PE Perspective on Insurance Brokers - [Business Breakdowns, EP.225]

27:33I think that's right. But I think insurance and insurance brokerage is probably 10 to 15 years behind. Now we're coming up pretty quickly, but there are a bunch of different areas where technology helps. First, most importantly, is having one agency management system across the organization. An agency management system, think of that as the ERP system where the brokers live in. They put potential clients in there. That's where they run all their processing, underwriting, acceptance, claims management, et cetera. In order to have one agency management system across your organization allows you to see your organization fully, understand what type of policies you're writing, what type of risks you're putting with what carriers, and you can have the data at your hands to be able to drive better negotiations with the carriers.

28:22But then it also helps the brokers. There are a tremendous amount of filings because this industry is regulated state by state. So the brokers need to have the technology to be able to quickly fill out forms and be able to submit them to the appropriate entities or the carriers to be able to do their jobs efficiently and sell more business. There's a lot of brokers out there. They're still using pen and paper. And then if you overlay the technology with AI, it should be able to allow brokers to have much, much more free time to be able to go out and sell new business, which is the goal. So I think this industry is on a journey.

29:05I like sports. If we're baseball, we're probably only in the third inning in terms of the ability to really use technology and data to be more efficient, leaner and drive better growth. And tying it back into the M &A, it's always great in concept, but sometimes where M &A can break down is the integration and it can be technology integration. Have you found that this sector, the integration follows a standard playbook? Do you see that cause challenges for businesses, whether it's ones that you've been around or have seen elsewhere? It seems M &A is just part of the model. But when you factor in the incorporation of what you mentioned with records and filings and everything that goes into it, I would imagine that it's not easy.

29:51It is not easy. It's probably not the hardest industry to integrate, but it takes time. You need a team and you need to do it right. Because what we've seen in this industry in the past is when you slack on integration or you cut corners and it looks like a small corner or you don't do one thing here and another thing there, before you know it, you're a large business and it's impossible to catch up. So for us, we just bought a business over in the UK called JMG Group. They focus on small insurance brokers in the UK and they have a playbook to integrate the business. Everyone's on the same system using the same data within 90 days.

30:35And that allows them to be able to run the business much more efficiently, not have surprises and be able to take control of those acquisitions that you bought. If you leave people on disparate systems, you're not running the business. They are. You're not getting the right KPIs to manage the business. You're not seeing what's coming around the corner. And what happens then is it's too hard to integrate. And then you're just 100 different corks floating down the river at your own speed. And eventually it catches up to you. To your point, I think FedEx might still be integrating the TNT acquisition from 10 years ago.

31:10It's a little different when there's hard assets and infrastructure and logistics networks involved where technology and incorporating some of those systems, not only could it be a bit lower of a hurdle, but it proves to add a lot of value as well. The flip side on that, Matt, is people are used to doing things a certain way. And we talked about the importance of people and they go home every night. And a lot of times brokers are set in their ways and they're older and later in their career and they don't want to learn a new system. So you have to make sure that you're buying a business where people are going to embrace that change.

31:47Otherwise, you could break it by forcing the integration on people who don't want to do it, aren't willing to do it, or just happy using pencil and paper. Yeah. Producers historically have found ways to write their own rules when it comes to managing systems, but keeping a clear mantra intact and getting people to follow protocols, I can imagine is just insanely interesting here. The general market, when you think about revenue growth for any of these businesses, you mentioned that diversification is an incredible positive. What does the trend line look like when you think about an insurance business and top line growth?

32:22If I were to use GDP growth as the standard and either being above or below that as being a line of demarcation, do you have a mental framework of what you expect organically insurance businesses to grow? Yes. I believe it's inflation plus. Don't ask me plus what. But for us, what we've seen, especially we're always talking PNC right now, property and casualty insurance, is the other thing that's driving it besides inflation, which of course inflation is just the underlying results of your assets being worth more, your business and services growing. The other thing is this industry is enduring right now is social inflation.

33:03So social inflation is a very nice word for large jury verdicts. If you are going to insure a bunch of trucks, and I keep on using that example because we've done a lot of trucking in the past, and you get in a fender bender and someone hurts their neck and all of a sudden a jury awards that person $20 million. They didn't have to take off more than two weeks of work and these jury verdicts are getting enormous. And I think juries are being more sympathetic to consumers relative to the big bad companies, I'm saying ingest. And so you have social inflation that's really impacting it. The other thing that's growing premiums, which isn't great, is new risks.

33:44So there's cyber risk. So how do you price that? That's a whole new industry that's being brought into the insurance sector. Then if you're underwriting schools, crime in schools, If you're underwriting an office building, we see these horrible, horrible tragedies that went on in Manhattan yesterday that are unspeakable. But then from a business perspective, and you're insuring those people in that risk, price is going to go up because these things are happening. So those are the things, unfortunately, that are driving this industry to grow at a bit faster than inflation. Yes. And acknowledging the dynamics that are causing it and just putting those to the side to focus on the impact that that would have for an insurance brokerage business.

34:30Is it right to just think if premiums are growing, the brokers are capturing a percentage of those premiums, therefore that is top line growth? Is that the most simplistic way to think about it? That is fair. And that's for the small and midsize world. So I'd separate that from if you think about the Fortune 500, they have really smart actuaries and insurance experts who are determining what type of insurance they need. They're going to the large broker houses and they're paying a fee and the broker house is getting a fee. the traditional mid -market SME, et cetera, PNC world where private equity has been incredibly successful for the last 20 years, that is commission.

35:15Yeah. So as premiums go up, the revenue of that insurance broker goes up. So it's a wonderful business because we don't have to ask our clients for raises. We don't have to change our price. We just get a percentage paid by the carrier back to us of their premium. Out of curiosity, is there a threshold where you move from the percentage to the fee? Is there a number that's involved there that you have mentally? There's not a number, but it's big. If you think about any type of growing business and a management team and a board of directors who are trying to set strategy and allocate capital, you have to be pretty big to say the next $5 million, I want to build an insurance department at this organization.

36:01So it's truly the largest of the largest corporations. And you mentioned some of the new risks coming into the system. One of the things that I often think about is cybersecurity and whether it's just the trend line of what's happened in the cloud, and now we have AI, but it's something that in theory should be more and more in focus going forward. Does that category fall under this bucket as well? Does it tuck into a large insurance brokers operations or would that sit outside? No, this absolutely tucks into all the insurance brokers that we've been talking about today. If you have a business, you need cyber insurance.

36:39Absolutely. And the irony is this is the first type of risk that I believe is very different than any other risk in insurance, which is why it's really hard for carriers to underwrite it. And I love talking about this and I get up on a little bit of a soapbox. Most other risks that you think about property damage, slip and fall, et cetera. Once the carrier or the insurance broker hears about the risk and the event, it's done. It's behind you. The fire happened. Your manufacturing facility burnt down. It's done. Cyber is real time. You call your insurance broker, you call your carrier and you say, someone is in our systems.

37:19We've had a breach. So carriers who obviously have to minimize their loss exposure, they have to be proactive and be prepared to move very quickly to help the insured exit or end this breach situation. So it's a very, very different risk than any other risk this industry has ever seen, which is why people are struggling with underwriting it, pricing it appropriately. And you're seeing some carriers have pretty adverse loss ratios because it's a very, very different outcome than any other risk in this industry. I think, again, it proves your point on why brokerages are the interesting niche within here where you don't have the carrier underwriting risk that sits on your balance sheet, but you still get to capture the upside of the growing market.

38:08So probably came across in all of your previous answers. But just to spell that out again, I think that one certainly proves the point. Yeah. I mean, the best part about this industry, insurance brokerage, is insurance brokers do not take risk. Now, of course, people could argue over the long term, they may. If they keep on placing bad risk with the carrier, the carrier may cut them off. But that would be adverse selection, which you don't see. If you have general loss ratios consistent with the industry and other brokers that are placing premium with that carrier, you are not taking any risk.

38:46And I mentioned it earlier. I do believe in insurance and broader financial services that if you own that customer relationship, you should increase your percentage of the ecosystem profits that you derive. And that's because you're helping the insured decide what carrier to go with. And what's interesting about that is if you think about it, most people, and when I say people, I'm talking businesses here, but people as well, they don't really care who their insurance carrier is. As long as they're A -rated and they're known to pay claims, they're happy to go with any of the top wonderful carriers out there.

39:25So their broker has a tremendous, tremendous impact on their decision. And when you think about an insurance carrier, they're large companies, they're capital intensive, and that's really what drives their value proposition. They bring capital. And capital is a wonderful thing, but it is a bit of a commodity. Sometimes it's more scarce than others. and commodities don't get the same value proposition as driving customers to decisions. On the difference between brokers, when you get down to the profitability metrics, and I think EBITDA margin, to your point, EBITDA translating to free cash flow, I would imagine that is the metric that tends to get a lot of focus.

40:08What does that range typically look like for these businesses? In terms of somewhat mature insurance brokerages, how much variance is there from one operator to the next? I think the financials of these brokers of similar size are very similar. Their EBITDA margins are all within a couple hundred basis points of each other. And that difference usually is organic growth. You can look at that over the course of the last 20 years. And a broker with 3 % higher margin probably has 1 % less organic growth. But they are very similar within bounds. And of course, as they get larger, they do have the ability to increase their margins because there are scale advantages and operating efficiencies.

40:51Is there a range out of curiosity that you could put numbers around? Just EBITDA margins, Matt? Yeah. A solid insurance broker could be in the range of 28 % to 35%. Certainly healthy when you factor in what that means for free cash flow. So in terms of the investments or anything below the line that would be required, putting aside leverage and the capital structure, what would go into other investments that need to be made, whether it's now or in the future that you think about as an investor? There are not large capital requirements in this business. This is a very, very clean cash flow. So besides capital structure, it's really just CapEx, which is a few percent of revenue growing a little bit faster than top line, probably because people are investing in technology and data and efficiencies.

41:48But it's a really, really clean business. And that's why everyone's done very well in this industry. And it's traded so well for so long. How do you view it? To your point, I think we've laid out why the private equity market would love this particular subsector. And I would imagine that's brought in more competition for you and your seat. What does that look like? And how do you think about the go forward in terms of the opportunity set here to find these businesses and to continue the playbook? So we have seen valuations grow pretty dramatically over the last 25 years. I think it's the result of a few different things.

42:31One is, I think before the financial crisis, insurance brokerage was not viewed that favorably from public market or private equity investors. They kind of viewed it as an industry where business was done on the golf course, and there wasn't much value proposition there. And people were just wrong. And I think the world saw that during the financial crisis when every other industry in the financial services world got decimated, being dramatic to prove a point. And insurance brokers grew. They grew. And I think it put a spotlight on the industry. So that brought in more competition, more capital.

43:14Then what we've talked about earlier in this call is I think pre -financial crisis and pre -turn of the century, a lot of the brokers were small, so they could not drive premium valuations because they couldn't drive their price. Even though they don't set price for the customer, they do set their commission rates with the carriers. And if the carriers didn't have large brokers that they were relying on to bring books and books of business to, they didn't have to pay them much. So one, the spotlight from how this industry performs. And number two, as they got bigger, they were able to increase their commission rates, either through variable or fixed commissions, saw that this is an industry worth investing in.

43:56The private equity industry entered this industry. Then we went on a run of 20 years of low interest rates, which obviously helps when you're doing M &A, if you could borrow very cheaply to buy these wonderful assets. So we've seen valuations, not quite, but maybe doubled in the last 25 years. I'd say pre -financial crisis, this industry traded eight and a half times. And now great brokers and the public brokers trade it 17, 18, 19 times. And I think it's driven a lot by the cashflow characteristics of this business. Everyone understands the recurring revenue nature of this business and the M &A opportunity.

44:35There's very few industries that have such a plethora of M &A opportunities. And what's amazing is this industry is still fragmented and there's still thousands and thousands of brokers for people to buy and get those synergies and get that operating leverage. And the funny thing now is you're seeing old brokers who have sold, run out their non -competes and start new businesses. So this industry still has a long way to go to get truly consolidated like we've seen in other industries. And there's still tremendous opportunity for value creation for investors. This somewhat overlaps with that question and answer, but you have a very interesting example with Assured Partners, a business that you invested in, exited, and then got back involved and have since made announcements.

45:23Can you talk a little bit about that, particularly the initial exit and then investing back into the business again and how that comes around and whether that is symbolic of the way that things can continue to operate in the future? Of course, but I'm going to correct your semantics, Matt, on one point. We didn't invest in Assured. We started Assured Partners. We formed that company. Okay, yes. So I'll go back to our leader strategy, which is we look to meet great CEOs, build relationships, and find assets to buy or build with them. Jim Henderson is the quintessential example of a leader strategy CEO.

46:02We built a relationship with Jim because he was on the board of another insurance business we were invested in, a carrier called Ironshore. So Jim is a legend in this industry. I've never met a CEO more well -liked because when you're a hard -nosed CEO, you always cross some people, not on purpose. Jim is the ultimate gentleman and he's been incredibly successful. He had a reputation and preceded him. When he joined the board of Iron Shore, my partner and I would change seats at dinner to be able to sit next to Jim. And we built a relationship with Jim over time. And after a couple of years, he was looking to do something different.

46:42and he called us down to Orlando where he lives. And we literally built the Assured Partners idea truly on the back of a napkin in his backyard. I mean, it's straight out of a movie. So Jim and we formed Assured Partners. GTCR committed several hundred million dollars to Jim to build this company. Obviously, Jim was in the space for 30 years prior, so he knew the entire industry, both people and target acquisitions. and our goal was to build an insurance broker with him. And he wanted to learn from what he did in his career and build a better broker, all about clients and brokers. And that was our goal.

47:22And someone like Jim, everyone was dying to work for him. So before we even owned an asset, we had about six people on the payroll that we were funding with equity, a president, a head of M &A, a CFO, because everyone wanted to work for Jim. So we were just burning cash until we found a platform. Now, we're not a venture capital firm, so we didn't say, go hire producers and start writing your first piece of business. We were looking for a platform. And our first platform was a company called Neese Lukens in Cincinnati, Ohio. And it was a small business, but it was big enough that had some basic infrastructure and the ability for Jim to professionalize the business.

48:01And we went off. So that is the quintessential GTCR story. Find a great CEO and a management team. find a business, bring that team in to run the business. So at the time, Neese Lukens was a very small business, but the management team we brought in, they were used to running billion -dollar businesses. And then on top of that, people wanted to sell. People wanted to work for Jim. I wouldn't say we were getting a discount, but we were winning ties because people wanted to be part of what Jim was creating. So we built a wonderful, wonderful business over five years. Unfortunately, in private equity, we do have to sell our businesses, even our great ones.

48:39That being said, we at GTCR like to own businesses longer than the industry average. So we were coming up on our five -year anniversary, and we were more than three times ahead of our back of our napkin plan. Our goal was to get to $40 million of EBITDA in five years. Like I said, we were well in excess of three times that. So we were excited. We spent so much time finding the right people, investing in the technology, investing in growth that we wanted to keep on compounding. And frankly, Jim, who was a wonderful partner, said, I recruited all these people. I promised them that in private equity, they were coming to work for me for the equity, the equity side of private equity, and we owe them a payday.

49:22So we sold the business and it was a wonderful success and one of the best deals in our fund. And of course, we stayed in contact with Jim. Jim is a personal friend at this point. And we were staying in touch. And I remember I was walking through Disney World. My kids were young then. And Jim called me up and said, let's do it again. And I said, Jim, do what? And he said his current sponsors wanted to sell. And we should work together again. At GTCR, that's the best phone call you can ever get, which is when a CEO wants to work with you again. And if you think about private equity and getting to a little geeky finance, risk and reward are correlated.

50:00Our biggest risk, especially as you hear us talk about the leader strategy, our biggest risk is finding a CEO where you think you're well aligned, putting them in a business, and you're not well aligned. And you have to change management and all the leakage that comes with that. That doesn't happen often, but that is a risk. And here, we've worked together. We've seen eye to eye. We understood the strategy we wanted to continue to execute. So all of a sudden, we had asymmetric upside because we had the same reward potential with a significant risk chopped off our other side. So we were very excited.

50:33We partnered with Jim and the management team to rebuy the business almost six years ago. And now we built it to over a billion dollars of EBITDA into a wonderful diversified specialty -focused business. And it was announced last November that we're selling the company to AJ Gallagher, just one of the absolute role models in the middle market insurance brokerage space and a family we have tremendous, tremendous respect for. That's an incredible story that really capsulates all of the higher level investment frameworks along with the nuance of the industry. I love hearing that and spelling out the details.

51:10On the point of the exits, which you need to think about, the scale becomes bigger. And there's certainly in private markets, various chapters where I think I know some smaller market PE folks that look and try to build businesses that they can sell to middle market. And once you get up to the size and scale that you operate in, it becomes a bigger challenge or there's less natural buyers. So how do you view the opportunity set for when you're exiting, whether it's finding strategic public companies that could potentially be buyers, IPO -ing? I'm just curious how you think through those opportunities and evaluate them.

51:49So Matt, I think you're talking about exits for much larger platforms, hundreds of millions, even billions of dollars of EBITDA. And I do think there are exits for those larger businesses. Now, I do appreciate you recognizing we're doing bigger deals. But at GTCR, we still love doing what we've always done, which is small buy and builds, consolidations in industries. And we do have a fund that allows us to do smaller deals as well because we have a flagship fund. Then we have a strategic growth opportunity where we are able to do smaller deals as well. But anyways, to your question, Matt, I think there's a couple of different paths for liquidity or exits for these larger brokers.

52:30First, if you think about many other industries, they all consolidate at the top. There's very few industries where there's seven mega players. And this is an industry where there's probably five to six players with billion dollars of plus of EBITDA. And there's probably another 10 players with $500 million plus of EBITDA. So I would expect the big players to consolidate and still get all those synergies of what you'd normally see in larger transactions of that size. Second, I do believe there are large strategics that still love the middle market and would be willing to do larger transactions.

53:10That being said, there's not that many and there's not enough large public strategics to buy the next 15 largest private companies. So last, you are talking about potential IPOs. This industry, as we've talked about, has performed incredibly well for public investors. And you should expect to see a handful of private equity -backed insurance brokers go public over the next couple of years. We've talked a lot about what makes this a very special industry. when you think about the risks, what stands out the most to you just as a risk that could be on the horizon or you look for in the operational results?

53:51What tends to stand out the most for you? I hate, hate, hate when people talk about investments and don't identify risks or ways to lose money because you could do that in any industry. But what is wonderful about this business is, I'm going to go back to the diversification. And we always used to laugh with Jim. If we lost our largest customer, Jim wouldn't call us because Jim wouldn't know because your largest customer is way less than 1 % of revenue. So there's not a risk out there. Like, I don't look at AI and say that could take down this industry. Can it make it more efficient for the carriers?

54:26Can it make it more efficient for the brokers? Yes. Insurance is one of the oldest industries in the world. And on the insurance brokerage side, I don't see something that would fundamentally change the industry. You can have years of slower growth. We didn't talk about the insurance cycle, which is hard and soft markets based on capital availability and carriers profitability. So you could have several years of a soft market where premiums are coming down and therefore your commissions are coming down that would slow your growth and impact your cash flow generation. Now you would hope in that environment, which we've seen before, tucking acquisitions probably get a little bit cheaper.

55:08So you could have, and there has been years of soft markets where the results aren't as strong as you'd like to see, but there is not an esoteric risk that is going to bring down this industry or I am worried about that will fundamentally change the structure of the industry. Just on the soft markets, is that typically tied to macro cycles? Is there something else that drives when you do have a slowdown? So it's funny because we've done a tremendous amount of work and sometimes soft markets have correlated with soft economic times, but it's not always the case. They're not perfectly correlated.

55:49What really drives them is insurance carriers' profitability. And the one most important thing to identify a potential hard or soft market is forget about carriers' revenue, their profitability, their net income, cash flow. When carriers have positive cash flow, they're happy, they're generating returns. It's when they dip into negative cash flow area that you'll see the market hardening because they got a push rate to drive returns. So cashflow is the number one predictor of a potential harder soft market. And the insurance industry's profitability, yes, it's underpinned by the overall economy, but you could have two horrible storms.

56:36You could have an earthquake in California and a hurricane in Florida in the worst economy in the world, and all of a sudden prices are going up and the insurance brokers are going to make more money because they get a percent of that premium. So there are risks that are independent from the broader global macro economy that would drive a hard and soft market. Very interesting. The last thing that I wanted to touch on, you brought it up earlier was it's a highly regulated industry. It seems like the impact for the brokers is mostly on the filing and whatnot. But in terms of regulation as either a risk or a potential catalyst and tailwind, are there any things out there that would directly impact the brokers from a regulatory standpoint that you're watching closely or there's a milestone that's upcoming that you would be looking out for?

57:22There's nothing on the horizon that's being discussed, whether at the state or federal level, that people are worried about. You had the whole Spitzer situation back in pre -financial crisis that really shook this industry. But right now, it's pretty well regulated. It works very well. And I think an advantage of being a slightly bigger broker is you have the ability to track the regulations and be able to grow by state because it's regulated by the state. So every state is different and you have the capital to be able to support having a regulatory team to just follow the regimes and understand what's going on.

58:04But there's nothing on the horizon that's material to this industry right now. Well, Aaron, this has been a pleasure. Thank you for sharing all the knowledge, the history, and some fun stories along the way. I appreciate you joining us. Matt, thank you for having me. It was a lot of fun. To find more episodes of Breakdowns ranging from Costco to Visa to Moderna, or to sign up for our weekly summary, check out JoinColossus .com. That's J -O -I -N -C -O -L -O -S -S -U -S .com.