Perpetuation Financing Fashionable New Look
Seven times…eight times…nine times…or more. As the largest brokerages have returned to the M&A market with a vengeance, we have witnessed EBITDA multiples paid for some of the larger independent brokerages reach levels not seen since the heyday of 2007. In some cases, buyers are valuing independent brokerages at multiples of EBITDA greater than the multiples realized by their own shareholders in the public market.
And yet, the spread between multiples paid for high-quality firms versus low-quality firms is increasing. This gap will only widen as stronger firms continue to leverage competitive advantages and weaker firms struggle to find ways to grow or even survive.
To borrow a phrase from Alan Greenspan, are today’s valuations another instance of irrational exuberance? It will take years to know for sure, but there are four factors at the heart of the valuation surge:
- Cheap debt and lots of it
- Effective post-closing cost-cutting strategies by buyers
- Scarcity of good assets and management talent
- Market timing.
Cheap Debt—The Fed has made clear that it intends to keep interest rates at historically low levels for the foreseeable future. As a result, debt has become inexpensive, with little risk premium for inflation, and banks are again chasing deals in cash-flow industries. It is not unusual to see bank debt turns, which is the multiple of cash flow to which they will lend, reaching five times or more for the most aggressive buyers. When buyers can borrow these amounts at such historically low rates, they can effectively pay more for the same asset while achieving an identical return on equity.
Cost-Cutting Strategies—The stickiness of commission renewals has enabled buyers to be more aggressive in cutting expenses to drive operating margins. Just look at how producer compensation plans have changed. Remember when 40/40 pay plans were prevalent? Since then the norm plummeted on renewals. Throw in tighter controls on travel and entertainment spending and centralization of overhead functions, and buyers have been able to drive significant growth in profits even if organic growth has been flat.
Asset and Talent Scarcity—The significant consolidation in the last decade has left fewer high-quality firms and management teams competing in the marketplace. When a top-caliber firm becomes available for sale, a well managed sales process generates intense competition among buyers and can achieve stunning results.
Market Timing—After nearly eight years of a relentless soft market, rates are not only bottoming out but are moving higher in certain lines of business. At the same time, economic activity is increasing. The combination of improved rates and overall economic activity has a powerful effect on the earnings growth of insurance brokers, especially brokers who derive the bulk of their income from commissions. And, if interest rates begin to rise, investment income on the float just adds to the bottom line. Buyers sense a turn at some point and are gobbling up assets as quickly as they can.
So this begs the question: Are sellers being irrational if they turn down an offer? At today’s valuation levels, is selling the prudent answer? Not necessarily.
For some firms, the answer is a clear yes, and they should seek advice in selling—maybe even consider taking equity in the buyer to retain some equity upside.
For others, the opportunity cost of handing over the dividend-paying power of their businesses and the reinvestment cost of having to put after-tax dollars to work in a low-return environment are too great. High multiples should not be the sole reason to consider a sale.
Consider the following examples:
- Owners of Agency X, with $15 million of revenue and 20% EBITDA margins, accept an 8.0x EBITDA cash offer. The owners pay taxes on capital gains and reinvest those proceeds in the S&P 500 index (assuming 5% annual return) for five years.
- Owners of Agency Y, also with $15 million of revenue and 20% EBITDA margins, elect to continue operations and are able to muddle along at 3% growth a year, mimicking the rate of inflation and collecting dividends.
- Owners of Agency Z, also with $15 million of revenue and 20% EBITDA margins, elect to continue operations and, with some market lift in rates and economic activity, are able to grow the business 7% per year while collecting dividends.
What multiples do Agency Y and Agency Z need to attract in year five to have more after-tax proceeds in their pockets than Agency X, which sold out? They are 5.0x and 4.6x, respectively.
If Agency Z, an increasingly scarcer asset, sells for 8.0x in five years, the additional wealth accumulated exceeds $7.6 million. Over 10 years, it is even greater: $19.5 million. Those are big numbers.
So, why do good firms sell today? For many, the ownership sits in one of two camps: those with a short horizon who simply want or need liquidity and start counting the money when they hear about the return of 2007-level multiples; and those who have a longer investment horizon and want to keep investing in the business to build and own a scarcer asset.
Many companies sell because a sales transaction becomes the only option to bridge the gap between the two camps. As insurance brokerage firms have become more valuable over time, it has become increasingly difficult for the second camp to provide liquidity to the first camp despite the opportunity and reinvestment costs of a sale. Plus, the next generation of management and business builders cannot afford to finance a buyout themselves.
In years past, insurance agents and brokers turned to Employee Stock Option Plans (ESOP) as an alternative to a sale to satisfy both camps and to perpetuate the business, but the allure of ESOPs has faded. As a perpetuation tool, it needs an upgrade.
The Rise and Fall of ESOPs
The Employee Stock Ownership Plan was first conceived by Louis Kelso in 1956. Kelso was a progressive and a Keynesian economist who spent a great deal of his life trying to figure out how to get a greater share of a firm’s ownership into the hands of its employees and then how to promote it across industries. Eventually his firm, Kelso & Company, developed into a merchant bank and is now one of the largest private equity firms in the United States.
Simply put, the ESOP was constructed as an employee benefit plan with the ability to invest in the stock of its own company (as well as others) and borrow money to do it. The tax benefits were significant. Contributions were tax deductible and debt was therefore retired with pre-tax dollars. Selling shareholders now had a mechanism to receive liquidity by transferring ownership to employees and avoiding an outright sale. The use of ESOPs was prevalent throughout the 1980s across a wide range of industries.
The problems came later. As a defined contribution plan, employee participants were allocated their share of plan assets—including shares of the agency—on the basis of salary and tenure. As a retirement plan, this makes sense.
But ESOPs do not allow for the allocation of assets on the basis of employee performance and relative contribution. Top performers had to rely on separate stock ownership plans and would find themselves as co-owners with a federally regulated plan.
A second major challenge for ESOPs is the repurchase liability. An ESOP plan does not allow for ESOP participants to be bought out for anything less than fair market value. For firms with an aging workforce, this liability could become significant and deplete capital otherwise available to build the business. In some cases, the ESOP repurchase liability can develop into such a financial burden that the company is essentially forced to sell to get out from underneath this liability.
A third challenge for ESOPs is from a valuation perspective. For participants, shares are valued using a combination of fair market value tests with discounts for marketability and liquidity. Shares are not “worth” the value that could be achieved in a change of control transaction.
Despite these challenges, studies have shown that firms with high levels of employee ownership have outperformed their peers. Particularly for service businesses, such as insurance brokerages, a culture of shared ownership is important to success. ESOPs were on to something as a perpetuation tool. The tool just proved too cumbersome and inadequate over the long run.
The Next Generation ESOP
Beginning in the 1990s and accelerating in the last decade, private equity investors emerged on the scene as buyers of insurance brokerage firms. They realized that, even though assets “went up and down the elevator at night,” the underlying cash flows are relatively stable and return on equity is excellent. Most private equity groups acquired a “platform” firm, or brought in a team to do so, and proceeded to build a large organization in which the majority of ownership resided with investors. Today, 17 of the 100 largest brokerage firms are financed and owned by private equity firms.
But what about the insurance brokerage that wants to retain significant ownership so that the bulk of the reward for building value in the firm stays with key employees and shareholders and not some outside private equity shareholder?
The minority investor can be the ideal solution for facilitating the transfer of ownership. Think of it as an iPad compared to a manual typewriter. The minority investor holds these three key advantages over an ESOP:
- With a minority investor, equity incentives can be doled out to employees who deserve ownership, as opposed to following rules imposed by federal labor laws based on employees’ salary and tenure.
- Future capital, to the extent required, is more easily obtained.
- The investor partner can help finance the shareholders who exit and/or retire from the company.
How does this next-generation ESOP work? First, it has attractive pricing. Like the ESOP, a minority investor provides selling shareholders with immediate liquidity at current market value. For owners who remain invested in the business, sharing in shareholder dividends continues.
Selling shareholders can also pick and choose who sells and how much. Unlike an ESOP, a minority investor can be flexible in providing liquidity to those shareholders who want to exit while aligning with those shareholders who want to remain owners.If you have deep-pocketed funding in place, the right minority investor partners can be a ready source of capital to the company for acquisitions, investments in staff or operations, and funding retiring shareholders over time.
Is the Next-Gen ESOP for You?
Some insurance brokerage firms are built to grow. Others have been built to be cash-flow lifestyle businesses. Both are ideal candidates for the next-generation ESOP. Before you consider a sale of your business, look into the next-generation ESOP. It may be the best wealth transfer decision you make.