AGENCY VALUATION: HAVE THE FUNDAMENTALS CHANGED?
by Bill Schoeffler
Which comes first, the chicken or the egg? There’s a general perception that agency value has been increasing during the past few years. Bill Schoeffler explains why this belief, which is partially true, results from a self-fulfilling prophecy.
During the past several years, there have been some notable acquisitions that seemed to push the agency value envelope. In some cases, banks were willing to pay top dollar for their first acquisition of a large, well-run firm. In others, publicly traded firms were able to exploit their high price-to-earnings ratios to offer a high price to the seller.
In reality, many of these deals weren’t quite as sweet as the word on the street. Large cash down payments provided a great start for the seller, but the next level of the purchase price was often tied to future performance. If these goals were not met, then payments beyond the down payment might not be realized.
Keep in mind that many of the famous lucrative deals were done between 2000 and early 2004. During much of this time, the hard market in Commercial Lines was in full swing. Employee benefits also increased at a double-digit pace in this period. Projected growth rates looked tremendous for insurance agencies, allowing sellers to play off these rates to project large future profits.
Buyers at that time, especially those outside of the insurance industry, had been willing to accept projections of double-digit annual growth (even as high as 30%) for the next few years. By using such high growth rates over several years, sellers could use the future earnings method of calculating value to project a high value.
Also during this period, profit/expense ratios for publicly traded brokers were peaking. The alphabet houses were able to use these high P/E ratios to make lucrative offers to sellers. What’s more, changes to accounting rules provided more favorable write-offs of purchases by publicly traded firms. Buyers were still in high gear throughout 2004. Brown & Brown, Arthur J. Gallagher, and Willis did 22, 17, and 10 acquisitions respectively during this period.
The question is: Have the fundamentals of agency value changed?
UNDERSTANDING AGENCY VALUE
Agency value is based on profitability and risk. For the most part, profitability has been flat during the past four years or so. Although the hard market added some nice top-line growth, such expenses as staff compensation, employee benefits, automation, and Errors & Omissions insurance all increased, having a neutralizing effect on revenue growth.
Because the first part of value — profitability — hasn’t changed much, this would not indicate an increase in value. Risk — the second part of agency value — hasn’t changed when looking at the overall industry. When factoring in these two elements of value, it appears that value should not have changed much during the past few years.
However, there’s a third factor in agency value: The marketplace. Perception becomes reality. If buyers outnumber sellers, then sellers will be able to play buyers against one another, pumping up the price. Sellers also hear the legends of other sellers getting high prices, so they become more willing to hold out for the big bucks. Herein lies the self-fulfilling prophecy. Because of the marketplace factor, agency value increased significantly between 1999 and 2004. As business appraisers, our firm has noticed an overall increase in value from about 10% to 25% during this period. Profitable, well-run firms posted increases of 20% to 35%.
So will the good times keep on rolling? The trend is for the rate of increase to drop. With the advent of the soft market, as profitability decreases, so will return on investment. However, as long as buyers continue to outnumber sellers, the marketplace factor will remain key. Because the “speculative seller” won’t sell for the true intrinsic value of the firm, but only for its perceived premium value, marketplace value will keep increasing.
A FINAL THOUGHT
There’s no magic to increasing your agency’s value. There are many factors that a buyer considers when looking at an acquisition. The main consideration is the ability to create and sustain a profit. The two key factors over which an owner has comparative control are profitability and risk. Capitalizing on the interest of the marketplace requires good timing from the seller.
Most buyers are interested in well-run firms that will enhance their current business situation. Agencies that are managed poorly have fewer interested buyers and often get low offers for the business.
A good rule to follow is to run your business as if you were going to sell it today. Streamlined operations have fewer problems and generate better bottom-line profits. The owners of these agencies will make more money now and in the future.
Bill Schoeffler, CIC is a partner in the consulting firm, Oak & Associates, based in Northern California. The firm specializes in financial and management consulting for independent insurance agencies, including valuations, mergers acquisitions, clusters, sales and marketing planning as well as perpetuation planning. Schoeffler can be reached at (707) 936-6565 or by e-mail at [email protected]. Reproduced by permission from Insurance Journal magazine.