Wall Street has definitely cooled, but agency mergers and acquisitions have not. A quite active seller's market is experiencing its own “bubble,” with prices definitely exhibiting “irrational exuberance,” to use Fed Chairman Alan Greenspan's phrase. The increasing activity level is enticing more buyers and sellers to jump into the action. However, as market activity increases, so should your caution. Chris Burand presents a few thoughts and caveats for anyone thinking of diving into the market.
WHY IS THE MARKET SO ACTIVE?
A key factor is that banks, brokers, and investment bankers are supplying large sums of money for the transactions. Given the number of acquisitions they're making and the prices they're paying, banks appear to have a lot of money available for purchases. Many seem more eager to buy agencies themselves than to loan money to others for purchasing them. Investment bankers are supplying money primarily to brokers/consolidators. Although equity markets have lost huge sums, plenty of cash is still available for investments, and few alternatives exist.
Another factor is that investors expect the hard market to drive profits and growth to high levels — levels that greatly exceed what will probably be realized. Investors are expecting a huge chunk of the industry's rate increases to drop to the bottom line. But revenues aren't rising at the same rate as premiums because insureds are buying less coverage and seeking alternatives to insurance. The hard market is also soaking up productivity. There's already evidence that prices are increasing at a much slower pace than last year. These are significant factors that many buyers aren't considering adequately.
WHO ARE THE PLAYERS?
As in Wall Street's heyday, consultants, buyers, and investors are coming out of the woodwork. Hopefully, they'll bring new ideas and energy to our market. But anyone new to an industry has a significant disadvantage: Not knowing its subtleties. A newcomer doesn't know entirely what to expect. I've seen some professionals make promises that no reasonable person who knows our industry would make.
IMPORTANCE OF ADVISERS
The active market is a whole new world for many agency sellers, so hiring an adviser can be helpful. Choosing the wrong one can also be a terrible mistake. Consider your goals first, and then decide what service(s) you need. If you want objective advice, hire a consultant who will represent only you; be wary of “consulting” firms advertising tombstones (notices of done deals), because they've become brokers who might be more interested in closing a deal than in giving you objective advice.
Business brokers and investment bankers can help you get deals done in ways that consultants often cannot. Each type of professional has a role to play, and your best bet might be to hire one of each. This can be costly and time-consuming, but it might also be the only way to cover all your bases. Just as baseball teams need all four infielders, agency buyers and sellers need four other players: A CPA for general accounting and tax issues; an attorney for legal and contractual issues; a business broker and/or investment banker for finding a buyer/seller; and a consultant to advise on industry specifics, look at the whole picture, and keep the agency's interests in mind.
Be aware of whether an adviser is advising you or cutting a deal. Focus on the heart of the matter: The adviser's ability and industry knowledge. Focus on protecting your interests and be wary of bad, but believable, advice.
IMPORTANCE OF CONTRACTS
When you hire an adviser, you'll probably be asked to sign a contract. Contracts vary greatly in how well they're written and how fair they are. Some are inadequately specific to our industry, suggesting that the adviser doesn't know enough about it.
Services to be provided are typically outlined in the contract — sometimes clearly, sometimes not. Some contracts are even contradictory. For example, I've seen ones that promise in one section that an adviser will perform due diligence and then deny it in another. So study any contract before signing it.
The contract usually stipulates fees, often considerable. Be certain you understand what you're expected to pay. Make sure the final price is well defined. Because many firms are paid a percentage of the sales price and many sales are based on multiyear retention factors or earn-outs, assessing the final sale price at closing can be difficult, even impossible. Also be aware of exclusivity. Some contracts tie an agency closely to a broker even if the broker does a poor job. Contracts are quite negotiable in regard to language but not nearly so regarding fees. Read them carefully and don't be afraid to negotiate anything.
SHOULD YOU CONSIDER A STOCK DEAL?
Taking a buyer's stock for your agency might result in deferred taxes, but such a transaction isn't necessarily better than a cash deal. Although you might make even more money if the stock appreciates, the value of the buyer's stock also could decrease, perhaps severely.
Which is better, stock or cash? The answer depends on the deal. A seller must determine why the buyer is using stock rather than cash. Cash is cheap now, thanks to low interest rates; but maybe the buyer thinks its stock is even cheaper. If the buyer thinks or knows that its stock is overpriced, it will be cheaper than cash. The buyer can issue fewer shares than it would have to if the stock price were lower, which will dilute its current shareholders' stock less. Analyze the buyer carefully before taking its stock; try to determine whether its stock's price will rise or fall after the deal.
As mentioned earlier, many analysts believe that huge percentages of the industry's rate increases will go straight to brokers' bottom lines. But any such improvement won't be perpetual, or even long-term. If any part of your compensation for your agency is to be paid later, make it contingent on realistic expectations to improve the odds that you'll get all your money. If realistic expectations decrease the price paid, at least you'll know this going in.
Some brokers' stock prices can't reasonably increase much more, leaving them only one way to go. This is not to say these brokers will soon collapse, but as Wall Street has shown, stock prices can climb only so high before gravity takes hold.
It's easy to get caught up in the excitement of an active market. No one wants to miss out on a great deal or be left behind. But do your homework first and you'll be better able to make that killer deal.