Solving for Perpetuation Financing: The Next Generation ESOP

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1 Solving for Perpetuation Financing: The Next Generation ESOP Seven times eight times nine times or more times As the largest brokers have returned to the M&A market with a vengeance, we have witnessed EBITDA multiples paid for some of the larger independent brokers touch levels not seen since the hey days of In some cases, buyers are valuing independent brokers at multiples of EBITDA greater than the multiples realized by their own shareholders in the public market. And yet, the spread between multiples paid for high quality firms versus low quality firms is increasing. In our view, this gap will only widen as stronger firms continue to leverage competitive advantages and weaker firms struggle to find ways to grow or even survive. 14.0x 12.0x 10.0x 8.0x 6.0x 4.0x 2.0x 7.5x 5.4x 5.4x 4.0x Private Insurance Broker Price / EBITDA Transaction Multiples YTD 14.0x 13.7x 13.2x 13.0x 12.0x 10.2x 10.1x 10.2x 10.0x 10.0x 3.2x 6.8x 2.9x 6.5x 5.4x 5.5x 2.7x 8.8x 8.8x 6.6x 4.7x 7.5x 7.1x 6.0x 4.4x 7.5x 3.9x 3.2x 7.5x 7.3x 3.6x 3.5x 7.8x 3.0x 4.1x 3.8x 12.5x 12.5x 7.4x 7.5x YTD EBITDA Max EBITDA Min EBITDA 3.0x Source: Dowling Hales Database Public Broker Price/EBITDA 25.0x 20.0x 15.0x 10.0x 5.0x 0.0x Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 SNL U.S. Insurance Broker Price/EBITDA Source: SNL Financial

2 Irrational Exuberance? To borrow the phrase coined by Alan Greenspan, are today s valuations another instance of irrational exuberance? Well, it will take years to know for sure, but there are four factors at the heart of the valuation surge: (a) cheap debt and lots of it; (b) effective post-closing cost-cutting strategies by buyers; (c) scarcity of good assets and management talent; and (d) market timing. Cheap Debt. The Fed has made it clear that it intends to keep interest rates at historically low levels for the foreseeable future. As a result, debt has become inexpensive with little risk premium for inflation, and banks are again chasing deals in cash flow industries. It is not unusual to see bank debt turns that is, the multiple of cash flow to which they will lend reach 5.0x or more for the most aggressive buyers. When buyers can borrow these amounts at such historically low rates, they can effectively pay more for the same asset while achieving an identical return on equity. Effective Cost-Cutting Strategies. The stickiness of commission renewals has enabled buyers to be more aggressive in cutting expenses to drive operating margins. Just look at how producer compensation plans have changed: Remember when 40/40 pay plans were prevalent? Today, the norm is paying 20-25% on renewals and most of the larger consolidators pay zero commission on accounts below a certain size. Throw in tighter controls on travel & entertainment spending and centralization of overhead functions, and buyers have been able to drive significant growth in profits even if organic growth has been flat. Scarcity of Good Assets and Management Talent. The significant consolidation in the last decade has left fewer high quality firms and management teams competing in the marketplace. When a top caliber firm becomes available for sale, a well-managed sales process generates intense competition among buyers and can achieve stunning results. Market Timing. After nearly eight years of a relentless soft market, rates are not only bottoming out but are moving higher in certain lines of business. At the same time, economic activity is increasing. The combination of improved rates and overall economic activity has a powerful effect on the earnings growth of insurance brokers, especially those brokers which derive the bulk of their income from commissions. And, if interest rates show any uptick, investment income on the float just adds to the bottom line. Buyers sense a turn at some point and are gobbling up assets as quickly as they can. Should I Sell? So, this begs the question: are sellers being irrational if they turn down an offer to sell their business? At today s valuation levels, is selling the prudent answer? Not necessarily. For some firms, the answer is a clear yes and they should seek advice in doing so. Maybe, even consider taking equity in the buyer to retain some equity upside. For others, the opportunity cost of handing over the dividend-paying power of their businesses and the reinvestment cost of now having to put after-tax dollars to work in a low return environment are too great. High multiples alone should not be the sole reason to consider a sale. Consider the following examples:

3 Owners of Agency X, with $15 million of revenue and 20% EBITDA margins, accept an 8.0x EBITDA cash offer. The owners pay taxes on capital gains and reinvest those proceeds in the S&P 500 index (assuming 5% annual return) for five years. Owners of Agency Y, also with $15 million of revenue and 20% EBITDA margins, elect to continue operations and are able to muddle along at 3% growth a year, mimicking the rate of inflation, and collecting dividends. Owners of Agency Z, also with $15 million of revenue and 20% EBITDA margins, elect to continue operations and with some market lift in rates and economic activity, are able to grow the business 7% per year while collecting dividends. What multiples do Agency Y and Agency Z need to attract in Year 5 to have more after-tax proceeds in their pockets than Agency X? 5.0x and 4.6x, respectively. If Agency Z, an increasingly scarcer asset, sells for 8.0x in five years, the additional wealth accumulated exceeds $7.6 million. Over 10 years, it is even greater - $19.5 million, actually. Those are big numbers. 8.0x Implied Breakeven EBITDA Multiple Five Years Out 6.0x 5.0x 4.0x 3.0x 2.0x 0.0% 2.5% 5.0% 7.5% 10.0% 12.5% 15.0% Annual Growth 20% Capital Gains 30% Capital Gains Rate Source: Dowling Hales Research So, why do good firms sell today? For many, the ownership sits in one of two camps: (i) those with a short horizon who simply want or need liquidity and start counting the money when they hear about the return of 2007-level multiples; and (ii) those who have a longer investment horizon and want to keep investing in the business to build and own a scarcer asset. Many companies sell because a sales transaction becomes the only option to bridge the gap between the two camps. As insurance brokerage firms have become more valuable over time, it has become increasingly difficult for the second camp to provide liquidity to the first camp despite the opportunity and reinvestment

4 costs of a sale. And, the next generation of management and business builders cannot afford to finance a buyout themselves. In years past, insurance agents and brokers turned to ESOPs as an alternative to a sale to satisfy both camps and to perpetuate the business. However, the allure of ESOPs has faded. As a perpetuation tool, it needs an upgrade. The Rise and Fall of ESOPs The Employee Stock Ownership Plan (ESOP) was first conceived by Louis Kelso in Mr. Kelso was a progressive and a Keynesian economist who spent a great deal of his life trying to figure out how to get a greater share of a firm s ownership in the hands of its employees, and then how to promote it across industries. Eventually, his firm Kelso & Company developed into a merchant bank and is now one of the largest private equity firms in the US. Simply put, the ESOP was constructed as an employee benefit plan with the ability to invest in the stock of its own company (as well as others) and borrow money to do it. The tax benefits were significant contributions were tax deductible and debt was therefore retired with pre-tax dollars. Selling shareholders now had a mechanism to receive liquidity by transferring ownership to employees and avoiding an outright sale. The use of ESOPs was substantial throughout the 1980 s across a wide range of industries. The problems came later. As a defined contribution plan, employee participants were allocated their share of plan assets including shares of the agency on the basis of salary and tenure. As a retirement plan, this makes sense. But ESOPs do not allow for the allocation of assets on the basis of employee performance and relative contribution. Top performers had to rely on separate stock ownership plans and would find themselves as co-owners with a federally regulated plan. A second major challenge for ESOPs is the repurchase liability. An ESOP plan does not allow for ESOP participants to be bought out for anything less than fair market value. For firms with an aging workforce, this liability could become significant and deplete capital otherwise available to build the business. In some instances, the ESOP repurchase liability can develop into such a financial burden that the company is essentially forced to sell in order to get out from underneath this liability. A third challenge for ESOPs is from a valuation perspective. For participants, shares are valued using a combination of fair market value tests with discounts for marketability and liquidity. Shares are not worth the value that could be achieved in a change of control transaction. Despite these challenges, studies have shown that firms with high levels of employee ownership have outperformed their peers. Particularly as a service business, a culture of shared ownership is important to the success of any insurance broker. So ESOPs were on to something as a perpetuation tool. The tool just proved too cumbersome and inadequate over the long run. The Next Generation ESOP The Minority Financial Investor Beginning in the 1990s and accelerating in the last decade, private equity investors emerged on the scene as buyers of insurance brokerage firms. They realized that despite the fact that the assets went up and down the elevator at night, the underlying cash flows are relatively stable and return on equity is excellent. The approach for most private equity groups was to acquire a platform firm, or bring in a team to do so, and proceed to build a large organization where the majority of the ownership resided with the investors. Today, 17 of the 100 largest brokerage firms are financed and owned by private equity firms.

5 But what about the insurance brokerage firm that wants to retain significant ownership so that the bulk of the reward for building value in the firm stays with key employees and shareholders, and not some outside private equity shareholder? The minority financial investor can be the ideal solution. It facilitates transfer of ownership without the burdens and shortcomings of the ESOP. A much needed upgrade to the ESOP: the ipad, if you will, as compared to the clunky typewriter. A minority financial investor is a mechanism for transferring ownership to the next generation of leaders while solving three major flaws of the ESOP: (i) equity incentives can be doled out to employees who deserve ownership (as opposed to rules imposed by federal labor laws based on salary and tenure), (ii) future capital, to the extent required, is more easily obtained and (iii) the investor partner can help finance the shareholders who exit and/or retire from the company. How does this next generation ESOP work? 1. Attractive pricing: Like the ESOP, a minority financial investor provides immediate liquidity to selling shareholders at current market value. For owners who remain invested in the business, sharing in shareholder dividends continues. 2. Selling shareholders can pick and choose who sells and how much: Unlike an ESOP, a minority financial investor can be flexible in providing liquidity to those shareholders who want to exit while aligning with those shareholders who want to remain owners. 3. Incentive programs for key management: Unlike an ESOP, a minority financial investor allows for creating stock option and equity incentive programs for executives and employees. In some cases, management can participate in a portion of the gains that would otherwise inure to the minority financial investor. The opportunity to build wealth can be significant. 4. Deep pocketed funding in place: The right minority financial investor partners can be a ready source of capital to the company for (i) acquisitions, (ii) investments in staff or operations and (iii) funding retiring shareholders over time. Is the Next Generation ESOP for Me? Some insurance brokerage firms are built to grow others have been built to be cash flow lifestyle businesses. Both are ideal candidates for the next generation ESOP. While the headline multiples today seem compelling particularly compared to late 2008 through early 2010 the firms that remain independent and build franchise value will become increasingly scarce and presumably more valuable. Before you consider a sale of your business, look into the next generation ESOP. It may be the best wealth transfer decision you make. About Dowling Hales

6 Dowling Hales is an advisory firm that assists insurance agents, brokers and insurance companies in M&A and capital raising activities. Its affiliate, Dowling Hales Securities, LLC, is a registered broker-dealer and member of FINRA/SIPC. Over the last 4 years, the firm has advised on over 100 transactions ranging from $1 million to $200 million in transaction value and has offices across the U.S. Its sister companies include Dowling Capital Partners ( DCP ) and Dowling & Partners Securities LLC. DCP invests primarily in the insurance industry, including underwriters, distribution firms and service companies. DCP provides its portfolio companies and co-investors with industry expertise, broad relationships and operating experience. For additional information, please visit

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