May, 2004 – Making mergers and acquisitions win-win deals



Few transactions are more important to agents and brokers
than selling their business—
or buying that of another party. For sellers, the transaction
can represent an opportunity to remain in business in an improved position or the cashing in of a life’s work in
preparation for retirement. For buyers, acquisitions represent the fastest
route to growth and the furtherance of
strategic plans.
At last fall’s Third Annual Target
Markets Program Administrators
Summit, mergers and acquisitions
were explored during a workshop presented by Kevin P. Donoghue, managing partner of Mystic Capital Advisors
Group, a consulting firm; and Scott
Reynolds, chief actuary and operations manager for American Wholesale Insurance Group, which has
made several acquisitions in the past
couple of years. Their presentation examined the process primarily from the
standpoint of buying or selling program administrators, but much of
what they said was germane to any
agent or broker involved in such
transactions. Following is an edited
transcript of their comments.
Kevin: The first step in selling your
business is to determine what it’s
worth. Before you solicit bids you
should get an independent appraisal
from someone who knows the insurance marketplace. What is the aftertax value that you need to realize from
this business to make it worth selling?
If, following an appraisal, you don’t
think you can get it, why go through
the process of selling your business?
Often people discover that their
agency is not worth what they think it
is and decide they’d rather keep it.
Sometimes an owner, acting without
the guidance of an appraisal, asks for
an outrageous price. Such owners do
themselves an injustice. Down the
road, when they decide they’re really
ready to sell, potential buyers may assume the sellers still have unrealistic
expectations. Valuations also are vital
to buyers. The time for a buyer to get a
fix on the value of an acquisition is before making an offer. That’s because
offers, once made, are almost impossible to renegotiate.
Generally, the value of a firm is expressed as a multiple of a particular
statistic. More often than not, that
statistic is EBITDA (earnings before
interest, taxes, depreciation and
amortization). For agencies and brokerages, however, I generally favor a
multiple of EBITA. I drop the “D” (depreciation) because I find it’s offset by
a buyer’s ongoing need for capital expenditures following an acquisition.
Buyers usually pay a multiple of EBITA (or EBITDA) ranging from 4.0 to
6.5. Profitable, growing agencies will
go for something close to 6.5. Smaller
businesses whose growth has been going downhill might go for less than
4.0. Retail agencies generally trade for
higher multiples than wholesale businesses do.
There are any number of factors
that can affect the multiple, including
whether the seller is a C corporation
or an S corporation, and the condition
of its balance sheet. How the seller
will be paid for the agency—whether
in cash up front or in retention-based
installments—also affects the multiple.
Scott: What I hope to bring you is a
buyer’s perspective. In the past two
years, we’ve entertained about 30 possible acquisitions of program administrators, MGAs or wholesalers, and
we’ve closed five of them. We aren’t interested in all-cash deals. Rather, we
offer sellers three payment components, and usually they are roughly
equal. First, there will be a cash component maybe equal to a third of the
selling price. Then there will an equity
component—stock in our combined,
post-merger organization. Last, there
will be a series of installment payMaking mergers
and acquisitions
win-win deals
This article was derived from
a presentation at the Third
Annual Target Markets Program
Administrators Summit, which was
held in October in Tempe, Arizona.
For sellers, the
transaction can
represent an
opportunity to
remain in business
in an improved
position or the
cashing in of a
life’s work. For
represent the
fastest route to
ments, usually retention- or performance-based, over a period of three to
five years or whatever span is negotiated.
We structure payments in this way
because we generally are not interested in acquiring a business whose
owner simply wants to cash out and
retire. If we were to offer an all-cash
deal to a seller, he or she then might
not have the incentive to continue to
lead a growing business that can
leverage the resources that our combined organization creates. The equity component of the payment gives
the seller a vested interest in the
growth and performance of the postmerger company.
Kevin: When an agency is bought
with cash up front, the seller will get
a lower multiple. If it’s a pure “earnout” deal (a series of performancebased installment payments), with
no cash up front, the seller will receive a higher multiple. Deals generally are struck somewhere in the middle, where you have a fixed
component (cash) and a variable component (the earn-out).
Sellers should assess the structure
of the earn-out. Is it achievable, or is
it unrealistic? Occasionally, a buyer
will offer what looks like a breathtaking multiple for an agency. But then
the small print compels the seller to
do the impossible, like double their
growth rate within a year, to fulfill
the earn-out. Before you sign a letter
of intent, know how you are to earn
the variable component of a deal.
Does it require you to grow 20% for
each of the next two years? Does it require you to just maintain the current volume? Know where the risk is.
Also, keep in mind the time value of
money. A buyer might say you’re going to get $1 million a year for the
next five years, if you reach a set of
goals. Well, the value of that offer
isn’t $5 million. Its present value is
probably closer to $4 million. And on
a risk-adjusted present-value basis,
it’s likely considerably less than that.
The other issue is equity. Scott’s
crew is building a larger organization. Maybe they one day hope to do
an initial public offering of stock. National brokerage houses, which also
are active in mergers and acquisitions, already are publicly owned and
generally pay for an acquired agency
at least partly with their stock. Publicly traded stock is easily sold, but
when sellers exchange part of the value of their agencies for a minority equity position in a privately held company, their stock will be highly
illiquid. So understand what you are
getting into. Ascertain under what
circumstances you can get out, and
how your stock will be valued when
you do.
In summary, cash is great. Equity
is fine if you can get yourself out of it
or it has a minimum guaranteed value. Then in regard to the earn-out,
you really have to assess whether or
not it is achievable.
The confidentiality agreement
Scott: In the course of a merger or
acquisition, three major events take
place. The first is the signing of a confidentiality agreement. Based on initial conversations we’ve had with the
seller, we decide we want to talk further and share information with each
other. So we each sign confidentiality
agreements and then start sharing
summary information. Among questions we ask are: Who owns the business? What is its corporate structure?
What is its nature? Why are you considering a sale? The seller would ask
us similar questions.
At this stage of the process, we are
looking at the big picture rather than
all the details. We ask ourselves how
the agency would fit into our organization. We’re not doing “roll-ups,” in
which a buyer simply assimilates acquired books of business. Rather
we’re looking for strategic fits, agencies that can continue to operate
more or less independently within
our organization. So if we already
have one MGA that writes ocean marine insurance, we wouldn’t be looking to acquire another. Although we
might increase our market share by
doing so, we’d be creating internal
competition and failing to enhance
our product portfolio. In short, we’re
interested in acquisitions that give us
a presence in some part of the country where we currently don’t have
one, or that provide a product or program that blends well with our portfolio.
Another business that would interest us would be one whose value we
could somehow leverage. We may
have resources that the seller lacks:
financial resources, financial oversight capability, actuarial resources,
marketing or technology resources,
human resource management, etc.
None of that has to do with brokering
insurance, but it’s everything behind
the scenes. Sometimes a firm will
have a weakness in one or more of
those areas. If we can eliminate that
weakness and thereby increase that
firm’s EBITDA multiple, it could
make an attractive merger candidate.
At this stage, we also examine all of
the seller’s relevant financial statements and, assuming the seller
would make an attractive strategic
fit, make an offer that will be subject
to confirmation of the seller’s representations via the due diligence
The letter of intent
Scott: The next phase of the transaction starts with the signing of the
letter of intent. At this point, we have
dealt with the big-picture issues and
are now ready to get into the details
to see if they confirm what we’ve seen
so far.
Kevin: When the parties sign that
letter of intent, the deal is not over.
The LOI typically is nonbinding. After it is signed, the buyer does due
diligence on the seller—and often the
seller does some due diligence on the
buyer. A lot of things can go wrong
between the time the LOI is signed
and the closing. The buyer will go
though the seller’s data with a finetooth comb. In doing so, it may find
that some of the seller’s previous representations do not pan out. If so, the
buyer in all likelihood will lower the
previous offer. So sellers need to be
certain—well in advance of putting
themselves onto the market—that
their house is in order and that their
records reflect that.
Scott: After the letter of intent is
signed, we basically have access to all
of the seller’s data. Likewise, the seller has access to our information, so
the LOI is not a one-way street. And
given that both parties have signed
confidentiality agreements, they
should be comfortable with sharing
At this point, we are ready to get
into the heart of the due-diligence
process. Among the matters we look
into are the following:
•Underwriting results: The first
thing we’re going to look at is the underwriting. (This discussion assumes
the acquisition of an MGA or program
administrator. Obviously, underwriting wouldn’t be a consideration if we
were acquiring a pure wholesaler,
which has no underwriting authority.) We look at the carrier underwriting audits. If we ask for the latest audit and the seller says he can’t find it,
that’s a red flag. Usually the reason a
seller “can’t find” an underwriting
audit is because it was a bad one. We
like to see two underwriting audits.
One bad audit may be understandable. But two in a row calls into question the soundness of a program and
the long-term relationship with the
We look at premium and claim details and from them derive program
loss ratios. If the numbers jibe with
the loss ratios the seller previously
gave us, that’s a strong green light to
proceed with the deal. Often, however, the premium and claim detail is
not available, and that’s troubling.
Sometimes when it is available, it’s
18 months old. As with “missing” underwriting audits, current data
might not be available because the
seller fears it will appear unflattering. But having as much up-to-date
information as possible makes the
merger or acquisition move along
more quickly than it will otherwise.
The exact form the information
takes (spreadsheet, database, text
file) doesn’t matter, so long as it’s detailed. As long as it includes data for
individual policies and associated
premiums, we can sort it as we wish.
We also need claims details, with
claim numbers and associated policy
numbers. Summaries really are not
sufficient, because they allow us to
look at the information only as it’s
presented in the summary. With the
detailed information, we can build
the summary any way we wish.
I’m an actuary, so naturally we pay
attention to the actuarial analysis of
a program. We love to see a carrier’s
actuarial analysis, and we also appreciate any third-party analysis
that a seller may have obtained. Then
we’ll take the seller’s premium and
claim data, update it and analyze it
ourselves. Usually our analysis
comes in pretty close to a carrier’s or
a third party’s; major discrepancies
are usually not an issue.
We look at how closely the seller
has adhered to his underwriting authority. We determine whether the
proper accounts are being written for
a program and whether they’ve appropriately priced. If this information
is available, that’s a good indication
that the program is sound and that
the carrier will remain on board.
•Carrier relationships: Good carrier relationships are important to the
successful conclusion of a deal. We
want to make sure the seller has
sound, carrier-supported programs.
Copies of the seller’s correspondence
(letters or e-mail) with his carriers
are helpful, as well as letters of authority that may have been granted.
Of course, we contact the seller’s
carriers at an early stage of the due
diligence process to inquire about
their relationships with the seller
and whether they will stay on after
the sale. Generally, they give their
blessing. That’s a plus; it is indicative
of a strong book of business that
won’t have to be remarketed. That
said, if a carrier is looking to get out,
a change of ownership in the agency
provides a good pretext for the insurer to end the relationship.
We look at the commission rate the
carrier has been paying the seller.
Maybe it has been knocked down a
couple of points or has been made dependent on underwriting results.
Maybe we see evidence that the seller’s underwriting authority has been
reduced over time. Such things raise
concerns about the status of the carrier relationship. It’s nice to see multiple carriers for a given program. That
means we still would have options if
one carrier decided to depart.
We look at cancellation clauses.
Once, carriers commonly granted sixmonth—or even nine-month—program cancellation clauses. Now, it
seems you can’t get anything more
than 90 days. We consider anything
longer than that a real plus. Anything less than 90 days concerns us,
because trying to move a program in
a shorter time frame can be difficult.
•Claims: If the seller is using a
third-party administrator to handle a
program’s claims, we will examine
the claims audit to see if the carrier’s
figures match the TPA’s. If they
don’t, we may need to rework our actuarial analysis of the seller’s underwriting performance. If the carrier is
adjusting the claims, the claims audit
usually is not a critical concern to us.
If the seller can readily get loss
runs from the carrier, that’s a plus.
I’m not sure why, but sometimes it
seems difficult for a seller to get loss
runs during the due diligence
process. Perhaps insurers are afraid
the information is going to get shared
with outside parties (other than us).
•Financial controls: We require an
aged account receivables report.
Without one, it will be difficult to produce an accurate balance statement.
We also need information about any
current litigation, as well as an E&O
claims history. We want to see
records for the premium trust account. Going out of trust, unfortunately, has been the downfall of more
than one program. We also want to
examine all leases—on real estate,
software, office equipment, etc.—to
see what kind of ongoing commitment we would be assuming if the
deal goes through.
•Distribution: We carefully examine the seller’s distribution system.
We examine the contracts and incentive arrangements a program administrator has with retail agents. We
like to see exclusivity agreements
signed by qualified retailers.
•Technology: We examine the seller’s software systems and procedures. A major point is how submissions are processed and how the data
on submissions is captured. Depending on the seller’s current platform,
this may be an area where we can
bring value to the deal through our
own technology resources.
•Human resources: We ask for a detailed organization chart, as well as
information about employee salaries
and benefits, bonus plans, etc. Sometimes we’ve discovered that key employees have been promised future
equity in the firm. We want to make
sure that all arrangements are disclosed during due diligence.
Kevin: Deferred compensation is
another issue that sometimes is not
reflected in the information initially
provided to a buyer. Sellers should
make sure that all such liabilities are
clearly disclosed in advance. Don’t
hide anything, because it’s going to
come up in due diligence. It’s much
better to get all the issues on the
table up front and let buyers determine whether they want to proceed.
But don’t withhold important facts
before signing the nonbinding letter
of intent and hope buyers either
won’t discover them or will accept
them without lowering their price if
they do. That just doesn’t happen.
Wrapping it up
Kevin: The final event that takes
place in the merger and acquisition
process is the signing of the purchase
and sale agreement. Unlike the letter
of intent, this document, of course, is
binding. All the hard work of a sale
should come after the signing of the
confidentiality agreement and the
letter of intent. If that work has been
done well, the only remaining chore
after this final document is signed
will be the popping of champagne
Kevin Donoghue can be reached at
kpd@mysticcapital.com. Scott Reynolds can be reached at scott.

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