Before we get started, isn’t Informed planning to be an agent? Why would I talk down distribution valuations?
Because we don’t do self serving here. We speak truth and me telling you brokers are still cheap isn’t going to stop the market from puking them someday. Don’t fight the facts.
So I’ve talked plenty about the dumb things investors do in the startup space. Now, it’s time to talk about dumb things that happen in the private equity space (though my comments, as you will see, are by no means limited to the private brokers).
Insurance broker (and MGAs, but we’ll save that for another day) valuations are unsupportable and indefensible. They assume perpetual growth to infinity and beyond as well as never ending low interest rates (don’t look now, but they’ve ended).
I’ll lead with a few conclusions and then we’ll do some analysis. First, no established broker is worth 15X EBITDA. That is ridiculous.
10X EBITDA is a reasonable valuation for a healthy broker. However, for long periods of time they traded at <8X and things tend to overshoot to both the upside and the downside.
Second, large brokers are not inherently double digit growers and their margins won’t increase forever without limit. A more sustainable level of growth is 5% (2-3% organic + 2-3% M&A = 5% revenue and flat margins and flat share count).
Third, there is substantial tail risk at the private brokers due to their level of debt. Remember, the concept of cost of financial distress in your business school WACC calculation? Yeah, private broker valuations assume the risk of financial distress is 0% even while their debt loads risk wiping out all their free cash flow.
With those conclusions established, let’s move on to supporting them.
How To Value An Insurance Broker
This section is really easy. You value it on its cash flows. Note, this does not mean you decide what you think EBITDA is going to be and slap a multiple on it. I said cash flows. EBITDA is only a rough proxy for that.
That means you need to count for cash taxes and interest, capital expenditures, and any working capital usage. Oh, and don’t forget stock buyback directly devoted to employee grants since that is compensation.
From there, we can discount all the future cash flows to come up with a valuation or we can take a small shortcut by using cash flow yield (FCF%). This essentially treats free cash flow like a dividend yield. It compares the cash flow to the stock price.
In our recent low yield world, FCF% above 5% was a screaming buy and investors would tolerate 2-3% yields. However, in more normal times you would want to see a FCF% around 5% to buy it and 8-10% yields weren’t uncommon.
Thus, for this exercise, we will deem “fair” valuation to be a 5% FCF yield. Please remember this for later.
Sustainable Growth For A Broker
One reason used to justify high multiples was the extraordinary growth in EBITDA and FCF over the last decade and longer. Brokers grow top line high single digits and always expand their margins generating double digit EBITDA growth. Then, with the power of leverage from cheap debt and share repurchase, they can grow earnings in the teens!
This is not sustainable, unfortunately. Margins don’t go up forever. People used to say these things in the 90s bull market. GE’s margins would always rise, Citi could always cut more costs, AIG could always reach that 15% EPS growth.
We have been through a wonderful period for brokers. Management teams have performed admirably to keep expanding growth and margins. However, trees don’t grow to the sky. The glory days are behind us.
So what’s normalized growth look like? First, assume margins flatten out. Note, this is generous to assume they never decline, but I don’t want to be accused of excess negativity so flat it is.
I will also assume tax rates remain flat though this is probably optimistic. First, a number of insurance brokers have been known for their aggressive tax planning and two, corporate rates are more likely to go back up over time than go down further.
Then, we need to think about top line. Realistically, organic growth shouldn’t be more than GDP over time. Insurance premium doesn’t even grow at GDP anymore. How can brokerage revenue grow faster?
You can then add on a little extra for M&A out of normal free cash flow. I will show later this is about 2-3%. Add that to the organic and you get about 5% top line growth in a low inflation world (yes, it would be higher if you expect sustained inflation although not 1:1 as clients may choose to buy less limit).
So 5% revenue + flat margins + flat tax and let’s say flat share count means…5% earnings growth. In other words, it grows similarly to typical corporate profits. This would support the idea of normal valuations equating to a 5% FCF yield.
Estimating Free Cash Flow
Our next step is to figure out what free cash flow looks like for a representative broker. To help, I’ve built a simple financial model. The biggest challenge was deciding what the balance sheet should look like given the large differences in leverage between the public and private (and even among the private) brokers.
For this exercise, I leaned towards the private model but with a “conservative” view of leverage for a private at 6X EBITDA and 2.8X interest coverage based on a 25% EBITDA margin and 6% interest.
|Free Cash Flow||$||notes:|
|EBITDA||250||$1B rev @25% margin|
|interest||-90||$1.5B debt @6%|
|cash tax||-32||20% cash tax rate|
|CAPX||-13||5% of EBITDA|
|FCF||115||46% of EBITDA|
So FCF is only about 1/2 of EBITDA. That may surprise you. Some of it is due to the high level of interest but those payments count. While it’s easy to dismiss them and focus on EBITDA, the more leverage you use, the more those coupon payments become a constraint.
In fact, as interest rates rise, they really begin to matter. Every 100bp reduces FCF another 5%. The other issue with interest payments is they reduce M&A capacity which is a meaningful source of growth.
Uses of Cash
While in recent years, brokers have been unconstrained in pursuing M&A, this was accomplished largely through low interest rates and continued increases in leverage. Going forward, M&A has to be funded through cash flow.
So what other calls are there on cash flow besides M&A? First, there is share repurchase. While this is a bigger topic at the public companies, all brokers have share creep from stock options. If creep grows your share count 1% annually, it takes 10-15% of EBITDA to buy this back (I’ll save the math for brevity).
The other alternative to M&A is dividends. For the public companies, this is something like another 20% of EBITDA. For the privates, there are often heavy dividends to pay off the investors though these can be eliminated if cash is tight.
You can come up with various permutations depending on the starting EBITDA margin, the level of leverage, the level of dividend, etc. but most outcomes result in something like 20-25% of EBITDA available for M&A.
Do you know how much revenue growth that typically buys? About that 2-3% I suggested in the sustainable growth section (quick math = pay 8-10X EBITDA and spend 20-25% of EBITDA = you’re buying 2-3% growth)!
Highlighting the Risks
So I’m sure I’ve already disappointed those who believe these are eternal double digit growers, but I have more bad news. Normalized growth of 5% isn’t a slam dunk. There are risks.
As mentioned, higher interest rates lower the free cash flow which lowers M&A capacity which lowers growth further. At the same time, it lowers interest coverage which can pressure debt ratings and require delevering which is yet another squeeze on cash.
These pressures can lead to toxic liquidity spirals where brokers have to dump assets at bargain prices to raise cash. This risk should require a higher risk premium and lower valuation, not all time high valuations as the interest rate risk grows.
One other overlooked risk is operational challenges. It is taken for granted that buying small brokerages and integrating them into a larger organization comes with no challenges and always leads to synergies and improved efficiency.
When I was a young lad, rollups of unconsolidated industries with lots of local operators were always considered a dangerous investment. Too many things could go wrong. Buyers get carried away and start overpaying (sound familiar?), M&A accounting could be abused until the music stopped, local operators could check out after they sell (or finish their earnout).
The fact that so much of the brokerage industry has been rolled up without scandal or disaster is really remarkable and praiseworthy. However, it is playing with fire to some degree. All the temptations that have tripped up other rollup industries still exist.
Forward Equity Returns
So let’s bring this together and look at how much valuation risk is there is in the brokers at the moment. We’ll do the easy part first. If valuations should produce a 5% FCF yield and FCF is 1/2 of EBITDA, then we would have a 10% EBITDA yield. Another way of saying this is brokers should trade at 10X EV:EBITDA.
In other words, every $5 of FCF is worth $100. There is $10 of EBITDA that produces that $5 of FCF. $10 of EBITDA at a 10X valuation equals $100.
Now, we get to the really interesting math. If valuations were to go from 15X to 10X EBITDA, you lose 1/3 of your investment, right? Wrong. Very wrong!
Remember, the valuation metric is “EV to EBITDA”. EV includes the debt. The debt is fixed at par. So all the valuation losses come out of the equity (just as all the gains in recent years accrued to equity).
Let’s do our math. Assume our broker is trading at 15X EV:EBITDA and has debt equal to 6X EBITDA. This means the equity is valued at 9X EBITDA.
If the valuation falls to 10X EV:EBITDA, all five of those points come out of the equity. The debt is still 6X.
So the equity falls from 9X to 4X EBITDA, or 55%!
|Valuation @ 15X||Valuation @ 10X|
|Debt @ 6X||$60||$60|
As mentioned near the beginning, while 10X EBITDA may be fair value, that doesn’t mean we won’t overshoot to the downside. If markets worry about FCF being absorbed by higher interest payments or difficulty refinancing maturing debt or ratings downgrades, they can certainly go lower.
What if we went back to the old days of 8X EBITDA? Just update the table above and reduce the equity value from $40 to $20. In other words, the equity would decline 78%!
By the way, the higher the initial leverage, the harder the fall. If you are at 8X debt/EBITDA, the decline from 15X to 10X is now 71% instead of 55%.
So yes, broker values are in the danger zone. They are overearning, expectations are unrealistic, they face serious pressures from higher interest rates, and the leverage creates compounding pressure on valuations as they fall.
Besides that, by all means, keep paying 15-20X for these businesses! I’m sure it will turn out well!