Industry Spotlight: Vehicle Service Contract Administrators

(upbeat music) Today we're going to continue on our industry spotlight series in which we do a deep dive into several of the industry verticals that Colony covers. Through our focused industry coverage, transaction experience and relationships we have built over decades, Colony does become a thought later across a number of verticals within the business services and financial services sectors. On our last episode, we talked about the insurance premium finance industry, a knee-shac at class favored by banks. This time, we'll kick off a number of episodes around the FNI products industry. Finance and insurance products include automotive finance, automotive warranties and much more. Colony has deep expertise in the FNI product sector, having been involved in dozens of transactions over the past decade. We work with entrepreneurs who have built great businesses and are getting ready to sell, private equity firms that are considering entering the industry or who are selling related portfolio companies, and large institutions seeking acquisitions in the space. Specifically, today we'll cover the vehicle service contract or BSC market in detail. In particular, we're going to talk about BSC administrators. I'm delighted to have my partner, Gina Cocking, as the featured speaker today, as she is the go-to banker in this industry. - Thank you, Jeff. - Gina, you are certainly the axe in this industry and there's a lot to cover in the FNI product sector, ranging from administrators, dealers, sellers, payment plan companies, data analytics companies, insurance carriers and more. So if you could just kick us off here with a broad overview of the industry and then we'll do a deep dive on administrators. - Thanks, Jeff. We do work quite a bit with the industry, and so we've gotten to see the whole ecosystem. So I'm going to start by talking about how everybody fits in. So typically, most products are sold through a dealership at the point of sale of the vehicle. So a car buyer walks into the dealership and says, "Ooh, I like that used Audi A4, and I would like to buy it." And they go into the FNI office when they're working on their auto loan. And the FNI team will say, "You know what? You should consider buying a vehicle service contract. A vehicle service contract is like a warranty, but cannot be legally called a warranty. Warranties can only be offered by OEMs. But essentially, a vehicle service contract is covering any mechanical failures, mechanical problems on a vehicle, can range from problems with the engine to the electronics, to the windows falling through, all kinds of different problems and different vehicle service contracts cover different problems with cars. Some have practically full coverage, others have more limited coverage. The consumer goes into the FNI office and will buy a vehicle service contract. That vehicle service contract will be rolled into the auto loan. They may also buy a tire wheel contract, a key fob contract, a pureance protection contract. There's a whole slew of products that can be used to cover mechanical failures or other problems with a car, basically none insurance related problems. So if you get hit by another car, you run into a stop sign. Those are covered by insurance. Those are collision damage, coverages. So this covers all of the mechanical failures. These products are becoming really popular. They're about 51% of cars sold in the United States through franchise dealerships are sold with a vehicle service contract attached to that car. So you have in this ecosystem the administrators of the vehicle service contract. So these are the companies that administer the contracts. So when a consumer has a mechanical failure, they contact the vehicle service contract administrator and that administrator will work with the repair facility to make sure the repair facility is paid for any claims. So the administrator is adjudicating the claims and if it's an admin obligor, it actually is responsible for the payments for the claims. This is where we get into what is the ecosystem. In an auto dealership, the dealership is selling you the product. So they're the distribution in this case. The admin is adjudicating the claims. Either the admin has the money on hand to pay for the claim, so it's the obligor or the dealer is the obligor. Basically what happens is when a vehicle service contract is purchased, part of the money is put into a trust to pay for future claims. And that trust may be owned by the dealer or an entity associated with the dealer or it may be owned by the administrator. - Complicated to the industry, a lot of moving parts here, you touched on sort of the value to the consumer. Let's talk about the economics of a contract which will lead into why these contracts are sold by dealers. A typical vehicle service contract is to make the map easy $3,000. It's usually anywhere between $2,800 and $3,500. But we'll just say $3,000 for this case. The dealer is going to sell it. Let's say Jeff, you're looking to buy the Audi A4. The dealership will say we can give you a vehicle service contract for $3,000. That $3,000 is actually a markup from the administrator cost. The administrator is probably selling it to the dealer for $1,000. And then there's maybe $500 that's being paid to an F&I agent kind of like an insurance agent. That's the intermediary between the administrator and the dealership. So the dealer is going to make $1,000 profit on that vehicle service contract dropping to the bottom line today. So those are profitable products. Especially when you look at margins on new car sales on new car, they might be making 2.3%, 2.5% on sale of a car. $1,000 on a vehicle service contract is real money. The administrator, they sold it to the dealer for $1,000. That $1,000 at the administrator pass. Part of it is to cover the administration costs. The people sitting in their offices who are adjudicating claims and interfacing with the repair facilities and making sure that payments are made. Part of the $1,000 is going into the trust to pay for future claims. If it's an admin obligor trust, that means the administrator, in this case, will use $800. The administrator is putting $800 into the trust to pay for claims on that vehicle service contract. Typical vehicle service contract is a five year contract. So that $800 will earn out over five years and will be used to pay future claims. Any excess funds that are sitting in that trust will be remitted back as profits to the dealer or whomever owns the trust. Obviously very profitable for the dealership or the selling entity here. And we'll talk about distribution in a different episode. But this is really a critical component to the dealerships profitability. And we've talked about this or recover this and track this in our quarterly updates. But the publics really have made a strong push to boost F&I income because it's such an important and critical component of their dealer profitability. As he said, you know, if you make $2,000 on the sale of a car and you can make an extra $1,000 on the sale of a warranty, that's pretty compelling for the dealerships. The publics actually show F&I product penetration of greater than 100% on average per vehicle sold over the last year. That means they are selling on average more than one product. So once again, vehicle service contract, tire and wheel, prepaid maintenance. Those are all products consumers are buying at a very high rate. And I think that rate has been increasing over time because consumers are having a good experience with the products. So let's say with your Audi A4, you've previously honed I don't know, a Buick Olds Mobile. And you had a vehicle service contract on your 1992 Olds Mobile. You got claims paid on that olds Mobile. And it was a really exciting product for you. It was a great product. So you went and then bought a vehicle service contract subsequently on your next car that you acquired. Now, the consumer experience has been good. There's been increased marketing efforts around these products. And dealerships are actively dialed in and more focused than ever before, in my opinion, on selling all of these products. You know, top tier dealerships, great dealerships, strong profitable dealerships have always been selling these products. But now, pretty much every dealership out there is selling F&I products. And they are working with the F&I agents and learning how to sell these products better by emphasizing the benefits to the consumer. And as a result, more products are being sold. The motivation for selling more products, these are really important to dealership sales, especially as new car sales slow. What we saw in 2020, even though car sales were down due to the pandemic, vehicle service contract or just overall F&I product sales will continue to be strong. And in fact, it seems to me we don't have the data yet, like there was an uptake in penetration in vehicle service. is contract sales across the board. So dealers like, gosh, you still need to pay payrolls. We still need to make money. So for not selling cars, we need to make more money on each car we sell. And we'll do that for our sales of F&M products. - And we track that data over many years. And you write, the penetration rates continue to increase in part because the dealerships are getting more savvy. They're looking at the public and seeing their great success and in optimizing profitability on the sale of a vehicle. But I think you're right, it's worth discussing the increasing consumer adoption because of the value proposition. There's been some bad press over the years about scams and frauds. Talk a little bit about sort of the value of the product again to the consumer and why those rates are increasing. - I call it the iPhone effect. I think there's a correlation between the increase in sales of vehicle service contract and other warranty type products for vehicles as there has been an increase in consumer electronics. I'm sitting here with my iPhone in my hand and I have a service contract on my iPhone. I have a service contract on my laptop. Many people do. Apple has been very good at selling these service contracts or warranties. And if you step back and think about it, why do I have a service contract on an $800 phone but I don't own a $34,000 car? That hitch, it's actually a financial decision by consumers is resonating. It's logical. You know what, if my phone doesn't work, yeah, that's kind of a problem. I'll have to find alternatives. But if my car doesn't work, I have to figure out how to get to work. And it's really important for me to get to my work in order to have a job in order to pay for my iPhone. So the piece of my component of service contracts of particularly vehicle service contracts is why consumers are going to these products. It is a financial product. It's an insurance type of product. It's a piece of my product. It's a good financial management product. 50% of Americans don't have $400 of accessible cash at any given time to pay for an unexpected repair. And so these products are a necessary financial planning product in order to protect their assets, one of the most valuable assets of car. People own a car before they own a home. And so if you have insurance on a home, you'd have a warranty on your phone. You should have a warranty on your car. Consumer adoption is really picked up and the consumer products analog is a good one. These piece of mind sales pitch is resonating with consumers. And as you noted, importantly, consumers are having a good experience. So I would say maybe 15 or 20 years ago, F&I products weren't as widely touted. The adoption rate is weren't as high. And you probably had some bad actors. I think over the last couple of decades, these companies have really become institutionalized and are focused on customer service, paying claims, being good to their customers because they want repeat business. Because of the work we do, and we've been involved in most of the F&I M&A transactions have taken place over the past seven or eight years. We've seen a lot of books of business. And so I've had the opportunity to look at why claims are denied. In contrary to popular opinion that you will read in the press, claims are not denied just because the administrator is like, oh, I'm going to make more money if I don't pay this claim. If you listen to the press, you'll hear a lot of that. But generally what I see are when claims are denied, those claims are usually made during the blackout window. So most vehicle service contracts will have a 30-day window post purchase where you can't make a claim for anything that happens in the first 30 days. The reason for that is adverse selection. And you'll see this more on either used vehicles or vehicle service contracts are sold directly to consumer. We'll talk a little bit more about direct to consumer in another podcast. But from an administrator perspective, if you're an administrator of a vehicle service contract that's sold direct to consumer. So not at the point of sale of the vehicle, but aftermarket. There is adverse selection. A consumer can say, you know what? I'm having a problem with my car. I should buy a vehicle service contract. And then my vehicle service contract will pay for the repairs. And so they buy vehicle service contract. They make a claim on day five. And it was obviously something that happened pre-vehicle service contract. That's the number one reason I see for exclusions on this contract. The other reason is it might not be something covered by the vehicle service contract. Once again, these contracts are not designed to nickel and dime and screw over the consumer. It's usually like a big category. For example, the vehicle service contract may not cover aftermarket additions to a vehicle. So let's say you have a car and you take it in and you have some new sound system put into your car aftermarket. Your vehicle service contract is not going to cover that. You'll sometimes see contracts that don't cover electronics. Because electronics can be a whole different ball of wax on a vehicle that vehicle service contract may not cover overall electronics. Usually that's pretty clear in these contracts. If they say they cover mechanical failures, it'll cover mechanical failures generally. There's some fine print for sure. And clients we work with were very thoughtful of indiligence about going through, what are the call scripts? What are these folks saying to consumers? And what's a claims history? What are they paying out on what are they not? And obviously you've seen a lot of books of business. And we try to work with the best players in the industry. So who are the major players here? And how do you sort of define scale and the attributes of a valuable company in this industry? The two largest vehicle service contract administrators that are none OEM are J M and A, which is a privately held family held company. And the other is Safeguard, which is owned by the private equity firm Stonepoint. Those two are the largest administrators of vehicle service contracts, especially Safeguard is doing a lot on new vehicles. Other administrators that are out there that are all great administrators include road advantage down in Austin. We have IAS, which is now owned by the Canadian Financial Services firm called IA Financial. We have APCO, which is owned by Canadian institution. Those are some of the biggest mid-tier ones. We have insurance companies that own administrators. So Fortegra owns smart auto care. As it's warranty administrative, we sold smart auto care to Fortegra. Assured owns the warranty group. Amtrust owns A-A-G-I. So you see a lot of the insurance players are owning some of these warranty companies. And then there are a number of warranty companies that may focus on independent dealerships and used vehicles. So one that comes to mind is CARS Protection Plus, which is actually now owned by Spectrum Automotive and Protective Asset Protection, which is a large insurance company and owns several warranty providers. So it seems like there's some vertical integration that's been going on. Obviously, a lot of consolidation that's happened over the last several years. Talk a little bit if you could about what are the trends, why are people integrating or not, and what are the benefits there? So vertical integration brings synergies and distribution. We saw this about five, six years ago when we were writing some of our early white papers on the sector. We could see that the value to an administrator is not only its products. Because remember, the products usually aren't strongly branded. Like a consumer doesn't walk into a dealership and says, wow, I really want the warranty provided by SafeGuard. Because SafeGuard's not advertising that brand. It's just coming through the dealerships. So really the value and administrators, their distribution network. And we'll do a whole other podcast on this. So what we see are M&A that's happening, first of all, of administrators locking up distribution channels. And some of that will come through buying FNI agencies, but sometimes it's coming through buying other administrators. Because if one administrator buys a second administrator, that second administrator could increase the geographic footprint, it can bring in a new market, like let's say in the first administrators largely in new franchise dealerships. And the second ones in independent use dealerships not franchise, so that's a nice synergy. We see insurance companies that are buying administrators. Because there's some vertical integration that you're taking out part of the cost structure. Part of the cost structure is called a clip, a contractual liability insurance policy. So I'm going to get a little technical here for a second. Once again, Jeff, you're going to buy an Audi A4. How are you confident that that vehicle service contract 4 1/2 years? from now that there's still the money there. If you pay today $3,000, that 4.5 years remember still the money there to pay for your claim. Any vehicle service contract that is rolled into an auto loan and many states also have this regulation must be backed by a rated insurance carrier, maybe A- or A- rated insurance carrier. So what the insurance carrier does is it provides a clip of contractual liability insurance policy. So you imagine a paper clip that's attached to the service contract. And what it is essentially a backstop to the re-insurance funds, the funds that are put in trust to pay for future claims. So if the administrator is an admin on the floor and they funded the trust for your vehicle service contract for $800 for future claims. And for whatever reason 4.5 years now there's not $800 in the trust to pay for your claim. The clip will ensure that the insurance carrier will provide the funds to pay for the claim. Thus you can sleep peacefully at night, Jeff, never worrying about the fact that your vehicle service contract might not be paid. And this is one of those great things in the industry and why consumers have such trust in these products. There's a failsafe by having a clip on these products. Okay, so it clips not free. And there is an expense associated with purchasing a clip on every product. And it differs by products. But it could be as much as 15% of the product cost could go to the clip. So an administrator that vertically integrates with an insurance company is going to take out some of the expense in the cost structure and can recognize some synergies. The number one driver of M&A activity in the industry is private equity. So private equity firms have been investing in the F&I industry for 10+ years because of the dynamics of the industry. One, it's large. We estimate that the F&I industry is about $80 plus billion in size at retail level. Two, it's growing. Consumer adoption of these products is growing. Penetration rates are growing. Three, these are high margin, high cash flow businesses. These are all checking the boxes for private equity firms. So key firms have been investing in administrators. And so oftentimes what we see is they acquire an administrator and then they'll do add-on acquisitions to increase distribution, to recognize synergies in the expense chain. And when I talk about synergy in the expense chain, it's not laying off for people. I never see that. But it's really taking out a layer of the cost structure. And so we've seen a number of private equity firms that have invested in these companies and have grown through acquisitions. One, for example, is spectrum automotive, which is owned by Cornell Capital. And spectrum automotive acquired and it was originally Vanguard dealer services. And then they did a number of acquisitions of different types of companies in the ecosystem and created a lot of synergies. Private equity capital is driving M&A activity across a number of verticals. And F&I products is definitely one of those. And as you said, there are success stories dating back to, at least in my memory, 2006 when HIG bought into and then subsequently sold safeguard to Goldman and really since the mid 2010s or so, there's been a lot of activity in your right. Folks are noticing that these are high growth, high margin businesses with recurring cash flows and are sort of perfect for private equity investments. And the success stories over recent years have proven that out and are driving increased interest investment to the sector for sure. So Gina, how are these companies valued? There's a little bit of secret sauce here in terms of looking at these companies and thinking about the right metrics. What do you guys look at in terms of valuation? Administrators are valued typically not on GAP, but on modified cash accounting. Okay, so what is modified cash accounting? GAP matches basically expenses and revenues with the value of the product, with the life cycle of the product. So, under GAP, a vehicle service contract, and once again, a vehicle service contract is $3,000. The revenue of $3,000 will be recognized under GAP pro-rata over 60 months. The expenses for the reserve for future claims and other components will be recognized pro-rata over 60 months. Under modified cash, because these products are rolled into an auto loan and the administrator gets payment up front. So, Jeff, you buy the product and we're sitting here on July 2nd. I will get the funding from the auto finance company that's financing your auto loan. I will get the funds here in July. And so, modified cash is recognizing the cash when it comes in. So, revenues are recognized at basically time of sale and the expenses associated with reserve for future claims and the clip, all the contract related expenses are re-recognized at the time of sale. So, essentially what you will see for a growing business that under modified cash earnings will be higher than under a GAP business. So, if I was selling one contract, under a one contract model, under GAP, the contract would have one-sixteenth of the earnings that would under modified cash. So, these companies are valued on a modified cash basis, which gets complicated, right? You have two sets of books that CFOs have to keep on these businesses. So, modified cash is looked at. Then, then the next question is, the re-insurance funds and the trust to pay for future claims. Who owns that? If it's an ad men obligor, there is real value in those trusts because there is excess funds that are put into those trusts. The products will be structured to a certain loss ratio. The loss ratio is claims divided by the premiums remitted to the trust. 800 dollars in reserves are going into the trust. Let's say the expected claims for your Audi A4 is going to be $400. These are not true to life numbers. These are genome-made up numbers. But that's a 50% loss ratio. But that means there's $400 in profits that are sitting there in that trust that will be coming out. That income from the trust should be included in the value of the company. So, we have a lot of different legal entities that are involved in considering how to value these companies. So, that's kind of a big component. The accounting, what are legal entities involved? And then, what is driving value for these companies? Is it a company with a narrow geographic reach? Is this an administrator only in the state of Texas? Or does it have a national reach? Do they have concentration? And this is a big concentration with a dealership group. Most private equity firms will not invest in a company if greater than 15 or 20% of its revenues come from a single source. Well, a single source isn't a dealership rooftop, but really a dealership group. So, if an administrator has 40% of revenues coming from one dealership group, there are many, many private equity firms that will not be able to invest in it. And therefore, it has a smaller universe of interested buyers. And we have, as we've talked about many times on this podcast, when you have fewer buyers that are potentially interested, it's going to drive down the bound. So, concentration is a big driver of value in this industry. And then finally, size matters. Once again, we always say this, size matters. Bigger companies are worth more than the smaller companies. That's for sure. Size definitely matters in this industry. And I think we offer some guidelines to folks that we chat with. Certainly, the big players that you mentioned are trading for double-digit multiples below a certain size, say, 5 million of earnings, are probably not as marketable to folks, at least on a broad scale. But there's still a large number of administrators that fall in the middle there. Folks that are doing 5 to 50 million of earnings that have built very valuable businesses, and could be attractive to a large audience of folks who've touched on strategics, private equity firms, and sort of right in the middle are the private equity-backed strategics. You know, folks that have already planted their flag, like Cornell did with Spectrum, and then followed on with the number of strategic acquisitions. So again, lots of activity in this sector. Interesting dynamics. Colinate has either been the cell side or BISIDE M&A advisor on many of the significant FNI products transactions that have taken place over the last decade. These transactions are complex and require an investment banking team with deep industry knowledge. We have insider level mastery of the driver's evaluation, competitive positioning, the business trends at relevant metrics, and the right buyer universe, enabling us to provide superior deal execution to our clients. If you are an FNI products company or a potential buyer of one of these businesses, and you are considering a transaction, please contact us and we can help you think through your next steps. Thank you for joining us as we discuss one of Colinate's areas of focus, VSE administrators. At Colinade we focus on M&A for financial services and business services. companies. This podcast is one in a series of episodes discussing M&A trends in the sectors in which we are subject matter experts. To learn more about Colonyd, the deals we've done and our thoughts on other M&A related topics, please go to our website at coladv.com or join us on LinkedIn.