Media headlines may have purported a flurry of broker consolidation activity in the run-up to changes in capital gains tax but others remain less than convinced. Rachel Gordon finds out if the spike in sales really did occur and whether, going forward, acquisition activity is likely to continue apace
When Chancellor Alistair Darling announced plans to reform capital gains tax, and boost government coffers, brokers had five months to decide whether they should sell up and benefit from a smaller bill of 10% or face the new flat rate of 18%.
For consolidators and their lawyer and accountant advisers, these past few months have been busy and lucrative as a result of the momentum created to strike and finalise deals. But now that the 5 April deadline is passed, will merger and acquisition activity go quiet - or will it continue apace?
Anyone reading the insurance press is likely to feel M&A activity has been frenzied; however, some claim the volume of deals appeared greater because of media hype. They say significant amounts of M&A were going on before and an extra 8% tax is tolerable, given that values are continuing to rise.
Stuart Reid, chief executive of the Axa broker vehicle Venture Preference, believes the column inches were misleading. "This marketplace comprises roughly 4000 brokers and if we count, say, 10 deals announced around the CGT deadline this suggests a 0.25% consolidation of the market. I'd hardly call that a flurry."
He expands by saying that while the CGT deadline was important to some, this was not the case across the board and believes consolidation will continue - albeit in a more pressurised environment.
"The appetite for acquiring quality businesses is a changing landscape. Competition among the smaller consolidators - Giles, Jelf and Oval, for example - will continue as they try hard to achieve critical mass, a geographic footprint and spend their money while it remains available to them," he says. "If they are unsuccessful in their attempts they will sell as pressure will grow from their investors to realise their asset. For those who have recently raised money this may be a way off, but the pressure will undoubtedly build. With hardening rates imminent, maybe those brokers who have dismissed approaches so far will hold on for a while longer. And maybe the consolidators, unable to get the deals they need will eat each other."
Most advisers do, however, admit to putting in a lot of graft leading up to 5 April. Peter Allen, a partner with Grant Thornton, says he was handling five deals that all went through on time. A skilled adviser would certainly have proved their worth and, he says, had unforeseen delays occurred, trust structures could have been implemented to crystallise the CGT bill.
At Littlejohn Fraser, numerous deals were handled in the three months leading up to the deadline. And tax manager Chris Riley reports that a number of brokers wanted guidance on earn-out agreements.
Earn-outs are common in broker sales and are a contractual commitment by a purchaser to pay a further sum if the acquired company meets agreed performance targets.
Payouts can be generous and exceed the amount received at the initial deal completion. Mr Riley says CGT applies to earn-out payments so, for deals taking place now, these will be subject to the 18% rate. He explains those deals that went though prior to 5 April can still benefit from the 10% tax rate by settling entirely in cash or ensuring that the earn-out mechanism allows proceeds to be settled in cash - as opposed to a deferred sale of a portion of the business. But, he adds, this may create potential cashflow issues for the vendor, as the tax liability will crystallise immediately and will need to be balanced against the potential overall tax saving.
Jeff Soar, account director with Ernst and Young, comments: "Earn-out agreements did not stop, but there were ways to structure them so CGT would be deferred. These will remain a part of many broker deals because these businesses are all about the people and the relationship with clients."
Certainly the brokers doing the deals insist a lot more is to come. According to Alex Alway, group chief executive at Jelf: "Deal flow will ultimately be driven by strategy and value rather than incidentals like CGT and, accordingly, while I believe there's still some consolidation left in the market, shareholder value will remain the key driver."
Giles - having gone from being a switched-on smaller provincial to one of the fastest growing firms in the UK over the last 10 years - also has a "full pipeline" of deals currently being transacted, according to M&A director Hazel McIntyre, who recently joined from Royal Bank of Scotland's private equity division.
She says Giles, which has a widely publicised war chest of £500m, has a team of three purely dedicated to M&A activity. "The CGT issue was important to some vendors and we were mindful of this; we accelerated some transactions. But although a higher rate is not welcome, even at 18% this tax is still relatively low."
Ms McIntyre agrees it was possible to structure deals to allow earn-out arrangements to be subject to the 10% tax rate but points out Giles' recent refinancing deal with private equity provider Charterhouse is evidence the market remains exceptionally dynamic.
Meanwhile Paul Jefferson, partner with Halliwells solicitors, worked with Ms McIntyre on a range of recent deals. He says vendors remain in a strong position and are likely to have a number of offers on the table. "Right now, you have Giles, Towergate and Jelf hovering over the market - and Giles is gaining momentum. It is a sellers' market right now and, beyond the deal itself, vendors are being influenced by the type of people involved. I know that in some of the deals I dealt with, the vendor did care about the people impacted; Giles chief executive Chris Giles is still someone who is very approachable and this is noticeable across the business. Brokers have said they don't want to deal with faceless, amorphous consolidators."
From an insurer perspective, Steve Albutt, sales and distribution director for Allianz Commercial, agrees: "Brokers talk about looking for a cultural as well as strategic fit. Despite the CGT deadline, some were not ready for the deal to go through and so decided to wait. I can't see deals drying up - there is still plenty of funding from insurers and private equity and there will be a lot of activity for at least the next 12 months."
Furthermore, following an outcry from small business interests, the Chancellor did agree to introduce a new 'entrepreneur's relief' - available in respect of gains made on the disposal of all or part of a business or on disposals of business assets.
The first £1m of gains that qualify for relief will be charged at an effective CGT rate of 10%. This £1m is a cumulative lifetime relief and as such can be used on a single transaction or a series. Gains in excess of £1m will be charged at the normal 18%.
John MacKay, tax partner with E&Y, comments: "This was a way to give something back as the old retirement relief has gone. For those with under a 5% shareholding, there will be no benefit at all, but for those above it will offer something - although it only equates to around £80,000 per person."
John Needham, partner with Littlejohn Fraser, comments: "The £1m is per person involved so you could well have a number of shareholders who could benefit - it is something of a sweetener for small to medium-sized enterprises." He adds that final details on this are yet to be provided and it might even be raised to a higher level.
What is notable is, despite the massive impact of the credit crunch globally, the provincial broker consolidation market seems awash with cash and so protected in its own golden bubble.
Odhran Dodd, M&A director with Littlejohn Frazer, comments: "It would seem that banks are still lending money although they are likely to be charging higher fees. But certainly for larger deals, private equity is very interested in broking with Englefield Capital, Stone Point and Charterhouse among those focusing on this sector."
Mark Speller, insurance M&A leader with Pricewaterhouse Coopers Corporate Finance, agrees private equity is becoming a dominant force in the broking sector. "The larger recent deals were dominated by the private equity community. For example, 3i Growth Capital took minority stakes in private medical insurance broker Jelf and Lloyd's broker Hyperion; while Charterhouse replaced Gresham at Giles. Although it is reported that Candover pulled out of a deal with Towergate at a late hour, Peter Cullum did manage to get an additional £100m from hedge fund Och-Ziff prior to the tax deadline."
So why is the PE community so keen to get a slice of broker action? "Entrepreneurs are not yet ready to sell out as they're enjoying themselves and have more deals to do, while PE houses are keen to support these successful entrepreneurs with their 'buy and build' strategy," says Mr Speller. "These companies have solid business models with strong potential cashflow, high levels of operational gearing and provide access to the insurance sector through profit share without the issues of investing in an underwriting vehicle."
Experts seem to believe consolidation will largely be a feature of the provincial market rather than national brokers. Mr Speller comments: "The multinational brokers, despite positive noises about M&A, appear to be focusing more on cost control and getting their internal structures right, as evidenced by Marsh's 10-year outsourcing contract with Capita."
He believes consolidation will continue to be fuelled by the new private equity money, "but probably not at the same level as Q1 2008 now that the tax benefits have passed."
Looking to Lloyd's
As for the Lloyd's market, Mr Speller says this should not be dismissed. "We believe there will be plenty of activity in the Lloyd's broking market too. The continuing weak dollar, soft insurance market, competitive trading conditions and non-optimal shareholder structures, render the sector a target for short-term consolidation."
Mazars partner Mark Grice adds: "We recently found that 86% of Lloyd's brokers expect their numbers to decrease as a result of consolidation. They have been hit hard by the fact so many are involved in US business and have been affected by the exchange rate and softening rates."
He says that a majority of Lloyd's brokers expressed negative sentiment towards insurers purchasing brokers - perceiving this to erode independent advice. However, he adds: "There are still going to be a lot of deals happening, and the UK broking sector remains attractive to European interests as well as private equity."
Clearly, the major players are committed to further acquisitions and nothing is going to stop them - or is it?
Although most experts say they are anticipating plenty more deals, a number of wise sages are sounding notes of caution.
David Coupe, partner with law firm Clyde and Co, observes: "I don't think a higher CGT tax rate will have much impact at all on future M&A activity. Consolidation will continue, but it is interesting to note in the recent Mazars report a majority of Lloyd's brokers felt insurers buying brokers was negative for the industry. I believe the regulator is also very mindful of potential conflicts of interest."
He feels the Financial Services Authority's work on commission disclosure - and in particular if more stringent rules come into play - will put a damper on deals. "Currently, multiples are high and brokers are producing high returns. But this cannot be guaranteed to continue. The EU's report into business insurance may not have found widespread market abuse but did highlight concerns. Beyond this, although brokers may have access to funding, the tougher economic climate is likely to have an impact."
Paul Upton, chief underwriting officer with Evolution, adds: "It's clear that a number of the consolidators have considerable amounts of money, but some businesses are being overpriced and valuing is indeed very difficult. While I do not see the end game for quite a few months, I believe things will slow down."
Reasons he cites include the FSA's ongoing investigations into commission disclosure and whether this should become mandatory. This, he points out, could call into question some of the high commission deals set up by the consolidators.
In addition to the "FSA biting", he also believes the current trend for 'big brokers' could lose its appeal. "These firms may be all the rage but I doubt they will succeed in offering the same levels of pre-consolidation service. I recall the national brokers experiencing huge service problems when setting up volume SME businesses - we are already seeing more support becoming available to start-ups and this option is looking a lot more attractive to many good people currently within the industry."
But Steve Burrows, chief executive of consolidator and network Cobra, predicts more deals happening and believes those consolidators sitting on vast funds are feeling the pressure to buy - and this could have an impact on quality. "We take debt as we go along and so are less pressured. We'll be getting more deals done, but there is a shortage in the market and that is also going to cause a dip in activity."
CGT bills or not, there is no doubt that on the supply side, the number of top notch brokers who are prepared to sell up is dwindling.
Although uber-consolidator Towergate was not available to comment, chairman Peter Cullum has since indicated to Post that it has a strong pipeline of deals after concluding its first buy following the Candover fall out with McDonald Reid Scott last week (see pp20-22).
Fierce M&A activity has been part of the broker arena for several years and CGT changes did prompt a spike in activity. But, going forward, there are clearly a number of reasons why the consolidators will be after tea and sympathy as well as deals.
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