How Do Public Broker Valuations Affect Your Independent Agency?
by Brian Deitz, April 2008
National Underwriter
In the first quarter of 2008, public equity markets have struggled. The Dow Jones Industrial Average, the S&P 500 and the NASDAQ are all down. So, too, are the publicly-traded insurance brokers. Indeed, the valuations of public brokers, expressed as a multiple of EBITDA-Earnings Before Interest, Taxes, Depreciation and Amortization-are at levels not seen since the late 1990s.
Other than a potential hit to your retirement account, what does this mean to independent agencies? It may seem like a distant phenomenon, but the current public broker valuation struggles can signal opportunity for the financially sound independent agencies, both in the mergers and acquisitions market and in day-to-day operations, by leveling the playing field somewhat between the two breeds.
What has happened to public broker stock prices? Let's start with 2007, when the stock performance of the six publicly traded brokers (Aon, Arthur J. Gallagher, Brown & Brown, Hilb Rogal & Hobbs, Marsh & McLennan and Willis), was, on average, negative. Together, the six publicly traded brokers were down 3.6 percent.
While a 3.6 percent drop isn't catastrophic, the publicly traded brokers were used to stock prices rising, on average, 7.9 percent annually for the six years prior to 2007, with no negative years. The 3.6 percent number is also slightly misleading, because Aon was actually up almost 35 percent in 2007. If Aon is removed from the analysis, the remaining five publicly traded brokers saw their stock prices fall 11.3 percent on average in 2007.
This year has provided no relief, as the brokers have continued to fall. On average, their stock prices are down 14.3 percent in the first quarter of 2008.
The continued fall in stock prices has significantly reduced public broker EBITDA multiples-perhaps a more important indication of the market's outlook on an industry than the absolute stock price trends. In recent memory, public brokers have consistently traded at multiples of 10.0-times-EBITDA or higher-meaning that the public brokers were worth, to investors, more than 10 times their annual EBITDA. However, at the end of March 2008, the average public broker EBITDA multiple was only 8.0 (see graph below).
Publicly Traded Broker EBITDA Multiples (1998 - Q1 2008)
The market, in lowering EBITDA multiples, is reacting to overall economic weakness and, more importantly, the softening property-casualty market. Lower EBITDA multiples signal the market's concern regarding the public brokers' ability to grow revenues and earnings.
M&A Impact
So, public broker valuations are low-perhaps even just temporarily. What does that mean to you? Public brokers are among the most active M&A participants, and their newfound valuation lows could have an effect on the dynamics of that market.
Over the past several years, when public brokers were trading above 10.0-times-EBITDA, they found themselves with a bit of an arbitrage opportunity. The brokers could buy agencies at 7.0- or 8.0-times-EBITDA and be rewarded in the public markets at 10.0-times-EBITDA or more.
For example, suppose a public broker purchased an agency with $2 million in EBITDA for 7.5 times-or $15 million. When the deal was completed, the market would reward that public broker at 10.0-times-EBITDA or higher, crediting them with value of $20 million or more. However, as the public broker valuations have come down, this arbitrage opportunity, at least temporarily, has been significantly narrowed or eliminated.
In addition, publicly traded brokers, and other publicly traded buyers, may find it more difficult to use stock in an M&A deal, given current market conditions. Most acquirers evaluate acquisition opportunities by answering the question: Will earnings per share be greater after the deal (an accretive deal) or will they fall because of the deal (a dilutive deal)? When share prices are lower, buyers using stock in transactions will have to issue more shares to deliver the same value to sellers, making it more difficult to do accretive deals.
While organic growth struggles and attractive opportunities will continue to motivate public brokers to acquire agencies, some of the "cushion" has been taken out of the public broker acquisition strategy. Public brokers may be slightly cautious, having to be more selective in deciding which deals to pursue.
This caution may create opportunity for independent agencies to compete for attractive agencies looking to be acquired or for merger partners. Traditionally, the public brokers have had an advantage over independent agents in this battle, due primarily to the arbitrage opportunity discussed above, producer compensation structures and access to capital. However, as the arbitrage opportunity for the public brokers narrows and they potentially get more cautious, the playing field could shift. The field isn't likely to be completely even, because public brokers will still have an advantage. However, this may represent a window of opportunity for independent agencies looking to grow through M&A but who don't face increased scrutiny from Wall Street or a board of directors.
If the public brokers to get more cautious, we still don't anticipate significant slowdowns in activity or rapid valuation decreases in the M&A marketplace. High quality agencies will continue to command premium valuations from the most strategic buyers. More frequently, however, those buyers could be other financially sound independent agencies.
Other Benefits
What do public broker valuations mean to agencies that are seeking to remain independent and are not interested in entering the M&A market? It may mean increased opportunity to compete with publicly traded brokers in the battle for clients and talent. When the marketplace lowered broker stock prices and EBITDA multiples, it did so because investors weren't as confident in the brokers' abilities to grow earnings and deliver returns to investors.
Public brokers can deliver returns to shareholders in three basic ways: organic growth, acquisitive growth and margin enhancement. Organic growth, in the current soft p-c market, has been difficult, with the public brokers growing organically at only 1.7 percent in 2007. As discussed above, given current market valuations, the public brokers may also have to be more cautious regarding acquisitive growth. That leaves only one area in which to generate significant shareholder returns...margin improvement. Public brokers may not have the capacity to invest as much as they have been in producers, value added resources and client support if they are looking to drive margin enhancement in a soft market.
That doesn't mean that they'll be giving quality producers and key clients away - far from it. However, on the margin, the competition for a free-agent producer may be tilted towards independent agencies for the time being. The battle for talent has traditionally been a pretty fair fight, with public brokers touting resources and size and independent agencies touting independence and equity opportunity. Now, with potential restrictions on margin dollars to invest in producers and a stock currency at lower valuations, it may be tougher for the public brokers to win that battle. In the same way, independent agencies may have opportunities to invest in value-added resources and client support to pick up key middle-market accounts.
Independent agents who don't have the intense external pressure on shareholder returns may be better positioned to invest in producers and value-added resources in this market. These investments are likely to improve the long-term competitive position of the agencies that are able to successfully make them.
Conclusion
The valuation pressures we've discussed aren't necessarily specific to the publicly traded insurance brokers. Any brokerage in this industry that is held by a private equity firm or contained within a publicly traded parent (such as a bank) may also face these pressures from time to time. And while the public brokers may be down, don't make the mistake of counting them out. They are real players who have significant market share and clout. However, they do have investor pressures that independent agencies will not face at times when the stock market is down. And this pressure may open up a window of opportunity for independent agencies, both in the M&A marketplace and in daily competition.