You can’t go a day in the US insurance industry without learning about a new merger or acquisition (M&A). It’s one of the loudest and most significant trends in the industry, and it’s showing no signs of slowing down in 2019.
One area of considerable M&A activity in the US insurance industry is the distribution channel – America’s brokerages and agencies. This is partly due to the fact that private equity (PE) investors have identified the distribution space as a “hot spot” for buying, selling and making quick returns, according to Steve Bolland, managing director at financial and M&A advisory firm, MarshBerry.
“In the past five years, we’ve seen year-on-year increases in the number of M&A deals completed in the insurance distribution space – and the prices for some of these transactions have never been higher,” Bolland told Insurance Business. “The price to earnings levels we’re seeing in the marketplace today would have been inconceivable 10-years-ago, and if you look back 20-years, PE was not interested in any way, shape or form in the distribution space. Then, a couple of successful deals happened in the early 2000s and the dynamics changed.”
One deal of note was the purchase of Hub International Limited by PE firm Apax Partners in 2007. Hub International claims to be the eighth largest insurance brokerage in the world. With PE backing, it has grown to include more than 400 integrated brokerages across North America, with 9,000 employees.
“When PE got involved in the insurance distribution space, they realized they could make very good returns on their investments,” said Bolland. “Also, it’s a record of significant success. In the past 15-years, I don’t believe I’ve seen an unsuccessful transaction by PE in the US insurance distribution space. A few of the successes we’ve seen have been of a very high magnitude, with PE firms making 5X, 6X, 7X their investment money within three to four-years.”
Another trend Bolland has noticed with regards to PE investment is their tendency to “grow, rinse, repeat.” This is when a PE company buys a small brokerage, builds it into a mid-sized brokerage via M&A, and then sells it on to another PE firm who will repeat the process to scale the firm further. The brokerage climbs the ladder in terms of size, while being passed on from PE owner to PE owner.
According to Bolland, there are around 24 major distribution entities in the US that are being driven by PE money – Hub International being one of the more well-known because of its transparent media strategy. For nearly all of these PE-funded entities, the model is to grow by acquisition within a three-seven-year period and then sell for a good price. But, as market dynamics evolve in the next few years, the returns on some of these transactions might start to drop.
“At MarshBerry, we think pricing for some of these distribution transactions will probably start reducing at some point because some of the elements that drive valuations are changing,” Bolland commented. “Rising interest rates could have a very large impact, especially if a PE firm takes on a large amount of debt to finance a transaction. Perhaps more importantly, a change in the US tax law, which limits PE firms’ deductibility of interest payments in a few years, could have an even bigger impact.”
M&A transactions today are often driven by EBITDA - earnings before interest, taxes, depreciation and amortization. The 2018 federal tax reform limited PE’s interest deductibility to 30%, and in 2022, amortization is due to be removed, so PE firms will only have access to 30% of EBIT.
“That’s going to have a huge impact on the PE firms because they’re currently amortizing the goodwill component in the acquisition cost that they’re paying to buy these firms and deducting it. If they can’t deduct it anymore, this, added to the loss in the amount of interest payments that they can deduct, acts as a significant limitation on the amount of leverage they can put on a transaction, and increases their potential tax burden.” Bolland added. “If they can’t leverage a transaction to the levels that they’re reaching currently, but they still want the same return rate, then PE firms will likely have to start reducing their purchase price. We think the market can’t continue the way it’s going unless PE firms are willing to reduce their returns, which we’re hearing they’re not willing to do.”