By Brad Unger
CAN WE AFFORD IT?
Making acquisitions with other people’s money
I’ve spent the better part of my career advising people that the answer to the question “Should we afford it?” is more important than “Can we afford it?” I genuinely stand by this statement.
Sure, the sophisticated student of finance might argue that asking “Can we afford it?” is really asking “Does the expected future cash flow justify the up-front investment?” But on a much more basic level: Do you have the capital to make the purchase vs. should you make the purchase at all? For this article, let’s assume you’ve done the strategic analysis and that the price you plan to offer for an acquisition is justified by the expected returns.
Now, can you afford it? Probably.
There are several ways to pay for a transaction, but we’re going to focus on four:
- Cash on hand
- Debt (from a third party)
- Seller financing (debt from the seller)
Also, we’re focusing on up-front payments at closing, but earn-outs could have the same or similar financing methods.
The largest buyers in the insurance industry pay with an average of 85% cash and 15% equity. In fact, much of their cash is generated by some form of debt, but from a seller’s perspective it looks like cash because those buyers did the financing work well in advance of the need. Either they raised the debt and warehoused it on their balance sheet until they needed it, or they implemented a revolving credit facility—a giant corporate credit card that can be drawn on at will.
Equity can be a great form of payment in that it aligns buyers and sellers (now co-owners) in the long-term success of the firm.
In the middle market, deals look a bit different; agents and brokers typically raise financing to do a specific deal at a specific time, and the bankers or lenders involved underwrite the deal. This adds a component of risk to completing the deal as well as increasing workload during an already busy time.
Cash. Cash is the easiest payment method to understand. You have cash on the balance sheet that you built up over years of earning and saving. You cut a check and you’re done. The first issue is that it’s fairly rare for agencies to have enough cash on hand to entirely finance an acquisition. The second issue is whether your agency should use cash if it doesn’t have to, as it might be wise to conserve it for other purposes.
Equity. Similar to cash, equity is typically easy to understand. Perhaps the seller was the 100% owner of the business and after the transaction, that seller will be a 2% owner of the acquiring company. The buyer issues new stock to the seller, and the seller receives cash only when a distribution is made to all shareholders or if/when the stock is sold. Equity can be an excellent form of payment in that it aligns buyers and sellers (now co-owners) in the long-term success of the firm. That said, it only works if you’ve picked the right partners.
Seller financing. This might be the absolute best option for buyers, and for the same reasons it’s perhaps the worst potential option for sellers. When sellers provide the financing, they have effectively retained the risk of owning the company. This means they must wait to get cash when/if it comes in. Hence, they’re similar to equity holders, albeit with a higher preference in the event of a default.
If the deal goes south—or the acquired business does not perform as expected—there’s a chance the parties could get into an argument leading to litigation. For example, the buyer could accuse the seller of misrepresenting the asset for sale, which may or may not be true, and ask for an indemnity payment. When the buyer has not yet paid the seller the entire purchase price, the leverage is clearly in the buyer’s favor.
When a deal involves seller financing, typically it’s because a third party won’t lend money against a deal, or at least won’t do so at a rate acceptable to the borrower. This is instructive: if a third party is unwilling to lend, it is likely that it sees significant risk. While this form of financing should be completed on a market-rate basis, it’s common for sellers to accept lower interest rates as it seems like a small price to pay (or a small risk to take) to get a deal done. This is foolish for the seller but could be good for the buyer.
Debt. True third-party debt is the talk of the industry; it’s popular and is a fairly common practice. Lenders have come to understand the industry and its lack of tangible assets; they are willing to lend against intangible assets, like renewal lists and the significant recurring cash flow they generate. Additionally, interest rates are at historically low levels, making the use of debt even more attractive.
Most banks will limit debt at a certain multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization); however, they are willing to lend against the EBITDA of the whole firm and not just the newly acquired firm’s EBITDA. Some lenders will accept certain pro-forma adjustments when reviewing pending deals, but others may have stricter guidelines. Of course, any debt will come with covenants: limitations on what the borrower can or cannot do, including specific financial metrics that cannot be breached.
For small and medium-sized loans, some national lenders are true experts in the insurance agency business and are able to respond fairly quickly to an opportunity. These firms often have strict limits on what they can do and what rates they charge, but they can execute more easily, as they do not need education about the industry and its current state. Local and regional banks also are active in the small and medium-sized market, but are a bit more of a wild card in terms of their rates and terms. Some can offer great terms and rates based on their long-term relationship with your business, while others will not be interested in lending to a business that does not have significant tangible assets available for collateral.
When you are considering borrowing, the devil is in the details. The terms and conditions are critical to understand and to negotiate. Advisers can help you navigate this market and the myriad moving parts. The key to successful borrowing is to meet lenders early and often, and to have your story straight. Building a presentation to explain your transaction and drive the discussion is critical, as opposed to leaving it to the lenders to create their own story. This is another area where outside help can drive the best possible outcome.
The net take
Do your homework now, and make sure you have a plan in place to fund a transaction. Know the amount of cash you have available to make the purchase (and still make any other critical investments), and understand private equity and the amount of debt you can reasonably incur. If you’re thinking about asking for seller financing, know that sellers likely will see this as a turnoff. And finally, if you don’t know the debt market, ask for help: find an adviser who works for you, not for a lender, and is able to help you build an optimal capital structure.
Brad Unger joined Marsh, Berry & Co., Inc. (“MarshBerry”) in 2015 as a vice president on the mergers and acquisitions team. In addition to his M&A advisory responsibilities, Brad also is involved with the firm’s financial consulting business. MarshBerry helps insurance agents, brokers and carriers as they work to maximize their value through a variety of industry-specific services. Contact Brad at Brad.Unger@MarshBerry.com or (440) 220-5435.
The 2019 year-to-date announced transactions are continuing to outpace 2018. Through September 30, 2019, 451 transactions were announced, compared to 429 announced transactions through last September. The number of announced transactions in 2019 is still well on its way to passing 2018’s total of 580 deals and likely exceeding 600.
The majority of the deals continue to be dominated by private-equity-backed buyers (56% of the total). However, independent brokers still make up about over a quarter of all announced transactions (28%). Hub International Limited, Broad Street Partners, Inc., and Assured Partners, Inc., are the top three most active buyers through September, each with at least 25 transactions. The top 10 most active private equity-backed agencies are responsible for 194 of the451 total transactions year to date (43% of the total). Almost 83% of all acquired agencies were retail, while managing general agents (MGAs) at 13% and wholesale agencies at 4% make up the remaining portion of acquired agencies.
Public brokers have seen a slightly diminished presence in the merger and acquisition market when compared to September of last year.
Thirty-nine transactions have been completed by public brokers year to date (8.6% of the total), which is down from 43 total deals done in the same time period last year. Arthur J. Gallagher & Co., on the other hand, has been more aggressive in 2019. It has participated in 22 deals through September 2019, up from 19 in 2018.
On September 23, Baldwin Risk Partners a private capital-backed broker, filed its S-1 form with the SEC in preparation for an initial public offering. The S-1 details an aggregate offering price of $100 million made up of Class A common stock. Upon completion of the offering, members of management will hold shares of Class B common stock. Class A and B shares are both entitled to one vote per share, and as a result the pre-IPO LLC members will be able to control any action that requires the approval of stockholders. The offering will be conducted through an “Up-C” structure, which is aimed at providing tax advantages to the public company and existing owners when they exchange their pass-through interests for shares of Class A common stock. Baldwin Risk Partners is proposed to trade on the Nasdaq under the symbol BRP.
|Buyer||2019 YTD Announcements||2019 YTD Rank||2018 Announcements||2018 Rank|
|Hub International Limited||28||1||28||6|
|BroadStreet Partners, Inc.||26||2||37||2|
|Patriot Growth Insurance Services, LLC||24||T4||0||N/A|
|Arthur J. Gallagher & Co.||22||6||30||5|
|Alera Group, Inc.||16||T7||34||T3|
|Hilb Group LLC||16||T7||11||11|
|Digital Insurance, Inc.||14||9||16||10|
|World Insurance Associates, LLC||12||T10||8||T13|
|Brown & Brown, Inc.||12||T10||24||7|
Securities offered through MarshBerry Capital, Inc., Member
FINRA and SIPC, and an affiliate of Marsh, Berry & Co., Inc.
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. Statistics for 2019 are preliminary and may change in future publications. Send any announcements to M&A@MarshBerry.com.
Sources: S&P Global Market Intelligence; http://www.insurancejournal.com; http://www.businessinsurance.com/; other publicly available sources and MarshBerry Opinion & Experience
2019 Acquisition Detail(September YTD)
Insurance Broker – Independent: 128
Insurance Broker – Public: 39
Insurance Broker – Private Equity- Backed: 251
Insurance and Other: 26
Bank & Thrift: 7
What’s Being Bought:
Full Service: 149
Retail vs. Wholesale: