Why PE Rollups Fail the People Who Built the Business

19:30Kison Patel:How do you become the best M &A practitioner? You learn from the best. That's it. That's the whole secret. It's what we've done at M &A Science from day one. 400 conversations with the best operators alive. You've heard them on the show. So we asked a better question. What if we turned that into a product? So we did. Two certifications. The first M &A fundamentals is for people new to the game. Or maybe you just close your first deal and you felt every gap. This is how you close them. The second is buyer-led M &A. Our flagship, we took the best of 400 deals and built them into one framework for the buy side.

20:14Kison Patel:Every stage of the deal covered. We built both with PhD learning scientists. the quality is past anything we'd make in-house and you'll feel it in the first 10 minutes you've already listened to the best now go train like them mascience.com

20:38Kison Patel:sounds like the biggest surprise on a deal comes down to the character of the owner and i'm just curious if you have like a story you want to share about where the character of owner surprise you either in a good or bad way after close? We've had some wonderful people join the company and just really positive. Again, this business is a culture play. It's all about the environment. And it's not something that management or leadership can install. We can inspire it. We can try to help define it. But ultimately, everybody here is coming together as a community, as an organism to create the culture that we have and the environment that we have.

21:18And so I always like to describe our culture as a culture of appreciation and good feelings, but also of high performance. We've had people come into the company, let's say that we've acquired, who've just brought great energy into the company. They've been great leaders. They've been great partners. They're generous. I always say partners are generous with one another and fair with one another. And then we've had some other people that have come in and had more difficult personalities. And in some extreme cases, they've been abusive to staff. And we've usually figured out a way to part ways with those kinds of people, whether it be maybe unwinding the transaction or figuring out some way that we can just get to having peace and harmony.

21:57Kison Patel:You had a winded transaction. I can't imagine things being more painful, but as for M &A, that's got to be tough. If somebody's not enjoying the environment if they can't figure out how to be happy or get along with the rest of the team and they're being abusive or whatever the case may be. It's like, we can't have that. We can't have that in a culture if we want to have a great culture. This isn't feeling good, apparently, for either side. So let's figure out how we go our separate ways. What point did you decide acquisitions weren't worth the risk anymore? The hardest thing to do in this business is to grow organically.

22:29It's relatively easy to go out and take on a bunch of PE money or take on a bunch of debt and go out and buy up a bunch of assets. The hard part is integrating them and then getting them to grow organically. I just realized for myself, I just enjoy getting up every day and focusing on how to grow the business organically and make it better and make it a well-oiled machine and develop talent and recruit talent and create a great environment. I just enjoy all those things a lot more than taking on a bunch of debt to acquire assets and then hoping it doesn't fall out the back door and worrying about my leverage or having to take on investor money that is going to have terms that I don't think are ultimately going to be good for the business in the long term.

23:15We've been able to grow in seven and a half years from$11 million to$250 million in revenue without taking on any equity. So we've had an incredible growth rate that's been largely driven by our organic growth and we've been able to keep our leverage in the four time range, which is good. And I'm happy to keep it that way. I'm happy to just keep growing organically, reducing leverage, having money for redemptions, equity redemptions, which we did a big one last year, last October, and we expect to do others in the future here. That just seems like a way to have a healthier environment ultimately in the business, to me.

23:54Kison Patel:You like working hard. And there's the quality of the business that you're building when you do it organically as well. Yeah, there's no issues with brand migration. There's no issues with people having different processes. It's easier to have uniformity of processes, uniformity of collateral, how we do what we do. It's very satisfying to bring talent into an environment that we feel like we've created something special, not only culturally, which is most important, but also how we operate, how we provide services to our clients and to our producers to help them maintain and get new clients, that makes me happy.

24:31Kison Patel:When you do M &A, you're still trying to do that as well. You just don't get that same level of focus that you just described. I'm not saying we're never going to do M &A again. We've done a couple of small deals this year, but it's like your senior leadership only has so much bandwidth. There's only so much attention to go around. The question is, are you putting most of that attention on raising equity, rolling up assets, integrating them in all those challenges? Or are you getting up every day, figuring out how to drive a better sales culture, how to develop talent that you have and develop new talent and attract new talent and streamline your processes and procedures and systems?

25:11It is tough to boil the ocean. It is tough to do everything.

25:14Kison Patel:Can we talk a little bit about the economics of the way you grew with acquisitions? Because you didn't have a big private equity sponsor, essentially did it with your own internal sort of cash resource management. And you mentioned Forex levered. Can we impact that a little bit of how do you think through of your business economics to make M &A doable but without betting the whole house? It's great to see it. And I'm always curious about it too as I build a software company up. How strong should the balance sheet be before you really start looking at acquisitions as another growth lever? and how do you look at those economics doing it off an organic balance sheet without raising money?

25:55Again, I just think it comes down to leverage. It's a great governor. If we want to keep leverage in the fours, then we can't go out and pay 10x cash for a bunch of assets unless we're growing organically at an incredible rate. Now, this year, we're up so far through July, We're up 25 % top-line revenue, and most of that is organic. So we're having incredible organic growth right now, which is really just based on all the talent that's coming into the company. A lot of that talent does take time to ramp up. There's carrying costs involved in that, which impact your EBITDA and your leverage. But once you get through that ramp-up period, then you're not carrying any additional debt.

26:40I've always just thought about it as wanting to have a healthy balance of organic and inorganic growth. And that would put us in a position to let that leveraged governor be in the comfort zone.

26:51Kison Patel:What do capital sources look like for you? Because you're not an asset-heavy company. I feel like you're not the most favored type of business to lend to. Actually, that's not true. Lenders love this business. It didn't used to be that way. I remember years ago talking to banks and they were like, oh yeah, we can't lend to insurance brokers. This is probably, I don't know, more than 15 years ago, but that has changed. And now they view the recurring revenue and the stickiness of our business and the high retention rates as very lendable assets. We've always had a senior credit facility until last year when we did a term loan B.

27:26That was a big step for us last year to close that term loan B. And then we have a revolver as well. But yeah, our capital stack is very simple. We just have simple common equity and then a term loan B and a revolver.

27:39Kison Patel:What's a term loan B? Term loan B is a debt instrument. It's basically investors that invest into the term loan Bs and they can sell in and out of their position. There's sort of a marketplace around that. So it's almost public debt, if you will, as opposed to going public and having public equity. but we have to do a quarterly call with all the lender, all the investors in the term loan B syndicate. But it's a seven-year guarantee of that money that we have, and it's an efficient form of capital. Can you share what type of range of interest you end up paying on those type of vehicle? Like how big of a company do you need to be to set one up?

28:19You need to be the low end of being able to qualify to be in the term loan B is probably about 80 million or so of EBITDA. The market's gotten a little tougher now than it was last October when we closed this deal, just due to the war and other factors. Pricing, that information is publicly available as well. It depends. You have to get rated by S &P and Moody's, which we did. Depending on your rating will depend on what kind of spread you pay. And I see maybe generally that the spread range might go from like SOFR plus two to SOFR plus 450, depending on the size of the company, the credit risk and other factors and what kind of rating S &P and Moody's give.

29:05And then there's usually like an OID, which is like a fee off the top. And that from what I typically see ranges anywhere from like nothing to 1 % of the loan.

29:16Kison Patel:Okay. Let's go back some decades back when you weren't this big. What did that look like? Did you just work with the local bank relationships or were there, I can imagine there's not this big of a private credit market that there is right now? I think our first borrowings came from InsureBank. They gave us like, I want to say like a$7 million line of credit or something like that. And then we upsized it and we ended up doing a deal that was led by Bank of Montreal BMO. And then they did a great job for us. And we had that for a few years. We expanded it a couple of times. And then JP Morgan came in and they took over the lead position on our credit facility and put together a syndicate of top tier banks.

29:56We had that in place for a number of years. And then when we did the term loan B last year, many of those banks stayed in our revolver. They helped us raise the term loan B money and then they participated in our revolver.

30:10Kison Patel:Pretty cool. It's pretty interesting to see how there's a life cycle, how the debt evolves. When you go back to mechanics of the deal, you sort of now kind of have this view of here's organic growth, here's inorganic growth you can attribute. And then you have how much you're leveraged. We sort of use that rule of thumb of around 4X, you want to stay within there. Then when you look at these targets, there's a 60 % cash. And here's, does that help offset it too? Like having them take the 20 % as an equity, and then you got the other 20 % redeemed. Is that part of that equation? Is that more of just a tool for alignment, both?

30:42Yeah, that's part of the equation. Of course, you're also building future obligations for yourself. If you do a deal at 10x and you pay 6x in cash, there's going to be a future 2x on some number future, which is probably going to be bigger on the retained interest. And then there's going to be another equity obligation coming down the pike as well. You have to keep in mind that even though you're laying out a certain amount of cash today, there's going to be that future obligation coming. Whereas with organic growth, it's less burdensome, but harder to come by, harder to achieve.

31:15Kison Patel:Got to work harder for it. How is this marketplace evolving? You've been in the space for decades. You mentioned there's 30, 40 of these private equity platforms that are running the same roll-up playbook right now. How's that going to pan out? What happens when the music stops? Yeah, it's going to be interesting. A lot of those companies will probably either go public or sell to a public. Some of them will merge. Some of them will be replaced by other PE backers. Some of those will be like the new front story we talked about, where there'll be some investor with a preferred position that's going to do very well and a bunch of disappointed people holding common equity.

31:52But a lot of those stories are going to play out over the next few years because most of these funds, they have a five-year life cycle. Typically, that they're a number of years into those cycles for many of those firms. In some cases, they just refinance out and they just keep going, especially with some of the minority ones. But you never know how that's going to play out.

32:14Kison Patel:That's true. I'm just curious because there's, I feel every sector we look at, it's just so many roll-ups. I wonder if there's an end in sight at all. Yeah, PE still loves the business, even though it's maybe not as easy as it was 10, 15 years ago. They've done very well with it. And the fundamentals of the business are still very attractive. The recurring revenue, the ability to grow it, high margins or very strong margins, the benefits that can come with scale. From what I see, there's still a lot of demand out there for PE in this space. And you may walk me through, I guess, one of the things we looked at building the parole up.

32:51Kison Patel:We talked so much about culture. It's essentially building culture at scale. I'm curious between the path you took, which didn't have the private equity pressure versus if you would have had the private equity pressure, is there a view on how that would have been different? There's a million variables there. For me, when you use that word pressure, I don't generally think pressure is a good thing for an organization. Pressure creates stress, which degrades the environment, the cultural environment. And when we talk to people, we observe that there are a lot of dysfunctional cultures out there in the industry, there are a lot of places that over-leverage themselves and or have PE sponsors that are just staring at spreadsheets and trying to figure out how to grind out a little more margin and whatever the human cost may be is considered secondary or inconsequential.

33:41For me, I've just had a very different thought process around it of wanting to create an environment that has as little stress as possible, that has a lot of harmony, that has passion. So people are working hard and growing because they love what they do, because they have passion about their work. To me, that's very healthy. But when you start talking about putting pressure on an organization in order to achieve a certain financial result by a certain date, in order to effectuate a liquidity event for some PE sponsors, that seems to me like a misalignment of interests.

34:18Kison Patel:It is different. Actually, I was thinking about a friend who was in a senior role at a P-back roll-up. That was his biggest frustration that he had a lot of pressure to cut costs and just meet certain KPIs for the sake of meeting their little metric KPIs that they try to target. And then you just walked me through how this is like a dumb decision that's going to end up getting reversed within a year later. The way you operate, you don't have that same pressure at all. It's less of that pressure and more of growing a healthy company and what's Yeah, just making decisions based on the long-term benefit of the company.

34:50Yeah. I see it in all sorts of ways. Over the years, we've looked at different acquisition opportunities and you see these pro formas where they cut down all these expenses and cut down the commissions to the owners and move them down to like, you got some owner who's managing a$2 million book who should be making 600 grand a year. And they put in the pro forma that he's just going on a straight salary for 150 grand a year. And that 450 difference just drops to the bottom line. And then they're like, okay, give me a 10 or 11 multiple on that$450 ,000 and do that three times with the three principles.

35:31And we see these deals and they're all of a sudden showing you a business that's got a 60 % margin and they want to get a 10, 11, 12 multiple on a 60 % margin, which you know is not sustainable. And you know that you can't replace that person managing that$2 million book in this example for 150 grand. You know, you're going to have to spend 100 grand to get a proper replacement if that person were to leave, and that's going to degrade your margin. But I see different PE firms like sign up for that all day long because in their mind, they're just buying EBITDA and then they're just going to flip it to the next guy because their recap is in 18 months and won't come home to roost.

36:12It'll be the next guy's problem. We would always just balk at that and say, it's got to make sense for the long term. And ultimately, it's like, are you creating a partnership? Are you acquiring somebody that's going to come into your organization and be there for a while? And this is a partnership. And as partners, we're going to try to grow this business together. Or are you just trying to get as much money out of this as you can and tweak the pro forma as much as you can to maximize that and go right off into the sunset and let it be somebody else's problem down the road.

36:43Kison Patel:Yeah, so it's running a business for the five-year timeline or running it for the long run. Is it different when, I'm thinking about when you buy a business and there's always the fabled integration. We make value, lose value. Is your approach different? Now a lot of these roll-ups get a lot more scrutiny around how well they're actually integrated because you just can't cobble revenue together and sell it. Now you're actually paying a lot more attention to it. How was your view on when it comes to executing the integration? Our view changed when we first started ramping up our M &A activity. And this was like beginning in 2021 through 22.

37:20And we were just saying, hey, don't worry. We're going to let you keep doing your thing, keep your brand. And then we just grew too quickly. And we got out of our skis. We didn't have the infrastructure to support that kind of revenue. We didn't have the quality of management and leadership that was able to operate that way. And with that kind of revenue at the beginning of 2023, we just hit the pause button on the M &A. And we had a big pipeline at that time, but we just realized that we needed to stop and really focus on building the foundation, building out our processes and systems and procedures, upgrading our leadership team, and then also integrating brand migrating and working toward having just one enterprise that operated with consistency and shared procedures and systems.

38:07That's a big job. And I'm glad that we stopped when we did, which was we were at about 150 million of revenue at that time when we hit the pause button. And I'm glad that we hadn't gotten up to seven or 800 million or a billion or something crazy and then decided to do that because, man, what a massive job and exercise that would be to try to tie all that together.

38:33Kison Patel:You learned it the hard way, but you learned it early enough the hard way. And I'm wondering, is there a way that you don't have to learn the hard way? I feel like everybody goes through this. They get to this point where it's just either catch it early enough where you got a lot of pain to endure. It's interesting also because it does tie back to what you were talking about of how do you get that initial scale without taking on equity money? While you're acquiring the stuff, you're also building an infrastructure. Our accounting department went from four people to 25 or 30 and building out HR teams and IT teams and operations teams and carrier relationship management and so forth and so on and proper leadership and the money it costs to bring in the level of leadership that you need to some degree.

39:18And this wasn't necessarily intentional, but the way that we did it, it did allow us to fund the infrastructure that we needed to build without having to take in the PE money because we had enough revenue and EBITDA to keep our leveraged governor under control and enough money that we could apply against the corporate overhead to pay for the resources that we needed, which is if we'd have done that slower and more incrementally, we may not have been able to, or maybe it would have taken us many more years to do it at a slower incremental pace.

39:56Kison Patel:It's like this integration is this, it's like an ongoing investment and it's not just integration. Essentially, it's part of the organic investment that you're making just as well. Yeah. Integration infrastructure, all the people that do that, the whole process around that. We had to really upgrade our process and go from a very sort of unsystematized integration process that was very slow into something that was much more proactive, where before the acquisition would close, leaders from each department and functional area of the company would come in, meet with the management of the company being acquired, get their arms around what was happening, how it was operating, and then build a road.

40:41roadmap and a plan to work to get that integrated as quickly as possible, ideally within 60 to 90 days.

40:49Kison Patel:You got any tips or tricks to make the deal successful? I'm looking to do my first deal. I'm trying not to screw up some important things. Try to find somebody you like that you think will be a good partner. And I always say one of our core values is fairness. And that's just because it's hard to cover every contingency in an agreement. And when there's just going to be situations that arise that are not going to be clearly fleshed out in the agreement and that are going to require two human beings to sit across the table with one another and just be fair with one another and hopefully see the eye to eye on what fairness is.

41:24If you can find that, then everything else will work itself out pretty easily.

41:28Kison Patel:It's like that working cadence, which I feel like you figure out pretty early in the deal. And I've had it before. This is the first thing to be a pain in the ass and this is going to be too hard of a deal to actually do. Yeah. Red flags can come up during the deal process and it's good to pay attention and listen to those and not be afraid to pull the plug even if you've spent a lot of time and energy getting to the point of getting close to closing. But if you start to see certain behaviors that you feel like they're not going to be a good fit in your culture, save yourself the trouble and just duck out before you close.

42:02Kison Patel:Yeah. The earlier the better. Anything like after you sign LOI, because I feel like that LOI to close is always a big race to get the deal done. But I feel like that's also where you can easily trip over things or miss things that are pretty important. That's definitely the time to hopefully allow someone's true character and nature to reveal itself. I always say that in general, when you get knocked on your butt in life or when things don't go your way, one of the blessings of that That is, it's a great opportunity to look around the landscape and have character be revealed and see who people really are, the people around you.

42:36And there'll be some people that will just reach down and offer a hand to help you up. There'll be other people that will just stand there and look at you and put their arms folded and walk away and everything in between. But it's always great when you can have an opportunity for true character to be revealed.

42:54Kison Patel:Maybe you'll simulate that. How do you create the scenario to test true character? Yeah, that's a great one. I'm sure there'll be some ways to do that. Just kind of introduce some element. Usually there's something of diligence you find to argue about. I guess we're getting close on time here, but I had a question. I asked Bill for his thoughts on how he sees Liberty offer to prospective acquisition targets compared with the serial insurance agency roll-ups, such as Acrosure, Hub, and the rest. But I believe that Liberty's culture, treatment, producer, staff, clients, and values are significantly greater.

43:24Kison Patel:How do you sell against the bigger publicly traded rollups out there? I feel like we've touched a lot of these themes for the interview, but if you want to summarize it. Like I said, I just think that this is about people. It's a people business. I always say if you want to get a sense of our organization, talk to our people. I'm a big believer in the bird to feather theory of life. Like energy attracts like energy. We've had a lot of people say that they had their best days when they were working in a nicer regional firm that had resources, but it still felt like a family. I've really tried to work to maintain that feeling here at Liberty where even though we're a national firm, I think a lot because of our ownership structure, it does still feel like a family.

44:06It does feel more personal. That has value to a lot of people. People maybe more and more are seeing the fallacy of scale and just being rolled up. It's like I say, the PE strategy is roll up a bunch of assets, grind out margin, and then flip it to the next guy. That's the strategy. It turns out human beings don't like to be rolled up, ground, and flipped. They like to be treated fairly. They like to be in a great environment where that feels good, where they can enjoy their work. And this is what we dedicate our lives to, this work, and where we spend the majority of our time. Money is important, but equally, and in my view, more important is the quality of your experience, the day-to-day working, the people you're working with, the environment, the culture.

44:50When it comes to those things, we've created something unique and special. And that's how we differentiate ourselves. And for people that's important too, they recognize that.

44:59Kison Patel:It's hard for sellers to find that. Like you even give that example, if it's a better process, like how do you identify with those? But it's extremely important. Before I let you go, Bill, I got to ask you, what's the craziest thing you see in M &A? The craziest thing in M &A, we had one example where there was just a gross misrepresentation and like lack of disclosure on something that was significant. And that led to a messy situation. Again, people, character, integrity. And it's not always easy to identify when you're first meeting someone. Character is revealed through action. That's what I learned through the movie business.

45:33Character is not revealed through dialogue. It's revealed through action. It takes a while, a lot of times, to be around people before character is revealed. Overall, we've won more than we've lost. And we've continued to trim that bonsai tree. I like to think about culture as like a bonsai tree. and it requires a lot of meticulous trimming and pruning. But if you put in that work and pay that attention, something beautiful emerges. We've been able to get to that place because of the quality of the people that have chosen to be in this organization.

46:05Kison Patel:Learn the true character people. I'm looking forward to meeting the face reader that you mentioned and then working on simulating some scenarios to help identify people's true characters. Bill, thank you so much for taking the time to have this conversation. I learned a lot. You've helped me become better. I'm a scientist. Nice chatting with you and I wish you well with the podcast. Thank you. Those of you that listened through, thank you so much, my fellow M &A scientists. Feel free to connect with me on LinkedIn. I love hearing feedback. Let me know what you think of this podcast. Let me know if you have other topic ideas I haven't covered, suggestions.

46:33Kison Patel:I'm open to it. Criticism, I'll take it. Trying to get better at this. Until next time, here's to the deal.

46:51Kison Patel:Thank you for taking the time to explore the world of M &A with our podcast. We love hearing feedback. Tag us on a LinkedIn post, add a review on Apple Podcasts. We'd love to hear from you. If you need help standing up an M &A function or optimizing one that you already have, we're here to help. And if we can't help you, we probably know someone that can. You can reach out to me by email, Kisan, K-I-S-O-N, at mascience.com. or you can text me directly at 312-857-3711. If you just want to keep learning at your own pace, visit mascience.com for a lot more content and resources. That's where you can also subscribe to our newsletter.

47:36Kison Patel:Again, that's mascience.com. Here's to the deal.

48:05Kison Patel:Thank you.