The Intelligent Quarterly from the publishers of The Insurance Insider

Summer 2013

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After years floundering in the quagmire of the soft market, global brokers have made a welcome return to positive territory with their organic growth figures in recent quarters, and Arthur J Gallagher & Co (AJG) is no exception.

The Itasca, Illinois-based firm was able to report 5.5 percent positive organic growth for the first quarter of 2012 in the core domestic P&C unit that houses its US retail and wholesale operations, following 4.5 percent and 2 percent growth in the previous two quarters.

This performance is compared to negative growth for all of 2008, 2009, 2010 and the first half of 2011.

AJG's international P&C operations also generated positive growth in the quarter, maintaining a return to organic growth that had started earlier and ran right through 2011.

But it is an increasingly prolific M&A strategy that is attracting the attention at AJG as the firm looks set to fuel-inject further top-line growth with a unique source of funding.

A record 32 transactions last year helped push AJG's total revenues north of $2bn and 2012 has seen further acceleration, with 12 deals announced in the first quarter and six more in the first half of the second quarter.

And the firm's chairman, president and CEO, J Patrick Gallagher Junior, says that many of the entities bought by AJG in its recent spree blur the line between organic growth and that by acquisition.

While acknowledging that 2011 included the biggest ever deal completed by his firm - with the £99.7mn ($164mn) acquisition of Heath Lambert by its London-based international arm - Gallagher says the strategy in the US could be considered more of an organic process.

"It's not as if we're out there buying HRH," he says with reference to the rather lumpier M&A deal where Willis bought US broker Hilb Rogal & Hobbs for $2.1bn in 2008.

The dozen first quarter transactions, for example, are expected to yield total revenues in the range of $30.6mn (or $31mn).

"When you're doing a $3mn tuck-in deal, isn't that as close as you can get to an organic hire and still call it an acquisition?" he asks.

"We're not synergising our costs, or taking people out. We're saying you've got a small, successful agency, you're making good money, you probably don't need to sell - and at $3mn of revenue we probably don't need to buy.

"But for your employees and for yourself, if we can put the two firms together you've got more to sell operating off a much stronger platform, and we can double that $3mn revenue fast. And we do," Gallagher explains.

AJG is looking to continue expanding its international footprint, following last year's acquisition of Heath Lambert, the 2010 deal to buy FirstCity, and the recently announced increase in its ownership of Caribbean broker CGM Gallagher group from 38.5 percent to 80 percent.

However, for the smaller "organic"-style additions, the broker's eyes are firmly focused on the US.

Buying baby-boomers
"In the US we have more people and we have more brokerages and so there is more opportunity to bring them aboard than you will see internationally," he says, adding that the international deal pipeline is probably "one-tenth" of that that exists in the world's biggest insurance market.

The key driver, according to Gallagher, is that many owners of smaller agents and brokers in the $1mn-$10mn revenue range are from the "baby-boomer" generation.

"There are 18,000 agents and brokers in the US, most of them are run by baby-boomers and there are only five brokers that are active acquirers. That's a lifetime consolidation opportunity," he explains.

"You've got to be careful on the culture quality, and pick the right people, but it really does grow your business." J Patrick Gallagher Junior, president and CEO, AJ Gallagher

With AJG's larger rivals Aon, Marsh and Willis not targeting the bite-size agents and brokers, the firm is left competing primarily with Brown & Brown and Hub International for the affections of legions of potential sellers.

But as a self-acknowledged salesman who maintains daily contact with clients, has the grandson of the firm's founder, Arthur Gallagher, been side-tracked by the sometimes protracted process of closing M&A transactions?

"Every deal is like getting married. It's a dating process and it takes a while," Gallagher acknowledges.

"But the division leaders and their people source the deals, and no deal stops at my desk, it keeps moving.

"It's a funnel approach and we've got a whole bunch of people who can price them and an entire legal staff that can close them. To do 12 deals in a quarter is no stress on the organisation at all," he says.

With such a well-stocked pipeline, AJG might have been expected to tap the debt markets at what continue to be historically low interest rates to ratchet up its M&A activity further.

Instead, the firm expects to fuel a spree where it has typically paid multiples of between five and seven times earnings with the cash flow coming in from its recent clean energy investments.

In 2009 and 2011 AJG invested in a number of commercial clean coal production plants that it currently forecasts will deliver up to $16.5mn of net after-tax earnings per quarter through 2019 and 2021, respectively (see box-out).

The cash "will be put to use in building out our core brokerage and risk management enterprises", Gallagher explained on the company's recent analyst call.

Organic growth
Of course M&A is not the only way of continuing to raise AJG's top line, and more traditional organic growth remains a major focus.

According to a recent Wall Street Journal article, 70 percent of businesses in the wider US economy are on course to have an equity event in the next decade because of the maturing of the baby-boomer generation.

That potentially creates additional growth opportunities as longstanding relationships between intermediaries and their clients are broken.

"When we send people out to compete for an account I believe our platform should win every time, but it doesn't, and by and large that's because of existing relationships.

"Another major change in the last 20 years is that expertise at intermediaries really matters, and we've built massive amounts of expertise. So at the very time those relationships are getting broken we can offer that expertise. We are on the phone pounding for new business every day," Gallagher says.

The recent return to positive organic growth has also, of course, been driven by changing market conditions and the emergence of a more positive economic picture - particularly in the US. Click to enlarge

"We faced the problem of exposure units going down dramatically at the same time as premium return audits because the business was slow. Now exposure growth is back. People are still cautious on hiring, but it feels like the headwind of the economy has more or less gone away. "Couple that with the fact the headwind of rate reductions is more or less going away and it's a much improved outlook," he observes.

Growth is currently fastest in Gallagher's wholesale arm, which is growing organically at around three percentage points better than the P&C retail business.

The $200mn business is expected to see strong margin expansion as business shifts back to the excess and surplus lines arena in a hardening market.

While it is not a classic P&C hard market - which he says would cause customers to turn away from insurance because they don't yet have the budget to pay significant rate increases - the leverage in the intermediary model means it doesn't take much to boost organic growth.

"The beauty of our business model is that there is very positive leverage. If I got a 2 percent rate increase and a 2 percent economic boost with my usual new business and retention ratios, I'd have 9 percent organic growth; so I think we could be in for a very interesting time," Gallagher predicts.

An 85-year-old business that went public in 1984 with a market cap of just $59mn has since swollen to $4.2bn, taking just nine years to double its revenues from $1bn to $2bn. It's full steam ahead...