The Squeeze: Market Changes Impacting Agency M&A
The low interest rate environment of the last decade gave birth to the bubble of the last 5 years. During that time, we saw an unending stream of buyers entering the M&A fray and agency valuations rise with them. Much has changed in 12 months with the Fed raising rates by 5% and carriers facing more rate pressure than any period in the last 40 years. Everyone in the insurance distribution chain is feeling the squeeze.
What impact have these changes had on agency valuations and dealmaking?
1 – Valuations are coming down.
It should go without saying that asset values decline when the cost of capital increases. On a typical acquisition loan (10-year amortization period), every 1% increase in interest rate increases the loan payment by 5%. In other words, the Fed rate hikes increased acquisition loan cost by 20+%. With higher interest costs, lenders have pulled back on leverage ratios as well, 1 to 1.5 x EBITDA according to Inside P&C. Much like with the real estate market, valuations didn’t drop overnight, but they are sliding down.
Buyers that have been active over the last few years are being forced to become conservative in dealmaking. For some, it means lowering the offers – typically 10-20% off the peak valuations. For others, it means adjusting the terms – typically by pushing value to the backend of the deal via an earnout.
2 – Buyer equity growth expectations have come back to Earth.
Gone are the good days when many private equity-backed buyers achieved 50%+ a year equity growth. Most PE-backed buyers are targeting 20-30% a year share price growth now, which makes the equity less attractive since it is locked up for an unknown period and much safer investments are producing higher returns than a few years ago. That creates a double-sided problem – less room for error and less incentive for equity holders.
3 – Buyers are becoming more aggressive but are acquiring fewer agencies.
This point seems counterintuitive based on my comment that buyers are more conservative. Understand that the PE-backed firms HAVE TO grow to generate returns. The aggression is showing up in the volume of outbound prospecting by buyers and the methods of how they pitch deals to sellers. Using a sales analogy, when your closing ratio goes down because what you are selling is less appealing, then you need more leads and need to sell harder. For top tier agencies, certain buyers have continued to be aggressive in offering price and terms – allocating more capital to acquire high growth, quality businesses versus distributing capital across more deals for revenue aggregation.
4 – Buyers are becoming more clever.
Let me back up to give some history. One of the top buyers over the last decade has successfully sold many, many owners an illusion. I say that because their offers look amazing on the surface but are not when you pull back the curtain. The sales pitch has worked remarkably well for the buyer, so, not surprisingly, more and more private equity-backed buyers have adopted the tactic – to the point where we are seeing offers like this weekly now.
A typical offer like this shows “Purchase Price of 15 x Closing EBITDA” and then goes on to relay that effectively 50% is paid in cash, 15% is rolled over in the buyer’s stock which is expected to double in 3 years (30% of the 15 x EBITDA price), and 20% is based on an earnout payment if the seller can achieve a 25% compound annual growth rate for three years. I call this a smoke & mirrors move because the buyer is really paying 7.5 x EBITDA (50% upfront) and then the rest is based on growth and the assumption that the equity will be liquid.
Anyone good at math recognizes that a 25% compound annual growth rate over 3 years equals 195% growth (i.e. basically doubling the business). In other words, the “15 x Closing EBITDA” becomes 7.5 x Final EBITDA since the EBITDA doubled for the same price. That is a huge win for the buyer – not so much for the seller.
The Bottom Line
The M&A market is changing. Buyers are getting squeezed and becoming more aggressive to get in front of sellers and make a pitch without the noise of competition or professional advisors. Now more than ever it is important to utilize an M&A advisor. Much like the hard market faced by your clients, it takes an experienced advisor to help navigate the marketplace to find the right match and best deal.
There is only one surefire way to maximize the value of your agency while exploring all options: Engage in the ABC Sale Process.
We know the market, including the players, and have successfully run our process for over 400 clients. Take advantage of our expertise and realize a 25-33% higher sale price, better terms, faster transaction time, and peace of mind!
Posted by: Michael Mensch, Founder and CEO
Direct: (321) 255-1309