Private Equity’s Secret Sauce

Private equity is our most robust buyer segment in M&A right now. It has risen from no deals not many years ago to more than 125 this year alone.

Private equity groups (PEGs) come in all shapes, sizes and flavors. They could have a centralized or decentralized structure, focus on specialty, be a generalist, allow you to keep your agency name, keep some ownership in your firm or roll some equity into a new firm, or they could give you access to capital for deals and even provide support to do follow-on deals on your behalf.

They might have one consistent compensation plan or many compensation plans, push you to consolidate carrier contracts, leave contracts to be negotiated at the local level, charge you with an overhead allocation, or potentially have no allocation even when providing back-office support.

They may have recently recapitalized, could potentially be looking to recapitalize, might be a start-up, could exceed $1 billion in revenue, be potentially bullish on the employee benefits space, might not really understand employee benefits, decide to have one automation system, or have every flavor of system.

It is like Baskin-Robbins ice cream—nearly unlimited flavors. That’s what is different.

So what is the same? Uber wealth creation.

In our experience, the typical PEG-funded brokerage produces an average return on equity of between 27.5% and 30%, returning between three and four times invested equity over a four- to six-year period. Some perform better than that. You have heard stories about firms that sold and invested 20% of their net proceeds back into their new PEG-backed parent. In some cases that 20% turned into them receiving more than the 80% liquidity at closing. But that’s not the end of the story. Upon PEG recapitalization, they do it again, taking out 80% of their proceeds, which ends up smaller than the rolled equity of 20% on four years. They’re like the old shampoo commercials trying to pump up revenues: rinse and repeat, then rinse and repeat again.

If you ask anyone who sold to a PEG-backed brokerage, they all have the same complaint: “I took out too much liquidity and reinvested too little equity.”

Stories are told constantly from someone who sold for 20 times EBITDA over a 10-year period if you figure in the initial liquidity, plus the recap, plus the recap, plus yet another recap divided by the closing pro forma EBITDA of the initial deal. And inevitably, like a broken record, it could have been better if they would have left more money in. 

All of those on the outside looking in like to claim this business is all a house of cards, a get rich quick scheme, and that “the PEG industry lacks integrity.” People on the inside know better. Why? Because they know the dirty little secret. 

Before we expose it, pause a moment and absorb this fact: The private equity industry is actually quite conservative about risk. Value appreciation is not a byproduct of recklessness. Getting significant liquidity then reinvesting is actually a conservative approach to wealth management. The returns are so high they could be reduced and they would still outpace most of your other investments.

Why?

How could it be true?

You mean I have to stop trying to convince everyone I know that the guys buying private islands are idiots? Yes. Yes you do. And here’s why: The secret is they don’t pay tax. They put most of the 45% of profit you send to the government back in their pocket. Private equity firms acquire most agencies as an asset purchase. They then amortize the purchase price over 15 years for tax purposes. In addition, the firms are levered up with debt, reducing the equity investment the PEG has in the deal. Sure the PEG has to pay interest. However, in this current interest rate environment, it is very inexpensive to borrow money. Most firms today have debt leverage approaching seven times EBITDA. The end result is no tax and high cash flow. There is also a small equity investment, but the return is on the entire business. 

For example, assume a firm has a $100 million valuation derived from an EBITDA of $8 million at a 12.5x multiple. The acquirer writes off nearly $6.7 million a year for 15 years—saving $3 million annually in taxes (assuming a 45% tax rate).

Now assume a 40% equity investment and 60% debt at 5% interest—$3 million of interest annually. There is thus $8 million of EBITDA, less nearly $6.7 million of amortization, less $3 million of interest expense and what have you got? Negative earnings.

You go from significant profitability and a high tax bill to a loss carryforward with roughly $6 million of positive cash flow. Yes you have to pay the interest, but the results are drastically better than without the leverage.

Now assume the value of the business grows just 10% to $110 million. The return on equity is 40%! How? Because the $10 million of value growth was added to the nearly $6 million of positive cash flow divided by the $40 million of initial equity. This equates to a 40% return ($16 million/$40 million). That’s the dirty little secret in a nutshell.

You may like it or hate it, but you have to admit it: Leverage and no tax creates shareholder value faster than an environment with tax and no leverage. Isn’t it a little easier to understand now why private equity is spending billions of dollars to get into and stay in the insurance industry? 

Market Update

Another 31 deals were announced in August, bringing the year-to-date total to 251. With four months left in 2015, the current total exceeds the annual total of five of the last 10 years. Private-equity backed brokerages have announced 100 domestic deals year to date and are on pace to shatter the buyer group’s total of 125 deals last year.   

If you use a smartphone or look on the Internet, you are aware of the significant volatility that has been occurring in the U.S. stock markets. The economy in China sent a shockwave across the globe and caused significant fluctuation in the latter part of August. The U.S. markets rebounded, then dropped again. What does this rollercoaster mean?

Your guess is as good as mine. Will reduced stock prices affect the publicly traded brokerage’s willingness to buy? Probably not. Will it affect how much they are willing to pay? Maybe. The reality is private-equity backed brokerages are the ones driving the competition and driving the pricing in the market. The publicly traded brokerages are forced to increase pricing to stay competitive. There is some speculation due to the stock market instability that the Federal Reserve might not raise interest rates this fall.

Some economists are concerned the U.S. economy is too fragile right now and a rate increase would be irresponsible. A continued hold on interest rates would likely allow the M&A market and valuations to hold their current trajectory. There is one thing you can be sure of: The market will correct. It is not a matter of if, but when. There are so many market forces at work that the timing of this correction would be pure speculation at this point. 

Hub International announced six transactions in August, bringing its annual total to 20 in the U.S. It is in a tie with AssuredPartners for the top spot in the industry. Confie Seguros continues its dominance of the non-standard auto niche, acquiring three more firms in August. That puts its year-to-date total at 13 deals. Arthur J. Gallagher is sitting in third with 11 deals.  Rounding out the top five are Brown & Brown and NFP. They are both sitting at eight announced transactions.