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Owners of high-performing agencies, while faced with crumbling P&C pricing in most areas of the country and stagnating group insurance commissions, can remain confident that the value of their agencies is rock-solid. This confidence comes from knowing that the investments they have made in their agencies are being looked upon favorably by the acquirers scouring the marketplace.
Private equity firms have brought a tidal wave of new money into the marketplace, the likes of which has not been seen since the “Flood of 1996,” when the U.S. Supreme Court's decision in Barnett Bank Inc. v. Nelson gave banks the green light to sell insurance and acquire agencies. While private equity firms have silently infused hundreds of millions of capital into insurance brokerages over the past 10 years, the combined $3.4 billion that private equity firms announced for the HUB International and USI deals alone should send a message loud and clear to the marketplace. Additionally, both deals were priced aggressively relative to private agency/broker standards. Meanwhile, banks and public brokers are paying more for acquisitions, too.
In 2006, banks paid an average of 7.9 to 8.2 times EBITDA (earnings before interest, taxes, depreciation and amortization) for the “foundation” agencies they purchased. That was up from 7.7 to 8.0 times EBITDA in 2001. Foundation agencies are the higher-performing agencies in a community, capable of meeting the insurance needs of the acquiring bank in terms of size, profitability, growth, and operational and management skill. For agencies banks subsequently acquire to add to a foundation agency, banks paid 6.75 to 7.0 times EBITDA, 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 the agencies they bought in 2006. That was up significantly from the 6.5 to 7.0 multiples they paid in 2001.
It is important to note that these transaction prices include earn-outs that are typically paid over a three-year period after a sale. Earn-outs are based on attaining certain revenue growth or profitability targets. After they are taken into account, foundation agency sellers have been receiving an average down payment of 7.25 times EBITDA (89% of the purchase price). The multiple is 5.28 for other agencies purchased by banks (76% of the purchase 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 transactions increased in 2006 relative to 2005. In all, there were 215, with banks and national brokers announcing 60 and 61 of them respectively. However, given that 1,761 publicly announced transactions have taken place since 1999, the pool of quality targets is shrinking.
Private equity buyers also are paying premium prices for desirable acquisition targets. Consider, for example, that the private equity buyers of USI and HUB International paid 10 to 12 times forward-looking EBITDA. Private equity buyers see the opportunity to privatize public brokers, leverage debt to increase the return potential, invest capital to create long-term organic growth and exit the business during a hardening market, thereby potentially capturing multiple arbitrage. This strategy summarizes the goal of the private equity gorilla. Now, these buyers have in their sights every type of distributor within our industry, including employee-benefits agencies and wholesalers.
Of the $130 billion of private equity capital awaiting deployment in the financial services sector, Marsh Berry & Co. estimates that $15 billion is looking for a home in the insurance distribution system over the next 18 months. Obviously, the market cannot accommodate $15 billion, but the numbers alone serve as a stark reminder that the competitive landscape continues to change. Private equity investors view insurance agencies and brokerages as attractive targets because of their renewable earnings streams, strong cash flow, minimal capital requirements and limited risk exposures. Therefore, private equity firms will remain aggressive and close several more transactions this year.
Private equity firms are committed to their acquistions' organic growth (often augmented with additional acquisitions). They have the time, discipline and capital to invest in producer recruiting, services, differentiation strategies, technology and high-level account executives. This may surprise most agents, who may believe that the private equity firms are just attempting to buy agencies and wring out some costs, only to turn them over.
Private equity buyers saw opportunity in the lower price/earning multiples of most public brokers. The dropping P/E multiples reflect the slowing organic growth most distributors are experiencing because of the soft market. The P/E multiples of the national brokers moved up in advance of the last hard market, however. When the market next hardens, private equity firms want to take their purchased agencies or brokerages public at what could be a significant premium.
Given the P&C industry's record surplus and profitability, a hardening market is nowhere in sight.
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Still, the private equity firms will retain positions in their acquisitions for five to seven years in hope of timing the market when they sell. But even if the market doesn't harden by the time they wish to exit, the private equity firms believe a steady stream of buyers will enable them to get out on attractive terms.
What are the implications of all this for the average independent agency? First, it is important to consider fair market value. The values cited earlier in this article are averages for specific types of transactions. Do they imply that every agency is worth seven to eight times EBITDA? Absolutely not. There are many factors that may differentiate your agency's fair market value from the acquisition EBITDA multiples banks and brokers paid last year in announced transactions. In some instances, those values were enhanced by an acquired agency's locale; by its specific attributes, including expertise or insurance companies represented; or because the buyer could achieve certain economies of scale. Furthermore, banks and public brokers are astute, professional buyers, and many of the agencies they bought have achieved above-average growth rates and profitability.
Valuation principles will likely place the fair market value of the average agency closer to six times EBITDA. At this level, an informed financial buyer, like another agency (as opposed to a strategic buyer such as a bank, public broker or private equity fund), will earn a rate of return commensurate with the risk undertaken and be able to pay for the agency out of its subsequent cash flow. A financial buyer applying fair market valuation does not factor in the increasing P/E multiples that may occur with the next hard market–which might not come for many years.
How, then, can average agencies enhance their value in today's market? First, they should understand that value is influenced primarily by two factors: growth and profitability. Profitability drives cash flow, and growth accelerates an investment's payback. Anything agencies can do to increase growth and profitability will enhance their value.
Certainly, after acquiring agencies and brokers, private equity firms try to increase their internal growth. At a time when the organic growth of all segments of our industry is in the single digits, private equity buyers, financed by tax-deductible debt, invest in new producers. They support them with risk management services that help them close more opportunities and provide superior service to existing accounts. At the same time, the firms look for opportunities to lower overhead and customer service cost. The resulting higher growth and increased earnings lead to enhanced cash flow during the period of time the private equity firms hold their investments, and they justify higher multiples when they sell them.
Private equity firms and other financially astute buyers also perform significant due diligence on their potential acquisitions. Those agencies that adopt practices that alleviate buyers' concerns will fetch higher prices. Those concerns include the following:
–Does the agency have employment and non-piracy agreements with its producers and key staff? If the agency is not protected by these agreements, buyers factor into their valuations the potential risk of business erosion from employee departures.
–Is the agency vulnerable to bad debts on agency-billed accounts receivables and the consequential distraction of collection efforts? Agencies that consistently follow sound receivables procedures reduce the risk of bad debts.
–Is the agency vulnerable to errors and omissions litigation because of a lack of training, understaffing, inadequate documentation or failure to adhere to workflows and procedures? Agencies that have documented, efficient procedures and that train their staff to follow them and monitor compliance reduce their risk of E&O claims.
–How will the softening market affect income? If contingency income seems likely to fall, buyers will make certain adjustments to the target's pro forma income statement.
–Are producers on a compensation program that rewards growth? Are new producers actively managed and terminated promptly if they are not meeting reasonable production goals? Are the customer service staff and support staff operating efficiently? Answers to such questions are vital, because compensation will always be an agency's single largest expense.
Third-party buyers also consider whether management and production talent crucial to the agency's success will remain after the acquisition. Furthermore, in the valuation of any agency, the age of the staff and the ability of the business to continue affect perceived value. For agencies perpetuating internally, qualified candidates must be on board and willing to write a check, guarantee a loan and grow the business.
What if you're an independent agent looking to buy rather than sell? Realize that you will find it hard to compete with the tidal wave of capital targeting the industry. There are ways you can do so, however. Focus on targets with which you have a relationship; e.g., a friendly local competitor or an agent whom you have gotten to know at insurance-company or association functions. Stress the quality of life you can offer for the owners and staff. Then be flexible in structuring the deal, using a combination of compensation, purchase price and possible earn-out scenarios. Of course, perform your due diligence thoroughly to avoid the potential pitfalls that exist when acquiring agencies and integrating them into your operation. Wayne A. Walkotten is a senior vice president of Marsh, Berry & Co. Inc., and shareholder in charge of the insurance consulting firm's Grandville, Mich. office. He can be reached at Wayne@Marsh-Berry.com or (616) 667-1056.
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