4 deal structure

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w w w . M e r g e r s A n d A c q u i s i t i o n s S e m i n a r . c o m

Deal Structuring for Success

Presented by Mathew KlossnerMystic Capital Advisors Group, LLC

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Topics to be Covered– Basic Deal Structure terms– How does Valuation affect Deal Structure and vice versa– Trends in Deal Structure– Types of Deals– Deal Structure Mechanics– Things to Consider when Structuring a Deal

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• What is the one question asked more than any other about insurance industry M&A?

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Answer:

“So what are transaction multiples these days?”

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Deal Structure

“Multiples, Multiples, Multiples” is the M&A version of “Marcia, Marcia, Marcia”

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Deal Structure and Valuation are closely intertwined– How much is the deal worth?

– When is the consideration paid?

– What is guaranteed vs. what is variable?

– What metrics will be used to measure performance?

– What must be achieved in order for a seller to receive the variablecomponent (earnout)?

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Valuation 101– Valuation is a function of cash flow and risk

• How long will it take to recoup my investment?• At what risk?

– Most deals are priced off EBITDA• Seller EBITDA x EBITDA Multiple = Base Value of Deal• Occasional exceptions

– Multiple of Revenue• Usually a Sanity check• Assumes you can run business post‐close at a competitive margin

– Multiple of Premium (or % of Premium)• Can come into play with a carrier buying a MGA or Program

Administrator with the intention of writing the business

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General Valuation Trends– Seller’s market, multiples are up

– Intense deal competition, often even for smaller deals

– Cash at close % and guarantees on deals are up

– Still uncertainty in Employee Benefits marketplace, especially for smallaccounts with ACA exposure

– Economic recovery seems to be fizzling

– Rush for PE Backed deals to gain mass and ultimately capitalize oninvestment

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Transaction Structure Components• Guaranteed Purchase Price

– This is as it says, GUARANTEED, not dependent on performance– Typically is the amount paid at closing, but some deals have

future payments that are guaranteed– No ability to “claw back”

• Base Purchase Price– What the seller would conservatively anticipate to receive after

the earn out period– We typically assume 0% growth

• Potential Purchase Price– “Upside”– Amount the seller could potentially realize based on future

performance– May require significant growth– The “Everything fell into place perfectly” price

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What is an Earnout?• The “earnout” is the non‐

guaranteed, variable portion of the deal

• If a deal has a variable component or “earnout” component, then consideration paid at closing is only a portion of the Base Purchase Price

• Consideration paid at closing can vary significantly, often 50%‐90% of Base Purchase Price, and is often dependent on the riskiness of the deal

• Length of earnout varies, but 1 to 3 years is typical

Simple Example

Revenue of Seller 1,000,000$ EBITDA 300,000$ EBITDA Margin 30%Multiple of EBITDA for Deal 6.0xBase Deal Value 1,800,000$ % of Deal Paid at Close 70%Payment at Close 1,260,000$ Multiple of Guaranteed Payment 4.2xAmount of Base Earnout 540,000$ Potential Deal Vaue 2,340,000$ Potential Deal Vaue Multiple 7.8x(Assuming maximum earnout with a 30% upside cap)

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Factors Affecting Valuation and Deal Structure• Size of deal

• Asset vs. Stock– C‐Corp– S‐Corp, LLC, Personal Goodwill Transaction– Over 80% of deals are asset deals, however, stock vs. asset is

less of an issue with larger transactions

• Risk Profile of Deal– Account concentration, carrier concentration, other

• % of Deal at Risk– The more at risk to the seller, the higher the multiple needed

to entice seller– More guaranteed, the lower the multiple

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Factors Affecting Valuation and Deal Structure‐ Cont‘d• Age and Ability of Owners and/or Management Team

– Younger owners and management teams (ages in 40’s and 50’s) will receive a premium

– Ability of seller’s team to organically grow business going forward and execute an acquisition strategy

– Deals where owners/management will not be continuing with acquirer are usually discounted

• “Hand over the keys” is risky for buyer

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• Type of Consideration– Cash or Liquid Stock

– Illiquid Stock or Restricted Stock• Seller rolls equity into the deal• Potential for “second bite of the apple”

– Seller note • Common in smaller deals and perpetuation scenarios

– Other forms of consideration• Higher commission rates• Bonus pools• Deferred comp plans

Factors Affecting Valuation and Deal Structure‐ Cont‘d

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• Control Premium– Minority investment is often discounted

• Length of earnout– Most buyers are willing to increase multiples if they have

longer payout horizon

Factors Affecting Valuation and Deal Structure‐ Cont‘d

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Types of Deals• National Platform or Hub Acquisition

• Regional Platform or Hub Acquisition

• Carrier Acquisition of MGA/Program Administrator (PA)

• Fold‐In Acquisition

• Producer Hire/Small Book of Business Acquisition

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Types of DealsPlatform or Hub Acquisition

– Usually a larger, high‐performing agency that serves as a “base” for an acquirer lookingto get into a market, region, or niche class of business

– Due to brokerage industry demographics, there is a limited number of possible targetsin this space.

– Size varies for what could be considered a platform acquisition• For Public and National PE backed acquirers this could be as small as $3 ‐5 million

in revenue depending on the market, but typically is $5m to $15m in revenue• For Private Equity groups looking for an initial entrée into this market (National

Platform) could be a minimum of $10 million in revenue, up to mega deals– Hellman & Freidman acquires Hub from Apex/Morgan Stanley– Onex Partners acquires USI from Goldman Sachs

– PE acquirers often require the sellers/management to roll part of the proceeds into theacquiring entity’s new deal

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Types of Deals‐ Cont’dCarrier Acquisition of MGA or Program Administrator (PA)– Carriers and other risk bearing entities have viewed buying non‐risk bearing entities as a cheap way to

grow premium and add underwriting talent as they will buy the MGA or PA and roll the business on totheir paper

– Focus is on underwriting results and underwriting talent– Niche businesses with mono‐line classes or niche programs are attractive– Buying MGA/PA allows carrier to eliminate a layer of commission expense– Often priced off profitability of the book and multiple of premium rather than EBITDA allowing a

converted EBITDA multiple to be higher than if sold to a strictly financial acquirer– If the Carrier is not planning on rolling book, then in effect they are a financial buyer– Earnout is typically tied to underwriting results– Can occasionally be used as a defensive measure to keep from losing book to another carrier– Examples include:

• Ironshore‐NSU• HIIG‐ Casualty Surety• Markel –Thomco

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Types of Deals‐ Cont’dFold‐In Acquisition

– Typically a smaller deal that can be consolidated into a platform or hub office of an acquirer– Acquirer is able to realize economies of scale in operations (rent, accounting, insurance, etc…)– Fold‐ins are typically firms that range in size from $1m to $5m of revenue– Competition from National, Regional, and Local Firms

Producer Hire/Small Book of Business Acquisition– Buyer is often smaller privately held regional agency, although recent deal demand has seen

National brokers “dip down”– Typically these deals are $1m in revenue or less

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Types of Deals‐ So what are the Multiples?– Disclaimer: There is no “typical” deal and there are numerous risk factors that vary greatly for all

deals

Type of Deal Base Deal Guaranteed Potential DealPlatform Agency‐ Mega Deals 9.0x‐12.0x 8.0x‐11.0x 10.0x‐13.0xPlatform Agency‐ Regional or Niche Deal 7.5x‐9.5x 5.5x‐7.5x 10.0x‐12.0xCarrier Acquisition of Distribution 7.5x‐9.5x 5.5x‐7.5x 10.0x‐12.0xFold‐In Acquisition 6.0x‐8.0x 4.0x‐6.5x 6.5x‐9.0xGroup Benefits Large Account 7.0x‐9.0x 5.0x‐7.0x 8.0x‐10.0xGroup Benefits Small Account 4.0x‐6.0x 2.0x‐4.0x 5.0x‐7.0xProducer Hire/ Book of Business 5.0x‐7.0x 4.0x‐6.5x 6.0x‐8.0x

EBITDA Multiple Range

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Other Mechanics of an Earnout• Timing of Payments

– Periodic payments made over the course of the deal (often with a “true‐up” with the final payment vs. one payment at the end of the earnout period

– “Front‐end loaded” vs “Back end loaded”• Earnout calculation driven off “average” basis vs. calculated on

“last period”– Example: Earnout is based on the three year average EBITDA

achieved• Minimum growth hurdle before seller is qualified to receive

earnout vs. 0% growth qualifies seller for earnout• “Straight line” or “Tiered” earnout vs. “All or none”

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Other Mechanics of an Earnout‐ Cont’d• Ability for Seller to recoup missed payments with extraordinary

results in future periods• How are fold‐in acquisitions handled post‐closing?• Caps and Floors

– Deal is capped on upside as a percentage of the base deal valuation. Often mirrors the floor, which is typically the consideration paid at closing

• For example, if consideration at close is 80% of the base deal value, then an acquirer may put in a cap limiting the potential deal value to 120% of base value.

• A cap protects the buyer, similar to the floor providing protection for the seller

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What makes an Earnout Succeed?• Aligning goals of seller and buyer• Make sure the seller understands what will need to be done to

make earnout• Clearly defined metrics to achieve• Making sure that the seller is able to control the metric that the

earnout is based on (EBITDA, revenue)– Fold‐in acquisition would combine operations with a

platform agency acquirer and it may become difficult to assess what the EBITDA truly is. Revenue based earnoutmay make more sense

– A platform acquisition that was stand‐alone would be more likely to favor a EBITDA deal as they will have the ability to control expenses

– Impeding the sellers ability to achieve the earnout is a fast track to a lawsuit

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Trends in Deal Structuring• The percentage of consideration at close and the % guaranteed has gone up over the

past year – Deals that were 50%‐70% down at close have moved to 60%‐80%– This is a function of competitive market– Makes it harder for the “little guys” (Regional and Local brokers) who need to work

harder to attract deals• Network and build relationships so that when a seller is ready to pull trigger,

they think of you• Sweeten terms (possible examples include maintaining a higher commission

rate for seller’s producers, ensure a softer transition for employees)• Some groups are making a push to minimize or even eliminate earnouts altogether

– Mindset is “when we buy it, we own it”– Don’t want seller focused on earnout, but rather goals of the acquirer

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Trends in Deal Structuring‐ Cont’d• There is still uncertainty in Employee Benefits marketplace, especially for small

accounts with ACA exposure– Currently, the market is putting a significant discount on clients with less than 50

lives and there is even some discount in the 50 to 100 hundred live segment of the marketplace

– Large group is viewed as the “best bet” and continues to attract similar multiples as P&C

– Some acquirers have even gone as far as to segment the book of business when making an offer

• For example, recently an offer was made where the small group was priced at 1.5x revenue and paid over three years based on retention of accounts, while the large group offer was 2.5x revenue paid over one year

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Deal Structure Considerations• Keep in mind the likelihood of achieving an earnout when assessing an offer.

Focus on the base valuation and amount guaranteed

• Focus on the total value of the transaction and the probability of achieving an earnout. Don’t get stuck worrying just about multiples

• The use of an earnout with a extremely high or unachievable growth target can create the perception of a high potential deal valuation and a high EBITDA multiple (often 9x‐10x), but if the hurdles are unachievable, then the high multiple is not worth the paper it is written on, and even worse, may be disparaging to the morale of a seller post‐transaction

– Don’t always believe the water cooler talk

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Deal Structure Considerations• Finally, keep in mind that a seller hitting the

maximum earnout on a deal is usually a win/win for both seller and buyer.

– Seller is happy to have received a high EBITDA multiple and to have maximized transaction value

– Buyer now owns a bigger business that generates more annual EBITDA

• Buyers base EBITDA truly starts after the earnout is complete

• A successful deal after revenue and EBITDA have grown suddenly seems cheaper in terms of multiples

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Questions and Answers

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4 deal structure