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Aiming for the Upper Deck: What's in the cards for great performing agencies? Will you get what your firm is worth?
Leader's Edge, May 2007
Fast Focus
- Aces and sluggers command premium prices in the M&A big leagues.
- Employee benefits, multi-line and niche players are hot prospects.
- Sellers should expect 30% to 40% of the total deal value to be tied to future performance.
With the crack of the bat and the ceremonial downing of the first hot
dog, America's favorite pastime is under way again. I'm referring, of
course, to the great sport of sitting in the grandstand, squinting into
the sun and saying "who's that guy?" The game of mergers and
acquisitions is not just limited to the insurance field, you know. As a
matter of fact, baseball free agency is very similar to selling or
buying an agency.
The important thing to keep in mind is not that record-breaking deals
are being made, but how you, an agency leader, can take advantage of
them. What numbers are real and which are just myths? Whether you're
hitting or fielding, selling or buying, it's good to understand the
valuation basics and buying trends that will affect your next free
agency deal.
Analyzing the Stats
If you need a scorecard to keep the M&A numbers straight, you're not
alone. The industry saw a record number of deals in 2006. There were 264
announced transactions in 2006, up 22% from the 216 deals announced in
2005. So what is driving free agency frenzy? Let's analyze the key
drivers.
As in 2005, the story last year continued to be about the immutable laws
of supply and demand. Demand has never been stronger and greatly
outweighs supply. With organic growth rates remaining low and product
rates soft, acquisitive brokers, banks and private equity groups fed
their need to aim higher by aggressively pursuing acquisitions. Demand
continued to be robust for larger, high-quality, high-performing
agencies especially because they have become fewer in recent years. I
compare a high-quality, high- performing agency to the baseball player
with the following stats year after year: .300 batting average, 30
homers and 100 RBIs. Few and far between.
Fueling this demand are soft product rates, which have resulted in weak
organic growth, at best. As of November 2006, MarketScout reported a
composite rate decrease of 9%. Rates in all sectors were down: small
accounts 7%, medium-sized accounts 10%, large accounts 12%, and jumbo
accounts 11%. While organic growth rates appear to be improving from the
low point reached in the last half of 2005, I expect continued low
growth rates during 2007 to fuel another year of high M&A activity. My
baseball comparison—consider the aging team who has many older players
whose productivity has declined significantly from year to year. These
teams are aggressively seeking free agents to improve their future
performance.
Finally, contrary to what many believe, banks' appetites for agency
acquisitions continue to be strong. Leading banks with insurance
platforms in place continued to aggressively pursue M&A, focusing on
second-tier and revenue acquisitions. I compare this to the 20-win,
left-handed pitcher. There just are not a lot of them out there, but
they are very competitive and have a significant impact on the market.
Negotiating Guidelines
Broadly speaking, industry professionals generally reference two forms
of calculations to use as a "low common denominator" when calculating
purchase price: multiple of earnings or multiple of revenue.
Multiple of earnings, which is really a multiple of EBITDA (earnings
before interest, taxes, depreciation and amortization), is the most
widely used measure when discussing the overall purchase price of an
agency. It essentially represents "free cash flow" of the agency at time
of purchase. Acquirers generally determine purchase price based upon the
trailing 12-month period of free cash flow, adjusted for certain "add
backs," such as excess owner compensation or non-recurring or atypical
expenses.
The second form of valuation multiple is based upon revenue. Quite
candidly, no acquirer really values an agency in the form of multiple of
revenue, but since I am always asked about revenue, I will provide such
data. As a humorous side note, I have had many smart, experienced deal
makers say to me this year, "I agree that the EBITDA multiple makes
sense, but I cannot justify the price based on such a high revenue
multiple." I still have not figured out that logic. It is like figuring
out the Florida Marlins' salary strategy.
So just like baseball salaries, the top players got paid more last year.
The average high-end multiple paid by public brokers increased from
7.25-times-EBITDA during 2005 to an average of 8-times-EBITDA during
2006. Banks with existing insurance distribution systems also paid on
average 8-times-EBITDA, and banks making a platform acquisition paid an
average of 8.5-times-EBITDA. See Figure 1 for a comparison of average
pricing for 2005 and 2006. Figure 2 translates purchase prices as
multiple of revenue.
Valuation Variables
A number of variables beyond supply and demand affect an agency
transaction. If you're contemplating a deal, consider the level of
earn-outs being proposed in a variable pricing format, as well as the
structure of the transaction and the currency being used.
Earn-outs are the norm when talking about transaction prices. As prices
being paid have risen, the growth has often come in the at-risk portion
of the deal. The guaranteed, or fixed, portion of the price for most
deals did not change significantly in 2006; higher multiples mostly
resulted from the variable portion.
This trend began in 2003, and it is expected to continue. So whether it
is the unknowns about product rates, uncertainties about contingent
commissions, or client and employee retention concerns, earn-outs are
here to stay. I tell my clients to expect anywhere from 30% to 40% of
the total deal value to be tied to future performance. Generally, deals
with higher valuation multiples exceeding 8-times-EBITDA are more likely
to be using this variable pricing structure.
As earn-outs continue to be a significant part of many deals, it is
important to understand the ramifications. A deal with an upfront
component that is 6-times-EBITDA and a variable pricing component that
brings it up to 8-times might be very attractive, whereas an upfront
5-times-EBITDA and a variable component tied to more significant income
growth that may result in a 9-times multiple would probably not appear
as attractive.
Consider Transaction Types
The financial implications of one deal versus another may hinge on the
type of transaction, how the seller is getting paid, and the resulting
tax ramifications.
For instance, is the purchase structured as a stock or an asset
transaction? While stock transactions generally allow for full capital
gains treatment to the seller, the buyer is not allowed to amortize the
goodwill associated with the transaction. This will often result in a
lower purchase price.
Whether the seller is an S corporation or a C corporation also has an
effect on the ability to fully realize favorable tax treatment. The
owner of a C corporation must structure the deal as a stock transaction
to get full capital-gains tax benefit, whereby selling assets can result
in double taxation—first on the corporation, then on the shareholder. An
S corporation can employ either transaction method, and in certain
situations, the deal can be structured in such a way to be recorded as
an "asset sale" and reap tax benefits for both parties. Knowing which
mechanism to use can maximize the transaction value.
Whether the deal is consummated with cash or stock can have tax
ramifications as well. As a general rule, if the buyer takes at least
50% of the purchase price in stock, the tax is deferred until the stock
is sold, but the seller pays tax on the entire transaction value if less
than 50% of the purchase comes as stock. For example, in a $10 million
transaction, if the seller receives $6 million in cash and $4 million in
stock, the entire $10 million is taxed upon consummation. However, if
the seller takes $6 million in stock and $4 million in cash, only the $4
million is immediately taxable, and the rest is tax-deferred.
In baseball, the $34 million salary with a $10 million signing bonus and
guaranteed contract of $8 million per year for three years is generally
more attractive than a $40 million dollar, three-year contract with a $2
million signing bonus, with a guaranteed salary of $4 million per year
and filled with incentives that only can be achieved by performance
results that the player has never even come close to achieving before.
And did you realize the $34 million contract was with a team in the U.S.
while the $40 million contract was with the Toronto Blue Jays! You
figure the taxes.
This Year's Model
What's the pennant race going to look like this year? The aces and
sluggers will continue to demand the premium prices, especially among
the larger agencies (more than $5 million in revenue, excluding
contingents) and the high-performers (pro forma EBITDA in the 25% to 30%
range).
Employee benefit agencies are still as hot as left-handed pitchers, as
are multi-line agencies or niche players and those in fast-growing urban
areas. Top-performing middle-market firms are still in great demand. In
all these categories, the high prices can best be explained due to
intensified competition among the top organizations in the market. In
other words, a Yankees-sized payroll means there are more superstars in
pinstripes.
Record-breaking deal volume and rising multiples of EBITDA may be luring
more agencies to suit up for free agency in the M&A field. As in
baseball, I expect valuations will continue to increase for the best of
the best but remain the same for the average player. Market dynamics
such as product rates and organic growth rates will continue to drive
supply and demand and impact valuations. If other market factors, such
as a changes in contingent commission practices negatively affect "Main
Street" brokers occurs, consolidation may quicken even further.
Earn-outs will continue to play a role in transaction valuations and may
drive some transaction offers to reach 9- or 10-times-baseline-EBITDA.
However, we expect to see some firms battered by the tough market
conditions who are "forced to sell" to expect multiples in the 5.5-times
to 6.5-times range.
Finally, as the age of the independent agency owner continues to
increase and the industry faces the lack-of-talent factor, I strongly
believe smaller independent agencies will continue to decline in
numbers, which will continue to fuel the M&A market.
So before you file for M&A free agency, make sure you understand the
market dynamics and other contract variables so you know where you fit
in. Are you a Derek Jeter or just the below average journeyman? The
answer will often depend on not only what team you play for next season
but also how valuable your next contract will be.
Figure 1
Agency Value as a Multiple of EDITDA
| Type of Transactions | 2005 | 2006 |
| Platform agency to bank | 7.50 - 8.25 | 7.50 - 8.50 |
| Agency to public broker | 6.50 - 7.25 | 6.75 - 8.00 |
| Agency to bank that already has insurance foundation | 6.50 - 7.25 | 6.75 - 8.00 |
| Agency to privately-held agancy | 5.25 - 6.00 | 5.25 - 6.00 |
Source: Mergerstat, Pratt's Stats, Public Filings, and Hales Private Databases
Figure 2
Agency Value as a Multiple of Revenue
| Type of Transactions | 2005 | 2006 |
| Platform agency to bank | 1.75 - 2.50 | 1.75 - 3.00 |
| Agency to public broker | 1.50 - 2.00 | 1.50 - 2.25 |
| Agency to bank that already has insurance foundation | 1.50 - 2.00 | 1.50 - 2.25 |
| Agency to privately-held agancy | 1.00 - 1.25 | 1.00 - 1.25 |
Source: Mergerstat, Pratt's Stats, Public Filings, and Hales Private Databases
Figure 3
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