Real Trends Mergers & Acquisitions White Paper


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Real Trends Mergers & Acquisitions White Paper

  1. 1. Mergers and Acquisitions 2010: A White Paper on Current Trends and Activities in Mergers and Acquisitions Stephen H. Murray and S. Nicolai Kolding of Murray Consulting
  2. 2. Table of Contents The ImpacT of The DownTurn In housIng sales on mergers anD acquIsITIons ........................................................................3 The markeT for mergers anD acquIsITIons from 2010 To 2012 ........................................................................................4 facTors In ValuaTIons anD sTrucTurIng mergers anD acquIsITIons ............................................................................................5 opTIons for ToDay’s sellers ..........................................................................6 conclusIon ..................................................................................................11 abouT The auThors ......................................................................................12 Page 2 Mergers and Acquisitions 2010
  3. 3. A White Paper on Current Trends and Activities in Mergers and Acquisitions For sellers considering the sale of their firm, Murray Consulting has put together the following white paper to lay out your options for terms and prospective buyers. The challenges for each seller are unique, and so too will be the terms and conditions of the sale of your firm. Finding a buyer that is right for you means understanding wthat’s out there and what their general offers may contain. To better understand the context of today’s market, this white paper outlines general information about national and regional firms that have expressed interest in growth through mergers and acquisitions (M&As). We will also look at how buyers typically valuate a brokerage and the different strategies for sellers to get paid. Finally, we will look at the options for sellers in terms of the potential buyers in the market today. The Impact of the Downturn in Housing Sales on Mergers and Acquisitions The period from 1996 through 2006 was the most active period of merger and acquisitions in the residential brokerage industry in modern times. In excess of 800 significant mergers, acquisitions, and other forms of combinations were completed in this period. NRT, HomeServices, Prudential Real Estate Affiliates (PREA), GMAC Real Estate, RE/MAX, and several large regional brokerage firms were the main acquirers during this time, with NRT accounting for well over half of all major acquisitions. There were a number of factors accounting for this volume of merger and acquisition, such as the boom in the housing market, the number of large independents without succession plans, and most importantly, the appearance of several well-capitalized national firms (such as those mentioned above) that had a strong appetite and capability for growth through M&As. As the market turned down in late 2005 and continued to do so through 2009, the pace of merger and acquisition turned down substantially as well. Purchasers became far more cautious about which deals they wanted to look at, and, as it became apparent that the downturn would last far longer than any prior recession in housing, the prices and terms they were willing to offer turned down significantly as well. While there were sellers willing and able to sell, the market for such transactions on terms acceptable to both parties declined. Also, there were changes in the national firms that led the acquisition surge. GMAC itself was acquired and its owned operations sold off (2009). NRT’s parent company went through first, a public offering, and then a leveraged private buyout that Mergers and Acquisitions 2010 Page 3
  4. 4. left it with significant debt. RE/MAX also took on some debt to acquire regional franchise operations and became more cautious about using its own capital for more acquisitions. Last, there were fewer candidates for growth through merger and acquisition among large brokerage firms. Many had already sold and there were few new firms of this type (more than 300 sales associates or $15 million in Gross Commission Income) available in the market. Thus, from the period of 2006–2010, acquisitions of major residential brokerage firms were at the lowest level in nearly twenty years. The Market for Mergers and Acquisitions from 2010 to 2012 We expect a slow recovery in both the housing market as well as the market for mergers and acquisitions. The challenges we list above outline the main impediments to the use of M&A’s as a tool for growth. Other challenges include lack of capital, lack of managerial and leadership talent, and the failure to appreciate the nonfinancial issues that sellers and purchasers alike face. First, while we do not expect a return to the era when purchasers were willing to pay 50 percent or more of the purchase price in cash at close, the percent of cash down will likely be better than it has been over the past 3–4 years. And, except for the smallest of firms, most large companies firms will require in some cases hundreds of thousands of dollars in cash-down payments to make a deal work. There are not that many independent realty firms nor affiliates of national, branded networks that have rebuilt their capital bases to such an extent that they can easily afford this level of commitment. This factor may favor NRT, HomeServices, PREA, RE/MAX, and Keller Williams Realty, as they do have access to capital at this level. One area that many firms overlook when seeking to grow through mergers and acquisitions is that of managerial and leadership talent. When one firm acquires another and grows significantly as a result, often the combined firms need additional talent to operate effectively and efficiently. While it can be profitable to combine two firms with 50–70 sales professionals each, it is one thing to manage two such enterprises and another altogether to manage one with 100–120 sales professionals. With the exception of one national franchise, most brokerages are not built on models that support this many individuals per office. Ultimately, for most sellers, the potential sale of their business is a hugely emotional and personal issue. For many, the sale is a sign of “giving up” rather than a way for a seller to grow. Given the likely prices and terms available in the market over the next 2–3 years, it is not likely that an owner is going to get rich from a sale. They may be relieved of many liabilities, but even this is questionable, given the level of such liabilities for many medium to small residential brokerage firms. Page 4 Mergers and Acquisitions 2010
  5. 5. The sale of one’s firm, therefore, is more likely a personal and emotional decision than strictly a financial one. Often, purchasers overly emphasize the deal prices and terms rather than the personal ones. Also, sellers can shift their views of a transaction almost daily at times; this is not the result of deal terms, but rather the seller dealing with a sense of either failure, exhaustion, or suspicion as to what will truly happen after a deal is completed. Those who appreciate each of these factors will likely enjoy success in growth through merger and acquisition in the years ahead. Those who focus inordinately on the financial and structural aspects of M&A’s are likely to have more difficulty than those who first look to the personal issues, then to the financial ones. There are several factors that will affect the market for growth through merger and acquisition in the next few years, some positive and some negative. Some of these factors are financial, some legal, some structural, and some psychological. Factors in Valuations and Structuring Mergers and Acquisitions While this is not meant to be an in-depth look at valuations, Murray Consulting/REAL Trends has updated its “Valuing a Residential Real Estate Services Business” as of 2010, which goes into more detail about how to value these issues. There are a few factors concerning what typical buyers will look at in valuating your firm that are relevant to considering your options for a potential merger. Valuations for residential brokerage firms are highly affected by the number of acquirers for a particular firm, any restrictions on the sale of the firm (such as from Buy-Sell Agreements or Franchise Agreements), the level of competition in a given market, and the compatibility of one firm to another in terms of commission plans and culture. While each of these factors is important, the compatibility factor is a larger issue during the downturn. In this case, compatibility refers to the potential of either retention or loss of sales professionals, which is perhaps the biggest issue affecting valuations. While brokerage firms employ a variety of both positive and negative incentives to prevent the loss of sales professionals, the potential of loss is a critical factor in valuing a residential brokerage firm. Due to the nature of risk in residential brokerage, both the purchaser and seller are trying to find a balance between price and terms. One affects the other significantly, and when one of these factors rises (such as price), the other tends to fall (the terms are less favorable). Generally, the higher the “price” sought by a seller, the less favorable the terms offered by the purchaser, such as a lower amount of cash down and longer period of time for “earn-out” payments. Therefore, as a general rule, the greater the price the seller wants, the more the purchaser will hedge its risk of the loss of sales professionals—resulting in less cash down and longer “earn-out” periods and terms. The lower the price the seller seeks, the more the purchaser will generally grant additional cash and easier “earn-out” provisions. Mergers and Acquisitions 2010 Page 5
  6. 6. The valuation of residential brokerage firms reached its zenith during the 1996–2006 period. With the advent of the downturn, both prices and terms were reduced by all acquirers. While prices did not fall quickly, purchasers did adjust the terms to reflect uncertainty in the level of future housing sales. Where previously a firm might expect to receive more than 50 percent in cash at close, purchasers were now offering from 10–30 percent in cash with the remainder in longer term “earn-outs” or contingent payments based on the retention of sales associates and production. For sellers, earn-outs mean that they must consider the long-term stability and profitability of the company purchasing their firm. With so many brokerages struggling in today’s market, this can be a significant factor in choosing to whom they ultimately sell. In our practice over the past four years, every deal we have been involved with resulted in more than 70 percent of the total deal in contingent payments in the form of “earn-outs” over at least two and up to five years. Nearly 1 in 5 had less than 10 percent of the deal in cash at closing. Purchasers are hedging their bets about the housing recovery as to the challenges of converting sales professionals from one system to another that is somewhat different. Options for Today’s Sellers There are noticeable differences in operating philosophy among brokerage firms. As Murray Consulting/REAL Trends pointed out in the 2009 white paper on Realty Business Models, there are at least four distinct models at work in the industry today. They were outlined as follows: 1. Traditional Graduated Commission Plan firms 2. High Commission Concept firms 3. Capped Company Dollar firms 4. Freedom Realty firms There are significant differences in the way these firms share commissions, charge franchise fees, charge fees for services or rent, and in their overall cultural approach to the relationship between the brokerage and the sales professional. Regardless of earnings before interest, taxes, depreciation and amortization, or company revenues, if there are large differences in fee and commission plans or structural differences in firms, then an acquisition or merger of two disparate firms becomes a very high-risk proposition. Several options are available to brokerage firms when considering whether to sell to or combine with another brokerage firm. We will break them down here and highlight the opportunities that each provides. Page 6 Mergers and Acquisitions 2010
  7. 7. In considering buyers, sellers should first weigh the options within the two categories of candidates for sellers today: 1. A local independent brokerage 2. A local franchise brokerage There are upsides and downsides to both that should be considered. 1. Local Independent Brokerage Regional or local brokerage firms will generally want to change the name of your firm to theirs, but they have the flexibility to do otherwise. There are documented cases where independent brokerage firms can maintain more than one brand in a market with some manner of identifying an affiliation with the parent company. Most of these are privately owned and require no permissions from others to do a transaction; that is, they do not have membership or franchise agreements that restrict or restrain them from growing in any direction or geographies they desire. Generally, there is no franchise fee that will be payable; however, in most cases, you will need to change the commission/fee program to the acquirer’s system or, in some cases, a new blend of the two. This, however, is true for any combination or merger. Commonly, these firms can pay the same prices and terms as those affiliated with national brands, but this is not always the case. Firms affiliated with certain national brands have access to capital that local or regional ones do not always have access to for the same prices and terms. The legal requirements, such as non-compete and non-solicitation agreements, are usually consistent with those required by firms affiliated with a nationally branded realty network. Independent brokerage firms differ widely on their cultures, commission plans, and the level of services they provide to their sales professionals. When considering whether a combination is the correct one for a particular firm, it is important to understand that there is no one standard that describes independent brokerage firms from market to market. 2. Local Franchise Brokerage With major franchise brokerages, it is most likely to be the actual local franchisee, not the franchisor that will act as the buyer. Depending on the franchisor, the franchisee may have the financial and logistical support of the franchisor in the purchase and transition. (One exception is NRT, the owned operations of Realogy, where it is the parent company doing the acquisitions.) We list these in alphabetical order and include several national brands, as well as independent brokerage firms. Mergers and Acquisitions 2010 Page 7
  8. 8. Keller Williams Realty (Keller Williams) The unique ownership and operational structure of Keller Williams offers potential merger-or-acquisition candidates alternatives to when and how they receive funds from a combination. It can and does offer options to remain an owner of a Keller Williams Market Center, either as a majority owner (known as an Operating Partner) or as a minority shareholder. This is generally unique in that most large regional brokerage firms, whether affiliated or not, do not usually provide for ownership in the acquiring firm to a seller. (It does depend on the comparable size of firms involved in a transaction.) Keller Williams may also provide financing to a local franchisee looking to make a sound acquisition. Keller Williams will enlist an incoming seller and their sales professionals in the Keller Williams Profit Sharing Program, where a seller can receive additional monies from the sales production and recruiting results of the sales professionals they bring with them. (This is a program that is generally unique to Keller Williams, although some firms are offering some incentive programs that resemble several features of the Keller Williams Profit Sharing Program.) Keller Williams has profit shared in the hundreds of millions of dollars since it began the program nearly fifteen years ago, so this feature can offer significant additional long-term compensation on top of the terms of the sale. Keller Williams will require that you change the name of your firm to Keller Williams, but, depending on whether you are being rolled in or will remain as a standalone, you may be able to keep your firm name as part of the Keller Williams brand (This is true for most nationally branded firms.); Keller Williams has a franchise fee that is equal to 6 percent of gross commissions with an annual cap of $3,000 that is all paid by sales professionals associated with Keller Williams; Keller Williams also operates with an “open book” style of management, where sales professionals are engaged in many facets of the brokerage, have access to financial and operational details of the firm, participate in most decisions, and assist with planning. This philosophy is unlike that found in most other brokerage firms, and it needs to be analyzed fully by those contemplating a combination with Keller Williams affiliates, as it can be a significant advantage in merging cultures and gaining buy-in from sales professionals (while also presenting a challenge to principals who are not used to such openness). In considering the Keller Williams option, one must also be aware that the operational focus on recruiting and training at the office level differs from most others. The focus on training, which Keller Williams considers one of its key strengths, is due to its philosophy that sales professionals can and will do most other functions to the level that suits their (the sales professional’s) own business. Page 8 Mergers and Acquisitions 2010
  9. 9. Prudential Real Estate Affiliates (PREA)/ Prudential Real Estate Financial Services of America (PREFSA) PREA itself does not acquire brokerage firms, but rather provides financing, through PREFSA, to assist its own affiliates in acquiring other brokerage firms or to assist other brokerage firms in acquiring or merging with existing PREA affiliates. Even in this downturn, they have continued to be active in providing such assistance. PREA affiliates generally have access to capital from PREFSA to do mergers and acquisitions, but not always. As a result, PREA affiliates have the ability to be more aggressive in the prices and terms that they may be able to offer. Financing from PREFSA can result in it taking either an equity or debt position in the assisted firm, which may then allow for PREFSA to have oversight into certain operational and financial decisions. PREA affiliates, whether they utilize PREFSA capital or not, generally require that a firm being acquired or merged adopt the name of the PREA firm. Regardless, when combining with a PREA affiliate, a firm must use the PREA brand name. Firms combining with an affiliate of PREA will pay a franchise fee that is dependent on the size of the firm with whom a seller is combining. To the best of our knowledge, the franchise agreement calls for a starting rate of 6 percent of gross commissions, but we are aware that it can be lower depending on a number of other factors. Another interesting point about Prudential is its ability to refinance brokerage firms whether in an acquisition or other form of combination, or simply due to the desire of an owner to sell interests to insiders or next generation owners. This is a very unique feature offered by PREA/PREFSA. Realogy-related brands (Better Homes and Gardens Real Estate, Century 21, Coldwell Banker, ERA, Sotheby’s International Realty) Realogy approaches mergers and acquisitions in several ways. First, it outright acquires firms through its wholly owned subsidiary, NRT. At this time, it is focused almost entirely on markets where NRT already has owned operations, and most often these are associated with the Coldwell Banker brand. The focus of this acquisition activity is currently with “roll in” transactions, whereby sales offices are consolidated. Second, Realogy assists its affiliates with acquisitions of other (non-Realogy affiliated) firms, or similarly with firms not affiliated with Realogy to acquire existing Realogy-branded firms (so long as the combined entity is Realogy affiliated). They do on occasion allow one of their brands to acquire one of a different Realogy brand and keep them separate, but this is not a regular occurrence. Last, they will help their affiliates acquire other firms with assistance in terms of candidate vetting, valuation assistance, and other consultative guidance. Mergers and Acquisitions 2010 Page 9
  10. 10. In terms of the merger or acquisition of Realogy-branded firms with others outside their network, Realogy will sometimes provide capital in one of two forms. First, a Development Advance Note (commonly referred to as a “DAN”), which is a note received at the time of closing and forgivable over the length of the franchise agreement so long as the affiliate remains in compliance with all franchise obligations and certain revenue targets. The terms and conditions of a DAN can vary considerably, but they are generally designed to cover the costs of brand conversion and allow for some assistance in the financing of the transaction. The second is an “APIP” or Additional Performance Incentive Premium, which is, in effect, an additional rebate on top of the standard PIP that all sizeable affiliates can qualify for. Affiliates cannot receive both a DAN and an APIP for a single transaction, although they can have more than one form of assistance if they have acquired multiple firms. At this time, it appears that Realogy has been modifying its use of DAN financing to create more customization in this program. Firms that become affiliated with a Realogy brand are subject to a franchise fee that varies with a stated rate of 6 percent of the gross commission revenues of the firm, and a rebate that is publicized in their FDD (Franchise Disclosure Document) which allows for the net effective rate to be lower than the stated rate, especially for larger firms. Firms that become affiliated with a Realogy brand must adopt the network’s brand name with which it is becoming affiliated in a format approved by Realogy. Firms can and do frequently retain their own local brand name in concert with the Realogy brand name. One great advantage that Realogy-branded firms have at this time is their ability to perform mergers with firms from various Realogy-branded brokerage firms. Since they have more affiliates in most markets than other networks, this generally creates more opportunities for growth through mergers and acquisitions. RE/MAX RE/MAX does have an active program to assist its affiliates with growth through mergers and acquisitions. It does not provide direct capital in most cases, but does contribute to a combination through the selective reduction of certain franchise fees that would be due under normal circumstances. RE/MAX has acquired some firms directly, but at this time does not have an active program to acquire other brokerage firms for its own account. We do not know when or whether it will resume its program for additional acquisitions. RE/MAX does require that all firms that become affiliated either through acquisition of an existing RE/MAX firm or other combination with an existing RE/MAX firm assume the RE/ MAX brand identity. Page 10 Mergers and Acquisitions 2010
  11. 11. RE/MAX does require that all firms that are affiliated with it pay franchise fees that are basically in two parts: a monthly flat-dollar amount on a per-sales professional basis and, secondly, a percentage of the Gross Commission Income earned by the sales professionals. These fees vary somewhat, depending on whether a firm is in a region owned by RE/MAX (the parent company) or is privately owned. RE/MAX offers its own unique culture with a focus on high-commission concept plans, which is also reflected in their having the highest per-person productivity as of this date. This culture and focus on high-commission payouts create both advantages and disadvantages when considering mergers and combinations. Whenever a merger or combination of some form is contemplated between firms, the commission plan and the culture can both have a significant effect on the prospects for success. For firms that combine with a RE/MAX affiliate, therefore, it is clear that a careful examination of how two potentially different programs mesh is needed. Conclusion While merger-and-acquisition activity has slumped along with the housing sales market, most national and regional firms have active and well-funded programs to grow their networks through assistance in this area. Some provide capital, and some do not. All provide guidance, education, and other tools to assist affiliates in growth through mergers and acquisitions. All will also generally expect that any form of assistance will be conditional upon the signing of a long-term franchise agreement (or the extension of a current agreement). The section on what the major national networks and leading independents are doing is not meant to be exhaustive, but gives a general overview. Each has made exceptions to their own rules when the opportunity was right for all parties. Each has senior-level executives involved on a full-time basis working in this area—a sure sign of the importance each places on this area of their business. We do expect that with slow but steady improvement in housing sales, the prices and terms available in the market will begin to improve. However, we do not expect a return to the prices and terms that were prevalent in the 2002–2005 era. In particular, while prices may return, a far lower percentage will be in the form of cash at close and a far higher percentage will be in the form of performance-based earn-out payments. Mergers and Acquisitions 2010 Page 11
  12. 12. About the Authors Stephen H. Murray and S. Nicolai Kolding of Murray Consulting have been the leading mergers, acquisitions, and valuation advisers in the United States and Canada for the past twenty-four years. The principals of Murray Consulting have been involved in more than 920 successful mergers and acquisitions with aggregate value over $15 billion. Page 12 Mergers and Acquisitions 2010