M&A activity in the financial services space is active. In addition to banks shedding non-core assets as a result of pressure from regulators, a confluence of other factors are playing a role in M&A activity in the space, such as favorable valuations, an overall healthier economy and a strong financing market. There’s no question that all kinds of financial services companies are up for grabs today. Mergers & Acquisitions convened a special roundtable to explore these issues. Madison Capital Funding LLC and Katten Muchin Rosenman LLP co-sponsored the event, and the excerpted discussion that follows provides a range of perspectives on what middle market dealmakers can expect from these companies going forward. Participants included private equity investors, a lender and an attorney. (For video, see below or click here)

Roundtable Participants: Christopher Ackerman, Managing Director, Flexpoint Ford LLC; Ryan Clark
Managing Director, Genstar Capital LLC; Thomas Costello Principal, U.S. Private Equity, Baird Capital; Danielle Fugazy, Moderator, Mergers & Acquistion;William Kindorf, Group Head, Insurance and Financial Services, Madison Capital Funding; Neil Shelton Associate, Katten Muchin Rosenman LLP.

Danielle Fugazy, Moderator, Mergers & Acquistions: Where are the attractive investment opportunities within the financial services space?

William Kindorf, Group Head, Insurance and Financial Services, Madison Capital Funding: Generally speaking, we will look at almost all financial services related businesses. However there are three areas we find really attractive. We’ve really been successful in and around insurance distribution—everything from retail agents, wholesale brokers, managing general agencies and program managers. They tend to be very active accounts and good fee generators for us over time. Additionally, we cover a lot of insurance services—whether that’s workers’ compensation related, vehicle service contract administrators or claims handling businesses. Lastly, we really like deals in and around asset management. We lend to everything from pure asset managers to broker dealers, registered investment advisors, and all the ancillary services that go with that, whether it’s technology or back office services.

Thomas Costello, Principal, U.S. Private Equity, Baird Capital (pictured): We’re seeing activity in and around insurance distribution and we’ve spent quite a bit of time there. In addition we look at businesses that provide services to the financial services industry. As an example, we have an investment in an internal audit business that focuses on retail banks and regional banks. This business has benefitted from the heightened regulation that’s going on in and around the financial services industry. In addition there’s a lot going on with mobile banking. We’ve seen a number of rapidly growing businesses that provide mobile applications developed for the financial institution industry.

Fugazy: Why is deal volume in the insurance subsector so prevalent today?

Christopher Ackerman, Managing Director, Flexpoint Ford, LLC: You have to bifurcate the answer to that question. There’s traditional insurance, which is the balance sheet world of insurance that historically tends to be a fairly difficult place for private equity to invest, and challenging from a returns perspective. And then there’s all the various service providers in the insurance world, and that tends to be where private equity plays the most—in distribution as well as other ancillary services that insurance companies need. Those valuations have continued to escalate as the leverage market has rebounded over the last three years. You’ll continue to see a lot of private equity capital go into those types of businesses.

Ryan Clark, Managing Director, Genstar Capital, LLC: People are interested in services around insurance because it’s a very stable business. Everyone has to buy insurance, whether it’s personal auto, personal property or commercial property. Insurance is a required purchase in any economic cycle. On the distribution and claims side the volume is fairly regular, so unlike the traditional insurance industry, which has underwriting ups and downs, services tend to be more consistent, which works better in a leveraged environment.

Ackerman: Also, insurance services companies tend to be a bit behind the curve in adapting new technologies and outsourcing services. A lot of other industries have already evolved into more outsourcing-type opportunities. Insurance is 10 to 15 years behind the curve in many circumstances. Private equity investors can play on the trend of outsourcing and help insurance services companies become more efficient as a service provider for the bigger insurance companies.

Costello: On the distribution side it’s a highly-fragmented industry. Lower middle-market private equity firms have taken some of the smaller mom and pops, aggregate them, and have created assets that are unique.

Kindorf: From a lending standpoint, when we look at a retail insurance broker, we frequently see 80 percent to 90 percent retention of the policyholders year over year. From a credit standpoint, that’s a really stable asset.

Fugazy: The insurance distribution market is fragmented. Will we see consolidation? Who will eventually be the buyers of these companies?

Costello: Consolidation is happening. As the larger strategics look to either gain a regional footprint or specialties that they don’t currently have, I think you’re going to see those folks buy unique assets in the market.

Clark: The largest insurance brokers today, whether it’s Marsh, Willis, Gallagher or Brown & Brown, have all been built through the acquisition model. They’ve all grown through acquisitions and will continue to make acquisitions to drive their growth. So they’re very logical acquirers of these agencies as they scale.

Fugazy: How competitive is it to get a deal done in the financial services sector today?

Neil Shelton, Associate, Katten Muchin Rosenman, LLP (pictured): My practice consists primarily of representing lenders, with a particular emphasis on deals in the financial services space. Initially Madison was the leader, but now you’re starting to see competitors jump into the space. It is becoming more competitive on the lender side, because lenders are becoming much more comfortable with the issues that come up in financial services deals.

Ackerman: It depends where you’re focused on within the financial services sector. There are financial services deals, particularly risk-bearing and balance-sheet-based companies that are a lot less competitive from a private equity perspective. And then there’s other business service type elements— more the service providers into those industries—that are as hyper-competitive as any other industry.

Clark: Services businesses are easier to understand. They’re easily leveraged by traditional banks. The businesses that Chris was talking about are much more unique and highly specialized, and generalist firms couldn’t walk in and understand them quickly.

Ackerman: There’s often a regulatory overlay on any of these balance-sheet-type businesses, particularly consumer specialty finance, or within the insurance world when you’re dealing with state insurance regulators, which is a cumbersome mechanism. So it tends to keep a lot of folks away from those businesses.

Fugazy: What are the advantages of being an industry-specific lender or fund versus being a generalist?

Ackerman: Having been investors within many financial services sub-segments, and understanding some of the downsides as well as the upsides of operating within a regulated environment, is extremely helpful. And then just being able to look at a business with a history that kind of overlays your own portfolio is a pretty relevant piece. Financial services—like health care and a couple of other industries, because of its uniqueness and the specialization with which you have to approach an investment—tends to attract only industry-focused firms. There are very few players within financial services, broadly speaking, that are highly-specialized in it. People don’t tend to dabble in financial services.

Kindorf: We put at lot of value institutionally on sponsors who specialize in this space. If there’s an issue, they’re going to manage it the right way. From a lender standpoint we just thought it made sense to put some dedicated resources there. There are regulatory elements that you need to understand and get comfortable with to do these deals. There are structuring nuances that are unique to the space, whether those are add-on acquisitions, earn-outs, seller notes and how you treat them, or how you structure it in the documentation. We find it to be beneficial to our sponsors to come in and not have to do Insurance 101 for us, or you don’t have to do Asset Management 101 for us. We feel like having the background knowledge is really beneficial to our sponsors.

Costello: Given the relatively high valuations being paid today, our view at Baird Capital is, you need an angle. And, typically, for us, that angle is an executive or a strategic relationship that can allow us to go into the business, do something different with that company than what’s been done, historically, in order to drive value in that investment over time. We look to bring those resources early in the deal process that we can develop our investment thesis and execute that plan going forward. Part of that plan is working with lenders like Madison, who understand the space, and who are lock-step with us and understand what we’re trying to do with the investment so we can get the right capital structure in place to grow the company.

Clark: It is rare for lenders to have the financial services expertise, and I find when we have to work on tight timetables, having them come up to speed that quickly is a critical differentiator for us as a buying group.

Ackerman: Ultimately, when you’re trying to get a transaction closed, the lending is often the critical element to that, and the last thing you want is to get to the five yard-line and find out that the lender that you thought was backing you doesn’t understand the business well enough and it isn’t comfortable moving forward. So having the expertise in-house within the lender gives us that comfort level to allow us to proceed with a transaction.

Costello: Bill’s got a number of investments across a lot of different types of businesses that are relevant. And so as things are happening within the marketplace, he’s usually very up-to-speed on that. That knowledge can be helpful as we try to adjust our investment philosophy in a particular investment.

Fugazy: How are financial services deals nuanced in terms of structuring?

Shelton: I think one of the difficult structuring issues, from a lender’s perspective, is that you’re often making holding-company loans. Lenders are basically lending to a shell company and all the revenue is generated below at a subsidiary. It can become difficult for a credit committee to get comfortable with the fact that its borrower is a shell. This means that you are relying on a dividend. If that dividend is never made, how are they going to service the debt? Also, there are a lot of different regulatory components that impact timing on deals and impact what you can take as collateral. There are restricted assets that you can’t include as part of your collateral package. These are true cash flow loans where the assets are really the people who work at the companies. The fear is that they walk out the door.

Kindorf: That’s certainly one of the struggles for certain lenders out there. We call them “elevator assets.” Your assets in these businesses leave every day. The fact of the matter is people can leave and so you have to get comfortable with the fact that you’re backing a team and people at the end of the day. You’re not going to have hard assets in a wind-down scenario.

Fugazy: How do you get comfortable with that issue?

Kindorf: We’ve had enough experience there to become comfortable with the management teams that are in place. One of the most important things we do is meet the team. I want to be comfortable with these guys, and that they’re thinking about the business the way we think they should and they’re doing the right things to retain their people. That’s probably the biggest piece in getting comfort.

Ackerman: The success and failure of most of these companies—distribution businesses or consolidation plays within insurance services or financial services—tends to be predicated upon having a great core management team; one that can motivate the people, keep them excited to work and convince other smaller acquisition candidates that they’re the right buyer because those smaller acquisition candidates are getting calls from five or six other potential acquirers.

Clark: You also have to be economically aligned, otherwise you always will run the risk that they might take their ownership elsewhere.

Shelton: This helps explain why a lot of the deals are earn-out heavy. Earn-outs are a big part of the acquisition conversation and structure. An earn-out is there to incentivize the management team to not only perform, but to stick around.

Fugazy: What role is the regulatory environment playing in terms of deal flow?

Clark: The Consumer Financial Protection Bureau has a broad mandate to protect the consumer and the regulations are very ambiguous. A lot of businesses we look at are selling insurance to an end customer, or offering mobile payments to an end customer, or providing auto warranties to an end customer and there’s always a question when we look at these businesses of what is the CFPB going to do, if anything. The mandate isn’t clear yet and there’s an element of uncertainty across all these consumer businesses.

Ackerman: Ultimately, you’re going to have to make a judgment call because the CFPB is still very immature, and there’s just not a lot of precedent. It’s still unclear as to what their span of domain is and what they are going to focus on. Going into a transaction, you’ve got to use your history and judgment and assess that risk.

Fugazy: Can you do any due diligence to hedge against this?

Ackerman: You hire specific counsel to focus on the regulatory issues. And there have been circumstances where we’ve gotten far down the road on a transaction and we’ve walked away because that risk is too high or too uncertain. And then there are other times where your judgment of the risks and the value of the business provides you with the comfort you need to proceed with a transaction.

Fugazy: Is the regulatory environment, at the same time it is creating some risk, also creating buying opportunities?

Clark: We’re not seeing traditional banks be strategic acquirers of assets. They typically have been the acquirers of insurance distribution companies and specialty finance and commercial finance companies. However, because the banks are so caught up in this regulatory framework and they’re so risk-averse right now they’re not competing. So, where they typically would be the strategic buyers that we would compete against, they’re actually divesting assets.

Ackerman (pictured): One of the elements that we look for in a specialty finance acquisition is a potential exit to a bank acquirer, because banks often have lower cost of capital and an ability to put incremental leverage on the business. But recently we have not seen many of those transactions. In the fall, Flexpoint sold a specialty finance business to a bank group, but there really have not been a lot of transactions that resemble that in the marketplace. We would have thought, given that banks are very hungry for assets that actually create yields, that there’d be much more interest from banks in acquiring specialty finance businesses, but there really has not been a windfall of those transactions.

Costello: The other thing that’s happening in the private equity world is the banks’ inability to be limited partners in funds now. You’re seeing a lot of secondary transactions happening as banks get out of their fund investments.

Kindorf: We wouldn’t categorically rule out a deal because of regulatory issues, but certainly we would be highly focused on the issues. There are structural ways to get comfort and give yourselves some protections.

Fugazy: Are you seeing more businesses coming up for sale as a result of the guidelines and the banks pulling out of the leverage business?

Kindorf: Absolutely on the latter point. We’re frequently providing what we consider a senior stretch deal. We are stretching another turn or so above a traditional senior leveraged multiple and offering lower amortization deals. The banks will shy away from some of those deals because bank credit committees frequently have difficulty getting their arms around it and approving it.

Ackerman: In the last 10 years you’ve seen a meaningful shift in the leveraged lending market away from banks toward more specialty finance, non-bank lenders — be it the Madison Capitals of the world or the business development companies. Years ago there were BDCs, but there were a tenth of the number of BDCs that exist today. The Madison Capitals and the BDCs tend to be our first calls, and the banks tend to be the second call.

Clark (pictured): BDCs are less regulated, which is their main competitive advantage. They don’t have to be regulated and monitored in the same way that the commercial banks do.

Shelton: The internal processes are also completely different. I represent both banks and non-bank financial institutions. There are fewer internal hurdles to get a deal done with a non-bank financial institution than a traditional bank.

Ackerman: As an equity player in the market, you’d much prefer to have a partner that has the flexibility of a non-traditional lender than going down the road with a bank. With banks, if there’s a bump in the road, they’re going to have to execute on a specific playbook as opposed to having the flexibility that a non-traditional lender might have, within structuring or pricing. As a result of increased regulations, banks tend to have very tight boxes in which they have to play and that can make them very difficult partners.

Fugazy: Where are we seeing strategics play today?

Clark: Mostly what we are seeing are strategic investors that are backed by private equity firms. Those platforms are very acquisitive and very competitive.

Ackerman: Over the last year or two, we have found ourselves competing against BDCs more and more often, which in many circumstances, are also our lending partners. So there’s an interesting dynamic where BDCs and non-traditional lenders are competing for the same assets that we’re competing for, which makes it a very challenging dynamic. On one transaction we may be partnered and they may be the debt provider. On another transaction, we may be competing for the equity, because BDCs are becoming more and more interested in buying the equity of certain financial services businesses.

Costello: Strategic’s balance sheets are still very strong and flush with cash. We have seen a couple of situations where we believed a deal was going to go to a financial buyer, and ultimately went to a strategic. It is very much on case-by-case, but the strategics are still extremely competitive, given the strength of their balance sheets right now.

Ackerman: The strategics are a double-edge sword, because, on one hand, you don’t like competing with them to buy assets, but, on the other hand, you like to sell to them.

Fugazy: What are biggest challenges facing the financial services sector today from an M&A perspective?

Kindorf: From a lending standpoint it has to do with the structuring. In almost all the financial services deals we do, we have a unique structuring element, whether that’s permitting earn-out payments and how you address that in a downside scenario, or whether it’s allowing for multiple acquisitions to occur quickly because that’s what the borrower ultimately needs. And you can be one entity removed from where the actual assets and cash flow are in the business, and you have to get comfortable with the fact that at the end the day, you just have a stock pledge and a business that really has no hard assets. These are the challenges we talk about most of the time when we’re in credit committee.

Clark: The biggest challenge for us is regulatory. For example, when we look at any insurance deal, there are 50 states that have 50 different regulations and they can change at any moment. This can also impact who the ultimate buyer is. You have to do as much diligence as you can, but nothing is really 100 percent. Our biggest risk is the unknown risk of regulation, which can be politically motivated, as well.

Shelton: From a legal perspective, one of the big issues is collateral, and what you actually have a lien on. In the regulated space, especially in insurance, you don’t always have a lien and it can be a struggle for lenders to get comfortable with the fact that all the assets are below. In addition, a lot of the regulated deals have change of control periods. So in your traditional corporate deal, in a downside scenario, which hopefully you never face, you can exercise your stock pledge and take over the keys right away. In a regulated deal, you may have to wait six months before you can actually take over the keys, and it’s tough for a lender to get comfortable with that.

Kindorf (pictured): In a generalist deal, a lender may want the ability in a real downside scenario to hire and fire management. But, for example, in an asset manager deal, management is your asset. So practically speaking, you’re never going to replace those guys. So it’s a different approach in a downside scenario. It’s really partnering with the management team and making it work, if it ever were to come to that.

Ackerman: In those situations, as an equity investor, whether it be asset management or insurance distribution, where the assets really are the people, we may be ultimately the majority owner of the business. But the entrepreneur, who owns 30 or 40 percent and controls all the people, really is ultimately in control. So we can put in all sorts of governance to protect ourselves, but if the assets decide to walk out the door, short of non-compete contracts and equity incentives, there’s not a lot you can do about it. So you’ve got to make sure that you see eye to eye with the partner on the other side of the table and think through all the different scenarios of what can happen.

Costello: You’re putting a lot of capital in the founder’s pocket, and his or her motivations may change over time when you do something like that. We try and have as much interaction as we can before the deal, but it’s really tough to know for certain seller’s intentions. We work to align incentives with the founder as best we can to drive the right outcome for the investment.

Fugazy: There’s no doubt there’s more interest in financial services deals, but are private equity firms really jumping into the sector, especially the ones that don’t have experience in the sector?

Ackerman: I still think financial services are probably the least competitive area within private equity, which is candidly why I like to participate in that market. Because of all the restrictions and regulatory issues and capital structure issues, it tends to not attract the broad group of private equity players. So, while there are plenty of people out there and it is competitive, it’s not hyper-competitive.

Kindorf: I would generally agree with that, although we’ve seen an uptick in what we consider more generalist-focused private equity firms looking at financial-services-related deals. They tend to be less interested in balance-sheet-related companies. They are usually more focused on services oriented companies because services companies are a little easier for generalists to get their arms around. And, frankly, we haven’t been able to gauge whether they’re really, truly interested in making a play to get into financial services, or if it’s just a function of lack of deal flow.

Clark: There are a number of private equity firms that are focused on financial services and seem to be doing very well. Because it may be less competitive, the returns are actually better and the sector will start attracting more capital. So, while it’s not as competitive as other sectors, if the returns continue to be strong, it will get more competitive.

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