Is it time to sell up?

Participants:
Tony Cornell Cornell Consulting

Oliver Laughton-Scott IMAS Corporate Advisors

Steve Manton Managing director of M Consulting

Charles Whitfield Marketing director at Layton Blackham

Jason Woolfe Where is the merger and acquisition(M&A) environment heading?

Tony Cornell: We had a very strong M&A period in 1999-2000, mainly fuelled by people like Charlie [Charles Whitfield ] here, and there was a lot of activity. It was the end of the soft cycle and there were quite a lot of reasons why people were getting out at that particular time, mainly age.

We then had profitability returning very quickly to the broker market. 2000 was a very good year, 2001 was an extra good year and 2002 will be a never-to-be-repeated profitable year for brokers. But 2003 will still be a good year and it will start declining in 2004.

If you look at the smaller end of the market, they [brokers] haven't made that much money because it was a tough time. They've been hit by the problems with the pensions industry, so a lot of them haven't been able to get out of the market.

Half are over 60 and they've had to stay in there during the good years purely to pay for a retirement lifestyle.

The result is that the prices being offered haven't been attractive enough, so they are not making that choice because there's not enough money in it to make it worthwhile.

Oliver Laughton-Scott: That's right. People are reluctant to sell. But as the market softens and rates go down, that may be better for the long term value, because the market is highly cyclical and people would be ill-advised to buy on that basis.

There has been a lull in the market, but look at the volatility in the stock market - people don't sell at times of high volatility.

The FSA regulations are out there and they do make people think. However, experience has shown that changes in regulation are always predicted to result in a mass of defections and it just doesn't happen. People have been in business for 20 or 30 years and they can't afford to get out.

Charles Whitfield: What will happen is that the increased cost of regulation will impact at the time at which Tony is predicting a decrease in profitability.

Steve Manton: One of the problems is that, certainly at the smaller end, there's just been no succession planning. With no succession planning, brokers are seeing high profitability when they've got to stay in knowing it's going to come to an end in two or three years.

Oliver Laughton-Scott: At the upper end of the market there's very little action. There are very few buyers, almost none in the quoted sector, because the quoted sector of eight to ten years ago has disappeared so the feeding chain has been destroyed. We are going to see that reinvent itself but it will take some time.

Steve Manton: The big boys, the Aons and others, don't have the free capital at the moment.

Tony Cornell: And why should people like Aon buy a small or medium-sized broker?

Oliver Laughton-Scott: Yes, it adds very little value to their business. One of the biggest fallacies is that the medium-sized insurance broker is an endangered species. It will go on being successful. There are new companies forming all the time and the idea of the industry consolidating is not right.

Tony Cornell: I disagree with Oliver about statutory regulation. There's enough evidence to say that, at the smaller end of the market, there are loads of people aged 60 and above who have done nothing towards regulation or GISC. They might want to apply, but have done no work. Emotionally they have left the industry. They have decided to pack in at 2004, harvest the profits as they are now, but get out soon.'

There could be 2,000 brokers exiting the market in 2004 - those who are under critical mass, under £3m premium income, no successors in their business and they're over 60. It would take £600m at current rates to buy them out. That £600m is not available from those people who want to purchase. And there aren't enough people who want to purchase, so the supply of brokers on the market will outstrip demand by a huge amount. Which means prices will just disappear.

There is one caveat to that and that's long chains. You have your Hill House Hammond, Country Mutual, Swintons and people like this who have money. They could easily go out and mop up a lot of people.

Oliver Laughton-Scott: While there's no doubt there are a lot brokers who are going to sell in the future. If that does happen it will build a strong business case for approaching the broking sector and money will be attracted to buy up these businesses, if there's a mass of businesses going relatively cheaply, there's no reason why a number of companies shouldn't take advantage of it.

Charles Whitfield: That's possibly right and the cost of capital today is relatively low.

Tony Cornell: It is very expensive for the high volume retailers to build up new business through conventional marketing. It certainly costs more than annual commission. So if they can buy a business for the price of annual commission, they can buy a client base which is more loyal to their supplier than the ones who buy over the web and over the telephone.

Steve Manton: You have this situation that's going to repeat itself, such as what we've seen among estate agents. They were selling very strong local brands, profitable businesses, at the peak of the market to the likes of insurers, who then try to rebrand them under their corporate name - and lost all their local loyalty. The businesses get sold back to the previous management who set up again and take all the business back.

Tony Cornell: I don't think we've got that situation with Hill House Hammond and Swinton. They are very experienced and established retailers.

Jason Woolfe: So how are the values of brokers' businesses going to change? Are they going to crash in 2004?

Charles Whitfield: That's a more extreme curve than we would expect. We've seen a gradual incline over the last two to three years and that will fall off in 2004 and 2005. It's a question of when the cost and reality [of FSA regulation] impacts and we won't see that before 2005.

Tony Cornell: No, we'll see the impact in 2004, because if the rules are what they say they are, in October 2004 people will be out of business.

Oliver Laughton-Scott: It's exactly the same in some ways as the FSA and life brokers.

The PI crisis was supposed to put them out of business, but in reality no regulator is going to put half of its constituents out of business. It's just not going to happen. If the market hasn't reacted in October 2004, they will put people out of business very slowly - it will take time. It will be over a much longer time period than people anticipate.

We are currently in a period of relative volatility, so activity levels are low. We will see a softening before FSA regulation is introduced. But that's only going to affect the smaller end of the market. The million-pound plus brokers are going to be well equipped for the FSA and they will see it as a benefit. They won't want to sell, they'll want a higher price for their business. So the impact will be split.

Tony Cornell: Those people who are prepared to go through the pain [of FSA compliance] will become bigger and those who aren't will find their prices reduced.

Jason Woolfe: What other factors will decide which side of the split our brokers fall?

Charles Whitfield: Demographics. If we're talking about 50% being over 60, and I wouldn't argue with that statistic, there's only so long you can carry on for. If you're thinking about it this year and you do something about it next year you won't see all your capital value until 2006 or 2007. That's a long time.

Tony Cornell: And you'll need to invest £1.5m to afford the things you need to move ahead.

Steve Manton: Last week I was judging on the Insurance Times small broker of the year award and it was evident there that there are small brokers that are really going places. They're doing all the right things in terms of business planning, bringing in strong management teams - as much as they can afford in terms of regulation and compliance - and they are grasping true market initiatives. And they are getting out and winning business.

They are winning business from the less efficient brokers who are likely, in my mind, to go to the wall long before the question arises of whether they are going to sell out.

Tony Cornell: The older guys won't go bust, they'll just do less and less out of their business.

Oliver Laughton-Scott: I believe the impact of the FSA will have an absolutely maximum impact of about 20% on price. It might be significantly less than that. It is not going to be a revolution.

Tony Cornell: Only about 15% of brokers are true acquirers. Of those, probably 5% would attempt a major acquisition. The majority are looking for small bolt-on acquisitions that could be absorbed easily into their business.

Oliver Laughton-Scott: But we agree that the guys who are going to be selling are the smaller ones and that's the bolt-on acquisition. You can make good money out of it. The payback period on those deals is very quick so there will not be a glut of businesses that can't be sold. If a mass of these brokers do want to sell, you will see the manufacturers in some way supporting that. What we've noticed since 11 September is that manufacturers, particularly in the Lloyd's Market, want to buy distribution.

Tony Cornell: If we ignore the very top of the market and look at the top 100 brokers, starting at about £12m premium and getting close to £2m commission and ending at probably £10m income, all of those have different dynamics.

Take the people at the top like Bland Bankart, Smart & Cook and Layton Blackham, their options for selling are fairly limited. Beneath them, the Folgate solution has provided an attractive solution for people worth £5m or £6m in the middle part of the market. But at the bottom end of the market, the £2m to £3m, it is still difficult to sell. There aren't that many purchasers and you can't bolt it on.

Oliver Laughton-Scott: I don't agree with that. The large brokers have much higher fees and are suffering, because they're doing much more work for the same amount of money. The problem area is at the top end of the £10m brokerage business. There are very few buyers and they are complex businesses. They don't have a value at the moment.

Charles Whitfield: It's a question of timscale. The average age of the Layton Blackham board is early 40s. That's not the case at one or two of the other names.

Jason Woolfe: So if you were running Hill House Hammond or Swinton when would you start your mopping up operation?

Charles Whitfield: If you agree with Tony's scenario there's not an awful lot that's going to bring prices in that sector back up again. These guys are getting smaller, older and less attractive.

Oliver Laughton-Scott: But you can't have an acquisition strategy that you turn on and off. You have to have people doing it over a long period.

Tony Cornell: You can count on one hand the number of people with acquisitions core to their strategy.

Charles Whitfield: If you're waiting for the right time, you'll be too late.

Oliver Laughton-Scott: A lot of people say to us: "We've just bought a business, it's fantastic - it's got the same IT system as us." That shows that IT is still a major hurdle to acquisitions.

Charles Whitfield: If we had an IT system that worked over 12 premises we wouldn't have 12 premises.

Steve Manton: It will stop being a hurdle, because if brokers don't get their IT systems together then they are not going to succeed in selling their businesses in five years.

Jason Woolfe: So what advice do you give to a broker who's approaching 60 and runs a small high street operation?

Charles Whitfield: Do it now.

Tony Cornell: Straight away.

Oliver Laughton-Scott: Look at your personal circumstances. What makes sense for you personally?

Jason Woolfe: What about the advice for a specialist broker?

Charles Whitfield: Size is irrelevant. As long as the market need is there, it doesn't matter. See it as a revenue stream.

Tony Cornell: Provided you're going to keep your underwriter for ever.

Jason Wolfe: And what if you're a medium sized regional player?

Tony Cornell: It's a market that depends on the bigger players. And I assume that once Folgate have filled their boots up, they're going to withdraw from the market. Who's a £5m brokerage going to sell to then?

Jason Woolfe: And finally we've talked about the factors affecting the M&A environment for insurance brokers as being FSA regulation, age, capital and IT. What's the most important single one?

Oliver Laughton-Scott:Age

Charles Whitfield: Age

Tony Cornell: Age

Steve Manton: Confidence in the future. If they're not confident, they should get out now.