We’re in the Money

We’ve talked previously about the growing pool of alternative capital parties who are interested in this sector, in addition to the typical private equity firm. Can you talk a little bit about who those parties are and why they’re so interested in this segment?

There are four broad pools of alternative capital providers outside of private equity. The first two are pension plans and sovereign wealth funds, both of which manage money on behalf of governments, states, provinces, municipalities or other similar organizations. The third is family offices, which manage money on behalf of wealthy families or groups of families. And lastly, there are what I call structured funds. This is a pretty broad bucket but tends to include parties like credit funds, long-term funds and other pools of capital that can generally be flexible in their form, structure or term of their investment. Across all of these, they’re largely managed by investment professionals who have come from the investing industry, and, broadly, they’re all looking for return opportunities where immediate liquidity or near-term liquidity isn’t an issue. As they’ve looked through the landscape of insurance brokerages, there has been a pretty attractive opportunity set.

Simply because it’s providing the kind of returns they are looking for, or is there anything else that drives that?

I think there are a few things within that. I think the why is actually more important. First of all, I’d say there is the return dynamic. If you look at what private equity firms have earned, they have an impressive track record of investing, so it’s no surprise that others would actively consider emulating what they have done.

Secondly, the underlying characteristics of their business are highly stable cash flows, recurring product, a mandatory product and strong cash flow generation. I think if you talk to the investment community about it, those are investments people love to find and are looking to consolidate and grow around.

And, lastly, a number of these funds have the opportunity to make direct investments into companies. As a result, it minimizes the fees—or even eliminates the fees in many cases—that they would have to pay as limited partners in private equity funds. So all in all, if you wrap those three together, it’s a pretty attractive opportunity.

Do these alternative capital providers offer something different from traditional private equity firms?

Before I discuss the differentiators, I should probably say that I think each situation and each firm is kind of unique. So while there may be a few general areas of differentiation between the alternative parties and private equity, it really is very situation-specific and the lines do tend to blur a lot. But as I think about the differentiators, there are a few key areas.

First, many can underwrite a longer hold period and give management teams a longer runway to focus on their businesses than private equity. Second, some are willing to take minority positions or joint control positions rather than full control.

Third, on the whole, they can be relatively passive investors. While they may want some board or governance representation, they are likely to be less active than traditional private equity firms. And lastly, like I said before, they’re open to investing in other parts of the capital structure as opposed to simply common equity.

Not to say these are all benefits. They each come with their pros and cons, and you have to think about them. But you put various elements of those together and, for many of the management teams and brokers in the space, they can be an attractive alternative.

Some reports have indicated that the joint approach to buying—for example, a combination of private-equity backed buyers and alternative capital providers, together—is on the rise. Can you discuss this as an element of the brokerage investment approach.

I think in selected instances—and I would say primarily in the larger brokers—is where you see them partnering. This has largely benefited both sides, and I expect it to continue. As brokers continue to get bigger, the equity checks to basically acquire these businesses continue to get bigger. So finding a partner for the private equity firms to help fund the transaction is a critical element of putting any of these deals together. On the other hand, the alternative capital providers also like the deal flow, the due diligence support, and other ongoing monitoring and functions that the private equity firms provide. So I expect that to continue.

The other thing I’d also mention: in some instances, some of these alternative capital providers have their own limitations on how much they can invest, whether that be in dollar terms or in terms of percentage ownership of companies.

So it makes for a nice partner in a way.

Exactly. It works well for both. They get good access to information, and it’s a deal that helps from a fee and cost perspective. So I think they marry up pretty well.

We know that valuations have been very strong over the past few years. Do you think this increased level of interest in this sector will keep valuations robust, or do you feel like some of the recent retrenchment in public equity valuation will impact brokerage valuations and the M&A market for larger and smaller brokerages?

I think there are two elements to this. You might call me a little bit of a contrarian here, but I think, aside from a meaningful economic slowdown, valuations in the insurance brokerage industry are somewhat insulated from the broader market volatility that we’ve witnessed. I talked about some of the characteristics of the businesses: the cash flow, the recurring nature, the visibility in the earnings profile. I think all of those things are highly sought after by the market and, in any period of volatility, these businesses are a great store of value for investors—public or private.

Now, your point about incremental capital coming into the industry: yes, I do think that’ll have some marginal impact on valuation. Others have put out studies that talk about how the valuation of tuck-in acquisitions or platform acquisitions has ticked up, so I expect that either may continue or level off. But, yes, that has definitely played an impact on the smaller end of the market.

Do you think we’ll see any of the larger, privately owned businesses end up going public?

It’s a good question and actually one I get asked a lot. My view is, absent the need to create some form of ongoing liquidity options for retiring or employee shareholders, there are actually very few incentives for many of the brokers to consider going public. The disclosure requirements, the compliance, the regulatory costs, the impacts on leverage are all important considerations that I think sway many people on the side of trying to stay private for as long as possible.

Now, that could change. Folks were saying a few years ago that some of the bigger businesses had to go public as they thought about their next evolution. But the sources of capital to fund these businesses has only continued to grow. So, with funds and the alternative capital that comes in, the ability to stay as a private company, as they get bigger, is only perpetuated.

And that’s not just insurance brokerages. It’s across all sectors, these days. You have some very large private companies in other parts of the economy which are private-equity owned because of the ability of capital to back them.

Turning away from the market, when you have worked with these firms, what are some of the primary areas of due diligence they’re focused on as they make these business moves?

There are a few areas that folks focus on. First of all, what are the operational characteristics of the business? What’s the organic growth? What are the margins, cap ex, working capital, etc. Investors really want to understand the historical and forward trajectory of these metrics.

Secondly, what are the operational enhancements that are being implemented to create a long-term sustainable business? How is the management team fostering cross-sell, how is acquisition integration managed, how are they using technology to empower the broker and deliver better customer service?

Third is the acquisition pipeline and capability of the management team. What competence do they have in that pipeline and the sourcing of deals and the ability to execute? This is somewhere people spend a lot of time. M&A is a very important driver of value here.

Then, lastly, there’s a real sense of understanding the fit with the management team—culturally, socially, philosophically. Are they entering into a partnership with a team they can back through thick or thin? Importantly, I’d say this is a two-way street. That’s where management needs to test out their potential partners as well. Can they see them working together?

I would think for some of these alternative partners, where they’re looking at longer holds, that might be even more crucial.

Absolutely. And in there, we end up talking largely about some of the succession issues that these firms need to start thinking about as well.

You mentioned technology as part of the due diligence process. Can you talk a little bit more about what it means to be prepared to address technology advances?

I think we all recognize that technology is drastically changing the way we interact and how we all do business these days. I look across the financial services landscape and at what has happened in banks or what has happened in payment technology. The speed at which this has all moved, and particularly moved to mobile, is somewhat fascinating. I mean, I don’t even walk into a bank branch. I don’t think I’ve actually had cash in my wallet for several months.

But you know what’s just funny? I still have to pay my insurance premiums with a check. So stepping back, I look back and say, “Wow, there’s a huge runway here for the insurance industry and brokers to really integrate this whole technology element into the core element of what they do.”

What do you think they can do to stay ahead of the change, if that’s possible at this point?

I absolutely do think they can. And, look, to be clear, I don’t think the agent or the broker is going away, especially in the middle market, large market or even in market niches. They provide real value in explaining the product, terms of conditions, deductibles, exclusions, advisory services, all of those elements, in addition to the sort of regulatory and legal issues that they help guide people through. As you know in the employee benefits role, that’s incredibly important. Also, they are the face of the businesses. This is fundamentally still a people business.

I do think, however, there’s huge potential to empower producers with better tools and products. Essentially to improve the ability to sell product and, secondly, improve the customer experience and ultimate value proposition to the CFO or the chief risk officer who has to manage this and is trying to figure that out for their organization. So what tools can you give them to empower them as better salespeople? What tools can you give them so the service experience incorporates all the developments we’re seeing in the banks and payments world?

Whether it’s the ability to create tools to use in a customer-facing way or to handle claims, are there certain areas where you think the insurance industry will be upended, potentially for the better, by insurtech?

I think there will be a number of changes across it. I think the place you’ll feel or experience the change first is largely going to be in consumer-facing businesses—personal lines as an example…auto, home and other near adjacencies that touch the individual. I think that is an easier market to first get your heads around than small or midsize commercial insurance, which has a whole variety of complexities to it.

I’ve spent some time with some really innovative companies in this part of the market, and I think they have the potential to build out some long-term, scalable platforms that will be real winners.

I will say, though, it’s very easy to talk about it, but I think we all understand insurance is a very complex product to ultimately get your hands around the risk…any of the victors or companies standing here at the end of the day as true operating businesses will have plenty of battle scars to show for it.

Are there any operational segments, in particular, that you’re seeing getting more attention from private equity capital?

There are very few private equity firms that truly think about insurtech, as most of these businesses are too early in their development for them to invest in. Most of the investments here come from the venture capital world or from insurance carriers that are really equipped to spend either the few hundred thousand dollars or the tens of millions that is required to get these companies up and running and demonstrate proof of concept. I think there is probably to come an evolution where more of the private equity players start looking at them as these businesses start to grow. I think that still remains to be seen. A few folks have dedicated funds or dedicated individuals to think about it, but it’s not as pervasive as it is with the VCs or carriers.

There’s value in brokerage consolidation, whether it’s backed by private equity or otherwise. But there is a view that, if consolidators don’t invest in technology and product, there’s a risk that much of the value of these rollups will prove to be financial engineering and basically someone will be left holding the bag. What are your thoughts on that view?

I disagree with the perspective that this is just financial engineering. While there are many factors that impact the sale of these businesses, this is fundamentally a highly fragmented market which faces a generational business transfer issue that the brokers, private-equity backed or otherwise, are helping to facilitate. But I do agree with the other element of your conversation that the underlying component of what management teams, executives and their capital partners—PE or otherwise—should be focused on is building a business that will last a hundred years-plus.

And in that context, what tools are they giving their producers? How do they foster the cross-sell? How do they deal with acquisition integration? What are they doing to improve finance and reporting? What kind of compliance and regulatory systems are they putting in place? How are they developing a long-term strategy for fostering and empowering the next generation of leadership within the businesses? These are all critical elements in creating a lasting business. I think it’s how the PE-backed folks empower and facilitate executive management teams to do that which is the real value creation they bring to operations.