External Growth With Successful Acquisitions

EXTERNAL GROWTH WITH SUCCESSFUL ACQUISITIONS

by Carol Hammes

Be prepared to do an acquisition before the opportunity presents itself.

INTRODUCTION

Most agencies will have the opportunity to acquire or merge with at least one other agency during the next year. Market conditions are forcing the owners of smaller agencies to seek business partners in order to meet the needs of their clients more effectively.

Owners of larger agencies who are tired of the hassles and perhaps fearful that agency values will continue to decline are opting for retirement sooner than they had originally planned. Merger and acquisition activity has been heating up in recent years, with current estimates indicating that 10 or 12 business combinations are being consummated every day.

Whether you’re actively looking for them or not, chances are that potential deals have been or will be presented to you shortly. Be prepared! An acquisition might be just the catalyst your agency needs to get off of dead center — or it could literally drive you into the ground. The temptation to seize upon an opportunity before the competition gets the chance to steal it away from you can be overwhelming. Many ill-fated business combinations have been made defensively.

YOUR ACTION PLAN

Because of the need to act quickly when an opportunity arises, it’s important to have an action plan that will force you to assess the situation rationally, within the context of your agency’s goals and objectives. A written set of questions and guidelines can take the emotional content out of the decision making process and help direct you to the right set of choices.

Before setting up the acquisition action plan, assess your agency’s individual strengths and weaknesses. Evaluate your current situation. What kind of business combination (if any) would complement these strengths and/or shore up the weaknesses? Would it be favorable to acquire another agency, merge with one, or cluster with several? Or is it perhaps more accurate to put you in the group of potential sellers?

If the only reason to acquire another agency is greater volume to cover expenses and/or keep your companies happy, it might not be such a good idea. Larger isn’t necessarily better; unless and until you’ve learned how to manage your agency profitably the way it is, adding more volume will rarely solve the problems — it will just make them bigger.

Although there are exceptions to every rule, a financially weak agency should not be in an acquisition mode. Even the best agency purchase will generally cost more money than it will make over the short term. Unless there’s a cushion to fall back on, the demands of the acquisition on total agency cash flow can literally drag the whole operation under. To be a healthy buyer, your agency should have a current ratio of at least 1:1, a trust ratio of more than 100%, a receivable/payable ratio of less than 75%, and a tangible net worth that’s in the black.

If you’ve recently made several acquisitions or are in the process of buying out a major owner, the existing demands of servicing this debt might preclude taking on the additional obligations of buying another agency. But a merger or cluster might make some sense. Several marginally profitable agencies might be able to get ahead by combining operations — if they can save on expenses by getting together and none of the entities will need additional cash to buy anyone out for the first couple of years. However, if you try to merge agencies that are all losing money separately, the chances are you’ll just lose that much more money that much faster.

REASONS TO ACQUIRE

Assuming that it passes the financial stability test, what are some of the more common reasons to do an acquisition or merger?

1. To buy accounts that will round out an existing book. This might be to expand a line of business that’s not large enough to be handled profitably by the agency, or perhaps to acquire an agency to fill out a branch that needs more volume. A good example of this situation would be an agency that has only $100,000 or so in Personal Lines commissions. If getting out of the Personal Lines business isn’t viable, buying an additional $80,000 to $100,000 in commissions will allow the agency to use one CSR more effectively, while adding $600,000 more in premium volume to keep available markets happy.
2. To bring in a younger producer who already has some business. You might not have the resources or the patience to hire someone from scratch, but you need people to support internal growth objectives or internal perpetuation transfers. An ideal candidate for this type of acquisition would be a smaller agency with an older owner and a younger producer (perhaps a family member) in which there’s not enough volume to support both producers, but there is enough to fund a buyout of the older one.
3. To expand a niche agency’s market beyond its immediate geographic region by buying another agency as a branch office.
4. To reduce a niche agency’s vulnerability to a single market by buying an operation with another specialty. For example, an agency specializing in Attorneys Legal Liability might acquire a shop that sells and services Accountants Professional Liability.
5. To nullify the competition. In smaller communities there might only be enough business to support one medium-sized independent agency. If two smaller operations are spending most of their time trading the existing accounts, it might make sense to explore a business combination — unless, of course, there has been too much bad blood spilled during the years of heated competition.

EVALUATING ACQUISITION CANDIDATES

Once you have determined why a business combination makes sense for your agency, transfer those reasons onto a list of criteria for target agencies that will give you a starting point for narrowing the field. If you’re in a passive acquisition mode (meaning that you’ll take a look at opportunities, but aren’t actively searching) the list will help you weed out unsuitable candidates before you waste time on something that’s not going to be a good fit.

When a candidate has been identified, the owners of the respective agencies should get together for the initial chemistry meeting, or “sniff” test. Is there a compatibility of management styles, underwriting/risk management viewpoints, organizational structures, and personalities? Are there significant differences in ethnic, religious, or political backgrounds that might impact the retention rate? Pay close attention to initial reactions and gut instinct. If something doesn’t seem quite right now, it will definitely turn wrong later on in the relationship.

Assuming that the initial meetings go well, get down to determining whether the agency will meet your needs and, if so, how much this is worth to you. The checklist below presents a comprehensive list of the items that should be reviewed, especially in a potential merger or cluster situation, but also for acquisitions of separate agency operations. Some of this information might not be available in smaller agencies, or you might be acquiring a book of business without any people. At the least, obtain income tax returns for the past five years and carrier production runs for the last year (and preferably the last three). The tax returns will provide income and expense information; the production reports will give you premium volumes, percentage of new business, premiums by line of business, and loss ratios.

ACQUISITION CANDIDATE EVALUATION CHECKLIST

1. Agency history, including areas of specialization and management philosophy and details of acquisitions during the past five years. How much of the business has been purchased and how much has been generated internally?
2. Description of affiliated agencies, subsidiaries and/or branches, including special arrangements among them.
3. Reputation: Image in the community and standing among the local competition and insurance companies.
4. Physical description of the agency, including: Location (condition, layout); owned and leased equipment (including company cars); and agency automation system.
5. List of stockholders or partners by name and percent of all types of ownership.
6. History of changes in ownership for which outstanding notes or agreements still exist.
7. Review of buy/sell agreement or other internal perpetuation documents.
8. Review of deferred compensation, non-compete, or other vesting agreements.
9. Current ownership of expirations, brokerage arrangements, etc., including details of settlement upon possible termination of employment/agreement or sale of agency.
10. Review of employment agreements. Who has them and what do they say?
11. Average number of employees and revenues per employee and compensation per employee. Compare to industry averages.
12. Biographies and impressions of key people (not necessarily limited to owners and/or producers).
13. List of commissions handled by each producer and CSR (include “house accounts,” if applicable).
14. Review of compensation and employee benefit plans for both producers and administrative support staff.
15. Discussion of changes in individual owners’ compensation that would take place once acquisition is completed.
16. A three-year review of leading insurance carriers, including premiums, loss ratios, and contingents earned. Are all contracts assignable?
17. Review of product mix by line of business. Look at the Personal/Commercial/ Life/Group breakout, and detail within each category.
18. Review of special programs of services provided, including, but not limited to: Underwriting activities for carriers; third-party administration; franchising/co-ventures with carriers, other agencies, or other financial institutions; special programs targeted at industry niches.
19. Review of the 20 largest accounts, including:
    • Customer name
    • Customer’s basic business
    • Location
    • Types of coverages purchased through the agency and policy terms (any three-year policies?)
    • Years serviced by agency
    • Amount of related commission income from all customer accounts (including Group and Life)
    • Producer handling account and special relationship considerations
20. Five-year review of revenues and expenses broken out by category and compared with industry composite ratios.
21. Review of balance sheet for the past fiscal year. Compute current ratio, receivable ratio, trust ratio, existing debt load, and tangible net worth.
22. Review of accounts receivable aging and general collection practices.
23. Review of Errors and Omissions policy limits and claim history. Is the current policy claims made?

If several agencies are thinking about combining (in either a merger or cluster) all of the agencies should compile and share the checklist information. To the extent possible, come up with a composite profit and loss statement, combined company volumes and loss ratios, and distribution by line of business. Does the “new” agency look better or worse than the parts? Once you start looking at the detailed breakdown, characteristics that might initially have appeared to be complementary could actually turn out to be incompatible.

The late Carol Hammes, principal of The Middleton Group, was one of the Independent Agency System’s most widely respected management consultants. She will be sorely missed.