Please set up your API key!

The Rough Notes Company Inc.

BUYER BEWARE … AND PREPARED

BUYER BEWARE … AND PREPARED

BUYER BEWARE … AND PREPARED
September 21
12:49 2017

Agency Financial Management

Due diligence is a critical component of acquisitions

They emerged from different centuries, but they’re both timeless pieces of advice. Caveat emptor, let the buyer beware, first appeared as guidance in marketplaces during the Middle Ages, where the message reminded purchasers to make careful choices. Be Prepared was coined by Robert Baden-Powell in 1908 as the motto for the Boy Scouts, and it continues to urge Scouts to be mentally and physically ready for whatever they may encounter in life.

This advice is especially valuable for managing general agents and underwriters who are considering acquisitions in today’s market. Deloitte’s 2017 Insurance Industry Outlook points to macroeconomic, social, and regulatory changes as sources of short-term uncertainty. The firm calls for more attention to a number of factors that will play an increasingly disruptive role in the industry over the longer term, among them the emergence of the IoT (Internet of Things, with new devices and connectivity), the imminent arrival of autonomous vehicles, and the growing risk and scope of cyber attacks.

Once you’ve identified your primary motivations, it is easier to determine whether a potential acquisition target will advance your goals and if buying it will boost your bottom line or have a less positive impact.

Although MGAs and MGUs have not seen consolidation activity at the same rate as retail agents and brokers, the activity is still present and increasing. Many acquisitions meet the buyers’ strategic goals. Others prove to be disappointments for any number of reasons. The difference between the two frequently rests in the amount and quality of due diligence performed by the buyer before completing the transaction. When making an acquisition, the more homework you do, the more likely you will be satisfied with the results.

Why are you buying?

Effective due diligence starts with an honest assessment of your motivation for making an acquisition. Why do you really want to buy?

The easy answer is “growth,” but what are the specific reasons you see growth as an attractive goal? Your primary objectives may be one or more of these:

  • Human capital. Always the most important for me: Assess the depth of management talent and expertise. Does your target have bright, energetic, customer-focused employees who readily accept change?
  • New markets. An acquisition can give you a foothold in a new geographic area or line of coverage.
  • Risk management. If your business is primarily in one market, one line, or with one kind of client, an acquisition can help you spread the risk and reduce the potential effects of negative economic situations.
  • Intellectual capital. Buying another firm may give you access to new underwriting expertise and product lines that improve your firm’s value to clients.
  • Economies of scale. An acquisition provides the opportunity to combine and reduce back- office operations.
  • Enhanced profitability. As a larger firm, you may be able to access more favorable fee structures and higher commission frameworks without redundancy in expenses.

Once you’ve identified your primary motivations, it is easier to determine whether a potential acquisition target will advance your goals and if buying it will boost your bottom line or have a less positive impact.

Why are they selling?

Just as you want to identify your true motivation for buying, you need to determine the seller’s true motivation for putting the business on the market, and the real value it offers to your firm.

Sellers may have a variety of legitimate reasons for wanting to turn their business over to someone else. It may be as simple as retirement or succession planning. Or it may involve something that’s hidden, such as a scandal or other “skeleton in the closet” that might resurface at a later date and affect your profitability and/or reputation.

Investigate the business thoroughly and understand the owner’s motivations—especially if you’re planning to pursue a stock transaction, which carries more risk than an asset transaction. If something you find looks fishy, assume that it is. You don’t want to put your business in danger by ignoring warning signs.

When looking at the firm’s value, do so within the context of the motivations you identified. If your goal is to gain access to new markets, be sure the firm has been successful serving those markets. If you’re after economies of scale, study the firm’s operations to identify specifically the expenses that will be eliminated and how well the culture will blend with yours. There’s a lot more to a firm’s enterprise value than the size of its book of business.

Due diligence

If the firm appears to be a good fit with your motivations and doesn’t present any hidden dangers, perform a thorough analysis of its business. Include your accountant, attorney, and other trusted business advisors in this process.

Assess the talent. If you’re planning to keep part or all of the firm’s staff, study them carefully. Learn about their relationships and whether they’re eager to remain with the firm. After all, depth of employee knowledge is part of the intellectual capital you are purchasing. Consider how well the staff will interact with your existing team and who will provide value from both a management and an employee standpoint. You may even want to ask for résumés and references to better understand the background and experience of the firm’s staff.

One hard and fast rule: Don’t consider firms that lack ironclad non-compete contracts with their producers. Ideally, employee contracts should include both non-compete and non-solicitation agreements.

Look at the book. Carefully analyze the seller’s book of business, but don’t stop with the dollar value of the commissions—the recurring revenue streams. Examine how many of the accounts have been on the books for more than two years, five years, and even 10 years. Retention can be a sign of a well-run business. Make sure that what the seller represents is truly in-force coverage, especially if you’re planning to include an earn-out provision in the transaction.

Also examine loss ratios, the length of carrier relationships, the way carrier contracts are written, and the kinds of clients the firm serves. Study the revenue structure to determine how much is regular and recurring and what represents contingency bonuses. Ask for bank statements, and compare deposits to recorded revenue.

Use tax returns to validate revenue reports. Examine ratios, margins, and non-operating expenses to ensure that you fully understand how the firm has been performing.

Consider revenue trends. Has revenue grown recently, or does one large account represent a disproportionate share? Looking at raw numbers isn’t adequate. Study the average revenue per account and compute the mean, the median, and other pertinent statistics. Assess whether current relationships are likely to continue after the acquisition and where the revenue stream may be vulnerable to attrition.

Know the numbers. You’ve looked at the book of business, and now it’s time to examine the firm’s overall financial health. When you dig into the financials, it is wise to look not only at current data but also at historical data as shown in tax returns and internal reports. Insurance businesses tend to trade using a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) to determine price and value; thus determining EBITDA is a good first step. Although not exactly cash flow, it can be considered the best approximation. As part of your analysis, also consider the components of any adjusted EBITDA calculations. What discretionary expenses will be added back after the sale? And keep in mind that although determining EBITDA has great value, it should not be the only factor you consider.

Finally, have your accountant create pro forma statements for the combined organization so you can get a sense of the financial impact you’ll see after the acquisition. And if you’re buying the other firm’s assets, be sure that they’re well defined, without any liens or encumbrances. Also, make sure the seller has been in compliance with all applicable laws and has paid all taxes.

Assess business trends. Identify which carriers are receiving most of the business from the firm and seek to understand why. If you have a relationship with one or more of the carriers, you might want to ask if they are planning any changes that could have a negative effect.

Funding your acquisition

Equally important in performing due diligence is deciding how to fund your acquisition. It is essential to determine whether you have the necessary capital on hand to make the purchase. If third-party financing is needed, take the steps to prequalify for funding during the due diligence process.

When seeking third-party financing, a first choice is often to explore your existing banking and lending relationships, but traditional banks aren’t always comfortable lending to businesses like yours. Most banks are geared toward making loans to businesses that have tangible assets like inventory, equipment, and real estate.

An alternative can be a specialty lender who is accustomed to working with MGAs and MGUs. These lenders understand how a firm like yours operates. They are familiar with the nature of your revenue streams and can approach the underwriting with realistic expectations and an appreciation for inherent risks. This understanding may lend itself to a preferred lending structure to meet your needs.

The author

Rick Dennen is president and chief executive officer of Oak Street Funding, which provides commission-based lending for insurance agents who need capital to buy, build, or sell their agencies. Dennen is a licensed agent in the state of Indiana for life, accident and health products and a licensed Certified Public Accountant in the state of Indiana. In addition, he holds an MBA in finance and is an instructor of venture capital and entrepreneurial finance at the Indiana University Kelley School of Business. He can be reached at rick.dennen@oakstreetfunding.com


Loans and lines of credit subject to approval. Potential borrowers are responsible for their own due diligence on acquisitions. California residents: Loans made pursuant to a Department of Corporations Lenders License. The materials in this paper are for informational purposes only. They are not offered as and do not constitute an offer for a loan, professional or legal advice or legal opinion and should not be used as a substitute for obtaining professional or legal advice. The use of this paper, including sending an email, voice mail or any other communication to Oak Street, does not create a relationship of any kind between you and Oak Street.

Related Articles

rn-subscribe-sidebar-cta_magazine rn-subscribe-sidebar-cta_blog rnc-advantageplus-sidebar_login rnc-pro-sidebar_login

Spread The Word & Share This Page

Trending Tweets