We contributed to the Gunner webinar on this subject in November, and this article in Money Marketing by Richard Farr explains why improving your perceived regulatory risk can make a big difference to the price you receive.
When thinking about selling your business, it’s easy to get mesmerised by the technical details.
You will need to consider things like tax optimisation, and whether to sell the business or just its assets. But improving a buyer’s perception of your risks and liabilities will do by far the most to make your business more attractive.
Information asymmetry
Good IFAs are, by definition, focused on building their business by meeting the needs of their customers, and will tend to be optimistic about its value.
If a potential buyer takes a more pessimistic view based on documented management information, this can come as quite a shock. But the surprise comes as a result of how transactions naturally work, rather than buyer malice. A wise seller will put some effort into achieving the best price by understanding the underlying dynamics of transactions regarding risks.
An IFA assesses risks using their intimate knowledge of the business and its clients. But most of this knowledge is inside their head, and the other party doesn’t have access to this. The buyer only has data records plus an awareness of negative headlines in financial services. The technical name for this imbalance in knowledge is “information asymmetry”. It underpins all risk transactions, and has a massive potential impact on price.
Moral Hazard
“Moral hazard” is a factor that can widen the gap between seller and buyer. Moral hazard is the presumption that people are motivated to offload risks that (secretly) they know are high. The term originated in health insurance where ill people had an incentive to buy health insurance. That’s why insurers introduced medical exams.
The prospect of moral hazard will tend to make buyers pessimistic about the risks they are likely to acquire. If relevant information isn’t disclosed to a buyer early enough, confidence can evaporate. Even if the seller never intended to hoodwink the buyer, this generally results in the conversation’s termination.
The combination of information asymmetry and moral hazard applies to all deals, whether a friendly merger, a complete sale of the business, or a transfer of assets combined with retention of some risk. The way to reduce both is to improve the information available to the other party.
Improve data quality
But how can a selling IFA go about this? Since buyers will study the management information, the most important thing you can do is improve the data to convey more confidence about the actual risks. The seller needs to do this before negotiations and due diligence; bad news discovered by a buyer will worsen their assessment of the actual risks and their subliminal perception of moral hazard.
We’re not talking about a full audit of regulatory records. Apart from being expensive, this is likely to generate extra work from false alarms without fixing many problems. The best approach is to find someone who can assess your data from a buyer’s point of view, using their practical experience to spot the risks that need covering off, and recommending actions to fill any gaps.
These gaps appear, not through any pernicious intent, but through the ratcheting up of regulatory expectations over time. The issue they face is not knowing what steps to take to forward-fix them. An intelligent approach can help repair the data where necessary and streamline other fixes into everyday operations. This approach is crucial for esoteric issues like defined benefit transfers and non-standard investments that might scare buyers away if left unaddressed.
Although average business valuations have been stable over recent years, the deviation from the mean has ballooned, and there is less and less inefficiency in the valuation methodology as each transaction completes. We would always encourage vendors to prepare as much as possible before entering the exit process with their best foot forward. Improving your data quality changes the external assessment of the risks inherent in your business and increases the price you might achieve on sale. It also has other potential benefits:
The very act of improving your data – whether ‘OK’ data or ‘awkward’ data – and making it available reduces the likelihood of moral hazard – your business becomes a more attractive purchase.
The moral hazards inherent in professional indemnity insurance are making premiums more expensive, if you can get cover at all. In the short term, you improve your ability to obtain PI on reasonable terms, irrespective of when you might want to sell.
You can decide on the best deal structure, including whether to go for an asset sale or a share sale. There are pluses and minuses for both, but an asset sale means you will have to retain some risk. A better understanding of that risk will put you in an improved position to deal with regulatory capital requirements that could restrict access to your sale proceeds. Since insurers rely on data too, you will have a better chance of securing run-off insurance if needed.
You can avoid being ‘picked off’ during negotiations by dramatic last-minute discoveries of unhelpful data.
Finally, your customers will benefit from a high-quality transaction that serves all parties’ interests. Most transactions include a deferred element of the purchase price, and high purchaser and customer satisfaction will maximise this.
Risk assessment may sound complicated, but it uses understandable principles that drive the negotiations around a transaction. By applying these principles, an IFA can improve business attractiveness today and ensure the best possible price when selling.