The Competitive Advantage: Agency Valuations

A Victim of the Credit Bubble?

In the early 1700s, John Law, a brilliant mathematician, advised the French government their economy could be improved by printing lots of paper money not backed by gold or silver. The key was getting people to trust the paper money. His method for establishing trust was promising huge financial gains for people willing to invest in France’s American colonies, which they did. The result built both the economy and the infamous Mississippi scheme, a huge land asset bubble that collapsed in four years and the decline was so severe it contributed to the French Revolution. It is a fascinating story with many similarities to today’s economy. The lesson for business valuations though is this: attempts to maintain asset prices above their fundamental value are eventually doomed to failure. (Buttonwood, Law of Easy Money, The Economist, Aug. 13, 2009)

This brings to question the huge prices paid for many agencies a few years ago and still some agencies today. Were/are those prices too high relative to the seller’s fundamental value?

In the bubble years, I think it is safe to say that many of my agency valuations were less than what banks, some brokers, and a few others were paying. My valuations were definitely lower than what a number of business brokers and consultants were using. In tough times now, a few of my valuations have been higher than what some banks and brokers will pay.

The difference is that I focus on the inherent value of an agency’s ongoing operations rather than the arbitrage value trying to be attained by heavily leveraged and publicly financed buyers. I absolutely consider this value implication too, but that is not where I place the most weight for Fair Market Value valuations because arbitrage based valuations in a bubble economy will always elevate prices beyond the firm’s fundamental value.

Why Agencies Sell

The hard truth is that the vast majority of acquisitions occur for only a few reasons, none of which is usually the stated purpose. A recent study showed that publicly traded company executives who lie, cheat, and steal, or more innocently just screw up, but never forthrightly admit these issues when caught, are treated more lightly by the markets than their more forthright and respectable peers who admit the problems occurred. I believe this same thought process applies to why the real reasons for most acquisitions are never disclosed. Those reasons are:

1. The buyer is in trouble and they need an acquisition to cover their problems. (“Deals from Hell” by Robert F. Bruner, is an excellent book on this subject.)
2. The buyer has a financial arbitrage opportunity. A great example of this is the way banks operate. They borrow from the Federal Reserve at effectively less than 0 percent interest today and make loans at 5 percent to 15 percent (or simply buy Treasuries at 3 percent). Many buyers, especially banks, can pay higher than normal prices, not because they are smarter, or can cross-sell or anything else, but simply because they have cheap financing. Many publicly traded companies have a similar advantage. Even some privately owned insurance agencies have this opportunity because they have carriers offering truly cheap financing.
In financial arbitrage then, the price can exceed the fundamental value for a time. Many serial buyers have collapsed under their own weight because sooner or later, the fundamentals will crush the financial margins.
3. The buyer has a valuation arbitrage opportunity. A simplified example of this is when a publicly traded broker is trading for effectively 7 times EBITDA and they purchase an agency for 25 percent more than it is really worth, but the effective price is still only 6.5 times EBITDA. As soon as the purchase is made, the buyer is effectively flipping the purchased agency to the market for an extra 0.5 times EBITDA. Now, this formula assumes the market never recognizes the excessive price paid and most of the time, the market does not recognize this issue until it reaches the tipping point.
If the key stakeholders can cash in on their holdings just before the tipping point, they will often make a fortune. The acquisition again is not really based on the fundamental value of the seller, but more the perceived value of the buyer and the margin between the two. Because attempts to maintain asset prices above their fundamental value are eventually doomed to failure always holds true, acquisitions based on this model will always eventually lead to a fall. It’s just a matter of musical chairs as to who gets caught out.
4. Executives are effectively paid a percentage of revenues, so the bigger the company, the more the executive is paid. After all, we all know that the bigger the company, the more skill that is required to manage it, right? Whether it is managed well or not is not a factor, as we have clearly seen. So some executives push mergers through so they can be paid more. It’s an ugly but true secret.
5. Egos.

When Acquisitions Fail

These are the underlying reasons many acquisitions are done by large buyers and serial acquirers. Numerous studies have almost universally shown that the vast majority of acquisitions and mergers fail to return an adequate return on investment, so it seems smart to quit pretending operational synergies will be attained (and we can see from the publicly traded brokers’ results that synergies are not attained by their hundreds of acquisitions when compared to non-serial acquirers’ private results).

While the acquisitions may fail, the damage is not limited to the acquirers. These factors impact the sales price of other agencies as well and good agencies are often the most negatively impacted.

For example, consider two agencies. The first is a mediocre agency with a 20 percent EBITDA and $3 million in revenues. It has a value then (assuming the balance sheet value is neutral) of $600,000 times some EBITDA multiple. The second is a well-run agency of the same size with an EBITDA of 30 percent. It has a value of $900,000 times some EBITDA multiple. Many buyers would choose one EBITDA multiple and apply to all acquisition targets. So let’s choose an EBITDA multiple of 6. The mediocre agency’s value would be $1.8 million and the value of the good agency would be $2.7 million. The buyers would say, “See, the good agency carries a greater value!”

This is a huge mistake leading to bad acquisitions and missed opportunities. I argue the EBITDA multiples should not both be 6. All else being equal, the good agency’s multiple should be greater, say 6.5. But if the buyer’s multiple is only 6.2, it is highly unlikely they would pay for the quality because quality is not the goal. The goal is the arbitrage opportunity, and it does not exist at a multiple of 6.5. This is why some buyers target lousy agencies. The arbitrage opportunity is greater.

The result is buyers overpay from a fundamental perspective for less than average agencies and the best agencies are undervalued. All firms get squeezed toward the average. The implication for the best agencies is internal perpetuation done well is likely to have more potential. For poor agencies, external acquisitions are most definitely better, especially when lots of easy money is flying around. For well-managed agencies, cherry-picking accounts from recently sold agencies is likely an excellent strategy.

During the credit bubble, many poor agencies were sold to firms profiting from leverage and arbitrage. This caused a bubble in agency values. Given the buyers’ focus was leverage and arbitrage, rather than operations, opportunities exist now to significantly improve operations of purchased agencies. And when competitors see operations not being improved, they can take good accounts and good people. Lots of opportunities exist even in this tough environment!

Topics Agencies