How a recession could affect M&A deals in P&C insurance

Threats of an economic recession in Canada are not likely to dampen mergers and acquisitions activity in the property and casualty insurance brokerage sector in 2023, one M&A expert predicts.

Although M&A activity contracted in some industry sectors towards the end of 2022 (such as public equity markets and cryptocurrencies), brokerages continue to be valued highly by potential buyers, Smythe LLP observes in its latest report, Mergers and Acquisitions: A Year in Review of 2022.

One reason is the P&C insurance industry is “recession-resilient,” in the sense that the industry’s market cycles related to profitability and loss don’t always coincide with those of the broader Canadian economy.

“For our clients running recession-resilient businesses (such as distributors of consumables used in diversified industries or P&C insurance brokerages), valuations remained strong and, in some cases, even continued to rise through 2022,” the Smythe Advisory report states. “We credit this dynamic to a relatively robust pool of capital chasing fewer deals.”

Smythe advised on 17 completed transactions across a range of industries in 2022. The advisory firm predicts M&A activity in recession-resilient industries such as P&C insurance will remain strong.

“Entering 2023, we don’t expect valuations and deal activity to return to 2021 levels in the near term,” the report states. “We do, however, expect M&A activity to remain just as active across recession-resilient sectors.”

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The behaviour of the buyers may change, however, since rising interest rates have increased the cost of borrowing money from financial institutions to finance the deals. This means potentially fewer deals involving buyers relying on leverage (debt).

“We expect that whether businesses are recession-resilient or sensitive, purchasers will be more selective of the acquisition opportunities they pursue and will likely apply more scrutiny in their due diligence processes,” Smythe states. “This will result in fewer offers at the high end of an expected valuation range, and will mark the dawn of a more ‘buyer-friendly’ market. In addition, we will likely see more term sheets with earn-outs or vendor financing to bridge valuation or financing gaps.”

Earnouts are contingent payments to the seller based on “satisfying post-deal milestones, most commonly the [seller] achieving certain revenue and EBITDA (net earnings before interest, taxes, depreciation, and amortization),” as defined by WallStreetPrep.com.

Smythe observed fewer M&A deals in the Canadian economy overall last year, compared to a record-breaking year for deals in 2021. Although the first half of 2022 was “robust,” the number of deals tapered off toward the end of 2022 as the threat of an economic recession loomed.

“For our clients operating in industries that are more sensitive to an economic downcycle (e.g., those that rely on discretionary spending), some decided to pause their succession planning until there was more confidence in the market,” the Smythe report notes. “However, for those clients that decided to proceed with a transaction process, we observed either fewer offers, lower valuations, or more sizeable vendor financing or earn-outs, as many buyers quickly adapted to the uncertain economic environment and were generally more pessimistic about the medium-term outlook of these sectors.”

Feature image courtesy of iStock.com/tadamichi