Are We at the Top of a Bull Market?
Brokerage purchasers have become pickier, make more demands
We have all become familiar with the brokerage rule-of-thumb valuation multiples of, say, three times commission revenue or seven times EBITDA. Assuming a typical commercial, personal and automobile lines mix, and a reasonable expectation to retain most of the customers, acquirers can expect to recover their investment over nine to 10 years on an after-tax basis. Asking an investor to wait this long for a pay-back is almost unheard of in any other industry. In most small- to medium-sized businesses, a valuation of three to four times EBITDA is common.
Let’s look at what has been driving the high valuations. The key revenue drivers are inelastic. That is, almost everyone requires insurance, so the demand will remain stable. The industry is mature with little growth. In order to achieve significant growth, you have to acquire competitors. Costs are predictable. In most cases, wage and premise costs account for over 80% of total expenses; therefore expense risk is low. Financing is easily available. The Bank of Montreal and domestic insurers have been providing loans at low rates and patient terms.
If these conditions are still present, which I believe they are, then what would stand in the way of continued high, or even higher, prices? Here are a couple of ideas that might be worth exploring. First, large consolidators are becoming more disciplined in their approach to acquisitions. They understand the improvements they can make to a particular brokerage operation and will price their offer accordingly. Second, regional consolidators have stretched themselves as far as they want to go and have become better negotiators. Finally, maybe the collective market feels the prices are just too high and wants a better return, given the perceived risks.
In my work, I have yet to see significant price declines. What I am observing are changes in the purchase process and the return of terms and conditions that previously were common. For example: future contingent profit commission revenue expectations are being lowered; business retention holdbacks are returning; purchasers are focusing on post-acquisition cash flow in their pricing strategy; more potential purchasers are walking away from the table if faced with a bidding war or an unreasonable vendor; and, finally, harder bargaining on the share purchase agreement representations and warranties.
Understanding current market conditions and the appetite for acquisitions has never been more important. Consolidators continue to show a high demand for commercial or specialized books of business, especially if they have good underwriting results. In the quest for growth, large Canadian consolidators have also expanded by acquiring wealth management and employee benefits businesses. It remains to be seen if this trend will continue to grow.
A vendor’s best strategy to maximize the price of a brokerage is to run a well-structured divestiture process. Generally the highest price will be achieved if there is competitive tension and deal momentum. While many purchasers claim they won’t get involved in a bidding war, they will participate in a well-organized acquisition process that they perceive to be fair. There is no escaping the fact that selling one’s life’s work is stressful and emotional. You can increase your chances of success by being well-prepared.
Are we at the top of a bull market? I say yes. Will prices decline? We will have to wait and see.
Mike Berris, CA, CBV is the practice leader of Smythe Ratcliffe, an insurance advisory and valuations practice. He can be reached at firstname.lastname@example.org.
Copyright 2014 Rogers Publishing Ltd. This article first appeared in the March 2014 edition of Canadian Insurance Top Broker magazine