14. Project Swiss Flashcards

1
Q

Walk me through Project Swiss.

A

We were retained by a $25 billion insurer / reinsurer to evaluate alternatives to create shareholder value, including a $9.4 billion acquisition opportunity that would diversify and enhance its presence in new markets and ultimately grow its commercial insurance segment.

Our client is a global provider of reinsurance and insurance products for insurance companies and multinational corporations. The target is primarily a property and casualty insurer with half of its business in North America and the other half in Europe.

Synergies
A potential acquisition of the target could be financially attractive to our client as well as strategically sensible and could generate significant operating synergies.
-Reduction of combined corporate expenses as well as selected underwriting/operating expenses
-Reorganization of non-core operations (lower ROE segments)
-Partial offset of reducing overlapping peak zone exposures could be managed through portfolio reshaping during the next renewal cycle

Valuation
The target has weathered the storm of the financial crisis and is showing health performance with a strong outlook; however, it is trading at a discount to book value and lower than its peers mainly due to its low ROE and investor scrutiny. Although the target’s management has made progress in repositioning the business since saving the company in 2008, we believe the company needs catalysts to address issues in its global P&C insurance business and run-off life operations

Our client has outperformed its peers in recent months and has a strong purchasing power with better than average valuation and a solid capital position

Deploying some of the capital in an accretive and growth oriented acquisition could provide the company with meaningful potential upside.

Timing
Consolidation in Bermuda and the broader market is squeezing the target from its historical dominance in the space, which may call for a strategic play

The P&C industry is anticipating a positive turn in rates after several years of a soft market. This could present an opportunity to enhance market position at the bottom of the cycle

Debt and equity markets are open and available particularly for acquisition financing

Underwriting and Diversity Balance
Balanced pro forma portfolio
Standalone: 57% Property / 43% Casualty, 11% Insurance / 89% Reinsurance
Pro Forma: 51% Property / 49% Casualty, 23% Insurance / 77% Reinsurance

Each company will benefit from greater diversification in terms of geography and business lines.

Acquirer could benefit from the leading specialized catastrophe reinsurance platform and XL’s capabilities in other specialty lines of business

Risks:

(1) Revenue cannibalization
(2) Managing pro forma peak zone aggregates
(3) Shareholder flow-back
(4) Deep underwriting / management bench mitigates risk of losing talent

Task: describe the challenges and expectations (i.e. scope of engagement)
We were expected to evaluate various alternatives to create shareholder value, specifically looking at a potential acquisition opportunity

Action: elaborate on your specific action in response

(1) Analyzed historical performance of target, trading multiples of comparable companies and precedent transactions
(2) Built dynamic merger model to analyze financial implications on book value, tangible book value and EPS basis
(3) Performed combination analysis to assess pro-forma impact on business portfolio and geographic mix

Results: explain the results of your efforts both qualitatively and quantitatively
The acquisition opportunity proved to be both financially attractive and strategically sensible. However, given the economic uncertainty at the tail end of 2012 and the general lack of an M&A appetite for large insurers, our client decided to hold off on a potential engagement and instead chose to deploy capital in the form of a special dividend.

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2
Q

What was the strategic rationale for the investment?

A

A potential acquisition of the target could be financially attractive to our client as well as strategically sensible and could generate significant operating synergies. The potential acquisition would diversify and enhance the acquirer’s presence in new markets and ultimately grow its commercial insurance segment

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3
Q

What are the five most notable merits of the deal?

A

(1) Undervalued: target is trading at a discount to book and lower than its peers mainly due to low ROE and investor scrutiny
(2) Significant operating synergies
- Reduction of combined corporate expenses as well as selected underwriting/operating expenses
- Reorganization of non-core operations (lower ROE segments)
- Partial offset of reducing overlapping peak zone exposures could be managed through portfolio reshaping during the next renewal cycle
(3) Accretive and growth oriented acquisition could provide the company with significant potential upside
(4) Opportunity to enhance market position at bottom of the cycle
(5) Diversification in terms of geography and business lines

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4
Q

What are the potential risks and pitfalls?

A

(1) Internal:
- potential for revenue cannibalization (overlapping customers?)
- systems integration can be challenging (much more diligence is needed)
- limited history of M&A success means investor community would be very skeptical of such a large acquisition
(2) External:
- uncertain macroeconomic environment with looming US presidential elections and fiscal cliff
- European sovereign debt crisis
- depressed valuations limiting deal activity (sellers would prefer not to sell their companies below book and buyers are content buying back shares at historically depressed valuations)

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5
Q

Describe the P&C insurance industry.

A

In the US, P&C insurance is a fragmented, mature industry. There are about 2,700 players, the largest being State Farm. The top ten insurance carriers control just over 50% of the industry’s premiums ($439 billion)

In general, premium growth is modest across a cycle. Total industry premiums grew 3% in 2011 and were up 4% in 2012. Premium growth has average -0.6% over the past five years and 3.4% over the last fifteen years.

Improving pricing could help premium comparisons over the next several years and economic growth could also provide a tailwind.

Personal auto (liability and physical damage combined) is the industry’s most important, followed by homeowner insurance and other liability

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6
Q

What is the size of the market and its growth prospects?

A

US P&C market = $667 billion (33% share)
Europe P&C market = $726 billion (36% share)
Global P&C market = $2 trillion

Modest growth prospects (~4%) due to improving pricing and economic growth acting as a tailwind

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7
Q

Discuss the industry outlook and trends.

A

P&C insurance is a fragmented, mature industry

The industry’s maturity is demonstrated, in part, by its modest premium growth across a cycle

Following a deep recession in the US, insurance premiums began growing again in most lines, which is expected to continue. The US, despite its problems, is currently viewed as a better place to invest than Europe or Japan, although some real values are developing in Europe

Demand for insurance continues to be impacted by sluggish economic conditions, and the Fed is actively signaling that it is determined to keep rates low through late 2014.

In the current low valuation environment, M&A activity often competes with attractive capital management such as share buybacks and special dividends

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8
Q

How will the target company outperform, underperform or be neutral with the industry?

A

We view the target as one of the best value names in P&C insurance because its balance sheet is strong, its reserve position appears more than adequate, and it should be well positioned to generate profitable growth in a rising P&C price environment

XL’s P&C business has stabilized and its capital position is strengthening. While management’s expectation for substantial ROE improvement from current levels could be overly optimistic, we believe the company’s reserve position is strong, meaningful share buybacks could continue, and the valuation is attractive.

The gradual improvement in commercial insurance pricing and the likelihood of the pricing gains continuing in 2013 leave XL positioned well for further improvement over the next two years, in our view. In addition, a changing business mix and a reducing expense ratio should aid the margins. As the margins and ROE improve, we expect the company’s price/book multiple to improve

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9
Q

Is there fragmentation in the P&C insurance market?

A

In the US, P&C insurance is a fragmented, mature industry. There are about 2,700 players, the largest being State Farm. The top ten insurance carriers control just over 50% of the industry’s premiums ($439 billion), although certain lines of business, such as personal auto, the concentration is greater. In contrast, the top 10 insurers in the UK control roughly 70% of the market

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10
Q

Is there seasonality / cyclicality?

A

The Company earns its revenue primarily from net premiums written and earned. The property and casualty insurance and reinsurance markets have historically been cyclical, meaning that based on market conditions, there have been periods where premium rates are high and policy terms and conditions are more favorable to the Company (a “hard market”) and there have been periods where premium rates decline and policy terms and conditions are less favorable to the Company (a “soft market”). Market conditions are driven primarily by competition in the marketplace, the supply of capital in the industry, investment yields and the frequency and severity of loss events.

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11
Q

Is the P&C insurance market attractive?

A

Relatively unattractive

Intensity of competition: (HIGH) fragmented; difference between one insurance company vs another is not great; insurance has become more like a commodity; insurer with lost cost structure and greater efficiency and better customer service will win out; mature industry with very little growth
Threat of new entrants: (LOW) high capital requirements, strong distribution network required, strong brand names are important, requires economies of scale
Threat of substitutes: (HIGH) plenty of substitutes in the insurance industry
Purchasing power of buyer: (MODERATE) huge number of buyers; product is important to buyer; but there are plenty of substitutes; customer poses little threat in the insurance industry
Purchasing power of supplier: (MODERATE) capital is very important to insurers; but there are plenty of sources of capital; suppliers of capital do not pose a big threat

Note: the industry is highly regulated

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12
Q

Describe the customer.

A

Insurance is distributed to the customer (individuals and businesses) in three primary ways: independent agents, captive agents or directly to the consumer.

Customer has a very unique need: risk mitigation. He is willing to pay a premium in order to mitigate potentially large downside losses, which results in relative price inelasticity. However, the government strictly regulates the insurance industry to prevent unreasonable premiums

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13
Q

What does your client do? What are its key financial metrics?

A

Operating in more than 20 countries and with a presence on five continents, our client is one of the world’s largest and most diversified reinsurers, alongside Munich Re and Berkshire Hathaway. With a business split about 50/50 between non-life and life reinsurance and a global platform characterized by a high level of in-house expertise, it can access all classes of risk in all major markets. In addition, it has pioneered the transfer of insurance risk to capital markets and remains a leading player in that space. The group targets an ROE of 700 basis points above the five-year risk-free, 10% average annual EPS growth and 10% average annual economic net worth per share growth.

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14
Q

Describe the business segments of your client.

A

Our client is predominantly a reinsurer (82% of NPE) with a business that is split about 50/50 between non-life and life reinsurance. It operates out of four main business segments:

(1) P&C Reinsurance (56%) – products comprise reinsurance coverage for property, credit and surety, engineering, aviation, marine, and agriculture; and reinsurance coverage for liability, motor, workers’ compensation, personal accident
(2) Life and Health Reinsurance (36%) – death, annuity and illness and disability coverage; also direct life insurance as well as direct corporate insurance
(3) Corporate Solutions (4%) – insurance for single-line and multi-line programs worldwide
(4) Admin Re (4%) – (run-off) solution through which Swiss Re acquires closed blocks of in-force life and health insurance business, either through reinsurance or corporate acquisition, and typically assumes responsibility for administering the underlying policies

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15
Q

What does the target company do?

A

The target is predominantly a P&C insurer (64% of NPE) and reinsurer (36%) with half of its business in the US/Bermuda and the other half in Europe. It operates out of three main business segments:

(1) P&C Insurance (64%) – primarily commercial insurance including professional casualty lines, other casualty lines, property cat, other property, marine, energy, aviation and satellite, and other specialty lines
(2) P&C Reinsurance (30%) – provides casualty, property risk, property catastrophe, marine, aviation, treaty and other specialty reinsurance on a global basis
(3) Life Operations (6%) – (run-off; not accepting new business) traditional life and annuity business; provided life reinsurance on business written by life insurance companies, principally to help them manage mortality, morbidity, survivorship, investment and lapse risks

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16
Q

What are the company’s competitive advantages?

A

(1) Commercial P&C insurance underwriting expertise
(2) Broad international mix with consistent access to distribution channels
(3) Financial strength (strong balance sheet)

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17
Q

What the company’s strengths, weaknesses, opportunities, and threats?

A

Strengths: weathered the storm of the financial crisis (exited survival mode it operated under during the financial crisis) and is showing healthy performance
Weaknesses: low ROE compared to peers; run-off life operations
Opportunities: growing strategic footprint; enhance market position at bottom of the cycle
Threats: consolidation in Bermuda and the broader market is squeezing the target from its historical dominance in the space, which may call for a strategic play

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18
Q

What does the company’s supply chain look like?

A

There is not a traditional supply chain as with a consumer products company. The company’s business is driven by the amount of capital that is available. Generally, the more capital an insurer has on its balance sheet, the more premiums that a company can write.

Insured = individuals and businesses 
Insurer = underwrites risk 
Suppliers = capital (debt and equity)
Reinsurer = insurer indemnifies another insurer
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19
Q

How does the company’s competitive advantage improve its position within the industry?

A

The P&C industry is anticipating a positive turn in rates after several years of a soft market. This could present an opportunity to enhance market position at the bottom of the cycle. The company can leverage its underwriting expertise and financial strength to gain further access to distribution channels internationally.

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20
Q

How does the company make money? (profitability analysis)

A

The company makes money in three ways: (1) underwriting (2) interest/dividend income (3) realized gains on securities

(1) Underwriting: historically, the industry has on average paid out $1.04 for every $1 earned in premiums, for a $0.04 underwriting loss
a. Collecting premiums: when an insurance company writes a policy, the premium is recorded as gross premiums written
- To help manage their risk and their capital needs, most companies buy reinsurance of some kind, paying ceding premiums to the reinsurer, which leaves us with net premiums written
- Those premiums are earned pro rata over the life of the policy, which leads to net premiums earned (if net premiums written are growing, the earned premiums will lag the written, and if the written premiums are shrinking, the earned will tend to be larger)

  • Claims: (Loss and loss adjustment expense) incurred losses can come in two forms – paid claims (cutting a check to the insured) or establishing a loss reserve to pay the claim at some point in the future
    a. loss reserve = liability on insurer’s balance sheet
  • When a claim that has been reserved for is paid, the loss reserve goes down by that amount as does cash
    b. Along with actual claim costs, an insurer must also pay for (or reserve for) loss adjustment expenses (LAE), such as legal fees and costs for loss adjustors
    c. the tail on the claims reserve, or the average length of time until the claim is reported and then paid, will depend on the business line
    - Short Tail: auto, homeowners’ and other property related lines
  • Long Tail: general liability, medical malpractice (company’s incurred losses in the year are largely an estimate of future claims payments)
  • Paying expenses: aside from the claims expenses, an insurer has other underwriting expenses, such as acquisition expenses to bring in premiums (e.g. commissions to agents and brokers)
    a. Other underwriting expenses include admin staff, technology, premium taxes and office space
    b. Expenses that are paid but not yet run through the income statement become an asset on the balance sheet, called deferred acquisition costs

(2) Investment Income: makes up the bulk of overall earnings for most insurers; between the time the company collects premiums and pays claims and expenses, it will invest those funds in an array of securities and investment vehicles
a. The interest and dividend income that derives from these investments has historically accounted for the bulk of the overall earnings for most insurers
- Those companies with long tail lines of business will hold on to their reserves for a longer period of time, so the funds supporting those reserves will build up faster than a company that focuses on short tail lines
b. Not surprisingly, changes in interest rates have a big impact on an insurer’s net investment income
- Declining interest rates over the past decade have eroded investment income and caused insurers to focus even more on underwriting profitability

(3) Realized Gains: investment income can also come in the form of realized gains due to the sale of securities and credit impairments
a. Although realized gains flow through the income statement and add to retained earnings, we do not include this income operating earnings forecasts due to the unpredictability

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21
Q

What is the most common measure of underwriting profitability?

A

Combined Ratio = Loss ratio + Expense Ratio

Loss Ratio = Losses & LAE / premiums earned (avg 74%)
Expense Ratio = Underwriting Expenses / premiums earned (avg 27%)

> 100% underwriting loss
< 100% underwriting profit

*Prior to 2004, the overall P&C industry had not made money from underwriting activities since before 1979. Therefore, the industry’s entire net income has come from investment activities

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22
Q

What are the industry’s operating metrics?

A

Operating Earnings = net income excluding realized gains/losses
ROE = operating earnings / average reported BV

23
Q

What does the competitive landscape look like?

A

Fragmented, mature industry. There are about 2,700 players in the US. The top ten control just over 50% of the industry’s premiums

Intensity of competition: (HIGH) fragmented; difference between one insurance company vs another is not great; insurance has become more like a commodity

24
Q

What is the company’s overall strategy?

A

Management’s goal is to build long- term shareholder value by capitalizing on current opportunities and managing through any cyclical downturns by reducing its property and casualty book of business and exposures if and when rates deteriorate during soft market periods.

25
Q

What is the company’s value proposition?

A

Without a compelling value proposition, you are ordinary and disposable—a commodity. With a distinguished value proposition, you are unique and indispensable.

The world is constantly changing. Problems are greater. The stakes are even higher and the answers are harder to find. Moving forward means risk. The target’s underwriters have deep expertise and understand your business. The target helps to mitigate business risk at attractive rates

26
Q

What are the company’s plans for growth?

A

The gradual improvement in commercial insurance pricing and the likelihood of the pricing gains continuing in 2013 leave the target positioned well for further improvement over the next two years. Taking advantage of this inflection point presents an opportunity to leverage its strong balance sheet and underwriting expertise in order to strengthen its market position.

27
Q

What is their market share?

A

P&C Insurance:
US Market = $667 billion
Target = 1.5%

P&C Reinsurance:
Global Market = $200 billion
Target = 1%
Acquirer = 11%

28
Q

Who is their customer base?

A

Large multi-national corporations as well as middle market companies worldwide.

29
Q

Who are the suppliers?

A

Suppliers of capital include banks, institutional investors, and individuals that comprise the debt and equity markets.

30
Q

What are some general observations on the acquirer?

A

Corporate solutions is a key growth area with substantial potential upside. Acquirer is well positioned to execute its strategy and enhance its global presence in the large commercial space

Positioning:

  • Acquirer brand recognition is a key strength, especially in emerging markets
  • Reinsurance is a sound but unspectacular core business providing good cash flow
  • Commercial insurance is currently subscale (ranked #19 globally)
  • Other reinsurance competitors have been more aggressive in expanding into specialty commercial insurance
  • Admin Re is viewed ambivalently as a non-core business that could potentially be divested

Public Market Perception:

  • Acquirer is viewed as a solid investment although perceived as a defensive play in the equity research community
  • Outstanding capital position and strong risk management capabilities support a stable outlook and provide grounds for strategic initiatives
  • Long term growth trajectory is unclear and could be a burden on current valuation

Competitive landscape:

  • Peers are constantly diversifying and enhancing presence in new markets
  • Life reinsurance business is under some systematic changes, with financial sponsors acquiring blocks of business while separating mortality risks from the spread lending businesses
  • Regulatory changes and upcoming increased capital requirements are a catalyst for M&A activity in the insurance / reinsurance sector

Valuation:

  • SOTP analysis suggests that the acquirer trades at a discount to its sum-of-the-parts
  • Has outperformed peers in recent months and has strong purchasing power with better than average valuation and a solid capital position
31
Q

What was the historical performance of the target?

A
  • Gradually improving operating leverage as defined by NPW / Total Capital (40% to 45%)
  • Stable business mix; consistently ~68% insurance and 32% reinsurance
  • Declining underwriting profitability but favorable pricing outlook bodes well for company; (above 100% for last 8 quarters)
  • Volatile profitability and returns with ROE ranging from 9% to -5%; improving over last eight quarters with 8% target ROE by 2014 (currently 4%)
  • Acquirer’s stock price has outperformed the target’s stock price on a relative basis in 2012 (0.37 exchange Target / Acquirer)
  • Acquirer and target have traded in line over the last three years but the acquirer is currently trading at a higher multiple (0.83x vs 0.79x); historical average of 0.70x for each company
32
Q

What were the comps? How did you choose them? Where are they trading?

A
  • Similar exposure to both the P&C reinsurance and insurance business as the target
  • Global presence
  • Similar size
  • Similar credit rating (target BBB+)
Median LTM PE = 11.3x 
Median NTM PE = 8.4x 
Median P/BV = 0.9x 
Median P/TBV = 1.1x
Median NTM ROE = 10%
Median Dividend Yield = 3%
Acquirer LTM PE = 8.8x 
Acquirer NTM PE = 8.8x
Acquirer P/BV = 0.83x 
Acquirer P/TBV = 0.96x
Acquirer NTM ROE = 8%
Acquirer Dividend Yield = 5%
Target LTM PE = NM 
Target NTM PE = 11.0x
Target P/BV = 0.79x 
Target P/TBV = 0.83x
Target NTM ROE = 7%
Target Dividend Yield = 2%
33
Q

What are the acquisition multiples? How does the multiple compare to past transactions?

A

We looked at precedent transactions in the reinsurance space over the last 6 years (10 transactions). Median deal value / BV = 1.0x. Median Deal Value / EPS = 10.5x

An acquisition of the target at book value or in line precedents transactions would represent a 25% premium to the target’s current stock market valuation or $9.8 billion

An acquisition at this value would represent a 13.7x PE multiple, which is well above the median of precedent transactions

The most recent transaction in the reinsurance industry was Validus’ $623 mm acquisition of Flagstone for 0.72x book

34
Q

Walk me through the accretion / dilution analysis.

A

Consideration:

  • 50% stock
  • $2.0bn of acquirer cash (2% foregone interest)
  • Remainder financed with debt (5.2% weighted average pre-tax cost of debt for acquirer)
  • Transaction costs equal to 75bps of implied equity value
  • Consensus EPS estimates used for target for 2013 and 2014
  • Synergies based on 30% of target’s G&A with 75% realization in 2013 and 100% realization in 2014
  • Tax rate of 21% used
  • Intangible amortization period of 8 years

(1) Aggregate the projected net income for the two companies
Acquirer Standalone: $2,767
Target Standalone: $733
Combined: $3,501

(2) Plus: pre-tax synergies
LTM Target G&A * Synergy Realization * % G&A
$1,137 * 75% * 30% = $256 mm

(3) Less: transaction costs
0. 75% * Implied Equity Value = 0.75%($9,400) = $70mm

(4) Less: interest expense on incremental debt
5. 2% * $2,700 = $140 mm incremental interest expense on debt

(5) Less: interest income from cash used
$2,000 * 2% = $40 mm

(6) Less: incremental D&A on write-up of book value
- Max(Implied Equity Value – Target TBV, 0) / Amortization Period = 0

(7) Plus: tax benefits from merger adjustments
Pre-Tax Adjustments * Tax Rate = $5 * 21% = -$1

(8) Divide the resulting pro forma earnings number by the pro forma fully diluted shares outstanding to arrive at fully diluted pro forma EPS
Pro Forma Earnings = $3,505 mm
Pro Forma Shares = Standalone shares + (50% * Implied Equity Value) / Acquirer Share Price
Pro Forma Shares = 365.3 + 69.2 = 434.5

(9) Calculate the change from pre-deal to post-deal EPS or the accretion/(dilution) percentage
Standalone EPS = $7.58
Pro Forma EPS = $8.07
Accretion = $0.49 or 6.5%

35
Q

How did you calculation accretion / dilution in terms of BV?

A
Standalone Book Value = $29,914
Plus: Equity Issued = $4,697
Less: Transaction Costs = -$70 
Plus: Gain on Bargain Purchase = $69
Pro Forma BV = $34,609

Gain on Bargain Purchase = -min(Implied Equity Value – Target TBV, 0)

TBV = Book value of common equity - goodwill and other intangibles = $9868 - $406 = $9462

Bargain Purchase = Financial assets acquired for less than fair market value. In a bargain purchase business combination, a corporate entity is acquired by another for an amount that is less than the fair market value of its net assets

Acquirer Standalone BV per Share = $81.89
Pro Forma BV per Share = $79.66
Accretion / Dilution = -2.7%

36
Q

How did you calculation accretion / dilution in terms of TBV?

A

Acquirer Standalone Intangibles = $4,036
Plus: Incremental Intangibles = 0 (bc target acquired for less than TBV)
Pro Forma Intangibles = $4,036

Pro Forma Book Value + Pro Forma Intangibles = Pro Forma TBV
Acquirer Standalone TBV per Share = $70.84
Pro Forma TBV per Share = $70.37
Accretion / Dilution = -0.7%

Only accretive to TBV up to 15% premium. And only accretive to BV up to a 5% premium.

37
Q

How did you determine the sources of funds?

A

The acquirer has $9 billion in excess capital above S&P AA level of rating capital. This means it has $4 billion in excess now above the $5 billion target buffer that the firm aims to retain, which fully supports our $2 billion deployment of acquisition capital.

Additionally, we sensitized EPS accretion dilution based on premium paid and % stock mix and 50% cash / 50% stock proved to be the most attractive option. The firm’s AA credit rating provides favorable options for debt financing, which explains our use of debt for the remainder of the transaction cost.

50/50 split proved to be accretive to earnings up to a 35% premium across 2013 and 2014.

38
Q

What are the sources and uses of funds?

A
Sources:
Stock = $4697
Cash = $2000
Debt = $2697
Total = $9394

Uses:
Purchase Equity = $9323
Transaction Costs = $70
Total = $9394

39
Q

What was the pro forma ownership?

A

At a 20% premium, or 0.95x book, and a 50/50 stock/cash split, the acquirer would retain 84% ownership of the proforma company

At a 20% premium, or 0.95x book, and a 100% stock mix, the acquirer would retain 73% ownership of the proforma company

40
Q

What made the model dynamic? What were the key assumptions?

A
  • Premium paid
  • form of consideration (% stock, % debt, % cash)
  • Synergies
41
Q

What are the potential synergies to be gained?

A

We only modeled reduction to G&A expenses, but there are significant operating synergies to be considered

  • Reduction of combined corporate expenses as well as selected underwriting/operating expenses
  • Reorganization of non-core operations (lower ROE segments)
  • Partial offset of reducing overlapping peak zone exposures could be managed through portfolio
42
Q

What did the pro-forma company look like?

A

-A combination could position the acquirer among the largest insurer / reinsurers globally; #3 largest insurer / reinsurer in the world (up from #6)

  • A combination would allow acquirer to strategically reorganize its business portfolio mix and substantially enhance its Corporate Solutions segment
    a. Acquirer Standalone: 56% P&C reinsurance, 36% Life and Health Reinsurance, 4% commercial insurance, 4% run-off life business
    b. Target Standalone: 64% P&C insurance, 30% P&C reinsurance, 6% life reinsurance
    c. Combined: 50% P&C reinsurance, 29% life and health reinsurance, 16% commercial insurance, 5% life insurance run-off businesses
  • Target’s dominant presence in the US and Western Europe would improve the acquirer’s global footprint and present opportunity to realize expense synergies by consolidating operations
    a. Acquirer Standalone: 42% Americas, 39% EMEA, 19% Asia Pacific
    b. Target Standalone: 11% Bermuda, 40% US, 49% Europe and Other
    c. Combined: 44% Americas, 41% EMEA, 15% Asia-Pacific
  • Target has improved its operating leverage as a function of Loss Reserves / Total Capital since 2008, which suggests that going-forward pro forma ratio could potentially look more favorable.
    Operating Leverage: Loss & LAE Reserves / TC
    a. Acquirer Standalone: 1.3x
    b. Target Standalone: 1.55x
    c. Combined: 1.55x

Operating Leverage: NPW / TC

a. Acquirer Standalone: 0.3x
b. Target Standalone: 0.44x
c. Combined: 0.32x

Financial Leverage: Debt / TC

a. Acquirer Standalone: 37%
b. Target Standalone: 13%
c. Combined: 32%

43
Q

What is the initial recommended bid amount and deal structure?

A

We believed that the target would only consider a bid in excess of 0.9x book.

We recommended paying 0.95x book (0.99x TBV, 13.2x earnings), which represents a 20% premium to the target’s stock price at the time.

We thought that a 50/50 cash stock split would be the most attractive deal structure. 50% stock. $2 billion in cash from acquirer’s balance sheet. And the remainder financed with debt at a weighted average cost of debt of 5.2%

The acquirer’s stock price has been performing relatively well over the last year, which explains our rationale for a 50% stock consideration. We believe the target would recognize significant potential upside.

44
Q

Are other competitive bids likely? Would another financial or strategic buyer pay more?

A

We believe that the target is an attractive acquisition opportunity that would likely pique the interest of other strategic buyers. However, there has been limited history of M&A success in the industry primarily because systems integration (e.g. agency interface, pricing, underwriting, risk management, claims and internal reporting systems) can be challenging. Whether or not a strategic buyer would be able to pay more is debatable. Very few insurers or reinsurers have the amount of excess capital that our client does and depressed valuations appear to be a limiting factor in deal activity. Our client has outperformed peers in recent months and has strong purchasing power with better than average valuation and a solid capital position, thus making it a highly capable strategic buyer. Deploying some of the capital in an accretive and growth-oriented acquisition could provide the company with meaningful potential upside

A financial sponsor is unlikely to be interested in the target company for two reasons:

(1) Financial sponsors are attracted to industries with predictable cash flows; the target’s operating performance has been very volatile over the last five years; the P&C insurance industry is an inherently cyclical business
- While insurers can, indeed, have fairly strong cash flow (especially those in long-tailed lines of business), the predictability of that cash flow can vary among insurers sometimes making it difficult to leverage these companies.
- Still, financial buyers have shown an interest in property/casualty insurers, some with a great degree of success. Kohlberg, Kravitz and Roberts, for example, increased its equity investment in American Re more than sixfold between buying the company from Aetna and selling to Munich Re
(2) Financial sponsors like bloated expense structures; management at the target has already worked to aggressively cut costs in order to create a lean, efficient operation
- High expenses are still a problem for some insurers, and a new financial discipline imposed from a new owner can be effective in helping to create a leaner operation.

45
Q

Was it an auction, limited auction or sale?

A

The project has not advanced that far. Our client asked to look at the acquisition to see if it made strategic and financial sense. However, due to the uncertain economic outlook at the tail end of 2012, they chose to hold off on implementing a transformative M&A deal. Instead, they chose to issue a special dividend at year end.

46
Q

What was your role in this deal?

A

As the only analyst on the deal, I was in charge of building the merger model from scratch. I also constructed a contribution analysis in order to see what the pro forma company would look like.

47
Q

What was the team structure?

A

I was the only analyst on this four person deal team. There was an associate, VP and SMD.

48
Q

What were your day-to-day responsibilities?

A

I was in charge of constructing the model, fielding questions from the client, and making changes to the model as necessary. I also put together management and board materials regarding the potential acquisition

49
Q

Discuss the model that you built.

A

I built a clean merger model from scratch that assessed the financial implications on an earnings, BV and TBV basis. I constructed it in such a way that you could change any one of the model inputs (e.g. synergy amount, % stock mix, etc) and assess the outcome. Everything was dynamic and flowed through the model.

50
Q

Explain the most challenging parts of the deal.

A

The most challenging part of the deal for me was getting up to speed on the insurance industry in a short period of time. Our client gave us relatively short notice and wanted a quick turnaround on the analysis. However, neither me nor my associate (also a first year) had any experience in the FIG industry. Our VP compared learning about the FIG industry for the first time to learning Chinese. At first, it does not make any sense at all, but soon we were speaking Chinese. By no means were we pros, but we understood how the business made money and how valuation in the industry worked, which allowed us to complete the task at hand.

51
Q

Discuss your favorite part of the deal.

A

My favorite part of the deal was being able to take on an investor mentality and think through not only all the potential merits of the deal but also all the possible pitfalls. Even though the transaction did not ultimately happen, I learned how to objectively evaluate an investment opportunity. Even though the transaction made sense on paper, there were a number of risks both internally and externally, which we considered and ultimately prevented us from moving forward.

  • Internal: potential for revenue cannibalization (overlapping customers?); systems integration can be challenging (much more diligence is needed); limited history of M&A success means investor community would be very skeptical of such a large acquisition
  • External: uncertain macroeconomic environment with looming US presidential elections and fiscal cliff; European sovereign debt crisis; depressed valuations limiting deal activity (sellers would prefer not to sell their companies below book and buyers are content buying back shares at historically depressed valuations)
52
Q

Is this a good investment? Why or why not?

A

On paper, this was a financially and strategically attractive investment opportunity.

(1) Accretive and growth-oriented acquisition. P&C industry is anticipating positive turn in rates after several years of a soft market. This could present an opportunity for the target to enhance market at the bottom of the cycle. Attractive and cheap acquisition opportunity
(2) Meaningful opportunities for operating synergies
- reduction of combined corporate expenses as well as selected underwriting / operating expenses
- reorganization of non-core operations (lower ROE segments)
(3) Diversify and enhance presence in new markets and ultimately grow acquirer’s commercial insurance segment. Expanding its corporate solutions business and entering into new lines of business would leverage existing relationships with distribution channels. A broader product line offering would be helpful to independent agents and brokers whose clients have very diverse insurance needs (e.g. multi-national corporations)

However, in the situation, the risks outweigh the benefits.

(1) Internal:
- potential for revenue cannibalization (overlapping customers?)
- systems integration can be challenging (much more diligence is needed)
- limited history of M&A success means investor community would be very skeptical of such a large acquisition
(2) External:
- uncertain macroeconomic environment with looming US presidential elections and fiscal cliff
- European sovereign debt crisis
- depressed valuations limiting deal activity (sellers would prefer not to sell their companies below book and buyers are content buying back shares at historically depressed valuations)

53
Q

What are some areas for further due diligence?

A

Profitability

(1) Growth: How much growth is projected and how much is attributed to growth of the industry versus market share gains?
(2) Opportunities to increase price?
(3) Opportunities to increase volume? Increase market share with new products?
(4) Opportunities to decrease costs? Management has been improving margins and ROE; how much more room for improvement is there

Opportunities

(1) Are there non-core or unprofitable assets or business lines? Explore life operations run-off
(2) Is there opportunity for improvement or rationalization?
(3) What impact will an acquisition and financial leverage have on the operations of the business? Will key customers be spooked?