Insurance Brokerage M&A: Key Considerations

On this Ropes & Gray podcast, private equity partners Jim Davis and Matt Richards discuss insurance brokerage M&A transactions—including the recent NFP-Aon transaction that Ropes helped lead—the attractiveness of the insurance brokerage sector for private equity investors, retention tools such as equity rollover and restrictive covenants, diligence issues, regulatory considerations, and more. They provide insights into the market outlook and share their experience on navigating dynamics specific to insurance brokerage transactions.

Transcript:

Jim Davis: Hello—thank you for joining us today on this Ropes & Gray podcast. In this episode, we are going to talk about insurance brokerage M&A transactions. I’m Jim Davis, a partner in our private equity group based out of Chicago, and I have with me, Matt Richards, who’s also a partner in our private equity group also based out of Chicago. We represent both private equity sponsors and other buyers of insurance brokerages, but we also represent sellers of insurance brokerages—founders maybe looking to go to market with their businesses. Matt recently helped lead the NFP-Aon transaction for $13.4 billion, which was the largest insurance brokerage transaction of 2023. Matt, can you tell us a little bit more about the NFP deal?

Matt Richards: Yes, thanks, Jim—happy to. That was a really interesting transaction. We’ve worked with NFP for a number of years now, starting back in 2013, when we helped one of our clients, Madison Dearborn Partners, take what was then called National Financial Partners private, and we’ve helped them in a number of financing and M&A matters since then. Aon is, of course, a huge insurance broker, one of the two large dominant public insurance brokers in this country—the other being Marsh—but it didn’t have a classic middle-market offering, which is really where NFP has always shined. Their offering has always been in the property casualty and wealth management space, including benefits and other similar items for small and medium-sized businesses, so the goal for Aon was to bring in a business that really has been very successful in serving those small and medium-sized businesses. We’ve got a number of other transactions throughout the firm representing both larger sponsors and middle-market sponsors, and also some other investors investing both in larger brokers, like HUB, but also investing in control and non-control transactions in smaller brokers in different parts of the country and in different market segments, sometimes in classic, core property casualty businesses, or sometimes in more niche businesses, like property casualty or liability insurance for the nonprofit space. So, the great thing about insurance brokerage is it’s such a large market that there really can be a lot of differentiated businesses out there and there’s a lot of opportunity for just different kinds of transactions.

Jim Davis: We work on all these things both from the buy-side and the sell-side, and so, we see them from all angles. Shifting gears to how markets have been recently for insurance brokerage M&A. In 2023, things were fairly flat. That’s not specific to insurance brokerage—that really is across the board, as, of course, many of our listeners will know. We are seeing signs of life in 2024. It’s also worth mentioning that even in a relatively slow period, you still have serial acquirers, companies like HUB, BroadStreet, or Inszone, that are doing quite a few acquisitions, and so, that’s something that’s worth keeping in mind, even as we talk about a “slow market.” Now, this is a space that we’ve heard a lot about as attracting private equity investments. Matt, do you want to speak a little bit about why this is so attractive for PE investors?

Matt Richards: I think that insurance brokers are kind of the classic private equity investment target—they are relatively stable, reasonably growing businesses with high cash flow and have a relatively stable customer base that doesn’t turn over much, year over year. I had the opportunity to have lunch with a client a little while ago whom we had worked with on an investment in an insurance brokerage firm. I said, “We’ve seen so much activity in this space, both with our clients and just in the marketplace, and we’ve seen so many successful transactions for sponsors making really attractive returns. It seemed like this had to be a business that was ripe for some sort of disruption.” He understood that perspective. At the margins, some technology providers were looking to do that, but fundamentally, designing insurance packages for even the smallest businesses takes a lot of human capital and scale, and that has their bespoke tailored solutions, which requires a lot of interaction, and the sales cycle is one that requires a lot of personal connection. It’s a business that requires that personal human touch, and so, it’s really resistant, in that respect, to outsourcing and to disruption by software solutions. Then, on the other hand, it’s a business that, because it is largely people-based, it is relatively low CapEx, there’s a pretty high conversion of EBITDA to free cash flow. Companies that place their coverage through a broker tend not to switch brokers very frequently, so the stability of the revenue and, hence, the EBITDA is pretty strong. There are natural opportunities for roll-up strategies by buying smaller brokerages. So, it’s just a natural target for any sponsor to invest in, and, I think, we’ve seen that, again, both in the larger space with NFP, HUB, Aperture, or somebody like that, but also throughout the middle market.

Jim Davis: Agreed that this is very much a people business and a lot of the features of these transactions are ones that are focused around people, essentially. One component that we often see in these transactions is equity rollover. It’s a very important retention tool and because it gives the seller personnel skin in the game of their buyer, it can also be very effective for the buyer, as well, for the simple reason that it’s not cash, so it’s something that helps align incentives between buyers and sellers. One thing that I should say about equity rollover is if you’re structuring a deal that way and you want to avoid an up-front tax hit, that can add some structure and complexity. Of course, it’s simple enough to just pay cash for the stock of a business or for the assets of a business, if you want to structure it in a way that the sellers end up holding equity of the buyer, going forward, and don’t have that as a taxable transaction immediately—that can make things a little bit more complicated, but certainly something we see and think through all the time.

Another tool that is important for retaining people is, of course, restrictive covenants. Matt, do you want to speak a little bit about that?

Matt Richards: That’s right—in these businesses, the people are key. While the incentive equity and rollover equity that sponsors offer is “the carrot,” so to speak, the restrictive covenants are often “the stick” to get people to stick around. I think every broker we have run across is very focused on making sure that those restrictive covenants that they put in place, whether that’s in connection with employment, an incentive equity grant, or a sale of business, is as enforceable as possible. I know that the brokers I’ve had experience with are very interested in actually enforcing their rights because it is not uncommon for someone, especially in connection with a liquidity transaction, to decide to somehow take their client list and go off on their own. There’s really constant churn in the brokerage space of people selling their business to a larger broker, working with them, and then deciding that there are greener pastures. We’ve seen, of course, a lot of movement in the world in the last couple of years about states and the federal government potentially restricting the enforceability of restrictive covenants, and that’s going to be a key concern for any investor—not just an investor in the brokerage space—so it’s something we’re keeping a close eye on.

Jim Davis: Then, one other motivational tool or people-based tool that we see a lot in these transactions is earn-outs. Those are a good mechanism for aligning incentives on, maybe, bridging a value gap between buyers and sellers, especially in middle-market transactions. Insurance transactions have a ready-made earn-out metric, just because often, purchase price will be based on some multiple of EBITDA, revenue, or some metric like that—then, that’s just a ready-made way to calculate the earn-out. Now, earn-outs are very heavily negotiated provisions. Purchase agreements can be complex documents, but you have the relatively short section that is the earn-out, and that can be one of the ones that’s most discussed, out of all the provisions that are in the deal. Talking about EBITDA for a second, to the extent that that is going to be the measure of the earn-out or revenue—let’s say, a similar metric like that—the devil is really in the details on these insurance brokerage deals on how that’s measured. You just have factors that you have to take into account, like whether commissions are the only type of revenue that should be counted, whether other revenue comes into play, or timing of when commissions are received—you have policy sales, and the commission may not be received or considered earned until later, and just what period that’s attributed to, how you count overhead and how you count things like return commissions, so just a lot of complexity to think through there. Of course, a lot rides on it when that’s what determines whether an earn-out is payable.

One last quiver in the bow, in terms of thinking about this being a people business and aligning incentives, is incentive equity. Matt, do you want to talk about that?

Matt Richards: Yes, that’s right, Jim. I think all of our sponsor clients, of course, focus on incentive equity as a retention tool for their people in these businesses. I think that in the brokerage space, what we tend to see is often a little more aggressive terms that are used to keep people around. Often, vesting terms that stretch well beyond a typical annual or quarterly vesting cycle, there might be a longer initial cliff on a vesting schedule, maybe, even a very aggressive cliff that lasts for several years or even to the next monetization event. Then, often, that’s paired with fairly aggressive repurchase provisions, where if someone were to leave the brokerage early, so to speak, they might have their equity, including potentially even their rollover equity, subject to repurchase at what are effectively penalty prices—significant discounts to the fair market value—even if they’re leaving in a situation that would not traditionally constitute bad conduct or cause. I think all of these are tools that our clients use to create incentives for people to stay because, to go back to Jim’s original point, this is a people business, and as many tools as you can put your hands on are necessary to get people to stick around. I think the incentive equity, obviously, is viewed as very valuable and a very valuable retention tool, but it really needs to have a retentive aspect and a means in which it can keep people around.

Jim Davis: Thanks, Matt. Switching gears to diligence issues that we commonly see on these deals. Of course, an insurance brokerage M&A transaction is, in many ways, like any other M&A transaction and you can have all the same sorts of diligence issues. One that we do focus on is third-party relationships, just given how the insurance brokerage business is, the interrelatedness of various parties, and flow of funds. And so, it’s just critical to understand what those third-party rights are, things like what the determination provisions are on key carrier contracts, whether there’s any third party that has some rights to the broker’s book of business—of course, the book of business is a key part of the value proposition, and so, just understanding whether that’s owned outright or whether there’s anything that compromises that ownership—or just any dependence on some small number of third parties. Again, we approach these issues from the buy-side and the sell-side, and so, have very good experience of counseling on how to deal with them from either direction. Thinking about diligence, generally: Of course, there are red flag diligence issues that go to whether a transaction should be done, but just thinking about how risk is allocated appropriately enough, there is an insurance product, rep and warranty insurance (“R&W”), that helps protect against some of these diligence risks and can reduce the indemnity burden on the seller, if we’re talking about an indemnity deal, so it’s relatively low cost. We work with R&W insurance brokers, all the time, who place these policies quite quickly, and so, that can be done quickly and efficiently.

Switching gears to regulatory issues. Matt, do you want to speak a little bit about the regulatory environment for insurance brokerage?

Matt Richards: Sure, I’m happy to, Jim. This goes a little bit to your point about the diligence concerns, and, as you’ve put it very well, these are businesses that have, in some respects, all of the same diligence challenges that any business might have. They might have, for example, a 401(k) plan for their employees that is deficient, in some respect, but with respect to their particular legal standing and regulatory posture, insurance brokers generally are fairly lightly regulated. They are not subject to the same degree of regulation that an insurance underwriter or carrier will be subject to. They don’t have minimum capital requirements or anything like that. I think those requirements have generally deterred financial sponsors from investing in true insurance companies, at least, to a large degree as portfolio investments. But insurance brokers do have some degree of regulation. Typically, their employees, to the extent they are selling insurance, will need to be licensed as brokers with the relevant states. In some instances, you may run into change of control issues. For example, the state of Texas, which we’re familiar with, does sometimes impose those obligations on a transaction. There can also be varying levels of scrutiny of insurance brokers’ ongoing business operations. It’s often the case that some states simply are more strict about their level of oversight of insurance brokers than others. New York, Florida, and others sometimes take a more careful view of insurance broker practices than other states do. And so, you need to be mindful about whether, in particular, a smaller brokerage, which doesn’t have the compliance infrastructure that a larger brokerage might have, is doing everything to stay in compliance with the law. If it hasn’t done everything in compliance, had those business practices given rise to an actual issue with a state regulator or had they given rise to a problem, that could become an issue with a state regulator. I think, nine times out of 10, we find that there’s unlikely to be any significant problem, but it’s still something you need to be mindful of. There are good lawyers who specialize very carefully and closely in insurance broker regulation and make sure that people have the specific licenses and other qualifications needed to be brokers, which you need to be mindful of. Of course, that translates, then, into making sure that, on an ongoing basis, your business has all the necessary qualifications that it needs to be a broker. So, those challenges exist, but they are, by no means, insurmountable, and, frankly, they’re much easier to deal with than the issues we see pop up in a lot of other highly regulated industries, such as in health care or otherwise. I think, in general, it’s nothing that should deter anyone—it’s just something that needs to be dealt with.

Jim Davis: I would just add that there are sectors within the insurance brokerage space where the regulation is somewhat heavier, for example, Medicare Advantage. We do have a very strong Medicare Advantage practice at Ropes, regularly advise on investments in M&A companies, compliance with marketing requirements, enforcement focus, and more.

Thank you very much, Matt, for this very interesting discussion. And thank you to our listeners. For more information on the topics that we have discussed or other topics of interest to you, please visit our website at ropesgray.com. Of course, if we can help you navigate any of these topics that we’ve been discussing, don’t hesitate to get in touch with us. You can also subscribe to the series wherever you regularly listen to podcasts, including on Apple and Spotify. Thanks again for listening.