Developing strategy, originating transactions, and vetting culture are always hot topics during acquisition financing. This is all predicated on the fact that you can afford to purchase an insurance firm. When providing a letter of intent, or a formal offer letter, potential buyers generally indicate how they intend to pay for the acquisition. When a buyer indicates the deal is contingent on obtaining financing, the seller will likely view this as a risk. When a buyer has financing in place, this reduces the risk of closing for the seller and can help reduce the workload necessary for a buyer’s staff to get the deal across the finish line.
Buyers may use four main components when setting up a financing program for an insurance firm’s acquisition funding strategy: cash on hand, third-party debt, seller-financed debt, and equity.
Cash on Hand: A Crucial Component in Funding an Acquisition
It has a thousand slang names, but cash is king regardless of what you call it.
Cash is often the first order of business when looking to fund a deal. It is generally the cheapest capital around, especially when it’s already in your business, and nobody is clamoring to get it out. In the current interest rate environment, the yield on liquid investments is low (check your savings account statement if you don’t believe it). Thus, the cash is likely sitting in an account with minimal returns. The cost of capital here is most often measured in opportunity cost, which represents the value of other things that the cash could be used for (e.g. that new boat you wanted).
Maintaining a war chest full of cash reserves, or “dry powder,” should enable you to move quickly on a potential transaction requiring significant cash as a complete or partial funding source. A well-run insurance firm should generate Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA), a proxy for free cash flow, of 25% of net revenue, meaning that a steady source of capital should be available. The key to maintaining available funds is limiting distributions to members or shareholders over time to build reserves. This should be far easier than asking shareholders to put funds back into the firm on short notice and, therefore, should be an integral part of the long-term planning and acquisition strategy.
Third-Party Debt in Insurance Firm Acquisition Funding
Using third-party debt to finance brokerage transactions is common, but it has not always been this way. Traditionally, debt was used to finance large fixed assets — capital-intensive items that can be used to collateralize the loans. Think factories or airplanes – things that can be revoked and sold if the loan defaults. The recurring nature of brokerage revenue appeals to educated lenders as it provides ample cash to repay the loans even though all assets are intangible.
The benefits of using debt are largely based on the low current interest rates and hence the lower cost of debt capital relative to equity capital. Notably, a buyer should be able to borrow against its total EBITDA, not just the EBITDA of the firm it buys, thus giving a mid-sized buyer more capacity to acquire small firms. Using debt facilities set up in advance can allow the buyer to move quickly and effectively pay cash upfront (from the seller’s perspective) for an acquisition. The drawbacks come from covenants built into the loan agreements that may restrict the borrower’s flexibility in managing the insurance agency.
Seller-Financed Debt: A Viable Choice in an Acquisition Strategy for Insurance Firms
Asking a seller to fund their buyout is an interesting concept. The plan here is that the buyer pays the seller with notes rather than cash and that the buyer pays off those notes over time, with interest. In theory, the rates on this debt should be market-based, neither cheaper nor more expensive than comparable third-party debt. The difference between seller notes and bank debt comes from covenants. Generally, it’s expected to see limited covenants on the borrower (the buyer in this case) as the lender (e.g. the seller) is likely not a sophisticated financial institution.
Some seller-financed deals could have contingent or variable features, where the loans could be forgiven if certain projections are not met. However, it would be inappropriate to consider this a financing feature; this is a purchase price adjustment achieved utilizing the notes.
Equity: A Strategic Asset in Insurance Firm Acquisition Funding
Now, the use of equity – issuing stock to a seller and making that seller a partner in the broader firm. Using equity as a funding source can be expensive if you have a well-run, high-growth firm (i.e., perhaps greater than 7% growth per year). The seller would benefit from any growth of the acquiring firm and would dilute the current owners’ ownership. On the positive side, this requires far less cash and aligns the buyers’ and sellers’ interests. Using equity to purchase part of the business from a partner nearing retirement does not make sense. However, using equity to align the interest of a young, hungry new partner could be well worth the ownership dilution. The key to understanding the cost and benefit of this lies in the projected growth of the new partner as part of the broader firm.
The Net Take on an Effective Acquisition Strategy for Insurance Firms
Consider your funding strategy upfront as you embark on an acquisition financing program. A professional insurance M&A advisor can help you evaluate the benefits and risks of each funding source in your specific scenario and facilitate crafting the appropriate strategy for your firm. Additionally, advisers can help source capital and make sure that it is available in advance of your need; doing this may help avoid a closing crunch, allowing you to use the most suitable capital options and provide you the flexibility to make unrestricted offers free from financing contingencies, which just may make the difference in winning a deal.
