The Hidden Costs of Dealership Mergers and Acquisitions

By Bernard Goldman & Gregory Reddock

With decades of increasing pressures in the automotive dealership space, the financial and operational challenges of running single stores and small multi-store groups are becoming more daunting. Today, Internet pricing and pre-negotiated buying club pricing are readily available to consumers, making margins incredibly lean. To compound the problem, vehicles are getting better, which leads to less service and fewer maintenance requirements, reducing the post-sale services and warranty revenue that has long been an industry safety net.

Owners of single stores and small multi-store dealership groups now face a stark reality: consolidate or perish. For most, the overhead advantages and increased ability to drive retail traffic that being part of a large multi-store dealership group bring are simply too great to forego. (They’re the same pressures that caused the death of “mom and pop” video stores 20 years ago.) But even as those single stores were acquired by larger groups, those larger groups, in turn, faced similar margin pressures from the mega-retailers like Blockbuster and Hollywood Video. In the end, we all know what happened to those retailers when first DVD-by-mail services and then internet-based services came into their own.

The auto dealership space, however, is not consumer video. Aside from franchise laws, internet-based sales solutions face significant consumer resistance. For most consumers, a car is either the largest or second-largest purchase they will ever make. Consumers want to see it, touch it and drive it. They also need to maintain it. So, for now, the mega dealership group remains “king of the hill” for retail sales and service.

Aquire, Aquire, Aquire!

Private equity groups and private and public investors all understand the dynamics. Scale is the key to success in the automotive dealership space, so acquire, acquire, acquire! This has spawned myriad rapidly growing dealership groups that often move at a frenetic pace in their drive to acquire more stores and, as a result, greater scale. Their mantra is simple: when an acquisition opportunity presents, move fast to “seal the deal,” or a competitive group will.  As a result, acquiring companies often do not conduct proper due diligence in reviewing the business’ current insurance program. The acquiring company may also not have a good grip on the potential liabilities that are inherent in the existing program and which may be absent from the dealership’s financial statements. Before acquisition, it’s important to determine whether uncovered claims or unrecorded deductible expenses exist, if there are changes in insurance market conditions or changes in claims history that could negatively affect the purchase. An insurance professional with a complete understanding of the dealership mergers and acquisitions landscape will significantly reduce costs to acquire dealerships and provide the tools for a successful transition.

Keep an Eye on Liability Deductions

At Foa & Son, we recently worked on a large dealership acquisition for which we were asked to review the insurance program of the acquired company several days prior to close.  The insurance company that backed the program was financially stable and the coverages were sufficient, but the design of the insurance program included a substantial deductible for garage liability, auto liability and workers’ compensation. Since the dealership being acquired was large, the number of claims was considerable, and the ongoing liabilities associated with those deductible payments (i.e., the tail expenses) would continue for many years.

To paint a full picture of the situation, we needed to provide an actuarial review of the current claims and expected growth of the claims to provide our client with an estimated future claims expense. In this case, those expenses were forecast to total several million dollars. During a deal, these expenses could reach eight figures after multiples are applied. This is an example of a property and casualty unrecorded expense. It can also apply to health insurance, as many dealerships record only the expense and do not accrue for future potential liabilities.

Another issue to consider is the loss experience and carrier. We recently reviewed a new client’s claim history for a dealer open lot policy and found there were significant hail damage claims made four days prior to the program renewal. In most cases, once a quote is released, the carrier will honor terms already presented. Since the large hail claim occurred so close to renewal, the carrier did not have a clear indication of the total claim cost. In the following year, renewal included a 35 percent increase in pricing due to these losses, and no other carrier could compete. In the analysis of an acquisition, insurance cost is one of the largest expense components. If there are significant changes (either an increase or decrease in cost), the buyer should be fully informed before making final decisions.

We recently worked on a dealership acquisition in which the acquired group was written through a major insurer that historically specialized in dealerships in the relevant geographic area.  Unfortunately, the insurer had recently announced that it would no longer write dealerships. The buying entity was unaware of the insurer’s changes or of the financial consequences associated with a replacement insurance program. In addition, there were implications for deductibles as well as self-insured exposures that the acquiring entity had not factored into their initial due diligence and financial pro-forma.  Fortunately, we were able to identify all the costs and exposures associated with the insurance market disruption and secure a competitive alternative for the acquiring entity.

Understand Where the Knots Are Likely to Be Located

In every sale, both the buyer and seller make certain representations and warranties about the dealership and its obligations for the future. Often, these assertions are the basis for many legal disputes after the sale. Compounding the issue, many private equity deals keep the dealer-operator in a management position, so if a lawsuit ensues, the new owner will be suing a current employee.

It’s a truth that many brokers do not offer or properly explain how an acquisition “representations and warranties” policy works. This policy, although often overlooked, can provide an insurance product that will cover the exposures for unknown or unrealized assertions made during the sale process.  For example, imagine that a large customer (such as a municipality) that purchases a large volume of cars each year has decided to buy a different make and model that the dealership does not sell, resulting in a 15 percent decline in dealership sales. Although this was unknown by the seller at the time of sale, this was a covenant made by the seller in the purchase agreement – one which significantly affects the profitability and therefore could have changed the sale price of the dealership. In the absence of a representations and warranty policy, this could result in years of expensive litigation. Now imagine that the prior owner is still involved in the dealership’s operations, which makes for a strained relationship that will hinder success. With the protections of an insurance back-stop, however, buyers are often able to put together more aggressive terms, including shorter earn-outs, and gain a competitive advantage in negotiating purchases.

Consider It a Point of Differentiation

Often, a dealership group is run by a family that has grown the operations through multiple generations, so family members are nervous about the transfer of the family’s business.  To differentiate yourself from other buyers, including a representations and warranty policy in the offer sheet to the seller. This can provide an advantage over the competition as this policy simplifies the closing process and gives the seller security that the sale will close and the potential for future litigation is mitigated.

goldman bernie | The Hidden Costs of Dealership Mergers and AcquisitionsAs General Counsel and a seasoned operations executive at Foa & Son, Bernie offers clients creative multi-disciplinary solutions to their most complex risk management and legal challenges.  An experienced trial attorney specializing in high exposure liability and sophisticated insurance coverage matters, Bernie spent more than sixteen years with a Fortune 100 property & casualty insurance company in executive roles with responsibilities including legal, sales, underwriting, loss control, and finance/accounting.  Bernie received his J.D. Cum Laude, from St. John’s University School of Law, and his B.A. degree in accounting with honors from the City University of New York at Queens College.


Greg Reddock | The Hidden Costs of Dealership Mergers and AcquisitionsAs a Senior Vice-President at Foa & Son, Greg heads Foa’s Automotive Dealership Practice. Greg and his team have handled many complex dealership acquisitions for both private equity and privately held groups.  With the rapid pace of acquisitions it is important to work with a broker that understands the complexities of the deal and can provide expertise throughout the process.  Prior to joining Foa & Son, Greg was a seasoned Certified Public Accountant where his accounting experience enables him to educate and advise clients on financial decisions with respects to cost versus risk when evaluating Captive’s, Self-insured retentions and traditional first dollar insurance coverage.