In today’s insurance agent marketplace, the phrase “Private Equity” or PE is quite the buzz phrase. The mention of PE causes a wide range of reactions from agency owners.
Some owners seek to sell their agencies to PE backed brokers and others are avoiding it like the plague. No matter where you fall on the “Seeking vs. Avoiding” spectrum, it is important to understand PE in today’s insurance distribution system.
In this series, the IA Valuations team is going to provide content intended to educate agency owners on PE in the IA system, the impact of it on agency’s value, options to consider when transitioning ownership, how to engage with PE firms, and the good and bad of the PE model. With approximately $35 billion of PE resources already invested in the IA system and another $88 billion raised and ready to deploy, agency owners must learn about this new funding model to ensure they can business plan for the future.
The 411 on Private Equity
PE firms gained in popularity after the Global Financial Crisis of 2007-2008. The appeal of PE as an investment strategy is high returns without reliance on public capital markets.
The private equity model works by sourcing their initial capital from a group of limited partners or LPs. These limited partners must be what is known as qualified investors, a legal designation. These LPs would be endowments, pension funds, institutional investors, high net-wroth individuals, and many other institutions with lots of capital, like an insurance company. Every PE firm could either be started with just one or multiple LPs.
Once they have the capital to get them off the ground, they seek businesses to purchase ownership stakes in. In its simplest form, a PE firm will acquire 100% ownership in a business they add to their portfolio and they will seek to optimize that business through creating as much margin as possible. They keep these acquired businesses for a length of time, often referred to as the “hold period,” until they sell the ownership to another individual or entity.
The profit generated during the hold period is nice, but the real return on investment (ROI) comes when they sell their ownership after the hold period. This process of reselling ownership is often referred to as recapitalization.
Recapitalization
To recapitalize is to change the capital structure of a company’s current debt to equity ratio. In the PE world, recapitalization specifically refers to a restructuring from bringing in a new owner or majority owner, thus shifting the equity structure of the business. The “restructuring” usually refers to ownership, not necessarily management. The employees operating and running the asset typically stay the same while a new PE buyer often becomes the new majority owner.
During a recapitalization event, it is typically a trigger event for all of the current owners to sell some or all of their ownership shares. PE firms typically target a 3-7-year time period for their investments with a 2X to 3X rate of return on the investment.
This is different than the typical public stock market investor that we are familiar with where we can buy and sell shares of stock with ease since the market of buyers is anyone with money and access to the stock market. However, when a PE-held company goes to sell or recapitalize, the only way to do so is if there is an interested buyer. A publicly held stock can trade for dollars and cents, meanwhile an entire business costs astronomically more, and thus the market of buyers is far more limited.
Herein lies the major concern within private equity investment: who will be the next buyer? As long as the PE firm is early in their lifecycle and growing, there is typically another buyer in line to replace the current PE firm. However, the big concern is which owner, PE firm or combination of owners, of the business or portfolio of businesses ultimately will not be able to find a buyer, and thus not be able to liquidate their shares? When a buyer cannot be found, the business or businesses in the portfolio must go public for shareholders to be able to liquidate their shares.
For agency owners who sell to PE-backed buyers, it is important to understand what phase of the cycle the PE firm funding the consolidator is in.
Questions to ask are: when was the last recapitalization event? What are the past historical results of the PE fund? How many partners are there in the new ownership model? When is the next recapitalization event expected to take place? How and when can I sell my equity?
In addition, the agency owner should also ask for references from some other independent agents that sold to the PE firm and sold their equity. Get insights on their experience selling equity. Typically, PE firms require owners to take around 20% of their guaranteed purchase price in equity so knowing how you can cash out that investment and when will be really important to maximizing the value of your sale.
The Stigma with Private Equity
PE firms were first on the rise in the 1980s. Deals started small, but as the model became more fruitful, the appetite of firms got larger. The deals got larger and that meant that PE firms needed larger loans to finance acquiring businesses. That meant PE firms often were highly leveraged. These deals were known as leveraged buy-outs, or LBOs.
With a lot of leverage weighing on the shoulders of PE firms when they acquired a new asset, that meant the first thing they were looking to do was generate more cash flow in order to pay off their debt. Michael Jensen, a Harvard Business School professor makes the point that a great disciplinary device for corporations is being heavily leveraged. Nothing keeps people honest and efficient like paying the interest bills. Oftentimes, the largest cost to any business is labor, so that was often the first thing nixed in the 80s. The large number of layoffs associated with PE firm buyouts in the 80s have left a sour taste in the eyes of the public for decades. PE cooled off after a catastrophic transaction with Nabisco in 1989. Thus, the stigma about PE and its layoff-riddled and destructive wake was born.
Nevertheless, time heals all wounds, and after the uncertain times of the Dot Com Bubble and the Great Financial Crisis, PE investment is back. However, many sales pitches that insurance agencies will hear today from PE-backed buyers are different from what would have happened in the 1980s with the LBOs, and thus the stigma should be reevaluated.
Today, many consolidators have “recruiters/head-hunters” that have roots in the insurance agent community, many being former or current agents themselves. They understand that a successful agency is built on relationships and that a successful agency is where it is today because of the people who work in the business. Sales pitches from many PE consolidators will tell you that you will get additional markets, opportunities for greater carrier commission rates, everything will remain the same, your staff will remain intact, and you will experience less stress after the purchase of the agency.
This structure is extremely different from the LBOs of the past. However, it’s not to say that agency owners should not be cautious and assume that every consolidator model is the same; they are not. The best way to understand each consolidator is to try and find testimony from those who have sold to that consolidator. If you are unaware of any peers that can offer a testimonial, then talk to IA Valuations or your state association to see if they have any insights for you.
Conclusion
Today, the PE firms that are involved with the IA system are different from the PE that started in the 1980s, the era responsible for the reputation. IA Valuations would encourage every agency owner to learn about the players that are in the market and make educated judgements about what PE’s role in the insurance agent industry is. Whether you want to engage with them or not, you will be competing with them so you should learn more about the model.
If you are curious about what PE means for your agency more specifically or are looking for more information on the topic, please reach out to Jarod Steed at jarod@iavaluations.com. If you want to learn more about PE, we encourage you to listen to the IA Valuations webinar, Private Equity in the Insurance Agency System.
By: Jarod Steed, Business Planning & Valuations Analyst
About IA Valuations and Agency Link – Founded in 2017, the IA Valuations team has performed over 270 valuations to independent insurance agencies across the U.S. Our advisors have 25+ years of experience guiding agency owners on maximizing their agency value, planning, and legal needs for ownership transition. In addition, IA Valuations has provided perpetuation planning, financial modeling and business planning for independent insurance agencies. Finally, IA Valuations has advised dozens of agency owners on selling their agencies through our Agency Link process. Agency Link is a platform that connects buyers and sellers together to further the growth and strength of the IA system. To learn more about IA Valuations, please visit IAValuations.com or contact@iavaluations.com.
The information provided in these documents is general in nature and shall not be construed as personal legal, tax or financial advice for your situation. Please contact@iavaluations.com to discuss your personal situation.
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