Market conditions propelled 2005 agency and brokerage mergersand acquisitions to their second-highest volume since 2000, andindications are that another boom year could be coming. The M&Aworld saw new and emerging players as well as niche market growth,but there also was evidence of pressure on both sides of the buyingand selling equation.

To better understand today's marketplace and prospects fornear-term consolidation, it is important to have a clear view of2005 M&A activity. After examining last year's statistics, I'llexplore consolidation trends while also looking at recent entrantsand the appetite of other buyers.

Based on recent activity, agency owners might have good reasonto consider a sale. With 216 announced transactions, consolidationin 2005 was just slightly under the record 2004 level of 224deals.

(Please note that announced transactions do not represent alldeals made in a year. Some public company acquirers and privatebuyers do not elect to announce all deals. However, trends revealedby this analysis should track with the larger universe oftransactions.)

Public brokers continued to lead the buying segment,representing nearly half (106) of the announced transactions,followed by 62 categorized under the “insurer and other” segment(other financial services and specialized companies) and 48 bybanks.

Before analyzing the activity in more detail, it is helpful tostep back and review the market with more of a macro perspective.When doing this, two trends become very clear–organic growth hasstagnated, and the basic rule of supply and demand is clearly inforce.

Organic growth rates are beginning to inch upward only slightlyfrom 2004 levels. The net growth among public company brokersduring 2005 was far below 2003, and is not projected to make anydramatic improvements in 2006. This places enormous shareholderpressure on many public brokers, who have no choice but to augmentflat or anemic organic results with acquired growth.

In the last few years, acquisition demand has resulted in anumber of high-performing agencies being acquired. In 2005, demandcreated more of a seller's market, as many buyers were chasingfewer high-quality and average-performing agencies. There is nodoubt this trend will continue. Declining organic growth rates andfewer high-quality agencies for sale will continue to have a rippleeffect on industry M&A pricing.

The fact that many large brokerages have ceased acceptingcontingent commissions due to New York Attorney General EliotSpitzer's investigations into bid-rigging and steering of accountshas made a marked impact on many major brokers' results. Withoutthis revenue stream, the industry leadership has turned even moresolidly toward acquisition strategies to augment their growth.

Wholesale business has been affected by the change as well.Leading acquirers–namely, Arthur J. Gallagher, Brown & Brown,Hilb Rogal & Hobbs and USI Holdings–acquired wholesalebusinesses last year, while Marsh, Aon and Willis all sold offtheir wholesale operations (presumably to address perceivedconflict-of-interest issues).

Brown & Brown was, for the fifth year in a row, the leadingacquirer of announced transactions. Fifteen deals were announced bythe company in 2005, while Arthur J. Gallagher and Willis each had11. Willis continued its international market approach, with eightof its 11 acquisitions being outside the United States.

USI and Hub International, both new entrants into the market in2003, continued to prove to be formidable in their acquisitionabilities. Their aggressive approaches resulted in 10 acquisitionsfor Hub and nine for USI during 2005.

HRH was the least active during 2005, with four acquisitions.Marsh and Aon were not active participants in agency consolidationdue to well-known regulatory issues and their focus onreorganization and realignment of marketing and services.

The continuing low cost of capital worked in the favor ofprivately-held brokers and banks, fueling their acquisitionappetites. Low interest rates reduced the barriers to entry formany regional and super-regional brokers, thus offsetting loworganic growth rates with acquisitions.

Property-casualty brokerages continue to dominate the volume ofannounced transactions with 106 deals (49 percent of the total),while nontraditional outlets (insurance and others) represented thesecond most active category, amounting to 62 acquisitions (29percent) in 2005.

Banks remained the third most active category among acquirers,with 48 announced transactions (22 percent). Although banksremained down significantly from 2000, when the banking industry's84 announced transactions accounted for 45 percent of the total,they still remain a viable component to agency consolidation.

Although the number of announced bank transactions decreased in2005, financial institutions remain highly committed to theinsurance distribution industry. Recently, banks have beenretrenching and integrating prior acquisitions, which is aprecursor to the next round of focused deal activity.

Softening product rates have contributed to this defensivestrategy. However, banks will continue to grow into their role as amajor influence in insurance product distribution.

According to the 2005 edition of “Who's Who in Bank Insurance”by The Bank Insurance Market Research Group, 25 of the nation's top100 insurance brokers were bank-owned–which makes a prettysignificant statement on the penetration these institutions havemade into the brokerage market during the past six years.

While the days of being a platform agency acquisition aredwindling for large, high-performing agencies being acquired by abank at a lucrative multiple, the lure still exists in certainsegments and geographies.

Recently, private equity groups have shown increased interest ininsurance distribution. PEGs have largely been focused in otherindustries during the past 10-to-15 years, investing in andpartnering with technology, manufacturing and risk-bearingbusinesses.

Now, however, many large groups seem to be drawn to theopportunities that have been developing within the insurance andfinancial services distribution consolidation, which has strongcontinued growth potential. It is very likely you'll see a PEGpartner with an emerging management team of industry professionalsattempt to “roll up” the next leading firm in 2006-2007.

The first matter that most insurance agency professionals wantto know about a potential M&A is what an agency is worth orvalued at.

This, of course, is most influenced by supply and demand.Despite rate softening cutting into revenue growth and the damageto the brokerage industry's reputation caused by the Spitzerinvestigation, the dwindling number of high-performing agencies andbrokerages available for acquisition–and willing to beacquired–drove average transaction prices higher across all marketsegments during 2005.

Notably, the most desirable firms being acquired by publicbrokers recognized an increase to 7.25-times earnings beforeinterest, taxes, depreciation and amortization (EBITDA) in 2005, upfrom a 6.75 multiple in 2004.

When reviewing all announced transactions, the percentage thatcommanded a multiple of greater than 7-times EBITDA increased from20 percent in 2004 to 45 percent in 2005. While this presents asignificant trend, it also is important to note that 2005transactions evolved more heavily toward earn-outs, which allowbuyers to structure higher valuations but still moderate theirpricing risks.

Multiples in some cases have gone even higher–the industrywitnessed a 10-times multiple and higher during 2005. But use ofthe earn-out mechanisms shows that buyers are using more caution byhedging their bets against future growth and profitability, postacquisition.

Regardless, the demand for high-performing firms is at thehighest level yet. If they perform well, post acquisition, theywill be handsomely rewarded, and at record multiples.

o High-performing, middle-market agencies–those few that arestill independent or acquirable–should be able to command apremium, especially from public brokers and banks. As independent,top-tier agencies of all segments become fewer and fewer,competition will intensify among top organizations looking toabsorb those firms.

o Employee benefits agencies are also in a good position toreceive premium multiples, as consolidating brokerages and banksseek to extend cross-selling opportunities.

o The small-to-midsize broker who seeks to remain independentshould be able to capture a significant amount of fallout from thelarger brokerage firms trying to purge their middle-market clientsdue to cost constraints. Expect a number of top, privately-heldbrokers to emerge as industry leaders during the next year ortwo.

In the short term–assuming flat product rates result incontinued lower organic growth–agency valuations should not varysignificantly from the current multiples being offered. Earn-outswill remain a significant part of transactions, with thepossibility of more variable purchase price being placed on futureindustry transactions.

With a dynamic marketplace, M&As continue to be afascinating aspect of the insurance agency and brokerage world andits continued consolidation.

Most leading public broker acquirers have indicated theiracquisition pipeline is full, and banks seem to be concentrating onintegration issues rather than expansion. However, I fully expectboth of these leading segments to continue to increase theirportfolios in 2006.

Banks very likely will try to leverage their low cost ofcapital, while overcoming previous integration issues. Publicbrokers will be driven by low organic growth to feed the bottomline through M&A growth. Private equity groups will continue toseek to be part of the system.