By Paul Buse, President of Big I Advantage^®

Recently I was struck by an article in an industry publication that gathered information on mergers and acquisitions of insurance agencies. In particular, one sentence in the article caught my attention. That is, "a surge in private equity-backed buyers…has resulted in sky-high valuations [of] annualized EBITDA [rising from four to seven] to double-digits." As students of the industry, you should know that multiples paid for agencies you hear about are all mathematically linked and an EV/EBITDA multiple of over 10 is, indeed, "sky high." In the S&P 500, an EV/EBIDTA ratio of 10.0 would equate to a P.E. ratio of 24 (based on averages of both since 1990).

So, how to make sense of agency multiples? Some math helps. If you hold key variables constant, a single agency can be described as selling at a commission-multiple, a EBITDA multiple or PE multiple. The key variables that must be held constant are the acquirer's cost of funds, the agency's pre-tax return on revenues and taxes. One also has to assume any amortization or depreciation of assets are removed from consideration such as building or other asset depreciation. With that, you can get to the table below mathematically assuming 10% cost of funds, a 20% pre-tax return on revenues/commissions and 35% effective tax rate. As you can see, an agency under these assumptions has to be assumed it will grow its profits by an average of 4% indefinitely. While seemingly not that difficult to grow at 4%, "indefinitely" it is a long and steady climb. Also, what is not shown below is if the cost of funds increases to a more typical long-term average of at least several points higher, you need 6% growth to get to a 10.0 EV/EBIDTA ratio.

 

Agency Multiples at 10% Cost of Funds, 20% Return on Commission and 35% Taxes

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Source: A.M. Best Aggregates and Averages IEE and Underwriting and Investment Exhibit