Private equity firms are paying high prices for well-managedwholesale brokerages and managing general agencies, but thatdoesn't mean they are a quick or easy way out of the business forretiring specialty producers, merger and acquisition expertswarned.

"Private equity is not necessarily an exit," said John Kraska,managing director for Hales & Company in New York, whointermediates and assists in transactions between brokers lookingto sell their businesses and potential buyers.

Brokers often begin discussions with him saying, "I hear privateequity pays a lot. Should I sell to private equity?" he reported,going on to reveal that what private equity firms really providefor specialty brokers is not an immediate solution to a brokerwithout a succession plan but partial liquidity for business growthat the time of the deal, he said.

Those brokers that go the private equity route should understandthat "achieving good value means partnering" with the privateequity firm to build the business, rather than selling out andwalking away at the time of the deal. "The real money comes at thesecond exit," he said, referring to the point in time when aprivate equity firm actually sells out of its investment. (Seerelated article, "What Is Private Equity?")

That means specialty brokers looking to partner with privateequity firms need to think about their five-to-10-year businessplans and how they'll work to grow their businesses, he said.

"Is capital really what you need" to achieve the results you'relooking for, he asked during a presentation last month at a paneldiscussion at the midyear educational conference of the KansasCity, Mo-based National Association of Professional Surplus LinesOffices, Ltd.

In agreement was Matthew Kelty, a principal for Allied CapitalCorp., a Washington-based private equity firm. Too many times,brokers think about transactions backward, asking, "'What's myEBITDA? What can I add back? What are the multiples?'" he said,referring to the fact that sales prices for insurance brokers aretypically expressed as multiples of earnings before interest,taxes, depreciation and amortization, such as 8-times EBITDA.

"That's really the last five yards. The important part is[figuring out] what's your plan [and] who's your partner," hesaid.

"We're less sensitive to valuations going in if all the otherthings fit" and if the go-forward business plan makes sense foreveryone, Mr. Kelty said. As a buyer, "you're not getting a deal bypaying a multiple less than the market if [you] wake up a yearlater and you're going to be strange bedfellows" with the broker onthe other side of a deal.

Mr. Kelty explained that having a five-to-10-year business planhelps the broker to decide whether to strike a deal with astrategic buyer, such as an insurance company or a larger wholesalebroker, or with a private equity firm.

Once you have a plan, then you should ask, "'What's going to getus there?'" he advised NAPSLO broker members.

Is it a situation where a very good small niche organization islooking to continue to grow, and where combining resources with abigger organization will get you to what he called "the promisedland?"

"That's a very different...set of inputs than saying, 'If Icould just find a private equity partner with capital, then inthree years, we can do A, B and C," he said.

Gerard Vecchio, a managing director with Century CapitalManagement, a Boston-based private equity firm, said private equitypartnerships work well for wholesale brokerages and MGAs that areled by entrepreneurs who want to go back to their roots of taking"calculated risks" to jumpstart business growth.

In particular, Mr. Vecchio described companies started by one ortwo people that "built their businesses up from scratch" withperhaps $100-to-$200 million of seed capital and are now sittingwith multimillion-dollar businesses.

"In the early days, they took educated bets [or] calculatedrisks, and it didn't matter if they lost the money because theyreally didn't have that much invested," he said. "Today, however,they've stopped taking those risks because they have so muchinvested in the business that they changed their perspective frombuilding to maintaining."

From the private equity perspective, "what we've found if yougive those entrepreneurs partial liquidity--so that they know thatif everything else goes wrong, they've got their little nestegg--they go back to taking those calculated risks, and again yousee a J-curve uptick in the business," he said.

So it's not a question of "do you or don't you sell out," heagreed. "The ability to take partial liquidity from our [theprivate equity] business model works for certain types ofentrepreneurs."

Mr. Kraska agreed, noting that management teams that arepassionate and have business plans are typically the ones thatdecide to partner with private equity firms. They "really do wantto take more risk in the business but prefer to do it with outsidecapital and take some of that pressure off," he said.

While the experts spent most of the session trying to helpwholesalers and MGAs understand the expectations of private equitypartners and distinguishing between different types of privateequity firms, Mr. Kraska began the session noting that deal pricesfor brokers have soared in recent years.

Noting that Hales has advised on $1.6 billion worth oftransactions during the last three years, with 31 deals last yearand six already this year (three involving MGAs and wholesalers,and three involving sales to private equity owned businesses), hesaid that shops that garnered for 6- or 6.5-times EBITDA for abusiness just a few years ago, are now gettingseven-to-eight-times.

"You're starting to see the real marquee firms--the firms thatreally have a strong management team and good growthpattern--getting 9-, 10-, or in some cases 11-to-12-times multiplesfor their businesses," he reported. "In the last year and a half,it has been very much a seller's market," he said, adding thatprivate equity ownership in insurance brokerage has strengtheneddramatically.

"If you go back five years ago, private equity owned insurancebrokers controlled about $325 million of commission revenue," hesaid, referring mainly to the retail side of the broker business."Today, that number is close to $2 billion," he added, noting thaton the wholesale/MGA side of the broker business, many of the largeplayers that used to be public companies are now owned by privateequity firms.

During an interview at NAPSLO, Alan Kaufman, CEO of Burns &Wilcox, told NU that while his firm has always been active inlooking for acquisitions, in the last couple of years, theindependent Farmington Hills, Mich.-based wholesaler and managinggeneral agency has made only a few small acquisitions because theenvironment has been so competitive.

"Our business has changed in the sense of ownership. A lot ofthe ownership today is not family ownership [but] public companies,private equity, banks--and we have been competing with those firmsfor acquisitions in [an insurance] market that was relativelystrong," Mr. Kaufman said, predicting that financial buyerappetites will change as the market grows softer.

During the session, Mark Watson, chief executive officer of ArgoGroup International Holdings Ltd., a Bermuda-based specialtyinsurer, noted that while his firm has been an active acquirer ofsmall companies and MGAs in recent years, beating a financial buyerisn't easy.

Ten-to-15 years ago, "if you were a strategic buyer, you werealmost guaranteed to beat a financial buyer. Today, it's theopposite," he said--suggesting, however that the tide is beginningto turn again. (See related article, "Soft Part of Market LiesAhead")

Mr. Watson also suggested that the upward trend in multiples isset to reverse. "I'm not sure if the top hasn't come off of some ofthose lofty multiples," he said.

"If it hasn't happened, I think it happens in the next six-to-12months," Mr. Watson said, predicting that both a softeninginsurance market and the crisis in the credit markets will have animpact. With respect to the latter, he noted that many privateequity deals are financed with debt, which has now become moreexpensive.

The consequence may be that some deals don't get done, or ifthey do, there won't be enough funds left for the PE firms todeploy to help grow acquired brokerage businesses, Mr. Watsonsaid.

Mr. Vecchio argued that the impact of the credit crunch onbroker deals might not be immediate because PE firms still havefunds with cash available--"dry powder"--to completetransactions.

Mr. Kelty and Mr. Kraska said the near-term impact may bestronger differentiation between good, strong target companies andweaker ones.

"I agree the credit markets until the last three or four monthshave been driving pricing up," Mr. Vecchio said, citing leverage(borrowing) figures that were in excess of total purchase pricespaid five years ago--"at the height of the free money, free credit[environment]. That's done for a moment, and I think it's going tobe done for awhile."

However, the "confounding factor," he said, is there has alreadybeen a tremendous amount of capital raised within private equity,and "there's a lot of pressure to put that money to work," notingthree-to-five-year time horizons on some funds to make newinvestments and for fund managers to make management fees.

"I think you will see some high multiples paid until thatcapital runs its course," Mr. Vecchio said. "While leverage hasbeen taken out, there is this conflicting factor [making it] hardto quantify" whether the result will be multiples coming down onenotch or four notches. "I just don't think we know yet," hesaid.

Mr. Kelty said that when credit markets started tightening lastyear, an expectation of an approaching buyers' market in which dealprices would drop did not materialize. Instead, "what we're seeingis that for good companies, there's really still a tremendousamount of competition out there"--and high multiples continue tohold.

"The lower-quality companies are not getting the samemultiples," he said, suggesting that this is a return to normalcy."That's the way the market should work," he added, noting thatlarger deals requiring greater amounts of financing are more likelyto hit snags than smaller deals.

Mr. Kraska said quality differentiation is playing out for hisclient base--agencies with $1-to-$200 million of revenue--with nochange in appetite for premier shops, but buyer pushback and pricesdropping for firms that aren't as well managed.

Throughout much of the rest of the session, Mr. Vecchio and Mr.Kelty on the private equity side, and Mr. Watson, representingstrategic buyers, highlighted the features that distinguish theirfirms as potential partners for NAPSLO brokers.

Mr. Vecchio highlighted the fact that his is a specialty firmthat has been investing almost exclusively in the insuranceindustry for more than 20 years. With an emphasis on the lowermiddle-market--covering transaction sizes from $20 million to $200million, he said Century Capital Management's focus on insurancemeans it has an extensive network of insurance relationships andexpertise in insurance accounting, among other things.

Mr. Kelty's firm described Allied Capital as a generalist fund,but made a similar case for expertise, noting that his outfit has afocus on service firms and that he heads up a unit investing in theinsurance industry for enterprises valued in the $50-to-$500million range. He also said Allied Capital, with assets of $5billion, is unique because it is a public company, and thereforehas permanent capital--making it possible to be a very long-terminvestor.

While both men said their firms are hands-off investors, makingthem poor choices for managements looking to retire, Mr. Vecchiodid note that two of Century's six financial partners have hadprior operational experience, each with 30-year careers runninginsurance brokers and companies.

In addition, he said that Century has an executive advisorypanel made up of CEOs of very large insurance companies, and ittaps those individuals to sit on boards as independent directors.He noted that these executives can act as mentors to theentrepreneurs in whose firms Century makes investments, suggestingtheir advice is more palatable than advice delivered from purefinancial buyers.

Mr. Watson said his firm is similar to the PE players infocusing on the management teams of target companies and generallylooking to partner with them and "help them grow their franchise asthey become a part of [Argo's] franchise."

But unlike the PE firms, Argo can offer an exit strategy, hesaid, going on to highlight his firm's access to capital as apublic company and its ability to handle transactions in a moresimplistic way than private equity deals--which can be somewhatcomplex. (Editor's Note: In March, after the NAPSLO session, Argoannounced that it acquired MGA Massamont. See related article.)

Mr. Kraska told brokers, "The reason why Mark [Watson] wouldwant to buy a business is that there may be opportunities for himto cross-sell products or...find other avenues to do businesstogether and start to do some other things. With private equity,you're not getting that feature," he said.

With private equity, "you're certainly getting expertise," Mr.Kraska said, but "it's not like you're getting another product setto go add to your tool case."

See also, related articles:

"What Is Private Equity?"

"Soft Part Of Market Lies Ahead"

"ARGO Group, Philadelphia Buy Program Managers"

Coming in April issue:

"Getting Down To Basics: Advisers Needed For Broker M&A"