In search of combinations (Lloyd's Banking Group)

Mergers and acquisitions (M&A) are a perennial topic of debate in re/insurance circles, with the potential for synergies, hostile take-overs and the favourability of market conditions all watched with interest by the market. And 2011 didn’t disappoint, with a number of significant deals being finalised over the 12 months and some still rumbling on as the year came to a close. Still further activity is promised for 2012, with the continuing soft cycle encouraging firms to explore the relative merits of M&A.

In 2011 a number of Bermuda players entered the M&A fray, with Allied World, Canopius, Haverford and Validus all pursuing—if not always successfully—the hand of potential acquirees. And the appetite for such deals is not confined to Bermuda: US and Lloyd’s of London-based firms have also got in on the act. As Seb Kafetz, relationship director at Lloyds Banking Group indicated, this pursuit of opportunities has been, and will continue to be, driven by two company-led factors.

“The first issue, which is more particular to the Lloyd’s of London market than elsewhere, is that of scale,” said Kafetz. Firms continue to adhere to the old adage that bigger is better, pursuing M&A to achieve economies of scale. Kafetz explained that this had become an ever more pressing concern in recent months as “increased natural catastrophe losses, heightened volatility—on both the investment and the underwriting sides of the book—the high cost basis of Solvency II compliance and reduced investment returns” had all served to create a troubled landscape, which has proved particularly difficult for smaller players to navigate.

“You need to be writing at least $400 to $500 million of premiums these days to be able to withstand the volatility and cost-base” of today’s re/insurance cycle, he said. Any less than that and you are in danger of underperforming the market, with the situation acting as a spur on smaller re/insurers’ pursuit of M&A. Kafetz cited Hardy Underwriting as an example. The firm announced significant nat cat losses from Japan, New Zealand and Thailand at the end of November, and said that as a result it was embarking upon a strategic review, which may result in it finding a buyer or strategic partner. Hardy’s gross written premiums for 2009 and 2010 were $380 million and $433 million, respectively—close to Kafetz’s predictions of the minimum premiums needed to withstand market volatility and the cost-base of doing business.

Other smaller players may also be feeling the pinch after a troubled 2011. Whether they act as acquirer or acquiree is likely to depend on their circumstances. It seems probable that in Hardy’s case they will be the acquired party in any future deal, even if the deal struck is a merger, rather than an acquisition. As Kafetz indicated, firms that suffered a few hiccups, either through investment losses in 2008 or underwriting losses in 2010-2011, and are struggling to convince investors to buy into their stock, are likely to be those “open to takeovers by larger peers”. The pursuit of scale, and the pressing need for it in the trough of a difficult cycle, will continue to act as a leading driver of M&A.

"Low book value-- which appear to be a consistent theme across the industry-- have hardly fuelled investment appetite for M&A."

The second company-led driver of M&A is likely to be the appetite of larger, global reinsurers to pursue M&A in order to develop “into a particular jurisdiction or niche” and diversify, Kafetz said. And with smaller, troubled re/insurers looking for potential ‘big brother’ partners, it would seem that there are opportunities for global re/ insurers which are looking further to strengthen their positions. National Indemnity’s interest in Transatlantic Re would seem to be a case in point. The firm evidently saw synergies with the USbased player, even if in the end its sale went to Alleghany. As Kafetz indicated, diversification through M&A brings with it the possibility of “generating greater returns”, with Lloyd’s of London’s platforms a particularly sought-after acquisition thanks to their global passport arrangements and the opportunities these present to “serve customers by providing global solutions and alternative sources of distribution”.

Examples of exactly this phenomenon were the acquisition of Brit Insurance by private equity houses CVC and Apollo and that of Chaucer by The Hanover Insurance Group, said Kafetz. In both instances the acquirers evidently saw attractions in having a Lloyd’s of London syndicate and the opportunities thus presented to write global business. Lloyds Banking Group was intimately involved in both deals, providing the finance that was integral in both acquisitions.

Other factors are similarly encouraging M&A. The capital demands of Solvency II, low book values and heavy cat losses in recent years, Kafetz outlined, are all prompting re/insurers to consider the meritsof M&A. Despite calls for proportionality it would seem that many— Kafetz included—expect European regulation to impact smaller players harder than their larger contemporaries. Depressed book values are also placing pressure on managers to pursue M&A as a means of building value for shareholders in a period when rates are challenging, while unprecedented insured losses in 2011—put at $90 billion by Swiss Re—are likely to trouble even the hardiest of re/insurers.

“With only a minority of classes experiencing rate increases and with investment returns down, firms are inevitably looking at ways to achieve growth,” Kafetz said. “M&A offers opportunities through positive synergies and opportunities in alternative markets so, for the right companies, M&A represents the prospect of increasing shareholder value.”

In addition he declared that the pursuit of M&A inevitably picks up in a soft cycle, with firms enjoying few options “to deploy capital to pursue lines of business”.

Nevertheless, impediments to M&A remain resolutely in place. “Getting the right finance for M&A deals from the capital markets and the ability to raise significant bank finance” are both more difficult than they were before the financial crisis, Kafetz said. In the face of depressed book values many of the deals have necessarily been sharefor- share offers. At the same time, low book values—which appear to be a consistent theme across the industry—have hardly fuelled sell side investor appetite for M&A. As Kafetz made clear “a lot of Bermuda companies still have their original private equity investors as shareholders”. Getting those people to sell out “at, or below, book value may be a hard sell” when there might be some expectation of a turn in the cycle and/or better underwriting results in 2012-2013.

However, within the Lloyd’s of London market “there are about five or six companies that need to do deals because they are subscale.” Kafetz said. With capital getting more expensive, and with the investment returns simply not being there “a number of smaller players that were set up five years ago are considering strategic initiatives that might include M&A”. He indicated that Barbican, Beazley and Novae “are all publicly looking to do deals and have been actively doing so for the last couple of years”.

Turning to Bermuda players, he said that there “are a couple of private equity or part private equity-owned Bermuda companies that have strategic issues that they need to look at. Flagstone Re after an above average cat year has announced it is reviewing its international operations that may result in a sale, so we expect there to be a good stream of M&A in 2012, with much of it already out there”. And there is always the possibility that either, or both the previously announced deals to acquire Omega and Transatlantic will unravel, Kafetz said.

As regards acquirers, Validus had been linked with a number of M&A deals since its acquisition of IPC Holdings back in 2009 and it continued to show an appetite for M&A. “Validus took a look at a number of companies in 2010 and was involved in the Transatlantic deal as well, and one would imagine it will continue to pursue an M&A strategy and try to acquire alternative or similar platforms in order to gain greater scale,” he added. Canopius is another Bermuda player that has pursued potential synergies—in this instance as a possible acquirer of London-based Omega—and it would seem that the appetite is definitely there to pursue deals.

Despite suggestions that private equity will increase its presence in the market—with the likes of Greenlight Capital, SAC Capital Advisors and Third Point all expressing interest in Bermuda reinsurance entities—Kafetz said that re/insurers will be the more likely acquirers in today’s M&A landscape. “We don’t think private equity and hedge funds are interested in creating a new class right now. Generally that kind of play occurs when there are imminent rate rises and we just aren’t seeing that in the market at present,” he said.

Rather, private equity had shown interest in “other plays, such as run-off vehicles, collateralised vehicles or sidecars”. Zeroing in on the desire to enter re/insurers into run-off, Kafetz said that there are “evident opportunities to enter troubled companies into run-off and release capital quite quickly, particularly in the case of shorttail business”, which might just prove a tempting prospect for private equity players considering acquiring troubled re/insurers.

Funding your ambitions

Raising funds for M&A in today’s troubled investment environment is unlikely to be easy, particularly for those would-be acquirers that are trading below book value. “Equity investors are only going to consider where the company is trading at that particular point in time,” Kafetz said, although he added that there were, nonetheless, opportunities to raise money in the bond or bank markets where the real net asset value of the company was considered, rather than its market capitalisation.

This difficulty in raising capital in the equity markets has encouraged an emphasis—where possible—on all-cash bids, such as that extended by National Indemnity for Transatlantic. Such an approach is attractive to investors as it offers “a clear exit price for shareholders if they are approached to buy”. This situation would suggest that acquisitions are more likely to garner shareholder approval than potential mergers and the share-for-share swaps such deals entail. And, as Kafetz detailed, many of the deals done during the last big spate of M&A activity back in 2005-2006 were cash buy-outs at “high multiples of book value”.

For mergers, the waters are rather muddier, with turbulence in the market created by a tough couple of underwriting years and low investment returns hardly proving conducive for deals. “While there is the potential to share in any upside as a shareholder, they often aren’t getting a clear exit price and instead are having to take a view on the new company and its management,” said Kafetz. It therefore represents a rather more uncertain outcome for investors. There is also the issue posed by fluctuating share value, with few deals being made in under three months, Kafetz said. “Given all the nat cats in recent months and exposure to market risk, there are always dangers that the ground for M&A may change,” he added, although he indicated that such concerns would always be an issue for acquirers.

Whatever the approach taken by the acquirer, Kafetz was clear that “having a finance facility in place—a committed and revolving credit facility that you can draw down to finance the cash element of any M&A deal, is a good way to prepare for M&A”. This would generally take the form of bank finance that would “act as a bridge to longer-term debt finance from the bond markets”. And with the majority of players in the industry “under-geared”, they can “afford more leverage to enter their capital structure”. It is exactly this kind of facility that Lloyds Banking Group specialises in extending to the market, the bank enjoying the scale of balance sheet and dominant position within the Lloyd’s of London market that enables it to speak with some authority as regards funding re/ insurance M&A.

Providing some final thoughts on the matter, Kafetz concluded that in pursuing M&A firms need to be upfront with their shareholders. “If shareholders understand your strategy and appreciate why you are doing what you are doing, they are more likely to support higher premiums to achieve your strategic goals. If a M&A looks opportunistic and you enter into a bidding war, the price is driven up and you have not articulated your strategic approach to shareholders, it will be much harder to get support to do the transaction.”