There are many challenges in navigating a successful advisory firm merger or acquisition, from ensuring that the firms align on investment, financial planning, and service philosophies, to finding an agreeable valuation and terms to the transaction, and navigating the post-transaction integration process. Yet in practice one of the biggest blocking points is simply figuring out how to effectively align the advisory fee schedules and fee calculations of the two firms – for instance, when one advisory firm charges substantially more or less than the other – to the point that one of the biggest blocking points of an otherwise-well-aligned merger or acquisition is simply whether it’s feasible to integrate their billing processes (especially when the firms have differences in their underlying business model, such as an AUM firm acquiring a retainer-fee firm).
In this week’s, we discuss the major issues to consider when integrating advisory fee schedules and billing processes, from strategies to adjust when one firm has an advisory fee schedule that charges more (or less) than the other, to reconciling differences in billing timing (i.e., billing in advance versus in arrears), and the unique acquisition problems that arise when trying to acquire retainer-fee firms.
For most, though, the biggest challenge is simply reconciling differences in fee schedules between the two firms. In situations where the acquirer charges more than the firm being acquired, there’s typically a desire to lift the newly acquired clients up to the fee schedule of the existing firm – which can make the transaction a strategically positive deal for the acquirer, if it can generate more revenue from the same clients, but also increases the risk that clients will reject the new fee schedule and not transition at all (which means it may be a good idea to leave the original fee schedule in place for a year or two, to allow clients the time to adjust, and build a relationship with the new firm). On the other hand, when the acquirer charges less than the firm being acquired, it gets even messier, as if the acquirer pays “full price” for the new firm’s revenue and then immediately cuts their fee schedule, the acquirer faces a substantial loss on the transaction (unless they can bring down costs in the merger business by even more than the loss in revenue!).
Even where advisory firms reasonably align on fee schedules, though, it’s also necessary to consider whether they have the same billing timing – in particular, whether both firms consistently bill in arrears or in advance. Because differences between the two firms in their billing process can lead to substantial disruptions in cash flow for either the acquirer, or the newly acquired clients! After all, if the acquirer needs to switch the new firm from billing in advance to billing in arrears, the firm could be forced to wait up to six months without receiving any new revenue from the new clients! And if the acquirer needs to switch in the other direction – from billing in arrears to billing in advance – then the first invoice to the clients may have to be a “double-billing” of the last arrears fee and the first advance fee all at once (which increases the transition risk for the acquiring firm!). In fact, even differences in the billing calculation process – such as when one firm bills on end-of-quarter balance, and the other uses average daily balance – can create billing gaps between expected and actual revenues!
And of course, this all assumes that both the acquiring and selling firms were both charging AUM fees in the first place. In the case where the acquiring firm charges AUM fees but the acquired firm charged retainers, it can be even more challenging to transition the retainer clients onto the AUM firm’s fee schedule (especially since many retainer-based firms proactively “sell against” the disadvantages of AUM fees, which effectively chases away potential buyers who may want to convert the business to their own AUM fee schedule). In turn, this means the marketplace of potential acquirers for retainer fee firms is drastically smaller, and retainer fee firms may have more difficulty finding an acquirer that will pay them a “fair” price – particularly for firms that charge retainer fees to clients who do have assets and “could” pay AUM fees (as the situation is different when using retainer fees to serve younger clients, or other “non-AUM” types of clientele).
Ultimately, though, the key point is simply to recognize how important differences in advisory fee schedules and billing processes can be when you’re looking at a potential merger or acquisition. As a result, doing detailed due diligence on advisory fee schedules is crucial. In particular, advisors should be evaluating any differences in the level of fees charged to clients, the timing of those fees, how those fees are calculated, and whether two firms have fundamentally different approaches to billing altogether. Of course, fee schedules don’t need to be identical in order to successfully navigate a merger, but approaching a merger with a clear understanding of the potential risks and opportunities involved is crucial!
Billing In Advance Vs Arrears (and on Daily Balance vs End-Of-Quarter Values)
Now, the second area that advisors need to watch when it comes to merging advisory fee schedules is the actual billing process. Because there are two issues that can crop here, one big and one a little bit smaller. The really big one is whether you bill in advance or in arrears. In other words, when a client starts with you, is their first quarterly billing for the prior partial quarter that they were with you or is their first billing in advance for the upcoming quarter, and if they decide to terminate the next quarter, do you refund them a pro rata portion of their fees?
Now, some firms just prefer to bill in arrears and they have a philosophy, “We’re not going to bill our clients until we’ve started doing the work,” other firms I know say, “I have a strong preference for billing in advance, that way I never have any accounts receivable, and I never have to collect from clients. I just refund pro rata if someone terminates, and not many people do because I’ve got a good retention.” On an ongoing basis, most firms don’t even think about this. You just bill your clients quarterly, whether it’s in arrears or in advance. After the first billing, no one really cares unless they’re going to terminate you and then you have to figure out if you will pro rata portion the last fee back if you billed them in advance.
But in a merger or an acquisition, this matters a lot, because if you bill in arrears and you acquire a firm that bills in advance, then when you buy them, you immediately take on the liability of refunding any clients who terminate in the quarter right after you’ve billed them. Unless you immediately convert the clients to arrears billing, you also have this potential liability in the future. But if you want to convert the clients, this gets even messier.
Imagine I bill in arrears and I acquire a firm that bills in advance. We’re in negotiations now, the deal closes in October, shortly after fourth quarter billing has happened at the end of September 30th. So the clients of the firm I just bought have already paid for Q4, they paid it in advance, which means if I want to bill them in arrears, my next billing isn’t going to happen for five months, until the end of Q1, March 31st, when I can bill them in arrears for the first billing as the acquired firm.
If I bought the firm in October, I don’t get any revenue at the end of the fourth quarter. There’s no Q4 billing in arrears because the firm already billed Q4 before they sold it to me. That seller has that money gone with it. And if I don’t bill in advance, I can’t bill them for Q1 at the end of the year. Instead, I have to wait three months into Q1. So you have to be cognizant of whether there were gaps between the firms billing in advance and in arrears.
And unfortunately, it’s not much better going the other direction. If the acquiring firm bills in advance and the firm being acquired bills in arrears, then the only way to true-up clients is that as the acquirer, you have to double-bill them. So in my earlier example, if you buy a firm in October that bills in arrears when you bill in advance, and at the end of Q4, on December 31st, you’re going to bill Q4 in arrears, because the clients haven’t paid for that yet, and you’re going to bill Q1 in advance because that’s what you do on an ongoing basis. And so the clients are going to get hit with two bills to get them on track the first time you do billing with them as the acquirer.
Now, it’s worth noting that you’re not cheating them or anything here. You’re not like literally double-charging them. They’re paying the Q4 fees because services were rendered in Q4, and you’re billing them in advance for Q1 because that’s what you do with all of all your clients, and if they terminate you you partially refund. But it does mean you have to be prepared to communicate that to transition them from arrears into an advance, there has to be a double-billing that occurs. You have to go two-quarters of fees to get an arrears closed out and an advance set up going forward. And so that’s a real risk, a real transition risk if you’re an acquirer, and you have to convince clients to stick around when the first thing you’re going to do is bill them for two-quarters when they’re still getting to know you. Now, it can be done. I know firms that have done it and they were able to get through it, and they were able to have retention. But at a minimum, it’s a really sensitive issue.
The other piece that goes along with these sort of mundane billing processes is you need to be aware of whether there’s alignment in how the fees are calculated. Specifically, when you do that billing, whether it’s in advance or in arrears, do you calculate based on end of quarter balance, or do you calculate based on average daily balance? Now, in theory, on average, these things average out, but not always. If your clients are net savers, end of quarter balances tend to be higher than average daily balances within the quarter because clients keep contributing lifting up the balance so that the end of quarter tends to be the highest one because it’s got all the contributions.
But if you’re mostly working with retirees, it may be the other way around. Average daily balances tend to be higher than end of quarter balances because at the end of the quarter all the withdrawals have occurred. And then, of course, in any particular quarter, you can get big gaps if the market moved sharply in the last couple of weeks in either direction and the end of quarter balance is very different than the average daily balance. In general, this adjustment tends to be more administrative (particularly in the quarter where the transition is occurring), but you need to know that the billing process is going to change. First, because you have to communicate it, second, because you probably need to reflect it in an updated advisory agreement, but you also need to consider whether there’s a risk that it may distort revenue in the first billing period after you acquire.
The Acquisition Problem With Retainer Fees In Lieu Of AUM Fees
Before I wrap up, there’s actually one other important dynamic I want to note here as well, and it’s the unique challenges that crop up when you’re trying to merge advisory firms where their fee schedule isn’t AUM fees in the first place, it’s retainer fees. Now, we know from industry research that the overall majority of advisory firms are still AUM-centric. And in fact, that the larger the advisory firm, the more affluent their clients, the more likely they are to charge AUM fees. Which means, on average, most buyers of retainer firms are still going to be AUM firms. And AUM firms acquire other firms to get more AUM. That’s what they do.
But what that means is that when an AUM acquires a retainer firm of clients who actually have assets, there’s usually a plan to convert those retainer clients over to an AUM fee structure. Except, unfortunately, that’s often very difficult because the firms that use retainer fees, particularly for affluent clients, tend to aggressively sell against AUM fees to convince their clients that the retainer model is superior, which means you effectively poison the well for most of your acquirers.
And this is one of the major drawbacks to pivoting from AUM to retainer fees that I find very rarely ever comes up in conversation (although I know a number of advisors who switched to retainer fees years ago and now want to retire and can’t find anyone to buy their firm because most firms charging retainer fees are relatively small, don’t have great margins, and don’t have the size and scale and cash flow to buy…while the AUM firms who’ve got dollars to buy, don’t want to buy retainer fee firms where the clients have been told that the AUM model is bad).
This isn’t necessarily an issue for those who are doing retainer fees for younger clients who don’t have assets, because the truth is, no AUM buyer is going to be acquiring a practice of clients who don’t have assets (or if they do, they’re going to acquire because they want to actually do the retainer model the way the retainer model is being executed). But if you’re a firm that works with affluent clients who have assets and simply charges retainer fees, this gets a lot harder to find prospective buyers because the AUM buyers want to convert but are afraid of the risk, and there aren’t very many non-AUM buyers. You risk drastically reducing the appeal for the bulk of prospective buyers.
And in fact, even other retainer firms often have trouble acquiring those who do complexity-based retainer fees because different firms characterize complexity differently. And so, even two firms doing annual retainer fees for affluent clients might charge very differently for some of those clients. Which means if you’re the acquirer, this is a really messy, one-client-at-a-time process of figuring out what each acquired client would be charged under the new firm’s model, and whether it’s more or less than what the old firm was charging.
Indirectly, this is actually one of the reasons why the AUM model happens to work so well because, by its nature, it’s actually a really systematized billing model. At worse, you have to change a few rates or break points on your AUM fee schedule, but there’s a standard fee structure for all clients. And that’s often not the case with retainer firms. And so, it can make the billing process much harder to reconcile for an acquiring firm. Sometimes so difficult that it may narrow the number of buyers, which means you have to spend more time trying to sell your firm and have fewer bidders competing and hopefully bidding up your price, which is not good news if you hope to be a seller some day. So do understand that most firms tend to get acquired by those who have comparable billing styles or business models, and make sure you know that you’re going to have buyers if you’re making business model decisions.
But anyway, the bottom line is just to recognize how important it is when you’re looking at a potential merger or an acquisition to do this kind of detailed due diligence on the advisory fee schedules and the billing processes. Do the firms have the same fee schedule? If not, who’s higher and lower all the way up and down the spectrum? Do they both bill in arrears or in advance, or is there a gap? Do they both bill on quarter and/or average daily balance or is there another gap? And if the firm charges retainer fees or separate planning fees (or a blended AUM plus retainer), are those fee structures and the way the fees are set consistent across the firms? Because, if they’re not, those kind of manually assigned retainer fees and planning fees are often the hardest parts to line up.
So be aware of that, and particularly if you’re thinking about moving away from AUM fees and towards the emerging range of “non-traditional” fee structures, as you may limit the potential market for buyers. It doesn’t necessarily mean it’s a bad thing to do if you think you can grow the business well enough in that direction. You may grow up on more than enough to make up for the fact that you’ve got a smaller market, but it’s really hard to find firms that will want to acquire you because of all these challenges in integrating fee schedules and billing if you use a substantially different fee model than everybody else.
I hope that’s helpful as some food for thought.
So what do you think? Are differences in fee schedules a potential problem when looking at mergers and acquisitions? Have you been in a similar situation? How did you manage the transition from one fee schedule to another? Please share your thoughts in the comments below!