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 is partially true and partly the result of a self-fulfilling prophecy.
During the past few years, there have been some notable acquisitions of agencies that seemed to push the agency value envelope. In some cases, banks were making their platform acquisition and thus willing to pay top dollar to their first acquisition of a large, well-run firm. In other cases, publicly traded firms were able to exploit their high price-to-earnings ratio 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 often was tied to future performance. If the future performance goals weren’t met, then payments beyond the down payment might not be made.
Keep in mind that many of the famous lucrative deals were done between 2000 and early 2004, when the Commercial Lines hard market was in full swing. Employee benefits increased at a double-digit pace for the past several years, as well. Projected growth rates looked great, allowing sellers to project large future profits. Buyers at that time, especially those outside the insurance industry, were willing to accept projections of double-digit growth (even as high as 30%) for the next few years.
Also during this time period, Profit/Expense ratios for publicly traded brokers were peaking. Publicly traded firms were able to use their high P/E ratios to make lucrative offers to sellers. Another factor is that changes to accounting rules provide more favorable write-offs of purchases by publicly traded firms. Brown & Brown, Arthur J. Gallagher and Willis did 22, 17, and 10 acquisitions respectively during 2004.
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. The hard market has added some nice top-line growth with few added expenses. However, expenses increased independently of the hard market. During the past few years, staff compensation, employee benefits, automation, and E&O premiums all grew, with 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. So, 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. Also, as sellers hear about other sellers getting high prices, they become more willing to hold out for the big bucks. This creates a 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%.
Will these good times keep on rolling? The trend is for the rate of increase to drop. With the advent of the soft market, decreasing profitability will drive down return on investment. However, because buyers will still outnumber sellers, the marketplace factor will remain a key. The “speculative seller” won’t sell for the true intrinsic value of the firm, but only for its perceived premium, thus keeping the marketplace value up.
A FINAL THOUGHT
There’s no magic to increasing your agency’s value. There are many factors that a buyer considers when looking at buying an agency. The main consideration is the ability to create and sustain a profit. The two key factors over which you have comparative control are profitability and risk. Capitalizing on the interest of the marketplace requires good timing by 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.
A good credo to follow is always to run your agency as if it’s going to be sold today. Streamlined operations have fewer problems and generate higher bottom-line profits. The owners of these agencies will make more money now and in the future.