A very tempting option

A number of mechanisms are driving the cur- rent market for broking businesses: continued consolidation; the emerging trend of insurers buying brokers; the number of broker owners now reaching retirement; and changes in the general operating environment.

Consolidation, and with it the phenomenal progress of Towergate and the emergence of 'super-regional' brokers like the Jelf and Oval groups, has forced many smaller brokers to review their position in the market. Some brokers, if they lack the size or critical mass to compete in this consolidating market, find themselves being forced to sell up. Others have changed, or are changing, direction and are looking to establish themselves as niche specialists.

Alongside consolidation, there is the recent trend of insurers buying brokers. This has pushed valuations for broking businesses even higher. With a sizeable contingent of broker owners approaching retirement, few would blame them for taking advantage of the situation and actively seeking a sale that could bring them more than they might achieve through a management buyout a few years down the line.

Market and economic conditions

Regulation is a word that has never been far from brokers' lips in recent years, and some might argue that, in certain circumstances, it can play its part in pushing owners towards a sale. Smaller brokers in particular have found Financial Services Authority regulation a hindrance, as they often lack the resources needed to implement the business processes that help them adhere to the rules. Moreover, the majority of smaller brokers are entrepreneurial businesses, which like to move quickly as different opportunities arise, and historically the niceties of drawing up processes and procedures were secondary considerations. Regulation needs to be embedded into the culture of the business from the top down, and this takes time and investment to achieve.

Other market and economic conditions playing on brokers' minds include soft premium rates, increasing interest rates, and a rise in the small companies' tax rate - which is due to hit 21% by 2008 and 22% by 2009. In addition, the weak dollar is not helpful to brokers operating in the London market or internationally.

The vast appetite of the consolidators shows no sign of diminishing. Recent figures have suggested firms were being bought at the rate of one a week in 2006. Towergate in particular has become a real force to be reckoned with, underscored by impressive hires such as Patrick Snowball, former Norwich Union executive chairman, as deputy chairman. While Towergate - at least at the time of writing - remains privately owned, Jelf listed on the Alternative Investment Market three years ago and raised a significant amount of capital to finance a string of acquisitions. Others are set to follow in its footsteps - Cobra Holdings, parent of Cobra Insurance Brokers, is due to list on the AIM imminently and hopes to raise £10m for acquisitions. Giles and Protectagroup are said to have similar intentions. A listed broker can offer shares as well as cash to potential targets, which allows them to follow a more bullish acquisition strategy without burdening the business with massive debts.

In recent months, however, it has been hard to ignore the emerging trend of insurance companies buying brokers. High profile deals like Axa's acquisition of Stuart Alexander, Layton Blackham and Smart and Cook, and Groupama's acquisition of Carole Nash have fuelled gossip as to who will be the next target. Spurred on by increased profits and the capital structures that allow them to make strategic acquisitions, the insurers' main motivations centre around a desire to get closer to clients and control their distribution channels. In commercial insurance in particular, brokers rather than underwriters have conventionally been in command of the client relationships. However, the market is very fragmented, the bulk being made up of numerous smaller players. According to estimates there are currently around 4000 brokers in operation. In relative terms, only a handful of businesses are going to attract real interest from underwriters.

Most would agree that brokers are unlikely to see significant interest from other financial institutions in the very near future. Most banks would find it difficult to put together a strong rationale for broker acquisitions, not least because of the size and profitability of the majority of broking businesses. One exception might be the Royal Bank of Scotland, which is said to control around 30% of the SME banking market and has built up a portfolio of brands to stand alongside Direct Line and Churchill: Devitt, a specialist motorcycle insurance broker; Finsure, a premium finance provider; and NIG, which provides commercial and personal lines products exclusively through a network of around 3000 brokers.

Interest from private equity groups and venture capitalists in outright broker acquisitions has so far remained at a low level, primarily because VCs depend on a strong and steady profit stream.

Given the current market, a trade sale to a bigger broker - or to an insurer - may sound like a tempting option. However, for those owners that have concerns about the long-term future of the businesses they have spent years building up, handing over control entirely may not be the right option. One alternative might be to sell to a network. This route offers a degree of continuity for older brokers looking to retire. Demand is still strong - in June, for example, it emerged the former head of Axa's commercial direct arm has joined Broker Network, with the aim of setting up a new subsidiary targeting small commercial business.

Traditionally, management buy-outs have been a popular exit route for brokers, especially those approaching retirement. If existing senior management are keen to take the helm, then this can still be a very good option, and certainly offers continuity to clients and employees. The main difficulty tends to be raising adequate capital to finance the transaction. Venture capital can offer a solution in some cases but negotiations can be complex and the exact split of equity subsequent to any deal is often a common source of contention. On the positive side, involvement of VC specialists can often work to the business' favour, and provide incoming management with the capital and connections they need to really push things forward.

A timely decision?

Of course, tough trading conditions do not necessarily mean that selling up is the right thing to do. If you have the right contacts, and can secure adequate capital, then turning poacher and acquiring or merging with another business is a possibility to consider. At the very least, any deal should put the new business in a stronger position should one of the original owner-managers decide to exit further down the line. It goes without saying that a deal has a better chance of lasting success if the target partner is a good fit, for example, a broker with a similar business culture and complimentary credentials.

Owners need to factor in both market conditions and growth cycles to decide whether an exit is a sensible and timely decision. Current business performance may not attract the right sort of interest and, therefore, favourable valuations from potential buyers. The business needs to be operating effectively and achieving optimum financial performance to boost value and make it an attractive purchase proposition. It is also important to make sure that the business is in a good position for potential purchasers to undertake due diligence. Ensuring that your corporate and financial documents are up to date is vital in speeding up the sales process and achieving the best price.

Once these considerations have been thoroughly evaluated, conveying change to staff, suppliers, customers and the market is vital. Many a good deal has not achieved its full potential because of poor communication and consultation with these groups.

An outright sale will almost certainly bring a degree of transformation to the business. Changes in management, structure, focus and services will all have serious effects on shareholders, clients and employees. In the worst case scenario, key stakeholders could end up cutting their ties as a result. Taking a holistic view of what a sale will mean for the business and its constituents is essential. The same considerations should apply to part-sales - to a VC, for example - that may be arranged to facilitate a change of control. However, more emphasis should be placed on grooming the management team so that they make a good impression on the backers of the transaction.

Difficulties might also arise because of unrealistic expectations on sale price - from seller, purchaser and founder alike. In current market conditions, brokers looking to exit could risk focusing on inflated valuations that may not be representative of the business being sold. To achieve a desired sale, more emphasis should be placed on profitability than size. However, if the buyer is willing to pay a premium for the volume of clients he is acquiring, profitability becomes less of an issue.

The market is in a state flux, but brokers looking to exit can achieve a good result if: they are aware of the market mechanisms at work; are as realistic and objective as possible when assessing the state of their business; remain on their toes in negotiations with potential buyers; and prepare themselves for stumbling blocks to emerge as the deal develops.

Mark Grice, Head of broker services, Mazars.