TAMING THE VALUATION MONSTER:  Merger mania keeps agency valuations high, but valuing a firm is as much art as science.

Leader's Edge, April 2006
Author:  Robert J. Lieblein

FAST FOCUS

• Weak organic growth is driving demand for high-performing agencies.

• With strong demand and limited supply, agencies valuations are high.

• Even with higher prices, a bigger portion is held back in at-risk earn-outs.

Have you read your 401(k) or IRA statement lately? Most people, in the current era of pension debacles, seem to be keeping closer track of their retirement wealth. As with many investment documents, it’s wise to keep in mind that old bon mot of the pinstripe crowd: “Past performance is not necessarily indicative of future results.”

Let’s trot out that advice for agency principals trying to understand the value of their most significant asset: their agency. The old mantra of two to three times revenue is not an accurate predictor of your agency’s value.

What are people paying to buy agencies these days? It’s a deceptively simple question that I’m asked often—but answering it is not easy. The most honest, complete answer is that your agency’s worth will result from a very individualized calculation. Valuation is as much an art as a science, in that each agency is truly unique and the results could leave an agency owner extremely satisfied, very disappointed or quite confused.

The dance steps that must be mastered by true valuation experts include many gyrations with the numbers: actuarial, micro- and macroeconomics, financial performance and business intangibles. Even many of the so called valuation experts truly have a hard time understanding the unique characteristics that drive agency valuation.

The Myth of the Multiple

Broadly speaking, insurance industry professionals generally reference two forms of calculations to use as a “low common denominator” when discussing purchase price: multiple of earnings or multiple of revenue.

Multiple of earnings, which is really a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), is the most widely used measure when discussing the overall purchase price of an agency. It essentially represents “free cash flow” of the agency at time of purchase. As a starting point, acquirers generally determine purchase price based upon the trailing 12-month period of free cash flow, adjusted for certain “add backs” (such as excess owner compensation, owner perks and other non-recurring or atypical expenses).

The second form of valuation multiple is based upon revenue. This is even less scientific than a multiple of EBITDA. Quite candidly, no acquirer values an agency in the form of multiple of revenue. However, industry pundits widely use this benchmark methodology, much to my dismay; therefore, I will address valuations in a broad sense using the much hated multiple of revenue.

Finally, one last point to make when discussing multiples is that, while it is appropriate to speak in terms of multiples, it is equally important to keep such reference points in the appropriate context. Multiples of EBITDA or revenue are simply an interpretation of both economic value (e.g., free cash flow generated) and intangible values (e.g., agency’s stature in its market). I do not endorse the concept that a multiple can be used as a direct correlation to valuation but rather a reasonable benchmark.

Considering Transaction Types

Is the multiple a myth? To a degree, yes. Another key factor that must be considered if you want to reach a meaningful calculation is the type of transaction. Segmenting the transaction into one of four major types, then comparing multiples within that sector, can put more fact into the urban legend of your multiple.

For statistical segmentation purposes, consider these four major categories of agency transactions: platform agency being sold to a bank, agency being sold to a public broker, agency being sold to a bank with an existing platform, and agency being sold to another private agency. If your valuation expert is able to categorize the transaction, you will gain much more meaningful information from pricing trends.

Let’s evaluate the differing factors involved in each one of these transaction types.

Platform agency to bank. An agency that will be able to serve this purpose for a bank will generally be one with a well-established territory, brand-name recognition, seasoned professionals, ample markets and a scalable infrastructure. Often the first acquisition of an insurance agency by a bank is referred to as the platform acquisition. Typically, post-transaction operations continue largely as they did pre-transaction. Banks often want the agency to remain largely autonomous, but they seek to leverage further growth or market penetration through post-transaction cross-selling. A premium is generally paid due to the banks’ need to acquire the expertise and knowledge.

Agency to public broker. This is the most common industry transaction in terms of the total number of deals. The target agency will either remain as a standalone operation with certain shared services or can be combined with an existing operation. While each acquiring broker approaches integration differently, most firms, recognizing that an insurance brokerage is largely a relationship business, subscribe to an evolutionary approach. Many valuation or pricing models used by large privately held agencies in making acquisitions are very similar to models that apply to public brokers. Therefore, we include such acquisitions within this category.

Agency to bank with an existing insurance platform. Banks already operating in the insurance realm will look for second-tier acquisitions or revenue acquisitions. Such transactions are remarkably similar to the second category—an agency being acquired by a public broker (or large privately held agency)—in terms of price, integration and post-transaction activities.

Agency to privately held agency. Often referred to as “book-of-business” or “roll-up” transactions, this sort of deal typically commands the lowest purchase prices. Unlike acquisitions by larger, privately held agencies, transactions in this segment would often include acquirers who have less than $10 million in annual revenue.

Now that we’ve outlined four types of transactions, we can look at multiples in a more meaningful way. Take a look at Figure 1, which shows agency values as a multiple of EBITDA. You can see from our analysis that in each of the four types of transactions being tracked, the values ended in a higher range in 2005 than in 2004. Similarly, in Figure 2, which shows multiples of revenue, the top end of the multiples ranged higher in 2005 than in 2004. 

The View from Here

Despite ongoing issues related to New York Attorney General Eliot Spitzer’s probes into contingent commissions, soft product rates and other industry factors that overall negatively affected insurance distribution financial results during 2005, the average valuation of an insurance agency involved in a transactions increased—significantly, in some cases.

By far the most significant impact on agency purchase prices during 2005 was the basic economic law of supply and demand. During 2005, industry leaders experienced either negative or, at best, low organic growth rates compared to prior years. This resulted in both public and privately held agencies aggressively seeking acquisitions. However, the number of quality sellers has decreased significantly from historical numbers. Therefore, during 2005, we had many buyers chasing fewer high quality agencies which, as we know from Economics 101 classes, will result in higher prices.

As we entered 2006, it appeared that organic growth rates were bottoming out and could potentially be on the rebound, particularly in the property market. Regardless, we still expect low organic growth rates to affect the industry during 2006, and we can continue to expect such low organic growth rates to significantly influence M&A activity during 2006 and to expect valuations to remain strong for high-performing agencies.

The New York attorney general’s investigation continues to have market effects as well. The impact of Spitzer’s probes became clearer during 2005 as several of the leading acquirers—including Aon, Arthur J. Gallagher, Marsh and Willis—announced they would no longer accept contingent commissions, as did several privately held firms. Therefore, these firms, particularly Arthur J. Gallagher and Willis, have used acquisitions to help offset the reduction in revenue and profits that were previously generated from contingent commissions.

Understanding the Bell Curve

What do these numbers mean when looking at what percentage of deals get done within the various price ranges to further understand market dynamics? Figure 3 presents an analysis of valuation multiples within various ranges during 2005. 

Statistics from 2005 revealed that nearly 45% of all transactions were in excess of a multiple of seven times EBITDA. This percentage is first and foremost affected by supply and demand and by the overall deal structure (e.g., up-front payments versus earn-out dollars). Comparatively speaking, during 2004, about 20% to 25% of all transactions were in excess of seven times EBITDA. The percentage of transactions in the various categories is also influenced by the type of deal. For example, the greater number of employee benefit agency and bank platform acquisitions would tend to drive a higher number of deals to 7 times EBITDA or greater since such transactions typically are structured as higher multiples than the typical p-c agency transaction.

If you look at the percentage transactions by range of multiples, as we’ve done in Figure 3, you will see a bell curve develop that shows where our statistical middle exists. By tracking this over time and analyzing types of transactions, we can see market dynamics at work.

While the overall “average” purchase price has increased from last year, it should be pointed out that both public brokers and banks will continue to pay a significant premium for a high-quality, high-performing independent agency. In addition, agencies in the larger revenue arenas will continue to demand valuations higher than those of smaller agencies. Our benchmark for a “larger” agency is generally defined as an agency with revenues, excluding contingents, greater than $5 million.

Valuations also vary based on the type of agency that is being sold. As a general rule, employee benefit agencies usually command significant valuation premiums, due to higher margins. With wholesale agencies, it is not unusual that the wholesaler does not generate the same profit margins as a well-managed retail agency. In addition, the wholesaler does not “own” the relationship with the consumer; hence, there is less of an ability to control the longevity of the revenue stream and “ownership” of the client list.  Therefore, as a rule of thumb, a wholesaler will usually have a slightly lower valuation than a retail agency.

Agencies that are truly multi-line (e.g., commercial p-c, employee benefits, personal lines and other) tend to command higher valuations than the average, comparable, p-c retail agency. This is because of the view that the business risk is more highly diversified than either a strictly p-c or employee benefit firm. However, from a strict dollar valuation, one must consider the overall profit percentage of the multi-line agency, which may be in between that of a high performing p-c agency (e.g., 25%) and that of an employee benefit agency (e.g., 35%).

Not all agencies sold at high multiples in 2005. As a matter of fact, many agency owners make the mistake of believing that all agencies are worth the seven to eight times EBITDA multiple. This is like saying all used cars of the same year have the same Blue Book. (Go ahead and try that theory on your next trade-in.) Agencies that were historically reactive versus proactive, did not have strong management, did not have a strong sales culture, were too small or were in a non-growing geographic region typically sold at either a lower multiple or with additional amounts at risk. Therefore, while the M&A market was robust for many sellers, more than a few realized that there truly is a difference in value and were often met with disappointment when selling their agency.

Factoring the “At-risk” Component

So, while the overall potential dollar amount of valuations has increased, the structure of the deal and how the multiples were computed can have a significant impact on the ultimate value received by an agency owner.

For instance, a significant trend that continued during 2005 was an increasing use of earn-outs: the “at risk” component of purchase price. The use of earn-outs can result in increasing the valuation multiple, but it also results in less cash at closing and shifts business risks from the buyer to the seller. Earn-outs continue to be a significant issue because acquirers needed to address several market variables: (1) significant competition for quality agencies (e.g., using earn-out to drive higher multiples); (2) the inability to predict product rates over the next 12 to 18 months and what that will do to a seller’s future financial performance; and (3) the impact of contingencies and how various acquirers handle contingencies in their valuation models. Therefore, while we see buyers willing to pay higher values by utilizing earn-outs, we also see additional caution being taken by acquirers so that. if future growth and profitability are not achieved, the acquirer’s downside risk is protected.

Generally, the higher the valuation multiple, the more likely that you’ll see variable pricing included in the transaction structure. We indicate to clients that the average percentage of the deal subject to risk is generally around 30%, so a normal range would be 25% to 35% for most transactions. It is natural to expect that, as the multiple of EBITDA exceeds eight times or greater, you will more likely see a higher earn-out percentage.

Therefore, when analyzing the increase in purchase prices in 2005 compared to 2004, recognize that the dollar amount of consideration paid up front at closing has generally not changed significantly due to this higher at risk component. At a minimum, we expect the average at risk percentage of purchase price during 2006 to remain consistent with that seen in 2005.

Looking forward, we do not expect any major shifts in agency valuations. This prediction is made under the assumption that product rates will continue to result in low organic growth rates and that the demand for quality agencies continues to greatly outweigh the supply.

While the guaranteed, or fixed, portion of the purchase price will continue to remain consistent, we believe that earn-outs will continue to play a major role in transaction valuations. In addition, we expect to continue to see an overall decrease in the opportunity for agencies to become a platform or foundation acquisition for a buyer.

Finally, as the age of the independent agency owner continues to increase and the industry faces an ongoing lack of talent in its leadership ranks, we strongly believe smaller independent agencies will continue to decline in absolute numbers and this will continue to fuel the M&A market. These factors, along with pressure from carriers on smaller agencies to increase volume, will force many independent agencies to consider a sale due to market and industry competition. If such factors come to fruition, smaller independent agencies, particularly those agencies with operating margins lower than their peers or with greater reliance on contingent commissions, can expect to see lower multiples than those of high-performing, larger agencies. 

Lieblein is a contributing writer and managing principal of WFG Capital Advisors. rlieblein@wfgca.com