Expansion: 5 Keys to Insurance M&A

The current political landscape and potential expiration of the Tax Cuts and Jobs Act (TCJA) add a layer of complexity to mergers and acquisitions (M&A) in the insurance industry. However, these very factors also present a strategic opportunity. Companies that prepare for M&A now gain an edge over competitors who wait. Additionally, pursuing M&A before the TCJA expiration could secure significant tax breaks. This proactive approach strengthens a company's position for growth, market expansion, and a competitive edge. To navigate these complexities successfully, insurance companies should consider five key factors recently discussed in one of our webinars: pro-forma EBITDA, financial performance, the role of audits, calculation of multiples, and non-financial factors.

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1. Understanding Pro-forma EBITDA

The first key to successful M&A is that both buyer and seller agree on the value of the firm for sale. According to Chris Hughes, managing director of M&A Services, the best basis for insurance valuation is pro-forma EBITDA. You’re likely familiar with EBITDA (earnings before interest, taxes, depreciation and amortization), but what is pro-forma EBITDA and why is it recommended?

In a pro-forma EBITDA calculation, all non-recurring expenses or expenses that are not likely to continue after the sale are removed. For example, a one-time IT consultant fee would not be included in the pro-forma EBITDA calculation. Making these adjustments helps both the buyer and seller better understand the true value of the firm.

2. Financial Performance

When entering into an M&A transaction, it is important that both parties can demonstrate strong, consistent financial performance. Of course, the buyer wants to know that the agency they are buying has consistent revenue and a solid financial record. However, it is important that the buyer also has consistent financial performance. Financials reflecting stable profitability, revenue growth, and cash flow for at least three years provide a solid foundation for projecting future performance. This is crucial for lenders to evaluate the long-term viability of the deal and increases their confidence in the merged entity's ability to repay loans.

3. Role of Audits in Enhancing Credibility

For insurance agencies contemplating an M&A transaction, undergoing a thorough audit is a strategic move that shouldn't be overlooked. An audit provides an independent assessment of the agency's financial statements, verifying their accuracy and adherence to accounting standards. This independent verification significantly bolsters the credibility of the financials presented to potential buyers or lenders. During negotiations and due diligence, audited financials offer a clear and reliable picture of the agency's financial health, fostering trust and transparency. This can lead to smoother negotiations, potentially higher valuations, and more favorable financing terms.

4. Application of Multiples to EBITDA

The chosen valuation multiple provides a rough estimate of the company's overall worth when applied to its pro-forma EBITDA. However, this figure isn't a one-size-fits-all number. Factors like the target firm's size, historical financial performance, growth potential, and market conditions all influence the valuation. According to Chris, for agencies with $2MM or less typically command a valuation of eight to 10 times EBITDA. For agencies in the $2MM to $5MM range, multiples can reach 10 to 12.5. Finally, he sees agencies with $5MM and above typically see the highest multiples of 12.5 to 14. Typically, larger and more established companies with consistent profitability command higher multiples compared to smaller or newer firms with less predictable financials. This reflects the perceived lower risk and higher potential return associated with the larger, more proven company.

→ Successful Insurance M&A

Join Chris Hughes, Managing Director at Merger & Acquisition Services, and Kim Grathwohl, VP of Strategic Markets Sales at Oak Street Funding, as they discuss the insurance industry's valuation methodology, deal structures, current market environment, and more!

5. Non-Financial Factors and Growth Strategies

While financial metrics play a central role in insurance M&A valuations, non-financial factors like cultural alignment and leadership strength hold significant weight. A well-matched company culture fosters smoother integration post-merger, minimizing disruptions and maximizing synergies. Strong leadership with a clear vision for the merged entity inspires confidence in lenders, clients, and employees.

Consider possible M&A opportunities in light of your growth strategy. Are you looking to expand your geographic footprint, add new staff, or offer new services? Maintain alignment with your goal and even if a great opportunity presents itself but doesn’t align with your growth strategy, it’s often better to wait for the better opportunity.

Conclusion

Regardless of the economic or political environment, strategic M&A is a valuable tool for growth. The five key factors we've explored – understanding pro-forma EBITDA, financial health, the role of audits, valuation multiples, and non-financial considerations – remain constant. By familiarizing yourself with these elements, you'll be well-positioned to capitalize on opportunities when they arise. Remember, many industry factors may change, but successful M&A hinges on a solid understanding of these five keys.