The Nourishing Force of Private Capital

Scally: The insurance brokerage industry on a stand-alone basis is exceptionally valuable. It has elements that both private equity and other investors really value, and that is recurring revenue, long-term relationships, and clearly being part of an ecosystem that generates a lot of dollars. If you look at total amount of premium that’s placed in the corporate market, whether it’s in the jumbo section or small market, it’s massive, and being able to be a part of that creates a successful foundation.

Now, it’s not all about throwing dollars into the space and just allowing it to grow. Private equity is as much about investing as it is about business building. And, given how fragmented the industry is, it’s created a lot of opportunities to sophisticate sales force management, to improve and sophisticate the placement of premiums, which creates value for the insured as well as for the brokerages themselves. I think all of this has in some way led to a really nice marriage between private equity and the insurance brokerage space. Of course, the other major driver that comes from its being a fragmented market is the fact that M&A and roll-up is extremely accretive to the companies that are being acquired but also to the platform that’s acquiring them. If $1 of EBITDA is worth eight, nine or 10 times in business number one (the smaller regionalized broker) and it’s worth 15 times plus in a larger platform, smart people are going to come into the market and figure out that arbitrage.

Scally: That’s question number one on all of our diligence support for our private equity clients and sponsors who are investing in the space. This is an industry that has seen roll-up M&A accelerate over the last five, 10, 15 years, but interestingly enough, very consistently, there’s more and more folks hanging their own shingle, which means, over time, there are new, smaller, mom-and-pop brokers that are coming up and growing their business. When we talk about core EB or human capital brokers plus P&C, there’s something like 22,000 or so brokerages in the U.S. based on our math. When we use that same methodology going back to 2016, that number was somewhere around 23,000. With all the accelerated M&A over the last five years, there’s been a decrease in maybe about 3% to 4% of the total brokerages that are out there. So when we see and talk about runway, we’re bullish on the ability of this to continue to happen. I think a major driver will be is there still enough of that arbitrage, that multiple delta between the value of a sub-$5 million revenue brokerage shop versus the large platforms of the world.

Balasubramanian: We do also believe that, in at least over the next five, seven years, the sources of value creation will expand. In particular, we think that there are three additional sources of value creation we are starting to see private equity sponsors as well as brokerages focus on. The first one being premium yield: how do you make sure that you’re able to appropriately optimize the commission dollars you actually collect for every dollar of premium. What we’ve seen a lot of brokerages do is start to bring in analytics to actually help identify where there are leakages, where there are opportunities for optimizing the premium yield. So we do think that’s a big source of value.

Organic growth is also going to be a big differentiator. Over the last several quarters, organic growth has been quite robust in the industry, in the mid-single digits. You are seeing differentiation starting to happen there across the brokerages. There are some brokerages that are starting to hit high single digits, low double digits in terms of organic growth. And again, there are a number of opportunities in terms of how you think about a sales and go-to-market model. How do you really use analytics to better identify prospects and retain clients over time?

Then finally, we think there’s going to be this theme around better leveraging digital and analytics across the value chain, whether it’s in terms of helping you drive up core performance, creating new revenue streams, providing benchmarking solutions to clients, or advising them on their loss optimization strategies, all the way to actually creating brand-new businesses. We do think that the arc going forward is going to focus a lot more expansively on value creation levels. The game will be won by those who are able to effectively deliver.

Balasubramanian: I think a lot of brokerages sit on a large treasure trove of data. It just sits in multiple different places inside a brokerage organization. They are in a unique position in the ecosystem where they’re actually seeing data both from the client as well as from the carrier. So I think that’s a great starting position to be in, and very few of them have actually tapped this data effectively, because it’s not been a priority for most people.

What we’re also now starting to see is augmenting the data which exists within brokerages with data which exists in the outside world. Think about geospatial information about your clients’ activities. If you’re a retailer, how do you know how the business is doing based on what the footfall traffic is in and out of the retailer, and how does that compare with the retailer that’s next to you? There are providers out there which are now starting to bring to bear different types of nontraditional data sets, which brokerages and carriers are finding to be quite valuable in helping to identify prospects. If you’re an MGA for example, you can use it to actually do the first level of underwriting of risks. So we do think that there is significant value in terms of combining data which exists for brokers with external data, obviously maintaining guardrails around PII and confidentiality, which is something which needs to be established. I think we are at an inflection point right now in terms of how brokerages can actually leverage data.

Scally: And the data that sits within brokerages, to Ramnath’s point, is certainly underutilized or under-mined. But private equity firms have consistently invested in and around the insurance ecosystem, and that includes service providers who have access to either proprietary data or algorithms to evaluate that data. I think that’s only going to continue. In order to best position yourself, I think utilizing your data to the utmost is going to be even more important over the next three, five, seven years.

Scally: I think, fundamentally, as long as there is going to be a difference in the value of that EBITDA, whether it sits on a small platform or a larger one, you will have M&A as one of the core drivers and core parts of an investment thesis for any financial sponsor. We have seen this movie play out over again for 10, 15 years now, and there has been more sophistication once you reach a certain size. Do I want to ensure that I’m centralizing a lot of my back-office functions to ensure I’m driving as much value as possible from that? Can I sophisticate the CRM process, the sales process? Another big driver of centralization post scale, post M&A roll-up is a succession plan. The brokerage industry is older in terms of demographics than the national averages. Because it’s such a relationship-driven business, the importance of succession planning coincides with a lot of the scale these businesses have acquired over time. I think that has driven more focus towards centralization. But again, I don’t see it as an either/or—a pure graduation from an M&A roll-up shop to a centralized, sophisticated broker that is not doing M&A. It is a bit of a balance between the two. But I don’t think you give up one for the other.

Balasubramanian: If the last decade was probably 90/10 in focus on M&A versus some of the other value creation levers, we think the next decade will be more like 50/50. M&A will still be an important part of the overall thesis. But some of the other levers we described—premium yield, organic growth optimization, digital analytics—will become a lot more important.

Scally: On the very macro level, we continue to see increasing and accelerating rates of the complexity of risks that have been placed in the market, both pre and we believe post pandemic. So the more complexity and more specialty, the more important underwriting becomes, the more important additional distribution channels become, especially in wholesale brokerages, and then the reinsurance for the carriers. So as long as you’re seeing and continuing to feel the acceleration and the complexity of the risks being placed, I think you’re going to see an interest from private equity sponsors following this trend and putting their dollars behind it. It ties back to value chain compression. Are you going to see more substantial roll-ups in combinations here? I think that remains to be seen.

Scally: I would say the acceleration of the complexity of the risk, yes, it is going to continue to happen. I mean, how do you think about valuing and protecting data? Five years ago, we discussed cyber risk. Sure. That’s one piece. But what about the data as it’s essentially insured, in and of itself? You talk about the value of NFTs [non-fungible tokens] that are happening now. Well, once you start placing a specific value on a data and it’s compromised, what happens then? How are you going to underwrite that as a carrier? How much of that risk do you want to keep on your books? How much do you want to offload to the reinsurers?

Scally: I think if you look across the distribution channel and you look at the large-scale or long-tail runway of those 22,000 or so smaller, regional, or mom-and-pop-esque brokers, they are now more and more competing with producers who have access to better sales channel management because they have been acquired. They have better access to data, have better access to benchmarking placement resources that exist. So how do they compete? I think you see affinity networks, where private equity has started to evaluate and put money towards. You see marketing agencies, as well as MGAs. MGAs to a certain degree all coming together. And a lot of the general support here is how do we make you as competitive as possible as a small-market broker and now competing against your rolled-up colleagues that are sitting there. So again, whether it’s an MGA, whether it’s an affinity network that is helping you with your own placement in a sales force, whether it’s a marketing agency that is improving your own position in your community or getting you access to carriers you wouldn’t have access to, these are all important levers.

Balasubramanian: I think the independent marketing organization space is probably five to 10 years behind the retail brokerage property and casualty and EB spaces for a few reasons. One is it’s still highly fragmented. Over the last few years, we have seen the emergence of what we would call consolidators, which are rolling up smaller platforms and trying to bring more organization discipline and formal support to the small audience. You see private equity actually participate in that space. A fair number of IMOs are still privately held or family owned. They were started by the founder, and they’ve grown over time organically, so there’s still a fair amount of opportunity out there for private equity to participate in this.

I think there are some inherently different characteristics between what IMOs do in terms of the product set. IMOs focus more on life and annuity products, and you need to have replacement sales every year. You don’t have the benefit of essentially having a large book of business and you just grow that business over time and that business is sticky. So you need to sell a new annuity every year—could be to the same plan, could be to a different plan. If you sold a life policy in a particular year to your client, it’s unlikely you’ll sell a life policy again that particular year. The way the compensation structures work in life insurance, it’s heavily, heavily weighted towards new sales. The onus for the agents or the advisors who are part of an IMO to actually go and hunt every year is much, much higher than when it comes to retail brokerage. So it is much more of a spiky view-driven kind of structure than it is a sticky, more certain business, which is why I think it’s taking a little bit of time for private equity owners to get their heads around this business.

Some of the larger IMOs are also trying to diversify their revenue streams. Because they have a book of business of clients, they’re trying to see if they can supplement that by adding RIA [registered investment advisor] type of services and capabilities. So you’re starting to see situations where IMOs are actually consolidating RIAs and bringing both suites of capabilities to the agents. [Here’s more on our life sector conversation.]

Scally: Well, “competitors” can be a loaded word. I think you’re right, though there’s blurring lines and overlapping Venn diagrams that we’re seeing here. I think one piece on the EB side where we’ve seen consistent growth is the PEO [professional employer organization] market. Pre pandemic we would estimate roughly four million lives were under a PEO employment model, meaning their workers comp, technically a P&C line, is being placed through those entities. A bit of a misconception is that all those lives are pulled into a centralized or master health plan. I think that’s not the case. I think the majority of PEOs offer that—something like 30 to 40, 30 to 50% of lives uptake—but that is certainly premium commissions and/or fees that are being pulled out of the small end of the broker market and aggregated up. It’s not revenue that’s leaving the distribution channel, but it is being consolidated because these PEO providers themselves have their preferred one, two or three brokers, typically more scaled, not as localized.

It varies very differently if you’re a large-scale PEO with 500,000+ worksite employee lives versus some of the micro fragmented PEOs that maybe have 10,000 or 15,000 lives. But at the end of the day, you’re seeing that as a tool that’s consolidating this. And it’s been a very effective way for businesses to improve their premium cost, because they’re getting larger scale per employee workers comp charges to them. It’s also a way for them to outsource simultaneously some of their traditional HRIS, whether it’s payroll or benefits administration. It’s a model that we think is going to continue to grow off that four million base. I think we’ve estimated it could grow in the 10% to 15% per annum range, which means five or seven years from now, you could have eight million-plus lives in that space. That starts to be meaningful, and to dimensionalize it, we think there are roughly 35 million lives that are addressable by the PEO market. So even that eight million number doesn’t really reach that ceiling or threshold.

Balasubramanian: In the employee benefits space this convergence between health and wealth is increasingly becoming relevant. As brokerages look to provide the full suite of capabilities and services to their clients, how do they add on to what they’re doing on the health side with capabilities on the wealth side? You’re seeing cases where they’re collaborating with RIAs or in other cases they’re actually acquiring RIAs to bring those capabilities to the client. I think you’re seeing this trend in terms of, “I have a client. How do I maximize the full suite of value and services I can provide?”

Balasubramanian: And another example would be benefits administration. Again, if you look at the workplace being the primary channel for accessing clients and customers, then who really owns that end client relationship? Today, it’s a very dynamic ecosystem. You’re starting to see a lot more convergence happening there. You’re seeing brokerages who acquired benefits administration platforms because things are moving away from employer-to-employer sales to actually voluntary and more employee-driven purchases. So having that point of access is important. You’re seeing carriers also trying to acquire some of the benefits administration platforms. Again, all in the spirit of how do you get deeper and deeper access to the end client, because the game is shifting from just being B2B to being B2B2C.

Scally: I think the brokerage industry as a whole has done a phenomenal job of adapting, continuing to add value, maintaining their relationships, and really being a trusted partner for the insurers. But one area where they may have slipped a little bit is seeding some of the administration and the enrollment capabilities to other players in the ecosystem. We think that’s going to become more and more important for a few reasons.

The first is just the general move to the consumerization of healthcare. You continue to see the growth in self-insured lives, as well as a model where consumers, not just millennials, but employees and consumers as a whole, are taking more control of their healthcare spend, their management, whether it’s through health savings accounts or just an active role in it. It’s not just a B2B component, where I own the relationship with the CFO, with the benefits manager. It’s also a relationship with the employee that matters. As healthcare becomes more consumerized, as we potentially have more remote work environments, the enrollment—and then the guidance and advice that the employee needs and ingests—is going to become more and more important. I think brokerages really have to think through what is their plan for enrollment period, what is the plan for our employers, employees, and how are we going to stay very, very relevant in that space?

Balasubramanian: I’d say that it’s been remarkable how resilient the economy has been in 2020. And I think it’s a function of interventions and what governments as well as central banks have done across the world. I think we remain cautiously optimistic about 2021 and beyond. You’re starting to see that in the indicators around us as well when it comes to consumer sentiment, manufacturing pickup, the last two or three quarters of economic growth, and you’re starting to see that optimism clearly reflected in the deal environment. If you’ve seen the deal environments since late summer, early fall of last year, it’s probably the hottest deal environment we have ever experienced. We expect the deal activity to be fairly robust for most of 2021 and into 2022. There is a huge pool of capital out there looking for investment opportunities. This also means that the competition for these deals is going up significantly. We’ve seen that as well in terms of the multiples that some of these assets have been trading at. You’ve seen special purpose acquisition vehicles as a big source of alternative exit strategies for a number of these players. And that’s going to continue.

I think it only emphasizes the point that core value creation has to be more expansive. It cannot be reliant on one or two things which we do well, which is largely M&A or consolidation driven. It has to be a lot more holistic. I think to be able to justify this premium valuation, you have to demonstrate that you can execute on these valuation levels better than anyone else.

Scally: To end on a somewhat positive note, I fundamentally believe private equity plays a core and important role in our economy. Everything from providing pensions, endowments, other capital sources with access to middle-market private growth companies, to sophisticating and growing those companies. They’re in the business of building businesses. I think that role isn’t going to change in the near future, and I’m bullish on their ability to execute on it even with some of the multiples growing.