Deal breakers and deal changers in advice M&A
The financial services industry has seen blow after blow recently with the introduction of new Financial Adviser Standards and Ethics Authority education standards and the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry.
The flow-on effect already experienced on the way financial planning businesses are bought and sold is expected to intensify further in the wake of the final royal commission report.
Some of the key changes we’ve already seen include:
- It’s now very much a buyer’s market. The supply of client books and AFSL companies is greater than demand and we expect this will only intensify further as we approach the FASEA exam deadline of 1 January 2021.
- There’s been a movement away from large dealer groups to AFSL companies and shared services hubs.
- New ways to value businesses, use price adjustment mechanisms and structure payment terms.
One thing for certain is buyers will be very discerning about what they buy. Sellers will need to prepare…
Whether you’re buying or selling a business, these changes mean due diligence, deal structure and the contract recording the deal are more important than ever.
Due diligence is an important part of the purchase process
From a seller’s perspective, they need to have comfort that the buyer has the money to fund the purchase. On the flip side, buyers need to be sure that they’re getting what they pay for.
Regardless of which side of the transaction you’re on, due diligence can help you determine:
- Whether to walk away: Buyers can now choose to be hard-nosed in their transaction negotiations. Deals have fallen over at the due diligence phase as buyers look closely at factors like:
- The quality of the books – age of clients and revenue model.
- How the business generates its revenue. Following the royal commission, the deals we now see no longer attribute any value to trail commissions and greater scrutiny of fee models for service.
- Cultural fit, including how clients and staff will move across and the gender diversity of staff.
- If you need conditions precedent: These are things that need to be resolved (or waived) before the deal is completed. These may include:
- Removal of encumbrances over assets that may negatively impact title and access to revenue streams.
- Prepayment of PI insurance.
- Requiring key people to remain. This is something we’re seeing more and it can benefit both parties. For the buyer, it can bridge the time divide between the new FASEA education requirements and the seller’s retirement (which is often the reason for the sale). Having the contribution, knowledge and client connection with the existing adviser over a longer period of time can also maximise the value of the purchase and help cement the client base. For sellers, this can also be an effective way to maximise the earn-out of their final instalment purchase price adjustments.
- Whether to restrict the business between signing and completion: Prudent buyers may require sellers to:
- Maintain and comply with their AFSL.
- Maintain professional indemnity insurance and let it run-off for a fixed term, often three years or more from completion.
- Have standard corporate and financial restrictions on changes to share structure (like restricting further share issues) and liabilities (like taking on further debt or changing current payment obligations).
- What warranties to impose or accept: Warranties are a contractual statement of fact that can lead to an award of damages if breached. Common warranties include:
- Tax compliance.
- Proper accounts and financial reporting compliance.
- AFSL maintenance and compliance. This includes understanding when the last time services or advice was given under the AFSL.
- Corporate compliance.
- Share capital.
- Whether there is any litigation or client disputes.
- If specific indemnities are necessary: Savvy sellers will often refuse general indemnities. Buyers can often reach an agreement by being specific about what indemnities are required (for example protection from liability for advice given before the client is next reviewed). Common issues identified in the due diligence process that may lead to specific indemnities include tax and AFSL related matters.
- What price adjustment mechanism is appropriate: It’s more common for buyers to push risk onto the seller using price adjustment mechanisms. These include:
- Pushing instalment payments out to medium or long-term payments.
- Using retention or escrow accounts in larger value transactions. These can reduce repayment risks if there are purchase price reductions in favour of the buyer.
- Using punitive clawback clauses to protect against future changes to the law in relation to remuneration/fees (e.g. royal commission risk).
How much due diligence is enough?
There’s an extensive list of things that buyers could investigate during due diligence. The key things to take into account are:
- What is at risk: If the purchase price is relatively low, buyers may try to rely on the warranties and indemnities in the transaction document to cure all unidentified ‘evils’. However, buyers will get better protection by identifying issues in the due diligence phase and adjusting the deal for these. For example, excluding certain clients from the calculation of the purchase price.
- The target: Buyers can generally limit due diligence investigations to clients they want to buy and take ‘the good’ and leave ‘the bad’. At a minimum, buyers should confirm the seller is the legal owner and that there are no encumbrances registered over the business that may impact the buyer’s title.
If the target is the company, then buyers will need to do more due diligence like those outlined above.
- The buyer’s budget: If the budget is trim, buyers need to have a laser focus on key issues like clear ownership, litigation risk and FSR compliance.
We expect to see more changes in the way financial planning businesses are bought and sold in the coming year.
Katie Johnston, senior associate, The Fold Legal
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