by Bobby Reagan, March 2007

National Underwriter

The level of merger and acquisition activity within the insurance distribution system has been active for years.  Up until recently, the volume of activity has been driven by financial institutions, consolidators and the public brokers, excluding the top three.  Over that same period of time, the prices being paid have trended up largely due to the aggressive pricing of the financial institutions.  Historically, private equity has been a part of the landscape but they have not driven the market either based on the volume of activity or based on the aggressiveness of their pricing and valuations.  The necessity of these private equity firms to liquidate their investments in five to seven years while achieving high rates of return have limited the values that private equity investors are willing to put on insurance agency/brokerage operation.  As evidenced by what we have seen with USI and Hub, that has changed.

Goldman Sachs is going to be acquiring USI for a total price of approximately $1.4 billion.  This represents a multiple of 12.0 times its pro forma trailing 12 months EBITDA.  Morgan Stanley and Apax are acquiring Hub for a total purchase price of $1.8 billion.  This represents a multiple of 12.5 times its pro forma trailing 12 months EBITDA.  Within the insurance distribution system, these are large transactions that are very aggressively priced.  The EBITDA multiples being paid are not only premiums of their publicly traded values but also trump the multiples being paid by even some of the most aggressive other acquirers.  Why are these guys so aggressive?  What has changed?  What are they seeing within the insurance distribution system?

Well, the first answer that you typically hear, is that there is a tremendous amount of private equity money looking for a place to be invested.  On top of that, many feel that the deterioration of alternative investment options has made the insurance space more attractive.  We have also seen that it is difficult to be a public company due to Sarbanes-Oxley, the challenge of public scrutiny and the problems created by strategies that result in dips in earnings.  Clearly, it is a lot easier (and more profitable) to operate as a private company and, as a result, many firms are finding it advantageous to shed public ownership.

In addition to these factors, though, I believe that the investments in USI and Hub were driven by a number of attributes of the insurance distribution system that are very appealing to prospective investors.  Consider the following for starters.  Aside from the initial investment to purchase these entities, the insurance agency/brokerage business is not terribly capital intensive.  That is appealing.  The insurance agency/brokerage business can also generate a lot of cash.  When you add the cash that is generated to the appreciation of the value of the asset that can be achieved, you can have some outstanding returns.  If the private equity investment is also leveraged, which many of them are, it can further increase the returns that can be achieved.

In addition, the insurance distribution system is a mature industry but, with some exceptions, it is not terribly sophisticated or terribly efficient.  It is the best distribution system available and its long term future looks bright.  At the same time, we all know that there is a lot of room for improvement.

Many of the smaller players within the industry have some very talented employees but are limited by a lack of scale, clout and capabilities needed to service large commercial insurance customers.  At the same time, there are a number of the largest brokers that do have scale, clout and significant capabilities but they find themselves limited by inefficient organizational structure, ego and the ability to create an environment where the best and the brightest want to work. 

All of this would suggest that there is a significant opportunity for those brokerage operations that are able to achieve a level of critical mass, sophistication and the capabilities to serve their customers, while at the same time creating a corporate culture that is entrepreneurial, focused, sales driven and one that will attract the best and the brightest.  The potential of insurance agents and brokers to achieve these type results is not just theory.  We are all seeing firms that are capable of achieving sustainable pre-tax profit margins in the high 30s while we are also seeing firms that are capable of achieving consistent organic growth in the mid to high teens.  Superior performance can be achieved as demonstrated by these firms that are distancing themselves from the rest of the pack.  The superior performance of the industry's top players certainly creates a vision for these private equity investors of the kind of results that can be achieved with their acquisitions. 

It is unlikely that these private equity firms are assuming that success will come exclusively from organic growth and improved operating margins.  Their assumptions also assume that they will be able to make accretive acquisitions.  If they are willing to pay 12 times EBITDA, they can do as many transactions as they want but they won't be accretive.  They will need to find a price at which they can get deals done that will also create value.  That may be a challenge.

Well, how should those of us within the insurance distribution system react to the investments made by these private equity firms?  To begin with, I think it speaks well for the future of the industry.  I think it supports the fact that there are great investments still to be made within the industry.  It also suggests that some very bright people, that have studied our industry carefully, still feel that there are great opportunities to make such investments and that these investments will achieve attractive returns.

Unfortunately, we won't know for a number of years whether or not these private equity assumptions and investments will pay off.  In the meantime, these investments are a positive endorsement of our insurance distribution system and should provide some stimulus to the level of interest and the aggressiveness of other potential acquirers.