as a result of the seller having reasonably skilled advisors who help establish deal expectations or through first-round indications of interest. As such, it should be no surprise for truly strategic buyers to be able to hurdle the offers of first round financial buyers or less optimal fringe buyers.Buyers should also be aware that third party deals must win against the seller’s potential ability to execute a leveraged buy-out with family members or senior managers, which may facilitate favorable tax outcomes versus the asset-based structures in open-market M&A processes. Of course, strategic buyers should be equally aware that many private equity or family-office buyers may also be strategic in their motivations and pricing capabilities based on pre existing portfolio holdings.Awareness of competing concerns for the target must be considered if you intend to win the deal. Buyers, with the help of skilled advisors, can actually help sellers address the balance of considerations that underpin a decision to sell. Having plans for human resource, communicating employee benefits and compensation structures, and laying the groundwork for a smooth integration process are part of walking the talk of a successful acquisition.Concluding ThoughtsWhether your motivations are based on synergies, efficiencies, or simply on the inertial forces of consolidation that cycle through many industries, a well-organized and disciplined process is paramount to examining and approaching the market for hopeful growth opportunities.Regardless of your past experiences and deal acumen, we recommend retaining a transaction advisory team familiar with your industry and possessing the valuation expertise to maximize transaction opportunities and communicate the merits your firm has to offer the target and all its stakeholders.Since Mercer Capital’s founding in 1982, we have worked with a broad range of public and private companies and financial institutions. As financial advisors, Mercer Capital looks to assess the strategic fit of every prospect through initial planning, rigorous industry and financial analysis, target or buyer screening, negotiations, and exhaustive due diligence so that our clients reach the right decision regardless of outcome. Our dedicated and responsive deal team stands ready to help your business manage the transaction process.

Desert Peak Minerals and Falcon Minerals Corporationrecently announced an all-stock merger, forming a pro form a ~$1.9 billion mineral aggregator company. This comes in the wake of Desert Peak’s attempted IPO in late 2021. In this post, we look at the transaction terms and rationale, the implied valuation for Desert Peak, and implications for the mineral/royalties space.Transaction OverviewThe merger will combine Falcon’s ~34,000 Eagle Ford and Appalachia net royalty acres with Desert Peak’s ~105,000 acre Delaware and Midland position, resulting in a combined company with ~139,000 net royalty acres. Approximately 76% of the company’s acreage position will be in the Permian, with 15% in the Eagle Ford and 9% in Appalachia. Pro forma Q3 2021 production was 13.5 mboe/d, which moves Falcon from the smallest (by production) publicly traded mineral aggregator in Mercer Capital’s coverage to number four, leapfrogging Dorchester and Brigham.The transaction is expected to close during the second quarter of 2022, at which time legacy Falcon shareholders would own ~27% of the company, while legacy Desert Peak shareholders would own ~73%. The combined company will be managed by the Desert Peak team and headquartered in Denver.Going forward, one of the key strategies of the company appears to be M&A. The company seeks “to become a consolidator of choice for large-scale, high-quality mineral and royalty positions” and touted its “strategic, disciplined, and opportunistic acquisition approach” in presentation materials.The company also highlighted its ESG credentials, noting the diversity of its workforce and structural economic disincentives for flaring gas. However, most ESG discussions focused on the often-neglected G – governance. Management incentive compensation is expected to be 100% in the form of equity with an emphasis on total shareholder returns, rather than relative returns or growth metrics.Desert Peak Implied ValuationDesert Peak was pursuing an IPO in late 2021, looking to raise $200 to $230 million at an implied enterprise value of $1.2 to $1.4 billion, based on Mercer Capital’s analysis of Desert Peak’s S-1 filing. However, the deal was postponedin November and ultimately withdrawn in January.Based on Falcon’s stock price immediately preceding the announcement, the merger terms imply an enterprise value of $1.4 billion for Desert Peak, slightly higher than the valuation implied by the top-end of the IPO range. However, Falcon’s stock price has slid since then, bringing Desert Peak’s implied valuation back in line with the mid-point of the IPO range.Implied valuations and relevant multiples are shown in the following table.IPO stock price reflects midpoint of $20 to $23 range indicated in Desert Peak’s S-1. Merger stock price reflects Falcon's closing stock price as of 1/11/2022 (immediately preceding merger announcement). Current stock price reflects Falcon's closing stock price as of 1/19/2022.IPO shares pro forma for anticipated IPO offering. Other figures reflect the number of Falcon shares to be issued to Desert Peak.IPO net debt pro forma for anticipated transaction proceeds, as indicated in Desert Peak’s S-1. Other figures reflect net debt as disclosed in the transaction press release.Metric per transaction press release (as of 9/30/2021).Metric per transaction presentation (as of 9/30/2021). Multiple calculated on a dollar per flowing barrel equivalent basis ($/boe/d).Metric per Desert Peak S-1 (pro forma as of 12/31/2020). Multiple calculated on a dollar per barrel equivalent basis ($/boe).Metric per Desert Peak S-1 (pro forma as of 12/31/2020).Metric per transaction presentation.ImplicationsDesert Peak's inability to complete its IPO highlights the lack of appeal of oil & gas assets among generalist investors, which is not welcome news for an industry facing capital headwinds and a dearth of IPO activity. However, Desert Peak was able to structure a new deal at essentially the same valuation should give mineral and royalty owners confidence that logical buyers can be found.ConclusionWe have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world. Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.

The November 2021 SAAR was 12.9 million units, down 0.7% from October and 19% from November 2020. This month’s SAAR came in below expectations as the industry experienced only slight inventory improvement from the historic lows of September and October. This seems like old news, as persistently limited inventory on dealer lots has affected the industry for months now and has been the principal issue concerning auto dealers. In this environment, vehicle prices remain elevated, with the average transaction price paid for a new vehicle reaching a November record of $44,000 this month. Light trucks continue to be red hot, representing more than 80% of all new vehicles sold and leaving dealer lots at a record pace. The average number of days a vehicle stays on the lot fell to a record low of 19 days in November, down from 48 days in November 2020. It is no secret that inventory issues at the dealer level are a consequence of production stoppages and supply shortages by OEMs. OEMs have all been subject to supply chain disruptions for some time, and these challenges have been met with a wide range of responses. Jeff Schuster, president of J.D Power’s Americas operations and global forecasts recently addressed these responses by saying: “The supply shortage is being managed in very creative ways, from building vehicles without certain content, to bringing chip development and production in-house for better supply chain visibility. However, the improvements in vehicle production are inconsistent around the world. China and India both saw stronger vehicle production in October, but North America and Europe remain constrained. Even as plants restart after being down for several weeks, they are not running near-normal levels. While the solutions are intended to minimize the disruption now or in the future, consumers will continue to find it difficult to purchase the exact vehicle they want for several months to come."At least partially as a result of these “inconsistent” conditions across countries, the market shares of certain manufacturers have fluctuated a bit over the last month. Toyota, Hyundai-Kia, Honda, Nissan, and Mazda are among the manufacturers that experienced market share growth in November, while American manufacturers Ford, Stellantis, and General Motors all saw market share losses. This trend in auto public equities has been around for a few months now, but it shouldn’t take long for American and European manufacturers to catch up with their counterparts in other parts of the world by establishing in-house microchip development and securing a consistent pace of production going forward.What Could 2021 Mean to the Industry’s Future?For the last SAAR blog of 2021, we thought it might be valuable to reflect on the unique year that auto dealers and manufacturers have had. This is not a comprehensive recap of a year, but instead a commentary on what seemed to work well in 2021 and what changes might be around for a while.2021 defied nearly everyone’s expectations.While 2020 presented its own set of challenges and opportunities, 2021 defied nearly everyone’s expectations. Analysts following the industry watched as OEMs and dealers reacted to unprecedented conditions in almost every phase of their businesses. We saw dealer principals shepherd their auto dealerships through a choppy market environment and thrive in the current pricing and inventory environments. As the second half of the year wound down, new records were being set every month relating to low stocks of vehicles, elevated, and persistently rising gross profits, and consumer demand for autos of all classes. We also saw a red hot M&A market, with elevated Blue Sky multiples and record-high earnings driving mass amounts of industry consolidation by the public auto dealers like Asbury, AutoNation, Group 1, and Sonic Automotive.The motivation behind a chunk of the sales volume in 2021 seems unique to the times.On the other side of vehicle-buying transactions, vehicle scarcity and inflated sticker prices have left many consumers feeling uncertain about the future of car-buying and when they may choose to make that big purchase. Prospective buyers on the margins may have decided to hold off on buying their next vehicle in the hopes that prices will fall as inventory levels normalize. Others have chosen to take the opportunity to cash in on high trade-in values for their used vehicles that won’t stick around for long. In either case, the motivation behind a chunk of the sales volume in 2021 seems unique to the times we are living through. Many consumers are under the assumption that when things “get back to normal” the car-buying experience will closely resemble what it was pre-pandemic. While that will surely be true for many aspects of the sales process, auto dealers and manufacturers would be remiss not to take the lessons learned in 2021 and make some of the changes permanent in how they do business going forward.We aren’t likely to see high margins on vehicle sales persist.Could pre-orders on many models become more commonplace as dealers find the perfect inventory balance on their lots? Absolutely. Could record low dealer incentives persist in an effort to assist dealers in competitively pricing their vehicles when sticker prices inevitably fall off? Perhaps. But for changes like these to stick, factors like test drive availability and matching model-specific production volumes with the pent-up demand that exists will have to be addressed. It is also important to note that many local, full-service dealerships seek to gain loyalty through providing as great a personal experience for the buyer as possible. Repeat customers and parts and service revenues are very important to these dealers, and making customers feel like they are getting gouged is not in anyone’s best interest. For that reason, we aren’t likely to see high margins on vehicle sales persist. However, dealers and OEMs certainly learned there’s been money left on the table in the past due to the relative inelasticity of demand for vehicles.ForecastWhile December is typically a big selling month for dealers, we don’t see much changing the supply issues in the next couple of weeks to close out 2021. From a dealer’s standpoint, inventories will most likely continue to be sold within days of arriving on the lot.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.

The three transactions in the Marcellus & Utica basins over the past year were just a trickle compared to the 16 transactions reported in the prior year for the Appalachian basins.  The number of transactions in 2020 was more than double the seven transactions in 2019, driven in part by the relative price stability of natural gas as compared to oil which would naturally tend to favor M&A activity in these gas-heavy basins.  One key observation of the transactions in 2020 was that companies were making critical decisions regarding where to operate on a forward-looking basis.  Companies, such as Shell, took the position of divesting their Appalachia assets, while other companies, such as EQT, chose to augment their Appalachian footprint.  The following table summarizes transaction activity in the Marcellus & Utica in 2020: Appalachia transactions announced so far in 2021 are shown in the following table: The decline in transaction activity in 2021 most likely indicates that anyone looking to get into or out of the Appalachian basins effectively did so in 2020, or was concerned with natural gas price volatility, which increased sharply in 2021 after several years of relative calm.  However, that is not to say that the activity in 2021 was any less interesting.  Notable changes in the statistics between the transactions in 2020 and 2021 include a sizable increase in the median and average deal values, price per acre, and price per production unit.  Based on the much smaller sample size of 2021, the magnitude of these differences probably doesn’t mean too much.  But one metric, production per acre (or MMcf/Acre), on an annualized basis, could be indicative of a greater focus on obtaining more productive assets in 2021 than the transactions observed in 2020. The following table summarizes the estimated annualized production per acre, including the median and average values, for the transactions in 2020 and 2021: Buyers in 2021 seemed to target producing rather than prospective, assets, as indicated by, as indicated by the median and average annualized MMcf/Acre metrics.  Irrespective of the smaller transaction count (sample size) in recent history, the minimum production density metric in 2021 (0.71 MMcf/Acre) was nearly 9% greater than the maximum metric observed in the 2020 transactions (0.65 MMcf/Acre), and 52% and 82% higher than the median (0.47 MMcf/Acre) and average ( 0.39 MMcf/Acre) metrics, respectively, observed among the transactions in 2020. Again, this back-of-the-napkin statistical analysis may fall far short of being arguably significant, technically speaking, but it’s pretty interesting as far as an eyeball test is concerned. EQT Corporation Adds to Core Marcellus Asset BaseOn May 6, EQT Corporation (NYSE: EQT)announced that it entered into a purchase agreement with Alta Resources Development, LLC (“Alta”), pursuant to which EQT would acquire all of the membership interests in Alta's upstream and midstream subsidiaries for approximately $2.93 billion.  EQT intended to finance the acquisition with $1.0 billion in cash, drawing upon its revolving credit facility and/or through one of more debt capital market transactions, and stock consideration consisting of approximately 105 million EQT common shares, representing $1.93 billion.  The asset was comprised of approximately 300,000 core acres positioned in the northeast Marcellus region.  Net production as of the transaction date was approximately 1.0 Bcfe per day, comprised of 100% dry gas.  The transaction also included 300-miles of owned and operated midstream gathering systems and a 100-mile freshwater system with 255 million gallons of storage capacity.  Toby Rice, President and CEO of EQT, stated that the acquisition represents an attractive entry into the northeast Marcellus while accelerating the company’s deleveraging path, providing attractive free cash flow per share accretion for EQT shareholders and adding highly economic inventory to the company’s robust portfolio.  Mr. Rice also noted the transaction increases the company’s long-term optionality, and should accelerate its path back to investment grade metrics while simultaneously achieving its shareholder return initiatives.Northern Oil and Gas, Inc. Acquires Non-Operated Appalachian AssetsOn February 3, Northern Oil and Gas (NYSEAM: NOG) agreed to acquire certain non-operated natural gas assets in the Appalachian basin from Reliance Marcellus, LLC (“Reliance”), a subsidiary of Reliance Industries, Ltd., for total consideration of $175 million in cash and approximately 3.25 million warrants to purchase shares of NOG common stock at an exercise price of $14.00 per share.  The transaction was expected to be funded through a combination of equity and debt financings and anticipated to be leverage neutral on a trailing basis and leverage accretive on a forward basis.  At the effective date of July 1, 2020, the acquired assets were producing approximately 120 MMcfe/d of natural gas equivalents, net to Northern Oil and Gas.  The assets were expected to produce approximately 100?110 MMcfe/d (or approximately 19,000 Boe/d) in 2021, net to Northern Oil and Gas, and consisted of approximately 64,000 net acres containing approximately 102.2 net producing wells, approximately 22.6 net wells in process, and approximately 231.1 net undrilled locations in the core of the Marcellus and Utica plays.  Furthermore, an inventory of 94 gross highly-economic, work-in-progress (“WIP”) wells was slated for completion over the following five years by EQT.  As of the transaction announcement, approximately $50 million of net development capital had already been deployed on the WIP wells, which was not subject to reimbursement by Northern Oil and Gas.  The acquisition complemented Northern Oil and Gas’s then-existing approximate 183,000 net acreage portfolio in the Williston and Permian basins.  As of year-end 2020, the acquired assets held an estimated 493 Bcf of proved reserves, of which approximately 55% were comprised of PDP reserves, with PV-10 of $269 million (at strip pricing as of January 20, 2021).Nick O’Grady, Northern Oil and Gas’s CEO, commented, “This transaction furthers our goal of becoming a national non-operated franchise with low leverage, strong free cash flow and a path towards returning capital to shareholders.  With this transaction, we expect increased opportunities to efficiently allocate capital and diversify risk, our commodity mix and geographic footprint.”ConclusionM&A transaction activity in the Marcellus & Utica shrank in number in 2021 relative to 2020.  However, the relatively greater magnitude of production density represented by the transactions in 2021 could prove to be a bellwether of more “transformational” transactions to come in 2022 as companies stake their claim in the gas and gas liquids rich basins of Appalachia.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

A recent Schwab survey asked RIA principals to rank their firm’s top priorities in the coming year. We were disappointed but not surprised to discover that developing a succession plan was dead last. This is unfortunate because 62% of RIAs are still led by their founders, with only about a quarter of them sharing equity with other employees to support succession planning. Not much progress has been made, and there doesn’t seem to be much of a push to resolve this issue any time soon. Brent Brodeski, CEO of Savant Capital, describes this predicament more crassly:“The average RIA founder is over 60 years old, and many are like ostriches: They stick their heads in the sand, ignore the need for succession planning, ignore that their clients are aging, let organic growth slow to a crawl or even backslide, and have increasingly less fun and a waning interest in their business.”Fortunately, it doesn’t have to be this way. There are many viable exit options for RIA principals when it comes to succession planning:Sale to a strategic buyer. In all likelihood, the strategic buyer is another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal. They will typically pay top dollar for a controlling interest position with some form of earn-out designed to incentivize the selling owners to transition the business smoothly after closing. This scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees or the company’s name.Sale to a consolidator or roll-up firm. These acquirers typically offer some combination of initial and contingent consideration to join their network of advisory firms. The deals are usually debt-financed and structured with cash and stock upfront and an earn-out based on prospective earnings or cash flow. Consolidators and roll-up firms may not always pay as much as strategic buyers, but they often allow the seller more autonomy over future operations. While there are currently only a handful of consolidators, their share of sector deal-making has increased dramatically in recent years.Sale to a financial buyer. This scenario typically involves a private equity firm paying all-cash for a controlling interest position. PE firms will usually want the founder to stick around for a couple of years after the deal but expect them to exit the business before they flip it to a new owner. Selling principals typically get more upfront from PE firms than consolidators but sacrifice most of their control and ownership at closing.Patient (or permanent) capital infusion. Most permanent capital investors are family offices that make minority investments in RIAs in exchange for their pro-rata share of future dividends. They typically allow the sellers to retain their independence and usually don’t interfere much with future operations. While this option typically involves less up-front proceeds and higher risk retention than the ones above, it is often an ideal path for owners seeking short-term liquidity and continued involvement in this business.Internal transition to the next generation of firm leadership. Another way to maintain independence is by transitioning ownership internally to key staff members. This process often takes significant time and financing, as it’s unlikely that the next generation is able or willing to assume 100% ownership in a matter of months. Bank and/or seller financing is often required, and the entire transition can take 10-20 years depending on the size of the firm and interest transacted. This option typically requires the most preparation and patience but allows the founding shareholders to handpick their successors and future leadership.Combo deal. Many sellers choose a combination of these options to achieve their desired level of liquidity and control. Founding shareholders have different needs and capabilities at different stages of their life, so a patient capital infusion, for instance, may make more sense before ultimately selling to a strategic or financial buyer. Proper succession planning needs to be tailored, and all these options should be considered. If you’re a founding partner or selling principal, you have a lot of exit options, and it’s never too soon to start thinking about succession planning. You will have a leg up on your competition that’s probably not prioritizing this. You’ve likely spent your entire career helping clients plan for retirement, so it’s time to practice what you preach. Please stay tuned for future posts on this topic and give us a call if you are ready to start planning for your eventual business transition.

As we wrote in our most recent investment manager sector highlight, Public Alt Asset Managers Have Nearly Doubled in Value Over the Last Year, alternative asset managers have outperformed all other investment manager sectors in the RIA post-pandemic rebound. According to Institutional Investor, eight of the world’s ten largest investment management firms by market capital are now alternative asset managers. Most notably, the private equity firm Blackstone surpassed the world’s largest investment management firm by AUM, Black Rock, as the most highly valued stand-alone investment management firm back in September of this year.The demand for investment management firms continues to reach new highs and has culminated in a number of prominent acquisitions over the past year. In the past month alone, three deal announcements of alternative asset managers by larger, traditional asset management firms and diversified financial institutions suggest the sector remains bullish.Franklin Templeton to acquire Lexington Partners acquisition – Nov. 1, 2021. At the time of the announcement, Lexington Partners managed $34.0 billion in AUM primarily in secondary private equity investments and co-investment funds. The deal marks Franklin Templeton’s second private equity acquisition in the past three years after acquiring Benefit Street Partners in 2019.T. Rowe Price to acquire Oak Hill Advisors – Oct. 28, 2021. The alternative credit provider, Oak Hill Advisors, currently manages about $52.0 billion in AUM. The $4.2 billion acquisition marks T. Rowe Price’s first in more than a decade.Macquarie Asset Management to acquire Central Park Group – Oct 21, 2021. Central Park Group is a private equity and real estate investment firm located in New York and has AUM of approximately $3.5 billion.Demand Drivers for Alternative Assets vs. Demand Drivers for Alternative ManagersThe deals listed above are indicative of strong demand for both alternative assets and the firms that manage them. While the niche investment expertise and narrow market presence of alternative asset management firms can sometimes complicate transactions, traditional investment managers are nevertheless finding value in the alternative asset management models which have proven to be highly profitable, resilient, and may be bolted on to existing asset management teams. Below, we look at several factors driving investor demand for alternative assets and for alternative asset management firms.Alternative Asset Demand & Performance Drivers:A low yield environment. When interest rates fall, investors are encouraged to take higher degrees of risk to maintain prior levels of return. Certain alternative assets such as private equity and venture capital are generally considered higher risk, higher reward investments. Interest rates have remained at historic lows since the Great Recession and dipped further during 2020.Heightened volatility. In times of heightened market volatility, investors flock to real assets and private equity which is less prone to price swings. Additionally, certain options-heavy investment firms are also positioned to benefit as the volatility on the underlying is directly related to the options value. The historic market volatility throughout the pandemic era has benefited hedge fund performance and left investors flocking to “safer” asset classes.Robust exit activity. While markets have been exceedingly volatile over the past year and a half, they have more than recovered from the lows at the onset of the pandemic. Asset inflation has run rampant, particularly in the private equity and venture capital space which is now well positioned to benefit from strong exit activity in the coming years.Inflation. According to data from Trading Economics, annualized inflation in October 2021 was 6.2%, the highest level in decades. Certain alternative asset classes are widely considered to be inflation hedges. Real assets such as commodities and private real estate traditionally outperform in times of high inflation because returns are tied to capital appreciation.Demand Drivers for Alternative Asset Manager Acquisitions:Positive Fund Flows. According to PWC’s midyear outlook for private equity, investor appetite for private equity has outpaced traditional investment manager fund flows over the past five years. Sector AUM increased nearly 20% in 2020 alone, and the trend seems to be gaining momentum. Currently, PE dry powder is at an all-time high at $150.1 billion, which is reflective of strong fundraising and investor demand.Fees. Alternative asset managers seem to be somewhat immune to fee compression which has been one of the strongest headwinds for asset management for over a decade. The widespread consensus among money managers is that alternative assets justify premium fees due to purported diversification benefits, higher return, and expertise needed to execute such strategies. The opaque nature of the investment strategies and asset classes employed by alternative asset managers may also help these firms avoid fee compression.Diversification. Implicit in most asset management models is operating leverage. Because revenues are directly tied to the performance of the market and expenses remain somewhat fixed to compensation and overhead, diversifying firm exposure by broadening product offering may smooth out the bottom line. For this reason, alternative asset management firms can make strong acquisition targets for traditional asset managers. While fund flows may taper off if systemic tailwinds subside, alternative asset managers will likely remain strong acquisition targets for traditional asset managers due to diversification benefits and superior fees. Additionally, demand for alternative asset managers from other financial institutions such as banks and insurance companies looking to gain exposure to the investment space will also likely remain strong.

Last week I got an email from the finance company that holds the lease on my car announcing that the “countdown had begun.” My lease ends in May, and the manufacturer was encouraging me to start thinking about my next vehicle – even offering to waive the $575 lease disposition fee if I terminated the lease early. Strange, I thought. Given the scarcity of new vehicles in the market, why is the manufacturer’s finance company offering me incentives to join the line of people who want but can’t get a new car?Eager to uncover the motivation for this surprising act of Teutonic generosity, I reviewed my lease agreement to see if I could solve the mystery. Knowing I had the option the buy the car at the lease’s stated residual value, I also checked some used car listings for comps with the age and mileage my roadster will have in May. This exercise suggested my car will be worth about 40% to 50% more than what I could buy it for at the end of the lease. So, my call option is in the money, and the finance company is keen to let me surrender that option to them.Alas, my good fortune isn’t all that good. If I choose to buy-and-hold my car at the end of the lease, I can’t monetize the option. If, instead, I buy-and-trade my car for something else, I may get market value, but I’ll have to find something to buy. These days that will cost me both in terms of time and money. At this point, the only thing I know for sure is that I won’t be returning my car to the finance company. Sorry fellas.In the Market for a Good Used RIA?A couple of times a week, we get calls from someone we’ve never met saying they’d like to talk with us about their RIA acquisition strategy. About half are RIAs or trustcos looking for expansion, and the other half are private equity or family offices. Very few are calling because they have a particular target in mind; fewer still have begun the process of negotiating with a potentially interested seller.If your acquisition strategy these days is starting from scratch, you’re in a tough spot. There’s nothing on the lot, and what is available looks expensive. That doesn’t mean you should give up, though. Here are some practical tips to pursue an acquisition strategy in this market environment, as well as the markets to follow.Build relationships. Sellers faced with a dozen potential suitors often exhibit a common behavior: they don’t know what they like – they like what they know. Sellers are drawn to preexisting relationships, even when the offer from those parties doesn’t quite measure up to other offers. This makes a lot of sense given that selling an RIA often means going into business with the buyer for several years. Acquisitions are a process, not an event, so get to know the people you might want to be in business with – early and often. It’ll help you win the auction – or avoid it altogether.Deliver what you promise. The most frustrating part of the transaction process is when counterparties (or their advisors) don’t meet deadlines. If indications of interest are due on Friday, don’t call on Friday to ask for more time. You might get it, but you’ll also earn a reputation for not meeting expectations, which will make sellers leery of dealing with you. Sellers are usually represented, and buyers often aren’t. If you need professional assistance in pursuing an acquisition, get them on board so that you’ll maximize your opportunity.Consider alternative structures. Not every seller needs or even wants a check. Some want a partner. Some want your stock. Some want a joint venture. Ask questions about the underlying needs of the seller to find out how you can creatively accommodate their needs and meet yours as well. Winning a deal isn’t always about being the high bid – it’s about being the best bid.Accept pricing for what it is. For lots of very rational reasons, pricing in the RIA space is high. It might not be quite as high as reported, because everyone in the deal community is motivated to dress up the multiples as much as possible (we’ve written before about reported versus pro forma numbers, pricing with and without earn-outs, the impact of rollover equity, etc.). But, like prices for new and used cars, RIAs are worth top-dollar. Neither situation is going to resolve itself anytime soon. Microchip availability may drive the supply/demand imbalance in automobiles for years. Low interest rates and a flood of PE capital may do the same for RIAs.Turn your acquisition strategy on its head. If you accept the fact that this is a seller’s market, why do you want to be a buyer? Think about selling - or merging - into a larger firm. As part of a larger buyer, you’ll have more support (talent and capital) for building through acquisitions, and you’ll have the benefit of firsthand experience as a seller.Don’t get caught up in FOMO. There is a frenzy to buy RIAs, but that doesn’t mean you have to be part of it. Discipline still matters. Some buyers are so desperate to acquire an RIA that they’re willing to look at “opportunities” that don’t make any sense. Remember that opportunity is a two-way street. The bull market of the past twelve years has redeemed a lot of bad acquisitions in the RIA space. These days, everybody on the buyside feels smart.Don’t wait for the market to become rational. If you’re sitting this “period” out because you’re waiting for valuations to come down, find another reason. Prices may drop – but it may be a long time from now. If paying full freight for acquisitions doesn’t suit you, I won’t judge you. But don’t base your expectations for the future on the hope that things will change. They may not change.You might do better on your own. For most firms, organic growth is the best growth. Competing for acquisitions is hard, and integrating them is even harder. Conventional wisdom these days is that organic growth opportunities in the RIA space are narrowing and growth is slowing. But conventional wisdom yields conventional results. If you can devise a way to generate organic growth, you’ll gain control over your future – and a standout presence as a target one day. Shortages and tight markets are more the exception than the rule right now. I’ve heard an emerging theory in fixed income that rates will stay “lower-for-longer.” If so, yield starved investors of all stripes will be drawn to the growth and income characteristics of RIAs – which will keep multiples “higher-for-longer.” Whether or not this turns out to be the case, the shortage of acquisition opportunities in investment management firms will likely outlast the shortage of microchips that’s plaguing car manufacturing, such that even scratch-and-dent RIAs will remain pricey. As a buyer, you can’t entirely sidestep this problem, but you can pursue some basic tactics that will help – both now and in the future.

October 2021 SAAR was just shy of 13.0 million, as new light vehicle sales saw their first month-to-month gain since April. The October SAAR is up 6.3% from last month but remains 20.8% lower than last October. Auto dealers began the month with record low inventory levels of 972,000 units, and low inventories continue to keep car buying activity constrained. Dealers are pre-selling a significant amount of the new inventory they receive as they attempt to satisfy demand. According to Thomas King, President of Data and Analytics, nearly 54% of vehicles will be sold within 10 days of arriving at a dealership.As of now, there is no expectation that inventory on the lot will increase anytime soon. There is some optimism around the industry that inventory levels will slowly increase throughout 2022, but it is likely that these inventories will remain below pre-COVID levels for the foreseeable future. Based on our discussions with dealers and reading of the tea leaves, we think it’s reasonable OEMs will see heightened profits under the status quo and seek to structurally tweak how much inventory is kept on dealer’s lots going forward. In October, prices have continued to rise and OEM incentive spending has continued to fall. This has been the case for several months now, and dealers have been realizing record profitability on vehicles sold for some time. If it seems like there are new profitability records being set every month, it is because there have been. Average incentive spending per unit has hit another record low of $1,628 in October. Total retailer profit per unit is on pace to reach another record high of $5,129 as well, the metric’s first time above the $5,000 mark. For perspective, this is an increase of $2,937 (more than double) from a year ago, and total aggregate retailer profits, a measure of the industry’s profitability as a whole, is up 213% from October 2019, reaching $4.8 billion. This October was the most profitable October on record for auto dealers, and it is likely that November will yield some of the same, if not better, results. Inventory shortages and record profitability are not the only persistent conditions in which auto dealers are operating. Fleet sales continue to be outpaced by retail sales, accounting for only 142,000 units over the last month. Trucks and SUVs are on pace to account for a record high 80.9% of new vehicle retail sales in October as well. As far as new vehicle prices are concerned, transaction prices on the average new car reached another record high of $42,921. While supply and demand imbalance plays a role in these increasing prices, we note the mix of vehicles is also important. Trucks tend to be more expensive than cars, so the mix continuing to shift towards higher profit trucks leads to higher transaction prices. The moral of the story is that October proved to be more of the same for auto dealers across the country, and most dealers are still thriving in a low inventory–high price environment. Microchip Background and UpdateMany OEMs, dealers, and research analysts following the industry have been looking ahead to try and predict when the ongoing inventory shortage might begin to improve. As we have mentioned earlier in this blog and on previous blog posts, the current estimate seems to be around the middle of 2022 at least, depending on your definition of improvement. One important determinant that many are looking at is the state of the semiconductor industry.Semiconductors, referred to by many as microchips or chips, are the brains behind electronic devices. As more electronic devices are being produced each year around the globe, the semiconductor industry has struggled to keep pace with demand for some time now. The rise of 5G technology can be blamed for increased demand, as well as increased demand from industries that have traditionally been semiconductor-free (auto makers can be included here, although chips have been common in new vehicles for years now). Another driver of increased demand is the rising number of semiconductors needed per manufactured unit across the many affected industries. For example, just one car can have anywhere from 500 to 1,500 different semiconductors. As we discussed previously, the pandemic exacerbated issues with people stuck at home reaching for electronics as a means of entertainment.The increased demand mentioned above, paired with supply chain disruptions have set up the perfect storm for a semiconductor crisis. The crisis is hitting OEMs particularly hard, as many manufacturers are announcing major slowdowns and stoppages during the fourth quarter of 2021. We have not touched on the geopolitical ramifications of the semiconductor shortage, although the sourcing of these chips going forward will be an important factor to keep an eye on.Toyota Motor recently announced that it was on pace to produce 40% fewer cars and trucks in October as a result of the chip shortage. This marks the second month in a row that Toyota slashed production estimates. GM, Ford, and Stellantis, who have all dealt with intermittent shutdowns over the last 6 months, account for 855,000 units of reduced vehicle production. Particular models from these OEMs that have been severely affected are Ford F-Series trucks, the Jeep Cherokee, the Chevy Equinox, and Chevy Malibu. Given that this crisis is becoming the single most important factor in getting vehicles on dealer lots, many executives are being asked when they think the supply chain for semiconductors will reach pre-pandemic levels.A Volkswagen executive recently released a statement, saying that “Without a doubt, this shortage is going to go well into 2022, at least the second half of '22."Likewise, Ford CFO John Lawler said that Ford is “doing everything we can to get our hands on as many chips as we can. We do see the shortage running through 2022. It could extend into 2023, although we do anticipate that the scope and severity of that to reduce.”Executives of the other major OEMs are echoing these concerns as all OEMs face similar challenges in securing chips for their vehicle production. That being said, the industry is prepping for an extended waiting game and cannot do much to produce more units in the meantime than what is allowed by current semiconductor inventories. While auto dealers are bearing the brunt of consumer frustration over the higher prices and lower availability, at least profits are up.ForecastLooking ahead to next month and the remainder of the year, we expect that the sales pace of the industry will continue to be constrained by the procurement, production, and distribution problems outlined above. From a dealer’s standpoint, inventories will most likely continue to be sold within days of arriving on the lot. However, the number of incoming units is not expected to materially change in November. Essentially, dealers can expect more of the same.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.

Despite the dip in the second quarter of 2021, RIA M&A activity continues to reach record highs putting the sector on track for its ninth consecutive year of record annual deal volume. The same three demand drivers discussed last quarter persisted throughout the third quarter of 2021: (1) secular trends, (2) supportive capital markets, and (3) looming potential changes in the tax code. While fee pressure in the asset management space and a lack of succession planning by many wealth managers continues to drive consolidation, looming proposals to increase the capital gains tax rate has accelerated some M&A activity in the short-term as sellers seek to realize gains at current rates. Increased funding availability in the space has further propelled deal activity as acquisitions by consolidators and direct private equity investments increased significantly as a percentage of total deals during the recent quarter. Private Equity Drives RIA M&AWe’ve written extensively on the prominence of acquisitions by private equity backed consolidators in the RIA industry. Over a decade of rapid growth and persistent profitability has established a class of RIAs with institutional scale as well as an influx of new entrants. According to a recent study by McKinsey, in 2020 there were 15 retail-oriented RIAs eclipsing $20 billion in AUM while approximately 700 new RIAs were started annually over the past five years. This dynamic of a handful of large, financially mature firms surrounded by a highly fragmented market has attracted immense buying activity from private equity sponsors looking to leverage the number of established firms with expertise and scale available to acquire lower valuation, high growth RIA firms in the earlier stages of development.... a handful of large, financially mature firms surrounded by a highly fragmented market has attracted immense buying activity from private equity sponsorsThree-quarters of Barron’s 2020 top 20 RIAs are owned by private equity firms or other financial institutions. Notable examples such as Focus Financial (backed by Stone Point Capital prior to IPO), HighTower Advisors (Thomas H. Lee Partners), Wealth Enhancement Group (TA Associates), and Mercer Advisors (Oak Hill Capital Partners) accounted for an outsized share of total deal volume during the third quarter of 2021, and the percentage of total acquisitions made by consolidators increased from 50% to over 70% of all transactions in the past quarter. Direct investments in the third quarter also reached an all-time high for a total of 12 transactions. Such interest from private equity backed buyers continues to support high valuation multiples.2021 RIA-to-RIA transactions as a percentage of total deal volume is expected to be at a ten-year low largely due to the increase in acquisitions made by consolidators and private equity direct investments. Increased competition for deals favors consolidators who have dedicated deal teams, capital backing, and experience to win larger transactions, and even multiple large transactions simultaneously. The trend is evidenced by increased AUM size per deal, which is on track to reach a record high for the fourth consecutive year. While this is partially a result of increased AUM due to strong market performance, Echelon Partners notes that the persistent increase is also likely due to the deep pocketed supply of capital by sophisticated buyers which has caused demand for acquisitions to outpace the supply of firms looking to sell.While systemic factors continue to be a primary driver of RIA deal activity, the surge in acquisitions made by financial buyers has led some to question the sustainability of recent M&A highs. Notably, while deal volume increased to record levels in September 2021, investor sentiment for RIA consolidators was mixed during the same period as investors have expressed concern about rising competition for deals and high leverage which may limit the ability of these firms to continue to source attractive deals in the future. Private equity buyers, and consolidators acting as private equity portfolio companies, are motivated by investment opportunity. As financial buyers flock to opportunities, they drive up valuations and simultaneously diminish IRR. Recent private equity and consolidator interest in the UK market exemplifies the saturated valuations in the U.S. market as buyers have begun to seek out cheaper entry points abroad.The RIA industry remains highly fragmented and growing.While deal volume has continued to reach new highs for nearly a decade now, there continues to be ample supply of potential acquisition targets (although not all of these firms are actively looking to sell today). The RIA industry remains highly fragmented and growing with over 13,000 registered firms and more money managers and advisors who are capable of setting up independent shops. Systemic trends and strong buyer demand will likely continue to bring sellers to market, and for now, there are no signs that momentum in deal activity is stalling anytime soon.What Does This Mean for Your RIA Firm?If you are planning to grow through strategic acquisitions, the price may be higher, and the deal terms will likely favor the seller, leaving you more exposed to underperformance. That said, a long-term investment horizon is the greatest hedge against valuation risks. As discussed in our recent post, RIAs continue to be the ultimate growth and yield strategy for strategic buyers looking to grow their practice or investors capable of long-term holding periods. RIAs will likely continue to benefit from higher profitability and growth compared to broker-dealer counterparts and other diversified financial institutions.If you are considering an internal transition, there are many financing options to consider for buy outs. A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but bank financing can provide the selling partners with more immediate liquidity and potentially offer the next-gen cheaper financing costs.If you are an RIA considering selling, valuations stand at or near historic highs with ample demand from buyers. That said, it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market. A strategic buyer will likely be interested in acquiring a controlling position in your firm with some form of contingent consideration to incentivize the selling owners to transition the business smoothly after closing. Alternatively, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference. Sellers looking to leverage the scale and expertise of a strategic partner after the transaction may have many buyers to choose from.

Several pre-pandemic years ago, my family and I enjoyed a long vacation in England, touring the usual castles, cathedrals, and museums.  At some point in the trip, my kids noticed that many of the buildings we toured and historical objects we saw were in some way tied to, owned by, or were on loan from, the royal family. Whether it was Windsor Castle, the Crown Jewels in the Tower of London, or the Bentley limousines garaged at Buckingham Palace, much of what you see as a tourist in England is recorded on Her Majesty’s balance sheet.I took the opportunity to point out to my kids that a reliable way to accumulate wealth was to invest in assets you would never want to sell, and then don’t sell them. The best assets tend to remain the best, and the avoidance of transaction costs removes a drag on returns that everyone – in my experience – underestimates.The increased prominence of “permanent” capital providers in the RIA space takes me back to the multi-generational buy-and-hold strategy of the royals, not just because of the avoidance of transaction costs but also because of the premium entry prices being paid. In 1852, Prince Albert and Queen Victoria paid £32,000 for a vacation home now known as Balmoral Castle. What was that price relative to market? I don’t know, but 170 years later, it doesn’t matter.GPs at private equity conferences once liked to boast about their success in booking “gains on purchase” – a clever way of saying they could buy at a discount to market. No one talks that way in the RIA community these days. If anything, I’m struck by how sponsor-backed acquirers are willing to state, publicly, their willingness to outbid each other. I won’t call anyone out with specific examples, but they aren’t hard to find.RIAs are probably the best coupon available in a low-to-no yield environment.It’s as if a land-grab is underway, with competing interests looking to consolidate as much market share in the investment management community as they can, as fast as possible. The trouble is that RIAs are a sort of land that is actually still being manufactured. Despite the rampant consolidation in the space, the number of RIAs is steadily on the increase. Nevertheless, there is legitimate cause for enthusiasm.As we’ve written many times in this blog, investing in the RIA space represents a singular opportunity. RIAs are probably the best coupon available in a low-to-no yield environment. They are a growth and income play like none other. They are practically the apotheosis of diversification in a way that Harry Markowitz could have only dreamed of when he started publishing his research nearly 60 years ago.Unfortunately, many reasonable ambitions, stretched far enough, eventually become wellsprings of regret.Returns and valuations are inversely related, after all. An unfettered willingness to pay more is just a race to the bottom on ROI. Financial engineering doesn’t repeal the laws of financial gravity. Taking more and greater risks leads to a greater variability of outcomes. Paying more compresses returns. To my way of thinking, this isn’t prudent – but I’m not paid to manage capital.Professional investors must work in the market they have, not the market they want. It’s all well and good to talk about “patient” capital, but LPs aren’t going to pay 200 basis points for someone to hold their cash, regardless of how advisable that might be. Given that mandate, the question of whether to make investments at these levels pivots to how best to do it. What opportunities are available in the present – and potentially lingering – environment of high entrance multiples?Financial engineering doesn’t repeal the laws of financial gravity.I’ll posit that the rise of “permanent capital” providers is both in response to and appropriate for current market conditions in the RIA space. This is in sharp contrast to the prevailing “fund” behavior in the private equity community, in which LPs commit capital for a specified length of time – ten years or so – and fund managers have to make investment decisions with an expectation of being in and out of an investment in less time than that – say five to seven – to generate the kind of ROI it takes to raise the next fund.Anyone who’s spent a few moments (or a career) with DCF models knows that there are a limited number of levers to pull to rationalize a high entry price with a five-year holding period. You can assume supernormal growth (unlikely in a mature space like investment management), high exit pricing (multiple arbitrage - aka the greater fool theory), squeezing margins (underinvestment), or low discount rates (race to the bottom on ROI).The other possible lever is, of course, leverage. Debt can enhance equity returns so long as it doesn’t wipe them out entirely. Unfortunately, it’s only in hindsight that we know what leverage ratio is (or was) optimal.Making a permanent capital investment doesn’t eliminate the depressive effects of current valuations on returns, but it mitigates them. Without the pressure to generate an exit within the foreseeable future, RIA investors can focus on the opportunities for sustainable and growing distributions. The longer distributions persist and the more they grow, the less of an impact the entry price has on total return.Further, without the financial friction of trading out of an investment in a few years and the costs and risks of reinvestment, the opportunity for superior returns – especially relative to those available at similar risk elsewhere in the current market – is greater.The question of how long “permanent capital” lasts is a good one. The investors backing many of these enterprises tend to be insurance companies with very long time horizons.  The thousand-year outlook of William the Conqueror probably isn’t relevant to investing in RIAs, but the mindset of an indefinitely lengthy holding period leads permanent capital sponsors to different decision making, which may prove useful in times like this. It’s hard to think long term when the M&A headlines keep coming, but the business cycle has a lot of staying power. In this market, investors need staying power as well.

September 2021 SAAR was 12.2 million, dropping for the fifth consecutive month amidst an ongoing inventory shortage. The September SAAR was the lowest since May 2020’s 12.1 million units but has not fallen near the COVID-19 pandemic low of 8.6 million units in April of 2020.Tight inventories limited both fleet and retail sales in September, which has been the same case over the last four months. Fleet sales continue to fall as a percent of total sales, making up just 12% over the last month, as higher profit retail sales continue to be prioritized.As mentioned in last month’s SAAR blog, auto dealers started the month with industry-wide record low inventory levels of 1.06 million units. Inventory levels have not improved much since then, but the industry inventory to sales ratio has modestly ticked up from 0.68 to 0.72. This could be explained by sales rates finally slowing down and keeping pace with production rates. High levels of demand and low supply have been coexisting for months, and there are only so many new vehicles to go around as consumers are increasingly pre-ordering vehicles before they even arrive on dealers’ lots. While high prices are keeping away certain customers that have decided to wait, wider margins are keeping dealers profitable. However, at current production rates there are only so many vehicles being produced by OEMs that can make it to the lot, and high trade-in values and wide margins can only do so much to bridge the gap for dealers that may not have a new car to sell to a potential trade-in customer down the line. In response to the current climate, average transaction prices have continued to rise. The average transaction price of a new vehicle is expected to top $42,800, another all-time high and the fourth straight month that prices have exceeded $40,000. Dealers have taken advantage of high prices to sustain profitability by achieving high margins on each vehicle sold for months now, and the factors involved continue to benefit dealers. For example, average incentive spending per unit is expected to reach another record low of $1,755 per vehicle, down from $1,823 a month ago, driving GPUs up even further. Another factor that influences dealer profitability, inventory turnover, decreased again as well. The average time that a new vehicle sat in the lot during September was 23 days, down from 25 days in August and 54 days in September 2020 reducing floor plan interest expense. What Do Tech Investments By OEMs Mean For My Dealership?In a previous blog outlining the different options that dealers have when allocating capital amidst excess liquidity, a few options were highlighted. Dealers can either 1) reinvest in the business, 2) return capital to debt and equity stakeholders or 3) seek acquisitions to drive growth. These fundamental decisions apply to OEMs as well, and over the last several months many OEMs have decided to reinvest in the core operations of the business by shifting their focus to electric vehicles.Listed below are narratives of some of the investments OEMs have made and how they might affect the value of your privately held dealership.Nissan has developed a new technique for assembling vehicles more efficiently and with less waste. This technique, called SUMO, enables Nissan to produce vehicles 10% cheaper than before, despite them manufacturing increasingly complex vehicles like hybrids and EVs.General Motors is developing a supply chain for rare-earth metals for the production of EVs, a move expected to pave the way for a more reliable stream of General Motors EVs in the future.Ford has also reinvested in EV operations, and has recently partnered with Electrify America, ChargePoint and others to bolster its charging network.Ford has also announced a state-of-the-art production facility that is set to be built in west Tennessee, creating 5,800 positions to produce electric F-150 trucks. The plant is also said to be a zero-waste-to-landfill facility. The point is that almost every major vehicle manufacturer is investing in the future of its EV production process, a move that some analysts think will lead to higher, Tesla-like, valuations. However, it is unclear whether OEMs will start to invest in support for dealership maintenance infrastructure. Many have already chosen to pass along the costs of investments needed for the sale and service of EV vehicles onto the dealer, creating several issues surrounding the economics of an upgrade for rural and smaller dealerships. Time will tell whether OEMs will choose to prioritize the amount of EVs on lots by further subsiding transition fees.ForecastLooking ahead to October, expectations for the full year 2021 SAAR have once again been lowered. Experts estimate that the global industry has already lost around 9 million units of production related to supply chain issues, and that number should continue to mount with no end in sight for OEMS until and likely into 2022. The demand for new and used vehicles is expected to remain feverish, but sales will have to contend with ongoing production constraints. Sales can no longer outpace production as inventory has been drawn down.At this point, we are pretty confident sales in Q4 won’t be high enough to reach our initial 2021 target. Despite a challenging year from an operational standpoint, we doubt many dealers will be complaining with the results and the profits achieved this year.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact a member of the Mercer Capital auto team.

In three consecutive weeks, 117 auto dealerships were bought across 3 transactions, each scooping up more dealerships than the last. The three smaller pure-play public auto dealership companies (Group 1 Automotive, Sonic Automotive and Asbury Auto Group) all made sizable acquisitions in a red hot M&A market coming after Lithia purchased a large private auto group back in April. Surely, executives of these companies have been reading our blog about achieving growth by reinvesting in core operations through M&A.Group 1 (188 dealerships) is acquiring 30 stores (13.8% of pro forma dealership count) from Prime Automotive Group, which is the smallest acquisition by the largest player in this post, though it still shows a significant trend for the industry. Sonic’s acquisition of 33-store RFJ Auto Partners is sizable compared to its 84 franchised dealerships as of mid-year (28.2% of pro forma) and renders our writeup of Sonic from two weeks ago stale.Asbury is acquiring 54 new-vehicle dealerships from Larry H. Miller compared to 91 dealership locations at mid-year (37.2% of pro forma) which is a considerable transaction particularly on the back of its Park Place Acquisition of 12 luxury stores just over a year ago.These transactions highlight a couple of key themes in the marketplace for auto dealerships. First, elevated performance and valuations mean that now may be a good time to sell. Secondly, scale will be increasingly important in the online retailing age, and even the public players are looking to catch up while some of the largest private players are willing to exit.Group 1 Acquisition of PrimeAs reported by Automotive News on September 13, Group 1 agreed to pay $880 million for 30 dealerships, three collision centers and related real estate from Prime Automotive Group, the 18th largest dealer by 2020 new retail volumes. The timeline for execution of the deal was set for 75 days, though this could be delayed by framework agreements, which govern the relationships between automakers and their largest franchised dealers, limiting the number of stores one owner can have of the same brand or in a certain region.The deal could also be delayed by investors in Prime’s majority owner GPB Capital Holdings, an alternative-asset management firm that has been marred by scandal and lawsuits. These legal issues led those in the industry to expect a sale in 2021 as Prime had received termination notices from a couple of its brands at three of its dealerships.Prime Automotive Group is based in Westwood Massachusetts with operations in the Mid-Atlantic and New England markets. Its brand portfolio includes Acura, Airstream, Audi, BMW, Buick, Chrysler, Dodge, Ford, GMC, Honda, Jeep, Land Rover, Mazda, Mercedes-Benz, MINI, Porsche, RAM, Subaru, Toyota, Volkswagen, and Volvo.  Once the acquisition is completed, Group 1's consolidated brand mix is expected to be approximately 43% luxury, 36% non-luxury import, and 21% non-luxury domestic.Group 1 executives highlighted cost synergies, diversification of its U.S. footprint, and extending the reach of its online digital retailing process “AcceleRide” as key reasons for the acquisition. While the Company has some international diversification (44 of 188 pre-transaction dealership locations are international in the U.K. or Brazil), this transaction should provide geographic diversification as Group 1’s domestic dealerships are heavily concentrated in Texas. The northeast is also a natural extension for Group 1, which already has 16 locations in the region.Sonic Acquisition of RFJ Auto PartnersAs reported by Automotive News on September 22, Sonic paid $700 million to add an estimated $3.2 billion in annualized revenues with its acquisition of RFJ Auto Partners. The deal is expected to close in December 2021 and management expects “day one” synergies based on its prior relationship with RFJ CEO Rick Ford, a former Sonic executive.Sonic management also noted the deal furthers their strategy to increase its geographic reach and expand its brand portfolio, diversifying within the auto retailing space which is important as the smallest of the pure-play franchised retailers. Like Group 1, Sonic also touted the benefits the transaction would have with launching its digital omnichannel platform later this year.RFJ Auto Partners, Inc. was established in 2014 and is based in Plano, Texas. It is one of the largest privately owned auto retail platforms in the United States, with nearly 1,700 employees and a dealership footprint of 33 rooftops located in 7 states throughout the Pacific Northwest, Midwest and Southwest. The RFJ Auto brand portfolio includes Chrysler, Jeep, Dodge, RAM, Chevrolet, GMC, Buick, Lexus, Toyota, Ford, Nissan, Hyundai, Honda, Mazda, Alfa Romeo, and Maserati.The transaction will add six incremental states (Idaho, Indiana, Missouri, Montana, New Mexico, and Washington) to Sonic’s geographic coverage and five additional brands to its portfolio, including the highest volume CDJR dealer in the world in Dave Smith Motors.The deal was touted as an acquisition of a top-15 dealer group. Reviewing the annual Auto News publication, RFJ came in as the 42nd largest dealership by new vehicles retailed. However, it is the 14th largest by revenues, meaning its portfolio has a heavier tilt towards luxury than those ranked above it. Also notable is that RFJ acquired 13 of its 38 dealerships in March 2020. While RFJ may or may not have benefitted from a price concession due to the uncertainty of the COVID-19 pandemic, the deal occurred well before the recent run-up in valuations.RFJ is currently owned by The Jordan Company, a middle-market PE firm headquartered in New York who classified the investment as an automotive dealership platform. While deal terms were not disclosed, it is likely the seller opted to monetize while valuations are relatively high. Private equity is typically viewed to not be a permanent source of capital with a typical investment horizon of 5-7 years. RFJ was founded in 2014, meaning its sale in 2021 was at the longer end of that range. The sale was likely aided by the market conditions for auto dealerships coming out of the pandemic.While other public players, namely Lithia, have sought to expand through numerous smaller acquisitions, Sonic opted to take a larger bite at the apple acquiring a dealership group that will contribute about 28% of Sonic’s post-acquisition stores. In valuation, a size premium is usually added to the cost of capital for smaller operations, meaning a premium is likely paid for larger dealership groups. However, this eases the efforts of integrating into Sonic’s established platform and also reduces excessive costs associated with doing due diligence across numerous deals.Asbury Acquisition of Larry H. Miller DealershipsNot to be outdone, Asbury announced its acquisition of Larry H. Miller Dealerships a week later paying $3.2 billion for annualized revenues of $5.7 billion. Larry H. Miller Dealerships ranked 8th in both revenues and new vehicles retailed in 2020, the second largest private dealership behind Hendrick Automotive Group. This is a significant statement made by Asbury, likely to make it the fourth largest new auto retailer behind only Lithia, AutoNation, and Penske.This “transformative” acquisition follows another transformative transaction all the way back in 2020 when it acquired Park Place, a deal that was downsized from its original announcement due to complications brought on by the uncertainty related to the COVID-19 pandemic. The deal is expected to close prior to the end of the year. Like Group 1, manufacturer approval is not anticipated to be a material concern though Asbury CEO David Hult did note one unidentified brand might pose an issue.Hult noted the acquisition will help the Company “rapidly expand [its] presence into these desirable, high-growth Western markets with strong accretion from day-one.” He continued to note how the geographic footprint will be complemented by “Clicklane,” its omnichannel platform.This transaction will diversify Asbury's geographic mix, with entry into six Western states: Arizona, Utah, New Mexico, Idaho, California, and Washington, and adds to its growing Colorado footprint. Larry H. Miller Dealerships portfolio mix is largely domestic brands, contrasting the Park Place Acquisition that was primarily luxury offerings.Going from 91 to 145 dealerships is a significant step up in size for Asbury. According to Automotive News, this acquisition may make Asbury too large for a takeover attempt by Lithia, who has been the most aggressive acquiror in the automotive retail space. While Asbury would have been complementary geographically to Lithia, the Miller locations would now create more overlap, complicating a deal.Trends for Private Auto DealershipsThese significant acquisitions show a clear appetite from the larger players to grow their operations. Current operating trends also provide some helpful perspective. Inventory shortages and potential for structural changes to inventory levels are likely to make sourcing vehicles increasingly important for auto dealerships.Dealers operating in multiple geographic areas are likely to benefit from sourcing vehicles from numerous places that can be reconditioned and sold where demand is highest. Vehicles can also be moved around to areas where demand is highest in order to maximize GPUs. From a valuation perspective, brand and geographic diversity also reduce risk for dealers looking to go all-in on automotive retail. While diversification is beneficial from a risk perspective, it’s also likely required from a practical standpoint due to framework agreements.Used-only retailers may have better name recognition among consumers than some of these public players because many acquired dealerships continue to operate under the name of the prevailing business. However, increasing scale and building out online platforms will help, and these dealers have the built-in advantage of also having the ability to sell new vehicles, which the Carvanas of the world cannot.For private dealers, it appears there is and will be a market for bolt-on acquisitions, though public players may be more likely to act on larger groups first if these transactions are any indications. Still, Group 1 acquired two dealerships in Texas on Monday, so it seems they are willing to listen to all sizes of deals. According to Erin Kerrigan of Kerrigan Advisors, these three transactions are “indicative of an accelerating pace of industry consolidation with the top 50 dealership groups that are private now looking, in many cases, to exit.” While the Asbury-Larry H. Miller deal may appear to be capping this trend with four mega-deals, Kerrigan indicates it may be “a harbinger for the future”.ConclusionLarger private dealerships exiting the business is something to keep an eye on. Transactions occur on a case-by-case basis, as illustrated by the turmoil surrounding Prime. However, a trend is clear with four of the largest privately held auto groups selling in 2021. Dealers will want to continue their dialogues with their OEMs for the future of automotive retailing and how they can best compete as the industry consolidates.As we’ve noted before, these transactions indicate that there are fewer owners now than in the past, but the number of dealerships hasn’t moved significantly, meaning even smaller players will continue to have a foothold and serve their local communities.Mercer Capital provides business valuation and financial advisory services, and our auto team focuses on industry trends to stay current on the competitive environment for our auto dealer clients. Contact a member of the Mercer Capital auto dealer team today to learn more about the value of your dealership.

Depository M&A activity in the U.S. has accelerated in 2021 from a very subdued pace in 2020 when uncertainty about the impact of COVID-19 and the policy responses to it weighed on bank stocks. At the time, investors were grappling with questions related to how high credit losses would be and how far would net interest margins decline. Since then, credit concerns have faded with only a nominal increase in losses for many banks. The margin outlook remains problematic because it appears unlikely the Fed will abandon its zero-interest rate policy (“ZIRP”) anytime soon.As of September 23, 2021, 157 bank and thrift acquisitions have been announced, which equates to 3.0% of the number of charters as of January 1. Assuming bank stocks are steady or trend higher, we expect 200 to 225 acquisitions this year, equivalent to about 4% of the industry and in-line with 3% to 5% of the industry that is acquired in a typical year. During 2020, only 117 acquisitions representing 2.2% of the industry were announced, less than half of the 272 deals (5.0%) announced in pre-covid 2019.To be clear, M&A activity follows the public market, as shown in Figure 1. When public market valuations improve, M&A activity and multiples have a propensity to increase as the valuation of the buyers’ shares trend higher. When bank stocks are depressed for whatever reason, acquisition activity usually falls, and multiples decline.Click here to expand the image aboveThe rebound in M&A activity this year did not occur in a vacuum. Year-to-date through September 23, 2021, the S&P Small Cap and Large Cap Bank Indices have risen 25% and 31% compared to 18% for the S&P 500. Over the past year, the bank indices are up 87% and 79% compared to 37% for the S&P 500.Excluding small transactions, the issuance of common shares by bank acquirers usually is the dominant form of consideration sellers receive. While buyers have some flexibility regarding the number of shares issued and the mix of stock and cash, buyers are limited in the amount of dilution in tangible book value they are willing to accept and require visibility in EPS accretion over the next several years to recapture the dilution.Because the number of shares will be relatively fixed, the value of a transaction and the multiples the seller hopes to realize is a function of the buyer’s valuation. High multiple stocks can be viewed as strong acquisition currencies for acquisitive companies because fewer shares are issued to achieve a targeted dollar value.However, high multiple stocks may represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be obvious even when the buyer’s shares are actively traded.Our experience is that some, if not most, members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved, there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to “value.”A fairness opinion is more than a three or four page letter that opines as to the fairness from a financial point of a contemplated transaction; it should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated.Key questions to ask about the buyer’s shares include the following:Liquidity of the Shares - What is the capacity to sell the shares issued in the merger? SEC registration and NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. OTC traded shares should be scrutinized, especially if the acquirer is not an SEC registrant. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.Profitability and Revenue Trends - The analysis should consider the buyer’s historical growth and projected growth in revenues, pretax pre-provision operating income and net income as well as various profitability ratios before and after consideration of credit costs. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated. This is particularly important because many banks’ earnings in 2020 and 2021 have been supported by mortgage banking and PPP fees.Pro Forma Impact - The analysis should consider the impact of a proposed transaction on the pro forma balance sheet, income statement and capital ratios in addition to dilution or accretion in earnings per share and tangible book value per share both from the seller’s and buyer’s perspective.Tangible BVPS Earn-Back - As noted, the projected earn-back period in tangible book value per share is an important consideration for the buyer. In the aftermath of the GFC, an acceptable earn back period was on the order of three to five years; today, two to three years may be the required earn-back period absent other compelling factors. Earn-back periods that are viewed as too long by market participants is one reason buyers’ shares can be heavily sold when a deal is announced that otherwise may be compelling.Dividends - In a yield starved world, dividend paying stocks have greater attraction than in past years. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. Sellers should examine the sustainability of current dividends and the prospect for increases (or decreases). Also, if the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed?Capital and the Parent Capital Stack - Sellers should have a full understanding of the buyer’s pro-forma regulatory capital ratios both at the bank-level and on a consolidated basis (for large bank holding companies). Separately, parent company capital stacks often are overlooked because of the emphasis placed on capital ratios and the combined bank-parent financial statements. Sellers should have a complete understanding of a parent company’s capital structure and the amount of bank earnings that must be paid to the parent company for debt service and shareholder dividends.Loan Portfolio Concentrations - Sellers should understand concentrations in the buyer’s loan portfolio, outsized hold positions, and a review the source of historical and expected losses.Ability to Raise Cash to Close -What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?Consensus Analyst Estimates - If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.Valuation - Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.Share Performance - Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Strategic Position - Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?Contingent Liabilities - Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too.The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. The professionals at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business. Give us a call to discuss your needs in confidence.

Selling the business you built from the ground up is a bittersweet experience. Many business owners focus their efforts on growing their business and push planning for their eventual exit aside until it can’t be ignored any longer. While this delay may only prove mildly detrimental to deal proceeds in other industries, in the investment management space, there are very few buyers who will be interested in YOUR business without YOU (at least for a little while).Long before your eventual exit, you should begin planning for the day you will leave the business you built. There are many considerations for investment managers contemplating a sale, but we suggest you start with these four:1. Have a Reasonable Expectation of ValueTaking an objective view of the value of your company is difficult. In many cases, it becomes a highly emotional issue, which is certainly understandable considering that many investment managers have spent most of their adult lives nurturing client relationships, growing their client base, and developing talent at their firm. Nevertheless, the development of reasonable pricing expectations is a vital starting point on the road to a successful transaction.The development of pricing expectations for an external sale should consider how a potential acquirer would analyze your company. In developing offers, potential acquirers use various methods of developing a reasonable purchase price. Most commonly, an acquirer will utilize historical performance data, along with expectations for future cash flow to generate a reasonable estimate of run-rate EBITDA, and an appropriate multiple that considers the underlying risk and growth factors of the subject company.With the recent run-up in RIA multiples observed, and the even faster run-up in headline multiples, setting reasonable pricing expectations given your firm’s specific risks and opportunities is an increasingly important step in preparing for a transaction.Valuations and financial analysis for transactions encompass a refined and scenario-specific framework. The valuation process can enhance a seller’s understanding of how a buyer will perceive the cash flows and corresponding returns that result from purchasing or investing in a firm. Additionally, valuations and exit scenarios can be modeled to assist in the decision to sell now or later and to assess the adequacy of deal consideration. Setting expectations and/or defining deal limitations are critical to good transaction discipline.2. Have a Real Reason To Sell Your BusinessStrategy is often discussed as something that belongs exclusively to buyers in a transaction, but this isn’t always the case.Without a strategy, sellers often feel like all they are getting is an accelerated payout of what they would have earned anyway while giving up their ownership. In many cases, that’s exactly right! Your company, and the cash flow that creates value, transfers from seller to buyer when the ink dries on the purchase agreement. Sellers give up something equally valuable in exchange for purchase consideration – that’s how it works.As a consequence, sellers need a real reason – a non-financial strategic reason – to sell. Maybe you are selling because you want or need to retire. Maybe you are selling because you want to consolidate with a larger organization to reduce the day-to-day headache of running a business, or need to bring in a financial partner to diversify your own net worth and provide ownership transition to the next generation. Whatever the case, you need a real reason to sell other than trading future cash flow for a check today. The financial trade won’t be enough to sustain you through the twists and turns of a transaction.3. Get Your Books in Order Today To Maximize Proceeds TomorrowAs Zach Milam, mentioned last week, in his post on bridging valuation gaps between RIA buyers and sellers, the best time to address a potential buyer’s concerns about your firm is before you start the process.In advance of transactions, sellers should consider an outsider’s perspective on their firm and take action to address the perceived risk factors that lower value. For example, distinguishing owner compensation and regular distributions of excess capital prior to a sale will decrease the buyer’s concern about liquidity and marketability of the investment and increase the perceived value of equity ownership.Similarly, focusing on staff development in client-facing roles, increasing the number of client contacts with the firm, and creating an internal pipeline of talent to manage the business will all serve to reduce key person risk from the perspective of a buyer, thereby increasing the value that the buyer ascribes to the firm.4. Consider the Tax ImplicationsWhen considering the potential proceeds from a transaction, you should contemplate the tax implications. A large number of RIAs are S-corporations and C-corporations, which is no longer the preferred structure as they constrain a company’s ability to easily grow and transfer equity. We recommend consulting with a tax attorney prior to a transaction on the tax implication of different transaction structures. Before selling your business, you should also be aware of the pros and cons of a stock versus an asset sale as well as an all cash transaction versus a combination of cash and stock consideration.How Can We Help?At Mercer Capital, we routinely perform valuations and financial analysis for buy-sell agreements and internal transactions as well as offer fairness opinions for proposed transactions. We can help you better understand the potential risks to your business model and the opportunities for growth, as well as help you establish reasonable pricing expectations so that when you are ready to sell, the process is more seamless.

Over the last year, deal activity in the Bakken has been steadily increasing after a challenging 2020.  Eight of the nine deals referenced below occurred in the last eight months as the price environment has turned more favorable.  As the industry seems optimistic that the worst of COVID-19 is behind us, deal activity may continue to increase into next year, but there is always hesitation, especially with the Delta variant on the rise.Recent Transactions in the BakkenA table detailing E&P transaction activity in the Bakken over the last twelve months is shown below.  Relative to 2019-2020, deal count was unchanged, but median deal size increased by roughly $480 million, which was lead by the $5.6 billion Devon-WPX transaction.Click here to expand the chart aboveOasis Adds Strategic Acreage in Core AreaOn May 3, 2021, Oasis Petroleum announced that it entered a definitive agreement to acquire select Williston Basin assets from Diamondback Energy in a cash transaction valued at approximately $745 million.  The effective date of the acquisition will be April 1, 2021, and the deal has yet to officially close.  The purchase consideration is expected to be financed by cash, revolver borrowings, and a bridge loan.  Transaction highlights include:Production (2021 Q1) – 27 Mboe/dAcreage – 95,000 net acres in Dunn, McLean, McKenzie counties, ND200 drilling locationsProved Reserves - 80.2 mmboe A pro forma table of the transaction is shown below: Diamondback has built a reputation of being focused on the Permian Basin, but in late 2020, the company acquired QEP Resources which gave them exposure to Williston acreage.  It took them roughly six months to sell their Bakken acreage package to Oasis, returning them to their pure-play Permian status. Equinor Lets Go of Its Bakken PositionOn February 10, 2021, Equinor announced that it was selling its Bakken asset portfolio to Grayson Mill Energy for $900 million.  Grayson Mill Energy is a Houston-based exploration and production company backed by Encap Investments, a private equity firm that has raised over $38 billion of capital.  An exit from the Bakken, which Equinor entered in 2011 by acquiring Brigham Exploration Company for $4.7 billion, follows the sale of its operated assets in the Eagle Ford for $325 million to Repsol in November 2019.  The deal closed on April 27, 2021 and included the following:242,000 net acres, and associated midstream assets48,000 Boep/d as of Q4 2020 In parallel with the transaction, Equinor Marketing and Trading entered into a term purchase agreement for crude offtake with Grayson Mill Energy.  Al Cook, Equinor’s executive vice president of Development & Production, referenced that the company is focused on improving the profitability of its international portfolio.ConclusionM&A transaction activity in the Bakken was steady through year-to-date 2021 and consisted of notable strategic acquisitions and exits in the basin.  Deal activity in the Bakken will be important to monitor as companies shift their focus to other basins and are forced to prioritize other initiatives.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

Valuation gaps are frequently encountered in RIA transactions. Buyers and sellers naturally have different perspectives that lead to different opinions on value: Where a seller sees a strong management team, a buyer sees key person risk. "Long-term client relationships" in the eyes of a seller translates to “aging client base” in the eyes of a buyer. When a seller touts a strong growth trajectory, the buyer wonders if that will continue.These different perspectives on the same firm, unsurprisingly, lead to different opinions on value, and the gap can be substantial. Bridging that gap is key to getting a deal done. Below, we address four ways that buyers and sellers can bridge a valuation gap.1. EarnoutEarnouts are a common way to bridge a valuation gap. Through an earnout structure, the buyer pays one price at closing and makes additional payments over time contingent on the achievement of certain performance thresholds. If, for example, a seller thinks that a firm is worth $100 and the buyer thinks the firm is worth $70, the deal might be structured such that $70 is paid at closing and an additional $30 is paid over time if certain growth targets are met.Through an earnout structure, if the seller’s optimistic vision for the future of the firm materializes, the price ultimately paid reflects that. Likewise, if the downside scenario envisioned by the buyer materializes, the hurdles for the earnout payment will likely not be met, and the price will reflect that reality. Rather than hoping they get what they pay for, the buyer pays for what they get. Similarly, sellers are compensated for what the firm actually delivers.2. Staged TransactionIf an RIA is being sold internally to next-generation management, then selling the firm in multiple stages is one way to help bridge valuation gaps. This is partly because it’s easier to come to an agreement on valuation when the stakes are smaller. But there’s also many potentially value-enhancing benefits to internal sales which take time to realize. Through internal transactions, founders get to hand pick their own successors and incentivize them to grow the firm through equity ownership. The buyers (next generation management) have a pathway to advance their career and increase the economic benefit they receive from their efforts.However, if an internal transaction is done all at once, the owner does not have time to benefit from the growth incentives management hoped the transaction would provide. By structuring the transaction over time, subsequent transactions will take place at higher valuations that reflect the growth that results from the alignment of next gen management’s incentives with existing ownership. As a result, sellers in internal transactions may be willing to come down on price for early transactions to incentivize employees to grow the business, while buyers may be willing to come up in price for the opportunity to become an equity partner in the business and participate in the upside.Selling an interest over time also lessens the capital requirement for the buyer, which is often a barrier in internal transactions where the buyer may not have the financial resources to purchase a large block of the company at one time.3. Deal FinancingBeyond the price, how the purchase price is paid can make a significant difference in the perceived economics of the deal. While external buyers will generally pay cash or stock at closing (with possible future earnout payments as discussed above), internal transactions are often seller-financed.We’ve seen a number of internal transactions where an otherwise attractive valuation was offset by payment terms that were extremely favorable to the buyer such as seller notes with low interest rates and long repayment terms. Similar to earnouts, such favorable payment terms allow the seller to feel like they are getting full value for the business while making the higher purchase price more palatable for the buyer.4. Mitigate Risk Factors Before You SellSellers can mitigate potential valuation gaps in advance of a transaction by addressing aspects of the firm that could be concerning to potential buyers. Consider an outsider’s perspective on your firm, and take action to address the perceived risk factors that lower value. For example, if transitioning the firm internally, distinguishing owner compensation and regular distributions of excess capital prior to a sale will decrease the buyer’s concern about liquidity and marketability of the investment and increase the perceived value of equity ownership.Similarly, focusing on staff development in client-facing roles, increasing the number of client contacts with the firm, and creating an internal pipeline of talent to manage the business will all serve to reduce key person risk from the perspective of a buyer, thereby increasing the value that the buyer ascribes to the firm.About Mercer CapitalWe are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, independent trust companies, and related investment consultancies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

Going Private 2023 presentation by Mercer Capitals’, Jeff K. Davis, CFA, that provides an overview of issues surrounding a decision to take an SEC-registrant private.Pros and Cons of Going PrivateStructuring a TransactionValuation AnalysisFairness Considerations

Ideally, our work with investment management firms at Mercer Capital distills both conventional valuation principles and real-world industry experience. These two influences typically align; valuation theory develops to represent the thinking of actual transacting parties, and – in turn – transaction behavior validates theory.Sometimes, though, we witness rational actors engaging in transactions that challenge certain norms of professional thinking. At such times, we ask ourselves whether valuation theory, as we know it, is doctrine or dogma.The pricing of minority transactions in the RIA space leaves some people scratching their head. Traditional valuation theory holds that investors pay less for minority interests than controlling interests. Reality suggests otherwise. Some established institutional buyers of minority interests in RIAs invest at similar, or even higher, multiples to what other consolidators will pay for controlling interests. Some institutional buyers even prefer taking minority stakes in investment management firms – not a circumstance we see much from the private equity community. Even insider transactions don’t always follow valuation maxims, as valuations for succession are colored by considerations far beyond the sterile realm of hypothetical buyers and sellers. It seems to some that the RIA community has turned valuation theory on its head, but the truth is more nuanced.Valuation Vacuum WonkeryConventional wisdom holds that minority interests in closely held companies are worth less than their pro rata stake in the enterprise. A 15% interest in a business that would sell for $10 million is widely believed by valuation practitioners to be worth something less than the $1.5 million that its pro rata stake in the enterprise would otherwise command. The difference between value inherent in controlling interests and minority interests can be illustrated by way of a diagram known as a levels of value chart. The value of an enterprise can be described as the present value of distributable cash flow – and this parameter is useful for thinking about the different perspectives of control and minority investors. A control level investor effectively has direct access to enterprise level cash flows, with unilateral influence over operations, the ability to buy, sell or merge the enterprise, pay distributions, and set compensation policy. Absent special considerations, a control investor can achieve the greatest benefit, and therefore pay (or expect to be paid) the highest price for an enterprise. Most reported transactions in the RIA channel are made on this basis, and M&A multiples reported publicly, or whispered privately, reflect change of control valuations. Minority investors lack two important prerogatives of control: influence and liquidity.Minority investors lack two important prerogatives of control: influence and liquidity. Discounts for lack of control – also known as minority interest discounts – reflect the inability of minority interest holders to direct the enterprise for their own benefit. The marketable, minority interest level of value is analogous to an interest in a publicly traded company, wherein investors can access the present value of distributable cash flow by way of an open market transaction but have no particular sway over a company’s strategy or operations.Discounts for lack of marketability (a.k.a. marketability discounts) capture the lack of access to enterprise cash flows via distributions or a ready and organized market to sell the interest. The nonmarketable, minority interest level of value is what most valuation practitioners think of when they think of minority interests in closely held enterprises: a value which is materially distinct from a pro rata controlling interest.Internal Transactions Challenge Valuation TheoryReal world economics of minority transactions in RIAs can look very different than our professional discipline would suggest, reflecting issues unique both to the industry and to the universe of typical investors in the industry.Much of the reason that RIA transactions don’t always conform to traditional valuation pedagogy is the nature of the investment management model itself. The theory behind the levels of value is intended to represent the perspective of hypothetical disinterested investors. In a world of financial buyers who can choose freely between alternative instruments, this idea holds.But most RIA investors are insiders, practitioners who work at the investment management firms. The lines between returns to labor and returns to capital are often blurred (although we strongly advise structuring your model otherwise). Insiders have different motivations to show loyalty to their employer, and in turn firms often bestow ownership on staff on favorable terms because of the labor-intensive, relationship-based nature of investment management.Insider ownership is often managed by buy-sell agreements, which at the same time restrict owners from certain actions but also provide them with access to liquidity (under specified circumstances) and a claim on returns. Buy-sell agreements often establish particular parameters for valuation as a way to side-step valuation theory to benefit the ownership and the business model of the particular RIA. Valuation theory operates in a ceteris paribus (all else equal) universe, whereas buy-sell agreements do not operate in this vacuum.Valuation theory operates in an all else equal universe, whereas buy-sell agreements do not.Finally, the issue of discounts for lack of marketability – that minority investors suffer from lack of ready access to enterprise level cash flows – is a byproduct of focus on old economy, heavy industry businesses structured as C-corporations in which dividend policy can be parsimonious. Most RIAs are structured as tax pass-through enterprises (LLCs or S-corporations) and don’t rely on heavy amounts of capital reinvestment. High payout ratios (often nearing 100%) mean minority investors do, in fact, typically enjoy regular returns from enterprise cash flows. Consequently, discounts for lack of marketability are usually smaller for investment management firms than for minority investments in many other industries.Institutional Investors Make Minority Investments With Majority ConditionsOne would expect institutional investors, as financially driven actors who are free to invest across a broad spectrum of opportunities, to behave in a manner more consistent with the hypothetical investors described by valuation theory. The institutional community has, however, developed practices to protect itself from many of the vagaries of minority investing. Achieving rights and returns similar to control investors has led to transaction pricing on par with control transactions, a phenomenon which isn’t inconsistent with conventional wisdom.Institutional investors in the RIA space have corrected for many of the disadvantages associated with being a minority investor by way of contractual minority interest protections.Institutional investors in the RIA space have corrected for many of the disadvantages associated with being a minority investor by way of contractual minority interest protections. No two firms handle this the same way, but board representation, performance reporting, rights to change senior management, compensation agreements, bonus plans, restrictions on non-cash benefits, assurance of timing and performance for distributions, and even revenue sharing arrangements can go a long way to putting a minority investor on terms comparable to a majority owner. Without the risks that accompany lack of control and lack of marketability, minority participants can focus on the value of the enterprise.As an added benefit, if management still holds most of a firm’s equity, then outside investors have more assurance that insiders will pay attention to their jobs. This avoids the issue of RIA leadership “calling in rich” following a lucrative recapitalization and mitigates the monitoring costs that accompany most private equity investing. Sitting alongside management on an economic basis, but knowing management is sufficiently motivated, many institutional investors have effectively created the best of both worlds in minority investing: comparable returns without comparable responsibility.Valuation Theory Is the Real WorldUltimately, valuation models are descriptive, not prescriptive. The economic principles underlying valuation models are the real secret sauce.The behavior of insiders and professional investors is often seen in conflict with the notion that minority interests carry a lower value than pro rata control. In fact, these minority investors are not typical, coupling their money with conditions of ownership that mitigate or eliminate the distinctions between value on an enterprise basis and value on a fractional basis. In our view, the behavior of professional minority investors substantiates the presence of valuation discounts for investors who lack similar protections and privileges.About the car: In the late 1950s, while Detroit focused on building huge, heavy, powerful, front engine sedans and wagons, Italian automaker Fiat designed a petite coupe with a canvas roof and a two-cylinder rear-mounted engine. The Fiat 500 was as contradictory to conventional wisdom at the time as it was easy to park and cheap to own. Detroit boomed, but the Cinquecento sold almost four million units over 18 years. Different markets have different needs.

Over the past year or so, many auto dealers “outperformed” particularly as inventory shortages have raised margins on new and used vehicles in 2021. Additionally, cost cutting initiatives have dealerships running more efficiently, leading to record profitability. The question now comes for public and private auto dealerships alike: what do I do with this excess liquidity?In last week’s blog, we looked at second quarter earnings calls from public franchised auto dealers. Several themes were present in these calls, one of which was the movement toward share repurchases in several firms’ capital allocation approach over the quarter. Many CEOs implied that high multiples and frenzied activity in the M&A market was a determinant in the decision to repurchase shares.In this post, we consider what options are available to both public and private dealers. We look at what decisions the publics are making, and what that could mean for private dealers.Capital Allocation OptionsAuto dealers, and many other businesses more broadly, have numerous options when it comes to allocating capital, including:Reinvest in the business Expand organically (including adding rooftops to current locations or adding new locations)Acquire other dealerships/companies to increase revenue and earningsReturn capital to providers of capital Debt repaymentsDividendsShare repurchasesReinvesting in the BusinessDuring the depths of the pandemic, M&A activity plummeted as significant uncertainty created a chasm between what buyers were willing to pay and what sellers were willing to sell for. As the operating environment stabilized and ultimately improved, deal activity picked up considerably. For the public auto dealers and larger private auto groups, acquisitions have been a clear way to reinvest in automotive retail. However, if recent earnings calls are any indication, this activity may begin too slow as sellers seek peak multiples on peak earnings, something we’ve discussed as unlikely to be palatable for acquirers for obvious reasons.Outside of M&A, options for growth or reinvesting in the business may be limited particularly for private auto dealerships with only a few stores/rooftops. Auto dealers, like other retail businesses have four primary avenues for growth:Penetration (same product, same markets: increase frequency of trips or size of transactions to get an increased share of discretionary spending). Auto dealers can focus advertising spend to seek to capture more market share, particularly on fixed operations side where there are more regular interactions with consumers.Expansion (same product, new customers: adding new store locations in different markets to get new customers with current product offerings). Auto dealers can look to open points in adjacent markets. This can also include investing in the Company’s digital sales strategy, if we consider the digital ether as another “market” itself even if the dealership location doesn’t change.Innovation (new product, same customers: to offer in their existing footprint or additional sales channels). This can be somewhat limited for auto dealers as OEMs exert control over what vehicles are produced. However, dealer principals can improve their product offering by adding new rooftops, whether connected to their existing footprint, or nearby. There are also opportunities to introduce or refine the suite of F&I products offered to consumers.Diversification (new product, new customers: companies can seek to vertically integrate their supply chain or enter adjacent/new lines of business in order to diversify both their product offerings and customer base). Auto dealers aren’t able to vertically integrate as they are dependent on their OEM. However, entering adjacent industries that may have synergies is still possible, whether that be a heavy truck dealership, powersports dealership, or business interest entirely. OEMs have significant power when it comes to awarding new points, which can limit Expansion. OEMs are also in charge of product innovation (what new models will be available), and OEMs and competitive market forces can leave relatively little wiggle room on vehicle pricing (part of penetration). Even capital expenditure decisions can be influenced by imaging requirements. Dealer principals seeking growth are likely to look at adding rooftops or new locations, increasing market share, or adding new business lines. However, efficient allocators of capital seek to hit certain return thresholds. Absent attractive prospects, it may be wise to instead return capital to its providers.Returning Capital to Debt Providers and ShareholdersIndustries have been impacted by the pandemic in various ways. While some saw material declines in activity, others have performed greater than they did in 2019, which has been the case for many auto dealerships. Companies that received PPP loans are likely to have even more liquidity, which has caused business owners to contemplate what to do with the funds once they’ve been forgiven. Many have chosen to pay down debt, reducing ongoing interest costs and helping the owners of more heavily indebted companies to sleep better at night.However, since inventory is financed by floor-plan debt and many auto dealers opt to hold the real estate in a separate entity, many do not carry material third party debt related to the core operations of the auto dealership. That leaves two options: paying dividends/distributions or share repurchases.Private companies are much more likely to be paying distributions as there is either not an active market for their shares, or those holding minority positions in the company are not interested in selling. There’s been much talk about restrictions on share buybacks in industries that received considerable stimulus (like airlines). Since executives of the auto dealers have begun buying back shares instead of splurging on what they view as expensive M&A, we give some thoughts on stock buybacks below.Stock BuybacksFor public companies, management teams may elect to buy back shares for a number of reasons. First, they likely will not buy back shares if they think the market is overvaluing their stock. As a corollary, buying back shares can serve to raise the stock price as it provides a signal to the market that they believe the stock is undervalued. Signaling is important in the presence of asymmetric information, which exists when corporate insiders have access to better information about the company’s prospects than outside investors.While the company may not receive any direct benefit from an increase in the stock price (no cash received), this can lower the cost of capital for the company. If the company takes on debt to repurchase shares, this shifts the weighted average cost of capital more towards debt than equity, which can lower the cost of capital if it helps achieve a more optimal capital structure. So long as the debt does not become burdensome to the point it leads to higher interest rates or increases the equity discount rate, this can be advantageous.Fundamentally, share buybacks are another form of distributing capital to remaining shareholders. While some investors pick companies for dividends, many investors, particularly in recent years, are investing for long-term capital appreciation. Share buybacks is a tax-advantaged way to return capital to shareholders that does not trigger dividend taxes. Instead, a company that elects to buy back shares instead of paying dividends would be expected to see higher levels of share price appreciation, and capital gains taxes are deferred until the investor decides to sell their shares.ConclusionAt Mercer Capital, we follow the auto industry closely in order to stay current with trends in the marketplace.  These trends give insight to the market that may exist for a private dealership which informs our valuation and litigation support engagements.  To understand how the above themes may or may not impact your business, contact a professional at Mercer Capital to discuss your needs in confidence.

In this week’s Family Business Director, Tim Lee, ASA, Managing Director of Corporate Valuation and John T. (Tripp) Crews, III, Senior Financial Analyst, discuss expectations around the timeline for your business transition or sale and summarize key points to keep in mind when driving towards an internal or external sale. Ownership transitions, whether internal among family and other shareholders or external with third parties, require effective planning and a team of qualified advisors to achieve the desired outcome. In this article, we examine some “typical” timelines involved in various types of transactions and expectations you can share with your family board members.Internal TransitionsIn this section, we discuss the importance of a buy-sell agreement in a sale to the next generation. Then we take a brief look at employee stock ownership plans as another potential avenue to an internal transition.Sale to Next GenerationInternal transitions are often undertaken in accordance with provisions outlined in the Company’s existing or newly minted buy-sell agreement. A buy-sell agreement is an agreement by and between the family members and other shareholders of a closely owned business that defines the terms for the purchase when an owner requires liquidity. Buy-sell agreements typically specify how pricing is determined, including the timing, the standard of value used, the level of value, and the appraiser performing the valuation.A buy-sell agreement is an agreement by and between the family members and other shareholders of a closely owned business that defines the terms for the purchase when an owner requires liquidity.As a matter of practicality, the timing for transfers using an existing buy-sell agreement is often dependent on the readiness of financing and the service level of the assisting legal and valuation advisory professionals. Experience suggests this can take as little as four to eight weeks, but often involves processes that can require three to six months to carry out.In circumstances where a newly crafted buy-sell agreement is being developed, you should expect a lengthier process of at least several months so that the attending financial, valuation, and legal frameworks are satisfactorily achieved.Mercer Capital has published numerous books on the topic of buy-sell agreements, which readers of this article should avail themselves of, or better yet, contact a Mercer Capital valuation professional to make sure you get directed to the most useful content to assist in your circumstance.Family-owned companies with an existing buy-sell agreement and those that obtain regular appraisal work, stand the best chance of achieving a timely process. Those Companies that are embarking on their first real valuation process, and that have stakeholders who require a thorough education on valuation and other topics, should allow for a deliberate and paced process.In the event of an unexpected need for ownership transfer (death and divorce to name a few), it is sound advice to retain a primary facilitator to administer to the potentially complex sets of needs that often accompany the unexpected.Employee Stock Ownership PlansThe establishment of an Employee Stock Ownership Plans (ESOP) is a necessarily involved process that requires a variety of analyses, one of which is an appraisal of the Company’s shares that will be held by the plan.For a family business with well-established internal processes and systems, the initial ESOP transaction typically requires four to six months. In a typical ESOP transaction, the Company will engage a number of advisors who work together to assist the family and its shareholders in the transaction process. The typical “deal team” includes a firm that specializes in ESOP implementation, as well legal counsel, an accounting firm, a banker, and an independent trustee (and that trustee’s team of advisors as well).Most modern-day ESOPs involve complex financing arrangementsMost modern-day ESOPs involve complex financing arrangements including senior bankers and differing types and combinations of subordinated lenders (mezzanine lenders and seller notes). There are numerous designs to achieve an ESOP installation. In general, the Company establishes and then funds the ESOP’s purchase financing via annual contributions.ESOPs are qualified retirement plans that are subject to the Employee Retirement Income Security Act and regulated by the Department of Labor. Accordingly, ESOP design and installation are in the least, a time consuming process (plan for six months) and in some cases an arduous one that requires fortitude and an appreciation by all parties for the consequences of not getting it right up front. The intricacies and processes for a successful ESOP transaction are many.A more detailed assessment of ESOPs is provided here on Mercer Capital’s website.The following graphics depict the prototypical ESOP structure and the flow of funds.External SalesMany families cannot fathom why success in business may not equally apply to getting a deal done. In most external transactions, there is a significant imbalance of deal experience: today’s buyers have often completed many transactions, while sellers may have never sold a business. Accordingly, family businesses need to assemble a team of experienced and trusted advisors to help them navigate unfamiliar terrain.Without exception, we recommend retaining a transaction team composed of at least three deal-savvy players: a transaction attorney, a tax accountant, and a sell-side financial advisor. If you do not already have some of these capable advisors, assembling a strong team can require time to accomplish. Since many transactions with external buyers originate as unsolicited approaches from the growing myriad of private equity and family office investors, it is advisable to maintain a posture of readiness.Up-to-date financial reporting, good general housekeeping with respect to accounts, inventory, real property maintenance, information technology, and the like are all part of a time-efficient transaction process. These aspects of readiness are the things that family business directors and managers can control in order to improve timing efficiency. As is often said in the transaction environment - time wounds all deals.In most external transactions, there is a significant imbalance of deal experience ... accordingly, family businesses need to assemble a team of experienced and trusted advisors to help them navigate unfamiliar terrain.Sellers doing their part on the readiness front are given license to expect an efficient process from their sell-side advisors and from buyers. We do caution that selling in today’s mid-market environment ($10-$500 million deal size) often involves facilitating potentially exhaustive buyer due diligence in the form of financial, legal, tax, regulatory and other matters not to mention potentially open-ended Quality of Earnings processes used by today’s sophisticated investors and strategic consolidators. A seasoned sell-side advisor can help economize on and facilitate these processes if not in the least comfort sellers as to the inherent complexity of the transaction process.The sell-side advisor assists the family (or the seller’s board as the case may be) in setting reasonable value expectations, preparing the confidential information memorandum, identifying a target list of potential motivated buyers, soliciting and assessing initial indications of interest and formal bids, evaluating offers, facilitating due diligence, and negotiating key economic terms of the various contractual agreements.The typical external transaction process takes four to seven months and is done in three often overlapping and recycling phases. While every deal process involves different twists and turns on the path to consummation, the typical external transaction process takes five to seven months and is completed in the three phases depicted in the following graphics.CLICK HERE TO ENLARGE THE IMAGE ABOVECLICK HERE TO ENLARGE THE IMAGE ABOVEConclusionAs seasoned advisors participating on both front-end and post-transaction processes, we understand that every deal is unique. We have experienced the rush of rapid deal execution and the trying of patience in deals that required multiple rounds of market exposure. A proper initial Phase I process is often required to fully vet the practical timing required for an external transaction process.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries. Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor, encouraging the right decision to be made by its clients.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help manage your transaction.

According to a recent Franklin Templeton Survey, only 14% of RIA principals expect to transact their ownership-interest in their investment management firm over the next year while 36% expect to sell between one and three years from now.Source: Franklin Templeton InvestmentsThese statistics are perplexing for an aging industry where less than half of advisors over the age of 65 have a formal succession plan and acquisition multiples continue to climb higher.Source:Franklin Templeton InvestmentsThere are some explanations to this disconnect. From an economic perspective, many RIA principals are hesitant to forego their high dividend coupon in a yield-starved environment. Additionally, when an RIA principal exits the business, they forfeit their salary and bonus payments, so the sale price would have to justify this substantial loss of annual income. Many principals also prefer to keep their firm employee owned, but it’s often difficult to sell the business to younger staff members who may be unwilling or unable to purchase the firm at its current market value. Additionally, the sale of smaller advisory practices (under $100 million in AUM) may not be practical since the primary principal often manages most of the client relationships, which may not transfer after he or she exits the business.These realities don’t excuse the industry’s ownership from failing to plan for an eventual sale or exit from the business. Most investment management firms have value beyond their founding principals. Not only can planning for that eventuality maximize your sale proceeds, but it can also ensure your key employees and clients will stick around long after your departure.How To Ensure a Successful SuccessionA logical starting point for accomplishing a successful transaction is tying management succession to ownership succession. Many of our clients’ principals sell a portion of their ownership to junior partners every year (or two) at fair market value (FMV). This process ensures that selling shareholders (who hope to sell at a maximum value) are incentivized to continue operating the business at peak levels while allowing rising partners to accrue ownership over time. Many buy-sell agreements also call for departing partners to sell their shares at a discount to FMV if they are terminated or leave within a pre-specified period to ensure they remain committed after the initial buy-in.Simply put, a successful succession requires the alignment of buyer and seller interests. Gradually transitioning ownership to the next generation of management at a reasonable price is one way to align your interests with the next generation of management.A successful succession plan also requires decoupling your day-to-day responsibilities from ownership. This can’t (and shouldn’t) happen overnight. After you’ve identified a capable successor(s), make sure he or she assumes more of your management responsibilities and not just your share count. Your work hours should decrease over this transition period.When advising clients on management and ownership succession, we often tell principals that are approaching retirement to ask themselves where they want to be in five or ten years (depending on their age and other factors) and work towards that goal. We rarely hear that they want to maintain their current work levels for the rest of their career. Have a goal in mind and steadily work towards it as others assume your responsibilities and ownership. It should pay off in retirement.

In this week’s Family Business Director, Tim Lee, ASA, Managing Director of Corporate Valuation and John T. (Tripp) Crews, III, Senior Financial Analyst, discuss internal and external exit options for you and your family business and summarize the possible buyers for your family enterprise. We regularly encounter family business owners contemplating the dilemma of ownership transition. After years (maybe even decades) of cultivating the business through hard work, determination, and perhaps a bit of luck, many families believe now is a sensible time to exit. Tax changes are looming, pandemic and post-pandemic winners see solutions to a myriad of operational challenges, and valuations remain favorable in most industries. However, a seller’s timing, the readiness of the business, and the readiness of the marketplace may not be aligned without careful preparation and real-time market awareness from your family business board of directors. Families often fail to realize that their preparation, their tolerance for post-deal involvement, their health and ability to remain active, and their needs for liquidity will influence the breadth and priorities of their options and will influence who the potential buyers might be and how they might target the business. Proactivity (or backfilling for the lack thereof) will also influence the design and costs of the process for effective representation. Under ideal circumstances, your family will begin planning for ownership transition well before the need for an actual ownership transfer arises. One of the first steps in planning for an eventual exit is to understand who the potential buyers might be and the different characteristics of these buyers. In this article, we discuss some exit options and summarize some of the specifics of certain types of buyers and what that could mean for transaction structure and economic outcomes.Internal Ownership TransitionPotential buyers in an internal transition generally include the next generation of the owner’s family or key employees of the company (or a mix thereof). When done carefully, an internal transition can be desirable in order to protect both the existing employees and the culture of the business. These transactions generally occur two ways: through a direct sale from the exiting owner to the next generation or through the establishment of an Employee Stock Ownership Plan (ESOP). While these transactions may not yield the pricing or turnkey liquidity that selling to an outside buyer might, they can provide comfort to the current generation of family owners regarding their legacy and the continuing prospects of the business as an independent going concern.Sale or Transfer to Next GenerationFor many family businesses, transitioning ownership and leadership to the next generation of family members is the primary exit consideration. For other families, a sale to the non-family management team makes more sense. In either event, the value of the shares being transferred is critical.Whether transferring ownership to the next generation of family members or to the non-family management team, the value of the shares being transferred is criticalFor sale transactions, the question of how the transaction will be financed is equally important. Internal transactions are often achieved by share redemptions in installments and/or through a leveraged buyout process. Often, the seller will provide financing using one of many potential structures. Seller financing carries the risk of the buyer’s inability to pay, which often requires the seller to reinsert themselves into active leadership. Many may view seller financing as desirable in order to control the terms and costs of the arrangements and to benefit from the interest and other terms of the financing.As noted, a seller’s liquidity requirements and the underlying fundamental borrowing capacity of the business play a big part in determining how much third party capital can be employed. Many sellers want their buyers, family or otherwise, to have real skin in the game by way of at least partial external financing.If the next generation of family members and/or employees are not well situated to achieve a buyout as a concentrated ownership group, then the feasibility of a more formal collective buyer group may be a good alternative. The following is a brief overview of Employee Stock Ownership Plans, which can serve as an alternative to a concentrated internal transition.Establishing an Employee Stock Ownership Plan“ESOPs” are a proven vehicle of ownership transfer. They can provide for either an incremental or a turnkey ownership transfer. They also facilitate the opportunity for legacy owners to continue contributing to the stability and success of the business while allowing employees to reap the rewards and benefits of capital ownership. Assessing the feasibility of an ESOP requires the advisory support of experienced financial and legal professionals who help ensure best practices are implemented and compliance awareness governs the transaction. To that end, family businesses contemplating an ESOP need to be keenly aware of the importance of following a well designed process that satisfies the requirements of the Department of Labor and adheres to governing rules and regulations.As a qualified retirement plan subject to regulations set forth by ERISA, ESOPs are regulated using strict guidelines for process, fairness, and administration. Accordingly, the entire life cycle of a contemplated ESOP needs to be studied in a process generally referred to as an ESOP Feasibility Study. Valuation, financing, plan design, plan administration, future repurchase obligations, and many other concerns must be assessed before venturing down the ESOP path.Establishing an ESOP includes creating an ESOP trust, which, using one of many possible transaction structures, becomes the ultimate owner of some or all the stock of the sponsoring ESOP company. ESOPs are unique in being the only qualified retirement plans allowed to use debt to purchase the shares of the employer corporation. Once an ESOP is in place, the qualifying employee participants are allocated interests in the trust annually according to the Plan’s design. As employees cycle through their employment tenure, they trigger milestone events that allow for the effective sale of their accumulated ownership positions, providing a nest egg for retirement. During their tenure of employment, the employee’s account is mostly concentrated in company stock, the valuation of which determines the amount they receive when nearing and eventually reaching retirement age. The stock accumulated during active employment is converted to cash and the Plan shares are either redeemed or recycled to perpetuate the ESOP.There are certain tax-related and transaction design features in an ESOP transaction that can benefit family business sellers in numerous different waysThere are certain tax-related and transaction design features in an ESOP transaction that can benefit family business sellers in numerous different ways. Sellers in ESOP installations must understand the necessary complexities and nuances of a well-run ESOP transaction. Sellers lacking the patience and gumption for an ESOP process or those who require turnkey liquidity in their ownership exit should consider an alternative liquidity strategy.External SaleIn general, the ability to sell your family business to an external party yields the highest proceeds. If you have succeeded in creating a sustainable business model with favorable prospects for growth, your business assets may generate interest from both strategic and financial buyers, the pros and cons of which are listed in the following sections.Strategic BuyersA strategic buyer is usually a complementary or competitive industry player within your markets or looking to enter your markets. These buyers can be generally characterized as either vertical or horizontal in nature. Such buyers are interested in the natural economies of scale that result from expanded market area and/or from specific synergies that create the opportunity for market and financial accretion (think 1 + 1 = 3).There is a good chance that a potential strategic buyer for your family business is someone or some group you already know. Such buyers don’t require the full ground-up familiarization process because they are already in tune with the risk and growth profiles of the business model. Accordingly, owners interested in a turnkey, walk-away sale of their business are often compelled toward a strategic buyer since strategic buyers can quickly integrate the family’s business into their own.The moving parts of transaction consideration paid by strategic buyers can cover a broad spectrum. We see simple nearly 100% cash deals as well as deals that include various forms of contingent consideration and employment/non-compete agreements.There is a good chance that a potential strategic buyer for your family business is someone or some group you already knowMany family owners in strategic deals are not inclined to work for their buyers other than in a purely consultative role that helps deliver the full tangible and intangible value the buyer is paying for. In many cases strategic buyers want a clean and relatively abrupt break from prior ownership in order to hasten the integration processes and cultural shift that come with a change in control. Further, strategic deals may include highly tailored earn-outs that are designed with hurdles based on industry-specific metrics. In general, earn-outs are often designed to close gaps in the bid/ask spread that occur in the negotiation process. These features allow sellers more consideration if post-transaction performance meets or beats the defined hurdles and vis-a-versa. Family business owners must be aware of the sophisticated means by which larger strategic buyers can creatively engineer the outcomes of contingent consideration.In certain industries, strategic buyers may structure consideration as part cash and part or all stock. Sellers in the financials sector are often selling equity ownership as opposed to the asset sales that dominate most non-financial sectors. In such deals, sellers who take equity in the merged entity must be cognizant of their own valuation and that of the buyer. The science of the exchange rate and the post-closing true ups that may apply are areas in which family business owners should seek proper professional advisory guidance outside their family boards and advisors.Financial BuyersFinancial buyers are primarily interested in the returns achieved from their investment activities. These returns are achieved by the conventions of 1) traditional opportunistic investment and 2) by means of sophisticated front end and back end financial engineering with respect to the original financing and the subsequent re-financings that often occur.Most traditional buy-out financial investors are looking to satisfy the specific investment criterion on behalf of their underlying fund investors, who have signed on for a targeted duration of investment that by nature requires the financial investor to achieve a secondary exit of the business within three to seven years after acquisition (the house flipping analogy is a clear but oversimplified one). Financial investors may have significant expertise acquiring companies in certain industries or may act as generalists willing to acquire different types of businesses across different industries.In general, there are three types of financial buyers:Private Equity Groups or other Alternative Financial Investors,Permanent Capital Providers, andSingle/Multi-Family Offices Despite their financial expertise, financial buyers usually do not typically have the capacity or knowledge to assume the management of the day-to-day operations of all of their investments. As such, the family’s management team at the time of a sale will likely remain involved with the Company for the foreseeable future. A sale to a financial investor can be a viable solution for ownership groups in which one owner wants to cash out and completely exit the business while other owners remain involved (rollover) with the business.A sale to a financial investor can be a viable solution in situations where one owner wants to cash out and completely exit the business while other owners remain involved with the businessWith respect to work force and employee stability, financial investors will ultimately seek maximum efficiency, but they often begin the process of making sure they secure the services of both frontline and managerial employees. In many cases, the desired growth of such investors can bolster the employment security of good employees while screening out those that resist change and impede progress.The value of the assembled workforce is becoming a more meaningful asset to prospective buyers in the marketplace, whether they be strategic and financial in nature. Further, larger acquirers often can present employees with a more comprehensive benefit package and enhanced upward mobility in job responsibility and compensation. All this said, financial investors will ultimately seek to optimize their returns with relentless efficiency.Lastly, as the financial buyer universe has matured over the past 20+ years, we have witnessed directly that many strategic consolidators are platform businesses with private equity sponsorship, which blurs or even eliminates the notion of a strictly strategic or financial buyer in many industries.ConclusionAn outside buyer might approach your family business with an offer that you were not expecting, you and your family might decide to put the business on the market and seek offers, or your family might opt to sell to the next generation of the family in an internal sale. Whatever the case may be, most owners only get to sell their business once, so you need to be sure you have experienced, trustworthy advisors in your corner.Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions. We have worked on hundreds of consummated and potential transactions since Mercer Capital was founded in 1982. We have significant experience advising shareholders, boards of directors, management, and other fiduciaries of middle-market public and private companies in a wide range of industries.Rather than pushing solely for the execution of any transaction, Mercer Capital positions itself as an advisor to inform sellers about their options and to encourage market-based decision making that aligns with the personal priorities of each client.Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction. Our dedicated and responsive team stands ready to help you and your family manage the transaction process.

The July 2021 SAAR was 14.8 million units, roughly flat compared to July 2020, but down 12% from July 2019.  SAAR was expected to fall for the third straight month, but this figure is lower than many experts predicted in June.  As far as contributing factors to this slip, automotive manufacturers continue to struggle producing enough vehicles to meet insatiable demand that is emptying car lots around the country.  Inventories continue to be drawn down and consumers are beginning to abandon their preferred color and trim selections as well as their preferred model and production year in favor of similar vehicles simply because they are actually available for purchase.As we detailed in last week’s blog, retail sales have crowded out fleet sales with an estimated 90% of total sales volumes in July, and this trend is also expected to continue as dealers no longer need to sell larger blocks of inventory at discounted prices. Dealers are doing everything they can to get new cars in the hands of consumers, as elevated prices continue to boost profits on a per unit basis.The average new-vehicle retail transaction price in July is expected to reach a record $41,044. The previous high for any month, $39,942, was set last month in June. Dealers are also capturing a greater share of these transactions prices as average incentive spending per unit, a measure of financial inducement used by manufacturers to motivate sales of specific vehicles, is expected to fall to $2,065, down from $4,235 in July 2020 and $4,069 in July of 2019.  However, this doesn’t necessarily translate to skyrocketing costs for consumers as high trade-in values and low interest rates mean average new vehicle monthly payments of $622in July are only up 6.4% while transaction prices have increased 17%.Despite lower volumes, dealers are seeing record revenue levels as supply/demand imbalances have led to these surging prices. It also illustrates the relatively inelastic demand for consumers. Record vehicle prices have been noted across mainstream media outlets, yet customers continue to buy what little inventory dealers have. Consumers who can wait to buy a vehicle may be starting to hold off. But for those returning to the office in the wake of a public health crisis, there may not be many functional alternatives to personal vehicles. As noted above, monthly vehicle payments also haven’t surged as much as sticker prices.The trends outlined above tell the story of what auto dealers have been experiencing for months now. Tight supply unable to keep up with demand are leading to a red hot market, and it looks like price and turnover metrics may continue to reach new heights until supply issues are alleviated.Pickup Truck Market Share StumblesOne effect that these current market conditions have had on the automotive industry involves sales of pickup trucks. According to Wards Intelligence, large-pickup truck market share was 13% of total sales in July 2021, down from 15.2% in July 2020. This was the lowest market share figure for the vehicle class since July 2016.  In April of this year, Ford decided to prolong its production shutdown for the F-150 pickup truck, citing parts shortages as the primary cause. During this period of shutdown for Ford, General Motors pressed forward with its production of the GMC Sierra, mentioning the importance of its pickup truck sales to the firm’s bottom line.  Ford was able to restart truckproduction in June, but the decision by General Motors to sink available resources into its truck models eventually resulted in its own forced production shutdown in late July.Stories like these have dominated automotive news cycles over the last several months and it is not hard to believe that, despite the importance of pickups to the profitability of these firms, trucks are equally as hard to produce during this period of input shortages as other vehicle classes, particularly for the larger trucks as compared to other trucks and crossovers. Manufacturers are having to make decisions regarding which models to prioritize, and it seems like start-stop production has already become normal for most manufacturing plants around the country. Manufacturers are expected to continue to intermittently shut down truck production until automotive supply chains recover, while production of other best sellers are prioritized for weeks at a time.With a more complete understanding of the lumpy nature of model-specific production during the last several months, it can be expected to see large swings in market share for under-produced vehicle classes. Shutdowns in April and May related to the F-150 and shutdowns in July and August for the GMC Sierra have resulted in fewer trucks hitting lots, and therefore less market share in the sale of all vehicles for an underrepresented truck class. For the ones that are sold, many may not even see lots as pre-selling has become increasingly important. Once the dust settles and the necessary inputs for vehicle production become more readily available, the market share for pickups is expected to normalize at historical levels or even expand in response to pent-up demand. Until then, expect volatility in metrics like market share going forward.What To Expect? ForecastOver the last three months, many experts have tried to predict vehicle production rates to no avail. Mercer Capital’s own December 2020 Forecastfor the 2021 SAAR was in the range of 16 million units, quite bullish at the time. Looking forward to the end of supply shortages and heightened demand has proven a difficult task, and many previously bullish analysts are rolling back their expectations for a third quarter rebound. For example, the LMC Automotive forecast was reduced by 200,000 units on its last iteration. With more frequent announcements on manufacturing stoppages hitting the presses each week, the industry should not expect inventory levels to change much over the next month. With this in mind, total light vehicle sales are still expected to be around 16.5 million unitsin 2021.ConclusionIf you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.

The June 2021 SAAR totaled 15.4 million units, which is up 12.4% compared to June 2020 (the lowest June figure in recent memory due to the COVID-19 pandemic) but down 9.9% from May 2021.  New light vehicles sales fell for the second straight month in June, highlighting the ongoing supply and demand imbalances in the market for new cars and trucks.After a strong start to the year, driven by feverish demand from retail and fleet consumers, a shortage of new car and truck inventory has started to weigh on sales.  The Inventory to Sales Ratio, published along with SAAR, continues to fall, as seen in the graph below.  This ratio captures what many auto dealers already know: demand has been strong and supply chain issues have not gotten any better. With such strong demand intersecting low supply, many vehicles are selling at or above MSRP. According to J.D. Power, in mid-June, 75% of vehicles sold for MSRP or above, up from 67% in May 2021 and up even more from the pre-COVID-19 pandemic average of 36%. SAAR ran hot from 17.0 million to 18.6 million from March to May this year, making supply even shorter. Inventories have plummeted as dealers are not able to replenish their lots.  While this has led to lower floor-plan costs and higher GPUs, the decline in SAAR in June shows dealers may finally be experiencing what people were concerned about. Business owners can draw down inventories to maintain sales levels, but eventually, those inventories will run out. Lower inventory levels are expected to continue to limit the sales pace of dealers around the country. Microchip Issues PersistAccording to the NADA, the inventory crunch is likely to get worse before it gets better.  Average inventories are expected to remain flat in June compared to May at around 1.5 million units, before dropping again to around 1.3 million units by the end of July.  Microchip shortages continue to plague the industry and are a predominant factor in the slowdown, though dealers have noted other parts and areas of vehicles are in short supply as well.  With little to mitigate the situation on the horizon, it has become clear that this shortage will impact the manufacturing of new vehicles for months to come.  This chip shortage is not unique to the United States or to the Automotive industry, as Automotive News Europe recently reported that the “exponential increase in demand for microchips will need a long term solution.”We note the “end” to the microchip shortage continues to be kicked down the roadMany sovereign governments are considering taking steps to increase production, as the number of industries that require microchips continues to grow. Economic agents are considering economy-wide solutions to this sweeping problem, but relief is not expected until sometime in early 2022. Until then, dealers will most likely have to continue to operate at lower-than-normal inventory levels or focus on vehicles that utilize less chips. We note the “end” to this shortage continues to be kicked down the road, so even the expectation this situation will be alleviated in early 2022 may not comfort dealers that have seen expectations continue to get pushed out.Several U.S. automotive manufacturing plants have had to suspend operations in response to the chip shortage. For example, the Ford plant in Chicago that produces the Ford Explorer will be shut down from the week of July 5th to the week of July 26th. Additionally, the Ford plant in Kansas City that produces the best-selling F-150 pickup truck announced it will be shuttering the production line for a few weeks in July as well. Ford’s Michigan assembly plant that recently started shipping the Ford Bronco will also be down for two weeks in July due to parts shortages. These shutdowns are not specific to Ford, as most auto manufacturers have been trying to find ways to react to the ongoing situation.It’s Not Just Microchips Many automotive plants have temporarily shut down due to the microchip shortage, but microchips are not the only input that has been scarce. Seating foam, plastics, and other petroleum-based products have been harder to acquire over the last several months due to longer lead times on orders, historically high prices, and very tight supplies.According to Industrial Specialties Manufacturing, the market is currently unable to supply the U.S. demand for plastics. Experts say that the complete restoration of the plastics industry could come in late 2021 or early 2022, but certain factors must be in play for this recovery to occur, like repairing oil and gas infrastructure, returning to normal volumes of chemical feedstock for plastics production, and repairing plastics compounding and extruding machinery in plants that have yet to ramp up to full production capacity.Used Vehicles In High DemandWhile the story surrounding new cars and trucks has been characterized by supply constraints over the last two months, used cars have stepped into a more prominent role at most car lots to fill this gap. Pent up demand for new cars is pushing car buyers into the used-car market, driving up prices of used cars in the process. Edmunds reported that the average price for used vehicles jumped from $20,942 to $25,410 from this point last year, the highest price jump on record for the auto research firm. This has had ripple effects throughout the economy.Edmunds reported that the average price for used vehicles jumped from $20,942 to $25,410 from this point last yearThe Consumer Price Index jumped 5.4% in June, stoking concerns about runaway inflation. However, the Federal Reserve has maintained its view that inflation is transitory, which appears to be supported by the significant year-over-year increases in used vehicles, gas, and airfare, which have played a large role in the jump in CPI. Excluding these, month-over-month core CPI would have only risen by 0.18% in June according to Bank of America.Used vehicle prices have climbed at a steep pace due to similar supply and demand-related pressures as the new car market, with scarcity issues coming in the form of hotly contested wholesale markets where dealers typically acquire most of their used inventory. Dealers are being forced to spend more to fill their lots with used vehicles, making it harder for buyers to negotiate on used car prices than in the past. Jonathan Banks, Vice President of Valuation Services at J.D Power had this to say about the used market:"After increasing for 24 consecutive weeks, wholesale auction prices peaked in June, attaining their highest level on record, and have now begun to gradually decline. Despite the recent cooling, the used market remains incredibly strong and, at the end this year, prices are expected to be up by approximately 29% on a year-over-year basis. The used market’s continued strength is driven primarily by the expectation that used supply will remain a challenge and that new-vehicle market challenges will remain in place for the foreseeable future."What Forecast to ExpectAfter an unusually hot start followed by a tightened market environment, this year has been unpredictable for dealers and manufacturers in the automotive industry. As far as demand is concerned, it is unlikely that the desire for new and used vehicles will cool off any time soon, as many consumers return to work and may be in search of a new or used vehicle to get them there. However, new light vehicle sales for the remainder of the year will likely continue to be supply-constrained.  If production can recover and exceed expectations, we could see sales close to 17 million units by the end of the year.  However, given the more likely outcome, total light vehicle sales are expected to be somewhere between 16.3 and 16.5 million units in 2021.If you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team.  We hope that everyone is continuing to stay safe and healthy.

The rise of the family office has been one of the most significant themes in family enterprise over the last decade. Looking forward, we believe that the number of family businesses raising non-family equity capital will grow dramatically in coming years.We don’t think we are going too far out on a limb with this prediction. In this post, we take a quick look at the growing supply of capital seeking minority investments in family businesses, the sources of growing demand from family businesses for such investment capital, and how directors can best position their family businesses to thrive.Growing SupplyWith an abundance of dry powder to invest, private equity firms are increasingly willing to acquire non-controlling stakes in family businesses. Governance and exit mechanisms vary, but more and more PE investors are willing to ride in the passenger’s seat rather than the driver’s seat.Family offices also represent a growing source of capital for family businesses. Following the old investment adage of “Invest in what you know,” some enterprising families seek to diversify their portfolios by acquiring minority stakes in other family businesses.Finally, in last week’s post, we commented on Amazon’s strategy in acquiring equity warrants for minority investments in suppliers. While we focused on the issue of customer concentration in that post, it is also an example of strategically motivated capital available to family businesses.Growing Demand?But will there be demand for the supply of non-family equity capital? For decades, many families have perceived a stigma to using non-family equity capital. What factors could cause that stigma to fade?We sense an increasing willingness to consider using non-family equity capital in our discussions with clients. This inclination seems to be especially pronounced among shareholders in the third and subsequent generations. Among those members of the family, we find more of a tendency to evaluate risk and return from the family business in the context of other investment alternatives. In other words, many shareholders want to treat the family business as an important part of their personal portfolios but are not enthused about having all their investment eggs in the family business basket.These family shareholders tend not to be enamored by either of the traditional family business capital management strategies: (1) constrain growth to that which is supportable by retained earnings, or (2) rely on periodic "bet the farm" debt levels to fund more aggressive growth plans. Using non-family equity capital opens a third path along which businesses can grow without starving family shareholders of current income or using uncomfortable levels of debt financing.Finally, given the challenges of managing family dynamics, the need to prune the family tree of unaligned shareholders will probably never go away. Exchanging Uncle Joe for a non-family equity investor can ease family tensions without adding to the financing constraints facing the managers of the family business.Questions for Family Business Directors to ConsiderWhat questions should family business directors begin asking themselves about this trend? Let us suggest five:Where is your family business going? What is your strategy for meeting the challenges and opportunities that are likely to arise in your industry? If long-term sustainability and family control is your goal, what should your family business look like in ten years?What is the return profile of your family business? Investment returns come in two – and only two – forms: current income from dividends and capital appreciation. What mix of these return components are you providing to your family (or prospective) shareholders? How do those return components compare to other investment alternatives available to your shareholders?Who should own your family business? Your current shareholder list is likely of function of time and chance more than intention. If you could start from scratch today, who would your family shareholders be, and why? Are some of your existing family shareholders a better fit for the return profile of your family business than others?How will investors value your family business? What are the expected cash flows, risk factors, and growth prospects that are relevant to your existing shareholders? To a potential equity investor? Remember that your family business has more than one value.When will your family business need outside capital? For many years, our colleague, Chris Mercer, has been asking, “Is your business ready for sale?". Opportunities often arise unexpectedly, and Chris’ point to business owners is that there are significant benefits to being ready to sell even when you don’t intend to do so. The same idea applies to family businesses that may need outside capital: the time to prepare for that day is now. We don’t make a lot of predictions here at Family Business Director, but the growing use of non-family equity capital in family businesses is one that we are confident making. Family business directors would do well to begin thinking about how to leverage this trend to their benefit. Look for more on this trend in future posts.

It’s been tough out there for equity capital markets bankers covering the upstream sector.  Since 2016, there have only been five U.S. exploration & production company IPOs. [1]  The dearth of activity is driven by a number of factors, including poor historical returns from the space, special purpose acquisition companies (SPACs) supplanting the traditional IPO process, and environmental, social, and governance (ESG) pressures resulting in less capital availability. Three U.S. E&P IPOs took place in late 2016 and early 2017.  Berry Petroleum, a California producer focused on conventional production methods, went public in mid-2018.  Nearly three years would pass until the next IPO: Vine Energy. Vine IPOVine Energy, a pure-play Haynesville gas producer, broke this nearly three-year dry spell with their IPO in March of this year.  However, Vine had a rough start as a public company.  The IPO priced at $14 per share, below the anticipated offering price of $16 to $19 per share indicated in Vine’s S-1.  Once trading began, there was no typical IPO pop, as the stock opened at $13.75.  The stock continued to trade down over the next several weeks, closing below $11 in mid-April. However, Vine’s stock price performance since the nadir has been relatively strong.  The stock price rose to almost $16 in late June, up more than 44% from its low.  Overall, the stock is up 8% from its IPO price, outperforming the broader E&P sector (as proxied by XOP, the SPDR S&P Oil & Gas Exploration & Production ETF), though still lagging the S&P 500. Are More E&P IPOs Coming?While we don’t have a crystal ball, there several are factors that could lead to additional E&P IPOs over the next several years.Restraint Leading to Returns: E&P companies were maligned for a “drill, baby, drill” mentality which led to huge amounts of capital being deployed to generate suboptimal returns. However, they seemed to have learned their lesson and are now showing capital discipline, even in light of a much-improved commodity price environment.  The result is that shale drillers are actually delivering free cash flow.  That appears to be impacting stock prices, as the year-to-date performance (through 7/13/2021) of XOP has trounced the S&P 500 (shown in the following chart).  If this performance holds, investors who previously shunned the industry may begin dipping their toes back in with increased allocations to the sector.Need for Private Equity to Exit: Between 2015 and 2019, private equity funds raised approximately $86 billion of capital to deploy on U.S. oil & gas assets. However, that capital raising has slowed, and traditional oil & gas PE sponsors (including Riverstone, EnCap, and NGP) have begun focusing on energy transition investments.  With less private equity capital in the ecosystem, and public E&Ps showing restraint with respect to capital spending, public markets may be the best exit opportunity for certain larger PE-backed companies. It Might Be Another Long Dry Spell Before We See Another E&P IPOLack of Public S-1 Filings: The IPO process is an involved and lengthy affair. One of the first steps required to go public is filing an S-1, which is the initial registration form for new securities required by the SEC.  The S-1, which is usually filed well in advance of an actual public offering, describes the company’s operations and includes financial information.  According to data from Capital IQ, there do not appear to be any U.S. E&P companies with active registration statements for material sized (>$50 million) offerings.  The most recent S-1 filings for uncompleted offerings are from Tapstone Energy and EnVen Energy Corporation.  However, both of those registration statements have been withdrawn.  With no E&P companies currently teed up to go public, it will likely be a while before one makes it through the process.Less Need for Growth Capital: As previously discussed, with many shale drillers generating free cash flow, there is less need for growth capital to support operating activities. As such, private operators may eschew the scrutiny and pressure of public markets and remain private.Continued ESG Pressures:  With increasing emphasis on ESG issues, it could be challenging to generate the typical level of investor appetite necessary to successfully execute an IPO, especially among large institutional investors who typically anchor many IPO processes.SPAC Alternative:  SPACs have emerged as a viable alternative to the traditional IPO process. Several E&P companies were early adopters of SPACs as a means to go public, including Centennial, Alta Mesa, and Magnolia.  While many energy-focused SPACs indicate that they are seeking opportunities in the energy transition space, there are a handful that may be seeking to acquire E&P companies.ConclusionVine’s public market debut brought an end to a long-running drought of E&P IPOs, though it may be more of an anomaly than a harbinger of things to come.  With no public S-1 filings among upstream energy companies and continued investor focus on ESG issues, we don’t expect to see any new public E&P companies any time soon.We have assisted many clients with various valuation needs in the upstream oil and gas space for both conventional and unconventional plays in North America, and around the world.  Contact a Mercer Capital professional to discuss your needs in confidence and learn more about how we can help you succeed.[1] We note that there have been other upstream companies that have gone public via a SPAC (e.g., Centennial, Alta Mesa, and Magnolia) as well as mineral-focused companies that have had traditional IPOs (e.g., Brigham Minerals and Kimbell Royalty Partners).  However, this post is focused on traditional IPOs of exploration & production companies.

In this post, we offer a unique perspective from Atticus Frank, CFA who worked in his family’s business for nearly three years prior to returning to Mercer Capital and joining the team’s Family Business Advisory Group. We hope the stories illuminate special issues family business directors need to consider from someone who lived them day-in and day-out. NYU Professor Aswath Damodaran has highlighted the mixed bag on value creation through acquisitions.  However, McKinsey & Company suggests that family businesses are more prudent in their M&A activity, and don’t necessarily seek the home run deals, but instead seek value creation. My family’s business did its best to be prudent when engaging in M&A transactions.  We developed objectives for selling and buying within the framework of our business’s meaning and family goals. During my stint in the family-business, the company was going through radical changes. We divested significant operating assets and acquired new businesses in a span of four months.  Over the same period, the shareholder base was reduced from 30+ individuals to a select handful. But why? Framing the question in terms of the following four meanings of family business can help answer it.Give Me One ReasonAs we have previously written, the meaning of a family business is a function of both family and business characteristics.  Most family businesses hold one of four “meanings” for their family shareholders, which we have summarized below:Economic Growth Engine - Create economic growth for future generations. Less emphasis on distributable income for the current shareholders; focus on growth opportunities for business to grow along with the family.Store of Value - Preserve the family’s capital. Serve as a stabilizing component of the family’s overall balance sheet.Source of Wealth Accumulation – Focus on significant current distributions that family shareholders are expected to allocate to unrelated investments.Source of Lifestyle – Priority on stability of dividend payments and the business is managed to protect the company’s dividend capacity to help facilitate travel, philanthropy, education, or other family objectives. With the above framework in mind, where did my family’s business fit in?The Times - They Are A-Changin’The family business was going through big changes when I arrived.  A major part of the business was being sold to another family and the shareholder base was in the process of consolidation.  From the mid-70s through mid-2010s, the business had been the economic growth engine for the family: minimal distributions and earnings plowed back in to achieve growth.  But with the passing of the patriarch (first generation), the new shareholders (majority control in second-generation) experienced a shift in their objectives for the business.After nearly 40 years of growth, many of the new controlling shareholders were ready to "de-risk" their personal balance sheets. The family business could help provide that, but the most immediate way to do that was to sell part of the operating assets.Thinking in terms of the “Four Meanings” framework, this transaction represented a radical wealth accumulation transition.  If the family were to develop more diversified personal balance sheets, either distributions from the legacy family business would have to increase in a hurry, or a sale of at least a portion of the business would be required (at the right price).  It just so happened the right price came along.Turn The PageAs we were spinning off a large part of the business, I was preparing to move to Florida to jump into the family business with my wife. We knew we were joining a company that was different than the one my wife had known her whole life.But what company would we be joining? For one, it would have a consolidated shareholder base, with our CEO, my father-in-law, the primary shareholder. Second, it would be considerably smaller. The assets we were selling to generate cash flow for the other major shareholders represented the lion’s share of the company’s revenues. Our objectives for the future, while not “to-the-moon,” were more ambitious than maintaining a “lifestyle” family business. We wanted the remaining company to scale to a level that could support the remaining shareholders’ goals and objectives.Following the divesture, we completed a smaller acquisition relative to the business units sold to achieve an expected cash flow level suitable for the new, smaller shareholder base. Our impetus was to grow to ensure the longevity and stability of the overall family enterprise for the remaining family shareholders and allow our family to pursue other strategic investments outside the business. Getting there will require a growth mindset for the next several years.  I’ll report back on our progress.Here Comes the Sun: What Will Family Business Directors Do?We have noticed that our wisest clients demonstrate patience and know where they are and what they are trying to accomplish through transactions.  These clients have focused on what the family business means to them: growth engine, store of value, wealth accumulation, or lifestyle.  This framework helps them make the right deals at the right times for the right reasons.  Otherwise, a “deal” can become a four-letter word for your family.ConclusionMercer Capital has a long history of working with companies on both the buy and sell-side of transactions. Let us know if we can help you and your fellow directors evaluate the transaction opportunities and challenges facing your family business.

Transaction activity in the Permian Basin picked up in earnest this past year, indicating greater optimism in extracting value from the West Texas and Southeast New Mexico basin.A table detailing E&P transaction activity in the Permian over the last twelve months is shown below.  Relative to 2019-2020, deal count increased by five transactions, representing an increase of 23% over the 22 transactions in the prior period. Furthermore, median deal size nearly tripled from $138 million to $405 million, period-over-period.  The median acreage among these transactions increased 2.5x from 14,500 acres to 36,250 acres (not shown below).  Given the concurrent increase in transaction values and greater acreages acquired, the median price per net acre was down a slight 4% period-over-period.The big story though, was production.  The median production among transactions from June 2018 to June 2019 was 2,167 barrel-oil-equivalent per day (“Boepd”); while over the past twelve months, the median production value was 8,950 Boepd (not shown).  As buyers “purchased in bulk” this period relative to the prior twelve-month period, the median transaction value per production unit declined nearly 41% from $53,584 per Boepd to $31,886 per Boepd.  Transactions came in waves.  There was one transaction announced regarding Permian properties between June and August 2020.  September saw three deal announcements, and 10 transactions were announced during Q4 2020.  Activity fell silent in Q1 2021 as the industry waited for the Biden Administration to settle in Washington.  Deal announcements then resumed in earnest in Q2 as WTI crude oil and Henry Hub natural gas prices showed signs of fairly stable upward trajectories, with the exception of a temporary spike in gas prices due to the mid-February freeze.Click here to expand the imageLooking a bit closer at the data, it appears there may have been an inflection point in deal valuations over the past twelve months.  First and foremost, there was a notable concentration of larger-than-average deals, in terms of transaction values, from July to October 2020.  Except for the Pioneer Natural Resources DoublePoint Energy transaction in early April, all deal values after October 2020 pale in comparison to those in the early period.  As presented in the comparative statistical tables below, bifurcating the presented metrics further between the periods of July to October 2020 and November 2020 to the present reveals the potential pivot in valuations.The post-October median transaction value declined 95% to just $294 million from the pre-November median value of $5.6 billion.  However, more tellingly, the cost per acre nearly halved with the median metric value declining from $20,449/acre in the July-October 2020 transactions to $10,482/acre in the post-October transactions.  If you remove the outlier value of the Northern Oil and Gas transaction ($180,303/acre), the nearly 50% decline is slightly reduced to an indicated decline of 45% in the price per acre.  I am not a gambler, but without soliciting direct commentary from the respective management of the buyers listed above, I would wager that the inbound Biden Administration and the uncertainty surrounding potential regulatory changes were a significant factor in this valuation decline.Click here to expand the imageOne noteworthy pair of transactions, which may receive further Mercer Capital analysis sooner than later, relates to acquisitions made by Pioneer Natural Resources, including the October 2020 announcement of a definitive agreement to acquire Parsley Energy and its April 2021 announcement of a definitive agreement to purchase the leasehold interests and related assets of DoublePoint Energy.  Pioneer was the only buyer to appear more than once on our list of transactions with a major transaction before November and one after (for which deal metrics were available), with indications of significant increases in the cost-per-net-acre and cost-per-Boepd valuation metrics.Northern Oil and Gas Enters the Delaware BasinIn September 2020, Northern Oil and Gas announced its entrance into the Permian with its acquisition of non-operated working interests in Lea County, New Mexico from an undisclosed seller.  The deal consisted of 66 net acres, with an initial 1.1 net wells proposed to be spud in late-2020 to early-2021 and production expected to start in Q2 2021.  The total acquisition costs (including well development costs) were expected to be $11.9 million.  At first blush, these metrics indicate a cost per net acre of approximately $180,300, which suggests a notable premium.The next highest cost per net acre value among the transactions listed was $67,000 forthe Pioneer Natural Resources-DoublePoint Energy dealannounced in April.  A premium was paid as far as net acreage acquired is concerned.  However, at the expected peak production rate of 1,400 Boepd, the cost per production unit was $8,500 per Boepd, the second-lowest metric after Contango Oil & Gas’s acquisition in late November, and one-third of the minimum $-per-Boepd metric among the transactions listed in the June 2019-2020 season.  Despite recent volatility in the industry due to energy prices and domestic regulatory changes–whether real or proposed–the economics of the Permian have remained attractive enough to induce Northern Oil and Gas, a stalwart Bakken E&P company, to try its hand in Southeast New Mexico.Vencer Energy Acquires Hunt Oil Company’s Midland Basin AssetsIn late April, Vencer Energy, the U.S. upstream Oil & Gas subsidiary of the Dutch energy and commodity trading giant, Vitol, announced its first investment in the Midland Basin.  While the total transaction value was not disclosed, the acquisition included approximately 44,000 net acres with a total estimated production of 40,000 Boepd.  This represents an estimated total annualized production of approximately 332 Boe per net acre.  This “production density” value (annualized production per net acre) is the second-highest value among the listed transactions, only behind the comparable metric of 376 Boe per net acre indicated from the Pioneer-Double Point deal (with acquired/estimated production of 100,000 Boepd across 97,000 net acres).Ben Marshall, Head of Americas – Vitol, commented on the transaction: “This is an important day for Vencer as it establishes itself as a significant shale producer in the U.S. Lower 48.  We expect U.S. oil to be an important part of global energy balances for years to come, and we believe this is an opportune time for investment into an entry platform in the Americas.  This acquisition represents an initial step to building a larger, durable platform in the U.S. Lower 48.”ConclusionM&A transaction activity in the Permian was a bit of a roller coaster over the past year in terms of deal timing, but the overall story is one of resurgence over the past twelve months relative to the twelve months before it.  Still, despite a renewed interest in acquiring greater acreage and production positions, even greater changes could be on the horizon.  This past week, it came to light that Shell was reviewing its Permian holdings for potential sale, according to certain people familiar with the matter.  However, it is pure speculation at this juncture as to what option(s) Shell may pursue regarding the partial or full sale of the company’s estimated more-than-$10 billion of Permian holdings. Assuming any dispositions, though, this news could portend even more opportunities for continued buy-in into the Permian by existing regional E&P companies and potential new entrants.

After three straight months of impressive gains, the SAAR fell 9.6% in May from 18.8 million units to 17.0 million units.  The summer is typically a strong season for auto sales, but several supply-side factors have limited the availability of vehicles over the last month.May 2020 SAAR (12.1 million units) is a poor comparison to this year’s rate, as the pandemic’s impact was still sending shock waves through the industry at that time.  In comparison to May 2019, SAAR is down roughly 2%.The dip in SAAR from April highs should not be viewed in a totally negative light, as many industry experts have spoken to the adaptability and resilience of the industry during a period of record high demand and increasingly less inventory.  As seen in the graph below, the inventory to sales ratio has hit record lows as dealers cannot keep inventory on the lots. As noted in JD Power’s Automotive Forecast for May, the average number of days a new vehicle sits on a dealer lot before being sold is on pace to fall to 47 days, down from 95 a year ago. Dealers are also selling a larger portion of vehicles as soon as they arrive in inventory, with 33.4% of vehicles being sold within 10 days of arrival, which is up from 18.2% in May of 2019.  Rising vehicle prices continue to reflect this supply and demand imbalance and benefit retailer profits.  As reported by JD Power, total aggregate retailer profits from new vehicle sales will be $4.5 billion, the highest ever for the month of May, and up 162% from May 2019. Fleet customers are continuing to suffer as OEMs prioritize deliveries to retail customers over fleet customers. NADA reported that fleet deliveries accounted for just 10% of new-vehicle sales in May, after averaging 16% the first four months of the year.  Notably, this was already depressed in 2021 as pre-pandemic levels were closer to 20% of monthly sales.  As we noted in our April SAAR, rental cars will continue to be hard to come by.  These high prices on rental cars and limited selection will most likely continue until the chip shortage has been straightened out and supply has stabilized. Consumer ReactionsConsumers are having to get creative in order to secure a vehicle.  As we mentioned on our April SAAR blog post, manufacturers are hoping that consumers will be flexible and purchase models with less features to save on chips.Consumers seem to be going the extra mile however, with Cars.com finding that nearly 1 in 3 recent buyers drove 100 miles or more to secure the car they want.  Kelsey Mays, Cars.com assistance managing editor, noted “With the current auto inventory challenges, recent car buyers are going to great lengths to find the car they want…I don’t anticipate this trend slowing down, either. Of consumers currently in the market and shopping for a car, 65% said they would consider purchasing in another state.”While the extra mileage to find car options presents a clear inconvenience for consumers, they may reap some benefits as well. Over half (53%) of those looking for a new car also plan to trade in their current vehicle to the dealerships.  As the inventory shortage has limited the availability of cars on lots, the dealerships are often willing to pay a premium for new inventory. The extent to which consumers are willing to travel to find a car sheds further light on the current supply and demand incongruencies.Government ReactionsThe chip shortage has reached such an extent that the U.S. government is trying to assist. According to Automotive News, the Senate has passed an expansive bill to invest nearly $250 billion in bolstering U.S. manufacturing and technology to meet the economic and strategic challenge from China.  More specifically for auto dealers, the bill includes $52 billion in emergency outlays to help domestic manufacturers of semiconductors expand production, which was a bipartisan addition sought by Republican Senators John Cornyn (Texas) and Tom Cotton (Arkansas) and Democrats Mark Kelly (Arizona) and Mark Warner (Virginia).  The addition of the semiconductor expansion was cheered by those in the industry who have been struggling to meet demand for months.  Though the bill would be welcomed with open arms by the auto dealer industry, its fate is still uncertain as support in the House of Representatives is somewhat unknown.  However, Senate Majority Leader Schumer has indicated that he believes the House will be able to get something passed through to President Joe Biden’s desk.When It Will End?With 93%of respondents to a survey conducted by Automotive News about the global chip shortage finding that they believe the chip shortage will have a severe impact on the auto industry, the question on everyone’s mind is when is the end date.While 72% of respondents believe that it will last the rest of the year, Goldman Sachs chief Asia economist Andrew Tilton believes the worst may be over. He has noted that there has been “noticeable tightening” of supply chains and shipment delays in North Asia, which will ultimately have an impact on downstream sectors such as auto production. He and his team believe the chip shortage could improve in the second half of 2021. However, this is a continuously evolving situation as multiple aspects of the supply chain are being disrupted, most recently in Taiwan. Chip manufacturing plants use large amounts of water, and Taiwan, home of the world’s largest contract chipmaker, is facing its worst water shortage in 56 years. This, as well as the continuing COVID-19 pandemic, will need to be monitored closely as the auto dealer industry hopes to move out of this ongoing chip shortage.ForecastWith the chip shortage still in full effect, inventory constraints are going to continue to be an issue through the remainder of the summer.  Thomas King, president of the data and analytics division at J.D. Power notes:“Looking forward to June, with sales continuing to outpace production in aggregate, falling inventory levels may start to put pressure on the current sales pace. However, based on what we have seen so far, retailers may continue to adapt by turning inventory more quickly to maintain sales velocity. However, regardless of inventory position, manufacturers and retailers will continue to benefit from strong consumer demand and a higher profit per unit sold.”Through June and the rest of the year, ability to turnover what inventory auto dealers are able to get their hands on will be critical to maintaining profitability levels. Consumer’s willingness to go the extra mile (literally) in order to secure a new car is a positive tailwind, and a continuation of this trend will be beneficial for dealerships. However, the chip shortage continues to need to be monitored closely, though expectations of it easing and government assistance are providing some optimism to the situation.ConclusionIf you would like to know more about how these trends are affecting the value of your auto dealership, feel free to contact any members of the Mercer Capital auto team. We hope that everyone is continuing to stay safe and healthy.

Evaluating a Buyer’s Shares From the Seller’s PerspectiveM&A activity in North America (and globally) is rebounding in 2021 after falling to less than $2.0 trillion of deal value in 2020 for just the second time since 2015 according to PitchBook; however, deal activity has accelerated in 2021 and is expected to easily top 2020 assuming no major market disruption due to a confluence of multiple factors.Most acquirers whose shares are publicly traded have seen significant multiple expansion since September 2020;Debt financing is plentiful at record low yields;Private equity is active; and,Hundreds of SPACs have raised capital and are actively seeking acquisitions. The rally in equities, like low borrowing rates, has reduced the cost to finance acquisitions because the majority of stocks experienced multiple expansion rather than material growth in EPS. It is easier for a buyer to issue shares to finance an acquisition if the shares trade at rich valuation than issuing “cheap” shares. As of June 3, 2021, the S&P 500’s P/E based upon trailing earnings (as reported) was 44.9x compared to the long-term average since 1871 of 16x. Obviously trailing earnings were depressed by the impact of COVID-19 on 2020 earnings, but forward multiples are elevated, too. Based upon consensus estimates for 12 months ended March 31, 2022, the S&P 500 is trading for 21x earnings. High multiple stocks can be viewed as strong acquisition currencies for acquisitive companies because fewer shares have to be issued to achieve a targeted dollar value. As such, it is no surprise that the extended rally in equities has supported deal activity this year. However, high multiple stocks may represent an under-appreciated risk to sellers who receive the shares as consideration. Accepting the buyer’s stock raises a number of questions, most which fall into the genre of: what are the investment merits of the buyer’s shares? The answer may not be as obvious as it seems, even when the buyer’s shares are actively traded. Our experience is that some if not most members of a board weighing an acquisition proposal do not have the background to thoroughly evaluate the buyer’s shares. Even when financial advisors are involved there still may not be a thorough vetting of the buyer’s shares because there is too much focus on “price” instead of, or in addition to, “value.” A fairness opinion is more than a three or four page letter that opines as to the fairness from a financial point of a contemplated transaction; it should be backed by a robust analysis of all of the relevant factors considered in rendering the opinion, including an evaluation of the shares to be issued to the selling company’s shareholders. The intent is not to express an opinion about where the shares may trade in the future, but rather to evaluate the investment merits of the shares before and after a transaction is consummated. Key questions to ask about the buyer’s shares include the following:Liquidity of the Shares - What is the capacity to sell the shares issued in the merger? SEC registration and even NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently. Generally, the higher the institutional ownership, the better the liquidity. Also, liquidity may improve with an acquisition if the number of shares outstanding and shareholders increase sufficiently.Profitability and Revenue Trends - The analysis should consider the buyer’s historical growth and projected growth in revenues, operating earnings (usually EBITDA or EBITDA less capital expenditures) in addition to EPS. Issues to be vetted include customer concentrations, the source of growth, the source of any margin pressure and the like. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated.Pro Forma Impact - The analysis should consider the impact of a proposed transaction on revenues, EBITDA, margins, EPS and capital structure. The per share accretion and dilution analysis of such metrics as earnings, EBITDA and dividends should consider both the buyer’s and seller’s perspectives.Dividends - In a yield starved world, dividend paying stocks have greater attraction than in past years. Sellers should not be overly swayed by the pick-up in dividends from swapping into the buyer’s shares; however, multiple studies have demonstrated that a sizable portion of an investor’s return comes from dividends over long periods of time. If the dividend yield is notably above the peer average, the seller should ask why? Is it payout related, or are the shares depressed? Worse would be if the market expected a dividend cut. These same questions should also be asked in the context of the prospects for further increases.Capital Structure - Does the acquirer operate with an appropriate capital structure given industry norms, cyclicality of the business and investment needs to sustain operations? Will the proposed acquisition result in an over-leveraged company, which in turn may lead to pressure on the buyer’s shares and/or a rating downgrade if the buyer has rated debt?Balance Sheet Flexibility - Related to the capital structure should be a detailed review of the buyer’s balance sheet that examines such areas as liquidity, access to bank credit, and the carrying value of assets such as deferred tax assets.Ability to Raise Cash to Close - What is the source of funds for the buyer to fund the cash portion of consideration? If the buyer has to go to market to issue equity and/or debt, what is the contingency plan if unfavorable market conditions preclude floating an issue?Consensus Analyst Estimates - If the buyer is publicly traded and has analyst coverage, consideration should be given to Street expectations vs. what the diligence process determines. If Street expectations are too high, then the shares may be vulnerable once investors reassess their earnings and growth expectations.Valuation - Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles.Share Performance - Sellers should understand the source of the buyer’s shares performance over several multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Strategic Position - Assuming an acquisition is material for the buyer, directors of the selling board should consider the strategic position of the buyer, asking such questions about the attractiveness of the pro forma company to other acquirers?Contingent Liabilities - Contingent liabilities are a standard item on the due diligence punch list for a buyer. Sellers should evaluate contingent liabilities too. The list does not encompass every question that should be asked as part of the fairness analysis, but it does illustrate that a liquid market for a buyer’s shares does not necessarily answer questions about value, growth potential and risk profile. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies garnered from over three decades of business.

Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. The demographics suggest that increased attention to succession planning is well warranted: over 60% of RIAs are still led by their founders, and only about a quarter of them have non-founding shareholders. Yet, when RIA principals are asked to rank their firm’s top priorities, developing a succession plan is often ranked last.What Is a Succession Plan?Despite the headlines suggesting that there is a wave of strategic takeovers that will ultimately consolidate the investment management profession into a few large firms, the reality we’ve encountered suggests that most RIAs will transition ownership and leadership from one generation to the next internally. The reasons for this are fairly obvious.Many RIA owners prefer working for themselves, and their clients prefer working with an independent advisor. Internal transitions allow RIAs to maintain independence over the long-term and provide clients with a sense of continuity and comfort that their advisor’s interests are economically aligned. Further, a gradual transition of responsibilities and ownership to the next generation is usually one of the best ways to align your employees’ interests and grow the firm to everyone’s benefit. While this option typically requires the most preparation and patience, it allows the founding shareholders to handpick their successors and future leadership.When managers at RIAs start thinking about succession, they immediately jump into who buys out whom at what price and terms. While this is one piece of a succession plan, we would suggest, instead, that the starting point is strategic planning for the business.One of the keys to understanding succession planning is understanding what it is not.A Succession Plan Is Not…A succession plan is not a continuity plan. A continuity plan ensures that your clients will have uninterrupted services in the event of a disaster. Your eventual retirement should not be treated in the same manner as a sudden death or earthquake.A succession plan is not an exit plan. An exit plan is a business owner’s strategic plan to sell their ownership to realize a profit or limit losses. This line can be fuzzy, but strategic transactions rarely obviate the need for succession planning. Leadership transition issues can loom large even in strategic transactions.The Time To Plan Is NowIf you’re a founding partner or selling principal, you have several options, and it’s never too soon to start thinking about succession planning. Proper succession planning needs to be tailored, and a variety of options should be considered. See our recent whitepaper for more information on succession planning.ConclusionSince our founding in 1982, Mercer Capital has provided expert valuation opinions to over 15,000 clients throughout the U.S. and six continents. We are a valuation firm that is organized according to industry specialization. Our Investment Management Team provides asset managers, wealth managers, and independent trust companies with business valuation and financial advisory services related to shareholder transactions, buy-sell agreements, and dispute resolution.

A few weeks ago, I sat down with Kevin Nill of Haig Partners to discuss trends in the auto dealer industry and the release of their Fourth Quarter 2020 Haig Report. Specifically, I wanted to focus on the unique conditions impacting the industry, and also the changing methodology that buyers are utilizing to assess dealership values. Haig Partners is a leading investment banking firm that focuses on buy/sell transactions in the auto dealer industry, along with other transportation segments. As readers in this space are familiar, Haig Partners also publishes Blue Sky multiples for various auto manufacturers based on their observations and data from participating in transactions in this industry.The Haig Report mentions many buyers are utilizing a three-year average of earnings to calculate the expected performance of the dealership. Why has this new trend occurred and how has a buyer’s pricing methodology shifted in 2020/2021?KN: Prior to the pandemic, the auto retail market had effectively plateaued with sales declining slightly and dealership profitability fairly stable. The roller coaster of 2020 - a lockdown, then a big upswing as pent up demand and stimulus money flowed through the system in the summer, followed by continued retail demand and tight inventories, created a lot of “noise” in dealer financial statements. Even with exclusion of PPP fund impact, overall dealership profitability was incredibly strong with many stores achieving all-time record profits. This created a challenge for buyers as they attempted to identify the correct income to base their buying decisions. When you apply a multiple against expected earnings to determine value, one needs to have confidence the earnings will materialize. Given the volatility in performance, buyers have been reluctant to price a deal solely on 2020 results, making the argument the performance was artificially inflated. Sellers counter by illustrating the strong results were not a summer phenomenon but have continued into 2021 and no end is in sight. Going forward inventory availability remains an issue creating nice margins, interest rates will remain low for the foreseeable future, and expense controls have taken some of the bloat out of the business. As a result, many buyers are using a three-year average (2018-2020) as their earnings baseline. This gives the seller credit for the strong 2020 numbers but reflects expectations that future results will likely settle back to pre-pandemic numbers. Notably, some markets that were harder hit by the pandemic did not generate record numbers, and some buyers are utilizing 2019 as their baseline so as not to punish a seller for a down year in 2020. Regardless, it takes more massaging of past performance to establish a baseline for future results. SW: The methodology described by Kevin compares to our longer-term view of a dealership’s earnings and profitability. A valuation considers the expected ongoing earnings or cash flow of the dealership, and as such, several factors should be considered including historical, current, and expected operations in the future. We are cautious not to overvalue a dealership in its best year or undervalue a dealership in its worst year, if neither are sustainable. As to the impact of the pandemic on dealership valuations, we think it is relative to each individual dealership and their unique set of factors.Will buyers revert to Trailing 12 Months (TTM) as their baseline or will the three-year average method remain for some time?KN: Adjusted TTM earnings became the primary baseline for applying a multiple because the industry performance had been fairly stable for some time. Yes, there were specific dealerships that had better or worse results, and those were valued with appropriate modifications to forecasted earnings. Given the aforementioned volatility in 2020, the expectations of a strong 2021 and a potential gradual return to pre-pandemic levels, using a three-year average of earnings has become a more accepted strategy. Until we see stability in the automotive retail sector for some time, it’s unlikely TTM will return as the primary earnings metric. Of course, there are always exceptions including unique market dynamics, identified changes to the business or a highly competitive market for a dealership that may require buyers to give more credit for 2020 and 2021 results.Has there been a prior time when a three-year average was the preferred method for calculating earnings and, if so, what were the underlying conditions at the time?KN: Using a three-year average was a fairly standard method until recently but as dealership performance became stable and predictable, both buyers and sellers gradually settled on TTM as an effective proxy to base their valuation. Simplicity and the lack of variance in performance made it an easy calculation and removed some of the tension during negotiations. Of course, there has and will continue to be discussion and debate on add-backs and proforma earnings when strategic shifts at the dealership might yield better results. In general, the more consistent the performance, the more likely the buyer can get comfortable using the most recent financial period to calculate a value. SW: As we discuss on a monthly basis, the auto SAAR (number of lightweight automobiles and trucks sold on an annual basis) is one of the general indicators of the conditions in the industry. To view Kevin’s rationale behind the stability in the industry through the lens of SAAR, SAAR was fairly stable and roughly averaged between 16 and 18 million units from mid-2014 through the first few months of 2020 prior to the pandemic. SAAR collapsed to 11.361 million units in March 2020, before bottoming out at 8.721 million units in April 2020.What other changes or areas of focus are buyers concentrating on given the unique 2020 environment?KN: As buyers look to 2021 and beyond and evaluate how a target might perform going forward, there are certainly some areas of the business that are receiving attention:New vehicle margins – Given industry constraints on production, new inventory levels on dealer lots are quite low, allowing dealers to increase transaction prices and realize stronger margins. This is expected for most of 2021 and possibly into 2022. There is also dialogue that given improved profitability at OEMs, suppliers, and dealers, a more balanced production vs. demand market may continue, maintaining improved margins.Used vehicle margins – The used vehicle market dropped initially during the pandemic lockdown, spiked again, and has remained fairly strong since the fall. Now with new vehicle shortages, we are hearing dealers are driving up acquisition prices on used vehicles. The lack of new availability could drive consumers to used and keep margins strong or the frenzy to buy inventory could lower margins if consumers balk at the higher costs of the vehicle.Fixed operations – Most dealers saw a drop in 2020 fixed operations as the lockdown cost them weeks and months of customers. Given most dealership service bays are at or near capacity, you can’t make the business up. However, the 4Q of 2020 saw fixed revenue return to pre-pandemic levels. Thus, we expect 2021 to show nice growth in fixed operations over a lower 2020 and the past trend of annualized revenue increases should continue in 2022 and beyond.SG&A expenses – Key expense categories including floor plan interest, advertising and personnel saw nice declines in 2020. It is likely interest rates will remain close to zero, possibly into 2023. Many dealers see lower advertising as a continued theme for the foreseeable future given demand is exceeding supply. Finally, as dealers refine their sales and delivery channels and more transactions move online, we hear a number of dealer principals indicate their staffing levels will be permanently lower.SW: Gross profit per unit numbers for new and used vehicles continues to be very strong, with average reported figures for March at $2,764 and $2,859 per unit respectively, according to the average dealership statistics published by NADA Dealership Profiles. As daily reports of inventory shortages and challenges due to the microchip crisis continue, it will be interesting to see if/when these constraints catch up to the industry and halt the record profitability. Perhaps, we will begin to see some of these hiccups finally materialize in the financial performance either in the April or May figures when they are published.With rumors of tax rates rising, what impact could this have on Blue Sky multiples?KN: The Biden administration platform includes a material increase in capital gains taxes which directly impacts sellers of dealerships. As a result, some sellers who have been considering a sale are accelerating their plans and pursuing a sale in 2021 before a likely tax change in 2022. There are a number of attractive opportunities for buyers and dealers looking to expand so its expected values will remain robust. If/when tax rates rise, several situations might occur:Fewer sellers come to market, reducing dealership inventory and putting upward pressure on valuations.Less after tax proceeds to the seller pressures them to require higher valuations to sell their store.Higher taxes reduce consumer spending, lower sales, reduce dealer profits and bring valuations down. As a result, it’s difficult to predict the future but there’s no doubt higher taxes will have a ripple effect throughout the dealer buy/sell market. SW: My colleague David Harkins previously authored a post highlighting the proposed tax changes and their impact on valuation by comparing expected earnings under several tax bracket structures.Looking back, how did the Tax Cuts and Jobs Act (TCJA) affect multiples and values?KN: Lower taxes certainly provided a boost to consumers and helped ensure stability in vehicle sales in an environment where we were beginning to see declining sales. Corporate tax rate changes did little to help dealers as most are not C-corporations, and some dealers saw personal taxes go up due to the changes in deductibility of certain items. Overall, the rates kept the momentum rolling, nice profits for dealerships, and stable valuations for stores. Buyers were also able to forecast higher after-tax proceeds from their stores to justify paying more. We thank Kevin Nill and Haig Partners for their insightful perspectives on the auto dealer industry. While the last year has been a turbulent one for the industry, auto dealers have been resilient in navigating the changing conditions. The first four to five months of 2021 have continued the momentum of the last half of 2020 in terms of dealership profitability and transaction volume. It will be interesting to see how long these trends will continue, or if auto dealers will experience any hiccups as market constraints threaten current profitability. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.

Last week we explained why RIA principals and board members should consider getting a Fairness Opinion; FAIR … The F-word in RIA M&A: Part I; When Do You Need A Fairness Opinion?.Under U.S. case law, the so-called “Business Judgment Rule” presumes directors will make informed decisions that reflect good faith, care, and loyalty. If any of these criteria are breached in a board-approved transaction, then the directors may be liable for economic damages.RIA boards hire valuation and advisory firms like ours to opine on the fairness of contemplated transactions in an effort to protect themselves from potential liability.In a challenged transaction, the “entire fairness standard” requires the court to examine whether the board dealt fairly with the firm and whether the transaction was conducted at a fair price to its shareholders. As a result, Fairness Opinions seek to answer two questions:Is a transaction fair, from a financial point of view, to the shareholders of the selling company?Is the price received by the Seller for the shares not less than “adequate consideration” (i.e. fair market value)? Process and value are at the core of the opinion. A Fairness Opinion is backed by a rigorous valuation analysis and review of the process that led to the transaction. Some of the issues that are considered include the following.ProcessProcess can always be tricky in a transaction. A review of fair dealing procedures when markets have increased should be sensitive to actions that may favor a particular shareholder or other party.Management ForecastsA thorough analysis of management’s projections is a key part of a fairness analysis. After all, shareholders are giving up these future cash flows in exchange for cash (or stock) consideration today. Investment managers’ revenue is a product of the market, which over the past year has withstood significant volatility. A baseline forecast developed in the middle of the COVID-19 pandemic may be stale today. Boards may want to consider the implications of the V-shaped market recovery on their company’s expected financial performance and the follow-through implications for valuation.TimingDeals negotiated mid-COVID, when it was unclear whether the market was in a V-shaped or W-shaped recovery, may leave your shareholders feeling like money was left on the table. It is up to the board to decide what course of action to take, which is something a Fairness Opinion does not directly address. Nevertheless, fairness is evaluated as of the date of the opinion, such that the current market environment is a relevant consideration.Buyer’s SharesIf a transaction is structured as a share-for-share exchange, then an evaluation of the buyer’s shares in a transaction is an important part of a fairness analysis. The valuation assigned to the buyer’s shares should consider its profitability and market position historically and relative to peers. If the purchaser is a public company, it is imperative that all recent public financial disclosure documents be reviewed. It is also helpful to talk with analysts who routinely follow the purchasing company in the public markets.It is equally important to note what a Fairness Opinion does not prescribe, including:The highest obtainable price.The advisability of the action the board is taking versus an alternative.Where an RIA’s shares may trade in the future.The reasonableness of compensation that may be paid to executives as a result of the transaction. Due diligence work is crucial in the development of the Fairness Opinion because there are no rules of thumb or hard and fast rules that determine whether a transaction is fair. The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling stock). We believe it is prudent to visit the selling RIA (if feasible), conduct extensive reviews of documentation, and interview management (either in person or virtually). Fairness Opinions are often memorialized in the form of a Fairness Memorandum. A Fairness Memorandum examines the major factors of the Fairness Opinion in some detail and summarizes the considerations of each factor for discussion by the board of directors. In many cases, the advisors rendering the Fairness Opinion will participate in these discussions and answer questions addressed by the board.ConclusionMercer Capital’s comprehensive valuation experience with investment managers enables us to efficiently provide reliable, unbiased Fairness Opinions that provide assurance to stakeholders that transactions underway are fair and reasonable. We’re happy to answer any preliminary questions you have on Fairness Opinions and when it makes sense to get one.

SAAR has continued its impressive run in 2021, increasing for the second straight month to 18.5 million.  This is a 3.1% increase from March 2021.  As we have mentioned in our previous SAAR blog post, comparing spring 2021 SAAR to 2020 does not hold much merit, especially in April which experienced the weakest sales of the pandemic in 2020.For those of you who are curious however, April SAAR is up 112% from last year.Compared to April 2019, a better comparison in our view, April 2021 is up 12.1%. Because of strong demand, OEMs continue to rely less on incentive spending. According to JD Power, average incentive spending per unit in April is anticipated to be $3,191, a decline of $1,762 from April 2020 and $382 from April 2019.  Still, average transaction prices are expected to reach another month high, rising 6.8% from last month to $37,572.  This is the highest ever for the month of April and the second highest of all time behind December 2020. Incentive declines and price increases serve as a major win for dealerships this month.In regards the expected April statistics, Thomas King, president of the data and analytics division at JD Power notes:“While falling numbers of vehicles in inventory at retailers is the primary risk to sales results in the coming months, to date, low inventories have not had a material effect on aggregate sales results. Instead, they have enabled manufacturers and retailers to reduce discounts and consumers are demonstrating a willingness not only to buy vehicles closer to MSRP, but also to buy more expensive vehicles.”Inventory Scarcity Continuing to be in PlayThough pent-up demand and higher levels of disposable income continued to drive SAAR growth this month, a surprising factor we considered to be a headwind may have actually boosted sales for the month: the microchip shortage. As the shortage continues to drag on and has started affecting other industries and big names (such as Apple), the shortage has become a household topic and consumers are taking notice. Behind the increase in April SAAR may be consumers rushing to dealerships to snag a vehicle before they become more difficult to find in the coming months.Automakers, keen on not having to completely shut down productions, are trying to work around the chip shortage by removing features, which may be incentivizing consumers to pay up for them now.As Automotive News reports, Nissan is leaving navigation systems out of thousands of vehicles that typically would have them because of the shortages. Ram no longer offers its 1500 pickups with a standard "intelligent" rearview mirror that monitors for blind spots. Renault has stopped offering an oversized digital screen behind the steering wheel on its Arkana crossover. All of these feature cuts being for the same reason: to save on chips.  This may become more prevalent going forward this year as the chip shortage is anticipated to continue.Despite automaker’s best efforts, inventory levels are suffering. While April inventory levels are not available yet, NADA forecasts that they likely will be at a decade-long low with no relief in sight.  According to BEA, the inventory to sales ratio for March (the most recent data available) is at the lowest levels of the reported data going back to 1993, at 1.36 (though the chart below only shows data through 2015). According to Auto Forecast Solutions, the semiconductor microchip shortage has caused worldwide production to fall off to 2.29 million vehicles.  Current forecasts put projected total vehicle production losses from the global chip shortage at 3.36 million units, with 1.11 million from North American production. With production flagging, dealers are having to draw down inventories to maintain and grow sales. However, April’s strong sales figure is unlikely to be sustainable as inventories cannot be drawn down forever, which explains why NADA forecasts 2021 SAAR of 16.3 million, or 11.9% below the April figure. Fleet Customers SufferingWhile the inventories of auto dealers are down,  inventories for fleet customers are down even more, as OEMs continue to prioritize production for retail customers over fleet customers. Retail sales in April are estimated to be up 114% from April 2020 and up 23% from April 2019 according to Wards Intelligence. Meanwhile, fleet deliveries increased by 88% from April 2020, but fell by 42% from April 2019.This is especially poor timing for fleet customers as travel has begun picking up again and rental car companies and other fleet buyers are in need of inventory as many had to sell chunks of their fleets in order to preserve money during Covid-19, creating a situation that many are referring to as “car-rental apocalypse.” Due to the new car shortages, they are having to look elsewhere.As Yahoo News reports, Hertz is "supplementing its fleet by purchasing low-mileage, pre-owned vehicles from a variety of channels including auctions, online auctions, dealerships, and cars coming off lease programs," a Hertz spokesperson told Insider in an email statement.The result of all of this is that rental cars may cost consumers over $500 a day for an SUV, compared to prices of $50 a day 2 or 3 years ago.  Until the chip shortage is back under control, travelers may be stuck having to pay sky high prices for rental vehicles on their next vacation.Looking ForwardThe best phrase we can think of to describe the auto industry going into May is “something’s got to give.” While demand for vehicles is still being fueled by pent up demand and traveling picking back up due to Americans getting vaccinated and a return to normalcy, the microchip shortage isn’t going away anytime soon.According to Mike Jackson, AutoNation’s CEO, that expiration date might even be 2022, as he notes “we performed despite the disruption from the shortages created by the chip disruption, which we expect to fully continue for the rest of this year."Stay turned for our blog next week when my colleague David Harkins breaks down the Q1 earnings calls and what the other leaders in the industry are noting about this year’s prospects.However, despite the lack of chips, if consumers are willing to make some sacrifices in terms of the number of features their vehicle has, SAAR may not see huge declines. If that is not something they are willing to do, the supply constraints may hinder SAAR’s recent run.

Fair. It’s the first-four-letter word that most children learn, and it often leads to more arguments than other choice words. Although children eventually learn that life is not always fair, we spend a lot of time ensuring that major economic events are. Transactions are rarely straightforward, and as the pace of M&A activity in the investment management community continues to accelerate, more shareholders are scrutinizing both the pricing and terms of transactions. Over the next two posts, we will explain when you should consider getting a Fairness Opinion and what that involves.What Is a FAIR Transaction?Under U.S. case law, the concept of the “Business Judgment Rule” presumes directors will make informed decisions that reflect good faith, care, and loyalty to shareholders. If any of these three are not met, then the “entire fairness standard” requires that, in the absence of an arms-length deal, transactions must be conducted with fair dealings (process) and atfair prices.Directors are generally shielded from challenges to corporate actions the board approves under the Business Judgement Rule provided there is not a breach of one of the three duties. However, once any of the three duties is breached, the burden of proof shifts from the plaintiffs to the directors. If a Board obtains a Fairness Opinion in significant transactions, they are more likely to be protected from this liability.Questions of value and fair dealing are subject to scrutiny, even in bull markets. Rapidly improving markets may lead your shareholders to question whether the price accepted in the context of negotiating and opining on a transaction could have been better. Below, we outline some circumstances when you should consider getting a Fairness Opinion before closing a deal.9x EBITDA in a 15x EBITDA World Fantasy The prominence of headlines touting impressive deal multiples has led to some unrealistic shareholder expectations around valuation. Yes, average deal multiples have increased over the last decade, more prospective buyers for your RIA exist today than there were five years ago, and maybe an irrational buyer with capacity will stroke checks for double-digit multiples. But the increase in average valuation multiples is being driven by a myriad of factors that do not perfectly correlate with the valuations of small to mid-sized RIAs.Echelon Partners 2020 RIA M&A Deal Report noted that the number of $1B+ transactions has doubled over the last five years. Most of these acquisitions, and especially the ones that attract headlines, warrant these higher multiples due to their sheer scale, rarity, and strategic significance. Not every RIA has the scale, growth pattern, and risk profile to warrant top-tier pricing. And, ultimately, no two asset managers, wealth managers, IBDs, OCIOs, or independent trust companies are alike.Nevertheless, boards facing a mismatch between shareholder expectations and market realities are in a tough position justifying a transaction. The evaluation and negotiation process is tricky when markets continue to climb day after day. Yet, Fairness Opinions can be used as one element of a decision process to evaluate significant transactions.Would You Prefer $10M or $7M Today, and $2M Each Year for the Next 3 Years?Most acquisitions of investment managers involve some form of contingent consideration. When evaluating multiple offers that involve varying amounts of upfront cash; equity consideration; and earn-out payments, periods, and terms, a Fairness Opinion can help Boards evaluate the economic merits of the terms being offered.Unsolicited OffersMany RIAs receive unsolicited offers from their friends, competitors, or institutional consolidators. When there is only one bid for the company and competing bids have not been solicited, the fairness of the transaction can more easily be disputed. Not every sale is best conducted in an auction process, but the prospective buyer making an unsolicited offer knows that it is, at least for the moment, the only bidder. The objective of an unsolicited offer is to get the seller’s attention and cause them to start negotiations, often giving the bidder an exclusive right to negotiate for a fixed amount of time. As the head of our investment management group, Mercer Capital President, Matt Crow, explains, “An unsolicited offer may be a competitive bid, but it is not a bid made in a competitive market.”The Investment Management Community Is SmallAlthough there are over 13,500 SEC-registered investment advisors in the U.S., the investment management community within a given sector or geography is fairly close-knit. Many RIAs join forces or sell to other RIAs they have known for many years. This is part of the reason deals work. In a relationship-driven business, it is hard to merge with or sell to someone with whom you don’t have an existing relationship. But anytime insiders or related parties are involved in a transaction, a Fairness Opinion can serve as a confirmation to a company’s shareholders that improper acts of self-dealings have not occurred.ConclusionWe have extensive experience in valuing investment management companies engaged in transactions during bull, bear, and boring markets. Mercer Capital’s comprehensive valuation and transaction experience with investment managers enables us to provide unbiased fairness opinions that directors can rely on to assure their stakeholders that the decisions being made are fair and reasonable.

Over the last year, many publicly traded investment managers have seen their stock prices increase by 70% or more.  This increase is not surprising, given the broader market recovery and rising fee base of most firms.  With AUM for many firms at or near all time highs, trailing twelve month multiples have expanded significantly, reflecting the market’s expectation for higher profitability in the future.  For more insight into what’s driving the increase in stock prices, we’ve decomposed the increase to show the relative impact of the various factors driving returns between March 31, 2020 and March 31, 2021 (see table below).Click here to expand the table aboveFor publicly traded investment managers with less than $100 billion in AUM, trailing twelve month (TTM) revenue for the year ended March 31, 2021 declined about 8% year-over-year.  Due to the operating leverage in the RIA business model, the decline in revenue also resulted in a lower EBITDA margin.  The net effect is that TTM EBITDA declined about 20% on average year-over-year for these firms.  The fundamentals for the larger group (firms with AUM above $100 billion) fared better, with profitability generally increasing despite the market downturn during the year ending March 31, 2021.  These firms saw positive revenue growth across the board, although in many cases the revenue growth was partially offset by margin compression.For both groups, expansion in the TTM EBITDA multiple was the primary driver of the stock price increases.  The larger group (AUM above $100 billion) saw the median multiple increase 70%, while the smaller group (AUM below $100 billion) saw the median multiple more than double.The multiple expansion between March 31, 2020 and March 31, 2021, while extreme, is not surprising given the trajectory of the market over the last year.  While EBITDA was down ~20% year-over-year for the smaller group (and up ~5% for the larger group), the market values these businesses based on expectations for the future, not on LTM performance.  As of March 31, 2020, AUM (and run-rate profitability) was down significantly, and depressed market prices continued to impact revenue for 2-3 quarters for many firms.  But the market recouped its losses relatively quicky and continued to trend upwards.  Today, AUM for many firms is hovering at or near all time highs.What’s Your Firm’s Run-Rate? The multiple expansion seen in the publicly-traded investment managers over the last year illustrates the importance of expected future performance on RIA valuations.  The baseline for estimating future performance is the firm’s run-rate performance today.  RIAs are unique in that run-rate revenue can be computed on a day-to-day basis using the market value of AUM and the fee schedules for client accounts.  After deducting the firm’s current level of fixed and variable costs, run-rate profitability can also be determined.Market participants tend to focus on the run-rate level of profitability because it’s the most up-to-date indication of a firm’s revenue and profitability and the baseline from which future performance is assessed.  As AUM has increased for many RIAs, so too has the run-rate revenue and profitability.  The significant improvement in run-rate revenue and profitability (and expectations for the same) is a driving factor behind the multiple expansion observed over the last year.Consider the financial results for a hypothetical firm (ABC Investment Management) shown below.  While illustrative, the growth of this firm since March 31, 2020 is not unusual relative to that exhibited by publicly traded investment managers and many of our privately-held RIA clients.  During the second quarter of 2020, ABC Investment Management billed on $1.75 billion in AUM at an effective realized fee of 65 basis points, resulting in revenue for the quarter of $2.8 million.  After subtracting compensation expenses and overhead, ABC generated $660 thousand in EBITDA for the quarter.  AUM grew rapidly as the market recovered, such that by the first quarter of 2021 the firm was billing on $2.8 billion in AUM at the same fee of 65 basis points.  For the full year, ABC Investment Management generated $14.2 million in revenue and $4.6 million in EBITDA.As of March 31, 2021, however, the firm’s run-rate performance was significantly higher than its performance over the last twelve months.  ABC’s $2.8 billion in AUM was generating $18.0 million in annualized revenue at the effective realized fee level of 65 basis points.  Assuming the same level of fixed costs and the appropriate increase in variable costs to reflect the higher revenue, ABC was producing run-rate EBITDA of $7.3 million at the end of the first quarter.  That’s a 57% increase relative to EBITDA over the last twelve months.Implications for Your RIAAs always, valuation is forward looking.  In relatively stagnant markets, there might not be much of a difference between LTM and ongoing performance.  But given the shape of the market recovery over the last year, the difference today can be material, as the example above illustrates.  If you’re contemplating a transaction in your firm’s stock, it’s worth considering where your firm is at today, not just what it’s done over the last year.

After what felt like an eternity of quiet transaction activity in the O&G industry, the M&A market in 2021 has been off to a more active start in 2021.According to S&P Global Market Intelligence, the industry announced 117 whole-company and minority stake deals in the first quarter of 2021, an increase of 28 transactions from the same period last year.  The combined deal value has also increased from $3.86 billion to $26.4 billion, as supermajors like Exxon Mobil Corp., Royal Dutch Shell PLC and Equinor ASA divested assets and corporate consolidation continued.  The trend continued early in the second quarter.In this post, we discuss the Pioneer-DoublePoint transaction (the “Transaction”) that could foreshadow for more M&A activity to come.Transaction Summary & Asset DetailsOn April 1, 2021, Double Eagle III Midco 2 LLC, wholly owned by DoublePoint Energy, LLC, announced that it entered a definitive purchase agreement to sell all leasehold interest, subsidiaries, and related assets to Pioneer Natural Resources Company (PXD) in a transaction valued at $6.4 billion.  DoublePoint is a Fort Worth, Texas-based upstream oil and gas company that is backed by equity commitments from funds managed by affiliates of Apollo Global Management, Quantum Energy Partners, Magnetar Capital, and Blackstone Credit.According to Piconeer’s Investor Presentation, the Transaction adds approximately 100,000 Tier 1 Midland Basin net acres to Pioneer’s existing assets.  The bolt-on acquisition will lead to the combined company owning approximately 920,000 net acres in the Midland Basin, making it the largest producer in that area.  The deal is expected to close in the second quarter of 2021.The purchase price is comprised of the following:Approximately 27.2mm shares of Pioneer stock (PXD) based on Pioneer’s closing share price as of 4/1/2021 ($164.60). After closing, PXD shareholders will own approximately 89% of the combined company and existing DoublePoint owners will own approximately 11%.Cash of $1.0bnApproximately $0.9bn of liabilities that includes debt of $650mm at 7.75% and approximately $300mm of reserve-based lending and working capitalPer PXD Investor PresentationThe Transaction implies the following valuation metrics: Pioneer anticipates approximately $175 mm in annual synergies related to G&A, interest, and operations.  The company expects to save approximately $15 mm in G&A by reducing DoublePoint’s expense by 60% in the second half of 2021.  Pioneer also plans to refinance DoublePoint’s bonds after closing to save roughly $60mm.  Last, the company projects about $100 mm in operational savings.  According to Pioneer’s Investor Presentation, the acquired acreage is highly contiguous and largely undeveloped, adding greater than 1,200 high-return locations.  Although the exact amount Pioneer attributed to PDPs and PUDs is unknown, this suggests that PXD most likely associated option value to the undeveloped acreage in their purchase consideration. Mixed Market Signals Investors responded relatively well the day of the announcement (prior to the press release), as PXD’s share price increased 3.64%, closing at $164.60 on April 1.  However, the stock has since produced mixed signals.  The next trading day, April 5, the stock closed at $152.18, a 7.55% decrease from the announcement.  The stock closed at $147.10 on April 21, a 10.63% decrease from April 1.  The company has still performed well in 2021, as PXD share price is up 29.63% year-to-date.  PXD has followed similar trends to the broad E&P value index (as proxied by the SPDR S&P Oil & Gas Exploration & Production ETF, ticker XOP) since the beginning of year, so this decrease may be geared more towards industry sentiment rather than deal reaction. On April 5, 2021 Fitch Ratings released a statement that Pioneer’s ratings are unaffected by the company’s deal announcement with DoublePoint.  On April 22, 2021 Fitch affirmed Pioneer’s long-term issuer default ratings and unsecured debt ratings at BBB.  Fitch also assigned a BBB rating to Pioneer’s 364-day unsecured revolving credit facility.  Fitch notes that their rating outlook for PXD is stable.  Pioneer’s credit rating outlook is a testament to its strong balance sheet and 2021 estimated net debt / EBITDAX of 0.9x. ConclusionThe Pioneer-DoublePoint transaction could set the stage for an active M&A market relative to a quiet 2020.  Also, Pioneer’s Fitch Rating could serve as a positive signal for utilizing leverage in future deals.  It will also be interesting to monitor deal values as it relates to what buyers are willing to pay for specific producing and non-producing assets (to the extent that the information is disclosed).  If an industry recovery is in sight, transaction activity could continue its healthy pace, but also has the potential to soften if uncertainty looms, causing the bid-ask spread to widen if buyers and sellers are not on the same page.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and experience to help you navigate a critical transaction, providing timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

We have previously written about six events that can trigger the need for a business valuation.  In each of these examples, the valuation will consider the dealership as a going concern or a continuing operation.  The valuation process considers normalization adjustments to both the balance sheet and the income statement, as we discussed in our whitepaper last summer.  For the balance sheet, normalization adjustments establish the fair market value of the tangible assets of the dealership and also identify and bifurcate any excess or non-operating assets.  Non-operating assets are anything of value owned by the company that is not required to generate earnings from the core operations of the dealership.Even if a dealer is considering a potential sale of the business, the other assets and liabilities not transferred in the proposed transaction still have value to the seller when they consider the total value of operations.  These non-core assets would then be added back to the value of the dealership operations determined under the other valuation methods. Profitable dealerships will accrue cash on their balance sheets over time. While these profits tend to either be reinvested into the business or distributed to owners, we frequently find that auto dealerships will carry a cash balance in excess of the needs of the core operations which could but have not yet been distributed. This excess is considered a non-operating asset, and as we discuss in this post, there are numerous considerations in determining the extent that cash buildup may represent an excess.Working Capital on the Dealer Financial StatementCash (and contracts in transit) and inventory tend to be the two largest components of working capital (current assets minus current liabilities) for auto dealers. However, inventory is offset by floor-plan debt, requiring little actual upfront investment on the part of dealers. Still, there is a certain level of working capital required to maintain operations. Most factory dealer financial statements list the dealership’s actual working capital, along with the requirements or “guide” from the manufacturer on the face of the dealership financial statement, as seen in the graphic below. A proper business valuation should assess whether the dealership has adequate working capital, or perhaps an excess or deficiency.  Comparisons to required working capital should not always be a rigid calculation.  An understanding of the auto dealer’s historical operating philosophy can assist in determining whether there is an excess or deficiency as different sales strategies can require different levels of working capital, regardless of factory requirements.  Often, the date of valuation coincides to a certain event and may not align to the dealership’s year-end.  The balance sheet at the valuation date could represent an interim period and may reflect certain seasonality of operations.  A proper assessment of the working capital should consider the sources and uses of cash including anticipated distributions, capital expenditures, accrued and off-balance sheet liabilities, etc.  For many reasons, it may not be appropriate to simply take the $616,218 from above and call this amount a non-operating asset. Additional Challenges to Working Capital Assessment Caused by Industry ConditionsSince the start of the pandemic, the auto dealer industry has continued to rebound after initial declines caused by lockdowns and shelter in place orders.  The industry has benefited from increased gross profit margins on new and used vehicles, reduced expenses in advertising, floor plan maintenance and staffing, and funds provided by the PPP.  All have contributed to record performance for dealerships.  The PPP funds pose additional challenges to assessing the working capital of a dealership; are the funds reported on the dealer’s financial statement or are they held in accounts not reflected on those financial statements?  Is there a corresponding liability for the PPP loan on the balance sheet or has that loan been forgiven?  The date of valuation and what was known/knowable as of that date frame the treatment of these and other items in business valuation.  For dates of valuation later in 2020 and early 2021, the loan portion of the PPP funds may be written off to reflect either its actual or likely forgiveness, and the removal of the corresponding PPP loan can increase the dealership’s working capital.The increased profitability of dealerships can also be viewed in the rise of current ratios (current assets divided by current liabilities) over historical averages.  According to the data provided by NADA, the average dealership’s current ratio has risen to 1.38, from prior averages around 1.24.  Statistical data from 2014 through February 2021 can be seen below: So how should the working capital of an auto dealership be assessed?  Let’s look to a case study of a recent project to determine the factors to consider. Certain figures have been modified to improve the discussion and protect client information. Case StudyConsider a dealership with a date of valuation of September 30, 2020 compared to their typical calendar year-end.  In a review of historical financial statements and operational performance, the Company reported increasing cash totals as seen below. A quick review reveals that cash has increased by over $6 million in 2019 and $9 million from 2018 through the valuation date.  Would the entirety of this increase represent excess working capital? Digging deeper, let’s examine the actual levels of working capital and working capital as a percentage of sales for the same company over the same historical period. As we can see above, working capital increased as a percentage of sales. A rigid comparison of the latest period’s working capital to the prior period might indicate excess working capital either on the order of $2.7 million or 1% of sales. We can also look at the manufacturer’s requirement.  This particular dealership had a net worth requirement and the more traditional working capital requirement.  These are simple figures indicating whether a dealership is properly capitalized considering both liquidity and solvency. All of these financial calculations and cursory level reviews of working capital and net worth fail to consider the specific assets and liabilities of the Company, the timing of the interim financial statements, and the anticipated uses of cash.  It is critical to conduct an interview with management to discuss these items and the operating level of cash and working capital needed for ongoing operations. Importance of Management InterviewIn this example, management indicated that the ongoing cash needed to facilitate day-to-day operations would approximate $5 million.  Deducting from the $14.7 million, would that indicate $9.0+ in excess cash based on comparison to the actual cash balance as of the date of valuation?Management also provided details of a related party note payable to one of its owners not readily identifiable on the dealer financial statement.  The note was a demand note that was callable at any time and was expected to be paid in the short-term. This is considered a non-operating liability, offsetting the excess cash.  Management also anticipated heightened capital expenditures for the fourth quarter in the amount of $325,000.  This type of information would be nearly impossible to discern from just analyzing the financials as this expenditure is an off-balance sheet item.After learning this information, we chose to assess working capital utilizing three different methods.  First, we assessed working capital in the context of net worth based upon the requirements from the manufacturer because the Company can’t distribute excess cash to the level that would reduce equity below this figure.  This method resulted in an assessment of excess working capital of approximately $1.4 million as seen below: Next, we looked at the dealer’s working capital position compared to OEM requirements. This method showed closer to $2.4 million in excess working capital. While this shows the dealership may have ample liquidity to facilitate operations with less cash in the business, the excess cash cannot materially impair the required book value above. The final assessment of working capital focuses directly on the cash and equivalents.  As discussed, management indicated that the Company had operational cash needs of $5 million.  Additional uses of cash prior to year-end included the likely repayment of the related party demand note and the cash required for the capital expenditures.  This method resulted in an assessment of working capital of approximately $1.3 million, compared to a rigid calculation of $9.6 million when only considering actual cash less operating level needs as seen below: Ultimately, we concluded the Company in this example had excess working capital in the form of approximately $1,350,000 in excess cash. While there was more cash on the balance sheet than historical periods, our other valuation methods assume appropriate investment in the business to sustain operations. As such, we would be double counting value to add back too much cash without considering necessary improvements to the business to generate profits in the future. This example highlighted a dealership with excess working capital that was reflected in excess cash.  Occasionally, an analysis might indicate excess working capital, but the Company’s cash is not elevated above a sufficient level to fund operations.  As discussed above, excess and non-operating assets are those that could theoretically be distributed while not affecting the core operations of the dealership.  However, non-cash current assets, such as Accounts Receivable and Inventory, are either not readily distributable or doing so might jeopardize the core operations. For a valuation performed in March 2021, industry conditions would also impact these calculations. Many dealerships likely have excess cash from increased profitability caused by inventory shortages. While cash balances would be higher when compared to historical levels, overall working capital may not be too unchanged as dealers struggle to maintain adequate inventory. Extracting value in the form of excess cash in this environment would need to be balanced with appropriate consideration of ongoing sales abilities with constrained inventories. As we’ve shown throughout this case study, none of these figures can be viewed in isolation. ConclusionsWorking capital and other normalization adjustments to the balance sheet are critical to the valuation of an auto dealership.  The identification and assessment of any excess or deficiency in working capital can lead directly to an increase or decrease in value.  Valuable datapoints to measure working capital include the requirements by the manufacturer and the Company’s actual historical cash and working capital balances, along with its current ratio and working capital as a percentage of sales.  None of these data points should be applied rigidly and should be viewed in the context of future sources and uses of cash, the presence of non-operating assets or liabilities, and the seasonality of an interim date of valuation.  Additional challenges for current valuations can be posed by PPP funds and prevailing industry conditions including scarce inventory and heightened profitability.The professionals of Mercer Capital’s Auto Dealership Team provide valuations of auto dealers for a variety of purposes.  Our valuations contemplate the necessary balance sheet and income statement adjustments and provide a broader view to determine the assumptions driving the valuation.  For a valuation of your auto dealership, contact a professional at Mercer Capital today.

We have previously written about six events that can trigger the need for a business valuation.  In each of these examples, the valuation will consider the dealership as a going concern or a continuing operation.  The valuation process considers normalization adjustments to both the balance sheet and the income statement, as we discussed in our whitepaper last summer.  For the balance sheet, normalization adjustments establish the fair market value of the tangible assets of the dealership and also identify and bifurcate any excess or non-operating assets.  Non-operating assets are anything of value owned by the company that is not required to generate earnings from the core operations of the dealership.Even if a dealer is considering a potential sale of the business, the other assets and liabilities not transferred in the proposed transaction still have value to the seller when they consider the total value of operations.  These non-core assets would then be added back to the value of the dealership operations determined under the other valuation methods. Profitable dealerships will accrue cash on their balance sheets over time. While these profits tend to either be reinvested into the business or distributed to owners, we frequently find that auto dealerships will carry a cash balance in excess of the needs of the core operations which could but have not yet been distributed. This excess is considered a non-operating asset, and as we discuss in this post, there are numerous considerations in determining the extent that cash buildup may represent an excess.Working Capital on the Dealer Financial StatementCash (and contracts in transit) and inventory tend to be the two largest components of working capital (current assets minus current liabilities) for auto dealers. However, inventory is offset by floor-plan debt, requiring little actual upfront investment on the part of dealers. Still, there is a certain level of working capital required to maintain operations. Most factory dealer financial statements list the dealership’s actual working capital, along with the requirements or “guide” from the manufacturer on the face of the dealership financial statement, as seen in the graphic below. A proper business valuation should assess whether the dealership has adequate working capital, or perhaps an excess or deficiency.  Comparisons to required working capital should not always be a rigid calculation.  An understanding of the auto dealer’s historical operating philosophy can assist in determining whether there is an excess or deficiency as different sales strategies can require different levels of working capital, regardless of factory requirements.  Often, the date of valuation coincides to a certain event and may not align to the dealership’s year-end.  The balance sheet at the valuation date could represent an interim period and may reflect certain seasonality of operations.  A proper assessment of the working capital should consider the sources and uses of cash including anticipated distributions, capital expenditures, accrued and off-balance sheet liabilities, etc.  For many reasons, it may not be appropriate to simply take the $616,218 from above and call this amount a non-operating asset. Additional Challenges to Working Capital Assessment Caused by Industry ConditionsSince the start of the pandemic, the auto dealer industry has continued to rebound after initial declines caused by lockdowns and shelter in place orders.  The industry has benefited from increased gross profit margins on new and used vehicles, reduced expenses in advertising, floor plan maintenance and staffing, and funds provided by the PPP.  All have contributed to record performance for dealerships.  The PPP funds pose additional challenges to assessing the working capital of a dealership; are the funds reported on the dealer’s financial statement or are they held in accounts not reflected on those financial statements?  Is there a corresponding liability for the PPP loan on the balance sheet or has that loan been forgiven?  The date of valuation and what was known/knowable as of that date frame the treatment of these and other items in business valuation.  For dates of valuation later in 2020 and early 2021, the loan portion of the PPP funds may be written off to reflect either its actual or likely forgiveness, and the removal of the corresponding PPP loan can increase the dealership’s working capital.The increased profitability of dealerships can also be viewed in the rise of current ratios (current assets divided by current liabilities) over historical averages.  According to the data provided by NADA, the average dealership’s current ratio has risen to 1.38, from prior averages around 1.24.  Statistical data from 2014 through February 2021 can be seen below: So how should the working capital of an auto dealership be assessed?  Let’s look to a case study of a recent project to determine the factors to consider. Certain figures have been modified to improve the discussion and protect client information. Case StudyConsider a dealership with a date of valuation of September 30, 2020 compared to their typical calendar year-end.  In a review of historical financial statements and operational performance, the Company reported increasing cash totals as seen below. A quick review reveals that cash has increased by over $6 million in 2019 and $9 million from 2018 through the valuation date.  Would the entirety of this increase represent excess working capital? Digging deeper, let’s examine the actual levels of working capital and working capital as a percentage of sales for the same company over the same historical period. As we can see above, working capital increased as a percentage of sales. A rigid comparison of the latest period’s working capital to the prior period might indicate excess working capital either on the order of $2.7 million or 1% of sales. We can also look at the manufacturer’s requirement.  This particular dealership had a net worth requirement and the more traditional working capital requirement.  These are simple figures indicating whether a dealership is properly capitalized considering both liquidity and solvency. All of these financial calculations and cursory level reviews of working capital and net worth fail to consider the specific assets and liabilities of the Company, the timing of the interim financial statements, and the anticipated uses of cash.  It is critical to conduct an interview with management to discuss these items and the operating level of cash and working capital needed for ongoing operations. Importance of Management InterviewIn this example, management indicated that the ongoing cash needed to facilitate day-to-day operations would approximate $5 million.  Deducting from the $14.7 million, would that indicate $9.0+ in excess cash based on comparison to the actual cash balance as of the date of valuation?Management also provided details of a related party note payable to one of its owners not readily identifiable on the dealer financial statement.  The note was a demand note that was callable at any time and was expected to be paid in the short-term. This is considered a non-operating liability, offsetting the excess cash.  Management also anticipated heightened capital expenditures for the fourth quarter in the amount of $325,000.  This type of information would be nearly impossible to discern from just analyzing the financials as this expenditure is an off-balance sheet item.After learning this information, we chose to assess working capital utilizing three different methods.  First, we assessed working capital in the context of net worth based upon the requirements from the manufacturer because the Company can’t distribute excess cash to the level that would reduce equity below this figure.  This method resulted in an assessment of excess working capital of approximately $1.4 million as seen below: Next, we looked at the dealer’s working capital position compared to OEM requirements. This method showed closer to $2.4 million in excess working capital. While this shows the dealership may have ample liquidity to facilitate operations with less cash in the business, the excess cash cannot materially impair the required book value above. The final assessment of working capital focuses directly on the cash and equivalents.  As discussed, management indicated that the Company had operational cash needs of $5 million.  Additional uses of cash prior to year-end included the likely repayment of the related party demand note and the cash required for the capital expenditures.  This method resulted in an assessment of working capital of approximately $1.3 million, compared to a rigid calculation of $9.6 million when only considering actual cash less operating level needs as seen below: Ultimately, we concluded the Company in this example had excess working capital in the form of approximately $1,350,000 in excess cash. While there was more cash on the balance sheet than historical periods, our other valuation methods assume appropriate investment in the business to sustain operations. As such, we would be double counting value to add back too much cash without considering necessary improvements to the business to generate profits in the future. This example highlighted a dealership with excess working capital that was reflected in excess cash.  Occasionally, an analysis might indicate excess working capital, but the Company’s cash is not elevated above a sufficient level to fund operations.  As discussed above, excess and non-operating assets are those that could theoretically be distributed while not affecting the core operations of the dealership.  However, non-cash current assets, such as Accounts Receivable and Inventory, are either not readily distributable or doing so might jeopardize the core operations. For a valuation performed in March 2021, industry conditions would also impact these calculations. Many dealerships likely have excess cash from increased profitability caused by inventory shortages. While cash balances would be higher when compared to historical levels, overall working capital may not be too unchanged as dealers struggle to maintain adequate inventory. Extracting value in the form of excess cash in this environment would need to be balanced with appropriate consideration of ongoing sales abilities with constrained inventories. As we’ve shown throughout this case study, none of these figures can be viewed in isolation. ConclusionsWorking capital and other normalization adjustments to the balance sheet are critical to the valuation of an auto dealership.  The identification and assessment of any excess or deficiency in working capital can lead directly to an increase or decrease in value.  Valuable datapoints to measure working capital include the requirements by the manufacturer and the Company’s actual historical cash and working capital balances, along with its current ratio and working capital as a percentage of sales.  None of these data points should be applied rigidly and should be viewed in the context of future sources and uses of cash, the presence of non-operating assets or liabilities, and the seasonality of an interim date of valuation.  Additional challenges for current valuations can be posed by PPP funds and prevailing industry conditions including scarce inventory and heightened profitability.The professionals of Mercer Capital’s Auto Dealership Team provide valuations of auto dealers for a variety of purposes.  Our valuations contemplate the necessary balance sheet and income statement adjustments and provide a broader view to determine the assumptions driving the valuation.  For a valuation of your auto dealership, contact a professional at Mercer Capital today.

Nearly all sectors of the stock market are up over the last year, but that’s especially true for the RIA industry.  Even if most wealth management firms don’t employ any debt in their capital structure, their performance is very much levered to the stock market due to its direct effect on AUM balances, and the operating leverage inherent in the wealth management model.  RIA aggregators are even more levered to market conditions, since they typically borrow money to purchase wealth management firms.  It shouldn’t be too surprising that our aggregator index is up 140% over the last year. After a rough Q1 in 2020, wealth management firms have fared particularly well over the last year, with favorable market conditions and rising demand for financial advisory services.  During times of excessive volatility and market turmoil, individual investors rely on their advisors to stay the course and rebalance portfolios in accordance with their investment objectives.  Wealth management firms have capitalized on this reliance as the number of advisors charging financial planning fees on top of asset-based fees or commissions increased 72% in 2020. Despite steady gains over the last year, wealth management firms still face challenges pertaining to fee pressure, succession planning and connecting with millennials who are more interested in robo-advisors and fintech products than being counseled by their parents’ advisor.  Additionally, the switch from in-person meetings to digital communication is viewed by many as another obstacle.  According to a recent Schwab study, 35% of advisors viewed clients’ ability to connect virtually as one of the biggest challenges to their business in 2020.  On the flip side, 37% of advisors view leveraging technology infrastructure to be able to seamlessly work remotely as one of the biggest opportunities to their business. Source: Schwab Advisor Services’ 2020 Independent Advisor Outlook StudyAnother near-term opportunity is the pending reversal of some or all of the Tax Cuts and Jobs Act of 2017, and the implications it has for estate planning in 2021.  Biden’s current proposal cuts the Unified Tax Credit (the exemption on gift and estate taxes) in half from $23.2 million to $11.6 million for married couples and from $11.6 million to $5.8 million per individual.  As a consequence, many high net worth families will have significant gift and estate planning needs from their advisors to avoid a substantial increase in their embedded estate tax liability next year.On balance, 2021 should prove to be another challenging but favorable year for wealth management firms that focus on their clients’ needs and take advantage of rising demand for financial planning services.  Industry headwinds remain, but we’re confident that the industry will prosper, diversify, and expand.

The Key QuestionAs 2020 progressed, a record number of oil & gas operators and related oil field service companies filed for Chapter 11 bankruptcy, which provides for the reorganization of the firm as opposed to full liquidation (Chapter 7).  In addition, consolidation by way of merger and acquisition (“M&A”) activity occurred, albeit such activity was at a 10-year low in 2020. Regardless of whether a company files for Chapter 11, is party to an M&A transaction, or executes some other form of capital restructuring – such as new equity funding rounds or dividend recaps – one fundamental question takes center stage: Will the company remain solvent?The Four TestsAs noted in our overview of solvency opinions last November, leveraged transactions that occurred pre-COVID-19 will continue to be scrutinized, with many bankruptcy courts considering the issue of solvency retroactively.  Due to increased energy price volatility in the first and second quarter of 2020, many operational and dividend programs were suspended.As oil & gas prices have stabilized and appreciated over the past one to two quarters (in its April Short-Term-Energy Outlook report, EIA projects WTI and Brent to average $58.89 and $62.28 per barrel, respectively), a large number of oil & gas operators have significantly reduced their debt, and are considering or have resumed their operational plans and dividend programs, albeit perhaps not exactly as before their suspension.Emerging from the chaos of 2020 with lower leverage, leaner and more efficient operations, higher commodity prices, and the continued low interest rate environment, it is not unreasonable to think that oil & gas companies may consider increasing leverage again as operations continue to recover or expand and boards approve the return of capital to shareholders by way of resuming regular or even special dividends.Often, a board contemplating such actions will be required to obtain a solvency opinion at the direction of its lenders or corporate counsel to provide evidence that the board exercised its duty of care to make an informed decision should the decision later be challenged.A solvency opinion, typically performed by an independent financial advisor, addresses four questions:Does the fair value of the company’s assets exceed its liabilities after giving effect to the proposed action?Will the company be able to pay its debts (or refinance them) as they mature?Will the company be left with inadequate capital?Does the fair value of the company’s assets exceed its liabilities and capital surplus to fund the transaction?A solvency opinion addresses these questions using four primary tests:Test 1: The Balance Sheet Test – Does the fair value and present fair salable value of the Company’s total assets exceed the Company’s total liabilities, including all identified contingent liabilities? The balance sheet test takes the fair value of the subject firm on a total invested capital basis and subtracts its liabilities. Test 2: The Cash Flow Test – Will the Company be able to pay its liabilities, including any identified contingent liabilities, as they become due or mature? The cash flow test examines whether projected cash flows are sufficient for debt service.  This is typically analyzed along three general dimensions, including the determination of the company’s revolving credit facility to manage cash flow needs over the forecast, the possible violation of any applicable covenants, and the likely ability to refinance any remaining debt balances at their maturity. Test 3: The Capital Adequacy Test – Does the Company have unreasonably small capital with which to operate the business in which it is engaged, as management has indicated such businesses are now conducted and as management has indicated such businesses are proposed to be conducted following the transaction? The capital adequacy test is related to the cash flow test and examines a company’s ability to service its debt with sufficient margin after giving effect to the proposed transaction.  While there is no bright line test for defining “unreasonably small capital”, we typically evaluate this concept based upon pro forma and projected leverage multiples utilizing management’s projections as a baseline scenario and alternative downside scenarios to determine if there is “unreasonably small capital” under more stressed conditions. Test 4: The Capital Surplus Test – Does the fair value of the Company’s assets exceed the sum of (a) its total liabilities (including identified contingent liabilities) and (b) its capital (as calculated pursuant to Section 154 of the Delaware General Corporation Law) The capital surplus test replicates the valuation analysis prescribed under the balance sheet test, but includes the par value of the company’s stock (or entire consideration received for the stock if no par value is given), in the amount subtracted from the fair value of the company’s assets.Solvency Considerations within Oil & GasPerforming a solvency opinion requires careful consideration of numerous factors even when everything clearly appears to be more or less favorable in a proposed transaction that involves increasing leverage.  It may be opportune to pursue a dividend recap as debt is cheap and the company is already exhibiting strong growth in an industry potentially starting to recover.  A company may increase leverage despite already having sufficient cash on hand for a special distribution, but it wants to maintain flexibility to act on unexpected growth opportunities that may arise.  Perhaps the company’s trajectory is so great that even its downside case(s) would be a lofty goal of the next closest competitor.  Still, the independent financial advisor must maintain a critical eye, taking a medium- to long-term perspective with a skeptic lens, to determine that the company may reasonably remain solvent.Now, consider the oil & gas sector in 2020.  Under the assumption that additional debt is needed just to survive, never mind paying special dividends, many additional questions to approaching the company’s baseline forecast and downside scenarios arise:If the fair value of the company’s assets is already greatly diminished in the current down cycle, how much should you temper – if at all – the downside future scenario(s) when conducting the capital adequacy test? An appropriate stress test scenario for a company at the top or mid-point of the business cycle may look far different from an appropriate stress at the bottom of the cycle.How will the balance sheet test fare given the concurrent decrease in asset fair value and increase in liabilities? Even if the capital adequacy and balance sheet tests do not raise any red flags on their own, the cash flow test may reveal significant concerns.  Is there enough flexibility with the existing revolver to address cash flow needs over the forecast, or will it need to be increased?  Could the revolver even be increased, if needed?Can the company financially perform well enough over the next three to five years that future (likely) higher interest rates won’t be overly burdensome if the company must refinance maturing debts?And while due diligence and financial feasibility studies are expected to be performed beforehand, what covenant violations are likely to occur and when (in the context of the forecast scenario)? Will the new debt be “covenant-light” and relatively toothless, or will the company find itself that much more constrained when the fangs sink in and the situation is already likely to be dire? While conversations regarding these questions and their implications may likely expose sensitive topics, these discussions must be candid if the independent advisor is to develop a well-founded and defensible opinion on the prospects of solvency. Mercer Capital renders solvency opinions on behalf of private equity firms, independent committees, lenders and other stakeholders that are contemplating a transaction in which a significant amount of debt is assumed to fund shareholder dividends, an LBO, acquisition or other such transaction that materially levers the company’s capital structure.  For more information or if we can assist you, please contact us.

After a tumultuous February due to weather conditions, March SAAR has bounced back with a vengeance.  March SAAR of 17.75 million units is the second-highest of all time for the month, just shy of March 2000.  There are two main factors driving this increase.  While the winter storms had a negative impact on February SAAR, it likely caused pent-up demand that helped drive sales in March. Beyond simple delays, flooding forced some to replace damaged vehicles. Secondly, the Biden administration passed a Covid-19 stimulus bill at the beginning of March, and $1,400 paychecks hit many Americans’ wallets. This influx of cash may have also spurred a massive increase in vehicle sales.Now more than 12 months into the Covid-19 pandemic, we don’t think that comparing March 2021 SAAR to March 2020 SAAR is prudent due to the change in the economic landscape (it’s a 56% increase for those of you who were curious).  For the next couple of months, this year-over-year comparison will continue as spring 2020 SAAR values were horrendous as dealers scrambled to grapple with the challenging operating environment.  We will instead try to show both a comparison to 2020 and 2019 levels.  Even with this adjustment, March SAAR for 2021 was an increase of 44% compared to 2019.Driving March SAAR were sales of light trucks which accounted for 78.1% of all new vehicle sales in March 2021. This metric is a slight uptick from the 74% they accounted for in March 2020. Breakdown of SAAR by vehicle type as presented by NADA is below for March 2021:Inventory and Production ProblemsThe March record sales levels come at the same time as lean inventories and production problems plague the industry.  Thomas King, president of data and analytics at J.D. Power, noted this:“At an aggregate industry level, Q1 inventories have been sufficient to meet consumer demand and delivered the opportunity for manufacturers and retailers to sell those vehicles with smaller discounts. Manufacturers who are experiencing supply chain challenges are prioritizing the production of their most profitable and desirable products, minimizing the net effect. There is no question that sales of specific models in specific geographies are being disrupted by low inventories, but consumers are nevertheless demonstrating their willingness to buy despite having fewer vehicles to choose from the in-retailer inventory.”It will be interesting to see how long inventory levels can meet demand, and if consumers will continue to be as flexible on car model choice. This factor likely hinges on the continuing chip shortage and how that impacts manufacturers during the rest of the year.  We have discussed the chip shortage at length in a prior blog post, and it ultimately could pose a problem to the current growth trajectory.At the end of February, dealers had 2.7 million vehicles in stock or being shipped to stores, a 26% drop from the same month last year.  The lack of availability has been more acute for crossovers and SUV models, including Jeep’s Wrangler and Chevrolet’s Tahoe, whose stock is running between 43-70% lower than last year.  Pickup trucks are the most recent type to be impacted by the shortages, with dealers having about 414,000 trucks at the end of February, about half of what they had a year earlier.  As a result, many consumers have had to order models from the factory or pick up vehicles in transit to dealerships.Long gone are the initial pandemic incentives to drive consumers to dealerships, and buyers are having a harder time finding bargains.  According to JD Power, average incentive spending per unit is expected to total $3,527, a decrease of $888 and $262 relative to March 2020 and March 2019.  High demand is driving record transaction prices, and reduced incentives are improving gross profit margins and overall profitability for dealers.  JD Power notes that average transaction prices are expected to reach $37,286, just below the all-time record set in December 2020.Fleet SalesWhile new vehicle retail sales have been booming, fleet vehicle sales have not seen the same resurgence and remain depressed.  According to NADA, manufacturers are prioritizing production of the most popular and profitable segments for retail customers. Fleet customers have had their orders pushed back or canceled for the 2021 model year in some cases.  Fleet buyers typically get discounts for buying in bulk. Fleet sales have struggled mightily during the pandemic and have not seen the same type of rebound experienced by retail sales.JD Power notes that fleet sales are expected to total 180,200 units in March, down 33% from March 2020 and down 51% from March 2019 on a selling day adjusted basis. Fleet volume is expected to account for 12% of total light-vehicle sales, down from 26% a year ago.  Fleet sales struggled inordinately compared to retail partially due to a decline in travel amid the pandemic.  Although the introduction of a vaccine and more consumer confidence in travel should have been a bright spot for bringing back fleet sales, the reallocation of vehicles to retail due to the chip shortage is another blow to an already struggling segment of the industry. With supply low, OEMs are prioritizing buyers willing to pay top dollar, so fleet buyers are losing that allocation.ConclusionLooking toward the rest of the year, vehicle sales success is going to be contingent on being able to acquire inventory. Consumer demand is high, and if dealerships can navigate the chip shortage and lack of models, they may see more numbers like that posted in March. However, if the chip shortage worsens and dealerships are unable to acquire inventory, this may be a headwind.If you have any questions on SAAR and what it means in the broader context of a valuation of your dealership, please do not hesitate to reach out to any member of the Mercer Capital Auto Team.

Despite the hiatus in M&A beginning with the onset of COVID-19, 2020 was a strong year for RIA mergers and acquisitions, and 2021 is expected to be even stronger. Many of the same forces that have spurred M&A over the last five years drove deal activity in late 2020 and early 2021.  Fee pressure in the asset management space and a lack of succession planning by wealth managers are still driving consolidation.  But the increased availability of funding in the space, in tandem with more lenient financing terms, has also caused some of this uptick. There has been growing interest over the last few years from private equity and permanent capital providers who find investment managers’ recurring revenue streams and availability for operating leverage attractive.  Investors, hungry for alpha in a low-yield environment, are driving up deal prices leading more firms to hang up a for-sale sign. Additionally, deal activity was bolstered by the low cost of credit and lenient financing terms by historical standards.  As Jeff Davis, our bank guru, explains; “Loans in the commercial banking system declined for the first time in a decade in 2020 and for only the second time in 28 years while deposits remain historically high.  In the current low-rate environment, revenue pressures are high for banks as cash and bonds yield little to nothing.  Without a competitive alternative, banks and investors flush with capital are under pressure to compete for lending opportunities to produce a return while loan demand is weak as the U.S. market rounds what many believe to be the very beginnings of a new economic cycle.”There is a growing number of banks interested in lending to the space. Live Oak Bank pioneered an SBA vertical in lending to RIAs and investment advisor Oak Street Funding has played a role in a substantial portion of leveraged transactions in this space, and most recently SkyView began offering financing solutions for RIAs.Further, the Biden administration's efforts to increase the capital gains tax rate may also accelerate some M&A activity in the immediate short-term as sellers seek to position transactions to be taxed at current tax rates.What Does This Mean for Your RIA?If you are planning to grow through strategic acquisitions, the price may be higher, and the deal terms will likely favor the seller, leaving you more exposed to underperformance.  In a market this competitive, acquirers need to distinguish themselves on more than price.  Sellers are often looking for buyers who can help them achieve scale, reduce the load of managing a business, and/or expand their reach or distribution capability. If you are considering an internal transition, know there are more ways to finance the buy-out than there used to be.  A seller-financed note has traditionally been one of the primary ways to transition ownership to the next generation of owners (and in some instances may still be the best option), but bank financing can provide the founding generation with more immediate liquidity and potentially offer the next-gen cheaper financing costs. If you are an RIA considering selling, there are many options, and it is important to have a clear vision of your firm, its value, and what kind of partner you want before you go to market.  A strategic buyer will likely be interested in acquiring a controlling position in your firm with some form of contingent consideration to incentivize the selling owners to transition the business smoothly after closing.  Alternatively, a sale to a patient capital provider can allow your firm to retain its independence and continue operating with minimal outside interference.

In this series of posts, we offer a unique perspective from Atticus Frank, CFA who worked in his family’s business for nearly three years prior to returning to Mercer Capital and joining the team’s Family Business Advisory Group. We hope the stories illuminate special issues family business directors need to consider from someone who lived them day-in and day-out. A business owner pitting his children against one another aiming to name the successor to a business empire, slow-burning ancestral battles, intra-family posturing, legal battles, helicopters, and yachts? No, I am not talking about my time in the family business, but HBO’s Succession, a series diving into how a family will “contemplate what the future will hold for them once their aging father begins to step back from the company”. But what the family undertakes throughout the series is a Hollywood-ized version of what all family businesses undergo throughout their life cycles. Knowing all families will eventually have to face succession, it’s somewhat surprising that the majority of family businesses have no succession plan at all. PWC’s 2021 Global Family Business Survey found only 30% of family businesses have a formal succession plan, which is an improvement from 2018 (15%) but still represents a huge challenge for business continuity and success. What can family business directors do to ensure a successful succession plan to the next generation? We assume that most directors would prefer to avoid the machinations and drama sufficient to fill out multiple seasons of a TV show.  Here are three lessons I saw (and continue to observe) with my family’s company.Succession Is A Marathon, Not A SprintFamily business leaders focused on generational wealth creation understand that decisions made today will impact the business well into the future. How are you building your business to ensure it can succeed without the incumbent generation?  My father-in-law worked tirelessly to build a business with my wife and I that was sustainable and scalable based on processes rather than key people. This was not an overnight process and one that is still ongoing.The goal of these strategies and conversations is to create a business structure that will function well when the next generation matures into leadership. As Travis W. Harms wrote in a previous blog post, are your senior executives focused on building a business that can flourish in their absence? My family talked regularly about operations as well as what the business would be with the next generation in charge, thanks in part to humility and grace from all parties.Create a Contingency PlanMy family’s long-term goal is for the next generation to slowly acquire ownership in the family business over five-to-fifteen years. What happens if things change drastically mid-stream? Business transition does sometimes proceed according to schedule, but often succession timetables accelerate unexpectedly.  The New York Times had a piece recently highlighting stories from two sons whose fathers died without a succession plan.  The article highlights stories of the stress put upon families when they don’t plan for succession, and the psychology that leads to plan-less exits: an unwillingness to let go, a refusal to listen to wise counsel, and the absence of a clear identity outside the role as family business leader.How did my family address the very real risk of an unexpected succession? Our next-generation took ownership of part of a life insurance policy on the key principal in the incumbent generation. If the unthinkable occurred, the next generation would have liquidity and flexibility to decide what direction to take in the absence of the incumbent leader.  The proceeds would also help with any tax liability in a sudden bequeath of familial ownership interests.  This strategy is quite simple but allowed us to focus on the long-term strategy of succession.Understand Where You Are GoingEventually, all family businesses will transact in some manner, whether through an orderly transaction with a third-party buyer, a succession plan, or any number of less favorable outcomes. Clearly define where you want to go, even if you do not necessarily understand how to get there.  Make sure you have the buy-in from all family stakeholders and everyone knows the ultimate destination. In my family, there are each member of the next generation knows which seat on the bus they ultimately want to sit in. These seat assignments have emerged from a lot of conversations, time, and value-alignment, something I wrote on previously in aligning family goals and business objectives. Getting the right people on the bus makes for a smoother ride as the family business matures and the family continues to grow.ConclusionA B+ succession plan today is better than an A+ plan later. Starting the succession planning process now – understanding that it will evolve – should spur family business directors to actionable plans that will help everyone sleep better at night.Mercer Capital has a long history of working with family business owners in crafting and structuring the transactions needed to support the succession plan process. Let us know if we can help you and your family today.

Over the last year, deal activity in the Eagle Ford was relatively muted after the impact that the Saudi-Russian conflict and COVID-19 had on the price environment.  M&A deals were largely halted in the second quarter of 2020 as companies turned to survival mode amid challenging realities.  Frankly, transaction due diligence was most likely last on companies’ agendas.  However, announced, and rumored transactions in the Eagle Ford picked up, relative to early 2020, towards the second half of the year as a price recovery began to take hold.Recent Transactions in the Eagle FordA table detailing E&P transaction activity in the Eagle Ford over the last twelve months is shown below.  Relative to 2019, deal count decreased by four, and median deal size declined by approximately $74 million, however it is important to note the small sample of disclosed deal metrics.Chevron Adds to Eagle Ford Play and Global Portfolio with Noble AcquisitionOn July 20, 2020, Chevron announced that it was acquiring Noble Energy, Inc. in an all-stock transaction valued at $10.38 per Noble share, based on the price of Chevron’s stock before the announcement and an exchange ratio of 0.1191 Chevron shares per Noble share, representing an approximate premium of nearly 12% on a 10-day average based on the closing prices as of July 17, 2020.  The total enterprise value of the deal (including debt) was pegged at $13 billion in the transaction press release.  The deal closed on October 5, 2020, marking the completion of the first big-dollar energy deal since the market turmoil began in March 2020.  The acquisition makes Chevron the second U.S. shale oil producer behind EOG Resources, Inc.  Noble’s international plays also add 1 Bcf of international natural gas reserve to Chevron’s portfolio.  Noble Energy’s domestic plays include the Permian Basin, Denver-Julesburg Basin, and the Eagle Ford.Ovintiv Further Deleverages with Eagle Ford Asset SaleOn March 24, 2021, Ovintiv Inc. agreed to sell its South Texas assets for $880 million to Validus Energy (portfolio company of Pontem Energy Capital), a privately owned operator.  The transaction occurred roughly two weeks after sources rumored that Ovintiv was in advanced discussions to divest its Eagle Ford assets.  The deal announcement comes shortly after Ovintiv’s debt reduction initiative outlined in February 2021, which includes generating approximately $1 billion by divesting certain domestic and international assets.  In 2019, Ovintiv’s debt increased to nearly $7 billion after its purchase of Newfield Exploration.  The company aims to reduce debt by 35% to about $4.5 billion by 2022 in order to gain investor confidence.  The company announced that the transaction will allow them to reach the debt target by the middle of next year.  Ovintiv has divested two geographic positions in consecutive quarters, with the first sale being their Duvernay position in Q4 2020.  The company’s Eagle Ford position was purchased for $3.1 billion in 2014 from Freeport-McMoRan Inc.  The company expects the deal to close in the second quarter of 2021.ConclusionM&A transaction activity in the Eagle Ford was fairly quiet throughout 2020 before Chevron’s $13 billion deal with Noble Energy.  The Chevron-Noble Energy transaction and the Ovintiv-Validus deal could be foreshadowing a busier M&A market in 2021, whether companies try to bolt onto previous acreage, or are forced to divest to pay down debt.Mercer Capital has assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, we provide investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  Our Professionals also have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate, and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence

As we previewed in our January 2021 SAAR post, February SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) declined as expected to 15.7 million from 16.6 million the previous month. This is a decline of 6.6% from the same period last year.However, given the circumstances with the winter storm that occurred this past month, many dealerships are most likely happy the decline wasn’t worse than it was.  Furthermore, adjusting for calendar variances between this year and last also paints a different picture. February 2021 contained two fewer selling days and one fewer selling weekend than February 2020. When this is taken into consideration, JD Power reported retail sales actually increased 3.3% compared to the year prior. SAAR continues to be dragged down by lagging fleet performance.Inventory levels remain tight due to both strong retail demand and the current microchip shortage. According to NADA Marketbeat, the global semiconductor microchip shortage is expected to cause production losses in North America around 250,000 in the first quarter of 2021. Nearly all OEMs have been affected, and it continues to add pressure on already tight inventory levels. However, the shortages are anticipated to resolve by Q3 of this year.The tight inventory levels are having impacts on average vehicle days on the lots, manufacturer incentives, and transaction prices.  As noted in JD Power’s February 2021 Automotive Forecast, the average number of days a new vehicle sits on a dealer’s lot before being sold is on pace to fall to 53 days, down 18 days from last year.For incentives, higher levels of vehicle turnover translates to manufacturers not feeling much pressure to offer discounts. The average manufacturer incentive is anticipated to be $3,562 per vehicle for February, a decrease of $614 from a year ago.Related to these declines in incentives, average transaction prices continue to be strong. Transaction prices are going up due to low supply most likely. Incentives go up when demand declines and they need to incentivize the purchases. JD Power notes that average transaction prices are expected to reach another monthly high, rising to 9.8% to $37,524, the highest ever for the month of February and nearly at the record set in December 2020.On the matter of the February SAAR, Thomas King, president of the data and analytics division at J.D. Power noted:"While the ongoing strength of the sales rate is impressive, the transaction prices and profitability of those sales is nothing short of remarkable. The combination of strong retail sales, higher transaction prices and smaller discounts means that February 2021 likely will be one of the most profitable Februarys ever for both retailers and manufacturers. As February results will show, while inventories are lean, there is still enough inventory to maintain positive sales growth in the near term. However, the lingering risk to the current retail sales pace for the balance of the year is supply chain disruption.”March ExpectationsAs we turn our attention to March, there are several positive tailwinds that could prove beneficial for SAAR, as well as potential headwinds.WeatherWith the winter storms that crippled Texas and much of the southeast behind us, there are hopes that March is going to bring back a sense of normalcy. Pent-up demand stemming from people being indoors due to the weather could prove to be a positive force for March SAAR. Anecdotally, daylight savings time always puts me in a good mood when it’s not dark outside at the end of the workday. We believe this will pair well with the below tailwinds.Government StimulusOn March 11, President Joe Biden signed a sweeping $1.9 trillion COVID-19 economic relief package into law.Key features of the plan include up to $1,400-per-person stimulus payments that will send money to about 90% of households, a $300 federal boost to weekly jobless benefits, an expansion of the child tax credit of up to $3,600 per child and $350 billion in state and local aid.  Additionally, billions of dollars will be distributed among K-12 schools to help students return to the classroom, small businesses hard-hit by the pandemic, and vaccine research, development, and distribution.The overall influx of cash into the economy is bound to have a positive impact on dealerships as consumer’s disposable income levels get a boost.Vaccine DistributionSince vaccine distribution began in the U.S. on December 14th, more than 107 million doses have been administered, reaching 21% of the total U.S. population. The U.S. is currently administering over 2.3 million shots a day. Furthermore, President Biden has issued a statement that vaccines be available to all Americans by May 1st. As the population continues to get vaccinated, there will be more opportunities for people to return to their day-to-day lives and participate in more in-person activities. This may prove to be a positive tailwind for dealerships that rely on in-person customer visits to move vehicles. We are cautiously optimistic that we will be able to attend summer auto conferences.Chip ShortagesAs we have touched on previously, the chip shortage is going to be a problem for boosting inventory levels until at least Q3 of this year. However, once the bottleneck due to the shortage is relieved, dealers should expect to be able to build back up their inventories. It will be interesting to see how gross margins perform as these shortages are alleviated.A Final NoteIf you have any questions about SAAR and what it means in the broader context of a valuation of your dealership, reach out to a member of Mercer Capital's Auto Dealer Industry Team. We hope that you and your loved ones are continuing to stay safe and healthy during this time!

As we previewed in our January 2021 SAAR post, February SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) declined as expected to 15.7 million from 16.6 million the previous month. This is a decline of 6.6% from the same period last year.However, given the circumstances with the winter storm that occurred this past month, many dealerships are most likely happy the decline wasn’t worse than it was.  Furthermore, adjusting for calendar variances between this year and last also paints a different picture. February 2021 contained two fewer selling days and one fewer selling weekend than February 2020. When this is taken into consideration, JD Power reported retail sales actually increased 3.3% compared to the year prior. SAAR continues to be dragged down by lagging fleet performance.Inventory levels remain tight due to both strong retail demand and the current microchip shortage. According to NADA Marketbeat, the global semiconductor microchip shortage is expected to cause production losses in North America around 250,000 in the first quarter of 2021. Nearly all OEMs have been affected, and it continues to add pressure on already tight inventory levels. However, the shortages are anticipated to resolve by Q3 of this year.The tight inventory levels are having impacts on average vehicle days on the lots, manufacturer incentives, and transaction prices.  As noted in JD Power’s February 2021 Automotive Forecast, the average number of days a new vehicle sits on a dealer’s lot before being sold is on pace to fall to 53 days, down 18 days from last year.For incentives, higher levels of vehicle turnover translates to manufacturers not feeling much pressure to offer discounts. The average manufacturer incentive is anticipated to be $3,562 per vehicle for February, a decrease of $614 from a year ago.Related to these declines in incentives, average transaction prices continue to be strong. Transaction prices are going up due to low supply most likely. Incentives go up when demand declines and they need to incentivize the purchases. JD Power notes that average transaction prices are expected to reach another monthly high, rising to 9.8% to $37,524, the highest ever for the month of February and nearly at the record set in December 2020.On the matter of the February SAAR, Thomas King, president of the data and analytics division at J.D. Power noted:"While the ongoing strength of the sales rate is impressive, the transaction prices and profitability of those sales is nothing short of remarkable. The combination of strong retail sales, higher transaction prices and smaller discounts means that February 2021 likely will be one of the most profitable Februarys ever for both retailers and manufacturers. As February results will show, while inventories are lean, there is still enough inventory to maintain positive sales growth in the near term. However, the lingering risk to the current retail sales pace for the balance of the year is supply chain disruption.”March ExpectationsAs we turn our attention to March, there are several positive tailwinds that could prove beneficial for SAAR, as well as potential headwinds.WeatherWith the winter storms that crippled Texas and much of the southeast behind us, there are hopes that March is going to bring back a sense of normalcy. Pent-up demand stemming from people being indoors due to the weather could prove to be a positive force for March SAAR. Anecdotally, daylight savings time always puts me in a good mood when it’s not dark outside at the end of the workday. We believe this will pair well with the below tailwinds.Government StimulusOn March 11, President Joe Biden signed a sweeping $1.9 trillion COVID-19 economic relief package into law.Key features of the plan include up to $1,400-per-person stimulus payments that will send money to about 90% of households, a $300 federal boost to weekly jobless benefits, an expansion of the child tax credit of up to $3,600 per child and $350 billion in state and local aid.  Additionally, billions of dollars will be distributed among K-12 schools to help students return to the classroom, small businesses hard-hit by the pandemic, and vaccine research, development, and distribution.The overall influx of cash into the economy is bound to have a positive impact on dealerships as consumer’s disposable income levels get a boost.Vaccine DistributionSince vaccine distribution began in the U.S. on December 14th, more than 107 million doses have been administered, reaching 21% of the total U.S. population. The U.S. is currently administering over 2.3 million shots a day. Furthermore, President Biden has issued a statement that vaccines be available to all Americans by May 1st. As the population continues to get vaccinated, there will be more opportunities for people to return to their day-to-day lives and participate in more in-person activities. This may prove to be a positive tailwind for dealerships that rely on in-person customer visits to move vehicles. We are cautiously optimistic that we will be able to attend summer auto conferences.Chip ShortagesAs we have touched on previously, the chip shortage is going to be a problem for boosting inventory levels until at least Q3 of this year. However, once the bottleneck due to the shortage is relieved, dealers should expect to be able to build back up their inventories. It will be interesting to see how gross margins perform as these shortages are alleviated.A Final NoteIf you have any questions about SAAR and what it means in the broader context of a valuation of your dealership, reach out to a member of Mercer Capital's Auto Dealer Industry Team. We hope that you and your loved ones are continuing to stay safe and healthy during this time!

January 2021 SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) increased to 16.6 million from 16.2 million in December. Though this is a decline of 1.4% from the same period last year, this is the highest that SAAR has been since the pandemic began. Light truck sales were behind this growth, as they captured 77.8% of all new vehicles sold in the past month.  Below is a full breakdown of vehicles sold by type for the month. [caption id="attachment_36204" align="alignnone" width="940"]Source: NADA[/caption] The year began with some inventory constraints (down 20% from January 2020), and as such, manufacturers have not had to spend as much on incentives such as those that were offered at the beginning of the pandemic.  According to JD Power, the average incentive from manufacturers on new vehicles is on pace to be $3,639 per vehicle, a decrease of $510 from a year ago.  Furthermore, lean inventories mean that cars are spending less time on the lots.The average number of days a new vehicle sits on a dealer's lot before being sold is expected to fall to 51 days, down from 70 days from last year.  Average transaction prices, according to JD Power, are expected to be up 8.4% compared with January 2020.Thomas King, president of the data and analytics division at JD Power noted this about January SAAR: “January continues the strong performance observed in Q4 of 2020 and points to a positive outlook for the balance of 2021. The growth in retail sales is encouraging, especially as it is being achieved with higher transaction prices and lower incentive levels. While retail demand remains strong, non-retail sales are still recovering, which is hampering total vehicle sales and SAAR.”As King noted, fleet sales are continuing to struggle as widespread travel is still down due to the COVID-19 pandemic. According to Ward Intelligence, retail sales are estimated to have increased by 7% from January 2020, as fleet sales dropped by 24%. Retail sales have been up year over year in four of the last five months, while fleet sales have declined for 13 straight months. For SAAR to fully recover, it might depend on a reverse in these declines. With vaccines being distributed, consumers may have renewed sense of confidence in their travels and could bring back demand.With February’s SAAR release coming in the next few days, there are already some insightful forecasts available for where the numbers will fall. Cox Automotive is anticipating February's sales pace to reach nearly 16.3 million, down from January’s 16.6 million pace. Despite this projected decline, the circumstances in February could have made things much worse. The two most significant events being the chip shortage and the winter storms through Texas and the South.Global Chip Shortage Continues As recently mentioned on this blog, the chip shortage is a pervasive issue for auto dealers going forward. According to LMC Automotive, the global chip shortage is expected to reduce North American production by some 230,000 units in the first quarter. For perspective, multiplying this by 4 for a simple annualization would reduce 2021 volumes by nearly 1 million.  Consulting firm AlixPartners expects the shortage will cut $60.6 billion in revenue from the global automotive industry. Different manufacturers are anticipating different levels of impact (see table below). This is an unfortunate situation, as many dealerships were counting on inventory recovery in 2021 to help boost sales, and the full extent of the situation is still unknown. As we’ll note in next week’s post, public auto dealer execs continue to kick the inventory stabilization expectations can down the road now to mid-2021. With the February SAAR release on the horizon, those numbers may shed more light on this ongoing situation. Storms Ahead for February SAAR (Literally)The event that might have the most immediate impact on February SAAR is the winter storm that went through Texas and the South between February 13–17. I’m based in Mercer Capital’s Dallas office and during that time we had no choice but to work remotely (the pandemic has given us lots of practice with remote working). Some of my coworkers were without power and water for days, sending videos of water pipes bursting in apartment buildings around them. Luckily, I only lost water for one day and my biggest tribulation of the week was forgetting to buy groceries before the storm and as a result, walking 2 miles to an open taco store and buying 15 to last me for a few days. Many were not so lucky, and we hope that everyone is recovering and getting back to normal from that time period.As a result of the storm, the concerns of most people across the state were around making sure they had food, water, and energy, and probably not trying to get out and buy a new car.  This week of “shut down” may have an impact on overall February SAAR.  However, as Texas and the rest of the south continues to thaw, the industry is anticipated to recover, though, in some areas, infrastructure damage and continuing water scarcity could depress some Texas markets for days to come.However, there may be a silver lining for Ford dealerships. Ford confirmed that it had seen an 18% spike in online searches for the F-150 during the power and water crisis in Texas. What could be driving these searches? News broke that Texas truck owners were using the generators on F-150s to heat homes. As one 2021 F-150 hybrid owner stated, “You’re living your life normally, and all of a sudden, you’re thrust into the dark… I think it got around 9 degrees. It’s been in mid-20s and low 30s. You don’t expect that in south Texas. You don’t expect to lose power when we have nuclear, natural gas, wind, and solar power. The truck gave us light at night, TV access to catch the news and weather. It helped give us a little bit of heat and a good pot of coffee.”Furthermore, Ford sent letters to its Texas dealers encouraging them to use the hybrid trucks as needed. "Due to the urgent and unprecedented weather situation in Texas, a number of our local dealers are using all-new Ford 150s equipped with Pro Power Onboard to help in their communities. Approximately 415 trucks fall within this effort. We're proud to pitch in to help Texas in this time of need." Mike Levine, Ford North American product communications manager said.We hope that this post finds everyone affected by the winter storms safe and with power and water, and that March has better weather in store. If you have any questions about SAAR and what it might mean for your dealership, feel free to contact any of the professionals on the auto dealer team at Mercer Capital.

Next week, during the inaugural RIA Practice Management Insights conference, we will set aside some time to answer your questions about succession planning.  Roughly two-thirds of RIAs are still owned by their founders, and only a quarter of those have non-founding shareholders.  We won’t solve all the pieces to the succession planning puzzle in our session, but we’ll address succession planning strategies, and what works best under different circumstances.We’ll cover some of these in more detail next week, but here’s a preview of our thinking about various succession planning (and exit) options.Sale to a Strategic BuyerIn all likelihood, the strategic buyer is another RIA, but it could be any financial institution hoping to realize certain efficiencies after the deal.  They will typically pay top dollar for a controlling interest position with some form of earn-out designed to incentivize the selling owners to transition the business smoothly after closing.  This scenario sometimes makes the most economic sense, but it does not afford selling principals much control over what happens to their employees or to the company’s name.Sale to a Consolidator or Roll-up FirmThese acquirers typically offer some combination of initial and contingent consideration to join their network of advisory firms.  The deals are usually debt-financed and typically structured with cash and stock upfront and an earn-out based on prospective earnings or cash flow.  Consolidators and roll-up firms usually don’t acquire or pay as much as strategic buyers, but they often allow the seller more autonomy over future operations.  While there are currently only a handful of consolidators, their share of sector deal making has increased dramatically in recent years.Sale to a Financial Buyer This scenario typically involves a private equity firm paying all-cash for a controlling interest position.  PE firms will usually want the founder to stick around for a couple of years after the deal but expect him or her to exit the business before they flip it to a new owner.  Selling principals typically get more upfront from PE firms than consolidators but sacrifice most of their control and ownership at closing.Patient (or Permanent) CapitalMost permanent capital investors are family offices, or investment firms backed by insurance companies, that make minority investments in RIAs either as a common equity stake or revenue share.  They typically allow the sellers to retain their independence and usually don’t interfere much with future operations.  While this option is not always as financially lucrative as the ones above, it is often an ideal path for owners seeking short term liquidity and continued involvement in this business.Internal Transition to the Next Generation of Firm Leadership Another way to maintain independence is by transitioning ownership internally to key staff members.  This process often takes a lot of time and at least some seller-financing as it’s unlikely that the next generation is able or willing to assume 100% ownership in one transaction.  Bank and/or seller financing is often required, and the full transition can take 10-20 years depending on the size of the firm and interest transacted.  This option typically requires the most preparation and patience but allows the founding shareholders to handpick their successors and future leadership.Combo DealMany sellers choose a combination of these options to achieve their desired level of liquidity and control.  Founding shareholders have different needs and capabilities at different stages of their life, so a patient capital infusion, for instance, may make more sense before ultimately selling to a strategic or financial buyer.  Proper succession planning needs to be tailored, and all these options should be considered.If you’re a founding partner or selling principal, you have a lot of exit options, and it’s never too soon to start thinking about succession planning.  Let us know what questions you have at the conference next week.Only 1 WEEK until the RIA Practice Management Insights conference begins!Mercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?

Based on available public data from S&P Global’s Market Intelligence platform, there were 25 merger and acquisition announcements in 2020 related to oil and gas companies at the entity level (including natural gas midstream and utility companies).  These 25 announcements represented at least $16.2 billion in total deal value, notwithstanding three deals where the value was not publicly disclosed.  On a quarterly basis, there were eight announcements in Q1 2020, eight in Q2 and Q3 combined, and nine in Q4.While the trend in the quarterly announcements is not very surprising, one phrase, in particular, creeps up with increasing frequency when reviewing transaction details as 2020 progressed: “Fairness Opinion.”In Q1, only one of the eight transactions was reported to have had a Fairness Opinion conducted.  None of the two transactions announced in Q2 had Fairness Opinions, but two of the six announced deals in Q3 did.  As the Oil and Gas industry began to get somewhat comfortable again, Q4 finished out strong with nine announced deals. However, nearly half of them were accompanied by Fairness Opinions.  We examine this trend from a monthly perspective in the following chart: Irrespective of what industry or sector a company may operate in, a fundamental question arises as mergers and acquisitions persist and company boards and management teams survey their options when a proposed transaction is put on the table: is it fair to all direct stakeholders? What Is a Fairness Opinion?A Fairness Opinion involves a comprehensive review of a transaction from a financial point of view and is typically provided by an independent financial advisor to the board of directors of the buyer or seller.  The financial advisor must look at pricing, terms, and consideration received in the context of the market for similar companies.  The advisor then opines that the transaction is fair, from a financial point of view and from the perspective of the seller’s minority shareholders.  In cases where the transaction is considered to be material for the acquiring company, a second Fairness Opinion from a separate financial advisor on behalf of the buyer may be pursued.  On this point, we note that among the six deals announced in 2020 where a Fairness Opinion was conducted, only one of the six had Fairness Opinions conducted on behalf of both the buyer and the seller; the opinions performed for the other five deals were solely on behalf of the sellers in those transactions.Why Is a Fairness Opinion Important?Why is a Fairness Opinion important?  There are no specific guidelines as to when to obtain a Fairness Opinion, yet it is important to recognize that the board of directors is endeavoring to demonstrate that it is acting in the best interest of all the shareholders by seeking outside assurance that its actions are prudent.One answer to this question is that good intention(s) without proper diligence may still give rise to potential liability.  In its ruling in the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985), the Delaware Supreme Court effectively made the issuance of Fairness Opinions de rigueur in M&A and other significant corporate transactions.  The backstory to this case is the Trans Union board approved an LBO that was engineered by the CEO without hiring a financial advisor to vet a transaction that was presented to them without any supporting materials.  Regardless of any specific factors that may have led the Trans Union board to approve the transaction without extensive review, the Delaware Supreme Court found that the board was grossly negligent in approving the offer despite acting in good faith.  Good intentions, but lack of proper diligence.The facts and circumstances of any particular transaction can lead reasonable (or unreasonable) parties to conclude that a number of perhaps preferable alternatives are present.  A Fairness Opinion from a qualified financial advisor can minimize the risks of disagreement among shareholders and misunderstandings about a deal.  They can also serve to limit the possibilities of litigation which could kill the deal.  Perhaps just as important as being qualified, a Fairness Opinion may be further fortified if conducted by a financial advisor who is independent of the transaction.  In other words, a financial advisor hired solely to evaluate the transaction, as opposed to the banker who is paid a success fee in addition to receiving a fee for issuing a Fairness Opinion.When Should You Obtain a Fairness Opinion?While the following is not a complete list, consideration should be given to obtaining a Fairness Opinion if one or more of these situations are present:Competing bids have been received that are different in price or structure, leading to potential disagreements in the adequacy and/or interpretation of the terms being offered, and which offer may be “best”; Conversely, when there is only one bid for the company, and competing bids have not been solicited.The offer is hostile or unsolicited.Insiders or other affiliated parties are involved in the transaction, giving rise to potential or perceived conflicts of interest.There is concern that the shareholders fully understand that considerable efforts were expended to assure fairness to all parties.What Does a Fairness Opinion Cover?A Fairness Opinion involves a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed in reaching a decision to consummate a transaction.  The financial advisor must look at pricing, terms, and consideration received in the context of the market.  The advisor then opines that the consideration to be received (sell-side) or paid (buy-side) is fair from a financial point of view of shareholders, especially minority shareholders in particular, provided the advisor’s analysis leads to such a conclusion.While the Fairness Opinion itself may be conveyed in a short document, most typically as a simple letter, the supporting work behind the Fairness Opinion letter is substantial.  This analysis may be provided and presented in a separate fairness memorandum or equivalent document.A well-developed Fairness Opinion will be based upon the following considerations that are expounded upon in the accompanying opinion memorandum:A review of the proposed transaction, including terms and price and the process the board followed to reach an agreement.The subject company’s capital table/structure.Financial performance and factors impacting earnings.Management’s current year budget and multi-year forecast.Valuation analysis that considers multiple methods that provide the basis to develop a range of value to compare with the proposed transaction price.The investment characteristics of the shares to be received (or issued), including the pro-forma impact on the buyer’s capital structure, regulatory capital ratios, earnings capacity, and the accretion/dilution to earnings per share, tangible book value per share, dividends per share, or other pertinent value metrics.Address the source of funds for the buyer.What Is Not Covered in a Fairness Opinion?It is important to note what a Fairness Opinion does not prescribe, including:The highest obtainable price.The advisability of the action the board is taking versus an alternative.Where a company’s shares may trade in the future.How shareholders should vote a prox.yThe reasonableness of compensation that may be paid to executives as a result of the transaction. Due diligence work is crucial to the development of the Fairness Opinion because there is no bright-line test that consideration to be received or paid is fair or not.  The financial advisor must take steps to develop an opinion of the value of the selling company and the investment prospects of the buyer (when selling stock).ConclusionThe Professionals at Mercer Capital may not be able to predict the future, but we have nearly four decades of experience in helping boards assess transactions as qualified and independent financial advisors.  Sometimes paths and fairness from a financial point of view seem clear; other times they do not.Please give us a call if we can assist your company in evaluating a transaction.

Awaiting kick off on the afternoon of the big game, one of the perennial features of the interminable pre-game show is the obligatory head-to-head matchup segment, in which the network analysts go through the starting lineups position by position, comparing the relative strengths and weaknesses of the quarterbacks, linebackers, kickers, waterboys, etc.  The conceit of the segment is that, while both teams will field the same basic positions, not all cornerbacks are created equal.  If the analyst can reliably discern which team has the advantage at the most individual positions, perhaps that will reveal the winner ahead of time.  For our part, we predict that Kansas City Tampa Bay will win by 10 22 points.All of which got us to thinking about, well, EBITDA (earnings before interest, taxes, depreciation, and amortization).  In the world of family-owned and other private businesses, EBITDA is the most commonly cited performance measure.  Much like left tackles, every company has EBITDA, but some EBITDA is better than others.  Why is that?What Is EBITDA and Why Does It Matter?EBITDA is an example of a non-GAAP performance measure, meaning it is not a line item on audited financial statements.  EBITDA gets a lot of attention because it is a proxy for the operating cash flow that is, in turn, available for a broad variety of corporate purposes.  EBITDA is especially popular in the M&A markets because it is a measure of the discretionary cash flow available to a potential buyer of a business.EBITDA also promotes comparability across firms by “normalizing” for structural features of how those companies are organized, financed, and assembled.  This is best seen by considering the various adjustments to net income that are made to arrive at EBITDA.  We will start from the bottom of the income statement.Income Taxes - Many family businesses are organized as tax pass-through entities (S corps or LLCs) and report no corporate income tax expense.  Because taxes are excluded from EBITDA, all companies are on equal footing, regardless of their tax structure.Interest Expense - Financing operations with debt rather than equity does not directly influence the operating results of the business.  As with taxes, interest expense is excluded from EBITDA, allowing direct comparison of performance by different companies having different capital structures.Depreciation Expense - Depreciation expense is a non-cash charge that accountants use to allocate the cost of long-lived assets to the accounting periods during which the assets are expected to be used.  As you might guess, a lot of assumptions go into those calculations, each of which potentially impairs the comparability of reported earnings to those of other companies that may make different assumptions.  Since EBITDA ignores depreciation charges, it erases that potential obstacle to comparability.Amortization Expense - Some companies grow through acquisition, while others grow organically.  If acquirers pay more than the value of the net tangible assets of the target companies, they must write off the excess in the periods following the acquisition.  Companies growing organically do not have comparable amortization expenses.  Thus, EBITDA is comparable for businesses, whether they grow through acquisition or organically.Limitations of EBITDAThe following chart (Exhibit 9 from our whitepaper, Basics of Financial Statement Analysis) illustrates the five basic uses of EBITDA. Importantly, of these five uses, only three provide direct returns to capital providers: paying interest, repaying debt, and distributing to owners.  The other two, paying taxes and capital expenditures, do not directly accrue to the benefit of shareholders. This is generally obvious with regard to taxes but requires more finesse for capital expenditures.  We can divide capital expenditures (in the economic rather than accounting sense) into two groups: Maintenance Capital Expenditures - Family businesses focused on sustainability recognize that a portion of operating cash flow must be set aside each year to maintain productive capacity.  Depreciation expense is an imperfect proxy for this obligation.  The reality of this maintenance capex burden lies at the heart of legendary investor Warren Buffett’s infamous tooth fairy warning on EBITDA.Growth Capital Expenditures - But not all capex is maintenance capex.  Family businesses also invest to grow (whether through M&A or organic investments).  Since these investments should only be made if the expected returns exceed the company’s cost of capital, these “elective” expenditures are made in lieu of distributions to capital providers in the expectation that they will generate long-term benefits that more than makeup for the deferral in distributions. The point of all this is that a dollar of EBITDA is not just a dollar of EBITDA.  The quality of a dollar of EBITDA depends on how much of that dollar is allocable to taxes and maintenance capital expenditures.  Consider the two companies summarized in the following chart.Company A and Company B both generate the same amount of EBITDA, yet Company B’s EBITDA is of much higher quality because taxes and maintenance capital expenditures consume a much smaller portion of EBITDA than for Company A.  Accordingly, investors will likely assign a higher EBITDA multiple to Company B than Company A (all else equal).  This is borne out when we look at data for non-financial companies in the Russell 2000. The value assigned by the market to each dollar of EBITDA follows a predictable pattern as depreciation & amortization consumes a greater portion of EBITDA.  Ideally, we would look at depreciation only, but the data aggregation services generally only provide the aggregate number.  Even so, the point stands. ConclusionSo, should family business directors be as dismissive toward EBITDA as Warren Buffett?  We do not think so, although it is important for directors to take Mr. Buffett’s reservations to heart and understand that not every dollar of EBITDA is created equally.  This is important for two reasons.  First, doing so helps directors take EBITDA multiples with the appropriate grain of salt.  Since the value of a dollar of EBITDA depends on the quality of that dollar, quoted EBITDA multiples should be evaluated with due caution.  Second, this underscores the importance of incremental EBITDA.  Once taxes and maintenance capital expenditures have been covered, marginal dollars of EBITDA are of the highest quality (and therefore most valuable).  As a result, improving EBITDA margins can have a multiplicative impact on the value of your family business by both providing more EBITDA and justifying a higher multiple.And that is a winning game plan.

Long before Reddit investors discovered that you could Occupy Wall Street more effectively with out of the money call options than you can with tents, Porsche briefly turned itself into a hedge fund and used a similar tactic to try to take over Volkswagen.  The story sheds some light on how market pricing does, and does not, reveal the value of a business.  Benchmarking the value of an RIA off the behavior of a few aggressive consolidators has similar limitations.Barbarians from BavariaAround 2005, a niche automaker from Stuttgart revealed that it intended to become the largest shareholder of the largest automaker in Germany.  At the time, VW Group sold more cars each week than Porsche sold annually, but its share price lagged its industrial scale.  Porsche had a CFO with larger ambitions and developed a strategy to use market manipulation to do what seemed impossible.  Within a year of its announcement, Porsche’s stake in VW reached 25%, and then 30% by March 2007.  Porsche denied mounting a full takeover intent, instead suggesting that it was protecting VW from hostile suitors (an accusation that turned out to be a confession). [caption id="attachment_35773" align="aligncenter" width="690"]For a brief moment, VW had the largest market capitalization of any company on earth, with a closing price on October 28, 2008, of over $1,100 per share, or over 5x its current share price (data from Bloomberg, L.P.)[/caption] By late 2008, Porsche’s ownership stake had climbed to over 40%, and it held options to purchase another 31.5%.  The burgeoning stock price for VW was recorded as a gain at Porsche – profits that exceeded what Porsche made from selling cars.  At the peak, VW was trading for more than 20 times where it was before Porsche started accumulating shares.  If Porsche could’ve gained control of 75% of Volkswagen’s stock, it would trigger a change of control, and Porsche could strip VW’s balance sheet with 8 billion euros.  Alas, the credit crisis intervened on VW’s behalf and Porsche’s self-inflicted wounds created insolvency that could only be remedied with a sale to, you guessed it, Volkswagen.GameStop TheoryBy now you’ve read plenty about the short squeeze on GameStop and other heavily shorted financial instruments and commodities (today it’s silver).  It seems like it was only a few months ago that cryptocurrencies were exciting.  We won’t bite at the opportunity to weigh in on whether or not loosely organized hordes of retail investors at aptly-named Robinhood should be allowed to out-manipulate billionaire hedgies.We will, however, consider the valuation implications of unusual market behavior.  The investment management industry hasn’t been the target of vigilante options traders, and we’re not aware of any sub-billion-dollar managers launching a leveraged effort to take over, say, Focus Financial.  But the RIA press is fond of breathless speculation about ever-higher prices being paid for firms.  One of the absolute truths of the current environment for buying and selling investment management firms is that there has never been a larger number of capital providers offering a greater variety of transaction terms.The question is, what does it mean to you and the value of your firm?The Rules of the GameSome things haven’t changed.  Valuation operates in an alternative returns world.  In other words, the value of any given investment opportunity depends on the rate of return it generates compared to other opportunities with a similar risk and growth profile.Value is a function of cash flow, rate of return (relative risk), and growth.  Assuming cash flow is a constant, for valuations to increase, either cash flow growth expectations must be higher or the expected rate of return must be lower – or both.It is through this lens that we have to view the news about industry consolidation.  When a particular buyer makes an eye-watering bid for an RIA, one or more of these three basic elements is in play.The buyer has a unique circumstance that allows them to extract more profitability from the target firm than other bidders or than the firm could extract on its own.There is ample reason to be skeptical of this expectation.  Investment management is labor intensive, and clients don’t like their relationship or investment people turning over.  While there are some back office efficiencies that come from some transactions, it usually isn’t enough to be meaningful.  In our experience, most buyers are genuinely interested in the talent-acquisition angle of an acquisition, because good and experienced industry veterans are rarely available.The buyer has a unique expectation of the growth opportunities inherent in an acquisition. Organic firm growth comes from market tailwinds and marketing discipline.  It’s hard to forecast market tailwinds, especially in this environment, and marketing discipline can be built more cheaply than it can be acquired.The buyer is willing to accept a lower rate of return than competing bidders. This is the technical definition of winner’s curse.  When Goldman Sachs paid up for United Capital, it wasn’t a big enough deal in the overall GSAM universe to dilute earnings, and it sped up Goldman’s foray into serving the mass-affluent.  So even though Goldman accepted a lower return on the deal from a closed-form perspective, it had larger implications for the company that justified getting it done.  Just because I found an exception doesn’t make it the rule.  All else equal, the highest multiple is the lowest earnings yield, so the buyer is just willing to get less out of the deal.Just Because You Can, Doesn’t Mean You ShouldOne of the pioneers of the RIA industry was a smallcap manager who also happens to be the father of a friend of mine.  One choice piece of wisdom that he passed on to his kids: “just because you can, doesn’t mean you should.”You can rationalize valuing RIAs higher today because interest rates are low and the space offers one of the few growth-and-income plays that has worked well for several decades.  Time will tell, but interest rates are probably low because economic growth is low.  If the market is leveraged to the economy, and RIAs are leveraged to the market, the rules of valuation suggest that low rates don’t necessarily defend higher multiples.Investment management firms used to be considered a value investment.  If that’s no longer true, will internal transactions be possible?  Will firms be compelled to sell into complex financial engineering schemes that cut every analytical corner in an effort to buy high and sell higher?  The NPV of financial engineering, over time, is zero (before fees).  No SPAC is going to change that.Does the high bidder set the market?  On paper, yes.  But the market for RIAs consists of tens of thousands of active participants, many of whom are quietly willing to sit out if financial returns aren’t high enough.  Full stop.A Plug for Mercer Capital’s Upcoming RIA Practice Management Insights ConferenceMercer Capital has organized a virtual conference for RIAs that is focused entirely on operational issues – from staffing to branding to technology to culture – issues that are as easy to ignore as they are vital to success. The RIA Practice Management Insights conference will be a two half-day, virtual conference held on March 3 and 4.Join us and speakers like Jim Grant, Peter Nesvold, Matt Sonnen, and Meg Carpenter, among others, at the RIA Practice Management Insights, a conference unlike any other in the industry.Have you registered yet?

The tyranny of the urgent imposes itself on family business directors just as it does on everyone else.  In this series of posts, we offer various to-do lists for family business directors.  Each list will relate to a particular family business topic.  The items offered for consideration will not necessarily help your family business survive the next week, but instead reflect priorities for the long-term sustainability of your family business.In last week’s post, we reviewed the role of diversification in family businesses.  This week’s to-do list includes important tasks for family business directors seeking to discern whether – and how – to diversify the operations of the family business.  Thinking about diversification is essential for helping family business directors fulfill their duty to manage the risk of the enterprise.  For mature family businesses, prudent diversification can be one of the most important means to promoting sustainability.1. Estimate What Portion of the Family’s Overall Wealth Is Represented by the Family BusinessAs we discussed in last week’s post, attitudes toward the benefits of diversification depend on whether one takes a “business” or “shareholder” perspective.  When evaluating diversification opportunities, directors should have a clear understanding of which perspective they are taking and why.  If the family’s wealth is concentrated in the family business, the “business” perspective will likely be appropriate.  If, on the other hand, family shareholders have significant assets and sources of income outside the family business, the “shareholder” perspective is probably preferable.  It is not unusual for larger families to have a mix of diversified and undiversified shareholders, in which case directors need to develop strategies for simultaneously managing the different shareholder “clienteles” within the family. Family shareholders may chafe at disclosing personal financial information, so this needs to be approached with some tact.  First, keep in mind that this is not an accounting exercise that needs to tie to the penny: broad percentages are acceptable.  Second, family shareholders may be more willing to be transparent with a trusted third-party intermediary who can collect, analyze, and present aggregate shareholder data on a confidential basis.2. Identify the Primary Long-Term Strategic Threats to the Sustainability of the Existing Family Business OperationsWhat are the risks of failing to diversify?  Assessing the strategic threats to the family business can help directors evaluate the most fruitful avenues of diversification for the family business.  We find the Porter framework to be a helpful way to think systematically about the strategic position of your family business.  The Porter framework organizes strategy under the headings of five basic competitive forces.Threat of New Entrants. How easy is it for new firms to enter your markets?  What protects your family business from competition by new industry players?Supplier Bargaining Power. Where does your family business sit along the value chain from raw material inputs to consumers?  Is your family business susceptible to supply disruptions?  How well could your family business absorb or manage a price hike from your key suppliers?Rivalry Among Existing Competitors. What factors determine market share in your industry?  Why do customers choose your family business over competitors?Threat of Substitutes.Is your family business selling steak or sizzle?  What are other (existing or future) alternatives for your customers to get their sizzle?Customer Bargaining Power.How diverse is your customer list?  What does your family business provide that customers cannot get elsewhere and are, therefore, willing to pay for? Careful and objective analysis of the strategic threats to your family business can help directors evaluate whether to diversify, by how much, and in what direction.3. Establish a Family LLC or Partnership to Hold a Portfolio of Diversifying Assets (Real Estate, Marketable Securities, Etc.)Depending on family dynamics, it may be desirable to set up a mechanism for diversifying inside the family, but outside the family business.  A family holding company structure can deliver both family governance and estate planning benefits.  Directors should understand that, from an estate planning perspective, one of the principal benefits of such entities is the ability to transfer wealth at the fair market value of an illiquid minority interest in the family holding entity, which is generally determined net of discounts for the lack of control and lack of marketability inherent in such interests.  The use of such discounts for estate planning transactions is potentially at risk under the Biden administration, so it may be beneficial to move quickly.4. Create Opportunities to Provide Seed Funding to Family Members with Compelling Ideas for New Business VenturesEstablished families may be in a position to make seed investments in start-up ventures as a way to both reap diversification benefits and promote engagement on the part of rising next generation family members.  This should not involve providing a blank check for every harebrained-scheme your shiftless nephew hatches.  Venture investing won’t be right for every family.  Moreover, successful venture investing is a disciplined, and occasionally ruthless, process of identifying, funding, nurturing, harvesting, and – often – pulling the plug on unsuccessful ventures.  Not every family has the characteristics needed to manage an in-house venture fund, but for those who do, the rewards can be substantial.ConclusionDiversification is too important to keep putting off until next quarter or next year.  Give one of our professionals a call to help you get started on knocking out your to-do list today.

For most independent RIAs, a future M&A transaction is inevitable.  The impetus behind the transaction could be the partners’ desire to retire, gain scale, accelerate growth, meet liquidity needs, reduce the time burden of non-client facing tasks, or some other motive.  Whatever the reason, picking the right partner is critical for the success of the transaction.  For both buyers and sellers, knowing where your firm fits into the RIA M&A landscape is an important first step towards identifying compatible transaction partners.  The universe of RIA sellers can be categorized based on firm culture, the motive behind the transaction, management’s expectations for post-transaction roles, liquidity needs, the status of next-generation management, and the like.  As RIA transactions have proliferated in recent years, several different buyer profiles have emerged that address the concerns of these different seller types.  In this week’s guest post, Louis Diamond of Diamond Consultants identifies four common buyer profiles and the types of sellers that fit well with each.Louis Diamond will be speaking on the topic of advisor recruitment and acquisitions at our upcoming RIA Practice Management Insights conference, to be held March 3-4.  Register now to hear more from Louis Diamond along with keynotes from James Grant, founder and editor of Grant’s Interest Rate Observer, and industry veteran Peter Nesvold, Managing Director of Nesvold Capital Partners.Most acquirers have traits within one of four categories—each offering a unique value to sellers. And having the “right” persona can make all the difference in attracting the right acquisition partners.Many independent firms reach a point in their business lifecycle where they can no longer sufficiently grow or compete on their own. It’s when discussions around finding a way to gain scale and solve for succession hit a wall that firms often consider a merger or acquisition opportunity. Yet finding the right M&A partner isn’t all that easy.As a firm that represents both buyers and sellers, it’s our job to keep a finger on the pulse of the market and listen to many value propositions from prospective buyers. That said, only a handful of firms are truly poised to be meaningful acquirers in this hyper-competitive marketplace. Attributes such as being well-capitalized (given that most sellers expect a decent portion of the purchase price at closing), having a repeatable and battle-tested M&A process, a unique value proposition, and strong leadership are now table stakes in this environment.Buyers and sellers alike often fail to recognize what a marriage between firms can mean for ongoing control, growth and quality of life. Therefore, it is paramount that firm owners are strategic in how they present their value to prospective sellers—and sellers come to the table prepared with clearly identified expectations of the new affiliation.One key area that many buyers often lose sight of – which helps to focus targeting, due diligence efforts and proper alignment – is being clear and honest about what “type of acquirer profile” your firm represents to a prospective seller. It’s equally important to recognize that remaining consistent in this regard is critical; that is, once a firm persona is established, any variances can lead an organization astray of its core competencies and culture, ultimately suppressing enterprise value. And for sellers, recognizing their goals and matching those with one of the four profiles will ultimately translate into a more strategic and focused sale process.The Four Acquirer ProfilesWe find that most acquirers have traits within the following four categories—each of which offer a unique value to sellers.1) Standalone RIAsThese firms are exemplified by a “one brand, one firm, one investment” approach. The most successful acquirers in this group manage more than $1B in assets and have a similar culture, operating structure, and approach as the firms they acquire. They tend to do a small number of deals, so they are typically more strategic in nature than financial. These firms may sometimes allow the seller to maintain an active voice in steering the ship and become a relatively significant equity holder, if so desired. Additionally, all back office and business operations will be taken off the seller’s plate.Another important distinction for those who become an equity owner: There is still the possibility of a significant liquidity event down the road if they take on an investor or sell the firm.Examples: Numerous RIAs have completed a handful of deals and are embarking upon M&A for the first time.Most attractive sellers: Principals who have a longer runway to retirement and are still looking to retain some managerial duties, and those who are primarily focused on a good cultural or local fit. Or an advisor close to retirement who identifies an ideal hand picked successor already at the acquiring firm.Least attractive sellers: Those who value maximum upfront money since these firms are not backed by deep-pocketed investors; those wanting more of a national footprint or brand; or anyone looking to remain fully in charge of operations, since to an extent, investment management and financial planning are standardized across the firm. Also, sellers looking to get a deal done quickly might steer clear of acquirers in this category as these standalone firms tend to be less-experienced deal makers.2) Aggregators or RollupsFirms that are very well-capitalized, prolific deal makers are frequently referred to as aggregators or rollups. They excel at operations, streamlining businesses, standardizing processes, and maintaining strong communities of like-minded advisors. They will take over the entire investment management program, as well as the financial planning process—essentially everything aside from client service. Many firms in this category have cracked the code on organic growth so may have a dedicated business development team, a well-oiled digital marketing or seminar-based lead development system, or be active in the various custodial referral programs.Examples: Mercer Advisors, Beacon Pointe, Mariner, Allworth, and Buckingham.Most attractive sellers: Firms that believe the acquirer has built a “better mousetrap” and are in complete lockstep with the acquirer’s values (i.e., a hard-core focus on financial planning). Also, a good fit those seeking an exit strategy or to gain considerable scale and vastly accelerate organic growth, as well as those who want to step away from the day-to-day operations and just focus on clients.Least attractive sellers: Any principal who is not ready to give up full control.3) Platform AcquirersThese are organizations with many different types of businesses under one roof, but with common middle- and back-office infrastructures. They want sellers to leverage their platform and scale, yet they are all about letting businesses continue to operate in silos.Examples: HighTower Advisors, Kestra Financial (Bluespring Wealth), Stratos Wealth Partners, Sanctuary Wealth PartnersMost attractive sellers: Those who are seeking a partial liquidity event or looking to step back from business ownership, yet still value being involved with portfolio management, financial planning, maintaining their brand, prospecting, and even running their own P&L.Least attractive sellers: Advisors who are close to retirement, yet do not have a succession plan; those who are seeking dedicated resources to fully take on planning, investment management, and day to day client facing responsibilities; and those who are no longer interested in managing a business.4) Financial Buyers or InvestorsThere’s no shortage of capital chasing the independent wealth space as countless private equity firms, family offices, sovereign wealth funds, and diversified financial services companies have made passive investments in larger scale firms. These firms offer prospective sellers the ability to take significant chips off the table by selling a portion of their business. They serve as a strategic growth partner to assist in the sourcing, structuring, and financing of sub-acquisitions, as well as provide the opportunity to retain brand and the client service model.Examples: Focus Financial Partners, Wealth Partners Capital Group, Emigrant Partners, Merchant Investment Management, CI FinancialMost attractive sellers: Those who value maximum upfront cash, retaining day-to-day control of the business, minimizing change, and growing by way of acquisition.Least attractive sellers: Advisors looking to offload the non-client service and business development processes, a firm without an internal succession plan, firms that struggle with profitability and scale, those less interested in focusing on organic and inorganic growth. A merger or acquisition can benefit both parties involved, provided each are equally motivated with compatible needs and goals. By identifying the unique needs and requirements of each party (prior to engaging in an M&A project), the process of meeting the right match can be far more efficient and lead to a successful marriage. About the AuthorLouis has guided many of the top teams in the industry as they’ve transitioned to another employee-model firm or launched RIA firms. And as a next generation leader himself, Louis has a passion for representing complex multi-generational teams.A George Washington University magna cum laude graduate with a BBA degree in Finance and International Business, Louis began his career with some of the biggest names in the financial services industry. His time working as a consultant at Ernst & Young, and in wealth management at Morgan Stanley and UBS, well prepared him to understand the financial world from a client’s perspective.We're excited to have Louis speak at our inaugural RIA Practice Management Insightsconference.

Coming into 2020, vehicle volumes in the U.S. were anticipated to dip below 17 million light vehicles sold.  The industry had eclipsed this mark in each year since 2014, though 2019 cut it close. Like most industries, automotive retail got off to a strong start in 2020.  While SAAR was just below the 17.0 million mark at 16.9 in January and 16.8 million in February, the boost of a leap year falling on a Saturday had total volumes at just shy of 2.5 million, up 4.5% from 2019.  While dealers were hopeful volumes would remain high, we all know what happened next in March and April, which put to rest any notion of 17 million vehicles sold.  In the U.S., 14.46 million units were sold in 2020 representing a 14.7% decline and the lowest total since 2012. Normalizing only March and April to their 2019 levels, volumes in 2020 would have been 15.7 million, showing nearly half the 2020 decline occurred in just those two months.The decline can also be attributed to a significant reduction in fleet sales as the COVID-19 pandemic’s impact on travel caused several major rental car companies to cancel orders.  In December 2020, monthly retail sales appear to have actually improved 0.5% from 2019, compared to a 33% decline in fleet volumes.  Viewed another way, fleet sales represented only about 14.3% of total volumes in 2020, compared to a 19.6% share in 2019.  We touched on the impact of retail vs total SAAR last month.The pandemic had a material impact on the sales process in March/April and the sales mix from fleet to retail, predictions from before the pandemic about sales volumes weren’t that far off the mark once stay at home orders were relaxed and dealers figured out how to navigate the new protocols. By September, SAAR had returned above 16 million. However, no month in 2020 reached seasonally adjusted volumes of 17 million, a mark reached seven times in 2019 and every month but two in 2018. So, while nobody could have predicted the depths of the pandemic, we see that the initial expectation of a lower run rate may have been correct.Eisenhower once said, “Plans are worthless, but planning is indispensable.” According to Scott Galloway, Professor at NYU Stern School of Business, “the same is true for predictions – they matter for the strategy and data behind them. Predictions are useless, but scenario planning is invaluable.” I find this quote to be even more telling as it appeared in a piece about predictions for 2020, which just about everyone missed.Heading into 2021, we’re going to make some predictions.  While they may or may not prove true in 2021, we believe this exercise is beneficial for auto dealers who should be looking forward to what the year might bring and prepare themselves should these trends materialize.  While nobody could have predicted their need for Clorox and face masks, the pivot to digital offerings and more targeted advertising was already in motion prior to the pandemic.  Intentional planning can help prepare for what lies ahead, whether or not things actually unfold as you project.  It’s the preparation itself that’s meaningful.Inventory Constraints Lessen and Fixed Operations ReturnsThis prediction is based on the trends seen at the end of 2020 continuing through 2021.  As vaccine distribution ramps up, auto manufacturing should continue as well.  The speed of each of these will likely be a significant factor in total volumes in 2021.  Fixed operations, particularly collision, were diminished in 2020 with fewer road miles driven.  Due to inventory constraints and potential affordability concerns, among other reasons, consumers shifted towards used vehicles.  We anticipate normalizing inventories and an improving economy should both tilt the mix back towards more new vehicles.  However, the recent increase in used vehicle sales should increase the average age of vehicles on the road, which tends to spur more business for dealers’ service and parts departments.  Since this is the highest margin business for auto dealers, we see tailwinds in terms of total profitability.  While higher volumes can bring in more bonus money to dealers on the backend, at the end of the day, profitability is what drives value for auto dealers.Crossovers Remain Popular as Low Gas Prices and High EV Battery Costs Don’t Make the Trade-Off Worth It to the Bulk of Consumers, Yet.Pickup trucks accounted for 19.7% of market share, higher than all cars combined (small, midsized, and large) excluding luxury. Combined with crossovers (43.3%), SUVs (8.7%), and vans (4.7%), light trucks accounted for 76.4% of all sales, up from 72.1% in 2019 and 69.2% in 2018.  Larger vehicles have become increasingly popular with consumers, and low gas prices and improved MPGs reduce the costs of the trade-up in size.  Even inventory shortages and reduced incentives haven’t deterred demand in this segment.  Incentives in December 2020 were down 12.7% from 2019, which along with the continued shift to higher priced vehicles, pushed average transaction prices to all-time highs of just over $38 thousand per vehicle.Nearly 96% of vehicles sold in 2020 were gas or diesel-powered, with EVs making up only 1.4% of the market.  While there has been significant investment in this space, and an incoming Democratic administration portends a shift towards sustainable fuels, we do not anticipate this to materially accelerate in 2021.  Instead, most of the EV progress anticipated in 2021 is more likely to be along the lines of infrastructure investment, legislative assistance, and vehicle improvements.  While many manufacturers such as Volvo have made claims their cars will be all-electric by 2030, we see that progress being back-ended.  While Elon Musk claimed EV battery costs could be cut in half, but this will still be years from now.  Ultimately, until the sticker price can meaningfully compete, EV’s won’t reach the majority of consumers.SAAR of 16 Million (Above NADA’s Forecasted Figure of 15.5 Million)NADA is forecasting a SAAR of 15.5 million in 2021, making our prediction slightly on the bullish side. While the industry appears set for a second straight year below 17 million, improved margins could leave dealers with higher gross profits, which would be a welcomed trade in the industry. According to NADA, headwinds for the vehicle market in 2021 include continued increases in COVID-19 cases, which could lead to production disruptions along the vehicle supply chain. They further noted a global shortage of semiconductor microchips used in many facets of auto production and tight inventory on dealer lots, particularly for pickup trucks. Alternatively, tailwinds for 2021 include a potential economic boom in the second half of the year once a coronavirus vaccination is widely available, and Americans return to work from WFH. Auto retailers also stand to benefit if consumers continue to prefer personal vehicle ownership over rideshare services and public transportation. Finally, low interest rates keep cars affordable, and the Fed has indicated it intends to continue to be accommodative, which should support vehicle demand.Conclusion As auto dealers know, SAAR is a decent gauge on the industry, but it tells us very little on its own. While we believe it’s important to track, we recognize the inherent limitations of just volumes. In the proper context of incentive spending, profitability, and other key metrics, SAAR can be helpful. While dealers can see how their volumes compare to wider industry trends, dealers need to focus on the underlying trends within their local markets to contextualize performance to make sure they are staying ahead of the curve.For an in-depth analysis of how your dealership fits in the auto dealer marketplace, contact a member of Mercer Capital’s Auto Dealer team today.

After a brief lull during the second quarter of last year, RIA deal activity surged in the fourth quarter, rounding out a record year in terms of reported deal volume.  Concerns about the pandemic and market conditions were quickly shrugged off, as deal terms and the pace of deal activity returned to 2019 levels after the brief pause at the peak of the shutdown.The strong fourth quarter deal activity reflects a continuation of the upward trajectory seen over the last several years.  Fourth quarter deal activity was further accelerated by the backlog of deals that had stalled earlier in the year and by the expectation for increases to capital gains tax rates when the new administration takes over.  The total reported deal volume in 2020 increased 28% from 2019 levels, and while deal count declined 15% from 2019 levels, the decline was almost entirely attributable to the brief slowdown in the second and third quarters.  The average deal count in the first and fourth quarters exceeded the 2019 quarterly average.Deal Terms Remain Robust Deal terms and multiples showed remarkable resilience in 2020.Deal terms and multiples for wealth management franchises showed remarkable resilience in 2020.  While the height of the market downturn caused some buyers to exercise caution regarding multiples and deal terms, the effect was short-lived.  As equity markets rebounded and the uncertainty diminished, deal terms and multiples quickly returned to 2019 levels, with attractive RIA sellers seeing high single digit multiples of EBITDA and meaningful portions of the purchase price paid in cash at closing.The strength of deal terms is not surprising given the influx of new buyers in recent years.  RIA aggregators, strategic acquirers, banks, and private equity have all been elbowing their way to the table, which suggests a continued seller’s market.Consolidators Drive Deal ActivityRIA consolidators and larger RIA strategic acquirers continued to be a driving force behind deal activity.  Wealth Enhancement Group, Focus Financial, Hightower, Creative Planning, CAPTRUST, and CI Financial each acquired multiple RIAs in 2020.  These firms sustained deal activity during the peak of the pandemic distraction, while smaller acquirers without dedicated deal teams were forced to delay or abandon planned transactions.  Consolidators and large strategic acquirers remain an attractive option for many RIA sellers due in part to the lower execution risk resulting from consolidators’ experience in closing transactions.Mega-DealsWhile consolidators accounted for a large percentage of deal activity, these deals are typically relatively small.  The uptick in total deal value during the year was driven by several mega-deals among publicly traded asset managers and discount brokerages.  Back in February, Franklin Templeton agreed to buy rival asset manager Legg Mason for $6.5 billion, and Morgan Stanley purchased online broker E-Trade for $13 billion just a few days later.  In October, Morgan Stanley agreed to buy asset manager Eaton Vance for $7 billion.  In December, Macquarie Group (a diversified Australian financial services company) agreed to buy asset and wealth manager Waddell & Reed for $1.7 billion.The differences between these larger transactions and the smaller wealth management firm transactions are noteworthy.  The recent mega-deals in the industry between public companies have been focused on sectors of the industry that many analysts believe are declining—asset management and discount brokerage.  These sectors have seen significant fee and margin compression in recent years, and as a result, these deals are largely defensive in nature and motivated by cost savings and increased scale to protect margins.In contrast, buyers of independent wealth management firms are typically attracted by recurring revenue, a sticky client base, relatively high margins, and attractive growth prospects due to market appreciation and demographic trends.  As a result of these differing motivations and outlooks, the multiples seen for wealth management franchises are often higher than their publicly traded asset management-focused counterparts.  In the case of the Waddell & Reed transaction, the multiple paid for the asset management component of the business may have been as low as 5x (see our post, Did Macquarie Pay 11x EBITDA for Waddell & Reed? Yes and No), well below what an attractive wealth management business can expect in the current environment.Internal TransactionsMany of our RIA clients have taken time over the last year to work on back-of-house issues like succession planning.  It’s no secret that succession planning is a major issue for the industry, and one of the questions RIA principals must answer when succession planning is whether to engage in an internal or external transaction.  Although there has been a proliferation of external buyers and deal terms remain strong, internal transactions can be an attractive option for a variety of reasons.  Compared to the stringent structure that an outside buyer might impose, internal transactions can offer greater flexibility for retiring partners.  They also sidestep one of the largest issues in RIA transactions—cultural compatibility—since no new parties are introduced and forced to work together.It’s no secret that succession planning is a major issue for the industry.One of the downsides of internal transactions is that the buyers, typically younger firm employees, often don’t have the financial resources to purchase a significant interest outright.  The good news is that capital options to facilitate these transactions have expanded significantly in recent years, with various banks, private equity, and minority investors increasing their focus on the sector.Another challenge with internal transactions is that they require a strong next-gen management team to be in place.  Without a strong bench, external transactions may be the only option for a founding partner seeking to exit the business.  For firms that lack the next-gen management to run the business and turn to external buyers to solve their succession planning problem, it may be difficult to realize full value.We’ll be addressing succession planning along with other operational, back of the house RIA issues at our upcoming conference, RIA Practice Management Insights, to be held virtually on March 3-4, 2021.

After steady increases, SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) experienced its first notable decline since April, dropping to 15.6 million from 16.3 million in October. November 2020 is down by 8.4% compared to the same period in 2019, and through 11 months of the year, new light-vehicle sales are down 16.7% compared to the same period last year. The calendar differences are important to note for this month with November 2020 only having 23 selling days relative to 26 days in November 2019. As Thomas King, president of data and analytics division at JD Power notes:November 2020 is a prime example of why accounting for selling day differences is important in measuring comparable sales performance. After two consecutive months of year-over-year retail sales gains, a quirk in the November sales calendar will result in new-vehicle retail sales appearing to fall 12%. This year, November has three fewer selling days and one less selling weekend compared with 2019. When these calendar quirks are accounted for, new-vehicle retail sales are expected to almost match 2019 levels. While the sales results illustrate the continued strength of consumer demand, that strength is further reinforced by transaction prices hitting another record high, even as manufacturers and retailers continue to remain disciplined on new-vehicle incentives and discounts.While adjusting for calendar differences is important in determining true trends that are occurring in the industry, it is also necessary to consider retail SAAR vs. total SAAR.While retail SAAR includes the daily selling rate for retail auto sales to individual customers, total SAAR also includes fleet sales to businesses, government, and daily rental companies. Because of this distinction, considering just total SAAR alone may not indicate actual consumer purchase trends. This has been especially notable for this year as fleet vehicle sales and rental companies have been inordinately affected by the pandemic compared to auto dealer sales.Though dealerships experienced a decline when they had to shut down due to stay-at-home orders, business picked back up once they could reopen. Fleet sales, on the other hand, are suffering from changes in consumer trends due to the pandemic, rather than government mandates. For example, many businesses have adopted a work from home model to keep employees healthy during the pandemic. As such, rental car needs for business purposes have declined. Furthermore, overall travel, in general, is down as people have been wary to fly, further impacting this market. May was the toughest month with rental units declining 91%, and Hertz announcing their bankruptcy. From March through September 2020, fleet sales have seen an average monthly decline of 53% with November fairing slightly better with a 25% decline from the same time last year.Observing the implications numerically can be helpful to further illustrate this point. As you can see in the chart produced by JD Power, while total SAAR is down 7.6% (unadjusted for calendar dates), retail SAAR is only down 5.1% (also unadjusted). These numbers reflect the brunt of economic difficulty that fleet sales have faced relative to retail sales. An important note is that this graph is primarily for illustrative purposes with both of these SAAR numbers being predictive rather than actual. Average incentive spending per unit is expected to top $3,800, marking the third straight month of incentives below $4,000, which reflects strong vehicle demand supporting sales. The average new-vehicle retail transaction price in November is expected to reach a record $37,099, topping the previous record last month of $36,755. While tight inventory constraints have plagued the industry all year, there are signs that things are improving. According to Cox Automotive Senior Economist Charlie Chesbrough, “The tight inventory situation, where available products at dealerships were drawn down to very low levels, reached a peak in late summer. However, factory production has improved while sales pace has slowed, and the combination is allowing dealerships to replenish somewhat. Overall, supply still remains far below last year's levels, and holiday sales may slow if buyers can't find what they want." With factories now operating at pre-pandemic levels, production has not been the hurdle it was through mid-year. It is important to note potential tailwinds to SAAR going into the end of the year, specifically in terms of the COVID-19 pandemic and ongoing U.S. politics. As of writing this blog post, coronavirus cases are surging throughout the country as a result of colder weather and indoor gatherings to celebrate the holidays. With restrictions being put back in place throughout the country, dealerships may see less foot traffic as people try to limit exposure as much as possible. However, with promising news on the vaccine front in the past month, hopes are high that there may be a return to normalcy on the horizon. The political climate continues to pose challenges for auto dealerships as a new stimulus continues to be stuck in a divided Congress. Weekly unemployment claims might be starting to be affected by the lack of stimulus with more than 947,000 workers filing new claims for state unemployment benefits the first week of December. Applications have risen three times in the last four weeks and are up nearly a quarter of a million since the first week of November. This is evident when looking at the chart below produced by the New York Times.Conclusion While we think it’s far too early to suggest we might be falling into a second decline, the downturn in SAAR this month shows we are not yet out of this pandemic. An effective and distributable vaccine should boost economic activity and support employment figures and in turn boost consumer spending on items such as vehicles. However, we note that reduced business travel may have long-term impacts on rental businesses, and fleet sales may not return to pre-pandemic levels as a second order impact. We will continue to monitor these trends as I’m sure you and all of our auto dealer clients will.If you want to discuss how SAAR (total and retail) and the greater macroeconomic environment may impact your dealership, contact a member of the Mercer Capital Auto Dealer team today.

Last week, Macquarie Group announced its acquisition of Waddell & Reed (WDR) for $1.7 billion.  Waddell & Reed is one of the oldest mutual fund and asset management firms in the U.S. with a range of investment styles and insurance products. Waddell and Reed’s asset management division will expand Macquarie’s investment solutions, boost Macquarie’s annuity earnings, and push Macquarie’s U.S. AUM to $276 billion, making it one of the top 25 active managers in the U.S.The transaction marks a shift in Macquarie’s past acquisition strategy, which has historically followed the old saying, “The time to buy is when there’s blood in the street.”  The firm’s last large acquisition was in 2010 when it acquired Delaware Funds (with $135 billion AUM) for $428 million. Instead, Macquarie is moving when the market is at an all-time high and paying nearly a 50% premium to WDR’s share price.Not only does this mark a shift in Macquarie’s deal strategy, but it is also the first acquisition by Macquarie’s new CEO.  Shemara Wikramanayake, who has been called the most powerful woman in Australian finance, is now dealing with skeptics who ask why she paid such a premium for a business whose AUM has halved over the last six years.Transaction OverviewAt first glance, the AUM and revenue multiples paid by Macquarie Group appear fairly normal for an asset manager, but maybe not for a firm with a 14% EBITDA margin and years of declining AUM.While EBITDA multiples over 11.0x are not unheard of in this space, one would likely expect an impressive growth trajectory to accompany it.  To understand the deal multiples implied by Macquarie’s acquisition of Waddell and Reed, we must dig into the details of the transaction.WDR has historically held lots of cash and investments on its balance sheet, for which Macquarie likely paid dollar for dollar.  Typically, RIAs hold between 6-8 weeks of operating expenses on its balance sheet as working capital, or approximately 10% to 15% of revenue. With an estimated $437 million of excess working capital on its balance sheet, the price for the operating business is approximately $1.26 billion, which implies multiples more in line with the typical range observed in the legacy asset management space. Additionally, upon completion of the deal, Macquarie Group will sell WDR’s wealth management division to LPL Financial (a U.S. retail investment advisory firm, BD, and RIA custodian) for $300 million.  The adjusted transaction price as a multiple of WDR’s asset management division’s AUM is 1.42%.  However, determining the post transaction revenue and EBITDA requires a good bit of speculation. With AUM of approximately $68 billion and pro forma effective fees of around 65 bps, the post-transaction business will likely generate about $450 million of investment income.  A little under 90% of WDR’s underwriting revenue was generated through its advisor network.  Post-transaction, Macquarie will be one of LPL’s top strategic asset management partners, which suggests that Macquarie will not lose all revenue associated with its advisor network.  As such, we have estimated WDR’s underwriting revenue stream could fall by approximately 80%.  There will be expense savings generated by selling this business and additional synergies from merging with Macquarie.  However, buyers don’t often pay for something they bring to the table, so WDR was likely only compensated for the cost reductions associated with selling its wealth management business. Thus, we have modeled a range of scenarios with between 50% to 60% cost savings. Even if Waddell and Reed’s AUM has been falling year-over-year, scale is valuable in the asset management space and we doubt that Macquarie was able to pick up WDR’s asset management business for a 5.0x EBITDA multiple.  But the 7x-11x range seems reasonable.  Macquarie’s acquisition of Waddell and Reed highlights how the success of legacy asset managers is currently dependent upon achieving scale. While the $25 per share purchase price represents a healthy premium to the latest pricing, the market has been down on investment managers since March’s sell-off.  Paying a premium does not necessarily mean that Wikramanayake overpaid.  Some may say that Macquarie is catching a falling knife by buying a business whose assets have been on the slide, but maybe it was just a butter knife…

In last week’s blog post, we covered five considerations for designing earn-outs.  To recap, these considerations are as follows:Defining the continuing business that will be the subject of the earn-outDetermining the appropriate period for the earn-outDetermining to what extent the buyer will assist or impede the seller’s performance during the earn-out periodDefining what performance metrics will control the earn-out payment(s)Determining other earn-out features (caps on payments, clawbacks, etc.) While there is no one set of rules for structuring an earn-out, keeping these conceptual issues in mind can help anchor the negotiation.  This week, we look at an example RIA transaction to illustrate how these considerations come into play when buyers and sellers are working out deal pricing and structure.RIA Transaction ExampleConsider the example of a depository institution, Hypothetical Savings Bank (HSB).  HSB has a substantial lending platform, but it also has a trust department that operates as something of an afterthought.  HSB’s senior executives consider options for closing or somehow spinning off the trust operation, but because of customer overlap, lengthy trust officer tenure with the bank, and concerns by major shareholders who need fiduciary services, HSB instead hopes to bolster the profitability of trust operations by acquiring an RIA.Following a search, HSB settles on Typical Wealth Management (TWM).  TWM has 35 advisors and combined discretionary assets under management of $2.6 billion (an average of $75 million per advisor).  TWM has a fifteen-year track record of consistent growth, but with the founding generation nearing retirement age, the firm needs a new home for its clients and advisors.The Seller’s PerspectiveTWM’s founders are motivated, but not compelled, to sell the firm.  TWM generates 90 basis points of realized fees per dollar of AUM and a 30% EBITDA margin.  Even after paying executives and advisors, TWM makes $7MM of EBITDA per year, and the founders know that profitability has significant financial value to HSB, in addition to providing strategic cover to shore up the trust department.Further, Typical Wealth Management has experienced considerable growth in recent years, and believes it can credibly extend that growth into the future, adding advisors, clients, and taking advantage of the upward drift in financial markets to improve revenue and enhance margins. Given what it represents to be very conservative projections, and which don’t take into account any cross-selling from the bank or potential fee enhancements (TWM believes it charges below-market fees to some clients), the seller wants 12x run rate EBITDA, or about $85 million, noting that this is only about 10x forward EBITDA, and less than 7x EBITDA three years hence. The Buyer’s PerspectiveThe commercial bankers at HSB are not overly familiar with the wealth management industry, but they know banks rarely double profitability in three years and suspect they’ll have a tough time convincing their board to pay top dollar for something without tangible book value.Bank culture and investment management do not always mix well, and HSB worries whether TWM’s clients will stay if TWM’s senior staff starts to retire.  Further, they wonder if TWM’s fee schedule is sustainable in an era of ETFs and robo-advisors.  They create a much less sanguine projection to model their possible downside. Based on this, HSB management wants to offer about $40 million for TWM, which is about six times run rate EBITDA.  This pricing gives the seller some credit for the recurring nature of the revenue stream, but doesn’t pay for growth that may or may not happen following a change of control transaction. The CompromiseWith a bid/ask spread of $45 million, the advisors for both buyer and seller know that a deal isn’t possible unless one or both parties is willing to move off of their expectations significantly (unlikely) or a mechanism is devised to reward the seller in the event of excellent performance and protect the buyer if performance is lackluster.  Even though the buyer is cautious about overpaying, they eventually agree to a stronger multiple on current performance and offer $50 million up front for TWM.  The rest of the payment, if any, will come from an earn-out.  Contingent consideration of as much as $30 million is negotiated with the following features:TWM will be rebranded as Hypothetical Wealth Management, but the enterprise will be run as a separate division of the bank during the term of the earn-out. This division will not pay any overhead charge to the bank, except as specifically designated for marketing projects through the bank that are managed by the senior principals of the wealth management division.  As a consequence, the sellers will be able to maintain control over their performance and their overhead structure during the term of the earn-out.The earn-out period is negotiated to the last three years. Both buyer and seller agree that, in a three year period, the value delivered to the seller will become evident.Buyer and seller agree to modest credits if, for example, the RIA recommends a client develop a fiduciary relationship with the bank’s trust department, or if the bank’s trust department refers a wealth management prospect to the RIA. Nevertheless, in order to keep matters simple during the term of the earn-out, both parties agree to manage their operations separately while the bank determines whether or not the wealth management division can continue to market and grow as an extension of the bank’s brand.To keep performance tracking straightforward, HSB negotiates to pay five times the high-water mark for any annual EBITDA generated by TWM during a three year earn-out period in excess of the $7 million run-rate established during the negotiation. It is an unusual earn-out arrangement, but the seller is compensated if AUM is significantly enhanced after the transaction, whether by steady marketing appeal or strong market returns.  The buyer is protected, at least somewhat, from the potentially temporary nature of any upswing in profitability by paying a lower multiple for the increase than might normally be paid for an RIA.  As long as the management of TWM can produce at least $6 million more in EBITDA in any one of the three years following the transaction date, the buyer will pay the full earn-out.  Any lesser increase in EBITDA is to be pro-rated and paid based on the same 5x multiple.The earn-out agreement is executed in conjunction with a purchase agreement, operating agreement, and non-competition/non-solicitation agreements which specify compensation practices, reporting structures, and other elements to govern post-transaction behavior between the bank and the wealth manager. These various agreements are done to minimize misunderstandings and ensure that both the buyer and sellers are enthusiastic participants in the joint success of the enterprise. As the earn-out is negotiated, buyer and seller run scenarios of likely performance paths for TWM after the transaction to see what the payout structure will look like per the agreement.  This enables both parties to value the deal based on a variety of outcomes and decide whether pricing and terms are truly satisfactory.Conclusion: Earn-Outs are Interactive With the Value of RIAsRisk is an unavoidable part of investing.  While we might all desire clairvoyance, it would only work if we were the sole investors who could see the future perfectly.  If everyone’s forecasts were proven accurate, assets would all be priced at something akin to the risk free rate with no premium return attached.  Uncertainty creates opportunity for investors, because opportunity is always a two way street.Pricing uncertainty is another matter altogether.  Not everyone “believes” in CAPM, or at least maybe not the concept of beta, but most agree that the equity risk premium exists to reconcile the degree of un-likelihood for the performance of a given asset with the value of that security.  In an ideal world, a reasonable cash flow projection and a reasonable cost of capital will yield a reasonable indication of value.In the vacuum-sealed world of fair market value, we can reconcile discordant outlooks with different cash flow projections.  The differing projections can then be yoked together into one conclusion of value by weighing them relative to probability.  The discount rate used in the different projection models captures some of the risk inherent in the cash flow, and the probability weights capture the remainder of the uncertainty.  In a real world transaction, however, buyers want to be paid based on their expectations if proven right, and sellers also want to be paid if outcomes comport with their projections.  With no clear way to consider the relative likelihood of each party’s expectations, no one transaction price will facilitate a transaction.  Risk and opportunity can often be reconciled by contract, however, by way of contingent consideration.

One November day in the late 1970s my dad noticed an ad on the bulletin board at work that caught his attention: someone had a Jensen Healey MkII for sale. The MkII was arguably the best product Jensen Healey ever made: a lightweight two seat convertible with a Lotus four-cylinder double overhead cam engine with dual Stromberg carburetors. The Jensen my dad was looking at was far from perfect – it was covered with a couple of years worth of dust and had a crease running down the middle of the fragile aluminum hood because someone hadn’t been careful closing it. It needed a tune up and who knows what else (British sports cars aren’t known for reliability). But at 2,400 pounds and 140hp, when it ran, it ran fast. Dad brought the Jensen home for the long Thanksgiving weekend and we drove it around Miami (due diligence) to decide whether or not to take the plunge.Part Two of Our Series on Earn-OutsLast week, we offered an example, ACME Private Buys Fictional Financial, to shed light on several issues presented by the use of earn-outs in RIA transactions. As explained, gathering comprehensive data on ultimate deal value in investment management transactions is problematic as most post-deal performance doesn’t get reported other than AUM disclosures in public filings. And, if the acquired entity is folded into another RIA, you can’t even judge a deal by that. Sometimes bad deals can be saved by good markets, but hope is not a strategy. Consequently, earn-outs are the norm in RIA transactions, and anyone expecting to be on the buy-side or sell-side of a deal needs to have a better-than-working knowledge of them.Earn-Out FunctionAs noted above, RIA transactions usually feature earn-out payments as a substantial portion of total consideration because so much of the seller’s value is bound up in post-closing performance. Earn-outs (i.e. contingent consideration) perform the function of incentives for the seller and insurance for the buyer, preserving upside for the former and protecting against potential losses for the latter. In investment manager transactions, earn-outs are both compensation, focusing on the performance of key individuals, and deal consideration, being allocated to the selling shareholders pro rata. And even though earn-out payments are triggered based on meeting performance metrics which are ultimately under the control of staff, they become part of overall deal consideration and frame the transaction value of the enterprise.For all of these reasons, we view contingent consideration as a hybrid instrument, combining elements of equity consideration and compensation, and binding the future expectations of buyer and seller in a contractual understanding.Earn-Out ParametersContingent consideration makes deals possible that otherwise would not be. When a seller wants twice what a buyer is willing to pay, one way to mediate that difference in expectations is to pay part of the price upfront (usually equal to the amount a buyer believes can safely be paid) and the remainder based on the post-closing performance of the business. In theory, earn-outs can simultaneously offer a buyer some downside protection in the event that the acquired business doesn’t perform as advertised, and the seller can get paid for some of the upside he or she is foregoing by giving up ownership. While there is no one set of rules for structuring an earn-out, there are a few conceptual issues that can help anchor the negotiation.Define the Continuing Business Acquired That Will be the Subject of the Earn-Out.Deciding what business’s performance is to be measured after the closing is easy enough if an RIA is being acquired by, say, a bank that doesn’t currently offer investment management services. In that case, the acquired company will likely be operated as a stand-alone enterprise with division level financial statements that make measuring performance fairly easy.If an RIA is being rolled into an existing (and similar) investment management platform, then keeping stand-alone records after the transaction closes may be difficult. Overhead allocations, staff additions and subtractions, expansion opportunities, and cross selling will all have some impact on the value of the acquired business to the acquirer. Often these issues are not foreseen or even considered until after the transaction closes. It then comes down to the personalities involved to “work it out” or be “fair.” As a friend’s father used to say: “fair is just another four-letter word.”Determine the Appropriate Period for the Earn-Out.We have seen earn-out periods (the term over which performance is measured and the contingent consideration is paid) as short as one year and as long as five years. There is no magic period that fits all situations, but a term based on specific strategic considerations like proving out a business model, defining investment performance objectives, or the decision cycle of key clients are all reasons to develop an earn-out timeframe.There is no magic period that fits all situations.The buyer wants the term to be long enough to find out what the true transferred value of the business is, and the seller (who otherwise wants to be paid as quickly as possible) may want the earn-out term to be long enough to generate the performance that will achieve the maximum payment. Generally, buyer-seller relations can become strained during an earn-out measurement period, and when it is over, no one wishes the term had been longer.We tend to discourage terms for contingent consideration lasting longer than three years. In most cases, three years is plenty to “discover” the value of the acquired firm, organize a merged enterprise, and generate a reliable stream of returns for the buyer. If the measurement period is longer than three years, the “earn-out” starts to look more like bonus compensation, or some other kind of performance incentive to generate run-rate performance at the business. Earn-outs can be interactive with compensation plans for managers at an acquired enterprise, and buyers and sellers are well-advised to consider the entirety of the financial relationship between the parties after the transaction, not just equity payments on a stand-alone basis.Determine to What Extent the Buyer Will Assist or Impede the Seller’s Performance During the Earn-Out.Was the seller attracted to the deal by guarantees of improved technology, new product options, back-office support, and marketing? Did the buyer promise the seller the chance to operate their business unit without being micromanaged after the transaction? These are all great reasons for an investment management firm to agree to be absorbed by a larger platform, and they may also help determine whether or not the acquired firm meets performance objectives required to receive contingent consideration.While bad deals can be saved by good markets, counting on overpromises is not a sound deal strategy. Instead, buyers and sellers should think through their post-close working relationships well in advance of signing a deal, deciding who works for whom, and defining the mutual obligations required to achieve shared success. If things don’t go well after the transaction – and about half the time they don’t – the first person who says “I thought you were going to…” didn’t get the appropriate commitments from his or her counterparty on the front end.Define What Performance Measurements Will Control the Earn-Out Payments.It is obvious that you will have to do this, but in our experience buyers and sellers don’t always think through the optimal strategy for measuring post-closing performance.Buyers ultimately are paying for the future profit contribution from the seller, so a measure of cash flow seems like the obvious performance metric to measure the acquired investment management operation’s success. However, there are at least two problems with using cash flow to benchmark contingent consideration.Returns from markets don’t determine long-term success nearly as much as returns from marketing.First, profitability is at the bottom of the P&L and is, therefore, (potentially) subject to manipulation. To generate a dollar of profit at an RIA, you need some measure of client AUM, market performance, a fee schedule, investment management staff, office space, marketing expense, technology and compliance, capital structure considerations, parent overhead allocations, and any number of other items, some of which may be outside of the sellers’ control. Will the sellers accuse the buyer of impeding their success? Can the factors influencing that success be sufficiently isolated and defined in an earn-out agreement? It is often more difficult than it seems.Second, much of the post-transaction profitability of the acquired business will depend on the returns of the financial markets, over which nobody has control. If a rising tide indeed lifts all boats, should the buyer be required to compensate the seller for beneficial markets? By the same token, if a deal is struck on the eve of another financial crisis, does the seller want to be held accountable for huge market dislocations? In our experience, returns from markets don’t determine long-term success nearly as much as returns from marketing. Consider structuring an earn-out based on net client AUM (assets added net of assets withdrawn), given a certain aggregate fee schedule (so business won’t be given away just to pad AUM).Name Specific Considerations That Determine Payment Terms.Is the earn-out capped at a given level of performance or does it have unlimited upside? Can it be earned cumulatively or must each measurement period stand alone? Will there be a clawback if later years underperform an initial year? Will there simply be one bullet payment if a given level of performance is reached? To what extent should the earn-out be based on “best efforts” and “good faith?”Earn-outs manage uncertainty; they don’t create certainty.Because these specific considerations are unique to a given transaction between a specific buyer and seller, there are too many to list here. Nevertheless, we have formulated a couple insights about earn-outs over the years: 1) Transaction values implied by earn-out structures are often hard to extrapolate to other transactions.  2) An earn-out can ease the concerns and fulfill the hopes of parties to a transaction about the future – but it cannot guarantee the future. Earn-outs manage uncertainty; they don’t create certainty.Above all, contingent consideration should be based on the particular needs of buyers and sellers as they pertain to the specific investment management business being transacted. There is no one-size-fits-all earn-out in any industry, much less the RIA community. If an earn-out is truly going to bridge the difference between buyer and seller expectations, then it must be designed with the specific buyer and seller in mind.Earn-Outs Are Like WarrantiesWhat happened to the Jensen Healey? Over that fall weekend in Miami, we detailed and waxed the car. My dad was able to get the crease out of the aluminum hood by reshaping it with his bare hands. It was a beautiful car and sounded great under power, but even a five-year-old British sports car in the 1970s was cause for concern, and they don’t come with warranties. My dad had lived with an old Jaguar in his 20s and didn’t mind getting grease under his fingernails, but one evening we were diving the Jensen home from dinner and it ran out of gas. The fuel gauge didn’t work; likely one of a string of problems that would lead my father to a level of buyer’s remorse that he had experienced with other cars and didn’t want to deal with again. He didn’t buy it.Like old sports cars, acquisitions don’t come with warranties, so protecting yourself against buyer’s remorse is critical. Even with escrows and punitive terms, you can’t guarantee that you’ll get what you pay for in an acquisition; but, with a properly structured earn-out, you can at least pay for what you get.

October lightweight vehicle sales had their second month in a row above 16 million, coming in at an annualized rate of 16.2 million for the month. Though this is down 0.6% from the September SAAR of 16.3 units, it is still a positive sign for the industry that sales have shown notable improvement since the start of the pandemic. As Thomas King, president of data and analytics at J.D. Power noted:“Two consecutive months of year-over-year retail sales increases demonstrates that consumer demand is showing remarkable strength. The strong sales pace is occurring despite tight inventories. The combination of strong demand and lean inventories is enabling manufacturers to reduce new-vehicle incentives and is allowing retailers to reduce the discounts they typically offer on new vehicles.”SAAR for October 2020 is off by 3% from that of October 2019. Light trucks are continuing to bolster sales, coming in at 77% of new vehicles sold in October and 76% of new vehicles sold this year.The average new vehicle turnover from lots to consumers has fallen to 49 days, the first time it has fallen below 50 days in more eight years. 20% of vehicles are being sold after being on a dealer lot for only five days or less.As we mentioned in our Q3 earnings call blog post, public auto dealers noted how vehicle demand has been outstripping supply as manufacturers struggle to get new vehicles to dealers. Among the major public dealerships, there is consensus that this inventory shortage will continue through year-end before beginning to normalize in 2021. However, tighter inventory has contributed to higher gross margins and higher selling prices. In October, these prices are expected to reach another all-time high, rising 7.3% from last year to $36,755. More expensive trucks and SUVs have been drivers of this average transaction increase.Looking toward the rest of the year, not much is anticipated to change unless there is an unexpected relief to the inventory constraints. The sales calendar for November 2020 is shorter than that of 2019 (28 days in 2020 vs. 32 in 2019), so slightly deflated SAAR is expected.Dealership Valuations Looking UpWhen considering the year that auto dealerships have experienced, an outside observer would likely assume that dealership values are down. However, more dealerships are bullish on their valuations over the next twelve months according to a Kerrigan Advisors survey of dealers. The second annual survey found that 33% of dealers expect the value of their stores to rise in the next year, up from 26% in 2019. Another 53% expect values to remain the same, while 14% think their values will be lower. This is a change from 2019 where 60% expected values to remain the same and 14% to expect a decrease. Erin Kerrigan, managing director of the firm, noted "The rebound in auto sales coupled with reduced dealership expenses and higher vehicle margins will result in record industry earnings in 2020.” As seen in the table above, Subaru, Toyota, Porsche, Honda, and Mercedes-Benz have the highest expected valuation gains. These trends are in line with Blue Sky multiple increases as well, as Subaru’s blue sky multiple has seen an increase to 5.0x – 6.0x, while dealerships such as Infiniti and Cadillac continue to be below blue sky multiple levels. Some CaveatsThough dealers being bullish on their valuations is a good sign in terms of the recovery of the industry, every dealership is different. While there are many factors that need to be considered when determining the value of a dealership, here are three that are critical, especially when considering the operating in a pandemic.LocationWhile 38% of Subaru dealerships surveyed anticipate valuation growth this year, that percentage is unlikely to be consistent across the country.When determining the value of a dealership, it’s important to consider the local economy where the dealership operates, especially considering stay-at-home orders and business restrictions stemming from the pandemic.In March and April, dealers in the northeast were harder hit by the stay-at-home orders than the dealerships elsewhere. As of today, with the virus surging across the country, looking at the impacts in each specific region is important to determining dealership values.SalesWhile many dealerships are seeing earnings growth in Q2 and Q3, what is the quality of that earnings growth and how do dealerships’ earnings compare to that of prior years?If earnings have only increased due to operation cuts, that growth should be scrutinized a bit. Cutting costs can improve the bottom line in the short run, but it may not contribute to overall company growth over the long-term. We’ve had clients remark how the Great Recession taught them just how lean they could operate. Since then it’s likely that dealers have added back some expenses but the pandemic has again forced cost cutting. The sustainability of earnings in 2020 will depend on how many of those expenses can continue to stay low and how gross profits look once inventories become less scarce.Earnings growth must also be evaluated in the context of pre-pandemic levels, not just improvement from the bottom. The recent pattern in GDP growth is a good example of this.  In Q3, GDP increased an impressive 33.1%, after having fallen 31.4% in Q2. While 33.1% is greater than 31.4%, we can see in the graph below that GDP has not fully recovered.OperationsIn an increasingly technological environment due to the pandemic, a dealership’s digital presence can contribute to their overall valuation. A dealership that has invested in their digital offerings has set themselves on a platform for growth.ConclusionThe valuation outlook for many dealerships is positive but dealerships are not created equal. The individual characteristics and performance of each dealership has to be analyzed in any valuation process.Feel free to reach out to us for more information about how current economic conditions may affect your dealership’s valuation or to discuss a specific valuation need in confidence.

Earn-outs are as common to investment management firm transactions as they are misunderstood.  Despite the relatively high level of financial sophistication among RIA buyers and sellers, and broad knowledge that substantial portions of value transacted depends on rewarding post-closing performance, contingent consideration remains a mystery to many industry participants.  Yet understanding earn-outs and the role they play in RIA deals is fundamental to understanding the value of these businesses, as well as how to represent oneself as a buyer or seller in a transaction. Contingent consideration remains a mystery to many industry participantsThis blog series is not offered as transaction advice or a legal primer on contingent consideration.  The former is unique to individual needs in particular transactions, and the latter is beyond our expertise as financial advisors to the investment management industry.  Instead, we offer these posts to explore the basic economics of contingent consideration and the role it plays in negotiating RIA transactions.Earn-Outs Are Fundamental to RIA TransactionsAs the saying goes (which has been attributed to at least a dozen famous figures): "It’s difficult to make predictions, especially about the future."  This reality is the single most difficult part of negotiating a transaction in the investment management industry.  The value of an RIA acquisition target is subject not only to a large number of variables but also a wide range of possible outcomes:Performance of financial markets (standard deviation varies)Skill of the investment management staff (difficult to measure)Sustainability of the acquired firm’s fee schedule (not as much a given as in the past)Retention of key staff at the acquired firm (absolutely necessary)Retention of key staff at the acquiring firm (absolutely necessary)Motivation of key staff (absolutely necessary)Retention of client assets (depends on third party behavior)Marketing strength of the merged enterprise (tough to predict) Without faith in the upward drift of financial markets, favorable margins in investment management, and the attractiveness of the recurring revenue model, no one would ascribe material value to an RIA.  But actually,  buying an investment management firm is making a bet on all of the above, and most people don’t have the stomach.Only by way of an earn-out can most investment management firm transactions overcome so much uncertaintyReaders of this blog understand that only by way of an earn-out can most investment management firm transactions overcome so much uncertainty.  Nevertheless, in our experience, few industry executives have more than an elementary grasp of the role contingent consideration plays in an RIA transaction, the design of an earn-out agreement, and ultimately the impact that these pay-for-performance structures have on valuation.If nothing else, earn-outs make for great stories.  Some of them go well, and others go like this.From Earn-Out to Burn-Out: ACME Private Buys Fictional FinancialOn January 1, 20xx, ACME Private Capital announces it has agreed to purchase Fictional Financial, a wealth management firm with 50 advisors and $4.0 billion in AUM.  Word gets out that ACME paid over $100 million for Fictional, including contingent consideration.  The RIA community dives into the deal, figures Fictional earns a 25% to 30% margin on a fee schedule that is close to but not quite 100 basis points of AUM, and declares that ACME paid at least 10x EBITDA.  A double-digit multiple brings other potential deals to ACME, and crowns the sellers at Fictional as “shrewd.”  Headlines are divided as to whether Fictional was “well sold” or that ACME was showing “real commitment” to the wealth management space, but either way the deal is lauded.  The rest of the investment management world assume their firm is at least as good as Fictional, so they’re probably worth 12x EBITDA.  To the outside world, everybody associated with the deal is happy.The reality is not quite so sanguine.  ACME structures the deal to pay half of the transaction value up front with the rest to be paid based on profit growth at Fictional Financial in a three year earn-out.  Disagreements after the deal closes cause a group of advisors to leave Fictional, and a market downturn further cuts into AUM.  The inherent operating leverage of an investment management firm causes profits to sink faster than revenue, and only one third of the earn-out is ultimately paid.  In the end, Fictional Financial sold for about 6.5x EBITDA, much less than what the selling partners wanted for the business.  Other potential acquisition targets are disappointed when ACME, stung with disappointment from the Fictional transaction, is not willing to offer them a double-digit multiple.  ACME thought they had a platform opportunity in Fictional, but it turns out to be more of an investment cul-de-sac.The market doesn’t realize what went wrong, and ACME doesn’t publish Fictional’s financial performance.  Ironically, the deal announcement sets the precedent for interpretation of the transaction, and industry observers and valuation analysts build an expectation that wealth management practices are worth about 10x EBITDA, because that’s what they believe ACME paid for Fictional Financial.ConclusionThis example highlights the difference in headline deal values (total consideration) and what actually gets paid after the earn-out payment.  Sometimes they’re the same but often only a portion of the contingent consideration is realized, which makes total consideration multiples difficult to interpret.  We’ll touch on this a bit more in next week’s post on transaction strategies and earn-out parameters.

One obstacle many families face when it comes to selling the family business is the potential loss of identity, culture, and jobs that such transactions often leave in their wake.  Even if it is the right time for the family to sell, there may be a reluctance to do so for fear that a sale will trigger adverse developments for the company’s employees and communities.If the family business is sold to a competitor, the buyer may elect to discontinue the company’s brand, eliminate “redundant” corporate overhead positions, or close operating facilities in a quest to achieve the cost savings that will help drive returns.Private equity buyers may not take such aggressive actions in the short-run but will look to “flip” the business to another buyer within five years or so. This “exit-driven” mentality is foreign to the sustainability focus of many family businesses and can undermine the family culture that made the business successful in the first place. A recent article by Paul Sullivan in the New York Timeshighlighted an option available to family shareholders: selling the family business to the employees.  Doing so has the potential to avoid the negative outcomes typically associated with corporate sales. As noted in the article, there are approximately 6,500 employee-owned businesses in the United States and some observers believe that number could increase in the coming years if capital gains tax rates rise under the Biden administration. Why would a family consider selling all or a portion of their family business to employees?  The article identifies three potential benefits.Benefit #1 – Selling to Employees Allows the Family Business to Remain Intact. When the family business is sold to employees, the existing management team will remain in place and the family culture will likely persist in the family business.  This is often a critical concern for family shareholders who are wary that a buyer will disregard, or potentially destroy, the legacy of the family among long-time employees and within the communities in which the family business operates.Benefit #2 – Tax Benefits for the Seller and the Company. Sellers in ESOP (employee stock ownership plan) transactions may be eligible to defer capital gains, and potentially avoid taxes that would otherwise be due.  Like all tax matters, it’s not always that straightforward, and the specific eligibility rules are beyond the scope of this post.  However, we note that many sellers do qualify for these benefits, which can materially enhance the overall economic benefit to the seller from the transaction.Following the transaction, there are tax benefits for the company as well since contributions made (and dividends paid) by the company to the ESOP are tax-deductible.  The resulting tax savings increases the company’s cash flow available for reinvestment and growth opportunities.Benefit #3 – Retirement Benefits for Employees. If the company performs well following the transaction, the contributions and dividends from the company, when coupled with growth in the value of the company’s shares, can provide retirement benefits for employees that exceed what would otherwise be available from traditional 401k or profit sharing programs. Of course, every silver lining has a cloud.  There are two primary drawbacks to ESOP transactions for family shareholders.Drawback #1 – Fair Market Value. Whether selling to a competitor or a private equity fund, such buyers may be willing and able to pay a premium price because of the cost savings or revenue synergies that they expect to achieve by implementing the types of corporate changes described at the beginning of this post.Because an ESOP doesn’t anticipate making such changes, the nominal transaction price when selling to employees – known as fair market value – may be less than a strategic or private equity buyer is willing to pay.  Depending on the circumstances, the tax benefits described above may offset this potential drawback.Drawback #2 – Regulatory Burden. Because ESOPs are qualified benefit plans, they fall under the purview of the Department of Labor.  So in any transaction with an ESOP, the DOL is a not-so-silent third party tasked with ensuring that the ESOP protects the interests of the employee participants.  Depending on the complexity of the ESOP, selling stock to employees may require a small raft of attorneys, accountants, trustees, and other advisors to ensure that the transaction and subsequent administration of the ESOP do not run afoul of DOL regulations. If your family is considering a sale of the family business, don’t overlook your employees as a potential buyer.  ESOP transactions are not right for every family but can generate benefits for a broad range of stakeholders. To discuss the fair market value of your family business and whether an ESOP transaction might be a good fit for your family, give one of our family business professionals a call.

COVID-19 adversely affected sector M&A for a couple of months when most of the U.S. was under shelter at home/safer in place orders.  However, deal activity is recovering quickly and now could be further accelerated as banks look to replace lost interest income with fee-based revenue.  An increasing number of clients on the banking side of our practice are showing interest in the wealth management space, and it’s easy to understand why.  Long-term rates hovering at historic lows have significantly impaired net interest margins, so banks are exploring other income sources to fill the void.  Wealth management is a natural place to start since so many banks already offer financial advisory services of one form or another. There are many other reasons why banks have wealth managers on their radar:Exposure to fee income that is uncorrelated to interest ratesMinimal capital requirements to grow assets under managementHigher margins and ROEs relative to traditional banking activitiesGreater degree of operating leverage – gains in profitability with management feesLargely recurring revenue with monthly or quarterly billing cyclesSticky client baseAccess to HNW/UHNW client base and opportunity to increase wallet sharePotential for cross-selling opportunities with bank’s existing trust and wealth management clients These incentives have always been there, but COVID amplified the banking industry’s need to diversify their revenue base, and RIA acquisitions are almost always immediately accretive to earnings.  The shape of the current yield curve suggests that long-term rates are likely to stay below historic norms for quite some time, dampening the outlook for bank interest income.  Acquiring an RIA or bulking up an existing wealth management practice with experienced advisors is a relatively easy way to pick up non-interest income and improve profitability.  Building-up non-interest income is also an effective hedge against a further downturn or future recessions that might require the Federal Reserve to lower rates even further. Still, there are several often overlooked deal considerations that banks and other interested parties should be apprised of prior to purchasing a wealth management firm.  We’ve outlined our top four considerations when purchasing RIAs in today’s environment:With most of the domestic equity markets back to near-peak levels, the financial commitment required to purchase a wealth management firm has likely increased in recent months, lowering the prospective ROI of an acquisition. We often see some temptation to pay a higher earnings multiple based on rule-of-thumb activity metrics (% of AUM or revenue), but we would typically advise against paying above normal multiples of ongoing EBITDA for a closely held RIA, absent significant synergies or growth prospects for the target company.Since many wealth management firms are heavily dependent upon a few staff members for key client relationships, many deals are structured as earn-outs to ensure business continuity following the transaction. These deals tend to take place over two to three years with a third to half of the total consideration paid out in the form of an earn-out based on future growth and client retention.  COVID-19’s impact on the markets and economy has elevated the demand for buyer protection, and many banks are now requiring larger earn-out components to protect themselves from future downturns or client attrition.It’s hard to know how the cultures of firms in any industry will mesh after a merger, and this side of due diligence has been most affected by COVID-19, as in-person meetings are still generally being avoided.  The culture issue is especially true for bank acquisitions of wealth management firms.  Compensation, work habits, client service expectations, and production goals can be drastically different at an RIA versus a bank, so it’s important to consider if these discrepancies could become problematic when the firms join forces.  We’ve seen culture clashes blow up deals that looked great on paper.Degree of Operational Autonomy. Wealth managers (and their clients) value independence.  Individual investors typically must consent to any significant change in ownership to retain their business following a transaction and may not be willing to do so if they feel that their advisor’s independence is compromised.  Senior managers at the target firm will likely need to be assured that the new owner will exert minimal interference on operations and strategic initiatives if key personnel are to be retained. These considerations manifest the need for an outside advisor to ensure that proper diligence is performed and the transaction makes sense from an economic perspective.  Bank boards need practical guidance on finding the right RIA at the right price and assessing cultural differences that could wreck the integration after the ink dries.  As always, we’re here to help.

Last quarter, we sat down (virtually) with Kevin Nill of Haig Partners to discuss M&A trends in the Auto Dealer Industry. He noted amidst the uncertainty, buyers and sellers were either applying pre-COVID multiples to lower earnings or lower Blue Sky multiples to pre-COVID earnings. Sluggish deal volume continued into Q2 with transactions down 16% compared to 1H 2019, but the pace is picking up.In this post, we review Haig Partners' Q2 report on trends in auto retail and their impact on dealership values. We also look at how Blue Sky multiples have rebounded after declines in Q1. While most brands saw a partial recovery, a return to pre-COVID multiples was largely reserved for brands with the highest multiples in their category (luxury, mid-line import, and domestic).The Haig report succinctly described the landscape thusly:When customers couldn’t come into showrooms, dealers responded by selling vehicles online. When inventory levels for new vehicles fell, dealers focused on used car sales and were able to hold for more gross on both new and used vehicles. While waiting for the recovery, dealers reduced advertising, personnel and floorplan expenses significantly. The pandemic forced dealers to adopt new technologies and leaner business practices sooner than they otherwise might have. The result is that most dealers have become stronger during this time of crisis, not weaker. Investors have noticed. The publicly traded franchised groups have higher values today than before COVID, and we have seen the values of private retailers rebound as well. Dealership buyers are betting that the future of auto retail is bright, even when the lift from trillions of dollars of government stimulus spending wears off.Activity Ground to a Halt, but It’s Picking Back UpAccording to Haig, about 25-30 dealerships have been bought/sold each month on average. While the pandemic curbed activity significantly from March through May, there is evidence of pent up demand. Haig indicated that of the 42 dealerships that transacted in Q2, 33 were sold in June.While transaction activity has largely come from private acquisitions as seen above, our review of public franchised auto dealer earnings calls indicates public acquisitions are likely to pick up. Public companies, such as Lithia and Asbury (with its Park Place acquisition) have increased their appetite for acquisition. In order to compete in a digital world, public franchised dealers are looking to scale their operations. Online-centric competitors such as Carvana and Vroom have experienced rapid growth in recent years, though they are used vehicle dealers and thus uninhibited by franchise agreements. In order to add scale, public franchised dealers will need to leverage their relationships with OEMs and be more pragmatic in their growth. Still, scale is anticipated to benefit these players by spreading digital innovation costs over higher revenues.Advantageous Buying Opportunities Were Somewhat Short-LivedAs we mentioned above, deal activity from March through May was paused for numerous reasons. First, having to perform the due diligence process virtually reduces the likelihood of a transaction between two parties that don’t know each other well, even if both sides were eager to press forward. Widening gaps in valuations between buyers and sellers also made sellers less likely to relinquish their assets in a spiraling economic climate at the onset of the virus. After all, for many families, their auto dealership is the principal asset on the family balance sheet, and owners were wise to hold tight to their assets in a spiraling economic climate.According to Haig, COVID caused buyers to pull offers or demand price concessions amid concerns of earnings stability. However, buyers have come back to the table in recent months as profits have been much stronger than initially anticipated. Haig estimated Blue Sky values declined about 10% from 2019 levels in Q1; this figure ended up being only about a 5% dip in Q2. Kerrigan Advisors, another preeminent investment bank in the auto dealer space, sees Blue Sky values actually up 3.3% in Q2 2020 compared to Q4 2019. We’ll discuss the rebound in valuations in depth below.While SAAR has declined, gross profits (on a per vehicle basis) have improved.We see an interesting parallel in the minds of buyers, both of vehicles and dealerships. While SAAR has declined, gross profits (on a per vehicle basis) have improved. Through July, average new vehicle gross was up 7.8% per vehicle retailed compared to 2019, while used vehicles improved 5.1%. Consumers hoped an economic disruption would create a unique buying opportunity, but a lack of new vehicle inventory and interest rate tailwinds allowed dealers to raise prices. People with the financial wherewithal to purchase a new vehicle amid skyrocketing unemployment early on in the pandemic likely got a good deal, but NADA estimates incentive spending per vehicle declined 17% from April to August.Similarly, dealership buyers that were able to successfully negotiate price concessions on transactions already in progress likely got a good deal with the surprising earnings performance. Through July, average dealer sales were down 13.6% compared to 2019, but pre-tax earnings declined only 4.6%. As noted in The Blue Sky Report for Second Quarter 2020, published by Kerrigan Advisors, average dealership profits rebounded from lows to highs in the span of two months.Deals that were scuttled, delayed, or that didn’t even get off the ground, ultimately, may have benefited the seller that chose not to sell at the April lows. And as one of our colleagues has told me during the sell-side transaction process, every day you don’t sell your business, you are effectively buying it back at its current value in the marketplace. Dealers who chose to “re-buy” their dealership in April will be glad they did.Blue Sky MultiplesIn Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple. The lone exception was Mazda whose multiples actually improved over Q4 2019. This likely has less to do with pandemic mitigation as it does with other recent troubles. While Mazda’s franchise sales fell the least (7% decline) of all the major franchises compared to 1H 2019, this may say more about 2019 performance than it does about pandemic mitigation. Its range of Blue Sky multiples has improved in each of the last two quarters, but Mazda still remains slightly below its range of 3.0x – 3.75x from Q3 2019.In Q1, virtually every brand covered in the Haig Report saw a decline in their Blue Sky multiple.Every other brand declined about a half turn of pre-tax profits in Q1 (e.g. Mercedes-Benz fell from 6.50x – 8.0x in Q4 to 6.0x – 7.50x in Q1). Fortunately, as SAAR rebounded, heightened levels of uncertainty abated, and dealers and the country at large embraced and adapted to the new normal, valuations rebounded in Q2. However, only Porsche, Toyota, Ford, and Kia rebounded fully to their Q4 multiple range. Hyundai actually saw a modest uptick on the high end to pull even with Kia at 3.0x – 3.75x compared to 3.0x – 3.50x in Q4 2019.Notably, Porsche, Toyota, and Ford have recently been the leaders of their peer group. No luxury brands besides Porsche saw a full rebound to the top end of the pre-pandemic range. After years of tracking at the exact same range, Toyota stuck its nose in front of Honda, whose range only regained half of its pandemic losses. Similarly, Ford's Blue Sky multiples have moved in lockstep with Chevrolet since Q2 2018. Pre-pandemic declines to Ford's dealer valuations allowed Chevy and FCA to pull in front in Q4 2019. Now, all three of these domestic dealers sit at a 3.0x – 4.0x Blue Sky range with Buick-GMC just slightly behind.ConclusionFortunately, while there is still uncertainty about when the economy will return to “normal,” the auto dealer industry appears to have adapted to the circumstances at hand. Valuations have rebounded as earnings have recovered, and the industry has largely avoided the doomsday scenarios prognosticated in March. Still, not many people would have predicted working from home would remain so prevalent heading into October. As Q3 wraps up, we hope dealers continue to navigate these waters as they continue to re-buy their dealership.Blue Sky multiples provide a useful way to understand the intangible value of a dealership, particularly in a transaction context for someone familiar with the auto dealer space but perhaps not the specific dealership in question. Buyers don’t determine the price they are willing to pay based on Blue Sky multiples; they analyze the dealership and determine their expectation for future earnings capacity (perhaps within the context of a pre-existing dealership where synergies may be present) as well as the risk and growth potential of said earnings stream. For dealers not yet looking to sell, Mercer Capital provides valuation services (for tax, estate, gifting, and many other purposes) that analyze these key drivers of value. We also help our dealer clients understand how their dealership may, or may not, fit within the published ranges of Blue Sky multiples. Contact a Mercer Capital professional today to get the ball rolling.

Over the past several years, the Bakken has generally had much lighter acquisition and divestiture activity than other major basins in the United States. Given that deal activity across the energy sector has dropped an immense 42.7% over the past year, acquisition and divestiture activity has dropped even further in this basin over the past year.Observed deal activity has largely been the result of Northern Oil and Gas growing its production base in the area during the past several years.Recent Transactions in the BakkenDetails of recent transactions in the Bakken, including some comparative valuation metrics, are shown below.Northern Oil and Gas Continues Core Acreage BuildoutNorthern Oil has constituted approximately two-thirds of the observed deal activity (based on disclosed deal value) in the basin, including its bolt on acquisitions in June and August 2020 for several hundred acres. This activity furthers Northern Oil’s mission of building out its core position in non-operating interests through consistent, strategic acquisitions.Although production is down across the country, wells are slowly beginning to come back online, and Northern Oil believes increasing inventory while pricing is advantageous should drive returns in the future.According to Northern COO Adam Dirlam, “We continue to add to our core inventory. Record levels of wells-in-process should drive strong volumes, and improve upon our return on capital employed metrics in 2021 and beyond.”Since the start of 2018, the company has made six large publicly announced transactions totaling more than $820 million, including its large acquisition of private equity-backed Flywheel Energy LLC in April 2019.Below is a map of Northern Oil’s acreage to show its overall footprint in the basin.[caption id="attachment_33656" align="aligncenter" width="489"]Source: Northern Oil & Gas September 2020 Investor Presentation[/caption] ConclusionThe energy industry in Q1 and Q2 2020 has seen extreme volatility that has had investors and operators alike remaining cautious and waiting to see what happens next. As a result, acquisition and divestiture activity has been put on the back burner as companies struggle to plan ahead while remaining solvent.As we have moved from the second quarter to the third quarter, fundamentals in the Bakken have steadily improved as crude oil pipeline and storage limitations were alleviated. Stabilization of WTI pricing and well differentials in the region over the past couple of months have also aided as well. Companies like Northern Oil look towards the future as demand begins to creep upward from its mid-year lows, and the company has taken advantage of lower pricing to accrete acreage to its core position.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

Is it time for your family business to make an acquisition?Growing through acquisition has a bad reputation because countless studies have shown that buyers tend to overpay for businesses.  In other words, the real winners in many corporate transactions are the sellers, not the buyers.That said, there is some evidence that acquisitions during a recession are more likely to be accretive.  A recent study by Brian Salsberg of global accounting firm EY indicates that companies making acquisitions in the depths of the 2008 financial crisis generated superior returns for shareholders than peer companies that waited until the storm passed before making acquisitions.  Not surprisingly, the study attributes the superior returns to the ability of buyers to pay bargain prices during the crisis.  Motivated sellers and fewer competing bidders tip the negotiating scales in favor of eventual buyers.  As our colleague Jeff Davis is fond of saying: “Bought right, half right.”In our experience, many family businesses are reluctant acquirers.  In addition to the fear of overpayment, family businesses are wary of the cultural challenges that can arise in the integration phase.  Since families often avoid having non-family shareholders, traditional equity financing is assumed not to be available, so if the family is debt-averse, significant acquisitions may not be financially feasible.  However, these concerns need not be absolute obstacles for your family business making an opportunistic acquisition while others sit on the sidelines to wait out the pandemic.We recommend that directors cast a wide net when evaluating potential acquisitions.  As we noted in last week’s post, directors should take this opportunity to think more broadly about the portfolio of assets owned by their family business.  Are any pieces extraneous?  Are there any pieces that are missing?  For family businesses that have hesitated to make acquisitions in the past, the missing pieces do not have to be big, nor do they have to be existing competitors.  It may be helpful to expand your list of potential acquisition opportunities to include five categories of targets (with an obvious nod to Michael Porter’s five forces framework).Competitors.  Competing firms are the most obvious acquisition candidates.  Competitors offer the opportunity both to cut costs and enhance revenue through improved pricing power.  The downside is that because the potential benefits are transparent, a competitor may be able to extract a larger purchase price.Suppliers.  All of us who have shopped in vain for toilet paper or Lysol during the past six months have a new appreciation of the importance of having a reliable supply chain for critical inputs.  Are there risks to your supply chain that can be mitigated by an acquisition?Customers.  Where does your family business sit in the value chain from raw material to the end user?  Would an acquisition of a customer allow one of your business segments to capture a greater proportion of the overall value created in your industry?Substitute Products/Services. Your family business competes against both other companies that provide the same product or service you do, and companies that offer products or services that your customers could reasonably substitute for what you offer.  Acquiring such a company can help to round out your product line/service offering and reduce the risk of your family business.Innovators.  This requires a higher degree of risk tolerance, but are there companies developing a product or service that could disrupt your business in three or five years?  If you can’t beat ‘em, you may want to buy ‘em.  While the unicorn tales populate the headlines, they are rare.   Many innovators are intrigued by the opportunity to sell now rather waiting years for a unicorn-type event that, statistically speaking, will likely never materialize.  Especially during a downturn, you may be able to reap the benefits of someone else’s development efforts at a reasonable price. Of course, it is possible to make a bad acquisition, even during an economic downturn.  Your family shareholders may not have the appetite for a “transformative” deal, but a smaller acquisition that enhances your overall portfolio may well be doable.  The main thing is to be deliberate.  Even if you are not ready to cut a check today, you and your fellow directors should be thinking about your acquisition strategy.  Call one of our experienced professionals for some outside perspective.

SAAR has continued its upward trend coming in at 14.5 million, an encouraging 11% increase from June. However, sales continue to trail pre-COVID numbers with July 2020 14% below the same time last year.With demand picking up as customers can return to brick-and-mortar locations, dealerships aren’t feeling the need to offer as strong of incentives as they did at the start of the pandemic. According to JD Power, preliminary estimates put incentive spending for the month at $4,236 per unit, down from June 2020, but up by $166 compared to July 2019.As we mentioned in our previous SAAR post, inventory problems continue to be a difficult hurdle for dealerships to contend with as demand returns. JD Power reported that 41% of all vehicles sold in July spent fewer than 20 days on dealer’s lots, up from 35% a year ago.2020 is also proving to be an interesting year for new and used vehicles, as thin margins on cheap, new vehicles have manufacturers abandoning the investment. According to data from KBB, vehicles between $20K and $30K have declined from 44% of the market share in 2015 to 22% of the market share in 2020. Cars under $20,000 make up only 1.3% of new car sales so far this year. With the average price paid for a new vehicle around $39,000, this is way above many buyers’ budgets. As a result, entry-level buyers have been looking to the used car market instead. With the used car market getting bumps from new technologies, this has proven to be a viable and cost efficient option for new buyers.Pandemic Silver Linings for Auto DealershipsWhile the reopening of the country is bringing people back to dealerships, many places still aren’t being frequented like they had been in the past. Included in this list are bars, concert halls, and public transportation means. With fewer events going on, demand for ride shares has decreased significantly according to the Q2 earnings calls (stay tuned for next week’s blog post for a full rundown on those calls).The empty subways and buses should be on the radar of dealerships and could prove to be an ultimate silver lining among all of the negatives that the Covid-19 pandemic has created for auto sales. With social distancing difficult to achieve in a closed space environment like public transportation, there seems to have been a shift in consumer sentiment in favor of car ownership.The empty subways and buses should be on the radar of dealerships and could prove to be a ultimate silver lining to the struggles caused by the pandemic.A survey released in mid-July from CarGurus tracked customers’ views around buying a vehicle, and the results were striking! 39% of people planning to buy cars are looking to avoid ride-sharing, and 44% of them say they want to decrease or stop public transit use. Furthermore, as people start returning to the office, this number could increase, with 44% of people who take public transit to work citing that this is their top concern in returning to the office.As more data has been released noting the potential risks of using public transportation, the data surrounding people’s comfort level with public transport in the current climate is understandable.  Even the government has become somewhat of a proponent of car ownership over public transportation during this time, as the CDC has encouraged companies to offer incentives for employees to use their own cars to ride to work, rather than public transportation or ride sharing.The Current State of Public Transportation and RidesharingWhen you look at the data behind public transportation usage since the pandemic began, it paints a clear picture of consumer preference during this time. Public transit ridership is measured by “unlinked passenger trips” with trips defined as whenever a person boards a transit vehicle, including transfers.Despite local governments pouring billions into public transit infrastructure, public transit ridership has been declining since at least 2014, with unlinked passenger trips falling 7.5%. The COVID-19 pandemic has escalated this decline significantly, with public transit unlinked trips dropping 85% from January to April at its lowest levels in more than a century. While this decline in usage could be attributed to overall declines in travel from stay at home orders, the graph below tells a different story. Vehicle miles did experience a decline as well, but it was strikingly smaller than that of public transit at 42%. Ridesharing services are facing a similar problem, as consumers are feeling uncomfortable sharing an enclosed space with a stranger. Uber has reported gross bookings on rides being down 75% in Q2. While Lyft declined to comment to the Washington Post on the impact of the pandemic on its business, the company has previously said its April ridership was down 75% in Q2. Recovery in this space as the country reopens has varied widely by city and state depending on which are reopening, recovering, or reimposing restrictions. For example, ridership recovery has been prominent in cities like New York that have recently been recovering after facing the brunt of Covid cases earlier this year. In San Francisco and Los Angeles, however, it has been depressed as California continues to struggle with its caseload. California’s gig worker legislation also poses an existential threat, particularly for Lyft where it derived 16% of its business. Manufacturers are encouraged by the changing sentiment surrounding car purchases, with Scott Keogh, Volkswagen’s U.S CEO noting that “We definitely do see a return to what I’ll call personal transportation and trust” and predicts a shift in consumer mindset to: “I know where this car has been; I know it’s mine.” What Increased Private Car Ownership Might Mean for the EnvironmentWith many cities having heavily invested in public transportation infrastructure, this Covid-induced fear of public transportation has many city officials nervous. New York City Mayor Bill de Blasio this past week issued statements against purchasing a car during the pandemic, as he told reporters “My advice to New Yorkers is do not buy a car. Cars are the past, the future is going to be mass transit – biking, walking – and there’s so many options right now and there’ll be more and more as we go forward.”The new guidelines by the CDC encouraging private car usage have raised concerns about what could be unbearable congestion and a surge of carbon emissions.While currently it may be safer to purchase a car to avoid unnecessary encounters with other individuals on public transit, ultimately this pandemic has an expiration date. More notable are worries that all of the efforts made to dissuade car usage for the sake of the environment could be unraveled through the emphasis on private car ownership.The new guidelines by the CDC encouraging private car usage have raised concerns about what could be unbearable congestion and a surge of carbon emissions if people turn to cars to avoid exposing themselves to the virus. University of British Columbia urban planning and public health professor Lawrence Frank notes that “promoting private vehicle use as a public health strategy is like prescribing sugar to reduce tooth decay.”However, both optimism from auto dealers on the prospect of new sales and concerns from public transportation advocates may be premature. With a vaccine predicted in 2021, consumer sentiments toward public transportation could easily revert back. Rebecca Lindland, an auto industry analyst, shares this viewpoint having seen previous trends come and go. For example, in 2008 when people started buying small fuel-efficient cars, she notes that “That only lasted two to three months, and then people went back to buying a vehicle that suited their wants and needs.” If people feel safer riding public transit with the development of COVID-19 vaccines and treatments, and parking and traffic once again become headaches, consumer preferences could shift off private car ownership.Looking ForwardWhile pandemic-related car sales stemming from public transportation avoidance may not be long-term, in the short run it could help boost dealership sales while they are trying to recover.However, many Americans are still hesitant to purchase a vehicle. This is despite a third of consumers saying they value having their own car more now than they did before Covid, and 93% were using cars more in the era of social distancing.The NADA expects new-vehicle retail sales to continue to recover for the rest of the year, while fleet sales will struggle.This hesitation stems not from opinions on transportation, but rather on the state of the economy. As unemployment remains high and there are uncertainties surrounding future government stimulus, consumers could be waiting for a more stable environment to make large purchases such as vehicles.Nonetheless, the National Auto Dealer Association expects new-vehicle retail sales to continue to recover for the rest of the year, while fleet sales will struggle.  Inventory constraints may continue to plague the industry, but barring more production shutdowns, supply should ultimately be able to reach demand levels by end of the summer further supporting SAAR’s upward trajectory.

The outlook for RIA M&A at the end of the first quarter was murky.  While we did not expect deals already in motion to be canceled, we did expect deal activity to temporarily slow.  We theorized that this slowdown could actually benefit the industry if RIA principals used the downtime to think about succession planning.  DeVoe & Company summarized similar expectations for RIA M&A in a "Four-Phase Outlook for M&A Post COVID-19" published in its Q1 RIA Deal Book:   Live transactions get completed.A lull in activity as owners respond to the COVID-19 pandemic rather than seek out new dealsA surge in activity caused by delayed deals coming to the marketReturn to normalcy where the trends of increased M&A continue with an aging ownership base and a need for succession planning So, were these expectations on track?Review of M&A in Q2 2020As anticipated, previously announced deals in the final stages of negotiations did close but new deal activity slowed some in the second quarter. According to Fidelity’s Wealth Management M&A Report, M&A activity in January and February kept pace with 2019 levels but fell off in March, April, and May. There were 24 transactions involving RIAs with over $100 million but less than $20 billion in AUM announced in Q2 2020 (and many of these deals were announced in June 2020).  Still, this represents a decline in M&A activity compared with last year, as shown in the chart below.[caption id="attachment_32836" align="aligncenter" width="675"]Source: Fidelity Wealth Management M&A Transaction Report; Complied by Mercer Capital[/caption] Interestingly, in the second quarter of 2020, independent RIAs, rather than consolidators, drove much of the deal activity.  Over the last few years, we have written about RIA consolidators time after time: Acquisition activity in the sector has been led primarily by RIA consolidators, with Focus Financial Partners, Mercer Advisors (no relation), and United Capital Financial Advisers each acquiring multiple RIAs during 2017 (January 2018)Several trends which have driven the uptick in sector M&A in recent years continued into 2018, including increasing activity by RIA aggregators (January 2019)RIA consolidators now account for about half of wealth management acquisition activity—and that percentage has been increasing (January 2020) In the second quarter, two independent RIAs—The Mather Group (TMG) and Creative Planning—accounted for approximately 21% of the total transactions announced, while consolidators accounted for only 17% of the deals. The Mather Group (an independent wealth management firm with seven offices around the U.S.) announced its sixth acquisition in the last 18 months on June 16, 2020, only one week after announcing a previous acquisition.  The acquisition of Knoxville-based Resource Advisory Services, with $116 million in AUM, will bring TMG’s AUM to over $3.9 billion.  TMG’s acquisition of Resource Advisory Services is indicative of a few M&A trends. First, in a relationship-driven business such as wealth management, the fastest way to expand a firm’s footprint is often through acquisitions.  TMG has been working to expand its footprint into the Southeast and this acquisition is a sensible addition to their recent acquisition of Atlanta-based Barnett Financial.  Additionally, this acquisition highlights a struggle many RIA owners face: a need for scale but a hesitation to partner with PE-backed firms who have a reputation for pushing growth at all costs.  Many RIA principals need a succession plan, and private equity capital isn’t always the right answer.  Resource Advisory Services’ founder David Lewis said, “I’m thrilled to partner with a next-generation founder who isn’t private-equity backed, and feel very confident TMG’s long-term vision will support my advisors into the future.” Creative Planning, based in Overland Park, Kansas, is one of the nation’s largest independent RIAs, announced three deals in the second quarter. Its most recent acquisition of Starfire Investment Advisers ($560 million AUM) was Creative Planning’s eighth deal in 2020 and its twelfth deal since it started on its acquisition spree last year.  Creative Planning organically grew its AUM to $48 billion and since February 2019, has added another $5 billion in AUM through acquisitions.  We expect to see more acquisitions from Creative Planning as it strives to reach $100 billion in AUM and become more of a household name.  While Creative Planning is a driver in the trend of consolidation, it differentiates itself from traditional RIA consolidators by acquiring 100% of target companies and integrating them into the Creative Planning brand and investment philosophy.  Additionally, while it is PE-backed, NY based General Atlantic holds a non-controlling minority share. Creative Planning’s M&A activity and investment from General Atlantic makes us ask: When does an RIA shift from being an independent wealth manager to an acquirer of independent wealth managers?  Mercer Advisors (no relation) seemed to make this transition when it first started buying RIAs in 2016.  Since then, it has acquired around 30 advisory firms and has financed its acquisition activity by selling a sizeable stake in the company to PE firm Oak Hill Capital Partners while maintaining an investment from Genstar Capital. The line between independent wealth manager and consolidator can be murky, but the trend this quarter was clear.  Established consolidators, who primarily rely on debt financing or capital from PE firms, slowed acquisition activity in the second quarter.  Dynasty Financial announced two deals in Q2, Focus Financial and Mercer Advisors each announced one deal, and Wealth Enhancement Group and HighTower Advisors did not report any deal activity in the second quarter – while strategic acquisitions by independent RIAs continued. RIA consolidators who use leverage to buy RIAs were much more vulnerable to the decline in the market at the end of March.  Most RIA consolidators have never been through a market downturn and their balance sheets may have not been as well-capitalized as needed to handle what many expected to be a few bad quarters and potentially years.   With leverage on the balance sheet, interest coverage ratios became a concern for consolidators and the downturn in March likely served as a warning for aggregators to reevaluate their balance sheets.  Most independent RIAs, on the other hand, have lived through market downturns previously and had capital built up to slug through a few bad quarters. Some even had the capital to acquire firms when competition from other buyers temporarily eased.Outlook for RIA M&AWhile RIA M&A did slow some in Q2, we don’t expect that this slowdown will continue as M&A activity picked up in June.  We have been contacted by several RIA principals who are using this time to reconsider their buy-sell agreements and their plans for their firms.  These conversations often prompt strategic discussions which can pique some firms’ interest in making acquisitions, can guide others down a path of internal succession planning as they prepare for retirement, and can serve as a wakeup call to others who are tired of dealing with the volatility inherent in many RIA practices.  We also hope that the recent downturn and lack of activity from RIA consolidators will lead buyers to proceed with more caution when partnering with leveraged consolidators.  Amid a market downturn, when RIA principals should be focused on servicing client assets, the charge to save margin to meet interest coverage ratios will trickle down to the principal of those RIAs.

Last week, we analyzed Asbury Automotive Group’s acquisition of Park Place, a deal scuttled by COVID-19 that came back to life under revised terms. This week, we are moving upstream to look at the merger between Fiat Chrysler (FCA) and Group PSA (manufacturer of Peugeot and Citroen) and observe the new name of the entity, the merits and hurdles of the ongoing deal, and some potential impacts on auto dealers.What’s in a Name?A fresh start with a new name feels reasonable.On July 15th, the name Stellantis was announced, which drew jokes from various people within the industry. The press release indicated the name comes from the Latin verb “stello," meaning to "brighten with stars.” The name will be used exclusively at the Group level, as a corporate brand, with the names and the logos of its constituent brands remaining unchanged. While the change drew some attention, we think it’s largely much ado about nothing. Sure, the press release was filled with a litany of corporate platitudes about how the name “draws inspiration from this new and ambitious alignment of storied automotive brands and strong company cultures …” but overall we think it might be more of a practical choice considering FCA-PSA doesn’t really roll off the tongue. Also considering its 18 brands on a combined basis, the sheer size of the transaction, and many previous corporate name changes, a fresh start with a new name feels reasonable.While Stellantis won’t appear on any of the cars, it’s not the only industry participant to not have one of its brands in the corporate name. GM and Daimler are the other exceptions in the industry whose names go back a lot longer. Every manufacturer besides Tesla makes cars under a brand other than the corporate name (Toyota makes Lexus, Volkswagen makes Audis, etc.).The company includes manufacturers in Detroit, Paris, Turin, Charlton, Russelsheim, and more. A full list of these brands are included in the graphic below.[caption id="attachment_32791" align="aligncenter" width="642"]*Parts manufacturer[/caption] Merits of the DealHaving exhausted the new name, let’s look at the deal. The deal was announced in October 2019, and in December, Group PSA and FCA released a joint press release highlighting:Benefits of scale in developing more sustainable, tech-savvy (including autonomous) modelsCombined company to be 4th largest global OEM by volume (8.7 million units in 2018) and 3rd largest by revenue (170 billion euros in 2018)Diversification across markets in Europe, North America, and Latin AmericaAnnual run-rate synergies of 3.7 billion euros with no plant closures50/50 merger expected to lead to investment-grade credit rating with high level of liquidity The company indicated 40% of its synergies would come from its combined technology, product, and platform. Stellantis expects another 40% of its synergies to come from sourcing its suppliers at a discounted price due to its bargaining power, or as the company called it, “enhanc[ing] its purchasing performance.” Savings on marketing, IT, G&A, and logistics round out the last 20% of anticipated savings. Mergers frequently try to cut duplicative costs and add to pricing power, both from suppliers and customers. However, since the combining legacy companies largely operate on different continents, minimal enhancements to market share are unlikely to drive higher selling prices to dealers and consumers. This could help enhance blue sky values for FCA dealers, which have lagged other brands.  Enhancements to technology and tweaks to its platform could also help improve the brands’ SSI ratings, which were generally below their respective averages in 2019.Pandemic Impact on the Deal Regulatory HurdlesThe initial press release indicated the deal was expected to take 12-15 months subject to “customary closing conditions, […] and satisfaction of anti-trust and other regulatory requirements.” While the COVID-19 pandemic was certainly not anticipated, the reasons for the deal are “stronger than ever,” according to FCA Chairman John Elkann. Last month, PSA CEO Carlos Tavares also expressed confidence that the $50 billion merger will proceed as planned, noting “the merger with FCA is the best among the solutions to cope with the crisis and its uncertainties.”The deal structure of the Stellantis merger shields it from some inherent issues in acquisitions.While many auto dealers are seeing transactions being placed on pause, the deal structure of the Stellantis merger shields it from some inherent issues in acquisitions. During the pandemic, acquirors are looking to either use a reduced Blue Sky multiple on 2019 earnings or an old multiple on reduced 2020 earnings. This has widened the bid-ask spread, as dealers don’t want to sell at depressed values. With this stock swap merger of equals (“MoE”), each side has to provide equal value to the deal, and pandemic related concerns may cancel each other out. According to Elkann, “both parties in FCA-PSA deal are committed to get parity in the merger deal.” PSA shares are set to be exchanged at a rate of 1.742 shares of the new combined company for each share contributed by FCA. However, it is possible the pandemic has disproportionate impacts on the two companies, requiring a change in the exchange ratio based on adjustments to their relative contributions.There are other issues at play besides the exchange ratio before this deal can be finalized. Both sides have already announced they no longer intend to pay their planned ordinary dividends of 2.2 billion euros for 2019 results which was included in the initial deal. While this is sensible to preserve liquidity in this environment, ordinary dividends aren’t expected to be a sticking point. It’s FCA’s 5.5 billion euros special dividend that may cause problems. According to Tavares, the “time has not come to discuss this issue,” though it is widely speculated that it could be revised downwards in light of the downturn in the global auto industry. This may be a point of contention for FCA shareholders. Peugeot shareholders were also supposed to get PSA’s 46% interest in Faurecia SE in order to help achieve a merger of equals status. This interest was worth approximately 3 billion euros at announcement when the French auto parts company’s shares traded at 50 euros. Shares have declined to about 37 euros (as of July 27th), meaning PSA’s interest is closer to about 2.2 billion euros due to the pandemic.Regulatory HurdlesHaggling between the two companies over the appropriate compensation of this interest and the special dividend isn’t the only hang-up. FCA’s Italian unit had been in talks with Rome over a 6.3 billion euro state-backed loan from Intesa Sanpaolo (Italy’s largest retail bank) to combat the coronavirus crisis. Optically, a special dividend approaching this amount did not sit well, but the loan was ultimately approved. This was the largest crisis loan to a European carmaker. The state support should “preserve and strengthen the Italian automotive supply chain,” according to Economy Minster Roberto Gaultieri. FCA’s COO for Europe said “100% of the money this facility provides will be directed to our Italian business,” though neither side indicated whether any conditions surrounding the special dividend had been imposed.Europe is expected to be the main regulatory roadblock (or maybe more of a speed bump).While the deal has received the green light in the U.S., China, Japan, and Russia, Europe is expected to be the main regulatory roadblock, though executives have categorized it as more of a speed bump.  In addition to earlier concerns in Italy about the special dividend, EU antitrust regulators began its investigation into the deal in June, citing potential to harm competition in small vans in 14 EU countries and Britain. So far, Stellantis has not offered any concessions. According to the European Commission, commercial vans are an “increasingly important market in a digital economy where private consumers rely more than ever on delivery services.” Through a joint venture, FCA and PSA already hold 34% of the van market in Europe. On July 22nd, the European Commission announced its probe had been suspended as the parties failed to provide requested information. The EU was originally supposed to offer its decision in mid-November, which has now been delayed.Will the Deal Happen?Though both sides are confident that the merger will go through as planned, there are clearly some details that will need to be tweaked throughout this process. Merger arbitrage traders usually provide a pretty good real-time view as to the likelihood of a transaction. For example, if a company is to be purchased at $50/share in cash, but shares are trading at $35, that means the market doesn’t think the deal will go through on those terms. However, the market’s view on the success of the FCA-PSA merger is nuanced. Arbitrage traders typically need to be able to short one side of the deal to execute their trade, but France has temporarily banned short-selling. Also, as an MoE, swapping stock certificates means both sides retain equity in the combined company, so share prices give different insight than an acquisition anyway. This means the share prices likely have more to do with the operating environment of the pandemic than the likelihood of the merger, though it may offer hints to what adjustments to the exchange ratio, special dividend, or Faurecia stock may be looming. Because the synergies are centered around cost-cutting measures, and regulatory hurdles don’t appear to be a deal backer, Stellantis will likely come into being if the two sides can hammer out the details.

One of my favorite memories as a kid was watching Monday Night Football.  Three things, in particular, stood out:  the iconic introduction theme music, the “Game of the Week” feeling, and the IBM: You Make the Call commercial segment.  Invariably at some point during the hotly contested game, the IBM commercial would be inserted.  The announcer would narrate a controversial play and the highlight would run to a critical juncture, only to be paused and allow for the viewer to play armchair referee and guess the outcome or “make the call.”  These commercials basically pre-dated instant replay review and the official’s ability to “go under the hood” to review the play and determine the proper outcome.With the revival and announcement of Asbury Automotive Group’s acquisition of the Park Place dealerships in Texas earlier this month, I was once again reminded of the IBM commercial.In this week's post, we review a timeline of the transaction, along with an analysis of Asbury’s stock price against the rest of its public competitors and also examine the operational strategy of Asbury over the years to explain aspects of the Park Place acquisition.As with any merger or acquisition, the true success or failure of the deal may not be known for years.  Investors and industry professionals can try and play armchair quarterback and try to predict the outcome. This blog post aims to provide ample information so that you can “make the call” on the transaction.Transaction TimelineThe original transaction was announced in December 2019 and would include 19 franchise locations, one open point, two collision centers, and an auction business all located in the Dallas and Austin markets.  Franchises included:  Mercedes-Benz, Lexus, Jaguar, Land Rover, Porsche, Volvo, Sprinter, and five ultra-luxury (Bentley, Rolls-Royce, McLaren, Maserati, and Karma).  At the date of the announced transaction, Asbury’s common stock traded at $122.67/share. On March 18, 2020, Asbury secured additional borrowings on its existing lines of credit and used vehicle floor plans.  Recall that the first two weeks of March saw COVID-19 cases and the impact of shelter-in-place orders and other economic interruptions in the United States.  At this point in the timeline, it still appeared that the transaction would continue, although Asbury’s stock price had already declined by a whopping 64% to $44.62/share. Just one short week later, Asbury terminated the Park Place transaction on March 25, 2020, citing the uncertain market conditions related to the COVID-19 pandemic.  Interestingly, Asbury’s stock had rebounded slightly from the week before to trade at $58.67/share. Earlier this month, news broke that the Asbury-Park Place transaction was moving forward again on July 6.  The auto industry had experienced some modest gains in the monthly SAARs for May and June, and this news was a shot in the arm for the auto M&A market.  As more information has been released, the revised transaction with Park Place is scaled slightly lower from the original proposed transaction in December 2019.  Terms of the revised transaction include the acquisition of 12 franchises, no open point, two collision centers, and the auction business.  Pricing terms include total consideration paid of $735 million, excluding vehicles, reflecting $685 million of Blue Sky value on $95 million of EBITDA with $20 million in run-rate synergies. As I reviewed Asbury’s Q1 earnings call from earlier in the Spring, there were hints that this transaction might have still been in the works.  At the time of the re-announcement, Asbury’s share price had increased to $78.41/share. In the two weeks following the announcement, Asbury’s share price increased by 25%.  It appears that investors are excited by the revived transaction in the short run.  We analyzed the historical trading prices of the other auto public competitors to determine how Asbury’s trends compared to the overall public auto market.  While other public competitors (Lithia Motors and Sonic Automotive) have experienced larger rebounds than Asbury, the boost provided by Asbury’s transaction announcement has exceeded the gains by any other public competitor in that short time.  It remains to be seen if investors will continue to show this level of enthusiasm in the months to come. Asbury’s Operational Strategy  In its presentation to investors and explanation for the transaction, Asbury executives cited the following objectives: 1) conscious effort to acquire more luxury franchises, and 2) move out of less desirable markets and move into more favorable markets.  Asbury management further postulated that luxury dealerships are more resilient than other franchises during market downturns, provide more stable margins, have less competition due to fewer dealers across the country, and maintain a higher portion of their gross profits from parts and service than other franchises such as import, domestic or mid-market.Let’s examine these objectives and play armchair quarterback with Asbury’s executive management.  Since a large focus of the proposed transaction centers around luxury dealerships and their performance during economic downturns, we analyzed Asbury’s franchise platform from 2008 to present day.  As much has been written in this space and in numerous industry pieces, perhaps the closest comparison to the present unstable economic conditions is the Great Recession in 2008 and 2009.Since 2008, Asbury has operated approximately 93 to 115 franchise locations in any given year.  While the overall number of franchise locations hasn’t shifted too dramatically, the shift in dealership types can definitely be viewed following the additions from the Park Place transaction.  As early as 2008, Asbury operated with only one-third of its franchises as luxury brands.  Post-Park Place, Asbury’s brand mix will now be almost 50/50 luxury vs non-luxury. In addition to the brand shift, Asbury has also vacated several markets and entered into more favorable new markets.  Specifically, Asbury has vacated Arkansas, California, and New Jersey.  In recent months, Asbury has also divested of its Mississippi locations and one of its Atlanta Nissan locations, but has made an acquisition in the Denver, Colorado market.  With the additional platform provided by the Park Place locations, Asbury’s focus will be on Florida and Texas as the two main sources of total revenue. Resiliency of Luxury BrandsIn order to test Asbury’s theories regarding the resiliency of luxury franchises against others during a downturn, we examined various financial indicators from public manufacturers’ from 2005 through 2012.  For purposes of our analysis, we categorized the following as luxury brands:  Audi AG, Bayerische Motoren Werke, Tata Motors Limited, Daimler AG, and Porsche Automobil Holding SE.  We also compiled a sample group for other dealership classifications including import, mass market, and domestic.  The results will be slightly skewed as several public companies overlap into multiple categories.  Nevertheless, we indexed and measured the performance of the luxury brands to the other dealership groups by median revenue, gross profit, earnings before tax (“EBT”) and earnings before interest, taxes, depreciation and amortization (“EBITDA”).Our study provided the following analysis of each financial metric indexed against a baseline median from 2005 data: [caption id="attachment_32683" align="alignnone" width="782"]Source: Capital IQ[/caption] For these indicators, luxury brands fared better than most other dealership groups but seemed to lag slightly behind import dealerships.  Asbury executives will be banking on similar success and performance of their luxury brands as the auto industry continues to try and recover from the turbulent economic conditions caused by the pandemic.ConclusionsSo how will Asbury perform and will the revived acquisition of the Park Place dealerships prove to be successful?  Only time will tell in the coming months and years.But for now, investors and industry professionals can hit the pause button and evaluate it just as viewers did with IBM's iconic commercials from Monday Night Football in the 1980s and “YOU MAKE THE CALL!”

After SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) rebounded in May, June’s results seem to pale in comparison. However, with SAAR coming in at just over 13 million, this is still an increase from May’s SAAR of 12.3 million, albeit a small one. Sales have continued to remain below the previous year's numbers, with June 2020 declining 20% from the same period 2019.After SAAR rebounded in May, June’s results seem to pale in comparison.Despite the country continuing to reopen, supply constraints, especially of popular pickup trucks, have been cutting into potential gains for the industry.  Rollbacks on the financing offers that dealerships had depended on at the beginning of the pandemic have also cut into vehicle sale gains.  Haig Stoddard, senior analyst for Wards Intelligence, noted that both extensive job and wage losses related to the pandemic also precipitated flat SAAR, and  that “with June 30 inventory expected to remain relatively close to May’s, total sales are not expected to get much stronger in July from June.”With no sign that sales will be returning to pre-COVID levels anytime soon, many dealerships are streamlining operating expenses to boost their bottom line. This has been especially true for advertising expenses, with dealerships reevaluating not only how much and where they spend, but whether the effort is converting to sales. Many dealership managers have cut everything from paid-search campaigns, to third party lead generators, to direct mail since March. While TV and print advertising have taken a hit, social media advertising has continued to do well.Social media ads have multiple advantages over more traditional advertising mediums. First, it allows for more targeted content as ads can be administered to demographics more likely to be interested in the product. Social media advertising is also cheaper and more transparent; it’s easier to track if someone clicks on an ad and ends up being a customer whereas it is less clear whether someone shows up to a Honda dealership because they saw an ad on TV. Although dealerships have long relied on both TV and print to advertise, the impact on advertising may be another way the COVID pandemic is pushing the industry into the 21st century.Advertising is not the only area that dealerships are cutting costs as employment issues continue to plague the industry.  Though the Paycheck Protection Program loans from the government have softened some of the blow, uncertain future revenues have kept dealerships hesitant to bring back employees. Specifically,  franchised dealers have terminated or furloughed an estimated 300,000 employees, which is more than a quarter of the industry’s workforce. This downsizing effect occurred at the onset of the pandemic and has grave implications for workers. Although sales came back in May and June, cash flow going forward is still uncertain, and the pandemic may trigger permanent changes to staffing models. Some of the biggest dealership groups across the country have already announced that thousands of their job cuts are permanent due to factors such as low vehicle sales and success of digital channels.Pandemic Production ConcernsWhile cutting costs can help boost bottom-line numbers in the short-term, dealerships are relying on manufacturing ramp-ups to provide the vehicles needed to drive sales. Even though the recent reopening of manufacturing plants reflects a glimpse of normalcy, the resurgence of pandemic cases in the United States could lead to a second shutdown. So far, production appears to be ramping up with minimal disruptions. As the New York Times notes, reopening factories will involve developing new procedures to screen workers for COVID-19 symptoms and reducing interactions between employees. Some of these new procedures include allowing time for cleaning workplaces, staggering arrival times, adding transparent barriers to assembly lines, and installing no-touch faucets and doors. Having adjusted their procedures, both Ford and G.M. are nearly back to normal with shift schedules, as ninety percent of GM’s hourly workers are back to work. With cases rising throughout the country, manufacturers are inevitably going to run into problems as the pandemic continues.However, with cases rising throughout the country, manufacturers are inevitably going to run into problems as the pandemic continues. At Ford’s truck plant in Louisville, Kentucky, around 1,300 of the plant’s roughly 8,600 workers miss work on an average day, said Todd Dunn, president of the UAW’s local at the plant.  Most of these absences have been attributed to virus-related issues such as being unable to get childcare or living with people at higher risk.  The company has been pulling workers from the third shift to cover the first two, as well as hiring hundreds of temporary workers to fill the gaps. Similarly, the GM engine factory is facing issues with its workforce, with about 8% of the employees out sick in mid-June.Worker discontent could also contribute to delayed production as some workers feel that not enough precautions are being taken.  At Fiat Chrysler’s Jefferson North plant in Detroit, employees refused to work because they believed one of their co-workers had the virus. Last month, workers at Ford factories in Michigan and Missouri questioned the automaker’s safety protocols after multiple workers tested positive for the virus. The UAW local in GM’s SUV plant in Arlington, Texas also pushed for the automaker to make temporary closures, citing the spiking COVID-19  cases in the area.Manufacturers have been hesitant to shut down again, and Fiat issued warnings after the production stoppage.  Mike Resha, Fiat Chrysler’s head of North American manufacturing, wrote in a letter on June 28 that “Unauthorized work stoppages in our facilities create both disruption, and, potentially, safety concerns, and therefore cannot be tolerated [and] will result in zero pay.” Both Ford and GM have cited the safety measures they have put into place to protect workers, and no closures are expected.If manufacturers are able to give their employees peace of mind through enhanced safety efforts, production ramp-ups should help alleviate the pent-up demand that auto dealers are experiencing as a byproduct of this pandemic. However, if these efforts are not a priority, production capabilities could suffer once again.USMCA and the Auto IndustryAs of July 1, 2020, auto manufacturers now have to contend with new regulations with the United States Mexico Canada Agreement ("USMCA") coming into effect. The USMCA was initially signed on November 30, 2018, and will serve as an updated version of the 25-year-old, trillion-dollar North American Free Trade Agreement (commonly known as “NAFTA”). Included in the updated agreement are new policies on labor and environmental standards, intellectual property protection, and digital trade provisions. It also will directly impact the automotive industry.According to IndustryWeek, while NAFTA originally required automakers to use 62.5% of North American-made parts in their cars to be imported duty-free (aka no tariffs), the new agreement gradually raises the bar to 75% by 2023. This imposed adjustment will incentivize automakers to increase the amount of North American parts they use in their cars and light trucks. Furthermore, 40 to 45% of automobile parts must be made by workers who earn at least $16 an hour by 2023.The new agreement could significantly impact the automotive supply chain by increasing production costs.The new agreement could significantly impact the automotive supply chain by increasing production costs. However, the USMCA removes the threat of a tariff fight within North America, so the tradeoff may be worthwhile. However, last-minute changes in the agreement have created confusion in the industry. Specifically, Kristen Dziczek, vice president of the Labor & Economics Group at the Center for Automotive Research in Ann Arbor, noted concerns as to how “[...] the labor value rule is going to be implemented, we found out this week.”Automakers who are currently dealing with the fallout from the pandemic and efforts to keep workers safe also have to worry about being in compliance with new regulations. To assist manufacturers during this volatile time, the federal government is providing some leeway with education and outreach efforts being a priority. If auto manufacturers incur higher costs, they will attempt to pass these onto auto dealers, who will in turn seek to pass them on to consumers in order to maintain their earnings (and valuations).Looking ForwardAll things considered, going forward, both the continued reopening of the economy and manufacturing plants working at full capacity are going to be critical to raise dealership’s flattened sales numbers. However, predicting the trajectory of the U.S. economy, let alone the trajectory of the auto sector, is extremely difficult considering the volatility exhibited during the pandemic.While May showed signs that the country may be returning to normal, the surge of cases in the U.S. in June is causing state governments to reconsider reopening plans. Another complete shutdown would be devastating for many dealerships. For auto dealerships to return to normal, it will take precautions on all ends of the supply chain, with manufacturing plants taking extra measures to keep their workers healthy, and dealerships taking extra precautions to ensure customer safety.

After SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks) rebounded in May, June’s results seem to pale in comparison. However, with SAAR coming in at just over 13 million, this is still an increase from May’s SAAR of 12.3 million, albeit a small one. Sales have continued to remain below the previous year's numbers, with June 2020 declining 20% from the same period 2019.After SAAR rebounded in May, June’s results seem to pale in comparison.Despite the country continuing to reopen, supply constraints, especially of popular pickup trucks, have been cutting into potential gains for the industry.  Rollbacks on the financing offers that dealerships had depended on at the beginning of the pandemic have also cut into vehicle sale gains.  Haig Stoddard, senior analyst for Wards Intelligence, noted that both extensive job and wage losses related to the pandemic also precipitated flat SAAR, and  that “with June 30 inventory expected to remain relatively close to May’s, total sales are not expected to get much stronger in July from June.”With no sign that sales will be returning to pre-COVID levels anytime soon, many dealerships are streamlining operating expenses to boost their bottom line. This has been especially true for advertising expenses, with dealerships reevaluating not only how much and where they spend, but whether the effort is converting to sales. Many dealership managers have cut everything from paid-search campaigns, to third party lead generators, to direct mail since March. While TV and print advertising have taken a hit, social media advertising has continued to do well.Social media ads have multiple advantages over more traditional advertising mediums. First, it allows for more targeted content as ads can be administered to demographics more likely to be interested in the product. Social media advertising is also cheaper and more transparent; it’s easier to track if someone clicks on an ad and ends up being a customer whereas it is less clear whether someone shows up to a Honda dealership because they saw an ad on TV. Although dealerships have long relied on both TV and print to advertise, the impact on advertising may be another way the COVID pandemic is pushing the industry into the 21st century.Advertising is not the only area that dealerships are cutting costs as employment issues continue to plague the industry.  Though the Paycheck Protection Program loans from the government have softened some of the blow, uncertain future revenues have kept dealerships hesitant to bring back employees. Specifically,  franchised dealers have terminated or furloughed an estimated 300,000 employees, which is more than a quarter of the industry’s workforce. This downsizing effect occurred at the onset of the pandemic and has grave implications for workers. Although sales came back in May and June, cash flow going forward is still uncertain, and the pandemic may trigger permanent changes to staffing models. Some of the biggest dealership groups across the country have already announced that thousands of their job cuts are permanent due to factors such as low vehicle sales and success of digital channels.Pandemic Production ConcernsWhile cutting costs can help boost bottom-line numbers in the short-term, dealerships are relying on manufacturing ramp-ups to provide the vehicles needed to drive sales. Even though the recent reopening of manufacturing plants reflects a glimpse of normalcy, the resurgence of pandemic cases in the United States could lead to a second shutdown. So far, production appears to be ramping up with minimal disruptions. As the New York Times notes, reopening factories will involve developing new procedures to screen workers for COVID-19 symptoms and reducing interactions between employees. Some of these new procedures include allowing time for cleaning workplaces, staggering arrival times, adding transparent barriers to assembly lines, and installing no-touch faucets and doors. Having adjusted their procedures, both Ford and G.M. are nearly back to normal with shift schedules, as ninety percent of GM’s hourly workers are back to work. With cases rising throughout the country, manufacturers are inevitably going to run into problems as the pandemic continues.However, with cases rising throughout the country, manufacturers are inevitably going to run into problems as the pandemic continues. At Ford’s truck plant in Louisville, Kentucky, around 1,300 of the plant’s roughly 8,600 workers miss work on an average day, said Todd Dunn, president of the UAW’s local at the plant.  Most of these absences have been attributed to virus-related issues such as being unable to get childcare or living with people at higher risk.  The company has been pulling workers from the third shift to cover the first two, as well as hiring hundreds of temporary workers to fill the gaps. Similarly, the GM engine factory is facing issues with its workforce, with about 8% of the employees out sick in mid-June.Worker discontent could also contribute to delayed production as some workers feel that not enough precautions are being taken.  At Fiat Chrysler’s Jefferson North plant in Detroit, employees refused to work because they believed one of their co-workers had the virus. Last month, workers at Ford factories in Michigan and Missouri questioned the automaker’s safety protocols after multiple workers tested positive for the virus. The UAW local in GM’s SUV plant in Arlington, Texas also pushed for the automaker to make temporary closures, citing the spiking COVID-19  cases in the area.Manufacturers have been hesitant to shut down again, and Fiat issued warnings after the production stoppage.  Mike Resha, Fiat Chrysler’s head of North American manufacturing, wrote in a letter on June 28 that “Unauthorized work stoppages in our facilities create both disruption, and, potentially, safety concerns, and therefore cannot be tolerated [and] will result in zero pay.” Both Ford and GM have cited the safety measures they have put into place to protect workers, and no closures are expected.If manufacturers are able to give their employees peace of mind through enhanced safety efforts, production ramp-ups should help alleviate the pent-up demand that auto dealers are experiencing as a byproduct of this pandemic. However, if these efforts are not a priority, production capabilities could suffer once again.USMCA and the Auto IndustryAs of July 1, 2020, auto manufacturers now have to contend with new regulations with the United States Mexico Canada Agreement ("USMCA") coming into effect. The USMCA was initially signed on November 30, 2018, and will serve as an updated version of the 25-year-old, trillion-dollar North American Free Trade Agreement (commonly known as “NAFTA”). Included in the updated agreement are new policies on labor and environmental standards, intellectual property protection, and digital trade provisions. It also will directly impact the automotive industry.According to IndustryWeek, while NAFTA originally required automakers to use 62.5% of North American-made parts in their cars to be imported duty-free (aka no tariffs), the new agreement gradually raises the bar to 75% by 2023. This imposed adjustment will incentivize automakers to increase the amount of North American parts they use in their cars and light trucks. Furthermore, 40 to 45% of automobile parts must be made by workers who earn at least $16 an hour by 2023.The new agreement could significantly impact the automotive supply chain by increasing production costs.The new agreement could significantly impact the automotive supply chain by increasing production costs. However, the USMCA removes the threat of a tariff fight within North America, so the tradeoff may be worthwhile. However, last-minute changes in the agreement have created confusion in the industry. Specifically, Kristen Dziczek, vice president of the Labor & Economics Group at the Center for Automotive Research in Ann Arbor, noted concerns as to how “[...] the labor value rule is going to be implemented, we found out this week.”Automakers who are currently dealing with the fallout from the pandemic and efforts to keep workers safe also have to worry about being in compliance with new regulations. To assist manufacturers during this volatile time, the federal government is providing some leeway with education and outreach efforts being a priority. If auto manufacturers incur higher costs, they will attempt to pass these onto auto dealers, who will in turn seek to pass them on to consumers in order to maintain their earnings (and valuations).Looking ForwardAll things considered, going forward, both the continued reopening of the economy and manufacturing plants working at full capacity are going to be critical to raise dealership’s flattened sales numbers. However, predicting the trajectory of the U.S. economy, let alone the trajectory of the auto sector, is extremely difficult considering the volatility exhibited during the pandemic.While May showed signs that the country may be returning to normal, the surge of cases in the U.S. in June is causing state governments to reconsider reopening plans. Another complete shutdown would be devastating for many dealerships. For auto dealerships to return to normal, it will take precautions on all ends of the supply chain, with manufacturing plants taking extra measures to keep their workers healthy, and dealerships taking extra precautions to ensure customer safety.

Transaction activity in the Permian Basin, and frankly elsewhere as well, is in a unique, and potentially critical situation as companies are facing unpredictable consequences and uncertain futures.A table detailing E&P transaction activity in the Permian over the last twelve months is shown below.  Relative to 2018-2019, deal count decreased by ten and median deal size declined by roughly $60 million year-over-year.  Although this table looks busy with a number of deals, the transactions that occurred before March are most likely not indicative of the road ahead.  Industry participants are much more concerned with deals that have been announced following the dramatic fall in oil price due to COVID-19 and the Russian-Saudi price war, which in this case was determined to be after March 1, 2020.  Looking at the table, only four deals have been announced post-March.  Although the sample is small, they could be the best indication of what is to come, assuming prices remain depressed.Black Stone Minerals Letting Go of Core Permian AcreageIn early June, Black Stone Minerals announced that they were selling a total of $155 million of royalty interest assets in two separate transactions to strengthen their balance sheet and liquidity position.  This appeared to be core acreage in the Permian as the price per flowing barrel was a premium compared to average private transactions of $40,000 per flowing barrel in March and April.  The deal with Pegasus Resources included a 57% undivided interest across parts of the company’s Delaware Basin position and a 32% undivided interest across parts of the company’s Midland Basin position.  Black Stone noted that proceeds from the sale will be used to reduce the balance outstanding on the company’s revolving credit facility.  Black Stone expects its total debt levels to be under $200 million after closing the two transactions.HighPeak Energy & Pure Acquisition Combine Forces After Early ComplicationsPure Acquisition, a blank-check company, announced in early May that it was acquiring Howard county focused HighPeak Energy in a deal worth $845 million.  The original deal, which was terminated due to the crash in oil prices and market uncertainty, included a three-way merger agreement with private-equity-backed Grenadier Energy Partners.  The new business combination between HighPeak Energy and Pure Acquisition will hold a pure-play 51,000-net-acre position in the northern Midland Basin.  Jack Hightower, HighPeak Energy’s Chairman and CEO, commented, “With the decline of energy prices over the last few months, several energy companies are struggling.  However, due to our low drilling and completion costs and our low operating costs, our breakeven prices are much lower than our competitors which enables us to operate profitably at lower price levels.”  Time will tell whether the merger will be able to capitalize.  The transaction is expected to close in the third quarter of 2020, with the combined company trading on the NASDAQ.Ring Energy Taking a Conservative Approach Moving ForwardIn mid-April, Ring Energy agreed to sell its Delaware Basin asset located in Culberson and Reeves Counties, Texas for $31.5 million to an undisclosed buyer.  The asset included a 20,000 net-acre position with current production of 908 boepd (63% oil) at the time of the deal.  Kelly Hoffman, CEO of Ring Energy stated, “The proceeds from this transaction will be used to reduce the current balance on the company’s senior credit facility.  The current environment mandates a cautious, conservative approach going forward, and strengthening our balance sheet is a step in the right direction.”  Ring Energy continues to hold positions in the Permian and Ventral Basin Platform and the Northwest Shelf.  The company recently completed a redetermination of its senior credit facility and expects the transaction to close before the end of July.ConclusionM&A transaction activity in the Permian was skewed, in terms of deal count, as most activity during the last twelve months occurred in the second half of 2019.  Deal motives moving forward will be interesting to monitor as companies may be forced to let go of premium acreage, notably in the Permian Basin, to improve their liquidity positions.  It does not appear to be a seller’s market, as sellers realize the intrinsic value associated with acreage.  If companies have the luxury and are not forced to sell, they seem to be holding on tight searching for the light at the end of the tunnel.

For this week’s blog post, we sat down with Kevin Nill of Haig Partners to discuss trends in the auto dealer industry and the recent release of their First Quarter 2020 Haig Report.  Haig Partners is a leading investment banking firm that focuses on buy/sell transactions in the auto dealer industry, along with other transportation segments.  As readers in this space are familiar, Haig Partners also publishes Blue Sky multiples for each of the auto manufacturers based on their observations and data from participating in transactions in this industry.It’s still early on, but how does the economic disruption due to COVID-19 compare to the Great Recession in 2008/2009 on the auto dealer industry?KN: 2008 provided a great recipe for how to manage dealerships in a time of financial stress.  But COVID-19 hit so quickly and with unprecedented shutdowns and associated reductions in sales volume and service revenue.  The financial disruption was far more harsh in 2020 but there were some tailwinds that dealers didn’t have during the Great Recession.  For example, almost 100% of lenders offered interest, principal and curtailment deferments immediately.  PPP funds were available to most dealers and provided some necessary working capital.  Interest rates were lowered to almost 0% immediately.  And most OEMs got aggressive quickly with 0% deals for 72 and 84 months. SW: As Kevin alludes to, the biggest difference between 2008 and 2020 in navigating these troubling times is the assistance from OEMs. Industry bailouts were widely debated, and these manufacturers have been conscientious about being part of the solution this time around.What impact has the COVID-19 pandemic had on a) Blue Sky multiples, b) deal flow, and c) overall dealership value?KN: The pandemic has clearly impacted dealership operating performance and instilled some uncertainty around future earnings for the remainder of 2020 and even into 2021.  In general, valuations have tended to recede approximately 10% but there are some dealerships that continue to attract pre-COVID 19 value due to franchise attractiveness and/or geographic demand.  Buyers appear to be taking 2 different approaches – 1) they are utilizing 2019 and pre-COVID 19 2020 YTD results (i.e. historic performance) and then applying a slightly lower historic multiple to arrive at a moderately discounted value; or 2) they are utilizing unadjusted pre-COVID 19 multiples but against a forecasted 2020 and 21 earnings base that reflects a slightly lower expectation for income.  Either way, it typically works out to about a 10% lower valuation.  But again, some stores remain as or more valuable than before the pandemic. New transaction deal flow has been impacted in the short term simply because potential sellers have been fully engaged and focused internally on operating their dealerships during an unprecedented period of stress.  They’ve been working on getting their PPP money, furloughing and rehiring associates, building a process to sell and deliver vehicles remotely, managing inventory, etc.  We expect when the proverbial dust settles, there will be some motivated sellers who have experienced the Great Recession of 2008 and now the pandemic and will raise their hands and say enough’s enough.  Additionally, the pandemic has further set in motion the need to have scale to compete in the new digital age of automotive retailing and some owners are recognizing it’s time to get big or get out. SW: Our valuation approach considers a broader analysis of historical earnings to estimate ongoing earnings.  We are cautious not to overvalue a dealership in its best year or undervalue a dealership in its worst year if neither are sustainable.  Typically, forecasted earnings approaches were only utilized on start-up locations or early-stage dealerships where historical financials could not be produced.  The economic impacts of the pandemic to the current year’s earnings will present a challenge to all valuation professionals.  As to the impact of the pandemic on dealership valuations, we think it is relative to each individual dealership and their unique set of factors.Has any segment/classification of franchise (luxury, domestic, import, high-line) type been hit harder with regards to the impact of their implied Blue Sky multiples than others?KN: Higher value dealerships – luxury, very large dealerships or very high performing dealerships might experience moderately lower interest in the near term.  This is strictly a function of capital availability as we wonder how many lenders are prepared to extend large amounts of credit on an expensive dealership.  These types of stores generally have less risk and yield attractive valuations and will still be in demand but it may take several months of normalcy before buyers and lenders are ready to step up for an expensive BMW or Mercedes-Benz dealership as an example.Have you seen different effects on value in different areas of the country?  If so, what are those differences?KN: The quantity and severity of COVID-19 cases and the related state shutdowns is partially correlated to valuations and demand for dealerships.  Businesses in the northeast and California, where the pandemic hit hard and governors reacted with severe operating restrictions, have suffered far more than dealerships in the southeast and TX.  The latter areas were able to operate, albeit with some restrictions, and sell and service vehicles more effectively.  As a result, we’ve spoken with a number of dealers who’ve enjoyed record performance in May as states reopened and consumers took advantage of good weather, stimulus checks, and big OEM incentives. SW: In our discussions with clients, the severity of the impact on operations/earnings is also widespread.  In addition to the pockets of the country mentioned by Kevin, we have noted dealers in Arkansas and Utah seem to have suffered less than other areas.Are there buying opportunities for larger auto groups, public companies, and those poised to be in the auto dealer market for the long-term?KN: Auto retail remains a highly attractive investment despite the inherent cyclicality of the industry.  Dealerships can be very profitable and generate significant cash, further supplemented by the offshore and captive insurance companies many owners operate.  Public companies, outside investment groups including PEFOs (private equity and family office investors), and well-capitalized private dealers have access to low-cost capital and are able to enjoy significant operational synergies.  As the industry continues to consolidate and as the need for technical proficiency to master and innovate within the digital retailing sphere accelerates, buyers are going to continue to find opportunities to invest with strong returns.What is the profile of buyers and sellers that you’re seeing on current M&A deals?KN: For sure, a majority of buyers, particularly for the more attractive and valuable dealership assets are the consolidators, both private and public.  They are pursuing opportunities to broaden their geographic footprint and franchise representation.  Growth becomes a way to leverage both their cost structure over more stores but also to take market share through their improved processes, customer acquisition and retention strategies, and digital strength. Of course, smaller stores remain attractive to local buyers who want to expand their portfolio in their “backyard” or extend into nearby markets. Lastly, outside investor capital or PEFOs are again evaluating opportunities in this sector as they believe stores have some newfound upside with the recent reductions in performance. SW: Family office investors tend to have longer-term investment horizons than public/private consolidators.  Additionally, family office investors present additional challenges as they often require more education, due diligence, and they also must bring a dealer principal/operator to the transaction or retain an existing person from the acquired company to assume this role. Once such a person is in the fold, bolt-on acquisitions become smoother and a platform can be created.What are your predictions for the auto M&A market for the remainder of 2020 and 2021?KN: We think 2Q 20 will again be slow as deals that were “inked” before or right at the beginning of the pandemic have been slow-walked to allow time for stability to return to operations.  However, judging by the strong progress within our pipeline and conversations with other dealers and professional service providers, the back half of 2020 and 2021 should see some pretty strong transaction volume.  Further, we anticipate some dealers will re-evaluate their future once they’ve had the chance to catch their breath from the shutdown and restart of business.  This could include a full exit or a partial disposition of certain stores either to raise capital or eliminate some problem stores.What impact has the pandemic had on digital retailing vs. facilities/image requirements?KN: The concept of executing the purchase of a vehicle remotely had begun to gain some smaller degrees of traction before the start of the pandemic.  However, a fully digital solution has received far more interest since consumers were forced or chose to transact as much of the vehicle purchase over their phone, tablet, or computer during the shutdown.  Even home delivery has ramped up for both sales and service.   Various surveys seem to indicate a digital end to end solution is becoming more desirable but a vast majority of consumers still want to come to the dealership for a test drive and thus complete the sale on site. We see those dealerships and groups who have the capital and sufficient intellectual horsepower to invest in digital solutions to be the winners over time.  This is one more reason consolidation will continue. We are also hearing that OEMs are recognizing this trend and may soften their stance around upgrades of facilities, larger buildings, more acreage, etc.  It’s a tough balance for dealers to have the best online solution and also invest millions of dollars to have the most extravagant and new building when fewer customers want to come to the store for both sales and service. SW: We tend to agree that these improvements appear to be declining as a value driver. We expect there to be more pressing needs for capital than facility upgrades, both from acquirors and dealer principals. These funds will go to consolidation efforts and shoring up finances coming out of the pandemic.What impact will the bankrupt rental car companies have on mitigating the sluggish used vehicle supply market?KN: It appears the bankruptcies of a couple of the large rental companies will restructure debt and equity, not necessarily eliminate operations.  It allows the weaker operators time to weather the storm until rental activity ramps up.  However, if the recovery goes slowly and business and vacation travel doesn’t pick up, you could see some permanent reductions in rental volume.  That could impact nearly new used vehicles from supply in the coming years which are good sources of inventory for dealers and generally produce strong gross margins. What effect will the slowing down of new vehicle production supply from factory shutdowns have on auto dealer valuations and M&A activity? We believe tight inventories will be a short-term disruption that gets resolved over the next few months as production returns to normal.  If you couple a big ramp up in production with lower new volume sales, dealer lots should get back to a steady state inventory level well before most current and any new transactions close. SW: Near-term supply will continue to remain a question as manufacturers cope with COVID outbreaks and the need to shut plants down for a day to sanitize. The stop-start nature may play a significant role in how quickly supply can ramp up.Do you anticipate that we will see a V, U, W-shaped recovery, or something else?KN: We are by no means economists and read the same data you and your clients see around the recovery expectations.  It seems the consensus lies in the U or W recovery as it’s highly unlikely we immediately return to the low levels of unemployment pre COVID-19.  Regrettably, too many businesses won’t reopen and certain industries that are large employers will be slow to recover.  Think hospitality, transportation, entertainment, energy, etc.  The near term improvement will occur far more quickly than the Great Recession comeback but it’s probably wishful thinking to believe we bounce back to past levels in just a couple of months.  The good news is we have low rates, stimulus, OEM incentives and a strong banking sector to accelerate growth this time around. We thank Kevin Nill and Haig Partners for their interesting perspectives on the auto dealer industry.  Industry participants are cautiously optimistic that retail sales, earnings performance and deal flow are trending in the right direction, but not without additional challenges.  To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to one of the professionals at Mercer Capital.

May ReopeningsMay brought some hope of a return to normalcy with most states easing lockdown restrictions and stay-at-home orders. With this easing of orders, businesses were optimistic that their economic struggles may be alleviated as their customers could finally return. However, the effects of shutting down an entire global economy do not go away as soon as lockdowns end with major supply chain disruptions contributing to bottlenecking and inconsistent inventories. This issue will be prevalent across many industries and auto dealers won't be exempt. The industry will be impacted by manufacturing slowdown problems.May SAAR UpdateAfter a devastating April SAAR (a measure of Light-Weight Vehicle Sales: Auto and Light Trucks), predictions for a rebound in May proved to be correct. Vehicle sales in the month jumped with SAAR increasing 38.6% to 12.2 million. Though this was a 29.7% decline from May 2019, the uptick from April and March numbers point to a recovery. Dealers are hopeful that April was the lowest the SAAR would reach, and with this new data, feel greater confidence in their predictions.May vehicle sales jumped with SAAR increasing 38.6% to 12.2 million.As we mentioned in our April SAAR post, many of these sales reflected dealers embracing online technologies and incentive programs to get cars out the door. Recently released data for May from Edmunds.com showed that the annual percentage rate (APR) on new financed vehicles averaged 4% last month. This was a drop compared to the April average of 4.3%. More strikingly, however, was the difference from the year-ago average of 6.1%. May’s 4% rate is the lowest average interest rate since August 2013.While auto dealers were able to use different methods to increase sales, factories that supply auto parts and cars did not have such flexibility.  The reopening of plants for General Motors, Ford Motor, in mid-May came after an almost 2-month production hiatus. Furthermore, though plants have begun reopening, they are not running at full capacity. Jamie Butters, Chief Content Officer of Automotive News, noted that disruptions in both Mexico and the U.S. manufacturing industries from the virus and social distancing measures threatens to cut the flow of vehicles and vehicle parts. According to a report from industry research firm LMC Automotive, fewer than 9 million vehicles are expected to be produced in 2020, the lowest since 2011 when an earthquake in Japan disrupted the global supply chain. If volumes are going to snap back like some have forecast, this will either require a pivot to used vehicles, or an increase in the expectations for vehicle production.Dealership Inventory HeadwindsEven if auto dealers wanted to reopen their dealerships at 100% capacity, they need the pipeline of inventory to do so. Dealers who liquidated inventory (sometimes at fire sale prices) may have trouble sourcing popular models if production can’t ramp back up quickly enough. As the Lansing State Journal notes, “Every vehicle that is sold is a catch-22 for the industry. Every sale depleted inventory but with manufacturing all but frozen those inventories could not be replenished.”According to data from the BEA, April saw an inventory-to-sales ratio of 3.6, its highest level since February 2009.  This likely says more about severely depressed sales than any excess in inventory. Prior to the pandemic, this ratio was actually below 2.0 for four consecutive months, a figure that has only occurred twelve times since 2000.  Although BEA data for May inventory has not been released yet, according to Motor Intelligence, new-vehicle U.S. inventory fell 32% in May, to about 2.6 million, the lowest in recent years.  Among the vehicles in the shortest supply are large pickup trucks.  In a research note Monday, Barclays warned of a “critical risk of supply shortages” of large pickups, estimating dealers had only 44 days of inventory before running out of models such as the Ford F-150 and GM’s Chevrolet Silverado. The truck stock is half of what it was earlier in the year.Barclays isn’t the only bank focused on inventory. John Murphy of Bank of America asked all of the public auto dealers about the potential for short inventory in the summer months, and many acknowledged the potential for shortages.  Below are some select quotes regarding the topic from the earnings call:“At the end of March, our total new vehicle inventory was $861 million, and our day supply was 105, up 18 days from the prior year. In April, we were able to drop our new car inventory approximately $120 million from March 2020. While these levels may seem high, because the OEM factories have been shut down, we believe we could run into a low day supply for the summer selling season. […] in some of our luxury and some of our domestic specifically, we could run into a lower day supply of some of the models.” –Dan Clara, SVP Operations Asbury Automotive Group“But I think we're going to have a big issue on incoming inventory from all the manufacturers. You've seen the German manufacturers starting and then stopping from the standpoint of a new production. I know from Daimler's perspective in Mexico. They pushed off heavy duty trucks like two months. It's not the fact that they don't want to open or not meeting the protocols in the plant is the fact that the supplier base -- in the old days, maybe back in '08 and '09 at least OEMs are more vertical from the standpoint of the supplier their parts for their vehicles. That's not the case today. So, they have to rely on many, many suppliers and I think that's going to be key.”  – Roger PenskeRental Company DeclineRental car bankruptcies could result in a high number of used cars diluting an already crowded used car market.A decline in the rental car industry may compound the problem.  In late May, Hertz and the parent company of Advantage Rent A Car filed Chapter 11 bankruptcy due to debt and global travel being wiped out from the COVID-19 pandemic. New vehicle sales to rental car companies accounted for about 10% or 1.7 million vehicles last year. That demand came to a screeching halt due to the COVID-19 pandemic, and some analysts expect no more than 250,000 such sales in 2020.  While the disruption in the rental car industry most directly impacts automakers, used car dealerships could find themselves in trouble as well. With downsizing expected among restructuring efforts, the rental car bankruptcies could result in a high number of used cars diluting an already crowded used car market and impacting overall used car prices. Although this may mean a good deal on a vehicle purchase for consumers, trade-in values would decrease and lower values could damage auto brands and impact newer model pricing.Despite the prospects of inventory shortages and used vehicle surpluses later in the summer, as long as there is not another major disruption to the supply chain and travel, these issues may not be long lasting. As Chris Holzshu of Lithia Motors noted in their earnings call, “Once the ramp up starts, it takes about 30 days for a vehicle to get completed on the production line and make it to one of our stores.” Though a month of disruption is not ideal, it can be managed. Dealers will hope to get through short supply by nudging customers towards less in-demand models. As travel picks up in the future, rental car companies can expect to see increased activity and thus, less saturation of the used car market.ConclusionWhile the rest of the country began to try to start fresh after months indoors, I decided that I needed a change in my own household as well in the form of an Australian Shepherd puppy. As you can see, Bobby loves Mercer Capital and the auto dealer industry team just as much as I do. We follow SAAR and other key industry trends to gain insight into the private dealership market. To discuss how recent industry trends may affect your dealership’s valuation, feel free to reach out to us.

April SAAR UpdateLast month, we mentioned the troubles that the auto industry is experiencing were most likely going to get worse before they got better considering the increases in COVID-19 cases and stay-at-home orders.  April was always going to be the low point with the first part of March largely unimpacted, and cities and states now beginning to ease restrictions in May. SAAR (a measure of Light-Weight Vehicle Sales: Autos and Light Trucks) declined to 8.8 million units in April, its lowest level since the data started being recorded in 1976. This was a 47.6% drop compared to April 2019, and seasonally adjusted sales volumes were 24.5% below March, which was already 32.2% below February.SAAR declined to 8.8 million units in April, its lowest level since the data started being recorded in 1976.It is important to note that while overall volumes fell precipitously, the impact was felt differently throughout the country due to differences in state and local laws and responses to the pandemic.  NADA noted that states with fewer restrictions on selling vehicles outperformed markets where restrictions were more stringent. Dealerships in the Northeast and West most likely felt stronger effects than those in the South or Plains.  With no statewide stay-at-home orders in place in April for Arkansas, Iowa, Nebraska, North Dakota, South Dakota, Utah, or Wyoming, dealerships in these states may have not felt the same pain as their counterparts in breakout areas such as New York and New Jersey.Another factor contributing to dealership performance in April was the allowance of online car sales. Pennsylvania went from mid-March to April 20th without vehicle sales as a law had to be passed to allow for remote notarization to facilitate online sales with contactless delivery.  Kentucky and Hawaii were also among the last states to ease online restrictions.  Online sales during this pandemic have been important in keeping numbers up, though the transition was not seamless which likely had a negative effect on April volumes towards the beginning of the month.Financing Deals Supporting April SalesDespite the grim numbers, dealerships and experts remain optimistic about the industry during this time.  One important reason for this is that although volumes declined throughout the country, dealerships managed to surpass expectations based on the impact on the Chinese auto market.  During February, at the peak of coronavirus in China, Chinese automakers experienced almost an 80% drop.  With less than a 50% decline, dealers in America are faring better than expected.  How did the U.S. manage to avoid China's fate? A lot of it comes down to financing and incentives.While April sales decreased, zero-percent financing deals hit a record last month. More than one in every four new vehicles sold in April featured 0% financing, up from about 5% of new cars in March. Furthermore, lenders are offering loans for both new and used vehicles that allow borrowers to delay making payments for up to 4 months.  With the Fed’s cuts putting downward pressure on interest rates, 0% financing is not as costly for dealerships as it might have been under normal conditions.  A caveat to this is that some dealers are avoiding long-term 0% financing as it can be harmful to resale values and thus, risky for car buyers. Bob Carter, Executive Vice President for Sales at Toyota Motor’s North American unit said, “We’re not into zero-for-84 months. It’s not only not healthy for the industry, but also for the consumer.” Prevalence of 0% financing has certainly increased, though likely only for certain qualified buyers with good credit.Cost Effectiveness of 0% Interest Rate DealsWith so many dealers delaying payments or offering 0% financing, we were curious to see the impact these would have on profits.  To do this, we used a present value calculation with certain assumptions to see the effects of 0% financing.  Basic assumptions include:60-month loanNational average interest rate of 5.27%Average vehicle price for April 2020 from Kelley Blue Book of $38,060Depreciation cost of $100/day We assumed a depreciation cost associated with the vehicle sitting on the lot.  Although determining a depreciation cost per day isn’t an exact science, we based this on the Sonic Automotive Earning Call, where Jeff Dyke, President of Sonic Automotive, equated sitting on inventory like a “banana rotting every day, $50, $100, $175 a day, whatever the number is, it’s rotting every day. If you’re sitting on it, you’re just creating a big bubble, and you’re going to have to pay for it at some point.”  For illustrative purposes, we settled on a $100 a day depreciation cost. The following charts show a summary of the results from three present value calculations. As seen above, delaying payments by two months only reduces the present value of the loan from $38,174 to $37,848, or about $325. This represents less than 1% of the value of the car, and these terms would likely appeal to furloughed consumers who expect to be rehired between the purchase and the beginning of payments. If instead, the dealer offers 0% financing for the life of the loan, the present value of payments received drops to $33,494.  That is a $4,680 difference between 0% financing and a 5.27% interest rate. While offering a 0% loan would not come from a bank, captive lending arms may find the F&I loss is worth the vehicle sale. These calculations illustrate that dealerships would be indifferent between selling a car today with 0% financing or waiting about 47 days to sell a car financed at 5.27%. Implicit in our depreciation assumption is that price concessions would likely have to be made to move the inventory. Additionally, every day a car sits on the lot costs dealerships on floorplan interest costs. It may be more comfortable for some to wait things out instead of accepting an upfront loss on F&I, but these calculations demonstrate that there are also costs to waiting, even if they are not as upfront. May SAAR ExpectationsThe outlook for the industry and the economy as a whole is steadily improving.Looking forward, expectations are high for a rebound in May.  Sonic Automotive has said that the second quarter will be “the worst in our history” but believes declines due to the coronavirus pandemic bottomed out in early April, and the summer will bring a return to pre-virus levels.  Lithia Motors CEO Bryan DeBoer has a similar stance, saying in their Q1 earnings call that, “I would say in vehicle sales, there's no chance that it will trough again unless there's a relapse or something in COVID-19 and the states get more strict because we’re already seeing relaxation of stay-at-home orders and early indications are we’re plus 10[%] week over week in new [vehicle sales]; we’re plus 30[%] week over week in used [vehicle sales].”  Both Sonic and Lithia are planning on monthly announcements as to what they project their volumes to be. Market data supports this optimism, as TrueCar CEO Mike Darrow said that the raw data he has been following had been growing more positive in the last several days of April.  Furthermore, JD Power released data and analysis suggest a rebound in the used car market mid-April.As stay-at-home restrictions and the outbreak of the virus begin subsiding, it is logical to assume that there will be an uptick in vehicles sold to both meet consumer current demand, as well as handling the pent up demand that the pandemic has caused.  It is important to remember the uncertainties still concerning how successful the economy will be in reopening, but fortunately, the outlook for the industry and the economy as a whole is steadily improving.As I still sit at my desk working from home and reflecting on how I spent much more time watching shows than I did cleaning out my apartment like I had planned on during this pandemic, I am heartened to remember that although the uncertainty surrounding this time period can generate a lot of anxiety, there will be a day where we can leave our homes, hug our friends and family, and go back to living our normal lives. I hope that everyone out there is staying healthy and continues to check-in on their loved ones.

April SAAR UpdateLast month, we mentioned the troubles that the auto industry is experiencing were most likely going to get worse before they got better considering the increases in COVID-19 cases and stay-at-home orders.  April was always going to be the low point with the first part of March largely unimpacted, and cities and states now beginning to ease restrictions in May. SAAR (a measure of Light-Weight Vehicle Sales: Autos and Light Trucks) declined to 8.8 million units in April, its lowest level since the data started being recorded in 1976. This was a 47.6% drop compared to April 2019, and seasonally adjusted sales volumes were 24.5% below March, which was already 32.2% below February.SAAR declined to 8.8 million units in April, its lowest level since the data started being recorded in 1976.It is important to note that while overall volumes fell precipitously, the impact was felt differently throughout the country due to differences in state and local laws and responses to the pandemic.  NADA noted that states with fewer restrictions on selling vehicles outperformed markets where restrictions were more stringent. Dealerships in the Northeast and West most likely felt stronger effects than those in the South or Plains.  With no statewide stay-at-home orders in place in April for Arkansas, Iowa, Nebraska, North Dakota, South Dakota, Utah, or Wyoming, dealerships in these states may have not felt the same pain as their counterparts in breakout areas such as New York and New Jersey.Another factor contributing to dealership performance in April was the allowance of online car sales. Pennsylvania went from mid-March to April 20th without vehicle sales as a law had to be passed to allow for remote notarization to facilitate online sales with contactless delivery.  Kentucky and Hawaii were also among the last states to ease online restrictions.  Online sales during this pandemic have been important in keeping numbers up, though the transition was not seamless which likely had a negative effect on April volumes towards the beginning of the month.Financing Deals Supporting April SalesDespite the grim numbers, dealerships and experts remain optimistic about the industry during this time.  One important reason for this is that although volumes declined throughout the country, dealerships managed to surpass expectations based on the impact on the Chinese auto market.  During February, at the peak of coronavirus in China, Chinese automakers experienced almost an 80% drop.  With less than a 50% decline, dealers in America are faring better than expected.  How did the U.S. manage to avoid China's fate? A lot of it comes down to financing and incentives.While April sales decreased, zero-percent financing deals hit a record last month. More than one in every four new vehicles sold in April featured 0% financing, up from about 5% of new cars in March. Furthermore, lenders are offering loans for both new and used vehicles that allow borrowers to delay making payments for up to 4 months.  With the Fed’s cuts putting downward pressure on interest rates, 0% financing is not as costly for dealerships as it might have been under normal conditions.  A caveat to this is that some dealers are avoiding long-term 0% financing as it can be harmful to resale values and thus, risky for car buyers. Bob Carter, Executive Vice President for Sales at Toyota Motor’s North American unit said, “We’re not into zero-for-84 months. It’s not only not healthy for the industry, but also for the consumer.” Prevalence of 0% financing has certainly increased, though likely only for certain qualified buyers with good credit.Cost Effectiveness of 0% Interest Rate DealsWith so many dealers delaying payments or offering 0% financing, we were curious to see the impact these would have on profits.  To do this, we used a present value calculation with certain assumptions to see the effects of 0% financing.  Basic assumptions include:60-month loanNational average interest rate of 5.27%Average vehicle price for April 2020 from Kelley Blue Book of $38,060Depreciation cost of $100/day We assumed a depreciation cost associated with the vehicle sitting on the lot.  Although determining a depreciation cost per day isn’t an exact science, we based this on the Sonic Automotive Earning Call, where Jeff Dyke, President of Sonic Automotive, equated sitting on inventory like a “banana rotting every day, $50, $100, $175 a day, whatever the number is, it’s rotting every day. If you’re sitting on it, you’re just creating a big bubble, and you’re going to have to pay for it at some point.”  For illustrative purposes, we settled on a $100 a day depreciation cost. The following charts show a summary of the results from three present value calculations. As seen above, delaying payments by two months only reduces the present value of the loan from $38,174 to $37,848, or about $325. This represents less than 1% of the value of the car, and these terms would likely appeal to furloughed consumers who expect to be rehired between the purchase and the beginning of payments. If instead, the dealer offers 0% financing for the life of the loan, the present value of payments received drops to $33,494.  That is a $4,680 difference between 0% financing and a 5.27% interest rate. While offering a 0% loan would not come from a bank, captive lending arms may find the F&I loss is worth the vehicle sale. These calculations illustrate that dealerships would be indifferent between selling a car today with 0% financing or waiting about 47 days to sell a car financed at 5.27%. Implicit in our depreciation assumption is that price concessions would likely have to be made to move the inventory. Additionally, every day a car sits on the lot costs dealerships on floorplan interest costs. It may be more comfortable for some to wait things out instead of accepting an upfront loss on F&I, but these calculations demonstrate that there are also costs to waiting, even if they are not as upfront. May SAAR ExpectationsThe outlook for the industry and the economy as a whole is steadily improving.Looking forward, expectations are high for a rebound in May.  Sonic Automotive has said that the second quarter will be “the worst in our history” but believes declines due to the coronavirus pandemic bottomed out in early April, and the summer will bring a return to pre-virus levels.  Lithia Motors CEO Bryan DeBoer has a similar stance, saying in their Q1 earnings call that, “I would say in vehicle sales, there's no chance that it will trough again unless there's a relapse or something in COVID-19 and the states get more strict because we’re already seeing relaxation of stay-at-home orders and early indications are we’re plus 10[%] week over week in new [vehicle sales]; we’re plus 30[%] week over week in used [vehicle sales].”  Both Sonic and Lithia are planning on monthly announcements as to what they project their volumes to be. Market data supports this optimism, as TrueCar CEO Mike Darrow said that the raw data he has been following had been growing more positive in the last several days of April.  Furthermore, JD Power released data and analysis suggest a rebound in the used car market mid-April.As stay-at-home restrictions and the outbreak of the virus begin subsiding, it is logical to assume that there will be an uptick in vehicles sold to both meet consumer current demand, as well as handling the pent up demand that the pandemic has caused.  It is important to remember the uncertainties still concerning how successful the economy will be in reopening, but fortunately, the outlook for the industry and the economy as a whole is steadily improving.As I still sit at my desk working from home and reflecting on how I spent much more time watching shows than I did cleaning out my apartment like I had planned on during this pandemic, I am heartened to remember that although the uncertainty surrounding this time period can generate a lot of anxiety, there will be a day where we can leave our homes, hug our friends and family, and go back to living our normal lives. I hope that everyone out there is staying healthy and continues to check-in on their loved ones.

The term “24-hour news cycle” doesn’t do justice to the rate at which new information becomes available and is consumed by people trying to understand the significant impact COVID-19 is having on all of us. Stay-at-home orders have created a huge demand shock, which is particularly harmful to a largely service-based economy. In this post, we contextualize some of the fallout that has been experienced and try to answer the question “when will things return to normal?”.March SAARSAAR came in at 11.372 million, the lowest level since April 2010.As expected, SAAR (a measure of Light-Weight Vehicle Sales: Autos and Light Trucks) declined considerably in March as the early effects of COVID-19 began to impact just about every industry across the globe.  SAAR came in at 11.372 million, the lowest level since April 2010. This also represented a decline of 32.4% from February. The 32.4% decline was only the fourth time since 1976 (when the SAAR was first recorded) that a 30% month-over-month decline has occurred. The first two instances were during a 6-month period of extreme volatility between September 1986 and February 1987, including three monthly increases of over 22% and two declines of 31.6%. Despite these anomalies, the only other significant month-over-month decline occurred in September 2009 when SAAR declined 35.8%. However, SAAR had increased by 14.2% and 28.1% in the two preceding months, so that September’s steep decline was only 6.1% below the preceding June.While the huge drop in volumes in March was certainly historic, it included a couple of weeks that were relatively unscathed by stay-at-home orders. April is likely to show further declines with significant uncertainty about when we will reach the bottom.Putting it in PerspectiveWhile there have been many sharp one-month declines in the SAAR, we note that even seasonally adjusting the data can fail to capture certain calendar anomalies, specifically when one month has an extra selling weekend. In looking at other significant events, such as the stock market crash in ’87 and 9/11, the drop caused by the market crash was relatively short-lived and auto volumes actually spiked in the month following 9/11 as the country braced for war. To better understand where we might be headed and when things might return to some level of “normal,” we analyzed prolonged declines, focusing on the 1981-1982 recession, the Persian Gulf War, and the Great Recession.  Though these events do not align perfectly with COVID-19, observing how periods of economic turmoil affect the industry and examining the length of recovery time historically can provide future insight as we seek to climb out of the current crisis.There are numerous ways to measure recovery. For purposes of this post, we measure “recovery” as how long it takes to return to a “steady state” of vehicle sales. We use a steady state figure of 15.6 million annual sales from a 2015 paper written by Austan D. Goolsbee (University of Chicago) and Alan B. Krueger (Princeton University). The paper analyzed the restructuring of General Motors and Chrysler. The inputs into the regression model used in the paper include:Real GDP GrowthThe unemployment ratePopulation growthThe Federal Reserve’s Senior Loan Officers’ Survey (SLOOS) measuring willingness to lend to consumersLog of average real price of a gallon of gasoline (for the preceding quarter)Standard deviation of gas prices over the preceding four quarters In every year since the paper was published, industry sales have surpassed 17 million, indicating the steady state may be biased upwards if rerun today. However, the data stops in 2007 just before the Great Recession, and because auto sales are procyclical, any increase in the steady state figure would likely be due in part to the longest economic expansion in the country’s history over the past 11 years. Further, since vehicle sales are positively correlated with population growth, we would expect a long-term figure to be higher than early years and lower than more recent years. Ultimately, we find a steady state figure of 15.6 million to be reasonable for this analysis. A Long Term View of SAAR A long-term view of SAAR is presented in the graph below: [caption id="attachment_30880" align="alignnone" width="940"]Source: FRED and Princeton University[/caption] The 1981 RecessionAt the time, the 1981 recession was the worst economic downturn in the U.S. since the Great Depression.  Triggered by a combination of monetary and global energy issues, unemployment reached 11%. While the effects of the recession were widespread, the manufacturing, construction, and auto industries were particularly affected. Auto manufacturers ended 1982 with 24% unemployment. The industry saw 4 straight years of year-over-year declines in sales from 1979 to 1982 with the largest annual decline in 1980 at 19%. SAAR bottomed out in October 1981 with only 9,209,000 annualized vehicle sales; from there, SAAR increased 17% in both 1983 and 1984. SAAR reached over 15.6 million sales in August 1985, approximately 7 years after it first dropped below this threshold in September 1978.As noted previously, population growth likely indicates the 15.6 million is a high threshold for this period, particularly since SAAR was only above this for a brief period in 1978. The precipitous decline at the beginning of 1980 appears to have been restored by the end of 1983, indicating just 4 years before recovery.The Persian Gulf WarThe Persian Gulf War, precipitated by Iraq’s invasion of Kuwait, caused the oil shock of 1990.  Though less severe than oil shocks that occurred in the 1970s, oil prices initially soared from a pre-invasion price of around $18 a barrel to above $40 in the late fall of 1990, leading to declining revenues for the auto industry.  At the same time, the Fed was tight on interest rates, endangering an already weak economy. This combination of oil prices and economic policy brought the U.S. into a recession that hit the auto industry particularly hard.  Vehicle sales declined each year from 1989 through 1991, with the biggest decrease in 1991 at 11%.  It took until April 1994 for SAAR to reach 15.6 million again, about 4 years after it first began to drop.The Great RecessionArguably the most impactful event on the industry in recent history was the Great Recession (2007-2009).  Precipitated by a financial crisis caused by a severe contraction of liquidity in global markets, businesses were forced to reduce their expenses and investments and layoffs resulted.  From December 2007 to June 2009, real GDP declined by 4.3% and unemployment increased from 5% to 9.5%, peaking at 10% in October 2009.The auto industry and other industries reliant on consumer loans (e.g., housing) suffered significant losses.  In 2006 and 2007, vehicle sales volumes decreased about 2.5% consecutively, and the auto industry hourly workforce was reduced from over 90,000 to approximately 40,000. Conditions worsened through 2008 and 2009, as sales declined 18% and 21%, which is the largest year-over-year decrease of any time period. SAAR dropped to just a little over 9 million in February 2009, 6.6 million below the steady state SAAR.  However, through the assistance of the government in the Troubled Asset Relief Program (TARP) and the end of the recession in 2009, the industry survived and returned to its steady state of 15.6 million vehicle sales in 2013, 5 years after it first dropped below that level in January 2008.COVID-19There are some positive takeaways from looking at these past events.Although economic conditions currently point to a difficult period of uncertain length, there are some positive takeaways from looking at these past events. Periods of high growth have followed periods of low sales as consumers who delayed purchases in rough times returned to the market. SAAR increased 17% consecutively in both 1983-1984, following the 1981 recession. There were increases of 8% in both 1993 and 1994 following the Persian Gulf War.  Finally, the auto industry experienced 5 years of expansion following the Great Recession, reaching similar sales as before the crisis and further set new highs in the 5 years after that.Again, it may take a while to return to the 17 million in sales seen in the past few years, but that is above the long-term average and should not necessarily be the level from which we measure recovery. NADA expects it could take three or more years to return to this level, which would be reasonable given historical recovery times.ConclusionThe auto dealer industry is resilient through tough times. We hope dealers are once again able to navigate both the known and unknown problems facing us today. Dealers must grapple with how to continue to pay their employees, alter their sales channels on the fly, and potentially even help teach their children at home.Mercer Capital stands ready to partner with dealers in their time of need. Prior to the nationwide lockdowns, we were anxiously awaiting the NADC Conference in Florida at the end of April as well as the TAA/KYADA Conferences in June. We had hoped to launch this blog in happier times, but we still plan to offer our unique perspective as valuation experts as the pandemic impact unfolds. Working from home, we have more time to write these blogs, and we hope they are interesting to you. Feel free to reach out to us if you have valuation questions as to how your dealership may be affected.Mercer Capital is a financial services firm specializing in business valuation. We also provide litigation support and transaction advisory services for clients big and small. Contact one of our professionals to discuss your needs in confidence. And stay safe.

Over the last year, deal activity in the Eagle Ford Shale was relatively steady, picking up towards the end of 2019 and carrying into early 2020.  The recent uncertainty caused by the coronavirus pandemic and the Saudi-Russian oil production level conflict, however, has hindered M&A activity in the region, and frankly everywhere else.  WTI closed below $23/bbl on March 18 with futures prices indicating a depressed price environment persisting for the near term.  Although deal count has decreased as of late, the M&A landscape has the potential to ramp up as some companies will need to sell assets in order to bolster their balance sheets amid the challenging commodity price environment, though wide “bid/ask” spreads between buyers and sellers may be difficult to overcome.Recent Transactions in the Eagle FordA table detailing E&P transaction activity in the Eagle Ford over the last twelve months is shown below.  Relative to 2018, deal count decreased by six transactions and the average deal size declined by roughly $650 million.Ensign Natural Resources Entering, Pioneer Natural Resources ExistingEnsign Natural Resources made its first acquisition as a company in May of 2019, acquiring Eagle Ford acreage from Pioneer Natural Resources.  Brett Pennington, President and CEO of Ensign, explained that the assets included meaningful production and attractive drilling inventory.  Pioneer on the other hand, was ready to become a pure-play Permian operator.  In total, Pioneer has sold approximately $1 billion of assets located outside the Permian Basin.  Pioneer seemed to make it clear that they are throwing all of their eggs in one basket.Callon Petroleum Expanding their FootprintThe biggest deal, in terms of dollars, was Callon Petroleum’s acquisition of Carrizo Oil & Gas.  Callon, a Permian Basin focused company, expanded its position in the Permian and entered the Eagle Ford with the acquired acreage.  The deal terms had to be revised after significant investor pushback.  The amended agreement stated that Callon shareholder would own approximately 58% (up from 54% initially) of the combined company and Carrizo shareholders will own approximately 42% (down from 46% initially).  It should be noted that this deal is not pure Eagle Ford shale.  Carrizo’s asset details included 76,500 acres in the Eagle Ford with roughly 600 undrilled locations and 46,000 acres in the Delaware Basin with about 1,400 undrilled locations.  The combined assets will include 120,000 net acres in the Permian and 80,000 net acres in the Eagle Ford.  The core positions in the Permian and Eagle Ford plan to produce over 100,000 boe/d of pro forma production.  Joe Gatto, president, and CEO of Callon, explained his vision of the larger company, which is to employ a more efficient scaled development model that aims to drive a lower cost of supply.  The multibillion-dollar merger officially closed in December of 2019, and now seems like unfortunate timing due to the current price environment.Repsol S.A. Picking Up Where Equinor Left OffEquinor, a Norway based petroleum refining company, agreed to sell its Eagle Ford assets to Repsol for $325 at the end of 2019.  The agreement gives Repsol, a Spain headquartered oil & gas company, 100% control of the asset while making them the operator.  In 2017, Equinor took an $850 million impairment on the asset due to lower than expected output.  In 2018, Equinor also released that part of their acreage lies on areas with high water stress variables.  Repsol expressed that the acquisition will give their producing assets portfolio a boost while taking advantage of operating synergies and efficiencies.  The acquisition is also aligned with Repsol’s intentions to expand in North America.  The deal plans to increase total production for Repsol in the Eagle Ford to approximately 54,000 boe/d.ConclusionM&A transaction activity in Eagle Ford was fairly consistent throughout 2019, as companies focused to acquire valuable acreage with production potential.  However, no one can ignore the tough current conditions in the energy industry.  Acquisitions that closed at the end of last year seem like the least of worries, as companies are simply trying to avoid bankruptcy.  If conditions allow only the strongest to survive, it could lead to an increase in transaction activity ahead.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

SAAR came in at 16.833 million for February 2020, down about 0.5% from January’s revised figure, but up 1.9% from February 2019.  However, part of this gain is attributable to calendar quirks as not only was 2020 a leap year, but this extra day fell on a Saturday, providing the first February since 1992 with five selling weekends.  Through February, 2.49 million light vehicles have been sold in 2020, up 4.5% from last year.  This increase comes entirely from light trucks, as year-to-date volumes have increased 11% for this segment while autos have declined 11% over the same period.  Trucks have made up 74% of light vehicle sales so far in 2020, up from 70% last year and continuing a trend since 2012 when trucks were just under 50%.As seen above, SAAR has been below 17 million in eight of the past twelve months with an average of 16.938 million. Solid performance in the first two traditionally slow months of the year puts 17 million units within reach for the year, though expectations in the range of 16.5 million to 16.8 million certainly seem plausible.  February’s performance may not be duplicated in March due to uncertainty surrounding the impact of COVID-19, commonly known as the Corona Virus.On the supply side, the key question will be how the virus impacts automotive manufacturers and their abilities to source products. Shutdown of Chinese plants has caused manufacturers to find alternative means, which can add to costs. If problems linger, the ramifications would likely decrease volumes globally, as Goldman Sachs recently downgraded its outlook on 2020 global auto sales to a 3.5% decline from 2019 per the Wall Street Journal. Vehicle sales in China were down a whopping 80% in February compared to the prior year. Similar effects were felt in countries where the disease has begun to spread with South Korea, Japan, and Italy, down 20%, 10.7%, and 8.8%, respectively.  While the impact on the U.S. has thus far been much lower than these countries, sales volumes are likely to be adversely affected. While the mortality rate is estimated at or below 1%, the economic fallout has already proved to be significant due to the uncertainty and panic.As for demand, there is little data available to determine the preliminary affects of the virus. However, should foot traffic decline with consumers limiting their social exposure, sales would likely decrease as internet sales have increased but the online experience remains far from substituting the experience of test drives. As discussed above, selling weekends are particularly important to the industry, which are in jeopardy if consumers opt to stay at home.On March 3, the Fed opted to cut rates 50 basis points to support the economy while citing domestic economic strength. This rare inter-meeting rate cut was the first such cut since October 2008, but this did little to ease markets as the S&P 500 still finished the day down 3%.  According to interest rate futures, an additional 25 basis point cut is nearly certain at the meeting on March 19-20 with a greater than 50% chance this cut is 50bps.Lowering interest rates seeks to induce economic activity, and specific to the automotive sector, this cut in part seeks to induce consumers into purchasing vehicles. While discounts may make people buy more on their weekly trip to the grocery store, a relatively small reprieve in ongoing interest payments is unlikely to change the decision of whether to make such a significant purchase as a car for most consumers. Lower funding costs also seek to encourage business expansion, though dealerships’ position in the supply chain (last stop before consumer) limits the impact rate cuts will have on their decision making. Dealers rely on their manufacturers for inventory, who in turn rely on the companies building these parts which means dealers’ supply will feel second-order impacts with minimal ability to navigate these changing market dynamics. However, lower interest rates should reduce floor-plan costs, which represents a nice benefit. If volumes are adversely affected, floor-plan costs will drop even further with less inventory on the lot. But as business owners are acutely aware, not all operating expenses are tethered to activity, and prolonged sluggish activity would weigh on dealerships, like many other businesses, particularly those with significant debt burdens. Like everyone else, we will continue to monitor the situation.The global uncertainty and equity market volatility resulting from COVID-19 may present investors with an opportunity to buy at a depressed valuation. Similarly, auto dealer owners who are bullish on the long-term investment merits of their business may see this as an opportunity to transfer their interests to future generations in a tax-efficient manner.  The professionals of Mercer Capital can assist in the process.  For more information or to discuss an engagement in confidence, please contact us.

February was a record month for headline transactions in the RIA industry.  Peter Mallouk sold a substantial stake in Creative Planning to PE firm General Atlantic on February 12.  Less than a week later, Franklin Templeton agreed to buy rival asset manager Legg Mason for $6.5 billion, and Morgan Stanley purchased online broker E-Trade for $13 billion just a few days ago.Interestingly enough, the smallest and least heralded deal, General Atlantic’s minority interest purchase of Creative Planning, is probably the most notable from our perspective since our clients are typically more similar to CP than Franklin, E-Trade, and LM in terms of size and product offering.Still, we can’t dismiss the implications of these larger transactions and what they say about two sectors of the investment management industry that many analysts believe are dying – active management and discount brokerage.  The Franklin / Legg deal was touted as being more about “offense not defense” according to Franklin chief Jenny Johnson, who said the acquisition was about building “an all-weather product line-up and world-class distribution platform.”  While that may be the case, the reality is that both firms had suffered significant outflows and increased competition from passive funds.  Combining both firms is expected to generate $200 million in cost savings and stem the tide of waning profit margins.Morgan Stanley’s purchase of E-Trade was likely also a defensive maneuver anticipated to yield approximately $400 million in expense reductions for the Wall Street giant.  It may have also been Morgan Stanley’s counter to Goldman’s purchase of United Capital last Spring in their bid to enter the mass affluent space.  E-Trade’s recent financial woes are primarily attributable to falling commission revenue, which, like active management fees, have been in free fall for quite some time.Both E-Trade’s and LM’s stock price rose over 20% upon announcement, and it naturally leads us to wonder if smaller active managers or broker businesses can expect such a windfall from a prospective acquirer.  Scale still matters for most asset management firms, so consolidation rationales are always going to be there especially for an industry looking to cut costs.  Brokerage firms’ commission revenue is less proportional to client assets, so bulking up just for the sake of it doesn’t make a whole lot of sense.  Many of these businesses are already transitioning to an asset-based revenue model anyways, so we’re seeing fewer acquisitions of brokerage firms in general.Even with asset manager deal-making holding up, the sector’s recent uptick in M&A activity is largely attributable to a growing interest in wealth management firms.  The driving force behind this increase is strong demand from RIA consolidators, PE firms, and strategic acquirers that are drawn to the sector’s recurring revenue model and sticky clientele base.  The lack of internal succession planning is another catalyst as founding partners look to outside buyers to cash out.Despite this uptick, there are still numerous challenges to sustaining this level of M&A growth for the RIA industry.  Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task.  The risks include cultural incompatibility, lack of management incentive, and size-impeding alpha generation.  Minority interest acquisitions (à la Creative Planning) sidestep some of these challenges, but the risks are harder to avoid in control acquisitions.  Well-structured deals and effective integration strategies can help mitigate risks and align interests, but only to an extent.And yet, with over 12,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back-office efficiencies.  Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression.  An aging ownership base is another impetus.The performance of the broader market will also be a key consideration for both buyers and sellers in the coming year.  The current downturn from the Coronavirus could curtail the recent momentum or spur buyers to negotiate lower pricing.  We’ll let you know how it all shakes out.

In previous posts, we have delineated between royalty trusts and mineral aggregators and discussed the valuation implications of prevailing high dividend yields of public royalty trusts.  Yields remain elevated, and these trusts have declined in their usefulness from a valuation benchmarking perspective. In this post, we focus on mineral aggregators.  We also offer insights on the investment landscape at large and particularly as it relates to the minerals subspace by providing an update on the most recent IPO, Brigham Minerals (MNRL).Market Data for Aggregators and TrustsThe following tables provide some critical market data for valuation purposes. Since our last update, SandRidge Mississippian Trusts I and II (SDT and SDR, respectively) were delisted in mid-November as the stocks fell below $1.00 in May and traded below that mark for six months.  All else equal, public royalty trusts are expected to decline in value as investors get their return almost exclusively from yields because production declines over time. Thus, trusts eventually being delisted is not a surprising outcome due to restrictions on acquiring additional acreage or wells. Given the eponymous operator SandRidge Energy’s struggles, it’s even less surprising these two trusts were delisted.  SandRidge Permian Trust has avoided this fate for the time being, due in part to its attachment to the prolific Permian and sale to Avalon Energy, but the trust has also been put on notice. Unlike public royalty trusts, mineral aggregators are not restricted from acquiring additional interests, which makes them more of a going concern by comparison.  This is among many reasons investors have increasingly turned towards mineral aggregators. Long-time readers of the public mineral interest portion of our blog will note the revamped look at value drivers and key benchmarks for mineral aggregators. Public Markets Unreceptive of Energy SectorThe stock market has been booming over the past decade as the economy has ridden the longest expansion in history.  Investors in the energy sector, however, have not experienced the same joyful ride.  In 1990, energy made up 15% of the S&P 500 sector weightings, but in 2019, that figure was down to 5%.  Ironically, over the same period, the United States’ oil and gas production surpassed all countries and claimed the top of the leaderboard, becoming the world’s largest producer. Depressed commodity prices have also likely aided valuations for companies in other sectors as transportation costs are lower in an increasingly globalized economy with two-day shipping becoming common place.The graph below shows the relationship between the Vanguard Energy ETF, created in 2004, and the SPY Index over a 15-year period.  Slow economic growth coming out of the recession caused Energy to outperform, but commodity price declines in late 2014 began a reversal that has widened since 2017.Energy vs. S&P 500 There are many reasons that this story has unfolded such as diminishing return on investment, fluctuation in commodity prices, and oversupply, but we do not dive into that in this post.  Instead, we want to illustrate the ways in which mineral aggregators have been able to manage some of these issues. Mineral aggregators are constructed to diversify capital among many superior plays and specific operators.  This niche in the energy market allows investors to capitalize on both current yield and capital appreciation with the aggregators’ reinvestment capabilities.  Crucially, royalty holders do not bear operating and drilling costs as these costs are paid by upstream E&P companies.  Brigham Minerals articulates the benefits of the business model as follows: “There are many advantages of the mineral acquisition model, including no development capital expenditures or operating costs, no exposure to fluctuating oilfield service costs and higher margins than E&P operators without associated operational risks.”Mineral aggregators receive a royalty based on revenue and are thus isolated from a number of field-level economic issues. This is not unlike the restaurant industry, where franchisors command a much higher valuation than the operators to whom they franchise.  Declining same-store sales figures in that industry are hurting profitability for operators grappling with the necessity for capital expenditures to fund future growth while those collecting royalties off the top can prosper with their asset-light models.  Sound familiar?Brigham Minerals Seasoned Equity OfferingIn a previous post, we discussed the much-anticipated Brigham Minerals’ IPO in April 2019.  The upsized offering was sparked by higher than expected demand.  Many saw the IPO as an investment opportunity that promoted cash flow, something that operators in the market were not providing.  There was speculation that additional mineral companies would likely IPO over the course of 2019 given the demand for Brigham Minerals, but that turned out not to be the case.  In December of 2019, however, Brigham Minerals announced in an S-1 a seasoned equity offering of 11 million common shares.  The Company offered 6 million new shares of its common stock, and some selling shareholders sold an additional 5 million shares.  Shares were priced at $18.10, likely a psychological threshold, as it was priced just ten cents above the IPO price only eight months prior. Credit Suisse, Goldman Sachs, and RBC Capital Markets acted as lead booking-running managers for the offering, and they were granted a 30-day greenshoe option totaling an additional 1.65 million shares though these were not exercised as the share price remained above the issuance price, averaging $19.70 for the first month of trading. Generally speaking, 2019 was a poor year for IPO’s with ride-share companies Uber and Lyft among the high-profile unicorns that floundered. Peloton opened 6.9% below its trading price and multiple companies, perhaps most notably WeWork, decided to scrap the IPO altogether. Brigham’s IPO success and perhaps more importantly its ability to issue additional equity just eight months later may encourage private equity firms invested in minerals companies to test the IPO market.ConclusionMineral aggregators appear to have supplanted public royalty trusts as a key means for investors to get exposure to the sector while avoiding costly drilling expenses. While functionally related to drilling activity and well performance, aggregators allow investors to avoid cost burdens.  As such, valuations for the aggregators behave differently than other participants in the energy sector.We have assisted many clients with various valuation and cash flow questions regarding royalty interests. Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.

Selling a business is a three-step process.  Some sellers elect to stop at Phase I or II and don’t proceed to closing, while others decide to complete the transaction process.  In reality, each of the phases overlaps to some degree, making the process more of a continuum than a finite set of procedures.  A turnkey, orderly process will often require four to six months.  When extra time is required to prepare and/or when multiple rounds of market outreach are involved, we’ve managed deals that required six to eighteen months and more to reach a close or no-close decision.Ultimately, the collective team goal as seller and advisor is to win the race, whether it be at the pace of the hare or the tortoise.Phase I involves “taking inventory.”  Taking inventory means gathering and analyzing financial and operating data for the family business.  The milestone goal of this process for most clients is obtaining a valuation in order to establish decision-making baselines and to set transaction expectations.  The valuation undertaking helps the advisor learn about the business and relate the “story” of the business to the financial and operating data for the company and its industry.  Equally important, Phase I promotes forthright discussions about family and ownership objectives that in turn help the advisor identify the selling family’s priorities and preferred transaction structures.  Telling the company’s story in a clear and compelling way is important in creating effective marketing materials. If, on the basis of value expectations and market option assessments from Phase I, the family decides to move forward with testing the market, we then enter Phase II.Phase II involves staging and organizing the relevant financial and operating data into a confidential information memorandum (CIM).  The CIM is designed to tell the story of the business, expound on the merits of the business and its market position, and describe the seller’s preferred transaction structure.  The CIM should provide enough information for prospective buyers to form an expression of interest (i.e. the initial offer).  Of course, prior to receiving the CIM, prospective buyers must execute non-disclosure agreements, which are designed to protect the seller from having their confidential information revealed to unintended audiences. Parallel with the preparation of the CIM, the financial advisor will create a list of prospective buyers.  These prospective buyers often include a mix of competitive and/or friendly industry players, private equity investors, and family offices.  Phase II may also involve conducting meet-and-greet exchanges with prospective buyers in order to negotiate and secure expressions of interest in the form of indications of interest (IOIs) or letters of intent (LOIs).  After careful study of the offers, the financial advisor will help the selling shareholders select the preferred bid.  Signing an IOI/LOI generally marks the end of Phase II. Phase III By signing and IOI/LOI, the selling shareholder commits to dealing exclusively with that buyer.  One of the first steps in Phase III is satisfying the buyer’s due diligence requirements.  Parallel with this process, legal advisors to the buyer and the seller begin drafting the legal documents required to complete the transaction. It is important to understand that the negotiating process from Phase II carries forward until the deal is closed.  Deal terms often contain various structural features including non-compete agreements, earn-out arrangements, equity roll-over provisions, escrow and holdback terms, working capital thresholds, real estate considerations, and other important make-or-break considerations.  The terms of these side elements can represent a significant portion of total deal value and cannot be overlooked.  The wording of the documents is part of the negotiating and deal monitoring process.  The focus is making sure that the offer and all its terms are clearly captured in the actual transaction documents. Assuming everything passes muster, closing occurs.  But even then the transaction is not completely finished until the selling family receives all of the consideration promised in the deal.  A portion (often 5% to 20%) of the total purchase price is usually held in escrow for 12 to 24 months after closing against potential claims of the buyer for violation of seller representations and warranties.  The amount, duration, and conditions of escrow release are important elements of the legal documents governing the transaction.  The significance of these terms points to the importance of remaining vigilant and engaged in the process to maximize the outcome. We hope this quick tour of the selling process helps readers better understand the steps involved in selling the family business.  Family shareholders and family business directors owe it to themselves and to their stakeholders to be aware of the liquidity options that may available in the expanding market for private companies.

Reading up on the commentary about the record number of RIA transactions last year, I’m struck by how simple the predominant narrative is: everybody wants in, valuations are up, and deal-flow continues to flourish.Headlines have their own wisdom, but the underlying reality of M&A activity is necessarily nuanced – especially as we approach the twelfth year of this bull market.  If transaction activity is higher and vectoring to grow from here, what is the catalyst? Investment management is a great business.  Firms that don’t need to sell, don’t sell. If transaction activity is up, does this mean that more firms need to sell?  If pricing and deal terms are better, are the transactions available today really that much more attractive than those available a few years ago?  And is the culture of consolidation that has emerged in the RIA community sustainable? The Go-Go 90s I’m no Marcel Proust, but these days take me back to the closing months of an earlier bull market that, in many ways, set up where we are today.1999 was a big year for me in what is now called “adulting.”  I turned 30, became a CFA charterholder, and celebrated my fifth anniversary of employment (deployment) with the same firm where I, stubbornly, still work.  I became an uncle for the first time, and I was about to become a father as well.My colleagues and I watched in disbelief as equity markets rose relentlessly in 1999, and I vividly remember saying that one day we would look back and talk about the “go-go 90s.”  It was exciting, but it also made me uncomfortable.  Warning signs were everywhere.  Nosebleed multiples.  Pets.com.  Nickelback.  The handwriting really hit the wall when I saw that the keynote address at the major business appraisal conference that October was to be given by the authors of a then hot but now forgotten book: Dow 36,000.Cap Rates and CouponsDow 36,000 is a clever fairy tale written by a journalist, James Glassman, and an economist, Kevin Hassett.  The authors assert that the bull market of the 1990s was fueled, in part, by multiple expansion that would persist as investors came to understand that stocks were no riskier than treasuries.  Stock and bond capitalization rates would eventually converge and - voila! - the Dow would quadruple from the levels at which it was then trading.  The book was panned by grouchy economists like Paul Krugman and perma-bears like Robert Shiller, the CAPE-crusader who has since predicted at least nine out of the last two financial catastrophes. Dow 36,000 forecast a sharp rise in the DJIA within three to five years.  It’s been two decades, and we still aren’t there – at least in the public equity markets.  In the private markets, though, I’m starting to wonder if Glassman and Hassett’s fanciful outlook on valuation has finally been realized.Adjusted RealityWhen the bull market of the 1990s abruptly ended in 2000, one casualty was an energy trading firm with very empathetic accountants.  The death of Enron, and the subsequent murder of its auditor, Arthur Andersen, set a regulatory buildup into motion which made it generally disadvantageous to be a public company.  20 years later, the number of U.S. public companies has been nearly halved, and out of the ashes of the public markets rose the phoenix that is private equity.Private equity can be as much about marketing as it is about markets: convince equity investors to lock up their money for a decade, then convince entrepreneurs to take the money.  Cheap debt brings both parties to the table, goading risk-averse investors to chase returns, and teasing sellers with bigger payouts.Twenty years post-Enron, sponsors have raised the art of “heads I win, tails I win more” to a science.  A smorgasbord of cheap debt has enabled financial intermediaries to routinely outbid strategic buyers for three years now.  Hockey-stick projections have been supplanted by higher order land-grab economics: the first idea to gain monopoly status wins.  Banks compete to lend to sponsors buying asset-light businesses based on EBITDA “addbacks.”  LPs look the other way as reality-check IPO exits have been replaced by mark-to-model fund-to-fund transactions.  And the SEC is talking about relaxing the requirements to be considered an Accredited Investor.  What could possibly go wrong?Barbarians at the Gate 2 – Electric BoogalooThe distorted reality of the sponsor community is having an impact on the RIA space as well.The null hypothesis of the RIA community is that investment management is a relationship business that cannot be scaled.  What we are witnessing today is big money trying to disprove that power rests within the advisor/client relationship through ensemble practices, roll-ups, robo-advisors, etc.The trouble is the current PE model of raising billions to create a monopoly around some lifestyle essential doesn’t work in investment management.  Investment management is fragmented for a reason.  It is an owner-operator business model.  It is a lifestyle business.Further, what is there to buy?  If RIAs only sell when they have to, are consolidators just collections of failed firms?  Are they optimized for a bull market?  Is it possible to stress-test these models for the next downturn?  We’ve recently been passing around a ten-year-old article on consolidation pains in the RIA space that is required reading for anyone who wants to learn from the past, or at least not be blindsided by it.Is there a sustainable consolidation model?  Joe Duran scored big with deliberate, strategic acquisitions of local RIAs into one, nationally branded firm – but the cost of being deliberate is time, something that sponsor-backed enterprises don’t have.  The sale of United Capital to Goldman Sachs is viewed by many (not necessarily me) as capitulation, maybe an admission that competing for deals with overcapitalized sponsor-backed initiatives was pointless.  Some dismiss the strategic importance of the deal because, for Goldman, the $750 million it paid for United wasn’t much money.  That may be true, but Goldman doesn’t do many deals, and didn’t have to do this one.The brains behind the United Capital acquisition model, Matt Brinker, is now at Merchant Investment Management.  Merchant has more of a co-invest mindset, and permanent capital, which says a lot about what the brains of the industry think is a successful consolidation strategy.  The co-invest model, in which a financial partner shares with management in equity ownership on a control or, usually, a minority interest basis, seems to have the most traction.  We think that approach can work, so long as returns to equity are clearly delineated from returns to labor.We may have already reached a tipping point.  Deal volume was up last year, but deal value was down.  The pace of transaction activity established early in 2019 didn’t sustain itself in the fourth quarter – usually a big one.  The most visible acquirer in the RIA community, Focus Financial, was called out last summer for becoming over-leveraged.  Focus management disputed this, but since then their acquisition announcements have been few.…like it’s 1999The song that Prince recorded about 1999 isn’t about the good times; it’s a song about the end-times.  As 1999 drew to a close, people weren’t as concerned about the Mayan calendar or Nostradamus as they were about the disastrous consequences of global IT systems locking up because of bad date programming – a fake crisis brilliantly marketed by the IT consulting community to sell their services.  The only real crisis was a missed opportunity to have a good time.My wife and I went out on New Year’s Eve 1999 to a very underattended extravaganza.  80% of the invited guests stayed home, afraid of what I don’t know.  Instead of the big blowout that most of us expected in the years leading up to the new millennium, the reality was that partying in 1999 meant withdrawing into a quiet paranoia.  If you cringe every time someone talks about selling a company for a big multiple of adjusted EBITDA, you get the idea.

As we find ourselves at the end of the decade, many pundits are considering what sector will be most heavily influenced by the disruptive impact of technology in the 2020s. Financial services and the potential impact of FinTech is often top of mind in those discussions. As I consider the potential impact of FinTech in the coming decade, I am reminded of the Mark Twain quote that “History doesn’t repeat itself but it often rhymes.”A historical example of technological progress that comes to mind for me is the combine, a machine designed to efficiently harvest a variety of grain crops. The combine derived its name from being able to combine a number of steps in the harvesting process. Combines were one of the most economically important innovations as they saved a tremendous amount of time and significantly reduced the amount of the population that was engaged in agriculture while still allowing a growing population to be fed adequately. For perspective, the impact on American society from the combine’s invention was tremendous as roughly half of the U.S. population was involved in agriculture in the 1850s and today that number stands at less than 1%.As I ponder the parallels between the combine’s historical impact and FinTech’s potential, I consider that our now service based economy is dependent upon financial services, and FinTech offers the potential to radically change the landscape. From my perspective, the coming “combine” for financial services will be not from one source or solution, but from a wide range of FinTech companies and traditional financial institutions that are enhancing efficiency and lowering costs across a wide range of financial services (payments, lending, deposit gathering, wealth management, and insurance). While this can be viewed as a negative by some traditional incumbents in the space, it may be a saving grace as we start the decade with the lingering effects of a prolonged historically low and difficult interest rate environment, and many traditional players are still laden with their margin dependent revenue streams and higher cost, inefficient legacy systems. Similar to the farmers adopting higher tech planting and harvesting methods through innovations like the combine, traditional incumbents like bankers, RIAs, and insurance companies will have to determine how to selectively build, partner, or acquire FinTech talent and companies to enhance their profitability and efficiency. Private equity and venture capital investors will also continue to be attracted to the FinTech sector given its potential.As the years in the 2020s march on, FinTech acquirers and traditional incumbents face a daunting task to evaluate the FinTech sector. Reports vary but generally indicate that over 10,000 FinTechs have sprouted up across the globe in the last decade and separating the highly valued, high potential business models (i.e, the wheat) from the lower valued, low potential ones (i.e., the chaff) will be challenging. Factor in the complicated nature of the regulatory/compliance overlay and investors, acquirers, and traditional incumbents face the daunting task of analyzing the FinTech sector and the companies within it.As a solution to this potential problem, the efficient operations and historical lessons learned in the agricultural sector from the combine may again provide insights for buyers of FinTech companies to learn from. For example, the major professional sports leagues in the U.S. all have events called combines where they put prospective players through drills and tests to more accurately assess their potential. In these situations, the team is ultimately the buyer or investor and the player is the seller. Pro scouts are most interested in trying to project how that player might perform in the future for their team. While a player may have strong statistics in college, this may not translate to their future performance at the next level so it’s important to dig deeper and analyze more thoroughly. For the casual fan and the players themselves, it can be frustrating to see a productive college player go undrafted while less productive players go highly drafted because of their stronger performance at the combine.While not quite as highly covered by the fans and media, a similar due diligence and analysis process should take place when acquirers examine a FinTech acquisition target. This due diligence process can be particularly important in a sector like FinTech where the historical financial statements may provide little insight into future growth and earnings potential for the underlying company. One way that acquirers are able to better assess potential targets is through a process similar to a sports combine called a quality of earnings study (QoE). In this article, we give a general overview of what a QoE is as well as some important factors to consider.What is a Quality of Earnings Study? A QoE study typically focuses on the economic earning power of the target. A QoE combines a number of due diligence processes and findings into a single document that can be vitally helpful to a potential acquirer in order to assess the key elements of a target’s valuation: core earning power, growth potential, and risk factors. Ongoing earning power is a key component of valuation as it represents an estimate of sustainable earnings and a base from which long term growth can be expected. This estimate of earning power typically considers trying to assess the quality of the company’s historical and projected future earnings. In addition to assessing the quality of the earnings, buyers should also consider the relative riskiness of those earnings as well as potential pro-forma synergies that the target may bring in an acquisition.Analysis performed in a QoE study can include the following:Profitability Procedures. Investigating historical performance for impact on prospective cash flows. EBITDA analysis can include certain types of adjustments such as: (1) Management compensation add-back; (2) Non-recurring items; (3) Pro-forma adjustments/synergiesCustomer Analysis. Investigating revenue relationships and agreements to understand the impact on prospective cash flows. Procedures include: (1) Identifying significant customer relationships; (2) Gross margin analysis; and (3) Lifing analysisBusiness and Pricing Analysis. Investigating the target entities positioning in the market and understanding the competitive advantages from a product and operations perspective. This involves: (1) Interviews with key members of management; (2) Financial analysis and benchmarking; (3) Industry analysis; (4) Fair market value assessments; and (5) Structuring These areas are broad and may include a wide array of sub-areas to investigate as part of the QoE study. Sub-areas can include:Workforce / employee analysisA/R and A/P analysisIntangible asset analysisA/R aging and inventory analysisLocation analysisBilling and collection policiesSegment analysisProof of cash and revenue analysisMargin and expense analysisCapital structure analysisWorking capital analysis For high growth technology companies where the analysis and valuation is highly dependent upon forecast projections, it may also be necessary to analyze other specific areas such as:The unit economics of the target. For example, a buyer may want a more detailed estimate or analysis of the some of the target’s key performance indicators such as cost of acquiring customers (CAC), lifetime value of new customers (LTV), churn rates, magic number, and annual recurring revenue/profit.A commercial analysis that examines the competitive environment, go-to-market strategy, and existing customers perception for the company and its products. This article discusses a number of considerations that buyers may want to assess when performing due diligence on a potential FinTech target. While the ultimate goal is to derive a sound analysis of the target’s earning power and potential, there can be a number of different avenues to focus on, and the QoE study should be customized and tailored to the buyer’s specific concerns as well as the target’s unique situations. It is also paramount for the buyer’s team to keep the due diligence process focused, efficient, and pertinent to their concerns. For sellers, a primary benefit of a QoE can be to help them illustrate their future potential and garner more interest from potential acquirers. Mercer Capital’s focused approach to traditional quality of earnings analysis generates insights that matter to potential buyers and sellers. Leveraging our valuation and advisory experience, our quality of earnings analyses identify and focus on the cash flow, growth, and risk factors that impact value. Collaborating with clients, our senior staff identifies the most important areas for analysis, allowing us to provide cost-effective support and deliver qualified, objective, and supportable findings. Our goal is to understand the drivers of historical performance, unit economics of the target, and the key risk and growth factors supporting future expectations. Our methods and experience provide our clients with a fresh and independent perspective on the quality, stability, and predictability of future cash flows. Our methodologies and procedures are standard practices executed by some of the most experienced analysts in the FinTech industry. Our desire is to provide clients with timely and actionable information to assist in capital budgeting decisions. Combined with our industry expertise, risk assessment, and balanced return focus, our due diligence and deal advisory services are uniquely positioned to provide focused and valued information on potential targets. Originally published in Mercer Capital's Value Focus: FinTech Industry Newsletter,  Year-End 2019.

Asset and wealth manager M&A continued at a rapid pace during the fourth quarter of 2019, rounding out a record year by many metrics.  Total deal count in 2019 rose 6% over 2018, reaching the highest level seen over the last decade.  While reported deal volume declined by 50% in 2019, this metric can be a less reliable indicator of transaction activity given the lack of disclosed deal terms and the influence of large transactions (the Oppenheimer/Invesco deal accounted for about a quarter of 2018 reported deal volume, for example).The rise of the RIA consolidator model continues to be a theme for the wealth management sector.  Wealth management firms saw a significant uptick in consolidation activity during 2019, which was attributable in large part to strategic consolidators.  According to Fidelity’s December 2019 Wealth Management M&A Transaction Report, there were 139 wealth management transactions in 2019 (43% more than 2018) representing $780 billion in assets (38% more than 2018).  Some of the more active consolidators included Focus Financial, Mercer Advisors, Wealth Enhancement Group, HighTower Advisors, and Dynasty Financial Partners—each of whom acquired multiple RIAs during 2019.RIA consolidators now account for about half of wealth management acquisition activity—and that percentage has been increasing.RIA consolidators now account for about half of wealth management acquisition activity—and that percentage has been increasing.  These consolidators are, in general, well-funded (often by PE backers) and have a mandate from their investors to grow rapidly via acquisitions.  They’re also not shy about knocking on doors to source deals, and given the demographics of the wealth management industry, their pitch for an exit plan often finds a receptive audience.Sub-acquisitions by consolidator-owned RIAs are a further driver of M&A activity for the sector.  These acquisitions are typically much smaller and are facilitated by the balance sheet and M&A experience of the consolidators.  For some RIAs acquired by consolidators, the prospect of using buyer resources to facilitate their own M&A may be a key motivation for joining the consolidator in the first place.There have also been several significant transactions of the consolidators themselves, which illustrates the broad investor interest in the consolidator model.  One of the largest deals of 2019 was Goldman Sachs’s bid to enter the mass-affluent wealth management market through its $750 million acquisition of RIA consolidator United Capital Partners.  Also during 2019, Mercer Advisors’ PE backers sold a significant interest to Oak Hill Capital Partners.Consolidation Rationales Building scale to enhance margins and improve competitive positioning are typical catalysts for consolidation, especially on the asset management side.  One way to stem the tide of fee pressure and asset outflows is to cut costs through synergies to preserve profitability as revenue skids.  The lack of internal succession planning is another driver as founding partners look to outside buyers to liquidate their holdings.Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task.  The risks include cultural incompatibility, lack of management incentive, and size-impeding alpha generation.  Many RIA consolidators structure deals to mitigate these problems by providing management with a continued interest in the economics of the acquired firm while allowing it to retain its own branding and culture.  Other acquirers take a more involved approach, unifying branding and presenting a homogeneous front to clients in an approach that may offer more synergies, but may carry more risks as well.M&A OutlookThe record transaction activity in 2019 marks a decade-long run of steadily increasing consolidation activity in the sector.  In 2020, we expect the trend to continue as many of the forces that shaped the industry over the last decade remain in place.  Consolidation pressures in the industry are largely the result of secular trends.  On the revenue side, realized fees continue to face pressure as funds flow from active to passive and clients become increasingly fee conscious.  On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs.  The continuation of these trends will pressure RIAs to seek scale, which will, in turn, drive further M&A activity. With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies.  Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression.  An aging ownership base is another impetus.  The performance of the broader market will also be a key consideration for both buyers and sellers in 2020.

It was a quiet year for M&A in Appalachia as only a handful of transactions occurred.  Surging associated gas production in places like the Permian and Bakken have kept a lid on gas prices, which have largely remained between $2 and $3/mmbtu for the year.  Near term expectations aren’t much better, with futures prices below $3 through 2029.  Management teams were likely preoccupied with various corporate and capital structure issues instead of changes to the underlying reserve base.  However, a bright spot is the easing of takeaway constraints that previously plagued the region.Recent Transactions in AppalachiaA table detailing E&P transaction activity in Appalachia during 2019 is shown below.  Overall, deal count and average deal size declined relative to 2018.  Diversified Gas & Oil’s acquisition of HG Energy II was the only non-royalty transaction of meaningful size during the year.  Cabot recently announced a $256 million divestiture of its 20% interest in NextEra Energy’s Meade Pipeline, though that transaction is not included in the E&P transactions listed below.Range Resources ORRI SalesRange Resources was the most active market participant in the basin with two overriding royalty interest (ORRI) sales and the sale of 20,000 non-producing acres in Pennsylvania.  The company intends to use the proceeds to paydown debt, offsetting much of the lost cash flow from the assets with decreased interest expense.  The company also announced a $100 million share repurchase program.Diversified Gas & Oil Acquisition of Unconventional Assets from HG Energy IIDiversified Gas & Oil acquired 107 gross producing wells and related surface rights from HG Energy II.  The acquisition is consistent with the company’s strategy of buying mature, low-decline PDP assets in Appalachia.  However, the transaction does represent somewhat of a departure from the company’s historical focus on conventional (non-shale) assets.  Management indicated that the transaction would be accretive on various per-share metrics including earnings and free cash flow.Operators Focused on Changes to Corporate and Capital Structure Rather than Asset BaseWhile it has been a quiet year in Appalachia on the M&A front, it was a tumultuous year for management teams and board members.Toby and Derek Rice’s proxy battle for control of EQT made headlines during the first half of the year.  The Rice brothers cited EQT’s poor operational performance after its acquisition of Rice Energy as a reason to shake up management and the board.  The brothers proposed a business plan which they indicated would generate an estimated incremental $400 - $600 million of pre-tax cash flow and unlock shareholder value.  They succeeded in July with Toby Rice replacing Robert McNally as President and CEO of EQT.  An organizational streamlining was announced in September, which included a 23% reduction in employees.Gulfport Energy, which has been targeted by activist investor Firefly Value Partners, announced a $400 million stock repurchase program in January 2019.  However, the company suspended the program in November, citing “current market conditions and a weak near-term gas price outlook.”  The same press release also announced that the company reduced its headcount by 13%, two board members were stepping down, and the chairman of the board would not seek re-election at the next shareholder meeting.Diversified Gas & Oil Company announced a novel financing transaction that may pave the way for other E&Ps looking for creative ways to fund operations.  The company created a special purpose vehicle that issued non-recourse, asset-backed securities collateralized by a working interest in the company’s PDP assets.  The company plans to utilize the proceeds from the financing to pay down borrowings on its existing revolving credit facility.Antero Resource’s midstream affiliate, Antero Midstream (AM), completed one of the more complicated MLP simplifications earlier in 2019.  In June, after Warburg Pincus divested its remaining ownership interest in the company, Warburg’s two board members resigned, reducing Antero’s board to just seven directors.  In December, Antero announced a $750 million to $1 billion asset sale program, which the company kicked off by selling $100 million of AM shares back to the midstream affiliate.  Management indicated that future asset sales could consist of “lease acreage, minerals, producing properties, hedge restructuring or sale of AM shares to Antero Midstream.”  As management teams work to fix capital structures through potential asset sales, 2020 might be a more active year for transactions in the basin.ConclusionM&A transaction activity in Appalachia was muted in 2019 as gas prices remained rangebound and management teams focused on corporate and capital structure issues rather than M&A.  However, with operators feeling the pressure from sustained low gas prices, and Antero’s announced asset sale program, 2020 will hopefully be a more active year.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

We’ve hesitated to put together a whitepaper on succession planning because so many people have already written excellent commentary on the topic. Nonetheless, when we surveyed what had been written about succession for RIAs, we didn’t see the kind of nuts and bolts explanation of the corporate finance aspects of succession.The industry is facing at least three major factors: an aging ownership base, an aging bull market, and – paradoxically – an exponential increase in the sources of capital to sell, grow, or transition. Despite the headline emphasis on consolidation, investment management is still an apprenticeship business model and, therefore, internal succession will be the order of the day for most firms.We hope you will find our whitepaper on the topic both unique and useful. We are here to help you succeed at succession. Click the whitepaper below to download.>>Click Here to Download<<

Succession planning has been an area of increasing focus in the RIA industry, particularly given what many are calling a looming succession crisis. The demographics suggest that increased attention to succession planning is well warranted: a full 62% of RIAs are still led by their founders, and only about a quarter of them have non-founding shareholders. Yet when RIA principals were asked to rank their firm’s top priorities in 2019, developing a succession plan was ranked last. Fortunately, there are many viable options for RIA principals looking to exit the business.

As noted in a recent post, there are many viable options for RIA principals when it comes to succession planning.  One way to transition ownership while maintaining independence is to sell internally to key staff members.  The most obvious roadblock when planning for internal succession is pricing.  But once you establish a price, how does the next generation pay?  An internal transition of ownership typically requires debt and/or seller financing as it’s unlikely that the next generation is able or willing to purchase 100% ownership in a matter of months.  In this post, we consider the expanding options for RIAs seeking debt financing and the typical terms they can expect.Is Debt Financing the Right Solution? Debt financing has become a more practical option for RIA principals working on succession planning as more specialty lenders have entered the market.  Some of the benefits of debt financing are outlined below.Debt financing, as opposed to seller financing, allows the exiting shareholder to make a clean break with the business. This benefits both the exiting shareholder and the remaining principals.  Exiting shareholders, who are likely at retirement age, receive liquidity at close that they can use to diversify their personal holdings, and the remaining principals don’t have ownership lingering in the hands of a former employee.Debt financing, as opposed to equity financing, allows the remaining principles to maintain autonomy. Excluding loan covenants, lenders have no control over your business.  On the other hand, equity partners usually require more intrusive oversight such as a board seat and/or budget approval, which remaining shareholders may not tolerate.Debt financing is cheaper than equity financing. Equity investors, who are subordinated to debtholders, require an additional premium over the average cost of debt.Interest payments are tax-deductible. Interest payments can reduce the borrower’s tax burden during the amortization period. Despite these benefits, debt financing does increase the remaining shareholders’ personal risk.  Debt financing is an obligation to repay the money acquired through it, unlike equity financing which typically does not require repayment.  Debt financing for RIAs also typically includes a personal guarantee, which many borrowers are opposed to.  Borrowers are also more exposed to their own business by levering up to purchase an equity stake.Increasing Number of Specialty Lenders for RIAsAs Financial Planning explained, “the market for RIA-friendly lending options has exploded” over the last two years.  Looking back, Live Oak Bank was one of the first to address the specific needs of RIA principals when they began providing favorable terms to independent advisory firms in 2012.  As explained on their website, “where most banks look for tangible collateral when they lend money, Live Oak Bank lends on cash flow to companies (like advisory firms) which have little to no collateral.”  Prior to this, most RIAs had to turn to local banks, who generally were not comfortable with the asset-light balance sheets and fee-based structure of RIA firms.RIAs now can turn to a growing number of specialty lenders who are accustomed to working with RIAs.  Some of the firms offering debt financing specifically for RIAs include Oak Street Funding, Merchant Credit Partners, PPC Loan, and SkyView Partners.Typical Terms for RIAsAdditionally, one provision may be contingent upon another.  For example, a higher origination fee could reduce the need for a pre-payment penalty. At the risk of providing an example of terms that may be unachievable for some RIAs, we have outlined terms RIA principals can generally expect when seeking debt financing.Most lenders require a personal guarantee, which is a legal promise by the partners to repay the loan made to their business in the event the business defaults.  While it is typical that lenders to small businesses require this additional layer of protection, it is important to understand how a personal guarantee works and what it could mean for your personal finances.Because RIAs do not have fixed assets to use as collateral, a personal guarantee gives your lender the right to pursue your personal assets if your business defaults on the loan.  The SBA is of the opinion that a personal guarantee “ensures that the borrower has sufficient personal interest at stake in the business.”  Notably, a personal guarantee is not released if you sell the business.  While you can ask your lender to replace your personal guarantee with a personal guarantee from a new owner, the lender is typically not required to do so.ConclusionSimilar to evaluating mortgage options, it is important to talk to multiple lenders to guarantee the most favorable terms for your business transition.  Having a knowledgeable advisor to manage this process can allow remaining ownership to stay focused on running the business while ensuring consideration of all appropriate options.

Private equity pervades the RIA industry, but most of their recent interest is through consolidators or roll-up firms.  In this week’s post, we’ll discuss the implications of this trend and other considerations for RIA owners’ contemplating the PE route. You may have not heard much about private equity firms’ addition of RIAs to their portfolios in recent years.  But that doesn’t mean they’re not interested.  The reality is that PE firms collectively have established an indirect interest in hundreds of RIAs via their investments in RIA consolidators.  This strategy enables private equity to achieve diversification and scale in a single purchase rather than buying dozens of investment managers and hoping a majority will work out.  Many of the leading RIA consolidators are or have been backed by PE.  Recent examples include investments made by Stone Point Capital (Focus Financial), Thomas H. Lee Partners (HighTower Advisors), TA Associates (Wealth Enhancement Group), and Oak Hill Capital Partners (Mercer Advisors). Since private equity firms are increasingly interested in growing their RIA exposure, there has been a lot of pressure for these PE-backed consolidators to increase their portfolio holdings via acquisition.  This has largely been positive for wealth manager valuations as consolidators bid up their pricing to grow AUM and appease their PE backers.  Private equity firms have gained broad exposure to the RIA space in recent years through this portal of indirect ownership. Like any other prospective buyer, there are pros and cons associated with a private equity partnership.Does this mean they’re not interested in making a direct investment in your firm?  Not necessarily; but remember that their primary objective (perhaps more than any other type of buyer) is to generate large returns to investors, which may be hard to achieve with an RIA with less than $1 billion under management.  Larger investment managers, though, do offer the scale, (usually) higher margins, and predominantly recurring revenue models that have captured the attention of many PE firms over the years.Like any other prospective buyer, there are pros and cons associated with a private equity partnership.  At the moment, many PE firms are flush with capital and willing to pay a substantial portion of the total consideration in cash up front.  Most can afford to buy a majority interest and typically do so to assume control over future operations.  Sellers generally appreciate the down payment but are less enthusiastic about relinquishing control.  Many RIA owners aren’t comfortable with the latter, so these discussions sometimes don’t get past the initial call.Private equity, however, is not a permanent solution.  PE firms aim to grow their investment as much as possible over the next five to seven years before flipping it to a new buyer at two or three times what they initially paid.  This scenario means they often put pressure on RIAs to take on more clients and/or reduce costs, so they can maximize profitability for a prospective sale.  Additionally, this means a new owner with new demands will take over in the not so distant future.Is a Private Equity Investment the Right Solution for You? Private equity is sometimes used to cash out a former partner or outside investor when the current owners don’t have the capital or desire to take on this additional investment personally.  Selling (outside) partners usually favor this type of investment because PE firms can pay more up front.  Principals remaining in the business usually don’t want any ownership lingering in the hands of former employees, but in this scenario, they’ve effectively swapped one outside investor for another.  There’s no guarantee that the second one will be any better.Private equity can also be a relatively straightforward path to diversification for existing principals.  In many cases, a significant portion of an RIA principal’s net worth is tied up in his or her business with no immediate access to liquidity.  PE firms allow these owners to take some cash off the table and reduce their dependency on the business.  RIA principals will have to weigh the benefits of diversification and instant liquidity with the costs of losing control to outside ownership.Your due diligence on the prospective buyer is just as important as their due diligence on you.On balance, private equity’s interest in the space has been good for the RIA industry.  They’ve likely had a positive effect on wealth manager valuations and are a significant source of liquidity for an otherwise illiquid business.  This doesn’t necessarily mean they’re a good partnership for your firm, so you still need to consider what you’d be giving up in a sale and how it could impact other employees and stakeholders.  Even if the price is right, it still may not be a good fit for you and your team.  Your due diligence on the prospective buyer is just as important as their due diligence on you.We strongly recommend hiring a team of experienced and trusted advisors to help navigate this process.

On October 14, 2019, Parsley (PE) announced that it was acquiring Jagged Peak (JAG) in an all-stock transaction valued at $2.27 billion.  The market’s reaction to the announcement was generally negative, as Parsley closed down more than 10% on the date of the announcement.  This appears to be driven, at least in part, by investors’ desire for Parsley to be acquired rather than be the acquirer. Despite the negative market reaction, we believe this transaction is emblematic of key trends we expect to see during the next wave of consolidation. All-Stock TransactionJagged Peak shareholders will receive 0.447 shares of Parsley stock per JAG share.  Legacy Parsley shareholders will own 77% of the combined company, while legacy Jagged Peak shareholders will own 23% of the combined company.With equity capital markets largely closed to E&P companies and investor concerns regarding leverage, we don’t expect to see any cash/debt-financed acquisitions in the near future.  The exception might be a transaction by a supermajor as Exxon and Chevron reported cash balances of $5.4 billion and $11.7 billion, respectively, at the end of September.Low- or No-Premium AcquisitionConsideration to Jagged Peak shareholders represented an 11.2% premium relative to JAG’s preceding closing price.  However, given JAG’s recent stock price decline, the implied price was only a 1.5% premium to JAG’s 30-day VWAP. Investors are increasingly focused on metrics like return on capital employed and cash flow per share accretion/dilution.  As an acquisition premium increases, these metrics worsen. After Callon announced its acquisition of Carrizo for 2.05 CPE shares per CRZO share, implying a 25% premium based on closing prices before the announcement (though the press release cited the lower 18% premium based on Carrizo’s 60-day VWAP), Callon faced intense investor pushback, especially by hedge fund manager John Paulson.  Last week, Callon and Carrizo announced revised deal terms in which Carrizo shareholders will receive only 1.75 CPE shares per CRZO share, resulting in a more modest 11% premium based on prevailing prices.  However, the press release again cited a lower premium, this time of 7% based on pricing just before the original transaction announcement in July. Low- or no-premium acquisitions are more palatable to sellers in all-stock transactions as they have the potential to realize the transaction’s synergistic benefits over time given their continued ownership interest in the combined entity.  With an all-cash acquisition, benefits to the sellers can only be realized from the purchase price, so meaningful take-over premiums are typically necessary. Corporate, Rather than Asset, TransactionA&D activity recently has been modest, with wide bid/ask spreads separating buyers and sellers.  However, with corporate transactions, public stock prices help align buyers and sellers on value.  Also, the inherent G&A expense associated with a corporation gives the buyer an obvious target for synergies.Focus on Concrete Cost Synergies Rather than Nebulous Strategic RationaleIn the acquisition presentation, the “Synergy Scorecard” slide (page 10) clearly emphasizes the G&A and operational synergies that Parsley expects to realize from the acquisition.  While the strategic benefits are also highlighted (and take up most of the real estate on the page), it is clear that these take a backseat to the tangible cost reductions.ConclusionParsley’s acquisition of Jagged Peak largely follows the playbook we expect to see in upcoming M&A announcements.  Despite the expected cost synergies and strategic benefits, shareholders reacted negatively to the news.  Even with the addition of Jagged Peak, Parsley’s status as the fourth largest operator in the Permian (based on rig count) would remain unchanged.  This will likely cause management teams to re-evaluate their thoughts on optimal size and scale as they survey the acquisition landscape.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

RIA M&A has been a well-publicized topic in the industry.  There was a record level of RIA M&A in 2018, and so far in 2019 there are no signs that deal pace is slowing down.  Against this backdrop, a new study conducted by Advisor Growth Strategies (AGS) and sponsored by BlackRock sheds light on the realities facing RIA buyers and sellers.  Based on transaction information for over 50 RIA deals, the study examines the relationship between deal price and deal terms.  The full study is available here.The study categorizes RIA deals based on purpose (short-term or long-term), size (small target or large target), and payment structure (certain or uncertain).  The synthesis of these factors impacts the transaction multiple, as shown in the chart from the study below.[caption id="attachment_28869" align="aligncenter" width="493"]Source: Advisor Growth Strategies[/caption] While the deal multiple is a convenient short-hand way to summarize a transaction, as the chart above suggests, it does not tell the full story.  Still, the deal price and multiples are what makes the headlines (if terms are publicly disclosed at all) because the nuances of an earn-out arrangement don’t make for an exciting press release. You Pick the Price, I’ll Name the TermsBecause of the lack of transparency and media focus on non-price deal terms, the market norms and trends for this important aspect of RIA M&A are often unfamiliar to first time buyers or sellers.  However, non-price deal terms can be just as important or even more important than the deal price.  This is particularly true in RIA deals, where buyer stock and/or contingent consideration may account for a significant portion of total deal value.  The AGS study provides some insight into the state of deal terms in the RIA M&A market from the perspective of both buyers and sellers.  We’ve highlighted some of the key takeaways from the study below.While there are many small (and successful) RIAs, the largest 5.4% of firms by AUM control 63.2% of AUM. The largest RIAs command premium multiples, but these firms are a minority.  The study (which focused on smaller RIAs) found that the median adjusted EBITDA multiple for M&A transactions between 2015 and 2018 was 5.1x, and there was little variation over the period.  RIAs must choose between pursuing scale through inorganic growth or maintaining a boutique approach.Large acquirers (e.g., Focus Financial, HighTower, CapTrust, Mercer Advisors) are setting the pace for deal terms. Given the proliferation of capital providers in the space, providing a successful long-term outcome is now the differentiator for these “acquisition brands.”  Compared to smaller, less frequent RIA acquirers, the acquisition brands have a leg up based on their demonstrated and repeatable growth engine, robust human capital and technology, ability to add service diversification, and access to capital.  For sellers, the turn-key offerings provided by acquisition brands are a benchmark for establishing rational expectations.RIA deal terms now provide an average of 60% of cash consideration at closing. For buyers, this means a high barrier to entry and critical need for a solid integration strategy.  For sellers, liquidity at close is nice, but accepting a relatively high upfront payment may not maximize the overall valuation.While RIA cash flows have been increasing, multiples have remained relatively consistent between 2015 and 2018. Buyers must find a balance between price and terms based on the transaction’s purpose to get sellers to commit.Up to 40% of consideration is being paid in buyer stock. In general, larger deals saw a greater proportion of total consideration in the form of buyer equity.  For buyers, this means that it is critical to demonstrate the merits of their business model and to articulate a path to liquidity (particularly for privately held acquirers).  For sellers, the burden is on them to evaluate the investment merits of their acquirer.  When buyer stock is part of the consideration, the buyer and seller are in the same boat after the transaction, so it is critical that both parties evaluate the investment merits of the combined entity.Buyers are assuming more of the risk in RIA transactions. 75% of the transactions in the study had less than 25% of the total consideration allocated to contingent consideration, and the contingent payments were relatively short-term (all were less than three years).  Given these terms, buyers must be willing to assume some of the risk of the transaction and have a clear integration plan.M&A OutlookWith over 11,000 RIAs operating in the U.S., we expect that consolidation will continue and deal volume will remain strong.  The AGS study suggests that, at least for most firms, multiples have been relatively consistent over the last several years.  Without major changes to deal terms and structure, this may continue to be the case.  Market forces have and will continue to impact non-price deal terms.  Acquisition brands are a growing force in the industry, and their influence on deal terms will likely grow accordingly.  At some point, every RIA will likely become either a buyer or a seller and will confront the tradeoffs between price and deal terms and other market realities as they exist at that time.

Software developers must regularly decide whether to purchase existing software for desired functionality or to write the software themselves. In fact, software developers make these decisions so often that there is an entire literature devoted to helping them make the best “build vs. buy” decision in any particular situation. Family business directors face a similar decision when it comes to making capital investments. There are essentially two options for capital investment:Capital expenditures (i.e., “build”)Acquisitions (i.e., “buy”) As shown on Exhibit 1, we classified each of the operating companies the S&P 1000 as either “Builders” or “Buyers” based on the relationship between aggregate cash flows for capital expenditures and acquisitions from 2013 through 2015. As groups, the Builders allocated 89% of total capital investment to capital expenditures, while acquisitions accounted for 81% of total capital investment for the Buyers. With regard to median size (measured by revenue) and operating margin, the two groups are virtually indistinguishable. The Buyers’ relative capital investment was greater, contributing to modestly faster revenue growth over the three years ending in 2018. Buyers are over-represented in the healthcare and IT sectors, while consumer sector (both discretionary and staples) is more hospitable to Builders. So how should you and your fellow family business directors decide whether to build or buy? What will be the most effective form of capital investment for your family business? Since software developers think more about the build vs. buy decision than most of us do, we thought it would be interesting to apply a software-related decision framework to family business investment decisions. For purposes of this blog post, we follow the six step decision framework advocated by Justin Baker. Step #1: Identify Functional RequirementsFor family businesses, all capital investment should begin with strategy. What strategic objectives require capital investment? What competitive advantage is the company seeking to extend, strengthen, or defend? Strategy should guide family businesses in selecting capital investments; too often, family businesses attempt to formulate a strategy out of available capital investments.Step #2: Define the Scope of Work and Reconcile Against ConstraintsFamily businesses face both financial and non-financial constraints when evaluating capital investments. Directors should be carefully attuned to both of these constraints. Since family businesses are often reluctant to raise equity capital from outside the family, the amount of capital available for investment is limited to operating cash flow and available debt financing. Non-financial constraints are most often either cultural (is there any precedent for making acquisitions?) or managerial (does our management team have the requisite capacity or skill set to execute the proposed capital project successfully?). If there is a managerial constraint, are there family members with the needed skills, or will it be necessary to bring in non-family managers? Regardless of the answers to these questions, a clear-eyed assessment of the relevant constraints will help ensure that directors are evaluating a feasible set of build or buy options.Step #3: Solution DivergenceSolution divergence simply means identifying the potential build and buy options. On the buy side, this might mean keeping a running list of competitors, suppliers, or customers that could provide a compelling strategic combination with the family business. On the build side, operating managers are often the best source of potential capital expenditures. In either case, is your family business’s corporate strategy have enough visibility throughout the organization so that operating managers have a good feel for what acquisition targets or capital projects are going to be worth pursuing? Has the board and senior management communicated a list of “must haves” for any capital investment? It can quickly become demoralizing for operating managers when there are no clear criteria against which proposed investments will be evaluated. Solution divergence is ultimately about nurturing a process for generating a sustainable pipeline of proposals (both “builds” and “buys”) for directors to evaluate.Step #4: Solution ConvergenceWhereas solution divergence describes the process of identifying potential capital investments, solution convergence refers to the process for selecting the capital investments to be made. In addition to strategic considerations, the selection process should also reference financial return metrics like internal rate of return (IRR) and net present value (NPV). Satisfactory financial metrics are a necessary, but not sufficient, condition for selecting a capital project. Capital investments should satisfy both financial and strategic objectivesShould financial hurdles be different for “build” projects than “buy” projects? Some families, concluding that acquisitions are inherently riskier than capital expenditures, assign higher hurdle rates to acquisitions. The risks traditionally ascribed to acquisitions include the tendency to overpay in competitive bidding situations and the difficulty of assuring a healthy cultural fit between buyer and seller. These risks are certainly real, but capital expenditures are not without their own unique risks. Specifically, capital expenditures create incremental industry capacity, and forecasting market demand and the impact of additional supply on pricing can be just as challenging as integrating acquisitions. The use of “premium” hurdle rates for acquisitions is ultimately neither right nor wrong, but simply a form of capital allocation by another name. Regardless of the hurdle rate selected, capital projects must satisfy both financial and strategic criteria to merit investment.Step #5 – Build or Buy or BothThis is the execution phase. Selecting the capital investments to be made is not the end of the process. Successful family businesses translate forecasts into operating results. Directors cannot just assume that the hand-off from the corporate development and finance teams to the operations team will be done well. In the case of an acquisition, integrating new employees and realizing planned synergies while minimizing negative surprises take top priority. For capital expenditures, avoiding cost overruns and delays that can eat away expected returns on projects is critical.Step #6 – Develop Guidelines for ReassessmentCapital investments are hard to reverse. Nonetheless, family businesses need feedback processes to ensure that the family doesn’t throw good money after bad, and to help improve forecasting techniques and improve accountability in the interest of making better capital investment decisions in the future.ConclusionIs your family business a builder or a buyer? Which factors contribute to your build vs. buy decisions? Do you employ a consistent framework for evaluating these decisions? Do you have a robust process for seeding a pipeline of potential future projects for consideration? Do you understand the cultural factors that make acquisitions or capital expenditures more palatable for your family shareholders? Simple answers elude each of these questions, but directors should assess what processes are in place or need to be developed to ensure that family capital flows toward the most productive uses in the family business, whether in the form of building or buying.

Through the first three quarters of 2019, asset and wealth manager M&A has kept up with 2018, the busiest year for sector M&A during the last decade.  Transaction activity is poised to continue at a rapid pace as business fundamentals and consolidation pressures continue to drive deal activity.  Several trends which have driven the uptick in sector M&A in recent years have continued into 2019, including increasing activity by RIA aggregators and mounting cost pressures.Total deal count during the first three quarters is set to exceed 2018’s record levels.  Reported deal value during the first three quarters was down, although the quarterly data tends to be lumpy and many deals have undisclosed pricing.  Dollar value in 2018 was also boosted by Invesco’s $5 billion purchase of OppenheimerFunds. Acquisitions by (and of) RIA consolidators continue to be a theme for the sector. The largest deal of the second quarter was Goldman Sachs’s $750 million acquisition of RIA consolidator United Capital Partners.  The deal is a notable bid to enter the mass-affluent wealth management market for Goldman Sachs.  For the rest of the industry, Goldman’s entrance into the RIA consolidator space is yet another headline that illustrates the broad investor interest in the consolidator model and yet one more approach to building a national RIA brand. Acquisitions by (and of) RIA consolidators continue to be a theme for the sector.Mercer Advisors’ recent sale to Oak Hill Capital Partners is further evidence of growing interest in the RIA consolidator space.  While deal terms weren’t disclosed, some industry analysts estimate a high teens EBITDA valuation that exceeded $500 million. These RIA aggregators have been active acquirers in the space with Mercer Advisors and United Capital Advisors each acquiring multiple RIAs during 2018 and the first three quarters of 2019. Sub-acquisitions by Focus Financial’s partner firms and other firms owned by RIA consolidators are further drivers of M&A activity for the sector.  These acquisitions are typically much smaller and are facilitated by the balance sheet and M&A experience of the consolidators.  For some RIAs acquired by consolidators, the prospect of using buyer resources to facilitate their own M&A may be a key motivation for joining the consolidator in the first place.  For the consolidators themselves, these deals offer a way to drive growth and extend their reach into the smaller RIA market in a way that is scalable and doesn’t involve going there directly.Consolidation Rationales Sector M&A has historically been less than what we might expect given the consolidation pressures the industry faces.Building scale to enhance margins and improve competitive positioning are typical catalysts for consolidation, especially on the asset management side.  One way to stem the tide of fee pressure and asset outflows is to cut costs through synergies to preserve profitability as revenue skids.  The lack of internal succession planning is another driver as founding partners look to outside buyers to liquidate their holdings.  While these factors are nothing new, sector M&A has historically been less than what we might expect given the consolidation pressures the industry faces.Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task.  The risks include cultural incompatibility, lack of management incentive, and size-impeding alpha generation.  Many RIA consolidators structure deals to mitigate these problems by providing management with a continued interest in the economics of the acquired firm while allowing it to retain its own branding and culture.  Other acquirers take a more involved approach, unifying branding and presenting a homogeneous front to clients in an approach that may offer more synergies, but may carry more risks as well.Market ImpactDeal activity in 2018 was strong despite the volatile market conditions that emerged in the back half of the year.  So far in 2019, equity markets have largely recovered and trended upwards.  Publicly-traded asset managers have lagged the broader market so far in 2019, suggesting that investor sentiment for the sector has waned following the correction at the end of last year.M&A OutlookConsolidation pressures in the industry are largely the result of secular trends.  On the revenue side, realized fees continue to decrease as funds flow from active to passive.  On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs.  The continuation of these trends will pressure RIAs to seek scale, which will, in turn, drive further M&A activity. With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies.  Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression.  An aging ownership base is another impetus.  The recent market volatility will also be a key consideration for both buyers and sellers for the remainder of this year and the next.

Acquisition and divestiture activity in the Bakken for last twelve months has been minimal. The lack of deals, however, does not mean that activity or production hasn’t been meaningful. In fact, as mentioned in our most recent post, production has grown approximately 10% year-over-year through September with new well production per rig increasing over 29%. Also, while other major basins have been decreasing rig counts, the Bakken has remained steady year-over-year as of the end of September.While the fundamentals of this basin are strong, relatively few companies remain interested. As such, deal activity has largely involved the familiar faces in the region. Companies with smaller positions in the region have continued to divest “non-core” positions as they focus their efforts in other regions.  Contrast this trend to the controlling acquisitions or takeovers like those that have been popular in the Permian.Recent Transactions in the BakkenDetails of recent transactions in the Bakken, including some comparative valuation metrics, are shown below.Balance Sheet Cleanup: Whiting and AbraxasA recurring theme observed throughout the year in multiple basins has been the optimization of assets. The theme continues in the Bakken for 2019 as transactions in the basin have primarily consisted of offloading portions of non-operated assets, the largest of which was the deal with Whiting Petroleum and an undisclosed buyer for $53 million. However, Whiting remains the third largest holder of net acreage in the basin.Abraxas Petroleum also sold approximately $16 million in non-operated assets in June. These assets were not part of Abraxas’ core Williston position. However, Abraxas appears to be open to conversations with parties interested in acquiring both operated and non-operated assets, as the company is seemingly in deal talks with Whiting Petroleum.Given the age of the basin and smaller number of players, consolidation and strategic deals between operators have been prevalent. Several players have left the Bakken for the Permian, and as a result, the top five net acreage holders account for roughly half of the existing operating acreage in the basin. Abraxas undertook a sizable debt load in 2018 to finance further capital expenditures and restructure debt maturities ($180 million due in 2020-20211).  An exit from the Bakken to pay down its debt and expand their Permian operations does not seem unreasonable.Continued Non-Operator Acquisitions: Northern Oil and GasSimilar to trends observed in the Bakken last year, acquisitions by non-operators have continued into 2019. For instance, Northern Oil and Gas has made several deals in the basin and its acquisition of private equity-backed Flywheel Energy LLC in April 2019 was one of the largest of the year, and represents a continuance of this trend.Northern Oil and Gas has been the basin’s most consistent acquirer of non-operating interests. As a nonoperator, Northern can enjoy cash flows received from acreage without the operator risk that has become ever more prevalent in the current environment, and consequently, the company has the luxury of continuing to strategically consolidate acreage in the basin. Since the start of 2018, the company has made four large publicly announced transactions totaling more than $820 million.Below is a map of the acreage Northern Oil and Gas acquired in the Flywheel transaction as well existing acreage to show its overall footprint in the basin.ConclusionEven though transaction activity in the Bakken has been minimal compared to basins like the Permian, production is up, and rig counts are steady. Acquisitions for operators and non-operators alike have been strategic and pinpointed as the experienced players look to build and maintain their large positions relative to others in the area. Despite a slowdown of A&D activity in the back half of 2019, the operators and non-operators in the Bakken appear undeterred and are staying the course.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.1 Abraxas Petroleum Corporation Annual Report December 31, 2018

Continuing with our succession series, this week’s focus is on internal transitions.  If you’ve ever wondered why there aren’t more transactions in the RIA space, it’s largely because most of these businesses ultimately transition their ownership internally to younger partners at the firm.  These deals typically don’t get reported, so you probably don’t hear about most of them.  Still, it’s the most common type of transaction for investment management firms and probably something that’s crossed your mind if you’re approaching retirement.A gradual transition to the next generation is a good way to align your employees’ interests and grow the firm.These types of transactions are common for a reason.  Most RIA owners like working for themselves and will eschew outside interference at all costs (unless the price is right).  Because many clients enjoy working with a wholly independent advisor, internal transitions are a good way to accomplish this in the long run.  Further, a gradual transition of responsibilities and ownership to the next generation is also usually one of the best ways to align your employees’ interests and grow the firm to everyone’s benefit.The most obvious roadblock when planning for internal succession is pricing.  We recommend that all firms have a buy-sell agreement that specifies the terms and the price that shares are transacted at as an owner exits to retire.  Because many wealth management firms are highly valuable, successors are often financially stretched to take over the founder’s interest in the firm.  By establishing the price and terms at which the shares will be transacted, a buy-sell agreement mitigates any potential drama.In their recent book Success and Succession, Eric Hehman, Jay Hummel, and Tim Kochis examine the complexities of the leadership transition process and summarize their findings from their own experience:Both the founder and the successor need to be aware that firm-wide growth often declines in the first year following the change in management, as the founder-centric firm shifts its brand image and the successor takes on responsibility for creating new business. If a successor is unaware of this trend, he or she could feel additional stress regarding the financial burden he undertook when buying out the former owner.  The founder could feel the need to resume full-time involvement in operations, fearing for his ongoing financial benefits from the firm.  The authors advise both founders and successors to take a long-term view and not focus on this short-term pullback.Regardless of the firm’s performance in the first few years following succession, both the founder and the successor need to set definite (as in finite) expectations regarding the founder’s continued involvement or lack thereof. The founder should remain accessible as his or her guidance is crucial when the successor faces major issues early on.  However, it should also be clear to everyone that the successor is now the one charged with minding the store.Though some things do need to change following a succession of management, the successor should avoid creating new positions to retain people who no longer fit into the firm’s long-term goals. One benefit of succession is that the new manager may have a fresh perspective on areas of the firm in which cost cutting measures or other efficiencies are possible.  Although it may be difficult to assess which employees should remain after the transition, allowing those who are poor fits to remain with the firm does significant damage to the firm’s culture and does not set the proper tone for post-transition success.It is crucial to separate compensation for labor from profit share rewards as the exiting owner becomes less involved in the day to day management of the firm. This issue can be resolved through the establishment of a strict reinvestment versus distribution policy going forward.  The authors even suggest that the founder employ an independent financial advisor in order to objectively estimate a fair amount of compensation following the sale.Though it is clear that the founder has taken on a significant amount of financial risk in the creation of the firm, it must be noted that the successor is also taking on risk in the amount of debt that he or she must incur to buy out the owner. Both parties have a lot to gain and a lot to lose in the process of succession, and both bear a significant emotional burden.  The founder may perceive the transition as a loss of a personal identity that is tied to the firm, and the successor must now bear the responsibility of the ongoing success of the firm.Controversy over what is fair or what is “enough” in terms of a sale price can be resolved through a third-party valuation. While it might seem easier to rely on rules-of-thumb metrics or attractive examples, these tactics are purely short term solutions and can result in overly optimistic estimates. The financial terms of the valuation are already emotionally charged. A third party valuation can provide a much needed “reality dose.” Obviously, there’s a lot to think about, and this is certainly not an exhaustive list.  It’s never too early to start planning for your succession.  The longer you wait, the more likely you are going to fall short or have to make series concessions on pricing.  Unfortunately, we see this more often than not, so don’t become another statistic.  We’re here to help with the valuation and advisory aspects, but it’s up to you to get the ball rolling.

In the late 1930s Henry Ford’s son, Edsel, commissioned a one-off convertible version of the Lincoln Zephyr to drive while he vacationed in Florida for the winter.  While the initial design is said to have been penned in about an hour, legend has it that Edsel Ford kept tweaking the details and wearing out the engineers such that they finally locked him out of the shop to finish the car.  Edsel Ford took his Lincoln, dubbed the “Continental,” to Florida, and came back with 200 orders.  Ford suddenly had a halo car, and Lincoln became a durable brand for decades.The Continental story is significant for many reasons, one of them being that it was a big success for second-generation leadership at Ford Motor Company.  Many businesses start and grow by force of the personality of the founder, and wither and die when there is no successor leadership to take over when the founder is no longer at the helm.  Ford succeeded where many other automakers failed, which is why this blog post is starting with that company instead of Pierce-Arrow, Packard, or Duesenberg.Succession is as often discussed as it is misunderstood.If succession is difficult to achieve in a “products” company like an automaker, it is mind-numbing to engineer in a “services” business-like investment management.  Riffing off the over-repeated metaphor to describe the substance of an RIA, if the assets get on the elevator and go home every night…does a change in assets mean a different company altogether?Succession is as often discussed as it is misunderstood.  While many practice management issues revolve around industry expectations, regulations, client expectations, and basic economics, succession involves all of those things plus personality, culture, and skill sets.  And while much has been written about succession in the RIA industry, we’ve seen plenty of topics get little, if any attention.  This post is dedicated to some of the latter.Internal Succession is the Default Plan for Most RIAsDespite the headlines suggesting that there is a wave of strategic takeovers that will ultimately consolidate the investment management profession into a few large firms, the reality we’ve encountered suggests that most RIAs will transition ownership and leadership from one generation to the next internally.  The reasons for this are fairly obvious.Even though there are on the order of 15,000 RIAs in the U.S. which are all generally in the same business (providing investment management consulting services in exchange for fees priced relative to the dollar amount of client assets), there are also about 15,000 business models.  Investment management firms are idiosyncratic, with practices and cultures unique to the individuals involved in the practice and the market niche served by the practice.Staff who grow up, or whose careers develop, at a given firm understand, inherently, the values and expectations of their workplace, and are in the best position to perpetuate the business after the prior generation of leadership retires.Strategic Transactions Rarely Obviate the Need for Succession PlanningLeadership transition issues can loom large even in strategic transactions.  We worked on a dispute situation a few years ago in which a strategic acquirer bought a substantial wealth management practice without even meeting the next generation of leadership.  The ink was hardly dry on the purchase agreement when generation two started looking for the exit, knowing many of their clients would follow them.  Litigation eventually resolved this in one respect, but most arms’ length observers would conclude that all parties (buyer, seller, and the second generation) were worse off as a result.RIAs often pride themselves on having a team-oriented atmosphere, which is great for serving clients, but not so great for negotiating succession issues.  When team members become buyers and sellers, temperaments that were heretofore aligned become opposed.  Arguments can easily break out between members of buyer and seller groups when goals diverge or perspectives on the future of the firm conflict.Some see strategic transactions as a way to avoid the uncomfortable conversations that accompany internal ownership transition.  Not so.  If the strategic transaction does not align with the priorities of the group responsible for leading the firm after the deal closes, then the likely outcome will be suboptimal.Continuity Planning is the Dog that Wags the Succession TailThe client doesn’t really care who owns your firm.  The client cares about the firm serving their needs.  It’s easy to forget this because…Succession is a Strategic Issue Often Mistreated as a Tactical IssueWhen managers at RIAs start thinking about succession, they immediately jump into who buys out whom at what price and terms.  We would suggest, instead, that the starting point is strategic planning for the business.Ownership should be a consequence of the business strategy, not the other way around.Ownership is the single biggest distraction for most closely held businesses.  But ownership should be a consequence of the business strategy, not the other way around.  Think of the strategic priorities of an investment management firm in the same order they appear on the P&L.Revenue comes first.  So, at a basic level, strategic planning for an RIA starts with growing client relationships and value provided to the clients to maximize revenue opportunities.Next comes operating expenses, which for an investment management firm consists mostly of employee compensation.  Spending on talent and tools to achieve the strategic revenue goals form the organization to be owned.Profits are at the bottom of your P&L for a reason.  They matter, of course, but returns to equity are the residual of client interaction and the organization formed to serve them.  Ownership is a by-product of strategy, and, at best, can be structured to support strategic initiatives.Timing is Everything, and so is TimeAnother famous Lincoln, whose first name was Abraham, famously said that if he was given seven hours to chop down a tree, he’d spend six hours sharpening his axe.  We would say this ratio of planning to implementation is about right for dealing with the issue of succession as well.

The capital markets in the upstream sector are leaving companies and investors in the lurch right now. Compared to 2018, equity and debt issuances have declined markedly and IPO’s in the sector have been relatively quiet apart from Brigham Minerals’ successful offering.[caption id="attachment_28082" align="alignnone" width="717"]Source: Shale Experts[/caption] Saltwater disposal and integrated water logistics companies have attracted a higher proportion of the sparsely available capital flowing into the sector, highlighted by the largest energy IPO of this year: Rattler Midstream LP. The continuing austerity trend toward cash flow sustainability for shale oil companies has provided limited attractive options for investors. In the meantime, drilling activity (particularly in West Texas) continues to grow, and therefore efficiency and scale grow ever more important across the board for upstream companies to remain competitive. One of the challenges producers face is handling the enormous amounts of water that have become part and parcel to the Delaware and Midland Basins. This is where saltwater disposal enters the picture. A horizontal well in the Delaware Basin can average four barrels (sometimes even up to 10 barrels) of water for every barrel of oil produced. Once produced, all that water must go somewhere and that somewhere is a saltwater disposal well. This is no new phenomenon as produced water has been an element of production for over 70 years. What is different in the Permian Basin is the higher ratio of water to oil (often called a “water cut”) that’s produced due to the native geology and today’s production techniques. Today’s U.S. oilfield water production is already around a colossal 50 million barrels a day. This contrasts with the U.S. producing only 15 million barrels of petroleum liquids every day. Most of that water is produced in the Permian Basin and there’s only going to be more of it. Much more. That’s to say nothing of the amount of water needed to fracture the rock during the production process. In a recent Raymond James research report, the authors noted that each well completion uses thirty Olympic swimming pools worth of water. [caption id="attachment_28080" align="alignnone" width="640"]Source: EIA, Drilling Info, Baker Hughes, Raymond James Research [/caption] This water needs to be transported, sometimes long distances, and logistically managed. This function is trending towards consolidation whereby a single entity combines these assets and services. Until the past couple of years there was very little aquatic pipeline infrastructure. Most was handled by trucking, but that is changing as increasing volumes are raising scrutiny on the inefficiency of trucking. Growing demand in West Texas has opened up an estimated $12 billion-dollar market potential in the Permian Basin alone, according to Raymond James. Fees for transporting and disposing produced water typically range from $0.50 to $2.50 per barrel. In addition, there is skimmed oil that can be gathered as well. However, where long distances stand between a production site and disposal infrastructure it can creep up to $4.00 to $6.00 per barrel. In today’s commodity price environment and focus on break-even prices, every dollar per barrel counts. Thus, there is a real incentive to improve infrastructure and push service costs lower. The investment merits of this water infrastructure include the opportunity for more steady business; with long term contracts tied to dedicated acreage, and stable cash flows that can fetch higher valuations than even some of the shale producers themselves in the region. It has been noted that some producers cannot begin drilling in certain areas until the water infrastructure is in place. In addition, there are consolidation opportunities for more fragmented business models between saltwater disposal facilities, equipment rental companies and pipeline companies. More integrated firms that combine these services will function more like traditional midstream operators. The trend has already begun and is being seen in valuations already. Rattler’s $765 million IPO opened at over 18 times EBITDA and recent water driven asset sales have traded between five- and ten-times EBITDA. For example, private equity backed WaterBridge purchased $325 million of Delaware Basin assets (assuming earnouts are paid) from Halcon Resources at an implied 14.5x trailing EBITDA multiple. Firms like NGL Energy Partners and EVX Midstream are also active in the space. Additionally, the opportunity for yield (which energy investors are craving) in the future can be more demonstrable than many upstream opportunities in the oil patch. [caption id="attachment_28081" align="alignnone" width="640"]Source: Company Filings. WaterBridge transaction assumes earnouts. Rattler transaction assumes total units outstanding not just traded ones.[/caption] Amid this activity, landowners are also finding another source of income from royalties stemming from new pipeline and below ground storage rights as well, leading to more local income for ranchers and residents as well as another potential asset base for mineral aggregators and related investors to pursue. Oil and water do appear to mix, and energy bankers will be glad to know they do because it is filling gaps for an otherwise tight capital market space. Originally appeared on Forbes.com.

As we explained in a recent post, there are many viable exit options for RIA principals when it comes to succession planning.  In this post, we will review some of the considerations when partnering with an RIA consolidator.The opportunity for consolidating wealth management firms is well publicized: an industry composed of many small, fragmented firms with aging ownership bases and no clear succession plans is supposedly poised for consolidation.  RIA consolidators have emerged to capitalize on this landscape, promising a means for ownership transition, back-office efficiencies, and best practices coaching.Acquisitions by consolidators represent an increasing portion of deal volume in the sector.Consolidators have been gaining traction in the industry.  Most well-known RIA consolidators have grown their AUM at double-digit growth rates over the last five years, and acquisitions by consolidators represent an increasing portion of deal volume in the sector.For RIA principals that are looking for an exit plan, selling to a consolidator is one option to consider.  A sale to a consolidator typically provides the selling partners with substantial liquidity at close, an ongoing interest in the economics of the firm, and a mechanism to transfer the sellers’ continued interest to next generation management.There are several considerations when considering a sale to an RIA consolidator.  Price, of course, is the big one.  But after the deal closes, the selling shareholders will typically have to stick around for several years at least (the deal terms will make sure of that).  Thus, another important feature to consider is what life will look like after the deal closes.  RIA owners who are considering selling to a consolidator should think carefully about which aspects of their business they feel strongly and how those aspects of the business will change after the deal closes.Consolidator Models There are several different consolidator models, and they can vary significantly in terms of the effect they have on the day-to-day operations of the acquired RIA.  This is largely a function of the amount of integration that consolidators do for their partner firms.At one extreme, there are consolidators such as Focus Financial that standardize only the minimum level of business processes across their acquired firms, which typically include back-office tasks such as compliance and accounting.  This “stay as you are” model has minimal impact on how the firm is run and theoretically maintains the selling partners’ sense of entrepreneurship.  Acquired firms can retain their own branding and client-facing processes after the deal closes, and there is usually little or no impact from the perspective of the firm’s clients.  This model also mitigates the risk of culture clash since acquired firms aren’t forced into a one-size-fits-all mold.At the other extreme, there are consolidators like United Capital (now part of Goldman Sachs) or Mercer Advisors, which unify the branding of acquired firms and present a homogenous wealth management platform to clients.  Under this model, most functions of the acquired RIA—things like marketing, HR, and technology—are moved under the corporate umbrella.  Sellers have much less control after the deal closes under this model.  Some sellers may see this as gaining freedom from the day-to-day management of their firms, but others may be reluctant to relinquish that much control.Deal PricingThe multiples paid by consolidators will vary depending on the current market environment, but they are generally competitive with other exit strategies.  Different consolidator models can have characteristics that more closely resemble either a financial buyer or strategic buyer, and this classification can impact the multiple that the consolidator is able to pay.Different models have characteristics that resemble either a financial buyer or strategic buyer, which impacts the multiple that it is able to pay.Consolidators like Focus Financial, which make minimal changes to the acquired business, are best classified as financial buyers.  Financial buyers purchase the business “as is”, with few plans to make changes to the way the business operates beyond moving selected business functions to the corporate office.  There may be some plans for expense reductions or revenue enhancement, but financial consolidators are unlikely to pay the buyer for those potential benefits.Other consolidators can be considered strategic buyers.  Companies like Mercer Advisors fall into this category.  By making major changes to the way the acquired RIA operates, strategic consolidators have more opportunity to realize synergies and initiate growth-oriented strategic objectives.  In theory, this gives strategic consolidators the ability to pay a higher multiple, but at a cost to the selling shareholders of giving up more control in how the business is run after the deal closes.Deal StructureConsolidators typically purchase 100% of RIAs, but that doesn’t mean that they purchase 100% of the acquired firm’s economics.  RIAs are for the most part owner-operated businesses, so some portion of the acquired firm’s earnings before owner compensation (EBOC) needs to be diverted to the selling shareholders in order to keep them around and align incentives after the close.  For RIAs, it can be difficult to disentangle EBOC into returns to equity versus returns to labor.  As a practical matter, the normalized or post-closing compensation for selling shareholders is a negotiating point when striking a deal with a consolidator.The selling shareholders are likely to maintain an ongoing interest in the economics through earnouts, employment agreements, or other deal features.  For example, Focus Financial structures its deals so that a portion of the acquired EBOC is directed to a newly established management company owned by the selling shareholders.  Initially, this structure provides the selling shareholders with compensation that varies with the profitability of the firm.  In the longer term, the management company equity can, in theory, be sold to the next generation of management when the selling shareholders retire.Cash vs Stock ConsiderationIt’s also worth noting that consolidators often use their own stock as part of the total consideration.  For publicly traded companies like Focus Financial, it’s clear exactly how much that’s worth at any given time.  For closely-held aggregators like Hightower and Captrust, their stock price is not readily apparent.Even if the consolidator is publicly traded, you should be wary of any lock-up provisions since stock prices for these companies can be volatile.Facilitating M&AAnother purported benefit of selling to a consolidator is that the acquired firm gains access to the consolidator’s balance sheet to pursue its own acquisitions.  The low cost of capital for consolidators can allow the acquired firms to complete their own acquisitions in a way that is still accretive to the selling shareholders.Many partner firms of Focus Financial, for example, have completed their own acquisitions, and presumably, these deals make financial sense for the partner firm’s principals.  For firms that are considering inorganic growth, this aspect of a sale to a consolidator may be a key consideration.Other OptionsSelling to a consolidator is just one exit strategy among many, and RIA owners should carefully weigh the pros and cons selling to a consolidator relative to those of other exit strategies.  In subsequent posts, we will discuss other viable exit options for RIA principals.

This post serves as an introduction to our succession planning series, which is intended to address an overlooked but critical issue facing many RIAs today.A recent Schwab survey asked RIA principals to rank their firm’s top priorities in the coming year.  We were disappointed but not surprised to discover that developing a succession plan was dead last.  This is unfortunate because 62% of RIAs are still led by their founders with only about a quarter of them sharing equity with other employees to support succession planning.  Not much progress has been made, and there doesn’t seem to be much of a push to resolve this issue any time soon.  Brent Brodeski, CEO of Savant Capital, describes this predicament more crassly:The average RIA founder is over 60 years old, and many are like ostriches: They stick their heads in the sand, ignore the need for succession planning, ignore that their clients are aging, let organic growth slow to a crawl or even backslide, and have increasingly less fun and a waning interest in their business.Fortunately, it doesn’t have to be this way.  There are many viable exit options for RIA principals when it comes to succession planning.  We’ll outline these options in this post and expound upon them in more detail later in the series.Sale to a strategic buyer. In all likelihood, the strategic buyer is another RIA, but it could be any other financial institution hoping to realize certain efficiencies after the deal.  They will typically pay top dollar for a controlling interest position with some form of earn-out designed to incentivize the selling owners to transition the business smoothly after closing.  This scenario often makes the most economic sense, but it does not afford the selling principals much control over what happens to their employees or the company’s name.Sale to a consolidator or roll-up firm. These acquirers typically offer some combination of initial and contingent consideration to join their network of advisory firms.  The deals are usually debt-financed and typically structured with cash and stock upfront and an earn-out based on prospective earnings or cash flow.  Consolidators and roll-up firms usually don’t acquire or pay as much as strategic buyers, but they often allow the seller more autonomy over future operations.  While there are currently only a handful of consolidators, their share of sector deal making has increased dramatically in recent years.Sale to a financial buyer. This scenario typically involves a private equity firm paying all-cash for a controlling interest position.  PE firms will usually want the founder to stick around for a couple of years after the deal but expect him or her to exit the business before they flip it to a new owner.  Selling principals typically get more upfront from PE firms than consolidators but sacrifice most of their control and ownership at closing.Patient (or permanent) capital infusion. Most permanent capital investors are family offices that make minority investments in RIAs in exchange for their pro-rata share of future dividends.  They typically allow the sellers to retain their independence and usually don’t interfere much with future operations.  While this option is not as financially lucrative as the ones above, it is often an ideal path for owners seeking short term liquidity and continued involvement in this business.Internal transition to the next generation of firm leadership. Another way to maintain independence is by transitioning ownership internally to key staff members.  This process often takes a lot of time and financing as it’s unlikely that the next generation is able or willing to assume 100% ownership in a matter of months.  Bank and/or seller financing is often required, and the full transition can take 10-20 years depending on the size of the firm and interest transacted.  This option typically requires the most preparation and patience, but allows the founding shareholders to handpick their successors and future leadership.Combo deal. Many sellers choose a combination of these options to achieve their desired level of liquidity and control.  Founding shareholders have different needs and capabilities at different stages of their life, so a patient capital infusion, for instance, may make more sense before ultimately selling to a strategic or financial buyer.  Proper succession planning needs to be tailored, and all these options should be considered. If you’re a founding partner or selling principal, you have a lot of exit options, and it’s never too soon to start thinking about succession planning.  You will have a leg up on your competition that’s probably not prioritizing this.  You’ve likely spent your entire career helping clients plan for retirement, so it’s time to practice what you preach.  Please stay tuned for future posts on this topic and give us a call if you are ready to start planning for your eventual business transition.

For bargain shoppers, the discounts at Nordstrom have been eye-catching lately.  And we don’t mean the clothes.  The shares of the fourth-generation family retailer, whose shares have been publicly traded since the early 1970s (ticker: JWN), have lost nearly 40% of their value during 2019.For bargain shoppers, the discounts at Nordstrom have been eye-catching lately.  And we don’t mean the clothes.According to a Wall Street Journal report, the Nordstrom family is preparing a bid to increase its ownership stake in the company from approximately one-third to over 50%.  Although the exact form of the proposed transaction has not yet been specified, it is almost certain that the family would need to offer a premium to the current share price to complete such a transaction. One interesting twist to this family drama is that at least some observers believe that the shares are depressed because of the inept management of the very family members who are proposing to increase their ownership stake.  The company is managed by two fourth generation brothers (three, until the oldest died unexpectedly in January), but a majority of board seats are held by non-family independent directors.  Amid stagnating operating performance, some on the board have been seeking to bring in an unrelated outsider to replace the family managers. These developments come after directors rejected a bid by the family to take the company private in 2017 for $50 per share (the shares closed on Friday at $29.30). Some stocks are underpriced; others are cheap for a reason.  Assuming the family’s proposal to increase its ownership stake goes forward, the independent directors will need to decide which is true of Nordstrom’s shares.  Reported earnings for 1Q19 fell 55% from the prior year as total revenue slid by 3.5%.  At Friday’s closing price, JWN shares imply a value of approximately 6.2x trailing EBITDA.  Department store peer Macy’s (ticker: M), whose shares have also languished during 2019, trades at a comparable 6.5x multiple.  As always, whether Nordstrom shares are undervalued or properly assessed by the market remains a matter of difficult judgment. Some stocks are underpriced; others are cheap for a reason.Since very few family businesses are publicly traded, their directors do not have to engage in these difficult deliberations under the public microscope.  The core issues however, are not uncommon to private family businesses.  The alternatives available to the Nordstrom investors likely include some combination of the following:Negotiate a transaction price at which the Nordstrom family could increase their ownership stake above 50% while remaining publicly-traded. If the directors accept a Nordstrom family proposal to increase their ownership, it would likely result in the family exerting more direct control over the company in the future.  If the current family managers are, in fact, a source of the company’s underperformance, allowing the family to gain control of the board could consign the remaining public shareholders to ongoing underperformance.Replace family management with non-family professionals. If the directors believe that recent performance does not reflect the company’s true operating potential, the best course of action may be to remove the current family managers and allow a new group of outside managers to steward the shareholders’ resources.  The principal risk with this decision is that Nordstrom’s recent poor performance is a function of inevitable industry trends that will not be eliminated by a new management team.  If that is the case, the shareholders (both family and public market investors) may see continued erosion in the value of their investment in future years.Solicit a financial partner to help take the company private. The past is the past, and allowing sunk costs to influence future courses of action is probably the most pervasive cognitive bias that afflicts family business decision-making.  That said, the fact that the board passed on an offer of $50 per share two years ago undoubtedly rankles for some shareholders while the share price now hovers around $30.  The price for a going private transaction today may not be as high as the former $50 per share offer, but is almost certain to exceed the current market price.  A financial partner may be allied with the Nordstrom family and allow the current management to remain, or a prospective partner may envision making substantial management and strategic changes following the going-private transaction.Sell the company to a strategic buyer. If the directors conclude that the current market price provides a realistic portrait of Nordstrom’s likely future within the new retail landscape, selling the company to a motivated strategic buyer may be the best financial outcome for the shareholders.  When motivated strategic buyers exist for a business, the potential synergies and strategic benefits available from the combination may increase the transaction price beyond what the selling shareholders could reasonably expect from any other outcome.Enterprising families should understand, however, that while selling the family business may eliminate some challenges, it creates new ones.  In an insightful article for the New York Times over the weekend, Paul Sullivan describes the new challenges faced by several families after selling the family business.Without the “glue” provided by the business, family ties may weaken.Ownership of the family business confers other forms of socioeconomic wealth. Following a sale, these benefits may evaporate.Stewarding an active business provides a greater sense of purpose than managing a portfolio of passive investments. Upon selling the business, family members previously active in the business may find they are somewhat adrift personally.The publicity around a sale of the family business can change perceptions of the family’s wealth, and create new claims on that wealth.Future returns from reinvestment of transaction proceeds may be less attractive than those earned from owning the family business. Most of the family business leaders we know are probably relieved they don’t have to make decisions under the burden of public and market scrutiny like the directors at Nordstrom do.  However, the types of decisions that they are called upon to make are often just as challenging.  Whether it is assessing the value of your family business, benchmarking the performance of your family business, or evaluating strategic alternatives, our experienced family business advisory professionals are here to help.  Call us today to discuss your needs in confidence.

I was initially intrigued by this match-up. Two of Europe’s greatest soccer clubs and intra-city competitors squaring off in front of a packed crowd on American soil for the first time in their storied history. Fittingly, the game was played in a football stadium because it was that kind of score. The New York Giants and Jets fans that typically frequent the grounds probably appreciated all the action, but Real Madrid supporters and other soccer enthusiasts had a different impression. Despite all the hype leading up to the game, only one team had any interest in being there, and the match itself has been widely panned by most (non-Atleti) observers.The Real/Atleti debacle is perhaps a microcosm for the broader International Champions Cup (“ICC”) in which it is played. The pre-season tournament has been criticized for the lack of quality competition and blatant apathy of the players despite broad participation by most of Europe’s top clubs. Blame the heat, injury aversion, or American nightlife, but it hasn’t been pretty. Like most pre-season affairs, there’s even talk of cancelling it all together, but that probably doesn’t make sense from an economic perspective. The real culprit is the lack of meaning to the games since they have no implications for the teams’ league status and no (direct) impact on the players’ compensation levels. There have been discussions of playing regular season European matches in America (much like the NFL and MLB are doing in London) to remedy this issue, but no definitive decisions have been made yet.I was similarly intrigued (and skeptical) of the recent reports that RIA aggregator Mercer Advisors was looking to fetch a $700 million-plus price tag in a prospective sale by its PE backers at Genstar Capital. A 15-16x multiple on an estimated pro-forma, run-rate EBITDA of approximately $50 million results in a $750 million to $800 million enterprise value for the business, which certainly got my attention. Still, this figure could be as meaningless as the ICC if it’s an unlikely appraisal of Mercer Advisor’s current market value. We’ll address our opinion from a fair market value and strategic value perspective in this week’s blog.The Fair Market Value of Mercer AdvisorsDespite the similar name, we have no relation to Mercer Advisors. On the one hand, this means that our opinion is not conflicted, but it also means that we are not privy to its financial situation, so we’ll have to opine in general terms. The 15-16x multiple feels a bit rich (we’ll address this later) but may not be nearly as big of a stretch as the “pro forma, run-rate EBITDA estimate” to which it is applied. We don’t know what adjustments were made to get from reported EBITDA to pro forma, run-rate EBITDA, but in our experience, they can be substantial and unsubstantiated.Historically, most publicly traded RIAs with under $100 billion in AUM have traded in the 8-11x range.The context of fair market value, according to most definitions, is a transaction between a hypothetical willing buyer and a hypothetical willing seller, both having reasonable knowledge of the facts and circumstances. The word hypothetical precludes any consideration for what an actual, specific buyer would pay for the business. This means that certain synergies that could be realized by a strategic buyer are typically not considered in a fair market value appraisal. Since the pro forma adjustments likely include such synergies, they are probably not relevant from a fair market value perspective.The 15-16x EBITDA multiple is probably also a stretch. Historically, most publicly traded RIAs with under $100 billion in AUM have traded in the 8-11x range, and this has actually ticked lower over the last few years. Even though Mercer Advisors isn’t really an RIA, it is in a similar line of business, so we can’t totally ignore the market’s current pricing of these companies. On balance, an inflated multiple on a stretched earnings estimate is likely outside a reasonable fair market value range for this business as a stand-alone entity. Especially since RIA aggregators market prices have declined over 30% over the last twelve months leading multiples to fall.The Strategic Value of Mercer AdvisorsSince many believe Mercer’s ultimate acquirer will have synergistic intentions, strategic value may be more applicable in determining the likely purchase price.Unlike fair market value, strategic value considers the particular motivations of a specific buyer and the synergies that could arise in a contemplated transaction. Since many believe Mercer’s ultimate acquirer will have synergistic intentions, strategic value may be more applicable in determining the likely purchase price. In this context, pro forma EBITDA estimates become more relevant, and we can look to recent transaction evidence for perspective on what strategic buyers are paying for these businesses. The most recent transaction in the space involved Goldman Sachs’ purchase of RIA aggregator United Capital for $750 million or an estimated 18x EBITDA. This price tag may be a bit rich for Mercer Advisors, which, at $16 billion in AUM, is quite a bit smaller than United’s $25 billion in client assets. Mercer’s pro forma EBITDA estimate may also be more heavily adjusted, so $750 million and/or 18x is probably a bit optimistic.The Focus Financial IPO last Summer offers additional guidance. The IPO price implied a total enterprise value of $2.8 billion or 16x (heavily) adjusted EBITDA. While Focus is much larger than Mercer and United, the 16x multiple may be more applicable here since it is on top of an adjusted EBITDA figure and is reasonably in line with current pricing. Overall, there does appear to be some support for a 16x multiple from a strategic buyer perspective, but we’d like to know more about the pro forma adjustments before validating the $800 million offering price.Where Do We Think this Deal Will Land?Providing a reasonable range of value for this business is nearly impossible without knowing the acquirer or anything about Mercer’s financial situation, but we’ll take a stab at it. If we back off the multiple a bit and revise our pro forma earnings estimate, we get something closer to a $450 million to $650 million transaction value. This estimate is purely speculative, and if $50 million in incremental EBITDA is truly achievable from a buyer’s perspective, then the $700 million-plus price tag looks very achievable especially since Mercer is one of the few independent RIA aggregators of this size left. Overall, we think the $700 million-plus headline value is a bit rich but certainly more meaningful than an ICC trophy.

On July 16, 2019, Comstock Resources, Inc (NYSE: CRK) finalized its acquisition of Haynesville operator Covey Park Energy LLC. Announced on June 10, 2019, the companies entered into an agreement under which Comstock would acquire Covey Park in a cash and stock transaction valued at approximately $2.2 billion, including assumption of Covey Park’s outstanding debt and retirement of Covey Park’s existing preferred units (totaling approximately $1.1 billion). Covey Park is a natural gas operator with core operations located in the Haynesville Shale Basin and is backed by private equity firm Denham Capital. This acquisition is the latest addition to the continuing resurgence of the Haynesville Shale Basin.For the purposes of this post, we will be examining this deal from a few different vantage points and reviewing the fair value of the various components that make up total deal value. We’ll also look at how this transaction compares to industry valuation metrics and what kind of strategic advantages Comstock may have a result of the deal.Deal OverviewThe transaction is structured in multiple layers, including a substantial investment from Dallas Cowboys owner and Comstock majority stockholder, Jerry Jones. Details behind the total deal consideration are outlined below: As a result of the finalized deal, Comstock’s holdings in North Louisiana and East Texas comes out to a total of 374,000 net acres with over 1.1 bcfe/d of net production. The company also holds assets in North Dakota. The chart below maps the acreage of Comstock and Covey Park prior to the merger and where it fits into the Haynesville Shale: As the various components of the deal are considered, we then begin to analyze the assets actually purchased by Comstock. Analysts, accountants, and investors alike look at fair value of the parts that make up the total purchase, and allocating fair value among the components begins to paint a clearer picture of how we get to deal value. Allocation of Assets and Liabilities to Fair ValueThe table below outlines the allocation for both the assets acquired and the liabilities assumed. The calculation is management’s estimate from the Definitive Proxy Statement that Comstock had filed with the SEC on June 24, 2019. For an E&P company, most of its asset fair value naturally derives from its property and equipment. It’s no surprise that of the assets acquired an estimate of nearly $2.2 billion is in the property and equipment camp. We can then take a step further into understanding the value of these assets by diving into the proven resource reserves that are contained within these properties. The SEC has clear rules and regulations regarding oil and gas reserve reporting (more commonly known as PV-10), and while these summaries of reserves under SEC pricing may not be accurate for determining fair market value, they do provide a general ballpark figure. Below is the summary of proved reserves for Covey Park from the Definitive Proxy Statement: Under the standardized measure, the total value of the proved reserves (both developed and undeveloped), totals around $2.3 billion. What is interesting is this amount is north of the purchase price by Comstock and may have some investors wondering if this falls into the territory of a bargain purchase. As we mentioned above, SEC pricing may not be the best indicator of fair value. It’s not unusual for fair value to vary 10-20% from PV-10 value, and most of that generally comes from the developed and undeveloped (PUD) reserve mix. The valuation of PUDs can be tricky at times, and they generally have a fair value that trades at a haircut. Given the mix of the total proved reserves is fairly PUD heavy, it makes sense as to why the management estimated value of properties comes in under the SEC PV-10 amount. Other assets of note that typically are glossed over are the derivative financial instruments. E&P companies often hold futures and other derivative contracts for hedging purposes, and these contracts are marked to fair value for the purposes of the allocation.  These are relatively less important given the magnitude of the other assets, but they certainly merit consideration, particularly for companies that may have significant hedging practices. How Do Reported Valuation Multiples Compare to the Industry?Below is a list of comparable companies that Comstock identifies in their latest 10-K as competitors, excluding non-gas players, and common valuation multiples (such as EV to Production) used for relative industry analysis. In comparison to other operators, the acquired assets come in slightly above the median values for EBITDA multiples but are generally close to direct competitors such as Cabot and Antero. The lower acreage multiple observed in the deal compared to the industry group makes sense given our analysis above of the sizable amount of PUDs in the proved reserves. After analyzing the structure of the deal and how it compares to other valuation metrics, we will take a look at some of the competitive advantages available to Comstock as a result of the deal. Large Footprint, Established Infrastructure, and Low Gathering CostsWhile the company already owns over 500 miles of gas gathering infrastructure, it also enjoys many locational benefits: limited basis risk due to proximity to Henry Hub, lowest in-basin gathering, treating, and transport costs (approx. 26¢ per Mcfe), and even twelve approved LNG export terminals located in the Gulf Coast.The Houston Ship Channel and other gathering and transportation pipeline infrastructure already present in the Louisiana and East Texas regions mitigate the risks of capacity constraints and bottlenecking unlike those that historically, up until recently, plagued Northeast gas production in the Marcellus/Utica Shale.The Competitive Edge: Capital AdvantageBeing the largest operator in the Haynesville Shale provides Comstock with a strategic advantage due to sheer size of acreage owned. Just as importantly though, Comstock has another major advantage that competitors have been struggling with for some time: access to capital.E&P companies have been facing headwinds in the public markets for some time. The major uptick in U.S. production over the past several years has triggered the need for upstream companies to increase capital expenditures to keep up with demand. However, investors have been unwilling to participate in the upstream sector because free cash flow has been directed to these capital expenditures and additional acreage as opposed to returns in the form of payouts. Consequently, investors have shifted into the realm of mineral rights aggregators because of the immediate returns in the form of dividends and returns on capital.  As a result, access to capital markets (both equity and debt) has proved difficult for E&P companies in general.Comstock, however, appears to have bypassed this hurdle before having to cross it. Jerry Jones’ large stake (75% ownership) and his deep pockets can facilitate large capital raises should the need arise. However, Mr. Jones isn’t Comstock’s sole non-public capital raising option. The aforementioned Denham Capital owns 16% ownership interest, and Comstock just renewed its bank credit facility to $2.5 billion concurrent with the transaction. This gives the company the ability to raise any needed funds before having to jump into the public markets.ConclusionAs a result of the transaction, Comstock is now the largest operator in the Haynesville Shale. While it may seem that Comstock managed to acquire Covey Park’s large amount of acreage at a bargain, the examination of the components of the fair value allocation show that the heavy mix of PUDs in the reserves account for much of the estimated fair value by management, even though it came out lower than the calculated PV-10 valuation. This seemed to be confirmed in our comparisons to industry multiples. However, given the advantages Comstock now has as a result of the deal, the company has positioned itself to be a strong player in the Haynesville Shale Basin.Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals.  Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Whether or not the road tests and sales figures confirm it, the new Corvette is already a success.  It’s only been two weeks since the car debuted, and I can’t remember another new model launch that generated as much conversation.  Last Thursday I had complete strangers asking me what I thought about it on the elevator ride up to the office in the morning and down that afternoon.  One told me he had already put down a deposit.Unlike previous iterations, the eighth generation Corvette sports a mid-engine configuration, and if you squint it looks like a Ferrari 488.  The Stingray is no Prancing Horse, however.  With a 6.2 liter normally-aspirated (no turbo) V-8 generating 495 hp, GM is eschewing the high compression engines favored by European manufacturers (the Ferrari produces more than twice as many horsepower per liter).  Corvette faithful will appreciate the old-school iron under the hood, if they can accept the “hood” being behind them, an automatic transmission, and a dizzying number of character lines in the bodywork.Focus Got People Talking, and MovingIt’s been a year since the Focus Financial IPO generated a similar level of conversation in the RIA community – and the transaction dominos have been falling ever since.  In that same year, Victory Capital pulled off a major acquisition, Affiliated Managers Group got back into the acquisition game following a two-year hiatus, United Capital was acquired by Goldman Sachs, and Mercer Advisors is soliciting bids.I was thinking about all of this on a road trip across the southeast last week, in-between blasting Tom Petty on satellite radio and dropping in on a few clients.  At one of my first stops, a client asked if I saw a lot of M&A activity in the RIA space.  Yes, I replied, but I see even more headlines about it.  Plenty has changed in the RIA community in the last twelve months, but even more has not.The Focus IPO was a Watershed MomentThe Focus management team is to be congratulated for surviving their first year as a listed company.  Serving private equity masters is no walk in the park, but public company life means enduring the unexplained ups and downs of daily trading activity, the tedium of analyst calls, and half-informed commentary from armchair quarterbacks such as myself.  It must weigh on Rudy Adolf and his colleagues, but they made it this far.  Their share price has been volatile but mostly resilient, and the analyst calls are becoming routine.  The question is: now what?The Voting Machine and the Weighing MachineBenjamin Graham developed the metaphor for the stock market acting, in the short run, like a voting machine (a popularity contest) and in the long run, like a weighing machine (based on sustainable profitability).  It’s a useful way to look at Focus, as well as the overall RIA consolidation movement.  Headline activity attracts capital and acquisition opportunities, and headlines begat headlines as others rush to join a crowded trade.  At least for now.  Eventually, all of these consolidators will have to demonstrate they can do something productive with their acquired businesses, and that’s when the robustness, or lack thereof, of the different rollup models will show.Benjamin Graham developed the metaphor for the stock market acting, in the short run, like a voting machine and in the long run, like a weighing machine.The IPO gave Focus an edge in vying for attention among RIA sellers.  As a quick reminder, Focus Financial is not an RIA.  It is a leveraged investment enterprise that accumulates preferred stakes in RIAs, encouraging their growth with best-practices coaching and sub-acquisition financing.  It is not unlike the European Union: financial bonds without much consolidated governance.  Nevertheless, Focus is viewed as a bellwether for acquisition behavior in the RIA community, and rightfully so.United Capital and Mercer Advisors are more typical consolidation models: national platforms with cohesive branding, marketing, management structure, compliance, and investment products.  Focus’s de-consolidated model probably guarantees independence.  Goldman Sachs, which recently acquired United Capital, could never have fit Focus into their framework.Now that Mercer Advisors has put a for-sale sign in the yard, it will be interesting to see who wants their franchise.  One would expect Goldman to consider the possibility of rolling Mercer into their United Capital unit, which could be awkward because Goldman is running the book, but it could happen anyway.  Goldman also led the Focus IPO, and anyone who doubts David Solomon’s commitment to building an investment management franchise hasn’t been paying attention.  My contacts within the Goldman partner network say 1) Solomon is committed to transforming Goldman Sachs and 2) they are impressed with what he’s doing - a powerful endorsement from a tough audience.For Now, It’s a Land GrabIn the near term, Focus will be judged as an acquisition model, which is much more difficult than it sounds.  Acquisition activity is difficult to sustain.   Focus announced eight transactions in the second quarter.  Skimming the ADVs of the acquired entities, these eight firms came with just under $10 billion in AUM and 83 employees.  That’s not insubstantial, although nearly half of that workforce and 70% of that AUM came from one deal.  The other seven transactions averaged about $400 million in AUM and six employees.When you’re the size of Focus Financial ($100+ billion in partner firm AUM and thousands of partner firm employees), it’s tough to move the needle with small deals.  Focus claims thousands of potential acquisition targets, but a realistic assessment is far fewer.  Their model won’t appeal to every would-be seller, and firms that work much outside of the advice and planning space won’t suit Focus.As Focus grows, the pressure will build to do larger transactions.  The rise of competing acquisition platforms will drive up the competition and the multiples, and limit the opportunities for arbitraging the cost of capital.  Deals will still be accretive in the future, but less so than in the past.  All of the consolidators will face this.How Will Things Look in Ten Years?In the longer term, Focus will be judged as an operating model.  Since Focus allows their partner firms to run independently, they have limited opportunities to widen margins with scale.  Monitoring marketing and compliance activities may become more labor-intensive.  Seeing hundreds of firms through succession issues could prove daunting.  Ultimately, the parent organization will have to justify its considerable overhead by helping partner firms grow faster (organically) or become more profitable (than they would be independently) – otherwise the whole will be worth less than the sum of its parts.As for the more integrated consolidation models, the future of Goldman Sachs’s mass-affluent wealth management practice would be easier to forecast if Joe Duran’s acquisition chief, Matt Brinker, had stayed.  Brinker left on the eve of the Goldman deal closing, perhaps to avoid a non-compete.  While he hasn’t said so, it’s hard not to imagine Brinker resurfacing in a similar role elsewhere.  With Brinker out, will Goldman try to grow this platform organically, or draw on other internal resources to hunt for acquisitions?  We’ll know more when Mercer Advisors announces their acquirer.  If Mercer flips to another PE firm, we’ll see more of the same from them.  Word is strategic acquirers are looking at the deal.  In any event, RIA sellers will have several acquisition models from which to choose.Who’s Paying for All of This?The equity multiples being bandied about for RIA consolidators are dizzying.  We know Focus went public at a high-teens multiple of adjusted EBITDA.  Similar multiples were rumored (and remain unconfirmed) for the Goldman/United transaction, and many have suggested the ask for Mercer Advisors is just as high.  RIAs cannot sustain those valuations, so either the pricing is overstated, the pro forma adjustments are substantial, the expected growth is steep, or these really are the end times.One of the earliest lessons I learned in finance was that labor-intensive businesses don’t handle debt well because all they can really mortgage is future compensation.We can only speculate about much of this.  However, much of this activity is financed with borrowed capital rather than equity, and because leverage is more formulaic, the behavior surrounding it is more transparent.  To that end, we’re puzzled about Focus’s debt burden.  In their Q1 2019 filings, Focus reported term debt of almost $800 million and another $290 million on their revolver.  Management reported that this represented a bit less than 4.0x a defined measure of cash flow.  Focus recently announced consolidating $300 million of revolver debt under the term loan, and then quietly filed an 8-K on Friday that upped that amount to $350 million.Term debt is generally more expensive, but freeing up the acquisition line offers flexibility.  With a $650 million revolver in place, Focus could expand their indebtedness considerably – in sharp contrast to what we’re accustomed to seeing.Most RIAs have unremarkable balance sheets.  One of the earliest lessons I learned in finance was that labor-intensive businesses (such as professional service firms) don’t handle debt well because all they can really mortgage is future compensation.  When leverage ratios get stretched and operating conditions dim, the analyst community becomes agitated.  Until then, with a sympathetic Federal Reserve on tap and a land-grab strategy to execute, it’s going to be tempting for Focus management to lever up.  We expect to hear more about this during the earnings call next week.As For Everyone ElseAt one-quarter the price of a new Ferrari, the new Corvette will attract a lot of buyers for Chevrolet.  GM would probably be satisfied with a lot of lookers.  The Corvette is what is known as a “halo-car," designed to showcase what the automaker can do and get people into the showrooms to look at all of their models (less than 5% of Chevy sales in 2018 were Corvettes).  Attention drives activity.I haven’t touched on Hightower or Victory or Captrust or Fiduciary Network or any of the other consolidation platforms.  And I haven’t talked about the PE platforms like Kudu Investment Management that are making headway in the RIA space.  It’s been an active year since the Focus IPO, and the domino effect that comes from transactions completed at seller-friendly pricing and terms sends ripples throughout the industry.  Whether you plan to jump into the fray in the foreseeable future or not, the marketplace around your firm is caught up in it, and it affects you.

Through the first half of 2019, asset and wealth manager M&A has kept pace with 2018, which was the busiest year for sector M&A over the last decade. M&A activity in the back half of 2019 is poised to continue at a rapid pace as business fundamentals and consolidation pressures continue to drive deal activity. Several trends, which have driven the uptick in sector M&A in recent years, have continued into 2019, including increasing activity by RIA aggregators and rising cost pressures.Total deal count during the first half of the year is on pace to slightly exceed 2018’s record levels. Reported deal value during the first half of 2019 was down significantly, although the quarterly data tends to be lumpy and many deals have undisclosed pricing. Acquisitions by (and of) RIA consolidators continue to be a theme for the sector. The largest deal of the second quarter was Goldman Sachs’s $750 million acquisition of RIA consolidator, United Capital Partners. The deal is a notable bid to enter the mass-affluent wealth management market for Goldman Sachs. For the rest of the industry, Goldman’s entrance into the RIA consolidator space is yet another headline that illustrates the broad investor interest in the consolidator model. If there was any doubt of that fact, just a few weeks ago it was reported that Mercer Advisors (no relation), an RIA consolidator managing $16 billion, is up for sale by its PE backer, Genstar Capital.  Mercer could fetch an estimated $700 million price tag, putting it in a similar size bracket as the United Capital acquisition. These RIA aggregators have been active acquirers in the space themselves, with Mercer Advisors and United Capital Advisors each acquiring multiple RIAs during 2018 and the first half of 2019. The wealth management consolidator Focus Financial Partners (FOCS) has also been active since its July 2018 IPO, although acquisitions slowed during the second quarter of 2019. Focus announced a total of eight transactions during the second quarter, most of which were smaller sub-acquisitions by partner firms, except for the acquisition of William, Jones & Associates, a New York-based RIA managing $7 billion. The prospect of using buyer resources to facilitate their own M&A may be a key motivation.Sub-acquisitions by Focus Financial’s partner firms and other firms owned by RIA consolidators are a growing M&A driver for the industry. These acquisitions are typically much smaller and are facilitated by the balance sheet and M&A experience of the consolidators. For some RIAs acquired by consolidators, the prospect of using buyer resources to facilitate their own M&A may be a key motivation for joining the consolidator in the first place. For the consolidators themselves, these deals offer a way to drive growth and extend their reach into the smaller RIA market in a way that is scalable and doesn’t involve going there directly.Consolidation RationalesThe underpinnings of the M&A trend we’ve seen in the sector include the lack of internal succession planning at many RIAs and the increasing importance of scale against a backdrop of rising costs and declining fees. While these factors are nothing new, sector M&A has historically been less than we might expect given the consolidation pressures the industry faces.Consolidating RIAs, which are typically something close to “owner-operated” businesses, is no easy task. The risks include cultural incompatibility, lack of management incentive, and a size-impeding alpha generation. Many RIA consolidators structure deals to mitigate these problems by providing management with a continued interest in the economics of the acquired firm, while allowing it to retain its own branding and culture. Other acquires take a more involved approach, unifying branding and presenting a homogeneous front to clients in an approach that may offer more synergies, but may carry more risks as well.Market ImpactIn 2019, equity markets have largely recovered and trended upwards.Deal activity in 2018 was strong despite the volatile market conditions that emerged in the back half of the year. So far in 2019, equity markets have largely recovered and trended upwards. Publicly traded asset managers have lagged the broader market so far in 2019, suggesting that investor sentiment for the sector has waned after the volatility seen at year-end 2018.M&A OutlookConsolidation pressures in the industry are largely the result of secular trends. On the revenue side, realized fees continue to decrease as funds flow from active to passive. On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs. The continuation of these trends will pressure RIAs to seek scale, which will in turn drive further M&A activity.With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation. Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies. Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression. An aging ownership base is another impetus. The recent market volatility will also be a key consideration for both sellers and buyers in 2019.

When clients call us seeking advice after receiving an unsolicited offer for their RIA, the first questions they ask generally revolve around two issues:Is the price reasonable? andDo we think the buyer will be willing to improve the offer? “Price” is a sticky wicket that we’ve covered in many posts, but whether or not the first offer is going to change in the negotiation and due diligence process is a certainty: yes.  The only question is which direction (higher or lower) the offer will move before the transaction closes.Universal Truths on Unsolicited OffersIf you receive an unsolicited offer for your investment management firm, you’ll find it is usually difficult to immediately assess the sincerity of the offer.  And while making generalizations about the M&A process can be more misleading than helpful, we will assert the following:An unsolicited offer is made based on limited information. Often the initial overture is based on information beyond what is publicly available on the seller’s website and in regulatory filings. Even with financial statements in hand, prospective buyers making their offer know very little about the seller. The due diligence process involves the review of hundreds of pieces of documentation that can and will shape the purchase agreement.An unsolicited offer may be a competitive bid, but it is not a bid made in a competitive market. Not every sale is best conducted in an auction process, but the prospective buyer making an unsolicited offer knows that it is, at least for the moment, the only bidder. The object of an unsolicited offer is to get the seller’s attention and cause them to enter into negotiations, often giving the bidder an exclusive right to negotiate for a fixed amount of time.Whether the offer is made at the high end or the low end of a reasonable range depends on the bidder’s perception of the seller. If a buyer thinks a seller is desperate, the initial offer may be at the low end of a reasonable range, in which the selling process should evolve to move pricing and terms more favorable to the seller.  In many cases, though, the initial offer is above what the buyer ultimately wants to pay (“bid it to get it”) and will use the due diligence process to beat the price down or insert terms that shift the burden of risk to the seller.  If the initial offer seems too good to be true, consider the latter a distinct possibility.An LOI is NOT a purchase agreement. Many sellers think the deal is done if they receive an unsolicited offer with a strong price and favorable terms.  We don’t want to suggest that buyers never put their best foot forward on the first round, but an unsolicited offer should be viewed more as an overture than a commitment.Once the offer is accepted, the real work begins. Stop and think for a moment about what you would like your employment arrangement to be post-transaction. Do you want a substantial base, incentive compensation, a multi-year arrangement, roll-over ownership, administrative responsibilities or just client-facing work, protections in the event of termination without cause, an internal or external reporting requirement, and/or other arrangements?  Imagine your situation as viewed by the buyer and what they would want. This is just one item which is rarely delineated in detail on the first offer. A legion of issues must be resolved in the process of negotiating a final purchase agreement, which is why “deal fatigue” is a prevalent cause of abandoned transactions.ConclusionThe offer gets the process started, but it’s the process that creates the deal.  Transacting an investment management firm is complicated. Advisors to buyers and sellers have the delicate task of aggressively representing their clients and covering every bit of ground in the due diligence process without killing the deal by exhausting the buyer and seller and making them wonder why they ever started negotiations in the first place.  The primary danger of an unsolicited offer is that it lures potential sellers into thinking the deal is done and the process will be easy.  As with most things in life, if something looks too good to be true, it usually is.

The Permian Basin is one of most prolific oil basins in the world and is the engine driving the resurgence of U.S. energy output. According to the latest EIA Drilling Productivity Report, anticipated oil production for June 2019 in the U.S. is almost 8.5 million barrels per day with the Permian alone accounting for nearly 4.2 million. The importance and impact of this basin to U.S. energy cannot be overstated.Operators in the play have had to pay a premium to access the black gold mine, and companies are still lining up for a chance to get in on the action. While the industry as a whole has been moving into a period of rapid consolidation, a substantial portion of this acquisitive activity has been in the Permian, far more than any of the other major basins.Targets with highly contiguous holdings and acreage have been of particular note to acquirers in the Permian. While acreage continuity has not always been the most important aspect of a potential deal, it has certainly become more of a focal point recently.Recent Transactions in the Permian BasinDetails of recent transactions in the Permian Basin, including some comparative valuation metrics are shown below.Oxy to Acquire Anadarko in $38 Billion DealOn May 10, 2019, Anadarko Petroleum signed a deal to be acquired by Occidental Petroleum (“Oxy”) in a cash/stock deal worth $38 billion. This deal was by far the largest and most newsworthy to come out of the Permian Basin, or any other region, for the year.The transaction creates a $100+ billion “global energy leader” with 1.3 million barrels of oil equivalent per day of production.The agreement concludes one of the most closely-watched bidding wars in recent history with Oxy battling with Chevron to acquire the Permian assets of Anadarko.  A month earlier, Chevron announced an agreement to purchase Anadarko for $33 billion in a cash/stock deal.  Oxy soon joined the fray with a deal that was more accretive to Anadarko shareholders.  The price ultimately became too much for Chevron, who received a $1 billion termination fee as part of the initial deal struck with Anadarko.  Some lauded Chevron for not raising their offer and potentially overpay for the assets, but as it stands, Oxy is the big winner of the prized Permian assets which present plenty of synergies with its existing acreage portfolio.According to Occidental, the transaction creates a $100+ billion “global energy leader” with 1.3 million barrels of oil equivalent per day of production. The company also said the deal provides “compelling strategic and financial rationale for all stakeholders.”Oxy is expected to fund the cash portion of the consideration through a combination of cash and fully committed debt and equity financing, which also includes a $10 billion equity investment by Berkshire Hathaway, Inc in the form of 100,000 shares of cumulative perpetual preferred stock at $100,000 per share. The investment from Berkshire comes at a steep cost though with a warrant to purchase up to 80 million common shares at $62.50 per share as well as a preferred stock dividend of 8% annually.Potential for TakeoverAlthough the Permian is far and away the most covered oil patch in the U.S. by analysts and journalists alike, the Occidental and Anadarko deal has brought some increased scrutiny to the basin particularly in assessing what other potential big deals could be out there. And the analysis seems to point to quite a few.DrillingInfo produced the map below (as of April 30, 2019) of acreage by major operators within the Permian. An interesting observation here is that several of these operators have assets and land that is largely connected. Concentrated assets and contiguous acreage make several of these companies very attractive targets for takeover. Pioneer Natural Resources, for example, has been hard at work becoming a pure-play Permian Basin operator. With the April 26 announcement that it is to sell off the remaining assets in the Eagle Ford, the company has made itself a more attractive takeover target because of its concentrated asset base in the Delaware Basin within the Permian. Contiguous acreage allows operators to drill longer lateral lengths, which are more productive and cost-effective given recent advancements in drilling technology.There are several benefits in owning such contiguous acreage. First, operators can take advantage of economies of scale, as contiguous acreage provides access to subsurface minerals with fewer well pads required, reducing costs.  Logistically, mineral rights considerations are also simplified by consolidation. Contiguous acreage also potentially allows operators to drill longer lateral lengths, which are more productive and cost-effective given recent advancements in drilling technology.Costs are further streamlined as the oilfields are less encumbered by multiple operators each bringing in their own drilling crews. Additionally, armies of tanker trucks for hauling away wastewater for various operators in a crowded field are replaced with efficient networks of surface pipes for wastewater disposal. Companies such as those with adjoining acreage to Pioneer could consider the advantages and synergies of such networks and efficiencies, especially if the infrastructure is already in place.EOG Resources, one of the largest independent operators, owns acreage that borders against Chevron and Occidental in multiple areas. Given the recent loss in the bidding war with Occidental for Anadarko’s assets, Chevron has additional cash (set aside for the prior merger attempt as well as the break-up fee) that could be used for another takeover attempt, and EOG would be an attractive target for the reasons described above.Other pure-play companies such as Diamondback or Concho Resources also have highly contiguous acreage adjacent to large companies who could take advantage of these economies of scale and efficiencies. These companies have been active consolidators in the basin, with Diamondback’s 2018 acquisition of Energen and Concho’s takeover of RSP Permian earlier in that year.ConclusionThe trends for the Permian are apparent. Companies have been working to establish firm footholds in this basin and are willing to pay premiums to get in and stay in. The basin is also in an interesting position that due to the layout of operator acreage and assets, large takeovers of neighboring operators with contiguous acreage and established efficiencies create the opportunity for higher return on investment.We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

While it’s no secret that the last year has been especially challenging for the RIA industry, Affiliated Managers Group (AMG) and Focus Financial (FOCS) have underperformed most of their peers by a fairly significant margin in the last few months.  AMG is down nearly 50% over the last year, and Focus has lost over 50% of its value since peaking last September. For this post, we’ll offer our take on the driving forces behind this decline.1) AMG and Focus’ Underlying Investments Have Likely Depreciated with the Industry, and These Losses Have Been Amplified by LeverageIf the RIA sector has underperformed the broader market by 10-15% in the last year (per above), it stands to reason that businesses that invest in this industry would experience a similar decline.  Then you have to factor in leverage.  Both AMG and Focus employ debt financing to make acquisitions, which magnifies losses when things go bad.  Even though the balance sheet isn’t a focal point for most RIAs, AMG and Focus both have growing debt obligations and deficit tangible equity.  Their income statements aren’t much better as Focus remains unprofitable (on a reported basis), and AMG is battling margin compression.Asset managers, in particular, have struggled over the last year, which may explain AMG’s underperformance relative to Focus during this time.  Fee compression, poor investment performance, and continuous asset flows from active to passive products are largely to blame for the sector’s recent woes.2) Market Declines Can be Particularly Damaging to High Beta Securities like AMG and FOCSA quick perusal of the graph above shows how sensitive these businesses are to market gains and losses.  The fourth quarter and recent weeks show significant declines as the market pulls back.  Volatility has likely compounded this issue as nervous investors shun active managers and look to products designed to mitigate losses. While Focus Financial CEO Rudy Adolf contends that Focus is relatively well insulated from market downturns, the reality is that this business (and AMG) levers up to buy companies that invest primarily in stocks or equity funds.  This dynamic creates an inherently volatile and market sensitive security that will almost certainly underperform the market in a downturn or correction.  The opposite is also typically the case, but not always.3) Goldman Sachs’ Recent Entry in the RIA Consolidation Space Means More Competition for Buyers and Possibly Lower ReturnsGoldman’s acquisition of RIA consolidator United Capital could be a game changer for M&A in the wealth management space.  A buyer of Goldman’s scale and resources is great for RIAs looking to sell, but not so great for other aggregators competing for deals.  Hightower also intends to ramp up RIA acquisitions in an already crowded space.  AMG and FOCS’s correction over the last couple of weeks may be attributable to these developments.A buyer of Goldman’s scale and resources is great for RIAs looking to sell, but not so great for other aggregators competing for deals.The public market seems concerned about AMG and Focus’ ability to find deals at attractive valuations (and returns).  While Focus has strung together over 20 acquisitions so far this year, keeping up that pace may be a tall order—especially if competition for deals increases.  AMG, on the other hand, has had a two-year acquisition dry spell that recently ended with the acquisition of Garda Partners.For aggregators like AMG and Focus, acquisitions are a key part of the growth strategy.  While these firms try to foster organic growth as well, acquisitions are still the fastest path to scale.  If the public market’s reaction to AMG and Focus is any indication, the outlook for this strategy appears to be facing some challenges.Don’t Read Too Much Into This…Focus and AMG are often regarded as bellwethers for financial advisory firms and asset managers, respectively.  We disagree.  They’re both in fundamentally different lines of business.AMG and Focus use debt financing to buy RIAs of one kind of another.  They’re not managing assets on behalf of clients (at least not directly).  They have huge balance sheets and debt obligations, unlike most investment managers.  They’re monitoring their own investments, not their clients’.  As publicly traded firms, they’re probably more concerned with the beating the Street and appeasing a much broader ownership base.Sure, the fortunes of AMG and Focus are tied to the fortunes of the firms they invest in over the long run.  But the business of acquiring RIAs is not the same as the RIA business.  So, while AMG and Focus may have lost half of their value in recent months, your business probably hasn’t.…But You Should Still Pay AttentionWe don’t think you should panic because publicly traded consolidators have struggled in recent months.  We do think it’s important to recognize the challenges they’re facing, especially if you’re starting to think about an exit strategy.  The RIA acquisition model isn’t dying, but investors seem to be anticipating a market share shift away from AMG and Focus.We don’t think you should panic over publicly traded consolidators' recent struggles, but we do think it’s important to recognize the challenges they’re facing.It’s also worth noting that these acquirers often use their own stock as part of the total consideration.  For AMG and Focus, you know exactly how much that’s worth.  For closely held aggregators like Hightower and Captrust, their stock price is not readily apparent.  Given what’s happened to AMG and FOCS over the last year, it’s probably reasonable to assume that other consolidators are not worth as much as they once were.  Even if they are publicly traded, you should be wary of any lock-up provisions since their stock prices are so volatile.In all likelihood, these businesses and other consolidators will continue to drive industry M&A.  RIA aggregators like AMG and Focus are just one of many exit options for RIA owners, but we’ll likely see their share of overall transaction volume increase with Goldman backing United Capital, and Hightower changing course to compete with Focus et al.  As the industry ages, these businesses are poised to play an increasingly important role in resolving the succession dilemma.  A few years ago, many of our clients had never heard of AMG or Focus.  That has definitely changed.

Brand value is difficult to create, hard to measure, and easy to ruin.In the late 1960s, Porsche and Volkswagen found themselves trying to develop similar cars.  Porsche needed a replacement for the 912, a Carrera look-alike with a smaller engine and a cheaper price, and VW needed an updated version of its top-of-the-range (for Volkswagen) Karmann Ghia coupe.  The two automakers combined forces to joint-venture what became the 914 model for Porsche and the new Karmann Ghia for VW.  Since the bodies and powertrains of the two cars were going to be very similar, Porsche faced the balancing act of preserving its exclusive image while taking advantage of the economy of working with the maker of “the people’s car.”  The automakers resolved this conundrum by deciding that only the Porsche would be sold in North America.  This marketing alchemy worked, and while the 914 is not regarded as the best performing or most beautiful Porsche ever developed, it did become their best-selling product, by far, during its seven-year run.Subsequent “down-market” Porsches like the 924 through today’s 918 series have produced the sales volume necessary for Porsche to be efficient while maintaining the pricing power conferred by a premium marque.  This combination has delivered higher margins for Porsche than other German automakers with a more consistent top line than the more upmarket strategies followed by rivals from Italy.  If you do it right, extending your reach can support your brand, not dilute it.Goldman Sachs Extends Brand to Wealth ManagementSome may wonder whether Goldman Sachs is putting its treasured name at risk by making a bid for the mass-affluent wealth management market in buying United Capital.  We don’t think so.Some may wonder whether Goldman Sachs is putting its treasured name at risk by making a bid for the mass-affluent wealth management market in buying United Capital.  We don’t think so.The announcement last week that Goldman was buying United Capital for $750 million caught many people by surprise, but the more I think about it, the more it makes sense.  The opportunity of consolidating the wealth management industry is well publicized: a highly fragmented and inefficient community of small firms in need of effective ownership transition strategies.  Several different approaches to this consolidation have emerged, not all of which would have suited Goldman.  Some industry consolidators leave acquired firms with their own brands and SEC registrations, which theoretically maintains their sense of entrepreneurship - but also makes national marketing impossible, regulatory compliance more expensive, and may not ultimately govern the ownership transition process reliably.  Joe Duran’s approach was different: bring everyone under the United Capital brand and sell it, coast to coast, as a homogenous wealth management platform with a local presence in nearly 100 markets.If there is one consistent story in these RIA rollups, it’s that building them takes longer than anybody expects.  Duran worked on building United Capital for nearly 15 years.  Some things require scale that cannot be acquired in one lifetime, however, and that’s where the CEO of Goldman Sachs, David Solomon, saw an opportunity.This Really Starts with David Solomon, not Joe DuranImagine you’re David Solomon.  You’ve got a really good job heading a global organization known for producing innovative financial products, outsized profits, and Treasury secretaries.  Your predecessor, Lloyd Blankfein, became a public figure by building Goldman in the wake of a crisis that took down several major competitors.  But the financial universe never stops changing, and despite their high-brow successes, one thing Goldman Sachs doesn’t have is much reach beyond the very wealthy.Solomon inherited a business that did well on large and risky trades but needed to transition into an era that is more staid and regulated.  In this environment, he’s looking to bring Wall Street to Main Street.  The opportunities Solomon sees are not upmarket, they’re mass-market.  Even as it celebrates 150 years of success as a powerhouse that profitably caters to the well-heeled, Goldman Sachs has plunged headlong into commercial banking, corporate cash management, and even a branded credit card, so it makes sense to prepare to court the mass-affluent through a wealth management advisory practice.  Goldman could have started from scratch, but buying United gives Goldman an established platform for outreach to the RIA community to seek other acquisitions, which it will undoubtedly begin to do.Will Goldman Sachs Pay 18x EBITDA for Your RIA?So, what does all this mean to you?It has been suggested that the $750 million Goldman paid for United represents something on the order of 18x EBITDA.  The actual multiple isn’t public, but given United Capital’s AUM of $25 billion, total revenue including management fees should be between $200 million and $250 million on an ongoing basis.  A multiple of 18x EBITDA suggests an EBITDA margin in the mid-teens to just over 20%.  That’s a bit thin, so perhaps Goldman Sachs sees opportunities for margin enhancement that buy-down the multiple.  At a 30% margin and midpoint revenue estimate of $225 million, Goldman would have only paid 11x EBITDA.  On a pro forma basis, at least, that makes more sense.United Capital is Duran’s accomplishment, but Duran’s accomplishment is now Goldman Sachs’s missionary effort.In any event, David Solomon probably didn’t reach his bid on a spreadsheet – at least not looking at United Capital on a standalone basis.  The opportunity is to get a substantial but manageable RIA with consistent branding and systems across a national footprint that puts Goldman Sachs in a position to test the platform and grow it accordingly.  Plus, the deal comes with Joe Duran.  United Capital is Duran’s accomplishment, but Duran’s accomplishment is now Goldman Sachs’s missionary effort.  Goldman will need a front-man to pitch their narrative to skeptics and prospects in the RIA community.  Duran will have more credibility than someone who didn’t grow up in the independent channel.This is Not Wirehouse 2.0Some of the early backwash I’ve heard on the deal is that Wall Street money is sucking another example of entrepreneurship into the machine.  I think that’s flat wrong.  If Goldman just wanted to build a new mass-market wirehouse to push investment products, they could have paid much less for many, many broker-dealers with far more FAs than United Capital.  All signs suggest that Goldman is looking for distribution for existing GSAM products (no doubt to upper end clients of United) and also to develop new ones for the more typical mass-affluent client.  But this is not simply a distribution play.  The decision to do this through a fiduciary practice suggests that this isn’t about Wall Street infecting the RIA community, but that RIA culture has finally come home to infect Wall Street.  If Goldman puts its might behind the effort and builds a national brand investment advisory practice, it will be a game changer.Focus + High Tower + Cap Trust + AMG + … + Goldman Sachs = More options for RIAsAlmost lost in the Goldman/United deal was that AMG recently announced their first acquisition (Garda Partners) in a couple of years.  And it was just earlier this month that a rebooted Hightower announced a plan to grow through investments in new RIAs.  With AMG back in the game, and Hightower muscling in on Focus Financial’s territory, the Goldman Sachs deal suggests that buyer competition is going to be heating up in the money management space – much to the benefit of sellers.  It further suggests that RIAs seeking an exit through a consolidation strategy are going to have a number of options depending on their perspective and needs.Even if you’d rather stay independent, stay tuned.  As we all know, an option has value, even if you don’t exercise it.

Much of the sector’s recent press has focused on the current M&A environment as well as practice management issues for RIA firms, so we’ve highlighted some of the more salient pieces on these topics and a few others that are making news in the investment management industry.Goldman Sachs Readies Splashy RIA Retail Debut as it (Likely) Adds $24-Billion United Capital to $35-Billion AUM Ayco for $59-Billion 82 Office Behemoth; Months After Buying RIA Lure From S&PBy Oisin Breen, RIABiz Goldman Sachs recently completed its acquisition of United Capital for $750 million, marking a major expansion into the RIA space for Goldman and a significant endorsement of the RIA aggregator model.  The deal value represents approximately 3% of United Capital’s $24 billion AUM and a little over 3x revenue of $230 million.M&A Gains Drive Focus’ 33% Revenue GrowthBy Jessica Mathews, FinancialPlanning RIA aggregator Focus Financial reported 33% year-over-year revenue growth in the first quarter.  The growth comes primarily from new partner firms acquired over the last year.  In its IPO filings last year, Focus management outlined a growth strategy based on continued M&A and organic growth at Focus’s partner firms.  While organic growth has faltered somewhat (partly due to market conditions), Focus has clearly executed on the M&A component of its growth strategy.  So far this year, Focus has acquired 21 firms, with 12 of those acquisitions taking place in the first quarter.Bye-bye Broker Protocol: HighTower Exits in Identity MakeoverBy Charles Paikert, FinancialPlanning HighTower Advisors has exited the broker protocol, the industry agreement which allows advisors switching employers to take basic client contact information with them.  Exiting the protocol reflects the evolution of HighTower’s business model from recruiting wirehouse teams to focusing on RIA acquisition activity.  For some, the decision to exit the protocol is seen as a way to increase retention — perhaps in preparation for a future liquidity event.  With recent liquidity events from the other two major roll-up firms, Focus Financial and United Capital, now may be a good time to exit for PE-backed HighTower.U.S. Wealth Management Becomes Hotbed of M&A By Chris Flood, Financial Times Private equity interest in wealth management has continued to increase, given the industry’s growth opportunities and stable cash flows.  The wealth management industry remains highly fragmented but is poised to consolidate.Merger Mania: Why Consolidation in the RIA Space is About to ExplodeBy Jeff Benjamin, InvestmentNews Some industry players see the pace of consolidation picking up.  Ron Carson, CEO of Carson Group, predicts that in seven years there will be a third less firms than there are today.  Historically, there has been less consolidation than we would expect given the size and fragmentation of the industry.  However, given the current dynamics of aging ownership, PE interest in the space, and consolidators offering scale and back office efficiencies, the pace of M&A may accelerate significantly.Kitces: The Ratios That Determine Advisory Firm SuccessBy Michael Kitces, FinancialPlanning Tracking productivity, identifying its drivers, and understanding how to improve are important aspects of managing a successful advisory firm.  Michael Kitces offers his take on some of the key performance metrics for advisory firms. In summary, consolidation and M&A continue to be major trends in the investment management industry.  RIAs continue to receive interest from PE investors due to the recurring revenue and growth potential that wealth management firms offer.  Aging ownership bases have also contributed to the consolidation tailwind.  The RIA aggregator model has now been endorsed by Goldman Sachs with its acquisition of United Capital, as well as the public markets with Focus Financial’s IPO last year.  Whether HighTower’s PE backers will seek an exit in the near term remains to be seen, but given the interest in the Focus IPO and the attractive multiple offered by Goldman for United Capital, it is clear that market interest in the aggregator model is strong.

It has been 34 years since the Delaware Supreme Court ruled in the landmark case Smith v. Van Gorkom, (Trans Union), (488 A. 2d Del. 1985) and thereby made the issuance of fairness opinions de rigueur in M&A and other significant corporate transactions. The backstory of Trans Union is the board approved an LBO that was engineered by the CEO without hiring a financial advisor to vet a transaction that was presented to them without any supporting materials.Why would the board approve a transaction without extensive review? Perhaps there were multiple reasons, but bad advice and price probably were driving factors.  An attorney told the board they could be sued if they did not approve a transaction that provided a hefty premium ($55 per share vs a trading range in the high $30s).Although the Delaware Supreme Court found that the board acted in good faith, they had been grossly negligent in approving the offer. The Court expanded the concept of the Business Judgment Rule to include the duty of care in addition to the duties to act in good faith and loyalty.  The Trans Union board did not make an informed decision even though the takeover price was attractive. The process by which a board goes about reaching a decision can be just as important as the decision itself.Directors are generally shielded from challenges to corporate actions the board approves under the Business Judgement Rule provided there is not a breach of one of the three duties; however, once any of the three duties is breached the burden of proof shifts from the plaintiffs to the directors.  In Trans Union the Court suggested had the board obtained a fairness opinion it would have been protected from liability for breach of the duty of care.The suggestion was consequential.  Fairness opinions are now issued in significant corporate transactions for virtually all public companies and many private companies and banks with minority shareholders that are considering a take-over, material acquisition, or other significant transaction.When to Get a Fairness OpinionAlthough not as widely practiced, there has been a growing trend for fairness opinions to be issued by independent financial advisors who are hired to solely evaluate the transaction as opposed to the banker who is paid a success fee in addition to receiving a fee for issuing a fairness opinion.While the following is not a complete list, consideration should be given to obtaining a fairness opinion if one or more of these situations are present:There is only one offer for the bank and competing bids have not been solicitedCompeting bids have been received that are different in price and structure (e.g., cash vs stock)The shares to be received from the acquiring bank are not publicly traded and, therefore, the value ascribed to the shares is open to interpretationInsiders negotiated the transaction or are proposing to acquire the bankShareholders face dilution from additional capital that will be provided by insidersVarying offers are made to different classes of shareholdersThere is concern that the shareholders fully understand that considerable efforts were expended to assure fairness to all partiesWhat’s Included (and What’s Not) in a Fairness Opinion A fairness opinion involves a review of a transaction from a financial point of view that considers value (as a range concept) and the process the board followed. The financial advisor must look at pricing, terms, and consideration received in the context of the market for similar banks. The advisor then opines that the consideration to be received (sell-side) or paid (buy-side) is fair from a financial point of view of shareholders (particularly minority shareholders) provided the analysis leads to such a conclusion. The fairness opinion is a short document, typically a letter.  The supporting work behind the fairness opinion letter is substantial, however, and is presented in a separate fairness memorandum or equivalent document. A well-developed fairness opinion will be based upon the following considerations that are expounded upon in an analysis that accompanies the opinion:A review of the proposed transaction, including terms and price and the process the board followed to reach an agreementThe subject company’s capital table/structureFinancial performance and factors impacting earningsManagement’s current year budget and multi-year forecastValuation analysis that considers multiple methods that provide the basis to develop a range of value to compare with the proposed transaction priceThe investment characteristics of the shares to be received (or issued), including the pro-forma impact on the buyer’s capital structure, regulatory capital ratios, earnings capacity, accretion/dilution to EPS, TBVPS, DPSAddress the source of funds for the buyer and any risk funding may not be available It is important to note what a fairness opinion does not prescribe, including:What the highest obtainable price may beThe advisability of the action the board is taking versus an alternativeWhere a company’s shares may trade in the futureHow shareholders should vote a proxyThe reasonableness of compensation that may be paid to executives as a result of the transaction Due diligence work is crucial to the development of the fairness opinion because there is no bright line test that consideration to be received or paid is fair or not.  Mercer Capital has nearly four decades of experience in assessing bank (and non-bank) transactions and the issuance of fairness opinions.  Please call if we can assist your board. Originally appeared in Mercer Capital's Bank Watch, April 2019

Initial public offerings in the upstream and midstream sectors of the oil and gas market have been lackluster at best for quite some time, and the trend has continued through the first quarter of 2019. Despite the rebounds in the energy sector and broader market to start the year, there has been a scarcity of energy equity capital markets activity, thus resulting in fewer IPOs in the E&P and upstream and is exacerbated by the fact that companies in this space have been underperforming relative to the broader market. This continued lack of activity has made this market fundamentally “underweight” due to the disproportionally small size of available public equities relative to the immense use and value of oil and gas in the national economy. However, in the midst of an underperforming energy market, there is a sector that has been an emerging bright spot: public mineral aggregators. Brigham Minerals (MNRL) is the latest mineral acquisition company to go public following a trend of other large mineral rights and royalty companies to IPO in recent years. Brigham began trading on April 18 at $18.00 per share on the New York Stock Exchange. While we have addressed trends in the mineral aggregators and royalty MLPs, we are taking a closer look into what these companies have to offer the investing public and why they have been so popular in recent years. We continue to see an uptick in IPO activity in this sector as the value of these companies addresses the current wants and needs of energy investors, i.e. high yield cash returns with low-risk characteristics. The timeline below shows how some of the major players in this space have appeared only within the last five years. [caption id="attachment_26224" align="aligncenter" width="680"]Source: Company filings and Brigham S-1[/caption] In this post, we will review the continued IPOs and valuation implications for the mineral aggregators market as well as examine Brigham’s operations and placement in this sector.Energy IPOs Slide While Minerals ShineIn the wake of the oil crash in 2014, there have been a total of 33 IPOs in the U.S. oil and gas market from 2015 through Q1 2019, excluding mineral aggregators. This contrasts sharply with the average of approximately 23 IPOs per year from 2011 – 2014.  This decline is illustrated in the chart below, which tracks deal volume by year in various subsectors of the energy market.[caption id="attachment_26223" align="aligncenter" width="892"]Source: Gibson Dunn Presentation "IPOs and Capital Markets Developments in the Oil and Gas Industry," February 26, 2019[/caption] The declines of IPO activity in recent years has been consistent with overall investor sentiment in the upstream and E&P space in that investors have been eager for current yield, not the future growth that these companies have been pedaling. These companies have been reinvesting into additional acreage and capital expenditures, leaving next to no free cash flow and little in the form of dividends to investors. While E&P and upstream IPOs have been trending downwards overall in the past five years, IPOs for mineral aggregators have been increasing.Since many of these newer companies are typically in the high growth and investment phases, they have achieved the capital necessary for growth through private funding rather than through public channels. So why have mineral aggregators been so popular in the public capital markets in a sector that has been so unimpressive from an IPO standpoint?Mineral aggregators have the ingredients investors have been craving for some time. They are cash flow positive, high margin, and have dividend yields that provide healthy returns straight to the investor’s pocket. They also do not carry the typical risk profile of traditional E&P and upstream companies as mineral aggregators provide opportunities to be exposed to mineral plays and benefit from technological advances without taking operator risk.While E&P and upstream IPOs have been trending downwards overall in the past five years, IPOs for mineral aggregators have been increasing, currently averaging around four per year and are continuing at an increasing rate going into 2019.Valuation ConsiderationsBased in Austin, Texas, Brigham Minerals had initially set out to raise $100 million in their IPO, but then increased the amount to be raised to $261 million at $18 per share in an updated S-1 filed on April 9 due to higher than expected demand. Current holdings for Brigham are shown below:[caption id="attachment_26211" align="aligncenter" width="755"]Source: Company filings and Brigham S-1[/caption] [caption id="attachment_26212" align="aligncenter" width="1000"]Source: Company filings and Brigham S-1[/caption] Brigham is averaging approximately 4,579 boe/d of production on approximately 68,800 net royalty acres as of 12/31/2018, pro forma, with a little more than half of the production being oil. Net income attributable to common shareholders was $0.66 per share, and adjusted EBITDA per share came out to approximately $1.11 per share attributable to common. The large gap here is due to depreciation and depletion rates nearly doubling in 2018 due to higher depletion because of the significant increase in production volumes in the current year and a revised depletion rate after evaluation of current reserve reports. By investing directly in the cash flows, mineral aggregators are able to bypass some of the riskier and more costly upfront aspects of the process, turning their investment into a return more quickly.After going public, Brigham will have an influx of cash which it can use to acquire more mineral interests, leading to increased production and free cash flow. At first glance, this might appear to be similar to the reinvestment cycle for E&P companies, but there are important differences. The mineral interests acquired are a revenue stream that can almost immediately be paid out as dividends to investors because the investment is in properties that are already producing and the mineral aggregators receive a portion of the proceeds. Contrast this to an E&P company that reinvests its cash flows into new projects where it must purchase property, equipment, infrastructure, etc. There are large upfront costs that eat into this capital and frequently require taking on debt as well. Before their investors start to realize a return, E&P companies aim to recoup their expenses first, not to mention servicing the debt. By investing directly in the cash flows, mineral aggregators are able to bypass some of the riskier and more costly upfront aspects of the process, turning their investment into a return more quickly.Market cap at the time of the IPO launch was approximately $377 million, and accounting for cash and debt on the books as of the 12/31/2018 financials, we arrive at an estimated enterprise value of approximately $514 million.Below is a table of selected multiples using these calculated metrics as well as other comparable mineral aggregators: Compared to other competitors in the mix, it would make sense for multiples for Brigham to come in under the peer group given the lower production figures. However, utilizing proceeds from the IPO to continue to acquire additional royalty acreage could push the Brigham into a position that is comparable in size and value to those like Falcon and Kimbell, so as long as it can produce free cash flow to pay out high dividends that investors have become accustomed to receiving from these other companies. Location and Production MixBrigham’s operations and focus are semi-diversified compared to other publicly traded mineral aggregators and has the most in common with Kimbell in this respect.  What do we mean by this?  While Brigham is not as concentrated in a single basin like Viper (Permian focus) and Falcon (Eagle Ford focus), it’s more focused than Black Stone which is by far the most diversified in its class with approximately 89% of holdings falling into the “other” category due to being scattered across multiple, non-traditional plays.  There are benefits and drawbacks to both concentrated versus non-concentrated strategies.  Consider the table below: Brigham sets itself apart by its presence in the DJ and Williston basins.  No other mineral aggregator has a concentrated or material focus there.  As well activity picks up in this area, Brigham will benefit.  However, it also misses out on activity in the Eagle Ford as well as gas driven plays such as the Haynesville and Appalachia. ConclusionAs we’ve noted before, this market has been frequently discussed among industry professionals for some time and has been featured regularly at oil and gas conferences. The vast market of the public royalty aggregators has been gaining momentum as investor demand for these investment vehicles is high. Given these factors, the chances are high that we see an increase in the number of IPOs from mineral aggregators in the future compared to upstream and E&P companies.In an industry that has seen a decline in public market activity that coincided with the steep drop in oil prices, mineral aggregators like Brigham have emerged as an attractive opportunity for investors looking to gain exposure to the industry with an opportunity to participate in the benefits sooner rather than later.At Mercer Capital, we have valued mineral and royalty rights located across the country.  We understand how the location of your assets affects value and work to monitor transactions in each region to understand the state of the current market.   Contact a Mercer Capital professional today to discuss your valuation and transaction advisory needs in confidence.

Last year marked the busiest year for asset manager M&A in the last decade, and the trend is poised to continue into 2019 as business fundamentals and consolidation pressures continue to drive deal activity.Several trends which have driven the uptick in sector M&A in recent years have continued into 2019, including increasing activity by RIA aggregators and rising cost pressures.  Total deal count during the first quarter of 2019 was flat compared to the same period in 2018, while deal count was up 35% for the twelve months ending March 31, 2019, compared to the comparative period ending March 31, 2018.  Reported deal value during the first quarter of 2019 was down significantly, although the quarterly data tends to be lumpy and many deals have undisclosed pricing.2018 marked the busiest year for asset manager M&A in the last decade, and the trend is poised to continue into 2019.Consolidation has been a driver of many of the recent large deals, as exemplified by the largest deal of last year, Invesco’s (IVZ) acquisition of OppenheimerFunds.  IVZ announced plans in the fourth quarter last year to acquire the OppenheimerFunds unit from MassMutual for $5.7 billion in one of the largest sector deals over the last decade.  IVZ will tack on $250 billion in AUM as a result of the deal, pushing total AUM to $1.2 trillion and making the combined firm the 13th largest asset manager by AUM globally and the 6th largest by retail AUM in the US.  The deal marks a major bet on active management for IVZ, as OppenheimerFunds’s products are concentrated in actively-managed specialized asset classes, including international equity, emerging market equities, and alternative income.  Invesco CEO Martin Flanagan explained the rationale for scale during an earnings call in 2017:"Since I've been in the industry, there's been declarations of massive consolidation.  I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike."  Martin Flanagan – President and CEO, Invesco Ltd. 1Q17 Earnings CallRIA aggregators continued to be active acquirers in the space, with Mercer Advisors (no relation), and United Capital Advisors each acquiring multiple RIAs during 2018.  The wealth management consolidator Focus Financial Partners (FOCS) has been active since its July IPO as well.  So far in 2019, FOCS has announced 11 deals (including acquisitions by its partner firms).  Just last week, Silvercrest Asset Management announced the acquisition of Cortina Asset Management, a $1.7 billion small cap growth equity manager based in Milwaukee, Wisconsin.Consolidation Rationales The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, aging shareholder bases, and slowing organic growth for many active managers.  While these pressures have been compressing margins for years, sector M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation.  Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure as long as it doesn’t inhibit performance."Absolutely, this has been an elevated period of M&A activity in the industry and you should assume … we're looking at all of the opportunities in the market." Nathaniel Dalton, CEO, Affiliated Managers Group Inc – 2Q18 Earnings Call"Increased size will enable us to continue to invest in areas that are critical to the long-term success of our platform, such as technology, operations, client service and investment support, and to leverage those investments across a broader base of assets." David Craig Brown, CEO & Chairman, Victory Capital – 3Q18 Earnings CallConsolidation pressures in the industry are largely the result of secular trends.  On the revenue side, realized fees continue to decrease as funds flow from active to passive.  On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs.  Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to realize economies of scale, enhance product offerings, and gain distribution leverage.From the buyer’s perspective, minority interest deals ensure that management remains incented to continue to grow the business after the deal closes.Another emerging trend that has been driving deal volume is the rise of minority interest deals by private equity or strategic buyers.  These deals solve or mitigate many of the problems associated with acquisitions of what are normally “owner operated” businesses (at least for smaller RIAs).  Minority interest deals allow sellers to monetize a portion of their firm ownership (often a significant portion of their net worth).  From the buyer’s perspective, minority interest deals ensure that management remains incented to continue to grow the business after the deal closes.Market ImpactDeal activity in 2018 was strong despite the volatile market conditions that emerged in the back half of the year.  So far in 2019, equity markets have largely recovered and trended upwards.  Publicly traded asset managers have lagged the broader market so far in 2019, suggesting that investor sentiment for the sector has waned after the volatility seen at year-end 2018.M&A OutlookWith over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies.  Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth and margin compression.  An aging ownership base is another impetus.  The recent market volatility will also be a key consideration for both sellers and buyers in 2019.

Over the last twelve months, the Eagle Ford Shale region has experienced steady growth and healthy transaction activity.According to the Society of Petroleum Engineers, crude production from the south Texas play climbed steadily throughout the year and continued to achieve its highest marks ever. New, upstart independents came back to the region, including one led by the former head of Occidental Petroleum, as investors looked beyond the neighboring Permian Basin with its crowded top-tier acreage and pipelines. And operators began joining forces to increase the scale of their operations, headlined by Chesapeake Energy’s merger with Wildhorse Resource Development.The region’s strengths, such as its low cycle times, high oil cuts and Louisiana Light Sweet crude and Brent oil pricing, has facilitated free cash flow and made the area attractive to both investors and operators.As long as entry costs and well costs remain reasonable, the Eagle Ford Shale has strong potential for continued economic growth.Recent Transactions in the Eagle Ford RegionDetails of recent transactions in the Eagle Ford Shale, including some comparative valuation metrics are shown below.Chesapeake Closes Acquisition of WildHorse for Nearly $4 BillionChesapeake has made several major transactions over the last nine months. In the middle of 2018, the company sold its entire stake in the Utica Shale, and experts speculated that the company would put the sales proceeds towards an acquisition in the Eagle Ford or Powder Basin area.Following the deal, Chesapeake is now the top acreage holder in the Eagle Ford with approximately 655,000 nets acres, pro forma.Chesapeake closed a deal with Houston-based WildHorse Resource Development with a transaction value of $3.977 billion. The consideration for the transaction consisted of either 5.989 shares of Chesapeake common stock or a combination of 5.336 shares of Chesapeake common stock and $3 cash, in exchange for each share of WildHorse common stock. Chesapeake intended to finance the cash portion of the WildHorse acquisition, which was expected to be between $275 million and $400 million, through its revolving credit facility.In a statement, Chesapeake’s CEO, Doug Lawler said: “In 2018, Chesapeake Energy continued to build upon our track record of consistent business delivery and transformational progress through both financial and operating improvements. The addition of the WildHorse assets to our high-quality, diverse portfolio, combined with our operating expertise and experience, provides another oil growth engine with significant oil inventory for years to come and gives us tremendous flexibility and optionality to help achieve our strategic goals.”Following the deal, Chesapeake is now the top acreage holder in the Eagle Ford with approximately 655,000 nets acres, pro forma.Trends and OutlookInvestor Returns and Free Cash FlowOne of the most attractive features of the Eagle Ford region for the last year has been the returns. The Eagle Ford generates solid economics and cash flow, which operators use to fund exploration projects both nearby and elsewhere. Portions of the Eagle Ford generate some of the best economics in shale, and the region is forecasted to generate stable production into the 2020s.Coupled with the fact that the Eagle Ford is one of the lowest costing basins in the U.S., reliable production and capital efficiency in a mid-life stage play has been translating to free cash flow, something investors have been vocal about trying to obtain from the oil and gas industry as a whole for quite some time.Portions of the Eagle Ford generate some of the best economics in shale, and the region is forecasted to generate stable production into the 2020s.Todd Abbott, VP of Resource Plays South for Marathon Oil Corp., recently said at the DUG Eagle Ford conference in San Antonio that Marathon is seeing “fantastic” returns with reliable production, capital efficiency, and free cash flow.At the same conference, Stephen Chazen, chairman, president and CEO of Magnolia Oil & Gas, noted “General investors want reasonable growth, earnings per share, and free cash flow.” The recently formed small independent company generated free cash flow in excess of capital on acquisition spending and ended 2018 with $136 million of cash on the balance sheet, an increase of approximately $100 million compared to the end of the third quarter.These kinds of results show that the region has been a cash flow generator for the year and has been a main driver for most of the recent and anticipated transaction activity, especially companies under $1 billion in market capitalization.Anticipated Large Operator Divestitures in 2019In recent reports from Shale Experts, several larger operators in the Eagle Ford area are potential candidates for divestiture. Following Q4 2018 earnings calls, five operators have indicated that they are open to selling all or parts of their Eagle Ford assets in 2019. Collectively, the net acreage under consideration totals to over 100,000 net acres. Below are four of the company responses to Shale Experts’ questions regarding where Eagle Ford assets fit into their portfolios:Encana Corp. - After purchasing Newfield, Encana now considers the Eagle Ford as non-core.Pioneer Natural Resources - They have been actively selling pieces of their Eagle Ford asset since 2018.Matador Resources - Matador will outspend cash flow this year, and therefore an Eagle Ford asset sale might help plug that gap.Earthstone Energy - Earthstone is trying to convert itself into a Permian-only player. Reports from Shale Experts expect they will be looking to offload their Eagle Ford assets in the near-term. In addition to the reports above, Norway’s Equinor announced plans to explore the sale of its Eagle Ford assets as well. Equinor has an ownership interest in the Eagle Ford Shale formation located in south Texas through a joint venture with Repsol. Through transactions in 2013 and 2015, Equinor obtained full operatorship in the joint venture and increased its working interest to 63%. The company’s net acreage position in Eagle Ford at the end of 2018 was approximately 71,000 net acres and production of 43,000 boe/d. In a recent interview, Al Cook, the company’s head of strategy, said that Equinor is looking to add to its large position in Appalachia in an attempt to chase natural gas-rich acreage. This move is consistent with trends we identified last quarter in our transaction analysis of the Marcellus-Utica region. Any divestiture of assets by these operators would pose an interesting opportunity, especially for aforementioned smaller operators to acquire acreage and capitalize on the cash flow generating ability of the region to facilitate growth and increase returns. We have assisted many clients with various valuation needs in the upstream oil and gas industry in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

Asset manager M&A was robust throughout 2018 against a backdrop of volatile market conditions.  Several trends which have driven the uptick in sector M&A in recent years continued into 2018, including increasing activity by RIA aggregators and rising cost pressures.  Total deal count during 2018 increased 49% versus 2017 and total disclosed deal value was up nearly 140% to $18.0 billion.  In terms of both deal volume and deal count, asset manager M&A reached the highest levels since 2009. M&A was particularly strong in the fourth quarter when Invesco Ltd. (IVZ) announced plans to acquire the OppenheimerFunds unit from MassMutual for $5.7 billion in one of the largest sector deals over the last decade.  IVZ will tack on $250 billion in AUM as a result of the deal, pushing total AUM to $1.2 trillion and making the combined firm the 13th largest asset manager by AUM globally and the 6th largest by retail AUM in the U.S.  The deal marks a major bet on active management for IVZ, as OppenheimerFunds’ products are concentrated in actively-managed specialized asset classes, including international equity, emerging market equities, and alternative income.  Invesco CEO Martin Flanagan explained the rationale for scale during an earnings call back in 2017: "Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike." Martin Flanagan, President and CEO, Invesco Ltd. – 1Q17 Earnings CallRIA aggregators continued to be active acquirers in the space, with Mercer Advisors (no relation), and United Capital Advisors each acquiring multiple RIAs during 2018.  The wealth management consolidator Focus Financial Partners (FOCS) has been active since its July IPO as well.  In August, FOCS announced the acquisition of Atlanta-based Edge Capital Group, which manages $3.5 billion in client assets.  FOCS also announced multiple sub-acquisitions by its affiliates during the second half of 2018.Consolidation Rationales The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, aging shareholder bases, and slowing organic growth for many active managers.  While these pressures have been compressing margins for years, sector M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation.  Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure as long as it doesn’t inhibit performance."Absolutely, this has been an elevated period of M&A activity in the industry and you should assume … we're looking at all of the opportunities in the market." Nathaniel Dalton, CEO, Affiliated Managers Group Inc – 2Q18 Earnings Call"Increased size will enable us to continue to invest in areas that are critical to the long-term success of our platform, such as technology, operations, client service and investment support, and to leverage those investments across a broader base of assets." David Craig Brown, CEO & Chairman, Victory Capital – 3Q18 Earnings CallConsolidation pressures in the industry are largely the result of secular trends.  On the revenue side, realized fees continue to decrease as funds flow from active to passive.  On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs.  Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to realize economies of scale, enhance product offerings, and gain distribution leverage.Market ImpactRecent increases in M&A activity come against a backdrop of a long-running bull market in asset prices that finally capitulated in late 2018.  Over the past several years, steady market gains have more than offset the consistent and significant negative AUM outflows that many active managers have seen.  Now that the market has pulled back, AUM, revenue, and earnings are likely to be lower for many asset managers.The recent market pullback will impact sector deal making in several ways.  Notably, earnings multiples for publicly traded asset managers have fallen considerably during 2018, which suggests that market sentiment for the sector has waned as the broader market has declined.  While the lower multiple environment is clearly less favorable for sellers, market volatility may force some smaller, less profitable firms into selling in order to remain viable.  For buyers, the lower multiple environment may make the sector look relatively underpriced though some may be spooked by the recent volatility.M&A OutlookWith over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies.  Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms struggle with organic growth.  An aging ownership base is another impetus.  The recent market volatility will also be a key consideration for both sellers and buyers in 2019.

The domestic natural gas market has benefitted from large expansion in recent years, and this can be largely attributed to the growth experienced in Appalachia. According to a Deloitte study, Appalachia was the world’s 32nd-largest natural gas producing region in 2007, with levels comparable to Bolivia and Kazakhstan. As of 2017, it was the third largest, trailing only the full United States and Russia.Companies already with an established presence are planning to put more wells online in the coming year and increase infrastructure to supply a growing demand in the natural gas market.Henry Hub prices have been hovering around $3/MMBtu for over three years and recently have increased to just over $4/MMBtu in November due to a combination of expectations of colder than usual weather and short squeezes, increasing trading and price influencing in a market that is much smaller than oil. Despite the long-term low price environment, supply and demand have increased, driven primarily by the increased demand needs from the power sector. Economic viability of recoverability has not been impacted in light of the lower prices as Deloitte estimates that 50 years’ worth of natural gas can be recovered for less than $3/Mcfe.Despite the continued growth, transaction activity in the Marcellus-Utica in 2018 was slower than in 2017. Some companies have been moving in to capitalize on the increased demand for natural gas, as indicated by the energy outlook by the EIA, while others are restructuring their balance sheets in order to focus primarily on oil. While companies may not be rushing to the Marcellus-Utica in a similar manner as the Permian, companies already with an established presence are planning to put more wells online in the coming year and increase infrastructure to supply a growing demand in the natural gas market.Recent Transactions in the Marcellus-Utica Details of recent transactions in the Marcellus-Utica, including some comparative valuation metrics are shown below. Overall, deal count and average deal size have decreased from twelve months ago. There have been a handful of large deals though that show increased interest in the area.Ascent Resources Acquires 113,400 Acres in OhioAscent Resources, a company founded by Aubrey McClendon after he left Chesapeake Energy, announced that it is buying 113,400 Utica Shale acres in multiple deals along with 93 operating wells located in eastern Ohio for a total of $1.5 billion. The new acreage puts Ascent at over 300,000 Utica acres and catapults the company into one of the largest privately owned E&P drillers in the U.S. The selling companies are CNX Resources and Hess (each selling their share of a joint venture for $400 million each), Utica Minerals Development and a fourth, unnamed seller.The CNX and Hess JV sale marks a complete exit in the play, and both companies plan to utilize proceeds to fund share repurchase programs, pay down debt, and focus on growth opportunities in other established plays, such as the Bakken.Chesapeake Energy Sells Entire Utica Position to EncinoIn an even larger deal, Chesapeake Energy disposed of its entire interest in the Utica Shale to Encino Acquisition Partners for about $2 billion. EAP is backed by the Canadian Pension Plan Investment Board and Encino Energy. Chesapeake sold its stake in the Utica Shale to strengthen its balance sheet and further shifts its focus from gas production to oil, Chesapeake CEO Doug Lawler said in an interview. “We will absolutely be driving for a greater percentage of oil production in our portfolio,” Lawler said. “We hope to achieve that through organic growth, exploration and future acquisitions.”The sale to Encino Acquisition Partners includes 320,000 net acres in Ohio’s Utica Shale and 920 wells that currently produce about 107,000 barrels of oil equivalent per day. The purchase price also includes a $100 million contingent payment based on future natural gas prices. With a sale price of approximately, $2,222 per acre, this appears to be in line with the median transaction amount for 2018.Observed M&A Trends in the Marcellus-Utica Large Exits and Balance Sheet AdjustmentsSimilar to trends we observed last year in the Marcellus-Utica, large companies that have had established presences are moving out of the play entirely to focus on higher margin assets. Demand for natural gas is very high, but the inexpensive extraction costs paired with longer laterals for extraction have allowed supply to catch up, causing prices to remain low and relatively flat in the long term, with the exception of the high trading volume experienced last month.The price run-up in November, however, appears to be short-lived, and the commodity appeared to be overbought.  High expectations and rising EIA forecasts for domestic production explain why the U.S. gas futures market has held backwardation even though near-term pricing has spiked. Futures prices for 2019 and 2020 have declined back to the $2.50 to $3.00 range, and with margins remaining low for the foreseeable future, it makes sense for companies to adjust their balance sheets and unload assets that are not meeting their margin goals.Continued Ease of M&AAlthough the low price and low margin environment has caused some to exit the Marcellus and Utica plays, the stable prices environments make mergers and acquisitions easier, with public companies in a better position to make deals than private equity investors.The stable prices environments make M&A easier, with public companies in a better position to make deals than private equity investors.According to Robert Hagerich, Senior Vice President at Macquarie Capital (USA) Inc., established public companies are looking to expand acreage and existing holdings, and can use their stock as currency to buy leases that are adjacent to their holdings with operating midstream infrastructure and production volumes that can be immediately booked with the purchasing company. On the other hand, private equity buyers are usually financing the exploratory drilling that expands the core fairways of the shale plays essentially buying an option on improved prices. This trend began in the later part of 2017, and it has continued into 2018. "Stable pricing brings buyers to the table," says Hagerich. "Buyers are looking for leases that are exposed to the core areas of the shales, contiguous acreage, leases held by production, ownership of the gathering system and access to more than one transportation pipeline." The low volatility nature of the natural gas market compared to oil or LNG facilitates M&A activity and allows for consolidation opportunities as observed from the merger of Blue Ridge Mountain Resources and Eclipse Resources Corp. in August and the heavy consolidation activity from EQT in 2017. The Marcellus-Utica continues to be a powerhouse for natural gas production and doesn’t show signs of slowing down anytime soon. Strategic transactions in the area allow companies to focus on assets that drive their core business and others to consolidate in the area and supply the growing demand for natural gas in the U.S. We have assisted many clients with various valuation needs in the upstream oil and gas in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

Last week was turbulent for equities around the globe, but Focus Financial (Nasdaq: FOCS) was hit particularly hard.  Less than five months since IPO, Focus closed Friday at $27.45, decidedly below where the offering priced at $33, and not much more than half the share price achieved less than three months ago. [caption id="attachment_23631" align="alignnone" width="756"]Source: Bloomberg[/caption] I was thinking about Focus Financial last week when I found myself in traffic behind a Hummer H1.  The H1 was the original Hummer, built by AM General based on their military vehicle, the Humvee.  An H1 is immense, weighing in at about 8,000 pounds.  H1s were capable of climbing boulders and steep grades and fording streams and rivers as deep as 30 inches.  Because of these extreme characteristics, the public initially overlooked how difficult the vehicle was to park, maintain, and even keep fueled.  Sales of the H1 peaked in the mid-90s. In 1998 GM bought the brand and started producing a more civilian variant, the H2, and then an even smaller (albeit still very large) H3.  About a decade later, GM gave up as the public lost interest.  Hummer executives must have been frustrated when the media lampooned their products for being ungainly and inefficient.  After all, Hummer never pretended to be anything else. I sensed a similar frustration in Rudy Adolf’s voice last week as he pleaded Focus Financial’s case at the Goldman Sachs U.S. Financial Service Conference.  The recent share price performance of Focus clearly suggests the market is losing interest in the issue, and it doesn’t seem to have anything to do with Brexit or yield curve inversions.  Instead, the analyst community seems to have soured on the Focus story, which is strange to us because the story hasn’t really changed since the company filed the first version of its S-1 back in May. Focus's Business ModelFocus translates their stake in EBPC into a preferred interest such that they have a beneficial asymmetric payoff.To revisit the narrative, Focus Financial’s principle business is acquiring preferred cash flow stakes in RIAs.  The preferred cash flow stake is a percentage (often half) of a “partner” RIA firm’s earnings before partner compensation (EBPC).   Focus translates their stake in EBPC into a preferred interest such that they have a beneficial asymmetric payoff.  The selling firm’s continuing partners retain all of the downside profit risk and share pro rata with Focus in the profit upside.  The partner firms retain a considerable degree of autonomy in that Focus doesn’t really effect operational control, doesn’t rebrand the partner firms using the Focus name, and doesn’t require partner firms to sell Focus branded investment products.As we have asserted previously, there is good and bad in the practice of transacting preferred stakes.  In theory, the practice puts a floor underneath Focus’s revenue stream in the event of bad markets.  Focus management suggests that only 75% of partner firm revenues are AUM driven, the portfolios generating those fees are only 56% invested in equities (44% fixed income), and there is a 70/30 split of partner firms that bill in advance versus those that bill in arrears.  Focus management states that this means a 10% change in equity valuation only moves Focus’s results by 2.9% in the same quarter (10% times 75% times 56% times 70%) and 1.3% in the following quarter (10% times 75% times 56% times 30%).  The granularity of this data may be more enticing than it is useful.  We know the reality of market impact on Focus is much more complicated, as changes in the margins of partner firms, the impact of bad markets on non-fee revenue, and the cumulative impact on fee producing assets all weigh in on cash flows.  Further, we wonder if a sustained bear market wouldn’t gut the management companies of Focus’s partner firms, as sustaining Focus’s cumulative preferred distributions would deprive the management companies of the partner firms from cash flows needed to maintain market compensation.Differing PerspectivesThe analyst community is fixated on Focus’s growth prospects, accuses the company of underperforming expectations in the third quarter, and is worried that the current market behavior will impede M&A opportunities.  Focus management responds that M&A is lumpy, and that their experience in the credit crisis a decade ago suggests that bad markets can slow larger deals, but small transactions still occur.  Further, management does not believe the company underperformed in the third quarter, just that the analysts expected too much of them.Management has stayed on message of 20% revenue growth and 20% growth in adjusted net income, but the problem is that word, “adjusted.”That comment – that the analyst community oversold Focus – caught my attention.  Having gone public at $33 per share on heavily adjusted earnings, Focus doesn’t have a history of profitability to form a reliable foundation for value.  If Focus had IPO’d at $18 and drifted up over the first few months to the mid-20s, it would be viewed today as a success.  I’m not suggesting that $18 was a more appropriate valuation at IPO, but an excessive valuation at offering can be an albatross for a public company – and that may be how we eventually see this situation.Management has stayed on message of 20% revenue growth and 20% growth in adjusted net income, but the problem is that word, “adjusted.”  Adjusted means they can grow by acquisition, but they’ll be expending cash and equity to fund that growth.  Organic growth is estimated at 10%, but it includes acquisitions by partner firms.  Management justifies this because broker-dealers include advisor recruiting in their organic growth rates.  That’s a risky justification, because the economics of broker-dealers has been eroding for decades, and many see the practice of paying to poach advisors as a sign of an industry in distress.Nine months ago, the investment banking community wanted to see Focus as the ultimate RIA – but it was never that.  Focus is a complex feat of financial engineering which demonstrates, above all, how difficult it is to build a consolidation model in the investment management community.  We think it’s inappropriate to fault management for doing what they said they would do in the S-1.  Nonetheless, like anyone who’s ever driven a Hummer, they could be in for a rough ride.

The tyranny of the urgent imposes itself on family business leaders just as it does on everyone else.  In this series of posts, we will offer various to-do lists for family business directors.  Each list will relate to a particular family business topic.  The items offered for consideration won’t necessarily help your family business survive the next week, but instead, reflect priorities for the long-term sustainability of your family business.In last week’s post, we explored how to respond to unsolicited acquisition offers.  This week’s to-do list is about being prepared for such offers if and when they come.Gauge Family Members' Appetite for a Sale of the BusinessDo you know what your family members think about a potential sale of the business?  Would they be aghast at the thought of selling the fruit of great-grandfather’s labors?  Would they be reluctant to sever the economic ties that bind the extended family together?  Or, would they welcome the opportunity to harvest the gains that have accrued through the family’s efforts?  Would they like to diversify their holdings?  Would the thought of being emancipated from the shackles of economic dependence on the family be liberating?  Would your family relish the opportunity to just be a family without the mental overhead of being a family business?Getting the answers to these questions can be as simple as have a few informal conversations with key family members, or by including questions designed to uncover such preferences in an annual shareholder survey.  Either way, it is best not to assume you know how the family feels.  The best time to get an unbiased view of what the family thinks about selling is before the acquisition offer comes in.Identify the Attributes of an Acquirer to Whom the Family Would be Willing to Sell the BusinessIf the family is not opposed on principle to a potential sale, what sort of acquirers would the family find palatable?  As we previously discussed, what sellers want economically is a motivated buyer, whether that is a private equity firm or a strategic acquirer.  However, the family is entitled to have a preference as to who the next owner of the family business will be.  Is the family comfortable with a group of MBAs in a faraway city determining the fate of the business that bears the family name?  What about a competitor that may close certain locations or institute significant workforce reductions?  What would be the impact on the family legacy if the business gradually (or abruptly) melted away into the legacy operations of a larger acquirer?These questions don’t have right or wrong answers, but the answers will reflect the family’s culture and values.  Having clarity and consensus around these issues now will make responding to unsolicited offers that may be received later less stressful.Identify Steps That can be Taken to Improve the “Curb Appeal” of the Family Business  How often have you heard a friend or colleague remark that, after having fixed their house up for sale, they wish they had made the improvements years earlier so they could have actually enjoyed them?  The same regret can apply to family businesses.  The same adjustments that you would make to improve buyer perceptions will likely also make your family’s ownership of the business more rewarding.  So why wait?  Even if you have no plans to actively market your family business for sale, now is the time to clean up the balance sheet (disposing excess or non-operating assets, securing favorable long-term financing, etc.) and fix the leaks in the income statement (expenses that don’t relate to the operations of the business, and other potential “adjustment” items that a buyer will cause a buyer to question the “quality” of your business’s earnings).Assess Reinvestment Opportunities for the Family in the Event of a SaleAfter a sale, the family will have a pile of money instead of an operating business.  What comes next?  Will you distribute proceeds to the shareholders, or will you set up a family holding company to reinvest the proceeds?  What are the implications for the family of reinvesting versus distributing sale proceeds?  What sort of reinvestment strategy is likely to meet the needs of the family?  Marketable securities?  Real estate?  Another established operating business?  Venture capital?  How do the prospective returns on those asset classes compare to the returns you would expect from continued ownership of the family business?Interview Potential Financial Advisors that can Help the Family Evaluate Offers and Execute TransactionsDo you have an existing relationship with a trusted corporate finance team that can help you when an unsolicited offer arrives?  If not, it is better to shop around for that advisor now, rather than in the heat of responding to an offer that you did not set the timetable for.  A qualified advisory team will have deep valuation and transaction experience.  A great first step in developing such a relationship is having the advisor perform a set of calculations to help establish a benchmark range for evaluating potential acquisition offers.  A corporate finance advisor can also help evaluate potential acquisition opportunities that your family business may want to consider.The professionals in our Family Business Advisory Services practice have decades of experience helping family businesses evaluate and respond to unsolicited acquisition offers.  Call us to help you get started on knocking out your to-do list today.

Successful businesses don’t have to go looking for potential acquirers—potential acquirers are likely to come looking for them. Most of our family business clients have no intention of selling in the near-term, and yet they often receive a steady stream of unsolicited offers from eager suitors. Many of these offers can be quickly dismissed as uninformed or bottom-fishing, but serious inquiries from legitimate buyers of capacity occasionally appear that require a response.What Kinds of Buyers are There?Buyers are generally classified into two categories.Financial buyers are groups like private equity funds that purchase businesses with a view toward earning a return on their investment over a finite holding period. These buyers generally use financial leverage to magnify their returns, and expect to exit their investment by selling the business to another buyer after three to seven (or maybe even ten) years. While financial buyers may have specific plans for making the business run more efficiently and profitably, they are generally not anticipating significant revenue synergies or expense savings from wholesale changes to the business. Rather, they tend to be more focused on incremental changes to boost value and clever financial engineering to be the principal engines driving their returns.Strategic buyers are competitors, customers, or suppliers of the business who have a strategic goal for making the acquisition. Such buyers certainly want to earn a return on their investment, but that return is expected to come from combining the target’s operations with their own, rather than through financial engineering. In other words, strategic buyers look to long-term value creation through assimilating the target into their existing business, not a short-term return from buying low and selling high. Strategic buyers may anticipate revenue synergies through the combination or may foresee the opportunity to eliminate operating expenses in either the acquired or legacy businesses to fuel cash flow growth. Distinguishing between financial and strategic buyers is important for evaluating unsolicited offers, but we suspect that a more important distinction is that between motivated buyers and opportunistic buyers. Successful family businesses will attract motivated buyers who have the capacity to pay an attractive price for the business, but should strive to avoid opportunistic buyers who are seeking to take advantage of some temporary market dislocation or cyclical weakness to get the business at a depressed price.Evaluating Acquisition OffersMost family businesses have no intention of selling; however, when a legitimate, unsolicited offer arrives, what do you do?Evaluating acquisition offers is ultimately the duty of the board of directors, not the family at large. Uncle Charlie may have strong opinions on the proposed deal, but if he is not a director, he does not have the responsibility or authority to respond to the offer. That does not mean that the directors will not care about Uncle Charlie’s perspective. As we’ve discussed, it is critical for the board to understand what the business “means” to the family, and the meaning of the business to the family may well inform how the directors evaluate the offer. For larger families, the prospect of receiving a potentially attractive unsolicited acquisition offer underscores the value of a regular survey process, whereby the board and senior management periodically take the pulse of the family on topics at the intersection of business and family.Family business directors should evaluate offers along several dimensions.Buyer MotivationWhat has prompted the offer? If it is a strategic acquirer, what sort of operational changes would be expected post-transaction? Will a sale result in facility closures, administrative layoffs, or discontinuation of the business name? Or, could the sale increase opportunities for employees and expose the brand to new markets? If the suitor is a financial buyer, what sort of debt load will they place on the company post-acquisition? Will the company’s ability to withstand normal economic downturns be compromised? Will the buyer want members of the family active in senior management to continue to run the business? The answers to these and similar questions should be considered in the context of what the business means to the family and help inform whether the offer should be entertained further.Buyer CapacityDoes the buyer have the financial capacity to actually execute the transaction if it is agreed to? If external financing is required, will it be available to the buyer when needed? Basic due diligence goes both ways. Going through a lengthy negotiation and due diligence process only to have the transaction fall apart at the closing table due to lack of financing will leave a bad taste in the family’s mouth.Price & Transaction StructureWhat seems on the surface to be an attractive price may, upon further examination, turn out to be a far less attractive transaction. A sale of stock may have a lower nominal price than a sale of assets, yet result in higher after-tax proceeds. A high nominal price may be subject to contingencies regarding future performance which cause the economic value of the offer to be far less. Or, a high nominal price may be payable, in part, in shares of the buyer rather than cash—what is the family’s appetite for trading stock in the family business for stock in a different business over which they will likely have no control? There are many other components of transaction structure, such as required representations and warranties or escrow provisions that can significantly influence how attractive an offer really is.Price is not EverythingJust because the price is adequate and the terms are acceptable does not mean that the timing is optimal for a sale. Directors should carefully weigh the potential outcomes for shareholders by deferring a transaction: Is the family better served by taking the bird in hand or waiting for more birds to materialize in the bush? If the company is on a growth trajectory or has its own acquisition opportunities to pursue, it may command a larger multiple down the road. Understanding the risks and opportunities associated with the timing of a transaction requires directors to be well-attuned to company, market, and industry dynamics. Family directors-in-name-only are unlikely to have anything meaningful to add to such deliberations.Reinvestment OpportunitiesDoes the family have a plan for putting sale proceeds to work? Once again, what the business “means” to the family comes to the fore. Will proceeds simply be distributed to the various branches of the family, to use or invest as they see fit? Or will proceeds be retained at the family level and redeployed in other assets for the benefit of the family? If so, are there reinvestment opportunities available that will “fit” the cash flow needs and risk tolerances of the family? Will such investments provide the same degree of family cohesion as the legacy business? A sale of the family business may have unintended, and potentially far-reaching consequences for the family.Responding to Acquisition OffersOnce the board has evaluated the unsolicited offer, there are essentially four responses to choose from:Reject the offer. If the directors conclude that the proposed price and/ or terms are unattractive, or if the timing of a transaction does not align with the broader goals of the family, the board may elect simply to reject the offer.Negotiate with the potential acquirer. If the directors conclude that the timing is right and that the suitor would be an attractive acquirer, the board may elect to negotiate with the buyer with a view toward consummating a transaction. If the perceived “fit” between the family business and the potential acquirer is good, proceeding directly to negotiating price and terms of the transaction may result in the quickest and smoothest path to close. However, without any exposure to the market, there is a risk that the negotiated price and terms are not really optimal. There is a reason private equity firms like to tout their “proprietary” deal flow to potential investors—direct negotiation with sellers presumably results in lower purchase prices than winning auctions does.Engage in a limited sale process. Given the potential for underpayment, directors may elect to discreetly contact a limited number of other potential acquirers to gauge their interest in making a competing bid for the business. The benefit of doing a limited market check is that it can generally be done fairly quickly without “putting the company up for sale” with the attendant publicity that the family may not desire. The initial suitor will, of course, generally prefer that even a limited sale process not be engaged in, and may seek some sort of exclusivity provision which precludes the seller from talking to other potential buyers. Directors will need to consider carefully whether the potential benefits of a limited sale process will outweigh the risk that such a process will cause the initial suitor to rescind their offer and walk away.Engage in a full sale process/ auction. Finally, the board may conclude as a result of their deliberations that the unsolicited offer signals that it is an opportune time to sell the business because pricing and terms are expected to be favorable in the market and the family’s circumstances align well with a sale. In a full sale process, the company’s financial advisors will prepare a descriptive investment memorandum for distribution to a carefully vetted list of potential motivated acquirers. After initial indications of interest are received, the universe of potential buyers is then narrowed to a manageable group of interested parties who are invited to view presentations by senior management and engage in limited due diligence with a view to making a formal bid for the business. With the help of their financial advisors, the directors evaluate the bids with regard to pricing, terms, and cultural fit, selecting a company with which to negotiate a definitive purchase agreement and close the transaction. A full sale process will likely involve the most time and expense, and may expose to competitors the family’s intention to sell, but carries with it the potential for achieving the most favorable price and terms.Bringing Together the Right TeamThere is a sharp experience imbalance in most transactions: buyers have often completed many transactions, while sellers may have never sold a business before. As a result, sellers need to assemble a team of experienced and trusted advisors to help them navigate the unfamiliar terrain. The transaction team will include at least three primary players: a transaction attorney, a tax accountant, and a financial advisor.Definitive purchase agreements are long, complicated contracts, and an experienced attorney is essential to memorializing the substantive terms of the transaction in the agreement and ensuring that the sellers’ legal interests are fully protected.Trusting the buyer to do your tax homework can be a very costly mistake.Business transactions also have significant tax consequences, and the tax code is arcane and littered with pitfalls for the unwary. Trusting the buyer to do your tax homework can be a very costly mistake. An experienced tax attorney is essential to maximizing after-tax proceeds to the family.The financial advisor takes the lead in helping the board evaluate unsolicited offers, setting value expectations, preparing the descriptive information memorandum, identifying a target list of potential motivated buyers of capacity, assessing initial indications of interest and formal bids, facilitating due diligence, and negotiating key economic terms of the definitive agreement. My colleague Nick Heinz leads Mercer Capital’s transaction advisory practice, and Nick likes to say that his job in a transaction is to run the transaction on behalf of the company so the company’s management can focus on running the business on behalf of the shareholders. Transactions can be time-consuming and mentally draining, and it’s simply not possible for company management to devote the necessary time to managing the transaction process and the business at the same time. An experienced financial advisor takes that burden off of management.When it comes to assembling the right team, business owners sometimes blanch at the cost. However, the cost of a quality and experienced team of advisors pales next to the cost of fumbling on the transaction. The family will only sell the business once, and there are no do-overs. As we recently heard someone say, “Cheap expertise is an oxymoron.”

The Family Business Director blog comes to you each week from Memphis, Tennessee.  Memphis is proud to be the home of AutoZone, Inc., one of the largest auto parts retailers in the U.S.  AutoZone founder and long-time director Pitt Hyde recently announced that he would not stand for re-election to the board of directors.Mr. Hyde’s announced transition highlights three lessons for family business directors and managers.Although publicly traded since 1991, AutoZone traces its roots to a family business.  Mr. Hyde’s grandfather founded Malone & Hyde, a grocery wholesaler, in 1907.  The first AutoZone store – originally “Auto Shack” before a bit of subsequent re-branding – opened in 1979, and the growing concept was spun out of Malone & Hyde in 1986.  Mr. Hyde turned over the reins as President and CEO of the company ten years later.Management transition is a sensitive topic for many family businesses.  Founders of successful family enterprises are by definition exceptional individuals.  The challenge for family business directors is ensuring that the unique attributes of key managers contribute to the sustainability of the family enterprise instead of crippling the business through unhealthy over-reliance or dependence on a single individual.  Mr. Hyde’s announced transition highlights three lessons for family business directors and managers.Lesson #1 – Think More Broadly About Managerial SuccessFor a senior executive of a family business, success must be defined more broadly than the current financial results of the business.  The notion of success should also encompass how the company is positioned to prosper after the executive’s tenure is over.  This broader view of success will not take hold automatically, so directors need to evaluate how they are equipping, encouraging, and incentivizing senior management to think about sustainability.Are your senior executives focused on building a business that can flourish in their absence?  Are you building a culture in which working yourself out of a job is a goal to be achieved rather than a fate to be feared?Lesson #2 – Commit to Developing a Successful Team & CultureCulture builds slowly in organizations, but once formed, culture is remarkably persistent even when there is turnover at the top.  Of course, culture can be either good or bad.  There have been plenty of stories in recent years about companies whose success has been undermined by a toxic culture.  Family businesses are no exception.  Ironically, a “family-first” culture at a family business can inhibit the retention of capable non-family executives that eventually become essential for the sustainability of the family business.AutoZone is known for a culture that is obsessively focused on the customer experience in their stores.  Culture is the environment that empowers the team to execute the founder’s vision on a greater scale than the founder possibly could by himself or herself.  At the time of Mr. Hyde’s retirement in 1997, the chain had grown from that original Auto Shack in Forrest City, Arkansas to approximately 1,500 locations.  In the following two decades, the culture and team that Mr. Hyde had developed grew the concept to over 6,000 stores.How do you and your fellow directors describe the culture of your family business?  Do the employees, customers, and suppliers who experience the family business’s culture every day describe it the same way?Lesson #3 – Develop a Passion for Things That Matter Outside the BusinessAlthough few would likely admit it, we suspect one reason that key executives avoid walking away from the family business is that they have not developed anything compelling to walk toward.  Mr. Hyde’s philanthropic endeavors have made, and continue to make, Memphis a better place to live.  Turning over management of a successful family business need not be followed by a “retirement curse.”  Whether a new business venture or philanthropy, family business executives who intentionally cultivate interests outside the family business are more likely to execute a successful transition to the next group of managers.Are you and your fellow directors encouraging senior managers to develop outside interests that will make eventual transition easier?Does it Really Matter: What’s the Financial Benefit?Family business directors are stewards of the financial resources that the family has allocated to the business.  So what are the financial benefits of focusing on management succession?  There are two principal benefits that directors need to be aware of.First, an emphasis on management succession increases the likelihood of continued financial success for the family.  AutoZone shares opened trading on April 2, 1991 at a (split-adjusted) price of $6.88 per share.  At the time of Mr. Hyde’s transition out of the President and CEO roles almost six years later, the share price had grown to approximately $25, a compound annual return for investors on the order of 25%.  The team and culture that Mr. Hyde left behind contributed to continued shareholder returns, with the share price today on the order of $800 (an annualized return over more than two decades of approximately 17%).Second, an emphasis on management succession actually increases the value of the family business in the present.  The flipside of failing to plan for management succession is allowing the family business to remain unduly dependent upon a single individual.  For multi-generation family businesses, such dependencies increase the risk profile of the company, which reduces the value of the business, and by extension, the family’s wealth.  Even when there is no intention to sell, directors should be mindful of the value of the family business and aware of steps they can take to enhance or protect that value.  Reducing key person dependency through active planning for management succession is an important step in doing so for many family businesses.Management succession needs and strategies will necessarily look different for every family business, but AutoZone provides a great case study for directors to consider.  Management succession is not just a human resources issue, but can have major financial repercussions for the family.  Our professionals welcome the opportunity to discuss in confidence how management succession is influencing the value and sustainability of your family business.For additional perspective on management succession, see Chapter 7 of our new book, The 12 Questions That Keep Family Business Directors Awake at Night.

Asset manager M&A was robust through the first three quarters of 2018 against a backdrop of volatile market conditions.  Several trends which have driven the uptick in sector M&A in recent years have continued into 2018, including increasing activity by RIA aggregators and rising cost pressures.  Total deal count during the first three quarters of 2018 increased 45% versus the same period in 2017, and total disclosed deal value was up over 150%.  In terms of both deal volume and deal count, M&A is on pace to reach the highest levels since 2009. Thus far in the fourth quarter, M&A shows no signs of slowing down.  Just last week, Invesco Ltd. (IVZ) announced plans to acquire the OppenheimerFunds unit from MassMutual for $5.7 billion in one of the largest sector deals over the last decade.  IVZ will tack on $250 billion in AUM as a result of the deal, pushing total AUM to $1.2 trillion and making the combined firm the 13th largest asset manager by AUM globally and the 6th largest by retail AUM in the U.S.  The deal marks a major bet on active management for IVZ, as OppenheimerFunds’ products are concentrated in actively-managed specialized asset classes, including international equity, emerging market equities, and alternative income.  Invesco chief Martin Flanagan explained the rationale for scale during an earnings call last year: "Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike. And, you have to be, as a firm, you have to be able to invest in the future.  And I think a number of smaller-sized firms are finding that hard." Martin Flanagan, President and CEO, Invesco Ltd. – 1Q17 Earnings CallRIA aggregators continued to be active acquirers in the space, with Mercer Advisors (no relation), and United Capital Advisors each acquiring multiple RIAs over the last year.  The wealth management consolidator Focus Financial Partners (FOCS) has been active since its July IPO as well.  In August, FOCS announced the acquisition of Atlanta-based Edge Capital Group, which manages $3.5 billion in client assets.  FOCS also announced several sub-acquisitions by its affiliates during the third quarter.Consolidation Rationales The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, aging shareholder bases, and slowing organic growth for many active managers.  While these pressures have been compressing margins for years, sector M&A has historically been muted.  This has been due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation.  Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure as long as it doesn’t inhibit performance."Absolutely, this has been an elevated period of M&A activity in the industry and you should assume alongside our proprietary calling effort, we're looking at all of the opportunities in the market." Nathaniel Dalton, CEO, Affiliated Managers Group Inc. – 2Q18 Earnings Call "[I] think again these trends towards greater regulation, greater exposure, greater need to diligence managers and all that kind of stuff, greater suitability, all these things are driving towards doing business with fewer managers, larger managers, more diversified managers…" Joseph Sullivan, CEO, Legg Mason, Inc. – July 2018 Earnings CallConsolidation pressures in the industry are largely the result of secular trends.  On the revenue side, realized fees continue to decrease as funds flow from active to passive.  On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs.  Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to realize economies of scale, enhance product offerings, and gain distribution leverage.Market ImpactRecent increases in M&A activity come against a backdrop of a bull market in asset prices that has continued through the third quarter of 2018.  Steady market gains have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years.  In 2016, for example, active mutual funds’ assets grew to $11 trillion from $10.7 trillion, despite $400 billion in net outflows according to data from Bloomberg.  Because of increasing AUM and concomitant revenue growth, profitability has been trending upwards despite industry headwinds that seem to rationalize consolidation.M&A OutlookWith over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back office efficiencies.  Expanding distribution footprints and product offerings will also continue to be a key acquisition rationale as firms have struggled with organic growth.  An aging ownership base is another impetus, and recent market gains might induce prospective sellers to finally pull the trigger, which could further facilitate M&A’s upward trend during the rest of 2018.

The third quarter just wrapped for upstream producers.  Stock performance has been volatile, infrastructure issues are lurking and the industry as a whole ended the quarter a notch above flat. However, approximately $21 billion in strategic acquisitions by BP and Diamondback Energy highlighted the continued optimism for the segment. BP’s merger looks particularly interesting as it focuses on the Eagle Ford while most investors have been looking to the Permian. BP’s earnings have yet to be reported, so stay tuned.BP’s Big DealBP brought on approximately 470,000 acres of rights and 90,000 barrels per day of current production.BP certainly wasn’t waiting for the industry’s current infrastructure issues to sort themselves out as they forged ahead with the biggest single upstream merger this year, a $10.5 billion acquisition of BHP Billiton. This is BP’s biggest acquisition in nearly 20 years. The primary assets acquired were spread across the Eagle Ford shale in South Texas, the Haynesville Shale in East Texas and to a lesser extent, the Permian Basin. Through this transaction, BP brought on approximately 470,000 acres of rights and 90,000 barrels per day of current production. BP was naturally enthusiastic about the deal, and after some review, this deal appears to have a lot of potential to create value for BP. Here’s why:This Is Not BP’s First Venture Into The Texas Shale PlaysBP dipped their toe into the Eagle Ford shale back in 2010, before they fully jumped into this deal.  Joining with local dry gas powerhouse Lewis Energy, BP bought at $4,000 to 5,000 per acre for joint venture rights on the dry gas window of the Eagle Ford shale. Over the course of the past few years, BP has more than doubled per-well production in the Eagle Ford by utilizing improved production techniques. This experience, particularly in that region, could serve BP’s shareholders well going forward.There’s Commodity Price UpsideBP based their return models on $55 oil and $2.75 gas.  As of the acquisition, oil prices were already in the mid-$60’s and closed around $75 this week. On the other hand, gas prices have been flat and returns have been driven by the cost side of the equation. Although only about 45% of the reserves purchased are liquids-based, it has the potential to boost returns and increase values.At First Glance, BP Does Not Appear To Have OverpaidWith over 80% of the assets weighted towards the lesser celebrated Eagle Ford and Haynesville plays, BP did not focus on the higher priced Permian Basin as much in this deal. Although the Permian’s stacked geology is superior, it is also more expensive. On a per net acre basis, BP paid just over $22,000 per acre.Diamondback Energy’s Big DealNot to be outdone, Diamondback Energy made two acquisitions within a week of each other that cost around $10.4 billion. Both transactions were in the Permian and were spread between the Delaware and Midland Basins. Both were similarly priced and are more oil and liquids heavy than BP’s acquisition, notable because margins for oil and liquids are generally much better than gas.The deals were notable because margins for oil and liquids are generally much better than gas.Diamondback’s larger deal was its purchase of Energen for  $9.2 billion, providing 179,000 acres and about 90,400 barrels per day of current production. Diamondback also purchased AJAX Resources for $1.2 billion, gaining over 25,000 acres and about 12,130 barrels per day of production. Although smaller, this deal was more focused on acreage located in the Midland Basin.Betting On SuccessBased on implied production multiples of other companies, deal pricing for both Diamondback mergers was generally in line with current implied values and creates one of the largest pure-play Permian producers. All three transactions appear to either be generally in line with implied public company market valuations in their respective regions.Overall, upstream indexes were muddled in the third quarter, although earnings reports could shift the sentiment. BP and Diamondback are betting big that future quarterly (and annual) performance will be better.The Bigger PictureGenerally, oil prices started and ended the quarter in almost the same place – around $73-$74 per barrel, but it took a circuitous route, dropping down to $65 in mid-August before climbing back.  West Texas, however, has been a different story. Differentials between the standardized Cushing, Oklahoma prices and more localized Midland prices have been climbing for much of the year and remained wide until the end of the third quarter. This gap has been created as a result of a supply traffic jam that has overwhelmed the Permian’s infrastructure. Production in Texas actually fell this summer due in large part to these issues, and this dynamic pervades beyond the Permian Basin. Appalachia and the Bakken have similar issues, although not discussed as often. Efforts are underway to alleviate these bottleneck issues in all of these areas, but it will continue to take time and capital.  This extends not only from public markets, but private equity as well. Have these issues impacted productivity or activity? So far, the answer is no.  Capex budgets, a harbinger of drilling plans, have continued to grow and be revised upward for many producers. Drilling and production figures continue to climb everywhere but West Texas. However, that is temporary. Noting the Permian’s drilled but uncompleted (“DUC”) well figure, the Permian’s effective inventory is waiting to be unleashed on the market. Could this be setting up strong earnings and production? One can only hope, and Diamondback and BP seem to think so. It appears the market may be transitioning from ascribing value on enthusiasm about potential shale production from undrilled reserves to realization of those reserves and more real dollars to show for it. Originally appeared on Forbes.com.

Earn-outs are as common to investment management firm transactions as they are misunderstood.Despite the relatively high level of financial sophistication among RIA buyers and sellers, and broad knowledge that substantial portions of value transacted depends on rewarding post-closing performance, contingent consideration remains a mystery to many industry M&A participants. Yet understanding earn-outs and the role they play in RIA deals is fundamental to understanding the value of these businesses, as well as how to represent oneself as a buyer or seller in a transaction.This whitepaper is not offered as transaction advice or a legal primer on contingent consideration. The former is unique to individual needs in particular transactions, and the latter is beyond our expertise as financial advisors to the investment management industry. Instead, we offer this to explore the basic economics of contingent consideration and the role it plays in negotiating RIA transactions.Download your copy of the whitepaper below.WHITEPAPERThe Role of Earn-outs in Asset Management M&ADownload Whitepaper

Over the past year, followers of the oil and gas industry have taken note of the multitude of transactions occurring in the Permian Basin with large deal values and hefty multiples. But the price differential between WTI and other benchmarks has grown over the last few months, and some attention has moved from the Permian to other domestic shale plays.  The activity in other regions such as the Bakken was at one point slow (when compared to the Permian) causing the recent increase in production and the swapping of acreage to fly under the radar while many were focused on Texas.Transaction activity in the Bakken in 2017 marked the departure of a number of companies that were active in the play, such as Halcon Resources. At the end of 2017 and into 2018, the exodus from the Bakken to the Permian continued. Recently, the Bakken is being viewed as another viable option to the Permian Basin, which has seen a growing price differential due to insufficient infrastructure. This, and rising oil prices, has resulted in an increase in production in the region, leading to more transaction activity and inflows of capital.Recent Transactions in the BakkenDetails of recent transactions in the Bakken, including some comparative valuation metrics are shown below.Overall, the average deal size has decreased from twelve months ago when companies sold off large bundles of assets to clean up their balance sheets and survive in the low oil price environment. While deals today may be smaller in size, they are more strategic in nature.Whiting Acquires 65,000 Acres from OasisOne of the largest deals in the region over the last twelve months was Whiting Petroleum Corp. purchase of 65,000 acres from Oasis Petroleum Inc. in June for $283 million.  A Seeking Alpha contributor noted that this transaction is a “case of one company believing that it can achieve better results in an area that the other company considered lower quality acreage.” This is observed in Oasis’ acceptance of a lower than average transaction price per acre, and Whiting’s willingness to pay an above average price flowing barrel.US Energy Acquires 1,600 Acres from APEGOne of the smaller deals was US Energy Corp.’s acquisition of 1,600 acres from APEG Energy LP (a related party) for $18 million. US Energy and APEG Energy II, LP announced a strategic partnership in October of 2017 in a deleveraging transaction. APEG Energy II is one of Angelus Capital’s (a private equity firm headquartered in Austin, Texas) funds focused on acquiring domestic oil and gas assets. Since then, US Energy has focused on cleaning up its balance sheet to focus on producing oil assets. Recently, US Energy has been working to add assets that will immediately increase production in the Williston Basin and South Texas.US Energy expects their most recent transaction “will create additional opportunities for development and acreage swaps that would permit the company to continue consolidating its leasehold position in the area.”  US Energy paid $44,500 per flowing barrel, which is in line with average production multiples paid in the region but is somewhat lower than those observed last year. Deal values last year may have been based on the expectation that production would increase in the future, inflating current multiples. Now that production has picked back up in the Bakken, deal multiples appear to have normalized somewhat.Observed M&A Trends in the BakkenThe following are two good examples of transactions we are seeing in the region this year:Strategic Deals Between Regional OperatorsOne of the disadvantages of the Bakken, as compared to the Permian, is that it is an older play and many of its sweetest spots have already been drilled.  However, age is often equated with wisdom, and the significant experience of operators who have been in this region since the early 2000s gives them a competitive edge.  As Senior Beck, a senior director at Statas Advisors explained, “The Bakken’s maturity and production characteristics could lead to a growth in consolidation over the next few years.”Acquisitions of Property by Non-OperatorsAdditionally, the prominence of activity of non-operators in the Bakken has increased.  Private equity funds like Angelus Capital, single-family offices, and other providers of capital that see an opportunity in the Bakken are buying acreage and partnering with the best operators in order to realize superior returns on investment.Combining these trends, Northern Oil and Gas Inc. is a non-operator who aims to be the Bakken’s “natural consolidator.”  In July it completed its largest acquisition yet of 10,600 net acres for $100 million cash plus approximately $190 million of Northern Oil stock.  Northern Oil is relying upon the superior abilities of longtime regional operators and the trend towards consolidation. However, it is also an example of a non-operator who has become more prominent in the last year.The Bakken may have gone unnoticed for a couple years after the downturn in oil prices in 2014, but it may be rising back to prominence as increases in efficiency and cost reductions impress investors.We have assisted many clients with various valuation needs in the upstream oil and gas in North America and around the world.  In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.  Contact a Mercer Capital professional to discuss your needs in confidence.

The oilfield service sector has recovered significantly since the crash in oil prices in mid-2014. As capex budgets have expanded, especially in the Permian Basin, demand for oilfield services such as drilling and pumping has increased. But what does this mean for transaction activity in the sector?The oilfield service industry was in consolidation mode over the last few years as smaller servicers struggled to survive in the low oil price environment which translated to lower day rates. Thus the relatively fewer transactions from 2015 through much of 2017 were mainly distressed sales.Now that oil prices have recovered, drilling activity has picked up, and day rates have increased, the reason for deals has changed. Rather than merging to survive, companies are acquiring in order to thrive. When discussing transactions in oilfield services sector over the past few years, maybe it should be called mergers THEN acquisitions.From Mid-2014 to Mid-2017 Oilfield Servicers Were SurvivingWhen oil prices fell, demand for oilfield services declined significantly. Despite the steep drop in prices, production did not fall through the floor because the cost of stopping and starting production can outweigh the loss incurred from lower oil prices. Still, the oilfield services sector felt the pain as many of its high value-added services occur at new sites rather than currently producing ones. With low oil prices, people became more judicious with how they deployed capital and new projects were largely tabled. Companies in financial duress were forced out of the market through consolidations and bankruptcy, as other sources of capital such as debt or additional equity offerings dried up due to the uncertainty surrounding future oil prices.M&A activity for the oilfield services sector was largely muted during the downturn in terms of both deal volume and value. Deal value would have been larger had Halliburton Company successfully completed its megamerger with its competitor Baker Hughes Inc. for an announced $34.6 billion. Instead of searching for synergies to boost revenue, companies were seeking to combine to eliminate duplicative expenses. In the case of Halliburton and Baker Hughes, the merger was expected to cut nearly $2 billion in annual costs according to the investor material seen below. Ultimately, this became the downfall of the deal as regulators denied it on grounds of decreased competition and reduced innovation on account of too much overlap in services. One year after the U.S. Justice Department blocked the deal due to anti-trust laws, General Electric bought a controlling interest (62.5%) in Baker Hughes. The combined entity resulting from GE’s investment caused GE’s combined revenue to surpass Halliburton, becoming the second largest company by revenue in the industry, trailing only Schlumberger. In early 2017, streamlining operations and eliminating expenses via consolidations was viewed as “the last big step to margin improvement,” according to the Coker Palmer Institutional. By the end of the year, there were 215 transactions in 2017, up 13% from 2016. As the tide began to turn, factors influencing transaction activity shifted from financial stress and cost efficiencies to economies of scale and enhanced offerings, particularly in digital technology. Oilfield Servicers Are Now ThrivingAs oil prices have recovered, up to $60 a barrel at the end of 2017 and peaking at $72 in May 2018, transaction activity has increased, but the reason for this increase in activity has changed. Companies that survived the downturn in oil prices stood to gain as rising oil prices aided margins and increased capex budgets for E&P companies. As break even prices became less of a concern for the industry, growth and innovation became the focus. Oilfield services companies depend on innovation to distinguish themselves in a highly fragmented industry, and when prices caused capital to flow out of the industry, companies were unable to fund the research and development necessary to innovate. Now, that trend is reversing with funding flowing into the sector to support growth and innovation. This is particularly important due to the capital-intensive nature of oilfield services, requiring significant investment to buy more equipment to meet growing demand.The following table shows some strategic transactions that have occurred thus far in 2018, as companies seek growth opportunities.  However, we are starting to see more investment from other sources.Private Equity Firms Are Suppling Growth CapitalAfter years of industry executives searching for diamonds in the rough, institutional investors have joined the fray. Over the last twelve months, there has been an influx of funds from private equity firms and hedge funds as growth, innovation, and fragmentation are all desirable traits for these investors.In March, Morgan Stanley Energy Partners (MSEP), the energy-focused private equity arm of Morgan Stanley Investment Management, completed an investment in Specialized Desanders, Inc. a Canadian-based oilfield equipment company that specializes in efficiently removing sands and other solids during the well flowback and production process.  MSEP’s investment seeks to accelerate growth in the U.S. market and expand their product offerings.In August, MSEP continued investing with its announcement of a partnership with Catalyst Energy Services. Proceeds from the investment will be used to buy state-of-the-art equipment which will allow the company to grow to meet increased demands for modern completion designs from E&P companies.Black Bay Energy Capital recently closed its inaugural fund with commitments of $224 million, exceeding their $200 million target.  This includes six investments in oilfield service companies exhibiting rapid growth that “improve the efficiency and cost-profile of oil & gas producers.”These investments made by MSEP and Black Bay show the three trends currently being exhibited in transactions in the oilfield services sector: niche product or specialty, innovative offering or technology, and growth. Whether it be strategic investors or private equity sponsors, acquisitions we are seeing now are largely spurring revenue growth instead of eliminating expenses.ConclusionTransaction volume in the oilfield services sector ebbed and flowed with oil prices over the last few years. On the way down, companies cut costs to survive, and mergers played an important role in increasing efficiencies in order to survive. On the way back up, companies sought capital to propel growth and fund innovation. As the market shifts from backwardation to contango and back again, Mercer Capital is here to help throughout all stages and economic environments.In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.Whether you are selling your business, acquiring another business or division, or have needs related to mergers, valuations, fairness opinions, and other transaction advisory needs, we can help.  Contact a Mercer Capital professional to discuss your needs in confidence.

Question: How many CFA charter holders does it take to change a light bulb?  Answer: When you ask “how many,” are you asking for the mean, median, mode, a rolling average, variance or semi-variance to a certain population sample...?Paralysis by analysis often seems like a viable career track in finance, especially when it comes to product development.  Even here, though, history offers a pattern of what to expect.  Product development usually follows one of two paths in investment management: greater innovation or lower pricing.  The former of these is a margin builder, while the latter can be a margin killer.  After watching the price of trading drop for decades, it wasn’t so surprising when J.P. Morgan announced that it would offer free online trading for certain investors last month, but when $2.5 trillion manager Fidelity Investments announced they were going to be offering two “free” index funds, the industry rocked on its heels.  Is this the next leg down for pricing of investment management, a publicity stunt by Fidelity, or something else altogether?Relating this, as I am wont to do, to historical events in the automotive history, I’m reminded of the down-market product disaster that Aston Martin attempted a few years back, the Cygnet.  In 2011, faced with looming and more stringent EU emissions standards, Aston Martin decided the only way to comply was to market a high-volume, high-mileage micro-car that would average out with the automaker’s low-volume, low-mileage GTs.  Developing an all-new car is prohibitively expensive, though, so a committee at Aston decided to license an existing eco-platform, the Toyota IQ, dress it up with leather and fancy badges, and sell it as a premium economy car.  This offspring was priced at about a third of the MSRP of Aston’s other cars, but it was still three times as much as a Toyota IQ.  So, was it an insanely cheap Aston Martin, or a ridiculously expensive Toyota?  When Aston Martin launched the Cygnet (a name which accommodated an “ugly-duckling” appearance by suggesting it was the adolescent version of the company’s beautiful models like the DB9), their CEO stood on a mountain of product research on brand extension and projected annual sales of 4,000 units in the UK alone.  Instead, Brits bought fewer than 300 baby swans over two years before Aston Martin gave up.The big asset gatherers like Fidelity, Charles Schwab, Vanguard, and Blackstone have been creating high volume, low price investment products at an increasingly prodigious rate for years.  With many index products already available at ten basis points or less, the trip to zero was a short one for Fidelity and likely one they expect to recoup in other products and services once the client relationship is secured and the assets are in-house.Fidelity’s move was meant to look revolutionary, but it’s really revolutionary, and I don’t think it says much about where the investment management industry is going.  Look no further than the progress of the robo-advisory business.  I was an early subscriber to Financial Engines’s portfolio evaluation tools, but frankly lost interest in quarterly model analysis and dropped out after a couple of years.  In the first ever “Robo Ranking” by Backend Benchmarking, the top-ranked robo-advisor is Vanguard’s Personal Advisor, mainly on the strength of its human advisor services that come with the algorithm in a competitively priced package.  The lowest ranking robos scored poorly, in part, because of the lack of access to advisors.The ongoing theme of the repricing of investment management is that if value can be articulated and justified, reasonable fees can be charged.  There is also ample evidence that human relationships are still highly valued in the RIA space.  So while investment management products are subject to a high degree of price scrutiny and competition, investment management services are largely unaffected.  It’s more likely that the fees available for investment management are being reallocated, rather than being diminished in aggregate.  Time will tell.In short, I don’t know if the no-cost Fidelity products are going to go the way of the Cygnet, but I don’t think this is a Black Swan event either.

On April 30, 2018, Marathon Petroleum announced its acquisition of the newly formed Andeavor making Marathon the largest refiner in the U.S. (by capacity) and one of the top five refiners in the world.  The merger is moving into its final stages, and Marathon’s CEO is positive about the combination of the two well situated companies.In this post, we analyze the recent acquisition history of Western Refining, Tesoro, and Marathon, which has started to look somewhat like nesting dolls of acquisitions. For an industry that has had sluggish M&A activity in the last couple years, this line of acquisitions seems to hint to a possible trend of consolidation.  Domestic oil production has increased significantly over the last couple years.  Even though export bans on crude oil were lifted a couple years ago, overall, there is more crude oil in the U.S. that needs to be refined.  According to the EIA, U.S. refining capacity is “virtually unchanged from 2017 to 2018.”  Domestic refineries are now running at average utilization figures of 90%, as compared to the IEA’s global average of 70%.  Building a new refinery takes time and money and has significant regulatory hurdles; thus U.S. refiners appear to be combining in order to increase efficiencies and meet the higher demand for their services as a result of the recent increase in domestic crude oil production. Recent Acquisition HistoryThe table below shows metrics from the line of acquisitions leading up to Marathon’s acquisition of Andeavor, along with other recent transactions in the downstream space for comparison.Western Refining’s Acquisition of Northern Tier for $1.6 BillionIn late 2015, Western Refining bought all remaining shares of Northern Tier Refining, not already owned by Western Refining and its subsidiaries, for $1.6 billon. (Western Refining previously bought a controlling interest in Northern Tier for $775 million in 2013.) The resulting company had three refineries in Gallup, NM; St Paul, MN; and El Paso, TX.Western Refining paid 5.3x EBITDA for the remaining minority position in Northern Tier.  Some analysts such as Albert Alfonso, originally believed that the deal was undervalued.  While the deal multiples were quite a bit lower than the multiples observed in the downstream space at the time, it is important to consider the premiums paid for acquisitions of control versus the price paid in this acquisition of a minority position by a company that previously paid for control.  For comparison purposes, this transaction is more similar to Delek’s 2017 acquisition of the remaining shares of Alon at 5.9x EBITDA for a minority stake.Tesoro’s Acquisition of Western Refining for $6.4 BillionIn November 2016, Western Refining and Tesoro Corporation merged to form Andeavor. Tesoro bought Western Refining for 10.6x EBITDA and 80% of revenues, which at the time was in line with the earnings multiples observed in Delek’s acquisition of shares of Alon U.S. Energy for 11.0x EBITDA. (Through this transaction, Delek gained control of the entity of which they originally owned 48%.)  The newly formed Andeavor was the fourth largest independent refiner in the U.S.Tesoro had refineries in California, Washington, Alaska, Utah, and North Dakota. The addition of Western Frontier expanded their presence by adding refining locations in Texas, New Mexico, and Minnesota.Western Refining shareholders received either 0.4350 Tesoro shares, or $37.30 in cash per share. As compared to the previous day’s closing price of Western Refining, the shareholders received a 22.3% premium, according to a Fortune article about the transaction.  In order to prevent dilution from the offering of additional shares, Tesoro announced it would increase its buyback program by $1 billion.  The deal was expected to create between $350 and $425 million in synergies to be realized in the first two years of their combination.In addition to expanded refining capacity, the combined companies had over 3,000 retail stations.Marathon’s Acquisition of Andeavor for $23.3 Billion (Enterprise Value of $35.6 Billion)Marathon Petroleum is expected to close on its acquisition, newly formed Andeavor for 12.7x EBITDA, which shows a slight premium to the few transactions observed in the refining space lately.  Andeavor shareholders will have the option to choose 1.87 shares of MPC stock, or $152.27 in cash per share. This represents a 25% premium to the closing price the day before the transaction was announced.   In order to prevent dilution from the issuance of additional MPC shares, Marathon’s Board approved $5 billion repurchase authorization.The two companies were largely located in different parts of the country as shown in the map below. Andeavor Chairman and CEO Greg Goff (who will become Executive Vice Chairman at MPC) explained,“Look at the map of the two companies and the way they are positioned geographically in the United States and you come to the conclusion that this is a great opportunity to be able to bring the companies together.”The map below shows the locations of both Marathon and Andeavor’s refineries. Marathon had six refineries in the eastern half of the U.S. and Andeavor had 10 refineries in the western U.S. and Alaska.  The combined company will have approximately 15% of total fuel making ability in the U.S. Additionally, the combined companies have over 7,800 branded fuel stations. Immediately Accretive DealAccretive deals add more value than they cost, either over time or immediately.  The Marathon and Andeavor deal is expected to be immediately accretive to earnings per share; meaning the price paid by Marathon is lower than the immediate expected boost in earnings per share post-acquisition.The deal is expected to create significant synergies resulting in around $1 billion over the first three years.  These synergies will come as a result of stronger purchasing power, system optimizations, procurement efficiencies, leveraging of assets, and retail network efficiencies. Additionally, according to Marathon’s Chairman and CEO, Gary Heminger, thinks that the potential synergies could be even greater than the estimated $1 billion.  However, that remains to be seen.  Many analysts are sometimes skeptical of synergies due to their somewhat abstract nature.Did Marathon Pay Too Much?Marathon’s acquisition of Andeavor comes at a time when U.S. refineries are positioned to benefit from the increase in domestic production of oil and gas. Many refineries that purchase WTI crude are currently benefitting from the discount of WTI to Brent, which has lowered their costs of sales as refined product prices are still increasing.  Refineries margins have increased 8% worldwide and almost 25% in the U.S. Midwest year over year according to British Petroleum’s Refiner Marker Margins and crack spreads have increased as shown in the graph below. Management of both companies seem positive regarding the deal and there seems to be little reason to believe that the deal would face any resistance from regulators as there was is little overlap in the locations of the refiners.  However, investors of MPC could ask if MPC paid too much? Stock buybacks are generally a signal to investors that the Company views its own stock as a good investment.  Additionally, management will generally not buy back shares if they think the stock is currently overpriced.  Marathon’s announcement of a buyback should somewhat ease investors’ concerns. ConclusionIt is hard to pinpoint the root cause of the recent consolidation activity in the downstream oil and gas space. The pressure of RIN expenses on smaller refineries that do not have the capacity to blend their renewable fuels could be one cause of consolidation.  The immediate need for more operating capacity as U.S. oil production has increased might be pressuring larger refiners to purchase rather than build additional capacity. Additionally, the recent tumult of the global trade environment adds an additional layer of uncertainty for U.S. refineries whose main export market is Mexico.In addition to our corporate valuation services, Mercer Capital provides investment banking and transaction advisory services to a broad range of public and private companies and financial institutions.  We have relevant experience working with companies in the oil and gas space and can leverage our historical valuation and investment banking experience to help you navigate a critical transaction, providing timely, accurate and reliable results.Whether you are selling your business, acquiring another business or division, or have needs related to mergers, valuations, fairness opinions, and other transaction advisory needs, we can help.  Contact a Mercer Capital professional to discuss your needs in confidence.

As World War II drew to a close, a military aircraft manufacturer in Sweden saw the post-war consumer economy as an opportunity to expand into cars, and the Saab automobile was born.  For about 45 years thereafter, Saab established itself as a scrappy automaker known for innovation.  Saab was the first automaker to introduce seatbelts as standard equipment, ignition systems that wouldn’t crush a driver’s knees in a collision, headlamp wipers and washers, heated seats, direct ignition, asbestos-free brake pads, and CFC-free air-conditioning.  Saabs were distinctive, substantial hatchbacks with strong but efficient motors and enjoyed a devoted following.  Unfortunately, Saab’s fan base was too small, and as the company struggled to build the scale necessary for global distribution, financial troubles drove them into the gaping maw of General Motors.In the late 1980s both GM and Ford were attempting to consolidate global automotive capacity and bring as many brands under their corporate hierarchy as possible.  With consolidation came homogenization, as global behemoths looked for ways to cut manufacturing costs.  Under Ford’s ownership, Jaguar and Aston Martin starting sharing parts with each other and their Dearborn parent.  Ford, arguably, saved both marques and orphaned them before they were ruined.  Jaguar is thriving today, and Aston Martin is planning its first public offering.  Saab wasn’t so fortunate, with GM blending Saab’s mystique with Subaru (sushi with meatballs?) and Saturn (a space oddity if there ever was one).  Saab struggled for about twenty years in GM’s dysfunctional family, but eventually the brand was wrecked and Saab was no more.Divergent Industry TensionsLike the automotive industry in late 1940s and 50s, the investment management industry is characterized by scores of independent firms who have found success in idiosyncrasy, providing clients a limitless variety of paths and approaches to common investment dilemmas.  Some would suggest that this is the source of the industry’s strength, but not everyone agrees, as evidenced by the Focus Financial IPO two weeks ago.A key element of the Focus market opportunity is “fixing” the fragmented nature of the RIA industry, providing an ownership structure, exit opportunity, and transition mechanism for the thousands of independent advisory practices with a stream of profitability threatened by aging founders.  This opportunity exists in an industry that is far from declining – in fact it is growing in clients, assets, and advisors.  Focus can provide ownership transition capital to bring some order to this creative process and share in the profits along the way.The RIA industry is growing, but it is doing so because it is largely in a stage of de-consolidation, rather than consolidation.  Most of our clients set up their own shops – whether in wealth management or asset management – because they were exiting larger firms they felt restricted their thinking, their business development, and their incomes.  Investment managers are characteristically independently minded and entrepreneurially motivated.  In many ways, the increase in investment advisory practices is an effort to recapture the careers available to what were once called stockbrokers forty years ago.  One client of ours who escaped his wire house environment earlier this year decried how his former firm had been taken over by lawyers and accountants who were conspiring to restrict opportunities for both him and his clients.So many wire houses are now losing advisors to the RIA industry, broker protocol is splintering, and the only BDs reporting growth in advisors are doing so at great recruiting costs, which may or may not be recoverable.  The alternative would be to acquire practices outright, but great entrepreneurs make miserable employees.  Focus aims to thread this needle by acquiring a preferred interest in the profitability of partner firms (defined as Earnings Before Partner Compensation, or EBPC) that assures Focus a basic rate of return on investment but leaves the leadership of partner firms the opportunity for upside.  Further, while the Focus holding company will provide programs in products, marketing, and compliance to partner firms, opting-in to those programs is treated like coaching, rather than being compulsory.Will the Focus “preferred stake in EBPC” work?  Will selling partners be motivated enough to continue to grow their practices profitably?  Will subsequent generations of partner firm leadership have enough upside to stick around or will they seek out other opportunities?  Is coaching through encouragement enough to manage the activity of boutique investment advisory practices?  Can subsidiary firm margins been grown enough to offset the corporate overhead of the parent?The Prevailing RhythmWe are obviously skeptical, but we’re not cynical.  We’ve been around long enough (and have been wrong enough), so we are intently watching and listening to the drumbeat of the consolidators.  Focus has put more thinking and garnered more capital to try to build critical mass in the wealth management industry than anybody else.  They are not the only group trying to do this, but they’ve gone farther than anybody else.  We don’t buy the idea that Focus is the public company barometer of the RIA industry, but it is the barometer of RIA consolidation.  The question for the investment management industry remains: is consolidation the answer?

After Focus Financial filed their S-1 in May, I drew some analogies to Ferrari’s public offering two years ago (NYSE: RACE), as both companies faced considerable skepticism at advent of their IPO.  Last week, the two stories intersected once again, as the man who steered Ferrari to its public offering, Sergio Marchionne, died unexpectedly at 66, and two days later Focus Financial went public (Nasdaq: FOCS).Marchionne leaves behind an indelible imprint on the automobile industry.  He almost single-handedly rebuilt the automotive landscape from its most unlikely corner, Italy, by squeezing $2 billion out of GM to recapitalize Fiat in 2005.  With Fiat rescued from oblivion, Marchionne rebuilt Alfa Romeo, Maserati, and Ferrari under the Fiat umbrella.  He took advantage of the credit crisis to bring Chrysler under Fiat’s control, and then took advantage of the subsequent bull market in luxury goods to take Ferrari public.  He was trained as a lawyer, practiced as an accountant, and fueled by expresso and cigarettes.  Above all, though, Signore Marchionne seemed to really love cars – something lacking in too many automotive executives these days.I won’t go so far as to compare Focus Financial’s founder, Rudy Adolf, to Marchionne, but it’s worth noting that, like Marchionne, Adolf pulled off what many others have tried, and failed, to do.  Now that Focus is public, we have a new channel with which to study and benchmark the industry.  We have lots of questions, but for this post, we’ll just look at the implications of the Focus valuation that is consequent from the IPO.Focus Is Richly PricedAfter a predicted pricing range of $35-39 per share, FOCS went public at $33.  Of the $490 million raised in the offering (after underwriting fees), Focus is going to use a bit less than $400 million to pay down debt, about $35 million to settle equity compensation and other obligations to existing owners, and the remaining $60 plus million they’ll hold in cash for opportunities as they come along.  If the underwriters exercise their greenshoe, Focus picks up another $75 million or so.We heard plenty of chatter about the implications of Focus pricing below the originally suggested range, but we don’t make too much of it.  The $35-39 range was very high (as we’ll get into later in this post), and in any event, the trading activity immediately raised Focus shares up to the range (no doubt guided by the invisible hands of market makers associated with the book runners).  The IPO was a success.Focus Didn’t Sell CheapOne thing we don’t have a question about is the magnitude of Focus’s valuation at IPO – it was expensive by any measure.  In the quarter ending March 31, 2018, Focus reported a net loss of nearly $37 million on $196 million in revenue.  In the prospectus, management provides a series of adjustments to redeem the quarterly loss to a net profit of almost $30 million and EBITDA of over $44 million. We don’t take issue with many of management’s normalizing adjustments, as there are several non-recurring expenses associated with taking a company like Focus public.  We are curious, though, about adding back non-cash equity compensation and the change in fair value of contingent consideration made for acquisitions.  From the perspective of a shareholder, equity compensation is still a drain on earnings, because it dilutes existing shareholders’ claim on profitability.  Since Focus is an acquisition company, it seems that any increased earn-out or other contingent payment expense increases the cost to Focus – whether in the form of cash or stock – such that these aren’t truly extraordinary items that a shareholder would disregard when calculating Focus’s profitability. Any argument with these adjustments takes an already lofty IPO valuation for Focus to nosebleed levels.  At the IPO price of $33 per share, Focus has an equity market cap (absent special allotments for the underwriters) of about $2.3 billion, and a total market capitalization inclusive of net debt of $2.8 billion. If we look at the most recent reported quarter, annualize it to develop a measure of ongoing performance and further look at a year forward assuming a 20% annualized growth rate (10% to the mid-year), we show strong multiples of revenue and earnings (compared to industry standards), and higher-than-usual multiples of EBITDA.  However, that’s only if you accept all of management’s adjustments.  If instead, you don’t give Focus the benefit of adding back non-cash (but nonetheless dilutive) equity compensation expense, the resulting multiples of profitability are other-worldly. The big issue that most analysts seem to have with Focus is that they want to be given credit for inorganic growth on their multiple while adjusting earnings to eliminate the cost of that inorganic growth.  The Focus prospectus and roadshow presentation made much of their 20% growth historical and prospective topline growth, and everyone knows that growth is because of acquisitions.  The prospectus doesn’t actually offer any estimate of organic growth, or same-store sales growth, because they credit organic growth for subsidiary-level acquisitions by partner firms.  It seems to us that the costs of that growth are, indeed, relevant to earnings.  So either we judge Focus as an acquisition company or an operating company, rather than give them credit for the topline performance of an acquisition company and the bottom line performance of an operating company. Peer Comparisons Are DifficultFocus isn’t really an RIA, it holds preferred interests in profit sharing units in RIAs.  Nonetheless, most analysts will lump them into the RIA space.  The question is where?Earlier this year a small RIA called Victory Capital went public (Nasdaq: VCTR).  Victory is an amalgamation of wealth management firms and an ETF offering.  It’s about half the size of Focus, and it hasn’t fared too well since the offering.  Another possible comp is Silvercrest, which probably feels forgotten by the public markets in the wake of attention given to Focus.  Since neither Victory nor Silvercrest are really RIA consolidators, Focus management probably wouldn’t appreciate the comparison to them.  Neither Victory nor Silvercrest have shown the topline growth of Focus Financial, although Silvercrest’s growth isn’t that out of line with what Focus has produced organically – maybe even better.While it’s difficult to find peers to compare Focus to, their valuation prices them more richly than even AMG.  Is it reasonable to compare Focus to Blackrock?  We don’t think so.Pricing ImplicationsMost CEOs appreciate the market validating their strategy with high multiples, but high multiples are a double-edged sword.  In the 1990s, I had a number of clients at Mercer Capital involved in roll-up corporations of one kind or other that went public.  Some worked, and some didn’t.  While Focus isn’t directly comparable to many consolidators, some of what has been observed in other industries holds true here as well.High valuation multiples must be justified, and are often tested stringently with newer public companies.  Focus promises high topline growth, with the implication that the profit margins will sort themselves out with scale over time.  This is a common story for public companies in consolidating industries.  The trouble comes when acquisitions are unavailable at reasonable terms or even accretive pricing, profits are uninspiring, and management feels pressured to do deals that don’t make sense just to demonstrate growth.Based on their own disclosures, Focus will have to continue an aggressive acquisition strategy to achieve the 20% plus growth expectations that it has set for itself.  If that growth is accomplished with new share issuances (as they have employed in the past), the market may not appreciate the dilution.  Focus could, of course, pay cash, as they have a fair amount of it on hand following the IPO; but cash isn’t free either.  What the market will eventually want to see – and several commentators have already mentioned this – is organic growth.  If the firms that sold Focus some participation in their profitability grow their AUM from either existing or new clients, the fees should translate into profit growth that will accrue to Focus.  The S-1 is curiously vague about Focus’s historical organic growth – defining it as inclusive of subsidiary-level acquisitions by partner firms.  We question whether or not this is a true metric of organic growth, and in any event, the numbers Focus has posted with regard to this aren’t terribly impressive: 13.4% in 2017 and mid-single digit growth in the two years prior to that.  We’ve written elsewhere that Focus will eventually have to prove itself as an operating model, and not just as an acquisition model.  Their success or failure in this regard will be judged, at least in part, by demonstrated organic growth.As for inorganic growth, Focus has interests, either directly or indirectly, in 140 plus firms.  This leaves lots of room to grow in an industry with 15 thousand or so firms and a solid growth trajectory.  If Focus stays priced at elevated multiples, it may raise expectations of sellers – especially in the circumstances where Focus is paying with stock.  If, on the other hand, Focus shares settle to more normal multiples of profitability, sellers may be wary of selling into a downward trending share price.  In some ways, it may be easier to attract acquisition candidates as a public company, but in others, it may be more challenging.Margins are another matter.  Most investment management firms benefit from operating leverage as they grow, and Focus has suggested the same opportunity exists for them as well.  Our concern here is that Focus is not a small startup asset manager, they are a $126 billion manager with over 2,000 employees in their affiliated firms and fourteen years of history – yet their EBITDA margin (even on a highly-adjusted basis) hasn’t crested 25%.  It’s possible that additional scale will improve this metric, but being a public company is labor intensive, as is tracking the activities of 140 plus partner firms, seeking out more, and seeking ways to improve the performance of existing firms.  It may be difficult to assess the Focus margin against that of more typical RIAs, but as the Focus story unfolds, management will have to explain how to evaluate the effectiveness of the 70 or so employees at the holding company, what a reasonable cost of operations is, and how much profitability can be expected.Nevertheless, They Did ItSetting all of my armchair quarterbacking aside, though, the fact remains that Rudy Adolf and his team pulled off what many have thought about but failed to do.  The investing public now has a way to be involved in the profitability of the RIA phenomenon, and the RIA industry has a new funding source for transaction activity.  Lots of questions remain, but if Sergio Marchionne could use the public markets to remake a moribund industry from a nation that isn’t terribly investor friendly, executing on the Focus business model should be an easy lap.

As we have discussed in previous posts, there are 21 main oil and gas-focused partnerships that are publicly traded, as of June 30, 2018. Publicly traded royalty partnerships have been slowly regaining the value lost when crude oil prices fell below $30 per barrel in early 2016. In the two years since June 2016, 16 of the 21 royalty partnerships have had positive returns with an average return of 48%. Over the past two years, the remaining five partnerships experienced a negative 31% average return. In those two years, natural gas prices have experienced an insignificant increase of just 5%, while oil prices have risen more than 50%. The underperformance of natural gas prices is due to the surge in production of shale gas since 2006 and the more recent rise of natural gas production as a result of increased oil production.Kimbell Royalty Partners, LP (KRP)The youngest of the 21 partnerships, Kimbell Royalty Partners, LP (“Kimbell,” “KRP,” or the “Company”), went public in February 2017. The Company’s IPO opened at $18.00 per share, initially offering 5 million shares. Since going public, KRP’s price struggled in its infancy and fell under $16 per share in mid-August 2017. This year has been much kinder to Kimbell due to the high crude price with its share price peaking at $23. Approximately 70% of Kimbell’s revenues are from oil and natural gas liquids. Of the 21 mineral partnerships, Kimbell, Dorchester Minerals LP, Black Stone Minerals LP, and Viper Energy Partners LP are the only non-trust royalty partnerships and are either C Corporations or MLPs.  These MLPs and C Corps are designed to gather assets and grow through acquisitions, focusing on both dividend payments and the growth of shareholder value. On the other hand, the other 17 are royalty trusts, which have a limited pool of assets and must return most of the cash flow earned from the royalties to the shareholders through dividends. Trusts’ capital structures limit opportunities for reinvestment, making it difficult to grow their asset base through acquisitions. Of the MLPs/C Corps, Kimbell has the highest dividend yield at 7.63%, with Dorchester, Black Stone, and Viper at 6.23%, 6.76%, and 6.02%, respectively. KRP is the smallest of the four partnerships with a market capitalization of $370 million, while Black Stone and Viper each have market capitalizations near $3.7 billion. 1Acquisition OverviewPrior to its acquisition of Haymaker Minerals & Royalties, LLC and Haymaker Resources, LP (collectively, “Haymaker”), Kimbell had nearly 5.7 million gross acres in nearly every major oil and gas basin across 20 states with a primary focus in the Permian Basin and the Mid-Continent. Kimbell solely invested in mineral and royalty interests with the largest portion of its production concentrated in the Permian Basin, where it had 1.75 million gross acres of mineral interests and ~200,000 acres of overriding royalty interests (ORRIs). Currently, KRP has 25 active drilling rigs on its acreage and mineral and ORRIs on 50,000 wells. Kimbell’s holdings in the Permian Basin alone account for 26% of its net royalty acres, 60% of its gross acreage, and 60% of active wells on its total acreage.In comparison, Haymaker had ~5.4 million gross acres and ~43,000 net royalty acres primarily focused in the Mid-Continent. Haymaker had royalty interests in 33,800 wells and had more than double the number of active drilling rigs than Kimbell with 51. Kimbell acquired Haymaker for $404 million with $210 million of cash and 10 million newly issued common units going to Haymaker’s sponsors. The acquired company’s private equity sponsors are KKR & Co. LP (“KKR”) and Kanye Anderson Capital Advisors, LP (“Kayne Anderson”). Alongside the acquisition, Kimbell converted its tax status from an MLP to a C Corp. Kimbell believes that this conversion will give the company access to a much broader base of investors and access to a more “liquid and attractive currency.” Kayne Anderson’s and KKR’s willingness to take the newly issued shares, which will account for ~37% of Kimbell’s outstanding common units, shows the potential for investment growth that is achievable for Kimbell but not necessarily for Haymaker. Kimbell estimates that the acquisition will not only be accretive due to the quality of the assets, the acquisition will also be highly scalable and reduce the G&A costs on a per Boe basis. After the acquisition, Kimbell will have more than 11 million gross acres spanning 28 states, with 38,000 of its 84,000 wells in the Permian Basin. As of April 27, 2018, Kimbell’s 73 rigs account for 7% of the total rigs in the United States. To calculate price per acre, Haymaker’s 42,759 net royalty acres must be converted to the industry standard 1/8 conversion since Kimbell uses a non-standard method of calculating net royalty acres. The conversion, which assumes eight royalty acres for every mineral acre, results with Kimbell acquiring 342,072 net royalty acres for $404 million. This results in an implied price of $1,181 per net royalty acre. At the time of the transaction, Kimbell’s market capitalization was approximately $327 million with an 8.7% yield.  Post-transaction, KRP’s FCF yield rose to 12%, implying a 15% yield for Haymaker prior to the transaction. Much of Haymaker’s acreage is congruent to Kimbell’s existing acreage and is an evenly split oil and natural gas mix. Haymaker’s acres enhance the Company’s position in the Permian and Mid-Continent and also increase its exposure in the Appalachian Basin and the Marcellus and Utica Shales. After the transaction, Kimbell’s production will be approximately 2/3 liquids and 1/3 gas. KRP believes that through the consolidation of costs, their pro-forma G&A expense can decrease by as much as 50% to $3.22 per Boe. This decrease is due to the increased scalability of Kimbell after the transaction. The transaction is also projected to increase the net production per unit by 56%. The Company estimates the increased production and the cutting of costs alone could lead to a 20% increase in distributable cash flow per unit. AnalysisWhy would two companies with relatively comparable assets have such drastically different yields? Is it due to the fact that Kimbell is publicly traded while Haymaker is private? Perhaps the solution lies between the vast differences in public and private mineral market share sizes.Kimbell estimates that the total mineral buying market is close to $500 billion, excluding ORRIs. Public companies only make up 2.5% of the total market with a combined enterprise value of ~$12.3 billion. The two largest public, Black Stone Minerals and Viper Energy Partners, make up a combined $8.3 billion of that total value. While the public minerals market is only made up of a handful of companies giving public investors a limited number of investment options, the private minerals market is highly fragmented.Small mineral aggregators can operate with a higher attention to acreage details. These aggregators have the ability to negotiate directly with the landowners and handpick the acreage of their choosing. As a result, they expect higher yields than the public companies. While these yields are higher, the acreage is typically much more focused on certain areas.  Combined with their small size, these investments are inherently riskier than a larger, more diverse pool of assets, such as those held by public royalty trusts.Kimbell’s acquisition of Haymaker demonstrates the disconnect between the public and private markets and the discounts at which private LPs are valued. It seems that private royalty LPs simply do not have the same access to capital as the public MLPs or C Corps. This lack of access is potentially why KRP and Haymaker have distinctly different yields, 8.7% and 15%, respectively, and why KRP was able to successfully negotiate such a highly accretive deal. Private equity investors/sponsors seem to recognize this–Haymaker’s sponsors for example. Haymaker’s sponsors, a well-respected private equity firm (KKR) and one of the leading energy investors (Kayne Anderson), most likely saw the potential behind the accretive mix of the two companies, which is why they were willing to accept roughly 50% of the purchase price in Kimbell shares. Not only was Kimbell public, its transition to a corporation opened itself up to a broad array of inexpensive capital, far less expensive than what Haymaker could find. This access to cheaper capital makes it easier for Kimbell to grow through acquisitions and continue to increase its returns and shareholder value. Kimbell has the potential for growth as a public corporation far beyond what a private company like Haymaker could achieve.Public investors are looking for opportunities to invest in mineral plays; however, many of these investors’ only opportunity to do so is through public companies. Following the rise of crude oil prices, the increased demand from public investors has driven up the prices of the royalty trusts and MLPs and, in turn, lowered the yields. More and more investors, including institutional investors, are looking towards the mineral market to find investment growth. The emerging field of mineral aggregators has the potential to provide this growth through accretive acquisitions, as well as steady dividend payments, that public investors crave.We have assisted many clients with various valuation and cash flow issues regarding royalty interests.  Contact Mercer Capital to discuss your needs in confidence and learn more about how we can help you succeed.[1] Capital IQOur thanks to Daniel Murchison who drafted and did much of the research for this post in collaboration with our Energy Group.

Money, being what it is, never sleeps. It also never goes on vacation. I was, however, about to spend ten days away from the office with my older daughter in Scotland and England when Focus Financial (finally) filed for a public offering. One of the most anticipated events in the wealth management industry, the pendency of the Focus IPO didn’t cancel my trip, but I knew that my vacation was going to be at least punctuated by reading the S-1 along with my peers’ commentaries. I’ve now read the 275-page document a few times, and while it’s not your typical beach novel, the Focus prospectus is required summer reading for anyone in the RIA community.The First Question to Ask of Any IPO is “Why?”Initial public offerings are sacramental in the church of capitalism. At one time, IPOs represented a coming-of-age when growing asset-needy businesses could finally have the financing they required to expand into leading, mature organizations. Today, public offerings may just represent the day when private equity backers decide they would rather someone else own a business instead of them. IPOs can, in many cases, be read as a sell-signal.In spite of this, public offerings still generate a surprising amount of enthusiasm. My daughter and I started our trip at the Aston Martin dealership in Edinburgh, and the characteristically friendly Scots there chatted excitedly about Aston Martin’s upcoming IPO whilst making sure my daughter learned the ins and outs of at least a million pounds worth of stainless-steel, aluminum, and carbon fiber. Aston Martin’s IPO not only represents permanent equity backing for a uniquely capital-intensive business, it is also the triumph of a marque bought out of obscurity by a wealthy English industrialist, Sir David Brown. Brown not only manufactured and sold tractors by the thousands, he also understood the halo effect of auto racing to underscore a nation’s industrial competitiveness, and he was tired of seeing English cars lose to the Italians. Sir David was also savvy enough to take a page out of Enzo Ferrari’s business model and financed his passion for auto racing by selling expensive road cars. It was a prescient decision for Brown, as his eponymous series of “DB” cars were adopted by a mythological British figure, James Bond, and the combination sustained the brand’s identity for fifty years. It is highly unlikely that the DB11 would exist today if Sean Connery hadn’t been assigned a DB5 as his company car in the 1960s.Today, Aston Martin is once again following in the hoof-steps of the prancing horse, as Ferrari’s 2016 public listing was a huge success (NYSE: RACE). Ferrari is much more than an automaker, of course; it is a brand. Despite devotees like yours truly, Aston Martin’s intellectual property is no match for Ferrari, which boasts an adjectival name, a primary color, and a mascot that are instantly recognizable and merchantable. For Aston Martin’s listing to be successful, it will have to make it as an automaker instead of a fashion label – no doubt a much tougher slough.What Exactly is Focus Financial?All of this brings me back to Focus Financial, whose business model is a little difficult to, well, focus. The IPO is being hailed as a validation of the RIA industry, but the RIA industry doesn’t really need validation (it is proven and profitable) and Focus isn’t really an RIA.The Focus brand, for example, doesn’t really extend to the investors with their partner firms. If you review many of their partner firm websites, for example, you don’t see much mention of Focus, and any mention certainly isn’t prominent. Focus’s brand is directed at the acquired firm, a back-of-the-house system. The storefront is still the individual tradename and people of the partner RIA. In much the same way, the Focus financial statements aren’t really the consolidated statements of their affiliate firms, but rather a specifically defined interest in the cash flows of the affiliate firms. In mathematical terms, you might say that the calculus of the Focus financial statement is the first derivative of an RIA income statement rather than the RIA income statement itself.Focus acquisition model (adapted from pages 120-121 of the prospectus) Focus Financial is an aggregation of RIA cash flow streams, contingent rights, and responsibilities. The Focus model is to acquire between 40% and 60% of an existing RIA’s earnings before partner compensation, or EBPC, which post-acquisition is referred to as “target” earnings (Focus also has a program for wirehouse broker groups who want to go independent). The remaining EBPC is retained by a management company formed by the affiliate firm as a wage pool for selling partners. Focus takes a preferred position in the affiliate firms’ EBPC; the selling partners are responsible for delivering at least the dollar portion of EBPC sold to Focus (termed the “base” earnings). Any excess above target earnings is split pro rata. This asymmetric payoff dampens the downside volatility for Focus, but obviously also raises it for selling partners. Focus has a handy chart in their S-1 that illustrates the potential repercussions of this on partner firms. As shown in the example above, assume Focus acquires 60% of a selling firm’s earnings before partner compensation and EBPC is $3 million. If revenue grows by 10%, EBPC grows to $3.5 million. In the upside scenario, selling partners and Focus share in this 40%/60%, and selling partners see their management fees increase from $1.2 million (40% of EBPC established at time of sale) to $1.4 million (the $200 thousand increase representing 40% of the overall $500 thousand increase in EBPC). One can see how enough growth in AUM enables selling partners to recover their pre-acquisition compensation level, in addition to receiving proceeds from selling rights to part of their EBPC to Focus. The downside scenario is fairly dramatic, however. In the example, a 10% drop in revenue causes the selling partner compensation pool to drop by almost half, from $1.2 million to $700 thousand, which is less than a quarter of pre-transaction partner compensation. Because we haven’t experienced a sustained bear market since Focus completed most of their acquisitions, the downside implications of this arrangement on selling partner groups (and, in turn, on Focus) aren’t yet fully known. The disproportionate risk borne by the partners of affiliate firms is, presumably, known to them – although knowledge and experience sometimes yield different outcomes. We wonder how selling partner groups would behave in a market environment in which their compensation was severely restricted, remembering that retained EBPC is effectively wages for the continuing efforts of affiliate firm leadership.How Does Focus Pay for This?As anyone who reads this blog is fully aware, RIA transactions are typically a mixture of upfront payments and contingent consideration. Focus is no different, and while the prospectus doesn’t describe a sample transaction, it is clear that Focus uses both cash and equity to provide fixed payments and earn-outs. The equity consideration is valued by Focus, apparently with the assistance of third-party appraisers (not us!). More than one commentator has suggested that a downside to Focus Financial going public is that they can no longer “assign” a value to their stock, as it will now be determined by market. I’m sure that my peers who provide valuation services to Focus don’t appreciate the slight.The valuation of Focus is, at this point, somewhat complicated, and we are very interested to see how the market treats them. In 2017, Focus reported a loss of nearly $50 million on total revenues of $663 million. Last year was a good year for most RIAs, and to explain their loss, Focus management suggests a lengthy list of adjustments to get to a pro-forma EBITDA margin of about 22%. Market pundits so far are suggesting an enterprise valuation of $2.0 to $2.5 billion for Focus, which works out to about 8x to 10x pro-forma EBITDA.The question becomes whether or not you agree with all of management’s adjustments to travel from reported to pro forma EBITDA. Some off these add-backs are not controversial (eliminating non-recurring items such as delayed offering cost expenses), but over a third of management’s adjusted EBITDA for 2017 comes from eliminating non-cash equity compensation expense and adding back the change in fair value of contingent consideration.The analyst community remains divided on how to treat equity compensation, but we quote Warren Buffett’s old saying –“If stock options aren’t compensation, then what are they? If compensation isn’t an expense, then what is it? If expenses don’t belong on the income statement, then where do they belong?”For a shareholder in an acquisition platform like Focus Financial, equity compensation and contingent consideration are dilutive to earnings per share, and one would expect them to be recurring in nature. Further, a 22% EBITDA margin is low for a large RIA – even on a reported basis. Then again, Focus isn’t really an RIA.So we don’t have a good sense of what Focus’s profit margins will be once it matures to a steady-state enterprise. The financial history shown in the S-1 doesn’t really demonstrate the kind of operating leverage we might expect, but, to be fair, I think it’s still too early to tell.What Does Focus Do After an Acquisition?While the 55 Focus partner firms employ over 2,000 people, the holding company itself has about 70 staff members, most of whom are charged with growing cash flows through acquisition or by improving affiliate firm profitability. To enhance organic growth, Focus has staff assigned to affiliate RIAs to provide them with ideas to improve operations and marketing, much as broker-dealers do for their network affiliate RIAs. Eventually, Focus will have to transition from an acquisition platform to an operating platform, and these services will become more critical to fueling the growth engine.It’s worth pointing out that there is a cost to the staff and their activities at the holding company that is borne under the Focus model but not by an otherwise independent RIA. Further, the Focus prospectus doesn’t suggest that this cost is mitigated by explicit post-acquisition synergies such as personnel redundancies, although this probably happens from time to time. In addition, the prospectus is explicit that holding company staff is there to assist partner firms with growth and operations, rather than to impose rubrics and expectations. The idea is to maintain the entrepreneurial spirit of the partner firms and to avoid “turning entrepreneurs into employees.” Can thousands of people be directed with only carrots and no sticks? Probably not, and I’ve no doubt that Focus management realizes that.One test of the Focus model is whether or not the staff at the holding company can pay for themselves. Can they improve partner firm cash flows to more than offset the cost of the aggregation? If so, this will be a big success.Does the Focus Model Work?Focus has been in operation for a dozen years now, but it’s still very much a development stage company. Focus has proven itself as an acquisition platform. RIA transactions are difficult, and Focus has managed to attract and retain 55 direct partner firms. Several of these firms have themselves engaged in acquisitions after they became part of the Focus network, bringing the total number of firms under one umbrella to 140. Indeed, one major asset Focus can boast is its knowledge of the RIA firm landscape and how to successfully acquire and integrate wealth management firms.That said, acquisitions either consume distributable cash flow (the prospectus is clear that the company does not plan to pay dividends, which is very different from typical RIAs) or result in equity issuance (which can be dilutive of existing shareholder returns). Focus can build shareholder value by arbitraging returns if it can acquire firms at a lower multiple than it trades for, but this requires the market giving it a premium multiple on a sustained basis. Since acquisition multiples in the RIA community don’t usually happen at substantial discounts to publicly traded asset managers, it may prove difficult to enhance shareholder returns through acquisition – at least on a sustained basis.No doubt Focus has plenty of room to run as an acquisition platform, but longer term shareholder returns will require Focus to develop an operating platform that widens partner firm margins and speeds revenue growth to a greater degree than those same firms would do on their own. One test is easy to measure, and the other is not. Together, they form a major part of the holding company’s “alpha.”Analysts can look at Focus’s profitability and determine whether the model enhances RIA cash flow or not; as I mentioned earlier, current margins suggest they still have room for improvement. Determining whether or not an affiliate firm is growing faster in association with Focus is more difficult – there are many variables that would have to be isolated to do that. Since management teams share in profit increases, they theoretically have incentive to help the organization grow. Post-acquisition, of course, Focus takes a pro rata piece of that increase in profitability, and while the selling generation of partners gets compensated for this in the form of earn-out payments, successive generations will not. It will be interesting to see how second-generation partner firm leadership behaves.The Focus S-1 reports organic revenue growth – essentially same store sales growth – of 13.4% for 2017 versus 2016. Organic growth for the prior two years was reported in the mid-single digits. Whether or not those organic growth rates best industry averages depends on whom you ask. We think this will be a closely studied metric for Focus as it matures.Further, because Focus is an amalgamation of RIAs which still report independently, it is possible to review ADVs and track their partner firm AUM over time. We’ve done this, and the study predictably shows a wide variety of growth patterns across these businesses which are still run as independent entities. Some appear to have grown more rapidly after being acquired by Focus, and others not so much. It would take a good bit of work to track these growth patterns relative to financial market behavior, industry trends, and to segment out partner firms that are growing at least in part because of their own acquisitions. For now, Focus’s report on organic growth may be the favored big-picture performance measure.What Questions Remain?The most significant remaining queries for Focus Financial revolve around the theme of sustainability. In the near term, can Focus continue to attract enough sellers to monetize their know-how and identity as an acquirer? In the longer term, can Focus transition into an operating brand and grow organically in such a way that it proves the value they add as an organizing force in the RIA space? Will they show growth rates and margins that prove the value-add of the holding company?Focus is organized as more of a quilt (independent businesses) than a blanket (think wirehouse). Given that, can Focus direct their partner firm employees’ and principals’ zeal while avoiding the behavioral risks that come with independence? Will Focus ultimately have to become more regimented in the investment products it offers, the marketing approaches its advisors employ, the training and compliance procedures they require, etc.? There is a natural tension in all investment management firms between development and risk management, and as firms grow, the latter usually overtakes the former.Will succeeding generation leadership at partner firms be sufficiently incented to continue the growth that first made them attractive as acquisition candidates to Focus? The selling partners of affiliate firms have a relationship with Focus that younger members do not share.Why Does All This Matter?Most of the questions I’m throwing out in this blog post apply to the broader RIA universe, and not just to Focus Financial. The Focus IPO is significant because it represents the single-most direct response to major industry issues, while at the same time leveraging industry trends. With managed assets increasingly leaving bank-controlled brokers, the retirement era of the baby-boomers leading more and more assets to independent firms, and a transition planning crisis among RIA ownership groups, someone had to develop a model to organize, if not consolidate, this highly fragmented industry. Fourteen years ago, Focus’s founder Rudy Adolf sat at his kitchen table and decided to do just that.The Focus prospectus makes it clear that engineering a profitable solution to the RIA industries primary conundrums is not, however, as easy as defining the situation itself. As a conglomeration of independent businesses, the Focus financial statements are themselves gerrymandered in a way that takes some getting used to, and we don’t think their results will track the RIA industry as closely as some have suggested.None of this detracts from what Focus has accomplished. They have developed a business model to address very difficult acquisition and integration issues and have steadily grown their brand as an acquirer in the parentage of several prominent PE sponsors. In going to market, Focus management is committing to prove viability in public filings, conference calls, and daily trading. It is a major undertaking for any company, but even more so for the one who goes first. If Focus Financial is, like Ferrari, successful as a public company, no doubt Hightower and United will, like Aston Martin, consider following their lead.We look forward to seeing more.“Dad, which button controls the ejector seat?”

Asset manager M&A was robust through the first quarter of 2018 against a backdrop of volatile market conditions.  Total deal count during the first quarter was up 32% versus the first quarter of 2017, though total disclosed deal value was down 25%.  In terms of deal count, M&A is on pace to reach the highest levels since 2014, although we note that the quarterly data can be lumpy.  Several trends which have driven the uptick in sector M&A have continued into 2018, including revenue and cost pressures and an increasing interest from bank acquirers.Notable TrendsThe underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, and slowing organic growth for many active managers.  While these pressures have been compressing margins for years, sector M&A has historically been muted. This is due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation.  Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure for certain firms."Since I've been in the industry, there's been declarations of massive consolidation. I do think though, this time there are a set of factors in place that weren't in place before, where scale does matter, largely driven by the cost coming out of the regulatory environments and the low rate environments in cyber and alike. And, you have to be, as a firm, you have to be able to invest in the future.  And I think a number of smaller-sized firms are finding that hard." Martin Flanagan - President and CEO, Invesco Ltd. 1Q17 Earnings Call"You need to have, of course, the right product set. But you need especially to have underlying firms, which are positioned as best they can in terms of alignment and focus to sustain alpha generation. And in that respect, scale is the enemy, not the friend." Sean Healey - 1Q17 Earnings Call, Affiliated Managers Group IncConsolidation pressures in the industry are largely the result of secular trends.  On the revenue side, realized fees continue to decrease as funds flow from active to passive.  On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs.  Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to gain scale in order to realize cost efficiencies, increase product offerings, and gain distribution leverage.Acquisition activity in the sector has been led primarily by RIA consolidators, with Focus Financial Partners (which itself was acquired by Stone Point Capital and KKR in a $2 billion deal last year), Mercer Advisors (no relation), and United Capital Financial Advisers each acquiring multiple RIAs over the last year.  While these serial acquirers account for the majority of M&A activity in the sector, banks have also been increasingly active acquirers of RIAs in their hunt for returns not tied to interest rate movements.  Despite a rising yield curve and the negative impact of goodwill on tangible book value, we suspect that RIAs will remain attractive targets for bank acquirers due to the high margins (relative to many other financial services businesses), low capital requirements, and substantial cross-selling opportunities.The Market's ImpactRecent increases in M&A activity come against a backdrop of a bull market that continued unabated through 2017 but faltered during the first quarter of 2018.  Steady market gains have continued throughout 2017 and have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years.In 2016, for example, active mutual funds’ assets grew to $11 trillion from $10.7 trillion, despite $400 billion in net outflows according to data from Bloomberg. While the first quarter of 2018 saw negative returns for most major indices, the gains seen during 2017 have yet to be eroded.  At the end of the first quarter, the S&P was down nearly 10% from its peak in late January 2018, but the index is still only 2% below year-end 2017.  As a result of increasing AUM and concomitant revenue growth (perhaps notwithstanding this last quarter), profitability has been trended upwards despite industry headwinds that seem to rationalize consolidation.ConclusionWith no end in sight for the consolidation pressures facing the industry, asset manager M&A appears positioned for continued strength or potential acceleration regardless of which way the markets move during the remainder of 2018.  Given the uncertainty of asset flows in the sector, we expect firms to continue to seek bolt-on acquisitions that offer scale and known cost savings from back-office efficiencies.  Expanding distribution and product offerings will also continue to be a key acquisition rationale as firms have struggled with organic growth.With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  An aging ownership base is another impetus, and recent market gains might induce prospective sellers to finally pull the trigger.  More broadly, the recent tax reform bill is expected to free up foreign-held cash and increase earnings, which could further facilitate M&A’s upward trend during the rest of 2018.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Mercer Capital’s marketing staff is trained to market valuation services, not perform valuations. Nevertheless, these folks have to read a lot about the practice in reviewing our articles, presentations, blogposts, books, and whitepapers, and I’ve wondered how much they absorb of what we write. I think I got my answer last week, when I showed our marketing director a photograph of an early-1960s Aston Martin DB4 and asked if she knew what kind of car it was.“Is it a Porsche?”Incredulously, I had to remind her that Porsche didn’t make GT cars in the 1960s, only rear-engine models like the 911, 356, and 912. The first Porsche with a front engine, grand-touring configuration was the 928, first produced in 1975. The 928 was supposed to be the replacement for the 911, which was expensive to build and difficult to drive (rear engine cars have an unrivaled penchant for oversteer). Porsche enthusiasts (a fandom like none other) balked, and the marque decided to build both the GT and their traditional rear-engine models until giving up on the 928 in 1995.The 928 was a brilliant car, but it wasn’t a game changer for Porsche. I suspect the jury is still out on the tax bill’s long-term impact on the investment management industry as well. One of the more interesting aspects of the 2017 Tax Cut and Jobs Act (TCJA) that is the bill’s potential impact on mergers & acquisitions. Most of the press assumes that the TCJA is going to be positive for M&A, although it cuts differently across different sectors. For the investment management community, the change in tax law is a mixed bag, and we’ve yet to see a compelling case to suggest that, overall, it will tend to encourage or to discourage transaction activity in RIAs on a net basis.Keep in mind that much of the TCJA did not apply to investment management firms. The new rules on expensing capital expenditures don’t matter for the asset manager that spends a few hundred thousand dollars (at most) per year on information technology equipment and licenses, plus a conference room table or two. Incentives to re-shore foreign capital doesn’t apply to most RIAs, and the limitations on interest deductibility won’t matter except for the most highly leveraged transactions. There is an argument to be made that the TCJA is bullish for RIA M&A, but there is a counter-argument as well.Point: New Tax Legislation Encourages RIA TransactionsMost commentators only see positives in the tax bill for M&A activity, and at least some of that extends to investment management firm transactions. We joined in this chorus, noting that rising asset prices have brought many RIAs a surge in AUM, which grows revenues similarly and profits even more, thanks to the magic of operating leverage.For RIAs structured as C corporations, the TCJA significantly improved after-tax cash flows since most firms pay high effective tax rates. And those higher after-tax cash flows are potentially even more richly rewarded by a market willing to pay higher multiples in a time of mostly bullish sentiment.All else equal, higher valuations usually encourage sellers to take advantage – which is important fuel to the RIA transaction community in which buyers usually outnumber sellers by a wide margin. And conglomerates with investment management firm divisions may be encouraged to make divestitures in a time when valuations are high and the taxes on gains they make in the sale would be relatively low.All in all, there are many reasons to believe that the tax act will spur more transaction activity for RIAs. However, there is another side to this story.Counterpoint: New Tax Legislation Does Nothing for RIA transactions, and Might Even Discourage ThemOne drawback of the TCJA is that it does little, if anything, for internal RIA transactions, the most common style of investment management firm transactions. While tax rates for C corporations were slashed, the top tax rate for individuals only declined modestly, from 39.6% to 37%. Most RIAs are structured as some kind of tax pass-through entity, either as an LLC or an S corporation. So taxes on investment management firm earnings are taxed as personal rates rather than corporate rates.Buyers in internal transactions at RIAs pay for their stock with after-tax cash flow (distributions), and purchasing capacity will be little improved by the TCJA (with a few exceptions). Without an improvement in after-tax distributions, internal buyers can’t pay more for their stock. So the tax bill isn’t really bullish for internal ownership transition. Further, to the extent that sellers now have expectations for higher prices, we may witness a widening of the bid-ask spread, which will discourage ownership transition altogether.Risky BusinessBack to my feature car – the 928 could have wound up on the engineering design floor had Porsche not decided to go ahead and produce it alongside the now (if not then) iconic 911. The legacy of the 928 – always a great GT – was eventually cemented onscreen by Tom Cruise in the 1983 film Risky Business. In the alternative, Porsche could have thumbed their nose at rear-engine aficionados and moved ahead with replacing the 911, but by being non-committal, they hedged their bet and ended up extending the brand. We recommend similar caution in assuming the TCJA is only good for RIA transaction activity. It might be, or it might not be. Risky business indeed.“…never driven in the rain.”

Viewed from the prism of “fairness” in which a transaction is judged to be fair to shareholders from a financial point of view, many transactions are reasonable; some are very fair; and some are marginally fair. Transactions that are so lopsided in favor of one party should not occur absent a breach of corporate duties by directors (i.e., loyalty, care and good faith), bad advice, or other extenuating circumstances. Obtaining competent financial advice is one way a board exercises its duty of care in order to make an informed decision about a significant corporate transaction.The primary arbiter of fairness is the value of the consideration to be received or paid relative to indications of value derived from various valuation methodologies. However, the process followed by the board leading up to the transaction and other considerations, such as potential conflicts, are also important in the context of “entire” fairness.A tough fairness call can occur when a transaction price appears to be low relative to expectations based upon precedent transactions, recent trading history, management prognostications about a bright future, and/or when the value of the consideration to be received is subject to debate. The pending acquisition of commercial finance lender NewStar Financial, Inc. (“NewStar”; Nasdaq-NEWS) is an example where the acquisition price outwardly seems to be low, at least until other factors are considered.NewStar ExampleOn October 16, 2017, NewStar entered into a merger agreement with First Eagle Holdings, Inc. (“First Eagle”) and an asset purchase agreement with GSO Diamond Portfolio Holdco LLC (“GSO”). Under the merger agreement, NewStar will be acquired by First Eagle for (a) $11.44 per share cash; and (b) non-transferable contingent value rights (“CVR”) that are estimated to be worth about $1.00 per share if the transaction closes before year-end and $0.84 per share if the transaction closes in 2018. The CVR reflects the tax benefit associated with the sale of certain loans and investments at a discount to GSO for $2.37 billion.Also of note, the investment management affiliate of First Eagle is majority owned by an entity that is, in turn, partially owned by Corsair Capital LLC, which is the largest shareholder in NewStar with a 10.3% interest.Acquisition PriceAs shown in Figure 1, the acquisition price including all of the CVR equates to 83% of tangible book value (“TBV”), while the market premium is nominal. Although not relevant to the adequacy of the proposed pricing, NewStar went public in late 2006 at $17.00 per share then traded to around $20 per share in early 2007 before sliding to just about $1.00 per share in March 2009. “Feel” is a very subjective term; nonetheless the P/TBV multiple that is well below 100%, when combined with the nominal market premium, feels light. NewStar is not a troubled lender. Non-performing assets the past few years have been in the vicinity of 3% of loans, while net charge-offs have approximated 1% other than 2015 when losses were negligible. Further, the implied haircut applied to the loans and investments that will be acquired by GSO is modest.Transaction MultiplesWhile the P/TBV multiple for the transaction is modest, the P/E multiple is not at 26.5x (the latest twelve month (“LTM”) earnings) and 18.4x (the consensus 2018 estimate). The P/E could be described as full if NewStar were an average performing commercial bank and very full if it was a typical commercial finance company in which low teen P/Es are not unreasonable.What the P/TBV multiple versus the P/E multiple indirectly states is that NewStar has a low ROE, which has been less than 5% in recent years. The culprit is a highly competitive market for leveraged loans, a high cost of funds absent cheap bank deposit funding and perhaps excess capital. Nonetheless, management’s projections incorporated into the recently filed proxy statement project net income and ROE will double from $20 million/3% in the LTM period ended September 30 to $41 million/6% in 2020.In spite of a doubling of projected net income, the present value (assuming NewStar is worth 18.4x earnings in 2020 discounted to September 30 at a discount rate of 13%) is about $507 million, or about the same as the current transaction value to shareholders. Earnings forecasts are inherently uncertain, but one takeaway is that the P/TBV multiple does not appear so light in the context of the earnings forecast.Additional perspective on the transaction multiples is provided in Figure 2 in which NewStar’s P/TBV multiple based upon its public market price consistently has been below 100% the last several years while the P/E has been around 20x or higher due to weak earnings.Performance and TimingAs for the lack of premium there outwardly did not appear to be wide-spread expectation that a transaction was imminent (as was thought possible in 2013 when Bloomberg reported the company was shopping itself). There were no recent media reports; however, the shares fell by 17% between May 2–May 19 following a weak first quarter earnings report. The shares subsequently rebounded 19% between June 6–June 14. Both the down and then up moves were not accompanied by heavy volume. Trading during most of this time frame fell below the approximate 100 thousand daily average shares.Measured from June 14–October 17, the day after the announcement, NewStar’s shares rose about 10% compared to 8% for the SNL Specialty Finance Index. Measured from May 19, when the shares bottomed following the weak first quarter results the shares rose 34% compared to 12% for the index through October 17. The market premium relative to recent trading was negligible, but it is conceivable some premium was built into the shares for the possibility of a transaction given the sharp rebound during mid-June when negotiations were occurring.Other Support for the TransactionFurther support for the transaction can be found in the exhaustive process that led to the agreements as presented in the proxy statement. The proxy confirmed the Bloomberg story that the board moved to market the company in 2013. Although its investment bankers contacted 60 potential buyers, only two preliminary indications of value were received, in part because U.S. banking regulators tightened guidelines in 2013 related to leverage lending by commercial banks. The two indications were later withdrawn.During 2016 discussions were held with GSO regarding a going-private transaction, in addition to meetings with over 20 other parties to solicit their interest in a transaction. By the spring of 2017, consideration of a going-private transaction was terminated. Discussions then developed with First Eagle/GSO, Party A and Party B that eventually led to the announced transaction. Given the experience of trying to sell NewStar in 2013 and go private in 2016, the board elected not to broaden the marketing, calculating the most likely bidders would be alternative asset managers (vs. banks with a low cost of funding).Fairness considerations about the process were further strengthened through a “go-shop” provision in the merger agreement that provided for a 30-day “go-shop” period in which alternative offers could be solicited. If a superior offer emerged and the agreements with First Eagle and GSO were terminated a modest termination fee of $10 million (~2.5%) would be owed. Conversely, if NewStar terminates because GSO cannot close, then a $25 million termination fee will be owed to NewStar.The go-shop provision was activated, but to no avail. More than 50 parties were contacted and seven other unsolicited inquiries were received. NewStar entered into confidentiality agreements with 22 of the parties, but no acquisition proposals were received.Financial AdvisorsOther elements of the agreements that are notable for a fairness opinion include the use of two financial advisors, financing, and director Thornburgh, who was recused from the deliberations given his association with 10% shareholder Corsair, which holds, with Blackstone, a majority interest in First Eagle. Financing was not a condition to close on the part of the buyers because GSO secured $2.7 billion of debt and equity capital to finance the asset purchase. First Eagle will use excess funds from the asset purchase and existing available cash to fund the cash consideration to be paid at closing to NewStar shareholders. While two financial advisors cannot make an unfair deal fair, the use of two here perhaps gave the board additional insight that was needed given the four-year effort to sell, take the company private, or affect some other corporate action to increase value.The Lesson from the NewStar ExampleWhile the transaction price for NewStar seems low, there are other factors at play that bear consideration. When reviewing a transaction to determine if it is fair from a financial viewpoint, a financial advisor has to look at the entire transaction in context. Some shareholders will, of course, focus on one or two metrics to support a view that is counter to the board’s decision.ConclusionEvery transaction has its own nuances and raison d’etre whether the price “feels right” or not. Mercer Capital has significant experience helping boards sort through valuation, process and other issues to determine what is fair (or not) to shareholders from a financial point of view. Please call if we can help your board make an informed decision.Originally published in Mercer Capitals Portfolio Valuation: Private Equity Marks Newsletter: Fourth Quarter 2017

This week we look back at transaction activity and trends in the Marcellus & Utica plays in 2017. When I reflect about what happened, for whatever reason, images resembling something out of an episode of Desperate Housewives come to mind whereby the prying eyes of the marketplace peer out of their windows, surveilling old competitors that pack up and leave whilst new, and sometimes mysterious, neighbors move in.But first, we point out recent articles that forecast that the U.S. may challenge Saudi Arabia and Russia in total oil production sometime in the next two years. For someone who has followed and worked within energy markets for many years, including before the shale fracking revolution, this is something I wasn’t sure I’d ever read.  Of course it is likely a temporary surge once the OPEC/non-OPEC agreement expires, but it's still fascinating to contemplate.The Appalachian BasinOK, now back to the subject at hand.  Transaction activity in the Marcellus & Utica shale was generally steady throughout the year and individual transactions were typically smaller in size.  Rationale for these deals were varied, from bankruptcy sales, to consolidation of acreage, strategy changes to more liquid rich plays, leverage reduction, and more. The chart below, drawn from Mercer Capital's forthcoming 4Q17 Marcellus & Utica-focused newsletter, provides transaction detail and comparative valuation metrics.Back Up the Truck, Dear! We're Moving onto Bigger and Better Things.In one of the few large transactions last year, Noble Energy exited the Marcellus in order to focus on more liquid rich regions with its $1.2 billion sale to HG Energy.  David L. Stover, Noble Energy's Chairman, President and CEO, commented, "The Marcellus has been a strong performer for Noble Energy over the last few years, which is a direct result of the success of our employees' efforts. During the same time period, we have also significantly expanded the inventory of investment opportunities in our liquids-rich, higher-margin onshore assets, which has led us to now divest our Marcellus position."In a similar vein, Carrizo Energy, a Houston-based producer, exited the play, utilizing the familiar "non-core" term to describe its position in the Appalachia region.  S.P. "Chip" Johnson, IV, Carrizo's President and CEO, commented, "With the announced sale of our Marcellus package, we have continued to execute on the divestiture program we outlined earlier this year. We expect to close the sale of both of our Appalachian packages during the fourth quarter and remain on track to reach our divestiture program goals." Carrizo has stated its desire to focus on liquid plays and reduce leverage which these sales went towards achieving.Look Honey, Those Folks Are Moving Out … and Their Wells Are Just Perfect for Us!Looking at the other end of the rationale spectrum, there were a number of buyers that were enthusiastic about the opportunities that companies like Noble & Carrizo left behind. Kalnin Ventures, a Thai-based coal and power generation company, made their 5th acquisition in the play in the past two years by buying positions from Carrizo's and Reliance Marcellus II, LLC. They also made a 6th in December by taking out Warren Resource's entire Northeast Marcellus position for $105 million. In strategic contrast to Carrizo's sentiment, Kalnin thinks these assets fit within their strategy of acquiring profitable, consolidated, low-risk assets that provide strong cash flow yields.Believe it or not, Kalnin's activity actually did not top the acquisition charts in 2017.  That distinction belonged to EQT, beginning with EQT's $527 million bankruptcy auction bid of Stone Energy's Marcellus and Utica acreage in February 2017. EQT, who made nearly $9 billion of Marcellus & Utica acquisitions in 2017, went on to highlight the year by its merger with Rice Energy in June 2017. Steve Schlotterbeck, EQT's president and chief executive officer said, "This transaction complements our production and midstream businesses and will deliver significant operational synergies to help us maintain our status as one of the lowest-cost operators in the United States." For a more in-­depth valuation oriented discussion on the Rice Energy transaction, a prior Mercer Capital blog post breaks down the deal.Are You Watching This, Sweetie?  So, What Kind of Deal Did They Get?Valuations for these transactions were relatively spread out depending on the metric observed, but were within an observable range.  Kalnin appeared to pay more than other buyers in a few deals from a $/Acre perspective (over $19,500/Acre), but it can be argued that they baked in economies of scale in light of their overlapping positions and infrastructure. EQT appeared to buy in a very tight range from a $/Mcfe/Day perspective ($6,300-$6,600). That said, due to the steady activity and universe of buyers and sellers, pricing and values appeared to be fairly consistent. We shall see if that continues in 2018, and speaking of that - we wish you all a happy 2018!A Plug for Mercer CapitalMercer Capital has significant experience valuing assets and companies in the energy industry. Because drilling economics vary by region it is imperative that your valuation specialist understands the local economics faced by your E&P company.  Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Asset manager M&A remained robust in 2017 against a backdrop of rising markets and higher AUM balances for most industry participants.  Total (disclosed) transaction value was up 6% from 2016 levels despite a 6% reduction in the number of deals.  Several trends, which have driven the uptick in sector M&A, have continued into 2017, including revenue and cost pressures and an increasing interest from bank acquirers.The underpinnings of the M&A trend we’ve seen in the sector include increasing compliance and technology costs, broadly declining fees, and slowing organic growth for many active managers.  While these pressures have been compressing margins for years, asset manager M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation.  Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure for certain firms.Consolidation pressures in the industry are largely the result of secular trends.  On the revenue side, realized fees continue to decrease as funds flow from active to passive.  On the cost side, an evolving regulatory environment threatens increasing technology and compliance costs.  Over the past several years, these consolidation rationales have led to a significant uptick in the number of transactions as firms seek to gain scale in order to realize cost efficiencies, increase product offerings, and gain distribution leverage.Acquisition activity in the sector has been led primarily by RIA consolidators, with Focus Financial Partners, Mercer Advisors (no relation), and United Capital Financial Advisers each acquiring multiple RIAs during 2017.  While these serial acquirers account for the majority of M&A activity in the sector, banks have also been increasingly active acquirers of RIAs in their hunt for returns not tied to interest rate movements.  Despite a rising yield curve which should make banks a little more comfortable with their core business, we suspect that RIAs will remain attractive targets for bank acquirers due to the high margins (relative to many other financial services businesses), low capital requirements, and substantial cross-selling opportunities. Recent increases in M&A activity come against a backdrop of a now nine-year-old bull market.  Steady market gains have continued throughout 2017 and have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years.  In 2016, for example, active mutual funds’ assets grew to $11 trillion from $10.7 trillion, despite $400 billion in net outflows according to data from Bloomberg.  As a result of increasing AUM and concomitant revenue growth, profitability has been steadily rising despite industry headwinds that seem to rationalize consolidation. It is unclear whether this positive market movement has been a boon or a bane to M&A activity.  On one hand, many asset managers may see rapid AUM gains from market movement as a case of easy come, easy go.  In that case, better to sell sooner rather than later (and vice versa from a buyer’s perspective).  On the other hand, as long as markets trend upwards, margin and fee pressures are easy to ignore.  In that case, a protracted market downturn could lead to a shakeout for firms with cost structures that are not sustainable without the aid of a bull market (as was the case in 2008 and 2009). With no end in sight for the consolidation pressures facing the industry, asset manager M&A appears positioned for continued strength or potential acceleration regardless of which way the markets move in 2018, although a protracted bear market, should it materialize, could highlight consolidation pressures and provide a catalyst for a larger wave of M&A activity.  With over 11,000 RIAs currently operating in the U.S., the industry is still very fragmented and ripe for consolidation.  An aging ownership base is another impetus, and recent market gains might induce prospective sellers to finally pull the trigger.  More broadly, the recent tax reform bill is expected to free up foreign-held cash, which could further facilitate M&A’s upward trend into 2018. Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

When we value an asset management firm, we do so in cash equivalent terms, as if someone were to pay that amount, on a given date, for a given firm or interest therein.  On many occasions, clients have asked us how our estimate of value compares with an offer they received for the same firm or an interest in the same firm.  It isn’t unusual for the offer to be ostensibly higher than our valuation, but it is unusual for the offer to be made in cash equivalent terms.  As a consequence, we often have to look beyond the face value of the offer to determine what the economic value of the offer is, which may be much less than the headline number.In this final blogpost on evaluating unsolicited offers for your RIA, we take on this issue of valuing an offer.  Valuing the offer for your RIA can be more difficult than valuing the firm itself.Similar Assets, Priced DifferentlySometimes, things which look similar are actually worth very different amounts of money – so one has to be careful making comparisons.  The headliner offering at RM Sotheby’s latest auto auction in New York was a 1959 Ferrari 250GT California Spider built in full racing spec for Bob Grossman.  The car is, of course, beautiful, but the story behind it is even better.  The apogee of sports car racing was the 1950s and early 1960s, when well-healed amateurs could enter major races against established professional teams and often do very well.  Bob Grossman was a successful sports car dealer and amateur racer in New York.  He ordered the Ferrari pictured above and had it delivered straight to the track to race in the highly competitive 24 hours of Le Mans in 1959.  The car had an aluminum alloy body (one of only eight made that way by Ferrari) and a race tuned V-12 with external plugs.  Grossman had never driven at Le Mans before, was unfamiliar with the car, and had a co-pilot for the race whom he’d never met and who didn’t speak English.  Grossman entered with the 250GT anyway and took third in his class.The car went on to perform very well in subsequent competitions before Grossman sold it.  It doesn’t have leather seats or a radio, but still sold for $18 million.  A similar 1961 Ferrari 250GT convertible, freshly restored but lacking racing heritage, was available at the same auction.  Despite a pre-auction estimate of less than one-tenth the sale price of the Grossman Ferrari, the ’61 failed to sell.  Two very similar cars offered at the same time in the same market; two wildly different valuations.Comparing Offers for Your RIAIf all RIA offers were all cash, this wouldn’t make much of a blogpost.  RIAs rarely sell on simple terms in all cash transactions, however, so converting offer pricing and terms to cash equivalents is critical to determining whether an offer is reasonable or not. Because investment management is often a relationship intensive business, transacting an RIA often involves performance based payments like earn-outs, compensation arrangements tied to client transition, non-compete agreements, and other terms which effect the value of the transaction to the seller.  Oftentimes cash consideration may only constitute two-thirds or so of total consideration offered.A selling client of ours a few years ago was counseled by a friend to assume that the cash he was paid up front would be the only consideration he ever got for his company, and not to take the deal if that wasn’t enough for him.  That’s a little extreme, but the maxim that “cash is cash and nothing else is cash” does establish a hierarchy to think about the value of other forms of consideration.Trading Your Stock…for StockTaking stock in another asset management firm in exchange for some of all of your shares isn’t necessarily a bad idea, but it does double the complexity of the transaction.  In addition to having to determine an appropriate value for your firm, you have to think about what the buyer’s stock is worth.  Sellers can take this issue for granted, but it has a huge impact on the value transacted.Think, for example, about the relative merits of two shares of stock.  If the selling firm’s stock is valued at 8x earnings, and the acquirer values their own stock at 10x earnings, then essentially for every dollar of earnings being given up by the seller, it now has a claim on 80 cents.  There may be reasons why the acquiring firm’s stock is worth more – higher quality earnings, lower risk profile, better growth opportunities, etc.  The trouble for most sellers, though, is that they understand the potential upsides and downsides of their own company, while having much less visibility into the relative merits of the acquirer’s stock.Does a stock for stock transaction involve giving up control of the selling company and taking an illiquid, minority position in the acquiring company?  What is the dividend policy of the buyer versus that of the seller?  Is the acquiring company a C corporation and how does that affect shareholder returns if the seller is a tax pass through entity like an S corporation or an LLC?Rolling your interest into the stock of your acquirer may be a good way to stay in the game.  The question becomes: whose game is it?Is Selling Your Firm Just an Advance on Your Salary?One thing that is very likely to change when you sell your investment management firm is your compensation package.  This is probably something you want to happen – within limits.  If you’re currently taking out, say, $1 million per year in total compensation and you could be replaced (at least in theory) for half of that, then your earnings are understated by $500 thousand.  At a multiple of 8x, that’s a difference in value of $4 million.  You would probably rather pay capital gains tax rates on $4 million today than receive an extra $500 thousand per year, taxed at ordinary income rates, for several years.That said, if there is no clear correlation between compensation give-ups and the value being received from the transaction, it may start to feel like the buyer is paying you for your stock with your money.  In some cases, that may even be true.  If post-transaction compensation is set too low, you and your partners may have little incentive to perform after the ink dries on the purchase agreement, which doesn’t lead to good outcomes for anyone.We usually counsel acquirers to agree to normal compensation levels with their seller as part of transaction negotiations.  If you do that, you’re much more likely to have a common understanding of the profitability of your RIA, and, thus, the negotiation is really about the multiple being paid.Performance Compensation as Risk SharingMany larger and more sophisticated acquirers use bonus compensation as a way to manage their risk.  The typical arrangement we’ve seen is for acquirers to take something equivalent to a preferred stake in an RIA – taking their pro rata piece of the upside and little, if any, of the downside, or holding a stake in which management gets more benefit from increases in earnings and more detriment from declines in earnings.  RIA consolidators seem particularly fond of this arrangement, and while it’s difficult to “value” the offloading of risk from buyer to seller (or continuing minority partner), it isn’t difficult to see who’s getting the better side of the deal.Earn-out Consideration is Never a GivenEarlier this year we had a whole series of blogposts about earn-out consideration, so I won’t rehash that here (Why Earns-outs Matter, Five Considerations in Structuring Earn-outs, and An Example of Structuring Earn-outs).  Suffice it to say that earn-outs are common in RIA transactions and often are necessary to ensure that the value of client relationships and investment products are effectively transferred from seller to buyer.  But an earn-out is only worth as much as it is likely to be earned, and this has to do with the target performance and terms associated with the earn-out.  The time value of money must also be considered, particularly in earn-out arrangements of three years or more.One thing to keep in mind, as a seller, is how likely you are to reach the targets set by the earn-out.  If the minimum growth target is, say, 15%, and your historical growth is less than that, consider how far markets have run to date and how you expect them to perform over the term of the earn-out.  Modest earn-out requirements after a lull in the equity markets are one thing, but robust expectations after a long bull run are quite another.  This issue is particularly poignant given where markets stand today.Don’t Forget to Value the TermsNon-compete agreements, office buildings, life insurance policies, working capital, contingent liabilities – there are a few dozen other issues that can change the economics of your offer.  We can’t cover everything in a blogpost, but I will end with a simple piece of advice that many of these issues should be isolated and dealt with on their own merits – as opposed to being interactive with the operating value of the company.  Even if the buyer wants to treat the transaction as an “all-in” or prix fixe price, you should know the breakdown of the offer on an a la carte basis.It isn’t always easy to determine whether an offer is too good to pass up, or too good to be true.  If you’re considering a proposal to buy your investment management firm – especially one that came in over the transom – let us take a look at it.  Whether you need a sounding board or an advocate, we can help.

Mercer Capital is headquartered in Memphis, where Elvis Presley lived most of his life.  It occurred to me recently that I’ve never written about Elvis's passion for cars, a pretty huge oversight for this blog.  Elvis bought a lot of cars – estimates number his purchases in the hundreds – for himself, family, employees, friends, and occasionally strangers.  A friend of mine who owns a few auto dealerships now was a young car salesman at the local Lincoln/Mercury dealer in the 1970s when he got a call in the middle of the night to "come on down to the dealership…Elvis wants to look at cars."  He and the other salesmen took scores of cars to Elvis's home, Graceland. Elvis sat in a chair on the front porch while they drove the cars, one at a time, past him in the circular driveway.  Elvis would either say "yes" or wave them off. By sunrise, he had agreed to buy a dozen cars – mostly as gifts.If you visit Graceland, you’ll get a strong sense of how the extravagant culture of Elvis Presley's entertainment enterprise was built around him: dozens of cars, customized jet aircraft, strings of horses, collections of firearms, fried peanut butter and banana sandwiches, all night jam sessions in a Hawaiian-themed den with carpet on the ceiling, and a racquetball house with a running track on the roof.Graceland is a perfect study in corporate culture at the extreme. On the Graceland tour, you’ll quickly understand that Elvis was a "package-deal"; you couldn't get the same entertainer from a person who lived a life of moderation. While most RIA founders aren't as "unique" as Elvis, investment management firms tend to be built around the peculiar interests and desires of their founders, and separating the firm from the founder is easier said than done.Culture Is KingCulture is the most glaring omission of any purchase agreement. We may not have any clients who show up to work at their RIA in white jumpsuits, but we have some who wear board shorts and flip-flops to the office, and others who dress so formally we suspect they wear neckties with their pajamas.  Some keep rigid office hours and some are always someplace else.  Some like a team approach to investment management and others act strictly on their own instinct.  Some drive flashy sports cars and others prefer run-of-the-mill SUVs.  None of them wants to change just because they're selling their firm, but what's not written in the purchase agreement is the difficulty in maintaining cultural identity for a seller after the transaction.Transitioning culture wouldn't be such a big deal if founding members of RIAs could just walk away after the transaction.  As we all know, though, even when an asset manager transacts, there are relationships to hand off and successor managers to groom and earn-outs to earn – such that partners usually have to stick around for three to five years after selling.  As a consequence, founders have to undergo a cultural change at the firm they founded, which can be galling.For folks who are considering offers for their investment management firm, we usually counsel them to remember a few things that aren't outlined in the LOI:You're not going to be the boss anymore. One seller was apoplectic when the bank that purchased his wealth management firm changed the color of his firm's logo to match that of the bank. It's going to happen.You're going to have a boss. Sellers often seem surprised that there is a reporting structure of which they are a part, in spite of being assured that the buyer will give them "maximum autonomy." Autonomy doesn't mean you get your own island.Your employees are going to have a new boss. And they might like that boss more than they like you. You think that you want that for them, but it won't do much for your ego.Your clients may question your commitment after the sale. If you start to enjoy your reduced responsibility and increased liquidity too much, your clients will assume you are "calling in rich" – and take their assets elsewhere.  Best to keep the overt transition low key until the earn-out period is complete.The same “founder's syndrome” that helped you build the firm will now fuel your frustration. Founders are driven by senses of identity and autonomy that are completely undermined by selling. So when you get up from the closing table, head straight for the therapist's couch. Elvis Presley's posthumous hit single, "A Little Less Conversation," pleads for actions instead of words. On the contrary, we suggest that founders think about what makes their firm unique and what aspects of that uniqueness you are, and are not, willing to give up in a transaction. Then have a little more conversation with the buyer about their post-transaction expectations for your firm's culture. If you can agree to how you're going to work together before the deal closes, everyone will be more successful after the deal closes. As always, feel free to reach out to us if you'd like to talk further.

In this continuing series on RIA partners responding to unsolicited offers, we thought it would be worthwhile to spotlight the number one killer of worthwhile transactions: deal fatigue.Transaction negotiations frequently take longer than anyone expects and often start and stop multiple times. The process has a tendency to terminate negotiations on bad transactions, but it also takes down many that should happen.Watching deal-making reminds me of car chase scenes in movies: unnecessarily long, fast-paced, often suspenseful, and with the potential for multiple fatalities – or at least bruised egos.The car chase scene that set the standard for the past fifty years was Bullitt, in which Steve McQueen, playing the role of Frank Bullitt, drove a 1968 Ford Mustang GT Fastback equipped with a 390 cubic inch V-8 and a four-speed manual transmission through the streets of San Francisco in pursuit of some hitmen in a Dodge Charger. Fiction being what it is, Bullitt catches the bad guys in his Mustang, even though in reality the Charger was faster. The car scene took three weeks to film, destroyed two Dodge Chargers and one Mustang, and ultimately resulted in a chase sequence lasting almost ten minutes that won the film’s editor, Frank Keller, an Oscar.Three weeks of filming for a ten-minute scene is about the ratio of time it takes to negotiate and finalize an RIA transaction relative to how long people think it ought to take. Many sellers believe that once a term sheet is agreed to or an LOI is signed, the rest is just papering the deal. Not so. Transaction negotiations, even drafting the purchase agreement, take months and sometimes years – but never merely weeks. I’ll spare you dozens of war stories, but I do have a few things to keep in mind if you find yourself going through the process.Have a Real Reason to Sell Your RIAStrategy is often discussed as something belonging exclusively to buyers in a transaction. Not true.Sellers need a strategy as well: what’s in it for you? When deals involving asset management firms fall through, I often hear things like “they just wanted to use our money to buy our firm from us.” Translation: the seller gives up shareholder returns (distributions and maybe bonus compensation) and agrees to work through a transition period (often three to five years) while the buyer capitalizes those same returns and uses them to finance or at least justify the purchase price.Sellers often feel like all they are getting is an accelerated payout of what they would have earned anyway while giving up their ownership. In many cases, that’s exactly right! On top of that, most investment management firm transactions have substantial earn-out payments included as part of the deal, such that the sellers may go from being masters of their own universe to singing for their supper.RIAs are professional service firms and the cash flow that creates value transfers from seller to buyer when the ink dries on the purchase agreement. Sellers give up something equally valuable in exchange for purchase consideration – that’s how it works.As a consequence, sellers need a real reason – a non-financial strategic reason – to sell. Maybe they are selling because they want or need to retire. Maybe they are selling because they want to consolidate with a larger organization, or need to bring in a financial partner to diversify their own net worth and provide ownership transition to the next generation. Whatever the case, you need a real reason to sell other than trading future compensation for a check. The financial trade won’t be enough to sustain you through the twists and turns of a transaction.Be Aware of Your Own PsychologyOne reason why we enjoy working with investment managers is that they are the kind of client who is wired like we are: analysts who think they can reduce most everything in life to an excel spreadsheet. Finance and much of economic theory are grounded in a neoclassical approach that can be expressed in logarithmic equations in which decisions are based on some logical assessment of marginal benefits. The reality of evolutionary neurobiology and the recent development of behavioral economics suggests that real life is much messier than that. People reason out dilemmas to the best of their ability, and then make a decision largely based on emotion.Even earning your CFA charter doesn’t enable you to escape your own humanity. People don’t refer to their firms as their “baby” for no reason – you will be emotional while you contemplate things like handing your relationships with clients and colleagues to a stranger for adoption, so be ready for it. It’s a normal feeling, and if you have the right acquirer, it will subside to relief that someone can carry on these relationships on your behalf, and is willing to pay you for the right to do so.A good analyst can justify his emotional impulse using financial analysis; a great analyst can prove it.One way to manage this through the deal process is to have an impartial counselor be a sounding board while you’re negotiating. This might be a friend or business colleague, but keep in mind you’re going to need a lot of counseling. Ideally, this is the same person who is representing you in the sale, and thus who knows you and the setting for the transaction. Getting this from your advisor requires a financial arrangement in which you can feel comfortable that he or she is representing you and not the transaction.Remember That Money Is Fungible and Value Is RelativeGive up on the notion of absolutes in transaction valuations or deal terms. The eleventh commandment is not 10 times EBITDA nor 3% of AUM, and neither one is engraved on any stone tablets in human history.Everyone wants to sell at the top of the market, but the top of the market for RIAs is usually the top of the market for other assets as well, so if you sell at the top you’ll pay more taxes and your after-tax proceeds will be reinvested in a fully priced market. It’s highly unlikely that your investment management firm will fetch top dollar in a bear market; so in many regards, the purchase price you exact in transaction negotiations only has merit relative to your reinvestment opportunities.This, again, is an argument for looking at the sale of your RIA through a strategic lens rather than a financial lens. Maybe you can do better than the market in selling your firm, but if you’ve been in the business long enough to have built a successful advisory business, you know how difficult it is to beat the market.Conclusion: Keep Your Eyes on the PrizeSo, if you’re entering into negotiations to sell your RIA, buckle up, stay composed, and be mindful of your goals. Steve McQueen was notoriously focused on managing his own career, which enabled him to drive even faster cars in real life, like his Ferrari 250 GT Lusso, shown below.Steve McQueen’s car in real life, a Ferrari 250GT Lusso (gentlemensjournal.com)As always, if you'd like to continue the conversation before our next post, give us a call.

After a fifty-year film collaboration with the James Bond franchise that started with Sean Connery piloting a DB5, Aston Martin pulled out all the stops and created a special model, the DB10, for the 2015 Bond movie, Spectre.  At the time, rumors abounded in the car community that the DB10 would go into production as shown in the movie, but it was not to be.  Aston Martin only built ten copies of the DB10, made from a stretched wheelbase Vantage and lots of custom sheet metal.  Like most concept cars, though, elements of the DB10 design eventually showed up in Aston Martin’s next production car, the DB11.As a rule, concept cars are marketing pieces as much as design studies, rendered to get attention and hold it until the production model (which may bear little resemblance to the concept) is available for purchase.  In the case of the DB10, this method worked, as Aston Martin’s launch of the DB11 has been the marque's most successful in history ("success" is relative; Aston Martin has sold fewer cars in its 104-year history than Toyota typically sells in two days).When clients call us seeking advice after receiving an unsolicited offer for their RIA, the first questions they ask generally revolve around two issues:Is the price reasonable? andDo we think the buyer will be willing to improve the offer? "Price" is a sticky wicket that we'll cover in a later post, but whether or not the first offer is going to change in the negotiation and due diligence process is a certainty: yes.  The only question is which direction (higher or lower) the offer will move before the transaction closes.Universal Truths on Unsolicited OffersIf you receive an unsolicited offer for your investment management firm, you’ll find it is usually difficult to immediately assess the sincerity of the offer.  And while making generalizations about the M&A process can be more misleading than helpful, we will assert the following:An unsolicited offer is made based on limited information. Often the initial overture is based on information beyond what is publicly available on the seller’s website and in regulatory filings. Even with financial statements in hand, prospective buyers making their offer know very little about the seller. The due diligence process involves the review of hundreds of pieces of documentation that can and will shape the purchase agreement.An unsolicited offer may be a competitive bid, but it is not a bid made in a competitive market. Not every sale is best conducted in an auction process, but the prospective buyer making an unsolicited offer knows that it is, at least for the moment, the only bidder. The object of an unsolicited offer is to get the seller’s attention and cause them to enter into negotiations, often giving the bidder an exclusive right to negotiate for a fixed amount of time.Whether the offer is made at the high end or the low end of a reasonable range depends on the bidder’s perception of the seller. If a buyer thinks a seller is desperate, the initial offer may be at the low end of a reasonable range, in which the selling process should evolve to move pricing and terms more favorable to the seller.  In many cases, though, the initial offer is above what the buyer ultimately wants to pay ("bid it to get it") and will use the due diligence process to beat the price down or insert terms that shift the burden of risk to the seller.  If the initial offer seems too good to be true, consider the latter a distinct possibility.An LOI is NOT a purchase agreement. Many sellers think the deal is done if they receive an unsolicited offer with a strong price and favorable terms.  We don't want to suggest that buyers never put their best foot forward on the first round, but an unsolicited offer should be viewed more as an overture than a commitment.Once the offer is accepted, the real work begins. Stop and think for a moment about what you would like your employment arrangement to be post-transaction. Do you want a substantial base, incentive compensation, a multi-year arrangement, roll-over ownership, administrative responsibilities or just client-facing work, protections in the event of termination without cause, an internal or external reporting requirement, and/or other arrangements?  Imagine your situation as viewed by the buyer and what they would want. This is just one item which is rarely delineated in detail on the first offer. A legion of issues must be resolved in the process of negotiating a final purchase agreement, which is why “deal fatigue” is a prevalent cause of abandoned transactions.ConclusionBond’s DB10 wasn't what it seemed to be.  It wasn't the prototype of a production car. It wasn't equipped with Aston Martin's most potent powertrain (what was Q thinking?). It wasn't even built on a "DB" series chassis. It was a movie car, and ultimately a design exercise for Aston Martin to whet the public's appetite for their next production release. That the concept was only a suggestion of the ultimate product is a reasonable metaphor for the relationship between an unsolicited offer and a closed transaction. The offer gets the process started, but it's the process that creates the deal.Transacting an investment management firm is complicated. Advisors to buyers and sellers have the delicate task of aggressively representing their clients and covering every bit of ground in the due diligence process without killing the deal by exhausting the buyer and seller and making them wonder why they ever started negotiations in the first place.  The primary danger of an unsolicited offer is that it lures potential sellers into thinking the deal is done and the process will be easy.  As with most things in life, if something looks too good to be true, it usually is.

A few weeks ago, I spotted a red Alfa Romeo Duetto Spider and my mind immediately wandered to Dustin Hoffman driving a Duetto in the film that launched his career, The Graduate.  Of all the small, four-cylinder convertible sports cars produced in the late 1960s, the Alfa Romeo stands out because of its prominence in the film.  Fifty years after it was released, The Graduate is still relevant because the plot captures a common theme: life is full of moments of great accomplishment that summarily dissolve into concern over what follows.Hoffman plays Ben Braddock, a newly minted college graduate returning home to Los Angeles.  In spite of his successes thus far in life, Ben is disillusioned and nervous about the future.  In the midst of his uncertainty, Ben is propositioned by the wife of his father's business partner, Mrs. Robinson. The movie sorts out the ensuing affair between Ben and Mrs. Robinson, and Ben coming to terms with his romantic preference for the Robinsons' daughter, Elaine. About the time he realizes he's in love with Elaine, Ben finds out she's getting married to someone else. He races to the church (the Alfa characteristically runs out of gas before he gets there), interrupts the wedding, and escapes with Elaine on a city bus. In the closing scene, Ben and Elaine sink into their seats and relish their victory, until satisfaction gives way to dread: now what?Around the time I spotted the Duetto, we were working with a client who had received an unsolicited offer to acquire their wealth management firm from one of the many consolidators trying to build national scale in the RIA space. The offer was calibrated to get our client's attention, with language that focused on “unlocking” value and projections of other-worldly financial returns from agreeing to the transaction. Irrational buyers with capacity don’t come along every day, so when a suitor presents themselves as "the one," you better decide if they are genuine or not.  If so, say “yes” before they change their mind. If the offer is too good to be true, take a pass.  This case was more of the latter.I know this particular consolidator has managed to convince numerous RIAs to join them over the years, so I can’t argue with their approach. Indeed, some of our client's partners seemed more than intrigued by the overture, while others weren't convinced. We were asked to review the offer from a dispassionate perspective and make recommendations to the partners about how to proceed.This wasn't the first time we've been asked to review an unsolicited offer to buy an asset management firm, and it surely won't be the last. As such, we thought it would be worth taking a few blog posts to talk about unsolicited offers, how to approach them, evaluate them, and decide whether to pursue or reject them.Over the course of the next few weeks, we'll cover topics relevant to dealing with overtures from acquirers, including:Be mindful of your own psychology. Selling an asset management firm is an emotional episode disguised with numbers.  Don't confuse your own fears and desires with what may be the largest financial decision you'll make in your career.Just because they want you doesn't mean you have to want them back. There is a strategic approach to selling an investment management firm just as there is a strategic approach to acquiring one.  Are they solving your problem or are you just solving theirs?Know what you are selling. You will be expected to give things up in exchange for the acquirer's check – and some of the most significant items transacted aren't listed in the purchase agreement.Be ready to value the offer. RIA transactions often include contingent consideration and terms that affect the cash equivalent proceeds of a deal.  It is almost unheard of for an RIA acquirer to make payment, take the keys, and be done with the deal.Think about using an intermediary. A third party, compensated to represent you instead of the transaction, can be a powerful way to achieve the best outcome in any transaction. Like young Ben Braddock, looking back on a successful life so far as a student but not knowing what adulthood will bring, partners in mature asset management firms can simultaneously feel both a sense of great accomplishment at what they've built and a great sense of discomfort at what lies ahead. An unsolicited offer is usually intriguing and sometimes presents a bona fide path forward, but it may also be a threat to everything you value. We'll be covering more on this next week, but feel free to give us a call if you'd like to talk sooner.

RIAs have long faced structural headwinds and consolidation pressure from increasing compliance and technology costs, broadly declining fees, and slowing organic growth for many active managers.  While these pressures have been compressing margins for years, asset manager M&A has historically been muted, due in part to challenges specific to asset manager combinations, including the risks of cultural incompatibility and size impeding alpha generation.  Nevertheless, the industry structure has a high degree of operating leverage, which suggests that scale could alleviate margin pressure for certain firms.Current Consolidation ConsiderationsConsolidation pressures appear to have reached critical mass in the last several years, and M&A activity has picked up notably as a result.  M&A activity in 2017, in particular, is on track to reach the highest level in terms of deal volume since 2009. For publicly traded asset managers, at least, the market seems to view recent M&A activity favorably.  Amundi has returned 46% year-to-date (as of October 20) after announcing the acquisition of Pioneer Investments last December.  Aberdeen was up 15% through May 31 after agreeing to be acquired by Standard Life in March.  KKR shares have risen 20% since April 19, when an investor group led by Stone Point Capital and KKR agreed to buy a majority stake in RIA aggregator Focus Financial Partners. Recent increases in M&A activity come against a backdrop of a now eight-year-old bull market.  Steady market gains, particularly in 2017, have more than offset the consistent and significant negative AUM outflows that many active managers have seen over the past several years.  In 2016, for example, active mutual funds’ assets grew from $10.7 trillion to $11 trillion, despite $400 billion in net outflows according to data from Bloomberg.  As a result, profitability has been steadily increasing despite industry headwinds that seem to rationalize consolidation. It's unclear whether this positive market movement has been a boon or a bane to M&A activity.  On one hand, many asset managers may see rapid AUM gains from market movement as a case of easy come, easy go.  In that case, better to sell sooner rather than later.  And vice versa from a buyer’s perspective.  On the other hand, as long as markets trend upwards, margin and fee pressures are easy to ignore.  In that case, a protracted market downturn could lead to a shakeout for firms with cost structures that are not sustainable without the aid of a bull market. We saw the effect a market downturn can have on M&A activity during 2009 when deal volume reached record levels as many distressed firms were sold.  The M&A activity spurred by the 2009 downturn was short-lived, however.  Deal volume was largely subdued between 2010 and 2013.  The fallow period ended in 2014, and deal activity has accelerated since then while broad market indices have marched higher. ConclusionIt seems likely that asset manager deal activity will continue to gain speed regardless of which way the markets are moving, although a market downturn could certainly expedite consolidation.  Asset managers face secular trends that threaten lower revenue and higher costs.  On the top line side, assets continue to flow into low fee passive funds at a good clip.  On the cost side, an evolving regulatory environment threatens increasing compliance costs.  Consolidation allows asset managers to spread compliance costs over a larger AUM base and increase distribution channels and product offerings, thereby combating revenue and cost pressure.But if a protracted bear market does materialize, margins will face pressure not only from the evolving industry dynamics but also from evaporating AUM.  A significant market downturn may highlight the consolidation pressures in the industry and catalyze a larger wave of M&A activity.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Ever since the Financial Crisis, wirehouse advisors have been pondering this question as the independent model continues to lure wealth managers from the big banks and brokerage firms.  This post discusses the various options that financial advisors (FAs) are faced with today and when it makes sense for them to stick around or do their own thing. It seems unlikely that English punk rock artist Mick Jones could empathize with future financial advisors when he unleashed his hit single, "Should I stay or Should I go" in 1981.  Rather, he was probably referring to his own pending departure from The Clash (though he would later deny that contention).  Either way, it seems oddly applicable to many FAs' current predicament as they contemplate the pros and cons of staying with their current employer or forming their own RIA.Considerations for Financial AdvisorsPerhaps the most obvious consideration is compensation.  Though it varies by firm and location, wirehouse firms generally pay out 35% to 55% of fee income to their FAs, with the larger producers typically taking home a bigger cut of the business, according to industry consultant, Michael Kitces.  Larger RIA firms, on the other hand, tend to pay their FAs 40% to 50% of fee income, 20% to 30% in non-compensatory overhead costs with the residual 20% to 30% in profits, depending again on size and location and dozens of other factors.  This means that a solo practitioner could earn as much as 80% of his or her fees by starting their own firm, collecting all the fee income net of overhead expenses.Based on this math alone, it's hard to comprehend why over 50,000 advisors and $7 trillion assets have remained at Bank of America Merrill Lynch, UBS, Morgan Stanley, and Wells Fargo alone, according to the InvestmentNews Advisers on the Move database.  IN attributes this phenomenon to signing bonuses at the wirehouse firms, the security they offer, increasingly higher compensation packages for top producers, and appealing retirement deals for senior FAs looking to cash out.  Or it may be that capturing that margin for oneself is easier said than done.Kitces contends that "end advisors are often able to keep 10% to 20% more of their gross revenue after making the switch" even after considering all the perquisites that the bulge bracket firms are offering.  So from a sheer economics perspective, it appears that going independent makes more sense, but there are still other factors to keep in mind.  For one, you have to get client consent, which is not always a given, especially if the client identifies more with the bank than the broker, which is often the case with elderly investors.  You'll also have to invest time and money in technology, personnel, and other overhead charges that were previously provided by the brokerage firms.  In addition, you'll be suddenly responsible for practice management unless you pay someone else to do that for you, which can also be costly.  Indeed, if you go, there could be trouble, as Mick Jones warned us.Don't leave without first thinking about your employment agreements, non-compete agreements, non-solicitation agreements, etc.  The only thing worse than starting a business with plenty of overhead and no clients is starting a business with plenty of overhead, a few clients, and a lawsuit from your former firm.The obvious advantage of staying with a wirehouse is the plug-and-play platform that allows financial advisors to concentrate on client service and selling, rather than running a business.  We hear plenty of grumbling about the big firms being run by lawyers instead of business development staff, spending so much time on defense that there's no time left for offense.Compliance issues are rising in the independent RIA space as well, though, and when you're in charge of your RIA, you're also in charge of the compliance department.  Oddly enough, at the same time brokers are weighing leaving big banks to go out on their own so they aren't constrained by back-office regulations, independent RIAs are consolidating to allow their top people to focus on clients instead of practice management.ConclusionThere are plenty of tradeoffs to being independent. But staying could be even more problematic.  The independent model allows you to better take advantage of the inherent operating leverage of the asset manager business.  Rather than earning a fixed percentage of the fee income from client assets, an independent RIA owner/operator can achieve significant levels of profitability to augment fee income by growing AUM with more modest increases to overhead expenses.  We've seen larger wealth management firms (client assets over $500 million) achieve EBITDA margins of 25% or greater when overhead costs remain relatively contained.  Potential returns do appear to be commensurate with the risk involved in most of these situations – which is, after all, kind of the theme of investment management.Mick Jones ultimately decided to go, and has enjoyed something of a post-Clash career (although you could be forgiven for not being able to name any songs by Big Audio Dynamite).  If you're considering going independent, we just hope you keep this all in mind.

Sometimes deals can go horribly wrong between the signing of a merger agreement and closing. Buyers can fail to obtain financing that seemed assured; sellers can see their financial position materially deteriorate; and a host of other “bad” things can occur. Most of these lapses will be covered in the merger agreement through reps and warranties, conditions to close, and if necessary, the nuclear trigger that can be pushed if negotiations do not produce a resolution: the material adverse event clause (MAEC). And MAEC = litigation.Bank of America’s (BAC) 2008 acquisition of Countrywide Financial Corporation will probably be remembered as one of the worst transactions in U.S. history, given the losses and massive fines that were attributed to Countrywide. BAC management regretted the follow-on acquisition of Merrill Lynch so much that the government held CEO Ken Lewis’ feet to the fire when he threatened to trigger MAEC in late 2008 when large swaths of Merrill’s assets were subjected to draconian losses. BAC shareholders bore the losses and were diluted via vast amounts of common equity that were subsequently raised at very low prices.Another less well-known situation from the early crisis years is the acquisition of Charlotte-based Frist Charter Corporation (FCTR) by Fifth Third Bancorp (FITB). The transaction was announced on August 16, 2007 and consummated on June 6, 2008. The deal called for FITB to pay $1.1 billion for FCTR, consisting 30% of cash and 70% FITB shares with the exchange ratio to be set based upon the five day closing price for FITB the day before the effective date. At the time of the announcement FITB expected to issue ~20 million common shares; however, 45 million shares were issued because FITB shares fell from the high $30s immediately before the merger agreement was signed to the high teens when it was consummated. (The shares would fall to a closing low of $1.03 per share on February 20, 2009; the shares closed at $25.93 per share on July 14, 2017.) The additional shares were material because FITB then had about 535 million shares outstanding. Eagerness to get a deal in the Carolinas may have caused FITB and its advisors to agree to a fixed price / floating exchange ratio structure without any downside protection.A more recent example of a deal that may entail both buyer and seller regrets is Canadian Imperial Bank of Commerce’s (CIBC) now closed acquisition of Chicago-based Private Bancorp Inc. (PVTB). A more detailed account of the history of the transaction can be found here. The gist of the transaction is that PVTB entered into an agreement to be acquired by CIBC on June 29, 2016 for 0.3657 CIBC shares that trade in Toronto (C$) and New York (US$), and $18.80 per share of cash. At announcement the transaction was valued at $3.7 billion, or $46.20 per share. As U.S. bank stocks rapidly appreciated after the November 8 national elections, institutional investors began to express dismay because Canadian stocks did not advance. In early December, proxy firms recommended shareholders vote against the deal. A mid-December shareholder vote was then postponed.CIBC subsequently upped the consideration two times. On March 31, 2017, it proposed to acquire PVTB for 0.4176 CIBC shares and $24.20 per share of cash. On May 4, CIBC further increased the cash consideration by $3.00 to $27.20 per share because its shares had trended lower since March as concerns intensified about the health of Canada’s housing market. On May 12, shareholders representing 66% of PVTB’s shares approved the acquisition. Figure 1 highlights the trouble with the deal from PVTB shareholders’ perspective. While the original deal entailed a modest premium, the performance of CIBC’s shares and the sizable cash consideration resulted in little change in the deal value based upon the original terms. On March 30 the deal equivalent price for PVTB was $50.10 per share, while the market price was $59.00 per share. The following day when PVTB upped the consideration the offer was valued at $60.11 per share; however, the revised offer would have been worth nearly $69 per share had CIBC’s shares tracked the SNL U.S. Bank Index since the agreement was announced on June 29. On May 11 immediately before the shareholder vote the additional $3.00 per share of cash offset the reduction in CIBC’s share price such that transaction was worth ~$60 per share, while the “yes-but” value was over $71 per share had CIBC’s shares tracked the U.S. index since late June. Fairness opinions do not cover regret, but there are some interesting issues raised when evaluating fairness from a financial point of view of both PVTB and CIBC shareholders. (Note: Goldman Sachs & Co. and Sandler O’Neill & Partners provided fairness opinions to PVTB as of June 29 and March 30. The registration statement does not disclose if J.P. Morgan Securities provided a fairness opinion as the lead financial advisor to CIBC. The value of the transaction on March 30 when the offer was upped the second time was $4.9 billion compared to CIBC’s then market cap of US$34 billion.)Fairness is a Relative ConceptSome transactions are not fair, some are reasonable, and others are very fair. The qualitative aspect of fairness is not expressed in the opinion itself, but the financial advisor conveys his or her view to management and a board that is considering a significant transaction. When the PVTB deal was announced on June 29, it equated to $46.35 per share, which represented premiums of 29% and 14% to the prior day close and 20-day average closing price. The price/tangible book value multiple was 220%, while the P/E based upon the then 2016 consensus estimate was 18.4x. As the world existed prior to November 8, the multiples appeared reasonable but not spectacular.Fairness Does not Consider 20-20 Hindsight VisionFairness opinions are qualified based upon prevailing economic conditions; forecasts provided by management and the like and are issued as of a specific date. The opinion is not explicitly forward looking, while merger agreements today rarely require an affirmation of the initial opinion immediately prior to closing as a condition to close. That is understandable in the context that the parties cut a deal that was deemed fair to shareholders from a financial point of view when signed. In the case of PVTB, the future operating environment (allegedly) changed with the outcome of the national election. Banks were seen as the industry that would benefit from a combination of lower corporate tax rates, less regulation, faster economic growth, and higher rates as part of the “reflation trade.” A reasonable deal became not so reasonable if not regrettable when the post November 8 narrative excluded Canadian banks. Time will tell if PVTB’s earning power really will improve, or whether the move in bank stocks was purely speculative.Subtle Issues Sometimes MatterAlthough not a major factor in the underperformance of CIBC’s shares vis-à-vis U.S. banks, the Canadian dollar weakened from about C$1.30 when the merger was announced on June 29 to C$1.33 in early December when the shareholder meeting was postponed. When shareholders voted to approve the deal on May 12 the Canadian dollar had eased further to C$1.37. The weakness occurred after the merger agreement was signed and the initial fairness opinions were delivered on June 29. Sometimes seemingly small financial issues can matter in the broad fairness mosaic, but only with the clarity of hindsight.Waiting for a Better Deal is not a Fairness ConsiderationAlthough a board will consider the business case for a transaction and strategic alternatives, a fairness opinion does not address these issues. The original registration statement noted that Private was not formally shopped. The deal was negotiated with CIBC exclusively, which twice upped its initial offer before the merger agreement was signed in June. It was noted that the likely potential acquirers of PVTB were unable to transact for various reasons. The turn of events raises an interesting look-back question: should the board have waited for a better competitive situation to develop? We will never know; however, the board is given the benefit of the doubt because it made an informed decision given what was then known.The Market Established a Fair PriceInstitutional shareholders had implicitly rejected what became an unfair deal by early December when PVTB’s shares traded well above the deal price. The market combined with the “no” recommendation of three proxy firms forced PVTB to delay the special meeting. The increase in the consideration in late March pushed the deal price to a slight premium to PVTB’s market price. CIBC increased the cash consideration an additional $3.00 per share in early May to offset a decline in CIBC’s shares that had occurred since the consideration was increased in March. The market had in effect established its view of a fair price. While CIBC could have declined to up its offer yet again, it chose to offset the decline.Relative Fairness from CIBC’s Perspective FluctuatedWhat appeared to be a reasonable deal from CIBC’s perspective in June became exceptionally fair by early December, if the market is correct that the earning power of U.S. commercial banks will materially improve as a result of the November 8 election. CIBC’s financial advisors can easily change assumptions in Excel spreadsheets to justify a higher price based upon better future earnings than originally projected, but would doing so be “fair” to CIBC shareholders whether expressed euphemistically or formally in a written opinion? So far the evidence of higher earning power is indirect via the market placing a higher multiple on current bank earnings in expectation of much better earnings that will not be observable until 2018 or 2019. That as a stand-alone proposition is an interesting valuation attribute to consider as part of a fairness analysis both from PVTB’s and CIBC’s perspective.ConclusionHindsight is easy; predicting the future is a fool’s errand. Fairness opinions do not opine where securities will trade in the future. Some PVTB shareholders may have regrets that CIBC was not a U.S. commercial bank whose shares would have out-performed CIBC’s after November 8. CIBC shareholders may regret the PVTB acquisition even though U.S. expansion has been a top priority. The key, as always in any M&A transaction, will be execution over the next several years rather than the PowerPoint presentation. Higher rates, a faster growing U.S. economy and the like will help, too, if they occur.We at Mercer Capital cannot predict the future, but we have over three decades of experience in helping boards assess transactions as financial advisors. Sometimes paths and fairness from a financial point of view seem clear; other times they do not. Please call if we can assist your company in evaluating a transaction.This article originally appeared in Mercer Capital's Bank Watch, July 2017.

Risk is enigmatic to investing.  While we might all desire clairvoyance, it would only work if we were the sole investors who could see the future perfectly.  If everyone’s forecasts were proven accurate, assets would all be priced at something akin to the risk-free rate, with no premium return attached.  Uncertainty creates opportunity for investors, because opportunity is always a two-way street.Pricing uncertainty is another matter altogether.  Not everyone “believes” in CAPM, or at least maybe not the concept of beta, but most agree that the equity risk premium exists to reconcile the degree of unlikelihood for the performance of a given asset with the value of that asset.  In an ideal world, a reasonable cash flow projection and a reasonable cost of capital will yield a reasonable indication of value.In the real world, there can be genuinely differing opinions of what the future holds.  Some think the future is all about batteries, with considerably stronger environmental regulations on the horizon (at least in Europe) not to mention the relative simplicity of battery power.  This sentiment bid Tesla’s share price to a larger market capitalization than Ford.  Others have equally questioned the wisdom of this, noting the reluctance of consumers, and many governments, to phase out the use of fossil fuels in transportation.  Naysayers note that Tesla’s 400 thousand plus pre-orders for the Model 3 pale in comparison to, say, the over 16 million Ford F150 pickup trucks sold over the past 20 years.  What would break that trend now?In the vacuum sealed world of fair market value, we can reconcile discordant outlooks with different cash flow projections.  The differing projections can then be yoked together into one conclusion of value by weighing them relative to probability.  The discount rate used in the different projection models captures some of the risk inherent in the cash flow, and the probability weights capture the remainder of the uncertainty.  In a real world transaction, however, buyers want to be paid based on their expectations if proven right, and sellers also want to be paid if outcomes comport with their projections.  With no clear way to consider the relative likelihood of each party’s expectations, no one transaction price will facilitate a transaction.  Risk and opportunity can often be reconciled by contract, however, by way of contingent consideration.RIA Transaction ExampleConsider the example of a depository institution, Hypothetical Savings Bank, or HSB.  HSB has a substantial lending platform, but it also has a trust department that operates as something of an afterthought.  HSB’s senior executives consider options for closing or somehow spinning off the trust operation, but because of customer overlap, lengthy trust officer tenure with the bank, and concerns by major shareholders who need fiduciary services, HSB instead hopes to bolster the profitability of trust operations by acquiring a RIA.Following a search, HSB settles on Typical Wealth Management, or TWM.  TWM has 35 advisors and combined discretionary assets under management of $2.6 billion (an average of $75 million per advisor).  TWM has a fifteen-year track record of consistent growth, but with the founding generation nearing retirement age, the firm needs a new home for its clients and advisors.The Seller’s PerspectiveTWM’s founders are motivated, but not compelled, to sell the firm.  TWM generates 90 basis points of realized fees per dollar of AUM and a 30% EBITDA margin.  Even after paying executives and advisors, TWM makes $7MM of EBITDA per year, and the founders know that profitability has significant financial value to HSB, in addition to providing strategic cover to shore up the trust department.Further, Typical Wealth Management has experienced considerable growth in recent years, and believes it can credibly extend that growth into the future, adding advisors, clients, and taking advantage of the upward drift in financial markets to improve revenue and enhance margins. Given what it represents to be very conservative projections, and which don’t take into account any cross selling from the bank or potential fee enhancements (TWM believes it charges below-market fees to some clients), the seller wants 12x run rate EBITDA, or about $85 million, noting that this is only about 10x forward EBITDA, and less than 7x EBITDA three years hence. The Buyer’s PerspectiveThe bankers at HSB don’t really understand wealth management, but they know banks rarely double profitability in three years and suspect they’ll have a tough time convincing their board to pay top dollar for something without tangible book value.Bank culture and investment management frequently do not mix well, and they worry whether or not TWM’s clients will stay on if the senior staff starts to retire.  Further, they wonder if TWM’s fee schedule is sustainable in an era of ETFs and robo-advisors.  They create a much less sanguine projection to model their possible downside. Based on this, HSB management wants to offer about $40 million for Typical, which is about six times run rate EBITDA.  This pricing gives the seller some credit for the recurring nature of the revenue stream, but doesn’t pay for growth that may or may not happen following a change of control transaction. The CompromiseWith a bid/ask spread of $45 million, the advisors for both buyer and seller know that a deal isn’t possible unless one or both parties is willing to move off of their expectations significantly (unlikely) or a mechanism is devised to reward the seller in the event of excellent performance and protect the buyer if performance is lackluster.  Even though the buyer is cautious about overpaying, they eventually agree to a stronger multiple on current performance and offer $50 million up front for TWM.  The rest of the payment, if any, will come from an earn-out.  Contingent consideration of as much as $30 million is negotiated with the following features:TWM will be rebranded as Hypothetical Wealth Management, but the enterprise will be run as a separate division of the bank during the term of the earn-out. This division will not pay any overhead charge to the bank, except as specifically designated for marketing projects through the bank that are managed by the senior principals of the wealth management division.  As a consequence, the sellers will be able to maintain control over their performance and their overhead structure during the term of the earn-out.The earn-out period is negotiated to last three years. Both buyer and seller agree that, in a three year period, the value delivered to the seller will become evident.Buyer and seller agree to modest credits if, for example, the RIA recommends a client develop a fiduciary relationship with the bank’s trust department, or if the bank’s trust department refers a wealth management prospect to the RIA. Nevertheless, in order to keep matters simple during the term of the earn-out, both parties agree to manage their operations separately while the bank determines whether or not the wealth management division can continue to market and grow as an extension of the bank’s brand.To keep performance tracking straightforward, HSB negotiates to pay five times the high-water mark for any annual EBITDA generated by TWM during a three year earn-out period in excess of the $7 million run-rate established during the negotiation. It is an unusual earn-out arrangement, but the seller is compensated if by steady marketing appeal or strong market returns, AUM is significantly enhanced after the transaction.  The buyer is protected, at least somewhat, from the potentially temporary nature of any upswing in profitability by paying a lower multiple for the increase than might normally be paid for an RIA.  As long as management of Typical can produce at least $6 million more in EBITDA in any one of the three years following the transaction date, the buyer will pay the full earn-out.  Any lesser increase in EBITDA is to be pro-rated and paid based on the same 5x multiple.The earn-out agreement is executed in conjunction with a purchase agreement, operating agreement, and non-competition / non-solicitation agreements which specify compensation practices, reporting structures, and other elements to govern post-transaction behavior between the bank and the wealth manager. These various agreements are done to minimize misunderstandings and ensure that both buyer and sellers are enthusiastic participants in the joint success of the enterprise. As the earn-out is negotiated, buyer and seller run scenarios of likely performance paths for Typical after the transaction to see what the payout structure will look like per the agreement.  This enables both parties to value the deal based on a variety of outcomes and decide whether pricing and terms are truly satisfactory.Structuring Earn-Outs Is the Key to a Successful TransactionMy very limited understanding of neuroscience has led me to a cursory knowledge of the shortfalls of human decision making.  As much as we might like to believe we think analytically, we mostly act on impulse, responding emotionally to our environment faster than we can reason.This capacity kept us alive when rapid escape from a predator was a more reliable reaction than stopping to think about what was happening.  This same brain function causes sellers to focus too much on the headline number offered in a deal negotiation and not enough on the terms surrounding the price.In RIA transactions, those terms frequently include large earn-out payments based on performance outlooks that are highly unlikely, or that at least should be discounted significantly.  As a rule, buyers get more protection from contingent consideration than sellers, and frequently have more experience offering earn-outs than sellers have living with them.  Seller beware!If you’re considering an offer for your firm that includes earn-out consideration, think about having some independent analysis done on the offer to see what it might ultimately be worth to you.  If you’re working the buy-side, prepare to spend lots of time fine-tuning the earn-out agreement – you won’t get credit if things go well for the seller, but you will get blamed if it doesn’t.

As covered in last week’s post, RIA transactions usually feature earn-out payments as a substantial portion of total consideration because so much of the seller’s value is bound up in post-closing performance.  Just as the financial press never writes about periods of “heightened certainty,” so too buyers of RIAs are justifiably concerned about the ongoing performance of their acquisition target after the ink dries on the purchase agreement.Earn-outs (i.e. contingent consideration) perform the function of incentives for the seller and insurance for the buyer, preserving upside for the former and protecting against downside for the latter.  In asset manager transactions, they are both compensation, focusing on the performance of key individuals, and deal consideration, being allocated to the selling shareholders pro rata.  And even though earn-out payments are triggered based on meeting performance metrics which are ultimately under the control of staff, they become part of overall deal consideration and frame the transaction value of the enterprise.For all of these reasons, we view contingent consideration as a hybrid instrument, combining elements of equity consideration and compensation, and binding the future expectations of seller and buyer in a contractual understanding.Twenty years ago, Toyota considered whether the future of automobiles would involve gasoline or batteries and developed a similar middle way, the hybrid engine.  A hybrid motor uses regenerative braking to charge batteries that recapture power to augment or substitute for the car’s conventional internal combustion engine.  Similar technology has been deployed in supercars like the Porsche 918 Spyder, but the Prius is responsible for helping shape the future of automotive transportation by making hybrid technology prevalent.As hybrids go, though, earn-outs are even more prevalent in asset manager transactions than Priuses are in Whole Foods parking lots, and it’s easy to understand why.Earn-Out ParametersContingent consideration makes deals possible that otherwise would not be.  When a seller wants twice what a buyer is willing to pay, one way to mediate that difference in expectations is to pay part of the price up front (usually equal to the amount a buyer believes can safely be paid) and the remainder based on the post-closing performance of the business.  In theory, earn-outs can simultaneously offer a buyer some downside protection in the event that the acquired business doesn’t perform as advertised, and the seller can get paid for some of the upside he or she is foregoing by giving up ownership.  While there is no one set of rules for structuring an earn-out, there are a few conceptual issues that can help anchor the negotiation.1. Define the continuing business acquired that will be the subject of the earn-outDeciding what business’s performance is to be measured after the closing is easy enough if a RIA is being acquired by, say, a bank that doesn’t currently offer investment management services.  In that case, the acquired company will likely be operated as a stand-alone enterprise with division level financial statements that make determining success or lack thereof fairly easy.If a RIA is being rolled into an existing, and similar, investment management platform, then keeping stand-alone records after the transaction closes may be difficult.  Overhead allocations, how additions and losses to staff will be treated, expansion opportunities, and cross selling will all have some impact on the value of the acquired business to the acquirer.  Often these issues are not foreseen or even considered until after the transaction closes.  It then comes down to the personalities involved to “work it out” or be “fair.”  As my neighbor’s father used to say: “fair is just another four letter word.”2. Determine the appropriate period for the earn-outWe have seen earn-out periods (the term over which performance is measured and over which contingent consideration is paid) as short as one year and as long as five years.  There is no magic period that fits all situations, but a term based on specific strategic considerations like proving out a business model, defined investment performance objectives, or the decision cycle of key clients are all reasons to develop an earn-out timeframe.The buyer wants the term to be long enough to find out what the true transferred value of the business is, and the seller (who otherwise wants to be paid as quickly as possible) may want the earn-out term to be long enough to generate the performance that will achieve the maximum payment.  Generally speaking, buyer-seller relations can get very strained during an earn-out measurement period, and after they’re done no one wishes the term had been longer.We tend to discourage terms for contingent consideration lasting longer than three years.  In most cases, three years is plenty to “discover” the value of the acquired firm, organize a merged enterprise, and generate a reliable stream of returns for the buyer.  If the measurement period is longer than three years, the “earn-out” starts to look more like bonus compensation, or some other kind of performance incentive to generate run-rate performance at the business.  Earn-outs can be interactive with compensation plans for managers at an acquired enterprise, and buyers and sellers are well advised to consider the entirety of the financial relationship between the parties after the transaction, not just equity payments on a stand-alone basis.3. Determine to what extent the buyer will assist or impede the seller’s performance during the earn-outDid the buyer lure the seller in with promises of technology, products, back-office support, and marketing?  Did the buyer promise the seller that they would be able to operate their business unit independently and without being micromanaged after the transaction?  These are all great reasons for an investment management firm to agree to be absorbed by a larger platform, and they may also help determine whether or not the acquired firm meets performance objectives to get contingent consideration.We have seen bad deals saved by good markets, but counting on false confirmation is not a sound deal strategy.  Instead, buyer and seller should think through their post-close working relationships well in advance of signing a deal, deciding who works for whom, under what circumstances, and what the particulars are of their mutual obligations to shared success look like.  If things don’t go well after the transaction – and about half the time they don’t – the first person who says “I thought you were going to…” didn’t get the appropriate commitments from their counterparty on the front end.4. Define what performance measurements will control the earn-out paymentsIt is obvious that you will have to do this, but in our experience buyers and sellers don’t always think through the optimal strategy for measuring post-closing performance.Buyers, ultimately, want to see profit contributions from the seller, and so some measure of cash flow is a natural way to pay for the kind of desired performance from an acquired investment management operation.  There are at least two problems with this, however, which suggest maybe another performance metric would be more effective for the buyer (and the seller).First, profitability is at the bottom of the P&L, and is therefore subject to lots of manipulation.  To generate a dollar of profit at a RIA, you need some measure of client AUM, market performance, a fee schedule, investment management staff, office space, marketing expense, technology and compliance, capital structure considerations, parent overhead allocations, and any number of other items, some of which may be outside of the sellers’ control.  Will the sellers accuse the buyer of impeding their success?  Can the factors influencing that success all be sufficiently isolated and defined in an earn-out agreement?  It’s more difficult than it looks.Second, much of the post-transaction profitability of the acquired business will depend on the returns of the financial markets, over which nobody has control.  If the rising tide indeed lifts all boats, should the buyer be required to compensate the seller for beneficial markets?  By the same token, if a deal is struck on the eve of another financial crisis, does the seller want to be held accountable for huge market dislocations?  In our experience, returns from markets don’t determine success, over time, nearly as much as returns from marketing.  Consider structuring an earn-out based on net client AUM (assets added, net of assets withdrawn), given a certain aggregate fee schedule (so nobody’s giving the business away just to pad AUM).5. Name specific considerations that determine payment termsIs the earn-out capped at a given level of performance or does it have unlimited upside?  Can it be earned cumulatively or must each measurement period stand alone?  Will there be a clawback if later years in the earn-out term underperform an initial year?  Will there simply be one bullet payment if a given level of performance is reached?  To what extent should the earn-out be based on “best efforts” and “good faith”?Because these specific considerations are usually unique to a given transaction between a given buyer and a given seller, there are too many to list here.  I have two quick thoughts on that: 1) transaction values implied by earn-out structures are often hard to extrapolate to other parties to other transactions.  2) The earn-out can address many of the concerns and hopes of the parties to a transaction about the future – but it cannot create the future.  Earn-outs manage uncertainty; they don’t create certainty.ConclusionAbove all, we would emphasize that a plan for contingent consideration be based on the particular needs of buyers and sellers as they pertain to the specific investment management business being transacted.  There is no one-size-fits-all earn-out in any industry, much less the RIA community.  If an earn-out is truly going to bridge the difference between buyer and seller expectations, then it must be designed based on buyer and seller considerations.  A bridge that doesn’t successfully link two points is not a bridge, it’s a pier.  A pier will eventually leave either buyer or seller in deep water.We’ll talk more next week about the structuring of earn-outs for RIAs, but drop us a line in the meantime if you’d rather not wait.

Pity the senior auto executive these days: their product is bearing much of the blame for killing the planet, but gas is so cheap they can’t even sell boring fuel efficient cars to the local chapter president of the Sierra Club.  The Economistran a cover story last week calling the internal combustion engine “Roadkill,” and repeated the estimate that car emissions kill more Americans every year than traffic accidents – yet the political climate in America doesn’t suggest that regulatory standards for burning fossil fuels of any kind will be tightening soon.Predicting what kinds of cars people will want to buy next year, let alone five years from now, has never been easy.  Today, there are too many options.  Will car buyers want all-wheel-drive pickups with huge internal combustion engines, or battery-powered autonomous-driving cars?  Will people even own cars in 20 years or will we all be driven around by some Uber-like service, making car ownership, parking lots, and garages obsolete?  Do you test the market with an expensive, limited production high-performance car like the BMW i8, or do you make a more affordable, mass market car like the Toyota Prius?  If you invest heavily in technology, will the market shower you with orders like it did for the Tesla Model 3, or spurn you like the doomed Fisker Karma?M&A in the RIA Community Wouldn’t be Possible Without Earn-outsAs the saying goes (which has been attributed to at least a dozen famous figures), it’s difficult to make predictions, especially about the future.  This reality is the single most difficult part of negotiating a transaction in the investment management industry.  The value of an RIA acquisition target is subject not only to a large number of variables, but also a wide range of possible outcomes:The performance of financial markets (standard deviation varies)The skill of the investment management staff (difficult to measure)The sustainability of the acquired firm’s fee schedule (not as much a given as in the past)The retention of key staff at the acquired firm (absolutely necessary)The retention of key staff at the acquiring firm (absolutely necessary)The motivation of key staff (absolutely necessary)The retention of client assets (depends entirely on third party behavior)The marketing strength of the merged enterprise (tough to predict) Without faith in the upward drift of financial markets, favorable margins in investment management, and the attractiveness of the recurring revenue model, no one would ascribe equity value to an RIA.  But actually buying an asset manager is making a bet on all of the above, and most people don’t have the stomach. Readers of this blog understand that only by way of an earn-out can most investment management firm transactions overcome so much uncertainty.  Nevertheless, in our experience, few industry executives have more than an elementary grasp of the role of contingent consideration in an RIA transaction, the design of an earn-out agreement, and ultimately the impact that these pay-for-performance structures have on valuation. This blog kicks off a series which we’ll ultimately condense into a whitepaper to explore and maybe demystify some of the issues surrounding earn-outs in RIA transactions.  If nothing else, earn-outs make for great stories.  Some of them go well, and some wind up like this:From Earn-out to Burn-out: ACME Private Buys Fictional FinancialOn January 1, 20xx, ACME Private Capital announces it has agreed to purchase Fictional Financial, a wealth management firm with 50 advisors and $4.0 billion AUM.  Word gets out that ACME paid over $100 million for Fictional, including contingent consideration.  The RIA community dives into the deal, figures Fictional earns a 25% to 30% margin on a fee schedule that is close to but not quite 1.0% of AUM, and declares that ACME paid at least 10x EBITDA.  A double-digit multiple brings other potential deals to ACME, and crowns the sellers at Fictional as “shrewd.”  The rest of the investment management world assume their firm is at least as good as Fictional, so they’re probably worth 12x EBITDA.  To the outside world, everybody associated with the deal is happy.The reality is not quite so sanguine.  ACME structures the deal to pay half of the transaction value up front with the rest to be paid based on profit growth at Fictional Financial in a three-year earn-out.  Disagreements after the deal closes cause a group of twelve advisors to leave Fictional, and a market downturn further cuts into AUM.  The inherent operating leverage of investment management causes profits to sink faster than revenue, and only one-third of the earn-out was paid.In the end, Fictional Financial sold for about 6.5x EBITDA, much less than the selling partners wanted for the business.  Other potential acquisition targets are ultimately disappointed when ACME, stung with disappointment from the Fictional transaction, is not willing to offer them a double-digit multiple.  ACME thought they had a platform opportunity in Fictional, but it turns out to be more of an investment cul-de-sac.The market doesn’t realize what went wrong, and ACME doesn’t publish Fictional’s financial performance.  Ironically, the deal announcement sets the precedent for interpretation of the transaction, and industry observers and valuation analysts build an expectation that wealth management practices are worth about 10x EBITDA, because that’s what they believe ACME paid for Fictional Financial.Earn-outs and Transaction StrategyMost post-deal performance doesn’t get reported, other than AUM disclosures in public filings.  If the acquired entity is folded into another RIA, you can’t even judge a deal by that.  Thus, we don’t have comprehensive data on ultimate deal value in many investment management firm transactions.  One example we have reported previously was the disastrous post-transaction performance of Killen Group after it was acquired by Tri-State Capital.  Killen missed by so much that it cut the total consideration paid by almost half and reduced the effective EBITDA multiple paid from nearly 11x to around 6x.  Which multiple represents the real value of Killen?  No doubt the buyer in this case, as in most others, would rather see the kind of performance that would justify paying the full earn-out, and the seller would prefer that as well.ConclusionSometimes bad deals can be saved by good markets, but that’s not much of an acquisition strategy.  As a consequence, earn-outs are the norm in RIA transactions, and anyone expecting to be on the buy-side or sell-side of a deal needs to have a better than working knowledge of them.  We’ll talk more next week about the structure of contingent consideration in investment management firm deals, but drop us a line in the meantime if you’d rather not wait.

This week, we’re sharing some recent media on trends in the RIA space.  We’ve blogged about asset flows, bank interest in the RIA space, the plight of active management, and the fiduciary rule, but these articles represent a deeper dive into each of these topics."ETFs, ETPs Record Robust Asset Flows in First Half"by Michael S. Fischer of InvestmentAdvisor. The march of passive products continued full force in June, which saw record inflows of $63.6 billion to ETFs and ETPs around the globe, bringing year-to-date inflows to an impressive $347.7 billion, compared to net inflows of only $123.6 billion in the first half of 2016."Switching From Wirehouse to RIA"by Michael Kitces. Amidst the wave of advisors transitioning from wirehouses to independent firms, Kitces takes fifteen minutes to discuss the factors advisors should examine when considering making the transition."Banks Gobbling up RIAs as Consolidator Field Shrinks"by Janet Levaux of Investment Advisor. Though the year-to-date number of transactions in the RIA M&A space is up over 10% from 2016, fewer transactions were seen in Q2 compared to Q1 and the average AUM of RIAs involved in these transactions has fallen to $700 million, compared to an average of $1 billion over the last four years. DeVoe & Co. attribute this trend to the falling number of consolidators in the business."ETFs Now Have $1 Trillion More Than Hedge Funds"by Sarah Krouse of The Wall Street Journal. Assets in ETFs first surpassed investment in hedge funds two years ago and have accelerated ever since as investors continue to shun active products."Active Can Be Fiduciary; The Value of an Advisor"by Bob Veres of Inside Information. Bob discusses his vision of an active manager’s role in a post fiduciary rule investment environment as the enforcement date draws nearer. He also explores the many ways active managers can add value to clients outside of traditional money management. If you have valuation questions regarding your RIA firm or if you would like to continue any of the above discussion further, give us a call.

We’re always perplexed by the lack of transactions in the RIA industry.  Sure, there are some out there, but a typical year reports less than a hundred deals in a space with almost 12,000 federally registered advisors.  This means that less than 1% of industry participants transact in a given year.  How could that be in an aging profession with a highly scalable business model?  We offer a few explanations in this week’s post.1. Most RIAs are not big enough to be consistently profitableAccording to the Investment Adviser Association, the “typical” SEC-Registered Investment Adviser has $317 million in AUM, between 26 and 100 accounts, nine employees, and is headquartered in New York, California, Florida, Illinois, or Texas.  It’s hard to envision that a business of this size would generate enough revenue to cover overhead and professional staff expenses (likely in an expensive market) and yield much profitability, particularly during a market downturn, especially if you consider that many believe $500 million in AUM to be the breakeven point for many asset managers to generate consistent levels of profitability (depending on size, headcount, location, client type, etc.). If valuation is based on earnings, then the average RIA may not have much to sell.2. Many asset managers don’t have sustainable enterprise value beyond their owner(s)A lot of RIA principals have not taken the necessary steps to transition their client relationships, investing acumen, business development capabilities, and/or managerial responsibilities to other staff or the next generation of firm leadership.  To a prospective buyer, this means there is significant risk that the RIA’s accounts and firm viability will not outlive its owners.  This is part of the reason why so many asset manager transactions are structured as earn-outs – to protect the buyer against future declines in fees or earnings associated with a principal’s departure or reduced activity levels in the business after the deal.3. Asset managers are (currently) expensiveDespite what you’ve been reading about industry headwinds (fee pressure, competition from passive products, etc.), most RIAs are more valuable than ever. Since the market is trading at an all-time high, many asset managers’ AUM balances are as well, which means higher fees, earnings, and valuations.  Such a high price tag makes them less appealing to prospective buyers looking to maximize ROI.4. Many RIAs have distinct cultures that don’t necessarily jive with prospective buyersThis is probably the case with many industries but seems especially true for asset managers.  The business and its reputation have come a long way from the Wolf of Wall Street broker culture of the late 80s and early 90s.  Still, these businesses tend to have unique attributes and identities that aren’t necessarily conducive to firms in different (or even the same) industries.  Banks, for example, have recently taken an interest in the business for its high margins and low capital requirements.  In our experience, though, bank and RIA cultures often don’t mesh; this can be an unforeseen hurdle in a deal that may make a lot of sense on paper.5. Asset managers value independence and often prefer to transition the business internallyMost RIAs are employee-owned, and that’s by design.  To keep the company’s culture and investment/client relations teams intact, many principals looking to exit the business will often look to the next generation of firm leadership as prospective buyers for their interest.  They do this to avoid outside influence and appease institutional investors who often seek independent RIAs wholly controlled by the firm’s principals.  Buy-sell or shareholders’ agreements that allow younger principals to buy in at a discount to fair market value are not uncommon for asset managers looking to encourage employee ownership and remain independent.ConclusionOn balance, though, we think the outlook for asset manager M&A is promising.  The industry is still fragmented and ripe for further consolidation.  An aging ownership base is another impetus, and the recent market gains might induce prospective sellers to finally pull the trigger.  Fee compression could also lead to more transactions if RIAs look to create synergies and cost efficiencies to maintain their profit margin.  We haven’t come across much of this yet but are seeing more clients and prospects ask about succession planning and exit strategies.  Perhaps this is a sign of more to come, which isn’t saying a whole lot.

Deal OverviewOn June 19, 2017, EQT announced the acquisition of Rice Energy (RICE) for approximately $6.7 billion. RICE will receive approximately $4.1 billion in EQT common stock and $1.1 billion in cash as well as be relieved from $1.5 billion in net debt that EQT is assuming.Based on EQT disclosures, the assets owned by RICE include (1) 255 wells currently producing 1,145 mmcfe per day (mmcfepd) which are expected to increase to 1,300 mmcfepd; (2) 252,000 in net Marcellus and Utica acres with more than 1,100 net locations remaining to explore; (3) 92% of RICE GP interest including the incentive distribution rights (IDR’s); and (4) 28% of Rice Midstream Partners (RMP). By all accounts, the location of the acreage is contiguous or nearby to EQT’s current acreage and the combination of the two companies will create the largest gas producer in the Marcellus and Utica.Reported Valuation Multiples Do Not Present the Whole PictureIn comparison to other operators in the Marcellus and Utica, the transaction is on the higher end of the range with Antero Resources Corp (AR) and Cabot Oil and Gas (COG) when considering an EV/Daily Production multiple and on the high end with the acreage multiple (See Table 2).  However, the “reported” value multiples may not be the whole picture. We have considered EQT’s offer to RICE shareholders, but RICE’s shareholders only own 28% of Rice Midstream and 92% of the GP interest.  Due to the accounting rules for consolidation, the majority of the income statement and production figures capture activity for 100% ownership (the non-controlling interest is not taken out until the end). Therefore, by not including the non-controlling interest that is consolidated into Rice’s balance sheet, we previously compared less than 100% of the Company’s Enterprise Vale to 100% of the Company’s production, acreage, and EBITDA. What Does the “All In” Enterprise Value Mean to Investors?The non-controlling interest on the balance sheet of RICE amounts to $2.4 billion as of the end of Q1 2017. The offer for $6.7 billion was for the interest RICE owns in the business' assets. Therefore, to compare production and acreage multiples to the publics, we would need to calculate an “all in” enterprise value as shown in Table 3. Under the “all in” approach, the production multiple of 48,415x is well above the other operators in the area (see Table 2) and investors should be excited about the proposed transaction according to the surface data. The EBITDA multiple is not a great indication here as some companies in the guideline group were marginally profitable at the EBITDA level leading to abnormally high EBITDA multiples. In response to the announced transaction, the share price of RICE increased approximately 25% or $1 billion. Based upon our experience in performing valuation services in the Appalachian play, the analysis above appears reasonable. Table 4 shows the previous 20 transactions in the area. Not all transactions could be broken down into producing and non-producing acres; therefore, it is shown as a total price to total net acres multiple. The EQT and Rice transaction shows as the most expensive price / acre transaction of the last 20 in the area. In Chart 1, disclosed by RICE and EQT, shows the acreage position with the resource play for RICE. According to this map, RICE has acreage in some of the most prolific and hottest areas in the Marcellus and Utica. Allocating Assets in This Transaction to Fair ValueConsidering the purchase price implications of the Rice Energy transaction, based upon the publicly disclosed information, the assets to allocate to fair value appear as found in Table 5.Does This Transaction Result in a Marcellus and Utica Mega-Producer?The result of this transaction is the potential creation of a Marcellus and Utica mega-producer with over 1.9 million acres, 591 barrels of daily flowing oil equivalent and a stronghold in the gathering pipelines that can transport gas to the East, Midwest, and South in the near future. The implied enterprise value of $24 billion would approximately double the enterprise value of the company next closest in size, Antero Resources.Further Reading on This DealOver the previous week there have been many articles written on this transaction.  We found the following articles most helpful:Rice Energy News Release: EQT To Acquire Ricer Energy for $6.7 BillionEQT Investor Relations: EQT Corporation to Acquire Rice Energy for $6.7 BillionOil & Gas Financial Journal: EQT to Acquire Rice Energy for $6.7 BHow Four Brothers Survived the Gas Bust to Make Family a BillionEQT to Acquire Rice Energy for $6.7 Billion -- UpdateThe EQT Corporation Acquisition of Rice Energy is SmartWith $8.2B Acquisition, Pittsburg’s EQT Becomes America’s Biggest Natural Gas ProducerMercer Capital’s ExperienceMercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals.  Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence.

Past blog posts have covered the almost peculiarly sleepy IPO market in the United States, its causes, and its consequences.  Megan Richards checks in this week to show that not much has changed despite the otherwise buoyant investment landscape.  The steady erosion in the number of publicly traded equities has been a tailwind for the market, and by extension, the investment management industry so far.  Longer term, we see challenges presented by the undercurrent of illiquidity brought about by the unavailability of public offerings as a reliable exit opportunity for private equity. The stock market rallied in the first five months of the year, with the Dow Jones and S&P 500 reaching record highs and continuing to climb.  Nevertheless, IPOs remain scarce compared to prior years.  Just nine venture-backed technology companies have gone public through May, down from 14 IPOs through the same period in 2016.  With the availability of favorable financing options that remain in the private market, the supply and demand balance is changing and companies choosing to go public aren’t following the traditional route anymore.  Snap’s public offering and Spotify’s potential IPO rumblings are indicative of these trends. Between the drought of new investment offerings and increasing support for passive investing that circulated in 2016, investors appear to be desperate to find the next big opportunity.  So even though Snap announced that its public offering of Class A shares would be devoid of voting power, investors still jumped at the chance to own a portion of the company.  Snap’s IPO, with its non-voting shares, was twelve times oversubscribed.  The demand for new public offerings is there, but the supply side is lacking and this imbalance is tipping power away from investors. Only 105 companies went public during 2016, the lowest number since 2009 and 65 fewer than 2015.  Total dollar value of public offerings fell to $18.8 billion from $30.0 billion the prior year.  Despite investor optimism earlier in the year, the IPO environment remains stagnant as we approach the halfway mark of 2017. Many companies are realizing they just don’t need an IPO.  Opportunities for M&A exits still exist, public company oversight is arguably onerous, and alternative sources of funding that are more favorable to the company – and its founders – are becoming increasingly popular. So when companies actually do decide to go public, they are finding ways that benefit the company – and founders – rather than investment banks or large investors.  Spotify announced its consideration of offering public shares later this year, but bucked tradition by stating that it intended to do so through a direct offering.  That means the company could bypass the investment bank, save on placement fees, and offer more of its shares to the general public, rather than to just large institutional investors.  Doing so might mean that Spotify would lose out on a first day share price pop, but with $1 billion in debt financing, Spotify’s public offering could be as much a way to return capital to investors as a way to raise funds for growth. These companies aren’t by any means committed to the IPO route.  AppDynamics has been another widely discussed deal this year after it entered into a transaction with Cisco shortly after announcing its plan to IPO.  With many competing options for startups and the declining appeal of traditional public offerings, public investors may have to settle for less than ideal terms.  In an environment where investor desperation is high and other profitable avenues for startups exist, the startups may be gaining the upper hand when it comes to going public and they are starting to play by their own rules.Related LinksCompensating for Something: Facebook’s GAAP ChangeIf It Was Easy, We’d All Be RichNon-Traditional Venture Investors are Changing The Rules Of The GameHow to Value a Company Planning to IPOMercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Before World War 2, Alfa Romeo developed a successful brand building limited numbers of large, powerful cars for wealthy Italian buyers.  That business model didn’t survive the war, however.  By the 1950s the company realized that, in order to survive, it needed to create smaller and more practical vehicles that could be produced and sold in large volume to the mass-affluent.  The second iteration of the new Alfa Romeo was the 750-series, which included not only a sedan and coupe but also a beautiful Pininfarina-designed convertible that Alfa Romeo romantically dubbed the Giulietta (as in Romeo and Juliette).  The Giulietta was light, mechanically robust, and very sophisticated.  Orders poured in, and Alfa Romeo’s future was assured.As the wealth management industry matures, we are sensing a similar shift to mass-produced wealth management services, building extensive technology platforms and centralized investment management to support broad networks of client service representatives.  What was once the wild-west of commissioned brokers living off the “5% rule” is transitioning to salaried staff and ETFs.  The transition is slow, but industry trends like fee pressure, regulatory upheaval, and partner demographics are persistent motivators.  Ultimately, these industry trends can only lead to one thing for the wealth management community: more M&A.For now, the investment management industry is highly fragmented both in number and in business model.  Even though the 12,000 or so individual RIAs operating in the U.S. mostly derive their revenues from a percentage of assets under management and have expense streams characterized mostly by personnel, office space, and strong coffee, we rarely see two business models that we think are similar to each other.  Investment management firms are reflections of their people - from the approach to investing to the types of clients they attract.  Consequently, putting two firms together is more difficult than a lot of people imagine.Hardly a week goes by that we don’t get asked what we think are optimal qualities of an RIA merger partner.  Answering that always feels a little like giving dating advice: different partners suit different partners.  No one disputes that the industry is ripe for consolidation, but there’s no easy way to “swipe-right” on a target company’s ADV, and it’s pretty unlikely that sec.gov is going to have its own version of Tinder anytime soon.Nevertheless, in honor of today's holiday, here are a few thoughts on what to think about when considering a merger partner.TrustNo amount of committee meetings, reporting metrics, or other disciplined management feedback mechanisms can guarantee how your new co-workers will behave when you aren’t around.  If your trust of their actions is conditional, or grounded in things like incentive compensation, the relationship won’t work for you or for them. People do not even change for their spouses – certainly not for their business partners.  Walk away.Shared ValuesDoes your prospective merger partner see the industry the same way you do?  Is their approach to investing, staff development, and going after new business the same?  Assuming that you and your merger partner have both been around long enough to develop your own way of working, you might learn a thing or two from each other, and you might have some influence over each other – but mostly you will be you, and they will be they.  Make sure you’re okay with that.Similar FriendsI think an underrated due diligence metric on a merger partner is their client demographics.  The type of client served by a merger partner is very telling as to what kind of firm they really are.  If you and your prospective merger partner have similar clients, then you’ll probably have a lot in common after the merger.Common InterestsVegans don’t like seeing bacon in the refrigerator, even if they’re not forced to eat it.  In our experience, firms that favor passive investing do not mix well with avid stock-pickers.  On the front end, it might look like such a merger expands product offerings and investment approaches to the clients of both firms, but in the end your portfolio managers won’t understand each other and will confuse the message for your clients.Compatible GoalsIf you want four kids but your fiancé doesn’t want any, having two kids will not constitute a workable compromise.  If you want to grow your RIA into a large business and sell it, but your merger partner wants to operate his as a practice until he’s too old to work, you’ll have conflict from day two.  Life can change certain individual and business goals, but it helps to have a common baseline at the start.A Good Pre-nupIn our experience, the only thing more contentious than a marital dissolution is a “business divorce.”  Your buy-sell agreement needs to offer a valid “out” that enables the parties to the merger to preserve at least some of their economic substance while maintaining the core business of providing investment management services to clients.  Not only do the partners depend on a good buy-sell agreement, but your employees and your clients do as well.  Granted, the best agreement doesn’t supplant the need to build a mutually beneficial relationship every day, but offering some certainty as to how to wind-down the relationship won’t hurt either.Notice I didn’t say anything about money.  Fee schedules, compensation plans, commitment to IT spending, and all of the numbers matter, of course; but that’s the easiest part of a merger to make work.  The real currency of work is people – so focus on that and the numbers will be what the numbers will be.The best RIA mergers aren’t necessarily composed of “like” firms so much as “like-minded” firms that have different strengths to supplement different weaknesses.  If you can see genuine opportunities with a potential target or acquirer that you cannot see alone or with another firm, then you might have a mutually beneficial relationship.Oh, and if by some chance your merger partner drives an old Alfa Romeo, skip the roses today and give him or her a dozen quarts of motor oil.  It won’t go to waste.

Deal Details 1On January 16, 2017, Noble Energy, Inc. (NBL) announced the acquisition of all Clayton Williams Energy (CWEI) equity for approximately $2.7 billion in NBL stock and cash. Noble Energy is a global independent oil and gas exploration and production company.  Over 50% of their sales volume is generated from domestic onshore production. The Company focuses onshore domestic operations in the DJ, Delaware, and Eagle Ford Basins and the Marcellus Shale. The Company’s acquisition of CWEI demonstrates their effort to accelerate high margin growth by focusing capital in productive regions such as the Permian Basin.Shareholders of CWEI will receive approximately $34.75/share in cash and 2.7874 NBL common shares for each share of CWEI stock. Based on CWEI disclosures, NBL will assume control of 330,000 net acres in the Permian Basin and Giddings area of the Eagle Ford which include 13.6 MBOE of net daily production. The 170,000 net acres in the Permian are located in Ward and Reeves County. Approximately 72% of the current production is crude oil. The transaction indicated a 48% premium to the publicly traded equity value for CWEI.   Noble Energy was willing to pay a premium for the CWEI because the CWEI’s acreage was continuous to Noble’s which provides Noble with potentially cost saving synergies.Based upon the consideration given by NBL, here is the implied market value of invested capital (MVIC) for CWEI: A summary of CWEI’s book value balance sheet is shown below.2 Before venturing into our approach to the allocation, we have compared pricing multiples of the CWEI acquisition and other oil and gas public companies. At the time of the transaction, CWEI owned acreage rights in one of the most popular domestic resource plays, the Delaware Basin. The chart below shows the implied pricing metrics for CWEI versus selected transactions involving companies with a significant presence in the Permian Basin. Noble Energy’s pricing multiples are also presented to show size comparisons. Observations: Noble Energy’s purchase of CWEI was one of the largest acquisitions in the Permian basin over the last few years.Based on BOE per day production, CWEI was priced higher than Yates and SHE, as both companies were producing more than CWEI.Based upon net acres acquired, the CWEI transaction was priced in the middle of Yates and SHE and slightly above its’ suitor NBL.While this acquisition appears to be priced high on the BOEPD metric, the significant amount of acreage acquired by NBL indicates a net acre multiple that is consistent with other transactions.Assets PurchasedThe following maps, disclosed by CWEI, shows the acreage positions within each of the core resource plays, the Permian Basin and the Eagle Ford. The highlighted acquired assets include:65,000 net acres in Reeves County, Texas (Permian Basin map below) with over 100 wells producing or soon to be producing. A target pay zone of 3,500 feet wide (between the depths of 8,000 ft to 11,500 ft,) and 1 rig actively drilling in the area.Eagle Ford shale property includes 160,000 net acreage positions, 40 completed wells, a demonstrated and repeatable drilling program and new well costs of $4m per well. Chairman, President and CEO of NBL David Stover had the following comments on their acquisition: "This transaction brings all the key elements we value: excellent rock quality, a large contiguous acreage position adjacent to our own and robust midstream opportunities, reinforcing the Delaware Basin as a long-term value and growth driver for Noble Energy.""This combination creates the industry's second-largest Southern Delaware Basin acreage position and provides more than 4,200 drilling locations on approximately 120,000 net acres, with over 2 billion barrels of oil equivalent in net unrisked resource."Earlier, we displayed the high level categories for an allocation of purchase price. Two of these categories are oil and gas related assets:  (1) the fixed assets on the balance sheet; and (2) the implied goodwill value. Each of these is inter-related as a majority of the fixed assets are related to the exploration and production of oil and gas resources. Based upon our experience, much of the “implied goodwill” is related to the present value of future benefits of the production of oil and gas. The valuation for current production and proved developed reserves can be straight forward. CWEI more than likely prepared a reserve report which would aid in the valuation of the currently producing wells and the remaining proved reserves. However, the valuation gap between the proved developed reserves and the remaining proved undeveloped, probable and possible reserves or acreage value can be detailed, tedious, and complex. The historically low oil and gas price environment and financial tension within the industry creates a complicated market place for using market transactions as indications of value.More information is needed to drill down into the specifics and valuation of each of the acquired oil and gas assets. Interested parties may want to consider the following information areas:Reserve Reports. Specifically, it is important to understand the amount of acreage in each of the maps above that have been drilled versus what areas are included in the drilling plan, PV 10 indications and price deck assumptions;Drilling plan and synergistic efficiencies. Rarely are specific drilling plans disclosed publicly, but they can be observed at a high level in the reserve report, as well as certain expense assumptions that provide company specific expense profiles for operating and capital expenditures for new wells. NBL’s acquisition of CWEI ranks as a top E&P transactions of 2017, not only because it is one of the first transactions of the year, but compared to 2016, it ranks in the top five in size. Based upon our experience involving public and private companies, we understand that pricing for proven undeveloped, probable and possible reserves have dropped significantly in the previous year, by upwards of 90% in some cases. In addition, due to the nature of the current oil and gas environment, we understand that historical transactions may have little comparability to transactions today and any comparison depends upon the details and assumptions of each transaction. Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals.  Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence. End Notes1 Clayton Williams Energy, September 22, 2016 Johnson Rice Energy Conference Presentation 2 As of September 30, 2016 per S&P Capital IQ

When oil prices collapsed in mid-2014, the M&A market soon came to a standstill as investors waited for clarity regarding the future of the domestic oil and gas market.  The low price environment led to a disconnect between the value of oil and gas reserves and the price that buyers and sellers negotiated in a distressed market.  As prices remained low, deal volume picked up in the beginning of 2016 as companies were forced to sell assets in order to quickly generate cash to pay off debt and avoid bankruptcy.  As the year continued, M&A activity increased and total deal value at the end of 2016 doubled that of 2015.Factors Leading to Increased M&A activity in 2016Price stabilization of crude in the range of $45 to $54 played a role in the increase in M&A activity as investors regained confidence in the sector.Cost reduction in certain plays from new technology has allowed more cost-efficient drilling.The low price environment made distressed companies’ assets acquisition targets as these companies were willing to sell them for heavy discounts.In order to decrease break-even costs, companies merged to realize potential synergies.Recent discoveries and low break-even costs in the Permian Basin attracted investors and producers to the play and increased overall M&A deal volume.Price StabilizationCrude oil price volatility declined over the last year as excess supply began to decline.  Since mid-April of 2016, US crude oil inventories have declined by approximately 6%.   Additionally, OPEC production declined in the second quarter of 2016 and had slower-than-normal growth in the fourth quarter, which helped to reduce excess supply 1.Cost ReductionIn a stacked play, multiple horizontal wells can be drilled from one main wellbore.  This provides increased productivity as multilateral wells have greater drainage areas than single wellbore.  Additionally, it can reduce overall drilling risk and cost.  For deep reservoirs, a multilateral well eliminates the cost of drilling the total depth twice.  In some plays such as the Permian, the reservoir is deep enough at some points that operators can drill multiple horizontal wells from one main wellbore. This advancement of drilling technology has allowed producers in certain plays to reduce costs so that drilling in lower price environment is economically feasible.Only the Strong SurviveIn early 2016, banks decreased lending to oil and gas companies.  In a low price environment, the value of a company’s reserves falls when valued using a traditional PV-10 calculation. Lower valuations have led to decreased borrowing capacity, which in turn has caused cash flow pressure for many companies.  Thus many companies have had to sell non-core assets in order to ease cash flow pressures.  But in order to generate liquidity quickly, they often were forced to accept heavily discounted prices.  This increased deal volume in 2016 as many companies tried to avoid bankruptcy and buyers moved quickly to get their hands on cheap assets.Mergers for SynergiesAs companies worked to reduce break-even prices, many looked for strategic acquisition targets in hopes of realizing operational efficiencies which could reduce costs and give them a competitive advantage in the market.  This increased the number of mergers in 2016 in the E&P industry and also in the midstream sector which benefits from the network effect.The Permian BasinApproximately $69 billion dollars of North American E&P assets and companies changed ownership during 2016 with the Permian Basin resource accounting for nearly 40% of the deal dollar volume. The most significant trend in E&P this year was production companies’ move to the Permian Basin.  Out of the 15 deals that were valued at over $1 billion, 8 were in the Permian Basin.  The Permian became the center of the M&A stage due to its low drilling costs, resource diversity, and large remaining reserves.  Although the Permian was discovered in the 1920s, the true potential of the Permian was not realized until 2007 when hydraulic fracturing techniques were used to access the tight sand layers of the play. Since then the Permian has been revitalized as producers have begun using unconventional drilling techniques in addition to traditional vertical wells. Because the crude in the shale layers has only recently been explored, there are still tremendous reserves left.  Just this year the USGS announced an estimated 20 billion barrels of crude oil, 1.6 billion barrels of NGLs, and 16 trillion cubic feet of natural gas were discovered in four layers of shale in the Wolfcamp formation.  Additionally, the Permian is a stacked play—which means that companies can drill multi-lateral horizontal wells to reduce costs.  And, companies that operate in the Permian do not have to choose between oil and gas, but can diversify operations. Last week, we briefly looked at the six largest transactions in 2016.  Recent asset deals in the US are summarized below. Due to the factors discussed above, average deals in Permian transacted at higher dollar per-acre multiples than other plays such as the Williston Basin. When prices declined, production in the Permian continued increasing while production in other domestic plays such as the Bakken and the Eagle Ford declined significantly.  Unlike the Eagle Ford and the Bakken, which are mostly drilled for oil, the Permian holds a more diverse combination of oil, gas, and NGLs, making it more economical to produce at low prices. The Bakken was center stage in the early 2000s during the onset of hydraulic fracturing.  The Eagle Ford, which was once the most active shale plays in the world, was the center of the M&A market in 2013 and 2014 when drilling activities increased there.  M&A in the Eagle Ford and Bakken was sluggish in 2016, and the transactions that did occur there were largely motivated by distressed companies looking for liquidity or an exit. M&A OverviewM&A activity is expected to remain strong in 2017.  It is expected that OPEC will follow through on production cuts and excess inventory should be absorbed in early 2017.  This will cause the price of oil to continue increasing.   As the price of oil continues to rise, drilling in other plays besides the Permian Basin will begin to become more economical and M&A activity should increase in other plays.  However, it is expected that oil and gas companies will have to turn to private equity in order to gain liquidity as banks remain cautious in lending to the energy sector.End Note1 Data from Bloomberg

Last Christmas, a gift grab almost ripped my entire family apart.  If you have never participated in a gift grab and all of its associated horrors, the rules are simple enough.  Each participant is tasked with finding a gift under a specific price point that (hopefully) everyone would enjoy.  On the day of the gift exchange, numbers are drawn by random to determine the order, with the first player choosing a gift to open, and the second player choosing whether to steal the opened gift or open a new one, and so on.  If a player has a gift stolen from them, they get to open a new gift.What was supposed to be a “fun” game soon devolved into a sort of passive-aggressive warfare, the likes of which I have never seen.  By the time every gift had been allotted, factions had been made, treaties broken, and at least three of us were on the verge of tears.  I, meanwhile, was happy as a clam with my punny bag of “hand soap” – quite literally, soap shaped into little hands that was once lovingly described as looking like a “bag of amputated baby hands.”  No one else wanted them, but what can I say; I’m a sucker for word play.As inspiration for fair deals and perfect swaps, we looked into Midland State Bancorp’s recent acquisition of Sterling National Bank’s trust department.  From what we’ve read about the deal, it appears both parties walked away with what they wanted.In November of 2014, Sterling National Bank announced the acquisition of Hudson Valley Bank (“HVB”) in order to expand Sterling’s loan and deposit market into the greater New York City metropolitan area.  The deal was a lucrative one in terms of both market expansion and balance sheet growth.  As of the closing in June of 2015, Sterling acquired 28 new branches across five counties, with $288 million in assets, $1.8 billion in loans, and $3.2 billion in deposits.  Along with the deal, however, Sterling also happened to acquire HVB’s small, but not immaterial, trust department with over $423 million in managed assets.  The only problem was that Sterling had opened an additive gift that they did not have the structure for and was too small to stand on its own, but too large to ignore.Midland States Bank announced its acquisition of Sterling’s wealth management assets in February of this year, the majority if which happened to be in Special Needs and Settlement Trusts.  Midland’s structure was well suited for the deal, with a specialty in trusts that had developed through a prior acquisition in 2013.  The deal closed for $4.8 million, retaining all 12 members of Sterling’s trust department, and bringing its wealth management AUM up to $1.6 billion.  The EBITDA margin was not disclosed in the announcement of the deal (the fact that the price alone was reported, is unusual), but following a typical EBITDA margin of 20% to 30% for a trust department, the deal falls within a range of EBITDA multiples from 5.7x to 8.6x.  The midpoint of the range, 6.8x, depicts a strategic sale that was neither a fire sale nor a purse buster. This appears to be a gift exchange done well – greater manpower and AUM for Midland’s trust department, and a cleaner balance sheet and some cash to boot for Sterling’s bank practice - a strategic deal for both buyer and seller.  My family should take note. With another holiday season upon us, we hope that if you get dragged into a gift grab, your gift be perfect for you.  And if you’re in need of some creepy soap, I know a guy… Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry. Follow us on Twitter @RIA_Mercer.

Though probably not as historic as Plymouth landing or even the Eddie Murphy comedy, Henderson’s purchase of Denver RIA Janus Capital last month is a rare sign of confidence in active managers that have been losing ground to passive investors for quite some time.  The era of ETFs and indexing has dominated asset flows for quite some time, so this transaction seems to counter the recent trend.Last week, we touched on the recent election’s possible impact on active management, and the gist of it is that potentially heightened volatility and lower asset correlations under a Trump presidency could bode well for stock and bond pickers (though most fixed income investors would not agree with that position at the moment).  Indeed, a quick look at active manager pricing over the last two weeks shows several industry leaders (Pzena, Diamond Hill, Hennessy, GAMCO, etc.) up 10% to 20% since the election.  Investor sentiment seems to be shifting, or is at least less bearish on the sector than just a few months ago.As for whether JNS or HGG will be more likely to give thanks this Thursday, both sides are up modestly since the deal was announced in early October, though it has been a rocky seven weeks.  Janus-Henderson should benefit from the ability to cross-sell each other’s products, though it is often harder to capitalize on this potential in practice.  They’ve also both been adversely affected by asset flows out of active strategies, but are now poised to benefit from any semblance of mean reversion.  With Janus serving primarily U.S. investors with domestic funds and Henderson having more of a European and global focus, there doesn’t appear to be much product overlap either.  Janus CEO Dick Weil recently told analysts that the two companies are “almost mirror images of each other on opposite sides of the Atlantic,” and they certainly do seem to complement one another.  Since Janus shareholders will now benefit from a lower (UK) corporate tax rate (and Thanksgiving is not celebrated in England), we suspect they’ll be more inclined to give thanks on turkey day.Looking strictly at the economics of the deal in the context of other recent transactions that we’ve analyzed, it doesn’t appear that Henderson overpaid for Janus with earnings and activity (revenue and AUM) metrics reasonably in line with precedent multiples.  Given the size of Janus and expected synergies ($110 million in annual net costs savings) of the deal, one might have expected a higher valuation, but recent share price volatility and client outflows likely precluded much of a premium.  Putting it all together, the transaction price appears appropriate to both sides from a financial perspective. One potential wrinkle in the deal is how famed 72 year-old bond investor, Bill Gross, and his new total return fund will be managed by the merged entity.  There is also the question of his succession planning and client retention once he finally retires, since there’s certainly the possibility that all those (non-Gross) assets could flow back to PIMCO or another actively managed bond fund.  Since Gross’ former co-manager, Kumar Palghat, recently left for another bond fund at Janus and his former boss, Dick Weil, just moved to Henderson’s offices in London (while Gross remains in Newport Beach), investors may hold some concern over the former bond king’s further alienation from the rest of the company. At this point, we don’t yet know if the Janus-Henderson marriage will end up as happily as Prince Joffer’s, but since Janus is named after the ancient Roman god of change and new beginnings, we’re hopeful for a smooth transition.

On October 13, 2016 RSP Permian (RSPP) announced the acquisition of Silver Hill Energy (SHE) for approximately $2.4 billion dollars. SHE will receive approximately $1.182 billion in RSPP common stock and $1.25 billion in cash. Based on RSPP disclosures, the assets received include (1) wells currently producing 15,000 barrels of oil equivalent per day (BOEPD); and (2) 41,000 in net acreage throughout Loving and Winkler County Texas. Approximately 69% of the current production is crude oil. Based upon the consideration given by RSPP, here is the implied market value of invested capital (MVIC) for SHE: The other side of the transaction ledger is the value of the individual assets acquired. Since SHE is not a public company, allocating the purchase price to the individual assets is, dare we say, educated guesswork at best. Here is our guestimate of the assets that will need allocated value. 1 Before venturing into our approach to the allocation, we have compared pricing multiples of the SHE acquisition and other oil and gas public companies. At the time of the transaction, SHE owned acreage rights in one of the most popular domestic resource plays, the Delaware Basin. The chart below shows the implied pricing metrics for SHE versus the market pricing multiples for publicly traded operators in the Delaware Basin. Valuation Metrics Based upon these ratios2, we have the following observations: RSPP is approximately 2x larger than SHE;Of the seven public companies, SHE is very close in size to Matador Resources Company (MTDR). SHE has acreage adjacent to acreage operated by MTDR;Based on per day production, the SHE transaction was priced at the highest indicated value;Based upon net acres acquired, the SHE transaction was priced at the higher end of the indicated value of all the publicly traded companies. Note that approximately 95% of the acreage acquired is considered developed; Based upon these observations, we have the following commentary on SHE:It appears the majority of SHE’s asset values are in the producing 58 wells: 95% of the 41,000 net acreage is considered producing;49 of the 58 producing wells are horizontal;Less than 5% of the net acres are undeveloped;58 wells over 39,050 acres equates to well spacing of one per 673 acres. While 49 are horizontal wells, it appears they may be opportunities to add additional wells;Additionally, with less than 5% of the net acres to be explored, a higher than average BOEPD multiple may be explainable.Lastly, based on the data reviewed to date and the location of SHE’s acreage, RSPP may have identified opportunities to recomplete existing wells, with longer lateral and horizontal wells which may produce from other resource plays within the area. The following map, disclosed by RSPP, shows the acreage position within the resource play as well as the depths of the highly sought after Wolfcamp resource. According to this map, SHE’s acreage is centered in the deepest portions of the Wolfcamp, approximately 7,500 to 8,500+ feet. This location allows for penetration into multiple zones. RSPP has thus far identified seven zones they would target. Additionally RSPP has identified other wells around the acquired acreage (shown below) that have seen success from multi-zone production. Some of these wells are that of SHE, others from competing operators. 3 Assets PurchasedEarlier, we displayed the high level categories for an allocation of purchase price. Three of these categories are oil and gas related assets: (1) 58 wells currently producing 15,000 barrels of oil equivalent per day; (2) proved developed reserves; and (3) 41,000 net acres, of which 5% are considered undeveloped. The valuation for current production and proved developed reserves is fairly straight forward. No doubt SHE prepared a reserve report which would aid in the valuation of the currently producing wells and the remaining proved reserves. However, the valuation gap between the proved developed reserves and the remaining proved undeveloped, probable and possible reserves or acreage value can be detailed, tedious, and complex. The historically low oil and gas price environment and financial tension within the industry creates a complicated market place for using market transactions as indications of value.More information is needed to drill down into the specifics and valuation of each of the acquired oil and gas assets. Interested parties may want to consider the following information areas:Reserve Reports. Specifically, we would like to understand the amount of acreage in each of the maps above that have been drilled versus what areas are included in the drilling plan, PV 10 indications and price deck assumptions;Financial Statements. It would also be helpful to understand more about SHE’s decision to sell and perhaps the financial situation immediately prior to the sale. If SHE was backed by private equity investors rather than a typical oil and gas operator, management could have had different reasons to exit their investments. Timing may also have played a part as Permian dominated assets currently appear to be selling for a Premium compared to other domestic plays.Synergistic efficiencies. Drilling efficiencies have been disclosed by RSPP, but we don’t know how many are new well locations verses recompletion of existing into multiple resource plays. Much of the acquisition details have not been disclosed, and we’ll wait for additional filings from RSPP to learn more. Regardless, RSPP’s acquisition of SHE ranks as a top five E&P related transactions of 2016 based on size and analyzing available information can help us to better understand the current marketplace. Based upon our experience involving private companies, we understand that pricing for proven undeveloped, probable and possible reserves have dropped significantly in the previous year, by upwards of 90% in some cases. In addition, due to the nature of the current oil and gas environment, we understand that the historical transactions may have little comparability to today. Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence. End Notes1 We have used publicly available information. As such this is a high level summary of approaching an allocation without having all the needed information. 2 BOEPD = Barrels of Oil Equivalent Produced Per Day PD Reserves = Proved Developed Reserves 3 RSP Investor Presentation Acquisition of Silver Hill on October 13, 2016

In the late 1960s, BMW introduced a simple product that made the company what it is today.  The 2002 was a straightforward, useful, two door coupe with a small but powerful motor, light weight, four seats, and a decent trunk.  It was economical, easy to work on, and fun.  It sold like crazy, and morphed over time into what is now known as their 3-series, the mainstay of their global automotive line.  One lesson from this trajectory is that strategy doesn’t have to be complicated to be successful – a lesson that has broad applications, including the topic of this blog post.It’s no secret that banks are facing tough times, with lousy spreads, exponential increases in regulation, indifferent customers, and cunning competition.  There are many fancy ways to navigate this, but one simple one is deploying capital in attractive financial businesses that generate strong margins – such as asset management.Banks looking to diversify their revenue stream with investment management fee income would be well advised to study TriState Capital’s acquisition-fueled buildout of its RIA, Chartwell.  The Pittsburgh depository started with an internal wealth management arm, bought $7.5 billion wealth manager Chartwell Investment Partners in early 2014, picked up the $2.5 billion Killen Group in late 2015, and last week announced the acquisition of a $4.0 billion domestic fixed income platform strategy from Aberdeen Asset Management.The Aberdeen acquisition represents about $4.0 billion in domestic fixed income over four strategies.  Realized fees appear to be just shy of 20 basis points.  Six portfolio managers from Aberdeen are coming with the acquisition, and the operation looks fairly profitable on a pro forma basis, with TSC expecting EBITDA on the order of $3.5 million (annualized on a run rate basis), for a margin of approximately 45%.A few things stand out about the TriState/Aberdeen acquisition.Consistent acquisition criteria. TSC has a well-defined acquisition criterion for growing the RIA that has remained consistent from the original Chartwell acquisition.  Appropriate and well-defined criteria are significant for any bank looking to augment asset management products through acquisition, because in many cases there are too many, often dissimilar, RIAs from which to choose.  TSC seeks out asset management capabilities with compatible product structures, competent management teams, and consistent profitability that will grow and enhance their existing business.  They also have consistently shopped within their existing geographic markets.Attractive Pricing.  TriState’s acquisitions are consistently well-bought.  Aberdeen had a strategic motivation to sell these fixed income products, which were a small enough part of their overall business to let go of fairly cheaply.  As a consequence, TSC is paying 1.5x run-rate revenue, and more importantly, a little less than 4.0x EBITDA – a very compelling valuation that sets up TriState Chartwell for an attractive internal rate of return.Embracing the RIA Strategy.  TSC appears to have gotten past the usual cultural angst that depository institutions have developing an RIA.  The TriState investment management business has a separate identity, and it doesn’t seem to bother bank management that these acquisitions are dilutive to the bank’s tangible book value – in fact, they don’t even mention it.  The RIA does what it is supposed to do – deploy the bank’s excess capital to produce discretionary cash flow.  The bank’s earnings grow, and so does the bank’s valuation. With the latest acquisition, TSC has nearly doubled run-rate assets under management since 2014, putting excess capital at the bank to work in attractively priced acquisitions which have been individually and collectively accretive to earnings.  The strategy has worked well for TriState, and investors have taken notice.  Over the past two years, TSC’s share price is up nearly 80%, while SNL Securities’ Small Cap U.S. Bank Index is up less than half that much.  Asset managers in general have fared much worse, with the broad U.S. Asset Manager Index constructed by SNL showing a modest decline over the same period. Many banks are understandably wary of trying their hand at investment management.  RIAs are a different kind of financial institution in every way, cross-selling is often more myth than reality, and it can be difficult to explain to bank investors how to reconcile the differences in investment management performance characteristics and more traditional bank measures.  Still, in a world where banks are caught in the gravitational pull of low NIMs and Basel III, and the asset management industry is in need of consolidation, there is ample reason to consider the possibilities of pairing up for mutual success.

Last week, we looked at the recent transition of E&P companies out of the Bakken and the Eagle Ford to the Permian.  We concluded that E&P companies are moving to the Permian for its (1) upside potential, (2) low break even prices, and (3) diversity of resources.  This week M&A activity reinforced this idea.  In the last week, there were 18 E&P deals in the U.S.1  Seven of those transactions were in the Permian and over half of the total deal value generated ($768 million in total) from September 30 to October 6 was in the Permian.  Today we focus on two transactions: Resolute Energy’s acquisition of Delaware Basin Acreage and Apollo and Post Oak Energy’s merger to form Double Eagle Energy Permian.  Before we drill down the details of these transactions, here’s a breakdown of total announced deal value generated in the U.S. this year.Resolute Energy / Firewheel Energy TransactionResolute Energy, a Denver based company, received notice twice in 2015 that it was at risk of being delisted from the NYSE and its EBITDA fell so low that the Company considered a Chapter 11 restructuring in late 2015.   The Company sold its Powder River and Midland Basin assets for $275 million which allowed it to reduce its debt and increase its drilling activity in the Delaware Basin. Since then they have more than tripled their Delaware Basin output.  They estimated third quarter output for 2016 to be between 16,000 and 16,500 Boe/d, which is a 37% increase from the second quarter of 2015.On October 4 Resolute announced its acquisition of 3,293 acres in the Delaware Basin from Firewheel Energy, a portfolio Company of EnCap Investments. The acquired acreage will increase Resolute’s position in Reeves County in the Delaware Basin by 25%, according to their press release.  The acquired acreage includes thirteen horizontal and fifteen vertical wells, which produce approximately 1,200 Boe/d.Resolute’s purchase price consisted of $90 million payable in cash and $45 million payable in common stock.  Although Resolute’s stock had been at risk of being delisted just 9 months prior, the Company was able to increase the value of its stock by refocusing operations in the Permian, which investors have lately placed a premium on, and by participating in a one-for-five reverse stock split. This allowed the Company to fund this transaction with common stock and generate cash to fund the acquisition with an offering of a new class of preferred shares.Resolute reported the value of the Proved reserves as $45.8 million and Undeveloped Acreage as $79.8 million.Double Eagle Lone Star LLC / Veritas Energy Partners Holdings LLC MergerTwo private-equity backed E&P companies recently merged their Permian focused operations.  Double Eagle Lone Star LLC, an affiliate of Apollo Global Management, assembled a portfolio of assets in the Powder River Basin, the DJ Basin, Mid-Continent, Eagle Ford and Permian. The Company sold its SCOOP (South Central Oklahoma Oil Province) and STACK (Sooner Trend Anadarko Basin Canadian and Kingfisher Counties) assets for $250 million in order to transition its focus away from Anadarko Basin in Oklahoma to the Permian in west Texas.  Veritas Energy acquired acreage mainly in the Midland Basin and Fort Worth Area and formed a partnership with Post Oak Energy Capital to focus on increasing acreage in the Midland Basin.  The two announced their merger on October 3rd.  The new Company will have more than 63,000 net acres in the Permian’s Midland Basin.  The deal values were not disclosed.Analysts with 1Derrick predict that the Company was formed in order to prepare for an IPO in order to take advantage of the high equity valuations of pure play Permian producers.  Industry averages of EV/ Boe of proved reserves are estimated to be $13.45, while Permian producers multiples are often higher than $25 / Boe.2In order to prepare for an IPO, however, Double Eagle Permian will have to focus on developing its assets as only 70% of the assets are currently operated. The Texas Railroad commission reports that the combined Texas production of both Double Eagle and Veritas is about 3,000 Boe/d. The appeal of the Permian to market participants is the low cost of drilling. Thus in order to reach its full potential, the Company must be able to achieve the double-digit production growth that many of its peers have.These two transactions demonstrate that market is currently placing high value on the equity of companies located in the Permian and E&P companies are doing what they can to take advantage of this.  Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels, and other minerals.  We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs.End Notes1Only includes packages valued at greater than $100 million. 21Derrick

M&A activity in the exploration and production industry has recovered from the standstill experienced one year ago as oil and gas companies waited to see what the market would throw at them next. When crude oil prices dropped, companies reduced their exploration budgets and stopped drilling new wells. When prices remained low, many companies began to sell off non-core assets in order to generate cash to pay off debt. Companies, who cut drilling activity when prices collapsed, are now looking to replace their reserves through acquisitions. Bloomberg analysts predict that the majority of M&A activity going forward will be asset purchases as E&P companies look to acquire more than 50% of their reserve replacement.The majority of these transactions have occurred in the Permian. This year, 38% of total E&P deal value was generated from deals in the Permian, and 24% of the number of total deals occurred in the Permian.1 This demonstrates that more deals and larger deals are happening in the Permian than in other plays in the U.S. Last week we looked in depth at EOG’s acquisition of Yates Petroleum for $2.5 billion. The acquisition helped EOG shift from the Eagle Ford into the Permian. EOG’s CEO Bill Thomas told investors, “We’ll be able to grow oil (production) with less capital and more efficiently than we do now.” EOG’s share price rose by more than 6% the day after the transaction. E&P companies are flocking to the Permian for many reasons, including its (1) upside potential, (2) low break even prices, and (3) diversity of resources. Upside PotentialAlthough the Permian was discovered in the 1920s, the true potential of the Permian was not realized until 2007 when hydraulic fracturing techniques were used to access the tight sand layers of the play. Since then the Permian has been revitalized as producers have begun using unconventional drilling techniques in addition to traditional vertical wells. Because the crude in the shale layers have only recently been explored, there are still tremendous reserves left.Low Breakeven PricesThe Permian has low break even prices compared to other reserves in the U.S. Although production costs may not be as low as Pioneer Natural Resources CEO, Scott Sheffield, boasted ($2.25 per barrel excluding taxes), costs are lower than other plays due to the geological makeup of the shale.The Permian is a stacked play which means that multiple horizontal wells can be drilled from one main wellbore. This provides increased productivity as multilateral wells have greater drainage areas than single wellbore. Additionally, it can reduce overall drilling risk and cost. For deep reservoirs like the Permian, a multilateral well eliminates the cost of drilling the total depth twice.2In many plays, the low price of crude oil has made drilling uneconomical. Many companies are trying to acquire acreage in the Permian, where production is cheaper, because it is unclear when crude prices will rise and if they will ever rise to the same levels as before.Diversity of ResourcesThe Permian is the largest producer of oil and the second largest producer of gas, after the Marcellus. Even as gas prices collapsed, production in the Permian increased. Companies that operate in the Permian do not have to choose between oil and gas, but can diversify operations. The market for commodities is inherently risky because producers are price takers. Although related, the price of natural gas and crude oil are not perfectly correlated. Thus when the price of natural gas fell six years ago, producers in the Marcellus and Utica were entirely exposed to the natural gas market, while producers in the Permian were able to rely on their profits from crude oil to fund operations. Exploration and Production companies are trying to get their hands on acreage in the Permian now before the next swing in crude oil prices. OPEC agreed on Wednesday to cut its production of crude oil. IEA analysts believe that the proposed cuts to between 32.5 million and 33 million barrels per day would bring production back in line with demand until the second half of 2017. Definitive policies are expected to be set in November, but there still remains doubt that the deal will be able to relieve supply due to OPEC’s inability to enforce these quotas. This uncertainty about the future price of crude oil has caused producers to leave other plays and increase their acreage in the Permian. Consequently, this has increased acreage prices in the Permian compared to other plays, such as the Bakken and Eagle Ford. A summary of some transactions in the Permian this year is shown below. Callon Petroleum increased its position in the Permian the same day as the EOG / Yates transaction. Callon was traditionally an offshore driller in the Gulf of Mexico. They began shifting out of the Gulf in 2010 due to the high costs of offshore drilling and sold their last offshore asset in 2013. Since then the company has steadily been increasing its stake in the Permian. Since the second quarter of last year the Company has increased production by 56%, while at the same time reducing capital expenditures by 48%.3 The company has recently been using its highly valued stock to fund acquisitions in the Permian. The price of Callon’s stock price has tripled since January even though they have increased their shares outstanding by 50% over the same time period. This demonstrates investor’s confidence in the Permian. The valuation implications of reserves and acreage can swing dramatically in resource plays. Utilizing an experienced oil and gas reserve appraiser can help to understand how location impacts valuation issues in this current environment. Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels, and other minerals. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs. End Notes1 1Derrick 2 New Aspects of Multilateral Well Construction. Fraija, José; Ohmer, Hervé; and Pulick, Tom. Online Available at http://www.slb.com/~/media/Files/resources/oilfield_review/ors02/aut02/p52_69.ashx. 3 1Derrick

On September 6, 2016 EOG Resources (EOG) announced the acquisition of Yates Petroleum (Yates) for approximately $2.4 billion dollars, by our calculations. Yates will receive approximately $2.2 billion in EOG common stock and $37 million in cash. In addition, EOG assumed $114 million (net) in Yates debt.1 Based on EOG’s disclosures, the assets received by EOG include (1) Wells currently producing 29,600 barrels of oil equivalent per day (BOEPD); (2) proved developed reserves of 44 million barrels of oil equivalent; and (3) 1.624 million in net acreage throughout New Mexico, Wyoming, Colorado, Montana, North Dakota and Utah. Approximately 48% of the current production and proved developed reserves are crude oil. Based upon the consideration given by EOG, here is the implied market value of invested capital (MVIC) for Yates: The other side of the transaction ledger is the value of the individual assets acquired. Since Yates is not a public company, allocating the purchase price to the individual assets is, dare we say, educated guesswork at best. Here is our guestimate of the assets that will need allocated value and their key information items.2 Before venturing into our approach to the allocation, we have compared pricing multiples of the Yates acquisition and other oil and gas public companies. At the time of the transaction, Yates owned acreage rights in several domestic resource plays with the most popular resource play of 186,000 net acres in the Delaware Basin. The below chart shows the implied pricing metrics for Yates versus the market pricing multiples for publicly traded operators in the Delaware Basin. Valuation MetricsBased upon these ratios, we have the following observations:3EOG is approximately 25x larger than Yates;Of the six public companies, Yates is very close in size to Matador Resources Company (MTDR);Based on per day production, the Yates transaction was priced at the lowest indicated value except for Apache Corp (APA);Based upon net acres acquired, the Yates transaction was priced at the lowest indicated value of all the publicly traded companies;Based on proved developed reserves, the Yates transaction was priced at the highest indicated value of the group. Based upon these observations, we have the following commentary on Yates:The attractive upside for Yates is not in the current production, but in the undeveloped acreage, possibly adjacent to EOG acreage (explains the low MVIC to BOEPD metric);Of the acreage that Yates owned, a large majority of it is not highly coveted by Yates and EOG (explains the low MVIC to net acre metric);Of the proved developed reserves known by Yates, EOG believes they can develop significantly more reserves in the future (explains the high MVIC to proved developed reserves metric);As the interest for EOG does not appear to be in vast amounts of acreage that Yates owns, the current production nor the developed reserve, this leads us to believe the highly coveted Delaware Basin positions were the primary drivers for the acquisition.Assets PurchasedEarlier, we displayed the high level categories for an allocation of purchase price. Three of these categories are oil and gas related assets: (1) Wells currently producing 29,600 barrels of oil equivalent per day; (2) proved developed reserves of 44 million barrels of oil equivalent; and (3) 1.624 million in net acreage. The valuation for current production and proved developed reserves is fairly straight forward. No doubt Yates prepared a reserve report which would aid in the valuation of the currently producing wells and the remaining proved reserves. However, the valuation gap between the proved developed reserves and the remaining proved undeveloped, probable and possible reserves or acreage value can be detailed, tedious, and complex. The historically low oil and gas price environment and financial tension within the industry creates a complicated market place for using market transactions as indications of value.Acreage Owned by Yates The highly publicized acreage includes: (1) 186,000 net acres in the Delaware Basin; (2) 138,000 net acres in the Northwest Shelf; (3) 200,000 net acres in the Powder River Basin and (4) other western basins which add up to 1.1 million net acres. The following maps, disclosed by EOG, show the resource plays Yates owned acreage within. These resource plays range from Texas to Canada. Of the eight resource plays named in the map, EOG classifies two as the “best plays”. These are the Delaware Basin and the Powder River Basin. Delaware Basin EOG then allows us a closer look at the location of Yates acreage in the Delaware Basin in comparison to EOG’s acreage. Many instances exist where Yates acreage is right next to EOG’s acreage, this could allow for longer and more cost effective lateral wells. Market transactions for acreage in this area vary significantly based on seller motivation, buyer synergies and commodity price timing. Our experience indicates acreage rights historically transact from $50 per acre to $14,000 per acre and above, depending on location. Northwest Shelf Another map comparing Yates and EOG’s acreage location in the Northwest Shelf shows less instances where the two companies acreage is connected but clearly demonstrates Yates is seemingly centered in the most desired areas of the Northwest Shelf. In addition to these two plays, the map shows Yates acreage located in northern Chaves and Lea counties. EOG does not show any acreage in these areas. Our historical transaction data indicates acreage rights transact for $50 to $350 per acre in northern Chaves, Lea, and Roosevelt counties. Compare this to the Delaware Basin and Northwest Shelf areas which have spots that historically transact for $5,000 per acre and above. Powder River Basin EOG also discusses their interest in the Powder River Basin. As the map shows, EOG has significant acreage positions in the middle of the play. Similarly, Yates has large clumps of acreage rights in the same general area and in some cases, right next to EOG. This tends to indicate efficient drilling benefits may exist in the Powder River Basin too. Similar to the resource plays in New Mexico, acreage rights pricing varies widely by location. Drilling DeeperMore information is needed to drill down into the specifics and valuation of each of the acquired oil and gas assets. Interested parties may want to consider the following information areas:Reserve Reports. Specifically, we would like to understand the amount of acreage in each of the maps above that have been drilled versus what areas are included in the drilling plan, PV 10 indications and price deck assumptions.Financial Statements. It would also be helpful to understand more about Yate’s decision to sell, and perhaps, the financial situation immediately prior to the sale. What we know is approximately 48% of the current production is oil which leaves 52% of the production as either natural gas or natural gas liquids. This leads us to ask: is Yates an example of oil prices exposing a struggling natural gas company? Yates had $245 million in debt, and $114 million in net debt. Based upon our calculated $2.3 billion MVIC indication, debt is approximately 4.85% of the capital structure. While this is just a guess on our part, this doesn’t indicate a financially stressed company. It does make us question their ability to obtain additional financing for new wells.Synergistic efficiencies. Drilling efficiencies have been disclosed by EOG, but we don’t know how many new well locations EOG created by having access to Yates acreage. Yates may not have been able to release on their own for many reasons. Much of the acquisition details have not been disclosed and we’ll wait for additional filings from EOG to learn more. Regardless, EOG’s acquisition of Yates was one of the largest E&P related transactions of 2016 and analyzing available information can help us to better understand the current marketplace. Based upon our experience involving private companies, we understand that pricing for proven undeveloped, probable and possible reserves have dropped significantly in the previous year, by upwards of 90% in some cases. In addition, due to the nature of the current oil and gas environment, we understand that the historical transactions may have little comparability to today. Mercer Capital has significant experience valuing assets and companies in the energy industry, primarily oil and gas, bio fuels, and other minerals. Our oil and gas valuations have been reviewed and relied on by buyers and sellers and Big 4 Auditors. These oil and gas related valuations have been utilized to support valuations for IRS Estate and Gift Tax, GAAP accounting, and litigation purposes. We have performed oil and gas valuations and associated oil and gas reserves domestically throughout the United States and in foreign countries. Contact a Mercer Capital professional today to discuss your valuation needs in confidence. End Notes1 $245 million in Yates debt less $131 million in Yates cash 2 We have used publicly available information. As such this is a high level summary of approaching an allocation without having all the needed information. 3 BOEPD = Barrels of Oil Equivalent Produced Per Day, PD Reserves = Proved Developed Reserves

Culture trumps everything.  A big part of RIA consolidators’ pitch to target firms is that they can trade paper, give the sellers access to their administrative and marketing infrastructure, but keep their unique culture.  We’ll hear more about this as Focus Financial gets closer to their IPO. MOEs (mergers of equals) are a different animal, and not just because “some of us are more equal than others” (ask Tom Hiddleston).  When firms of similar size join forces to get a bigger footprint, solve leadership issues, stop advisors from competing with each other, etc. – realizing those benefits is the easy part.  The hard work happens because different firms have different histories, and different histories create different cultures.  Blending cultures can be awkward.  My father was on a business trip in Asia at Christmastime 30 years ago.  He walked into a large mainline department store in Tokyo and was stunned at the holiday display just inside the front door: Santa Claus on a cross (!).I don’t know that Pathstone Federal Street is going to have quite as difficult a time merging in Convergent Wealth Advisors, but no doubt there will be moments.   If it works, others will want to follow suit.  If it doesn’t, it will be a cautionary tale we’ll talk about for some time.  For now, it might be helpful for RIA managers considering MOEs to read the following piece written by one of our colleagues, Jeff Davis.  Jeff usually works with depository institutions, but no doubt his checklist of dos and don’ts for MOEs will ring true in the investment management community as well.– Matthew R. Crow, ASA, CFA When asked about his view of a tie years before the NCAA instituted the playoff format in the 1990s, Coach Bear Bryant famously described the outcome as “kissing your sister.” If he were a portfolio manager holding a position in a company that entered into a merger of equals (MOE), his response might be the same. Wall Street generally does not like MOEs unless the benefits are utterly obvious and/or one or both parties had no other path to create shareholder value. In some instances, MOEs may be an intermediate step to a larger transaction that unlocks value. National Commerce Financial Corporation CEO Tom Garrott once told me that part of his rationale for entering into a $1.6 billion MOE with CCB Financial Corp. in 2000 that resulted in CCB owning 47% of the company was because bankers told him he needed a bigger retail footprint to elicit top dollar in a sale. It worked. National Commerce agreed to be acquired by SunTrust Banks, Inc. in 2004 in a deal that was valued at $7 billion.Kissing Your Sister?MOEs, like acquisitions, typically look good in a PowerPoint presentation, but can be tough to execute. Busts from the past include Daimler-Benz/Chrysler Corporation and AOL/Time Warner. Among banks the 1994 combination of Cleveland-based Society Corporation and Albany-based KeyCorp was considered to be a struggle for several years, while the 1995 combination of North Carolina-based Southern National Corp. and BB&T Financial Corporation was deemed a success.The arbiter between success and failure for MOEs typically is culture, unless the combination was just a triumph of investment banking and hubris, as was the case with AOL/Time Warner. The post-merger KeyCorp struggled because Society was a centralized, commercial-lending powerhouse compared to the decentralized, retail-focused KeyCorp. Elements of both executive management teams stuck around. Southern National, which took the BB&T name, paid the then legacy BB&T management to go away. At the time there was outrage expressed among investors at the amount, but CEO John Allison noted it was necessary to ensure success with one management team in charge. Likewise, National Commerce’s Garrott as Executive Chairman retained the exclusive option to oust CCB’s Ernie Roessler, who became CEO of the combined company, at the cost of $10 million if he chose to do so. Garrett exercised the option and cut the check in mid-2003 three years after the MOE was consummated.Fairness Opinions for MOEsMOEs represent a different proposition for the financial advisor in terms of rendering advice to the Board. An MOE is not the same transaction as advising a would-be seller about how a take-out price will compare to other transactions or the company’s potential value based upon management’s projections. The same applies to advising a buyer regarding the pricing of a target. In an MOE (or quasi-MOE) both parties give up 40-50% ownership for future benefits with typically little premium if one or both are publicly traded. Plus there are the social issues to navigate.While much of an advisor’s role will be focused on providing analysis and advice to the Board leading up to a meaningful corporate decision, the fairness opinion issued by the advisor (and/or second advisor) has a narrow scope. Among other things a fairness opinion does not opine:The course of action the Board should take;The contemplated transaction represents the highest obtainable value;Where a security will trade in the future; andHow shareholders should vote. What is opined is the fairness of the transaction from a financial point of view of the company’s shareholders as of a specific date and subject to certain assumptions. If the opinion is a sell-side opinion, the advisor will opine as to the fairness of the consideration received. The buy-side opinion will opine as to the fairness of the consideration paid. A fairness opinion for each respective party to an MOE will opine as to the fairness of the exchange ratio because MOEs largely entail stock-for-stock structures. Explaining the benefits of an MOE and why ultimately the transaction is deemed to be fair in the absence of a market premium can be challenging. The pending MOE among Talmer Bancorp Inc. (45%) and Chemical Financial Corp. (55%) is an example. When the merger was announced on January 26, the implied value for Talmer was $15.64 per share based upon the exchange ratio for Chemical shares (plus a small amount of cash). Talmer’s shares closed on January 25, 2016 at $16.00 per share. During the call to discuss the transaction, one analyst described the deal as a “take under” while a large institutional investor said he was “incredibly disappointed” and accused the Board of not upholding its fiduciary duty. The shares dropped 5% on the day of the announcement to close at $15.19 per share. Was the transaction unfair and did the Board breach its fiduciary duties (care, loyalty and good faith) as the institutional shareholder claimed? It appears not. The S-4 notes Talmer had exploratory discussions with other institutions, including one that was “substantially larger”; yet none were willing to move forward. As a result an MOE with Chemical was crafted, which includes projected EPS accretion of 19% for Talmer, 8% for Chemical, and a 100%+ increase in the cash dividend to Talmer shareholders. Although the fairness opinions did not opine where Chemical’s shares will trade in the future, the bankers’ analyses noted sizable upside if the company achieves various peer-level P/Es. (As of mid-July 2016, Talmer’s shares were trading around $20 per share.) Fairness is not defined legally. The Merriam-Webster dictionary defines “fair” as “just, equitable and agreeing with what is thought to be right or acceptable.” Fairness when judging a corporate transaction is a range concept. Some transactions are not fair, some are in the range—reasonable, and others are very fair. The concept of “fairness” is especially well-suited for MOEs. MOEs represent a combination of two companies in which both shareholders will benefit from expense savings, revenue synergies and sometimes qualitative attributes. Value is an element of the fairness analysis, but the relative analysis takes on more importance based upon a comparison of contributions of revenues, earnings, capital and the like compared to pro forma ownership.Investment Merits to ConsiderA key question to ask as part of the fairness analysis: are shareholders better off or at least no worse for exchanging their shares for shares in the new company and accepting the execution risks? In order to answer the question, the investment merits of the pro forma company have to be weighed relative to each partner’s attributes.Profitability and Revenue Trends. The analysis should consider each party’s historical and projected revenues, margins, operating earnings, dividends and other financial metrics. Issues to be vetted include customer concentrations, the source of growth, the source of any margin pressure and the like. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated.Expense Savings. How much and when are the savings expected to be realized. Do the savings come disproportionately from one party? Are the execution risks high? How does the present value of the after-tax expense savings compare to the pre-merger value of the two companies on a combined basis?Pro Forma Projected Performance. How do the pro forma projections compare with each party’s stand-alone projections? Does one party sacrifice growth or margins by partnering with a slower growing and/or lower margin company?Per Share Accretion. Both parties of an MOE face ownership dilution. What is obtained in return in terms of accretion (or dilution) in EBITDA per share, (for non-banks) tangible BVPS, EPS, dividends and the like?Distribution Capacity. One of the benefits of a more profitable company should be (all else equal) the capacity to return a greater percentage of earnings (or cash flow) to shareholders in the form of dividends and buybacks.Capital Structure. Does the pro forma company operate with an appropriate capital structure given industry norms, cyclicality of the business and investment needs to sustain operations? Is there an issue if one party to an MOE is less levered and the other is highly levered?Balance Sheet Flexibility. Related to the capital structure should be a detailed review of the pro forma company’s balance sheet that examines such areas as liquidity, funding sources, and the carrying value of assets such as deferred tax assets.Consensus Analyst Estimates. This can be a big consideration in terms of Street reaction to an MOE for public companies. If pro forma EPS estimates for both parties comfortably exceed Street estimates, then the chances for a favorable reaction to an MOE announcement improve. If accretion is deemed to be marginal for the risk assumed or the projections are not viewed as credible, then reaction may be negative.Valuation. The valuation of the combined company based upon pro forma per share metrics should be compared with each company’s current and historical valuations and a relevant peer group. Also, while no opinion is expressed about where the pro forma company’s shares will trade in the future, the historical valuation metrics provide a context to analyze a range of shareholder returns if earning targets are met under various valuation scenarios. This is particularly useful when comparing the analysis with each company on a stand-alone basis.Share Performance. Both parties should understand the source of their shares and the other party’s share performance over multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Liquidity of the Shares. How much is liquidity expected to improve because of the MOE? What is the capacity to sell shares issued in the merger? SEC registration and even NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently.Strategic Position. Does the pro forma company have greater strategic value as an acquisition candidate (or an acquirer) than the merger partners individually?ConclusionThe list does not encompass every question that should be asked as part of the fairness analysis for an MOE, but it points to the importance of vetting the combined company’s investment attributes as part of addressing what shareholders stand to gain relative to what is relinquished. We at Mercer Capital have over 30 years of experience helping companies and financial institutions assess significant transactions, including MOEs. Do not hesitate to contact us to discuss a transaction or valuation issue in confidence.

Despite the inhospitable IPO climate, one tech company managed to brave the market with just the right mix of novelty and disruption to garner attention and reap rewards. Twilio, a cloud communications platform designed to help developers add messaging, voice and video to web and mobile applications, went public on June 23. Priced at $15 per share, Twilio’s share price closed at $28.79, the largest single-day increase of an IPO in over two years, which increased the company’s market cap by 95% to nearly $2.4 billion.   The next day, on June 24, the UK voted to leave the European Union. Brexit effectively wiped out over $2 trillion in global equity, ushering in weeks of market volatility and a freefall of the pound. Despite the global volatility, Twilio’s share price as of June 30 was up to $36.50 per share. Optimistic investors lauded the IPO as an indication of a turnaround in the venture-backed IPO market, and for good reason. Over the 2010 to 2015 period, more than half of the 200 tech companies that went public were trading below their initial IPO price by mid-2016.The number of venture capital exits completed in the second quarter of 2016 (153) was the lowest total since the second quarter of 2010, with only 19 venture-backed IPOs in the first half of 2016 (well below the 52 IPOs completed in the first half of 2015).   As discussed previously, unfavorable IPO market conditions have led many companies to alternative exits such as M&A. A growing number of venture capital firms have also turned towards another source for cheap cash: debt.Given the current interest rate environment, several unicorns, including Airbnb, Didi Chuxing and Uber, have capitalized on the cheap debt available in the market as an alternative to issuing more equity. The debt markets are proving unusually receptive to venture financing, for example giving Uber, a cash flow negative company with famously opaque financials, over $1.6 billion at 5.0%. Concerns over weaker credit standards in the banking industry have risen as competition for quality loans has driven down loan yields. Prolonged periods of low interest rates have compressed margins and impeded any profitability gained from an increase in loan growth alone. Since the Fed first announced progressive rate hikes in December, banks have positioned themselves as asset sensitive in order to benefit from an increase in rates that has yet to occur. In fact, thanks to Brexit and the wave of capital market uncertainty it created, the central bank has even discussed cutting short-term rates.   In order to maintain profitability, banks need lending volume – which is where unicorns come in. Venture capital has taken advantage of the perfect storm that is the banking industry to acquire low-cost debt and build credit for future rate negotiations, should the need ever arise. In addition, private companies use debt financing to avoid breaching the 2,000 accredited investor threshold for remaining private. Crossing the 2,000 limit would require full disclosure of company financials, which could bring to light certain underperforming metrics these companies have been trying to overcome, as evidenced by their refusal to undergo an IPO. Whether more companies choose to go down the debt route is yet to be seen, but it is a financing vehicle that enables companies to avoid having to leave the sympathetic capital still available in private markets.

My older daughter turns sixteen next month. Most parents dread giving their children vehicular independence, but I managed to repress that instinct by concentrating on the more delightful prospect of adding a new car to the family fleet: a Fiat 500. The original 500 (or Quattrocento) came out in 1957, and Fiat sold almost 4 million of them before they discontinued the model in 1975. Since Fiat announced they were returning to the U.S. market and bringing the Italian equivalent of Britain’s Mini or Germany’s Beetle, I wanted one. While I couldn’t make the Quattrocento work for me, I thought the size (big enough for four adults but easy to park), powertrain (peppy but economical), and unique features (like a folding fabric roof) made it perfect for a new driver who appreciates cars like her dad.Unfortunately, as my daughter’s sixteenth birthday approached, my fantasy of what she should drive had a head-on collision with reality. The Fiat’s small size is handy when you have to wedge your car down Italian city streets (I found one on vacation that was EXACTLY five inches wider than my rented Volvo wagon, with the side mirrors retracted), but not so pragmatic in our town, where every third vehicle is a giant SUV that probably wouldn’t even notice a collision with a 500. I think Fiat may have had the same realization, as their U.S. sales have been far lower than expected, and as a consequence has delayed the reintroduction of Alfa Romeo to the U.S. (a real tragedy). There are at least two lessons to be drawn from this: 1) sometimes bigger is unquestionably better, and 2) some ideas look a lot better on paper than in practice.I was reflecting on both of these themes last week after word got out that Focus Financial Partners had started preparing documents to file an initial public offering. Because Focus has less than $1 billion in revenue, it can keep details of the offering private until three weeks before the offering, so unfortunately we don’t have an S-1 to review. The Company itself hasn’t said anything about filing.Focus is another great idea, at least on paper, but has garnered success in a timeline littered with lots of bumps along the way. If they choose to go through with the public offering this time, their S-1 will be a treasure map of information about RIA consolidation, which is probably going to be as painful as it is inevitable.We have so many questions about the Focus IPO, it’s hard to know where to start. For example:Why Now?Focus is a ten year old company that has been headed for IPO since day one. Part of their pitch to prospective RIA targets is enabling them to ride the rise in Focus’s valuation at the offering. Focus previously started the filing process for an IPO last summer. So, in one regard, this isn’t unexpected.Further, Focus is backed by the VC/PE community, having picked up financing by Summit Partners in 2007 and Centerbridge Partners in 2013. Polaris is also still involved. The timing of those deals is noteworthy, because asset manager multiples were at peak levels in both 2007 and 2013 (so much for booking gains on the buy). We wonder if Centerbridge isn’t looking at the stakes Polaris and Summit have held – for longer than they wanted – and are seeking an exit while they can. We’ll probably never know why Focus didn’t go through with an offering last summer. Compared to a year ago, valuation multiples in the space aren’t any stronger, and the IPO market isn’t any more robust. One would think that Centerbridge, which has been in Focus for three years, would be getting impatient. However, if the stock market coughs and the IPO window closes, it could be some time before Focus is ready to go public again.About the only two compelling reasons we can come up with for a Focus IPO today is 1) the SEC’s proposed rules on transition planning and 2) scale. With regard to the former, the Focus IPO narrative will undoubtedly feature that it appears the SEC is going to require RIAs to document some kind of ownership exit strategy. Focus is all over this issue, and has the capacity and expertise to offer a pre-packaged solution to this aspect of SEC compliance. As for the matter of scale, Focus may be big enough now to garner a better valuation…How Much?Thinking about valuation may be a little premature, since we haven’t yet seen the S-1. Numbers on the order of $1 billion have been bandied about, but not whether that’s pre-money or post. Focus has plenty of debt and preferred stock (possibly north of $750 million), but since debt is cheap, one wonders if the company is in a hurry to pay it down. What we do know is that Focus currently has run rate revenue on the order of $400 million. If Focus is running an EBITDA margin between 25% and 35%, and the IPO prices at 9x to 12x EBITDA, Focus could deleverage and wind up with a balance sheet that looks a little more like a typical RIA, and/or get their VC and PE investors liquidity. The RIA managers who got stock by selling their shops to Focus will probably have to wait.Some have suggested that Focus is pulling a stronger EBITDA margin than my range, and could command a higher multiple. We admittedly don’t know enough to comment at length on margin expectations, but the infrastructure necessary to manage a consortium of small to medium size wealth management firms, some of whom are owned outright and some of whom are partially owned, is expensive. As for the multiple, I think it comes down to whether or not the market is ready to accept this business model.How is This Not a Roll-Up?More than anything, the Focus IPO will cast some light on what the market really thinks of RIA aggregators. Focus management has been, and will likely remain, defiant that their company is not a roll-up firm – probably because they don’t want to be compared to National Financial Partners. But I just did, and so will the market. A more favorable comparison might be to Affiliated Managers Group, but AMG’s valuation has also struggled recently, and is down by almost a quarter over the past year.That said, the notion of a national RIA focused on retail clients makes sense. What Focus and other firms like it are trying to assemble looks a lot like the retail side of the old wirehouse firms, absent all the conflicts of interest. But the RIA landscape may be fragmented for a reason, and re-assembling a diaspora of heterogeneous personalities and corporate cultures will undoubtedly prove challenging. I remember a client of mine in a different industry joining a roll-up in the mid-1990s, and being reassured that change would be “evolutionary, not revolutionary.”That sounds attractive, and Focus has made best efforts to create a platform that allowed acquired RIAs to maintain their individual sense of identity. Trouble is that the RIA industry is highly, and increasingly, regulated. The need for compliance and training and comparable pricing and marketing efficiency will create a gravitational force that will pull the dozens of individual RIAs acquired by Focus toward some regimented similarity.Nothing wrong with that; but it sounds a lot like a roll-up.

James Bond’s engineering mastermind, Q, makes his living out of planning for the unexpected. Over the years, the star of the franchise has been saved from nearly certain demise by a remarkable variety of devices – but none of them more preposterous than the one that saved Roger Moore’s character in The Spy Who Loved Me, in which Bond escapes a typical car chase in his Lotus Esprit by driving into the Mediterranean, only to have the car immediately transform into a submarine. The whole scene could have been a metaphor for Lotus Motors itself, which was very much underwater – financially – at the time.Lotus’s founder, Colin Chapman, was a genius at designing sports cars, but had a harder time making the business consistently successful. By the late 1970s, Lotus was gasping for air. Desperate for cash, Lotus got involved with John DeLorean to design his eponymous car, the DMC-12, and promptly got embroiled in the DeLorean scandal. The pressure built on Lotus and on Chapman, who died of a heart attack in 1982 at the age of 54. The untimely death of Chapman, coupled with poor sales and the ongoing investigation, almost bankrupted Lotus. Q may have planned ahead for the unexpected for James Bond, but Chapman unfortunately didn’t do a similar amount of planning for Lotus. As a consequence, the Bond franchise has been, all in all, more successful.Picking up on this, the SEC seems concerned about RIAs doing some planning for the unexpected, and hence they’ve unleashed 206(4)-7. By now you’ve probably read the SEC’s proposed rules on Adviser Business Continuity and Transition Plans. While there are two weeks left on the comment period, I’ve been a little surprised at how few comments have been posted, so far at least. Maybe that means the RIA community has decided this is inevitable, and they’re already looking forward to how to comply with the rules once they’re finalized.Most of the proposed rule simply codifies a reasonable standard for practice management at an RIA. Certain of the proposal’s requirements, such as IT management and being able to conduct business and communicate with staff and clients in the event of a natural disaster, are likely to be met with turn-key solutions from vendors. Mercer Capital has had some firsthand experience with these kinds of issues: we had to move to temporary quarters for a year after a fire in our office building fifteen years ago, and we provided an alternative location for a New Orleans-based valuation firm for a short time after Hurricane Katrina. It’s amazing what you can do with remote hosted data, laptops, and cell phones when you have to.Of more interest is how the requirement for a “transition plan” in the event of the death or incapacitation of an advisory firm owner will be implemented. The primary elements the SEC wants to see on business transition planning are:Policies and procedures that would safeguard, transfer and/or distribute client assets during transitionPlans for transitioning the corporate governance of the adviserIdentification of any material financial resources available to the adviserPolicies and procedures that would generate client-specific information needed to transition client accounts to a new adviserAssessing the applicable laws and contractual obligations governing an RIA and its clients that would be relevant given the adviser’s transition Again, much of this is check-the-box kind of stuff that will become fairly routine over time. The one sticky wicket, as we see it, is the requirement to have a plan to transition the corporate governance of the RIA. In other words, if a key owner becomes incapacitated, dies, or for whatever reason cannot fulfill his or her position on the organization chart, who will? Since corporate governance at an RIA is usually accompanied by ownership, what the SEC is really asking is “who is going to own and manage the advisory firm in the event that a key owner/manager cannot?” Most of the commentary on this topic has been directed at small RIAs with one owner, which essentially operate as sole proprietorships. For small firms, the options are many, but follow a similar theme: sell the firm immediately at a pre-arranged valuation to another RIA that is in a position to take over. The narrative included with the SEC’s proposal is careful not to define the parameters of any particular RIA’s transition plan too specifically. Every situation is going to be different, but eventually, the regulation is going to have to get fairly granular with regard to expectations of transition plans. Thinking ahead to that time, we would suggest the following might be a descriptive (as opposed to prescriptive) guide to what issues are going to be prominent for RIAs, depending on size. As has been suggested by several commentators on the proposed regulation, solo practitioners and smaller RIAs probably have no recourse for a transition plan that provides for corporate governance (and, thus, control ownership) than some version of a living will for their practice that sells it, immediately, to either a peer RIA or a consolidator like Focus Financial (who filed for an IPO over the weekend). One thing to keep in mind, at that size, is counterparty risk; will the contracted acquirer/operator of the RIA be in a position – financially and operationally – to purchase and run the selling firm if something happens to its owner, and will the acquirer be able to do it on a moment’s notice such that client service is not interrupted? Will the SEC require some kind of “fire-drill” to check if the transition plan works? And who will be held accountable (estate of the Seller, contracted buyer, or both) if the transition plan fails when it’s triggered? Transitions don’t always go smoothly even in a regular acquisition setting, when everyone has time to plan for them and when the seller is available to assist with the transition process. As the size of the firm increases, so typically does the number of owners. One awkward size might be the next one, a medium sized RIA with up to $1.0 billion under management, a few owners and a dozen or more employees. At that scale, it’s not uncommon for the founding partner to hold a majority stake or at least a substantial minority stake. An RIA of this size usually generates more value, per dollar of AUM, than a smaller firm. More value means, of course, a higher purchase price. So while it may be easier to manage the client service issue internally, not every RIA in this size range will be in a position to finance the purchase of the deceased or disabled partner. The largest RIAs have the internal resources to protect their clients in the event of an untimely death. At these sizes, the most significant issues are whether or not the ownership agreements providing for repurchase of a deceased or disabled partner are thorough and current, and whether or not the ownership group has some agreement as to the value of the business. We are involved in numerous matters each year where one or more of these factors is not present, and as a consequence there is a material disagreement as to the value of a buyout. We are also involved with many clients who substantially mitigate this risk by reviewing their buy-sell agreements regularly and have annual valuations prepared so the owners know what to expect in the event of the unexpected. Obviously, we recommend the latter. Regardless of how much planning you do, your RIA is unlikely to emerge from an unexpected calamity without a scratch, but at least you won’t be all wet.Photo Credit: Sun Motors

When asked about his view of a tie years before the NCAA instituted the playoff format in the 1990s, Coach Bear Bryant famously described the outcome as “kissing your sister.” If he were a portfolio manager holding a position in a company that entered into a merger of equals (MOE), his response might be the same. Wall Street generally does not like MOEs unless the benefits are utterly obvious and/or one or both parties had no other path to create shareholder value. In some instances, MOEs may be an intermediate step to a larger transaction that unlocks value. National Commerce Financial Corporation CEO Tom Garrott once told me that part of his rationale for entering into a $1.6 billion MOE with CCB Financial Corp. in 2000 that resulted in CCB owning 47% of the company was because bankers told him he needed a bigger retail footprint to elicit top dollar in a sale. It worked. National Commerce agreed to be acquired by SunTrust Banks, Inc. in 2004 in a deal that was valued at $7 billion.Kissing Your Sister?MOEs, like acquisitions, typically look good in a PowerPoint presentation, but can be tough to execute. Busts from the past include Daimler-Benz/Chrysler Corporation and AOL/Time Warner. Among banks the 1994 combination of Cleveland-based Society Corporation and Albany-based KeyCorp was considered to be a struggle for several years, while the 1995 combination of North Carolina-based Southern National Corp. and BB&T Financial Corporation was deemed a success.The arbiter between success and failure for MOEs typically is culture, unless the combination was just a triumph of investment banking and hubris, as was the case with AOL/Time Warner. The post-merger KeyCorp struggled because Society was a centralized, commercial-lending powerhouse compared to the decentralized, retail-focused KeyCorp. Elements of both executive management teams stuck around. Southern National, which took the BB&T name, paid the then legacy BB&T management to go away. At the time there was outrage expressed among investors at the amount, but CEO John Allison noted it was necessary to ensure success with one management team in charge. Likewise, National Commerce’s Garrott as Executive Chairman retained the exclusive option to oust CCB’s Ernie Roessler, who became CEO of the combined company, at the cost of $10 million if he chose to do so. Garrett exercised the option and cut the check in mid-2003 three years after the MOE was consummated.Fairness Opinions for MOEsMOEs represent a different proposition for the financial advisor in terms of rendering advice to the Board. An MOE is not the same transaction as advising a would-be seller about how a take-out price will compare to other transactions or the company’s potential value based upon management’s projections. The same applies to advising a buyer regarding the pricing of a target. In an MOE (or quasi-MOE) both parties give up 40-50% ownership for future benefits with typically little premium if one or both are publicly traded. Plus there are the social issues to navigate.While much of an advisor’s role will be focused on providing analysis and advice to the Board leading up to a meaningful corporate decision, the fairness opinion issued by the advisor (and/or second advisor) has a narrow scope. Among other things a fairness opinion does not opine:The course of action the Board should take;The contemplated transaction represents the highest obtainable value;Where a security will trade in the future; andHow shareholders should vote. What is opined is the fairness of the transaction from a financial point of view of the company’s shareholders as of a specific date and subject to certain assumptions. If the opinion is a sell-side opinion, the advisor will opine as to the fairness of the consideration received. The buy-side opinion will opine as to the fairness of the consideration paid. A fairness opinion for each respective party to an MOE will opine as to the fairness of the exchange ratio because MOEs largely entail stock-for-stock structures. Explaining the benefits of an MOE and why ultimately the transaction is deemed to be fair in the absence of a market premium can be challenging. The pending MOE among Talmer Bancorp Inc. (45%) and Chemical Financial Corp. (55%) is an example. When the merger was announced on January 26, the implied value for Talmer was $15.64 per share based upon the exchange ratio for Chemical shares (plus a small amount of cash). Talmer’s shares closed on January 25, 2016 at $16.00 per share. During the call to discuss the transaction, one analyst described the deal as a “take under” while a large institutional investor said he was “incredibly disappointed” and accused the Board of not upholding its fiduciary duty. The shares dropped 5% on the day of the announcement to close at $15.19 per share. Was the transaction unfair and did the Board breach its fiduciary duties (care, loyalty and good faith) as the institutional shareholder claimed? It appears not. The S-4 notes Talmer had exploratory discussions with other institutions, including one that was “substantially larger”; yet none were willing to move forward. As a result an MOE with Chemical was crafted, which includes projected EPS accretion of 19% for Talmer, 8% for Chemical, and a 100%+ increase in the cash dividend to Talmer shareholders. Although the fairness opinions did not opine where Chemical’s shares will trade in the future, the bankers’ analyses noted sizable upside if the company achieves various peer-level P/Es. (As of mid-July 2016, Talmer’s shares were trading around $20 per share.) Fairness is not defined legally. The Merriam-Webster dictionary defines “fair” as “just, equitable and agreeing with what is thought to be right or acceptable.” Fairness when judging a corporate transaction is a range concept. Some transactions are not fair, some are in the range—reasonable, and others are very fair. The concept of “fairness” is especially well-suited for MOEs. MOEs represent a combination of two companies in which both shareholders will benefit from expense savings, revenue synergies and sometimes qualitative attributes. Value is an element of the fairness analysis, but the relative analysis takes on more importance based upon a comparison of contributions of revenues, earnings, capital and the like compared to pro forma ownership.Investment Merits to ConsiderA key question to ask as part of the fairness analysis: are shareholders better off or at least no worse for exchanging their shares for shares in the new company and accepting the execution risks? In order to answer the question, the investment merits of the pro forma company have to be weighed relative to each partner’s attributes.Profitability and Revenue Trends. The analysis should consider each party’s historical and projected revenues, margins, operating earnings, dividends and other financial metrics. Issues to be vetted include customer concentrations, the source of growth, the source of any margin pressure and the like. The quality of earnings and a comparison of core vs. reported earnings over a multi-year period should be evaluated.Expense Savings. How much and when are the savings expected to be realized. Do the savings come disproportionately from one party? Are the execution risks high? How does the present value of the after-tax expense savings compare to the pre-merger value of the two companies on a combined basis?Pro Forma Projected Performance. How do the pro forma projections compare with each party’s stand-alone projections? Does one party sacrifice growth or margins by partnering with a slower growing and/or lower margin company?Per Share Accretion. Both parties of an MOE face ownership dilution. What is obtained in return in terms of accretion (or dilution) in EBITDA per share (for non-banks), tangible BVPS, EPS, dividends and the like?Distribution Capacity. One of the benefits of a more profitable company should be (all else equal) the capacity to return a greater percentage of earnings (or cash flow) to shareholders in the form of dividends and buybacks.Capital Structure. Does the pro forma company operate with an appropriate capital structure given industry norms, cyclicality of the business and investment needs to sustain operations? Is there an issue if one party to an MOE is less levered and the other is highly levered?Balance Sheet Flexibility. Related to the capital structure should be a detailed review of the pro forma company’s balance sheet that examines such areas as liquidity, funding sources, and the carrying value of assets such as deferred tax assets.Consensus Analyst Estimates. This can be a big consideration in terms of Street reaction to an MOE for public companies. If pro forma EPS estimates for both parties comfortably exceed Street estimates, then the chances for a favorable reaction to an MOE announcement improve. If accretion is deemed to be marginal for the risk assumed or the projections are not viewed as credible, then reaction may be negative.Valuation. The valuation of the combined company based upon pro forma per share metrics should be compared with each company’s current and historical valuations and a relevant peer group. Also, while no opinion is expressed about where the pro forma company’s shares will trade in the future, the historical valuation metrics provide a context to analyze a range of shareholder returns if earning targets are met under various valuation scenarios. This is particularly useful when comparing the analysis with each company on a stand-alone basis.Share Performance. Both parties should understand the source of their shares and the other party’s share performance over multi-year holding periods. For example, if the shares have significantly outperformed an index over a given holding period, is it because earnings growth accelerated? Or, is it because the shares were depressed at the beginning of the measurement period? Likewise, underperformance may signal disappointing earnings, or it may reflect a starting point valuation that was unusually high.Liquidity of the Shares. How much is liquidity expected to improve because of the MOE? What is the capacity to sell shares issued in the merger? SEC registration and even NASADQ and NYSE listings do not guarantee that large blocks can be liquidated efficiently.Strategic Position. Does the pro forma company have greater strategic value as an acquisition candidate (or an acquirer) than the merger partners individually?ConclusionThe list does not encompass every question that should be asked as part of the fairness analysis for an MOE, but it points to the importance of vetting the combined company’s investment attributes as part of addressing what shareholders stand to gain relative to what is relinquished. We at Mercer Capital have over 30 years of experience helping companies and financial institutions assess significant transactions, including MOEs. Do not hesitate to contact us to discuss a transaction or valuation issue in confidence.

This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. To view or download the original report as a PDF, click here. This publication provides general insight about emerging issues and topics discussed in recent forums and events sponsored by the ESOP Association (“EA”), The National Center for Employee Ownership (“NCEO”) and elsewhere. Much of the current discussion is related to general valuation discipline, but none are new to a longstanding agenda within the ESOP community. Heightened Department of Labor (“DOL”) attention and the recent settlement agreement concerning the Sierra Aluminum case are driving renewed discussion of numerous critical topics within the ESOP fiduciary domain. All guidance, perspective and other information contained in this publication is provided for information purposes only. The issues and treatments highlighted in this publication do not produce the same response from all ESOP professionals and valuation practitioners. Certain treatments and perspectives contained herein lack consensus in the valuation profession and may be addressed or treated using alternative rationales. This publication is not held out as being the position of or recommended treatment endorsed by the EA or the NCEO. The purpose of this publication is to alert and inform ESOP stakeholders and fiduciaries regarding the rising standards of practice and prudence in the valuation of ESOP owned entities.IntroductionIn recent years there has been increasing concern among ESOP sponsors and professional advisors (trustees, TPAs, business appraisers, legal counsel) regarding the scrutiny of the DOL, the Employee Benefits Security Administration (“EBSA”), and the Internal Revenue Service (“IRS”). These entities (and agencies thereof) are tasked with ensuring that ESOPs comply with the Employee Retirement Income Security Act (“ERISA”) as well as with various provisions of the federal income tax code concerning qualified retirement plans (including ESOPs). Citing concerns for poor quality and inconsistency in business appraisals, the DOL has sought in recent years to expand the meaning of “fiduciary” under ERISA to include business appraisers. In the most recent forums of exchange and deriving from various court actions, there are numerous areas of concern that DOL/EBSA appear to have regarding ESOP valuations. These areas of focus include but are not limited to:Valuation Issues Receiving Recent Attention and ScrutinyThe use of financial projections in ESOP valuationThe prevalence and manifestation of conflicts of interest concerning pre- and post-transaction advisory servicesThe use and application of control premiums in ESOP valuationThe valuation of and implications stemming from seller financing used in a great many transactions now coming under reviewThe poor quality of ESOP valuation reports and the attending inconsistencies between narrative explanations and methodological execution; and, The lack of or inconsistent consideration of ESOP repurchase obligation and how it interacts with ESOP valuationThese topics have received heightened attention from numerous committees of the ESOP Association including the Advisory Committees on Valuation, Administration, Fiduciary Issues, Finance, and Legislative & Regulatory. This paper will focus on the use of financial projections in ESOP valuations. While all of the cited issues are of importance, the use (or misuse) of financial projections is often the most direct cause of over- or under-valuation in ESOPs. Other Mercer Capital publications provide insight regarding control premiums, the market approach, and other important ESOP valuation topics.Projections Used In ESOP Valuations: Assessing Growth Rate Assumptions In ValuationBusiness appraisers who practice valuation using one or more credentials in the field are required to adhere to their respective practice standards (ASA, AICPA, NACVA, CFAI). Additionally, there are overarching standards and guidance that generally dictate to and govern the valuation profession and the general considerations and content of a business valuation. The Appraisal Standards Board of The Appraisal Foundation promulgates the Uniform Standards of Professional Appraisal Practice (“USPAP”) and the IRS issued Revenue Ruling 59-60 (“RR59-60”) more than 50 years ago.Collectively, these standards and protocols provide a basic outline for procedural disciplines, analytical methodologies, and reporting conventions. Specificity on the disciplines and procedures for vetting a financial projection (and growth rates in general) are generally lacking in the body of valuation standards, but that does not exempt appraisers and trustees from the core principle that a valuation must collectively (and in its constituent parts) constitute informed judgment, reasonableness and common sense.Traditional financial and economic comparative analysis suggest vetting a projection by way of studying it from numerous perspectives:How do the projections compare to the historical and prevailing financial performance of the subject enterprise being valued (“relative to itself over time”)?How do the forecasted results compare to the past and expected performance of peers, competitors, the industry, and the marketplace in general (“relative to others over time”)?How do the projections reflect the specific outlook and capacity of the subject enterprise (“relative to its specific opportunity”)?The answers to these questions provide the appraiser a foundation upon which to construct the other required modeling elements in the valuation. An appraiser may elect to disregard projections in the valuation process in situations where forecasted outcomes are deemed beyond the organic and/or funded capacities, competence, and/or opportunity of the subject enterprise. An appraiser may elect to consider justifiable risk and/or probability assessments, among other adjustments, that serve to hedge the projections and their respective influence on the conclusions of the valuation report. Regarding valuation and the general concern for rendering valuations that heighten an ESOP trustee’s anxiety for a sustainable ESOP benefit over time, many appraisers elect to capture only proven performance capacity, avoiding the counting of eggs with questionable fertility. If today’s projection proves excessive in the light of future days (when the DOL/EBSA comes calling), the concern for a prohibited transaction rises and poses significant risk and potentially fatal consequences for the plan and the parties involved.Discrete Projections versus Implied ProjectionsA complete, formal appraisal opinion requires the consideration of three core valuation approaches. These approaches are the Cost, Income, and Market Approaches. Generally speaking, valuations of business enterprises using the Income or Market Approaches contain either an explicit projection in the methodology or capture an underlying implicit projection embedded in (or implied by) a singular perpetual growth rate assumption or in a singular capitalization metric. Appraisers and reviewers that fail to recognize this are simply blind to the basic financial mechanics of income capitalization. Accordingly, the concern for projections, in the view of this practitioner, extends beyond the discrete modeling of cash flow to the broader domain of growth in general. For the sake of further discussion, assume the following comments relate specifically and only to the Income Approach and its underlying methods.Discounted Cash Flow Method versus Single-Period CapitalizationThe size and sophistication of the subject enterprise often dictates whether or not an appraiser will enjoy the benefit of management-prepared projections. Projections are often crafted for purposes of promoting operational and marketing outcomes, or for satisfying the reporting requirements that many companies have with their lenders, shareholders, suppliers and other stakeholders. In cases where the subject enterprise is small and its performance subject to unpredictable patterns, appraisers commonly employ a single period capitalization of cash flow or earnings. In lieu of a series of discrete cash flows projected over the typical five-year future time horizon, the appraiser simply employs a measure of current or average performance and applies a single-period capitalization rate (or capitalization multiple as the case may be) in order to convert a base measure of cash flow directly into an indication of value. Seeking not to speculate on a finite sequence of future growth rates, many appraisers employ a rule-of-thumb mentality by correlating cash flow growth to a macroeconomic, inflationary, or industry-motivated rate, often ranging from 3% to 5%. In many instances this could be appropriate; in others it could reflect surprisingly little attention regarding the most basic long-term market externalities and/or internal opportunities of the subject company.The veil of a single-period capitalization approach does not relieve the appraiser from examining the various combinations of growth that could reasonably apply to the base measure of cash flow assumed in an appraisal. Many appraisers are of the mind that in the absence of management-prepared projections, no discrete projection can be developed and thus no Discounted Cash Flow Method can be employed. In lieu of fleshing out the dynamics of operational cash flow, the required capital investments, working capital needs, or the cash flow benefits deriving therefrom, the appraiser simply defaults to the time-honored single period capitalization of cash flow and calls it a day. The binary position that an appraiser cannot prepare cash flow projections lacks credibility and in some cases is simply flawed thinking. Furthermore, any appraiser that applies a perpetual growth rate assumption to develop a capitalization rate is, in fact, asserting a projection over some projection horizon. This is the simple and inescapable mathematical construct that is the Gordon Growth Rate Model. With all due respect and concern about projections - appraisers, trustees and regulators must recognize the inherent projection represented by a perpetual growth rate assumption in a single-period capitalization method. In essence, there is no income approach without either an explicit or implicit projection of future cash flows.Performing Due Diligence On Company Issued ProjectionsImagine you are a trustee tasked with reviewing an ESOP valuation prepared by the plan’s “financial advisor.” Business appraisers in their role as the trustee’s financial advisor issue opinions of value they believe to be supported by the facts and circumstances, but ultimately the appraisal of the plan assets is the trustee’s responsibility. How can the stakeholders and fiduciaries of an ESOP gain understanding and comfort in projections prepared by the Company and employed by the appraiser?The foundation begins with the general process of examining historic and prospective growth. Company projections must make sense to gain inclusion in the valuation of an ESOPowned company. A disconnect or sudden shift (whether in magnitude, trend or directionality) in expected performance is a red flag that requires specific explanation. Absent a sound rationale for a significant change in the pattern of future performance, projections that seem too good (or too bad) to be true must be reconciled with management and potentially disregarded in the appraisal process.Not all projections are created equally. Some are prepared for budgetary purposes and are constrained to a single year of outlook. Projections may be prepared for many reasons including the study of operational capacity, financial feasibility concerning capital investments, debt servicing and lender requirements, sales force management, incentive compensation, and many other reasons. Projections may be the product of a bottom-up process (originating in the operational ranks of the business) or may originate as a top-down exercise (descending from the C suite).Business appraisers cannot be indiscriminate in their employment of forward-looking financial information. Understanding the goals, intentions, motivations, and possible shortcomings of a budget or projection is vital to assessing the viability of a direct or supporting role for the projections in the valuation modeling. The nature and maturity of the business are also significant to understanding and troubleshooting a projection. For the sake of further commentary we will assume that most ESOP companies are relatively mature and not subject to the intricacies and uncertainties of valuing a start-up business (albeit, even mature business can experience significant swings in business activity).Projection Due Diligence InquiriesWho prepared the projections?What is the functional use or purpose of the projection?How experienced is the Company in preparing projections?When were the projections prepared?Do the projections incorporate increased (new) business, and if so, in what manner is the new business being generated?Do the projections reflect the discontinuation of specific segments of the revenue stream?Are the financial projections reconciled to or generated from a meaningful expression of unit volume and pricing?Does the company operate as the exclusive or concentrated agent for certain suppliers and/or customers?How does the company’s current projection reconcile to past projections?How closely does the company’s most recent actual performance compare to the prior year’s projection?Does the projection depict a transition in industry or economic cycles that may justify near-term abrupt shifts in expected outcomes?How comprehensive are the projections and the supporting documentation?What are some typical warning signs that a projection may be too aggressive or pessimistic?Who prepared the projections?A bottom-up process whereby front-line managers project their respective business results, which are then combined to create a consolidated projection, is often the most informative projection. Motivation mindset can be important as many projections are designed to “under-promise” results. Conversely, some projections are deliberately overstated to impart a mission of growth or goal-oriented outcomes. Projections that emanate and evolve through multiple levels of an organization are typically subject to more checks and balances than projections that originate in the vacuum of a single executive’s office. Conversely, such a process can also depict an organizational mob mentality that could distort reasonable expectations.A CFO’s budget may vary significantly from the sales projection of a sales manager or the projections of a senior executive. In some cases, an appraiser may review projections prepared for a lender that vary from a strategic plan projection. Often the differences can be reconciled. Projections prepared for external stakeholders such as lenders and as communicated to shareholders and possibly endorsed by a board of directors are likely to be the most relevant and appropriate for the valuation.If numerous projections exist, the trustee and appraiser are best advised to inquire about the outlook that best reflects a consensus of the most likely outcome as opposed to aspirational projections that are tied to new and/or speculative changes in the business model. In a recent engagement, a client was deploying significant capital to extend core competencies into adjacent markets. Rather than the hockey stick of growth most typical of such projections, this client’s net cash flows were relatively neutral in the foreseeable future because they included significant capital and working capital investment, which effectively paid for increased business volume. The premise behind their strategy was simply one of being larger and more diverse under the assumption that size and diversity facilitated a less risky business proposition and a broader range of potential long-term outcomes for the business.What is the functional use or purpose of the projection?Functional use is often linked to who prepares the projection. Be wary of projections that may intentionally (or as a byproduct of purpose) under or over shoot actual expected forecast results. In many cases a bottom-up projection process receives the review of senior management before becoming a functional element of business planning and accountability.How experienced is the Company in preparing projections?Are past projections reconciled to actual results with adequate explanation for variances? Firms with consistent and organized processes often produce more informative projections. Granted, a company may consistently under or over perform their projection. The quality of a projection may be better measured by its consistency over time than by its ultimate accuracy in a given year. One clue to the experience and care taken in the projection process is the model underlying the projection itself. For example, was the forecast model developed using numerous discrete modeling assumptions (such as year-to-year growth, and year-to-year margin) or from more global assumptions that are carried across all years in the projections? While modeling complexity can serve to obscure and is not automatically a sign of a well-developed projection, the inability of a projection model to be adapted quickly to alternative scenarios and assumptions may be a sign that the model was not studied for its sensitivity and reasonableness. A projection that appears to be “living” and easily modified could be a sign that the company actually uses the projection and modifies it in real time to assess variance and to modify assumptions as business conditions evolve and change. Appraisers and trustees should empower themselves with the ability to study the sensitivity and outcomes of a projection. Projections that lack detailed growth and margin details (year-to-year and CAG) should be replicated and/or reverse engineered in some fashion to facilitate basic stress testing and/or sensitivity analysis before the appraiser simply accepts the projections.When were the projections prepared?In general, valuation standards call for the consideration of all known or reasonably knowable information (financial, operational, strategically or otherwise) as of the effective date of the appraisal, which for most ESOPs is the end of the plan year. As a matter of practicality, financial statements (audits and tax returns) are not prepared for many months subsequent to the plan year end. Likewise, projections are often compiled in the first few months of the following year and may be influenced by the momentum of activity after the valuation date.Appraisers typically cite financial information delivered after the valuation date to be known or knowable and projections, while potentially exposed to a hint of subsequent influence, are often integrated without much question regarding their timeliness to the valuation date. In many cases, clients struggle to get information to us in order for their 5500s to be filed in a timely fashion (typically July 31st). In most cases we find that projections prepared after the end of the plan year are perfectly fine to employ. We inquire with management if there are aspects of the projection that were influenced by subsequent events and if so, with what degree of certainty could the subsequent event or activity have been expected at the valuation date. In some situations it may be advisable or reasonable to alter a projection’s initial year due to subsequent influences; typically the more distant years of a projection follow a pattern of knowable expectation unless there has been a material subsequent event that alters the global posture of the business. If a material subsequent event occurs that is not factored into the projections, then as a matter of common sense, the appraiser may elect not to perform a DCF, or better yet, may request that the projections be modified to take the event into financial consideration so that a DCF can be more accurately informed regarding changes in business posture.Do the projections incorporate increased (new) business, and if so, in what manner is the new business being generated?If a projection reflects a pattern of significant change in business activity, it is vital to consider whether new business represents an extension or replication of past expansions. If the company has proven the ability to expand and absorb new business (territory, staffing, productive capacity, etc.) then a projection depicting such an increase is likely reasonable, but should be gauged by past similar experiences whenever possible. And, any business expansion must be reflected in the investment and working capital charges applied to develop net cash flows. We refer to this as “buying the growth” – remember there is no free lunch.Projections with significant topline and profit growth must reflect adequate investment. This investment may take the form of the organic investment in the existing business lines or strategically by way of acquisition. If the projections include a speculative expansion into new revenue areas, the appraiser should properly assess the likelihood of successfully achieving the projection. Business extensions into logical adjacencies which leverage pre-existing supply and customer relationships may be more believable than the widget company whose projections include entry into the healthcare industry.In cases where projections include speculative ventures, the appraiser has numerous potential treatments that can temper speculative (high-risk) contributions, essentially replicating the framework applied in the valuation and capital raising processes for start-ups or early-stage companies. In some cases the appraiser may request the projection be revised to eliminate contributions from new growth projects that lack adequate investment or are simply too speculative to consider until they become observable in the reported financial results of the business. In some rare cases, not only is the projection hard to believe, but concerns are compounded by the risky and foolish deployment of capital. Betting the farm on the next reinvention of the wheel is not the making of a sustainable ESOP company.Perhaps it’s a dirty little secret in the hard-to-value world of closely held equity, but valuations using the standard of fair market value (as called for under DOL guidance) are inherently lagging in nature and typically less volatile than is the stock market or the public peers to which a company may be benchmarked. This is generally a function of regression to the mean captured in virtually every conservatively constructed projection and DCF model. The terminal value of a DCF is effectively a deferred single period capitalization using the Gordon Growth Model and often comprises 50% or more of the total value indicated under the method. Near-term performance swings (whether favorable or not) get smoothed out in the math of the terminal value calculation. As depicted in the appended growth scenarios and projection modifications, the regression of future performance to a targeted benchmark can have a similar influence on valuation as the old-guard habit of using historical averages in a single period capitalization method. The primary valuation differences between such a DCF and single period capitalization stem from the specific cash flows during the discrete projection period (years one through five).Do the projections reflect the discontinuation of specific segments of the revenue stream?A sound reason for employing a DCF model is to capture the pro forma performance of a business based on its going-forward revenue base. Most mid to large sized businesses, particularly mature ESOP companies, experience contraction and rationalization of business lines and markets over time. In many cases, the valuation might reasonably improve based on the discontinuation of unprofitable operations and the recapturing of poorly deployed capital. However, care must be taken to understand how all P&L accounts from revenue down to profit are affected by changes in facilities, products, services, staffing, etc. Projections that pretend unsupportable improvement by way of the deletion of a relatively small portion of the business lines are inclined to excessive optimism and may suggest the belief in bigger issues that management deems too daunting to fix. Regarding profitability, so-called “addition through subtraction” is similar to the concern public market investors have with public companies that cut expense merely to manufacture earnings in the near term.As the maxim goes, you can’t cut your way to success in the business world.Are the financial projections reconciled to or generated from a meaningful expression of unit volume and pricing?Financial projections that lack an operational perspective can be difficult to assess. Not all business are margin based, many are spread based – meaning that profits are more of a function of a nominal spread over cost as opposed to some percentage of sales. This is particularly true of service businesses, financial services entities, and commodity driven operations. Accordingly, neither past nor future performance can be properly understood without some idea of how much stuff is getting sold and at what price. In many cases, the required comfort level of a projection simply cannot be reached without it. Breaking revenue into primary volume and price components, as well as further into its departmental or categorical groupings, allows appraisers and trustees a better understanding of the projection and its relation to past performance and market expectations. Revenue per full-time equivalent employee, units produced per labor hour and many other performance metrics are helpful in teasing out reality from a potentially fictional projection.Does the company operate as the exclusive or concentrated agent for certain suppliers and/or customers?Our comments here exclude the consideration of risk associated with high levels of concentration on the rain-making parts of a business – such considerations are often tackled in the appraiser’s assessment of the cost of capital by way of firm-specific risk.Many dealerships, distributors, parts manufacturers, fabricators and service companies owe their existence to market demand created by their suppliers and customers. Many companies service the needs of customers and suppliers by effectively outsourcing some aspect of their respective industry model to an external provider. For example, a producer of value-added materials may use an external company to provide sales and logistical support to get product to its end users (i.e. classic bulk breaking, repacking and transportation). Regardless of which leg of the multi-leg industry the subject business may represent, the assessment of projected growth should include a consideration of what is happening to suppliers and customers (the other legs of a common stool). This same path of inquiry serves the dual purpose of understanding the risk side of the valuation equation. If these multiple legs of consideration don’t reconcile, the projection could prove too unstable for use in the valuation.How does the company’s current projection reconcile to past projections? How closely does the company’s most recent actual performance compare to the prior year’s projection?Studying projection variance can be a highly useful tool in communicating about value and in assessing the correlation between expectations and actual results. Let’s face it - we all like it when people do what they say they are going to do. But the first thing we know about any projection today is that it will be wrong tomorrow. Variances need to be explained and reconciled against the continuing willingness of the appraiser (and the trustee) to employ projections moving forward. Providing financial feedback to management and the trustee during the process of due diligence and in the form of a valuation can help refine the projection process over time. Just as we reserve the right to improve how we do things in the valuation world, so too must our clients have the leeway to refine and improve their processes.Valuation is a forward looking (ex-ante) discipline. History can be highly instructive regarding how projections are scrutinized in real time. Projections that under-promise and over-deliver tend to undervalue companies in real time. Conversely, projections that over-promise and under-deliver can lead to an over-statement of value. In the case of the later occurrence, most appraisers operate under the axiom of “fool me once shame on you, fool me twice shame on me.” Ultimately, attempts at value engineering via optimistic projections need to be balanced with an equal measure of devil’s advocacy from both appraiser and trustee. Ultimately, a DCF model views the impact of any projection through a risk-adjusted lens. The process of hedging a projection generally begins with an observation of historical variances in projected performance and actual results over time, with the primary emphasis place on most recent periods. Projections that appear to overshoot are often hedged either through risk assessment, probability factoring, or a more exotic multi-outcome analysis.Does the projection depict a transition in industry or economic cycles that may justify near-term abrupt shifts in expected outcomes?In recent decades the concept of the traditional five-year business cycle lost favor in some circles. Thought evolution evolved to encompass a lengthier cycle of ten years, mitigated volatility (not so high and not so low as in the past), higher fundamental causation (such as globalization) versus the classical cyclical drivers (such as swings in productivity), continuing evolution of the information sector, disruptive technologies, and since the early 2000s, the persistence of and sensitivity to geopolitical and terrorist events. Then along came the debt crisis followed by the great recession. Lessons of business cycles past have now garnered renewed attention and distant economic history seemed more relevant despite the modernization, globalization and regulation of the economy.Presently, we are witness to a reasonably stable economy that is slowly being weaned from years of fiscal and monetary life support and subsidization. For us business appraisers, we are beginning to lock in on the new norms of our clients’ businesses. For the last many years, our clients were reticent to speculate on a projection (“no visibility”). Many clients recall with anger and humility the great glory projected from atop the last peak cycle in 2006. Almost a decade later, many have finally re-achieved their former glory. Many others can only look up from the corporate grave. From this point forward we can only assume that some version of the business cycle is still with us. Many are now disposed to the concept of a prolonged period of relatively modest and unevenly distributed economic performance, similar to the patterns demonstrated by Japan and characterized as “secular stagnation.” The academicians can argue about how to brand it; valuations professionals and ESOP Trustees are faced with how to consider it in our valuations.Speaking from personal experience, there is a greater appreciation for industry cycles as opposed to macroeconomic cycles. Given such, we see companies vacillate between boom and bust based on numerous underlying elements and drivers that are not purely correlated to the overall economy. Recall the classic business cycle (peak / contraction / trough / expansion / peak). Appraisers and trustees must be attentive and weary of projections that cannot be supported by reasonable facts and circumstances. Some may wonder - when are projections unrealistic? The truthful answer often includes the echo: “not sure, but I know it when I see it.”Companies emerging from the trough of a business/industry cycle may have unusually robust projections. High growth during a period of recovery does not constitute grounds for the dismissal of the projection. Likewise, declining growth from a peak level of performance is not necessarily overly pessimistic. As discussed in the growth scenarios studied in the appended examples, regression to a mean level of future expectation can be achieved in varying ways. The concern for appraisers and trustees alike is the comfort and common sense of near-term expectations relative to recent performance and the level of steady-state performance assumed in the terminal value modeling of the DCF. Ex-post and ex-ante trend analysis, as well as benchmarking to relevant indices from both public and private sectors is vital to establishing the context of a specific projection.On the weight of evidence and common sense, if a projection is highly contrary to external expectations and lacks symmetry with the proven capabilities of the company, appraisers and trustees are cautioned from directly using the projection. An alternative approach for employing the projection is iterating the discount rate and terminal value modeling assumptions required to equate the DCF value indication to value indications developed from other methods (past and present). There are many instances when data lacks reliability during a given period or cycle. In such cases we tend to study the information and reconcile it to the alternative valuation results deemed more reliable. In this fashion we alert the report reviewer that projections exist that may appear contrary to the weight of history and/or external expectations.How Comprehensive are the Projections and the Supporting Documentation?Are the projections lacking detail and limited in supporting documentation? Projections that are not integrated into a full set of forward looking financial statements and that lack explanation for critical inputs may be unreliable or require significant augmentation before being integrated into a DCF valuation model. As a matter of practicality, many companies do not project more than a simple income statement. Does the lack of a balance sheet and a cash flow statement automatically exclude the projection from consideration? Not in my view, however, under many circumstances there could be a need for augmentation to consider numerous significant aspects required to develop the typical DCF model. These considerations include:Capital expenditures, which initially decrease cash flow before generating the returns that constitute future growth. Not only is the dollar amount a significant consideration, but the capacity/volume effect of physical additions relates to future growth modeling.Incremental working capital requirements, which typically absorb a portion of growth dollars in perpetuation of higher operating activity, or which may accumulate on the balance sheet in a downturn when demand for financial resources can temporarily decline.In cases where a DCF is used to directly value the equity of an enterprise, changes in net debt must be captured. Are the cash flows sufficient to cover the company’s term debt and line of credit obligations? Are new sources of debt capital required to support capital and working capital grow?Collectively, these cash flow attributes can have a significant effect on the discrete cash flows of an entity during the projection. Absent a balance sheet and/or cash flow statement, the impact of these considerations may be difficult to properly assess. In cases where the business is not deploying significant new capital and the projection is following a more or less mature pattern, capital expenditures and incremental working capital may be easily determined based on historical norms and comparative analysis with peer data. Accordingly, a full detailed projection of the balance sheet may not be required to develop reasonable modeling and outcomes. As always, a vetted and complete projection of the financial statements is desirable. Supporting documentation can take numerous forms. Reconciliation of modeling assumptions to external drivers, operating activities, market pricing, throughput capacity, supplier expectations and trends, bellwether industry peers and market participants, downstream and upstream expectations and many other supporting considerations is always helpful but generally lacking for many projections. Often, a review of the projections using such benchmarks leads to a modification or adjustment of the projections by management. In this fashion, the appraiser’s and/or trustee’s review serves to effectively adjust the projections before and/ or during their use in a DCF model – thus the need for a flexible and adaptive modeling platform built from the projection.What are some typical warning signs that a projection may be too aggressive or pessimistic?A baseline for assessing reasonableness or believability is always a good first step. A graphic representation of revenue, EBITDA and key volume measures can assist a reviewer in studying the reasonableness of a projection. Supernormal and/or counter-trend activity requires a compelling justification. Let’s use the information in the following graphic as a baseline for demonstrating some fundamental curiosity and addressing some basic questions regarding reasonableness. The five-year trend for adjusted EBITDA at the valuation date reflects a pattern of strong growth (illustrated by the dotted blue line in Figure 1), but at a decelerating rate (illustrated by the columns in Figure 1). The projected annual growth rate for each of the next five years is 10%. In this case, management represents that the 10% annual growth projection is based on the compound annual growth rate for the five years leading up to the valuation date. This is an all too familiar “technical” rationale for growth forecasting. However, it begs the question of why the decelerating trend would suddenly flip favorable as opposed to continuing its decline or perhaps stabilizing at the most recent level of modest growth. Of course, the current trend could mature as a contraction in performance before an upturn that repeats the prior cycle. Figure 1 depicts a wide variety of plausible alternative projections based on a technical review of the trend and a healthy dose of analyst scrutiny of management’s optimistic projection. The projection provided by management could easily be an order of magnitude overstated relative to other plausible outcomes. If EBITDA growth remains at the most recent rate (5% annually) then management’s projection is overstated 25% by year five (the orange dotted line). If EBITDA flatlines at current levels management’s year five projection is overstated by 60% (the black dotted line). If the deceleration of growth actually turns to a steady contraction (5% annually) then management’s projection is almost 100% overstated. If a modest near-term contraction is followed by a renewal of the previous growth cycle (the green dotted line), then management’s base 10% annual growth projection is overstated by 35% in year five. We could iterate infinite variations in future outcomes, but I submit that the variations shown above stem from a reasonable risk averse, conservative framework. The real concern is how well the projection reconciles to external and internal drivers that have proven to influence past business outcomes and/or drivers that are virtually assured to influence future outcomes. In the present case example, the platform of management’s projection is built on the prevailing economy (generally favorable but inconsistent growth) and involves a market-beta industry (highly correlated to the overall economy). More specifically, the subject company is a construction contracting concern whose early growth began from a deep trough in the cycle, then was temporarily juiced with shovel-ready government funded activity which eventually dried up as the general economy stabilized. New norms are uncertain but project budgets and financings are expected to be more difficult as real interest rates become more than zero and underwriting hurdles remain quite high. In this light, a simple extension of the five-year CAG into the future for five more years appears to ignore the decelerating trend. Absent specific contracts and backlog, industry-based drivers, and perhaps geographic hotbeds of significant in-migration, management’s projection outcome appears over optimistic if not outright aggressive. Projections that appear contrary to external trends and opportunities and which are not reconciled to the company’s capacity (whether existing or planned with the associated capital required) may need to be disregarded in the valuation process. Alternatively, the appraiser and trustee could view the projections with heighten concern for their realization and elect to effectively hedge the projections using appropriate discount rates, probability assessments, or other treatments that mimic the behavior of hypothetical investors. Ultimately, the reliance or weight placed on a projection based valuation method demonstrates the comfort of the appraiser/trustee with the method. If the final weights or reliance are placed on alternative valuation methods with materially different value indications than the DCF, the appraiser/trustee is effectively disregarding or modifying the projection. Surely, every valuation conclusion, under any valuation approach or method, has an underlying implied projection through which the same value outcome is produced.Rules Of Thumb For Growth RatesRecent Macro-Economic HistoryAssuming a company’s growth and/or projected financial performance is highly correlated to general macroeconomic growth is often an underpinning of long-term sustainable growth rates. Care must be taken when observing data reported from government agencies as such data can be “real” or “nominal” in quantification. Real rates are generally representative of movements net of the influence of inflation and nominal growth is generally total growth including inflation. Accordingly, growth rates in valuations that mirror inflation are effectively zero real growth rates. Gross domestic product is almost always reported and discussed in real terms, meaning the addition of a long-term inflation rate is typically called for in cases where the appraiser/trustee considers a company’s performance to be similar to that of the overall economy. For perspective, Figure 2 presents the history of economic cycles and the more recent performance of real GDP over the last several years (Figure 3). On the basis of inflation of approximately 2.5% in recent years, nominal overall economic growth has approximated 4.5% to 5% subsequent to the great recession. Ah, the rule of 5% +/- for growth. There is a wide variety of alternative economic measures and subsets of GDP that could serve as a proxy for long-term sustainable growth in most valuations. Of course, such growth rates may fail to capture all the underpinnings of a given industry or market and may also fail to recognize the specific financial and operational details of a given company. Most companies tend to grow in phases as capital investment, hiring, product offerings and other business attributes evolve over time. This discussion could extend to an infinite spectrum of data and benchmarks.Equity Market PerspectiveAppraisers employ various tools and data resources to determine the appropriate cost of capital for use in a valuation. Employing a bit of analytical deduction using the disciplines of the Capital Asset Pricing Model and the Gordon Growth Model, one can observe some tendencies regarding the markets’ implied earnings growth expectations. One of the most frequently employed resources is the annual Morningstar/Ibbotson SBBI publication. Given this data, and an assumed range of price-to-earnings ratios, one can deduce the implied perpetual earnings growth rates embedded in the market’s pricing over time. This framework can be applied to a specific company, a group of companies, or an industry. The example in Figures 4 and 5 demonstrates market-based influences regarding analyst predispositions about earnings growth over time. As with other tools and sensitivity analyses in this publication, changes to the inputs can result in significantly different outputs. Relative to the growth dynamics of the different sized public companies depicted in the preceding table, it’s no wonder that the closely held, mostly mature, mid-market companies typically seen in the ESOP world (with enterprise values ranging from $10-$500 million) are imbued with net cash flow growth rates on the order 3% to 5% in the appraisal process (the “comfort zone” ). However, the timing of growth during the projection can be significant to a DCF value indication and can also influence growth rates in single-period capitalizations to measures outside of the comfort zone.Framework for Studying Projections and Growth Rate AssumptionsBy convention, virtually all business valuations include a presentation composed of five years of historical financial performance. Depending on the nature of the underlying financial reporting of the sponsor company, the presentation will include balance sheets, income statements and cash flow statements. The notes to the reported financials may also contain a myriad of underlying detail and disclosures supporting the chart of accounts displayed on the core financial exhibits. Commonly, these financial exhibits are augmented with derivative analysis to study the common size (percentage of assets) balance sheets, common size income statements (historical margins expressed as a percentage of revenue), financial ratios, peer/ industry data sets, and year-to-year and compound annual growth rate measurements.The foundation for studying the reasonableness (or believability) of a forecast derives from a firm grasp of the relevant history of the subject enterprise. The reported financial statements are often recast to reflect the proper historical base from which most projections are cast. Ultimately, the valuation methodology captures the adjusted, pro forma financial performance and position of the company that serve as the appropriate base from which forecast results are projected to emerge.Financial history is not the only context for vetting projections. To the extent possible, the financial exhibits should be annotated and/or augmented with operational data (and graphics) that allow the appraiser to demonstrate and consider how the company’s activities relate to its financial performance. In addition to common size financial data, revenue and profit segmentation can be critical to understanding what aspects of a business are performing well and what parts are hindering results. In addition to perspectives on revenue mix, the report should also reflect a functional unit volume analysis that promotes an understanding of how pricing and activity volumes drive revenue and profitability. In turn, these observations help inform the appraiser about the physical capacities, break even levels, labor resources, and other aspects of the business model and operational flows that should dove-tail with the projections.For example, if a projection implies that a business will exhaust its current operating capacities or markets, then an adequate and properly timed charge to cash flow for capital expenditures should be included in the forecast to promote continued growth. Otherwise, little or no growth (beyond the price component of revenue) should be reflected in the model. Additionally, the duration of the discrete forecast should span the number of periods required for the company’s operating and financial performance to reach a reasonable normative state from which a steady level of continuing performance can be expected. Thus, a five-year projection may require augmentation of a few periods to regress a high-growth model to a mature state, or a negative growth model to a new state of sustainable performance. Ultimately, the timing of when growth occurs can be an important value determinant in a DCF model as well as a vital consideration to developing a perpetual growth rate for cash flow.When assessing a perpetual growth rate assumption, which is required in a single-period capitalization of earnings or net cash flow, one key to estimating a reasonably correct growth rate is an understanding of the internal and external factors that drive the assumption. While some appraisers are of the mind that projections cannot or should not be developed by an appraiser; surprisingly there is no debate as to the requirement of postulating a perpetual growth rate. These seemingly different disciplines are in fact one in the same. Arguably, an appraiser seeking to quantify or justify a perpetual growth rate must employ elements of the DCF mentality to define what that growth rate should be. Of course, the base amount of the cash flow is a vital starting point. For those appraisers who gravitate to the 3%-5% perpetual growth rate range, the use of a multi-period cycle-weighted historical average of cash flow can create a significant error in the valuation.Let’s construct a simple example to demonstrate the valuation issues that could result from two different historical conditions that have the same average of performance. As crazy as it may be in practice, it is not uncommon for appraisers using multi-period averages to effectively ignore prevailing conditions and use a nominal long-term average growth rate that is correlated to GDP or some other prominent macroeconomic or industry performance measure. This mentality renders real time trends and real time expected directionality in performance as irrelevant. The following example is engineered to demonstrate how far astray the mentality for averaging and the failure to model growth can lead the valuation.Example ConditionsThe average after-tax net cash flow is $10,000,000Depreciation and capital expenditures are substantially offsettingIncremental working capital needs are minimalThe cost of equity is 15%The “assumed” perpetual annual growth rate in net cash flow is 5% As can be seen in Figure 6, relative to the common valuation of $105,000, Scenario 1 represents undervaluation by approximately 30% (10 x $15,000 = $150,000) relative to recent annual performance, while Scenario 2 reflects an overvaluation by over 100% (10 x $5,000 = $50,000). More disturbing than two quite different trends giving rise to a common valuation of $105,000 is the spread of the value range from $50,000 to $150,000 derived from the “Current CF” measures of each scenario. Which valuation is more reasonable? Are there alternatives to modeling growth that represent more plausible projections or growth rates? As can be seen in Figure 8, a valuation of $105,000 is derived from the two distinctly different historical scenarios. How might alternative projections be modeled that provide an enhanced perspective from which to study a reasonable perpetual growth rate for each scenario? Frankly, most seasoned valuation professionals would admonish the appraiser in each of the example scenarios for failing to study a projection that “engineers” the prevailing cash flows from their current respective conditions to an assumed cycle-neutral point five years hence. Simultaneously, how could a discrete projection be modeled that develops the value associated with a series of future cash flows that reconciles to a reasonable steady-state measure of cash flows and forward growth? Taking Scenario 1 first, the five-year average cash flow ($10,000) results in a measure of cash flow well below the current performance ($15,000). What might a superior path of analysis be to capture the concern that current performance is unsustainable in the near-term? Substituting the implied growth rate of cash flow resulting from the assumed perpetual growth rate of 5% and a base average of $10,000, one might postulate a more believable pattern of performance and valuation as in Figure 9. Note that the year five CF is determined as the same amount ($12,763) ultimately reached in both implied forward cash flow scenarios using the 5% perpetual growth from the base average cash flow of $10,000. An alternative modification to the original implied projection would be to regress the current cash flow performance ($15,000) to the forward year five adjusted base ($10,000 x 1.055 = $12,763). The valuation resulting from the modified projection is 7.4% higher due to a less abrupt decline than the default first year drop from $15,000 to $10,500. While this is not a radical percentage difference in the valuation, the alternative smoothed projection is a more intuitively appealing and believable model. Such a construct allows for analysis to support the development of a growth rate applicable to the cyclical high Current CF of $15,000. Using the following proof we can devise a perpetual growth rate that will reconcile the Current CF to a similar adjusted valuation of approximately $113,000. Based on Figure 9, a growth rate of approximately 2% could have been reasonably applied to the Current CF ($15,000), lending enhanced credibility to a single-period capitalization than using 5% against the multi-year average performance of $10,000. The original, default approach used by many appraisers represents a 50% immediate first year disconnect from prevailing performance that lacks a reasonable basis. This is not to say that some circumstances don’t call for an abrupt shift in assumed cash flow versus prevailing cash flow, but that is typically a fundamental issue such as the loss or gain of a significant product, territory or customer. Too often this type of flaw is the result of the default five-finger rule to averaging five years of cash flows and using a 5% growth rate. Repeating the previous exercise for Scenario 2 results in Figure 10. Based on the example in Figure 10, a growth rate of approximately 8.7% could have been reasonably applied to the Current CF ($5,000), lending enhanced credibility to a single-period capitalization than using 5% against the multi-year average performance of $10,000. Again, this is not to say that some circumstances don’t call for an abrupt shift in assumed cash flow versus prevailing cash flow, but such a scenario is typically a fundamental issue such as the loss or gain of a significant product, territory or customer. Now that both of the implied projections have been modified to reflect more gradual regression to a mean level of assumed stable performance and sustainable future growth, the valuations reveal differentials from approximately 7.2% higher to 8.9% lower relative to the $105,000 derived from the default valuation mentality often employed. More significantly, the respective valuations are better suited to the prevailing cash flows and the expected directionality of performance. Each model now reflects a more thoughtful consideration of the time value of money. Figure 11 shows how the respective projections for each scenario converge on an estimated cyclically neutral level of future performance. The respective valuations, either in the form of a DCF or in the form of a single-period capitalization, are refined to capture the time value of money corresponding to a more believable performance regression/progression forecast. It should seem logical that the refined projection showing a gradual decline (Scenario 1) that starts with an above historical average level of performance, results in a higher value than the original $105,000. Likewise, the increasing projection (Scenario 2) that starts with below historical average performance results in a lower valuation than the original treatment. The chart in Figure 11 implies that performance has a gravitational attraction to the five-year outcome as a notional level of future performance ($12,763). An alternative and perhaps more realistic projection would craft a regression of the growth rate rather than a regression of performance to a notional future amount. Decelerating growth from either its peak performance (Scenario 1) or applying rapid growth during a mode of recovery (Scenario 2) seems more logical in most real world situations than the default trend. These competing projections are depicted in Figure 12. The valuations resulting from the smoothed growth patterns are developed in Figures 13 and 14 respectively. Of course, the pattern of future deceleration or acceleration requires specific study and support. The assumed patterns are presented for example purposes. A study of these alternative modeling inputs suggests that the original valuation of $105,000 is potentially flawed. Let’s summarize the various valuation outcomes from the two different scenarios. Remember, common averaging techniques coupled with seemingly benign growth assumptions result initially in the same valuation under both scenarios. However, scrutiny of the growth and/or projection modeling reveals some dramatic differences. Admittedly, in most valuations there would be underlying facts and circumstances supporting one of three modeling conditions applied to each scenario. One can easily see how valuations can be viewed quiet differently by differing parties under differing circumstances. The primary valuation differential for each stems from the implied projection and growth modeling. The common appraiser mentality of using historical average performance (rule of thumb mindset) combined with the typical “normal/benign” assumptions concerning growth and the cost of capital, can serve to understate or overstate value. Growth analysis and reasonable forecasting (birds of the same feather) allow for a more believable and optically pleasing analyses and conclusions. Comparing alternative projections from otherwise implied projections can provide better insight into growth modeling and promote more rational forecasting.Appendix A | Case Analysis: Understanding Growth RatesOne of the most debated and poorly supported assumptions in business valuation is that of the growth rate in performance, be it earnings, net cash flow, or debt-free cash flow. The default reliance on macroeconomic or industry based data is a good beginning but often falls short of the full growth profile for a specific business in a specific industry in a specific geography at a specific point in time. The real world is often lumpy and most companies experience shifts in top-line activity, cost efficiencies, and operating leverage throughout the business cycle or in conjunction with changes in the business model. Skill and experience are powerful influencers for what feels “right,” but too often the five finger-growth mentality rules the day. What tools can an appraiser use to develop and defend growth rate assumptions and how can such a tool be used as a critical review tool?Let’s study an example featuring a combination of typical facts and circumstances.Example Conditions:The economy is stable, with nominal GDP on the order of 4% and real GDP on the order of 2%The subject Company is stable, and operating with consistent resultsThe Company is twenty years old and has experienced 10% growth in annual sales over the last five yearsThe subject Company has moderate pricing power and operates in an industry with commodity players as well as value-added players (implying a range of profit margins and revenue sizes)Historical pricing for the Company’s goods and services follows a more or less inflationary pattern (say 2.0%), and the markets resist price increases such that Company profits can be squeezed without constant attention to expensesThe goal for the Company is to expand its market from the current 25 states to all 50 states in the next five years (all states represent equal market opportunity)With margins constant, sales growth represents a reasonable proxy for growth in earnings and net cash flow (EBITDA margin +/-10%)Public companies, larger and already national in market exposure, are expecting 5% annual sales volume growth over the next five years (consistent with industry expectations) and 10% annual earnings growth (implying margin expansion)Capital structure is expected to remain unchanged for the foreseeable future (debt free) » The Company has no excessive or abnormal risk exposures or concentrationsThe Company’s goods and services do not represent new or disruptive/paradigm technologyIt is not uncommon for an appraiser to uncover the above information in the course of due diligence. Yet, the same management team that can relate such feedback to the appraiser will not “speculate” on a projection. A competent appraiser should be able to cobble together the framework of a projection for purposes of quantifying a growth rate for a single-period capitalization as well as performing a summary DCF analysis (perhaps as a test of reason or as additional direct valuation evidence). Figure 16 depicts how the facts and circumstances are expected to play out in sales and EBITDA. Most often the typical approach would be to grab a recent average level of performance and use a growth rate likened to nominal GDP (4%), perhaps influenced up a bit to reflect the recent growth performance. However, the 6.3% perpetual growth rate developed does not tie directly to the underlying data and general information. For an appraiser to get the single-period perpetual growth rate correct, he/she would simply have to get that “just right” feeling. Clearly, a bit of extra effort and the constructive extension of logic would allow for an anecdotal or direct DCF-type study that could offer support for the generally favorable growth rate required in the analysis. Figures 16-18 serve notice that macroeconomic growth rates, sprinkled with a little current and near term company performance are often misleading and can fail to capture the influence of timing on the value of future cash flows.Reconciling Multi-Stage Growth Rates to a Single, Perpetual Growth RateReport reviewers are frequently confined to terse, misguided, or unjustified positions concerning growth rates. Typically, report users are bludgeoned with anecdotal growth evidence or with historical observations that fail to translate directly into reasonable future expectations. The time value of money is frequently obscured by a failure to reconcile multi-stage growth expectations into a meaningful single-period growth rate. Figure 19 displays a matrix of single, perpetual growth rates derived from the blended short term and long term growth rate expectations based on a 15% equity discount rate. Given a beginning measure of net cash flow or earnings, the table provides the single-period growth rate necessary to derive the same value result as a DCF using a five years of annual growth from the vertical axis (displayed left) and a terminal value developed using the growth rate from the horizontal axis (displayed top). For example, a company expecting to achieve 10% annual growth for years one through five and a terminal value growth rate of 5% would require a perpetual growth rate of 6.4% to equate a Gordon-style capitalization to a DCF valuation. The 6.4% perpetual rate may lack direct or specific support anywhere in the industry or economic data, but it may functionally capture the short-term and long-term expectations that are reasonable. Some appraisers may find this simple concept too burdensome to develop and communicate and thus a trustee often ends up with the five-finger approach to growth analysis. Figure 19 provides a quick and powerful tool for assessing growth rates in valuation reports (at the specific 15% equity discount rate). Even if future growth lacks “visibility,” the fact is that years one through five are more predictable than beyond five or more years. That being a matter of common sense, a given company’s prevailing and near term trends might reasonably serve as the annual growth rate for years one through five while an industry/GDP/inflationary assumption might reasonably serve as the perpetual growth rate after the initial five-year implied projection (e.g. the terminal value growth rate). Figures 19-21 are based on alternative equity discount rates. The use of the subject’s company’s equity discount rate is vital to developing a proper growth rate perspective. We note that growth rates applicable to alternative cash flows, such a cash flow to total invested capital, can also be studied using a similar approach as described in these examples. Replicating the math of these growth tables is relatively easy for any experienced analyst or reviewer.Appendix B | Case Analysis: Testing Projection Outcomes Using DCF AnalysisFor purposes of the following case study analysis, let’s refer to the various projection scenarios depicted in Figure 22. Additionally, let’s frame the effect on the valuation from the projection scenarios using a valuation of the unadjusted management projections. Figure 22 highlights the various projection scenarios one might reasonably develop as alternatives to the base management projection. Figure 23 depicts both a DCF and single-period capitalization developed from a base projection. As can be observed in Figure 24, the valuation using a modified growth rate reduced the total equity valuation by 20%. If the appraiser and/or the trustee concur that this lower growth scenario is a more plausible outcome than management’s original projection, particularly in light of the trustee’s core concern for a long-term sustainable and serviceable ESOP benefit, then all things held constant in the base projection model, the use of an equity risk premium on the order of 2.0% applied to the equity discount rate of the original model (making it 17% versus the original 15%) would converge the value of the original projection with that of the alternative 5% growth scenario. Using this technique, the appraiser/trustee has not directly modified the projection, but the valuation is hedged for the horizon risk believed to be associated with management’s base numbers. This is a simplified but powerful example of how the appraisal process can serve to effectively adjust the valuation outcome for the uncertainty of achieving a projection. Numerous other DCF treatments including discounting timing conventions, terminal growth rates, terminal value methods, capital structure for determining the WACC, working capital assumptions, and other tweaks can individually or collectively result in significantly different valuation outcomes using the same projection. These adjustments and modeling exercises can aid appraisers and trustees in determining reasonable and credible valuation outcomes. It goes without saying that these adjustments cannot simply be arbitrary. Rather, they must be reasonable and supportable in the context of the company’s capabilities and the marketplace for ESOP ownership interests in the company. With regard to valuations over time, changes in assumptions and modeling techniques should not be buried or obscured and should be clearly reconciled for the benefit of both the appraiser and the trustee. As can be observed in Figure 25, the valuation using the 0% growth scenario reduced the total equity valuation by 37% from the original growth projection. If the appraiser and/or the trustee concur that this alternative growth scenario is a more plausible outcome than management’s original projection, particularly in light of the trustee’s core concern for a long-term sustainable and serviceable ESOP benefit, then all things held constant in the base projection model, the use of an equity risk premium on the order of 4.0% applied to the equity rate (making it 19% versus the original 15%) would converge the value of the original projection with that of the alternative 0% (no) growth scenario. Using this technique, the appraiser/trustee has not directly modified the projection, but the valuation is hedged for the horizon risk believed to be associated with management’s base numbers. As can be observed in Figure 26, the valuation using a declining growth scenario reduced the total equity valuation by 48%. If the appraiser and/or the trustee concur that this alternative growth scenario is a more plausible outcome than management’s original projection, particularly in light of the trustee’s core concern for a long-term sustainable and serviceable ESOP benefit, then all things held constant in the base projection model, the use of an equity risk premium on the order of 6.0% applied to the equity rate (making it 21% versus the original 15%) would converge the value of the original projection with that of the alternative -5% annual growth scenario. Using this technique, the appraiser/trustee has not directly modified the projection, but the valuation is hedged for the horizon risk believed to be associated with management’s base numbers. As can be observed in Figure 28, the valuation using a modified growth rate reduced the total equity valuation by 32%. If the appraiser and/or the trustee concur that this alternative growth scenario is a more plausible outcome than management’s original projection, particularly in light of the trustee’s core concern for a long-term sustainable and serviceable ESOP benefit, then all things held constant in the base projection model, the use of an equity risk premium on the order of 3.3% applied to the equity rate (making it 18.3% versus the original 15%) would converge the value of the original projection with that of the alternative cyclical growth scenario. Using this technique, the appraiser/trustee has not directly modified the projection, but the valuation is hedged for the horizon risk believed to be associated with management’s base numbers.Synthesis of Outcomes Using Alternative Projections/ Equity Discount RatesFigure 28 depicts the various growth rates scenarios studied for this example. This serves as an example of the type of sensitivity and stress testing the trustee/appraiser can employ to support the due diligence process and the documentation of the projections employed (and/or not employed) as called for under the DOL settlement protocols. As previously stated, alteration of numerous other modeling inputs could be studied in the same fashion as this example using growth rates and reconciling equity (horizon/projection) premiums. The various scenarios can be used to support concerns for downside risk concerning the valuation, the ability to service debt, and the ability to support ESOP repurchase obligation (all procedures and considerations called for under the settlement protocols). These same sensitivity processes can be used to assess the quality and relative value of the subject ESOP company to transaction data and/or guideline public company data employed and/or adjusted in the valuation.As can be seen in Figure 28, modeling alternative growth scenarios can be a powerful tool in assessing the risk profile and alternative outcomes associated with a given set of projections. While this lengthy working example has examined downside scenarios associated with projection shortfalls, the same framework can be used to assess upside potential in cases where management projections appear conservative in light of past performance and/or external business drivers. It could be argued that the assessment of repurchase obligation should include the potential impact from positive budget variances, as undervaluation today could result in an underestimation of future repurchase liability, which could lead to under-informed and potentially adverse business decisions by the sponsor company.Appendix C | SETTLEMENT AGREEMENT (DOL V. GREATBANC)UNITED STATES DISTRICT COURT | CENTRAL DISTRICT OF CALIFORNIA | Case No. ED-CV12-1648-R(DTBx)THOMAS E. PEREZ Secretary of the United States Department of Labor (Plaintiff) V. GREATBANC TRUST COMPANY, et al. (Defendants)This SETTLEMENT AGREEMENT (“Settlement Agreement”) is entered into by and between Thomas E. Perez, Secretary of the United States Department of Labor (“Secretary”), acting in his official capacity, by and through his duly authorized representatives, and GreatBanc Trust Company (“GreatBanc”), by and through its duly authorized representative (individually, a “party” and collectively, the “parties”), to settle all civil claims and issues between them.WHEREAS, the Secretary’s predecessor, Hilda L. Solis, acting in her official capacity, pursuant to her authority under Title I of the Employee Retirement Income Security Act of 1974 (“ERISA”), 29 U.S.C. § 1001, et seq., as amended, filed this action in connection with the June 20, 2006 purchase of Sierra Aluminum Company (“Sierra”) stock by the Employee Stock Ownership Plan sponsored by Sierra (the “Sierra ESOP”), and Thomas E. Perez, current Secretary of the United States Department of Labor, in his official capacity, substituted for Hilda Solis and is now the plaintiff in this action;WHEREAS, the Secretary and GreatBanc have negotiated this Settlement Agreement through their respective attorneys in a mediation process;WHEREAS, the Secretary and GreatBanc have engaged in a constructive and collaborative effort to establish binding policies and procedures relating to GreatBanc’s fiduciary engagements and to its process of analyzing transactions involving purchases or sales by ERISA-covered employee stock ownership plans (“ESOPs”) of employer securities that are not publicly traded. Those policies and procedures, to which the parties have agreed, are set forth in Attachment A hereto, which is incorporated herein as an integral part of this Settlement Agreement (hereinafter collectively, “Settlement Agreement”);WHEREAS, each party acknowledges that its representations are material factors in the other party’s decision to enter into this Settlement Agreement;WHEREAS, the parties agree to settle on the terms and conditions hereafter set forth as a full and complete resolution of all of the civil claims and issues arising between them in this action without trial or adjudication of any issue of fact or law raised in the Secretary’s Complaint in this action and other claims and issues as set forth in this Settlement Agreement;[.][Terms and conditions delineated as items A through U omitted]Attachment A Of The Settlement Agreement AgreementConcerning Fiduciary Engagements And Process Requirements For Employer Stock TransactionsThe Secretary of the United States Department of Labor (the “Secretary”) and GreatBanc Trust Company (“the Trustee”), by and through their attorneys, have agreed that the policies and procedures described below apply whenever the Trustee serves as a trustee or other fiduciary of any employee stock ownership plan subject to Title I of ERISA (“ESOP”) in connection with transactions in which the ESOP is purchasing or selling, is contemplating purchasing or selling, or receives an offer to purchase or sell, employer securities that are not publicly traded.A. Selection and Use of Valuation Advisor – General. In all transactions involving the purchase or sale of employer securities that are not publicly traded, the Trustee will hire a qualified valuation advisor, and will do the following:prudently investigate the valuation advisor’s qualifications;take reasonable steps to determine that the valuation advisor receives complete, accurate and current information necessary to value the employer securities; andprudently determine that its reliance on the valuation advisor’s advice is reasonable before entering into any transaction in reliance on the advice.B. Selection of Valuation Advisor – Conflicts of Interest. The Trustee will not use a valuation advisor for a transaction that has previously performed work – including but not limited to a “preliminary valuation” – for or on behalf of the ESOP sponsor (as distinguished from the ESOP), any counter-party to the ESOP involved in the transaction, or any other entity that is structuring the transaction (such as an investment bank) for any party other than the ESOP or its trustee. The Trustee will not use a valuation advisor for a transaction that has a familial or corporate relationship (such as a parent-subsidiary relationship) to any of the aforementioned persons or entities. The Trustee will obtain written confirmation from the valuation advisor selected that none of the above-referenced relations exist. C. Selection of Valuation Advisor – Process. In selecting a valuation advisor for a transaction involving the purchase or sale of employer securities, the Trustee will prepare a written analysis addressing the following topics:The reason for selecting the particular valuation advisor;A list of all the valuation advisors that the Trustee considered;A discussion of the qualifications of the valuation advisors that the Trustee considered;A list of references checked and discussion of the references’ views on the valuation advisors;Whether the valuation advisor was the subject of prior criminal or civil proceedings; andA full explanation of the bases for concluding that the Trustee’s selection of the valuation advisor was prudent.If the Trustee selects a valuation advisor from a roster of valuation advisors that it has previously used, the Trustee need not undertake anew the analysis outlined above if the following conditions are satisfied: (a) the Trustee previously performed the analysis in connection with a prior engagement of the valuation advisor; (b) the previous analysis was completed within the 15 month period immediately preceding the valuation advisor’s selection for a specific transaction; (c) the Trustee documents in writing that it previously performed the analysis, the date(s) on which the Trustee performed the analysis, and the results of the analysis; and (d) the valuation advisor certifies that the information it previously provided pursuant to item (5) above is still accurate. D. Oversight of Valuation Advisor – Required Analysis. In connection with any purchase or sale of employer securities that are not publicly traded, the Trustee will request that the valuation advisor document the following items in its valuation report,1 and if the valuation advisor does not so document properly, the Trustee will prepare supplemental documentation of the following items to the extent they were not documented by the valuation advisor:Identify in writing the individuals responsible for providing any projections reflected in the valuation report, and as to those individuals, conduct reasonable inquiry as to: (a) whether those individuals have or reasonably may be determined to have any conflicts of interest in regard to the ESOP (including but not limited to any interest in the purchase or sale of the employer securities being considered); (b) whether those individuals serve as agents or employees of persons with such conflicts, and the precise nature of any such conflicts: and (c) record in writing how the Trustee and the valuation advisor considered such conflicts in determining the value of employer securities;Document in writing an opinion as to the reasonableness of any projections considered in connection with the proposed transaction and explain in writing why and to what extent the projections are or are not reasonable. At a minimum, the analysis shall consider how the projections compare to, and whether they are reasonable in light of, the company’s five-year historical averages and/or medians and the five-year historical averages and/or medians of a group of comparable public companies (if any exist) for the following metrics, unless five-year data are unavailable (in which case, the analyses shall use averages extending as far back as possible). a. Return on assets b. Return on equity c. EBIT margins d. EBITDA margins e. Ratio of capital expenditures to sales f. Revenue growth rate g. Ratio of free cash flows (of the enterprise) to salesIf it is determined that any of these metrics should be disregarded in assessing the reasonableness of the projections, document in writing both the calculations of the metric (unless calculation is impossible) and the basis for the conclusion that the metric should be disregarded. The use of additional metrics to evaluate the reasonableness of projections other than those listed in section D(2)(a)-(g) above is not precluded as long as the appropriateness of those metrics is documented in writing. If comparable companies are used for any part of a valuation – whether as part of a Guideline Public Company method, to gauge the reasonableness of projections, or for any other purpose – explain in writing the bases for concluding that the comparable companies are actually comparable to the company being valued, including on the basis of size, customer concentration (if such information is publicly available), and volatility of earnings. If a Guideline Public Company analysis is performed, explain in writing any discounts applied to the multiples selected, and if no discount is applied to any given multiple, explain in significant detail the reasons.If the company is projected to meet or exceed its historical performance or the historical performance of the group of comparable public companies on any of the metrics described in paragraph D(2) above, document in writing all material assumptions supporting such projections and why those assumptions are reasonable.To the extent that the Trustee or its valuation advisor considers any of the projections provided by the ESOP sponsor to be unreasonable, document in writing any adjustments made to the projections.If adjustments are applied to the company’s historical or projected financial metrics in a valuation analysis, determine and explain in writing why such adjustments are reasonable.If greater weight is assigned to some valuation methods than to others, explain in writing the weighting assigned to each valuation method and the basis for the weightings assigned.Consider, as appropriate, how the plan document provisions regarding stock distributions, the duration of the ESOP loan, and the age and tenure of the ESOP participants, may affect the ESOP sponsor’s prospective repurchase obligation, the prudence of the stock purchase, or the fair market value of the stock.Analyze and document in writing (a) whether the ESOP sponsor will be able to service the debt taken on in connection with the transaction (including the ability to service the debt in the event that the ESOP sponsor fails to meet the projections relied upon in valuing the stock); (b) whether the transaction is fair to the ESOP from a financial point of view; (c) whether the transaction is fair to the ESOP relative to all the other parties to the proposed transaction; (d) whether the terms of the financing of the proposed transaction are market-based, commercially reasonable, and in the best interests of the ESOP; and (e) the financial impact of the proposed transaction on the ESOP sponsor, and document in writing the factors considered in such analysis and conclusions drawn therefrom.E. Financial Statements.The Trustee will request that the company provide the Trustee and its valuation advisor with audited unqualified financial statements prepared by a CPA for the preceding five fiscal years, unless financial statements extending back five years are unavailable (in which case, the Trustee will request audited unqualified financial statement extending as far back as possible).If the ESOP Sponsor provides to the Trustee or its valuation advisor unaudited or qualified financial statements prepared by a CPA for any of the preceding five fiscal years (including interim financial statements that update or supplement the last available audited statements), the Trustee will determine whether it is prudent to rely on the unaudited or qualified financial statements notwithstanding the risk posed by using unaudited or qualified financial statements.If the Trustee proceeds with the transaction notwithstanding the lack of audited unqualified financial statements prepared by a CPA (including interim financial statements that update or supplement the last available audited statements), the Trustee will document the bases for the Trustee’s reasonable belief that it is prudent to rely on the financial statements, and explain in writing how it accounted for any risk posed by using qualified or unaudited statements. If the Trustee does not believe that it can reasonably conclude that it would be prudent to rely on the financial statements used in the valuation report, the Trustee will not proceed with the transaction. While the Trustee need not audit the financial statements itself, it must carefully consider the reliability of those statements in the manner set forth herein.F. Fiduciary Review Process – General. In connection with any transaction involving the purchase or sale of employer securities that are not publicly traded, the Trustee agrees to do the following:Take reasonable steps necessary to determine the prudence of relying on the ESOP sponsor’s financial statements provided to the valuation advisor, as set out more fully in paragraph E above;Critically assess the reasonableness of any projections (particularly management projections), and if the valuation report does not document in writing the reasonableness of such projections to the Trustee’s satisfaction, the Trustee will prepare supplemental documentation explaining why and to what extent the projections are or are not reasonable;Document in writing its bases for concluding that the information supplied to the valuation advisor, whether directly from the ESOP sponsor or otherwise, was current, complete, and accurate.G. Fiduciary Review Process – Documentation of Valuation Analysis. The Trustee will document in writing its analysis of any final valuation report relating to a transaction involving the purchase or sale of employer securities. The Trustee’s documentation will specifically address each of the following topics and will include the Trustee’s conclusions regarding the final valuation report’s treatment of each topic and explain in writing the bases for its conclusions:Marketability discounts;Minority interests and control premiums;Projections of the company’s future economic performance and the reasonableness or unreasonableness of such projections, including, if applicable, the bases for assuming that the company’s future financial performance will meet or exceed historical performance or the expected performance of the relevant industry generally;Analysis of the company’s strengths and weaknesses, which may include, as appropriate, personnel, plant and equipment, capacity, research and development, marketing strategy, business planning, financial condition, and any other factors that reasonably could be expected to affect future performance;Specific discount rates chosen, including whether any Weighted Average Cost of Capital used by the valuation advisor was based on the company’s actual capital structure or that of the relevant industry and why the chosen capital structure weighting was reasonable;All adjustments to the company’s historical financial statements;Consistency of the general economic and industry-specific narrative in the valuation report with the quantitative aspects of the valuation report;Reliability and timeliness of the historical financial data considered, including a discussion of whether the financial statements used by the valuation advisor were the subject of unqualified audit opinions, and if not, why it would nevertheless be prudent to rely on them;The comparability of the companies chosen as part of any analysis based on comparable companies;Material assumptions underlying the valuation report and any testing and analyses of these assumptions;Where the valuation report made choices between averages, medians, and outliers (e.g., in determining the multiple(s) used under the “guideline company method” of valuation), the reasons for the choices;Treatment of corporate debt;Whether the methodologies employed were standard and accepted methodologies and the bases for any departures from standard and accepted methodologies;The ESOP sponsor’s ability to service any debt or liabilities to be taken on in connection with the proposed transaction;The proposed transaction’s reasonably foreseeable risks as of the date of the transaction;Any other material considerations or variables that could have a significant effect on the price of the employer securities.H. Fiduciary Review Process – Reliance on Valuation Report.The Trustee, through its personnel who are responsible for the proposed transaction, will do the following, and document in writing its work with respect to each: a. Read and understand the valuation report; b. Identify and question the valuation report’s underlying assumptions; c. Make reasonable inquiry as to whether the information in the valuation report is materially consistent with information in the Trustee’s possession; d. Analyze whether the valuation report’s conclusions are consistent with the data and analyses; and e. Analyze whether the valuation report is internally consistent in material aspects.The Trustee will document in writing the following: (a) the identities of its personnel who were primarily responsible for the proposed transaction, including any person who participated in decisions on whether to proceed with the transaction or the price of the transaction; (b) any material points as to which such personnel disagreed and why; and (c) whether any such personnel concluded or expressed the belief prior to the Trustee’s approval of the transaction that the valuation report’s conclusions were inconsistent with the data and analysis therein or that the valuation report was internally inconsistent in material aspects.If the individuals responsible for performing the analysis believe that the valuation report’s conclusions are not consistent with the data and analysis or that the valuation report is internally inconsistent in material respects, the Trustee will not proceed with the transaction.I. Preservation of Documents. In connection with any transaction completed by the Trustee through its committee or otherwise, the Trustee will create and preserve, for at least six (6) years, notes and records that document in writing the following:The full name, business address, telephone number and email address at the time of the Trustee’s consideration of the proposed transaction of each member of the Trustee’s Fiduciary Committee (whether or not he or she voted on the transaction) and any other Trustee personnel who made any material decision(s) on behalf of the Trustee in connection with the proposed transaction, including any of the persons identified pursuant to H(2) above;The vote (yes or no) of each member of the Trustee’s Fiduciary Committee who voted on the proposed transaction and a signed certification by each of the voting committee members and any other Trustee personnel who made any material decision(s) on behalf of the Trustee in connection with the proposed transaction that they have read the valuation report, identified its underlying assumptions, and considered the reasonableness of the valuation report’s assumptions and conclusions;All notes and records created by the Trustee in connection with its consideration of the proposed transaction, including all documentation required by this Agreement;All documents the Trustee and the persons identified in 1 above relied on in making their decisions;All electronic or other written communications the Trustee and the persons identified in 1 above had with service providers (including any valuation advisor), the ESOP sponsor, any non-ESOP counterparties, and any advisors retained by the ESOP sponsor or non-ESOP counterparties.J. Fair Market Value. The Trustee will not cause an ESOP to purchase employer securities for more than their fair market value or sell employer securities for less than their fair market value. The DOL states that the principal amount of the debt financing the transaction, irrespective of the interest rate, cannot exceed the securities’ fair market value. Accordingly, the Trustee will not cause an ESOP to engage in a leveraged stock purchase transaction in which the principal amount of the debt financing the transaction exceeds the fair market value of the stock acquired with that debt, irrespective of the interest rate or other terms of the debt used to finance the transaction. K. Consideration of Claw-Back. In evaluating proposed stock transactions, the Trustee will consider whether it is appropriate to request a claw-back arrangement or other purchase price adjustment(s) to protect the ESOP against the possibility of adverse consequences in the event of significant corporate events or changed circumstances. The Trustee will document in writing its consideration of the appropriateness of a claw-back or other purchase price adjustment(s). L. Other Professionals. The Trustee may, consistent with its fiduciary responsibilities under ERISA, employ, or delegate fiduciary authority to, qualified professionals to aid the Trustee in the exercise of its powers, duties, and responsibilities as long as it is prudent to do so. M. This Agreement is not intended to specify all of the Trustee’s obligations as an ERISA fiduciary with respect to the purchase or sale of employer stock under ERISA, and in no way supersedes any of the Trustee’s obligations under ERISA or its implementing regulations.

This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. The market approach is a general way of determining the value of a business, business ownership interest, security, or intangible asset by using one or more methods that compare the subject to similar businesses, business ownership interests, securities, or intangible assets that have been sold. Functionally, market methodologies are similar to direct capitalization income methods in that a benefit (or performance) measure of the subject business is converted to value by a capitalization factor. It is the specificity of the data supporting the capitalization factor that differentiates market methodology from income methodology.In general, income methodologies rely on indirect, broad market rates of return on capital (Ibbotson, et al.) and on various data sets and trends to establish growth rates. For cases in which there is more direct information from a comparable market, such information is used in a market approach to develop a value for the subject entity. These comparable markets offer evidence of either direct- or relative-value metrics based on transaction activity among investors. Such markets can be described as direct—in that a similar ownership interest or security in the same subject entity has transacted—or as indirect—in that a group of publicly traded securities of similar companies can be observed and/or that transactions of entire entities can be observed. The market approach includes numerous methods, which are generally named according to the nature of the direct or relative-value market data. Naming conventions for certain market methods differ among valuation practitioners but most fall into three categories: (1) the transaction method, (2) the guideline public company method, and (3) the guideline transactions method. As with market data sets used in income methodology, the appropriateness of the data (i.e., its comparability and overall strength of relevance) is the primary concern. Market evidence may require adjustment to address a variety of issues before it can be used to value the subject interest. These adjustments differ based on which of the various market methods is employed as well as on the nature of the transactions observed. The following provides an overview of the primary elements of comparability and adjustments under the three primary categories of market methodology.Valuation Methods Under The Market ApproachThe market approach includes a variety of valuation methods under which pricing metrics are drawn from transactions of interests in companies that are comparable to the subject company. The three primary valuation methods under the market approach are summarized below.Transactions Method — derives value using pricing metrics of historical or contemporaneous transactions of interests in the subject company.Guideline Public Company Method — derives value using transaction information drawn from publicly traded securities of companies in the same or similar lines of business as the subject company.Guideline Transactions Method — derives value using pricing metrics of mergers and acquisitions involving controlling interests of companies (public and private) in the same or similar lines of business as the subject company.The comparability and reliability of observed transactions is the central concern. The three core market methodologies yield differing types of valuation information for a given ownership interest or entity. Based on the market in which the observed transaction(s) occurred, there can be differing relative valuations. The transaction method may yield valuation information at various levels of value (control or minority). The guideline public company method generally yields valuation information at the marketable minority interest level of value. The guideline transactions method generally yields valuation information based on the controlling interest level of value. Accordingly, the value definition used for an appraisal may suggest which single method or combination of methods might directly apply in the appraisal process. Rarely is a guideline transactions method employed in a valuation calling for the minority interest level of value. Conversely, observed transactions in minority ownership interests of the subject entity may not provide appropriate valuation information for valuations in which the engagement calls for use of the controlling interest level of value. Although market methods can result in valuations at varying levels of value, each of which may differ from the level of value defined for a given appraisal, there can be useful information in transaction activity even if such activity implies a valuation that is not directly equivalent to the value definition specified in the appraisal engagement. Frequently, there are circumstances in which the appraiser may observe activity that provides indirect support for the valuation or that can be reconciled to the value definition called for in the appraisal report. As with income methods, the valuations developed using market methodology can result in a value indication for the equity of the subject or for the assets (invested capital) of the subject. In the latter case, the market value of debt is subtracted to derive the equity value of the subject. Appraisers may elect to use market methods that result in direct value indications that differ from the value definition called for in the appraisal engagement. In such cases, valuation discounts and premiums are usually applied to adjust the value indication to the specified level of value defined for the engagement.Rules of ThumbA valuation rule of thumb relates an operational or financial measure of a company to a measure of value. Most metrics are operational in nature (based on some unit of business activity or volume) or are financial (representing a multiplier to capitalize revenue, cash flow or some other financial benefit stream). There is rule-of-thumb valuation innuendo in almost every industry. In some cases, such information provides useful insight into the mentality and predisposition of what an owner of a business or business interest believes their holding is worth. This is particularly true of industries whose participants adhere to a relatively narrow range of norms in operating, financial, and/or physical composition.A rule of thumb value indication is typically a controlling interest level of value. In some cases, rules of thumb reflect a strategic value as opposed to a financial controlling interest value. Appraisers using or referring to rules of thumb must be aware, to the degree possible, of the origin of the rule of thumb in order to assess whether it captures synergies or other premium benefits (or expected profitability) available only to specific strategic investors. Because most rules of thumb have their genesis within a given industry or trade group, strategic elements are often included. Accordingly, ESOP valuations using the fair market value standard may result in conclusions lower than the common industry rules of thumb. However, industry rules of thumb may also coincide with fair market value if the hypothetical investor is closely aligned with likely market participants in the industry or market.Most rules of thumb relate to the total enterprise value of assets as opposed to the total equity value of a business. Hence, the determination of equity value requires the subtraction of debt from the total enterprise value. As with the private transaction databases, rules of thumb generally require adjustment for certain types of assets and liabilities that are not typically part of transactions. Cash balances, certain liabilities, working capital, real estate, and other balance sheet amounts may be treated separately from core business assets.Rules of thumb can be highly misleading as most subject companies differ from the stereotypical company in the stereotypical market with a steady-state cycle of performance. Even when such normalcy appears evident, there are marketplace and economic factors that result in valuations that deviate from the central point of a suggested range. Some valuation texts refer to the use of a rule of thumb as a valuation method. Likewise, there are proprietary transaction databases that, when viewed across multiple industries over extended periods of time, are promulgated to represent meaningful information in the valuation of small business enterprises. Appraisers have the task of determining whether or not such data rise to an acceptable level of reliability and/or relevance. In most cases, we see such data as constituting a rule of thumb, and, therefore, subject to healthy scrutiny and devil’s advocacy.Many small- to middle-market companies (enterprise valuations of $5 to $500 million) have enjoyed increased access to capital funding alternatives and exit strategies in recent years. The rise of private equity buyout firms and the general increase in knowledge among business owners has influenced evolution in rules of thumb. Historically simplistic references to unit revenue measures have evolved and been reconciled to financial measures.For example, an old-guard rule of thumb in the beverage distribution industry was based on annual volume of cases sold. A distributor of a given type or brand of product might generally assume or expect a certain business value based on annual case-volume activity. However, changes in product mix caused by evolving consumer preferences over time rendered these rules less reliable in explaining the value of a given distributor whose margin was below or in excess of norms. Eventually, the industry vernacular became more focused on gross profit, which better characterizes profit by taking into account the mix and pricing of product offerings. However, operating expense structures of distributors vary to the extent that gross profit is often inadequate in explaining value differentials in transactions. In the current environment, rules of thumb have taken the next step by reconciling to financial measures (such as a multiple of cash flow). Any rule of thumb based on an industry metric (i.e., tons, cases, etc.), can be reconciled to a financial equivalency. Doing so facilitates easier value comparisons and provides a financial basis for reconciling the concluded value in an appraisal to a broad industry rule of thumb.Consistent with the business valuation standards issued by the professional organizations, we do not suggest using a rule of thumb as a stand-alone valuation method under the market approach. However, when valuing a subject entity or interest using a controlling interest level of value, we do encourage appraisers and reviewers to be aware of any rule of thumb that may characterize value in the subject’s industry. In most cases, an indirect reference to a rule of thumb can provide support for a value conclusion developed under more conventional and financially sound methods. If a conclusion deviates from a rule of thumb, it can be useful for the appraiser to explain why.Transactions MethodThe transactions method is a market approach that develops an indication of value based upon consideration of observed transactions in the ownership interests of the subject entity. Transactions should be scrutinized to determine if they have occurred at arm’s length, with a reasonable degree of frequency, and within a reasonable period of time relative to the valuation date. Inferences about current value can sometimes be drawn, even if there is only a limited market for the ownership interests and relatively few transactions occur.The timeliness of a transaction is important. However, time itself is not the only parameter that determines whether a transaction is reliable for use in a given appraisal. If internal and/or external business conditions or other factors have changed or evolved in a significant way from the time of the observed transaction to the date of the valuation, then use of the transaction may be unreliable. This could also be true for a transaction occurring in close proximity to the valuation date. While a dated transaction may be unreliable in absolute value terms, the implied relative value of the transaction may be useful to examine (such as price to book or enterprise value to cash flow). Arguably, any transaction that has occurred in reasonable proximity to the valuation date should be disclosed and distilled even if it is not directly considered toward the valuation. In such a case, the appraiser may need to explicitly qualify why a transaction is not being given direct weight in the valuation. In select cases where entity and market performance have remained stable over time, transactions that are somewhat dated may provide meaningful direct or indirect support to the appraisal. Transactions occurring subsequent to the valuation date should not be considered unless the facts and circumstances of such activity were known or reasonably knowable as of the valuation date and there is (was) a high likelihood of the transaction closing.There are many corporate and shareholder events in the ordinary course of business that may produce meaningful transaction data. Shareholder redemptions, capital raising, transactions among the ownership group, recapitalizations, buy-sell trigger events, equity compensation grants, business acquisitions, dispositions, and other events are not unusual, particularly in larger entities or in entities with large and/or active ownership groups. It is important that any transaction used to develop an indication of value for the entity, or more directly for the subject interest, be considered in the proper context (in terms of value definition) of other valuation methods developed in the appraisal. Frequently, transactions must be adjusted using estimated (and reasonable) discounts or premiums to derive a meaningful base of comparison to the subject interest.Guideline Public Company MethodThe Guideline Public Company Method (GPCM) involves the use of valuation metrics from publicly traded companies that are deemed suitably comparable to the subject entity. Direct comparability is difficult to achieve in many situations, as most public companies are larger and more diverse than the subject, closely held entities in most business appraisals. However, the threshold for direct comparability need not be so inflexible that public companies with similar business characteristics are disqualified from providing guidance in the valuation of the subject company. In some cases, public companies may not be reliable for direct valuation purposes but may yield information helpful in ascertaining norms for capital structure assumptions and growth rate analysis.There are relatively few industries in which direct comparability is readily achieved, and most of those present challenges by the sheer scalar differences between the public operators and most private enterprises. The selection of, adjustment of, and application of public company valuation data can be a complicated process involving significant appraiser skill and experience. Absent proper execution, the GPCM can render valuation indications that differ significantly from other methods and thus lead to confusing and/or flawed appraisal results.Guideline companies are most often publicly traded companies in the same or similar industry as the valuation subject and/or that provide a reasonable basis for comparison to the subject company due to similarities in operational processes, supply and demand factors, and/or financial composition.Investors in the public stock markets often study the P/E ratio of a security for purposes of assessing the merits of the investment. The P/E ratio of a stock is utilized in a common variation of the GPCM whereby a guideline public P/E ratio is used to capitalize the subject company’s net income. Other variations include the use of valuation metrics to capitalize pre-tax income, numerous versions of cash flow, book value, revenues, or other performance measures of the valuation subject.Investors in the public securities markets are said to be transacting minority investments (non-controlling) in the issuer’s security, and such investors enjoy the benefit of regulated exchanges and mandatory information disclosures by the issuer. Regular filings by publicly traded companies allow investors to assess the valuation of the security in relation to an almost endless array of operational and financial performance measures for the public company. Guideline company valuation metrics produce marketable minority interest valuation indications. The term “as- if- freely- traded” is often used to describe value indications under the GPCM. Guideline companies are used to develop valuation indications under the presumption that a similar market exists for the subject company and the guideline companies.Ideal guideline companies are in the same business as the company being valued. However, if there is insufficient transaction evidence in the same business, it may be necessary to consider companies with an underlying similarity of relevant investment characteristics such as markets, products, growth, cyclical variability, and other salient factors.Although a guideline group may provide some indication of how the public markets value the subject company’s shares, there are limitations to the method. For example, it is virtually impossible to find identical guideline companies. In addition, analysts must assume that all relevant information about a company is embedded in its market price. A guideline group can sometimes provide useful valuation benchmarks, but it is ultimately left to the analyst to derive an appropriate capitalization factor for a subject company based upon a thorough comparison of the selected group of guideline companies to the subject company.Variations of the Guideline Public Company MethodThe GPCM can be used to develop value indications for both invested (or enterprise) capital and equity capital. There are numerous sub-methods for performing both types of valuations. The nature of the denominator in a guideline valuation metric or ratio determines the nature of the value indication. Consistent with the rules governing proper income method execution (namely, matching the discount rate to the proper measure of the subject’s earnings or cash flows), the benefit stream of the valuation subject should be capitalized by the appropriate guideline valuation metric. Performance measures and benefits streams have one primary differentiating feature – they are either before debt-service costs or after. The performance or benefit measures that capture cash flows before the payment of debt costs (i.e., interest expense) are used to develop value indications for the invested capital (i.e., total assets) of the guideline companies and, therefore, result in the same valuation for the appraisal subject. The performance measures that capture cash flow after debt service are used to develop value indications for equity capital. As with any approach or method that results in a direct valuation of invested capital, debt is subtracted to arrive at the value of equity. Although it is true that a valuation metric can relate a pre-debt cash flow to equity value (and vice versa an after-debt cash flow to invested capital), we view this as a likely source of valuation error and would discourage such methodology unless there is a convincing reason to do so. We would likely disregard the use of the GPCM if such mixing of benefit streams and capitalization factors were the only calculations developed (e.g., price-to-sales or priceto-EBITDA, etc.).Appraisers have the task of developing guideline company cash-flow measures and value metrics in a fashion consistent with the cash flows and valuation math used for the valuation subject. Mismatching the guideline valuation metric with the wrong benefit measure of the subject is a common mistake. Appraisers are encouraged not to take valuation multiples for a given public company or group of companies from a published or electronic data source unless the underlying definition and/or development of the metric is adequately detailed. There can be subtle but meaningful variations in how an appraiser tabulates a benefit measure, such as EBITDA, versus how it was tabulated in the cited source material.Appraisers must also be mindful of understanding the implications of developing guideline company valuation metrics using financial information and pricing data from periods that are reasonably consistent with the benefit measures of the valuation subject. Public market stock pricing conventions follow a rolling four-quarter or 12-month norm. Often, the acronym LTM (last twelve months) or TTM (trailing twelve month) is used to denote that a given cash flow or earnings measure was tabulated using the most recent annualized performance measure of the public company. That is, a given P/E ratio or MVIC/EBITDA ratio is based on the market capitalization as of a defined date and the most up-to-date, 12 month earnings or cash flow measure of the public company.Although it is not absolute that timing of the data used in developing a guideline valuation metric must be applied to the subject’s benefit measure from the same period, it is recommended that this be the base convention in most business valuations. Due to performance fluctuations and the timing of the business cycle (among other things) from the valuation subject to a given peer guideline company group, some appraisers may use average pricing metrics spanning several years for the guideline companies against a similar average of cash flows or earnings for the valuation subject. This type of execution seemingly parallels common disciplines used in various income methods in which an ongoing, average expression of earnings and cash flow is capitalized by a factor whose underlying discount rate and growth rate were derived from data observed over some historical time frame.We urge caution when not following consistency of timing regarding pricing measures and/or benefit streams from subject to peer. For example, when a multi-year average of subject earnings is capitalized using the median LTM P/E ratio from a guideline group, the valuation of the subject can be characterized as being adjusted for fundamentals resulting in a valuation that is higher or lower than would be the case had the LTM P/E ratio been applied to the LTM earnings of the subject. This type of fundamental adjustment is but one of many implicit or indirect adjustments that an appraiser can capture under the GPCM. These adjustments need not be construed as flawed as long as there is adequate purpose and explanation for why such a discipline was employed and perhaps even a calculation of the impact on the valuation indication versus a valuation using the typical timing conventions (i.e., guideline LTM to subject LTM).For valuations in which the GPCM is employed, the guideline data may serve an additional purpose. A properly developed appraisal opinion may have numerous value indications under the cost, income, and market approaches. Value indications from various methods are typically correlated with, or weighted toward an overall valuation conclusion that attempts to reflect the entirety of process and consideration captured in the valuation. Some appraisers have long practiced providing a relative value analysis at the end of their valuation reports that educates the reader on numerous observations of relative value. In such a fashion, the appraiser can present the valuation conclusions from perspectives that extend beyond the direct methodology employed. Accordingly, the appraiser may effectively assert that the conclusions directly developed are consistent with alternative or additional valuation methods that had would support the conclusions reached had such alternative or additional valuation methods been employed.The relative value analysis is often used to articulate the sanity and appropriateness of the conclusions based on comparing various valuation ratios to broad-market norms, market transactions, or public market pricing for similar (guideline) companies. Relating the valuation conclusion to the reported book value of equity, to the adjusted value of tangible equity, to various measures of cash flow, etc. is an often used technique to support the valuation and to provide a basis for explaining why the conclusion reflects or differs from various peer measurements. In some cases, a guideline company group may have been identified but not used directly. Regardless, when such market evidence is reasonably observable, comparing the data and reconciling it against the valuation conclusions can be a useful and informational exercise.For example, consider a valuation in which equal weights were applied to the cost approach (e.g., net asset value method) and the income approach (e.g., direct capitalization of earnings), resulting in a correlated equity value of $8,000,000 (marketable minority interest level of value). The subject has $2,000,000 of debt, implying a market value of invested capital (MVIC or TEV) of $10,000,000. Assume the subject entity has a debt-free net cash flow of $1,000,000, EBIT of $1,667,000, and EBITDA of $2,000,000. The resulting MVIC ratios to EBIT and to EBITDA are approximately 6.0x and 5.0x, respectively. If market data were identified but not directly employed, it may be that the valuation conclusion can be compared and reconciled to the market data. All such comparisons must be assessed using the same level of value for both the guideline peer data and the subject company. The table in Figure 1 presents an example of a multi-method execution of the GPCM. Some of the valuation metrics result in a valuation for equity and some for invested capital. In the example, it is by design that each indication of value is the same. Valuation indications from varying methods within the GPCM will vary, and, in some cases, the variations can be significant. We note that capitalized revenue and capitalized book value will often yield different valuation indications than capitalized earnings or cash flow. In such cases, the appraiser must develop and/or select from those methods and indications believed to be reliable for the appraisal assignment and the definition of value called for therein. Several caveats and considerations are required to properly execute a GPCM.There is a fundamental adjustment of 20% applied to each equity value indication developed under each method. A following section of this publication will provide an overview of how fundamental adjustments for guideline data can be developed.There is a line item for the market values of non-operating assets (and liabilities). Appraisers should apply adjustments to the earnings and other performance measures to eliminate the effects of non-operating assets because the values of such assets are typically captured on the back end of the analysis in order to develop the final indications of value. Failure to adjust the performance measures can result in double counting errors.There is a line item providing for the potential application of a control premium. Such a premium applies only when the engagement definition calls for the controlling interest level of value. The consideration of a control premium at this stage serves as a proxy for other adjustments not otherwise captured in previous adjustments or reflected in the guideline multiples or applied as a subsequent treatment after a correlation of the GPCM with other methods employed in the appraisal. We caution that blind application of published control premiums is a frequent source of flawed, over-stated valuation. Published control premiums are consequential measures of investor expectations for efficiencies and other value pick-ups from the reported transactions. They reflect expectations of post-deal operating and strategic economies. In the context of appropriately adjusted performance measures and other valuation inputs, most financial control premiums for small private companies are quite modest to nil. This can be particularly true in ESOP situations where the entity is remaining an independent going concern and will not benefit from postmerger efficiencies and synergies embedded in most market-based transactions.A memo section in the example displays what each value indication implies on a relative basis by way of comparison of each value method to the subject’s book value, net income, and EBITDA. In this fashion, appraisers and users of valuations can assess how a valuation indication using one valuation metric relates to another.When multiple indications of value are developed using the GPCM, the appraiser may elect to average the indications into a singular expression of value or may elect to carry individual value indications from the GPCM into a broader exercise to correlate the overall conclusion of value from all methods developed using the three core approaches to value. We believe both of these presentations to be appropriate, but we caution that appraisers and report users should be aware of the total consideration applied to each methods and approach.Identifying Guideline CompaniesThe initial stage generally includes the identification of relevant subject company characteristics to serve as a basis for a public company or transaction search. These characteristics include (among other things):The subject entity’s portfolio of products and/or servicesThe subject entity’s vertical and/or horizontal integration in its respective industryThe subject entity’s market share in the industry or in subsets of geography or by customer type, and so forth (to whom and where are the subject’s products and services sold?)The subject entity’s operational and organizational structureThe characteristics outlined in this list can be used to identify codes under the Standard Industrial Classification (SIC) and North American Industrial Classification Systems (NAICS - used in the United States, Mexico, and Canada). These codes can be used to identify transacting companies and public companies with common economic activities to the valuation subject. Appraisers may need to augment such global screenings with key word searches or perform parallel searches of other SIC or NAICS codes that represent businesses with substantially similar business attributes. Screening of electronic and web-based resources is a virtual standard in valuation practice today. Such resources often include industry data and noteworthy public and private participants. Additional criterion used for selecting and narrowing selections include consideration of the subject’s and the guideline companies’ financial performance and composition, the nature of the assets, the supporting capital structure, trends in absolute and relative performance via size and margin considerations, and consideration of internal and external factors that drive or influence business activity. Choice of Valuation MetricThe valuation metrics applied in a given appraisal should be commonly accepted and recognized as relevant to the subject’s industry (earnings, EBITDA, book, etc.) and should be reflective of business cycle or other relevant issues affecting the subject, its industry, and its guideline peer group. For example, guideline capitalized net income is a common valuation norm for many financial institutions and service companies, while capitalized EBITDA is a more recognized valuation norm for asset-intensive business such as manufacturers. In many valuation engagements, the value of an entity in relation to its book value can be important.The reliance of securities markets on various types of valuation information can shift during economic and industry cycles. Businesses that typically have higher valuations during economic expansions may be valued with higher reliance on capitalized cash flow or earnings, while valuations in recessionary periods or down cycles may place greater reliance on asset-based valuation methods. The point is that valuations performed from one time to another or for one purpose to another may require differing degrees of reliance on and consideration of the GPCM as a whole, as well as differing degrees of reliance on and consideration of varied indications of value underlying the GPCM. A rigid average of underlying methods in the GPCM as well on other methods and approaches in an appraisal may constitute little more than a rule-of-thumb or formulaic approach to value and can lead to flawed valuation results.The Fundamental AdjustmentUnder both the guideline public company method and the guideline transactions method, it is necessary to adjust the market evidence observed in transactions of comparable companies for fundamental differences between the subject company and the guideline companies.Adjusting Guideline Valuation Metrics for Use in Business ValuationWhat is a fundamental adjustment? The term “fundamental adjustment” is not a universal term, but it is a universal treatment applied explicitly or implicitly in virtually every GPCM and guideline transaction method (GTM). Where market-value evidence is observed, screened, and modified for use in the GPCM or GTM, one can be virtually assured that some adjustment has been applied to the data. The adjustment of market-value evidence, whether it is through selection criterion, central tendency observations, or otherwise is what we refer to as a fundamental adjustment. Labels and terms aside, we acknowledge the need for an explanation of how an appraiser adjusts market-value evidence used in the appraisal process. The obfuscation of or failure to consider such adjustment is a common feature of and/or source of error in many appraisals.Figures 2 and 3 provide perspective concerning the conceptual framework of market-value evidence and its adjustment for use in business valuations. Figure 2 relates to the marketable minority level of value that by default is the typical level of value arising from the GPCM. We note that the financial and strategic control levels of value may differ from guideline to subject using the same concepts discussed here.The necessity for fundamental adjustments is frequently overlooked. These adjustments are required to reconcile differences between the subject company and the selected group of guideline companies (or transactions as the case may be). Fundamental adjustments are generally applied as discounts to the observed market-value evidence (reflecting a typically smaller and riskier valuation subject versus larger public companies that populate a guideline company group), but they can also represent premiums in relationship to the base market-value evidence.Core comparative considerations between the valuation subject and the guideline companies include the following:Size. Publicly traded guideline companies are often larger and more diversified than the valuation subject. Diversification and scale regarding geographic footprint, customer concentration, supply inputs, and other common risk factors typically favor guideline public companies and acquirers in transactions. All things being equal, this would imply a lower valuation multiple for a relatively smaller subject entity.Growth. The growth expectations of guideline companies may be materially different than the growth expectations for the subject company. All things being equal and using the basic representative equation of valuation and the underlying elements of a valuation multiple, higher growth translates to higher valuation multiples and vice versa.Access to and Composition of Financing. The ability to obtain financing and negotiate favorable terms can facilitate future growth and provide superior returns on investment. The capital structures and financing power of large public companies can reduce the cost of capital and provide greater operational and strategic flexibility. Such factors translate to higher valuation multiples than may be reasonable for smaller companies lacking such resources.Financial/Operating Strength. Guideline companies may be better capitalized and have greater depth in their respective management teams.The underlying need for fundamental adjustments arises because of differences in the risk profile and growth prospects of the valuation subject in relation to the companies whose trading and transaction data are used in a valuation. By process, the adjustments are developed (through explicit analyses or otherwise) by substituting the risk and growth attributes captured in the guideline data with the risk and growth attributes of the valuation subject. In this fashion, the appraiser attempts to answer the question – how would the market-value evidence differ if the guideline companies and/or the transaction participants had the same risk profile and growth prospects as the valuation subject? This question provides the genesis for understanding a quantitative method for assessing the magnitude of a fundamental adjustment. There are numerous variations of quantitative adjustment and most are predicated on the principle of substitution. Quantitative Process for Assessing a Fundamental AdjustmentAs a preface to the following example, readers are reminded of the build-up and ACAPM methods for developing the required rate of return on equity capital. These CAPM-based disciplines provide the basis for disaggregating the P/E ratios of public companies in a fashion that facilitates the process for substituting the subject risk profile and growth of the subject and determining the effect on the P/E ratio. Such quantification may suggest the magnitude of an appropriate fundamental adjustment. The following assumptions and conditions are used in the example. The figures and assumptions in this example are purely for demonstration purposes.Ten public companies were identified as guideline public companies. The median P/E ratio of the group was 10x. The reciprocal of this P/E ratio equals a capitalization rate of 10%.The median equity market capitalization of the 10 guideline companies would place the hypothetical guideline company near the bottom of 9th decile of public companies according to the Morningstar/ Ibbotson SBBI Yearbook. The 9th decile companies reflected an implied size premium on the order of 4.0% in excess of returns on the S&P500 index (large cap stocks). The median beta was 1.0, implying equal volatility to the S&P500.Financial composition and performance of the subject company were reasonably consistent with the guideline company. The elements of risk were primarily related to differences in firm size.Stock analysts following the guideline companies were projecting annual earnings growth of approximately 10% for the next five years. Long-term industry prospects suggested annual earnings growth on the order of 4%. The guideline growth rate expectations equate to a perpetual earning growth rate of approximately 6%. The implied required rate of return for the hypothetical median guideline company is 16%. This measure of return minus the perpetual growth rate of 6% equals the observed capitalization rate of 10%. The subject company was mature and displayed recent earnings growth of 10%, near-term growth expectations were expected to decline by 1% each year and level out at a long-term growth rate similar to the overall industry (4%). The subject growth rate expectations equate to a perpetual earning growth rate of approximately 5%.At the valuation date, the risk-free rate of return on long-term U.S. Treasury bonds was 5%. The assumed large stock equity premium was assumed to be 7%. The size premium deemed appropriate for the subject company was 6%, and firm-specific risk was assumed to be 1%.The table in Figure 4 depicts the changes in the median guideline P/E ratio via the sequential and combined substitution of subject growth and risk into the build-up process. The differences between the resulting adjusted capitalization factors and the median guideline P/E ratio represents the fundamental adjustment.The risk differential (combined size- and firm-specific) suggests the median guideline P/E ratio be reduced by 23% solely based on the valuation subject’s risk. The growth differential suggests the median guideline P/E ratio be reduced by 9% based solely on the valuation subject’s risk. Considering risk and growth differentials, the median guideline P/E ratio would be reduced by 29%. In operation, this adjustment would be applicable to pricing metrics that result directly in value indications for total equity or could be applied to the resulting equity value derived after subtracting debt from value indications for invested capital. Using the foregoing example, we might see an appraiser use a fundamental adjustment of 15% to 25%. Every situation is unique, and the exact quantified result of this technique is not the absolute adjustment that need apply.Fundamental Adjustments in DisguiseThe following bullet points highlight some of the possible implicit adjustments we see applied to market-value evidence. These points are random in fashion and are designed to spark the necessary analytical curiosity required to scrutinize valuation methods under the market approach.Most appraisers, even those who have never employed the term “fundamental adjustment,” have employed the same concept in appraisals. In fact, any appraiser who has selected guideline company multiples other than the median (or perhaps, the average), whether above or below, has implicitly applied the concept of the fundamental adjustment. Based on comparisons between private companies and guideline groups of companies, appraisers often select multiples above or below the measures of central tendency for the public groups.Analysts routinely add a small stock premium to the base, CAPM-determined market premium based on historical rate of return data. In addition, analysts routinely estimate a specific company risk premium for private enterprises, which is added to the other components of the ACAPM or build-up discount rate. Implicitly, analysts adjust public market return data (from Ibbotson or other sources) used to develop public company return expectations to account for risks related to size and other factors. In other words, they are making fundamental adjustments in the development of discount rates.What are the differences between the subject company and the guideline companies, and how does one incorporate them into the analysis? If all of the guideline companies were identical to one another and the subject company was identical to the guideline companies, then subject value would be equal to the values of the guideline companies. Because this is never the case, the analyst has to identify the important differences and determine what adjustments are required to arrive at a reasonable estimate of value for the subject.The actual value measure applied to the subject may be anywhere within (or sometimes even outside) the range of value measures developed from the market data. Where each measure should fall will depend on the quantitative and qualitative analysis of the subject company relative to analysis of the companies that comprise the market transaction data. Valuation pricing multiples are influenced by the same forces that influence capitalization rates, the two most important of which are: (1) risk and (2) expected growth in the operating variable being capitalized.Therefore, in order for the analyst to make an intelligent estimate of what multiple is appropriate for the subject company relative to the multiples observed for the guideline companies, the analyst must make some judgments about the relative risk and growth prospects of the subject compared with the guideline companies.The analyst should be aware that a search criterion could represent the beginning of a fundamental adjustment in the eyes of potential users of a report. The analyst can unwittingly (or overtly) apply a fundamental adjustment before the mathematical process even begins.As with any discount or premium, a fundamental adjustment has limited meaning unless the base against which the adjustment is applied is clearly defined. Define such base in error, through either commission or omission, and the selection and adjustment of public company valuation metrics may be faulty.Use of generic methodology in lieu of an emphasis on relevant metrics can be construed as a fundamental adjustment.Ultimately, as a result of weighing alternative valuation methods to the ultimate valuation conclusion, the valuation may reflect a significant discount to public company multiples and potentially a higher (or lower as the case may be) fundamental adjustment than explicitly articulated (or implicitly captured) under the guideline method.ConclusionAs with many tools in the valuation, there are variations of this process. Some appraisers may elect to quantify adjustments for application to differing valuation metrics so as to take into consideration specific differences in profit margins or capital structure. Fundamental adjustments can be small or large and can be positive or negative. Appropriate quantification techniques can be useful tools in augmenting qualitative-based adjustments. Fundamental adjustments can be explicit in nature or implicit and disguised in numerous ways. Ultimately, it is the appraiser’s responsibility to select and reasonably adjust market-value evidence for use in the GPCM or the GTM.Guideline Transactions MethodThe transactions method and the GPCM follow a generally recognized (more or less) set of procedures and practices. The guideline transaction method (GTM) is inherently different in its requirements due to potential idiosyncrasies in the underlying data.The largely private purveyors of market-value evidence used in the GTM provide varying degrees of data from varying markets. Transaction events are generally classified by industry, facilitating SIC- and NAICS-enabled screening. However, transaction consideration and various valuation ratios may follow differing definitions. Certain adjustments are required to add or subtract values associated with excluded assets or to compensate for the effect of specialized transaction consideration and other deal terms in order for an appraiser to develop an appropriate valuation of the subject.The required adjustments and considerations vary from one data source to the next. Such adjustment items may include employment contracts, non-compete agreements, contingency payments, seller financing terms, working capital, real estate, specialized expressions of cash flow and other transaction attributes. Care must be taken to ensure that the methodology results in value indications that are consistent with the value definition required in the appraisal description. Appraisers and report users are cautioned that data sources should be reviewed to understand what kind of valuation is captured in the transaction data (typically it is the market value of invested capital) and how that data needs to be adjusted to derive the intended subject valuation (equity value in most valuation engagements). Confusion in the proper use of transaction data bases has fueled a veritable professional niche of publications intended to instruct appraisers on the proper use of market-value evidence from the various databases. This suggests that transaction observations be supported by sufficient (perhaps significant) underlying financial detail.In operation, the GTM is similar to direct capitalization income methods and to the GPCM in that a specified subject performance measure is capitalized by a capitalization factor that is derived from observable market-value evidence (transactions). As with other guideline data processes, capitalization factors are typically drawn from numerous transactions implying some average valuation metric or ratio. Adjustments to reconcile fundamental differences between subject and guideline follow similar considerations as discussed in the GPCM. Differing valuation metrics may be used to describe transaction values based on the nature and industry of buyers and sellers in the cited transactions. As with income methods and other market methods, consistency between performance measures and capitalization multiples is required.Valuations using transaction data result in a controlling interest valuation indication. As such, the GTM may not be employed (or useful) in a valuation intended to develop a minority interest level of value. Alternatively, a controlling interest value can be adjusted by valuation discounts to derive alternative levels of value. Market transactions are used to develop valuation indications under the presumption that a similar market exists for the subject company.As with the guideline public company method, ideal guideline transactions involve companies which that are in the same business as the company being valued. However, if there is insufficient transaction evidence in the same business, it may be necessary to consider companies with an underlying similarity of relevant investment characteristics such as markets, products, growth, cyclical variability, and other salient factors.One or a combination of data sources are typically employed in the GTM. Additionally, there are countless other potential sources of information that are reported by specialized industry trade groups, investments banking concerns, industry consultants, and other market participants. Information may also be gleaned from the corporate development activities of publicly traded buyers and sellers because such data may be reported in SEC filings. There is a wealth of potential information from diverse providers of financial and market market-based information including (among others) SNL Securities, Thomson Reuters, and Bloomberg.Virtually every caveat and caution discussed for the GPCM and the transaction method extend to the GTM (and then some). Appraisers are challenged with adequate documentation of transactions, proper application of the data, and proper adjustment of the results. Many appraisers include citation of transaction data in their reports but may elect to use such data as a supporting element to an appraisal conclusion derived from alternative methodologies. Direct use of transaction data is often reserved for situations in which adequate transaction volume can be observed, the transactions occurred within a reasonable timeframe of the valuation data, and the transaction participants’ data and deals can be reasonably adjusted and reconciled to the valuation subject.

Often branded as an industry bellwether for its size and breadth of services, BlackRock (ticker: BLK) has been as solid as the name would imply given the recent fallout in asset manager valuations. In last week’s earnings call, CEO Larry Fink attributes the company’s recent success to “the differentiating platform we have built at BlackRock over the past 28 years…, the diversity of our product offerings, the risk capabilities of Aladdin, [and] the market insights offered by the BlackRock Investment Institute.” Specifically, BLK benefited from $126 billion in net inflows over the last year as many RIAs have leaked client assets to passive funds and robo-advisors. BlackRock is clearly gaining market share within the industry and currently manages $4.9 trillion in client assets. This scale has allowed it to make the necessary investments in technology and talent to continue the upward growth trajectory in a sideways market. In addition, BlackRock has also recently invested in ETF businesses to take advantage of the rising popularity of indexing strategies. In essence, BlackRock has used its size (and balance sheet) to evolve with the industry and gain market share in the process. Still, the last twelve months have been anything but a magic carpet ride for most industry participants. A low yield environment dominated by ETFs and passive products has not been conducive to many RIAs, especially active managers like Pzena and Legg Mason, which are down 31% and 43%, respectively, over the six months ended June 30, 2016. As we discussed last week, investors are growing increasingly intolerant of the high fee/low performance combination, so both traditional and alternate asset managers are feeling the heat. Mounting regulatory pressures are additional headwinds as the Financial Stability Oversight Council is currently reviewing six areas of the asset management business for potential enhancements to regulatory oversight – liquidity and redemption, leverage, securities lending, data and disclosure, operational risk of service provider concentrations, and resolvability and transition planning. The SEC is also assessing the sector’s systemic risk exposure and should finalize three proposals on mutual fund and ETF regulation at some point this quarter. While the current trend toward passive investing hasn’t shown any signs of strain, we don’t foresee active management ever going away for good. In fact, best-in-class stock and bond pickers should build market share as enterprising investors seek the few diamonds in the rough (last Aladdin reference, I swear) that have actually outperformed their relevant benchmark. Depressed valuations may induce further consolidation, so this trend could ease the number of stand-alone active management firms as competitively priced passive strategies continue to collect AUM. With over 11,000 RIAs and aging owner demographics, such consolidation is probably long overdue.

This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. The correlated indication of value is a value that is arrived at through some reasonable, well-articulated, replicable, and credible process of selection, averaging or otherwise, of the total valuation evidence generated from the valuation methodologies employed. Correlating a valuation conclusion that subsumes all the information, processes, analyses, and market evidence in a valuation engagement is no simple task.The term used by some appraisers for the resulting valuation distillation is “correlated indication of value.”For valuations in which the value methodology directly results in the value definition specified in the engagement, the correlated indication of value may represent the final conclusion of value.For cases in which the value definition differs from the direct results of valuation methodology, the correlated indication of value is typically adjusted by valuation discounts or premiums (typically the former) to develop the value definition specified in the engagement. Figure 1 depicts the typical correlation framework.There are numerous variations and potential interjecting steps and adjustments.In operation, developing a correlated indication of value may appear reasonably straightforward (sometimes it is), but the considerations in the process can reach back to the smallest of details and considerations in the underlying valuation methodologies. A brief review of the global valuation approaches provides a good review for the subsequent observations. Figure 2 presents the three valuation approaches.Global Considerations in the Correlation ProcessThe following provide some global considerations used by many appraisers to navigate the correlation process (which is not to say all are best practices).These points are not listed in any order of significance because the priority of consideration changes with every appraisal.Nature and Industry of the Subject BusinessManufacturing, distribution, retail, service, professional, contracting, etc. Differing business models have differing value drivers and differing financial infrastructures.Some methods will be the primary or sole path to value for some types of businesses.The relative asset-intensity of a business may influence the selection of valuation methods. Manufacturing concerns make capital investments differently than do professional service firms; the methods weighed should reflect this basic reality.All businesses have resources at risk in the marketplace and should by logical extension rely on earnings (cash flow) as the core driver of value.In other words, the capitalized cash flow of the subject company should at least validate the value of underlying net asset value.In a very real sense, the value of capitalized cash flow defines the value of underlying net assets, based on risk, return, and growth parameters.Yet many businesses, at different points in their life cycles, are more appropriately valued based on (or with partial reliance on) underlying net assets.It is the job of the appraiser to determine the driver(s) of value in general and on a given valuation date and to utilize that perspective in fashioning a conclusion.Although all firms employ assets to generate profits, some are better at it than others.The store of value in hard assets can serve to sustain value (or soften downturns) for many types of businesses, particularly in times when profits are low or non-existent.For businesses lacking significant hard assets (and other balance sheet resources), a lack of earnings or cash flow, when coupled with poor business prospects, likely means a lack of value.Businesses that hold assets are typically valued using the appraised values of the underlying assets and/or on asset values that can be readily evidenced from an active, observable market.In such cases, a singular method such as the net asset value method may be employed.Additional analysis based on income and market methods may be used to support valuation discounts that are applied to the direct asset-based value indication.Most closely held businesses are too small or narrow in focus to be valued using the market approach.Accordingly, many (most) appraisals do not employ the guideline public company method. In similar fashion, other market methods may not apply either.Stage of Business Maturity and DevelopmentMature businesses with established performance may be valued using methods that are not appropriate for early stage businesses or businesses in decline.Start-ups or liquidating business should be valued using methods that capture the eventual or ultimate expected economic norms or outcomes for the business.In such cases, there is little correlation required because only one method may be used.Position in Industry or Economic CycleBusinesses that display periodic down cycles may be valued with more weight placed on balance sheet indications of value, particularly when projected performance is uncertain or lacking all together.However, income methods showing little to no value may be weighted as a proxy for lack of control issues (also known as minority interest discount), to capture appraiser concerns regarding the economic obsolescence of assets, or to capture anticipated financial losses for the period of time until a return to profitability or stabilized performance is can be expected to be achieved.The weighting of low-to-no value income methods serves to effectively discount the asset-based method in many valuations.Businesses performing at historic average levels and/or with continuing expectations for stability will likely be valued using income methods or with market methods that focus on earnings and cash flow.Businesses in high or low cycles may be valued using discrete projection methods that adjust the business up or down over time toward a steady state of performance that is more in keeping with proven history or is better aligned with industry performance and/or expectations.Nature of Underlying Adjustments in the Valuation MethodsAll valuation methods require underlying adjustments. Asset-based methods follow a mark-to-market discipline. Income methods may be adjusted for unusual expenses. Projections may be more or less believable in the context of history and external market expectations. Market methods may rely on market evidence that is not directly comparable or is unreliable due to an economic or industry shock.The point is that many valuations include methodologies and results that are more or less speculative than other methods. This can be acute when a business is at a peak or trough in its cycle.Under the ubiquitous standard of fair market value, appraisers must take into account the balance of considerations from both the hypothetical buyer’s and hypothetical seller’s perspectives.Standard and Level of Value (The Value Definition)An appraisal performed using the controlling interest level of value may rely more heavily on the higher value indications than on the lower value indications. This kind of consideration may serve as a proxy for the highest and best use or operation of the underlying business assets.It can also lead to error and/or alleged bias.Conversely, a minority interest value definition may influence the consideration of lower value indications or indications from methods that are believed more reflective of the expectations of investors who lack the prerogatives to bring about the changes or choices that might otherwise increase the indicated value.This too, can lead to error and/or alleged bias.Some appraisals are performed for specific purposes using a standard of value other than fair market value.In such cases, certain methodologies may be dictated and others prohibited.Fair value under FASB reporting requirements may require considerations and perspectives very different than under fair market value.Fair value (yes, a different “fair value”) under operation of law (either by statute or judicial guidance) can vary from state to state and from issue to issue.Dissenter’s rights, marital dissolution, securities fraud, and other matters in which an appraisal is developed for expert consulting or expert witness purposes may require unique valuation considerations and often include specific instruction from legal counsel concerning what “counts” in the calculations and how.In matters requiring a very specific set of defining elements, the value definition must be top of mind when developing or reviewing the work product, which is often a scope of report other than the typical appraisal opinion.The Quality and Availability of Subject Financial DataThe lack of proper financial reporting does not provide license for an appraiser to resort to obtuse measures such as total assets or gross sales as a foundation for establishing value.Some situations may require consideration of broad financial measures and/or somewhat remote market evidence as a basis for speculating on value when the quality of net worth and /or the visibility of cash flow are obscured.Such situations may require the valuation to be qualified as falling short of a formal appraisal opinion under most professional standards.In other cases, an appraiser simply has to operate with the available information.These considerations are based on experience, observations of public and private markets over time, and a dose of informed judgment; differences, both semantic and substantive, can exist from one appraiser to the next.One could ask:When should a valuation not reflect balanced consideration of all approaches and methods?The right answer is – never.It is always helpful to assess the value indications from all approaches and methods in the context of one another.However, consideration and direct reliance are different things.In many cases, there is simply not ample information, market evidence, or cause to develop values under each approach.Appraisers owe the users of their reports a credible explanation of where reliance was placed and in what proportion.There are times when financial information and valuation evidence suggest that brevity is the high road and that too much analysis along lines that are ultimately not relied upon in the valuation is confusing or misleading.Appraisers simply must use the judgments extended them by the appraisal standards to present a complete picture of the relevant methodological landscape.However, appraisers and their audiences benefit from the use of a core set of processes and considerations for deriving and displaying the correlation of value.The table in Figure 3 is provided for perspective.We note that the valuation of most business enterprises is ultimately driven by the economic returns generated on the assets that comprise the business.As such, the income approach is the primary indicator of value in most business appraisals where the business is a going concern and not simply a fund of underlying net assets.Unfortunately, the income approach can be difficult to model in certain circumstances such as a recession.For ESOP appraisals, the above perspectives can be shift based on the comfort and confidence of the appraiser/trustee in the company’s ability to maintain a sustainable ESOP benefit.Repurchase obligations ultimately require cash flow.Depending on the overall design and management of the ESOP plan, appraisers and trustees are cautioned when relying on asset-based value indications without taking into consideration the ability of the company to sustain the asset base when cash flows fall short of servicing the ESOP’s needs, let alone the needs of the business.ESOP companies that experience a decline in business activity and which have little prospects of recovering to past performance levels (or worse, remaining a going concern) should likely include consideration of a liquidation premise.The liquidation premise is often developed and studied using an asset value perspective, adjusted for the time-value and liquidation consequences that could befall the assets as they are sold.Such a premise need not be a death sentence for the ESOP or the Company, but may relevant to consider during a time of reorganization for the sponsor company.When businesses are displaying significant volatility and/or a fundamental change in business posture (particularly on the downside), appraisers and trustees are encouraged to communicate about the underlying methodology and the potential need to redefine the level and premise of value for the appraisal.Such changes could materially rebalance the consideration of the underlying approaches and methods toward the conclusion.Correlation ExamplesFollowing are some typical examples of a correlated indication of value.We have provided differing examples based on varying scenarios.The numerical values and weights are for demonstration purposes; the weights applied are not based on any rigid formula and will vary for each appraisal based on the totality of underlying factors for each appraisal.Example 1 in Figure 4. Small to medium service business; stable market, consistent performance and expectations; valuation definition is FMV minority interest, correlated value before discount for lack of marketability. Example 2 in Figure 5. Small distribution business; challenging market conditions and sub-par expectations; company owns real property and other fungible assets; valuation definition is FMV minority interest, correlated value before discount for lack of marketability.Example 3 in Figure 6.Large producer of value-added capital assets; stable markets and expectations; advanced financial management and capital resources; value definition is FMV minority interest, correlated value before discount for lack of marketability.In Figure 6, we can see that the income approach was allocated two-thirds of overall weighting. Looking deeper, if the GPCM exclusively considered cash flow calculations (say net earnings and EBITDA), then income measures were effectively weighted 100 percent in the overall valuation; the only difference being the specificity of the market evidence used to value the income and cash flows.For cases in which the GPCM is used, there may be reasons that some calculations should receive greater underlying consideration than others (say capitalized book value rather than EBITDA).This may simply be a variation of the same theme of shifting weights between asset-based and income-based methods to address issues related to business and economic cycles.Variations on these examples are almost endless.There are often circumstances in which value indications vary greatly and require thoughtful explanation about why a value that appears at one end of a spectrum was exclusively weighted.In some cases, a simple average might be appropriate but appraisers should be cautious when averaging a potentially non-meaningful indication with a meaningful indication. Rarely does the averaging of an unreliable indication make the end result correct unless additional explanation and support are provided about how the resulting correlation relates to the most meaningful valuation evidence.Accordingly, a relative value analysis, as in Figure 7, may be a useful tool in helping explain how each indication relates to other indications.Let us expand on the third example with some additional information to see how the various indications compare to each other.Such a comparison could be used in an iterative fashion to reach a final weighting scenario as well as to provide support for the conclusions reached in the report.Note that the relevant comparisons are being made at the marketable minority interest level of value. At the marketable minority interest level of value, the subject’s relative value measures can be directly compared to the relative value measures of the guideline public companies. Relative value assessments that compare subject valuation results to peer valuation evidence must be performed using an appropriate and comparative level of value for both the subject and the peer.Section 5 of Revenue Ruling 59-60 addresses the weight to be accorded to various factors in an appraisal.In the context of an operating company appraisal, judgment is required to reconcile what may be diverging indications of value among the various valuation approaches (or even methods within a single approach or method).Although averaging widely diverging indications of value from various valuation methods may be appropriate in a particular valuation, appraisers should assess why such large differences exist.Do indications from the market approach suggest that assumptions made in methods within the income approach be revisited?Or do the results from an income approach shed light on the appropriate fundamental adjustment (or selection of guideline companies)?Within the market approach, indications of value can vary widely, depending on the financial measure capitalized.The appraiser may glean hints with respect to the weight to a particular indication by considering why such differences occur.Differences between indications derived from capitalized net income and EBIT are a function of the financing mix. Differences between indications derived from EBIT and EBITDA may reveal varying degrees of asset intensity.Capitalized revenue measures provide a view of “normalized” margins – are the margins of the subject company likely to improve or deteriorate?Finally, capitalizing measures of physical volume (number of subscribers or units sold, for example) could reveal unit-pricing disparities between the subject and the selected guideline companies.There can be no fixed formula for weighing indications of value from various valuation methods.Responsible appraisers, recognizing this, should apply common sense and informed judgment in developing a correlated indication of value. ConclusionGiven the potential diversity of valuation evidence and methodology in most business appraisals, a well-reasoned and adequately documented process is required to support the initial and final valuation conclusions derived in a business valuation. In this publication we provided insight on the functional processes and analytical considerations underlying the determination of a correlated indication of value. Additionally, we discussed methods and perspectives that can be used to justify the underlying methodology and valuation evidence relied upon while providing relative value observations to support the reasonableness of a valuation conclusion.

This article first appeared as a whitepaper in a series of reports titled Appraisal Review Practice Aid for ESOP Trustees. There is a protracted and clouded legacy of information and dogma surrounding the universe of discounts and premiums in business valuation. It seems logical enough that as elements of business valuation, the underlying quantification and development of discounts and premiums should be financial in basis, just as other valuation methods are founded on financial principles. Much of the original doctrine surrounding the determination of discounts and premiums was based on reference to varying default information sources, whose purveyors continue the ongoing compilation of transaction evidence (public company merger and acquisition activity, restricted stock transactions, pre-IPO studies, etc.). After begrudging bouts of evolution, there has been maturation toward more disciplined and methodical support for valuation discounts and premiums. Perhaps as the state of the profession concerning discounts and premiums has progressed, so, too, has the divide in skill and knowledge among valuation practitioners become wider. Certainly this seems to be the case regarding many users and reviewers of appraisal work (ostensibly the legal community, the DOL and the IRS). There remains ample debate concerning numerous issues in the discount and premium domain. Unfortunately, in the quest for better clarification on the determination of discounts and premiums there has developed an arms’ race of sorts. Despite the emergence of compelling tools and perspectives, no method or approach appears to have the preponderance of support in the financial valuation community. Nowhere is this truer than with the marketability discount (also known as discount for lack of marketability or DLOM). Within the ESOP community much of the confusion over DLOMs is mitigated due to the presence of put options designed to ensure reasonable liquidity for ESOP participants. However, in the ESOP community a legacy of concern over control premiums has now become an acute issue as stakeholders and fiduciaries have increasing concerns regarding flawed valuations and prohibited transactions.The Levels of ValueRegarding the concept of control premiums and minority interest discounts (also known as “lack of control discounts”), there is less conflict and more uniformity on how and when these discounts are used in a business appraisal. That is not to say that differences among appraisers don’t exist regarding certain issues. For purposes of establishing a platform to converse on valuation discounts and premiums, let us use the conventional levels of value framework to anchor the discussion. Figure 1 provides structure about where the traditional valuation discounts and premiums are applied in the continuum of value.The integration of the basic income equation of value into the levels value chart results in the equations and relationships shown in Figure 2. It is here that we can begin to understand that valuation discounts and premiums are not devices in and of themselves. Each is the product (consequence) of the relationships among and between the underlying modeling elements that constitute financial valuation(cash flow, risk and growth). We note that the conceptual core of the mathematical relationships is generally centered on the freely traded world of the public stock markets, which is characterized as the “marketable minority” level of value (enjoying readily achievable liquidity in a regulated, timely, and efficient market). Although other levels of value can be directly observed in various markets, the marketable minority interest level of value characterizes the empirical world from which most valuation data and observations are made (i.e., Ibbotson).CF = cash flow; CFe= cash flow to the business enterprise; CFsh = cash flow to the shareholder; subscript “c,f” and c,s” denote, respectively, CF available to financial control investors and CF available to strategic control investors.R = risk as expressed by the required rate of return on investment; Rmm, Rfand Rsdenote risk as perceived through the eyes of marketable minority investors, financial control investors and strategic investors, respectively.G = growth rate in cash flow or value (see notes above on “R”). Gmm, Gfand Gsdenote growth as expected from the perspective of marketable minority investors, financial control investors and strategic investors, respectively. Gv differs from the other growth expressions in that it is an expression of the growth rate in value for the subject security in an appraisal exercise. All other expressions of “G” are growth rates in the cash flow of the business enterprise.The take away from the relationships depicted in Figure 2 is that risk is negatively correlated to value (the universal reality of the time value of money) and that cash flow and the growth rate in cash flow are positively correlated to value. According to the preceding relationships, a control premium only exists to the degree that control investors reasonably expect some combination of enhanced cash flows, lower risk, or superior growth in cash flow, all as a result of better financial and operational capacity (financial control). Taking the financial control relationships one step higher via specific synergies results in a strategic control premium (which is not considered within the continuum of fair market value and generally exceeds adequate consideration for ESOP transaction purposes). Conversely, a marketability discount exists to the degree that investors anticipate subject returns (yield and capital appreciation) that are sub-optimal in comparison to the returns of a similar investment whose primary differentiating characteristic is that it is freely traded (also known as liquid). That is to say, minority investors (buyers and sellers) in closely held businesses that have investment-level considerations such as higher risks, lower yield, and/or lower value growth require some measure of compensation to compel a transaction in the subject interest. Otherwise, the investor would seek an alternative.Perspective on the Control PremiumWhat is a control premium? The American Society of Appraisers (ASA) defines a control premium as an amount or a percentage by which the pro rata value of a controlling interest exceeds the pro rata value of a non-controlling interest in a business enterprise, to reflect the power of control. In practice, the control premium is generally expressed as a percentage of the marketable minority value.Based on this definition, it might seem that no controlling interest valuation can be developed without an explicit quantification to increase a value that is initially developed using a marketable marketable-minority interest level of value. This might be true in for circumstances in which the control value is not the direct result of the underlying methods. The fact is that most controlling interest value appraisals are developed based on adjustments and methods that result directly in the controlling interest level of value. Therefore, no explicit control premium is required. Consequently, the appraiser cannot explicitly define the magnitude of the control premium in the appraisal.In many cases, the appraiser may state that no control premium is added because all the features and benefits of control have been captured in the earnings adjustments and/or through other modeling assumptions in the underlying methods. We have seen numerous situations in which an appraiser was accused of failing to develop a control valuation because there is no explicit control premium applied to the correlated value or to the individual methods that are weighed in the correlation of value. Archaic though it may be in the context modern valuation practice, such accusations still exist even when the valuation features all the perfunctory control adjustments and treatments. For cases in which normalization and control adjustments were applied to cash flows and other elements, the additional application of a discrete control premium implies that there are further achievable control attributes. In such cases the control premium is likely quite small in comparison to typical published measures. If control adjustments are applied and a control premium is also applied, there is a potential overstatement in the valuation. This type of circumstance is a hot bed issue with the Department of Labor as such treatments could be the underpinning of a prohibited transaction. Appraisers and trustees are cautioned about the potential for double counting when applying an explicit control premium.The primary published source for control premium measurements is Mergerstat Review,published annually by Mergerstat FactSet. Mergerstat Review reports control premiums from actual transactions based on differences between public market prices of minority interests in the stock of subsequently acquired companies prior to buyout announcements and actual buyout prices. It is worth noting that Mergerstat’s analysis indicates that higher premiums are paid for public companies than for private concerns because publicly traded companies tend to be larger, more sophisticated businesses with solid market shares and strong public identities. From a levels-of-value perspective, most of the transactions reported in Mergerstat Review are believed to contain elements of strategic value, which explains the relatively high level of control premiums cited therein. This strategic attribute of the data also makes it potentially troublesome when relied upon in ESOP appraisals.Noteworthy is the now widely accepted presumption that public stock pricing evidence is reflective of both the marketable marketable-minority and controlling financial interest levels of value. Referring to the expanded levels of value chart, minority interest discounts and financial control premiums are thought to be much lower in comparison to annually published data in Mergerstat Review.Thus, the two central boxes in the four-box vertical array of the expanded levels of value chart are essentially overlapping as in Figure 3.The parity of value between financial control and marketable minority requires a few assumptions: normalized earnings adjustments are required, and these adjustments include some considerations that certain appraisers believe are not part of the minority interest equation (namely owners’ and executive compensation). We believe that return on labor and return on capital are reasonable to segregate in valuations based on all levels of value. However, there may be differences between financial control and marketable minority valuations based on enterprise capital structure. There may be some consideration for the lack of liquidity to both control and minority investors when adjusted income streams overstate the real economic cash flows available for distribution or other shareholder-level benefits (including cash flows necessary to sustain an ESOP). There may be some justifiable difference in value for situations in which the valuation subject’s capital structure appears more conservative than its peers. However, wanton manipulation of capital structures (for example, in the development of a weighted average cost of capital or WACC) in deriving the cost of capital is a frequent source of error in appraisals using a discounted future benefits (DFB) method. Such errors can lead to under- or over-valuation.Control Premiums — Substance Over FormMost appraisals that employ a controlling interest level of value definition do not (or should not) display a discrete or explicit control premium. That is because the adjustment processes underlying most individual valuation methods provide for the full consideration of control and thus do not require or justify further adjustment in the form of an explicitly applied control premium. So, despite the lack-of-control form that many control appraisals have, there is ample structure within the methodologies to capture the substance of a control premium. The following perspective plays off the basic equation to business valuation as well as the levels of value chart that depicts the relationships between risk, growth, and cash flow as one moves up and down the levels of value conceptual framework.Control premiums can be the result of earnings adjustments that eliminate discretionary expense, such as excess and non-operating compensation. Shareholder compensation paid to individuals who do not contribute to operations or management, directors’ fees paid to family or others for non-vital roles, management fees paid to retired owners, loan guarantee fees paid to shareholders whose capital resources are not required, and other similar types of expenses are often the underlying control “pick-up” in an appraisal. Arguably, many of these adjustments should be part of the normalizing process for all appraisals so that returns on capital are clearly differentiated from returns on labor. When such adjustments are used to underpin an ESOP transaction, subsequent expenses and policies of the ESOP sponsor in future periods should confirm the credibility of the adjustments.Control premiums can take the form of adjustments that place related party income and expense at arm’s length pricing. Rents paid to related parties, management fees paid to affiliated entities, optimizing value or discretionary income from non-operating assets, and many similar adjustments that optimize the subject benefit stream are all part of the control mindset.Control premiums can be related to the optimization of capital structure. Many businesses enjoy the quality of having little to no interest interest-bearing debt. Perhaps in the paradigm of today’s financial landscape, this is a better quality than previously appreciated. However, if a hypothetical investor can easily use debt in an efficient and responsible fashion to provide for the financial needs of the business, the subject’s cost of capital may be reduced and correspondingly, the return on equity of the business can be improved. That is not to say that increased debt, as low cost as it may be, does not increase the potential risk profile of equity holders. All things equal, a reasonable blend of debt in the capital structure for a bankable group of assets and cash flow will provide a potential enhancement of return on equity. Many appraisals that refer to public company debt ratios or to private peer balance sheet ratios to support an assumed capital structure that is different than actually employed at the subject entity. This can constitute a control premium. However, when taken too far or when assumed in a fashion that does not properly capture the incremental risk that a higher level of debt has on equity investors, the manipulation of capital structure can result in material valuation flaws.Control premiums can emerge from weights applied in the correlation of value. In many cases, the valuation methods used to value a business result in similar value indications for both control and minority situations. However, a control valuation may include differing weights on the value indications such that the correlated value is higher than would result from the weighting scenario applied in a minority interest appraisal. Additionally, if a guideline transaction method is used in a control valuation and is weighed toward the correlation of value, the resulting value may represent a premium to the other indications of value developed in the appraisal.In tandem, capital structure efficiencies, income and expense efficiencies, and the consideration of peer transaction evidence are significant, albeit seemingly silent, control premiums.Perspective on the Minority Interest DiscountWhat is a minority interest (lack of control) discount? The ASA defines a minority interest discount as the difference between the value of a subject interest that exercises control over the company and the value of that same interest lacking control (but enjoying marketability). In practice, the minority interest discount is expressed as a percentage of the controlling interest value. A minority interest is an ownership interest equal to or less than 50 percent of the voting interest in a business enterprise (or less than the percentage of ownership required to control the assets and/or the discretionary expense structure of a business).As with the control premium, the minority interest discount is infrequently called upon in the valuation (as an explicit treatment) of most operating businesses because the majority of methodologies used to value nonmarketable minority interests results in an initial value at the marketable minority interest level of value. Accordingly, only a discount for marketability is required to derive the end nonmarketable minority valuation result.Minority interest discount discounts are a more common feature in the valuation of certain types of investment holding entities such as limited partnerships. This is because such entities have highly diverse purposes versus the relatively narrow operating focus of most operating business models. As such, the assets owned by the entity are generally best appraised by a specialty appraiser or from direct observation of market evidence concerning the asset. That being the case, most such entities are valued using an asset-based approach, which inherently captures the controlling interest level of value for the underlying assets. This makes it necessary for the business valuation to be adjusted first for lack of control considerations and second for lack of marketability concerns. Additionally, in cases involving operating business that hold operating and/or non-operating real property assets, such assets may need to be appraised by an appropriate expert and adjusted with a minority interest discount when integrated into the minority interest enterprise value of an operating business.Although minority interest considerations are captured in the majority of appraisals by reference to returns on marketable interest investments in the public marketplace, there are techniques for developing the discount. One such method involves mathematically imputing the discount based on an assumed control premium. Other methods involve observations of securities trading values in the context of the valuation of the issuer’s underlying assets, such as the case with closed closed-end funds and other securities in which underlying assets have an observable value that can be compared to the security’s trading price.The following formula provides an expression of the percentage minority interest discount as a function of an assumed percentage control premium. Although the expression is useful in identifying the minority interest discount as a percentage of an assumed or developed measure of control value, it is rarely used in a direct sense in the valuation of minority interests.In the valuation of minority interests in asset investment entities (limited partnerships et al.) that are invested in various classes of assets, many appraisers look to the observed discount to net asset value (NAV, the market value of a fund’s asset holdings less its liabilities) that closed-end funds (CEF) typically trade at as evidence of an applicable minority interest discount for a subject partnership or similar ownership interest. As a general rule, CEFs report their net asset values and the price-to-NAV relationship typically reflects a discount. Observed discounts to NAV reflect the consensus view of the marketplace toward minority investments in the underlying portfolios of securities. That is, the discounts are illustrative of the market’s discounting of fractional interests in assets, making them somewhat comparable to a minority interest in an entity that is heavily invested in other assets (such as marketable securities and other asset classes).Discounts to net asset value for closed-end funds have been consistently observable for many years. The precise reasons for such discounts are subject to debate, but common attributes include the following factors:A lack of investor knowledge about the underlying portfolio;Absence of investor enthusiasm about the underlying portfolio;Enthusiasm, or lack thereof, about the fund’s manager;Expense ratios;Tax liabilities associated with embedded gains;Lack of management accountability; andLack of investment flexibilityAlthough closed-end funds may not be directly comparable to the subject interest in an appraisal, the discounts typically observed are evidence of the market’s discounting of portfolios of generally liquid securities, and, therefore, offers valid indirect evidence of minority interest discounts applicable to asset-holding entities and operating businesses.Marketability DiscountsThe ASA defines a marketability discount as an amount or percentage deducted from the value of an ownership interest to reflect the relative absence of marketability. Augmenting the consideration of marketability is the concept of liquidity, which the ASA defines as the ability to readily convert an asset, business, business ownership interest, security, or intangible asset into cash without significant loss of principal. Lack of marketability and lack of liquidity overlap in many practical regards. However, lack of liquidity is often attached to a controlling interest, while marketability discounts are used to describe minority interests.Despite the proliferation of marketability discount studies and models, most models fall into one of three primary categories. These categories are based on the underlying nature of the analysis or evidence from which each model emanates. They include market-based perspectives (commonly referred to as benchmark analysis), options-based models, and income-based (rate of return) models. Although it is not our place to define a given model as the model, we do recognize that some models (or perspectives) provide general guidance for the appraiser regardless of the specific model employed. The following is a list of the so-called Mandelbaum factors, which are derived from the Tax Court’s ruling in Mandelbaum v. Commissioner (T.C. Memo 1995-255, June 12, 1995). In essence, these factors serve a similar guidepost for the assessment of marketability, as does Revenue Ruling 59-60 for the valuation of closely held interests in general.The value of the subject corporation’s privately traded securities vis-à-vis its publicly traded securities (or, if the subject corporation does not have stock that is traded both publicly and privately, the cost of a similar corporation’s public and private stock);An analysis of the subject corporation’s financial statements;The corporation’s dividend-paying capacity, its history of paying dividends, and the amount of its prior dividends;The nature of the corporation, its history, its position in the industry, and its economic outlook;The corporation’s management;The degree of control transferred with the block of stock to be valued;Any restriction on the transferability of the corporation’s stock;The period of time for which an investor must hold the subject stock to realize a sufficient profit;The corporation’s redemption policy; andThe cost of effectuating a public offering of the stock to be valued, e.g., legal, accounting, and underwriting fees.This list extends to considerations beyond the pure question of marketability. However, the ruling is instructive in its breadth. The Mandelbaum process is characterized by many appraisers as a qualitative or scoring procedure. However, most of the parameters are mathematically represented by financial elements and assumptions under the income- and options-based models. Such parameters are also used, to the degree possible, in searching out market evidence from restricted stock transactions, which are documented in varying degrees by numerous studies over several decades. Benchmarking analysis relies primarily on pre-IPO studies and restricted stock transactions. In essence, benchmarking calls for the use of market-based evidence to determine a lack of marketability discount. Some appraisers have pointed out the oxymoron of benchmarking (market transactions) analysis for use in determining marketability discounts. On the same note, other appraisers cite the restricted stock studies for capturing market evidence that at its core demonstrates the diminution to value associated with illiquidity. Imputed evidence concerning the implied rates of return for restricted stock lends support for more specific analyses within certain marketability models. Options-based models, most of which are derivations and evolutions of the Black Scholes Option Model, are based on assessing the cost to insure future liquidity in the subject interest. Rate return models are based on modeling the expected returns to the investors as a means for determining a valuation that results in an adequate rate of return given the investment attributes of the subject interest. There is no one method that is acknowledged as superior to all others. Indeed, virtually every method employed in the valuation universe has been challenged or debated in the courts as well as by and among the professional ranks of appraisers. Perhaps the best approach, stemming from a review of the IRS’s DLOM Job Aid, which was discovered and published a few years ago, is the use of multiple disciplines in a fashion consistent with the breadth of valuation approaches called for in business valuation (principally the income and market approaches).DLOMs in ESOP ValuationNotwithstanding the previous perspectives on DLOMs and the methods and processes for developing them, most ESOP appraisals that involve a minority interest definition of value reflect a relatively minimal DLOM of 5-10%. This is due to the obligatory put option feature required for qualified retirement plans holding closely held employer stock.The virtual guarantee of a market for the ESOP participants’ interests is believed to all but eliminate the DLOM. The consensus treatment from most appraisers is that a DLOM applies and is relatively small (say 5-10%) but not 0%.Some appraisers use the DLOM as a proxy for concerns about future liquidity as it relates to the sponsor company’s ESOP repurchase obligation. If a business is floundering, has a significant bubble of participants requesting near-term liquidity, has pour cash flow, has limited financial resources or financing options, and/or any other underlying fundamental challenge, some appraisers will use a DLOM to reflect this concern.DLOMs quantified in the correct fashion may indeed be a viable approach to capturing the cash flow needed to service repurchase obligations and the associated effect on the sustainable ESOP benefit (the stock value). However, many appraisers use a more direct and explicit approach to studying and treating the repurchase obligation by iterating the associated expense into the valuation modeling (generally using an income method).The expense is determined through a repurchase obligation study which informs trustees, sponsors, and plan administrators what measure of cash flow will service the foreseeable needs of the plan. To the degree that the assumed ongoing retirement plan funding is insufficient to service the obligation, an additional expense may be applied or a single present-value adjustment may be quantified to adjust the total equity value of the business.ConclusionThe application of a discount or premium to an initial indication of value is an often controversial and necessary input to the valuation process. Fortunately, appraisers are equipped with numerous income and market methodologies to derive reasonable estimates of the appropriate discount or premium for the subject interest.As with the determination of the initial indication of value, it is ultimately up to the valuation analyst to choose the appropriate methodology based on the facts and circumstances of the subject interest.None of the available methodologies are perfect, and all of them are subject to varying degrees of criticism from the courts and members of the appraisal community. Critics of the various market approaches often cite the lack of contemporaneous transaction data that are rarely comparable or applicable to the subject interest.Arguments against the income methodologies often focus on the model’s inputs, particularly the holding period assumption, which is typically uncertain for most private equity investments.The number of discount methodologies and their respective criticisms will, in all likelihood, continue to expand into the foreseeable future. It is ultimately up to the appraiser to consider the various options and determine the appropriate model or study applicable to the subject interest.There are no hard-and-fast rules or universal truths that are applicable to all appraisals when it comes to the selection of an appropriate discount methodology. Appraiser judgment is ultimately the most critical input to any valuation, particularly in regard to the application of an appropriate discount methodology or control premium.Admittedly, the number of discount methodologies and their corresponding criticisms can be a bit overwhelming to anyone unaccustomed to reviewing or writing business valuation reports.At the end of the day, the most important thing to keep in mind is how reasonable the discount (or premium) is in light of the liquidity and/or ownership characteristics of the interest being appraised.An appraisal may have carefully considered all the pertinent discount methodologies and their criticisms, but if the ultimate conclusion is not reasonable or appropriate for the subject interest, it will probably not hold up in court or communicate meaningful information for the end user of the report. Appraisers should investigate the reasonableness of their conclusions when preparing valuation reports and related analyses.

Last week, Affiliated Managers Group (ticker: AMG) announced the completion of its investment in three alternative asset managers — Capula Investment Management LLP, Mount Lucas Management LP, and Capeview Capital LLP. These transactions are the cornerstone of AMG's 6/6/16 definitive agreement with Petershill Fund I, a group of investment vehicles managed by Goldman Sachs Asset Management, LP, to acquire all of Petershill's minority interests in the aforementioned firms as well as two other alternative investment managers, Partner Fund Management and Winton Capital Group, which haven't yet closed.Under the terms of the agreement, AMG will acquire these interests for approximately $800 million to be paid in cash at closing (roughly half of which was just paid for Capula, Mount Lucas, and Capeview with the balance expected to close by year-end). Given that RIA disclosures only present ownership percentages in range form and three of the entities are headquartered in London, the ADV is of little use to us in ascertaining the exact interest acquired in these businesses (though it's probably safe to assume something close to 50% given their typical investment structure discussed in a previous post).Perhaps more instructive is AMG's admission that management expects the transaction to increase economic earnings per share by $0.50 to $0.80 in 2017, availing some insight on deal pricing (though much of this accretion is likely due to synergies). At first glance an effective multiple of 18-29x next year's earnings seems a bit rich, even in this market, but closer inspection reveals pricing more in line with industry peer measures. The high level of variance in the metrics is largely attributable to the uncertain and variable nature of performance fees and carried interest income. Such ostensibly high valuations are more a function of depressed earnings from fee pressure and fund outflows than overly bullish sentiment on the sector’s prospects. In an investing landscape dominated by indexing strategies and passive products, investors are becoming increasingly weary of the high fees and recent underperformance associated with many hedge funds and private equity firms. Publicly traded alternative asset managers have clearly fared the worst over the last year relative to other classes of RIAs and trust banks. AMG apparently sees this decline as a buying opportunity, since these businesses might be the cheapest they've been in quite some time. And although trying to catch a falling knife is typically ill-advised, AMG has partially hedged this risk by investing in established hedge fund managers with over $1 billion in client assets. At any rate, the market doesn't seem convinced — though only time will tell.

When facing a business transition, owners have two basic options. Sell the company to outside parties or to inside parties (other owners and employees). While there are numerous variations of the two, basically the owner can sell to an outside group, which may be a strategic buyer (someone in the industry already), or a financial buyer, which may be a private equity firm or other investor that wants to own the company. An internal buyer is either a sale to some or all of the employees directly, or through the use of an Employee Stock Ownership Plan (ESOP). ESOPs are usually very cost competitive and many times may pay the highest price. Sale to the employees individually is with “after tax” dollars and can be very tax inefficient.Until 1974, Employee Stock Ownership Programs were almost unheard of. However since then, they have increased in popularity. In fact in 2014, there were 13.5 million workers in the United States who were covered under ESOPs.There are many reasons as to why employers offer these types of programs. While some people think ESOPs are used to save companies that are about to go bankrupt, this usually isn’t the case. It’s a great way to transfer ownership from one generation to the next without needing a financing plan.As an added benefit, these programs tend to be offered as a way to motivate and reward employees. Of course, there are the numerous tax advantages to be gained too. For the most part, market shares are given to workers and they don’t have to purchase them.How Does an ESOP Work?When a company chooses to create an ESOP, funds are set aside in a trust fund. The monies are used to buy new shares of stock. Additional funds are contributed to buy new shares as well as to pay back any funds that are borrowed from the ESOP to buy additional market shares. It does not matter how the company pays for the shares, the contributions are tax-deductible as long as certain requirements are met.Within the trust there are individual employee accounts. The company, of course, decides who has the right to take part in the ESOP. For the most part, however, all employees who work full-time and are at least 21-years-old have the right. An employer decides how the market shares are distributed to each employee’s individual account, with many companies operating on a vested basis, meaning workers with more seniority are given more market shares than those who have less seniority.Employees receive the cash value of their stocks when they leave the company (most companies mandate that the employees work for them for at least five years), or when they retire. The amount of money that they receive for the stocks is based on their fair market value at the time.Employer Benefits of Executing an ESOPFor business owners without an established plan to transfer direct ownership to either children or trusted personnel, ESOPs are a strategic way to increase direct ownership to the following generation without having to purchase it outright.With the establishment of an ESOP, there are significant tax savings to be gained. In 1974 ERISA, or the Employee Retirement Income Security Act, created the modern ESOP as well as a whole host of other retirement vehicles that incentivize companies and employees directly through tax incentives to save money for retirement. Since the government sees a positive social purpose for ESOPs, it provides extraordinary tax incentives for an owner and a company to use an ESOP as a business succession and liquidity tool. Some of these tax advantages include: 1The seller of the stock may meet the requirements to defer and then avoid paying state and federal Capital Gains tax on the sale of their stock regardless of basis (i.e. IRC § 1042 exchange). It allows the seller to exchange the proceeds from the sale of stock to purchase stocks, bonds, notes or U.S. Domestic Securities (this includes, stocks, bonds or notes) that meet certain qualifications. Once the exchange is established and the owner maintains the exchange, upon death the seller receives a “stepped up basis” and the capital gains tax evaporates.The company receives a dollar for dollar annual deduction for every dollar’s worth of stock that is sold by the sellers. If the company buys $500,000 of stock, the company can realize a $500,000 tax deduction. This is realized on the tax return of the company as they pay for the stock, and is subject to certain limitations.The company can either be a “C” or an “S” Corporation to install an ESOP. There are some advantages and disadvantages to both structures, but ultimately, if the company is or becomes a “S” Corporation, and is 100% owned by the ESOP, the annual K-1 would then go to the ESOP, which is a State and Federal tax exempt trust, similar to a 401(k) and as such is no longer subject to State and Federal income tax. This makes the company “tax free” and can more than double cash flow, and places the company in an optimal operating platform. As they compete with other market players that are paying tax, they have a distinct financial advantage which they can leverage into getting jobs at lower prices and still maintain margins.Another advantage of an ESOP is that the sellers can maintain control of the company even after the sale, as the ESOP has a Trustee that can be “directed”. This directed Trustee is directed either directly by the Board, or by the ESOP Administrative Committee, which is a Board committee. Effectively, the day-to-day control of the business doesn’t change and control can be left with the selling owners until they receive all their money or control can be placed with whomever they direct, such as senior management, etc.Rewarding Employees with Market SharesIn addition to the above tax benefits, offering employees company ownership helps establishes professionalism and lines up owner goals with that of the employees. First-rate job candidates are attracted to companies that they know appreciate and reward their workers. Also, when a company shows it is interested in helping its workers succeed, it’s much more likely to retain its key employees. More so is the fact that the employees will strive to make the company succeed because they will want their market shares to be worth more money.It’s also with an ESOP that an employer can reward its workers without draining its cash flow. Instead of giving cash bonuses, market shares are issued. Furthermore, an ESOP comes with the benefit of the employer being able to strictly decide who gets the market shares and how much. With fringe benefits, specific selection is mostly prohibited.Next StepsAlthough an ESOP has significant tax advantages and provides a mechanism for current owners to exit the business at fair market value, the process requires the work of an experienced team in the creation and execution of an ESOP. Because of this, you should work with a group of advisors experienced in implementing an ESOP.This article was originally published in Valuation Viewpoint, February 2015.Footnote1 Business Transition Advisors

Black swan events and the very nature of the asset management business illustrate the importance of contingent consideration in RIA acquisitions for prospective buyers. The volatility associated with equity managers means AUM and financial performance can swing widely with market conditions, so doubling down on a one-time payment for an RIA can be extremely risky, particularly at high valuations. Of course, the market can just as easily pivot in the buyer’s favor after the deal closes, but gaining Board approval for such gambles is an exercise in futility if insurance is available in the form of contingent consideration.Back in December, we blogged about Tri-State Capital’s recently announced acquisition of $2.6 billion manager, The Killen Group of Berwyn, PA. The deal terms included an initial $15 million payment and contingent consideration of 7x any incremental growth in Killen’s annual run rate EBITDA in excess of $3 million for the pending calendar year (2016). Upon announcement, the estimated total deal value was in the $30-$35 million range, but when the deal closed in April, this estimate dropped to $15-$20 million. The table below illustrates the implied valuation metrics and returns had this deal been structured as a one-time payment under the two value scenarios. Fortunately for Tri-State, the bank elected to structure the deal as an earn-out whereby roughly half of the total potential consideration was guaranteed and the remaining half had to be “earned” by meeting certain earnings objectives following deal closure. The downward revision implies that the business is not likely to generate more than $3 million in EBITDA this year, and an ~11x purchase for a closely held RIA with compliance issues and a declining AUM balance (ADV disclosures indicate that Killen’s AUM fell 27% in 2015) would have been hard to justify had the total deal value been paid up front. Instead, Tri-State is still likely to boast a decent ROI on this deal without paying another dime for it if the business fails to perform in line with initial expectations. The following table shows the implied total deal value under four different scenarios of EBITDA for this year. Under this structure, the seller is incentivized to ensure the business continues to perform after the initial payment. This assurance is critical in many RIAs that are often heavily dependent upon the selling shareholder(s) for client relationships or investing acumen. If key accounts are not transitioned to the prospective acquirer or the market corrects itself following the transaction, the buyer will likely be off the hook for further consideration. Contingent consideration doesn’t always have to be based on future earnings. Perhaps the most acquisitive business in the RIA space is Affiliated Managers Group, whose investment model includes a revenue sharing agreement whereby the target’s fees are split (at a fixed percentage) into two segments: the operating allocation and the owners’ allocation. The operating allocation covers all operating expenses of the affiliate (target) at the discretion of the target’s management, while the owner’s allocation goes to the firm’s partners and AMG according to their respective ownership interest in the business. [caption id="attachment_11668" align="aligncenter" width="500"]Source: AMG[/caption] This structure allows the affiliate to retain operating autonomy while limiting AMG’s exposure to operating leverage because the owners’ allocation is set at a fixed percentage of revenue, not earnings. Since there’s usually some portion of an asset manager’s expense base that is predominantly fixed, earnings are typically more volatile than fee income, so the revenue sharing agreement is a partial hedge against earnings volatility during a Brexit or other black swan event. Still, the best hedge against a market downturn is a solid profit margin, as we’ve discussed in a prior post. With Brexit coinciding with a quarterly billing cycle for many asset managers, earnings are likely to take a huge hit along with the market. Those RIAs with a robust EBITDA margin will likely stay in the black as opposed to their less profitable counterparts that may be under water until market conditions improve.

Crude prices in North Dakota are even lower than the already depressed price of WTI and Brent. This is largely due to region’s insufficient pipeline network. This creates high transportation costs, and in turn decreases realized wellhead prices. As of June 15th crude oil prices in North Dakota were almost 20% lower than the price of WTI and 21% lower than the price of Brent. On top of lower revenue per barrel, the Bakken faces higher initial drilling costs than many other mineral reserves. Together these factors mean that production is not economically feasible in the current low price environment. As of June 17, even as oil prices rose to above $45 per barrel, Baker Hughes reported that there were only 24 rigs operating in North Dakota. In order to survive, when producing is no longer economically feasible, production companies are selling “non-core” assets to generate the cash.In October of 2015, Occidental Petroleum Corporation sold its Bakken Assets to Lime Rock Resources. This sale marked the first exit of the downturn by a major oil company from the Bakken Shale formation. So far, M&A activity of Bakken assets has slowed in 2016, but most Bakken assets are selling for heavy discounts making them attractive to buyers. Some other recent transactions in the Bakken are highlighted below.The sale of Emerald Oil’s Bakken assets can help us understand the current pricing environment. Emerald Oil, an independent producer in the Williston Basin, filed for Chapter 11 Bankruptcy on March 22 and was delisted from the NYSE on March 24. During this time, Emerald had entered into a deal with Latium Enterprises to sell acreage at $1,740 per acre, but the transaction fell through.   Last month, Emerald Oil announced that CL Energy Opportunity fund would buy substantially all of their assets for $73 million which equates to less than $980 per acre. This represents a 44% haircut in just two months. What we see in this case is a continuing fall in the value of acreage as investors learn that assets in the Bakken can be bought at even lower discounts if they wait for the continuation of low oil prices to put more and more pressure on distressed buyers to make a sale.   While this is a stalking horse offer, they are not likely to get much higher on the final deal. As Emerald oil became more desperate to reorganize in order to avoid Chapter 7 bankruptcy, they became more willing to sell at a lower price.Oil Prices are expected to remain low into the third quarter of this year and possibly into the second quarter of 2017. As the price of oil remains depressed, many companies avoiding bankruptcy or reorganizing through Chapter 11 will be forced to sell non-core assets in order to generate cash. In a distressed market, it is extremely important to push for the best offer possible. Mercer Capital can help you understand the true value of your assets and can help you through the Chapter 11 Process.

A fellow Mercer Capitalist recently purchased this beauty, a 1976 VEB Trabant or “Trabi,” at a car auction in Chicago. Ironically labeled as “the car that gave communism a bad name,” the Trabi was the most common vehicle in East Germany during the Soviet Bloc era and even made the Los AngelesTime’s prestigious “50 Worst Cars of All Time” list. If these rankings culminated in a March Madness style bracket pool, the Trabi would definitely deserve a #1 seed given its two-stroke pollution generator (that maxed out at 18 hp) and lack of basic amenities like turn signals and brake lights. The body was made of a fiberglass-like Duroplast (reinforced with recycled fibers of cotton and wood) and even had some parts manufactured from papier-mâché when the VEB production plant ran low on steel. As the Berlin Wall fell in 1989, thousands of East Germans drove their Trabis across the border as a sign of automotive liberation from the Communist Bloc.Like the Trabant, business divorces can be liberating, but are mostly just ugly and ill-conceived. This is especially true for RIA firms where the founding principals typically serve as Chief Investment Officers or portfolio managers for the larger accounts. As a result, these shareholders (and the RIA itself) have the most to lose when corporate disputes or partner buy-outs arise. Many times, these conflicts are unavoidable and are the natural bi-product of ownership transition and firm evolution. In these instances, a carefully crafted buy-sell agreement (“BSA”) can resolve these disputes in a fair and equitable manner (from a financial point of view) if the valuation process avoids these common pitfalls:Employing a fixed or formulaic valuation methodology. The most commonly used rule of thumb for valuing asset managers is price (or enterprise value) to AUM, which is fraught with all sorts of issues covered by a previous blog post. Even worse are formulas that call for a departing shareholder to be bought out at a pro rata percentage of book value or his/her capital contribution. Such metrics make little sense for RIAs, which often have minimal capital requirements and balance sheets, meaning one-side is likely to get bought out a price that is in no way indicative of fair market value for his or her equity interest. BSAs that call for fixed multiples of earnings or cash flow are less offensive to us, but don’t account for natural variations in cap rates and can be subject to margin manipulation by the managing partners.Delaying a valuation until a triggering event actually takes place. Business owners often have an inflated (and sometimes deflated) view of what their company is worth. Having the business appraised on a regular basis (annually or bi-annually) precludes the inevitable surprise that takes place when a trigger event occurs and allows both sides to gain familiarity with the appraisal process.Employing multiple appraisers and tie-breaker valuations when both sides’ experts inevitably disagree. Besides being costly and time-consuming, this technique can be especially problematic when there’s an outlier valuation or the parties can’t agree on a third appraiser. In any event, the process can be a huge distraction for an RIA’s management team and shareholder group. The problem that we most often see with shareholder agreement disputes is the potential of a forced transaction creating winners and losers. If a departing shareholder is bought out at a premium to the value of the enterprise, that premium comes at the expense of the remaining shareholders. If the shares are bought at a discount, the remaining shareholders reap a windfall. Some buy-sell agreements are intentionally engineered to favor either the selling shareholder or the continuing shareholders, but if so everyone who is a party to the agreement should be aware of that long before the triggering event. At Mercer Capital, we recommend a regular valuation process for buy-sell agreements at investment management firms for a number of reasons:The structure and process, in addition to being defined in the agreement, will be known by all parties to the agreement in advance.The appraiser’s valuation approaches and methodologies are seen firsthand by the parties before any triggering event occurs.The appraiser’s independence and objectivity will be evident in the consistency of methodology utilized over time.Because the appraisal process is exercised on a recurring basis, it should go smoothly when employed at triggering events and be less time-consuming (and expensive) than other alternatives. Our colleague with the Trabi says that one benefit to ownership is that you never know what’s going to happen when you get into the car. Your buy-sell agreement should, on the other hand, be free of surprises. If it’s been a while since you looked under the hood of your shareholder agreement, we recommend you pull it out of the drawer, read it, and then call your legal counsel if you see the potential for any problems down the road. Then call us.

As the Baby Boomer generation continues to age toward retirement, many “founder-centric” asset management firms face the prospect of internal succession. The recent book “Success and Succession,” by David W. Bianchi, Eric Hehman, Jay Hummel, and Tim Kochis, is written from the perspective of three individuals who have experienced successful ownership transitions. The book provides some interesting insights into the logistical, financial, and emotional process that internal succession entails through colorful accounts of past triumphs and train wrecks.Some of the authors’ perspectives and insights are what one might expect. Operational realities cause many asset management firms to revolve around a key man, who may not prioritize a strategic succession or may lack a viable successor. He or she may have flawed beliefs that could doom the transition process, including the insistence that the firm remain the same following succession or the assumption of an unreasonably high valuation of the firm. While ownership transition should celebrate the achievements of the founder, it must also recognize the need for change in order to continue to serve the clients. Clearly, client communication during the transition is crucial, especially for a founder-centric firm in which the majority of client meetings and responsibilities have fallen on the exiting owner.Much of the above, while important, has been said by many others in many forums. The strength of “Success and Succession” is in more than a handful of unique insights into RIA ownership transition which get little if any attention from other industry commentators.Both the founder and the successor need to be aware that firm-wide growth often declines in the first year following the change in management, as the founder-centric firm shifts its brand image and the successor takes on responsibility for creating new business. If a successor is unaware of this trend, he or she could feel additional stress regarding the financial burden he undertook when buying out the former owner. The founder could feel the need to resume fulltime involvement in operations, fearing for his ongoing financial benefits from the firm. The authors advise both founders and successors to take a long term view and not focus on this short term pullback.Regardless of the firm’s performance in the first few years following succession, both the founder and the successor need to set definite (as in finite) expectations regarding the founder’s continued involvement or lack thereof. The founder should remain accessible, as his or her guidance is crucial when the successor faces major issues early on. But it should also be clear to everyone that the successor is now the one charged with minding the store.Though some things do need to change following a succession of management, the successor should avoid creating new positions to retain people who no longer fit into the firm’s long term goals. One benefit of succession is that the new manager may have a fresh perspective on areas of the firm in which cost cutting measures or other efficiencies are possible. Although it may be difficult to assess which employees should remain after the transition, allowing those who are poor fits to remain with the firm does significant damage to the firm’s culture and does not set the proper tone for post-transition success.It is crucial to separate compensation for labor from profit share rewards as the exiting owner becomes less involved in day to day management of the firm. This issue can be resolved through the establishment of a strict reinvestment versus distribution policy going forward. The authors even suggest that the founder employ an independent financial advisor in order to objectively estimate a fair amount of compensation following the sale.Though it is clear that the founder took on a significant amount of financial risk in the creation of the firm, it must be noted that the successor is also taking on risk in the amount of debt he or she must incur to buy out the owner. Both parties have a lot to gain and a lot to lose in the process of succession, and both bear a significant emotional burden. The founder may perceive the transition as a loss of a personal identity that is tied to the firm, and the successor must now bear the responsibility of the ongoing success of the firm.Controversy over what is fair or what is “enough” in terms of a sale price can be resolved through a third party valuation. While it might seem easier to rely on valuation metrics or attractive examples, these tactics are purely short term solutions and can result in overly optimistic estimates. The financial terms of the valuation are already emotionally charged. A third party valuation can provide a much needed “reality dose.” All in all, the book is a practice-management must read for RIA owners contemplating succession – whether they are on the buy side or the sell side. Our experience advising clients on internal succession, in particular, is that successful transition requires a certain level of patience and humility on the part of both founder and successor, but above all long term commitment to a process rather than an expectation of a near term result. The book plugs the necessity of a third party valuation – and we would certainly second that – but we would add that a third party advisor with experience can often provide much needed perspective to keep a succession process realistic and give it the maximum opportunity to work for everyone.

In the late 1960s, Enzo Ferrari committed to building an "entry-level" sports car that would appeal to a more mass-affluent buyer than his eponymous marque. His design team engineered a mid-engine two seater with a 2.4 liter, six cylinder motor called the Dino, named after his late son who was to be heir to the Ferrari dynasty. Although Ferrari manufactured the car and eventually badged a later version of it, the original design was never a “Ferrari Dino,” just a Dino. Buyers of the car did well on their entry-level investment – well preserved Dinos now routinely sell at auction for close to half a million dollars.There are a few Dinos for sale right now in Scottsdale, where Brooks Hamner and I are attending Bank Director’s Acquire or Be Acquired conference. We spoke today on how banks can build value through trust and wealth management franchises. It just so happens that there are a number of annual collector car auctions going on here at the same time, and I could draw more than a few parallels between the events.Much like Enzo Ferrari’s strategy fifty years ago, banks are looking to reach a mass-affluent investor community by offering sophisticated asset management services and personal attention once reserved for high net worth and institutional clients. Time will tell if this acquisition binge is as transformational for the banking community as the Dino was for Ferrari (today more than half the cars they sell follow the same mid-engine format). I’m sure acquiring bankers hope that investing in their trust and wealth management businesses will pay off as well as the purchase of a Dino did in the late 1960s – even if ownership may not be quite as much fun.Here’s the slide-deck from our presentation. Even with the present market instability, banks have an interesting opportunity to expand their financial services while diversifying their revenue streams with asset management. We sense some growing demand for sophisticated trust services, and a lot of RIAs in the wealth management space see banks with existing trust departments as a complementary environment to sell into. Give us a call if you’d like to know more. I’ll be back with some conference hearsay next week.

Over the Christmas holiday weekend I had the coveted experience of riding in a friend’s recently restored 1970 DeTomaso Mangusta.  I didn’t take him up on the offer to drive the car as the roads were a little damp and Mangustas are notorious for being a little tail-happy, especially in the wet.  The last thing I wanted was to be responsible for putting so much as a scratch on a specimen car that is as rare as hen’s teeth.  DeTomaso built 401 of them before switching production to the much more common Pantera in 1972.  There are maybe 200 Mangustas surviving today.  This particular car was bought by my friend’s dad at an auction in Florida over twenty years ago.  It had been owned by a member of Pablo Escobar’s drug cartel and still had a bullet hole in the fender.  After restoration, it’s probably better today than new – so despite the sordid provenance I wasn’t too keen on sliding it into a bridge abutment.What’s even more rare than the Mangusta was the announcement earlier this month that Tri-State Capital Holdings, Inc. (traded on the Nasdaq as TSC) bought The Killen Group, a $2.5 billion manager of the Berwyn mutual funds, for about six times EBITDA.  More specifically, TSC paid Killen $15 million cash up front (based on trailing EBITDA of $3.0 million), plus an earn-out paying 7x incremental EBITDA (which could add another $20 million to the transaction price).  So, best case scenario for Killen is for them to deliver about $6 million in EBITDA and get paid $35 million (!).On the surface, the deal looks awfully cheap.  Reading between the lines, Killen has a (very sustainable) effective average fee of 56 basis points, a normalized EBITDA margin of 35%, and a five-star rating form Morningstar on its largest mutual fund product, the Berwyn Income Fund (BERIX).  All good.  So why didn’t Killen make a killing (extract a double-digit EBITDA multiple from TSC)?  No one expects that kind of an asset manager to sell low.  At first glance, it’s the bookend to the Edelman transaction back in October, which appeared to be priced astronomically high.  In the end, though, the two deals have more in common than not.  In both cases the headline price gives one impression of the deal, while the underlying narrative says something very different.Much of the valuation work we do in the RIA space is, for one reason or other, performed pursuant to a standard of value known as fair market value.  The standard of value is essentially a framework for the perspective of a given appraisal.  Fair market value is defined by the American Society of Appraisers as:The price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under compulsion to buy or sell and when both have reasonable knowledge of the relevant facts.When we look at transactions data in preparing fair market value appraisals, one thing we keep in mind is that transactions do not occur at fair market value – or if so only by coincidence.  Transactions involve real buyers and sellers, not hypothetical ones.  They might act at arm’s length in an open and unrestricted market, but usually they have a compelling reason to transact.  It seems like that was the case in the TSC/Killen transaction.The press release and slide deck that went with the announcement didn’t go into detail, but TSC management alluded to Killen reporting $3.0 million in trailing twelve month EBITDA, which was really about $5.0 million net of a trading error.  A $2.0 million trading error is substantial, but we don’t know much else about it.  What we do know from looking at Killen’s ADV is that they also reported some FINRA compliance issues which appear to be connected with their president and chief compliance officer.Admittedly, the disclosure is thin and what is disclosed doesn’t sound terribly ominous.  But some consider any “yes” answer to regulatory issues to be a big red flag, especially in connection with a $2.0 million trading error.  Charlie Munger once said that, in the securities industry “integrity is like oxygen, no one thinks about it until it’s gone – then it’s the only thing they think about.”  If the regulatory issue threatened Berwyn’s five-star rating, it could have a huge impact on client behavior.  Put all of this in the context of a small firm (13 employees) with an aging founder who still holds a control position in the stock, and you’ve got what appears to be a motivated seller.We won’t speculate on what the multiple “could have been” in absence of the factors mentioned above, or what specific role they played in generating the terms of the Killen sale to TSC.  But it appears to be an outlier transaction for outlier reasons, and like the Edelman deal shouldn’t be misinterpreted as signaling anything unusual about valuations in the asset management industry.Mercer Capital's RIA Valuation Insights BlogThe RIA Valuation Insights Blog presents a weekly update on issues important to the Asset Management Industry.

There's something about nature that abhors a vacuum. Right now that vacuum seems to be the imbalance between the public and private markets, with the latter attracting maybe too much interest since the credit crisis, at the expense of the former. Blame fair value accounting or Sarbanes-Oxley or the plaintiff's bar, but it has been some time since being public was actually considered a good thing. With interest running high in the "alternative asset space" and cheap debt for LBOs, the costs of being public have not been particularly worthwhile. This situation is not sustainable, and was never meant to be. Family businesses can stay private forever, but institutional investors eventually need the kind of liquidity that can only come from the breadth of ownership afforded by established public markets. Valuations are never really proven until exposed to bids and asks. So the circumstance in which private capital markets are considered more desirable than public markets is to express an illiquidity preference which is at odds with basic investment logic and the requirements of portfolio management. This cannot last, and the end – which appears to now be unfolding - will ripple throughout the asset management industry. Continuing a trend set into motion in the first half of 2015, third quarter IPO activity fell 34% year over year in 2015, while the median capital raised in private fundraising rounds hit a staggering $92 million. The tech industry in particular has suffered from a glut of capital in late-stage funding rounds, leading to a general hesitation to leave the safe (because it is comfortably theoretical) harbor of the private market. Only 11% of IPOs completed in 2015 so far involved tech companies, with a majority of them generating returns of less than 3% from their IPO prices, and producing a negative 15% from their debut closing prices. Within the tech industry, the sheer amount of capital inflow from the private market has distorted the usual hubbub around the IPO. Private valuations have quietly (and in some cases, publicly) reached levels unsustainable in the public market, and companies now face a reality in which going public may in fact devalue the company – at least from late financing rounds. It seems only fitting that a company whose entire platform is built on the concept of impermanence should fall prey to the largest tech devaluation in the private market in 2015. Snapchat, a photo, text and video messaging app in which messages "self-destruct" in ten seconds or less, took a hit this past week when it was revealed that Fidelity Investments cut the value of its stake in the company by a whopping 25%. Earlier this year, BlackRock reduced its valuation of the cloud-storage software DropBox by 24%. However, as mutual funds, both Fidelity and BlackRock are obligated to mark their portfolios to market on a regular basis and disclose their valuations. In the third quarter, plummeting gas prices, unstable Asian markets, and whatever new catastrophe was going on with the Eurozone were in full effect. As a result, Twitter saw its stock price fall by 29%, while Facebook also had less than stellar returns. In all likelihood, Snapchat and DropBox were victims of market pressure rather than fundamental performance. It's a buyer's market in the IPO world, as 16% of IPOs downsized their debuts during the third quarter. Investors burned by lower than expected returns in the public market are putting pressure on startups to offer protections or lower their share price. Square, Inc., a mobile payment company founded in the heart of Silicon Valley, recently announced plans to sell 27 million shares in an IPO offering ranging from $11 to $13 per share, a significant discount from the company's October 2014 funding round that valued shares at $15.46. Granted, late stage Square investors are operating under a "ratchet" agreement (not the adjective kind). Square agreed to provide extra shares to certain investors if the company went public at a share price lower than the funding valuation the investor bought in at. If Square goes public at a share price below $15, the IPO will trigger the ratchet and diminish the outstanding shares. But terms don't fix price, as the "protection" afforded some Square investors will come from other Square investors. Ultimately, price is a zero sum game. Although startups do not often publicize whether investor protections are in place, it is an additional factor that has led several startups to postpone a planned IPO. LoanDepot is the latest company to get cold feet before their big day, as the company's prospective share price plummeted from a high of $18 per share to below $12. Instead of floating the lower valuation, LoanDepot walked, citing "market conditions" as the primary culprit behind the lower valuation. The IPO market has become a waiting game, as more and more startups have punted going public in favor of private capital. Whether the current market squeeze filters its way down to affect private valuations is only a matter of time. It's hard to imagine that a buildup of companies waiting to go public will somehow improve IPO pricing. And it is hard to imagine this ending well. ZIRP and arguably over-regulated public markets have created a robust private market, but it is a market of "Level 3" assets without validation. If private markets seize, will they also become more regulated? If rates ever rise significantly, can financing get rolled over to sustain leveraged ownership? Can pension plans and endowments satisfy their funding liabilities without liquidity for alternative assets? At some point, liquidity preference is going to have to restore some reason for public ownership. Ultimately, though, the question is whether that comes from improvement in the public markets or deterioration in the private market.

Despite the recent setback in the markets, RIA transaction activity posted solid gains for Q3 and into the month of October. We caution against reading too much into this since transaction value is often not reported, though it is promising that the number of deals has increased fairly consistently over the last year. The fourth quarter looks to continue this trend with Hellman & Friedman’s recent purchase of Edelman Financial (covered in a previous post). The quarter-end multiples for the public RIAs reveals that pricing remains firm but not egregious, a conducive environment for continued transaction activity in the sector. Prospective buyers will also be intrigued by many of these businesses now trading at a 30% discount to their 52 week high. [caption id="attachment_9618" align="aligncenter" width="650"] Source: SNL Financial[/caption] Placing the recent uptick in its larger historical context reveals a lull in deal making after the active 2006 to 2009 period that culminated in BlackRock’s purchase of Barclay’s asset manager business. The sector’s ability to shrug off the most recent correction is a testament to its resiliency in the face of declining management fees and impending regulatory changes. Despite the recent uptick, we believe the backlog for deal making remains fairly robust given the four year pause in transactions from 2009 to 2013 and the aging demographics of many investment management firms. The real threat to deal making would be a longer, more pronounced downturn in the equity markets that would crater AUM levels and investor confidence. We note the decline in transaction activity following the financial crisis of 2008 and 2009 as indicative of what another bear market could do to M&A trends. The outlook for deal making is therefore more nuanced and dependent on market conditions. The market’s stabilization since the last correction has clearly boded well for sector M&A, and the future appears bright – as long as security pricing holds up. Another significant setback would likely curtail the recent momentum and valuation levels.

Last week brought the news that PE firm Hellman & Friedman had acquired Lee Equity Partners's controlling interest in mega wealth manager Edelman Financial. Edelman is headed by radio-show personality Ric Edelman, and manages about $15 billion for over 28,000 clients. While terms of the deal were not officially disclosed, the Wall Street Journalreported the transaction valued Edelman at a number north of $800 million, a nice pickup from Edelman's going private deal in 2012, which transacted the company at $263 million. The financial press was practically hyperventilating over the price last week, but a little analysis on the number reveals pricing that is more normal than most would imagine.Breathe normallyThe headline optics of the deal are eye-popping. An $800+ million price is more than triple the transaction value only three years ago, and further implies a price to AUM multiple of over 5% (!). The financial press that immediately followed the announcement ballyhooed the deal as proof that RIAs were hot properties fetching premium pricing and that we could expect more of the same. Count us as being a little more measured in our perception of the deal. While we're not going to describe the Edelman deal as a "meh" transaction, the firm's underlying fundamentals are likely far more responsible for the price than an overheated market. Indeed, our analysis suggests Edelman's pricing was fairly normal. Here are a few reasons to be happy, but not ecstatic, about the Edelman sale:Edelman is a growth machineWhen Edelman went private three years ago, the company reported assets under management of about $8 billion. It's almost twice that today. While a 30% CAGR in AUM has no doubt been assisted by bull market tailwinds, most of Edelman's growth has been from growing its investment advisor base and, correspondingly, the number of clients.Past growth explains the change in valuation from the 2012 going private transaction to the current deal, but Edelman is showing signs of continued growth as well, increasing the number of investment advisors by about 20% this year. RIAs can't always count on the market to grow the top line, but if a marketing platform is there to add clients, value will accrue.Edelman fetches premium feesThe real reason Edelman commanded such a high multiple of AUM is the firm's superior ability to extract fees per dollar of AUM.Investment management fee schedules are all over the map, with robo-advisors clocking in at around 25-40 basis points, and wealth managers often sticking between 100 and 125 basis points. Historical disclosures suggest that Edelman commands big fees for what they do. In their last public filing (Q2 2012), Edelman boasted investment management fees of over $32 million. Using that quarter as a proxy for an annual run rate of almost $130 million, Edelman was earning realized fees of 160 basis points on AUM of $8 billion. Even assuming that has been dialed back some by market forces puts Edelman's investment management fee base today at something on the order of $225 million.Add this to the Company's other revenue streams (which probably haven't scaled up to the same extent in the past three years), and we would estimate Edelman's revenue today to be on the order of $300 million. That's no threat to Schwab, but in the independent RIA space it suggests that Edelman has defied certain laws of gravity for wealth managers that have plagued other shops at much lower levels of performance. No doubt the scale of Edelman, the pricing power of their services in the market place, and the potential to grow further attracted a strong multiple.As a caveat to this, higher than market fee schedules are at risk of being "normalized" and doubtless this influenced the valuation of Edelman. That said, it is likely they have been successful at maintaining their value to customers in the marketplace so far.Edelman has revenue sustainabilityRic Edelman built his firm as a radio personality dispensing advice and gathering assets. His advisor network was excellent at client conversion and retention, and that formula has held up. The cult of personality firm, which we have written about in other posts, has drawbacks. Some still suggest that the firm's dependence on Edelman at the helm is a risk. We do not entirely disagree, but note that with 28,000 clients investing on average $536 thousand with Edelman, the firm has a solid lock on the mass-affluent investor market.Client demographics are a big factor in the value of investment managers, and while it's easier to service a few huge clients, if they leave they take firm value with them. The great thing about larger wealth managers like Edelman is that there is client diversification and product diversification, such that revenue is highly sustainable going forward.For a PE manager looking for investment return opportunities in what seems to increasingly be a low return environment, Edelman offers a higher quality coupon than most. We know that better coupons pay lower yields, which in Edelman's case suggests a multiple at the high end of the range.Edelman probably has a solid marginSince Edelman has been private for three years, we don't have a lot of margin visibility, but we can look back to 2012 and see what we can normalize to get there, especially if it's consistent with industry norms. Our analysis of Edelman's run rate at the time of the going private transaction suggests an EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) margin on the order of 30% to 35%. That's strong, but not out of range with similar firms in the wealth management space. Edelman may have achieved some margin leverage with the growth it has experienced over the past three years, but probably not much. Thus Edelman's margin provided an optimal circumstance for the valuation multiple, with solid profit performance that does not need "repair" from a new owner, but also not so high as to risk being unsustainable.Edelman likely got a good, but not extraordinary, multiplePut it all together and the Edelman transaction looks fairly normal. Assuming an EBITDA margin at or just about 30%, consistent with the level of profitability the company reported before the 2012 going private transaction, HF paid a high single digit multiple of EBITDA. The deal multiple was likely upward biased by the growth pattern and trajectory of the company, and the risk mitigation afforded by a diverse client base and large scale. Weighing down the multiple was likely some lingering concern over the dependence on Ric Edelman as the spiritual guru of the organization, concern over the sustainability of the firm's fee schedule, and some angst in general over the direction of capital markets. As solid as this pricing was, we wonder if Edelman couldn't have fetched closer to $1 billion a year ago when folks believed the market had more room to run. But that's neither here nor there. Kudos to Edelman and Lee Equity Partners for a solid return on their three year investment in the company, and to Hellman & Freidman for acquiring a great franchise at a reasonable price such that their investors can also profit. All in all, an increasingly rare event in the PE universe.

August has become the new October for markets in terms of increased volatility and downward pressure on equities and high yield credit. This year has seen similar volatility as was the case in some memorable years such as 1998 (Russian default; LTCM implosion), 2007 (tremors in credit markets), 2008 (earthquakes in credit and equity markets) and 2011 (European debt crisis; S&P’s downgrade of the U.S.). Declining commodity markets, exchange rate volatility and a pronounced widening of credit spreads finally began to reverberate in global equity markets this year.So far the downdraft in equities and widening high yield credit spreads has not slowed M&A activity. Preliminary data from Thomson Reuters for the third quarter indicates global M&A exceeded $1 trillion, which represents the third highest quarter on record and an increase of 11% over the year ago quarter. Activity is less broad-based though as 8,989 deals were announced compared to 10,614 a year ago.Immediately prior to intensified pressure on risk-assets, Thomson Reuters estimated that as of August 13 global M&A was on pace for a record year with $2.9 trillion of announced transactions globally (+40% vs. LYTD) and $1.4 trillion in the U.S. (+62%). Within the U.S., strategic buyer activity rose 53% to $1.1 trillion while PE M&A rose 101% to $326 billion.LBO multiples have been trending higher since 2009. The median LBO EBITDA multiple for broadly syndicated large deals was 10.1x through September, while middle market multiples expanded to 10.3x. Debt to EBITDA multiples for LBOs were 6.0x for large deals YTD and 5.5x for middle market transactions.No one knows what the future holds for markets. Deal activity could slow somewhat; however, a weak environment for organic revenue growth will keep many strategic buyers engaged, while lower prices for sellers if sustained will make more targets affordable for private equity provided debt financing costs do not rise too much. As of October 14, the option-adjusted-spread (OAS) on Bank of America Merrill Lynch’s High Yield Index was 6.31%, up from 5.04% at year-end and 4.83% a year ago.The role of the financial advisor becomes tougher too when markets are declining sharply. Obviously, sellers who do not have to sell may prefer to wait to see how market turmoil will play out while buyers may push to strike at a lower valuation. Questions of value and even fair dealing may be subjected to more scrutiny.Fairness opinions seek to answer the question whether a proposed transaction is fair to a company’s shareholders from a financial point of view. Process and especially value are at the core of the opinion. A fairness opinion does not predict where a security—e.g. an acquirer’s shares—may trade in the future. Nor does a fairness opinion approve or disapprove a board’s course of action. The opinion, backed by a rigorous valuation analysis and review of the process that led to the transaction, is just that: an opinion of fairness from a financial point of view. Nevertheless, declining markets in the context of negotiating and opining on a transaction will raise the question: How do current market conditions impact fairness?There is no short answer; however, the advisor’s role of reviewing the process, valuation, facts and circumstances of the transaction in a declining market should provide the board with confidence about its decision and the merits of the opinion. Some of the issues that may weigh on the decision process and the rendering of a fairness opinion in a falling market include the following:Process vs. Timing. Process can always be tricky in a transaction. A review of fair dealing procedures when markets have fallen sharply should be sensitive to actions that may favor a particular shareholder or other party. A management-led LBO after the market has fallen or a board that agrees to buyback a significant shareholder’s interest when prices were higher are examples. Even an auction of a company may be subject to second guessing if the auction occurred in a weak environment.Corporate Forecasts. Like the market, no one knows how the economy will perform over the next several years; however, consideration should be given to whether declining equity markets and widening credit spreads point to a coming economic slowdown. A baseline forecast that projects rising sales and earnings or even stable trends may be suspect if the target’s sales and earnings typically fall when the economy enters recession. A board should consider the implications of any sustained economic slowdown on the subject’s expected financial performance with follow-through implications for valuation.Valuation. Unless markets experience a sharp drop from a valuation level that reflects a widely held view that multiples were excessive, a sharp pullback in the market will cause uncertainty about what’s “fair” in terms of value. DCF valuations and guideline M&A transaction data may derive indications that are above what is obtainable in the current market. Transactions that were negotiated in mid-2007 and closed during 2008 may have felt wildly generous to the seller as conditions deteriorated. Likewise, deals negotiated in mid-2012 that closed in 2013 when markets were appreciating may have felt like sellers left money on the table. There is no right or wrong, only the perspective provided from the market’s “bloodless verdict” of obtaining a robust market check if a company or significant asset is being sold. It is up to the board to decide what course of action to take, which is something a fairness opinion does not address.Exchange Ratios. Acquisitions structured as share exchanges can be especially challenging when markets are falling. Sellers will tend to focus on a fixed price, while buyers will want to limit the number of shares to be issued. The exchange ratio can be (a) fixed when the agreement is signed; (b) fixed immediately prior to closing (usually based upon a 10 day volume-weighted average price of the buyer); or (c) a hybrid such as when the ratio floats based upon an agreed upon value for the seller provided the buyer’s shares remain within a specified band. Floating exchange ratios can be seen as straightjackets for buyers and lifejackets for sellers in falling markets; rising markets entail opposite viewpoints.Buyer’s Shares. An evaluation of the buyer’s shares in transactions that are structured as a share exchange is an important part of the fairness analysis. Like profitability, valuation of the buyer’s shares should be judged relative to its history and a peer group presently and relative to a peer group through time to examine how investors’ views of the shares may have evolved through market and profit cycles. The historical perspective can then be compared with the current down market to make inferences about relative performance and valuation that is or is not consistent with comparable periods from the past.Financing. If consummation of a transaction is dependent upon the buyer raising cash via selling shares or issuing debt, a sharp drop in the market may limit financing availability. If so, the board and the financial advisor will want to make sure the buyer has back-up financing lined-up from a bank. The absence of back-stop financing, no matter how remote, is an out-of-no-where potential that a board and an advisor should think through. Down markets make the highly unlikely possible if capital market conditions deteriorate unabated. While markets periodically become unhinged, a board entering into an agreement without a backstop plan may open itself to ill-informed deal making if events go awry. A market saw states that bull markets take the escalator up and bear markets take the elevator down. Maybe the August sell-off will be the pause that refreshes, leading to new highs, tighter credit spreads, and more M&A. Maybe the October rebound in equities (but not credit, so far) will fade and the downtrend will resume. It is unknowable. What is known is that boards that rely upon fairness opinions as one element of a decision process to evaluate a significant transaction are taking a step to create a safe harbor. Under U.S. case law, the concept of the "business judgment rule" presumes directors will make informed decisions that reflect good faith, care and loyalty to shareholders. The evaluation process is trickier when markets have or are falling sharply, but it is not unmanageable. We at Mercer Capital have extensive experience in valuing and evaluating the shares (and debt) of financial and non-financial service companies engaged in transactions during bull, bear and sideways markets garnered from over three decades of business.

A fairness opinion provides an independent objective analysis of the financial aspects of a proposed transaction from the point of view of one or more of the parties to the transaction.They are often used to protect the interests of company directors, stockholders, investors and involved parties with any kind of fiduciary responsibility. While fairness opinions can not only help avoid disagreements among the individual stakeholders or between stakeholders and the Board, a fairness opinion is often necessary for a Board to have fulfilled their fiduciary duties.Mercer Capital leverages its historical valuation and investment banking experience to help clients navigate a critical transaction, providing timely, accurate and reliable results. We have significant experience advising boards of directors, management, trustees, and other fiduciaries of middle-market public and private companies in a wide range of industries. Our independent advice withstands scrutiny from shareholders, bondholders, the SEC, IRS, and other interested parties to a transaction, and we are well-versed in the new industry standards regarding fairness opinions issued by FINRA in late 2007.A variety of factors in transactions involving both public and private companies can trigger the necessity for a fairness opinion, including:Merger or sale of the companySale of subsidiary businesses, or distinct lines of businessRecapitalizationsStock repurchase programsSqueeze-out transactionsSpinoffs, spinouts, or split-upsCertain ESOP-related transactionsOther significant corporate events When performing a fairness opinion, it is also important to take into account any number of alternatives that may exist to the proposed transaction. As a valuation services firm, Mercer Capital is particularly well-equipped to provide the analysis for a deal in which a consideration other than cash if offered – namely, when the consideration is an interest in a closely held company. Mercer Capital's comprehensive valuation and transaction experience with public and private capital companies empowers us to efficiently provide unbiased fairness opinions that can rely on to assure stakeholders that the decisions being made are fair and reasonable. Contact a Mercer Capital professional to discuss your needs in confidence.