[I]t can be assumed that by focusing on building and running a best-in-class insurance brokerage, owners can command their own destiny and be shareholders in
a resilient and rewarding asset class.
By James Graham
WHEN WILL THE MUSIC STOP?
Despite not knowing the future, a few key risks can affect market pricing
It is no secret that valuations of insurance brokers have been rising steadily for well over a decade. A question that MarshBerry constantly receives is, “When will EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) multiples for insurance brokers start to decline?” The truth is—no one knows. Further, just as multiple compression cannot be predicted, neither can the magnitude of the compression. Multiples could decline materially and pricing would still be better than it has been for most of the industry’s history.
Despite us not being able to predict the future, a few key risks to current market pricing can be highlighted:
- A visible failure. The steady increase in insurance brokerage pricing has been driven by demand coming from the success of an increasing number of serial buyers. If a failure of one of these buyers were to occur, it could make the industry seem riskier to investors, potentially causing pricing to decline. Not all failures would lead to less demand for an agent or broker. For example, there have been overleveraged buyers that have been forced to pump the brakes on acquisitions, buyers have failed to achieve their growth goals and exit to another strategic buyer, and there have been buyers that were accused of fraud and sold at auction. What these failures have in common is that they are all unique and not the result of industry-wide characteristics.
- Sharp rise in interest rates. An important backdrop of the rise in agency and brokerage pricing has been a consistently low cost of capital driven by low interest rates. One risk to this monetary environment is a rising rate of inflation. Through the last twelve months, ending August 2021, the Personal Consumption Expenditures price index rate was 4.3%, as measured by the Bureau of Economic Analysis, which is the highest 12-month rate since the early 1990s. If this current trend is not transitory then it could lead to the Federal Reserve raising interest rates to protect price stability. Also, lenders tend to demand higher interest rates during an inflationary environment to compensate for the lost purchasing power of expected future cash flow on previously made lower interest loans. If interest rates rise high enough, downward pressure will be placed on the multiples that buyers can afford to pay.
- Government regulation and taxes. The nationalization of a major line of insurance that excludes the broker channel is an example of a detrimental risk related to potential government policy. The risk of single-payer healthcare is not new to the marketplace. If the government were to nationalize the health insurance industry, then it could be devastating to valuations in the insurance brokerage community. A less obvious threat in the current environment could come in the form of tax legislation that reduces buyers’ purchasing power or makes the after-tax gains to sellers not attractive enough to sell. A potential threat on the horizon is the result of the Tax Cuts and Jobs Act passed in 2017, where businesses with revenue in excess of $25 million can deduct interest expense up to 30% of EBITDA through December 31, 2021. This, however, moves to 30% of EBIT (not including Depreciation and Amortization) after December 31, 2021. This change could materially affect highly leveraged buyers’ after-tax cash flow, and result in downward pressure on pricing.
In conclusion, at the time of writing, there do not appear to be any signs of the merger and acquisition market for insurance agents and brokers slowing down or purchase prices declining. Despite any risks from a macro perspective, the greatest risk to the value of a particular brokerage is related to things its management team can control. The value gap between high-growth and high-profit brokerages versus low-growth and low-profit brokerages can be substantial. Brokerage firms are not commodities and each one has unique characteristics that add to or detract from its value. While no one may know when the music will stop, it can be assumed that by focusing on building and running a best-in-class insurance brokerage, owners can command their own destiny and be shareholders in a resilient and rewarding asset class.
James Graham, CVA, joined Marsh, Berry & Company, Inc. (“MarshBerry”), in 2015 and currently serves as a vice president in the California office. His activities include merger and acquisition services, preparing valuation reports, creating perpetuation plans, providing business planning and general consulting. James is also a relationship manager for MarshBerry’s Connect Networks. Prior to joining MarshBerry, James was a senior consultant with Deloitte Consulting LLP. While at Deloitte, he provided financial analysis work on a wide range of consulting projects. James currently maintains the FINRA Securities Industry Essentials (SIE®) Exam in addition to the Series 62, 79 and 63 FINRA Registrations through MarshBerry Capital, Inc., the affiliated FINRA-registered Broker/Dealer of Marsh, Berry & Co., Inc. He earned a bachelor’s degree in finance from Azusa Pacific University and a Master’s in Business Administration (MBA) from George Mason University. He is also a Certified Valuation Analyst (CVA). Contact him at James.Graham@MarshBerry.com or (949) 272-0351.
Deal activity in Q3 2021 was the second most active quarter ever seen, falling short only to the fourth quarter of 2020. Activity is being driven by seller concerns over potential federal capital gains rate changes and the broader investment community pushing to find investments in the insurance industry. Deals are closing at a record pace and Q4 2021 will undoubtedly set a record for transactions in a three-month period.
There have been 534 publicly announced M&A transactions in the United States so far in 2021. Total announced transactions in the United States have increased by 22.5% compared to this time last year. A robust backlog of transactions and announcements from earlier in the year are expected to further widen this gap as the end of the year approaches.
Private-capital-backed buyers accounted for 397 (74.3%) of the 534 transactions through September, while independent firms have held steady at 12.2% of the total deal count. The activity of independent firms is consistent with last year in terms of percentage of the total number of transactions. However, there has been an overall decrease in activity by this buyer segment since 2019.
Deals involving specialty distributors have also seen an increased presence in 2021. The 108 specialty transactions through September represent a 40.3% increase compared to this time last year.
Investment banking services offered through MarshBerry Capital, Inc., Member FINRA and SIPC, and an affiliate of Marsh, Berry & Co., Inc., 28601 Chagrin Blvd., Suite 400, Woodmere, Ohio 44122 (440-354-3230) Disclosure: All deal count metrics are inclusive of completed deals with U.S. targets only. Scorecard year-to-date totals may change from month to month should an acquirer notify MarshBerry or the public of a prior acquisition. 2021 statistics are preliminary and may change in future publications. Please feel free to send any announcements to M&A@MarshBerry.com. Source: S&P Global Market Intelligence and other publicly available sources.