It’s important to make sure financing is in place before approaching a potential acquisition target.
Developing strategy, originating transactions and vetting culture are always hot topics when looking to acquire an insurance firm. This is all predicated on the fact that you can actually afford to purchase an insurance firm. When providing a letter of intent, or a formal offer letter, potential buyers generally indicate how they intend to pay for the acquisition. When a buyer indicates that the deal is contingent on obtaining financing, the seller will likely view this as a risk to the deal. When a buyer has financing in place this not only reduces the risk to close for the seller but can help reduce the workload necessary for a buyer’s staff to get the deal across the finish line.
When setting up a financing program for an acquisition strategy, there are four main components that buyers may use: cash on hand, third-party debt, seller financed debt and equity.
Cash on Hand
It has a thousand slang names, but regardless of what you call it, cash is king.
Cash is often the first order of business when looking to fund a deal. It is generally the cheapest capital around, especially when it’s already in your business and nobody is clamoring to get it out. In the current interest rate environment, the yield on liquid investments is low (check your savings account statement if you don’t believe me) and thus the cash is likely sitting in an account with minimal returns. The cost of capital here is most often measured in opportunity cost, which represents the value of other things that the cash could be used for (e.g. that new boat you wanted).
Maintaining a war chest full of cash reserves, or “dry powder,” should enable you to move quickly on a potential transaction that requires significant cash as either a complete or partial source of funding. A well-run insurance firm should generate Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA), a proxy for free cash flow, of 25% of net revenue meaning that there should be a steady source of capital available. The key to maintaining available funds is limiting distributions to members or shareholders over time, in order to build reserves. We believe this is far easier than asking shareholders to put funds back into the firm on short notice and therefore should be an integral part of the long-term planning and acquisition strategy.
The use of third-party debt to finance brokerage transactions is rather common, but it has not always been this way. Traditionally, debt was used to finance large fixed assets—items that are capital intensive and can be used to collateralize the loans. Think factories or airplanes – things that can be taken back and sold if the loan goes into default. The recurring nature of brokerage revenue appeals to educated lenders as it provides ample cash to repay the loans despite the fact that all of the assets are intangible.
The benefits of using debt are largely based on the low current interest rates and hence the lower cost of debt capital relative to equity capital. Notably, a buyer should be able to borrow against its total EBITDA, not just the EBITDA of the firm that it is buying, thus giving a mid-sized buyer more capacity to acquire small firms. Using debt facilities set-up in advance can allow the buyer to move quickly and effectively pay cash upfront (from the seller’s perspective) for an acquisition. The drawbacks come in the form of covenants built into the loan agreements that may restrict the borrower’s flexibility in managing the insurance agency.
Asking a seller to fund their own buyout is an interesting concept. The plan here is that the buyer pays the seller with notes, rather than cash, and that the buyer pays off those notes over time, with interest. In theory, the rates on this debt should be market-based thus neither cheaper nor more expensive than comparable third-party debt. The difference between seller notes and bank debt comes in the form of covenants. Generally, we would expect to see limited covenants on the borrower (the buyer in this case) as the lender (e.g. the seller) is likely not a sophisticated financial institution.
Some seller-financed deals could have contingent or variable features, where the loans could be forgiven if certain projections are not met, but it would be inappropriate to truly consider this a financing feature; this is really a purchase price adjustment that is achieved by means of the notes.
Now we get to the use of equity – issuing stock to a seller and making that seller a partner in the broader firm. If you have a well-run, high growth firm (i.e. perhaps greater than 7% growth per year), using equity as a funding source can be an expensive proposition. The seller would benefit from any growth of the acquiring firm and would dilute the current owners of their ownership. On the positive side, this requires far less cash, and aligns the interest of the buyer and seller. Using equity to purchase part of the business from a partner nearing retirement does not make sense. However, using equity to align the interest of a young, hungry new partner could be well worth the ownership dilution. The key to understanding the cost and benefit of this lies in the projected growth of the new partner as part of the broader firm.
The Net Take
As you embark on a strategic acquisition program, you should take the time to consider your funding strategy up front. A professional adviser can help you evaluate the benefits and risks related to each funding source in your specific scenario and facilitate crafting the appropriate strategy for your firm. Additionally, advisers can help source capital and make sure that it is available in advance of your need; doing this may help avoid a closing crunch, allowing you to use the most suitable capital options and provide you the flexibility to make unrestricted offers free from financing contingencies, which just may make the difference in winning a deal.
If you have questions about Today’s ViewPoint, or would like to learn more about how MarshBerry can help you determine the funding needed to support your growth goals, please email or call Tobias Milchereit, Vice President, at 212.972.4883.
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.
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