This is going to be another shorter piece. Why? First, the response to last week was pretty good. Second, events in the AI space are moving too fast.
For example, when the insurance technology provider (distinct from “insurtech”) stocks began their recent freefall, I pointed out to a few friends that insurance brokers would probably be shot next and started to draft a piece to address the topic.
For those who have been paying close attention, the market reached that conclusion about two days later, so rather than give full theses on who in the insurance ecosystem is safe and who isn’t (I will get there but it will take more time), I thought I’d try to drop at least one thought that I believe is still ahead of the market.
The biggest risk I perceive at the moment is to the private equity owned insurance brokers.
Lessons From Software as a Service (Saas)
The reason I was initially concerned about insurance brokers as much as the insurance data providers is their business model is very similar – long term, predictable revenue with high margins. To quote Jeff Bezos, “your margin is my opportunity”.
Why have Saas stocks been so hammered? Because the market historically felt it had high visibility into long term earnings sustainability and thus paid a higher multiple.
Those who still own software object that “but the earnings aren’t changing!” and they may not in the near term. But a simple DCF will tell you the valuation multiple should be lower because you can’t project those earnings as far out into the distance as you could a year ago.
Worse, software is one of the biggest holdings of private equity and private credit. If you think the impact on public stocks has been bad, imagine the conversations happening in the offices of those who aren’t traded.
Even if the earnings hold up, who will PE flip the firm to next? If they don’t hold up, look out below. Ironically, because Saas models had such “predictable” earnings, PE owners justified putting more debt on them than their other investments (it’s the mathematically “right” thing to do!).
Thus, if there is any future pressure on the business model, such as having to lower prices to retain customers, EBITDA collapses, you can’t service the debt, and your investment is worth $0 (at least the equity, the debt is likely worth something but well below par).
Insurance Brokers as Saas
Have you figured out where I’m going with this yet?
What other business do we know where private equity has bid up multiples to unprecedented heights due to the predictability of the earnings stream? Insurance brokers!
And what has happened to leverage at private insurance brokers over time? It’s spiraled out of control.
Public brokers used to have debt of 2X their EBITDA in order to maintain their investment grade ratings while private equity backed brokers were 5-6X. Now, private brokers can be 8-10X levered…just like software companies!
So, if something does go wrong with the model due to AI, it will face the same challenges private software companies will. Any pressure on pricing or organic growth means EBITDA will come under pressure and they won’t be able to service the debt.
There will no longer be an option to come public because the multiples will be too low for the math to work. There will be no flip to the next private owner. You can try to refinance the debt to buy time but the interest rate on that transaction will be higher which makes your coverage even worse.
I understand PE has made a lot of money keeping brokers private (and thus keeping the leverage up) but that is not a game you can play forever. Inevitably, there will be a change in business conditions and PE owners will wish they had done an IPO to cash in some chips and to reduce the leverage.
Is AI going to be the event that triggers this spiral? I don’t know, but I bet you there are some very nervous PE investors at the moment worried they imitated Chuck Prince and kept dancing because the music was still playing.
So yes, there may be some issues with the larger public brokers. I’ll cover that somewhere in the coming weeks, but their issues pale in comparison to the private brokers because they have much more manageable debt loads and, while a lower near term stock price is an inconvenience, it is not a threat to their going concern status.
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