M&A activity and consolidation in the Asset Management (“AM”) arena continue apace, fueled by the rewards of scale in a still-fragmented industry. Those rewards are particularly attractive now, given a challenging global macroeconomic outlook, growing regulatory burdens and, for all but the most differentiated strategies, fee pressure.
Current Trends Driving AM M&A
M&A activity in the AM space, while falling below 2022 levels, nonetheless remained healthy in the first half of 2023, with more than 30 transactions with a value of at least $100m occurring across a varied array of AM targets and purchasers, including retail managers, insurers, fintech firms and private fund managers.
The sustained activity has been driven by a number of trends, including:
- Consolidation – The AM sector has been consolidating for years, so as to better withstand the macro economic headwinds of inflation, geopolitical fragmentation and rising interest rates, all of which make it more difficult to raise funds, successfully navigate the public markets and exit private investments at desired valuations.
Participation in the AM industry’s consolidation has allowed PE firms to pursue four objectives: (i) achieve greater access to capital for their primary fundraises through a strengthened IR function and by leaning into the trend that sees limited partners increasingly commit more capital to fewer managers; (ii) achieve economies of scale; (iii) compete with larger players; and (iv) induce investors (including LPs) to invest by providing lower fees and greater value.
- Increasing Regulatory Burdens – Both U.S. and non-U.S. regulators continue to focus on the private fund industry, increasing compliance and reporting burdens for managers. Managers have thus needed, and will continue to need, increased resources devoted to compliance personnel and systems to meet these requirements. Greater scale allows managers to spread these costs over a larger fee base.
- Tech-driven Acquisitions – Technology, and in particular AI, has the potential to change the face of the AM industry as firms move, at least in part, to automate their investment processes. To keep up with competition, many AM firms without proprietary technology are looking to acquire fintech start-ups and/or technology-driven asset managers.
- Product and Geographic Diversification – Diversifying product lines and geographic exposure is a strategic priority for many AM firms, leading them to pursue acquisition of niche AM firms, such as fund managers specializing in secondaries, infrastructure or emerging markets.
- Sell-side Commercial Considerations – Being acquired can be an attractive way for founders/management of AM firms to manage generational change, secure the capital and backing needed for their firm’s next phase of growth and achieve at least partial liquidity to reap the benefit of the growth of their business to date.
- Buy-side Commercial Considerations – Purchasers, including PE funds and pension funds, often acquire AM assets to gain exposure to that manager’s human capital and investment opportunities by, for example, having the ability to seed new funds or obtain co-investment opportunities.
While there is no one-size-fits-all AM M&A transaction, the deals we see generally fall into one of—or a combination of—the following five categories: (i) a stock sale, asset sale or merger; (ii) a majority or control acquisition; (iii) a minority investment (sometimes with a future option to take a controlling stake); (iv) a spin-out of a portion of the business to management; or (v) a sale of a product line or portion of the overall business. These transactions can entail different types of securities, including common, preferred or structured equity and debt.
The asset being acquired also varies from deal to deal. For example, certain purchasers will acquire an entire AM entity, whereas others will acquire economic interests in the funded GP commitments and/or carry entitlements of specific managed funds or future funds.
Many AM M&A transactions couple an equity interest in the target with preferential commercial arrangements to invest in the target’s future funds, to obtain co-investment opportunities or both. Conversely, such transactions may obligate the purchaser to commit to future funds to be established and managed by the target, thus giving the target greater certainty in its future capital raises.
Some Structuring and Key Legal Considerations
As with any transaction, structuring and legal considerations are crucial for the success of an AM M&A deal. These may include:
- Consideration Structure – Valuing AM targets is often complicated, with the valuation of illiquid and contingent assets leading to gaps between sell-side and buy-side expectations. To bridge these gaps, parties often use structures that include earn-outs and other forms of contingent consideration or exclude from the transaction certain assets, such as existing carry entitlements, especially where the valuation gap is large.
- Client and LPs Consent/Amendment of Documents – Depending on the applicable regulatory regime and existing contractual terms, clients of the AM firm being acquired may need to consent to the deal. The purchaser and seller will need to negotiate how that process will occur (including the form of consent, timing and disclosure) and the purchaser will want the ability to consent to any amendments to the agreements between the AM firm and its clients, particularly when those amendments touch on economic matters. Typically, where client consent is required, closing of the transaction will be conditioned on receipt of consents by a specified minimum percentage of clients (usually measured by AUM or revenue run-rate); the agreement may provide for a purchase price adjustment if consenting clients fall below a specified threshold.
- Management and Roll-over Incentives – In most AM M&A transactions, an important part of the deal is retaining and incentivizing management, usually through a combination of “carrots” and “sticks.” Potential carrots include carry allocation, bonuses and equity awards. Sticks may include restrictive covenants aiming to limit managers’ ability to work in competing AM players and equity forfeiture provisions if they do so. Where the target is becoming part of a larger AM group, the purchaser may consider whether to harmonize the arrangements reached with the acquired firm and those in force for the larger group.
- Regulatory Approvals – Depending on the nature of the target business and the jurisdictions in which it operates, approvals and clearances from financial services regulators (such as the Financial Conduct Authority or the Prudential Regulation Authority in the UK) may be required for the deal to close. These approvals could be required at the level of the target AM firm as well at the level of any portfolio companies it owns or controls. The transaction may also be subject to various antitrust or other foreign direct investment reviews. Although substantive antitrust problems at the firm level are uncommon given the fragmented nature of the AM industry, it is still important to conduct thorough due diligence of the target, including regulatory, antitrust and freedom of information analyses.
- Interim Covenants – The purchaser will need to negotiate appropriate interim covenants to (i) protect itself from a reduction in the value of the target between signing and closing and (ii) ensure the company continues to operate in the ordinary course and does not take on additional commitments without the consent of the purchaser. However, antitrust and regulatory considerations, as well as commercial considerations, will limit the ability of the purchaser to control the business prior to closing.
- Representations and warranties and Indemnities –Purchasers typically seek a complete package of representations and warranties providing post-closing protection (either through a rep and warranty insurance policy or an indemnity), while sellers seek to minimize post-closing risk. A purchaser-favorable set of reps and warranties will cover all main areas of the target, including, in particular, compliance with laws and regulations—a key risk area in the AM space. Depending on the due diligence findings, the purchaser might also seek indemnity protection for known exposures. On the other hand, where management is also a seller, purchasers will want to avoid the need to sue management. This consideration – as well as the seller’s own desire to avoid post-closing claims – may lead the parties to rely on a rep and warranty insurance policy.
- Tax Structuring – Depending on the type of transaction, the nature of the target and the jurisdictions involved, the proper tax structure may be crucial to maximize value for the parties, reduce tax leakage, allocate tax assets and liabilities and optimize exit. Given the types of legal entities involved, the various types of assets at issue, including carried interest, and the need to efficiently incentivize management, the tax structuring for an AM M&A deal may be more complex than for transactions in other sectors.
- Post-Closing Governance – Depending on the type of transaction and the target, a key area of negotiation will be post-closing governance. Specifically, parties will need to agree on governance structures (e.g., board and investment committee mandates and composition) and how day-to-day and strategic decisions will be made. Topics to be covered include entry into strategic transactions, launch of new funds/products, incurrence of debt, management of liabilities and hiring/firing decisions and carry allocations.
- Post-Closing Commercial Arrangements – As mentioned above, many AM M&A transactions include commercial arrangements between the parties relating to future investment opportunities and fundraises. The most common arrangements include target commitments to provide investment opportunities to the purchaser and its affiliates, whether through primary fund raises, co-investment opportunities, or both, and purchaser commitments to invest a minimum amount in future fundraises. One potential downside of these preferential arrangements is that they may affect the client consent process and may ultimately limit the target’s ability to fundraise from third-party LPs post-close.
- Post-Closing Business Integration – Purchasers should consider how best to integrate the target, including from a cultural perspective. Parties will also need to pay special attention to (i) whether and how the purchaser and the target will be consolidated from an accounting perspective, as well as the consequences of any such consolidation; and (ii) due diligence as to whether the use of control-based affiliate definitions in their contracts will trigger unintended consequences (e.g., restrictive covenants applying to the purchaser’s affiliates, including portfolio companies).
The AM sector's M&A landscape offers exciting opportunities but market participants need to be well prepared and fully informed to capitalize on them.
The Private Equity Report Fall 2023, Vol 23, No 3