Hold ’em or fold ’em?

Not that buying or selling an insurance brokerage is a game of poker, but I am reminded of the song by Kenny Rogers. ‘You got to know when to hold ‘em, know when to fold ‘em, know when to walk away, know when to run.’ At the moment, brokerages are being sold at historically high multiples of commission income. Among the questions facing potential buyers and sellers is whether these multiples will continue to rise, whether they will plateau or whether they will start to decrease.

I wrote a blog a few days ago suggesting there are reasons to believe these multiples may plateau or start to drop. That blog has generated some discussion. While this is a good thing, it has made me realise that I should have elaborated on some of the points I raised in that earlier posting.

Although the selling price of a brokerage is often expressed in terms of a multiple of commission income, the actual calculation of the value of a brokerage is normally based on a multiple of anticipated earnings. For the sake of argument, let us imagine a brokerage that generates $1 million in annual commission revenue. If the potential purchaser reckons that the brokerage will produce future net earnings of $400,000 a year and if the purchaser is prepared to offer a multiple of eight times EBITDA (earnings before interest, tax, depreciation and amortisation), the purchaser will offer $3.2 million. In this example, it can truly be said that the brokerage was offered 3.2 times commission even though the original calculation was based on EBITDA.

If there is good reason to think that this same brokerage will generate future net earnings of only $350,000, that same buyer may well make an offer of only $2.8 million. The multiple of earnings hasn’t changed. It’s still eight times EBITDA. However, the reduction in anticipated earnings has triggered a reduction in the multiple of commission income.

There are a number of factors that can lead to an expectation of lower EBITDA. As an example, if personal lines automobile premiums fall off in the future due to government-mandated rate decreases or because of a decline in the need for individual insurance (i.e. self-driving cars or car-sharing services), many brokerages could see their commission income reduced. This impact on commission income could include a reduction in Contingent Profit Commission (CPC). For any brokerage, a reduction in commission income, whether regular commission or CPC, could lead to a decrease in the brokerage’s projected net income (EBITDA).

A risk I did not address in my earlier blog is disintermediation. The word itself is quite a mouthful. A simple definition is ‘cutting out the middleman’ (or perhaps I should say ‘middle person’). Some industries have already been hit hard. Think of travel agencies. There was a time when virtually all airline tickets were purchased through a travel agency. Now, the idea of calling a travel agent to buy a ticket to fly from Toronto to Calgary seems quaint. For insurance brokerages, the threat is that consumers will increasingly turn to direct writers, especially those with websites that allow for easy on-line quoting. This is a particular threat for automobile insurance because the product itself, in terms of the policy language, is standard across all providers.

In my earlier blog, I discussed the impact of interest rates on prices. No brokerage will be immune from a potential reduction in selling price due to the chilling effect of higher interest rates. However, many brokerages will be insulated from the effects of disintermediation and/or a reduction in the automobile insurance market. These would include brokerages that derive a very large portion of their commission income from commercial insurance as well as brokerages that write a significant volume of group, personal lines business.

For a brokerage with a book of business comprised largely of regular, personal lines accounts with a significant portfolio of automobile insurance policies, there is a risk that the day will come when potential purchasers will contemplate a reduction in the brokerage’s future net income (EBITDA). If this happens, the selling price could end up being a smaller multiple of the brokerage’s current commission income.

There is certainly no indication that this type of thinking is taking place now. Today, if a potential purchaser attempted to reduce an offer price for any of the reasons I have given above, he or she would risk being trampled by a stampede of other potential buyers ready to place an undiscounted bid.

It remains to be seen whether this will always be the case. Brokerage owners who are contemplating a sale at some point in the foreseeable future have a lot riding on correctly guessing where the market will head.