M&A Due Diligence: Understanding the Issues and Solutions to the Pitfalls
Mergers and acquisitions in the insurance industry continue steadily despite a slowdown due to COVID-19 and higher interest rates.
After the price and terms are negotiated and a Letter of Intent (LOI) is executed, then it is time for the buyers and their advisors to perform due diligence. Our role as consultants in the industry is to guide the seller through the due diligence process and coordinate the flow of documents and data with the buyer. This article highlights some key areas in the due diligence process to be aware of if selling or making acquisitions.
What Is Due Diligence?
Due diligence is a comprehensive investigation and evaluation of the seller’s assets, background, financial standing, risk exposure, and other relevant factors. This process is necessary to ensure the buyer understands the potential risks of buying a specific insurance agency.
Some buyers, especially local/peer-type buyers, will perform the work internally. Others, such as buyers backed by private equity money, will hire an outside firm for an independent assessment, especially the financial and legal due diligence.
Usually, a lengthy checklist is sent, and a place is established for the seller to download all of their various files for financial statements, leases, bank records, carrier statements, and myriad computer reports (employee records, book of business breakdown, new and lost accounts, legal documents, etc.).
Key Milestones
Typically, the buyer will make an offer to the seller, contingent upon successful due diligence. It is not uncommon for an offer to be revised based on the findings during due diligence. So, be prepared to renegotiate the terms of the deal.
Prolific buyers will do the financial and general due diligence work first. This would be revenue verification, pro forma analysis, a review of the book of business, general risk assessment, and a review of employees, compensation, and benefits. The legal review and draft of the purchase agreement usually follow but can be done concurrently. Generally, the timeframe is four to six weeks.
Common Issues
Agency owners are often surprised when issues arise during due diligence. This is because buyers have a different perspective than the seller. The seller might operate in a manner that makes sense to them but is a potential risk for the buyer. For example, an agency might have several large accounts owned by an individual who happens to be the seller’s best friend. That is a good arrangement for the seller, but the buyer will be concerned that those accounts might shop their business elsewhere when the seller retires.
Another situation that sellers don’t consider is the impact of account ownership. The agency cannot sell accounts if a producer owns them. Sellers will insist that the producer is going nowhere and has been happily employed for years. As for buyers, they would love to keep that revenue stream, but they need to “lock it up” before closing the deal. Two standard options are for the seller to buy the book before the agency sells, or the buyer can purchase the book from the producer in conjunction with the agency acquisition. Other options include excluding the revenue from the purchase price but keeping it in for any bonuses based on profitability.
Other issues include:
Revenue — Adjustments can be due to discrepancies or pro forma adjustments.
Expenses — This is usually related to pro forma adjustments.
Compensation and Benefits — This usually concerns meeting the buyer’s standards.
Outside Business Interests — This can create a conflict of interest with the buyer.
Unusual Business Practices — The agency might operate in a manner the buyer will not accept. For example, large buyers typically do not charge policy fees to personal lines clients.
Risk Concentration — The seller might be overly dependent on a large account, a small carrier/market, or an unusual niche.
Use of PEO — Termination of contract with the PEO must be understood. If the PEO manages the retirement/401(k), this creates extra steps for the transaction.
Network Membership – Termination of contract with the network must be understood. There can be a fee/penalty to leave the network or a waiting period before exiting. Contingent income can also be impacted by leaving the network.
Verify Commission Revenue
One of the most important purposes of due diligence is to verify the revenue. There can be many issues with an agency’s stated revenue. The timing of when things are recorded can distort the “true” 12-month revenue generated by the agency. For example, it is possible that 11 or 13 months of direct bill commissions can be recorded. Or a large agency bill client can be invoiced well before the effective date to overstate accrued agency bill commissions.
Certain revenue might be adjusted in the pro forma. For example, non-recurring revenue is often excluded if there is no long track record of that income, such as commissions from term life policies, large bonds, or wrap/builder’s risk policies.
Multi-year policies, such as directors and officers, are annualized. Contingent income can be adjusted to a three-year average or modified for other reasons.
The standard process to verify the commission revenue is to obtain carrier statements, bank statements, client invoices, carrier invoices, and premium finance statements for the analyzed period.
Usually, a limited selection of the larger accounts and carriers is made rather than sending in everything. These documents are cross-referenced, along with the general ledger and the production report, to establish a certain level of confirmation that the revenue is correct or to determine what adjustments need to be made.
Expenses
Expenses are important for deals based on EBITDA (earnings before interest, taxes, and depreciation/amortization) and less of a concern for revenue-based deals. Buyers and the due diligence provider look at historical spending levels and general reasonableness to assess the pro forma expenses.
Owners are often very liberal in expensing things through the business. That is taken into consideration in the pro forma. Personal and discretionary spending, such as auto, meals, and entertainment, are trimmed or eliminated. Sometimes, the buyer and seller will have different opinions on expenses. For example, an agency might attend an annual trade show as part of its marketing. The seller might insist it is unnecessary, but an astute buyer would leave that expense in the pro forma. Some buyers will have overhead or burden charges factored into the pro forma. A common target is a minimum pro forma profit margin of 30% for the seller.
Compensation and Benefits
When we work with a client that is selling, we often change the compensation for the owners, producers and sometimes the service staff to reflect an optimized situation for staffing and compensation. Often, the assumption is to keep the agency as a “stand-alone” business. However, if a regional or national firm is acquiring, we may remove accounting and some administrative people. We often look at removing any “deadwood,” including producers that are not performing well. When payroll records are sent in for due diligence, those changes must be accounted for, as the past does not equal the future.
Buyers understand that any decrease in compensation could mean an exodus of employees. So, compensation rates are usually kept the same, including bonuses and benefits. However, the number of staff may to be cut. Some buyers will have standard compensation plans for producers. This can be an issue if the current compensation rate is generous. Those buyers must be flexible when changing producer compensation. A solution is for the seller or buyer to offer a one-time bonus or grandfather’s old compensation rates for existing accounts.
Most large buyers have generous benefits plans for their employees. Those rates are allocated to the seller’s payroll. If the seller has limited or no benefits, the cost of the buyer’s benefits can be a significant hit to the bottom line. Sometimes, the seller could have a more lucrative benefits package than the buyer. For that scenario, the employee’s compensation is adjusted upwards to account for “lost benefits.”
Legal Review
Ensuring the seller has complied with all applicable laws and regulatory requirements is another essential aspect of the due diligence process. Buyers and their lawyers will also review the licenses, corporate documents, leases, carrier contracts, membership in networks, HR matters, open and pending litigation, and E&O claims as part of the review. It is essential to fully disclose all issues, despite how bad it might look. Deals can be structured so the buyer only takes on certain liabilities, allowing the deal to close. The seller can then later resolve any issues the buyer did not accept as part of the deal.
Due Diligence Results
There is a good chance that financial due diligence will result in differences from the pro forma used in the LOI. This can result from losing a large account after the LOI was signed, the discovery of non-recurring revenue, expenses not considered, or different pro forma assumptions. It is not always negative for the seller; the revenue or profits sometimes increase, perhaps due to new business having been added since the LOI was signed.
Depending on how large the difference is or who the buyer is, the two parties might need to renegotiate the deal. In some cases, the buyer will honor the original terms, even if there is a noticeable decrease in revenue or profits.
Other issues, such as problems terminating network membership, potential risk with keeping employees or large accounts, and producer account ownership, can impact the terms of the deal.
Summary
Navigating the due diligence process in M&As is a complex and multifaceted task. As a seller, try to stay focused and provide the correct information asked for. Using a consultant to prepare the profile and pro forma from the beginning and negotiate the sales price and terms is a good step. The adviser can also help a seller rectify the due diligence results against the original offer in the Letter of Intent.