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Insurance Broker M&A
Opportunities Amid Complexity
Executive Summary
In 2022, most pundits, including Sica | Fletcher, forecasted 2023 to be a dreadful year for insurance brokerage M&A. The industry is dominated by private equity, which uses lots of leverage to drive investment returns, and there was an expectation that rising interest rates and higher financing costs would taper deal activity. However, most of us turned out to be wrong. While transaction volume in 2023 declined slightly, valuations remained elevated as the same inflation caused rising rates and a sharp rise in insurance premiums due to the proliferation of buyers, helping offset some of the financing costs. Strong revenues have also led to increasing demand from more buyers.
These trends have continued into 2024, and while M&A activity remains strong, the growing number of buyers and deal structures have made the market increasingly complex. For example, deal volume by investor rotates, cash consideration as a percentage of deal value varies, and more complex capital structures exist.
However, this complexity offers opportunities for both buyers and sellers. Buyers can find value by focusing on smaller agencies without a strategic advisor. Sellers can maximize the price and find optimal buyers by running a competitive process.
The Changing Role of Private Equity in Insurance Distribution
Private equity traditionally did not play a significant role in insurance brokerage M&A until around 2007. Historically, private equity only accounted for about 10% of all insurance broker transactions, with the buy-side being dominated by public insurance brokers and banks, including Bank of America, Wells Fargo (Acordia), and Wachovia.
Before 2007, private equity relied primarily on leveraged buyout models to conduct transactions, using acquired assets as collateral and borrowed money to support deals. In a leveraged buyout model (LBO), the buyer contributes a portion of the purchase price with their equity and then borrows the rest from lenders, with the capital secured by the acquired company's assets. The problem with this model was insurance brokers typically had few substantial assets to use as capital, leaving deals few and far between.
New Opportunities in Private Equity
In 2007, the situation changed when two large private equity funds, Goldman Sachs Capital and Apax Partners, convinced lenders that an insurance broker's cash flows were solid collateral against which to lend. They pinned this on the idea of predictable cash flows, as insurance brokerage was a high margin business, where 90% of the business renewed annually.
Under this model, Goldman took publicly-traded USI (NASDAQ:USIH) private in an LBO worth $1.4 billion. A few months later, Apax Partners took publicly traded HUB (NYSE:HBG) private in a $1.8 billion LBO. The Goldman and Apax deals were especially notable because they paid a premium price at the top of the 2007 stock market, just ahead of the biggest financial crisis since the Great Depression. Even against these headwinds, the deals still generated impressive returns, at a reported 2.5x for Goldman Sachs and 3.5x for HUB.
In January 2008, Genstar Capital teamed up with well-known insurance executive John Addeo to invest approximately $60 million into a new firm called Confie Seguros. Genstar sold Confie to ABRY partners in 2012 for around $600 million. After paying lenders, Genstar reportedly netted $360 million from the $60 million investment. This eventually inspired other deals (Figure 1) and was a game-changer, demonstrating to private equity companies that they could earn solid and predictable returns. As a result, private equity net interest in the insurance brokerage M&A grew notably, from 10% of deals in 2007 to more than 74% in 2023
Methodology
Sica | Fletcher closes 100+ client deals annually and has one of the most robust data sets in the industry on insurance brokerage M&A.
With 8-10 bids for each sell-side assignment, Sica | Fletcher has amassed thousands of data points on the sell side, including revenue multiples, EBITDA multiples, profitability data, auction vs. non-auction, and offer spreads.
Valuations and Multiples
Agency deal valuations are based on a multiple of proforma EBITDA. Our data considers several valuation metrics from Q1 2019 to Q2 2024:
Multiple of EBITDA
Represents the guaranteed at-close purchase price paid, not including earnouts, holdbacks, stock appreciation, or other bells and whistles a buyer offers. Given the variability in other purchase price components, we believe this is the only real way to compare transactions.
“Multiple of What"
Represents how multiples are calculated, as we believe this is more important than the face value of the multiple. For example, two identical agencies may sell for the same multiple but have vastly different purchase prices based on the pro-forma EBITDA.
The Inverse of a Multiple
Represents the buyer's expected rate of return, which is the inverse of the multiple. For example, a Multiple of 10x can be described as 1/10, which equals a 10% expected return.
Rising Interest Rates
Interest rates play a critical role in returns. The Secured Overnight Financing Rate (SOFR) is a benchmark interest rate that replaced LIBOR (London Interbank Offered Rate), previously used as a benchmark for short-term interest rates. The average insurance broker borrowing rate is based on a premium paid above SOFR or, for our estimate, SOFR +450 basis points.
The Spread
The difference between the borrowing rate and the expected return has changed dramatically in the past few years. For example, in Q1 2019, a buyer paying 8.5x EBITDA could expect an 11.7% forward return. At the same time, they were borrowing at 6.9%, leaving a spread of 4.8%, very attractive returns. However, by Q1 2020, the onset of the pandemic caused valuations to pull back, and interest rates dropped, creating a spread of 6.9%.
However, borrowing costs rose notably as the Fed began to raise rates in Q2 2022, and the spread was gone by the end of the year. At the time, most pundits, including Sica | Fletcher, expected that 2023 would be a terrible year for insurance brokerage M&A as interest rates would have to decline or multiples would have to drop to get the spread back.
Higher rates made companies more selective in how they used their cash. At the time, some were also restructuring their debt and needed to preserve cash and be more thoughtful. While some companies stepped back, others stepped in, changing the landscape in the process.
A Look Back at 2023
Due to rising interest rates and an overall increase in the cost of capital for acquirers, there were many questions about the insurance brokerage M&A market heading into 2023. Expectations were that deal volume and transaction values would decrease substantially and lead to a bad year for the market.
Decreasing Deal Volume
Compared to previous years, deal volume decreased in 2023 to 857 transactions, down from 1,043 transactions in 2022 and 1,204 transactions in 2021. As the cost of capital increased, this aligned with expectations
Much like the overall market, Sica | Fletcher's volume also decreased in consecutive years, from a high of 163 transactions in 2021 to 109 transactions in 2022 and 101 transactions in 2023. 2021 was an anomaly due to fears of increased capital gains tax, which never materialized. The Sica | Fletcher Index, which tracks the activities of 22 of the most acquisitive buyers in the space and represents 70% of the overall market, saw transactions decline from 811 in 2021 to 704 in 2022 and 566 in 2023.
Interestingly, despite a 20% decrease in overall deal volume from 2022 to 2023, the acquired revenue of SF Index Members decreased by only 9%, meaning deals done in 2023 were more prominent on average in terms of revenue compared to deals completed in 2022.
Increasing Transaction Valuations
While the expectation was that valuations would decrease, data shows that EBITDA multiples increased in 2023. Raw deal data of >$1 million EBITDA transactions that Sica | Fletcher advised on shows an 8% multiple expansion between 2022 and 2023. Over the past four years, multiples have expanded yearly from a low in 2020 at 9.5x EBITDA to a high in 2023 at 11.6x EBITDA, a 22% increase.
The difference was even more dramatic when comparing deals with advisors versus no advisors. On average, deals with an advisor traded approximately at a multiple that was 1.8 times higher than those without.
The Negative Spread
Investors using financing naturally expect a higher return than their debt financing rate. However, when comparing the 90-day Secured Overnight Financing Rate (SOFR) and the anticipated debt costs for a well-capitalized buyer at SOFR + 450 basis points, the expected return has fallen from the largest spread ever (6.96%) in Q3 2020 to negative territory. This was the first time the spread had fallen negative.
What is Driving Resilient Valuations?
Based on our analysis and conversations with buyers in the industry, we believe there are three main drivers of the higher-than-expected deal pricing in 2023, which have contributed to the resiliency: a proliferation of buyers driven by PE interest in the sector; insurance revenues have grown nearly 10% annually for the past three years ; and, multiple arbitrage.
There is a proliferation of buyers driven by PE interest in the sector. Since the deals in 2007 attracted more private equity, the number of buyers in the space grew from five to more than 50 by the end of 2023. Even in the face of the rising cost of capital, competition has grown significantly, and Sica | Fletcher regularly sees eight to ten offers for sellers it represents. Many financial services firms either want to acquire a platform in insurance brokerage or are actively seeking to grow one they own. Additionally, PE-backed brokers have a substantial amount of dry powder to deploy for M&A, keeping EBITDA multiples at historic levels.
While inflation has run rampant, insurance revenues have grown nearly 10% annually for the past three years. This offers investors the protection of built-in revenue growth through rate increases, lowering the risk of investment and further solidifying the resilience of this industry.
Another issue is multiple arbitrage, where buyers trade at higher multiples than the agencies they acquire. For example, if a particular buyer is valued at 15x EBITDA and acquires a $1 million EBITDA agency for 10x EBITDA, or $10 million, the buyer's overall enterprise value increases by $15 million. Subtracting the $10 million spent in cash, debt, and stock for the purchase price shows a net increase in enterprise value of $5 million.
The Changing Landscape
In addition to high multiples, other elements add complexity to the market. The growth in private equity-sponsored buyers and the rapid rise of interest rates have changed the characteristics of buyers. PE-sponsored brokerages are increasingly differentiated by their transaction structures, capital structures, and buyer rotation. This has added several layers of complexity to the M&A market: buyers are using a higher percentage of stock; more buyer rotation; and, evolving capital structures.
Buyers are Using a Higher Percentage of Stock
Acquisitions are typically comprised of a combination of cash and buyer stock.
Historically, buyers mainly paid in cash, with between 15% and 25% paid in equity. However, rising rates and debt costs have led buyers to use more equity as part of the closing payment, now between 20% and 40% of the upfront purchase.
This isn't necessarily a negative development, as equity has historically appreciated faster than any other investment. However, with more than 50 PR-sponsored brokerages, equity performance can vary on a company-by-company basis.
More Buyer Rotation
The market has also experienced an increase in buyer rotation with some becoming more active while others become less active. An analysis of the Sica | Fletcher index by number of transactions closed in 2022 and 2023 notes that some companies have increased acquisitions while others have held back (Figure 15). This has made it more challenging for sellers to maintain a feel of the market to capture the right players for their clients.
Evolving Capital Structures
In the past, most PE-sponsored brokerages used an uncomplicated capital structure with one class of debt and one class of equity. However, the high cost of capital led many to use more differentiated structures with multiple layers of capital with different risks and rewards. This has made it more difficult for potential sellers to understand, especially those without a strategic advisor.
Those selling a company should understand several issues, especially where their stock lands on the cap table. As a seller is changing their company's equity for the buyer's equity, the cap table determines who is entitled to the proceeds of a sale of the company and in what order.
Classic vs. Advanced Capital Structure
In the classic capital structure, two parties are entitled to the proceeds of the sale: the senior lender and the common equity holders. The senior lender comes first and gets the principal of the debt and accrued interest before any payment to the common equity holders. The ordinary equity holders, including the PE investor, senior management, and the selling business partners, are all an equal class and get all the remaining sale proceeds.
However, the advanced capital structure frequently used today is more complex, with multiple layers of debt and equity. This structure has several parties with claims to the proceeds of the sale of the business with a waterfall of priorities of cash distributions.
Senior Debt is the priority, and principal and accrued interest are repaid before any other party has claims to sale proceeds. A tranche of mezzanine debt is subordinated to the senior debt but senior to all classes of equity. It typically has a higher interest rate than senior debt and can come with options or warrants to purchase a class of equity.
Preferred Stock can also include one or more classes. One may be from an outside investor with a higher coupon, while another could be a management team who sold their companies. While the preferred stock may pay dividends in cash, it more typically pays in "payment in kind" dividends, which can accrue and are paid in additional amounts of preferred stock and are paid at the sale. The holders of other classes of securities might have options or warrants to acquire common stock, and multiple classes of securities have claims to the sale proceeds before the common stock receives a penny.
* Sica | Fletcher is not making a value judgment between the classic or advanced capital structures. Both offer different levels of risk and reward and may be superior under various scenarios.
Challenges and Opportunities for Buyers
The two notable challenges for buyers are that valuations are at all-time highs and that there is more competition for available agencies. However, these challenges also present new opportunities.
One opportunity is to buy smaller agencies. Sica | Fletcher's data shows brokerages with more than $1 million of EBITDA sell at an average EBITDA multiple 22% higher than agencies with less than $1 million of EBITDA. Consequently, an acquirer can pay a lower EBITDA multiple by acquiring a few smaller agencies instead of one larger one.
Buyers can also find opportunities in agencies without a strategic advisor. Data indicates that agencies with less than $1 million EBITDA sell at a discount of approximately 20% to agencies of the same size with a strategic advisor. Even regardless of size, agencies without a strategic advisor often sell at a substantial discount. One reason is that the buyer can control the timing and process with less competition than a competitive advisor-led process. Additionally, without an expert representing the seller, the buyer can control the calculation of the Pro-Forma EBITDA, which ultimately controls the valuation.
Challenges and Opportunities for Sellers
Sellers face many challenges, including more buyers, complex capital structures, and complex transaction structures. Additionally, there are more differentiated buyers. However, sellers can also find opportunities in today's market by focusing on other criteria components of value in addition to multiples of EBITDA.
One way is to focus on broker characteristics such as type of business, size, growth parameters, and management quality. As buyers seek agencies' sustainable growth potential, management teams can play a prominent role in driving growth post-transaction.
Additionally, sellers can focus on calculating the purchase price using two variables: EBITDA Multiple x Pro Forma EBITDA. Focusing only on the EBITDA multiple often underprices the agency because the Pro Forma EBITDA is miscalculated or left to the prospective buyer to calculate. Pro Forma EBITDA is the last 12 months of actual financials adjusted for several items; however, figuring this is part art, part science. While sellers often think they can do this by themselves or with an accountant, they rarely understand the complexity of the calculations and put themselves at an enormous competitive disadvantage. Savvy buyers will use the calculation as a weapon to push down purchase prices.
The calculation of Pro-Forma EBITDA can enormously impact the purchase price (Figure 18). While broker A and broker B are the same size and sell for the same multiple, broker B sells at twice the value of broker A because its Pro Forma EBITDA is twice as large.
Now is the opportunity for sellers to maximize the purchase price while increasing the odds of choosing the ideal partner. Sellers can also find greater opportunities by hiring an advisor and running a competitive process. Doing so enables the seller to control the calculation of the pro-forma EBITDA, the timing, and due diligence. Creating a sense of pressure encourages buyers to offer more for the agency. It also enables the seller to make a more informed decision by speaking to buyers of all sizes and types with different personalities.
The 2024 Market and Beyond
So far, the insurance broker M&A market in 2024 remains robust. Sica | Fletcher has advised on 33 sell-side and 14 buy-side transactions, and deal volumes and valuations are roughly the same as in 2023. At the end of Q2, the leverage spread remained negative, with the cost of debt capital exceeding future expected investment returns.
Despite the negative spread, we are more bullish now than at the end of 2022. Interest rates aren't expected to rise and are likely to be cut. Even with high rates, demand for M&A will remain high due to the number of buyers. In this environment, insurance broker investments will remain an attractive asset class. Hotter inflation will push premiums and commissions up even further, and falling interest rates should eliminate the negative leverage spread. Additionally, there are 50 institutions whose managers face career risk if they don't deploy capital.
As a result, we expect the market to remain strong for the remainder of 2024 and early into 2025.
About Sica | Fletcher
Sica | Flecther is well known as the leading strategic and financial advisory firm in the U.S. that specializes in the insurance brokerage space and related industries that complement it. We are also the leading advisor to the private equity firms that are most interested in investing in insurance brokerages and and the private equity-sponsored agencies that have been created in recent years. The firm was founded in 2014 by Michael Fletcher and Al Sica, two of the industry's leading insurance M&A advisors who have closed over $16 billion in insurance agency and brokerage transactions since 2014. Sica | Fletcher has been ranked by S&P Global as the #1 insurance M&A advisory firm since 2017 in terms of total deals advised.