At SNL Financial’s November Insurance Brokerage Conference, Doug Hammond, chairman and CEO of NFP, discussed the necessity for leaders to innovate, which he defined as the ability to adapt to change.
Innovation, he said, requires a balance between three key tenets: (1) managing the present, (2) selectively forgetting the past and (3) creating the future. Number three, he said, is the key to driving value.
Value means different things to different people. For the purpose of this discussion, value means wealth creation. As a consultant, I push clients to recognize the beauty of a healthy balance of both revenue growth and profitability—building value by investing in growth without sacrificing short-term return to owners. Most believe growth and profit are mutually exclusive. But the best firms in this industry have struck a balance, placing their performance in the top 25% for both organic growth and EBITDA margin.
We preach producer reinvestment, mentoring, carrot-and-stick compensation models, minimum new-business requirements, and developing a differentiated, consistent value proposition. All of that entails building a systematic new-business engine, which is all a firm needs to create a lasting foundation to drive long-term shareholder value.
The traditional business model includes hiring producers and paying them adequately so they produce new business. You don’t overpay them on renewal. This ensures you can reinvest in value-added services and staff to support strong operations. And all of this is done while still producing a decent margin.
But what if there is a faster—dare I say “innovative” way—to get significant value for shareholders but on a closer time horizon? Forget the long-term grind of new producers and instead construct a model that essentially overpays to create a growth engine at the cost of margin.
My next few paragraphs go against every fiber of my being, but I hope the concept is intriguing. Assume your singular reason for entering the insurance distribution world is wealth creation (to drive value to shareholders). Our experience has shown organic growth has a much greater return than acquired growth because the acquisition cost is significantly lower.
Imagine if you could restart your agency. You publicize to the world you are going to pay your salespeople 50% commission on new and renewal business. Your compensation model is intended to attract the best and brightest producers in the industry while surrounding them with high-quality service teams and a slew of resources (loss control, claims, analytics, ERISA attorneys, compliance resources, etc.). Producers have the ability to make significant income while at your firm and have one job: to drive top line revenue. Your unstated goal is to grow revenues as quickly as possible in a five- to 10-year period and ultimately sell externally at the highest valuation possible. You sacrifice short-term return for your growth-at-all-cost mentality.
The producer compensation model and cost of resources will leave you with little to no income through the short term. But if you attract the right producers that generate significant revenue, you should be well positioned to grow your firm at an incredible clip.
Then when you meet the requisite revenue size, you cut the compensation of all producers to 40% new and 25% renewal, input a small-business unit to handle any business under $5,000 in commissions, and—abracadabra—you have a 30% margin and 3x revenue valuation (in today’s market).
Of course agency acquirers would be wary of the massive compensation change and having producers jump ship at closing. Solution: You cut them into the deal at a significant level. You pay them 4-5x their compensation reduction in exchange for a recommitment to the new employer. Perhaps you make that a part of the pre-negotiated producer agreement when you initially hire them. Let them know that the better they do as a producer during their tenure, the more successful they will be when the transaction occurs. Without actually having ownership in their book, they have a vested interest in growing it as quickly as possible. So not only will the producers be paid roughly double the industry average for renewal commission, they have a chance to receive a significant payment when an agency sale occurs.
Another potential roadblock would be restrictive covenants of your new producers. It will be important for you to honor all restrictive covenants (non-solicitation and non-compete agreements). It’s important when you bring producers on initially that you allow them to wait out their agreements. This will give a buyer comfort that when it acquires your firm, it won’t be bogged down with lawsuits over producer defections shortly after closing.
I know your next question. What are these producers going to do while sitting out their non-solicit agreements? Two things: go find new accounts and mentor the new salespeople from outside the industry whom you are hiring concurrently. Seasoned producers should have significant industry knowledge and make a meaningful impact mentoring salespeople recruited from outside the industry. Motivate both producer types through compensation and their payoff from the ultimate buyout. The bigger the book, the bigger the payday.
It may sound farfetched. The creation of the organization and hiring must be done strategically. If wealth creation is the core goal, this could be an innovative way to get there.
Market Update
October’s 31 deals marked a new annual record high of 326 transactions. 2015 is now officially the most active M&A year in brokerage history. With two months left, 400 deals is possible.
Fifteen buyers have completed five or more deals this year. Combined, they account for 161 deals, 49% of all transactions. There have been 154 firms that have done deals, 118 of which have completed just one.
Assured Partners (28) and Hub (27) continue to be the top domestic acquirers. Non-standard auto-focused Confie Seguros has 17. Arthur J. Gallagher announced 13, and Acrisure has 11. Greg Williams, chairman and CEO of Acrisure, said recently the firm expects to complete 54 transactions this year, nearly half of which will be small agency or book of business purchases. For strategic reasons, it has chosen not to announce most of its deals.
With about 18 private-equity backed buyers, four publicly traded brokerages, a handful of banks, and many independent firms all interested in continuing their acquisition strategies, there is a demand that continues to drive both deal volumes and valuations. And with nearly $3 billion of acquisition demand annually, the momentum will continue in 2016.
The Fed has signaled a rate increase soon. That may increase pricing as leverage becomes more expensive, but only time will tell if this valuation headwind is enough to slow down the marketplace.
