Insurance agency ratings have weathered the high interest rate environment relatively… (+) Unscathed.
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For nearly two decades, private equity (PE) has been a transformative force in the insurance agency sector, driving consolidation and increasing valuations. Currently, 72% of all agency transactions involve private equity buyers. There are currently more than 50 active merger companies vying for acquisitions, and fierce competition has caused valuations to bubble up. It’s no coincidence that the multiple has increased by more than 50% since the introduction of PE.
Private equity deals account for nearly three out of four transactions.
Sources: Waypoint, S&P Global Market Intelligence, Insurance Journal
When discussing PE activities within the insurance industry, it is important to distinguish between insurance companies and agents or intermediaries. PE has shown little interest in carriers, which are more capital intensive and exposed to underwriting risk. In contrast, insurance agents and wholesalers (MGAs), which represent customers in the process of finding the best insurance at competitive rates, have become prime investment targets.
but why? To understand this trend, you first need to understand how private equity operates and why insurance agents fit neatly into investment strategies.
What is private equity?
Private equity firms invest in privately held companies with the goal of generating huge profits. Currently, U.S. PE firms are sitting on nearly $1 trillion of “dry powder,” or money waiting to be invested. These companies are under pressure to invest because they risk losing money if they don’t take advantage of it.
Most PE firms pursue a consolidation or rollup strategy. This includes leveraging platform companies to purchase and integrate smaller add-on acquisitions to quickly achieve scale. Given the short holding period, when PEs seek to grow their portfolio companies, they generally prefer to acquire established, established companies rather than start new locations themselves. The goal of consolidated entities is to understand the spread between the high valuation multiples demanded by large companies and the low valuation multiples paid by small companies.
Why do insurance agents enforce PE?
PE typically looks for specific fact patterns and gives a high priority to opportunities with stable cash flows, giving lenders peace of mind. Insurance agents are good candidates for the following reasons:
Recurring and stable revenue: The majority of an agency’s revenue (often 90% or more) is renewed annually. Additionally, agencies tend to be recession-proof because businesses and individuals generally need to maintain insurance coverage regardless of broader economic conditions. Premium increases: Because agents earn commissions based on a percentage of premiums, increases in premiums directly translate into increased revenue. Insurance premiums have increased by nearly 10% every year since COVID-19, far outpacing the rate of inflation. Increased commission rates: Unlike previous challenging insurance markets, underwriters are sharing more favorable commission rates with agents, creating an additional revenue tailwind. Fragmented Markets: Private equity rollups are most effective in fragmented industries, such as the insurance agency sector, where no single player holds a dominant market share. The top four agencies in the US control only about 10% of the market, leaving plenty of room for consolidation. Asset light and scalable operations: Insurance agencies do not require large amounts of capital. The additional cost of adding a new producer is relatively low, allowing agencies to scale efficiently. Consolidating agencies can also reduce costs by eliminating redundant back-office operations and having the scale to deal directly with carriers and general agent agencies (MGAs).
What buyers like
After engaging with and negotiating with dozens of insurance agency buyers, I have found that there are certain consistent preferences.
No single producer generates a disproportionate amount of business, and they strongly prefer diverse revenue streams. Similarly, lack of focus across customers, industries, regions, and departments can be viewed positively. Not all revenue is created equal. The most desirable business field is one that provides unlimited recurring revenue. In contrast, one-time sales or heavily advanced sales, such as construction risk insurance or life insurance, are less marketable and have lower valuations. Similarly, conditional payments are naturally viewed with skepticism. Intrinsic growth from new accounts and increased coverage for existing customers is more valuable than growth from premium inflation. A young and hungry team is seen as a valuable asset, as PE prefers sellers who are willing to actively continue to grow their business rather than retire. A strong reputation within your target market is essential and is best evidenced by low customer churn rates. Conversely, a history of lawsuits or errors and omissions (E&O) claims can be red flags that can scare off potential buyers. Almost all buyers require the agent to have a “book” of the agent’s transactions in order to be credited with the proceeds based on the appraised value. In other words, producers are contractually restricted from taking customers with them if they leave the company.
Why is now the time?
Even though interest rates have risen, valuations remain high relative to historical levels. This flies in the face of conventional wisdom, as rising interest rates generally reduce affordability and put pressure on PE’s ability to generate the returns investors expect. The spread between borrowing interest rates and expected rates of return is certainly narrowing, and in some cases has become negative. Buyers motivated to deploy dry powder continue to deliver high marks using creative approaches. For example, buyers are adopting more complex capital structures and reducing the proportion of upfront cash.
EBITDA multiple maintained at peak level despite rising interest rate environment
deer fletcher
Deal volumes have cooled from their 2021-2022 peak as buyers have become more selective (if a more average set of companies were involved in the past year, the corresponding multiples were lower) ). Notably, most of the decline was driven by PE buyers. Some of the most aggressive consolidators, such as PCF Insurance Services, slowed down considerably, completing 83 deals in 2022, but just seven deals in 2023. Taken together, these factors indicate that the market is likely nearing saturation point. Given the underlying dynamics, the risk is asymmetric, and it is much more likely that the price will fall further than it will rise.
Trading volume is down by one-third from its peak in 2021
optis partners
Previous acquisitions were made at high multiples and financed with floating rate debt, meaning high interest rates would weigh on profitability. Additionally, premiums are cyclical and are likely to decline at some point, adding new risks for potential buyers.
Like many trends in M&A, this wave won’t last forever. Market sentiment plays a key role and the situation can change quickly if there is a major failure in the industry. PE investors are herd animals and act in unison. If they fear that the pool of prospective buyers will shrink, they will become more cautious and refocus their attention on other, more promising industries. Once the tide ebbs, it can take decades to return to similar valuation and volume levels. For agency owners looking to sell, now is likely the best time to take advantage of these favorable conditions, or be ready to patiently wait for the next market cycle.
Many thanks to Ari Shedlock for his help with this article.
