The sellers' market for insurance agencies got another jolt of momentum during the past six months, as USI and Hub both announced they are being acquired by private-equity investors.

The prominence of the investors involved (Goldman Sachs and Morgan Stanley) and the aggressiveness of the multiples of historical EBITDA they paid (earnings before interest, taxes, depreciation and amortization of roughly 10.5 and 12.5, respectively) have sent shock-waves through the industry.

Today, speculation is rampant that one or perhaps several of the other public brokers will soon announce their own private-equity deals.

What does all of this mean for agency owners? Last month, Reagan Consulting held its biannual Mergers, Acquisitions & Internal Perpetuation Workshop in Atlanta to discuss the state of the marketplace and the future for independent agents and brokers. A record crowd of 175 assembled, including representatives from 40 of the 100-largest U.S. brokers.

What follows are some of the key questions (and attempts at answers) that were discussed during the workshop.

o What is driving buyers to be so aggressive in pursuing acquisitions?

Buyers are flush with capital, and their investors expect them to deploy it–now! This is especially true of private-equity investors, who are receiving record levels of investor dollars and are chasing a limited number of investment opportunities.

Within the insurance brokerage sector, brokers are facing an additional challenge. Their investors want 15 percent earnings growth year-in and year-out, regardless of property-casualty market cycles.

Yet with the market currently in the fourth year of soft pricing, the publicly traded brokers struggled mightily in 2006 to generate 5 percent organic growth, which isn't going to cut it for investors!

That 10-point gap between organic growth and investors' required earnings growth represents an “acquisition imperative” for public brokers–that is, the percentage of their annual revenue that must be acquired to keep their investors happy.

The accompanying bar graph shows graphically the “acquisition imperative” faced by the public brokers over the past five years, which has averaged 9 percent of revenue per year, since organic growth has averaged only 6 percent annually.

Going forward, if the soft market continues, public brokers will be forced to continue to supplement their weak organic growth with acquisitions if they want to keep investors satisfied.

o What is driving so many privately held agencies to sell?

There is a misconception in the marketplace that most deals are driven by greedy agency principals who want to capitalize on today's high valuations. Certainly valuations are a factor, but the real driver in most deals is basic ownership demographics.

Studies have consistently shown that the average agency principal is in his/her mid-to-late 50s. Many of those owners have been unsuccessful in building another generation of talent in their agency.

Others have brought in talented younger employees, only to find out later that those recruits did not want to take the financial risk necessary to perpetuate ownership internally.

Either way, as these agency owners approach retirement age, their only real option is to sell their business. There is an entire generation of baby boomer agency principals out there that will likely sell their businesses over the next five years.

What agency owners need to keep in mind, however, is that the valuation multiples delivered for USI and Hub reflect entry premiums paid for large, nationally established, publicly traded insurance brokerage operations.

For smaller, local firms, there has been some upward pressure on valuations, but valuation multiples for those agencies have been nowhere near those paid for USI and Hub. For most agencies, the old range of multiples of 5.0-to-8.0-times pro forma EBITDA still applies.

The two primary drivers of where in that range a particular agency will be valued are buyer synergy and expected agency growth.

o With so many hungry buyers trying to acquire, won't they soon run out of agencies to buy?

We hear this question frequently, and it seems to make a lot of sense. After all, if one calculates the loosely defined “acquisition imperative” for the five brokers Arthur J. Gallagher, Brown & Brown, Hilb, Rogal & Hobbs, USI and Hub for 2006, it requires the collective acquisition of roughly $400 million in annual revenue!

Given that only a small number of large agencies sell each year, there's simply no way to get there, right?

Wrong. While it's true that acquiring brokers love to find large, marquee agencies to buy, many transactions these days are smaller agencies–and there is a mind-boggling number still out there.

Indeed, Reagan Consulting recently put together its own estimate of the universe of agencies in the United States, as provided in the accompanying table.

We estimate there are approximately 33,500 privately owned U.S. agencies, of which perhaps only 300 generate more than $10 million in annual revenue.

Assuming those 300 agencies average approximately $13.5 million in revenue, then the largest firms represent acquirable revenue totaling only about $4 billion–which isn't enough to satisfy hungry buyers for long.

But observe the groups below $10 million–specifically, the three groups that range from $500,000 to $10 million in revenue. Those three groups total 18,250 agencies, and they control a whopping $28.6 billion in annual revenue.

For perspective, USI reported revenue of $551.6 million in 2006. This means there are 52 USIs out there waiting to be aggregated by hungry buyers. Or, stated another way, this group could satisfy the national brokers' $400 million “acquisition imperative” for another 71 years or so!

So, if you're waiting patiently for the marketplace to return to “normal,” it may be awhile. In the meantime, you can take heart in the fact that another group of industry “outsiders” has decided the insurance brokerage industry is a great place to invest.

For Bar Graph: