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Agency Financial Management Acquisition growth strategy Acquisitions should be considered a normal element of the growth process By Paul J. Di Stefano, CPA, CPCU
The larger an agency gets, the more difficult it becomes to grow organically—especially in a softening market environment. When one looks at the national insurance brokers, one can see that a substantial portion of the growth of these firms has come by acquisition. In the case of the publicly traded brokers, one of the motivations for aggressive acquisitions is that their stock performance is usually directly correlated with their growth pattern, which needs to remain consistent, hard market or soft. Brown & Brown is an excellent example of a national broker that has grown through the aggregation of agencies acquired around the country. Brown & Brown was a large, privately held agency until the early 1990s when it merged with Poe & Associates, a publicly traded broker. HRH was originally a spinoff from a public company where the management buy-out team raised initial capital from several insurance companies and proceeded to go public and grow by acquisition. Although these are dramatic examples of successful growth through acquisition, the fact is that an acquisition strategy can be a valid part of any agency’s growth plan. In fact, the majority of our clients have completed one or more acquisitions. Even agencies that may not have been actively looking for acquisitions are likely to be approached by a friendly competitor who wants to exit the business. When considering acquisitions, agency principals should think of funding acquisitions as an investment in the agency. Looking at it from that perspective, although the numbers are much bigger, acquisition of another agency is not much different from making the commitment to hire producers, which typically entails agreeing to a compensation package, otherwise referred to as “negative cash flow” or “burn rate,” over a year or more until the producer starts generating positive cash flow. In many cases, agencies have hired a number of producers over the years, some of whom have worked out and some of whom have not. Many agency principals have bought out partners, usually structuring the buyout with some cash up front and with payments made over a period of time. One of the differences between this buy-out scenario and the acquisition of another agency is the level of comfort the buyer has reached when agreeing to make a commitment. In the case of the purchase of a partner’s equity, the other partner theoretically has complete knowledge of what he or she is buying, including the solidity of client relationships. When acquiring another agency, however, the principal usually starts the process with only a broad overview of the agency’s operations until due diligence is completed. Even then there is a certain amount of business risk associated with the acquisition, which in most cases can be addressed by structuring the deal in an intelligent and equitable manner. Due diligence is key If performed properly, due diligence will highlight the business risks associated with the acquisition of an agency. Understanding those business risks will enable the acquirer to structure a transaction that addresses those risks intelligently. The objective here is the minimization of risk, not the complete elimination of risk, which is impossible. From time to time we hear that an acquisition was not successful. In most cases, the reason is that due diligence was not comprehensive in uncovering potential problems. But the real cause of most unsuccessful acquisitions is that it took longer to pay off the deal than was originally anticipated because cash flow was less than projected. A good example of dealing with business risk was highlighted in a recent Harbor Capital transaction in which the buyer was having some difficulty deciding how to structure the deal. In this case, one of the selling principals was retiring and the other principal’s main concern was the ability to continue an active role with the agency. The buyer’s initial view of the deal was that it involved several risk factors, one of which was the potential fallout that might result from the fact that business was currently being moved to new markets because of the loss of a market. This risk was somewhat offset by the fact that the buyer was bringing additional markets to the table. The other issue was the sustainability of the high level of contingent commissions that the agency was consistent in generating. As it turned out, the solution to structuring the deal addressed the concerns of both parties to the transaction. The partner who wanted to stay active with the agency had agreed to sell only one half of his equity in the agency. The fact that this partner continued to have skin in the game with a level of equity was enough to convince the buyer that the business risks were more perception than reality. We have seen some clients approach the acquisition process tentatively, then realize the value of acquisitions, and ultimately embark on an active acquisition program. In our experience, a major challenge in pursuing this course of action is the availability of capital. Trying to do acquisitions on a retention basis with little or no cash up front is a low probability game. This leads to comments by sellers that “we are being purchased with our own money.” The truth is that buyers are always acquiring a stream of cash flow and paying for that cash flow. The perception of the sellers in these cases is that the buyer is not putting up his or her own money. The reality is that buyers must have capital available to be competitive in acquisition negotiations. Accumulating capital may be as simple as retaining earnings in the agency instead of distributing those earnings, which is the equivalent of creating a war chest. The other option is to have a line of credit available from a financial institution. Banks are much more willing to offer financing for acquisitions than in years past. Today many banks are in the insurance business and got there through acquisitions. Insurers are also very supportive of the acquisition process and will uncover acquisition prospects because they like to see their successful agencies growing. Investments in office space, producers and computer systems are all taken for granted as part of the process of building a successful agency. Acquisitions also should be considered a part of the growth process. We find that the more acquisitions an agency completes, the more adept the principals become at negotiating and structuring deals. As with other things in life, practice makes perfect. A track record of successful acquisitions is also important in closing future deals because the ability to point to past successful deals helps with future negotiations. * The author |
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