Agencies At A Crossroads When It Comes To Expansion

As we enter 2009, we believe that many independent agencies are at a crossroads. Do they sell? Do they buy? Or do they execute organic growth strategies? To put these tough times into perspective, we need to set the stage by looking at the impact of the two challenging years preceding this one.

If 2007 can be referred to as "The Year of the Perfect Storm" for agency mergers and acquisitions, then let's just call 2008, "The Year of the Financial Tsunami," what with all the talk of recession, subprime mortgages, the credit crisis, layoffs, foreclosures, bailouts and stock market meltdowns making life so difficult.

While insurance as a whole did not suffer as dramatically as other financial sectors--AIG excluded--the industry still had its share of "storms," what with a continuing soft market, low organic growth rates, the impact of economic woes, investment losses and natural catastrophes.

How did these "storms" affect insurance agency M&As? While we could not have foreseen the extent of economic issues that impacted the nation, we did predict in our "2008 Industry Sourcebook" that 2008 would be called "The Year of Consolidation."

In hindsight, we were spot on, as agency consolidation during 2008 resulted in a record year, with an increase in the number of announced transactions rising from 279 in 2007 to 307 in 2008--a 10 percent increase.

The easiest explanation for the increase in the number of transactions is that public and national brokers, along with privately held agencies, aggressively pursued acquisition candidates to help offset four-plus years of a soft market and weak organic growth rates, coupled with a significant increase in the number of agencies that were for sale. (The accompanying chart provides a five-year summary of the total number of announced transactions.)

Public and privately held brokers continued to lead the consolidation efforts, followed in the distance by insurance and other acquirers, as well as banks.

The industry continued to see the same leading acquirers as during the prior five years. Brown & Brown once again was the leading acquirer, with a total of 41 announced transactions, followed by AJG with 26, Hub International with 16, and BB&T with 10 announced transactions.

Put into perspective, these four firms combined represented 30 percent of the total transactions for 2008.

The most important question is how did the economic and industry-specific challenges of 2008 impact the valuations of agencies involved in transactions during 2008? Unfortunately, for most agency owners, the window of opportunity for the record amounts paid for agencies vanished.

Dreams of receiving eight-times-EBITDA (earnings before interest, taxes, depreciation and amortization) or greater are a vision of the past for most agencies. The valuation gap between the high-performing agency and the average agency has spread significantly during the past year, and will probably continue over the next few years.

As we moved into the second half of the year, the supply of agencies for sale increased and the number of active buyers decreased--which further impacted the valuations of many agencies that only a year ago would have sold at a price of 15-to-25 percent higher. (The accompanying table presents a historical look at agency value as a multiple of EBITDA for 2007 and 2008, as well as projected values during 2009.)

Several factors contributed to the overall decrease in valuation multiples during 2008:

o Low Organic Growth Rates: The soft market, driven by declining premiums along with the current economic recession, negatively impacted revenues and profits at most agencies.

o Supply Versus Demand: The balance of power is shifting toward equilibrium. While demand was still strong, fewer buyers and a significant increase in sellers began to lower pricing.

o Less Competition: During 2008, we experienced a significant reduction in acquisition activity from both private equity firms and banks, which resulted in less deal competition in many transactions.

o Public Broker Multiples: The decline in public broker multiples resulted in buyers not being able to pay the same price as in prior years due to the decrease in deal arbitrage.

o Economic Issues: The availability of capital, higher borrowing costs, layoffs and general economic issues tied to the recession resulted in a general decrease in pricing overall.

Looking out to 2009, we begin to see the impact of declining market trends affect agency pricing as many transaction values will likely fall by 100 basis points or more when compared to the record year of 2007 and early 2008.

Given the predicted substantial increase in sellers, combined with the decrease in the number of buyers in the market, we expect many smaller agencies will ultimately sell to buyers who will treat them as a revenue- or fold-in acquisition, or sell to regional or local buyers--who, historically, have paid lower prices for agencies.

What can we expect from merger and acquisition activity in 2009? Will it begin to slow, or will it remain as robust as it was during 2008?

As we focus on the future, we clearly have certain market dynamics that will continue to drive M&A activity during 2009. These factors include:

o Soft market conditions are expected to last through the majority of 2009.

o Deteriorating organic growth rates in all likelihood will not change until at least 2010.

o Demand will continue to outweigh supply.

o Pressures from carriers for smaller agencies to consolidate due to lower premium volume.

o Shallow talent pool and the rising age of the average agency owner.

o Inability to perpetuate internally.

o Changes to the health care distribution system.

o The impact of the potential increase in capital gains.

These key drivers will clearly continue to be the catalysts for shaping the forward trends of distribution consolidation. With public and national brokers leading the way, along with mid- to large-size privately held agencies dominating the M&A landscape, 2009 should once again be a year where we experience significant consolidation.

From a valuation standpoint, the pricing pressures experienced during the second half of 2008 will continue, and we expect that valuations will keep dropping for the average agency.

Only those firms that make a commitment for strong organic growth and other strategic initiatives to drive their future will continue to enhance shareholder value.

Others will probably experience a steady decrease in the value of their agency caused by lower profitability and be ascribed a lower valuation multiple.

To assist agency owners choose their proper path for maximizing shareholder value, Hales & Company, The National Underwriter Company and American Agent & Broker (a sister publication of National Underwriter) will be sponsoring four day-long seminars this spring which will include topics such as:

o Economic and Industry Events Impacting Insurance Distribution.

o M&A Outlook for 2009 and beyond.

o How to Use Valuation as a Management Tool.

o Transaction Pricing, Earn Outs and Deal Structures.

o Successful Organic Growth Strategies.

o How to Successfully Execute a Buy or Sell Side Transaction.

o Best Practices on How to Effectively Manage an Agency for Growth and Profits.

Seminars are currently scheduled for Los Angeles (April 30), New York City (May 5), Washington, D.C. (May 7) and Tampa (June 4).

Go to www.NUCO.com/MandA to register.