Private Equity:
An Emerging Competitor for Insurance Distributors
John M. Welper and Patrick T. Linnert

Patrick T. Linnert is an Executive Vice President and John M. Wepler is President of Marsh, Berry & Co., Inc., a Willoughby, Ohio based management consulting and investment banking firm for public and private insurance distributors.






Website: www.MarshBerry.com

The competitive landscape is changing. Private equity capital has silently permeated the insurance distribution space over the last ten years, facilitating the creation of public brokers and backing several of the nation’s largest private brokers. Recently, the silence has turned into a roar with over $3.2 billion in announced transaction value is only the beginning. In addition to USI and HUB, to private equity within the next eighteen months as capital aimed at the insurance distribution system is deployed. The strategy of private equity investors revolves around: 1) building a broker capable of sustainable organic growth in an industry where few can and where the public brokers are dependent upon acquired growth; and 2) investing in a public broker or private broker that has the capability to years through debt leverage and a subsequent IPO or divestiture. They have the capital, time and discipline to make it happen. Organic growth is no longer a choice.

The soft market in not going away. During 2006, the financial performance of the P&C carriers was one of the best of the past century. The combined ratio was approximately 93%, which had not been pressure to drive returns that mirror The Fortune in twenty years (around 14%).

Net income for the P&C industry set a record at $60 billion during 2006 while surplus remains at an all time high approaching $500 billion. Such financial strength was no doubt accelerated by minimal insured catastrophic losses, falling from $62 billion in 2005 to just $8 billion in 2006.

Analysts project net written premium growth between 1.5% and 4.0% during 2007, including a boost from higher premium rates in areas with catastrophic exposure. Rates for most lines due to the low cat losses, the strength of carrier balance sheets and record underwriting profitability on core business should allow P&C carriers to sustain solid performance going forward. Despite low premium growth in the coming years, most analysts range. Such performance will come, in part, at the expense of insurance agencies that lack the ability to drive predictable growth in premium.

In prior soft cycles, carriers handed out new appointments in droves. This soft market is different as many carriers have tiered their agency plant (or are planning to). In response to Wall Street pressure, carriers are desperate to find a way to increase market share through rate reductions while maintaining profitability and in turn, high return on equity ratios.To find the solution, P&C carriers have looked inward and many have identified two main obstacles.

1. The bottom tier of a carrier’s insurance distribution base is characterized by uncommitted agencies or brokers that have no organic growth plan, low premium volume, and heavy underwriting losses.
2. Many carriers have an agency distribution plant that is too large. The average volume of premium per appointment is small and as a result, most carriers are allocating too much time and capital toward the bottom agencies. The associated labor intensity contributes to inflated operating expenses and in turn drains operating earnings.

In response, many regional carriers are looking at the 80/20 rule with respect to their agency distribution force. By eliminating the bottom 20% or even the bottom 40% of agency appointments, operating expenses will decline and underwriting profitability will improve. For many carriers, this strategy will create a reservoir of additional profitability to support further rate reductions while maintaining or even enhancing return on equity results.

The key to the long-term sustainability of earnings in an agency or broker is an operating model that is customer focused, supported by organic growth and complemented by acquired growth. Most of the public brokers, however, are in a bind. While the necessity of designing, implementing and managing an organic growth engine is obvious, the market makes it difficult for public brokers to take any type of short-term expense hit to invest in a long-term sustainable organic growth platform. A short-term reduction in profit margin in today’s market basically translates to a hit to market cap.

Few public broker CEO’s, if any, are willing to be a digit organic growth. However, if one or more brokers miss earnings targets, the market may shift platforms versus consolidation platforms.

The Organic Growth Movement

The P/E multiple (and market cap) of a publicly traded insurance broker correlates directly to profitability. Top line organic growth, however, has much less of an impact on public valuations. So, a public broker’s hands are tied with regards to reinvesting in long-term organic growth. Agencies that sell to brokers generally have a meaningful EBITDA based earn out structure and are in turn rewarded handsomely for ceasing reinvestment to drive short term profitability and earn out proceeds. The result of the above is sub-par organic growth within most of the public broker ranks. The by-product of the paradigm that directly rewards short-term earnings and margin expansion is pushing public brokers to become more and more consolidation focused, which we believe may be at the expense of the needs of insureds.

Public broker investment in value-added services, reinvestment in producers, professional field dedicated account management assistance, specialty units, service timelines, stewardship reporting and risk mitigation programs are potentially at risk in this cycle. In the past, the cash flow to reinvest in the above areas was derived from producer renewal compensation as low as 20%. Now some public brokers are taking broker renewal rates to the teens to balance margin and the cost of a customer-focused platform. Nobody knows where additional future increases in margin will come. In our opinion, compensation cannot be reduced further and it is only a matter of time before access to resources becomes the next expense cut.

The air is getting thin as buyer trading multiples have declined to almost match purchase multiples. After factoring in the reduction in earnings that results from the amortization of a purchase under GAAP accounting, margin expansion and earnings growth must occur post closing in most cases to make the deal accretive to EPS. It is a brutal cycle that is headed in the wrong direction. The public market obsession with tomorrow's margin has eclipsed longer term rational strategies to build a sustainable organic growth engine — an obsession not necessarily shared by private distributors.

Given the endless buy-side demand and the limited number of sellers, coupled with the necessity to close deals to drive value, acquisition pricing is at an all time high and competition for deals is fierce.

In the first two months of 2007, public brokers have already closed deals equating to over $100 million in annualized revenue, compared to approximately $340 million in total for 2005 and $312 million total for 2006. Additionally, the market experienced a short-term pause in deal activity in 2005 and 2006 as banks focused on integration issues and the number of high-quality agencies willing to sell dwindled. Throughout 2007, supply and demand will find equilibrium as more agencies seek a quantifiable exit strategy while buyers seek growth. This will result in a push relative to the number of deals consummated.

For high-growth agencies and brokers, the challenge faced by the public brokers presents an opportunity, not a threat. By virtue of private ownership, many leading organic growth organizations will continue to accept a more moderate margin today while investing in a business engine that can produce sustainable growth and profitability — an investment that is full of resources that many of the largest brokers talk about, but will find increasingly difficult to afford to deliver. The time is now to take away larger accounts with a comprehensive risk mitigation platform that is enforced by compliance accountability to prove to the insureds that you are the polar opposite of over promising and under delivering.

However, with every opportunity comes a threat. Just when you thought it was going to become easier to compete with the publics, your worst nightmare has hit the big screen - private equity. Private equity is anything but new. For years, the landscape has been filled with private equity capital backing such brokers as American Wholesale Insurance (2002), Summit Global (2000), Alliant (1999), Hobbs (1999), Willis (1998), Acordia (1997), etc. But the momentum has shifted into overdrive. Consider HUB, USI, BenefitMall, Arrowhead, Sedgwick CMS, Crump, Swett and Crawford, Stewart Smith, Beecher-Carlson, Genatt, Tanenbaum Harbor, Integro and Lockton. And the pace will only accelerate.

In general, fund-raising by financial sponsors in the private capital market has grown to over $130 billion. We have been in the thick of the private equity movement and have tallied up over $15 billion looking for a home within insurance brokerage over the next 12-18 months. And that figure excludes the already announced 2007 USI and HUB deals. While there is not a home for such a volume of capital, the suitors are scrapping and clawing for placement.

The strategy of the private equity firms looking for placement in the brokerage industry has a unique twist. First, call time out to the traditional short-term focus on maximizing margin. Private equity investors are willing to take a hit to today's profit margin to reinvest in building tomorrow's organic growth engine. The priority after the private placement is to focus on implementing a producer recruiting, hiring, and retention program that is consistent, process driven and procedural versus an early focus on aggregating acquisitions. The result of the producer investment strategy will be a budgeted expense load that settles out in the 3-5% of revenue range after the initial hit to expense. They are looking to build a business that has sustainable organic growth AND strong profitability. The second motivation of the private equity firms is to invest in a public broker or private broker that can leverage shareholder return during the next 5-7 years through debt leverage and a subsequent IPO or divestiture.

Any good strategy requires confirmation in the short-term to retain support from the board. The first step in the organic growth story to the board revolves around cross-selling. Consider that private equity firms have private placement funds made up of portfolio companies which, in many cases, have ceded a controlling interest ownership position to the private equity investors. Adding an insurance brokerage to that fund is followed immediately by a discussion with the other portfolio companies within the fund that sounds something like the following: "Ladies and Gentlemen, we have a new member of the family. It is time to keep the business within the family to help all of us. We expect you to give them a shot at writing your commercial and group health insurance."

Just like banks, private equity will try to take advantage of the low hanging cross-sell fruit. However, these private equity relationships are tighter than most bank-consumer relationships by virtue of ownership, thus spurring the potential for early and meaningful cross-selling hits. There is no anti-tying legislation that stops an owner with a controlling interest position in one privately held firm from having a strategy to buy insurance from another firm controlled by the same ownership group. Banks talk to their commercial lending clients and depositors about "giving us a look." Private equity firms are in a position to talk about "giving us the business." It will never be that easy, but it's a great leveraged introduction.

Interest in Public Brokers

The interest in taking public brokers or bank-owned insurance brokers private is motivated by the potential for significant multiple arbitrage. This is evidenced by the premium pricing paid for recent private equity transactions in the 10X - 12X retrospective EBITDA range. Looking at the last cycle, broker P/E multiples were a leading indicator of the hard market, ramping up in anticipation of premium increases. In that last cycle, as confidence increased that the hard market was approaching and advancing, the market speculated that earnings growth would improve and as a result, so did P/E multiples. When will this market cycle change from a soft to a hard market? The answer is not clear but once rate increases become visible and the market predicts earnings expansion through those rate increases, P/E multiples should jump.

Financial sponsors are aggressively making investments now while the hard market is not on the horizon. If history repeats itself, as a hardening market approaches, arbitrage will provide for a massive return on equity for investors that supported the initial private placement. The trick is making the private placement prior to the run up, executing the business plan, demonstrating earnings continuity and achieving full placement liquidity before the P/E multiples peak. The private equity firms also need to invest today so their position can be liquidated systematically and so that there is enough float in the market to avoid flooding it, which could downwardly influence price. Given the last cycle, the ultimate goal is to have full placement liquidity prior to the peak in the P/E multiples, which many speculate to be about two years prior to the peak in the next hard market. Finally, it is beneficial to close a deal quickly as the book amortization of acquired identifiable assets for GAAP reporting purposes are often booked on an accelerated basis. So a closing now could enable the private firm to front load much of the book amortization so that earnings are less encumbered at the time of the IPO.

If timing the market seems a bit too ambitious, the capital group can always sell to a seemingly unlimited number of buyers. In short, the strategy is to emerge as an organic growth engine maximizing predictable and sustainable revenue and earnings expansion by the time the soft market cycle starts to harden. At that point, private equity players will look to subsequently time the market and drive liquidity when valuations are high.

Interest in Private Brokers

This is not exclusively a public broker privatization or large private broker acquisition, followed by a plan to position for an IPO. In fact, despite the HUB and USI deals, there is more of a groundswell of interest for brokers in the $10 million - $200 million revenue range that are not within striking distance of going public. There is a readily available capital market positioned acutely at investing in mid-sized agencies and brokers. While privatizing a public broker followed by an IPO prior to the next hard market will likely prove to provide tremendous upside, there is risk associated with trying to time the market. Consider that the last soft market cycle turned out to be approximately twelve years in length. Few, if any, equity funds want that long of a tail.

The real leverage of a private equity investment in a broker of any size comes from the utilization of debt leverage. The return on invested capital that can be generated by layering in debt can be significant, regardless of the rate cycle, in the 25% - 35% range. The nature of the insurance brokerage business is ideal for a one two punch of equity and debt, given the fact that about 90% of the revenue renews each year and insurance brokers generate significant cash flow without regulated or legislated capital requirements. At the same time, a regimented producer hiring and retention program can generate returns on invested capital of over 60% when properly structured and executed.

The interest in mid-sized brokers is also strong given that smaller deals come with a lower risk profile. Many mid-sized agencies are further advanced in their organic growth initiatives. The Organic Growth Rates chart illustrates the organic growth of the TASC Network Partners (a consortium of the nation's leading executives committed to driving organic growth) versus the public brokers.

Agencies and brokers in the $10 million - $200 million revenue range that are exploring a marriage with private equity firms are doing so for many reasons.

Among the most prevalent include:

• Many agencies are too large to cash flow internal perpetuation
• Agency executives can retain an equity stake in the organization while partially capitalizing on today's high valuation multiples
• Instant liquidity is created
• Owners can participate in the upside created through debt leverage
• Owners can get a second bite of the apple in a secondary transaction (a sale to another private equity fund, a public broker or a bank)

The real question for the owner of the average agency or broker is whether the significant upside in value and the very real potential for a double dip offsets the discomfort and uncertainty that often accompanies a deal with a partner that has a temporary investment time horizon.

Regardless of size, independent agencies need to become knowledgeable about the overall private equity organic growth strategy as this may validate or challenge your existing growth strategy.

The market is going to be filled with capitalized players that have organic growth as their core strategy. And the cost requirements of having a robust value added services platform, pipeline management systems, accountability processes, recruiting and training modules are microscopic relative to the value that will result through debt leverage or an eventual IPO. Whether idealistic or realistic, private equity firms making a placement (or planning to) want to invest in a broker that can achieve peak performing organic growth rates AND a high operating margin.

Summary

Equity firms have an interest in insurance agencies and brokers for a number of reasons, including:

• A retention-based business with predictable and strong cash flow
• Relatively low forward looking capital requirements
• Fragmented industry with a large number of private firms
• Opportunity to create a broker that can achieve sustainable organic growth
• A ready market of buyers ensuring that private equity firms have an exit strategy
• The potential to participate in multiple arbitrage in an IPO or divestiture in advance of the next hard market

This is a critical time to leverage your resources and capital to get your organic growth engine in order. The world is changing and competition is on the horizon like you have never seen before. New players have emerged and will continue to emerge that are willing to take a short-term hit to profit with the goal of capturing market share. They will do this by targeting your customers with the support of high level account executives and a regimented value-added service platform that provides predictable service and embraces accountability to insureds. They have the money to spend and recognize the competitive significance of available capital and leverage: most public brokers can not spend the money and small privately held agencies rarely have access to large capital reserves.

Many of you are well on your way through the organic growth journey. Open your mind, expand your horizon and position your firm to thrive during the wildest ride this industry has ever faced.