Insights and Observations from a Decade of Private Equity-Backed Distribution Aggregation Platforms

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Welcome to 2023. Now that we’re a decade into PE-fueled distribution consolipalooza and observing the first actual interval of restrictive capital markets, let’s pause to look at some of the lessons learned over this period.

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The Pioneers: Alignment of Interests

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First, credit to the early participants who exploited a financial arbitrage opportunity before others solved for it. Think of the Acrisures and Assured Partners of the world who realized that you could acquire meaningful independent agents and brokers for 7x (remember that?) EBITDA and “trade” at enterprise multiples approaching 13x EBITDA (remember that?) with minimal integration of those assets.

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While organic growth in those businesses was heavily influenced by financial incentives to selling shareholders (enterprise EBITDA was glorious, net income not so much…), time would reveal that alignment of interests in the form of equity participation was enough to prevent wide-scale deterioration of the acquired assets (a fear that existed in the investment community not so very long ago). What is the significance of these durable revenue streams? The ability to take on debt… lots and lots of debt! Goosing ROE in a major way (however illiquid), also stressing net income, though doing no violence to EBITDA (nice how that works).

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The interest commitments were perceived as manageable even into the 7.5x+ debt to EBITDA ranges given the historically low cost of debt capital.

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Private Equity Opportunists Flood the Market

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But before Q2 2022 began unfolding its history lesson, let’s reflect on what the preceding eight years brought-me too mania! No, not the social movement, but the one in which PE Firms were seeking to replicate the incredible success of the Genstars and GTCRs of the world. I mean – how often are you spotted a margin of safety of 2x on valuation arbitrage alone and the ability to scale it with cheap debt?

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Before long, PE-backed platforms, guided by management teams of varying skill, were consuming independent agents and brokers at an astounding pace, with more than 1,000 such deals occurring in 2021 alone. The proliferation of the PE-backed aggregators created competition for individual distribution assets driving prices from 7x-8x EBITDA to 13x-15x EBITDA range for well-performing, large platform assets. At peak froth, small agencies were aligning to sell en bloc at 12x EBITDA despite never actually operating on a common platform. And never mind the contortions in the sale pro formas to drive exaggerated operating and financial performance on which transactions were priced – with EBITDA “calculations” that were more fantasy than simply fiction and had never been fact.

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While indiscriminate acquisition activity – with the aggregation platforms essentially intermediating a mix of investor capital and debt – might have seemed reckless, keep in mind that the platforms themselves were still able to capture progressively larger enterprise multiples given the desirability of the sector (low CapEx, variable / scalable expenses, strong cash flows, recurring revenue streams, resilient to macroeconomic shocks). At the same time, PE Firms were pushing the bid to 17x+ on recaps and a good time was had by all. Certainly, like all things financial and economical, this was destined to go on forever.
Right? Right?!

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Pandemic: Economic Policy Changes & The Beginning of the End

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During the pandemic, we learned two things (well, we learned many things but most don’t belong here):
1. Insurance distribution is indeed incredibly resilient
2. Flooding the market with stimulus (printing lots of money without corresponding, underlying economic expansion) is inflationary (Milton Friedman is as relevant today as he ever was – and, yes: he has always been very relevant).  

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With inflation running at 8%+ on a published basis, the Fed began taking action to correct course in early 2022 by hiking the interbank lending rate and quantitative tightening (removing “excess” liquidity from the financial system).  

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These policy choices had the net effect of making capital (equity or debt) more valuable… and correspondingly more expensive and scarcer – something priced into all practices and behaviors of firms providing that capital. Think about your mortgage. If you had a 4% mortgage and your monthly payments were $3,000, what would a 3% increase mean to you? It isn’t $90 more (3% of $3,000), it’s $3,000 x 7/4 = $5,250. That’s a huge difference… now imagine having that kind of escalation over hundreds of millions or even billions of dollars in debt and the impact it would have on the net income of a business – especially one heavily reliant on debt relative to their operational scale.

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For businesses carrying aggressive debt levels and already not net income positive (never mind those delightful EBITDA metrics), operating (or, more accurately, financing today with tomorrow’s promise) becomes challenging. Very challenging. This economic reality – and the higher cost of capital generally, is having a meaningful impact on competition in the M&A and recapitalization marketplace. Mainly, it is reducing the number of participants with dry powder and changing the underlying transactions' economics. The increased cost of financing a deal on a per-dollar basis will, at least partially, be reflected in lower valuations. Think of housing as an analogy. The decreased number of bidders will also have an impact.

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So Now What: What Sellers Should Consider

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What does this mean for individual agents considering the sale or perpetuation of their businesses in the current environment? Here are some things to consider:

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• This market is more of a buyers’ market, with viable participants able to show greater restraint and seeking opportunistic situations.
• The more conservatively capitalized players with large scale are at an advantage over other players. The larger ecosystem's Marshes, Aons, and Gallaghers can self-fund most non-transformative deals. Does it mean that nothing changes? No – of course it does; they aren’t going to overpay vs. market… but they will undoubtedly be able to “afford” a deal they like. If you are going through a potential sale process and the large publics aren’t included, I’d want to understand why – as they are favored in this environment. Are they the only answers – absolutely not, but they should be at the table as they are the least constrained;
• There is always a market for great assets. Demonstrate that you’ve built one to maximize valuation.

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Many additional factors will influence the reception your business receives in the current economic environment. Having a conversation with someone who has seen the game from the inside may be beneficial in determining the best pathway to total or partial sale of the business – the benefits of retaining a skilled advisor, able to maximize the value you realize in the sale of the business you’ve built, can have a significant impact on the generation wealth you are able to create in selling your business.

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