Growing pains

When brokers are looking for extra finance for their businesses - whether equity or debt - there are many questions that need to be asked before considering who to approach for funding.

When seeking to borrow money, the first thing to ask should be 'why? what for?' and the answer must be clear and well thought out. The most common reason brokers seek finance is to fund expansion, either through acquisition or organic growth. In either case a clear plan is needed, showing the logic of the transaction, the benefits it will bring, the money it will generate, and over what timescale the lender will be repaid.

Good strategic plans should also take into account all the consequences of the expansion and, if involving acquisition, all the steps necessary for successful integration.

Funding buyouts

Another motivation for seeking finance is to buy out existing shareholders, whether they are retiring or are senior partners seeking to realise part of their investment to transfer it to the next generation. This requires quite different amounts of finance. It is important to focus on the broker's reputation and track record.

A business that has borrowed before, and successfully repaid the lender, is in a better position than one seeking to borrow for the first time. Establishing a good reputation and relationship with likely backers in advance of needing funds stands potential borrowers in good stead. This means sharing information, including cash flow, business plans and sensitivity analysis, with a potential lender in order to build confidence in the management team and also the underlying worth of the business.

It often seems that the more a person seeks to borrow, the easier it is to find funding. This is partly because there are more people willing to lend larger amounts of money than small. This is partly a matter of economics - the amount of work required to raise £500,000 is not greatly different from that for £20m, but the rewards for the lender are considerably diminished.

There are various sources of finance available to UK brokers. The first place to look is within the resources of the business or its principal - could the retained funds of the firm's current operations be used? The profitability of the existing business is crucial, as it demonstrates the management's ability to perform and get the most out of an acquisition. Retained profits are the cheapest source of capital, although an aggressive dividend payout or drawings regime can prejudice it. The ability to continue to generate profits is also a determining factor in whether a sustained acquisition programme is possible.

The structure of the business should be examined to see if the different divisions will complement each other after the expansion. If not, the firm should consider disposing of the non-core activities and using the spare funds as a source of finance. (All lenders require borrowers to put their own funds at risk alongside theirs, so it is essential there is some security or other funding). With the right advice, these parts of the business can be disposed of discreetly and confidentially, and announced along with the acquisition. Professional assistance when processing transactions will improve the likelihood of success and enable management to concentrate on running the existing business - if overlooked, it could prove detrimental to the business' financial health.

Bank relationships

High-street banks are in business to lend funds to expanding businesses but they are usually cautious and often require security. Banks focus on free cash flow first, then profitability and asset backing. Having a good relationship with an existing lender is important but competition always helps, especially when it comes to price, and maintaining relationships with two banks at the same time can be beneficial.

Insurance brokers are good clients for banks as they hold cash balances and benefit when interest rates rise - unlike many of the banks' other clients. The scale of funds they are likely to lend is limited, however, and will be of most use for funding organic growth, modest acquisitions or buying out existing partners. By itself, a bank is unlikely to be a good source of finance for a management buyout as brokers are people-based businesses without the solid asset base that banks typically like to see as security.

Insurers can be a cheap source of finance but they come in and out of the market depending on how concerned they are about controlling distribution. It is this interest that determines their broker lending, which can take the form of either a minority equity stake or cash as a straight loan or advance of commission.

Insurers' approach to 'ties' varies but all are focused on generating a volume of business. Some have formal agreements going into varying degrees of detail and include soft benefits, others rely on verbal understandings. Where lending is involved all have terms under which the funds have to be repaid.

Venture capital

Given the current state of the market, it is perhaps not surprising there are no active participants making themselves known. Venture capital or private equity is an often discussed source of finance but one where brokers really need to understand the dynamics. Scale is a key issue for VCs and their involvement needs to be sufficient to carry their costs.

VCs have differing appetites and approaches. Many of the more publicly visible funds look for transactions that require in excess of £50m, while the more specialist managers consider investments of between £2m and £10m. Many high-street banks have VC arms and a successful introduction to one of these may give access to the right mix of finance for transactions.

However, VCs require high rates of return for their investments and will normally be looking to realise them in three to five years. The use of debt finance can reduce the overall return but equity involvement will still be material. Many VCs now look to own the business and hire the management to run it for them in return for a significant minority stake and seats on the board. Using VCs to buy out an existing majority shareholder will probably mean the owner selling for significantly less than full value, although it provides a clean exit.

To attract interest, the strategic plan needs to show a doubling of equity value every three years and this may involve making acquisitions along the way. For example, when Caledonia Investments announced the creation of Oval and its acquisition of RP Hodson, it made it clear Oval was seeking investments in other brokers with the consequent assumption of growth through the creation of a new national broker.

Brokers should not forget that a common exit route for VCs is a trade sale. Management has some influence as to where it is sold but control is likely to be with the VC. Initial Public Offerings are a possible exit for VCs but have been rare in the past few years, certainly among insurance brokers. The problems experienced by HLF and its VC backers highlight the pitfalls for other potential investors, and stock market sentiment is unlikely to change quickly. Secondary buyouts are now becoming a possible exit option.

The key benefits of flotation - whether listing on the London Stock Exchange or the Alternative Investment Market - are access to capital and the acquisition currency that brings. A company can use its listed paper to expand faster than in the private arena and access more flexible and cheaper finance than its unquoted rivals, though commercial benefits can also flow from the higher profile gained via listing. This is only really available to the larger companies, typically those generating in excess of £3m operating profits.

It is important to remember that a quoted company is in the public spotlight and if profit expectations are not met the share price can suffer, ultimately damaging client relationships and employee morale.

As markets are subject to trends, sectors can fall in and out of investor favour. In the past, the cyclical profits historically associated with the insurance broking sector led to a lack of investor interest and low valuations, making the sale or issue of shares difficult.

An AIM listing can be a quicker and more simple route to accessing institutional funds and is proving popular for businesses. The benefits can prove illusory, however, particularly on AIM as the paper will be illiquid, causing price overhangs when a vendor sells paper issued in a transaction, and the market may not support the issue of further paper to raise the cash for a transaction.

This is illustrated by comparing the gross trading volumes of JLT, Windsor (both with full listings) and THB Group (on AIM). In the year to 31 December 2003, JLT had 51.8% of its total issued shares traded, while THB had only 15.9%. Windsor had 63.9% of its total shares traded but if just three days are excluded, where one particular investor was selling on their holding, this falls to 38.4%

When seeking a listing, a company should have a clear understanding of the shareholder base it requires and the nature of the one proposed. In circumstances where the next generation wishes to take over and the majority shareholder is seeking to reduce their exposure to the business, a viable source of finance may be the exiting shareholder.

By converting an agreed proportion of the equity into preference shares and then allowing the next generation to buy new equity in the company, the exiting shareholder provides the necessary finance to affect the transaction.

Bank debt may be needed to provide the exiting shareholder with the certainty of some cash upfront but if the transaction is amicable, then the exiting shareholder is potentially a good source of funds for an MBO.

Networks may be able to assist with rising bank debt, according to the extent of their involvement. As banks are dependent on brokers' financial reporting, if networks provide assurance this is being performed to a high standard it reassures them.

When seeking finance for expansion, brokers should always make sure their own house is in order first and that the envisaged transaction makes good sense both in the short and longer term. The potential acquirer should always remember that they will need to realise the investment in their own business at some stage in the future and that to do this successfully they must ensure their overall business remains focused and attractive to their own potential purchasers.