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Brokerage Valuations – Let’s Talk Management Buy-Outs

Planning for the FutureThe market for property and casualty (P&C) brokerages continues to be intense. Books of business are attracting prices from 3.5x to 5.0x commissions – and even more for online business. So, are conditions right to start seeing more management buy-outs? Although you might not think so given the prices being paid by third-party buyers, the reality is that there is a vibrant and growing appetite for internal succession in general and management buyouts in particular – our firm has acted as financial advisors for three of these types of transactions in the last twelve months. Why? To answer that question, we must explore the dynamics of the P&C brokerage market.

The P&C Brokerage Market

Let’s start with the level of senior (bank) debt that brokerage cash flow can support. While every deal is different, based on recent term sheets we have seen a stand-alone brokerage with a 30% EBITDA margin and a 25% marginal tax rate might be expected to support a loan equal to 1.8x commission revenue.[1] This clearly falls short of the 4.0X commissions being paid. While large consolidators generally earn higher EBITDA, which could increase the debt available, it still does not explain the price gap.

We believe that underwriter demand for premiums and the related book is at an all-time high and is driving current prices. The 2016 average return on equity for Canadian P&C insurance companies was approximately 5%.[2] An analysis using the same assumptions as above suggests a price of 4.5x commission may be wholly acceptable.[3] If you consider other issues, such as public company investor expectations for growth and its impact on share price, as well as InsureTech and other potential market changes, 4.5x for a book of business might be very appealing to an insurance company.

As with the brokerage industry, there has been considerable insurer consolidation in the past several decades. In 2016, the ten largest Canadian insurance companies had a combined market share of approximately 67%, compared to approximately 55% in 2000. Insurers have also attempted to grow by developing new products, expanding existing sales channels and acquiring, both directly and indirectly, brokerages and managing general agents.

So how does this relate to management buy-outs?

Management Buy-Out Dynamics

Ultimately, insurance companies want to earn a return on their equity and protect and grow their premium base. What better way than to either finance or partner with a strong and entrepreneurial management group that knows their customers and has a stake in the success of the business? In addition, a properly structured and financed management buy-out gives the current ownership group options on the timing and degree to which they want to divest in their brokerage.

However, management buy-outs are not without their challenges. A lack of experience in structuring a deal, unequal levels of power, poor understanding of risk and lack of personal net worth can stand in the way of a successful deal. Owners frequently want to maintain control and may not be clear on how they want to exit their business. Management often resists putting any money down or assuming the business risks that are commensurate with their expected return. Without having a consistent message and view of the future, it is difficult to bring potential financing partners on board.

A Way Forward

What is the solution for an owner who is considering transitioning their P&C brokerage to a management group? Our experience has been that a two-stage approach can effectively navigate the challenges of a management buy-out.

This first stage involves addressing what we call Value Considerations. These considerations include the acceptable sales price, financing terms, tax issues and estate planning that would be required by ownership to sell 100% of the shares to a third party. When discussing value considerations with our clients, we stress that terms and ultimate return are as important and perhaps more important than any stated price.

The second stage involves addressing what we call Values Considerations – note the “s” on values! This includes family considerations, management and employee relationships, timing and of course legacy and reputational goals. We work with our clients to identify goals that are “must haves”, “want to haves” and “nice to haves”. We then review these goals in the context of the value considerations identified and craft a comprehensive transition and financing plan.

Only at this point should ownership approach sources of financing, including banks, insurance companies and management. A well thought out and structured plan will generally attract interest from multiple potential partners both inside and outside of your organization. Just like you compete for business, you should make both management and financers compete to participate in your transition plan. Phoning your favorite company broker relations vice president is probably not a good strategy for getting the best deal.

If the circumstances are right, owner to manager succession arrangements or management buy-outs are well worth looking at.

If you’re interested in learning more about this topic, contact Mike Berris or take a look at our Smythe Advisory website.

[1] Assuming a 5% bank loan with 12-year amortization with a maximum 1.20x debt service ratio and Debt to EBITDA ratio of 6.0x

[2] 2016 MSA Report, Property & Casual, Canada

[3]  Profit margin (30%*(1-.25*)/ ROE 5% = 4.5 Revenue

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