By Steven M. Weiss and Emily K. Watson
With hundreds of deals reported each year during the last 15+ years, the insurance distribution market has been one of the more consistent M&A sectors pre-pandemic with new buyers entering the market each year. The reason for the run-up is clear: private equity loves low capex, recurring revenues, and high retention rates on a product that, in simple terms, is non-discretionary. Even though some buyers have temporarily hit the pause button on M&A activity, Levenfeld Pearlstein remains bullish on the sector as a number of the buyers whose corporate ethos is rooted in M&A have drawn on massive credit facilities to continue to support acquisition opportunities during the current environment.
Levenfeld Pearlstein partners Steven M. Weiss and Emily K. Watson interviewed a number of the most active investment bankers and buyers in the insurance distribution space to get a better sense of what the insurance distribution M&A market looks like in the current environment.
The investment bankers and the buyers were asked the same four simple questions. Today we are sharing the responses from the investment bankers, and within the next few days, we will share the responses from the buyers. Rather than provide an interpretive narrative of the interviews, we have conveyed the responses in their own words, edited for clarity.
What are the biggest challenges of completing the purchase and sale of an agency in the current environment?
- Phil Trem, MarshBerry: "Buyers are trying to be good partners (mostly). They are struggling with the potential black hole that the pandemic could create as it relates to future revenue streams. So historically, a buyer would examine the last twelve months of revenue to gauge the profitability of a company. Today, they are trying to estimate the next twelve months to understand the overall risk profile of a seller. The diligence process has become much more stringent since COVID-19 began. An inability to meet face-to-face with senior management has proven to be a challenge, as well."
- Brian McNeely, Reagan Consulting: "Two new challenges have arisen from COVID-19. First, the inability to connect face-to-face. Insurance brokerage is a relationship business, and the ultimate success of a transaction often depends on the chemistry between the buyer and the seller, which is primarily determined via in-person meetings and social interaction. The COVID-19 restrictions hinder this important component. Second, the due diligence process has intensified and become more granular with an attention to industry exposures and COVID-19 impacts. There is also additional focus on forecasting the agency's overall performance for the next two years. This includes revenue forecasts by line, contingent projections, and potential expense mitigation opportunities."
- Michael Fletcher, Sica Fletcher: "When the pandemic started, I expected there was a distinct possibility of deals coming to a complete halt, but as of today and at least for us, it has been business as usual. Prior to the pandemic, there was already too much capital chasing too few deals. Any buyers that were scared off by the pandemic were quickly replaced by buyers that saw this as an opportunity to finally win a deal regardless of the pandemic. Obviously, in-person meetings have come to a halt, but Zoom and general teleconference calls have seemed to work just fine. If you step back and look at the bigger picture, insurance is a GDP-trailing business. If GDP is looking strong, then so will insurance, unlike other cyclical businesses such as travel, restaurants, etc. With the government printing over $3 trillion, it shores up GDP and insurance. With such government support, the risk of investing in insurance distribution, even during a pandemic, is greatly mitigated."
- Michael Mensch, Agency Brokerage Consultants: "For some areas of the country, the immediate challenge is the inability to meet in person. Most banks were also inundated with PPP loan applications and requests for loan payment deferments over the last three months, which drastically reduced their ability to focus on any other loans. We just had one deal go sideways and are having to go back to market as a result of the bank being unable to close the deal."
- Justin Jeangerard, Cross Keys Capital: "Agencies face two key challenges in today's M&A market. The first focuses on the availability of credit. Banks and other alternative providers of debt capital continue to reduce, in a significant manner, both their willingness and the amount allocated to M&A transactions. Investment bankers and agency owners need to verify the preferred buyer possesses an acquisition line of credit, which contains enough borrowing capacity to complete the acquisition. Alternatively, the buyer must commit to funding the transaction with all equity if using debt is not an option. This should not be an issue on smaller transactions. The second and more obvious challenge facing agencies relates to declining revenues. Agency owners should anticipate a downward purchase price adjustment should revenue decrease greater than 5%. In this COVID environment, some buyers will offset the purchase price decrease by increasing the earnout amount or by creating a separate earnout for lost clients (and the eventual recapture of those clients)."
- Michael Yardley, Dowling Hales: "The biggest challenge is now diligence. Before COVID, diligence "light" was the order of the day. Today, diligence is very thorough and exhaustive."
- Kieran Pinney, Tag Financial Institutions Group: "We have seen three major challenges with regards to completing insurance brokerage M&A transactions in the current environment, all of which are related to COVID consequences. The first would apply to larger transactions which were in early stages when the initial COVID quarantining began. The inability for deal participants to travel made it hard to move transactions forward at the typical pace. The use of Zoom, and other video conferencing software, has helped keep some momentum; however, these programs cannot fully substitute a face to face meeting. While some smaller transactions have been completed with no in-person meetings, this has not been the common case for transactions with values in excess of $10 million. The second challenge is related to sellers' declining revenues during the months of March, April, and May. We have seen several transactions be put on hold due to a steep decline in a seller's revenue during these months. Many of the agencies had a concentration of accounts in the hospitality and entertainment sectors. The expectation is that buyers would like to see the revenues begin to rebound before completing the transaction. The third challenge relates to the credit markets and buyers' ability to borrow capital. With the onset of the COVID pandemic, many of the industry's direct lenders tightened their lending requirements, or in many cases, halted all new lending. This meant if buyers did not have committed facilities in place, they had a tough time raising debt to complete acquisitions. For those buyers who have committed facilities available, the trend we have seen is buyers being more selective with the deals they pursue, and complete, as the debt available is likely to be limited until the current environment changes."
If you were pitching a potential agency seller, what would you say are the reasons why now is actually a good time to transact?
- Michael Yardley, Dowling Hales: "We continue to generate pre-COVID valuations for quality assets from a wide variety of buyers. I would say reasons to sell are (1) valuation, (2) optionality, and (3) potential for an increase in cap gains taxes on the horizon."
- Kieran Pinney, Tag Financial Institutions Group: "Many agencies, particularly smaller ones, can really benefit from the added resources that buyer partners can bring to the table. These resources will allow agencies to be more competitive during these difficult times and position themselves well for growth when commerce begins to move back to normalcy. Additionally, while we have seen a slight adjustment to how transactions are structured (mainly a portion of what would traditionally be up-front consideration being shifted to a 6 or 12 month true-up) the overall valuation multiples still remain extremely high."
- Justin Jeangerard, Cross Keys Capital: "Today, institutional investors hold available capital in excess of $2 trillion. The unused funds must be invested within a set timeline, usually ten years from the originating date of the fund. Should capital not be deployed, it must be returned to the investors under the private equity fund's charter. Earning zero return on investable capital is arguably the worst possible outcome for any private equity group. However, it does create a sense of urgency for the fund to deploy capital, thus avoiding the downside of failing to deploy the capital raised for investment purposes. Currently, dozens of private equity-backed agency rollups continue to compete with each other on a deal by deal basis. Over the last decade, private equity-backed rollups proved they can achieve exceptional returns, despite paying high single-digit / low double-digit EBITDA multiples. Assuming interest rates stay subdued (plenty of cushion today), sellers should achieve similar EBITDA multiples as experienced in 2019 due to the growing amount of private equity investment in the insurance agency space."
- Michael Mensch, Agency Brokerage Consultants: "Between the pandemic, civil unrest, and an upcoming, contentious presidential election, we're in the midst of a very tumultuous period. Some agencies will be impacted more significantly than others, so the questions principals need to ask themselves are (1) "Do I think the agency will be performing better or worse over the next few years?" and (2) "Do I have the ability and motivation to rebuild if the business declines?". If the principal expects the business to shrink materially and they lack the motivation to rebuild, then they should give serious consideration to selling. For some, the loss in equity over the coming years will outpace the earnings received from the business. Luckily, we are not seeing a decrease in market multiples yet because the capital markets are very robust. That will quickly change if individuals and/or companies start defaulting on debt in large numbers, though. Debt will become more expensive and harder to secure, which will drive down multiples as we saw in 2008. I will add that banks have started pulling back on their leverage in deals, which means either the buyer has to put more cash into the transaction or the seller has to hold a larger percentage of the price as a note or under an earnout."
- Michael Fletcher, Sica Fletcher: "If you are contemplating the sale of your agency, now is a good time to transact because, as I mentioned above, there is too much capital chasing too few assets, which in our market leads to favorable outcomes for a seller. By our count, there are now 25 private equity-backed and five public brokerages who want to make acquisitions. This creates a ton of strong demand and additional incentive for a seller to find not only the best economics but the best fit as well. Prior to the pandemic, our biggest concern was that we were at the top of a business cycle and expected some form of downturn ahead. As of today, we think the only thing that could change the market over the next 12 months would be some form of a second wave of the virus that is worse than the first. Outside of that, we remain bullish."
- Brian McNeely, Reagan Consulting: "We ask every seller that we represent what their primary reason for considering a partnership is. Even with pricing at an all-time high, money is rarely the answer. The primary reason is often the need for more tools and resources to remain competitive in the market. COVID-19 has not changed that dynamic. If anything, it has exacerbated the need for tools and resources. Additionally, presidential election years generate uncertainty about future taxes and regulations. Increased tax rates and revisiting universal healthcare are a few topics that would have direct impacts on agents and brokers."
- Phil Trem, MarshBerry: "Ultimately, an insurance brokerage needs to determine what they want with their future. Some firms are digging in, reinvesting, and doubling down. Others are taking advantage of strong valuations, a favorable tax environment (compared to historic norms), and partnering with a firm that provides them tools and resources to be more competitive. Valuations are still high teetering near all-time highs, and there continues to be very strong demand. There are also concerns by some potential sellers that capital gains tax rates could increase in the coming year/s as a result of all the stimulus being pumped into the economy. Some specialty brokers are also faced with ever-increasing technology costs related to enhanced underwriting, requiring a strategic partner with a strong balance sheet."
What are the key attributes of a target agency that make it most attractive to a buyer in the current environment?
- Kieran Pinney, Tag Financial Institutions Group: "While I think the general answer to this question is that it will vary from buyer to buyer, we have seen the following attributes rank highly amongst most agency buyers in this environment: (1) strong historical annual growth (higher the better), (2) younger owners and management/producers (key being that the seller would be staying on and continuing to help build the agency rather than selling as a retirement or perpetuation strategy), (3) core geography (buyers seem more eager to pursue transactions which are in, or nearby, their current geographical footprint rather than pursue opportunities in new markets), (4) limited concentration in sectors highly impacted by COVID (e.g., restaurants, bars, entertainment, hospitality, etc.) and (5) opportunity for economies of scale/efficiencies (i.e., tuck-ins which can provide a lift in margin once fully integrated seem to be highly attractive in this market)."
- Michael Fletcher, Sica Fletcher: "I mentioned above, there are 30 acquisitive firms all backed by institutional capital. Each of the firms has its own view about what makes up an attractive asset. As a result, as I like to say, "every ass has its seat." So the key attributes that one buyer finds attractive are, in many cases, very different and, in some cases, the opposite of what another buyer might find attractive."
- Brian McNeely, Reagan Consulting: "I do not think target agency key attributes have changed. Buyers still look for partners that are growing organically, are profitable, and have strong leadership teams. Yet, buyers are evaluating industry exposures more closely as they could impact future growth."
- Phil Trem, MarshBerry: "It sounds basic, but growth remains the key. A firm that has a strong sales culture and focuses on metrics and accountability is very attractive. Especially in a down market – firms who write enough new business to grow in and out of down economic cycles are very valuable. Buyers, in most cases, are not just aggregating revenue. They are trying to acquire talent, resources, leadership, etc. Firms that continually invest in their colleagues and community tend to rise above the rest."
- Michael Yardley, Dowling Hales: "Agencies that are growing and niche are highly attractive. Agencies that fill a geographic hole or have strong (youthful) management talent also seem to be attracting top valuations. Certainly, larger firms (defined as those with revenue in excess of $15,000,000) generate a lot of interest as well."
- Justin Jeangerard, Cross Keys Capital: "Buyers will certainly focus more attention on an agency's customer base and how that customer base segments by industry. For instance, niche-focused agencies, in segments such as tourism, hospitality, or aerospace, may face challenging times over the next 24 months. Other than increasing awareness of an agency's customer segmentation, acquirors will continue to target agencies which will improve the buyer's business model in areas such as (1) expertise across verticals, (2) geographic footprint and (3) cross-selling abilities. In addition, buyers favor younger management teams as the entire industry continues to struggle with an aging workforce."
- Michael Mensch, Agency Brokerage Consultants: "The factors that drive value in the eyes of buyers have not changed. What has changed is the level of scrutiny in vetting deals. Buyers are being more cautious of lines of business and regions of the country that may be impacted from the pandemic. In those cases, deals are getting structured with larger earnouts, or buyers are passing on the opportunities altogether."
What are the key considerations in integrating an agency post-acquisition in the current environment?
- Michael Mensch, Agency Brokerage Consultants: "Over the last few months, we had to run virtual meetings between buyers and the staff of the agencies they were acquiring. The M&A teams for most buyers that we're talking to are getting back to traveling to meetings now, though. There will be more bumps in the road than normal due to social distancing and staff working remotely or being temporarily furloughed, but these are operational adjustments that buyers are already working through with their existing employees."
- Kieran Pinney, Tag Financial Institutions Group: "We have not seen any significant change in integration in this environment versus the immediate pre-pandemic time period. We tend to see three primary types of acquires with regards to integration post-closing: (1) Fully Integrated Model, (2) Partially Integrated Model (primarily accounting, carrier relationships, HR, IT, etc.) and (3) Limited or A La Carte Model (i.e., shared carrier relationships and consolidated financial accounting but local accounting, HR, IT and other types of service remain managed by the individual location unless the seller chooses to handoff the responsibility). From transactions actively in discussions, or for transactions that have closed in the last few months, we have seen sellers who are more interested in integration shed some management responsibilities, and leverage reduced overhead. Many agency owners, particularly commercial P&C and benefits-focused operations, seem to be having great results from staff working from home. This may lead to more staff permanently working remotely and therefore reducing occupancy expenses on agencies' P&L going forward. This will likely lead to more immediate integration for agency acquisitions."
- Brian McNeely, Reagan Consulting: "The primary integration issue is how quickly the seller needs to access the tools and resources of the buyer. If the seller is largely self-sufficient, the integration challenges presented by COVID-19 are less. However, if the seller needs immediate access, the restrictions on travel could create delays in closing until the buyer can travel and operate more fully."
- Justin Jeangerard, Cross Keys Capital: "COVID-19 provided agency owners the opportunity to assess, in real-time, current infrastructure needs and whether the agency is compatible with today's technologically advanced environment. Paperless agencies possessing documented, standard operating procedures and a clear chain of command (whether centralized or decentralized) are better able to overcome COVID-19 hurdles more effectively. Therefore, they are better acquisition targets in the current environment."
- Phil Trem, MarshBerry: "Initially, a number of transactions were delayed because everyone was moving to a remote environment in mid-March. No one was prepared to onboard and integrate new colleagues in a completely remote environment. It took a little time for firms to work through the nuances. From technology enablement to communication best practices, the industry is learning how to be a bit more efficient while closing a transaction. Ultimately, people are what matter most. Insurance brokerage is a very relationship-driven industry, and the people involved in each firm will dictate whether a deal is successful. Ensuring that new colleagues find out about their new employer/partner in a productive way and that they don't skip a beat as it relates to servicing their clients are the most important items that buyers are focused on given the current pandemic."
About the Authors: Levenfeld Pearlstein is a leading law firm for buyers and sellers of insurance agencies. Partners Steven M. Weiss and Emily K. Watson lead teams of M&A, tax, employment, employee benefits, and real estate leasing lawyers that have closed on the purchase and sale of more than 150 insurance agencies.