A Unique Answer to the Seller’s Dilemma
Though the almost inconceivable number of mergers and acquisitions announced in 2021 grabbed the headlines, perhaps the most interesting development was a shocking achievement by a relatively new type of buyer—a type of buyer that, in the 12 months ending in January 2022, succeeded in acquiring four of the insurance industry's largest brokerages.
Who is this new buyer? The super-regional independent brokerage that sells a minority interest (less than 50% of its ownership) to an outside investor. We refer to this brokerage as an IMOE, for independent with minority outside equity. Three examples are Higginbotham (original outside equity investment purchased in 2007), Heffernan (2019) and IMA (2020).
Brokerages considering a sale confront the seller’s dilemma: how to get the benefits of a sale without the negatives.
The question of why firms sell is never easy to answer, even by the firm being sold.
Independents with minority outside equity believe they’ve created the perfect answer to the seller’s dilemma.
In 2021 and early 2022, these three firms acquired a total of 49 brokerages. Of those, six were large-platform transactions, including Higginbotham’s acquisition of Lipscomb & Pitts (Memphis, Tennessee) and The Underwriters Group (Louisville, Kentucky) and IMA’s purchase of k.p.d. (Springfield, Oregon), Bolton (Pasadena, California), Diversified Insurance (Salt Lake City, Utah) and Parker, Smith & Feek (Bellevue, Washington).
In a marketplace already saturated with buyers, how did this tiny buyer category succeed so dramatically over the past 15 months? What made these deals happen?
To answer this question, it is necessary to dissect a firm’s complicated decision to sell. The question of why firms sell is never easy to answer, even by the firm being sold, because the decision is nearly always based on a combination of factors.
Our work with clients has revealed the following commonly perceived benefits of a sale.
- A third-party “market” valuation typically represents a sizable premium over the seller’s internal valuation.
- A buyer may bring resources, market clout, expertise, capital and/or other tools to help the seller become more successful.
- A buyer may offer an equity opportunity that seems superior to that of the seller.
- A seller may need to buy out a retiring shareholder but doesn’t have enough capital or enough next-generation buyers to do so. The buyer can help solve its perpetuation challenge.
For many brokerages, however, a sale feels like a betrayal of everything they stand for. They’ve built their company on the value of independence, and it serves as a frequent rallying cry among employees. Even the mere discussion of a potential sale threatens to undermine the strength of this conviction, so contemplating a sale can be a challenge.
There are several commonly perceived negatives of a sale.
- Employees might view the transaction as “selling out” and reversing course on employee-ownership messaging that has been communicated to clients and employees.
- Employees might fear the seller’s culture will be diminished or destroyed by a buyer whose business and values are very different.
- Equity opportunities may be altered.
- The equity of the seller is typically exchanged for cash and/or buyer equity.
- Even if the buyer’s equity will likely perform better than the seller’s, it frequently possesses a different risk profile and different investment characteristics, such as an end to regular profit distributions and the uncertain timing of liquidity.
- The opportunity for future owners to accumulate equity may be reduced or eliminated.
- The seller’s senior leaders will likely be required to defer to a higher leadership authority, often based in a distant place, reducing their decision-making authority.
- The buyer may force conformity to bureaucratic, big-company policies and procedures.
The bottom line is this: brokerages considering a sale confront the seller’s dilemma: how to get the benefits of a sale without the negatives.
Independents with minority outside equity believe they’ve created the perfect answer to the seller’s dilemma. The IMOEs believe they can deliver the “holy grail” opportunity to a high-performing peer firm by offering:
- A market valuation competitive with those offered by the most aggressive buyers
- An employee-owned and client-centric culture that more naturally aligns with its own values
- An equity opportunity for the seller’s employees that can go as broad and deep as desired, with a “buy-in rather than sellout” mindset
- Opportunities for current and emerging leaders to expand their role and opportunity for growth
- A collaborative philosophy of resource-sharing and teamwork
- A lack of bureaucratic, big-company policies and procedures.
What led the IMOEs to position themselves in this way? A quick backstory might be helpful. Prior to raising outside equity, Higginbotham, Heffernan and IMA shared some similarities.
- Each was a mature regional brokerage, focused on organic growth, with a strong employee-centric culture and brand.
- Each was deeply committed to employee ownership and to perpetuating internally.
- Each recognized that, as its revenue surpassed $100 million, M&A and other capital-intensive investments would become an increasingly important means for growing its talent base and deepening its resource pool.
The three firms were each limited by some constraining factors.
- Internal perpetuation requires significant capital. So does M&A. Balancing the demands of both can be a real challenge, especially given the constraints imposed by lenders and other traditional capital providers.
- Their valuations were discounted relative to their “street value.” A conservative valuation can be very helpful in perpetuating ownership internally, since its affordability makes it attractive to the next generation of buyers. But it can be a major hindrance for a firm trying to win in a highly competitive acquisition environment, since the buyer’s own valuation multiple typically represents a maximum it can justify paying for a target. If, for example, a buyer values its own stock at 1.5x revenue for internal perpetuation, it can be very challenging for that firm to justify paying 3x revenue (or more) for an acquisition.
To address these limitations, Higginbotham, Heffernan and IMA determined that raising minority outside equity capital was the answer. Each went to the capital markets and found an investor or group of investors eager to purchase a minority equity stake in their business.
While each of their deals had unique nuances, minority deals typically include the following attributes:
- The valuation is broadly similar to “street value” or what could be achieved in a third-party control transaction. Historically, investors required a discount of 10%-15% for minority investments. However, as the concept has been spreading, with heightened competition among investors looking for opportunities, minority discounts are largely being negotiated out of these deals.
- The minority investor receives some basic protections, but—with only a few exceptions—the brokerage’s leadership team retains broad authority to operate the day-to-day business.
- The minority investor receives board representation generally proportional to the size of its investment.
- The minority investor’s capital is contractually committed for several years. At the end of the agreed-upon timing, the investor has the right to obtain liquidity for its shares. At that point, the investor has the choice to remain invested or to require the company to find another investor.
- The minority investor is typically eager to invest more in the firm if given the chance, so additional equity is often available if needed.
- The presence of the minority investor creates both broader access to lenders and better terms. The company and the investor work together to create the optimal capital structure to serve the growth and perpetuation needs of the company.
Minority equity also has some inherent challenges.
- Since the minority investor can contractually sell its shares after a specific period (typically four to six years but longer in some cases), the company may need to incur the time and expense to go through a capital-raising process every few years to find a replacement investor.
- The investor’s interest in deploying more capital in the company and the favorable access to the lending community result in a fantastic deepening of capital resources. But there are limits to how much growth capital can actually be deployed. The brokerage must continually balance its cash, debt tolerance and desired limit for the percentage owned by outside investors. Too many acquisitions lead quickly to uncomfortable debt levels, too high an equity percentage for the outside investor, or both.
- Determining the valuation methodology after the initial investment can be a challenge, since it must now be pegged to potentially volatile market forces, such as public brokerage valuations or comparably sized transactions. This could lead to greater share-price volatility, which could reduce employee interest in ownership.
- The brokerage will still need to recycle most of its shares between employees from multiple generations—and now at a significantly higher valuation. This higher valuation might seem to be an impediment to employees investing in the IMOE. In our work with IMOEs, however, we often see employee interest in owning stock increase when the outside investor is bought in, despite the higher valuation. Employees seem to draw confidence from the presence of an outside institutional investor.
- The end game is uncertain, and finding a replacement minority investor in the future is inherently unpredictable. Twelve years of rising valuations for brokerages has led to unprecedented interest from outside investors; finding replacement investors has been easy. But when valuations eventually decrease (and valuations are inherently cyclical), will interest from outside investors decrease? If so, this might create tension among the brokerage’s shareholders. It is conceivable that outside investors would push to sell the firm to a rival brokerage to maximize financial returns, in opposition to employee shareholders, who might prefer to accept a lower valuation in order to preserve private ownership.
Independent and Employee Owned
Our industry is being transformed before our eyes. Driven by an influx of capital and the perceived advantages of scale, unprecedented levels of consolidation are reshaping the brokerage landscape, and the move to consolidate shows no signs of slowing.
As brokerage leadership teams evaluate their path forward, some will consider a third-party sale or merger to achieve their operational and financial objectives. But the weight of the seller’s dilemma is heavy. The power of the IMOE brokerage model is its unique answer to the seller’s dilemma.
Others are mobilizing to emulate the IMOE model’s key elements in a variety of ways. Some brokerages are seeking outside minority equity themselves. Some larger brokerages, backed by private equity, are repositioning themselves as “employee-owned” by highlighting the amount of their ownership held by active employees. Other acquirers are sharpening their messaging regarding long-term independence and their employee-equity models.
Independence and employee ownership are a compelling combination in our industry, and even record-setting rates of consolidation won’t lead to their demise. Today’s IMOEs believe they have discovered the capital structure that will allow them to grow to sizes never before achieved by privately held firms while maintaining all of the benefits of independence and employee ownership.
Kevin Stipe is CEO of Reagan Consulting.
Harrison Brooks is a partner at Reagan Consulting.