Carrots And Sticks: Making Investment Management Deals Work

Of all of the sectors involved in private equity investing and acquisition activity, the most interesting, fun and challenging is the investment management sector.

The margins of the companies involved are compelling, as are the cash flows. The players are smart and usually wealthy, with a strong independent streak. Partnering with the management team of an investment management firm can be like partnering with professional athletes or even rock stars. The regulatory environment is complex and ever evolving. The business has clients, not customers, and the distinction is important: Most clients have contracts that are terminable at will and thus an important seat at the table in transaction negotiations. Most importantly, the principal assets of the business—the people—go down the elevators each night. The challenge is to keep them coming back up the elevators in the morning and staying late into the night in their offices, thinking of ways to increase franchise value.

This article explores how investors and strategic acquirers have approached the challenges and opportunities presented by the investment management sector. Unlike many other sectors, there are a number of different models for investment management transactions, with different underlying philosophies. At bottom, some emphasize “sticks”— restrictions on the principals’ activities that bind them to the firm, whereas others emphasize “carrots”—techniques designed to incentivize wealth creation over the long term.

Market Evolution

The buying and selling of investment management firms has been occurring for many years. Indeed, the Investment Company Act and the Investment Advisers Act included specific provisions addressing sales of investment management firms when they were adopted in 1940.

Prior to the 1980s, the private equity industry was nascent and investment management M&A was the province of larger financial institutions. In the 1960s and 1970s, for example, The Boston Company pioneered the asset management holding company concept by aggregating subsidiary managers with multiple investment styles to offer clients a full suite of services and smooth the performance bumps that inevitably occur from sector to sector. Each of The Boston Company’s affiliates had regional market exclusivity but not investment or financial autonomy.

Later in the 1980s serial acquirer United Asset Management altered the model by introducing the concept of a revenue sharing arrangement. In this model, United Asset Management acquired 100 percent of a management firm’s equity and the right to a share of revenue off the top, leaving management to run the business with a substantial degree of operational autonomy. The firm used very long-term employment agreements, bonuses and non compete agreements to assure that the managers of the acquired firms remained locked in.

Private equity investors, led by firms such as TA Associates and Hellman & Friedman, entered the arena in the late 1980s. These investors pioneered the use of cash flow based leverage to acquire firms like Travelers’ Keystone unit and First Chicago’s Brinson Partners, borrowing from their venture capital roots by offering equity to management teams. Affiliated Managers Group, launched in 1993, and others further refined this concept by offering management liquidity and equity in their respective units, redeemable upon retirement, as well as equity at the parent holding company level. The expansion of investment activity that followed included minority recapitalizations and new asset classes such as real estate investment management. During the decade from 2000 to 2010, investment activity in the investment management sector reached a level of intensity commensurate with the market generally, marked by transactions such as Madison Dearborn‘s acquisition of Nuveen utilizing leverage at the level of 9X EBITDA and the entry of new market participants. Also during this period leading investors in the sector began to expand globally and newer sub-sectors such as hedge fund and other alternative asset managers attracted investment attention.

As we head into the second decade of the 21st century, the pressures of the economic collapse that occurred in 2008 and 2009 may give rise to a new era of acquisition and investment activity. While it is hard precisely to categorize eras in the evolution of the market for investment management businesses, activity levels of private equity investors tend to be roughly correlated with the relative strength or weakness of larger financial institutions. Recently announced transactions such as the lift-out of Neuberger Berman from the bankruptcy of Lehman Brothers and the acquisition by Pacific Century Group of AIG’s investment unit with management to form PineBridge Partners, suggest a new round of opportunities for private equity and strategic investors to acquire investment management franchises as larger firms divest them and for management teams to establish their firms as free-standing entities. Also, management and founders may also look to bank capital as levels of assets under management begin to recover but memories of plummeting firm valuations linger. Deals are in the works, and others are likely to follow.

A Different Kind Of Deal

What then are the keys to success in acquiring and investing in investment management firms? There is no single answer, as the personalities and styles of investment management firms across the nation and the globe vary considerably.

Most fundamentally, an acquisition of an investment firm, whether majority or minority, is a fundamentally different exercise than the acquisition of, say, a factory, or a software company, or even another kind of financial/professional service firm. One of two principal assets of an investment management business is its professionals, and to a greater or lesser degree they control the other principal asset, the client relationships. An investor can own a majority of an investment management firm’s equity, but as one highly successful investor in the sector puts it, “Control is a state of mind.”

In the investment management sector more than almost any other, a partner-like approach has been a cornerstone of investment success. This manifests itself in all areas of the relationship between capital and management. Related closely to a partner-like approach is an understanding of the economics of investment firms. Whatever may be said about current bonus levels within the nation’s large financial institutions, the fact remains that talented investment professionals command spectacular levels of pay. Savvy investors understand that acquiring substantially all of an investment management firm’s equity does not mean that they will or should acquire substantially all of the cash flows, and these investors price their investments accordingly. Traditional multiple analysis is altered in the context of investment management M&A, as pricing is less a question of what an investor pays than what it buys in terms of cash flow. I

A related conceptual issue involves the use of carrots versus the use of sticks in structuring ownership and compensation arrangements Some acquirers offer large up-front payments to current owners in exchange for contractual lock-ins in the form of lengthy non-competes, employment contracts and bonus arrangements to assure they will stay engaged in the business. Others tend to emphasize a more carrot-oriented approach, using equity (subject to vesting) coupled with interests in current cash flow to incent managers to build the firm. In practice most investors use a combination of carrots and sticks.

Structures, Key Terms

Within the overall framework, investment management M & A involves special considerations in the areas of both economics and governance.

Cash Flow. A substantial portion of the cash flows in an investment management firm (consisting principally of management fees and in some cases performance fees and carried interest payments) may be captured by the management team, as “ownership” of cash flow and ownership of residual equity are less correlated than in other types of companies. Much of the cash flow in a well structured investment management M&A transaction typically is allocated within a bonus pool, with the managers’ shares in the pool often including a fixed portion and a variable portion designed to reward current year contributions. Bonuses are substantially tied to performance and the plan design usually provides incentives for management to improve margins, such as a “pegged” margin provision. Over time bonus shares are allocated and re-allocated to reflect shifting contributions and personnel changes, often with the goal of incentivizing and tying in second and third generation firm leaders. Acquirers recognize that exceptional performance must be exceptionally rewarded, and a bonus pool is the principal vehicle for rewarding year to year performance.

Equity Ownership. Investors and management teams in investment management firms seek to accomplish a number of goals through equity ownership. These include giving managers a stake in discrete investment units where they most directly affect results, creating a sense of buy-in and ownership of the overall enterprise when a multi-manager enterprise is involved, and enabling favorable tax treatment. The percentage shares are usually fixed to a greater degree than with bonus pool interests, but can vary over time as next-generation managers rise to prominence and older founding members cycle out. Equity interests are almost always subject to vesting.

Governance. Governance terms in investment management firms vary widely, and some push the boundaries of the historic correlation between ownership and control. To a greater or lesser degree, management teams in investment management firms tend to be autonomous creatures. Reflecting this, most governance arrangements implicitly or explicitly cede control over investment management operations to the management team, subject to board oversight. Management governance rights in investment management transactions sometimes go beyond investment operations, however, to include control or joint control over such matters as personnel decisions within the investment unit, CEO selection, allocation of bonuses and bonus pool shares, decisions with respect to new investment products within a set budget, and more.

Just Passing Through. Many investment management firms are pass-through entities for U.S. federal income tax purposes due in part to the substantial cash flows they generate, among other reasons. Accordingly, investors in this sector need to be deeply familiar with the ins and outs of tax pass-throughs, and track pending Congressional proposals that could alter the tax treatment of some equity interests in these entities.

Great Rewards

There are few deals as challenging to do well as an acquisition of a multi-asset class investment manager with a world class investment team. The constituencies to be satisfied are many and the negotiations are multiple. The regulatory environment is complex and serious. The personalities can be large. The assets do indeed go down the elevators every night and can be gone in a flash.

Yet the rewards too can be great, especially if an investor is experienced and the cycle is right. The economic debacle of the last two years may have set the stage for a positive turn of the cycle from the perspective of private equity investors, as large institutions look to shed investment units and management teams seek to establish free-standing entities apart from large institutions. Those who carry forward the best learning offered by the experience of the last decades into the new cycle will be well positioned.

John LeClaire is the co-founder and chair of the Private Equity Group at Goodwin Procter LLP. The late Dick Floor was a partner at Goodwin for 35 years until February 2010, when he succumbed to cancer. LeClaire wrote that “he worked with his fellow partners and clients to the end, doing what he loved to do best. An outstanding attorney and business counselor, he was a leader of his generation; moreover, he was a friend and mentor and a committed family guy, touching many in the happy life he joyously lived.” The authors thank Richard Morris for his contributions.