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Talent Scout: Private equity groups recruiting brokers in the M&A game for their solid renewals and healthy, predictable returns.
Leader's Edge, April 2007
Fast Focus
- Flush with cash, private equity groups will continue to raise the stakes in the M&A market.
- Private equity groups target agencies with strong leadership, talent and strategic vision.
There are plenty of players in the minors who never made it to the
majors. To have the professional scouts take notice so that some day
your firm plays in "The Show," you need to consistently hit the truly
big winning numbers and your throw must be accurate and decisive.
To peg that recruiter's eye, the savvy insurance broker must position
himself just right and be at the top of his game. That is the quality
being sought by the private equity groups (PEGs) that are taking the
game out of the family room and into the board room. PEGs are having a
major effect on the insurance distribution industry.
In recent years, PEGs have had much capital to invest, and they've made
some of the largest deals in the brokerage world. If you haven't been
across the table from one of these investor groups, you might be
wondering who they are.
Private equity groups typically represent well-capitalized entities
funded by third-party investors from both the public and private
sectors. They're looking for top-performing businesses in high-growth
markets. Often, they seek to assemble a larger, industry-leading
organization, then "flip" the entity (through sale, recapitalization or
an initial public offering) to monetize the investment.
During the past two years, a number of groups have focused intensively
on the brokerage world, seeking to capitalize on a high-growth,
predictable source of revenue and earnings. Private equity groups have
considered the turmoil of the industry's legal and regulatory issues
along with the soft market as ideal conditions for their brand of
renovation. With a brokerage's stable cash flow and low capital
expenditure requirements, what's not to like? An acquisition is
especially desirable because debt can be used to magnify the
investment's return on equity. And they have been hitting very near the
mark.
Private Equity Groups 101
Almost everyone has heard about PEGs but my experience has taught me
that very few people truly understand how they operate. Before we get
into all that detail, I thought a little "PEG 101" course might be
necessary. A recent article published by several University of
Pennsylvania Wharton School of Business professors stated that "private
equity investors of all types are flush with cash—from venture
capitalists and hedge funds to large leverage buyout firms such as The
Blackstone Group and The Carlyle Group—private financing hit record
levels in 2006 and is likely to remain strong in the new year."
The article reported there were $660 billion in corporate buyouts in
2006 and that private equity groups still have a "war chest" in excess
of $750 billion that they have yet to deploy. The article continued,
stating, "Private equity firms, often working in teams, are now going
after increasingly large deals that once were considered so big only the
public markets could provide financing….Private equity firms are no
longer spreading themselves thin in a lot of investments; now they are
going after more mature investments even if there is a smaller return,
but that's better than just parking the money or not doing much with
it."
Given the current private equity situation, it is no wonder PEGs are
pushing hard into the insurance distribution space. Insurance brokerages
operate in a rather well-regulated environment with fairly predictable
cash flows occurring due to the nature of insurance renewals, recurring
risk management services, etc. In addition, brokerage operations do not
bear risk on behalf of insured persons and thus require far smaller
capital reserves than insurance carriers.
Who's on First?
Consider some of the recent private equity transactions among wholesale
operations—firms made more vulnerable due to the fallout of the Spitzer
investigations. Here are the "Big Three" of recent deals:
- Parthenon Capital acquired a majority ownership position in
American Wholesale Insurance Group (AmWINS). Prior to the Parthenon
transaction, AmWINS had acquired Stewart Smith Group, the U.S. wholesale
unit of Willis Group Holdings.
- An investor group including Hicks, Muse, Tate & Furst (HMTF), Banc
of America Capital Investors, and Emerald Capital acquired Swett &
Crawford, the U.S.-based wholesale brokerage operation of Aon Corp.
- J.C. Flowers & Co. acquired Crump Group, the U.S.-based wholesale
brokerage operation of Marsh.
But the party didn't stop there.
- Lindsay Goldberg & Bessemer invested in Alliant Resources Group
during 2005. Prior to this, Alliant was backed by another private equity
firm, GTCR Golder Rauner.
- Integro was formed during 2005 with the backing of more than $300
million in private equity money coming from a who's who of the private
equity world: DLJ Merchant Banking Partners, Weston Presidio Capital,
Century Capital Management, the pension trust unit of General Electric
Co., hedge fund Highfields Capital Management, and Leucadia National
Corp.
- Mercator Risk Services was formed during 2006 with the backing of
$20 million in private equity.
- Robert Lockhart, former president of HRH, formed Kinloch Holdings
and acquired Genatt Associates during 2006 with PEG backing.
If you thought it was over, you haven't been paying attention. On Jan.
16, USI announced it had entered into a definitive merger agreement to
be acquired by GS Capital Partners, a private equity affiliate of
Goldman, Sachs & Co., in a transaction valued at $1.4 billion. And in
late February Hub International announced that it agreed to be acquired
by the private-equity firm Apax Partners together with Morgan Stanley
Investments for about $1.7 billion.
Also currently aiming at the bull's-eye is one of the biggest players in
the field. Last year, it was widely reported that Willis made an
informal offer to acquire the world's largest broker, Marsh & McLennan,
with financing from the private equity firm Kohlberg Kravis Roberts. KKR
took Willis private in a 1998 leveraged buyout and turned its $305
million investment into $2.6 billion gain when it took Willis public
again in 2001.
Why Target Brokers?
Private equity investors find the insurance brokerage industry
attractive for a number of reasons beyond the vulnerability caused by
the Spitzer probes. It's an industry that has long been in consolidation
mode but still contains much fragmentation. And with fragmentation, a
PEG can use its platform agency as the transaction vehicle for
additional acquisition, which leads to the ability to grow quickly.
But beyond those factors, the industry presents lucrative possibilities.
The brokerage business has low capital expenditure requirements and
provides relatively stable cash-flow. Analysts expect the long-term
brokerage growth rates to surpass the growth rates of other, more mature
industries.
Investors see the potential to put significant amounts of money to work,
too, as the fragmented nature of the business offers plentiful
merger-and-acquisition possibilities. All these factors combine to
present an opportunity to reap significant financial returns from an
attractive risk/reward equation.
How to Get PEGed
What's the profile of a brokerage that would be attractive to a private
equity group? It's a combination of management acumen and firm size.
People are the primary characteristic being sought. PEG investors are
looking for a great management team with a proven track record. The
majority of deals will continue to be with larger agencies that can meet
those criteria. But, as we've seen in some of the recent deals discussed
above, investors are willing to invest in start-up firms if the key
players behind a new venture are industry veterans with proven
experience with PEG money or public company experience.
If an experienced management team is needed to attract a PEG investment,
that goes double for the qualities of a CEO, so I have additional advice
for the CEO who thinks he would like to have a private equity partner.
Make sure you, personally, possess a majority of these qualities:
- Exhibit proven leadership ability
- Are able to recruit and retain talent
- Show strategic vision
- Set goals for the board and constantly exceeds those goals
- Are willing to challenge goals that are not realistic
- Seek advice from others
- Communicate expertly, particularly with your board
Bring up important challenges and issues early and often. Financially, a
firm must be of a significant size in order to be attractive to a PEG.
Typically, such investors will need minimum revenue and EBITDA (earnings
before interest, taxes, depreciation and amortization) thresholds,
simply because of the volume of money they have to put to work. An
investment of $15 million may be minimum, and that number easily soars
from there based on the size of the PEG. As a result, the pool of
insurance brokers that fit these firms' investment requirements narrows
considerably. To sum up, an agency that would be a particularly good
candidate for a PEG investment would fit this profile:
- Minimum revenue of $15 million to $20 million
- Top quartile for profit margins (30%)
- Seasoned management team
- CEO who is a true leader
- Strong sales culture
- Value-added franchise with brand name
- High retention rates
- Established platform with infrastructure
- Demonstrated ability to make and integrate acquisitions
- Strong, long-term distribution relationships.
Anatomy of a PEG Transaction
What can management expect if the brokerage is the recipient of a PEG
investment? While it is impossible to characterize a "typical" private
equity transaction, there are some customary characteristics.
First, the PEG generally takes a majority or controlling interest. The
types of investments can be equity, mezzanine or subordinated debt, or
senior debt. Typically, the PEG will not invest in common stock, but
rather require preferred stock that delivers a preferred return.
The PEG will exert its influence over the direction of the company.
Often, board control is demanded, and the PEG's leadership will focus on
strategic direction.
A PEG will often hold an investment for five to seven years. During that
time, management is expected to co-invest. Transaction fees will
typically fall in the range of 2%-to-5% of the invested amount. An
annual management fee will be imposed. It's not uncommon for a PEG to
co-invest with other PEGs on large transactions. The PEG will expect
returns in the 15%-to-30% range, based on the type of investment.
Minority investments are sometimes made by PEGs, without requiring board
control. However, one of the standard provisions in such investments is
that if certain financial results are not met, then the PEG has the
right to obtain board and operating control of the business.
Private equity groups have become major players in brokerage industry
consolidation, a trend we expect to see retained in coming years. There
are multiple PEGs currently holding hundreds of millions of dollars,
making them very formidable competitors in the M&A realm. They will
continue to have significant impact on the industry during the coming
years.
I expect that private equity firms will confine their activity to larger
targets, based on the minimum requirements of capital that they have to
put to work in a deal. As a result, the publicly traded insurance
brokers and banks are likely to face additional competition by PEGs in
the acquisition of larger, high-quality agencies during 2007 and beyond.
Stepping up to the plate with a full wallet and a clear eye on the
prize, competitors in the acquisition world will find these groups are
tough competitors in scouting out the best firms and recruiting them to
the majors.
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