The Long and Short

Re-assessing the landscape in wake of the AON/WLTW deal collapse

| August 20, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The insurance brokerage industry has generated a lot of attention with the recent cancellation of the merger between the #2 and #3 operators in the industry, which has left investors guessing how the fallout could impact the individual investment grade players in the segment. Generally speaking, the long-term fundamentals for the industry remain positive and there is good overall value for some names relative to their insurance underwriting counterparts.

Insurance broker Aon Corp (AON: Baa2/A-/BBB+) was in the market this week with a two-part $1 billion debt launch. The 10-year tranche came at +80 from IPT of +105 and the 30-year tranche came at +100 from IPT of +130. We thought the launch levels were a little too rich relative to existing comps. In particular, spreads seemed to price tight given that the proceeds of the deal will likely be used primarily to kickstart share buybacks in wake of their deal for Willis Towers Watson PLC (WLTW: Baa3/BBB/BBB) falling through (though technically the use of proceeds was listed as general corporate purposes). Undoubtedly, shareholder enhancement will be a priority for management as they seek to assuage any disappointment from the deal’s cancellation. AON is also on the hook for the $1 billion termination fee owed to WLTW and has upcoming maturities of $426 million next year and $298 million in the following year, so there is no shortage of potential uses for the debt funding generated this week.

Exhibit 1. Insurance Brokers

Source: Amherst Pierpont, Bloomberg/TRACE Indications

Insurance brokers – trading recommendations

  • The new AON 10-year and 30-year bonds priced at levels that we believed were too rich relative to comps (specifically MMC); although the 30-year now seems to be trading closer to fair value on the turn. Aside from that, we generally support adding AON at a discount to industry leader MMC.
  • We see good value in BRO as a potential takeover candidate by one of the larger players in the industry. BRO 2029s appear particularly attractive at current valuations.
  • Now that bond levels have settled post-merger cancelation, WLTW investors appear compensated for the risk of possible modest leveraging for both smaller M&A and/or additional shareholder enhancement.
  • We prefer WLTW 2048s and 2049s to AJG 2051s.

AON and WLTW officially ended their efforts to merge at the end of July, resulting in a $1 billion termination payment by AON to WLTW. The proposed merger had been challenged via an antitrust lawsuit from the Justice Department announced on 6/16. The deal was put in further question by a federal judge’s subsequent ruling that they would not be able to plan a summer trial, which meant in all likelihood the issue would remain unresolved when the deal’s expiration date was scheduled to hit on Sept 9 of this year. The cancellation came despite the fact that EU regulators (the European Commission) conditionally approved the combination, subject to the divestiture of key business units to Arthur J. Gallagher. The rating agencies affirmed AON’s ratings following the break-up.

The break-up of the AON/WLTW merger could have further implications for event risk in the industry. Cancellation of the deal favors competition in the industry, as it avoids the creation of a clear, sizable leader over current leader MMC and the remainder of the peer group. While failure to close this deal means consolidation among the big 3 is unlikely, AON (or WLTW for that matter) could potentially seek alternative strategies, among them could be a bid for the considerably smaller Brown & Brown Inc (BRO: Baa3/BBB-) – a deal that would presumably face less regulatory scrutiny for either potential candidate. We also would not rule out a scenario where BRO could see an overture from MMC or #4 player AJG to better compete with the big 3 MMC/AON/WLTW.

Exhibit 2. IG Insurance Brokers – Relative Size and Leverage

Source: Company Filings, Bloomberg LP

Despite consolidation over the past several years, the insurance brokerage (and related services) industry does remain highly fragmented. BRO is the #6 sized competitor (#5 among the IG peer group) with an enterprise value of just $17.4 billion and total annual revenue of roughly $2.6 billion on a trailing basis. That compares with an EV of $31.6 billion and annual revenue of $9.4 billion for WLTW, making BRO a significantly easier partner to consolidate from a regulatory standpoint for the larger, higher-rated players in the industry. BRO maintains the highest margins in the industry among the IG operators and very manageable leverage, making it an even more attractive candidate.

WLTW received the $1 billion termination fee from AON, which management immediately returned to shareholders in the form of a special share repurchase. Shortly after the cancellation of the deal was finalized, talks recommenced regarding the sale of WLTW’s reinsurance unit, Willis RE, to fellow insurance broker Arthur J Gallagher (AJG: Baa2/BBB/BBB). The unit had originally been planned for sale to AJG for $3.5 billion, partly as a means to smooth the regulatory process of the AON/WLTW deal. AJG and WLTW have since agreed to a sale price of $3.25 billion, and the deal is scheduled to close by year-end. AJG had already redeemed their outstanding 10-year notes ($650 million), which were issued with an optional redemption feature (at $101) conditional on the Wills Re deal closing as originally agreed upon. Since the deal was canceled and then renegotiated, AJG was able to redeem the 10-year notes (the 30-year notes did not contain the same redemption feature), as they were trading north of $101. They may choose to issue more bonds again now that another deal has been reached.

With a reported approximately $1.25 billion in annual revenue and $360 million in annual EBITDA at Willis Re, the new price would value the unit at approximately 9x EBITDA and about 2.6x revenue. The sale would represent about 13% of WLTW’s annual revenue and about 17% of last year’s EBITDA. While WLTW would most likely seek to return a large portion of the proceeds to (still somewhat disappointed) shareholders, we believe maintenance of IG ratings also remains a priority and that at least a portion should be utilized to reduce an appropriate amount of debt and/or directed to M&A to help reduce the impact of lost revenue and cash flows. Obviously, there are a lot of moving parts right now for the involved parties and the industry at large in wake of the AON/WLTW deal falling through, so there is a bit of speculation here about what the motivations of management teams might be right now.  We would also reiterate that despite the larger players getting larger over the past several years, the insurance brokerage industry still remains rather fragmented, offering the prospect for continued growth through smaller strategic bolt-on acquisitions for WLTW as well as its peers.

Dan Bruzzo, CFA
1 (646) 776-7749

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