Interest rates are rising as the Fed seeks to tame inflation, with futures markets pointing to a Federal Funds rate of 3.5% by year-end. Combined with a 2-percentage-point widening of credit spreads on high-yield debt this year, the debt market is becoming materially less favorable to issuers.
The private brokers are heavily reliant on debt financing, typically operating with debt-to-Ebitda ratios of 5x-10x, with most in the 7x-9x range, and well ahead of the 2x-3.5x for the public brokers. This cheap leverage has fueled dramatic consolidation plays from these brokers led by the likes of Hub, Acrisure and AssuredPartners, firms that have consistently inked tens of deals a year, and over 100 in Acrisure’s case.
The M&A playbook works well in insurance broking, with platforms able to execute high numbers of deals quickly, extract synergies and profit from a positive delta between tuck-in acquisition multiples and the valuation they themselves can cash out on.
Since Q3 2020, they have also benefited from the fillip to organic growth resulting from the combination of P&C rate hardening, the rebound of the economy after its pandemic dive and an increased appreciation of risk, which Inside P&C’s Research team has dubbed the “brokerage supercycle”.
Alongside this, partially thanks to the Fed’s efforts to support debt markets, these platforms were able to refinance debt with record low coupons during the pandemic, resulting in a glut of issuance.
Summary table on private broker financial metrics
Note: Data period differs by source and broker. Please see appendix for full details. Source: Inside P&C, Moody’s, S&P
The 30-plus private equity-backed platforms will now have to adjust to operating in a less congenial environment. How much less congenial remains to be seen, with unanswered questions around how high rates will go, and on the magnitude and duration of any recession that results from the shock being dealt to the economy by the Central Bank.
Private brokers have been throwing money around for the last couple of years and bidding up asset prices. Platform assets that were changing hands at 12x in 2017 when KKR bought USI – in a deal then perceived as a rich price – are now being valued at 16x-18x. Smaller broker and agency tuck-ins are able to command 10x-12x multiples, after years of mid- to high-single-digit multiples.
The combination of the proliferation of platforms, the scale of leverage and the apparent indiscipline is causing observers to ask if a reckoning is coming for the sector as tailwinds reverse.
In all likelihood, the answer is no.
The model is incredibly resilient, with strong cash generation, a very high percentage of non-discretionary recurring revenues and controllable margins.
Private equity is also highly committed, along with the private debt market, and will continue to play a major role in broking in years to come.
However, the sector is undoubtedly heading for a pullback in returns that will be painful after the windfall years it has just passed through. But then this is true of most of the economy.
Equity return squeeze
Annual equity returns for private equity backing broking platforms have run in excess of 25%, according to sources, and it has not been uncommon for returns above 30% to be achieved. There have also been blow-out returns for some. (Just ask Flexpoint Ford, which recently cleared close to 4x its equity investment in two years on TigerRisk.)
The sector has also done this with a zero failure rate in the US over the last 10 years, drawing in an ever larger universe of sponsors keen to follow in the footsteps of early backers like Hellman & Friedman (H&F), Onex, KKR, Stone Point and Madison Dearborn Partners (MDP).
Equity returns are now set to be reined in substantially via the direct and indirect impacts of tightening monetary policy.
This will initially reflect the impact of a squeeze on margins and cashflows from increased debt servicing costs. But it will ultimately also reflect lower assumed exit valuations.
There may be a lag around the narrowing of valuations, but 18x valuations are not sustainable long term in an environment with rapidly rising interest rates and sharp pullbacks in the valuation of the equities market. The brokers have already shown significant selloffs since their April peaks, with Aon’s forward Ebitda multiple down to 16x now from almost 20x in April.
The levered brokers have some relief on rising financing costs provided by fixed rate debt that was raised in significant amounts through 2020 and 2021, or Libor floors, and in some cases interest rate hedging. But higher costs will bleed in and be factored into deal models for the existing players.
Platform sales have been defying gravity – as was seen with Carlyle’s recent acquisition of MGA platform NSM at 18x Ebitda – but this is likely to be where pressure emerges first, given entirely new debt structures need to be built to support such deals.
If platform sales are impacted more quickly than tuck-in deals (for which there is still substantial dry powder) then the arbitrage between acquired and sold earnings will fall.
In addition, PE houses will effectively lose access to dividend recaps, where businesses naturally delevering through growth raise additional debt to pay a dividend to their backers. Hub dramatically demonstrated this in November last year when it raised $1.2bn of new debt, before paying a distribution to its backers that is believed to have been around $1bn.
Downward pressure on deal volumes
Deal volumes reached an all-time high in 2021. Optis clocked over 1,000 agency and broker deals, and some sources believe that the true number could have been twice this level including undisclosed transactions.
Volumes were down modestly in Q1, and while some considered this a “false negative”, an appreciable pullback in valuations and a more challenging macroeconomic backdrop could prompt a true slowdown in dealmaking.
Such a development would likely reflect both a reluctance from sellers and a greater conservatism from buyers.
After so many years of appreciation, it is not clear how price sensitive the small broker and agency owners are in the US, but if they sense a falling market and are not under pressure to sell, some may hold back. And certainly, sophisticated platform owners will be inclined to look to ride out the recession before seeking to monetize.
Meanwhile, buyers may also become cautious around both the multiples they will pay and the amount of cash they want to deploy through M&A, thinning out the herd of buyers.
It seems unlikely that the whole market will grind to a halt, but a plausible base case is that it will move down a gear or two.
If – as seems likely – the economy is tipped over into recession, organic growth will become more challenging for the levered brokers, establishing a second headwind on growth along with reduced deal velocity.
Greater challenges – but for a resilient model
But falling valuations and declining deal velocity need to be kept in perspective. This isn’t the death knell of the model.
It’s just a reversal of a period of unusual tailwinds. The likeliest case will see returns squeezed but with no threat to the solvency of these businesses. This reflects the positive characteristics of the broking space.
Most estimates put recurring, non-discretionary revenues in a broker at 80%-90%, and brokers have weathered both the Great Financial Crisis and the pandemic recession incredibly well from a revenue perspective.
At worst during these stress tests, the brokers shrank 1%-3%, and private equity sources believe it could be better this time as inflation has scope to sustain rate rises as an offset to reduced exposure units.
Again, as the pandemic has proven, brokers can effectively manage their costs when they face pressure by flexing variable compensation and managing down discretionary spend.
And ultimately, if pressure starts to become sharper, these brokers can power down M&A, at which point they become cash-generating machines. This is not a binary decision, with scope for firms to ease down the pace of acquisitions to ward off future issues.
All this means that even with interest coverage ratios typically at a fairly aggressive 1.7x-2.1x, it is hard for these brokers to come under real stress.
The private equity owners can also benefit from the fact their portfolios are not marked to market, which gives them scope to wait out the recession and hold on for a recovery in asset values. A number of PE funds have chosen to “play the long game” anyway in broking and re-invest in existing platforms, with examples including Hub (H&F), Alliant (Stone Point) and NFP (MDP).
The relative attractiveness of the sector to capital is also crucial to its resilience. Multiple private equity sources have said that insurance distribution is a core investment for any sponsor investing in financial services, with the same thing true for debt funds.
PE investors love the defensiveness of the sector, and even if insurance broking returns narrowed to the teens – as some sources believe likely – a low volatility investment with this kind of return profile looks attractive as the economy prepares for a recession.
The outlier failure
Crucially, there have been failures in the past – just not many. Towergate in the UK got into trouble in 2015 and was effectively bought for £1 before being used as the foundation investment for Ardonagh (enterprise value: $7.5bn). Colemont and Swett & Crawford struggled under their debt piles at the end of the financial crisis.
Earlier this year, Tysers was under careful watch in the debt market, as its creditors took advice from investment banks around a potential takeover of the company. But the business pulled through, and secured an A$880mn ($605mn) deal with strategic buyer AUB, which ensured debtholders were paid and even made sure there was equity value for PE backer Odyssey.
But these are clear outliers, not your average levered broking platform.
Nevertheless, as the environment worsens the chance of a repeat rises, particularly if firms choose not to manage themselves more conservatively.
However, multiple sources believe that for another case to emerge, interest rates need to move beyond current forecast levels, with a prolonged recession coming in its wake. An important marker of such an environment would be greater conservatism from debt markets, with fewer turns of debt lent for leveraged deals.
Under these circumstances, they acknowledge that an operationally weaker firm, which has mismanaged its maturities and not moved to cash conservation soon enough, could become stressed.
Even then, such a business wouldn’t fall over. It would just go through some kind of debt restructure.
Even though none of the scaled platforms are going anywhere, broking CEOs are concerned about this kind of scenario. Because if one does stumble, there will be reputational contagion to the rest of the sector.
That will damage the narrative these businesses rely on when they pitch themselves to PE, which includes very forgiving downside scenarios.
But even if one mismanaged platform poisons the well for the others, there will be no going back to the 2007 industry structure, which was dominated by public and family ownership.
The story of huge private equity involvement in the sector and LBOs is going to go on…
Inside P&C provides unparalleled market intelligence on the entire US P&C market – from small commercial and personal lines right through to reinsurance and Bermuda. Redeem your complimentary 14-day trial for more premium content from Inside P&C.
Scan here to download the app