Private Equity Likely To Fuel M&A Drive

Consolidation within the agency/brokerage community was active last year, with over 250 deals taking place--beating out 2005 by a long shot. If the recent move by USI Holdings is any indication, M&A activity in 2007 could be equally frenetic, thanks in part to growing interest from private equity firms flush with cash.

There are three primary buyers of agencies and brokerage firms today cited by M&A experts: larger insurance brokerages, banks and private equity investors. Of the three, brokers remain the most active, accounting for the majority of deals, while bank appetite for acquisition has waned somewhat.

However, with private equity players reportedly looking for investments in industries under distress, new M&A opportunities are being presented to brokers having difficulty achieving organic growth in a softening insurance market, according to analysts commenting on the $1.4 billion USI deal between the Briarcliff Manor, N.Y.-based insurance brokerage firm and the private equity firm GS Capital (see NU, Jan. 22/29, page 6).

Among the valuation experts, the acquisition statistics may not be exactly the same, but they all point in the same direction--up. (M&A experts explain that acquisition figures vary primarily because many deals are not announced publicly and may not get counted.)

Robert J. Lieblein, managing principal with WFG Capital Advisors in Harrisburg, Pa., said that according to their figures, 2006 saw 264 deals compared with 216 in 2005. Of those, 60 percent were by insurance brokerage firms, 21 percent by banks, and the remaining 19 percent were by private equity firms and others.

Using figures supplied by Charlottesville, Va.-based SNL Financial, John Wepler, president of the agency consulting firm Marsh Berry and Company Inc. in Concord, Ohio, cited 215 deals in 2006, 3 percent more than in 2005--not bad since the year started out as a slow one for M&As, he noted.

"2006 was a landmark year for us in terms of deal activity, as well as the sizes and types of deals we worked on," said Michael J. Fletcher, vice president with Hales & Company in New York. "Based on our current pipeline, we expect 2007 to be just as active."

Sharon Cunningham, president of Business Management Group, a wholly-owned subsidiary of The Hartford, said while her firm had not finalized its figures for 2006 at the time of this interview, she expected the numbers to be about the same as the 180 deals counted in 2005. She said activity has not slowed and the primary need for acquisition remains.

One compelling driver behind all the acquisition activity is the softening insurance market outside of property-catastrophe exposures, the analysts said.

"[Insurance brokers] need to grow their revenues, and profits have been hurt by the soft market," observed Mr. Lieblein. "They have hit a trough on organic growth and need to supplement their internal growth with acquisitions."

"The emergence of the latest soft market is taking its toll on even the best planned growth strategies," agreed Mr. Fletcher. "Many brokers who were enjoying 15-to-20 percent annual growth only two years ago are now struggling to keep their growth rates from going negative."

"It is a very competitive market and it is not easy to go out and write new business," Ms. Cunningham said, adding that projections for premium growth are modest, which will mean no dramatic increase in revenues for brokers.

On the bank side, said Mr. Fletcher, their position is becoming less and less important in the M&A structure. He said they have found the cultural differences between banks and agents very demanding, adding that more than a few have decided to unload their insurance interests.

However, Mr. Wepler said he believes what is happening is not so much that banks are losing interest. While a few banks have sold their agency acquisitions because they failed, he contends the majority of sales were by banks that never intended to be in the insurance business in the first place, and obtained those assets through bank mergers.

"There are no longer that many banks that are experimenting with insurance," observed Mr. Wepler. "There may be fewer buyers, but they are more committed buyers."

Banks that have committed to insurance have found the cross-selling strategy that works, and have been more successful at organic growth than have publicly-owned brokerage firms, according to Mr. Wepler. However, he added, banks still need to find acquisitions to keep growing.

"To keep pace with bank earnings, they can't continue with organic production alone," and that is driving the need for acquisition by them, he explained.

The biggest splash in the M&A waters these days is being made by the private equity firms. Outside of the USI deal, Mr. Wepler pointed to several private equity acquisitions or creations of some significance--such as the creation of Integro, cash infusions to Beecher Carlson, Aliant, as well as rumors about Willis trying to purchase Marsh with the backing of the private equity behemoth Kohlberg, Kravis and Roberts.

However, according to Mr. Lieblein, while the private equity market's interest will be in securing big deals, the public brokerages--such as Arthur J. Gallagher, Brown & Brown, and Hilb Rogal & Hobbs--are willing to aim at acquiring agencies of $2-to-$3 million in revenue.

With all that activity, one thing is certain: the competition for quality agencies remains intense, which is driving up the price in many cases for buyers confident they can make operational changes that will cut costs and boost profitability to justify the premium paid, according to Reagan Consulting of Atlanta, Ga., which developed and produces the "Best Practices" study and support program for the Independent Insurance Agents and Brokers of America. (See page 12 for details.)

In some cases, the acquirer may be looking to establish a presence in a particular location, which will draw their interest to a target agency. But often, aside from growing revenue, acquirers are not looking just for a book of business. They also want the "intellectual capital"--the people--to go along with it.

"They are looking for quality operations with good people," said Mr. Fletcher. "Most of the time, few people are let go after an acquisition, and often [those producers] see growth after an acquisition. In fact, it is more likely you will see the employee headcount rise as smart acquirers look to expand the operation."

He added that "this is not like buying a widget manufacturer. Here you are buying people and relationships. Smart buyers want to make sure they maintain the people well after they close the transaction."

As far as dollars go, the time is ripe for selling, M&A experts say.

"The demand is greater than the supply," said Mr. Lieblein. "This is not the peak of the cycle, but over the next three years there will be a good growth opportunity, and that means a significant amount in earn-out," which are payments made to the seller based on the performance of the acquired book.

"But people make a mistake to sell just to exit the business," he added. "Buyers are not interested in making a sale and the main person leaving."

In terms of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), said Mr. Fletcher, most other industries sell at four-to-five times EBITDA. Agencies, on the other hand, are seeing six-to-seven times EBITDA, though he cautioned these numbers could drop in the coming year.

"Purchase prices are at historically high levels and may have even peaked," Mr. Fletcher said, adding that if an owner is considering a sale within the next three-to-five years, they should start thinking about the transaction now.

"No sophisticated buyer wants to pay a premium valuation for an operation where the owner is looking to check out right away," he said. "Although there are many exceptions to this rule, most buyers are looking for the owner to stick around for three-to-five years."

Mr. Wepler noted both advantages and disadvantages to making a deal with a broker, bank or private equity firm. He noted that:

o Public brokers are able to move faster and can close a deal within 45 days.

o A bank can take up to nine months because of their bureaucracy--but banks can offer greater access to customers.

o Brokers offer access to resources and peer groups, which the others do not.

o Private equity provides an opportunity to participate in value creation beyond an earn-out--first in the initial sale and again when the entity becomes public at some point.

Beyond pure price, how does a seller choose a buyer? "Usually the seller finds the best cultural fit and how that fits with what they want to do with the rest of their lives," according to Mr. Wepler.

With rising buyer demand, one would think the drive to sell agencies would be greater, but there are other, very personal factors that keep an owner from selling.

"Selling requires a lot of soul searching," Ms. Cunningham observed. "One has to ask, 'Is this your personal objective, or are you just getting caught up in getting a price tag for your company?' There are plenty of stories about agency owners buying back because they didn't like the company [that bought them out]. If there is a significant culture clash [the seller] may not find him or herself with the company after awhile."

A reason for selling may be a perpetuation strategy that is not working out, or growing weariness over managing the agency and the desire to enjoy one's personal life. Others just like the idea of being a part of a larger organization, or selling different kinds of accounts, she continued.

"It's not just dollars and cents. There is always an emotional element to it," she said.

"A lot of agency owners don't want to be acquired," Ms. Cunningham noted. "It is very hard for them to stop entrepreneurial thinking and go to work for someone else. There is the thrill of running and growing something that is theirs, and to have that control is far more important than selling out. It is what makes them get up every day and makes life worth living."