The Agency Acquisition Market is Down, But Not Out
by Jim Campbell, July 2009
National Underwriter
From 2006 through 2008, the mergers and acquisitions market for insurance agencies and brokerages was robust. Activity and valuations both soared as highly-motivated buyers competed against each other to get deals done. But by late-2008, conditions were changing, buyers were becoming more deliberate and deal activity was slowing. What happened?
To answer this question, let's first look at what was driving deal activity during the first half of the decade. From 2000 to 2005, the fragmented insurance distribution system was moving through a natural consolidation process. Both buyers and sellers were seeking the benefits of scale, including potentially higher margins and reduced volume-related pressure from carriers.
In addition, banks became aggressive acquirers of agencies during this period. The combination of natural consolidation plus active bank buyers drove a fairly consistent baseline of approximately 200 agency acquisitions per year. In fact, in five of the six years between 2000 and 2005, the total number of announced deals fell within five percent of 200.
But by 2006, additional factors emerged to drive deal activity to new heights. The softening commercial property & casualty market was creating a drag on organic growth and was encouraging some of the public brokers to acquire in order to meet Wall Street's earnings expectations. The public brokers' appetite for deals was further increased by an acquisition arbitrage opportunity. Their strong stock valuations meant some brokers could pay six to eight times EBITDA for an agency's acquisition and get credit in the public markets at nine times EBITDA. Motivated by both the need for growth and an arbitrage opportunity, the public brokers were the most active buyer group in each of the last three years.
Another key factor to emerge at this time was strong access to acquisition capital. Investment capital was becoming more abundant and debt was relatively inexpensive. Private equity groups that had long-admired the economies of insurance distribution seized the opportunity to acquire agencies using the highly-leveraged deal structures they prefer. By the end of 2008, four of the top 20 U.S. brokers were owned by private equity groups.
With the emergence of these additional factors, deal activity surged. In 2006 and 2007, activity was more than 15 percent above the 200-deal-per-year baseline established for the first half of the decade. And in 2008, the 264 announced deals beat the baseline by more than 30 percent.
But by the late-2008, many of the factors that had been driving deal activity to record levels were receding and deal activity was slowing. Specifically, each of the following developments dampened demand for deals:
- Acquisition arbitrage was eliminated. The 2008 stock market crash reduced stock valuations for the public brokers, effectively closing the acquisition arbitrage window.
- Leverage became scarce. Investment capital and debt capital became less available and more expensive, restricting the activity of private equity buyers.
- Banks began preserving capital. The banking industry found itself at the epicenter of the financial crisis and focused more on preserving than investing capital.
By the end of last year, these developments were in full-bloom and deal demand was falling simultaneously across the three leading buyer groups (i.e., public brokers, private equity groups and banks).
But there was more. Uncertainty was permeating the market with a paralyzing effect. Markets dislike uncertainty, especially when it is as pervasive as it had become by late last year. Each of the following continues to contribute to the uncertainty in the current market:
- Economic uncertainty. By the second-half of 2008, it was clear the U.S. economy was in the grips of a brutal recession. Since then, GDP has continued to fall, unemployment has continued to climb, and there are no indications the end is near. As the economy has contracted, exposures have been reduced and agency revenue has fallen. The timing and pace of the recovery are unknown but will have a direct bearing on agency values.
- Political uncertainty. In late-2008, a new administration and new Congress were swept into office. With them came a greatly increased probability of healthcare reform and capital gains tax increases, both with the potential to directly impact the agency acquisition market.
- Soft market uncertainty. The first quarter of 2009 marked the 21st consecutive quarter of pricing declines in the commercial property & casualty market. A soft market depresses growth projections and can make both buyers and sellers hesitant. Although declining carrier profitability suggests a turning point in the market may be near, no one can predict the market with certainty.
So, is the market closed? No. Despite the uncertainty in the market and the declines in buyer demand, deals are still getting done. Approximately 45 deals were announced during the first quarter of this year. While this puts us on pace for the slowest deal year in a decade, it is a pace not materially off the baseline of activity we saw from 2000 through 2005.
Although it is unlikely deal activity or deal valuations will soon return to the levels of 2006 to 2008, deal momentum will likely return by late-2009. The natural drivers of consolidation remain in force. The industry is still fragmented, there are benefits to scale and demographic pressures will continue to increase as the Baby Boom generation moves through the industry.
In addition, private equity groups will re-enter the market when highly-leveraged deals become possible again. And community banks are increasingly interested in insurance distribution as a potentially relevant source of non-interest income.