CLIMB OUT OF THE INDUSTRY CYCLE WITH AN ACQUISITION

Health Insurance Underwriter - July 2005
Author:  Steven S. Wevodau

Are you seeking to grow your agency but spending most of your time chasing renewals? Does the synergy of an acquisition seem like an attractive way to diversify out of your focus on group health sales? You’re not alone with those thoughts but, in order to achieve successful growth, you need a solid acquisitions plan.

Market trends validate an acquisition strategy. Since the turn of the century, public and private insurance brokers have grown significantly through acquisitions. In fact, last year saw more activity than ever before, with 224 announced transactions. That’s a nearly 25% increase over 2003. Increased competition and low-cost capital mean that the trend is likely to continue this year.

Systematic Approach
The best way to achieve sustainable growth that will increase the value of the business is to approach acquisitions systematically. Instead of sitting back and waiting for the perfect prospect to appear, draw up a clear, well-reasoned plan that will enable you to find the right prospect, then follow through with a successful deal.

Here are the basic steps: Set up an evaluation matrix that includes essential components you will need to make the acquired company add shareholder value. Make certain that company’s culture will mesh with your own, and that you and the seller view the transaction under the same terms. Assemble a crack team of experts and any key staff you rely on when making your strategic decisions. Then consider all of the steps needed for purchasing and integrating the firm. We’ll tackle these steps one at a time here.

Finding Acquisition Candidates
First, how do you gather good prospects? You may think you know your marketplace, but prospecting and evaluating the market opportunities may be easier said than done. Considerations include how to leverage your current platform and whether to expand your product mix. Do you seek to increase market share within your territory, or expand beyond current markets? Answering these questions may best be done by involving an external expert.

Set your parameters so your staff or hired guns know what they are looking for. The good acquisition candidate must have staff with experience that complements your own and an industry reputation. Good carrier relationships are vital. The company’s technology must be up-to-date and conversant with your own.

The firm must be healthy. Here’s what to look for:

- a solid history of financial performance
- good potential for revenue and profit growth
- a culture that can be integrated with yours
- reasonable financial expectations by the current owners.

To be successful, you must not waver from these mandates, especially when it comes to purchase price and the potential for a cultural problem between the two merged companies.

How Will Cultures Merge?
Possibly the most vital consideration is whether an acquired company will provide the right cultural fit. It is important to evaluate this up front. How will different leadership styles or management practices be addressed? What are the “sacred cows” or special exceptions that might come with buying a particular firm? If two firms are generally a good fit and these problems are addressed early in the process, often a middle ground can be found to overcome the issues, and a palatable solution will be revealed.

Then there is the issue of managing expectations. Potential misunderstandings, especially those monetary in nature, must be addressed and dispensed with early. For instance, both parties must agree to a method of valuation. An inflated self-worth by the principal of the agency being acquired must be brought into the realm of realism. Market value, and the components included in the calculation, must be unambiguous.

Prospective incentives and post-transaction compensation must be clearly delineated. All these elements are especially important when the transaction includes incentives and earn-outs tied to future performance.

How do you handle these steps and thoroughly prepare your firm for evaluating potential acquisition targets? The work won’t get done by itself – you must field a savvy acquisitions team.

Building an Acquisition Team
Whether a firm is large or small, an acquisition is best done with a team that includes senior leadership from within your firm and targeted external experts to handle legal and financial details.

Internally, the acquiring company’s owner must be involved. He or she is the voice of the buyer and the strategic decision-maker. The company’s accountant will be tapped to answer the financial questions and a working partner or senior staff member must be a key player too, as it will fall to that person to determine whether successful integration can be achieved. As we said earlier, this may be the most important decision to be made.

There is a big difference between just making a transaction and making it successful. A recent study by The Boston Consulting Group determined that 61% of transactions between 1995 and 2001 actually destroyed shareholder value. Tapping outside expertise in key areas can be the balancer between success and failure.

Typically, a company will bring in an attorney, a financial advisor and an accountant or tax advisor. These three specialists provide the best support for your team to complete a successful evaluation that will lead to an acquisition. You might also consider the services of specialized investment banking firms that regularly handle mergers and acquisitions. Transaction professionals will protect your best interests, help minimize distractions from your core business activities, ensure a smooth transaction, and guide the combined firm to positive post-transaction results.

Can the work be done internally? Possibly. But many small to midsize firms do not have the organizational structure or staff time to expertly fill all the necessary roles.

Evaluate Your Needs
Expert help is advisable, too, because you’ll be stretching staff resources even thinner as you evaluate your firm’s needs. A strategic view of the agency, its impediments and desired area of growth is essential. We advise clients to perform a SWOT analysis to get a clear picture of their firm’s place in the market:

Strengths: Consider your highest-performing lines and strongest industry relationships.

Weaknesses: Evaluate areas for improvement in personnel, programs or operations.

Opportunities: Regard recent changes by competitors or the business climate that may have left holes in coverage. Also consider where you can gain from enacting efficiencies.

Threats: Assess the competition and analyze the approach of competitors. You need to know what’s out there that might sabotage your plans.

Before effectively executing an acquisition, the agency must remediate its inefficiencies, jettison unprofitable markets and products, and establish a growth plan.

The SWOT analysis also will help you create an acquisition profile that will define your strategic motivations and narrow your search. The analysis will also help you prioritize your needs. It may show that you need a product specialist to fill a gap, or that territorial expansion is the best route. You might decide to gain synergy by combining with an agency much like yours, or to expand the current product mix. Maybe you need access to a competing firm’s people. You might be forced into acquisition mode just to stay competitive.

Whatever the motivation, recognize that most acquisition candidates will not meet all your stated criteria. It’s a good idea to use a formal evaluation matrix, which will further take the guesswork out of your choice.

As a buyer, you must have a thorough understanding of market dynamics and how they are affecting the pricing of agencies on the market. For instance, in many markets there are well-funded ventures vying for the same targets. This might drive up prices. But unless you go into the market knowing the pricing rationale, you may end up with unrealistic cost expectations or you might find yourself settling for a “fire sale” target. In either case, you’d be buying into disaster.

Funding Your Purchase
Perhaps the most disturbing mistake often made by acquiring agencies that believe they can buy another agency purely on an installment basis, offering a note to the seller or retention of the business that you’re slowly taking over. This is simply an unrealistic approach. In today’s marketplace, we often see 90% of the contemplated value paid up front. Your installment offer wouldn’t stand a chance.

It is equally important that agency owners evaluate the cost-of-capital component prior to proceeding with a potential purchase. Debt service or financial impact should be carefully modeled against market trends so that the agency owner is fully apprised of what to expect from near- and long-term results of a combined entity. It is critically important to weigh economies of scale when combining businesses, as well as to consider potential risks that the market and cultural barriers may present.

The financial impact of integration also needs to be seriously reviewed to fully anticipate the capital needs. Careful planning and integration timing will provide the basis for a sound financial decision.

Ultimately, the acquiring agency’s owners may need to forgo immediate perceived gains, and take a slower route to integrating the acquired firm. The true profit will be revealed only when true integration has taken place.

All of these steps lead up to the ultimate safety net that must be part of any transaction: due diligence. Investigation of the seller’s business prior to purchase is absolutely vital. Consider the company’s carriers and client relationships, its leases and contracts, and its licenses and standing with regulators. Study the firm’s personnel and compensation programs. Review its tax records, complaints and any significant interaction with governmental authorities.

Typically, a thorough review of all relevant business documents must be done to ensure that there are no salient risk issues. Then you must consider how to manage issues like customer attrition and brand integration, which are naturally part of the acquisition process.

Act on Your Plan
If your analysis tells you that you’ve found a purchase that works, act promptly. There are two things that always kill a deal: greed and time. Timely execution will put momentum on your side and place the deal in a positive light for your staff, customers and the industry, not to mention the staff and clients of the firm being acquired. Even if you’re making all the turns at full speed, the process takes six months on average, and can easily take nine months.

When it comes time to approach your target firm, take care. Confidentiality is an issue, and non-disclosure must be assured if you’re soliciting a direct competitor.

An offer can be made through direct contact, such as a phone call or letter. Often, agency owners utilize a third-party advisor to coordinate initial contact. Typically, an advisor will contact the potential seller, profile the buyer in generic terms to protect the client’s identity, and assess whether there is interest in merger discussions. If there is interest, a bilateral non-disclosure agreement is executed. This protects and binds both parties to confidentiality during the next phase of the process.

Confidentiality is sometimes breached – especially in transactions between larger firms – because more and more people are involved on each side, thus more possibility exists for word to get around. The best antidote to the rumor mill is to move quickly through the due diligence and contracting phases.

During this time, both parties need to stay committed to the complete execution of the transaction. This is easier said than done. Countless distractions could cause either party’s attention to wander, which would slow your momentum and raise unanticipated problems.

It is equally risky to go through with the purchase, then sit back, relax and say, “The deal is done.” That’s human nature. But it is often said that anyone can do a deal, but not everyone can make it effective. Statistics support that view. Shareholder value usually becomes depleted by an acquisition – and the fallout is not fully visible until years in the future.

That’s why the “transaction” truly requires action that transcends the sale itself. A complete purchase transaction includes integration, cultural assimilation and execution of the long-term business strategy created when the purchase was contemplated. Only when all these steps are done in a cohesive environment can you say that you successfully beat the industry averages through acquisition.