IT’S ALL ABOUT CASH FLOW
The importance—and benefits—of real discipline
By James Graham, CVA
The valuation of an insurance brokerage is the result of the risk-adjusted rate of return a buyer expects from a projected amount of future cash flow. This is typically communicated in the valuation of private companies as EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization, times a multiple.
EBITDA is a widely accepted proxy for projected free cash flow and the multiple is an inverse of a buyer/investor’s risk-adjusted required rate of return. While there are a number of variables that go into how buyers calculate multiples to pay for an insurance brokerage, at the end of the day, demand from other buyers often drives the final number. In contrast, while the market does impact the pro-forma EBITDA that buyers accept, buyers tend to have more flexibility over this variable.
Despite the high cost of capital, demand remains strong,
and pricing continues to be well above historical norms.
With the cost of capital increasing, buyers are feeling the pressure. However, those who have shown great discipline paying for real cash flow find themselves in a strong position going into 2023. To illustrate the importance of buyers maintaining discipline on EBTIDA margin, consider the following example: Suppose a buyer paid 10x EBITDA for $1 million of EBITDA and gave credit for pro-forma adjustments that were not likely to materialize, resulting in an actual EBITDA one year later of $800,000. This means that the buyer actually paid 12.5x EBITDA, or 25% more than intended. This situation not only results in a lower rate of return than the buyer requires, but it also reduces the amount of capital the buyer has to deploy on future deals, as their maximum debt facility is limited to a multiple of EBITDA.
From a seller’s perspective, it has never been more important to have expert advice when going to market. Buyer demand remains strong, but they are looking to reduce risk by advocating for conservative margin assumptions. An expert sell-side advisor will help a seller understand what kinds of pro-forma adjustments to EBITDA a buyer will likely accept. An advisor also helps sellers understand how different buyers view various types of adjustments.
Not all buyers bring the same synergies to a deal, which leads to widely different opinions about certain adjustments. Expert advisors don’t encourage their clients to strip their firms to the bone but instead focus on recasting a seller’s expense structure to maximize both growth potential and profit.
From a buyer’s perspective, it’s more important than ever to pay for real cash flow. Below is a non-exhaustive list of expense categories that buyers should focus on during due diligence:
- Owner’s compensation. Some sellers attempt to reduce compensation tied to the owner’s labor to a rate far below market. While a reduction in owner’s compensation is often warranted, it is a key area that buyers should consider to ensure they have enough compensation to replace the position if needed in the future.
- Staffing needs. Have a good understanding of the number of staff and pay rates required to operate the insurance agency or brokerage.
- Non-owned business. Many agencies have co-broker relationships with other brokers where they are either providing expertise or need outside expertise. Be careful not to pay for non-owned business.
- Technology spend. Match the target’s current spend on technology with their own.
Despite the high cost of capital, demand remains strong, and pricing continues to be well above historical norms. Buyers and sellers who retain proper advisors will continue to achieve tremendous results in 2023.
The author
James Graham joined MarshBerry in 2015 and is a vice president on MarshBerry’s Financial Advisory team in its Dana Point, California, office. His expertise includes merger and acquisition advisory, capital raising, business valuation, perpetuation and succession planning, and strategic planning. James provides his clients with customized financial and capital strategies to help them accomplish their goals. He also is a facilitator for MarshBerry’s Connect Network and actively publishes articles relevant to the insurance distribution marketplace.
Prior to joining MarshBerry, James was a senior consultant with Deloitte Consulting LLP.
James currently maintains the FINRA Securities Industry Essentials (SIE®) Exam in addition to the Series 62, 79 and 63 FINRA Registrations through MarshBerry Capital, LLC, the affiliated FINRA-registered broker-dealer of Marsh, Berry & Co., LLC. He earned a Bachelor of Science in Finance from Azusa Pacific University and a Master’s in Business Administration (MBA) from George Mason University. He is also a Certified Valuation Analyst (CVA). Contact him at James.Graham@MarshBerry.com or (949) 272-0351.
The year 2022 delivered a total of 749 insurance brokerage transactions (reported as of 1/20/23). This total deal count represents an 18.9% decrease from 2021, but a Compound Average Growth Rate (CAGR) of 6.6% since 2018.
Private capital-backed buyers accounted for 552 of the 749 transactions (73.7%) in 2022, as they continued expanding their presence in the marketplace. Total deals by these buyers have increased at a CAGR of 12.5% since 2018. Independent agencies accounted for 97 deals (or 13% of total deals) and is consistent with 2021, yet an overall decline since prior years. From 2015 to 2020, independent firms completed 23.2% of deals on average.
In 2022, retail transactions accounted for 592 of the 749 transactions (79%),a 23% decrease year-over-year. Specialty distributors outpaced the rate of consolidation of their retail broker counterparts, with total M&A transactions going from 123 in 2020 and 153 in 2021 to 157 in 2022. This represents a 2% increase year-over-year and a five-year CAGR of 17%.
Property Casualty (P-C) brokers as acquisition targets accounted for 418 of the 749 transactions (55.8%) in 2022. That is down from 60.6% of P-C transactions in 2021. Employee Benefits Consulting firms as targets accounted for 165 of total deals (22%), up from 17.8% in 2021. Full service or multi-line brokers as target accounted for 166 of total deals (22.1%), up from 21.5% in 2021.
Investment banking services offered through MarshBerry Capital, LLC, Member FINRA and SIPC, and an affiliate of Marsh, Berry & Co., LLC. 28601 Chagrin Blvd., Suite 400, Woodmere, Ohio 44122; (440)354-3230. Disclosure: All deal count metrics are inclusive of completed deals with U.S. targets only. Scorecard year-to-date totals may change from month to month should an acquirer notify MarshBerry or the public of a prior acquisition. 2022 statistics are preliminary and may change in future publications. Please feel free to send any announcements to M&A@MarshBerry.com. Source: S&P Global Market Intelligence and other publicly available sources.
