Key questions a potential investor should ask before moving forward with a transaction
While equity is just one part of the equation in picking a partner, it can have
material ramifications on your agency’s valuation.
By James Graham, CVA
It has been 16 years since private equity (PE) firms started pouring capital into the insurance distribution space. In 2007, sellers only had access to two national firms offering PE-engineered returns and both have proven to be stellar investments to date.
Looking back over this timeframe, MarshBerry data suggests sellers in the early years could hardly go wrong from an equity-returns perspective when picking a partner. Holding equity in the vast majority of PE-backed insurance brokers has resulted in investors seeing returns in excess of standard PE targets.
While it is impossible to predict the future, there are reasons to believe that these above-average returns are still possible albeit more difficult to achieve, given the increase in the cost of capital and the large number of firms competing for market share.
It is harder than ever for sellers to differentiate between the various options and understand the risk-adjusted return expectations of each option. While equity is just one part of the equation in picking a partner, it can have material ramifications on your agency’s valuation.
Buyer stock in a typical PE-backed insurance broker transaction is typically between 10% and 30% of the purchase price. Meaning, if a firm receives an offer for $40 million with 25% of the purchase price to be paid in stock, the seller is keeping $10 million at risk in their new partner. That is $10 million that the seller has invested in securities they likely misunderstand.
Again, historically, this has largely worked out for sellers. However, there have been negative stories in the industry and it is possible there could be a few more with the increasing number of PE-backed firms in the space. It is also important to note that there is material risk in owning all stock including publicly traded brokers and independent brokers who have not taken on private equity capital.
It is inherent that equity holders are taking risk, but how does a seller understand the type of risk they are taking and if it is commensurate with expected returns?
The first thing a seller should recognize is that the individuals implementing these equity structures are smart people who are not only looking to maximize upside for all shareholders but are also seeking to mitigate downside for their limited partners. These partners are the investors providing capital and not the employee shareholders of the broker.
A seller who is unadvised is at a disadvantage when analyzing the investment decision they are about to make. The U.S. government has recognized this disadvantage and excludes most people from participating in private investments unless they are accredited investors. Potential investors should seek outside advice before making these investments in order to understand what they are getting themselves into.
Below are examples of key questions and issues a potential investor in a brokerage should ask and further understand before moving forward with a transaction:
- How many classes of stock are there and what rights do minority shareholders have? For example, do minority shareholders have tag-along rights?
- If there are multiple classes of stock, what are the different features of each class? Does stock owned by the PE sponsor have a preferred return?
- How does the firm value its stock? How often do they value their stock? Is it done internally or does a third-party valuation firm provide an unbiased value?
- What do the company’s current and projected cash flow look like?
- What is the broker’s current leverage ratio?
- How have past recapitalization events gone and what is the return history?
- What is the timing of the next recapitalization event?
- Is there an internal market for equity owners who retire or need liquidity between recapitalization events?
- How does the firm recognize revenue? Does the firm use ASC (Accounting Standards Codification) 606 to pull future revenue into the current period?
Understanding the features of a buyer’s equity is one essential component to maximizing valuation in a sale. Seeking advice from a trusted advisor around such questions can help protect a seller from taking risk that they do not understand.
It should also be of note that the equity structures and LLC agreements for buyers are often not negotiable. As a result, it is important to get a good understanding of the key features before agreeing to sign a term sheet.
M&A MARKET UPDATE
Through September 30, 2023, there have been 454 announced insurance brokerage merger and acquisition (M&A) transactions in the United States.
Private capital-backed buyers accounted for 334 (73.6%) of the 454 transactions, which is nearly a 4% increase from the proportion of announced transactions at this time in 2022. Total deals by these buyers increased at a Compound Annual Growth Rate (CAGR) of 11.1% since 2018, with a marked increase after the onset of the pandemic.
Deals involving specialty distributors as targets accounted for 107 transactions (or 24%) of the total 454 deals in 2023—a five percentage point increase in transaction share over 2022. Specialty firm deals have increased by a CAGR of 22% from 2018 through 2022, a trend that is anticipated to continue as traditional retail brokers expand into the wholesale and delegated authority space.
Through September, independent agencies as buyers accounted for 60 transactions (or 13.2%)—down from 17.2% in 2022. Bank and thrift as buyers accounted for five announced deals (or 1.1%)—down from 2% in 2022.
Deal activity from the marketplace’s most active acquirers remains strong in 2023. Ten buyers accounted for 49.6% of all announced transactions, while the top four (BroadStreet Partners Inc., Hub International Limited, Risk Strategies Company, LLC, and Inszone Insurance Services, Inc.) account for 26.7% of the 454 total transactions.
Deal counts and valuations in the final months of 2023 will likely continue to remain strong. However, heading into an election year, and with the pending fiscal policy decisions in 2024 and 2025, the crystal ball is not clear.
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. 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.
James Graham joined MarshBerry in 2015 and is a director 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.