Although three ratings agencies are reticent about debt incurred by Willis North America Inc. in its planned acquisition of Hilb Rogal & Hobbs, announced last week, they believe the transaction in the long run will enhance the broker's business profile, especially in North America. The $2.1 billion takeover boosts Willis' revenues by some 30 percent, but the broker remains well behind Aon and Marsh.

Under the terms of the definitive agreement, Willis will acquire all of the outstanding shares of common stock of HRH for $46 a share–50 percent in cash and 50 percent in stock–in a transaction having an equity value of approximately $1.7 billion and an enterprise value (or total purchase price) of about $2.1 billion.

The transaction is expected to close in the fourth quarter of 2008, subject to customary closing conditions, including regulatory and HRH shareholder approval.

HRH is a leading middle-market, U.S.-based insurance broker with a large-account portfolio, according to a joint statement, which noted that HRH generated $800 million of revenues in 2007–$57 million from its international operations, which are based in London.

Willis produced nearly $2.5 billion in total brokerage revenues last year, including retail and reinsurance commissions and fees. On a pro forma basis, the combined entity would have generated some $3.3 billion in brokerage revenue for 2007–a boost of nearly one-third, but still leaving Willis behind Aon ($6 billion) and Marsh ($5.4 billion) in brokerage revenue.

“The HRH footprint in the United States will result in a significant expansion of Willis's already extensive retail platform,” said the joint statement. “The combination will boost the contribution of North America to Willis's overall revenues from 30 percent in 2007 to an estimated 45 percent on a pro forma basis, enhancing the mix among its North America, International and Global segments.”

The deal, according to the statement, “also will positively rebalance Willis's business lines mix, with the reinsurance businesses–which in 2007 accounted for 15 percent of Willis's revenues–going to 12 percent of the revenues of the combined company.”

However, following the announcement of the $2.1 billion deal, rating agencies were quick to cite their concerns:

o Fitch Ratings placed Willis North America Inc. and Willis Group Holdings Ltd. on “Rating Watch Negative.”

o Standard & Poor's Ratings Services dropped the counterparty rating of Willis Group Holdings Ltd. to a “triple-B-minus” from “triple-B.” It also listed the outlook on Willis as negative.

o Moodys Investors Service placed Willis North America Inc. under review for possible downgrade.

While Fitch expects the operating performance of the combined entity to compare favorably with the other major brokerages, “this deal, with all the uncertainty and the integration risks that attends it, will reduce the clarity in that regard,” Gregory Dickerson, a director at Fitch Ratings in New York, told National Underwriter.

“That being said, our ratings action…was really based on the expected material increase in financial leverage at Willis to finance the deal, and Willis was already the most highly leveraged of the insurance brokers that we rate, so it was the more aggressive leveraging that was more of a driver of the rating action,” he explained.

Indeed, from a competitive positioning standpoint, the merger looks like a “sensible step” for Willis, added Mr. Dickerson. “Merging with HRH will augment the company's North American presence, particularly in the middle-market space. So they'll grow there, which should be a positive,” he said.

Bruce Ballentine, vice president and senior credit officer on Moody's insurance team, said the transaction should improve the Willis business profile, but may weaken its financial flexibility. “If the deal goes through as expected,” he said, “we expect to downgrade Willis by one notch in recognition of the increased financial leverage.”

Pat Regan, chief financial officer at Willis, told NU that “obviously we've borrowed money to do the transaction, so they reflected that in their rating–but importantly, we're still investment grade.”

He added that Willis “talked to the rating agencies and explained the rationale of the structure to them. I think all the rating agencies in their write-ups said positive things about the deal structure and our management track record of delivery and execution.”

Mr. Regan estimated it will take about a year for the merged company–which will be named Willis HRH–to get its ratings back where they were before the merger, or higher. “[Fitch and S&P] both said that as we integrated over time and started generating the synergies we've talked about, they can see us getting to one notch above where we were,” he noted.

Willis expects to double its North American business, and will also bring a global footprint and specialist expertise to benefit HRH's retail network, Joe Plumeri, chairman and chief executive officer of Willis Group Holdings Ltd., said in a conference call last week.

Outside the United States, he explained, “we'll be adding HRH's London-based operations to further expand the range of our specialty expertise and blend in with the things we do in London.”

“It's really the best of both worlds for our clients,” he added. “We bring global reach and expertise, while HRH brings added talent and local market presence. All this should translate into significant value for our shareholders.”

Willis expects to achieve annualized synergies of $100 million in 2010 through integrating operations, he said. This only represents about 8 percent of North America's pro forma 2007 expense (on a combined basis), and about 3 percent of the pro forma for the combined companies on a global basis.

Moody's last rating action on Willis was in March 2007, when it assigned a “Baa2″ rating to a $600 million guaranteed senior unsecured net offering of Willis North America Inc. Willis's rating will move to a “Baa3.”

Moody's said it expects to downgrade the Willis ratings by one notch, in recognition of “the integration and financial risk associated with a sizable leveraged acquisition.” These risks, Moody's added, are elevated by the general price-softening in the property-casualty insurance market and the weakening overall economy.

At Fitch, Mr. Dickerson also noted that “we are in a softening rate cycle that will dampen growth and crimp margins for these insurance brokers.” The current cycle, he said, will make it more difficult for Willis to “digest this acquisition and maintain what we would consider to be the superior levels of operating performance that Willis has historically demonstrated, relative to the other brokers.”

However Mr. Regan countered that “even in the current soft market, there are many opportunities.” He said Willis brings HRH its global expertise, “which they didn't have access to before,” along with “much greater access to industry 'specialisms,' whether that be aerospace, energy, construction, marine, financial institutions, real estate–so we think that in itself provides growth opportunities.”

He added that Willis is excited about the “critical mass we get in big-growth areas,” including Texas, Florida, the New York/New Jersey region, California and Chicago. “We felt we were in the top-three broking companies in five out of the top-20 insurance markets before the deal, and now we're in the top-three in 15. So it really transforms our presence in those big cities.”

Mr. Dickerson at Fitch said the soft market could have an even greater impact because Willis has to forgo HRH's $40-to-$50 million in contingent commissions after three years, according to an agreement made with the New York Attorney General's Office and Insurance Department.

Willis agreed to give up contingency fees when New York authorities, after an investigation, accused the biggest brokerages of using them to mask kickbacks from insurers with which they rigged bids.

“The world's a little bit different now than it was when contingents went away in 2004, or the start of 2005,” said Mr. Regan. “Certainly for us as a company, we've done a whole program of what we call 'shaping our future marketing.' So we are much more coordinated in how we place business now, the terms and conditions we ask for our clients, and how we get paid by the insurance company.”

He added that “we're much more confident now with our ability to coordinate our market efforts. And the fact that we're placing something like $20 billion in the North American insurance markets now on a combined basis, we're very confident that over that three-year period, we'll at least make up in base commissions what we lose in contingents.” In other words, he explained, “over that three-year period, we get to phase down the commissions and build up the base commissions. It's the same dollars–just paid in a different form.”

Willis HRH will combine Willis's 70 locations and HRH's 140 locations, giving it 210 offices and about 750,000 employees, Mr. Regan said, noting that very little overlap is expected.

The new Willis HRH organization in North America will be led by an Office of the Chairman, including Don Bailey (now CEO of Willis North America) as chairman and CEO, F. Michael Crowley (now president and chief operating officer of HRH) as president, and Martin L. Vaughan III (now chairman and CEO of HRH) as vice chairman of Willis Group Holdings.

“Detailed plans are being developed to combine the two companies,” Willis noted in a statement. “The integration will be led by Mr. Bailey, effective immediately, to ensure a smooth and seamless process.”

HRH's Mr. Vaughan said in the joint statement that the combination has the full support of his board of directors and senior management team. “Our complementary footprint and Willis's strength in important global specialties…make our two companies an outstanding strategic fit,” he said.

The joint statement added that the deal will boost employee benefits business from 10 percent of Willis's current revenues to 13 percent of the combined company.

Willis estimates that the transaction will be 7 percent accretive to cash earnings per share in 2009, 10 percent in 2010 and 14 percent in 2011. It is expected to be 3 percent dilutive to GAAP earnings per share in 2009, 2 percent accretive in 2010 and 6 percent in 2011.

“It is the company's intention to buy back over time the majority of the shares issued as part of the transaction,” the statement noted.

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