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M&A Earn-Outs Under the Microscope


Earn-outs, those additional contingency payments that executives at firms being acquired can earn if specified certain targets are met in the future, are nothing new within the financial services industry. But the earn-out terms of Amvescap's recently announced acquisition of PowerShares Capital Management have raised some eyebrows, as they are extremely optimistic and extend over a five-year period.

While Amvescap, of London and Atlanta, will pay the principals of PowerShares, of Wheaton, Ill., $60 million in cash at the closing, additional contingency payments could push that figure as high as $730 million if PowerShares' assets surpass $125 billion by 2011. That's a tall order, since PowerShares' assets would have to increase 3,500% from their current $3.5 billion level.

The price of the deal is higher than other recent M&A's, said Eric Fitzwater, a senior analyst in the financial institutions group at SNL Financial of Charlottesville, Va. Most asset management companies are typically bought for 2% to 3% of total assets under management, he said, with equity assets bringing a higher price than fixed-income assets. In this case, the earn-out payments would raise PowerShares' price to nearly 6% of assets, Fitzwater said.

Could that be the standard cost of acquiring an asset management firm specializing in ETFs only? Those waters are virtually unchartered, since this is the first such acquisition, Fitzwater said.

"The incentive here is to keep the managers around. You're buying the people and their knowledge," Fitzwater noted. Earn-outs are the ultimate golden handcuffs that prevent sellers from taking off and becoming new competitors, industry insiders agreed.

However, in analyzing this particular earn-out arrangement, if the goals aren't reached, PowerShares' principals walk away with $60 million, which translates into a price of only 1.7% of assets.

Earn-outs are popular for this very reason, because they allow buyers to pay less up front but bank on future growth, said Jeff Lovell, chairman and managing director of Lovell Minnick Partners of Rolling Hills Estates, Calif. This balances the fundamental difference in opinion that typically rests between a buyer and a seller as to what a business is worth, industry experts said. Underlying that, they often also "disagree about growth prospects," said Charles M. David, managing director of the mergers and acquisitions division at Challenger Capital Group in Dallas. "An earn-out basically allows a seller to enjoy the benefits of growth over time, while the buyer pushes that risk off in case that doesn't happen," he said.

In general, "earn-outs have become a lot more popular in the post-bubble economy," said Sarah Richmond, a partner with the Boston law firm of Gesmer Updegrove. Before the meltdown, companies were bought for much higher multiples than were really appropriate, and buyers got burned. Earn-outs became a "great compromise for sellers with great projections and buyers who didn't want to pay for potential up front," she added.

Because there are so many variables and targets may never be realized, Richmond counsels sellers to get as much as they can up front, and treat future contingencies as gravy. However, deferred payments can be good because they defer taxes, she added.

Moreover, experts agree that five years is a long term for an earn-out, with three years being closer to the standard in most industries. "Five years is pushing the ragged edge," David said. After three years, there's often difficulty discerning who is driving growth, the buyer or the seller.

In reality, earn-out agreements often end in disputes and, ultimately, lawsuits. "In 70% to 75% of cases we've seen, the earn-outs do not achieve what the buyer expected," said Brad L. Whitlock, a partner with the Dallas law firm of Jackson Walker. Most often, earn-outs are achieved where the seller stays and, culturally, gets along well with the buyer's management, Whitlock said.

The real problem can arise down the road, not when targets aren't met, but where targets are met, David said. Often, buyer and seller lock horns over how much each contributed to the successful venture. Most buyers resent having to pay additional contingencies to sellers if they feel they were the reason assets grew, he noted. Further, sellers may accuse their buyers of not helping them enough, he added.

The two parties must also be sure to hash out details in advance as to exactly how growth will be accounted for, in gross or net figures, what happens if the buyer or seller decides to exit, and what happens if the acquirer itself is acquired by an entirely different firm, experts cautioned.

This is not Amvescap's first deal to include earn-outs, nor its first bargain buyout. In February 2001, the firm acquired National Asset Manage-ment, an institutional asset management firm based in Louisville, Ky., for an up-front payment of $200 million and earn-out payments of up to $75 million, plus senior management retention payments of $25 million paid over five years. All told, Amvescap committed to pay a maximum of 1.7% of the firm's $17 billion in assets under management. Excluding the retention payments, that figure drops to 1.62% of assets under management.

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