Broker Multiples: Does Gravity Still Apply?

For brokers who have spent the greater part of their careers building up their brokerage businesses, there will always be a great amount of interest when it comes to questions about selling the business – when should it be sold? to whom should it be sold? for how much should it be sold?

For most brokers, their brokerage represents the largest contributor to their personal net worth. The sale of their business will always generate a great deal of interest, but this is even more the case now: multiples for which brokerages are being sold have reached historic highs.

OVERHEATED MARKET

Many describe the current market as overheated. A number of factors contribute to this. One is the economic law of supply and demand: whenever demand outstrips supply, prices will rise. Unquestionably at this moment, there are far more buyers than sellers; this has had the predictable effect of driving prices up.

Part of the buying pressure comes from other brokers. Brokerages are feeling the pressure to increase their size in order to have greater clout with their existing markets and to be able to gain the benefit of economies of scale. A brokerage can always grow organically, but the quickest way to grow is through the acquisition of another brokerage.

Interest rates are also a factor contributing to the seller’s market. They are higher now than they were a couple of years ago, although they are still low in comparison to the rates we have seen over the last quarter century. These relatively low interest rates reduce the cost of making an acquisition.

The eagerness of many insurers to provide financing is also making acquisitions more attractive at the moment. A number of reasons may explain this eagerness. Insurers may wish to see a brokerage sold to ‘one of their own,’ for example, as a means of protecting a valued book of business. Or they may hope that, having provided funds to the acquiring broker, that broker will then favour the insurer with a disproportionately large share of any new business and/or the rollover of a profitable book of business that is currently written through a competing insurer.

The point is: the money is there, it is relatively easy to come by, and it is relatively cheap.

Add to this the fact that it isn’t only brokers who are bidding to buy brokers: insurance companies or their holding companies – i.e. Royal & SunAlliance Canada and ING Canada – have entered the fray. As potential investors, these insurers no doubt view the purchase of insurance brokerages as a way to increase their market share and/or to earn a good return on their investment. The entry into the broker marketplace of insurers and their holding companies has resulted in no shortage of controversy; in some cases, it has created ill will. The independent brokers’ associations, in particular, have seen the purchase of brokerages by insurers or their holding companies as a grave threat to the independence of brokers. In response, some insurance companies have become quite vocal in their opposition to the purchase of brokerages by an insurer or an insurer’s holding company.

Whether the purchase of brokerages by insurers truly represents a threat to the independence of the broker is a question for another day. The point here is that the entry of deep-pocketed insurers into the marketplace for insurance brokerages has added to the demand, thereby leading to a bidding-up of the prices for which brokerages are being sold.

The entry of some non-insurance investor groups – i.e. Newport Partners Income Fund – has even further contributed to the demand. These non-insurance groups are attracted to the marketplace by the significant returns on investment that can be earned by purchasing a general insurance brokerage. They see this as nothing more than a wise and potentially lucrative investment decision. Although most insurers have earned profits in the last couple of years, this follows a number of years in which the shareholders of insurance companies witnessed dismal returns on their investment. The return on equity for brokers has been better and more stable than that of insurers or reinsurers; hence, capital is more attracted to brokers than to insurers or reinsurers.

DETERMINING WORTH

As much as the current marketplace may be overheated, any sensible buyer will need to receive assurance that an acquisition can be capitalized over a reasonable period of time. This leads to the question: what is a fair price to pay for a brokerage?

Although the selling price is almost invariably based on a multiple of net commissions (that is, commissions net of contingent profit commissions), the process of determining what multiple to offer is based on normalized Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA). The determination of the ‘normalized earnings’ for a brokerage is never an exact science. If you were to look at the financial statements for most insurance brokerages, indeed for most privately-held businesses of any kind, you would expect to find room to cut expenses. Without cataloguing what those expenses might be, one can assume the acquirer will ask the following question: What would the bottom line look like if this brokerage were being run as a cold-blooded business enterprise rather than as a family business?

Normally, the answer is that the bottom line looks much better when all extraneous expenses have been eliminated and all exaggerated expenses reduced. Once a normalized EBITDA figure has been calculated, a reasonable purchase price might be determined as being eight or nine times this figure. Taking into account the effect of taxes, this would allow the purchaser to pay for this acquisition within a period of approximately 12 years if all the earnings of the brokerage are used to pay off the purchase price.

Let us say, for example, that the selling brokerage generates net commissions of $1 million. According to their latest financial statements, the net profit before tax is $100,000. An analysis of their operations reveals that if this brokerage were to be run as a hard-hearted business, the normalized EBITDA would be $300,000. Using the above-mentioned figure of eight to nine times EBITDA, this would suggest a purchase price of $2.5 million. Although the purchase price in this example is two-and-a-half-times commissions, the thought process leading up to this purchase price was not based on commissions: it was based on the normalized EBITDA.

To the extent that the selling price will almost certainly be a factor of EBITDA, it is in the seller’s best interest to have a brokerage that is capable of generating substantial net earnings. As is the case with any business, not all brokerages are created equal. Some brokerages are inherently more profitable than others. This may be a result of the brokerage’s mix of business, its level of automation, a favourable lease, or any of a number of other factors. All things being equal, however, anything that drives up the net earnings of the brokerage will drive up the asking price for that brokerage.

As stated at the outset, for a variety of reasons, the purchase price of brokerages is currently at an all-time high. This leads to the question: Does what go up necessarily have to come down? Is it possible that multiples will simply continue to climb?

DOES GRAVITY APPLY?

It is difficult to say whether multiples will continue to climb, whether they will plateau at their current peak or whether they will start to fall. All anyone can do is provide an educated guess.

A number of factors suggest the law of gravity may indeed make its presence felt sooner rather than later.

One of these factors is the demographic curve. According to the brokers’ association, the average age of a brokerage owner in Ontario is roughly 60 years. It is reasonable to assume that many of these owners will be looking to sell within the next five years. It is to be expected that this increase in supply will inevitably lead to a reduction in prices.

The long-term trend in interest rates also suggests multiples may be cooling off sometime in the future. Although it is always difficult to predict with accuracy where interest rates will be two or five years down the road, most economic forecasts call for interest rates to rise. Insofar as any increase in interest rates adds to the cost of borrowing, this should put downward pressure on the price of brokerages.

Another factor that should cause multiples to ease back to more normal levels is the general reduction in bottom-line profits as the underwriting market softens. If we compare the financial statements for most brokerages, we are already witnessing a falling off of profitably for the current fiscal period in relation to the previous 12-month period. As commission incomes stagnate or fall at the same time expenses increase, this can only cause EBITDA calculations to moderate; in turn, this will reduce the reasonable purchase price of a brokerage.

For brokers whose timeline for selling is long, the decision to sell the brokerage may be put off until the next underwriting cycle hardens. For brokers with a relatively short time line for selling, they may not be prepared to wait for the next hardening of the underwriting cycle and so may decide to sell their interest now while the multiples are still strong.

Making predictions is hazardous at the best of times. Although the selling price of brokerages is not subject to the physical laws of nature, it seems reasonable to suppose that the equivalent of a law of gravity will at some point make its presence felt.