Talent Scout: Private Equity Groups Recruiting Brokers In The M&A Game For Their Solid Renewals And Healthy, Predictable Returns

February 19, 2008

by Rob Lieblein, Managing Principal of Hales & Co.

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.

Robert Lieblein  is a Managing Principal of  Hales & Co.  - one of the oldest and most experienced investment banking firms specializing in the insurance and financial services industries. Prior to joining Hales, Mr. Lieblein was the founder and president of WFG Capital Advisors, a leading financial advisory firm in the insurance industry. He brings more than 20 years of experience in providing financial advisory services to the insurance and financial services industry. He has been involved in more than 100 investment banking transactions, and is known for expertise in insurance-related merger and acquisition services, including acquisition analysis, acquisition strategy, transaction valuation and structuring, due diligence, negotiations, and post-acquisition consulting. Prior to founding WFG, Mr. Lieblein, a Certified Public Accountant, spent 13 years with the international accounting and professional service firm KPMG. At KPMG, he worked with many leading insurance and financial services firms, assisting them with implementation of growth strategies such as mergers and acquisitions. In addition, Mr. Lieblein is the co-founder of Wharton Capital Partners, a private equity firm involved in starting and acquiring companies since 1997. Mr. Lieblein earned degrees in accounting, mathematics and computer science from Shippensburg University.

Contact:

Rob Lieblein
Email: [email protected]
Phone: 717-541-9300 x101

(SOURCE:   Leader's Edge Magazine )

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