Buying or Selling? Think Local

Florida independent agents and brokers contemplating mergers or acquisitions are at a crossroads — a seminal moment in time that brings an end for some and a profound new beginning for others. Consider these current financial and market conditions:

1. The average enterprise (stock) value (including terms) for agencies has fallen 25 percent since the peak of mid-2007, and the long-predicted hard market in Florida is not going to materialize anytime soon to help that situation.

2. Selling an agency these days means much less cash up front, significant pressure on earn-outs, and claw-back provisions in the first year or two if a minimum performance assumed in the valuation is not achieved. Multiples of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) are now around six, down from the 7.5 range of not long ago, and still falling. This is a mirrored condition of the mid-1970s — and those 5.25 multiples lasted for nearly two decades. In short, it is a terrible time to sell except for one thing — in the next few years, it is going to get worse.

Here's why:

A. Contingent income is trending downward, especially in places like Florida where loss ratios are climbing. Chubb has announced that zero-growth means zero-profit-sharing regardless of your single-digit loss ratio. Though typically less than nine percent of total income, contingencies represent nearly half of end-of-year liquidity to fund obligations, retire stockholders, pay taxes, fund a 401(k), true-up producer books, bonus stock buyers, and pay down working lines (if you are lucky enough to have one). That goes double for all S-corporations in Florida — and it is getting worse.

B. The New York Insurance Commissioner held extensive hearings recently on revisiting contingent income. This may signal a d?j? vu back to the crusading days of former New York Attorney General Eliot Spitzer.

C. Carriers have thus far weathered an unprecedented nine quarters of consecutive surplus erosion. That is one reason many insurers bought non-descript savings and loans — to qualify for TARP relief. Congress is now considering federal oversight of carriers, citing deficiencies within the state commissioners' regulatory role at a time when vast commercial real estate portfolios held by insurers are due to re-paper (beginning 2010 through 2116). Deutsche Bank predicts a 25 percent failure rate by 2114, largely affecting insurers and smaller regional banks. If that comes to pass, then the feds will have to step in to rescue both, or fund massive losses states cannot afford, and monetize FDIC “insurance” to regional banks. This next capital crisis will affect agency revenues adversely.

D. Florida property rates are not hardening anytime soon. In the few areas where we are seeing rate firmness, insured values are down and deductibles and retentions are up, which mitigates per-account revenue increases.

E. If you grow 10 percent over the next three years and then sell, you will actually go backwards because of increases in capital gains tax rates. That goes double for S-corporations whose owners' W-2s exceed $250,000.

Opportunity Still Knocks

Brown & Brown and a half dozen other firms that are heavily into acquisitions have already consolidated much of the Florida distribution system. Unlike other states where consolidation has run its course, Florida's non-compete and non-piracy laws are pretty tough to get around. As a result, there are not a lot of fresh start-up firms, and therefore not a lot of buying opportunities. Those who have resisted selling so far have generally said “no thanks” to the buyer-models out there.

However, there are still some interesting opportunities in Florida, especially for regional firms. When selling an agency becomes an option due to transition or economic considerations, smaller firms are more comfortable with a regional firm than a national one. In reality, there has not been a buying opportunity like this for regional players since the mid-1980s.

Small firms in Florida have fallen below the interest level of most national buyers. Those smaller shops are typically diversified generalists with a modest amount of benefits revenue, a few large accounts, and a fair amount of small commercial and personal lines. Carriers have not taken their plaques off the wall because these boutique shops are typically quite profitable.

A merger or acquisition between a regional firm and a small agency offers advantages for both entities. Regionals are willing to listen to bolt-on ideas such as using cashless exchanges of stock and long-term modeling of employment and contributions. Smaller Florida shops will accept a regional firm's stock, offer seller-financed alternatives, and comfortably accept longer-term earn-outs. Additionally, an agency's book of business will juice the volume numbers of commonly shared carriers, and the office typically runs on AMS or APPLIED, which eases the conversion process. Moreover, although the carriers will never admit it publicly, they simply love the idea! They will fall all over themselves to help a large regional acquire a smaller, profitable firm. They know that few things in Florida sell like the “we're local” tag.

Additionally, national firms cannot carve around issues as easily as regional ones. By definition, national players must offer more cash-up front in exchange for the forfeiture of some of those very things most small shops want when they sell.

If the regional firm has a risk-management selling model, it can more easily promote a partnership to its youthful producers who might otherwise recoil at the differences in commission splits. Conversion of book equity into stock or vested interest is also much easier for non-publicly traded firms because the owners do not have to pass the Accredited Investor test, which limits ownership to those making more than $300,000 in the past three years and/or have a net worth threshold in excess of a million dollars.

Baked into the current market chaos and economic uncertainty is a genuinely unique Floridian opportunity that can involve small and regional players alike and, when the dust settles, leave the regional firm alive and well.

Dan Romain is the founder of Broker's Path, an operational consulting firm based in Oregon. He may be contacted at 503-577-3866 or www.brokerspath.com.