As the cost of capital has increased to some of the highest levels experienced in over ten years, investors are reassessing their financing strategies for today’s unique environment, including capital structures in their investments.
MarshBerry spoke with John Vaglica, the Chief M&A Officer at Accession Risk Management Group (Accession) changing the landscape of insurance brokerage mergers and acquisitions (M&A) activity. Accession is the newly formed holding company of Risk Strategies Company, a long-time private equity-backed platform, and One80 Intermediaries, its specialty business.
In part one, The Sky Isn’t Falling, But There Are Clouds, the discussion focused on deal structuring terms and the degree of economic impact resulting from a contractionary monetary policy. This second part explores the key implications of the rising cost of capital for buyers, including how higher financing costs are pushing buyers to focus on capital structure and cash flow management.
Rising financing costs push buyers to focus on cash flows
Higher financing costs and tightening lender requirements are requiring buyers to focus on their free cash flows while satisfying debt covenants. Private equity-backed consolidators tend to carry meaningful levels of debt, which may approach (or exceed) 10x Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) and this does not include preferred equity positions which may act as “debt-like” securities.
In highly leveraged situations, this pressures an organization to monitor their operating cash flows in conjunction with their available capital. This is critical as consolidators will need these cash sources to fund:
- Additional acquisitions.
- Principal and interest payments on borrowed funds.
- Earnout payments of acquired firms.
Financial results of sellers over the last few years have been enhanced by the hard insurance pricing environment, which has resulted in lucrative earnout payments.
Vaglica explains how this post-transaction growth has often resulted in consolidators needing to fund significant levels of additional deal considerations to sellers via earnout payments, which tend to be three years in duration. As a result of these potential payments, certain buyers have been caught off guard, emphasizing the need to closely monitor cash availability to ensure adequate funding.
“Accession has historically paid earnouts that equate to just shy of 2x the initial pro forma EBITDA of acquired targets,” says Vaglica. “When you add stock appreciation over the same term it approaches 3x.”
This is an example of just how material earnout payments may be – as the earnout may comprise 20% of total deal consideration. The materiality of these potential payments emphasizes the fiduciary responsibilities placed on buyers to monitor these potential cash outflows.
Some firms are turning to preferred equity for financing
When buyers have financial challenges, they tend to utilize the lowest cost of capital available. Generally operating cash is the cheapest form of capital, followed by debt, then equity. Preferred equity is generally the most expensive form of capital. It comes in two forms: participating and non-participating.
Participating preferred typically has a conversion feature that allows owners to yield the preferred return and then convert and share in equity value, this is the most expensive form.
Non-participating receives the coupon payment only, most carry a PIK (Payment-in-Kind) feature. PIKs generally accrue dividends, it saves on cash flow but can erode returns to common equity shareholders if not prudently utilized. In light of tighter lending requirements and the resulting financial challenges for certain firms, preferred equity has reemerged as a common form of capital.
Vaglica points to the use of preferred equity in the industry: “We have experienced increasing costs of capital across the board. For instance, we have seen PIK rates go from approximately 14% to 18% over the last year – but with more preferred being built into capital structures with bells and whistles like warrants or participation.”
While Accession themselves took on preferred stock in one of their recent capital raises, Vaglica notes: “Preferred stock in itself is not bad. However, utilizing this form of equity should be done in a way to maximize the return for ALL shareholders. Specifically, equity holders should be wary of preferred equity held by those with Board control and not shared pro rata among all ownership parties, as this causes a misalignment of financial interest. Accession’s placement was at an era low coupon and a very small issuance, not held by Kelso & Company (Accession’s private capital backer) which maintained alignment across shareholders and allowed Accession to have a lower blended cost of capital.”
Meaning – preferred equity is typically only subordinated to debt. If one of the ownership groups (i.e., private capital sponsor) owns all of the preferred stock and the operations team does NOT, it could create a divide in interests between the ownership groups due to a misalignment in how and when capital is liquidated (i.e., when a firm is sold and/or who it is sold to).
Buyers need to be cognizant of their capital structure and the pros and cons of taking on additional capital in today’s environment. Sellers need to understand the class of stock they are taking and where it sits in a capital structure. There may be unintended consequences from these very important funding decisions.
Continued investor interest in the insurance brokerage industry
MarshBerry has dubbed the insurance brokerage industry “one of the greatest industries in the world.” There are several reasons for this, including: insurance is often a necessity to purchase, the industry’s repeated demonstration of resilience in hard times, high barriers to entry (via relationships), and sustainable cash flows. Private capital investors picked up on these points about 15 years ago and since then their dominance in the transaction league tables has continued to grow. Over the last few years private capital (including private capital backed buyers) has comprised around 70-75% of M&A deal activity.
Returns have been phenomenal for investors, especially given the low investment risk of the industry. As a result of this risk profile investors should be willing to accept lower returns on capital invested in this sector. Luckily for investors, returns have generally not been an issue.
Calculating returns on equity is simple from a 30,000-foot view – but can get very complicated on the ground. From an airplane’s view, inputs of valuation multiples and pro-forma EBITDA are used to arrive at an enterprise value (EV). This EV is then funded with a combination of operating cash, debt, and equity. Owners need to grow the operations (to maximize value), fund the operations and growth, and generate an acceptable return to equity holders.
However, returns on investment are likely getting tested as consolidators strive to maximize shareholder returns in a valuation environment that is less advantageous than experienced in the last decade. In this stretched environment as cost of capital increases, buyers will need to weigh the pros and cons of how they grow operations. This generally comes down to how they will focus resources on organic and/or inorganic activities.
In doing so, buyers will (or should) be assessing the inputs to their inorganic growth strategy. After all, one of the most influential aspects a buyer controls on their inorganic growth strategy are the valuations and deal terms offered to potential sellers. Cost of capital from a market perspective is largely out of an acquirer’s hands, however their capital structure is very much within their control. Thoughtful valuations will allow buyers to manage equity returns AND perpetuate their business with a maximized valuation.
Buyers may be challenged by shifts in financing costs
However, what happens if external (cost of capital) variables outside of the buyer’s control were to change?
Vaglica describes potential future scenarios for financing costs: “If cost of capital stays flat or goes down by 100-200 basis points, I think capital will be more readily available and equity returns will stay strong for players in the capital stack. However, capital raise terms will still be difficult because the risk [profile] of lenders and capital providers does generally not adjust that quickly.”
But Vaglica points out that if the risk-free interest rate stays above 500 basis points, returns for common shareholders (often employee shareholders) may materially be impacted. This will be particularly true for those companies without a prudent capital structure where equity interests are economically aligned between financial sponsors (i.e., private capital investors) and management.
Financial sponsors are very savvy when it comes to realizing returns that are acceptable to their investors. As a result, sponsors are likely 6-12 months ahead of management when it comes to understanding the resulting implications of a rising cost of capital environment and shifting economic landscape on equity returns. There is a dynamic playing out as certain investments of private capital have resulted in unique and/or more complicated capital structures. This is a direct result of private capital investors being ahead of the curve.
The use of preferred equity, which has attributes of both debt and equity securities, is an example of this “creativity”. While these securities may limit the upside to financial investors, they also protect their downside valuation risk. In adverse financial return situations, deal structures that favor certain interests will bolster returns of one party at the cost of another.
Vaglica states: “As a result, in certain capital structures, common shareholders could see returns half of what they have historically enjoyed. Rest assured, the next three to five years will be dynamic as financial sponsors will structure deals where they continue to achieve very strong returns.”
The M&A landscape is being impacted by shifts in financing costs, macroeconomic factors, and insurance industry market cycles. Agile firms that are well prepared and thoughtful regarding various future economic scenarios and their downstream impacts will be better positioned to prosper and generate industry-leading organic growth. These firms will be seen as platforms and long-term players and therefore continue to drive value and be attractive homes for sellers and investors alike.
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