The Competitive Advantage: Agency Valuations

In the early 1700s, John Law, a brilliant mathematician, advised the French government their economy could be improved by printing lots of paper money not backed by gold or silver. The key was getting people to trust the paper money. His method for establishing trust was promising huge financial gains for people willing to invest in France’s American colonies, which they did. The result built both the economy and the infamous Mississippi scheme, a huge land asset bubble that collapsed in four years and the decline was so severe it contributed to the French Revolution. It is a fascinating story with many similarities to today’s economy. The lesson for business valuations though is this: attempts to maintain asset prices above their fundamental value are eventually doomed to failure. (Buttonwood, Law of Easy Money, The Economist, Aug. 13, 2009)

This brings to question the huge prices paid for many agencies a few years ago and still some agencies today. Were/are those prices too high relative to the seller’s fundamental value?

In the bubble years, I think it is safe to say that many of my agency valuations were less than what banks, some brokers, and a few others were paying. My valuations were definitely lower than what a number of business brokers and consultants were using. In tough times now, a few of my valuations have been higher than what some banks and brokers will pay.

The difference is that I focus on the inherent value of an agency’s ongoing operations rather than the arbitrage value trying to be attained by heavily leveraged and publicly financed buyers. I absolutely consider this value implication too, but that is not where I place the most weight for Fair Market Value valuations because arbitrage based valuations in a bubble economy will always elevate prices beyond the firm’s fundamental value.

Why Agencies Sell

The hard truth is that the vast majority of acquisitions occur for only a few reasons, none of which is usually the stated purpose. A recent study showed that publicly traded company executives who lie, cheat, and steal, or more innocently just screw up, but never forthrightly admit these issues when caught, are treated more lightly by the markets than their more forthright and respectable peers who admit the problems occurred. I believe this same thought process applies to why the real reasons for most acquisitions are never disclosed. Those reasons are:

When Acquisitions Fail

These are the underlying reasons many acquisitions are done by large buyers and serial acquirers. Numerous studies have almost universally shown that the vast majority of acquisitions and mergers fail to return an adequate return on investment, so it seems smart to quit pretending operational synergies will be attained (and we can see from the publicly traded brokers’ results that synergies are not attained by their hundreds of acquisitions when compared to non-serial acquirers’ private results).

While the acquisitions may fail, the damage is not limited to the acquirers. These factors impact the sales price of other agencies as well and good agencies are often the most negatively impacted.

For example, consider two agencies. The first is a mediocre agency with a 20 percent EBITDA and $3 million in revenues. It has a value then (assuming the balance sheet value is neutral) of $600,000 times some EBITDA multiple. The second is a well-run agency of the same size with an EBITDA of 30 percent. It has a value of $900,000 times some EBITDA multiple. Many buyers would choose one EBITDA multiple and apply to all acquisition targets. So let’s choose an EBITDA multiple of 6. The mediocre agency’s value would be $1.8 million and the value of the good agency would be $2.7 million. The buyers would say, “See, the good agency carries a greater value!”

This is a huge mistake leading to bad acquisitions and missed opportunities. I argue the EBITDA multiples should not both be 6. All else being equal, the good agency’s multiple should be greater, say 6.5. But if the buyer’s multiple is only 6.2, it is highly unlikely they would pay for the quality because quality is not the goal. The goal is the arbitrage opportunity, and it does not exist at a multiple of 6.5. This is why some buyers target lousy agencies. The arbitrage opportunity is greater.

The result is buyers overpay from a fundamental perspective for less than average agencies and the best agencies are undervalued. All firms get squeezed toward the average. The implication for the best agencies is internal perpetuation done well is likely to have more potential. For poor agencies, external acquisitions are most definitely better, especially when lots of easy money is flying around. For well-managed agencies, cherry-picking accounts from recently sold agencies is likely an excellent strategy.

During the credit bubble, many poor agencies were sold to firms profiting from leverage and arbitrage. This caused a bubble in agency values. Given the buyers’ focus was leverage and arbitrage, rather than operations, opportunities exist now to significantly improve operations of purchased agencies. And when competitors see operations not being improved, they can take good accounts and good people. Lots of opportunities exist even in this tough environment!