by Kevin Stipe, July 2004

National Underwriter

With a weekly stream of merger & acquisition-related press releases and analysis, agency principals are more attuned than ever to the agency M&A market.  As a result, it seems their behavior is increasingly influenced by what they hear. 

Today, many agency principals are like homeowners who evaluate every investment in their home based on how it will impact resale value rather than simply whether the investment will make their home a better place to live.  They've taken Stephen Covey's advice to "begin with the end in mind" -- which isn't necessarily a bad thing, so long as the information they are relying on is accurate! 

We find that there are a number of common misconceptions that need to be corrected-- or at least balanced.  Have a little fun and test your own knowledge of the current M&A marketplace by answering the following questions either "True" or "False":

1. With a significant number of agencies selling for more than 2.0 times revenue, the typical agency?s value now is in the ballpark of 2.0 times revenue.  False.  Yes, there have certainly been a number of high-profile deals such as McGriff, Seibels & Williams and Hobbs that sold for multiples north of 2.0, but the valuation in these deals remains the marquee-deal exception rather than the rule.  For agencies with annual revenue of less than $5.0 million (which constitutes the vast majority of transactions) revenue multiples most commonly fall between 1.25 and 1.75. 

   It is widely known that buyers don?t use revenue multiples to determine value.  However, they will express value by use of a revenue multiple.  The problem with the use of a revenue multiple is that it's a shortcut which totally ignores the single most important factor in valuation, namely profitability.  If you are attempting to discern roughly what your agency is worth, or if you are looking at a potential acquisition, a better shortcut is to apply a multiple to the agency's EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization.) after eliminating non-recurring income and/or expenses and after normalizing shareholder compensation and perks to levels expected under 3^rd party ownership. 

   Although EBITDA multiples range widely, they most often fall within a range of 6.0-7.0.  Variables that influence the EBITDA multiple include the expected future growth rate of the profits of the business and the risk that the future profits the buyer is counting on won't materialize once acquired.  The higher the expected growth in profits and the lower the perceived risk of disappointment, the higher the EBITDA multiple. 

   A simple shortcut for determining a multiple of revenue is to multiply the EBITDA valuation multiple (6.0 for example) times an agency's EBITDA as a percentage of revenue (25% for example) to determine a resulting multiple of net revenue (6.0 times 25% equals 1.50 in this example.)  A 2.0 multiple of revenue is uncommon because most agencies don't possess the rare combination of high profit margin, high expected growth, and low perceived risk necessary to motivate a buyer to pay such a high price.

2. Given that acquirers base their pricing on a multiple of EBITDA rather than a multiple of revenue, the most effective way to maximize an agency's value is to maximize its profit margins.  False.  This is one of the most destructive misconceptions in the marketplace today, and has caused many agencies to be ill-prepared for the inevitable softening of the P&C marketplace.  As agency principals have become profit-margin focused in recent years, many have gone too far and mistakenly under-invested in the next generation of sales and service talent.  In doing so, they are poised to "hit the wall" in terms of agency growth.  A savvy buyer looks for the optimum level of current profitability and future growth potential and will pay the highest overall price for the right combination of the two. 

3. Banks have generally "overpaid" for agencies they have acquired and have frequently been disappointed by the results of their acquisitions.  False.  Many agency principals have arrived at this conclusion through a combination of a) talking to a former agency-principal friend who sold to a bank and has come to realize he liked his old boss (himself) better than his new one (the bank), and b) reading the trade press accounts of certain banks getting out of the business.  The facts are: 1. Most agency principals don't prefer any owner - bank or otherwise - over themselves, but see selling their business as a necessary perpetuation-driven evil. 2. The vast majority of bank-agency divestitures have not been caused by a change in the bank's strategy due to poor agency results.  Instead the divestitures were the result of a sale or merger of the agency-owning bank with a larger bank that did not want to be in the insurance business.  In the most recent American Bankers Insurance Association (ABIA) Study of Leading Banks in Insurance, only 6.5% of banks who had acquired an agency were disappointed with the results of the acquired agency.

4. A bank will typically pay a premium for its first acquisition, but then will reduce its pricing in the unlikely event that it needs to do any subsequent acquisitions.  False on two counts.  First, as banks have become more experienced in the insurance brokerage business, many have learned that quality is worth paying for, wherever and whenever it can be found.  As a result, the pricing for subsequent acquisitions has often equaled or exceeded that paid for the initial one.  Second, future acquisitions by banks already in the business are anything but unlikely: banks that have done one or more acquisitions are aggressively planning for more.  The ABIA study indicates that 88% of those that have acquired an agency plan to buy another.

5. With so many agencies having sold over the past few years, buyers must be running out of agencies to acquire.  Definitely false!  Yes, there is a declining number of large, platform-type agencies with revenues greater than $10 million, but these represent a small fraction of the agency universe.  The overall number of independent agencies remains staggering, with various estimates in the neighborhood of 40,000.  The table below provides a recent estimate of the independent agency population by Reagan Consulting. 

To put the data in perspective, Brown & Brown, the most active acquirer of agencies over the past 4 years (72 acquisitions) reported total revenue in 2003 of $551 million.  This compares with the aggregate amount of independent agency-controlled (and therefore potentially acquirable) revenue of nearly $35 billion.  This market is therefore roughly 62 times the size of Brown & Brown! 

The implications of this information are fascinating.

• Large agencies with revenues of $10 million or more are becoming increasingly scarce (and therefore valuable) businesses and have extremely bright future.  A sense that some of these players have that they need to sell-out now to avoid "missing the moment" is in our view misplaced.  The scarcity of these larger players, coupled with the attractiveness of the market-share they control in their region or product-niche, will provide buoyancy to their value in the future regardless of what happens to p&c pricing.

• Agents and brokers that regularly rely on buying agencies to supplement their organic growth need not be concerned with running out of candidates, so long as their focus isn't confined to the largest agencies.  There is a vast middle market which we would define as consisting of agencies with revenues ranging between $1.25 and $10.0 million.  The aggregate acquirable revenue of this group totals roughly $18.6 billion.  However, to complete the large number of these acquisitions necessary to produce meaningful growth each year will require a core competency in sourcing and executing acquisitions that only a few have a stomach for developing.  But based on the numbers, this group should be able to satisfy acquirers-- appetites for years to come.

• For banks and others desiring to get into the business in a meaningful way, true "platform" agencies are becoming increasingly scarce and difficult to acquire.  Some who have investigated getting into the insurance brokerage business have decided to invest elsewhere, concluding there isn't enough acquirable revenue to make the effort worth it.

With the top buyers in the marketplace noting that their acquisition pipelines are bursting with more and higher quality candidates than ever before, it appears they will continue to drive a rapid consolidation of the industry for the foreseeable future.  With fact separated from fiction, agency principals can determine whether their best strategy is to beat 'em or join 'em.

Kevin Stipe is a senior vice president and principal of Reagan Consulting, Inc., an Atlanta-based management consulting firm that developed and produces the "Independent Insurance Agents and Brokers of America Best Practices Study."  The Best Practices Study may be accessed free of charge at Reagan Consulting's website www.reaganconsulting.com.  Kevin may be reached at (404) 233-5545 or by email at Kevin@reaganconsulting.com.