In today’s competitive market conditions, being able to spot red flags may prove helpful in knowing when to pull out of a discussion or for negotiating a more equitable transaction.
The new year certainly hasn’t slowed the pace of consolidation among AEC firms. That became apparent in a recent two-day stretch when I had three in-person meetings with design firms and a long phone call with a fourth. All four firms asked me to keep them in mind if I hear about firms looking to sell.
Indeed, many design firms are exploring acquisitions, especially given their difficulties filling key staffing needs to meet increasing demand for their services and to fulfill their desire to diversify. The latter may be a lesson from the Great Recession; many firms hit hardest were overly dependent on a relatively monolithic client base, while having a limited service, specialty mix, or geographic scope. Equally telling: Three of the four firms I met with are actively engaged in acquisitions. And they aren’t necessarily larger firms; one only has three licensed professionals.
In discussions involving M&A, one wonders how much attention is (or should be) given to risk and insurance. While the firms I met may not have overlooked these issues, it was clear their ongoing discussions were pretty far along. They were meeting with me for some other reason and to find out if I knew of any sellers, and only then did they ask if there was anything they should know or ask the sellers about insurance.
Over the years, many checklists have been compiled of documents buyers should ask for from sellers, including loss runs, copies of policies and endorsements, applications, etc., in addition to considerations about possible impacts an acquisition might have on the seller’s and buyer’s insurance programs.
Understanding how to evaluate, structure, and minimize any additional costs involving insurances may help a seller (especially a small- or mid-sized firm) distinguish their offer from several competing bids. For buyers, this involves conducting a detailed review of a seller’s insurance-related information; often relying on the expertise of insurance advisors.
While it may not be practical to start discussions about a possible acquisition with a request for details about losses and insurance, some of this information can be especially insightful to buyers. And it may help prospective sellers gauge how they stand relative to their peers – so they can highlight outstanding loss experience or proactively get their business in order in areas where they’re underperforming.
Consider professional liability, given that most AEC firms focus on delivering professional services. Certain service types have inherently higher risk than others. These include geotechnical investigations and structural engineering design services. Unfortunately, these services tend to be more prone to severity losses – and not just on mega projects. Thus, it is not unusual for even well-performing geotechnical firms to pay four times in rate (unit cost for professional liability coverage as calculated on the basis of premium as a percentage of revenues) compared to a median rate or one for lower-risk classes, such as interior design or landscape architecture.
Perhaps it’s surprising that environmental engineering firms are viewed by insurers underwriting that coverage as fairly low risk – quite different from the perception some 20 years ago. Still, be sure to ask for details about how they handle Phase 1 investigations: Do they do them? And do they insist on using only their form agreement/terms and conditions? The modest fees collected by firms for these services can still give rise to disproportionate liabilities.
On the project side, residential remains high risk. That’s true not just for condos, but for all residential from multi-unit to single-family and even custom-built homes. Recently, a client described a “great” opportunity to buy out the geotech group of a larger, multi-disciplined engineering firm. It turns out the group derived most of its revenues from the residential home-builder segment and was the firm’s only operating unit with professional liability losses in recent years!
School work is also higher risk – typically K-12 but not college/university – so, know exactly where the seller is working within this segment. Meanwhile, modest risk is typically associated with the healthcare segment, but that depends on whether the work involves hospitals (higher) or senior living. Don’t overlook services being performed; HVAC is significantly higher risk than civil/site services in this segment.
How often should a firm expect a claim? In fact, very few design firms have never experienced a claim. One leading professional liability insurer calculated that firms with annual billings greater than $5 million on average experience one claim for every $10 million in revenues. Meanwhile, smaller firms tend to have greater claims frequency: those with revenues of $500,000-$5 million average about two claims for every $10 million in revenues; firms below $500,000 see five or more claims for every $10 million in revenues.
Not all claims are equal in terms of impact. Loss ratio – reserves (expense and indemnity; paid or not yet paid) divided by premium collected by the carrier(s) – is a key factor in comparing the loss history of firms across various revenue bands. Early on, buyers should get copies of the seller’s carrier loss runs, at least for professional liability coverage. And sellers should be sure to have their loss runs handy. Basically, a loss ratio below 30 percent typically indicates a good risk for an insurer. Alternatively, firms with ratios of 60 percent or higher will be categorized as poor risks. If these sellers can’t show how they can improve on their experience, you might choose to look elsewhere.
Despite the imperatives for growth, there are no shortcuts in M&A due diligence. Given today’s ultra-competitive market conditions, the ability to spot red flags may be helpful in knowing when to pull out of a discussion or for negotiating a more equitable transaction. Working with risk and insurance advisors can help identify potential insurance-related pitfalls.
Rob Hughes is a senior vice president and partner at Ames & Gough. Contact him at at rhughes@amesgough.com.