Options for internal perpetuation
In previous columns, MarshBerry has articulated the benefits of using today’s relatively inexpensive debt capital for a variety of purposes:
- Making acquisitions;
- Refinancing existing higher interest rate loans;
- Putting new revolvers in place to fund short-term cash needs;
- Removing personal guarantees provided by majority shareholders or;
- Providing new shareholders with capital to pay for one’s equity stakes by borrowing from the corporation.
It is this final point that is worthy of some further examination. Specifically, how can a brokerage firm raise debt capital that can be provided to key employees in the form of shareholder loans?
Often times, shareholder loans are part of a larger internal perpetuation strategy. Specifically, an insurance brokerage borrows funds from a specialist insurance lender at attractive rates. The brokerage, in turn, lends its borrowed capital to key individuals (e.g. producers, underwriters, C-suite executives with little to no equity, etc.) to buy common shares as part of an internal perpetuation strategy. These purchases can either be completed directly with selling shareholders or with the brokerage firm itself (in the form of newly issued stock). In all cases, however, the brokerage firm is assuming the credit risk of the individual purchasers and that these shareholders will make timely principal and interest payments when due.
But what if a brokerage firm does not want to assume this credit risk? What if the insurance brokerage wants to avoid having its balance sheet burdened with liabilities of individual shareholders? What happens if one of these shareholders leaves for employment elsewhere?
There are ways to partially mitigate these credit risks for insurance brokerages. For instance, MarshBerry has relationships with specialty lenders that will consider lending directly to new shareholders, provided that those shareholders are key drivers of business for the brokerage. Some lenders will provide loans directly to shareholders, seeking personal guarantees and a pledge of the borrower’s stock. These loans are likely to be at a higher borrowing cost than the cost at which the brokerage could borrow directly as a corporate entity. However, such a trade-off could be a reasonable one given the added risk of credit default (on the part of individual borrowers) that a lender may be assuming without such a corporate backstop.
Alternatively, an insurance brokerage firm could provide to the lender a corporate guarantee (for one, some, or all of the individual borrowers) and reduce the borrowing cost to the individual(s). The obligation to repay principal and interest would still be the primary responsibility of the shareholder. The corporate guarantee would only be triggered in the event that a shareholder defaults on principal and/or interest payments, or otherwise triggers a covenant default. Moreover, if the lender requires as collateral the stock holdings of the individual borrower, the brokerage could negotiate a buyout of that stock from the lender in the case of default by the individual borrower to ensure that the lender does not become a shareholder. Finally, depending upon how a specific loan is structured, an insurance brokerage might be able to keep this contingent liability off of its balance sheet (provided, among other things, that the loan is fully up-to-date on principal and interest payments and that it is not otherwise in covenant default).
If you have questions about Today’s ViewPoint or would like to learn more about leveraged internal perpetuation planning, please email or call Gerard Vecchio, Managing Director at 212.972.4886.
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More information on this topic will be shared during MarshBerry's 15th Annual IMPACT Summit!
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