The broking sector has continued to see significant activity when it comes to mergers and acquisitions despite potential barriers such as Covid-19 and a dwindling number of larger targets. Ida Axling asks whether inflation and rising interest rates might be the headwinds that finally dampen the appetite for deals.
Brokers have stated that high inflation and rising interest rates are no reasons to panic, and the economic climate is not having an impact on deal activity in the sector – at least not for now.
At the time of writing, the latest government figures had revealed a surprise jump in inflation to 10.4% in February. The Bank of England responded by hiking up interest rates for the 11th consecutive time to 4.25% on 23 March (see the UK inflation box below).
UK inflation and interest rates
According to figures released on 22 March, UK inflation saw an unexpected increase to 10.4% in the 12 months to February 2023, driven by the surge in food and energy prices. This marked a change from three consecutive months of slowing price increases, and the Bank of England had previously forecast a decline from January to 9.9%.
Speaking to the House of Lords Economic Affairs Committee recently, chancellor Jeremy Hunt warned that levels of inflation above 10% were “dangerously high”.
The Bank of England, which has continuously hiked up interest rates to slow down inflation, bumped rates up for the 11th time in a row to 4.25% on 23 March. This came after BoE governor Andrew Bailey previously suggested that interest rates may have peaked after 10 successive increases.
In total, since December 2021, the BoE has raised interest rates from 0.1% to 4.25%. Its target is to get the level of inflation down to 2%. While increasing interest rates may help slow down inflation, economists have warned that increasing the official cost of borrowing, combined with the cost-of-living crisis, could result in a recession.
Higher interest rates mean a higher cost of borrowing, and one could be forgiven for thinking that acquisitive brokers could be starting to feel the crunch. According to experts, though, this is not yet the case.
Speaking to Insurance Age, brokers confirmed that the interest rate rises had driven the cost of funding up and admitted that this is bound to make some people in the market think more about the cost of making deals.
“However, you just don’t see it yet in the competitive bidding process,” said Howard Lickens, executive chairman at The Clear Group. “At the moment, people seem to be pretty unnerved by it.”
Lickens predicted that if interest rates remain high, then M&A activity in the broking sector will eventually slow down, and explained: “I can’t help feeling that it’s going to edge back sooner rather than later. The IFA sectors have pulled somewhat. But in my world, I’m not feeling it [right now] and buying brokers is still expensive.”
Stuart Reid, chairman at Partners&, agreed that he had not seen a change in deal activity due to economic pressures. But Reid added that, theoretically, some brokers could decide that now is not the right time to sell because interest on any monies they hold, in addition to client monies, would be charged at the higher rate.
“But to be honest with you, even though what we’re seeing now is a big difference to the heady days of small interest charges, most businesses for sale in the broking world tend to be at the smaller end of the market, and therefore the interest rate hikes would have little effect on an increased income line,” Reid said.
They have decided that even though debt is more expensive, making sensible acquisitions is still the right thing to do.
The UK broking sector is a competitive space for buyers and Peter Blanc, executive chairman at Howden UK & Ireland, said most of them will be taking a long-term view of the economic situation.
“They have decided that even though debt is more expensive, making sensible acquisitions is still the right thing to do,” Blanc added.
He also pointed out that the rise in interest rates is in line with the long-term trend.
Indeed, while interest rates have remained consistently low over the past few years, they have previously been much higher than the current levels. In 2008, they reached 5.75% before starting to decline, and looking back even further, they were at a whopping 12.38% in 1991.
“For the past five years it has been a good time to be acquiring on almost free money,” Blanc said.
“Those days are gone, and it means that acquisitions have got to make complete sense again and drive proper organic growth.”
While the UK broker market very much remains a sellers’ market, there are some vagaries that could affect brokers’ appetites for acquisitions. If interest rates remain high when brokers come to borrow more money, the higher cost of borrowing will have an impact on multiples.
Additionally, other costs such as capital gains tax are an added risk. It also remains to be seen whether private equity-backed brokers will face obstacles when the time comes to refinance (see the Private equity-backed brokers box below). However, Reid did not see this as having much of an impact on the levels of consolidation in the industry either.
The long-term impact on private equity-backed brokers
According to Imas’s 2022 UK Insurance Distribution M&A annual review, private equity interest in the UK broking sector has started to calm down. The main reason for this is that PE requires a high return that can only be achieved by making a certain number of acquisitions.
Olly Laughton-Scott, partner at Imas Corporate Finance, predicted that the number of PE-backed consolidators will decline over time following the reduced supply of sellers in the UK market. However, PE capital was still behind more than half of all deals in 2022, and brokers were not worried that all PE investors would be looking to exit, arguing that the sector is still considered an attractive investment.
Howard Lickens, executive chairman at The Clear Group, said: “It’s a positive thing that when markets generally are uncertain. You tend to go towards parts of the market that are resilient – if not recession proof, then recession resilient – and of course insurance brokers are that.
“Individually, we might be thinking that this borrowing money lark is getting quite expensive, but there’s still an appetite because of our repetitive incomes, and the fact people will have to renew their insurance policies. We’re still in demand because of those things and despite the extra cash costs.”
PE-backed brokers normally borrow money with a fixed margin, and this means that when the base rate goes up the cost goes up.
Peter Blanc, executive chairman at Howden UK & Ireland, warned that this could provide a challenge for brokers when they come to refinance.
“It’s not an easy debt market so refinancing the bigger deals will be difficult. They’ll get it done because broking is an attractive sector, but at what cost? The margin over base will be higher, the fees for arranging will be higher and some of the terms might be tighter.
“A few years back it was pretty straightforward to borrow six or even seven times Ebitda, but those days are gone,” he argued.
“Any educated acquirer would flex the terms and conditions they’re buying a new business at so as to reflect the increase in the interest they may be charged when they’re borrowing money to do so,” he said.
But Reid noted that for businesses that are financed by debt outside of equity, it could lead to changes in the prices paid or in the way that
they are paid.
“If this higher interest rate is sustained for a long period of time, the methodology of how you pay a vendor may change,” Reid continued.
When it comes to financing deals, Blanc argued that it is “all about leverage. If you’re seven or eight times leveraged then you’re going to struggle because your debt costs are going to kill you, whereas if you’re sensibly leveraged, and you’ve actually got a resilient model where you can still borrow money cheaply, then you’re going to be fine.”
According to Olly Laughton-Scott, partner at Imas Corporate Finance, brokers remain in a good position to raise debt. Debt providers, that are looking at the risk profile of the companies they lend to, will see businesses such as restaurant chains and nightclubs as much higher risks during the cost-of-living crisis.
“But so far that hasn’t happened in insurance broking and we’re not seeing a squeeze on credit in the sector,” Laughton-Scott, said.
No squeeze… yet
He warned that when lenders start pulling out of a sector, that is a point of concern and, as a result, prices will come down. However, he explained that brokers do not need to worry at the moment because their risk profiles have not changed due to the economy.
Brokers, helped by the annual cycle and renewal nature of insurance products, combined with the fact that people will always need cover, have fared relatively well through recent economic difficulties, including the financial crisis and the Covid-19 pandemic, where other sectors have struggled more.
Inflation tends to increase interest rates, and that will tend to feed through into pricing. People talk about a possible softening of prices, but we have not seen it.
Laughton-Scott described commercial broking as “remarkably robust”, and added: “What happens is that – and this is being repeated in terms of inflation – the product changes in price, the client is grateful for the job the broker does even though the broker is getting paid, and the client doesn’t realise that the broker is being paid more.”
He continued: “Inflation tends to increase interest rates, and that will tend to feed through into pricing. But the underlying business is doing so well for brokers. People talk about a possible softening of prices, but we have not seen it.”
Currently, smaller deals make up most of the M&A activity in the UK broking space. This follows a change in the landscape over the past few years, after a period where a majority of the larger and mid-sized brokers were bought up by consolidators.
Ever resourceful, buyers have adapted their business models, and are now spending more time and effort on small acquisitions in addition to being on the lookout for strategic bigger-sized deals and targets outside of the UK.
Reid noted that, while the total interest rate rise from 0.1% to 4.25% since December 2021 is “substantive”, the effect it will have on broking businesses with an income of £5m and less is “negligible”.
“Therefore, I would guess it will have a negligible impact on whether they would hold or delay their plans to sell,” he continued.
Despite stating that he believed M&A activity could slow down, Lickens argued that the current state of the broking sector, where there is a limited number of substantial-sized businesses to buy, means it is likely to remain a seller’s market.
The supply of quality brokers of size is declining, but plenty of people are looking to acquire. The dominant factor is supply and demand.
“The supply of quality brokers of size is declining, but plenty of people are looking to acquire. The dominant factor is supply and demand,” Lickens noted.
Meanwhile, Reid explained that another reason brokers are not panicking about high inflation and interest rates is that currently it is unlikely the UK will go into another recession. He hopes rates will start to come back down again over the next 12 to 18 months.
But Laughton-Scott warned that if high inflation causes the economy to nose-dive then broker clients will start going bust and people will be tightening their belts.
“The interest rate is not having that much of an impact, but if the economy went into a sharp reverse, we’d see that feed through,” he added.
“If their clients keep going, insurance brokers do well, but if their clients go bust then no one can avoid that.”
So, while it is still business as usual for consolidators, they will undoubtedly be keeping an eye on interest rate movements during this time of economic uncertainty.
Asked who would be the winners and losers if we do start seeing an impact on consolidation, Lickens argued that the victors will be those brokers who are buying businesses because they fit with their business model.
“The losers will be people who are just buying things as trophies and storing them on a shelf. There has to be some extra value in integrating properly and buying businesses that add to your underlying proposition rather than just buying anything,” he added.
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