Owners of high-performing agencies, while faced with crumblingP&C pricing in most areas of the country and stagnating groupinsurance commissions, can remain confident that the value of theiragencies is rock-solid. This confidence comes from knowing that theinvestments they have made in their agencies are being looked uponfavorably by the acquirers scouring the marketplace.

Private equity firms have brought a tidal wave of new money intothe marketplace, the likes of which has not been seen since the“Flood of 1996,” when the U.S. Supreme Court's decision inBarnett Bank Inc. v. Nelson gave banks the green light tosell insurance and acquire agencies. While private equity firmshave silently infused hundreds of millions of capital intoinsurance brokerages over the past 10 years, the combined $3.4billion that private equity firms announced for the HUBInternational and USI deals alone should send a message loud andclear to the marketplace. Additionally, both deals were pricedaggressively relative to private agency/broker standards.Meanwhile, banks and public brokers are paying more foracquisitions, too.
In 2006, banks paid an average of 7.9 to 8.2 times EBITDA (earningsbefore interest, taxes, depreciation and amortization) for the“foundation” agencies they purchased. That was up from 7.7 to 8.0times EBITDA in 2001. Foundation agencies are the higher-performingagencies in a community, capable of meeting the insurance needs ofthe acquiring bank in terms of size, profitability, growth, andoperational and management skill. For agencies banks subsequentlyacquire to add to a foundation agency, banks paid 6.75 to 7.0 timesEBITDA, as opposed to 6.75 to 7.25 times EBITDA in 2001.
Public brokers paid an average of 7.5 to 7.9 times EBITDA for theagencies they bought in 2006. That was up significantly from the6.5 to 7.0 multiples they paid in 2001.
It is important to note that these transaction prices includeearn-outs that are typically paid over a three-year period after asale. Earn-outs are based on attaining certain revenue growth orprofitability targets. After they are taken into account,foundation agency sellers have been receiving an average downpayment of 7.25 times EBITDA (89% of the purchase price). Themultiple is 5.28 for other agencies purchased by banks (76% of thepurchase price) and 6.23 for agencies bought by public brokers (81%of the purchase price). (Please see the chart on p. 64.)
The number of publicly announced agency/broker transactionsincreased in 2006 relative to 2005. In all, there were 215, withbanks and national brokers announcing 60 and 61 of themrespectively. However, given that 1,761 publicly announcedtransactions have taken place since 1999, the pool of qualitytargets is shrinking.
Private equity buyers also are paying premium prices for desirableacquisition targets. Consider, for example, that the private equitybuyers of USI and HUB International paid 10 to 12 timesforward-looking EBITDA. Private equity buyers see the opportunityto privatize public brokers, leverage debt to increase the returnpotential, invest capital to create long-term organic growth andexit the business during a hardening market, thereby potentiallycapturing multiple arbitrage. This strategy summarizes the goal ofthe private equity gorilla. Now, these buyers have in their sightsevery type of distributor within our industry, includingemployee-benefits agencies and wholesalers.
Of the $130 billion of private equity capital awaiting deploymentin the financial services sector, Marsh Berry & Co. estimatesthat $15 billion is looking for a home in the insurancedistribution system over the next 18 months. Obviously, the marketcannot accommodate $15 billion, but the numbers alone serve as astark reminder that the competitive landscape continues to change.Private equity investors view insurance agencies and brokerages asattractive targets because of their renewable earnings streams,strong cash flow, minimal capital requirements and limited riskexposures. Therefore, private equity firms will remain aggressiveand close several more transactions this year.
Private equity firms are committed to their acquistions' organicgrowth (often augmented with additional acquisitions). They havethe time, discipline and capital to invest in producer recruiting,services, differentiation strategies, technology and high-levelaccount executives. This may surprise most agents, who may believethat the private equity firms are just attempting to buy agenciesand wring out some costs, only to turn them over.
Private equity buyers saw opportunity in the lower price/earningmultiples of most public brokers. The dropping P/E multiplesreflect the slowing organic growth most distributors areexperiencing because of the soft market. The P/E multiples of thenational brokers moved up in advance of the last hard market,however. When the market next hardens, private equity firms want totake their purchased agencies or brokerages public at what could bea significant premium.
Given the P&C industry's record surplus and profitability, ahardening market is nowhere in sight.

Still, the private equity firms will retain positions in theiracquisitions for five to seven years in hope of timing the marketwhen they sell. But even if the market doesn't harden by the timethey wish to exit, the private equity firms believe a steady streamof buyers will enable them to get out on attractive terms.
What are the implications of all this for the average independentagency? First, it is important to consider fair market value. Thevalues cited earlier in this article are averages for specifictypes of transactions. Do they imply that every agency is worthseven to eight times EBITDA? Absolutely not. There are many factorsthat may differentiate your agency's fair market value from theacquisition EBITDA multiples banks and brokers paid last year inannounced transactions. In some instances, those values wereenhanced by an acquired agency's locale; by its specificattributes, including expertise or insurance companies represented;or because the buyer could achieve certain economies of scale.Furthermore, banks and public brokers are astute, professionalbuyers, and many of the agencies they bought have achievedabove-average growth rates and profitability.
Valuation principles will likely place the fair market value of theaverage agency closer to six times EBITDA. At this level, aninformed financial buyer, like another agency (as opposed to astrategic buyer such as a bank, public broker or private equityfund), will earn a rate of return commensurate with the riskundertaken and be able to pay for the agency out of its subsequentcash flow. A financial buyer applying fair market valuation doesnot factor in the increasing P/E multiples that may occur with thenext hard market–which might not come for many years.
How, then, can average agencies enhance their value in today'smarket? First, they should understand that value is influencedprimarily by two factors: growth and profitability. Profitabilitydrives cash flow, and growth accelerates an investment's payback.Anything agencies can do to increase growth and profitability willenhance their value.
Certainly, after acquiring agencies and brokers, private equityfirms try to increase their internal growth. At a time when theorganic growth of all segments of our industry is in the singledigits, private equity buyers, financed by tax-deductible debt,invest in new producers. They support them with risk managementservices that help them close more opportunities and providesuperior service to existing accounts. At the same time, the firmslook for opportunities to lower overhead and customer service cost.The resulting higher growth and increased earnings lead to enhancedcash flow during the period of time the private equity firms holdtheir investments, and they justify higher multiples when they sellthem.
Private equity firms and other financially astute buyers alsoperform significant due diligence on their potential acquisitions.Those agencies that adopt practices that alleviate buyers' concernswill fetch higher prices. Those concerns include thefollowing:
–Does the agency have employment and non-piracy agreements with itsproducers and key staff? If the agency is not protected by theseagreements, buyers factor into their valuations the potential riskof business erosion from employee departures.
–Is the agency vulnerable to bad debts on agency-billed accountsreceivables and the consequential distraction of collectionefforts? Agencies that consistently follow sound receivablesprocedures reduce the risk of bad debts.
–Is the agency vulnerable to errors and omissions litigationbecause of a lack of training, understaffing, inadequatedocumentation or failure to adhere to workflows and procedures?Agencies that have documented, efficient procedures and that traintheir staff to follow them and monitor compliance reduce their riskof E&O claims.
–How will the softening market affect income? If contingency incomeseems likely to fall, buyers will make certain adjustments to thetarget's pro forma income statement.
–Are producers on a compensation program that rewards growth? Arenew producers actively managed and terminated promptly if they arenot meeting reasonable production goals? Are the customer servicestaff and support staff operating efficiently? Answers to suchquestions are vital, because compensation will always be anagency's single largest expense.
Third-party buyers also consider whether management and productiontalent crucial to the agency's success will remain after theacquisition. Furthermore, in the valuation of any agency, the ageof the staff and the ability of the business to continue affectperceived value. For agencies perpetuating internally, qualifiedcandidates must be on board and willing to write a check, guaranteea loan and grow the business.
What if you're an independent agent looking to buy rather thansell? Realize that you will find it hard to compete with the tidalwave of capital targeting the industry. There are ways you can doso, however. Focus on targets with which you have a relationship;e.g., a friendly local competitor or an agent whom you have gottento know at insurance-company or association functions. Stress thequality of life you can offer for the owners and staff. Then beflexible in structuring the deal, using a combination ofcompensation, purchase price and possible earn-out scenarios. Ofcourse, perform your due diligence thoroughly to avoid thepotential pitfalls that exist when acquiring agencies andintegrating them into your operation. Wayne A. Walkotten is asenior vice president of Marsh, Berry & Co. Inc., andshareholder in charge of the insurance consulting firm'sGrandville, Mich. office. He can be reached at [email protected]or (616) 667-1056.