Will pending investigations of insurance brokers halt the robust pace of the industry’s mergers and acquisitions (M&A) activity? In mid-October 2004, New York State Attorney General Eliot Spitzer filed a civil lawsuit against Marsh & McLennan Cos., alleging marketplace corruption via contingent commissions and bid rigging. While settlement talks are underway now, similar inquiries have been posited throughout the industry with Marsh and other brokers.
To pre-empt further regulatory scrutiny, some insurance brokers are removing contingency agreements. Arthur J. Gallagher & Co. is just the latest of the large U.S. brokers deciding to discontinue contingencies, following in the footsteps of Marsh & McLennan Cos., Aon Corp. and Willis Group Holdings Ltd. More will undoubtedly follow suit.
It is not yet clear what new fee or commission arrangements may replace contingencies. Any new fee/commission transition likely will result in minor disruption in revenue and earnings, but will not likely have a lasting impact on insurance brokers’ valuations and/or profitability.
The spectrum of investigation may raise questions about organizations that own both retail and wholesale brokers. In other words, is the wholesale broker getting the best rate and policy for the client? Or is the broker providing the business, without adequate competition, to the retail agent within their group? If “tying” is occurring, and the wholesale broker is not getting the best deal for the client, more stringent actions will likely be taken. At a minimum, adequate disclosure to the client may be the ultimate outcome in order to avoid a potential conflict. At a maximum, retail brokers may divest their wholesale operations.
Some acquirers, including banks and equity funds, may espouse a “wait-and-see” approach to their M&A strategies as they anticipate future industry challenges and await outcomes from the contingent payment issue. Other acquirers, like insurance brokers, will forge ahead with acquisitions, but will likely insist on deals structured to provide a “claw back” if contingent fees are eliminated or require repayment. Shareholders of acquired companies may seek deals structured to protect them from broker buyers if shareholders take stock as part of the consideration. They may want an opportunity for additional payment in cash or stock if contingent fees or commissions have to be repaid, or if the broker has to pay a substantial settlement. Deal structure will become more important than ever now.
So far this year, acquisitions have been robust. Year-to-date (as of Sept. 30, 2004), 56 insurance broker deals have been completed with an estimated revenue impact of $530 million. By comparison, there were 56 deals in all of 2003, which provided a total revenue impact of $330 million. Many of the middle-market brokers have already exceeded their total revenue acquired in 2003, including Brown & Brown ($99 million in 2004 vs. $40 million in 2003), Hub International Ltd. ($114 million vs. $33 million), U.S.I. Holdings ($129 million vs. $26 million).
In addition, there have been a greater number of larger deals in 2004, with six deals thus far in 2004 exceeding $25 million in revenue, up significantly from only two deals of this size in 2003.
This pace may slow slightly as the regulatory probes caution some potential bidders. However, acquisitions have become a critical growth component, as many public brokers must close the gap on declining organic revenue gains. With nearly 20,000 insurance brokers/agents as viable acquisition targets, public brokers have ample opportunities.
Emerging from the late 1990s “hard cycle,” many brokers are now subject to weakening price environments and dropping premium rates, all of which lessen the possibilities of organic growth. According to an article in SNL Insurance Daily, “More M&A by Insurance Brokers Likely Amid Weakening Price Environment,” Hilb Rogal & Hobbs lowered its full-year organic growth rate to a range of 1 to 5 percent in July 2004; Hub International Ltd. said organic growth was only 4 percent in its U.S. operations. Public middle-market brokers seeking higher growth (assuming typical 1 to 5 percent internal growth) will need the additional percentages to stem from acquisitions.
Attracting a crowd
Some investors are in a “wait-and-see” mode due to current industry concerns. However, investors will likely continue to look favorably upon the insurance broker industry considering its potential for 20 percent plus return on capital, significant free cash flow generation, 15 to 20 percent EPS growth on average, significant dividend yields, 80 to 90 percent recurring revenue base, low capital requirements and strong balance sheets. Attractive properties have enticed potential suitors ranging from middle-market brokers, large public traded brokers, banks and private equity players.
In the middle-market, players like Brown & Brown, Hilb Rogal & Hobbs Company, Hub International and U.S.I. Holdings Corp. have reaffirmed their commitment to making acquisitions from within the smaller-broker sector.
Large publicly-traded brokers like Marsh & McLennan Cos., Willis Group Holdings Ltd. and Aon Corp. will remain in the consolidation game, but will likely seek only larger broker acquisitions, international acquisitions or specialized smaller firms. However, the intense scrutiny by legal and regulatory entities will likely put a damper on acquisitions in the short term.
Banks have been acquiring insurance brokerages that specialize in the distribution of property, casualty and benefits insurance. After identifying insurance distribution as an area with the potential to generate strong returns coupled with high stability and predictability of fee income, banks quickly joined the M&A fray. From 1999 through 2003, there were approximately 986 publicly announced insurance brokerage transactions. Banks and thrifts consummated approximately 35 percent of these deals, according to “Banks in Insurance: Acquisitions, Growth, and Measures of Success,” in Bank Director. Banks will likely put a temporary hold on acquisitions until compensation questions are resolved.
The last competitors are the private equity firms/financial players, including firms like Apollo Management LP, Austin Ventures, Conning Capital Partners, GTCR and others. Private equity firms have found their niche with “platform” companies seeking to create powerhouses out of small providers, which will then be taken public or sold to the highest bidder.
The recent regulatory probes won’t likely impede future M&A activity, as smaller brokers realize capacity and specialization constraints and potential bidders report full acquisition pipelines. However, M&A transactions will take on a cautious tenor; deal structure may be redefined as both acquirers and those acquired seek to protect themselves from the investigation outcomes regarding contingent fees and associated matters.
Linda Garner, a former Arkansas insurance commissioner, is a managing director at Stephens Inc., where she specializes in insurance. Contact: (501) 377-2333, email@example.com.
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