We are experiencing a rebound in alternative asset manager acquisitions linked to an ongoing global repositioning within the financial industry. This development follows a several year lull in alternative asset management acquisitions attributable to the economic crisis and the concurrent short-term decline in the approbation of alternative asset managers. Financial institutions are seeking sizeable investments in, and sometimes control of, alternative asset managers.
These financial institutions – including banks, private equity buyers (for their own accounts, not their funds) and other substantial alternative asset managers – are seeking immediate attractive returns, and supplementary revenue streams that do not require leveraged trading in the financial institution’s own capital. These transactions often present an attractive opportunity to leverage their global distribution networks, by guiding investors into alternative asset products in which the buyer not only benefits from distribution fees but also shares in the manager’s equity upside as its business grows.
Buyers are typically seeking targets with superior current and historic track records that the buyers’ distribution network can effectively market, and that have a pedigree that satisfies the institutions’ reputational standards. Managers that have not recovered from the financial crisis or that have experienced larger than average net withdrawals or redemptions are, to some extent, being left behind in these developments.
Alternative asset managers, in turn, are looking to expand, stabilise and diversify their investor base and assets under management through a relationship with a buyer with a well-suited distribution network. The owners of the target frequently have most of their wealth invested in their alternative asset management businesses and also seek these transactions in order to monetise a portion of their equity. With reduced public interest in alternative asset manager IPOs, owners of these managers exploit these transactions to grow and institutionalise their businesses, with equity structures that maintain permanent equity for the founders while incentivising the next generation of investment professionals with equity stakes.
This article describes the challenges presented by these transactions and some of the structures and methods used to balance the competing interests of the buyers and selling equity holders. We also discuss the challenges of client consents, the impact of bank acquisitions of alternative asset managers (including the frequently misunderstood restrictions of the Volcker Rule) and developing tax legislation that could impact these transactions.
Retaining talent
Agreeing to a price is the initial step in negotiating an alternative asset manager acquisition. Valuations of alternative asset managers are difficult, particularly given the volatility of incentive-based returns and fluctuations in markets and investor redemptions in recent years. Valuations have to take into account the reliance of asset management businesses upon a relatively small number of highly talented individuals, as well as the need to continuously incentivise and, from time to time, replace or augment them. Because of the narrow pool of talent and the opportunities that successful portfolio managers have to participate in other organizations or to start-up their own firms, acquirers need to establish an incentive and retention program that ensures the longevity of the target.
The earn-out
The long-term earn-out has become the primary method to address valuation and longevity concerns and is now the hallmark of alternative asset acquisitions. Frequently less than half of the total anticipated purchase price is paid at closing. The remainder, which may or may not be capped, is based on one or more measures of performance – most frequently, total or average EBITDA or management fees – covering a three to seven year period post-closing.[1]
The most obvious method for retaining sellers in the target business – making the earn-out payment contingent on seller retention or compliance with non-compete obligations – may not give the sellers the anticipated tax treatment with respect to the transaction, and is therefore not common in practice. Current US federal tax law generally treats the net profits from properly structured earn-out payments as capital gains to the sellers and eligible for long-term capital gains treatment for assets or interests held over one year, to the extent of the goodwill in the sellers’ business.
There are two exceptions to this general principle. First, a relatively small portion of the earn-out payment will be deemed to be interest income because of the deferred nature of such payment. Second, to the extent that a seller’s share of the earn-out exceeds $5 million, the excess may be subject to an annual interest charge, so long as the potential for the earn-out remains outstanding (possibly even if the earn-out is highly contingent); that interest is not deductible by non-corporate sellers.
Earn-out formulae generally capture both AUM (or management fee) growth as well as the impact of incentive fees/allocations. Earn-out structures that are based on both income streams motivate the sellers to focus on investment returns, not only AUM growth. They have become a useful tool in satisfying investors in funds managed by targets that the sellers share an ongoing interest in preventing performance compression as AUM expands. Earn-out formulae also frequently credit the sellers with most or all of the benefit of the buyer’s post-closing distribution efforts and any integration into the buyer’s existing platform.
Long-term non-competes
Sellers are generally required to enter into long-term non-compete arrangements. While non-competes do not deter retirement, they remove any motivation for a seller to leave the target business in order to pursue other opportunities.
Unlike non-competes in the employment context, non-compete arrangements designed to protect the buyer of a significant business can frequently be relied upon to sustain long-term non-competes. We expect that courts would sustain long-term non-competes by sellers of alternative asset managers because the purchase price is based on the goodwill of the target business which is inexorably tied to the sellers’ capability and reputation. As a companion concept, the sellers and other employees may be required to be stripped of the right to utilize the performance track record of the target company and enter into long-term confidentiality and employee and investor non-solicitation arrangements, all of which further limits their ability to compete through any venture outside of the target company.
Reinvestment by sellers
Requiring significant percentages of the sellers’ after-tax sale proceeds to be reinvested in the manager’s funds for several years is another mainstay of asset manager acquisitions. That reinvestment further incentivizes sellers to commit themselves to the business after the initial purchase price is paid because a sizeable portion of the initial payment will be at risk in the business. Fund investors also appreciate the alignment of interest created by that obligation.
Partial sales
Financial buyers and sellers are becoming increasingly reluctant to purchase and sell 100% of the equity of the target business. On the one hand, buyers are motivated to leave the sellers with sufficient equity in the business to motivate the sellers beyond the earn-out period and provide a pool of available equity that the sellers are motivated to share with the other professionals who continue to operate the target manager. Similarly, sellers often seek to retain substantial ownership of the target manager in order to benefit from permanent equity in the business as it grows under the new relationship as well as to express their confidence to the buyer.
Platform for growth
Sellers often rely on access to the institutional buyer’s distribution network to add stable institutional investors to the targets’ investment products, which in turn promotes the value of their permanent equity. A variety of techniques protect their interests in maintaining a premier, if not exclusive, position in the buyer’s distribution platform. For example, rather than prohibiting a buyer from acquiring or distributing for a competing asset manager, the parties may agree to accelerate the earn-out, or portions of it, or provide the sellers with a limited right to call back their equity, in those circumstances. These types of protections are obviously more critical where the sellers are relying on growth to hit long-term earn-out targets.
Three stages of governance
Next to negotiations over purchase price, including the earn-out, dividing up and sharing governance rights is the most challenging and intricate aspect of reaching an agreement in alternative asset management acquisitions. The competing interests of buyers and sellers typically come together in practice through a complicated set of checks and balances that shift over time with changes in the parties’ interests and leverage.
Stage one: pre-earn-out
The balance of governance rights tends to favor the sellers during the initial earn-out stage, even where a majority or 100% of the target has been sold to the buyer. Sellers insist on and frequently attain a high degree of – if not complete – control over the day-to-day operations and other matters that could impact their ability to obtain the earn-out portion of the purchase price. This governance dynamic is further justified by sellers pointing out that although a substantial portion of the target equity has been transferred, the full purchase price (i.e., the earn-out) has yet to be paid. As sellers remain the key relationship with the investors in the target’s products, investor comfort with the sellers’ authority to manage the day-to-day investment process is vital to obtaining investor consent where required and to the success of the business going forward.
Even where the buyer has not yet paid most of the purchase price, it has made a significant investment and may have control and therefore responsibility for the target from a regulatory perspective or at least bear significant reputational exposure to the target. At a minimum, the buyer will demand broad veto rights over fundamental business decisions. Where the buyer acquires voting control, the sellers will likewise require vetoes over fundamental business decisions to protect themselves from the buyer forcing changes which impact their ability to hit the earn-out targets.
Dueling veto rights present a risk of deadlock on key business decisions. Such situations are normally avoided in standard deal-making in favour of a resolution process that allows the decision of one party or the other to govern or allow one party an exit right. In asset manager acquisitions, however, the logic is different. In a deadlock, the selling partners by default continue to operate the business in the ordinary course during the initial earn-out period.
Where buyers commit an exclusive portion of their platform and distribution capabilities to the target, the dynamics vary. There, the buyer’s dependence on the target creates a greater need for the buyer to have input on target operational or strategic matters, at least in the case of significant adverse events or a sustained period of poor performance.
Stage two: post-earn-out
Where the buyer has acquired a majority of the business, governance typically transitions to the buyer after the earn-out period. The sellers relinquish some veto rights, but nevertheless maintain more control than in a typical majority acquisition because of the need to assure investors in target products that the management team they are counting on continues to manage investment matters. As a result, the selling partners continue to run the day-to-day operations, but will no longer have the right to block all decisions of the buyer, if the buyer decides to move the business in a new direction.
Sellers that retain a meaningful portion of the equity will negotiate for economic rights and minority protections in the post earn-out period. In many instances, these minority protections resemble the minority rights that the buyer bargained to have during the earn-out period.
Stage three: renegotiation
In our experience, the original transaction terms do not typically survive significant changes in personnel and market cycles. Nearly every arrangement undergoes renegotiation within approximately three years of closing (during the earn-out period), and some even earlier. The sellers may outperform the metrics contemplated by the earn-out and make themselves invaluable to the business, and demand an expansion of the potential earn-out payments. The sellers may underperform, the earn-out may be out of reach, and the buyer may need to bring in and compensate fresh talent to turn around the business. Platform commitments may not survive market events, strategic developments or personnel changes on either or both sides.
Of course, the original contract is binding, and frequently sets the framework for third stage negotiation – but the original contract cannot create working satisfaction or commitment if the foundation of the alignment dissipates. Frequently, stage three is driven by fear that one or more sellers, having significantly increased his or her wealth in the transaction, would rather go his or her own way.
Where sellers retain significant equity in the target company, the transaction essentially becomes a permanent strategic alliance, premised on an ongoing mutually beneficial business relationship. Therefore, in advising clients what to anticipate in the governance/partnership negotiations, we frequently suggest to clients that they develop the mindset of negotiating a prenuptial agreement. If the marriage works, no one cares what the agreement provides, but if there is a difference of opinion, a deadlock or a falling out, the agreement takes on special meaning.
The core of the governance/partnership agreement is the process of dealing with the “what ifs” (e.g., what if there is a deadlock on significant issues, what if the platform relationship ceases to be mutually beneficial, what if there is a crisis at the target or at the buyer that makes the alliance difficult, and what if the buyer revises its strategic direction in favor of a competitor of the target). These are not easy topics to address at the time that the relationship is in its infancy, and, in fact, not all arrangements address these issues.
At times, the governance negotiations detour into negotiations of exit scenarios that can take varied forms, including buy-sells, puts and calls, and earn-out acceleration. Where the parties need clarity and certainty to predict the outcome of these events, the parties dedicate the effort up front to work out a resolution. In our experience, however, the actual circumstances giving rise to the exit have invariably proven to be different than the ones that were specifically contemplated.
Challenges of client consents
Determining whether client consents to the transaction are required involves an in-depth, “facts-and-circumstances” analysis. The preferred method of obtaining those consents can turn into a strategic decision.
If the target manager is registered as an investment adviser under the Investment Advisers Act of 1940, a change of control and deemed assignment of the manager’s advisory contracts with its funds and managed accounts may be presumed to occur under Advisers Act rules and related SEC no-action letters. Minority acquisitions can trigger a change of control depending on a number of factors, including the percentage of equity being sold and the control rights the buyer is obtaining. In fact, a change in control may occur even though target management continues to control day-to day operations.
Fund documents of a private investment fund rarely provide a blueprint for how to obtain consents to a change of control, and the SEC has not directly addressed how client consents should be obtained in the private investment fund context. A variety of practices have developed, which range from: obtaining “negative” consents, in which the transaction goes forward with notice to investors who are permitted to withdraw from the funds if they object; obtaining “affirmative” consents from the percentage of investors that would be required to amend the fund documents; obtaining consent of independent directors (for offshore funds, where independent boards are in place); or simply obtaining the consent of the general partner of the funds (which is somewhat riskier, since the general partner is controlled by the sellers). The approach taken depends on several factors, including the risk tolerance of the buyer and the sellers, the existence of periodic withdrawal rights of investors, and the timing constraints of the transaction.
Bank acquisitions and impact of Volcker
Contrary to some erroneous press reports, the “Volcker Rule” contained in the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act does not prohibit banks or their affiliates from acquiring equity, even controlling interests, in alternative asset managers. While the Volcker Rule will eventually impose severe limits on the ability of “banking entities”[2] to invest proprietary money in hedge funds and private equity funds, the statute explicitly permits banking entities to continue to sponsor and manage funds. Accordingly, since the Volcker Rule does not generally prohibit such activity, even if conducted directly by banking entities, it does not prevent banking entities from investing in, or acquiring, third-party managers who, themselves, engage in such activities.
Moreover, investments by banking entities in third-party managers may offer certain unique benefits to both parties. From the standpoint of the manager, an investment by a banking entity allows the manager to benefit from the significant distribution capabilities of most banking entities and enables the manager to market its funds to the banking entity’s client base. From the banking entity’s standpoint, an investment in a third-party manager will likely be the only way, post-Volcker, for it to participate in the profits of funds it does not sponsor itself.
When a banking entity acquires equity in a target asset manager, the parties must either structure the deal as a “controlling” or “non-controlling” investment under federal banking law.
“Control” deals
The benefits of structuring the transaction as a controlling investment are that no limits are placed on the percentage of equity the banking entity can acquire, the voting or other governance rights the banking entity can have, or the other commercial relationships the parties can maintain. Following a control deal, however, the target will become subject to various federal banking laws, and the federal banking regulators can hold the banking entity responsible for the target’s compliance with those and all other applicable laws.
Accordingly, prior to entering into a control deal, an asset manager should understand the effect federal banking law would have on its business. For example, the manager’s funds could, depending on their structure, become subject to certain investment limitations that apply on a consolidated basis to the banking entity and all of its affiliates (which would include a controlled manager and its controlled funds). If such limitations apply, they may affect the investment strategy of the funds and, in any event, would require the funds to provide the banking entity with real-time position transparency.
In turn, since a control deal renders the acquiring banking entity potentially responsible for the target’s legal compliance, a banking entity should first determine what rights it will need, or what requirements it will want to impose on the manager, to get comfortable with this potential liability. For example, the acquirer will need to determine what level of involvement it will want in the compliance activities of the target and what mechanisms it will need to ensure that compliance issues are adequately addressed.
“Non-control” deals
Because of the regulatory issues a control deal creates for both parties, they may seek to structure the transaction as a non-controlling investment instead. In order for a banking entity’s equity stake in a manager to qualify as non-controlling, the banking entity must hold less than 25% of any class of the manager’s voting securities and less than one third of its total equity. Under certain circumstances, however, a banking entity may need to reduce its holding to as little as five percent of the target’s voting securities or 25% of its equity in order to avoid being deemed to control the manager.
Depending on the size of the banking entity’s proposed interest, the banking entity may also be required to make certain “passivity commitments” to the Federal Reserve Board in order to avoid a control determination. Such commitments are normally required for non-controlling investments consisting of 10% or more ofany class of the target’s voting securities or 25% or more of its total equity, but, under certain circumstances, may be required for even smaller investments.
In making such commitments, the banking entity agrees that all other business relationships between it and its affiliates, on the one hand and the target and its affiliates, on the other hand, will be quantitatively limited and qualitatively non-material. The specifics of such limitations are determined by the legal staff of the Federal Reserve Board on a case-by-case basis and are designed to prevent the banking entity from gaining influence through the combination of substantial ownership and commercial relationships.
As part of the required commitments, the banking entity also agrees to limit its representation on the manager’s board (to no more than one, or possibly two, voting members and one, or possibly two, non-voting observers), forgo any rights that would enable it to exercise a controlling influence over the manager’s management or policies (such as all veto or consent rights, except in very limited circumstances), refrain from taking any actions to pressure management (such as soliciting proxies, proposing directors in opposition to those nominated by management, or threatening to dispose of stock). While such commitments generally prevent the acquirer from playing a role in the business of the manager, properly structured deals should, nonetheless, provide the banking entity with ways to protect its economic interest in the target manager.
Potential US tax law changes
Sales of asset managers have become increasingly more complicated from a US federal income tax standpoint. The three areas described below may have significant implications on asset manager transactions, and have driven many managers to seek and, if feasible, close deals before year-end.
Carried interest legislation
The antagonism on “Main Street” and in the political arena towards private investment funds has generated several legislative proposals over the past few years that target private investment funds and would affect alternative asset manager acquisitions. The proposed “carried interest” legislation would, if enacted, deprive private investment fund managers and their owners of favorable tax treatment in a number of areas that they have enjoyed virtually from their inception. In particular, the US Congress has focused on the taxation of performance-based compensation earned by alternative asset managers from advising funds that are treated as partnerships for US tax purposes. Alternative asset managers of such funds typically divide their operations into two or more separate businesses. One company provides asset management services and generates fee income for such services. Another entity earns performance-based compensation in the form of a profits interest in such funds (the so-called “carried interest”).
The US House of Representatives has passed legislation that the US Senate is currently considering, which would change the tax treatment of the sale of “investment services partnership interests.” While there is some ambiguity as to what constitutes an “investment services partnership interest,” our view is that the term generally does not include the sale of a management company; it would, however, include the sale of the entity receiving the carried interest.
Specifically, two critical items are under attack. First, the proposed legislation limits the ability of fund managers to pass through to themselves, in respect of their carried interest, the capital gains treatment enjoyed by investors in these funds – treating 75% of the carried interest as ordinary income from the provision of services (even if such carried interest would otherwise have been treated as capital gains), except that only 50% would be treated as ordinary income for profits attributable to assets that were held for at least five years. In addition, the amount treated as ordinary income would carry with itself-employment tax (currently at 2.9%).
Second, and more directly impacting sales of managers, the legislation applies the same re-characterisation rules to a sale of an entity receiving carried interest. As a result, asset managers would bear a much higher tax burden from selling the goodwill they create if they earn carried interest than do sellers of businesses generally.
Needless to say, the currently targeted 1st January 2011 effective date for the proposed legislation seems to have encouraged increased alternative asset manager acquisition activity with a 31st December 2010 target closing. In addition, asset managers may be more inclined to seek a higher percentage of upfront payments in 2010, as any earn-out payments made after 2010 may be subject to the re-characterisation rules. Moreover, the allocation of purchase price between the management company and the carried interest recipient will take on a more significant role for future sales.
Expiration of Bush tax cuts
Unless the US Congress enacts new legislation, the current top marginal individual tax rate for ordinary income and short-term capital gains will increase from 35% to 39.6% in 2011, and the current top marginal individual tax rate for long-term capital gains will increase from 15% to 20% in 2011. While there has been recent activity in Washington indicating that legislators may try to extend the current tax rates, it is difficult to tell at this point whether they will extend tax rates at all and whether any extension would apply to individuals in the highest tax brackets. As a result, asset managers may try to finalize sales before the end of 2010 and also structure as much of the consideration as upfront payments to be made by 31st December 2010.
Medicare tax on investment income
The healthcare reform legislation enacted earlier this year included a new tax on investment income that is effective starting in calendar year 2013. The law imposes a 3.8% tax on individuals’ investment income over a specified amount ($250,000 generally for married individuals and $200,000 for others), and that tax is not deductible. It applies to interest, dividends and capital gains from investments and may also apply to the gains realized on the sale of asset managers. This tax creates additional motivation for asset managers to sell their firms prior to 2013, including negotiating for the payment of any earn-out to be made no later than 31st December 2012.
Closing thoughts
Alternative asset management acquisitions are complex joint venture transactions, and, not surprisingly, negotiations are often protracted. Where banks are involved, dealing with federal banking regulation adds to the hurdles and extends the duration of the pre-closing process. We have experienced a number of transactions in which over one year was expended on the courtship and the legal negotiations.
We have found that a sometimes neglected key to the success of these negotiations is starting off with the proper mindset and preparation. The principals should expend the effort towards understanding what they are seeking from the relationship, what they might be willing to sacrifice and what goals are fundamental, and what the other side is seeking from the relationship and how each party’s goals can be made compatible with the other’s. During this effort, hopefully a relationship of trust develops that can be instrumental in overcoming the inevitable hurdles that rear up during the negotiations. While, as with all complex deals, the devil will be in the details, the mutual understanding of goals and the development of a relationship will be necessary to find solutions.
It should go without saying, but in our experience the parties should not permit the negotiations to become overheated or hostile. In a typical acquisition, heated negotiations are considered almost perfunctory; there, after all, the closing is an ending. In perpetual joint venture transactions, the closing, like a wedding, isthe beginning. What occurs beforehand should be a foundation for the future, not a heated effort to win points, which are in abundant supply.
Complementary to the uptick in alternative asset manager acquisitions, a number of banks are spinning off or considering spinning off alternative asset managers. This is being spurred by the legislation relating to controlled hedge fund relationships as well as changes in strategies by some banks. Here they are impelled by their boards, shareholders and the difficulty that some banks had with their internal hedge fund-like trading strategies or with their owned alternative asset managers. Ultimately, we expect these spin-offs to be followed by the creation of new strategic alliances of the separated asset managers and other institutions.
Footnotes
1. Typically the buyer acquires equity in the manager, so that the buyer and sellers who retain equity are “partners” in every economic sense. Alternatives have arisen over the years, however, in which the buyer’s equity is not equivalent to a percentage of net income. For example, buyers may purchase a unique class of equity, a share of revenues or a share of revenues minus some but not all operating expenses. Revenue shares create greater freedom for the sellers in operating the business post-closing, because the buyer need not insist on the same types of controls over budget and expense matters, but do not result in a “partnership” in the sense of the buyer and sellers sharing the opportunities and risks of a business proportionally. The tax and structural issues presented by these types of investments are beyond the scope of this article.
2. Defined as US banks, or foreign banks with a US banking presence, and all their affiliates.
The authors of this article: Messrs. Benedict (Tax), Fredman (Investment Management), Harrison (Business Transactions – M&A), Vitale (Bank Regulatory), and Weiss (Business Transactions -M&A) are members of the Schulte Roth & Zabel team that represented the buyer or sellers on certain of the hallmark alternative asset manager acquisitions completed by Schulte Roth & Zabel over the past several years, including the JPMorgan/Highbridge and Blackstone/GSO transactions, as well as the recently announced acquisition of a non-controlling minority stake by Credit Suisse in York Capital Management. The authors acknowledge the assistance of David Griffel (Tax) in preparing this article.