With the number of buyers down –banks and private equity funds are basically out of the hunt–there is less competition for deals, leaving agents feeling the wounding effects of low M&A activity. Also, the ability to leverage deals at the levels seen 2 years ago is gone; the amount of equity needed to do a deal has gone up. When this happens, the ROI must go up. This means that if the agency is less profitable or even flat, the amount a buyer will pay has to go down. These factors have nothing to do with the soft insurance market. When this is added on top, all prices are down, making for much leaner times for agency sellers whose expectations for a sale were aligned with the environment that was around before 2008.

In our business, we advise prospective sellers who are evaluating their alternatives. Often, they want to test the market to see if they can get their prices and terms from a deal, especially with the current capital gains tax rates. However, many are concluding that they should wait for a better deal and are prepared to hold out for the economy and soft market to change. Additionally, they are unsettled as to where they would invest the after-tax proceeds to generate a safe and adequate return.

The faltering economy also has encouraged personal and commercial insurance buyers to re-evaluate their insurance needs and requirements. This includes higher deductibles, decreasing coverage and lowering payrolls.

Soft markets also generate increased competition on a number of fronts. This manifests itself across all lines of business as everyone needs to grow and a shrinking pie means taking market share away from someone else. Also, in the personal lines arena, the Internet encourages insureds to buy their insurance coverage on a direct basis. This will probably increase over time as more and more young people prefer the Internet as a distribution channel.

Add to this the uncertainty surrounding healthcare reform. Only a short time ago, agents were encouraged to add life-health business to their property-casualty portfolios to help mitigate the cyclicity of the property-casualty business. Many experts in the insurance industry thought this combination of property-casualty and life-health business would generate cross-sell opportunities, benefiting agency profit margins. Today, that strategy could place an agency in a “no-man's land.” If the smaller health insurance customers are covered by a government plan or pools, the commissions agents receive on selling those policies will disappear, further eroding profits. More importantly, it is very difficult in this uncertain environment for a prospective buyer to value the life-health book of business, thus potentially dampening their enthusiasm for an agency with combined property-casualty and life-health benefits business.

AA&B: Who's buying in this market?

Richard Schlicher: Leading the group of acquirers in 2008 were Brown & Brown, Arthur J. Gallagher, Hub, BB&T Corp., National Financial Partners Corp., Wells Fargo, LTC Global, Ascension and Bollinger. Total deal activity in 2009 is down more than 40 percent from 2008 levels. In 2009, the banks and private equity firms are notably absent. Some former buyers themselves have been acquired–such as Hilb, Rogal & Hobbs and Webster Insurance. Brown & Brown and Arthur J. Gallagher were, and continue to be, the most active acquirers in 2009, with 41 and 26 deals, respectively. Ascension Insurance, backed by the private equity firms Parthenon Capital and Century Capital, has also been active, with 6 acquisitions in the last year and a half.

The issues facing the banking industry are no secret. Today, bank management is forced to carefully allocate capital resources. If the bank's insurance agency operations do not have the potential to become a core business unit of the bank, additional acquisitions have stopped. In some cases, banks are divesting themselves of their insurance operations to allocate capital to their core businesses.

Up until 2009, some private equity firms were extremely active acquirers of insurance agencies and MGAs. However, today private equity firms have generally retrenched and some would like to exit the business but cannot recoup their initial investment. Senior lenders have become much more cautious and likely will only provide 2 or 3 times EBITDA into the capital structure of an acquisition. This lower level of debt also carries much more stringent covenants and reporting requirements. Expensive equity or equity-linked instruments must make up the balance. Projecting a 25 to 30 percent internal rate of return on this larger investment is very difficult, especially in a soft market.

Some regional agencies continue to be active participants in the M&A market. Organic growth in this environment is extremely challenging, and we are seeing more well-run and well-capitalized regionals folding in geographically complementary agencies

AA&B: What are buyers looking for? Have the best firms been cherry-picked?

Myer: There are still a lot of very successful and well-run agencies out there, all of whom will face the buy or sell decision at some point. The obvious candidate for selling is an agency owner in his or her early 60s without a perpetuation plan. If you are in your 30s or 40s, you probably are much less motivated to sell right now. You have time to build your business. You can wait for valuations to improve. The other issue is, what would you do with the proceeds from a sale? You may be receiving a higher return on your capital through the agency than you might get in publicly traded investments. The obvious counter-argument to waiting is the impending capital gains tax increase (to 20 percent in 2010) and the realistic potential for even further increases.

In our experience, buyers are interested in agencies that are high performers. High performers have a number of things in common, led by an aggressive sales culture which generates organic growth. This engine is then supported by an efficient and productive staff, as well as state-of-the-art technology and IT resources. These solid fundamentals help generate growth, high retention ratios and above average operating profit margins. Superior efficiency measures such as revenue per employee and EBITDA per employee are also measures of a well-run agency or MGA. There are a number of qualified buyers who will pay attractive multiples to acquire properties with these traits.

Recently we talked with an MGA owner interested in selling. He was evaluating whether the agency would be more attractive if he invested heavily in upgrading his technology. We advised that if he is ready to sell, a potential buyer already may have a highly efficient operating platform and would not be swayed by his system or lack thereof. Consequently, his time and capital investment might not generate the desired returns. Conversely, if he was not planning to sell in the short term, we would have encouraged him to make the investment and reap the benefits and efficiencies.

AA&B: What about valuation? How does an owner calculate agency worth?

Schlicher: There are some regions in the country, such as those heavily reliant on the auto industry or residential real estate markets, where agents have much less certainty about their agency's worth because of the influence of these macro economic trends. These agencies need to think long and hard about selling, unless they have a need or desire to initiate a liquidity event.

There is no simple approach to valuation. Agencies differ markedly in the way they operate. Setting value as a multiple of revenues is not a good measure because this does not take into consideration the cash generating ability of the agency, its growth prospects, and the quality of an agency's management and producers.

Many owners of smaller agencies think their businesses are worth one-and-a-half to two times revenue. However, most of these smaller agencies are an extension of the owners. When they retire, the business may go away from a new owner. The same thing happens when agency principals fail to hire new producers, acquire new technology or enter new markets. If you don't invest in the business, the value of that business will decline over the long-term.

The most critical factors in valuing an agency are growth, profitability, and customer and carrier relationships. Behind these general themes are the components of a valuation that include EBITDA, make up of revenues and contingencies, organic growth rate, uniqueness of the business, age of the principals and their bench strength, culture of the agency, mix of commercial versus personal lines, technology, and size and fit in the potential acquirer's footprint.

AA&B: What advice would you give a prospective buyer or seller today?

Myer: We talk with owners of insurance agencies and MGAs every day. Many are considering their options and want an independent observation of their operation. Our initial discussions center around their short-term and long-term desires and aspirations, both on a personal and professional basis. We take this view initially so we can then look at what they do well and where they have weaknesses. Each entity has its own unique operating style, history and culture. This is their DNA. We try to build on these features and characteristics. Once we have this high-level understanding, we drill down to the historical financial results and estimate future or pro forma results for a detailed comparison and analysis. Soon we have a pretty good idea of the agency's core beliefs, strengths, weaknesses, value and options. Often the owner has spent many nights awake thinking of these very issues but has never tested them on an outsider. In the end, we come back to the initial questions and on a mutual basis decide on the best course of action to maximize the agency's enterprise value. we'll be able to hire people.”

Dale Myer and Richard S. Schlicher are senior vice presidents at Gill and Roeser Holdings Inc., a member of FINRA. Both have extensive experience in insurance M&A, banking and structuring M&A transactions and hold Series 7 and 63 licenses. Gill and Roeser Holdings works with its sister company, Gill and Roeser Inc., a reinsurance intermediary. Contact the participants at [email protected], [email protected] or www.gillroeser.com.

Dodging the capital gains bullet

The mergers and acquisition environment is very cloudy. Compared with previous years, 2009 has been very slow in terms of completed transactions. Most industry insiders expect the transaction environment to pick up over the next 12 months, but most seemed amazed it hasn't already started to happen.

While the credit markets have played a major role in limiting transactions, that's just one of the reasons for the downturn. Others include: (1) price perception imbalance between buyers and sellers, (2) soft market concerns and (3) political uncertainty. But the one issue which has been discussed as a positive for getting deals done–the expected increase in capital gains–has yet to play a major role in driving deals. Why is that?

If you are an owner who has plans to sell your agency in the next 5 years, you should consider moving the sale date up to the next 12 months, as the expected change in the capital gains rate will have a material effect on your after-tax value. Any rate increase in capital gains, both federal and state, would have a multiplier effect on how much you would have to grow your agency to return to the after-tax value. It is therefore vital that agency owners strongly consider these rate changes when they assess their near term strategic options.

To illustrate this point, let's pose the following: How much would you have to grow your agency to get back to the same after-tax value today if the federal capital gains rate increases 10 percent (from 15 to 25 percent)? We estimate you will have to grow your agency at least 14 percent. This is no small task, given the soft market and the intensely competitive marketplace.

Let's examine a simple comparison to drive home the point. Let's compare two sale scenarios: sell in 2010, or sell in 2011. The following is a list of the assumptions:

o Agency revenue $1 million

o Agency EBITDA margin 25%

o EBITDA* valuation 6

o Agency valuation $1,500,000

o Payment at closing 80%

o Payment after first year 10%

o Payment after second year 10%

o 2010 capital gains rate 15%

o 2011, 2012 and 2013 capital gains rate 25%

o Discount rate 3%

*EBITDA = earnings before interest, taxes, depreciation and amortization

In this example, the owner would have to pay an additional $120,000 in taxes, or the equivalent of a high-end BMW or Mercedes. Wouldn't you rather have this money in your hands rather than the government's?

For those who are planning to sell within the next 5 years, it is time to determine when is the best time to monetize your agency's value. Absent a huge belief that the pricing environment is going to harden fast, or your organic growth is going to skyrocket, strong consideration should be made to test the market over the next 12 months.

Kevin P. Donoghue, managing director, and Allen M. Go, director, serve Mystic Capital Advisors Group LLC, an investment banking firm specializing in the insurance industry.