Buyers Take Fresh Look at Capital Strategy

The insurance distribution industry continued its reign as one of the greatest industries in the world. 

After a frenetic 2021, many expected the industry to slow down and collect its breath as global and economic uncertainty overshadowed the global economy. However, the brokerage merger and acquisition engine in the United States chugged along by bringing in more activity than any year other than 2021. We will continue to look with a watchful eye at how much stamina this train has left, but it won’t be the first time the industry has overcome difficult uphill financial terrain. The insurance brokerage industry is often underestimated, but because of its fundamentals it has remained an attractive industry to investors across the globe.

Throughout 2022 and into 2023, as the debt markets have tightened, supply and demand in the insurance brokerage sector has equalized. Sellers have enjoyed several years of premium valuations, as buyer demand outpaced available sellers. But now, as debt has become more expensive or even unavailable to certain acquirers, some firms have decided to (or have been forced to) sit on the sidelines, making the M&A field a bit more level.

The good news for the industry is that many buyers were sitting on a significant amount of capital or dry powder (mostly funded by debt) heading into 2023. The buyers took advantage of robust market conditions in late 2020 and through mid-2022 and raised capital to employ in the coming months and years. Let’s take a step back and examine the fundamentals of the capital structure most private-capital backed brokerages use.

Components of Corporate Funding

Most organizations have common equity issued to individuals that put them into an ownership position. Common equity is typically the stock held by founders and employees. However, many private equity firms are also willing to hold common equity so that all shareholders have a single class of stock.

For purposes of this discussion, let’s assume the basic makeup of most acquirers in our space has standard common equity across all shareholders and a combination of different kinds of debt all aggregating into their “debt stack.” The debt stack is typically the “engine” behind all of the M&A over the past 15 years in the industry.

Lenders, composed of both banks and private lenders, are willing to allow a firm to borrow a multiple of their earnings before interest, tax, depreciation and amortization (EBITDA). The amount smaller independent firms are able to borrow is somewhere between 1x and 3.5x the firm’s EBITDA. For example, if you have $10 million of EBITDA, a lender may be willing to allow you to borrow up to $35 million to use for some specific purpose—usually M&A. Firms that have private equity or family office owners included in their common equity group are often afforded the ability to borrow more than 3.5x EBITDA. As the interest rate environment remained very low for an extended period and company cash flows continued to increase, some lenders allowed private-capital backed brokerages to borrow up to 7.5x their EBITDA. This access to capital has allowed for dramatic increases in M&A activity and pricing.

Fast-forward to today. Not all firms took advantage of what was possible. Some firms kept their leverage (debt) levels at 5x to 6x EBITDA and did not stretch into the 7x+ range that lenders were willing to offer. However, a number of firms did because the opportunity to scale through M&A was available, the capital was inexpensive, and the cash flows of their business supported those levels of debt.

As interest rates have risen, two things have happened: (1) the interest expense on the existing debt has increased, causing borrowers to use more of their free cash flow to pay interest; and (2) lenders have reduced the amount of debt they are willing to lend, to a maximum of 6.5x EBITDA in most cases. This is causing a bit of belt tightening in the industry.

A firm that currently has debt greater than 6.5x its EBITDA is not “in trouble” per se; it just is not able to borrow more until it grows its EBITDA to a level that is below 6.5x its current debt. So, while it may be able to afford taking on more debt and there is debt available from lenders, the firm is not able to borrow until its ratio of debt to EBITDA gets below the maximum allowable thresholds.

This is causing several firms to look at alternative capital options, including preferred equity. Like common equity, preferred equity represents ownership in a company, but it typically has a higher claim to dividends or asset distribution than common equity. Preferred equity has characteristics of both debt and common stock, which makes it appealing to certain investors.

To simplify this concept: when a company issues preferred equity, it is a way for the company to raise capital for specific use (usually M&A), and it is less dilutive than issuing more common equity but more expensive than raising capital via debt. Firms may decide to issue preferred equity over debt for a few different reasons:

a.         Preferred equity is not counted or included in a company’s debt to EBITDA ratio. If a firm is not able to borrow more in today’s market because its ratio is over 6.5x, it can raise capital via preferred equity. This is often more expensive than debt but less costly than—or at least neutral to—bringing in more capital through the issuance of common equity.

b.         Some firms issue preferred equity because of concerns that their common equity might be overpriced internally. If a firm had to issue common equity to a new investor and the investor disagreed with the valuation, it could cause a reduction in the firm’s last internal mark. This would be an admission of distressed value or that it issued common equity to its new partners via M&A at a valuation that was overpriced. Using preferred equity—given the characteristics that it is senior to common equity and convertible—lets firms set a higher value to it and not recognize a decline in the common equity value to their shareholders and the market.

While firms in today’s market might be issuing preferred equity for different reasons, the most likely reason is that the debt markets will not lend to them because their debt to EBITDA ratio is too high. Preferred equity is an expensive but available option in today’s capital markets. Buyers will need a steady flow of capital to fund earnouts that are coming due from the glut of activity in 2020 and 2021 and to keep acquiring new partners that can be additive to their business. Firms will use existing dry powder and cash from operations and may need to tap other sources like additional debt or preferred equity to keep the train moving forward in the months and years to come.

The good news is that demand is still outpacing supply, albeit by a smaller margin than in prior years. Today there are still more than 35 well capitalized buyers who are active in the market, who are looking for the best firms, and who are willing to pay competitive, and in some instances, record-level multiples to get them. There is also still a significant amount of capital trying to get into the insurance distribution marketplace. Debt, common equity, and preferred equity are all available, but the fundamentals at which firms can borrow have changed as the Fed continues to raise interest rates.

What does that mean for firms looking to partner? It means the environment has become a bit more challenging and buyers have the luxury of digging deeper into firm valuations. Multiples are still important, but arriving at a fair EBITDA margin is no longer a simple process.