Down But Not Out

The State of the Insurance M&A Marketplace

During most of the past three years, the mergers and acquisitions (M&A) market for insurance agencies and brokerages has been marked by strong deal volume and soaring valuations. From 2006-2008, aggressive buyers were plentiful and selling firms were ready to accept lofty prices in exchange for their agencies. However, today’s M&A market has changed.

As buyers and sellers approach transactions today, they are doing so in an environment where capital is an issue and where uncertainty over future performance is causing both sides to hesitate. The M&A market is low on fuel and short on momentum. But, although the M&A market may have changed, it has not closed.

Understanding the Past

From 2006-2008, the market produced an increased number of deals — 15 percent to 30 percent above typical annual volume. While deal volume jumped, deal pricing also increased, driving guaranteed multiples to as much as a full point of EBITDA (earnings before interest, taxes, depreciation and amortization) higher than during the first part of the decade.

The increase in activity and value was driven by three primary factors. First, the public brokers, the most active buying group, enjoyed strong market valuations during a soft commercial property and casualty (P/C) market. This was a significant driver of M&A activity. The soft market put pressure on organic growth, forcing public brokers to turn to acquisitions to meet Wall Street expectations. The resulting acquisition activity was facilitated by strong public broker stock market valuations, which allowed for multiple arbitrage as the public brokers bought agencies across the country.

Second, the availability of equity capital and low borrowing costs made leveraged acquisitions an attractive means of generating high investor returns. Private equity investors used this access to capital to invest heavily in the insurance distribution space, acquiring USI Holdings Corp., Hub International Ltd., and several other high-profile agents and brokers. By the end of 2008, four of the top 20 brokers were owned by private equity firms.

Finally, banks were continuing their very acquisitive entry and expansion into the insurance distribution space. Banks were often high-multiple buyers, paying premium valuations for platform agencies. Fold-in acquisitions and the acquisitive growth of larger bank players created significant activity in the past three years.

Together, these dynamics created intense competition for deals between public brokers, banks and private equity investors. Sellers responded to the aggressive buyers by entering into transactions in record numbers at record valuations.

However, due in no small part to the national liquidity crisis and recession, and the accompanying stock market decline, the three driving forces faded in 2008, and the M&A market retreated. Public broker valuations fell, all but eliminating the arbitrage opportunity. Leverage became scarce and expensive, restricting private equity buyers. Banks were at ground zero during the financial crisis, and were preserving capital and refocusing on their core operations of lending and cash management.

Today’s Topsy-Turvy Market

M&A activity now rests on the fundamental drivers of consolidation in the insurance distribution industry: a fragmented market with benefits to scale and a steady supply of selling agencies. These factors are more than enough to generate solid deal activity. However, the economic and insurance environments have produced two additional forces that are now influencing M&A activity: capital conservation and uncertainty. These two forces are acting as a governor on deal activity, slowing the natural tendency toward consolidation.

As a result, the market is unpredictable. It doesn’t mean M&A activity has ceased, and it doesn’t mean that all deals are being done at bargain valuations. But it does mean that buyers and sellers are more deliberate and cautious today than they were just 12 or 24 months ago. Today, it is more difficult to predict when sellers will market their agencies and where buyer interest will come from when they do.

According to Reagan Consulting research, the overall number of agencies nationwide has held steady in the past couple of years around 37,500. This suggests a level of fragmentation — fantastic fodder for consolidation. However, the sought-after acquisition targets within this universe of independent agencies are a smaller, but still sizable group.

Of the 37,500 independent agencies, about 84 percent have annual commission revenues of less than $1.25 million. Industry buyers generally are not pursuing these firms, but are setting their sights higher to acquire local and regional players with more than $1.25 million in revenue. There are nearly 6,000 local and regional acquisition targets with $1.25 million to $500 million in annual revenues. These companies in aggregate control roughly 43.7 percent of the market, a substantial market share available for consolidation.

National and global brokers, each above $500 million in annual revenues, control only 31.1 percent of the U.S. market. These brokers, the most active acquirers of agencies, still have a large runway of market share growth available to them, which will fuel consolidation for years to come. Active buyers in the regional and local categories can also look down the ladder at plenty of acquisition opportunity.

In insurance distribution, bigger is frequently better, at least economically. Carriers are looking to consolidate their distribution force. They want to deal with fewer, larger agencies and have tried to reward agencies for handling increasing books of business. Scale can bring increased overhead leverage and ability to attract talent, both important attributes in value creation for insurance agencies and brokerages.

Fragmentation and benefits of scale drive demand for consolidation while demographics drive supply. When agency owners approach retirement, they evaluate their perpetuation options. Although internal perpetuation is the preferred option, not all agencies are prepared to perpetuate internally. In those cases, or when the pricing of a third-party sale become too attractive, agencies enter the M&A market as sellers.

Examining the age of the independent agency shareholder base provides evidence for the steady supply of agencies that are contemplating perpetuation. A large number of firms with a weighted average shareholder age (WASA) over 55 are approaching an external perpetuation event, and firms with a WASA between 50 and 55 are running out of time to perpetuate internally. In fact, most agencies are now owned by the Baby Boomer generation. These owners, now between 45 and 63 years old, will move out of the workforce in the next 20 years, creating opportunities for M&As.

Market Challenges

While deal activity in the insurance distribution industry will continue, the M&A market must contend with two dynamics.

First, finding new capital is difficult and/or expensive, making bank and private equity acquisitions challenging. Furthermore, the public brokers, also battling the financial crisis, have seen their stock prices come down and their borrowing costs go up. This has made using stock as an acquisition currency difficult and has made raising corporate debt an expensive proposition. Restrictions on capital for anyone buying group would put a dent in acquisition activity. However, the current environment is limiting both debt and equity capital for all buying groups, making funding acquisitions difficult for some and impossible for others.

Accompanying the credit crisis are an economy in recession and a P/C market that continues to be soft. Further, there is significant instability in the political arena, which could change the regulatory landscape for both P/C and health insurance. The lack of clarity on these important variables, including agency performance, is holding back deal activity.

There is nothing a market dislikes more than uncertainty. Selling agencies are wary of consummating a transaction when a declining economy and soft pricing may prevent them from earning a significant portion of any contingent pricing, or earn-out. Buyers are hesitant to invest their limited capital in an uncertain performance environment. If they are willing to invest, it may be at a lower valuation.

Valuation

Valuations are generally down, but are strong when there is a strategic fit. The majority of deals contain two components: guaranteed price and earn-out consideration. The guaranteed price — the price a seller will receive regardless of future performance — is down by approximately 10 percent. The perceived value of earn-out consideration — additional proceeds in excess of the guaranteed price that the seller is eligible to receive based on future performance — has fallen in the eyes of potential sellers. As a result, both components of agency valuation have declined. Going forward, pricing will be influenced by market stability, economic recovery and future P/C market tightening.

With valuations down, it’s tempting to say that the industry is experiencing a buyers’ market. However, sellers that are choosing not to enter the market are currently exercising as much control over M&A activity as the buying group. Top-performing agencies are still receiving premium valuations in the marketplace, as buyers recognize that they need to pay for superior growth potential, effective management teams, operational excellence, and industry or product specialization.

Overall, while uncertainty and capital constraints have limited M&A deal activity, market fundamentals will keep the current flowing, albeit at a lesser pace. With each passing day, more of the 5,990 agencies between $1.25 million and $500 million will reach retirement age and consider their perpetuation options. When they do, there are still buyers that will view the acquisition of that firm as a strategic opportunity to gain market share and create value.

While the current M&A market is less active, more deliberate and marked by uncertainty, it is still functioning. Well-positioned, top-performing agencies — whether buyers or sellers — always have good options, and that continues to be case. In short, the insurance distribution M&A marketplace is down, but not out.

This article is based on the report, “Down But Not Out. The M&A Marketplace for Insurance Agencies and Brokerages in 2009” by Reagan Consulting. For more information, visit www.reaganconsulting.com.

Topics Agencies Property Casualty