Business Breakdowns
· Aaron Cohen
[00:00:00] S1: 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. Absolutely. 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 burned 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, we'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.
· Matt Reustle
[00:00:00] S0: 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. So probably came across in all of your previous answers, but just to spell that out again, I think that one certainly proves the point.
· Aaron Cohen
[00:00:00] S1: 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. And 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. So 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.
· Matt Reustle, Aaron Cohen
[00:00:00] S0: 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. What 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? [00:00:00] S1: 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. [00:00:00] S0: Is there a range, out of curiosity that you could put numbers around? [00:00:00] S1: Just EBITDA margins, Matt? [00:00:00] S0: Yeah. [00:00:00] S1: A solid insurance broker could be in the range of 28 to 35%. [00:00:00] S0: Certainly healthy when you factor in what that means for free cash flow 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.
· Matt Reustle, Aaron Cohen
[00:00:00] S0: Certainly healthy when you factor in what that means for free cash flow 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. [00:00:00] S1: There are not large capital requirements in this business. This is a very, very clean cash flow. 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. But 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. [00:00:00] S0: 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?
· Aaron Cohen
[00:00:00] S1: So we have seen valuations grow pretty dramatically over the last 25 years. I think it's the result of a few different things. One 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. Then 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 reliant 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. The 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 at 17, 18, 19 times. And I think it's driven a lot by the cash flow characteristics of this business. Everyone understands the recurring revenue nature of this business and the M&A opportunity. There'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.