Latest Trends in P&C Brokerage Valuations – Let’s Talk Multiples

While we are always monitoring changes to financial issues related to the P&C insurance industry, we have long stopped trying to predict the future, especially in terms of the valuation of brokerages. Having said that, we are in the unique position to observe brokerage transactions on a regular basis, talk to the parties involved, and try to make sense of the motivations behind the deals being made.

Although it is common for both buyers and sellers to talk about the multiples implied by a transaction, whether based on revenue or EBITDA, transaction prices are ultimately based on the market’s expectations of investment return (i.e., future cash flow) and the perceived risk of earning it. For years, we saw pricing in the range of 7x to 8x normalized EBITDA (operating earnings before interest, taxes and amortization) or 2.5x to 3x commission revenue. This suggested the market felt a 12% to 15% pre-tax return on investment was adequate, assuming a 25% to 30% EBITDA margin. Consolidators would typically seek to improve that return through efficiencies, better management and higher commissions.

RECENT DEVELOPMENTS

Over the past twelve months there has been another significant price increase for certain books of business. Why is this? On a basic economic level, prices will increase when demand is greater than supply. As the industry consolidation continues, the available supply of good books of business has fallen, leading to greater competition between buyers and increased prices. However, this does not fully explain why pricing is as high as it is. So, what else is going on?

First, we should recognize that the market for books of business is not homogenous. Prices vary widely depending on the books size, composition and quality.

Second, the motivations and circumstances of purchasers is varied. Our observation is that there have been several changes in market dynamics, including:

• Insurance companies committing themselves to move downstream in the distribution channel;
• Purchasers are willing to accept return on investment below 10%;
• A low cost of capital is an incentive for insurance companies and consolidators to acquire brokers; and
• They are pricing in the potential future market disruption, such as online distribution.

VALUE DIFFERENTIATION

While there is a consensus that prices and multiples have significantly increased, the truth is that transactions take place with a wide range of multiples, anywhere between 8x to 15x EBITDA and potentially higher.

What factors influence this disparity in pricing?

At the low-end of the range, we tend to see following common scenarios:

• A seller decides not to go to auction and doesn’t obtain competitive offers;
• There is little or no opportunity for the purchaser to achieve synergies;
• Less than a controlling interest is being offered for sale; and
• There is uncertainty whether the book can be transferred to new ownership.

At the mid-range, we might expect to see the following scenarios:

• A mid-sized commercial brokerage with commissioned producers;
• Less than a 100% interest is being offered for sale;
• A mid-sized brokerage with limited ability to run an effective auction; and
• A brokerage that consistently has poor underwriting performance

The highest prices are achieved for a variety of reasons. Some typical scenarios include:

• A well-managed auction where numerous strategic purchasers compete for the brokerage;
• Specialized books of business with good underwriting results;
• Large multi-line brokerages; and
• Proven on-line marketing capability.

MORE THAN A MULTIPLE

You might have noted that we have tried to avoid talking too much about revenue multiples, instead focusing on profitability represented by EBITDA.

Although future expected cash flow ultimately drives pricing, we would suggest that pricing is consistently and increasingly being expressed as a multiple of revenue due to the fact that purchasers feel that the expense structure is less important than the premium. That is, they believe they can take the revenue, plug it into their system and achieve operating profit margins of 35% and greater.

While we agree this is possible, our experience is that more profitable brokerages still tend to realize higher pricing. This means that brokers should not neglect the existing profitability of their book. Improving a brokerage’s profitability will not only improve the cash flows generated while they own the business, but will also increase the likelihood that they can achieve prices at the high end of the range when they ultimately decide to sell.

While the market will ultimately determine the price of your brokerage, it is safe to say the prices are high. Should you have any questions or want to share information about current market conditions we encourage you to contact Mike Berris.