Private Ayes

After a frustrating run of lackluster growth and declining profit margins in 1999, some of Barney & Barney’s partners worried that the firm’s best years were behind it. Did continued private ownership make sense? Should the San Diego–based brokerage sell out?

The partners decided after much discussion that the firm would remain privately held. What came next was one of the great stories in the industry over the past decade.

Barney & Barney, a single-office $16 million brokerage, grew to become a $78 million regional player with multiple offices. Its ownership group nearly quadrupled, from 10 to 36 partners. Today it’s the largest privately held brokerage in California.

What’s the firm’s secret? Paul Hering, Barney & Barney’s 49-year-old CEO, says it’s simple: “Our perpetuation plan is the key driver of our success. It helps us recruit people, and it helps us retain people.”

While people across the industry sometimes use “perpetuation planning” and “succession planning” interchangeably, perpetuation planning usually refers to transfers of ownership, while succession planning refers to a transfer of roles and responsibilities from the current leadership team to the next generation. In some firms, the next generation is wondering: “Should we buy in?” And the older generation, typically staunchly independent, is wondering whether internal perpetuation can still work. Even firms with established, culturally ingrained perpetuation plans have to continually monitor and manage internal perpetuation to ensure that it is not thrown out of balance by any of the multitude of dynamics that combine to make it successful.

Given these complexities and the toxic combination of a seven-year-old soft p-c market, a weak economy and recently passed healthcare reform that is conspiring to make internal perpetuation even more difficult, Reagan Consulting recently completed The Private Ownership Study, an assessment of insurance agency perpetuation plans. Done in conjunction with The Council, Liberty Mutual, Hanover, Amerisure and Cincinnati, the study demystifies internal perpetuation, providing agency principals with new insights on how to achieve their perpetuation goals.

The study was fueled by two surveys:

• The first, a baseline survey, was designed to assess the desire of agents and brokers to remain independent; their confidence in their ability to do so; and the biggest challenges faced by privately held firms. Nearly 900 firms across North America completed the baseline survey.
• The second looked at those firms most committed to private ownership. The 146 firms who participated in this in-depth survey revealed details of their agency operations and perpetuation plans.

The Four Pillars

In attempting to increase the understanding of internal perpetuation, the first step was to break perpetuation down into its component parts. The study revealed that, for an agency to internally perpetuate, four key elements must be in place. If any of these “four pillars” of internal perpetuation is missing, the plan will ultimately fail.

1: HEALTHY OPERATION

Internal perpetuation begins with a healthy operation, primarily defined by growth and profitability. Profit levels are crucial because they must be high enough to justify an agency valuation in line with the expectations of selling shareholders. This can be a big problem in today’s low-margin environment, where the typical agency’s profit margins have declined by about 25% from the levels achieved a few years ago.

Many selling shareholders have traditionally viewed their shares to be worth 1.5 times agency revenue, or at least they use this metric to benchmark their value. In reality, while value can be expressed as a multiple of revenue, it should be determined as a multiple of profitability. For most agencies, an appropriate valuation multiple for internal ownership transfers is 5 to 7 times EBITDA (earnings before interest, taxes, depreciation and amortization).

The problem in today’s market is that EBITDA margins have fallen below the level where most firms can transfer shares at anything close to 1.5 times revenue. As shown in the pie chart, more than half of agencies in the study are generating EBITDA margins below 20%. At a multiple of 6 times EBITDA, these firms should be valued at no more than 1.2 times revenue—and most should be well below that.

Profits are also important because they fund perpetuation. Buyers normally rely on profit dollars to finance their ownership purchases. Without profit dollars to use as payment, ownership purchases become extremely difficult.

A healthy operation consistently invests in growth. Only about half of the nation’s agencies will grow organically in 2010. In a flat-growth environment, consistent reinvesting of profits into growth is even more crucial. An agency that doesn’t grow loses its viability in the marketplace. Carriers leave for other agencies that can provide the premium growth they need. Insureds leave for other agencies that can develop new and better value-added resources to satisfy their needs. Employees leave for other agencies that can offer better opportunities for pay advancement and career development.

This is a lesson that Barney & Barney has taken to heart, investing aggressively in recruiting and developing young producers. As a result, the firm has averaged about 14% annual growth over the last decade while maintaining strong levels of distributable profit to fund internal perpetuation.

One of Barney & Barney’s great success stories is 38-year-old Travis Trask. Hired as a producer trainee in 1998 after cold-calling the firm for an interview, Trask manages the company’s Orange County office. His ascension through the ranks illustrates how a well designed perpetuation plan can be a potent weapon.

“From the day I was hired, my number one goal was to become a partner,” he says.

It didn’t take long. Along with two other high-performing youngsters, Trask was invited to buy his first block of ownership units in 2004—at age 32—after his book of business crossed the million-dollar threshold. Was he nervous about the financial commitment? “Not at all,” he says. “I couldn’t wait to buy in. I’ve bought shares two other times since then. I believe in our leadership team, our business model and our ability to outperform the market. Like many of my peers, I’ll buy every share they’ll allow me to.”

2: REASONABLE SELLERS

For internal perpetuation to work, the current generation needs to be willing to sell its shares to the next generation and to do so on “reasonable” terms. Our definition of reasonable is one by which actions support, rather than undermine, internal perpetuation and are generally consistent with industry norms.

Therefore, a reasonable seller is defined in the study as an owner who:

A.    Is willing to sell their shares at a discount to a third-party sale valuation. One alarming finding of the study is that, of those firms expressing a high commitment to internal perpetuation, less than half indicated their sellers are willing to take a discount to a third-party valuation. Something will have to give here. It is widely known that third-party buyers have certain advantages in what they can afford to pay for an agency, and it isn’t always just a higher multiple of the same expected profits. Outside buyers can often justify a higher value based on the achievement of higher post-transaction profitability due to cost reductions they can implement. They can also add an earn-out component that is uncommon in an insider deal. Or they might achieve tax benefits in the deal, which they are willing to share with the seller. Whatever the reason, a shareholder who requires a third-party valuation for his or her shares will probably undermine the internal perpetuation strategy they espouse.

B.     Is willing to finance the sale of their shares (or help to arrange third-party financing). Another key finding of the study was that most sellers participate in the financing of their deal. Only 32.2% of sellers in the study receive all cash at closing. The remaining 67.8% receive payments for their stock over time, with a median financing period of seven years.

C.     Is willing to time-share sales to avoid redemption logjams where too many shares must be redeemed simultaneously. Many agencies run into perpetuation difficulty because sellers wait too long to begin the perpetuation process. Reasonable sellers successfully combat this problem by selling shares over time and allowing younger shareholders to come on board when ready. Barney & Barney has done this well, and in an industry where most owners are in their mid-50s, today nearly half of Barney & Barney’s shareholders are 45 or younger.

3: ABLE BUYERS

The biggest challenge to internal perpetuation identified by the study is finding able buyers. Nearly one third of the agencies surveyed acknowledged that they don’t have the next generation of buyers in place to begin with. Yet even those that have identified their next generation of buyers face challenges—both financial and non-financial.

The greatest of challenges is obvious: The young people who agencies need for an internal purchase (those in their 30s) are those who can least afford it. Even for a frugal young producer (yes, there are a few of them), coming up with enough money to buy a meaningful amount of agency stock can be nearly impossible.

The study indicated that agencies are alleviating this problem by offering buyers payment terms that stretch out long enough to allow buyers to help cover the payments with future profit distributions.

A new metric developed in the study is called the Buyer Coverage Ratio (“BCR”), which is calculated by taking a buyer’s first-year expected profit distribution and dividing it by the first-year note payment (principal plus interest). Thus, if the buyer’s first-year distribution is $50,000 while the note payment is $100,000, the BCR is 50%.

The study revealed a startling fact: Over 50% of the agencies in the study have a BCR of 100% or more. This means that they’ve set up ownership purchases to essentially pay for themselves. (The BCR doesn’t take into account the down payment, nor does it include income taxes on the profit distribution.)

This dynamic helps to explain Barney & Barney’s experience of shareholders who are eager to buy. Buyers at the firm receive long-term financing with payments that are generally covered completely with profit distributions from day one.

4: EFFECTIVE TRANSFER MECHANISM

Even if all other pieces are in place, every firm needs a method for transferring shares from one generation to the next. In this area, the study reveals a couple of key insights:

1. A wide variety of transfer mechanisms are being used across the industry, and many firms use more than one mechanism.
2. The primary mechanism being used most commonly (almost 7 times more likely than the next most common) is ownership purchases, in which a buyer purchases stock from another shareholder or from the company.

Selecting an effective transfer mechanism is critical. Not all mechanisms work for all types of agencies, so the choice must be based on an agency’s unique attributes. What are those attributes? An agency’s philosophy about profit distributions is one key issue. Revenue growth aspirations are another. The age and desired timing of the older generation is yet another.

For example, an agency with strong profit margins and a desire to distribute profits is a good candidate for direct ownership purchases. However, a growth-focused agency without the ability or desire to distribute profits may look toward a stock grant program.

The intense pressure on agency performance is making perpetuation harder than ever. Yet, the Private Ownership Study indicates that agency principals remain strongly committed to internal perpetuation, even if it comes at a cost.

Agency principals sometimes raise an interesting question: What if they aren’t completely committed to internal perpetuation or they are committed now but want to leave their options open? Will the effort to build a perpetuation plan hurt them if they change their minds and sell to a third party? The good news for nearly all agency owners is that building an internal perpetuation plan will result in a higher value at the time of sale—regardless of the buyer.

If an agency’s leadership does the heavy lifting required to perpetuate internally—improving operating results, investing in the next generation and inviting the high performers into ownership—the range of perpetuation options will increase rather than decrease. Ultimately, effective perpetuation planning is about keeping options open. An agency that has built a viable internal perpetuation plan is the most valuable agency in its marketplace. There is nothing more appealing—to insiders or to an outside third-party buyer—than an agency that’s healthy enough to perpetuate internally. As Mr. Hering notes, “When you’ve got 75% of your shareholders competing to buy more stock, it fuels a powerful motivation to do those things that grow the value of the company.”