If you are a regular follower of Insurance Journal, you may have noticed that there have been fewer announcements of agency acquisitions since the beginning of the year compared to 2021.  There may be several reasons for this anecdotal observation.  One consideration is that the 4th quarter of 2021 included a record number of acquisitions, driven by a potential increase to capital gains taxes, and the market is just catching up after such a large surge in deal flow.  Another theory is that the large buyers have made so many acquisitions in the past two years that they are focusing on integrating the acquired agencies to improve efficiency, cash flow and organic growth.  On the other hand, it is possible that deal activity is slowing down due to the rapidly rising rate of inflation and corresponding increase to interest rates.

Where is inflation headed?

In the past thirteen months, the Consumer Price Index, a common measurement for inflation, has increased from 1.7% to 7.9%, which was the largest increase in 40 years.  According to a recent survey of economists by Bloomberg, inflation in 2022 is expected to rise another 5.1% due to the impact of the war in Ukraine.  If that occurs, we will approach the 14.8% inflation rate of March 1980 during the infamous Carter Administration!

While most Americans do not pay close attention to the CPI numbers each month, by now everyone is feeling the price pressures.  Food and gasoline prices are  areas that impact all Americans.  If we look at gas prices, the increase has been dramatic.  Since the November 2020 election, gas prices increased from $2.11/gallon to $3.52/gallon in February 2022, a 67% increase.  As the cost of fuel goes up, the prices of all products that are transported go up.  Due to the war in Ukraine, the price of gasoline now exceeds $4.00/gallon in many parts of the country.

US Inflation Rate

The CPI is not the only measurement of inflation.  The median sale price of homes across the US also serves as a measurement.  The median home price in 2Q2020 was $322,600 compared to $357,300 in February 2022, a 10.7% increase.  Some regions, such as Florida, saw a 25% year-over-year increase in home values.  Meanwhile, the 30-year fixed mortgage rate has also increased more than 10% over the last 12 months.

While the Federal Reserve has been slow to raise the Prime Rate, they made the first increase of 25 basis points on March 16 and is expected to make seven more rate increases in 2022.  On March 21, Fed Chairman Powell was a bit more hawkish and stated that the Central Bank would be open to raising rates by a comparatively aggressive 50 basis points at multiple Fed meetings. The Fed hasn’t raised its benchmark rate by 50 basis points since May 2000.

Will inflation impact agency values?

In 2007, the Federal Funds Rate was 5.25% and insurance agencies generally sold in the range of 5 to 7 times EBITDA.  Prior to this month’s rate hike, the Federal Funds Rate was 0.25% with insurance agencies generally selling for  7 to 10 times EBITDA.  Not surprising to most, the value of assets that are purchased using debt, such as real property or businesses, inevitably increase with decreasing interest rates.  That was the trend observed over the last 10 years.  The opposite is also true, i.e. rising interest rates decrease asset values.  That was the environment of the mid-2000s and likely what we will see in 2023.

Furthermore, inflation increases the cost of living, which in turn pushes up wages for most businesses.  As we are already seeing, employees will either ask for a raise or seek other employment to elevate their income.  Given that payroll is the largest line item expense on an agency’s P&L, increases to wages will have a material impact on an agency’s value.  Let’s use a simple and realistic example.  Let’s say the agency spends 30% of revenues on wages and gives its staff a 10% pay increase to combat inflation in 2022.  The agency just lost 3% off its EBITDA margin, which is likely around 10% of its value.  Given that wages never go down, the agency then needs to grow its revenue by 10% to get back to the same valuation.

So to answer the question, yes inflation impacts agency values.  The rising cost of debt drives down the multiples and the rising cost of living drives down the margins (the two key variables to an agency’s value).

What is the good news?

The slow pace of the Federal Reserve in raising the Prime Rate is a benefit to agency owners that wish to sell in the short term.  (For once, the government’s inefficiency is working in your favor.)  Furthermore, Private Equity-backed firms have a boatload of unspent capital known as “dry powder”.  For those reasons, valuations remain high, and we do not expect a negative impact of the declining economic landscape until late 2022 or possibly 2023 depending on how the year shapes up.  If the war ends soon and inflation stabilizes at current levels, valuations may hold, but it certainly feels like this rollercoaster that we’ve been riding on is about to go over the top.

What should you do?

We all know the old saying of “what goes up, must come down.”  Having worked with agency owners through the Great Recession, we saw firsthand how quickly equity can get wiped out when economic conditions change.   We had clients that sold during that time for 30-50% less than they would have one, two, or three years prior.  For some, they worked a few extra years with no financial gain since they could have sold early for significantly more than they earned holding on to their agency and selling for much less later on.

So what should you do?  Find out what your agency is worth today, evaluate your risk, and make an informed decision on the course of action.  Knowledge and action are your best weapons for protecting your financial future during uncertain times.

When you do decide that it is time to sell your agency, remember that the ABC Way of going to market and having us solicit offers from a variety of qualified buyers is the only way to ensure that you get the highest price and best terms for your agency!

Written by:  Michael Mensch, CBI, M&AMI and Partner

and Lou Vescio, CBI, M&AMI and Partner

Direct:  (321) 255-1309