M&A Activity in the P&C Insurance Industry – The Limits of Current Pricing

Over the years, we have written several pieces about the state of mergers and acquisitions (M&A) activity in the Property and Casualty (P&C) industry and think it is safe to say the market has been, and will continue to be, robust in the foreseeable future. Having said that, there are limitations to this growth. We feel this is a good time for broker owners to better understand the dynamics that drive pricing in order to better position themselves for an eventual sale.

While we can only accurately speak about broker transactions when we are directly involved, we believe we have a good understanding of the overall marketplace. Before discussing the current marketplace, let’s step back and look at where the market was ten years ago.

In the three-year period, including 2007, 2008 and 2009, we were involved in 13 transactions. Revenue multiples ranged from 2.1X to 3.2X gross commissions including contingent commissions. The median price paid was 8.0X EBITDA with a revenue multiple of approximately 2.6X. This implies the average EBITDA margin was 30%.

In addition to strong prices, deal terms were also tilting in the vendors’ favor. For example, earn-outs became less common, working capital targets greater than $nil were effectively removed and post-closing reps and warranties were less stringent. There was also a lot of competition for brokerages and books of business effectively bidding up prices. Small brokers, regional consolidators, as well as national consolidators were all very active in M&A.

In the years following 2009, we have continued to see prices increase, but the market dynamics have evolved. While there are many reasons that drive pricing, let’s look at some changes that have likely impacted pricing. These include:

• Faced with a mature market and few acquisition targets, insurance companies are aggressively looking for ways to protect and expand their premium base;
• Most of the major banks have become more comfortable with financing the goodwill related to books of P&C business;
• Small brokers have, for the most part, been priced out of the M&A market;
• Large, well-managed brokerages have become more efficient and profitable. This allows them to expect more synergies from a potential acquisition.

All these factors combined have resulted in prices increasing even further. At present, pricing in the range of 3.0X all the way to 4.0X gross revenue are not uncommon.

While a seller might not care how the buyer is going to make a return on their investment, we can assure you that buyers do, and this is inevitably impacting the market. For most brokers, a 4.0X multiple translates into a return of less than 7%. Although we won’t get into the financing in this blog, we can tell you that at this rate of return, buyers simply cannot get the financing they need, and even if they could, the return does not justify the risk. So, what is going on given that values are holding for now?

We believe that it is not a good strategy to assume your brokerage will eventually sell for an ever-increasing multiple of revenue, or even be at the high end of the current ranges. Well-managed organizations and profitable books of business will continue to attract high prices if offered in an appropriate manner to the right potential purchaser.

While not mutually exclusive, we like to focus on four streams for a potential exit. These are outlined as follows:

STREAM 1

Brokers that want to divest with mixed books of personal, auto and commercial business with normal underwriting profit will generally be able to extract the highest price in a controlled auction process with the business being offered broadly to a pool of potential buyers. Smaller brokers, as well as regional and national consolidators, are being careful about their acquisitions. They are picking up fewer acquisitions and are looking for those who are either unaware of market conditions or who do not want to run an auction. It can be a challenge to get multiples at the high-end of the range unless they can demonstrate that the book can easily be bolted onto to an existing brokerage.

STREAM 2

Direct writers and underwriters with broker partners or subsidiaries have been very active in the marketplace. Acquisition of books of business serve several purposes. First, it protects their premium base. Second, their required return on equity is generally lower than might be expected with a private business. They are generally looking for a specific type of book composition and undertake a rigorous due diligence process. While you can usually extract top dollar for the business, you must be able to demonstrate the value of the book.

STREAM 3

Specialty brokerages, including large commercial brokers are very active in the marketplace, and if conditions are right, they can pay a premium price for a high-quality book of business. Transition of the book and key personnel are important. Also, a successful deal can often require a lot of creativity to bridge any pricing gaps. A clear understanding of the value of the book, any available synergies and even sharing in the prospective risk can yield a great return for the selling broker.

STREAM 4

Entering into partnership or merging several brokerage entities can offer tremendous benefits for brokers that need an eventual path out of the business. While often not offering an immediate full payout, they have many other advantages and under the right circumstances, can be a good option. We have worked with several brokerage that have successfully created arrangements with ultimate returns significantly greater than a one-time divestiture transaction.

We want to be very clear that there is no burning platform forcing a broker to make quick choices on succession. We are trying to remind the reader that there are two sides to every transaction and if conditions change, this ultimately will impact the pricing of brokerages and their related book of business. Knowledge, experience and careful planning can pay big dividends.

Should you have any questions or comments, we encourage you to contact a member of the Smythe Advisory team here.