Strike before the market cools down

For nearly two decades, private equity (PE) has been a transformative force in the insurance agency industry, driving consolidation and increasing valuations. Currently, 72% of all agency transactions involve private equity buyers. With more than 50 active consolidators currently vying for acquisitions, intense competition results in uncertain valuations. It’s no coincidence that multiples have increased by over 50% since PE’s advent.

When discussing PE activities in the insurance industry, it is important to distinguish between insurers and agencies or brokerage houses. PE has shown little interest in carriers that are more capital intensive and exposed to insurance risk. In turn, insurance agencies – companies representing customers in the process of finding the best insurance at competitive rates – and wholesalers (MGA) have become the main investment targets.

But why? To understand this trend, we must first understand how private equity works and why insurance agencies fit perfectly into their investment playbook.

What is private capital?

Private equity firms invest in private companies to generate outsized profits. Currently, U.S. PE firms have nearly $1 trillion in dry powder, or money waiting to be invested. These companies are under pressure to invest because they risk losing the funds if they don’t use them.

Most PE firms pursue a consolidation or rollup strategy. This involves use platform company buy and integrate smaller ones additional acquisitions to get to scale quickly. Given their short holding periods, when PE tries to expand its portfolio companies, it usually prefers to acquire proven, existing companies rather than open new locations on its own. The purpose of a consolidated entity is to capture the difference between the higher valuation multiples enjoyed by larger companies and the lower multiples paid to smaller companies.

Why do insurance agencies encourage PE?

PE typically looks for certain fact patterns, giving high priority to opportunities with stable cash flows that provide comfort to lenders. Insurance agencies are good candidates for several reasons:

1. Recurring, sticky revenue: The majority of an agency’s revenue—often more than 90%—is rolled over annually. Moreover, agencies tend to be recession-proof because businesses and individuals generally must maintain insurance coverage regardless of broader economic conditions.
2. Premium increase: Because agencies earn a commission based on a percentage of the policy cost, rising premiums translate directly into higher revenues. Since Covid-19, insurance premiums have been rising by almost 10% annually, well above inflation.
3. Increasing commission percentages: Unlike previously difficult insurance markets, insurers share more favorable commission rates with agencies, creating additional tailwinds.
4. Fragmented Market: Private equity rollups are most effective in fragmented industries – such as the insurance agency sector – where no single player has a dominant market share. The four largest agencies in the U.S. control only about 10% of the market, leaving plenty of room for consolidation.
5. Low resources, scalable operations: Insurance agencies do not require much capital. Adding new producers has a relatively low incremental cost, allowing agencies to scale efficiently. Combining agencies can also reduce costs by eliminating redundant back-office operations and providing the scale to work directly with carriers versus managing agents (MGAs).

What do buyers favor

After working with and negotiating with dozens of insurance agency buyers, I have observed some consistent preferences:

• A strong preference for diversified sources of revenue, with no single producer generating a disproportionately large turnover. Similarly, lack of concentration between customers, industries, locations and industries is also perceived positively.
• Not all revenues are created equal. The most desirable lines of business are those characterized by unlimited, recurring revenues. In contrast, one-off or well-advanced sales, such as builder’s risk insurance or life insurance, are less marketable and result in lower valuations. Likewise, contingent payments are naturally viewed with skepticism.
• Organic growth through new accounts or expanding reach among existing customers is more valuable than growth from premium inflation.
• A young, hungry team is seen as a valuable asset because PE prefers salespeople who are motivated to continue aggressively growing the company rather than retiring.
• A good reputation in target markets is essential and is best demonstrated by a low customer churn rate. Conversely, a history of lawsuits or errors and omissions (E&O) claims can be a red flag that deters potential buyers.
• Almost all buyers require agencies to have their “book of business” to include matching revenues in the quote – meaning producers are contractually limited to taking clients with them if they leave.

Why is now the time?

Valuations remain elevated from historical levels, even in the face of higher interest rates. This goes against conventional wisdom because rising rates generally reduce affordability and put pressure on PE’s ability to generate the returns investors expect. The gap between lending rates and expected returns has actually narrowed and in some cases turned negative. Motivated to implement their own dry powderbuyers are taking creative approaches to continue offering high valuations. For example, buyers benefit from more complex capital structures and reduce the percentage of cash taken upfront.

Transaction volumes are down from their 2021-2022 peak as buyers become more selective (note that if last year average set of enterprises, the corresponding multiplier would be lower). It’s worth noting that most of the decline comes from PE buyers. Some of the most aggressive consolidators, such as PCF Insurance Services, have slowed dramatically, completing 83 transactions in 2022 compared to just seven transactions in 2023. Taken together, these factors indicate that the market is likely approaching a saturation point. Given the underlying dynamics, the risks are asymmetric – prices are much more likely to decline further than to rise.

With prior acquisitions made at high multiples and financed with floating rate debt, high interest rates will put pressure on profitability. Moreover, insurance premiums are cyclical and will likely decline at some point, adding another layer of risk to potential buyers.

Like many M&A trends, this wave won’t last forever. Market sentiment plays a significant role, and a major industry failure can quickly change the landscape. PE investors are herd animals, moving in unison. If there is concern that the number of future buyers may decline, they become more cautious and refocus their attention on other, more promising industries. Once the tide turns, it could take decades to return to similar valuations and volume levels. For agency owners considering selling, this is probably the optimal time to take advantage of these favorable conditions or prepare to wait patiently for the next market cycle.