Deals that look good on spreadsheet often suffer from a lack of strategic focus

Way back in September when Marsh & McLennan Companies (MMC) agreed to buy JLT I summarised the deal like this.

“There are deals that make sense in spreadsheets and deals that just make sense. Our preliminary view of MMC’s acquisition of JLT is that it falls firmly into the latter camp. In fact, we think it is probably the best piece of insurance industry M&A since Ace transformed its business (and the sector) with the acquisition of Chubb in 2015.”

I think it’s fair to say I am not alone in thinking that Aon’s short-lived interest in Willis Towers Watson probably fell into the former category - of deals that just make sense in spread sheets?

In the case of Chubb, Ace bought a company with a fundamentally better business and transformed itself into a global leader, while also gaining further financial synergies from tax and ceded reinsurance.

And though not as transformational, MMC is still buying a faster-growing business with additive capabilities through talent and data. With the use of debt to fund it, the deal has the economics of a leveraged buyback but for a faster growing earnings stream bought at a discount to MMC’s own multiple when adjusting pro-forma for expense synergies.

A good strategic rationale can be described in a simple sentence or two like this. But I’m not sure I can do that for Aon’s short-lived interest in Willis.

As we pointed out immediately after the deal was announced, the deal is difficult to square with Aon’s previously announced strategy.

Perhaps I can just about make sense of it as a purely opportunistic financial deal. Given succession issues at the target and perhaps some discontent from its shareholders, a nil premium, all-stock merger is not entirely implausible.

At this level, you could think about it as a kind of financial arbitrage. You pro-forma the target’s earnings for some standard deal synergies. Even if you then issue your own shares at a discount, you can probably still issue them at a significant premium to the pro-forma multiple you’d be paying to buy earnings.

This would make the deal accretive to EPS and provide a multi-year tailwind to earnings without having to do anything heroic on organic growth. On top of that, given the seven point spread on margins between Aon and Willis, you have the opportunity for further longer term earnings growth as you slowly grind those Willis margins higher. And that extra market power is probably worth something too.

However, deals that look good on spreadsheet often suffer from a lack of strategic focus. In the case of Aon and Willis, I think there are three obvious issues.

The first is what I would call the “opportunity cost of opportunism”. This type of deal might look great from an ROI or IRR perspective. But if it undermines the strategy you have been selling to your stakeholders, whether investors, executive team, or employees, then there can be serious real-world consequences.

The second is simply strategic drift and distraction. This would turn on its head Aon’s prior stated goal to grow the insurance pie, and turn it into an all-hands on deck operation to do the messy work of consolidation and cost efficiencies while minimising revenue leakage.

There is no way organic growth would not suffer from a lack of focus, let alone the issues of dis-synergies from client concentration, talent flight, and anti-trust.

The third and final is simply that Willis is a weaker business. For sure it has some excellent pieces, and some first rate talent. But it runs at substantially lower margins than all of its public peers, and still just has a lot of heavy lifting to finish its own integration work following the merger.

I don’t think I am really saying anything particularly controversial here. And the fact that this has so quickly become conventional wisdom I think tells us something interesting about the market.

One of the consequences of the XL-Catlin and Ace-Chubb mergers was a sudden realisation across the industry that investors were willing to consider dilution to tangible book at levels once thought of as unconscionable. I think of these two transactions as the tipping point moment for industry consolidation among carriers.

I don’t want to go so far as to say we have reached the end of that journey. But I do think this week served as a useful reminder that there are real market forces that act as a constraint on infinite consolidation.

We saw this in the market’s negative reaction to Aon’s proposed deal, with the shares down 6 percent on the day, and a rush of analyst notes focussed more on potential anti-trust issues rather than growth synergies.

Arguably, we are also seeing some of these issues manifesting in talent leakage issues. The recently announced start-up by former Aon president Steve McGill is one example.

And just this week, this publication revealed Guy Carpenter’s North American chief executive Timothy Gardner was leaving with two colleagues to join Lockton Re, probably motivated by the combination of an opportunity to be entrepreneurial with compelling personal compensation for high performance. This is harder to find within the corporate cultures of the public companies if you’re not in the very top job.

The big brokers love to talk up their margins, but so-long as broking executives continue to own clients and revenues, the industry structure will never tolerate monopoly, duopoly, or anything close. The market won’t let you consolidate to infinity.

To be clear, I expect the meat and potatoes consolidation of broker and agency to continue to run unabated. But I think the chances of a mega-deal is substantially lower than it was at the start of the week. To some in the carrier space, this likely comes as a welcome relief.

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