Buying and selling - Does everyone want a broker?

The market for buying brokers has been characterised by a large volume of deals over the past few years and not necessarily the scale of them. The international brokers have been hit by Spitzer and do not have sufficient cost-effective models to compete significantly for small to medium-size brokers; only the merger of Saga and The AA will have popped onto a once-active radar screen. The deal raises the question of why it has taken so long for big broker transactions to return.

A survey of delegates at the British Insurance Brokers' Association conference in April 2006, commissioned by Lloyd's, identified that many brokers foresaw a wave of consolidation in the UK and London Market broking sectors. When considering the biggest threat to their businesses, 24% of respondents chose 'super brokers created by consolidation'.

The average broker at BIBA comes from the smaller broker fraternity and their most popular answer to the question of what change is most likely to affect the UK broking landscape over the next 18 months (from May 2006 to November 2007) was 'the growth of large brokers through the acquisition of smaller brokers' at 78%. This was closely followed by "the consolidation or merger of mid-size brokers" at 68%.

Since then, we have seen the emergence of: vertical integration with insurers entering the fray to acquire brokers; proposed changes in distribution at Lloyd's leading to the first signs of consolidation of the wholesale broker community; and rising prices paid for brokers that have made selling a business attractive for many broker owners.

What the 2006 survey could not have foreseen was the impact that the credit crunch would have on the stock market value of the listed brokers. For example, Benfield's share price fell from a high of 381p in January 2007 to a price of 225p before the proposed Aon transaction, a fall of 41%.

Valuation trends

The majority of recent mergers and acquisitions transactions have been in the regional commercial market, where average deal multiples rose by 20 to 25% cumulatively in both 2006 and 2007. These rising prices were, in part, a result of competition among a new breed of consolidators and, also in part, due to the emergence of insurers willing to acquire distribution assets - notably Axa and Groupama and others such as Equity and Highway. By the end of 2007, average deal multiples for transactions above £20m were in the region of 12 times profit before tax and interest charges.

Prices have since fallen as the credit crunch has bitten and the amount of debt available to purchasers has reduced. This has affected the private equity community, which has been captivated by brokers due to their relative insensitivity to credit ratings, their stable cash flows and good earnings prospects.

The appetite for acquisitions continues, albeit it is now on a different pricing scale. There is a recognition that the insurance cycle is about to turn, which can only be beneficial for the average brokers' earnings.

Investigating the depths of the soft market provides the explanation as to why insurers entered the buying fray and why this led to rising prices for brokers. With rates falling, insurers and commercial lines insurers looked to capture control of their distribution; this met with competition from brokers and hungry private equity firms, with the result that valuations for brokers rose. Insurers, some of whom were desperate for more SME business, were forced into the M&A arena in an attempt to eliminate the risk of their exposures to the major broker consolidators, who were controlling more business and demanding higher commissions. It was about insurers remaining in control of their destinies.

Axa has developed a substantial broking arm in its business by acquiring Smart & Cook, SBJ, Layton Blackham and Stuart Alexander. In Towergate and Axa, the market had two strategic buyers in the SME sector and this, in part, caused the upturn in deal multiples.

Towergate recognised at an early stage the inherent value in a broker that exists from the underwriting profitability of the book of business it controls. In the past, when people valued a broker, they focused on what was perceived as the intrinsic value of an insurance intermediary. As such, they considered the level of maintainable earnings, an assessment of the prospects for the business and whether any surplus assets could be identified or not.

However, this historic approach did not focus on the economic value of the underwriting opportunity because, in general, the acquirers were other intermediaries. It is now recognised by some vendors that a valuation based on the intrinsic value of an insurance intermediary alone ignores the economic value to an underwriter stemming from the underlying profitability that can be secured. In some cases, this can be significant and needs to be factored into the valuation.

The vendor needs to understand three elements in order to achieve maximum value:

- The intrinsic value of the intermediary business

- The economic value of the underwriting opportunity

- The different characteristics of individual buyers

Each of these has had its part to play in rationalising why UK regional broking deal multiples have increased in recent times.

Endgame

For the UK regional market, consolidation will continue in the short to medium term. The major consolidators are in a race for scale and the winners will be those that have the finance available to effect acquisitions, integrate those acquisitions quickly and manage their insurer relationships to maximise revenue while delivering organic growth.

In the UK regional market, the long-term endgame is likely to see a small number of large consolidators controlling the majority of premium. The structure of the market will change as a result and will start to look more like a tied or multi-tied model, with independent small brokers increasingly becoming parts of networks.

For wholesale brokers, consolidation is only just starting. Age demographics will drive an immediate increase in transaction volumes as departing shareholders seek to cash in. Clear winners will emerge to compete with the major international brokers for placement on the London Market.

Among the true big boys, the international brokers, Benfield was the true jewel and has fallen to Aon. Further consolidation among the other international brokers is unlikely in the short to medium term. Finally, we should not forget personal lines brokers, of whom three out of the four major players are already owned by private equity interests that are likely to seek an exit in the short to medium term.

Ian Clark, partner, Deloitte

Sales drivers

From the vendor's perspective, there have been numerous drivers that have led them to dispose of their businesses. While not exhaustive, the main drivers have been:

- Age demographics: Analysis by IMAS in 2007 suggested that 66.1% of broker principals were over 50 years of age. In 2002, this figure was as high as 78.3%. Given that two thirds of shareholders remain over 50, this is likely to be a key driver. The reduction in the number of brokers from an estimated 8,000 in 2002 to approximately 4,000 today can be explained partly by this simple demographic. This is particularly an issue in the Lloyd's Market among wholesale and international brokers, where the breakaways from big brokers and establishments of new businesses in the 1980s and early 1990s created their own demographic time bomb.

- Inability to compete: For the smaller brokers in particular, the emergence of broking consolidators on their doorstep with far-superior commission deals, a wider selection of insurer accounts and better products and pricing has caused some distress. Many smaller brokers have chosen to join a network to secure some of these benefits as a result, however, others have chosen to exit.

- Increasing regulation: The intervention of the Financial Services Authority - and all that was required to register - put a number of small brokers off continuing in business. Those that chose to trade through and register with the regulator expected that, once inside the new club, regulation would reduce, making their lives easier. This has proven to be far from the reality, as shown in ever-increasing compliance costs.

- For wholesale and international brokers, there are other drivers such as the issues caused by the softening market at a time when the dollar exchange rate has reduced sterling income significantly while expenses continue to be paid in the latter currency. Further to this, Lloyd's amended its own rules to make it easier for overseas brokers to access Lloyd's direct. Together, these factors have created a difficult trading environment with few prospects of the situation being resolved immediately. Consolidation and the synergies that this can bring have therefore become increasingly attractive for those brokers with a healthy financial disposition.

- Price: The competition among buyers referred to previously has led to a gradual upward drip-feed in values achievable on disposals, making it more attractive for vendors to exit.