Private Equity Has Met the Enemy...

This first ran at Empire Financial Research.

Private equity has met the enemy... and it's staring at itself in the mirror.

Think about it...

Before the bubble burst, private equity was buying anything and everything that wasn't nailed down: car washes, dental offices, housing contractors, trash haulers, urgent care centers, hospices – the list goes on.

And maybe no industry epitomizes what's?really?going on more than the insurance brokerage industry...

I've spent a decent amount of time on this one, via Brown & Brown (BRO), which is an open recommendation in my?QUANT-X System?newsletter. (Subscribers can read the full write-up?right here... If you aren't a subscriber, find out how to gain instant access to it – along with the entire portfolio of open recommendations – by?clicking here.)

The company has been a great compounder for years and years... and?years. That is, until the last two quarters, which I view as a setback in a longer-term story.

A big part of the Brown & Brown story for decades has been acquisitions...

I'm not generally a fan of "roll ups" – companies that generate much of their growth from acquisitions.

But the insurance brokerage industry is different, with acquisitions playing a perpetual and central role to the model...

It's simply the nature of the industry, as small, family-run agencies – which are always popping up – look to sell...

Some deals are large, such as Brown & Brown's purchase last year of Irish broker Global Risk Partners, which has revenue of about $340 million.

But most are considerably smaller, with a never-ending supply of targets. Thousands of agencies exist in the U.S... And for every agency sold, another is started with the ultimate goal of selling itself.

This is why the industry has been one of the most active spaces for private equity. As CEO Powell Brown said on an earnings call a few years ago...

There is a recognition, particularly among people who this is their single largest asset. The average agency owner in the United States is 54 to 57 years old. Sometimes, they're either going to have to invest more heavily in those capabilities to compete, or they might benefit from partnering with somebody, whether it be a strategic, to enhance those capabilities or potentially sell to a [private equity firm] to monetize the assets.

Increasingly the answer had been to sell to private equity, which is what I like so much about Brown & Brown – the company didn't get itself sucked into the bidding wars.

As far back as 2015, this is what CEO Brown was saying...

There's definitely a walkaway price that we have, and we're more than comfortable in walking away from a deal if we just think that price is too high that's out there. And there's a lot of them that are bid really, really high today.

The cheap capital that exists in this market today is driving, in certain places, some irrational pricing on certain deals, and that's OK.

We're comfortable with passing on any of those. We don't think that there's anything that's out there that's critical to our platform that we absolutely have to have. And so therefore, we don't want to overpay.

Which gets us to where we are today...

Private equity is stuck, unable to flip these things to someone willing to pay even more...

That's evident in the insurance brokerage space, where acquisitions have slowed – so much so that on his company's fourth-quarter earnings call last week, Brown said...

I think that there is this interesting sort of – we're kind of at this unusual clash point, if you want to call it that, which is the market with increased interest rates... and buyers would like to see a slight decrease in multiples paid.

And yet there are businesses, some of which are owned by private equity, that would like to monetize their businesses at what were historic levels or multiples in anticipation of other opportunities for them.

Or maybe better said, maybe they think there will be pressure on multiples going forward, so they want to get out at a higher multiple, if possible, than they might think of in a year from now.

But that isn't happening. As the?Financial Times?noted last year...

For more than a decade buyout groups binged on cheap debt, allowing them to buy up a ton of assets while also raising huge sums of cash from investors desperate to boost returns. With interest rates rising, the problem is that a lot of what they now own may be worth less than what they paid for it. Given the private nature of these assets, it's hard to tell how bad the losses might be.

That was echoed by?Fortune, which recently reported...

For the year, total U.S. [private equity] deal count fell 2.4% while value dropped by nearly 20% from 2021, per PitchBook data...

The [initial public offering] market, for one, was effectively slammed shut for most of 2022, and has few signs of reopening anytime soon; M&A [merger and acquisition] exits, meanwhile, halved after a frenzied 2021, per PitchBook. Last year, [private equity] firms exited 1,274 U.S. companies, which in total valued nearly $296 billion – roughly 28% and 66% lower, respectively, from 2021's record-setting levels.

It doesn't end there...

As Julian Klymochko of Accelerate Financial Technologies puts it...

The [private equity] industry has been the victim of its own success, as institutional and retail investors have thrown money at private equity funds. However, with its rapidly increasing assets under management, the private equity industry has a problem deploying the capital as fast as it comes in. As a consequence, the industry's "dry powder," or committed but unspent capital, sits at record levels.

The leveraged buyout industry has approximately $1 trillion of dry powder, waiting to be spent on buying public companies or acquiring assets from competitors.

This means that private equity may be forced to continue to overpay... just because that money has to go somewhere.

As prices continue to be bid up, that will test the discipline of acquisitive companies like Brown & Brown...

As CEO Brown said on the recent earnings call...

I think we're going to see a lot of activity in the next 12 months...

The good part about our business is, we're focused on the long term, and long term to us is not one year or three years. It's a very long time. And so, we're looking for businesses that fit culturally and make sense financially, and we believe there will be those businesses out there.

In the meantime, if the company can't find those with the right fit for the right price, Brown said management will be "aggressively paying down our debt. We're investing in teammates and focusing on growing our business organically."

All while private equity is having a field day overpaying for assets it hopes it can pass along at even higher prices down the road.

But as one friend who has been studying private equity for decades sees it...

The private equity industry is going to find itself in serious trouble. They've paid way too much using way too much leverage based on completely artificial cash flow numbers.

Sounds about right.

As always, feel free to reach out via e-mail at [email protected] or comment below. I look forward to hearing from you.