A deluge of private capital is entering the private broker market as valuations peak, John Wepler, CEO of investment bank Marsh Berry, has told The Insurance Insider.
In addition to the private equity (PE) capital that has dominated the sector over the past decade, new types of investors are entering the space.
“Sovereign wealth, pension funds, the balance sheets of public companies, it’s like a freight train right now,” Wepler said.
Up to $188bn of investors' capital has been allocated to the insurance sector, including $141bn of private equity capital, Marsh Berry data show.
Major deals involving pension fund capital include Caisse de dépôt et placement du Québec's 2017 investment in USI alongside PE royalty KKR.
Brokers have been on the M&A war path so far this year, with 451 transactions taking place in the first nine months of 2019, the highest ever level, according to Marsh Berry.
Data from the company puts the average valuation for a top quartile insurance broker deal at 13.73 x earnings before interest, tax, depreciation and amortisation (Ebitda).
The average of the 12 months to 30 September 2019 was 11.56 x Ebitda. For the full year of 2018, valuations were 10.85x Ebitda in 2018, up from 10.37x in 2017.
The valuation figures include shareholder earn out bonuses if growth targets are met, but even stripping out these bonus payments, the prices paid for independent brokers are escalating.
The investment bank’s data shows that the base purchase price for agencies in 2019 grew by 15.8 percent to nearly 9x Ebitda. Back in 2016, the base purchase price for brokers was 7.73x Ebitda.
“The current broker valuations are appropriate at the moment, given the returns the funds have achieved,” explained Wepler.
“This is not a fad, it’s the new normal.”
Wepler said “insurance broking is the greatest industry in the history of mankind" because of the manner in which renewal books create a steady flow of income that can be borrowed against to invest in further growth.
He added that, unlike most business, even a mediocre insurance broker would be able to renew the vast majority of its accounts each year.
Using the renewal book income as a basis, private equity firms apply debt leverage to insurance brokers to fuel inorganic growth.
Analysis by sister publication Inside P&C on privately held brokers found that Acrisure is carrying the most debt, with a debt to Ebitda ratio of 9.2x. Alliant has a 9x debt to Ebitda ratio. Hub operates at 8x Ebitda and USI at 5.4x.
Of the top 20 most acquisitive brokers, 15 were PE-backed in Q3 2019. Hub was the busiest acquirer over the year to date, completing 28 transactions.
But there are some potential challenges facing the sector. Most of the private equity-backed brokers' corporate bonds are rated as junk, BBB, by credit rating agencies.
In a recession, the liquidity on BBB rated securities is “the first to freeze and the last to thaw” in the event of a recession, he said.
“If the economy stumbles, the cost of capital is going to go up.”
Some of the tax advantages of the private equity model are also set to change in 2022 under President Trump’s reforms to the tax code. Currently, private equity-owned brokers pay less tax and operate at higher leverage than their publicly-listed or independently-owned peers.
Wepler concludes that over a three-year time scale “valuations of where they are today” appear “very fragile”.