By Brad Unger
WILL TAX REFORM LEVEL THE PLAYING FIELD?
Regional buyers will be able to compete in the active M&A game once tax reform brings down pricing
The playing field is about to change for buyers and sellers in the insurance space, and regional buyers could be the winners if they want to start being competitive in mergers and acquisitions.
The Tax Cuts and Jobs Act that was rolled out in 2017 introduced a key provision regarding deductible interest that will go into effect in 2022. As we clear the third quarter of 2018, the coming 18 months will be a time of change for everyone in the insurance industry, whether you’re buying, selling or staying put.
What does tax reform mean for agencies and brokers that are looking to sell? And what about regional buyers that have been priced out of the market by the high valuations and corporate leverage that large private equity-backed companies bring to the table?
Here are some key trends we believe you can pretty much bet on.
Down go the rates. We’ve seen a reduction in income tax rates for corporations and for pass-through entities like S-corporations, limited liability companies and the like. This theoretically would increase the seller’s valuation, but valuations long have been based on the buyer’s tax circumstances (or lack of tax circumstances, in the case of PE-backed buyers), rather than the seller’s circumstances. That said, this does affect the tax rate for regional buyers, which may allow them to pay a bit more for an acquisition.
Down goes the leverage. PE-backed brokers will experience a change in their financial models. The models are designed to max out their returns by maximizing leverage and interest deductions to their taxable income. In some cases, successful PE-backed brokers have been able to lever up to 7.00x EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), but tax reform will change that. They’ll be forced to reduce leverage when the deductibility definition for interest changes in 2022 to 30% of EBIT (Earnings Before Interest and Taxes) from 30% of EBITDA; this means they’ll need to pay less to acquire a firm if they want to achieve the same financial returns in a lower-leverage world. Make no mistake, they definitely want to achieve the same returns.
Down goes the value. As a result of these trends, we’re expecting pressure on valuations. Although acquisition demand might hold strong, pricing is expected to decline as companies restructure ahead of the 2022 rule change. Firms need to begin the de-levering process and adjust for the resulting valuation change well in advance of the deadline. Plan on more of the same high valuations and pricing that are advantageous for sellers in the next 12 months, but after that we’ll be looking at a different playing field.
Is tax reform a buyer-beware situation?
Not any more so than usual. As with any change in the law, there are winners and losers, so individuals and firms need to consult with their advisers (lawyers, accountants and tax experts) to ascertain which group they are in.
A new day for regional buyers
What’s the net effect of the tax changes for local and regional firms that want to buy other agencies? For starters, your market value is under pressure. This would be an issue if you wanted to sell your firm after 2020, but if you’re committed to holding the firm indefinitely and you have done your cash flow analysis and know that the firm can perpetuate internally (or at least not be forced to sell), this is a non-issue.
From the perspective of buying firms, the tax changes could be a positive, as the playing field is getting closer to level. The tax circumstances of regional firms are improving, as the corporate income tax rate and pass-through tax rates have decreased. This means that regional firms now can pay higher prices for small local acquisitions and still make the financial math work. This is coming at a time when the large PE-backed buyers need to reduce the valuations they are paying so they can meet their financial targets after de-levering. With these two changes converging, regional buyers could be players if they have a solid merger and acquisition program in place.
Fizzle or pop? We believe it’s going to be fizzle, not pop.
Sellers have been fetching prices for their agencies that they probably never dreamed of a decade ago, before private equity entered the insurance market and decided to stake a claim. Because of their ability to leverage so significantly, PE-backed brokers have set the price point, and that price point has risen steadily over the past few years. Based on what we are seeing in the insurance M&A market, if there was ever a time to sell, this probably has been the time. Of course, for sellers, tax reform sets a tangible deadline on the period during which they can maximize their value in this way. We’ll say it like this: Sellers, you’ve got it good today, but the end of the golden days is nigh. That said, you may see your value going from “outstanding” to merely “great” or “very good.” That could still cost you millions of dollars, but it’s not catastrophic.
For buyers, all the leverage over the past 10 years has pushed out many regional and mid-sized firms. Tax reform could create some real opportunities for the thousands of middle market agencies and brokerages that want to buy and consolidate the smaller end of the market. Regional buyers likely will get a better shot at making acquisitions, but let’s not pretend that it’s going to be totally fair. This presents some nice opportunities for mid-sized firms that want to grow through acquisition, but there’s no blood in the streets and you’re not going to be getting great deals—just fair ones.
Does this mean the bubble is popping? No, but it’s going to lose some air. We see no sign that the pace of acquisitions is slowing, but we do believe there will be a reduction in value.
What’s your plan?
If you’re a mid-sized regional buyer looking to expand your footprint, add a specialty or grow your client list, the future is bright. But you must plan for it. You still have to differentiate your business today to position yourself as an attractive buyer tomorrow, once pricing returns to parity.
What does that mean?
Take a look at your people and processes. Who’s on your bench, and how are you actively working to recruit talent? What training and career development opportunities do you offer your people so they realize they can grow with you? What systems and technology have you adopted to improve efficiency and stay on the cutting edge? We have seen that talent and tech are the two greatest challenges the insurance industry faces, and by addressing those head on, you’ll build a higher-valued firm that should perform well on the M&A field once it’s your time.
Tax reform can mean opportunity if you prepare for it. For many buyers this means fine tuning operations and improving profitability today. For sellers it could mean considering what the future market will bear for your succession plan. We’re about to enter a new season, and the M&A game will always be dynamic—but it certainly will look different.
Brad Unger is a vice president of Marsh, Berry & Company, Inc. You can reach him at (440) 220-5435 or Brad.Unger@MarshBerry.com.
Marsh, Berry & Company, Inc., and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction. Circular 230: Any tax advice or communication contained within this document was not intended or written to be used and cannot be used for the purpose of avoiding penalties that may be imposed. Securities offered through MarshBerry Capital, Inc., Member FINRA and SIPC, and an affiliate of Marsh, Berry & Company, Inc.,28601 Chagrin Blvd, Suite 400, Woodmere, OH 44122, (440) 354-3230.
September added 45 more transactions to the year-to-date (“YTD”) total, which is up to 392 announced transactions. This compares to 418 deals announced over the same time period in 2017. With the continuance of retroactive announcements, it appears as if 2018 has the potential to out-pace 2017’s 557 total deals.
Private equity backed independent agency/brokers remain the most active buyers in the marketplace, with AssuredPartners, Inc., announcing 28 deals YTD and BroadStreet Partners, Inc. and Acrisure, LLC each announcing 26 deals through September.
Several large transactions hit the headlines in September, with Marsh & McLennan Companies, Inc. (“MMC”) (NYSE: MMC) set to acquire Jardine Lloyd Thompson Group Plc (“JLT”) (NYSE: JLT) and American International Group (“AIG”) (NYSE: AIG) agreeing to acquire Glatfelter Insurance Group (“Glatfelter”). Although public brokers have remained quiet within the market place, only accounting for 9% of total announced transactions YTD, it seems that when they do announce a transaction it is certain to make noise. MMC has received board approval for its acquisition of JLT, which was ranked 16th on the 2018 100 largest brokers of U.S. business list, ranked by 2017 brokerage revenue generated by U.S.-based clients. The JLT transaction is anticipated to close in the spring of 2019. Glatfelter is one of the largest specialty program and insurance brokers in the U.S., headquartered in York, Pennsylvania. The Glatfelter transaction is expected to close later in 2018.
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. Please feel free to send any announcements to M&A@MarshBerry.com.
Source: S&P Global Market Intelligence; publicly available sources; and MarshBerry Opinion & Experience
Securities offered through MarshBerry Capital, Inc., Member FINRA and SIPC.