As a result of the macroeconomic environment and subsequent monetary policy changes, the cost of capital has ascended to rates not experienced in over a decade. This begs contemplating whether investors are adjusting their inorganic growth strategy to account for the changing macroeconomic landscape.
To further explore this topic, MarshBerry spoke with John Vaglica, the Chief M&A Officer at Accession Risk Management Group (Accession) – the newly formed holding company of Risk Strategies Company, a long-time private equity-backed platform, and One80 Intermediaries, its specialty business. The discussion focused on the changing landscape of insurance brokerage mergers and acquisitions (M&A) and related deal structuring terms, given the rising cost of capital and degree of economic impact resulting from a contractionary monetary policy.
Acquisitions are a key part of Accession’s growth strategy, with 29 acquisitions closed thus far in 2023, and approximately 30 deals in each of 2022 and 2021. In August 2023, Accession closed on both a $300 million preferred equity raise and a $700 million delayed draw term loan (DDTL) to assist in funding transactions. These most recent raises follow Accession’s $950 million lending facility in early 2022, which occurred prior to the Federal Reserve beginning its series of eleven consecutive Federal Fund rate hikes.
Vaglica compared and contrasted the current economic backdrop to that of the last decade, specifically how the over decade-long low cost of capital environment acted as a catalyst to broadly promote strong returns on invested capital in the insurance brokerage industry.
Vaglica states: “Previously, equity returns of 25% to 30% during a [private equity] hold period over the last ten years were easily obtainable given the low cost of capital and valuations being paid. However, over the last 18 months, the cost of capital has risen, materially, and buyer platforms need to adjust how they think about valuations and related deal terms when executing an inorganic growth strategy in light of the changing dynamics.”
Adjusting to the “new” cost of capital environment
There are implications of a higher cost of capital scenario that buyers should consider when evaluating their inorganic growth strategy. Furthermore, buyers need to contemplate the implications of contracting lending terms and conditions (i.e., lower debt leverage requirements from lenders) on equity returns.
First, many economists are touting that we may be in a “new normal” when it comes to prevailing interest rates, which Vaglica agrees with. “From a historical perspective, interest rates are pretty much in line with where we have seen them prior to the Great Recession,” says Vaglica. “While this is a new normal compared to the last decade, I don’t think rates will revert back to the levels seen leading up to 2021. They may decline slightly from here but a new normal of 3.5% to 4.25% as a Fed Funds rate is likely the new environment and, sans a black swan event, will likely persist for a decade.”
Second, in an elevated interest rate environment, investors may have a tougher time generating the returns received over the last decade compared to when we were in a relatively inexpensive, looser debt financing environment. This is especially true as valuations of sellers are now approximately 70% higher than those paid ten years ago. Furthermore, debt leverage requirements have contracted. The change to equity returns have two possible consequences:
- With higher interest rates, additional cash resources will be allocated toward principal and interest payments. This draws down cash, which hinders the value of an organization. This is fairly intuitive. However, what may not be as intuitive to those outside of the private capital world is the second consequence.
- With lower leverage requirements (i.e., the amount of debt lenders will lend) it may be harder to achieve historical equity returns. Since more equity capital will be needed (in place of debt capital) to finance transactions, relatively greater value appreciation will be necessary on the invested equity capital (i.e., cash) to achieve equivalent returns.
To make this more relatable, here’s an analogy: A person buys a $1 million house with 10% cash (i.e., equity) and 90% debt. Over the course of the year, the house value goes up to $1.1 million and is sold. The owner generates a 100% return on equity as the owner’s initial $100,000 of cash is now $200,000 – ignoring taxes, interest and principal payments on the loan over the year. Now, let’s assume the same situation, but the owner put down 50% equity ($500,000) as the lenders would not allow that much debt. After a sale, the owner now experiences a 20% return on equity as the $500,000 initial payment is worth $600,000 after selling the property and paying off the mortgage.
Private equity is measured (and compensated) based on the return on equity they are able to generate. With equity capital comprising a higher percentage of investments, you need more value appreciation to achieve a similar return on equity. In the latter example, the house would need to appreciate to $1.5 million over the course of the investment to generate a similar return as the first example.
To mitigate the challenges of these developing factors, investors that acquire sellers with strong growth that complement the investor’s organic growth strategies will likely see higher returns on their investments.
Vaglica notes that, “Focusing on strategic acquisition targets that are diversified, partially countercyclical, and offer differentiation of expertise is the key to a successful M&A strategy as it offers synergies that help boost revenue of an acquirer. More importantly it should lead to better and more sustainable organic growth.”
The challenges of an arbitrage strategy
Buyers who primarily focus on “multiple arbitrage” and acquire to amass revenue (i.e., volume) as a growth strategy may face challenges with rising interest rates. Particularly if interest rates continue to increase from here. Vaglica explains that “Companies who mainly buy revenue for volume purposes will find it more challenging to hit returns as the firms may not experience medium- to long-term synergies that otherwise result from a more strategic M&A plan.”
Firms may still achieve an increase in short-term equity growth with an arbitrage strategy, but it will be harder to enhance ongoing returns and perpetuate the platform to future financial partners if there are little operational synergies, diversification and specialty expertise in an M&A transaction.
A major challenge of a volume play is that it may hinder obtaining acceptable returns on invested capital if valuations of consolidators come down. Consolidators lacking internal controls, systems and processes may be impacted by these valuation risks as acquired firms tend to operate in silos, and therefore, are less likely to realize potential synergies with acquirers. This would adversely impact valuations at the parent level. For example, if there are two organizations of the same revenue size, the firm with better systems, controls and processes demonstrates a stronger platform that is better able to support future growth. Hence, they receive higher valuations.
In a scenario where firms rely on a volume play to drive value, the benefits of multiple arbitrage will diminish when compared to the past decade. The reasons are simple:
- Sellers are more highly valued today, partially because certain platform buyers have unaligned capital structures.
- The valuation multiples of the volume acquirers are more susceptible to downward pressure as these firms may be seen as having inferior business models due to potential future growth constraints (relative to peers).
As a result of this, the historical returns may begin to decline for those consolidators relying on arbitrage as a growth strategy, unless these firms reevaluate valuations of acquisition targets and regain the benefits from multiple arbitrage. It should be noted, this shift in valuation dynamics has not yet been experienced for well-run sellers for this buyer type. This may be due to certain firms’ capital structures pressuring growth at any cost.
Demand continues to drive high multiples for firms with strong growth rates
Compared with the exuberant valuations seen over the last 24-36 months, the market is experiencing some downward pressure on valuations and/or deal terms. Some of this may be in the form of slightly lower valuation multiples (mainly for firms with less than desirable revenue size, growth rates, margins, etc.). But current valuation multiples remain above those seen in 2010-2019. Capital is available but at a much higher cost than it was just a couple years ago, resulting in fewer potential bidders on select sell-side opportunities. However, there is still healthy demand on par with what was experienced just 3-5 years ago, with plenty of capital (at the moment) to maintain a competitive supply and demand balance.
It only takes a couple of potential buyers in a process to maintain valuations that are around those experienced over the last few years and broad buyer interest remains robust. The public players have significantly reengaged in this higher interest rate environment due to the advantageous cost of capital in the public market. To this point, valuations of firms with over a couple million in EBITDA with acceptable compound annual growth rates (i.e., 7%+ over a multiyear period) continue to fetch historically high EBITDA multiples. Firms with growth rates below this level and EBITDA of a million or less are seeing lower buyer interest compared to the peak in 2020-2022, but still above pre-pandemic levels.
In this transitory cost of capital environment, it will be critical to assess how debt and equity markets react. It will be the responsibility of buyers to stay on top of these changes to ensure they are making appropriate adjustments along the way to ensure business continuity and perpetuation as well as generating acceptable returns to their financial partners and employee shareholders. To this point in time, valuations have remained resilient, which is undoubtedly linked to the continued availability of capital. However, with lending facilities coming due over the next 1-2 years and at least a half dozen platform buyers likely to enter a transaction cycle it will be telling to see how this shapes buyers’ appetite and reactions.
Read part two of MarshBerry’s discussion with John Vaglica, The Evolution of Capital Structures In Insurance Brokerage M&A, which explores the key implications of the rising cost of capital for buyers.
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