AGENCY FINANCIAL MANAGEMENT

WHAT'S IT WORTH TO YOU?

Valuations in the heated agency acquisition market

By Paul J. Di Stefano, CPA, CPCU

One of the few positive areas of the U.S. economy has been the insurance brokerage business. Many of Harbor Capital Advisors' clients are experiencing rapid revenue growth as a result of both price increases and new business. As we all know, pricing increases on commercial property/casualty business have been quite dramatic, especially since the fourth quarter of 2001. In addition, new business opportunities have arisen out of client dissatisfaction with the way some pricing increases have been delivered by many incumbent agents. Giving a client little advance notice of dramatic increase in premiums, sometimes as large as 100%, is not the most advisable bedside manner when it comes to client retention. Enterprising agency producers are taking full advantage of taking BORs from competitors' disaffected clients.

Those same pricing increases have fallen, for the most part, to the bottom line of the public brokers and accordingly boosted their price earnings multiples; thus translating into higher prices being paid by the public brokers for acquisitions. Acquisition multiples have also risen as a result of added demand coming from financial institutions seeking to grow their property/casualty operations through agency acquisitions. Larger agencies have not been the sole beneficiaries of the current competition for acquisitions by banks and national and regional brokers. Demand for smaller agencies that can be rolled into larger acquired platforms has also increased dramatically.

The result of all this pressure is acquisition multiples of earnings in the range of six to eight and sometimes higher. This represents a dramatic increase from the five to six multiples of earnings paid by acquirers prior to the beginning of the current hard market. From a seller's standpoint, the effect of these increases in purchase price multiples is compounded since it is being applied to higher agency operating margins. For example, let's look at a typical, well-run agency that two years ago had $1,500,000 in revenues and a pro forma EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) of $300,000 for a pre-tax margin of 20%. The same agency's results today conservatively might show $1,800,000 in revenue and a pro forma EBITDA of $450,000. The value of that agency two years ago, assuming a multiple of 6, using the high end of the range at that time, would have been $1,800,000. Applying a multiple at the middle of today's range would result in a valuation of $3,150,000 for an increase in value of over 75%.

While these results might seem dramatic, a similar effect can be seen in the stocks of public brokers such as Arthur J. Gallagher, Brown & Brown, and Hilb, Rogal & Hamilton where market capitalization of all these firms has increased markedly.

So how does one make an intelligent assessment of what an agency is worth at any point in time? If you are approached with an offer of six times EBITDA earnings, is that acceptable or should you seek out a higher offer? Harbor Capital Advisors' approach has been straightforward and consistent. We recommend that if you have decided to sell your agency for whatever reason--perpetuation considerations, to take advantage of a larger agency's leverage, or simply because you feel that the valuations may be at their peak, you should fully explore the market before making a decision.

A number of factors go into determining what multiple your agency can command in today's marketplace. The growth rate of the agency is one of the more important factors. Growth normally depends on several elements, including the number and quality of the agency's producers as well as the prospects for their continued tenure. Another important element in evaluating growth potential is the existence of programs or niches within the agency that can be expanded. Programs and niches are loose terms which can incorporate anything from blocks of business in which the agency has an expertise all the way to exclusive arrangements with carriers where the agency acts as an MGA or program manager.

Another factor in determining the multiple which an agency can command is the quality of the agency's staff. More and more, one of the motivating factors in acquisitions is the ability to access quality experienced people. Our clients indicate that it is becoming more and more difficult to find talent, and in many cases the cost can become prohibitive. If one of the high points of your agency is your agency's talent pool, acquisition multiples are likely to reflect that fact.

Market relationships are also becoming more and more important. Having quality relationships and good underwriting experience with a number of key carriers will make your agency more desirable to a potential acquirer.

While the financial aspects of a transaction are important, it is equally important to find the right cultural fit for your agency, since it is likely that you will be making a commitment to the acquiring organization for a number of years. Harbor Capital Advisors' goal is always to match up the buyer preferred by our client with the optimum shareholder value. Seem easier said than done? Remember that negotiations take place for a reason. If deals were done simply by accepting the first offer made, life would be very simple. The reality is that the buyer's goal is to purchase an agency at the lowest price possible, consistent with not losing the deal. The seller's goal is obviously diametrically opposed to that of the buyers. Many a seller has been lulled into a sense of security by a smooth initial approach by the buyer, only to ultimately realize that the buyer's offer, when made, is totally inadequate.

Many acquirers are fairly dogmatic in their approach stating that "we only pay five or six times pro forma EBITDA and no higher." That may or may not be true since there are always exceptions to every rule--and who said you have to play by acquirers' rules? When an acquirer dogmatically tells you what it will and won't do, you quickly realize that one entity is not the market. If they can find sellers that take what they perceive to be the easy way out and accept a first offer, more power to them.

In summary, the market for agents and brokers is a dynamic one where prices paid for acquisitions are reflective of the attractiveness of the agency and are ultimately a function of supply and demand. This is a unique time within our industry and many agents will seek to capitalize on that fact. If the determination is made to explore being acquired, remember that there is a lot at stake, so do so carefully with appropriate experienced representation. *

The author

Paul J. Di Stefano, CPA, CPCU, is the managing director of Harbor Capital Advisors, Inc., a national financial and management consulting firm which offers services to the insurance industry. Services include agency appraisals, merger & acquisition representation, strategic and management consulting. Harbor Capital Advisors, Inc., can be reached by phone (800) 858-2732, and through its Web site (www.harborcapitaladvisors.com).