Finding a favourable exit during the economic downturn has proved tricky for broker owners. Leigh Jackson reports on how the tide may be turning for those looking to sell.
Although the fragile and difficult economic conditions facing the UK are being closely monitored by the length and breadth of the insurance industry, none will be watching more intently than broker owners.
With a demographic that continues to age, many owners who have been running their businesses for decades are hoping to exit with a nest egg suitable for retirement.
However, executing an exit on favourable terms has proved difficult for owners over the past few years. An increase in initial public offerings among intermediaries, predicted earlier this year by Marsh, has yet to be seen — with those keen to realise the value of their businesses forced to wait for the right offer.
"It is difficult to see where the value is in IPOs for most companies; there really is little demand for it," says John Needham, a partner in Littlejohn's financial services team. "There are some companies in the wider financial services sector that have considered delisting. Firms get some money, but sometimes not as much as they wanted, and the overheads are huge."
The belief is that flotation is an option for companies of a sufficient size, arguably making it an inappropriate exit option for many broker owners. As Olly Laughton-Scott, managing director of vendor advisory firm Imas, explains: "As a company we are very sceptical of IPOs other than for the largest firms. There is nonsense talked about them because, for small businesses, it simply doesn't provide an adequate exit."
If IPOs do not represent an 'adequate exit', what options remain open to brokers looking to sell up? One of the problems arising when a sale is considered is price. With vendors hoping to get the most from their business, their own valuation could be rather different from that of the buyer.
As broker acquisition levels have declined over the past two years, prices have reduced to more sustainable levels — with valuations now more focused on underlying profitability than income multiples. Paul Meehan, Axa's customer experience director, says that underlying profitability has always been used as a measure of valuation but agrees that it has become more widely recognised as the effects of the economy began to bite.
"Every acquisition ever made has been influenced by profitability," Mr Meehan explains. "You could have a £10m top-line broker that makes £50 000 and you can have a £2m top-line brokerage that makes £1m. It is right that the focus has shifted, as most brokers are far less profitable than in the past — and what you don't want to do is buy a broker that is not making any money." He adds: "The drivers to sell are still there. Some of these guys that set up their businesses in the 1960s and 1970s are getting old. They are keen to get out and realise their assets."
Using underlying profitability as a measure of valuation can present its own problems for brokers seeking an exit. A narrowing of margins and a raft of new financial measures may see profits shrink and with it company value falling. "At the moment, insurers are squeezing brokers on their commission rates and by the amount of business that they can do," explains John Harrison, sales and marketing director of CCV. "As a result they are becoming less profitable. They might even end up with less than they would do if they used the old formula of multiples of revenue."
More recent changes, such as those in the coalition government's emergency budget, may also impact on vendors hoping for a sale. While the budget might have seemed tough for insurance companies and their consumers, there is a belief that it provides a unique opportunity for an exit.
Mr Harrison explains that, with capital gains tax likely to increase to 28%, now could be good time to try and complete a sale. "People were a little bit cautious before the budget," he explains. "But the government has left a window open on CGT, which is very positive move."
He adds: "People will be wondering how long it will last, as the recession is here and we know the tax bill is likely to increase. We have not seen levels of interest in sales like there have been in the past three months. Brokers that had given up talking to us 12 to 18 months ago have suddenly got back in touch. If they are going to cash in, now may be a good time to do it."
With the CGT window expected to close, and rates eventually increase, there is a chance that valuations are more likely to decrease, rather than increase, in the future. Simon Williams, a director at Gambit Corporate Finance, says: "Conditions for selling a business are currently better than many people would believe for several reasons. Valuations have declined to a more stable level, as compared with two years ago, but I don't see valuation multiples increasing significantly in the next few years. From a tax perspective, business owners can benefit from entrepreneurs relief at the moment, whereas many commentators believe that capital gains tax rates will increase closer to income tax rates in the medium to long term, with the emergency budget being the first step in that process. It's the net of tax return to the shareholder that needs to be considered, and not just the headline price."
He adds: "Many brokers who are looking to sell, perhaps for retirement reasons, may feel they missed the boat by not selling two to three years ago. Some business owners will feel that they've already delayed the exit event over the past two years, and won't want to continue for another few years hoping for improvements in valuations that may not transpire. Now isn't a bad time to be considering selling your business."
Looking for a quick exit
However, there is little consensus on this point and, with valuations reaching a short-term high, Mr Laughton-Scott believes that any brokers looking for a quick exit should rethink their plans. He explains: "The budget will not have any effect on broker exits whatsoever. Most insurance is a semi-compulsory purchase and, as long as the taxes and regulations affect the industry, the costs will be passed on to the consumer."
He adds: "However, greater regulation, while initially pushing up costs, increases barriers to entry, which actually makes businesses more valuable rather than less. In terms of capital value, an increase in regulation is a very positive development. The right time to sell is when it suits you personally but if people see greater regulation on the horizon they would definitely not sell in the short term."
On the purchaser side of the coin, regardless of the timing of the sale, there remains the issue of raising funds. With the economic downturn hitting the credit markets, the belief among some experts is that it remains difficult for many companies to secure the funding needed to make a move.
"Raising finance is a serious problem," Mr Meehan explains. "Getting credit could be extremely difficult; the bigger guys — like Giles and Oval — have got cash and they are in a position to buy but smaller brokers will struggle."
However, Mr Needham believes the situation is improving, with entities like Lloyds TSB Corporate Markets and Macquarie looking to put more debt in the market — albeit on tighter lending criteria. "We work closely with finance providers and, up until three to four months ago, we were negative about companies being able to get acquisition credit," he says.
"But the doors are starting to open up. Creditors are having conversations they haven't had in a while, which is a positive development. Lloyd's TSB Corporate Markets is advertising the fact that it is out there lending again."
Lloyd's TSB Corporate Markets relationship manager James Smyth, explains that the bank is indeed putting together a number of deals but admits it would take more than a credit injection to re-stimulate the market. "We are, by some margin, the largest provider of debt to brokers in the UK. We already have a number of very large important relationships in the sector and are committed to that."
He adds: "What the market needs is a catalyst to spark the next round of deals. You might see some refinancing but you need a catalyst, such as a consolidation of consolidators or a big new private equity injection."
A further option for brokers looking to exit their business could be an insurer sale. With many underwriters not facing the same sort of pressures as brokers, Mr Williams believes insurers might begin to see intermediaries as serious acquisition targets. "Insurers are keen to secure their distribution channels," he explains. "They focused their attention on consolidators for a period, and have now switched the focus back to brokers."
Mr Williams adds: "We have several clients who are in dialogue with insurers about having a facility available to either undertake a buy-out or make an acquisition. The funding environment has improved, with renewed interest in the broking sector from private equity funds, and some signs of improvements in the availability of debt."
Questions remain about the long-term objectives of insurers buying into the distribution channel though, including worries over the independence of brokers that are purchased. Mr Needham says: "Insurer purchases are on the increase and I find it quite an interesting development. From a broker's perspective, if an insurer has a stake, it will have an influence on your behaviour whether you like it or not. Brokers could start to lose their independence more quickly than they might think."
Lower risk option
With many brokers having waited a number of years for a suitable exit to emerge for their business, one option that may gain in popularity is a management buy-out. Mr Williams explains: "I would expect to see an increase in the number of MBOs. During 2009, across all sectors, there was a 72% decrease in their value. Activity levels started to return in Q4 2009 and this continued in Q1 2010. For a vendor, an MBO represents a lower risk option and it is easier than selling externally. Ultimately, the management team understands the business far better than a trade buyer and, at the moment, there is a better opportunity for them to compete with a value from a trade buyer than two to three years ago."
However, Mr Meehan says that while MBOs may represent a viable option for an exit, many second tier managers may shy away from taking up the debt necessary to fund the buy-out. "There are a number of issues with MBOs," he explains. "Firstly, sellers get your money on the drip, so you have to wait for it. In addition, it usually goes for less than if it was sold to an external buyer. A lot of second tier managers haven't the guts to do this because it still requires a lot of money — especially at the smaller end of the market. The MBO is potentially a last resort for a vendor."
While the jury remains out on the range of exit options for broker owners, it seems as if most will have to continue to wait for their big sale and retirement. But with Lloyds TSB Corporate Markets leading the lending charge, attention has fallen on banks, and the authorities, to make more credit available during leaner times.
Mr Harrison says: "The government needs to get involved to push banks to lend. It has tried to give banks an enticement to lend but what the industry needs is some kind of instruction or requirement. If that was in place it would lead to a freer market, with not so much increased overrides on the existing deals that take place."
According to Howard Lickens, chief executive of the Clear Group, the nature of the broker market will allow it to attract credit from the necessary sources to increase future activity. "Brokers still represent good returns and good security for banks, as we are strong and reliable. There was cash flow around property lending and brokers are no way as risky. The industry is a relatively good bet."
He concludes: "People who wouldn't have dreamed of selling their businesses up to five years ago are hopeful as it could prove to be a good opportunity."
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