This closes industry speculation that the company could default on substantial earnout liabilities due this quarter, and represents a real boost for the retail broker consolidator.
The deal also allowed PCF to issue a bullish enterprise valuation of $4.7bn, which would probably put it on the fringes of the top 20.
Sources said PCF was marketing off adjusted Ebitda of around $250mn for its pref raise, implying a multiple of almost 19x.
The best platform in the market probably wouldn’t fetch 19x adjusted Ebitda in a common equity deal, given the current macro backdrop.
This underscores the absurdity of valuations that come out of pref deals, with investors in these securities paying little attention to this number compared to other terms. Setting that bluster aside, the raise puts PCF in a materially stronger position.
In November, the firm clearly moved into cash preservation mode, in an obvious manifestation of the squeeze on levered brokers resulting from the increasing cost of capital.
At this point, the Lehi, Utah-headquartered brokerage let go of its entire M&A team, as well as much of its integration staff. According to banking sources, it also dropped a slew of acquisitions that had reached Letter of Intent (LOI) stage. (Until Q4, it was rare for small agency deals that progressed to LOI not to proceed to completion.)
All the levered brokers are facing greater cashflow strain because of a ~400 bps increase in their cost of capital, with those that did not have fixed rate or hedging seeing costs of debt around the 10%-12% mark.
Moreover, brokers have found their ability to upsize debt facilities curtailed, with refinancing firms obliged to accept debt ceilings of 6.25x Ebitda – down from 7.5x or even 8x over the last two years.
Multiple sources in industry, private equity and banking have said that PCF faced sharper pressure than its peers because it had done so much M&A over the last two to three years, and had used deal structures which included uncapped earnouts.
Earnouts on normal capped structures typically run to 2x-3x Ebitda at the time the deal is agreed, with scope for uncapped earnouts to pay more – particularly in a strong growth environment like the one seen through the brokerage supercycle of the last two years.
They normally pay out after two or three years, sometimes on a stagger – which means that deals agreed in 2020 and 2021 are starting to come due.
Along with the cash it is generating now that its deal pipeline has been severed, PCF likely has the dry powder for these earnouts, suggesting its short-term crisis is at an end.
However, substantial medium-to-long-term challenges remain:
Expensive money – Prefs carry high coupons, raising the risk that common equity value could fall (particularly in an environment where platform multiples are under downward pressure).
Growth imperative – PCF will need to outpace the prefs, which might require high-teens revenue growth. This will likely require it to take the challenging step of resuming M&A, given building headwinds on economic growth and rates.
Integration emphasis – Sponsors are increasingly forcing an emphasis on integration, as they seek to build organic growth engines and position platforms for consolidation.
Let’s take an in-depth look at each of those three points.
Preference share money is expensive
Details of the deal are being closely guarded, but pref deals for non-distressed businesses are currently attracting coupons of 15-16% – essentially a ~500 bps spread over debt.
A typical structure would include Payment in Kind (at least at first) allowing PCF to avoid near-term cashflow pressure. However, the high cost of the money effectively sets a high bar for growth. Essentially, you need to find a way to outgrow that coupon.
With the common equity junior to the prefs, if a business fails to deliver Ebitda growth that outpaces the coupon, the common equity value could shrink, particularly if there has been downward pressure on platform multiples.
This would potentially be painful for its private equity backers Owl Rock and HGGC (although the latter is in the prefs deal, alongside Carlyle). But it is even more painful to agency principals that have sold their business to PCF in deals where they receive some of the consideration in paper.
In these instances, the principals – who will expect appreciation of the paper – would instead receive less on a liquidity event than the face value of the PCF stock when they sold their firms. This scenario would create significant motivation and retention problems in a business where key production talent represents the key locus of value.
The imperative to grow revenue in the high teens
Given these dynamics, long-term success requires PCF to outgrow the prefs coupon. Unfortunately, it will need to do this in an environment in which the economy is slowing and still at risk of recession, and commercial lines rates are (unevenly) decelerating. The public brokers provide a lens on the deceleration which all brokers are facing, although many of the private ones will be buoyed by their personal lines businesses.
Most of the private brokers grew by high-single digits organically through 2022, and PCF has said it achieved 10% organic growth “by year-end 2022”. With a less favorable growth environment going forward, PCF will likely find it hard to outgrow the coupon without returning to M&A.
This is financially challenging, given the pressure this creates on cashflow and the stubborn buoyancy of tuck-in valuations (even if downward pressure now seems to be emerging).
Just as challenging, however, will be the impact of PCF’s decision to slam the brakes on M&A in Q4. The broker will need to rehire M&A staff and rebuild a deal pipeline to get things moving again.
The reputational challenge posed by its withdrawal from the market will also make it harder to originate deals, with agency principals and sell-side banks likely to be wary around deal certainty and long-term value creation.
This in turn creates the risk that PCF may be pushed to either pay danger money to targets or suffer a skew toward lower-quality assets. Businesses which rely on acquiring weaker agencies with lower growth profiles and older principals can then compound their own organic growth challenges.
Integration mania
PCF will need to rise to this challenge in an environment in which sponsors are increasingly emphasizing the need for the levered brokers to work hard at integration.
This shift in emphasis away from deal origination and value creation through multiple arbitrages has few holdouts, though some firms may be constrained when making investments by financial covenants that specify minimum margins.
On the surface, integration mania is geared toward building organic growth engines, but it also seems likely that it partly reflects attempts to manage the next exit.
Sources believe that the most integrated firms will be able to secure higher multiples on equity refinancing. Critically, they will be able to position themselves as dominant during a phase in which we see the consolidation of consolidators. (There are now 30+ consolidators, following a surge over the last five years.)
PCF has always had a relatively decentralized model – more akin to an Acrisure than a Hub – and will have to wrestle with this strategic challenge, alongside its need for growth.
A narrow path forward
All these pressures create a narrow path forward for PCF as a successful independent franchise. Narrow paths are sometimes successfully walked, but management will need to be sure-footed.
The firm would benefit from some favorable external conditions, like a soft landing for the economy, a further extension of the rating cycle, a significant fall in tuck-in valuations and – most importantly – a significant easing of debt markets.
Unless someone else stumbles, PCF will continue to be the most closely watched of the levered brokers for signs of stress.
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