Private equity firms are paying high prices for well-managed wholesale brokerages and managing general agencies, but that doesn't mean they are a quick or easy way out of the business for retiring specialty producers, merger and acquisition experts warned.

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

Brokers often begin discussions with him saying, "I hear private equity pays a lot. Should I sell to private equity?" he reported, going on to reveal that what private equity firms really provide for specialty brokers is not an immediate solution to a broker without a succession plan but partial liquidity for business growth at the time of the deal, he said.

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

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

"Is capital really what you need" to achieve the results you're looking for, he asked during a presentation last month at a panel discussion at the midyear educational conference of the Kansas City, Mo-based National Association of Professional Surplus Lines Offices, Ltd.

In agreement was Matthew Kelty, a principal for Allied Capital Corp., a Washington-based private equity firm. Too many times, brokers think about transactions backward, asking, "'What's my EBITDA? What can I add back? What are the multiples?'" he said, referring to the fact that sales prices for insurance brokers are typically 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," he said.

"We're less sensitive to valuations going in if all the other things fit" and if the go-forward business plan makes sense for everyone, Mr. Kelty said. As a buyer, "you're not getting a deal by paying a multiple less than the market if [you] wake up a year later and you're going to be strange bedfellows" with the broker on the other side of a deal.

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

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

Is it a situation where a very good small niche organization is looking to continue to grow, and where combining resources with a bigger organization will get you to what he called "the promised land?"

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

Gerard Vecchio, a managing director with Century Capital Management, a Boston-based private equity firm, said private equity partnerships work well for wholesale brokerages and MGAs that are led 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 or two people that "built their businesses up from scratch" with perhaps $100-to-$200 million of seed capital and are now sitting with multimillion-dollar businesses.

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

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

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

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

While the experts spent most of the session trying to help wholesalers and MGAs understand the expectations of private equity partners and distinguishing between different types of private equity firms, Mr. Kraska began the session noting that deal prices for brokers have soared in recent years.

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

"You're starting to see the real marquee firms--the firms that really have a strong management team and good growth pattern--getting 9-, 10-, or in some cases 11-to-12-times multiples for their businesses," he reported. "In the last year and a half, it has been very much a seller's market," he said, adding that private equity ownership in insurance brokerage has strengthened dramatically.

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

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

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

During the session, Mark Watson, chief executive officer of Argo Group International Holdings Ltd., a Bermuda-based specialty insurer, noted that while his firm has been an active acquirer of small companies and MGAs in recent years, beating a financial buyer isn't easy.

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

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

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

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

Mr. Vecchio argued that the impact of the credit crunch on broker deals might not be immediate because PE firms still have funds with cash available--"dry powder"--to complete transactions.

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

"I agree the credit markets until the last three or four months have been driving pricing up," Mr. Vecchio said, citing leverage (borrowing) figures that were in excess of total purchase prices paid 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 to be done for awhile."

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

"I think you will see some high multiples paid until that capital runs its course," Mr. Vecchio said. "While leverage has been taken out, there is this conflicting factor [making it] hard to quantify" whether the result will be multiples coming down one notch or four notches. "I just don't think we know yet," he said.

Mr. Kelty said that when credit markets started tightening last year, an expectation of an approaching buyers' market in which deal prices would drop did not materialize. Instead, "what we're seeing is that for good companies, there's really still a tremendous amount of competition out there"--and high multiples continue to hold.

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

Mr. Kraska said quality differentiation is playing out for his client base--agencies with $1-to-$200 million of revenue--with no change in appetite for premier shops, but buyer pushback and prices dropping 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, representing strategic buyers, highlighted the features that distinguish their firms as potential partners for NAPSLO brokers.

Mr. Vecchio highlighted the fact that his is a specialty firm that has been investing almost exclusively in the insurance industry for more than 20 years. With an emphasis on the lower middle-market--covering transaction sizes from $20 million to $200 million, he said Century Capital Management's focus on insurance means it has an extensive network of insurance relationships and expertise 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 a focus on service firms and that he heads up a unit investing in the insurance industry for enterprises valued in the $50-to-$500 million range. He also said Allied Capital, with assets of $5 billion, is unique because it is a public company, and therefore has permanent capital--making it possible to be a very long-term investor.

While both men said their firms are hands-off investors, making them poor choices for managements looking to retire, Mr. Vecchio did note that two of Century's six financial partners have had prior operational experience, each with 30-year careers running insurance brokers and companies.

In addition, he said that Century has an executive advisory panel made up of CEOs of very large insurance companies, and it taps those individuals to sit on boards as independent directors. He noted that these executives can act as mentors to the entrepreneurs in whose firms Century makes investments, suggesting their advice is more palatable than advice delivered from pure financial buyers.

Mr. Watson said his firm is similar to the PE players in focusing on the management teams of target companies and generally looking to partner with them and "help them grow their franchise as they become a part of [Argo's] franchise."

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

Mr. Kraska told brokers, "The reason why Mark [Watson] would want to buy a business is that there may be opportunities for him to cross-sell products or...find other avenues to do business together 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 set to go add to your tool case."

Special Reports /

Private Equity Deals No Automatic Exit For Sellers Of Wholesale Brokerages

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