When selecting investment managers, fund sponsors devote significant effort to examining the performance and investment process, as well as the quality of personnel, stability of the firm, and its prospects for continued success.
As individuals within the investment firms approach retirement, fund executives must understand how the asset manager intends to continue the firm's desired level of investment performance and client service as its principals are succeeded by a new generation of managers. Although fund executives understand these demographic inevitabilities, they are rightly concerned about the form, structure and incentives involved as firms begin to transfer ownership and management responsibilities.
For founders of private firms, long-range planning is critical to provide for the best interests of their clients while simultaneously affording themselves a fair value for the equity they have built in their firms. This planning involves not only succession planning for individual managers, but also continuity planning for the firm as a whole. While partners in the few firms with publicly traded equity can turn to the open market, equity participants in the far more typical private firm have had only four possible options to liquefy their ownership interests. These are:
a 100% sale of equity to a holding company;
a 100% sale of equity in a merger or consolidation transaction;
an internal equity transfer to younger partners; and
a partial equity sale to an independent minority investor.
But there is another, a fifth option that offers the stability and clear path to continuity sought by fund sponsors, that is affiliation, not a sale.
Many investment firms were founded shortly after the 1975 enactment of ERISA and their principals are in their mid-50s. (A recent report by Investment Counseling Inc. estimates there are more than 680 investment firms in the United States today in need of a proper succession plan.) Because of retirement or death, control of these firms will pass to younger managers either by default or through proper succession planning.
Plan sponsors and other clients are willing to pay for excellent investment performance and top-notch client service. In addition, they deserve to have their interests put first as owners of privately held firms consider their future. When planning for continuity, one must consider, in order of priorities: clients, employees and founder/owners. Partners in many privately held firms have accumulated valuable equity that will provide for their comfortable retirement, but only if these partners develop a thoughtful continuity plan that reflects their desire for liquidity, the firm's continuity and growth.
Yesterday's solutions to succession have not reflected these goals. But affiliation with an institutional equity partner can meet the continuity needs of investment managers and their clients. Sponsors need to look closely at the type of succeeding ownership structures to these independent firms.
A complete sale of equity to a holding company provides the exiting partners with instant liquidity, but because the partners have transferred all of their equity, they no longer will participate in the upside of the firm. A 100% buy-out by a holding company permits the firm to remain fairly autonomous and might provide some operational or marketing support. The management personnel often are required to sign long-term employment agreements and non-compete agreements.
As a result, however, selling managers might lack some of the incentives to perform, and younger managers may see little reason to remain without upside participation in the future equity of the firm. Shortly after the partners sell, certain younger members of management might leave in search of equity participation opportunities. As new managers replace those who leave, fund executives might find they are invested with strangers.
Merging with others
Merger or consolidation transactions also provide partners with immediate cash for their equity and the possibility of participation in future earnings, but not equity. The partners often are told of the strategic benefits of such a merger and the new assets it will bring. But mergers often are accompanied by internal changes that impair the strategic autonomy and entrepreneurial spirit that led to the firm's earlier success. As with a total equity sale, junior managers might leave in search of equity participation or professional growth opportunities.
The acquiring firm often will require managers and key personnel to sign long-term employment contracts or non-compete agreements. Either of these covenants might be viewed as unnecessarily restrictive and add to the dissatisfaction created among the managers who are losing their equity potential.
Keep it in the firm
Internal equity transfers can provide the exiting partners with some level of cash for their equity and possible participation in future earnings as the sale transitions. Remaining managers become equity owners and are rewarded for their continued performance through equity appreciation.
However, internal transfers are problematic as purchasing shareholders typically lack the resources to fairly compensate sellers, and most lenders are unwilling to lend even a fraction of the funds required, given investment firms' lack of hard assets. Should they somehow find the debt, junior management will struggle to place client interests ahead of the demands and needs of their creditors. Also, this type of transaction will have significant tax consequences to sellers that further complicate an already unattractive financial situation.
A partial equity transfer to a minority investor will provide some liquidity for senior partners, but often in an amount below the equity's actual value because it does not contain a control premium. The acquiring partner often requires a voice in the operation of the firm in spite of its status as a minority equity holder and lack of understanding of the investment business.
Most problematic, the minority shareholder will, at some point, wish to sell its equity in order to reap its financial reward. This inevitable subsequent transaction creates future instability for the firm and might take managers' attention away from important client considerations.
Affiliation: a new option
This option benefits liquidating partners and remaining managers through retention of direct equity in their firm. This option is the affiliation with, rather than sale to, a holding company. In this type of transaction, the firm and affiliated holding company establish a revenue-sharing arrangement with an agreed upon portion of the firm's revenue being used to pay employee salaries, bonuses and other operating and development expenses. Non-operating revenue, or free cash flow, is divided between the firm's management shareholders and the affiliated holding company in accordance with their ownership.
For ownership stakes not sold at the initial transaction, the affiliated holding company will provide the funds necessary to purchase the partner's ownership at a predetermined market multiple when each partner is ready, individually, to liquidate all, or part, of his or her interest. Because some passage of time occurs between the initial affiliation and ownership liquidation, partners have the opportunity to enhance the vale of their interest by increasing the firm's overall revenues.
Remaining managers continue to enjoy the same strategic and operational autonomy they had before the affiliation. However, because the holding company operates with the benefits of larger scale, it can provide its affiliated firms with assistance through access to new distribution channels, enhanced administrative functions and assistance in the operation of the firm.
As partners liquidate their ownership interests, the affiliated holding company rolls the freed equity back into the firm, giving younger managers incentive to cultivate the business. Where managers do not hold an equity stake, such as wholly owned subsidiaries of brokers, banks or insurance companies, this type of structure can help the management team buy out their firm and obtain ownership in the process. One final benefit of this type of equity transference: it inherently funds a succession plan.
William J. Nutt is president and chief executive officer of Affiliated Managers Group, Boston.