Soft Market Spurs Some Brokerage M&As, but Other Agencies Put Off Making Deals
by Brian Deitz, September 2008
National Underwriter
The unavoidable topic in any discussion about the insurance brokerage industry today is the soft property-casualty market, and that chatter extends to the impact of declining prices and profitability on the mergers and acquisitions field.
Largely, the soft market is credited with driving continued strong deal activity, especially for public brokers with organic growth struggles. Deal volume in 2007 was at record levels, attributed primarily to public broker acquisition activity.
In 2008, public brokers such as Arthur J. Gallagher and Brown & Brown continued to match down the acquisition path. Through mid-August, Gallagher is on pace to easily exceed last year's activity, while Brown & Brown has already surpassed its 2007 acquisition total.
However, the effects of the soft market on M&As go beyond the obvious. Sure, the soft market will drive some deal activity, but it has other ways of ensuring that it stays at the forefront of the conversation.
We've noticed three additional effects the soft market has had on M&As in 2008. For agencies considering buying or selling, recognizing these less-obvious soft market trends is essential to a complete understanding of the M&A marketplace.
The Soft Market and the Hesitant Seller:
Hungry for growth, some buyers have been driven by the soft market to be even more aggressive. Some sellers, too, are being pushed toward a sale by the soft, hoping to capitalize on their agency's value before things get worse. Interestingly, though, for certain sellers, the soft market is bringing out the opposite reaction. Why?
In an acquisition, sellers are typically rewarded by buyers in two ways-a guaranteed purchase price and additional consideration available though an earn-out, based on the agency achieving future financial goals. An agency maximizes its value in a deal by excelling after the closing and thus capturing as much of the earn-out as possible.
In the current M&A market, guaranteed pricing is at high levels, just as it was in 2007. However, as the soft market continues to constrain organic growth, some sellers are coming to view the earn-out portion of the purchase price as more promise than reality.
Consequently, it is more common for sellers, when evaluating offers, to place significantly less value on an earn-out than in previous years. With sellers perceiving earn-outs to be less attainable, the overall economics of a deal can be less compelling.
As a result, some sellers, who are otherwise interested in pursuing a sale of their agency, are choosing to wait out the soft market before entering the sale process. By delaying, they believe that they will have a better chance of securing more of the earn-out, thus receiving greater value for their agency.
Of course, with every potential reward comes risk. When these sellers decide to wait, they are taking a risk that guaranteed multiples will remain at current levels into the future, and that they will continue to grow or at least maintain, their books of business until the soft market relents.
The Soft Markets and The Elongated Earn-Out:
Due to its complexity, the earn-out is often the most heavily negotiated provision in an acquisition. Generally, the sellers want to minimize the length of the earn-out, while the buyer is at least partially motivated to lengthen it. However, the soft market influencing today's M&A discussions may be changing sellers' views.
We've seen, this year more than ever before, sellers considering longer earn-outs than buyers are offering. These sellers are requesting longer earn-outs as a form of protection against the current soft market, thinking that a longer earn-out gives the market more time to turn around-and when it does, so will their results. Imagine what extending the earn-out for a year could do for the ultimate purchase price if that extra year was the first year of a hard market.
The downsides of this strategy are also obvious. What if the market doesn't turn around? What if that extra year is another soft one, further depressing results?
Even in the face of these risks, some sellers in today's markets are willing to gamble on the p-c pricing turnaround and pursue a longer earn-out.
The Soft Market and The Absentee Buyer:
In 2007, Hilb Rogal & Hobbs was a major player in the acquisition market. HRH completed 10 acquisitions in 2007-acquiring, according to their annual report, over $150 million in annualized revenues.
However, HRH's pending merger with Willis has brought their acquisition activity to a stand-still. Arguably, this is an indirect impact of that familiar culprit-the soft market.
HRH stock price fell in the early part of the year after disappointing earnings announcements. The company's performance was attributed to (you guessed it) the soft market.
As the stock price continued to decline, deals became harder to do, but HRH became easier for Willis to buy. The soft market led the stock price downward, allowing Willis to pay the necessary premium to acquire HRH. With HRH now in the middle of its own sell-side process, it has effectively been removed from the M&A market as a viable buyer for independent agencies.
The absence of HRH, in itself, impacts the market, but HRH isn't the only buyer with reduced deal activity. The soft market can put pressure on financial strength and internal valuations, making deal activity more difficult for a variety of buyers. As buyers pull back, deal activity suffers.
In conclusion, deals are still getting done in 2008, and many are happening because of the soft market. Buyers and sellers continue to come together in transactions, and valuations remain high. However, thus far, deal activity in 2008 isn't what it was in 2007, and, as it turns out, the soft market that is the engine of deal activity for some is acting as a discourager on deal activity for others.