For the fourth year in a row, private equity (PE) outperformed other private market asset classes, based on global funds raised in 2000-2017. Here, the role of insurance agency valuation services becomes important as these services provide a foundation for financial decision-making. Impressively, PE maintained its status as the asset class with the highest returns in private markets since 2006 (PE funds raised from 2007-2017). The top-quartile group of these PE funds (raised between 2007-2017) had a net Internal Rate of Return (IRR) of 21.3% from 2006 to September 30, 2020, outpacing private debt, real estate, natural resources, and infrastructure funds, according to McKinsey’s Global Private Markets Review 2021.
While there are many reasons for these impressive returns, including a lack of restrictive regulations that public companies have, one key driver is PE companies’ aggressive use of debt. Insurance brokerage firms should also consider the use of debt financing as a component of achieving above-average growth and returns.
Some executives may see higher debt levels on the balance sheet as risky or a potential negative. However, a firm could benefit from more leverage, as debt can multiply returns on investment and offer tax advantages. Insurance brokerage firms don’t have to be as aggressive as PE funds with debt financing, but they can periodically assess whether lower leverage levels are making them less competitive.
Could Sub-Optimal Debt Levels Compromise the Benefits of Debt Financing in Your Insurance Brokerage?
According to MarshBerry’s proprietary financial management system, Perspectives for High Performance, the Best 25% of firms with the highest organic growth rates also have higher than average levels of long-term debt. This pattern was consistent over the last five years.
In 2020, the group with the Best 25% organic growth delivered commissions and fees organic growth of 11.9%, compared to the average of 4.2%. The Best 25% cohort also had 64% more long-term debt than the average on their balance sheets.
The debt financing likely allowed the faster-growing firms to invest in drivers of new business expansion, such as salespeople and technology. New business differentiates high-performing companies from average companies and drives organic growth. Firms that invest in hiring, technology, and other resources are more likely to achieve above-average growth and returns.
Respondents in MarshBerry’s Organic Growth, Profitability, and Perpetuation Pulse Study noted that hiring new producers and focusing on larger accounts ranked as the top two most important categories driving their 2021 organic growth goals. Debt could help increase cash flow and growth by hiring additional producers and gaining larger accounts.
Debt vs Equity Financing in Insurance Brokerage: Three Considerations to Maximize Growth
- Debt financing in insurance brokerages, via issuance of debt instruments and bank loans, can have tax advantages. Firms that issue bonds can benefit by taking annual tax deductions for a portion of imputed interest. For bank loans, firms can also deduct interest payments. This can help improve margins and lower expenses.
- There are some advantages to debt financing vs. equity financing: equity financing involves diluting ownership and some potential control of the business. Another current benefit of debt financing is borrowing costs hovering near record-low interest rates. Borrowing costs remain inexpensive, with the 10-year U.S. Treasury yield at 1.4% in July 2021. According to Charles Schwab, nominal 10-year Treasury yields are below market expectations for average inflation of about 2.5% during a 10-year time horizon.
- Even with the advantages of debt financing options, firms must ensure sufficient operating cash flow to service interest and principal payment obligations. Interest coverage is one of the measures that investors use to assess a firm’s financial strength. Credit-rating agencies use the metric when deciding on a rating for the firm’s securities.
Ultimately, to maximize returns in your insurance brokerage, your firm should attain an optimal capital structure with a sufficient level of debt that maximizes organic growth and returns while maintaining appropriate risk levels.
MarshBerry continues to be the #1 sell side advisor in the industry (as ranked by S&P Global). If you’re considering selling your firm, we are the best choice to help you through the complicated process. If you don’t hire MarshBerry, hire a reputable advisor that can help you navigate one of the most important business decisions you will ever make. You will be much better off having an advisor in your corner that knows the industry than trying to do this on your own.