Why Post-Close Economics Determine Acquisition Success

By Scott Freiday

When one independent insurance agency acquires another, they should be able to model the results with realistic accuracy. However, a year after the close of the sale, the actual financial results often do not mirror the projections. Why? Because the focus was on the front-end of the deal–for example, the multiple that was paid. Yet, the post-close economics were not thoroughly considered and modeled to reality.

In agency acquisitions, the focus on the purchase price can lead to tunnel vision. But the four pillars of the deal–amortization, interest expense, tax allocation, and owner distributions–ultimately determine whether a transaction succeeds or strains the borrower’s cash flow. Building those considerations in the financial modeling should be reckoned with in acquisition modeling. By examining the post-close economics from a lender’s perspective, better modeling can provide a more realistic economic view.

Siren Call of Using Multiples

Relying on agency valuation metrics can lead to a misalignment between projected and actual results. But turning the viewpoint around from a lender’s perspective will lead to a better understanding of the post-sale cash flow.

For example, when modeling the purchase, the borrowing agency generally starts by forecasting the amortization and interest expense. Often tax allocation and owner distributions are not accurately projected in the acquisition pro-forma. Although tax allocation is a non-cash item, it still impacts reported earnings, which can cause a problem with loan covenants.

It can be a particular area of tension in negotiating the deal parameters as buyers would like to have as much of the purchase be treated as an asset purchase as possible because the stepped-up basis provides larger amortization deductions. Conversely, the owners selling the agency want to allocate as much of the transaction as they can to a stock sale so they can realize capital gains treatment of their ownership.

Similarly, underestimating owner distributions has a very real impact on cash flows. The prior owners often understate the amount that they withdraw from the agency as compensation and fringe benefits such as a car lease and country club dues. To avoid any eventual misunderstanding and negative feelings in developing the sale terms, attention needs to be paid to capturing total draws by the prior owners.

Missing Assumptions

Banks that provide financing for agency acquisitions apply a “Debt Service Coverage Ratio” that targets a post-expense, after distributions ratio. Typically, banks look for the cash flow after distributions to cover annual loan expense greater than 1.0 up to 1.25 times. But the distribution needed may not be as large as expected when modeling for amortization and interest expense, which reduces the overall profitability and, in turn, the size of the distribution owners may need to cover the tax liability. The purchasing agency should avoid assuming that 100% of the income as broker of record will roll over because competitors may use the sale to target key accounts of the seller.

Further, due diligence should be performed to confirm that the carriers the seller is appointed with will agree to appoint the buyer’s agency. There could be factors such as if the acquiring agency’s location is in a different geographic area, or certain market factors with the carriers that prevent the seller’s appointment from transitioning. In addition, unforeseen costs related to harmonizing agency management systems, retaining key staff, and possibly higher benefit costs than the seller provided can result in higher expenses, which impacts profitability, especially in the first 12 months. So, it’s important to have a thorough understanding of the proforma analysis and a good industry consultant can help with this.

Avoid Buyer’s Remorse

If sellers use comparative data to optimize the purchase price, the buyers may believe their purchase offer reflects prevailing M&A deals. However, if the modeling does not adequately forecast the impact of amortization, interest expense, tax allocations, and owner distributions within the specific context of the selling agency, they may find themselves stressed from a cash flow perspective and satisfying their loan covenants. Potential buyers should keep top of mind that accurate modeling will not kill a good deal. Rather, it prevents a potential buyer from entering into a bad one. IJ

Freiday is senior vice president and division director of InsurBanc, a division of Connecticut Community Bank, N.A. Email: sfreiday@insurbanc.com.

Topics Mergers & Acquisitions