Industry the December 2023 issue

Time to Get the House in Order

Higher interest rates and capital costs mean some brokerages must reassess their value proposition to remain an attractive investment.
By Russ Banham Posted on December 1, 2023

This year, however, is a different story altogether.

M&A activity for 2023 is expected to hit its lowest point since 2016, when 515 brokerage deals were completed.

Across the globe and across industries, third-quarter M&A deals decreased by 28.3% from a year ago.

If the hard market persists, the strong premiums supporting brokerage revenues may continue to drive M&A deals.

Ten benchmark rate hikes have occurred since the Fed’s first increase in March 2022, which remained at 5.5%, the highest level in 22 years, at press time. The central bank’s policy rates and the higher cost of capital the actions engendered took a toll on insurance brokerage M&A transactions in the first three quarters of 2023. According to investment banking and consulting firm MarshBerry, 454 deals have been announced, about 150 per quarter. Assuming another 150 or so transactions in the fourth quarter, overall M&A activity will hit its lowest point since 2016, when 515 brokerage deals were completed.

The pause is most noticeable among a few private-equity backed brokerages that grew fast through multiple acquisitions in a short period of time. With debt capital constrained by the Fed’s actions, some PE-backed brokerages are expected to pull back sharply, though not entirely, on dealmaking in 2024, turning their attention inward to integrate their numerous recent acquisitions and present a more unified business organization to insurance markets or a potential buyer.

“Private-equity backed brokers are still acquiring but not all at the same pace,” says Phil Trem, president of the financial division of MarshBerry. “Cash flow is tighter because of higher interest rates and earnout liabilities [owed to] the sellers of the firms acquired. Some have had to take on preferred equity or other forms of capital to ensure they had enough cash to meet these obligations.”

The 25-month M&A bubble that began in December 2020 was led almost entirely by private-equity backed buyers who found…sellers willing to sell for larger-than-expected valuations. The bubble has now burst.
Steve Germundson, partner, Optis Partners

One reason why PE-backed brokerages are still acquiring but not at the same pace, Trem says, is the three-year earnouts they signed with the sellers of the acquired firms. “For brokers that concluded acquisitions in 2020 and 2021,” Trem says, “those earnouts are now coming due.”

Other brokerage M&A advisors share this view. “The 25-month M&A bubble that began in December 2020 was led almost entirely by private-equity backed buyers who found…sellers willing to sell for larger-than-expected valuations,” says Steve Germundson, a partner at Optis Partners, an investment banking and financial consulting firm. “The bubble has now burst.”

In the United Kingdom and Europe, a different M&A forecast is in the works, says Peter Blanc, group head of M&A at Howden Group, which had 44 acquisitions underway at press time. Although the number of completed deals exceeded last year’s acquisition volume, their total value was slightly lower.

Although 2023 M&A activity among brokerages is expected to hew closely to historical norms, no one expects to see a merger deal along the lines of the proposed $30 billion Aon-Willis Towers Watson (WTW) transaction that was called off in July 2021, due in large part to regulatory objections. “Most acquisitions to date this year have involved selling agencies between half a million dollars in revenue to
$10 million in revenue, which represented about 85%” of deals completed in the United States and Canada, says Sean O’Neill, a partner and the leader of the global insurance sector at management consultancy Bain & Co., where he specializes in M&A.

Nevertheless, Steve Germundson, a partner at Optis Partners, says the possibility of M&A deals involving brokerages in the bottom 15 of the top 20 brokerages is not far-fetched. “Very large firms need to show continued growth, which is easier if they buy a big firm instead of 20 smaller ones,” Germundson explains. “There might be value for a large, privately held broker in the top 20 or so to become a public company, making it an attractive acquisition opportunity for an even larger broker.”

Meanwhile, brokerage size is a matter of perspective. “In just a few years, we now have the largest grouping of billion-dollar brokers our industry has ever seen,” says Dave Eslick, chairman and CEO of Marsh McLennan Agency (MMA), a wholly owned subsidiary of publicly traded Marsh. “Some of them are private equity backed, with revenues from $3 billion or so down to $1 billion. Over the next 10 years, what does that group do? Do they go public, look to merge their corporations together, continue to be independent? A few may wait for the capital markets to reopen and do an IPO as an exit. Others may go from one [private equity] fund to a different backer.”

While sources predict acquisitions will continue along historical lines, O’Neill says the next decade will involve a “doubling down” on value creation demonstrated by operational efficiency and organic growth. He cites the example of Gallagher, which bought Willis Re from WTW for $3.25 billion in 2021, as a brokerage that has done this well.

“It’s been widely reported that Gallagher acquired many companies over the years, ranging from traditional retail brokers, specialty brokerages and benefits broking businesses both in North America and global markets,” O’Neill says. “Not only has it demonstrated prowess in the deal-making process, but it has also been able to demonstrate to the markets that it could drive year-over-year operational efficiencies and margin expansion.”

In other words, one should never discount the possibility of other truly large brokerages in the future, given the payoff. “Gallagher is now firmly established as one of top four leading global brokers, with a footprint extending beyond North America into Ireland, Australia, U.K. and other European markets,” O’Neill says. “The bigger the broker, the bigger and more wide-ranging are the clients.”

“At the top end of broker consolidations, while some of the larger private-equity backed firms appear not to be retrenching, we’ve certainly seen the peak in prices,” says Blanc. “Further down the food chain, however, we’re still seeing huge appetite for broking business in the U.K. and all across Europe. Though times are tough [for private-equity backed brokers], the repeatable revenues and cash flow dynamics remain highly attractive.”

Even in the United States, 454 M&A transactions through third quarter 2023, a year in which most economists predicted a recession, is not inconsequential and is on par with historical norms. The drop-off in activity isn’t confined to the brokerage industry either. S&P Global Market Intelligence’s global Q3 2023 M&A report indicates that the number of global deals across industries in the third quarter was down 17.3% from the prior quarter and 28.3% from year-ago levels. “The prospects for dealmaking going forward are challenged by economic uncertainty and the likelihood that interest rates will stay higher for longer,” S&P stated.

In the brokerage industry, buyers and sellers remain in near-constant conversations. “There is still strong demand among private equity to be in the insurance brokerage space,” Trem says. “Insurance distribution is one of the most highly sought-after investment opportunities.”

Dealmaking remains historically normal for many buyers and sellers, in part because the ongoing hard insurance market is helping to drive retained deal consistency. Commission revenue from higher premiums presents the opportunity for continuing organic growth and higher brokerage and agency valuations. “The buyer benefits from a seller in a hard market that’s getting organic growth it historically didn’t have,” Trem says, “and the seller benefits because the buyer has to make a cash payment that is a multiple of that growth.”

It all depends on where interest rates go, but my sense is we’ll see six to 10 private-equity backed brokers, some in the top 10 and some in the top 30, restructure their capital in 2024.
Phil Trem, financial division president, MarshBerry

Sean O’Neill agrees. A partner and the leader of the global insurance sector at management consultancy Bain & Co., O’Neill notes the hard market’s moderating impact on the cost of capital. “Despite higher interest rates and continuing economic uncertainty, brokerage valuations have not collapsed and are maybe off 1 or 2%,” he says.

“Typically, about 900 to 1,000 deals are done per year, on average. If we hit 700 deals this year, that’s still two acquisitions a day.”

Plus, O’Neill says, recent activity shows signs of an uptick. “If you compare first-half 2023 to first-half 2022, the actual number of deals is down about 24%,” he says, “but if you look at deal activity over the past 12 months from where we sit today, it’s down about 10%.”

Aggregation to Integration

If the hard market persists, O’Neill says, the strong underlying premiums supporting broker revenues will continue to drive or buttress deal activity. “The serial acquirers playing this game over the last decade will continue acquiring because there are still many businesses out there to be bought,” he says. “But the other narrative that is playing is the need to drive operating efficiencies in the business to show up in the insurance market as one firm versus a series of acquired firms—using scale and operating efficiencies as the means to place insurance at optimum coverage terms, conditions, limits and premiums with the carriers.”

He makes an excellent point, one evidenced by plans put forth by private-equity backed Acrisure to launch an initial public offering in 2024, at a reported $23 billion valuation. “Acrisure bought hundreds of companies over the last several years but now needs to tell an integrated story of why all those deals made sense insofar as its value creation story, which is a story of EBITDA growth and margin growth,” O’Neill says. “Other acquisitive brokers need to begin telling the same narrative.”

Such firms include so-called “aggregators,” a private-equity owned brokerage that acquires smaller brokerages and agencies at a rapid clip, seeking to merge them together and obtain synergies and cost reductions through economies of scale. The intent is to increase the valuation of the combined entity for a potential sale at a premium. “Acquired growth is faster and easier than organic growth,” O’Neill says.

In the low-interest-rate environment, the aggregators benefited from cheap debt to fund numerous acquisitions. But the higher cost of capital following the Fed’s rate actions is crimping the acquisition spree for some. “If you pulled out all the private-equity owned brokers and created a market segment out of them, their M&A activity overall is flat relative to a year ago,” O’Neill says.

Other sources agree. “If you look at M&A activity in recent years, the different private-equity owned brokers that did the most deals have fallen off the leaderboards,” says Clark Wormer, managing director at private-equity owned Hub International, which focuses on acquiring firms with revenue from $500,000 to $100 million, some even larger.

“The number of private-equity backed brokers grew substantially over the last 15 years because interest rates were extremely low, but in less than a year that world has changed dramatically,” says Dave Eslick, chairman and CEO of Marsh McLennan Agency (MMA). Eslick blamed the change on the higher cost of leverage. “It’s eating up free cash flow at a few private-equity owned brokers.”

Eslick says that some private-equity backed brokerages “have announced that they’re either shutting down or slowing down their acquisition activity to focus on integration and be more methodical about future deals.”

With the acquisition engine stalling due to higher interest rates, the aggregators’ focus needs to shift toward integrating acquired firms to present a single face to the market. “Over-levered brokers need to digest what they’ve bought, moving from an active acquirer to becoming an integrator with a focus on operations,” Germundson says. “Buying so many firms through the years, they figured they’d do the integration later. Later is now here.”

According to Vaughn Stoll, the director of acquisitions for publicly traded Brown & Brown Insurance, “To be successful in today’s M&A environment, you need to be an operator, not just a financial engineer.”

Stoll’s comments suggest some aggregators piled up acquisitions purely to increase the firm’s valuation, with the expectation of selling the business at a premium within a few years. “Once the newer aggregators burn through existing cash, they’ll need to figure out how to operate a business and build a culture,” Stoll says. “Some of them don’t know how to operate an insurance business…and will probably be rolled up into a more successful strategic broker. The question is, at what valuation. The brokers without a robust insurance service culture are not going to drive a premium valuation.”

Typically, about 900 to 1,000 deals are done per year, on average. If we hit 700 deals this year, that’s still two acquisitions a day.
Sean O’Neill, leader of the global insurance sector, Bain & Co.

Blanc, from Howden, agreed that integration is the only way to build a sustainable business for the long-term. “In the prior era of incredibly cheap money, brokers could acquire apace and worry about integration later,” he explained. “Some acquirers made a load of cash without doing the hard work. Like a game of musical chairs, the last chair has been ripped away.”

He added, “You can’t buy a business and promise the previous owner, now a minority stakeholder, that you’ll rebrand it, change their computer systems, and do this and that for the better in two years and not do it. Otherwise, you end up with a lot of unhappy investors…expecting you to deploy capital in the business.”

Recapitalization

With interest rates taking the bloom off the rose, some private-equity held brokerages are hoping for an infusion of cash from existing or new investors to maintain their acquisition pace. “It all depends on where interest rates go, but my sense is we’ll see six to 10 private-equity backed brokers, some in the top 10 and some in the top 30, restructure their capital in 2024,” Trem says. “The recapitalization story is different if the broker has $100 million in revenue or $2.5 billion in revenue.”

The bigger a private-equity backed brokerage is, he explains, the more limited field of potential investors that can write a big check. In such cases, Trem says, the recapitalization may involve a club deal, in which several private equity firms pool their assets to acquire a large brokerage they otherwise could not afford to buy. “Theoretically, we could also see some larger private-equity backed brokers sell to a strategic broker. They always have their eyes open looking for a new partner to take them to the next level. They’re always evaluating opportunities in the market.”

Recapitalization is “much on the minds” of brokerages in the United Kingdom and the rest of Europe also, says Blanc. “It’s happening because of concerns that firms may be overleveraged. Before, if you needed more cash for acquisition purposes, you could borrow another turn or two in EBITDA. It’s a different ballgame today. Capital is not as liquid as debt; it doesn’t go out as quickly. To secure capital you have to have a good story of future business growth.”

Publicly traded brokerages owned by shareholders are less vulnerable to the impact of higher interest rates on M&A dealmaking. “What public companies have that others don’t is their publicly traded equity,” Trem says. “They don’t carry as much debt as private-equity backed brokers, and the debt they acquire is typically much cheaper.”

According to one source, publicly traded brokerages like Brown & Brown, Gallagher and Marsh McLennan Agency ramped up activity as interest rates rose, and they are significantly more competitive and aggressive in the transactions they want to win.

In the U.K., the middle market is hollowed out. Ten years ago, there were about 1,500 firms with staffs larger than 10 people; today, there are only 600.
Peter Blanc, group head of M&A, Howden

“We made 15 acquisitions in 2022 and are on track to do slightly less this year,” Eslick says of MMA. “We’re fortunate in that we have a great backer in Marsh and no worries about interest rates.”

Stoll says Brown & Brown’s acquisition activity has been normal the last three years. “We’re a strategic acquirer, buying brokerages and agencies that make sense, love the insurance business, and are culturally and financially a fit,” he says.

A Never-Depleted Well?

The M&A advisors say readers should not think all publicly traded and private-equity backed brokerages share similar M&A strategies or are equally affected by economic trials and tribulations. “The brokers are not a monolithic universe,” Germundson says. “They all have their own appetites, cultures and geographic targets.”

Trem points out that, even with the Fed’s rate increases, “there are still 50-plus active buyers out there, with the public companies increasing their activity and the private-equity groups lowering theirs.”

A slightly different scenario is playing out in Europe. “While the number of available prospects has declined, there are still a lot of assets out there to buy, albeit much smaller [brokerages],” says Blanc. “In the U.K., the middle market is hollowed out. Ten years ago, there were about 1,500 firms with staffs larger than 10 people; today, there are only 600. However, there are still 2,000 or so firms with no more than five or seven people on staff [as possible acquisition candidates]. The challenge [for them] is growing from a small broker to a bigger one. They need cheap debt, which is unavailable. Organic growth is an option, but that’s problematic when you lack staff.”

Interestingly, the acquisition of thousands of agencies and brokerages over the years in the United States has not depleted the well, with new agencies and brokerages continually being developed and launched to replenish their number. “Despite extremely robust M&A activity over the past decade, the number of brokers remains the same,” O’Neill says. “The newer ones may be a bit more specialized, the case with managing general agencies focused on a particular type of risk or geographic part of the country.”

Several brokers say the rumor mill is churning with stories of other aggregators considering recapitalization options, becoming public companies, or selling to a strategic brokerage. “The rollups in our industry recognize they need to get to the next level of integrating their business or consider going public, but they may not have the infrastructure to support an IPO at this stage,” Wormer says. “Viable options have become more limited.”

Among the options is buying a brokerage or an agency that specializes in a particular vertical, like transportation, entertainment, construction, agriculture, manufacturing or the life sciences, or that is lasered in on a specific risk like surety or cyber. “Most active buyers out there really want specialty business and middle-market accounts, which is why they still get a premium valuation,” Germundson says.

Asked to predict the future, Trem paints two pictures. “We’ve got a presidential election coming up, which always causes anxiety for people relative to tax changes,” he says. “Depending on who is in the White House, the Trump tax cuts in 2017, that lowered ordinary income rates for all Americans, sunsets at the end of 2025, effectively raising everyone’s taxes. The question is, will the government freeze tax increases for middle Americans and increase capital gains taxes instead?”

If this is the case, Trem says, brokerages and agencies holding on for another few years before selling may decide to sell sooner to offset the impact of higher capital gains taxes. “If supply rises to meet demand, we could see another year of record-setting transaction volume.”

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