- Premium to book value is a good exit for current Aspen investors.
- Few mergers or acquisitions are happening lately in the reinsurance space.
- Low investment returns and higher price to book across the industry forecast lower returns going forward.
The recent announcement of hostile takeover attempt by Endurance Specialty Holdings (NYSE:ENH) of Aspen Insurance Holdings (NYSE:AHL) has created a stir in the reinsurance sector. The offer was for 60% stock and 40% cash and values Aspen at $3.2 billion. This offer is a great deal for Aspen investors, and I think management's announcement of the adoption of a poison pill plan is ill-advised and destroys shareholder value. There are three key reasons for this.
Firstly, Aspen has gone from the lowest price to book among this sector to around the peak of the pack, as a result of the stock price run-up from this attempted takeover. I have frequently compared price to book among companies in previous articles. The news caused a rapid 15-20% increase in the share price of AHL. The buyout was priced at about 116% of AHL book value, representing a premium over the 95-99% price to book at which AHL had been trading the past few months. Thus, I would have suspected AHL as the most likely acquisition candidate on that valuation basis. Indeed, this was part of my thinking in being long the stock via naked puts. The reasoning is that in a capital-intensive, highly competitive and price-sensitivity industry like reinsurance, that any underwriting skill tends to get arbitraged away, and over the longer term valuations such as book value become a major way of determining relative value. This proved to be the case with Flagstone which had by far the lowest price to book in the sector at the time of its acquisition a few years ago. A low price to book can overcome a lot of mediocrity and I think that was the case with Flagstone.
Secondly, not many mergers have been happening lately so it is unclear that a better deal will emerge. Other recent acquisitions in this space in 2012 included Validus Holdings' (NYSE:VR) purchase of Flagstone Reinsurance, and a year prior to that the purchase of Transatlantic by Allegheny (NYSE:Y). Aspen's situation is a bit different in that the range of valuations in the sector are much more compressed within 95 to 110% price to book. This is part of my thesis for why Aspen should not fight this takeover. They have been offered a valuation that took them from the lowest to among the richest valuations in the space. As an aside, the timing for this is terrible, from the standpoint of the acquirer, Endurance. Aspen was trading more than 35% lower a year ago. I never understand why the "urge to merge" gets so strong after such a big run-up.
Thirdly, investment returns have been spiraling downward for all companies in the space, as they turn over their maturing bond portfolios at today's dismal yields. This unfortunate circumstance also has the double whammy of exposing their bond portfolios to risk in the event rates finally tick upward. It's a lose-lose situation for the industry, and the only protection is to either tighten up on shorter durations - hurting yields even more - or moving into equities or alternatives with their attendant risks. But my point is the bond market could switch from a tailwind to a headwind and become a drag on returns in this sector. In terms of current yield, that has already happened. This is one of the reasons companies have used surplus capital to buy back shares because at least that is accretive to earnings (but even that is no longer the case now that no company trades below book value any more).
Commentary from Endurance last week at the time of the buyout offer announcement mentioned operating synergies of about $100 million a year for the proposed combined company. I have never trusted those types of estimates. These types of numbers get influenced by "deal fever" and are almost always overestimated. In fact, I cannot think of a single merger that resulted in higher than estimated synergies. I am sure they can save some money by merging the two companies' underwriting and back office operations, but I feel those are best left as a bonus and not the basis of making the deal. Keep in mind this is a competitive industry and that some of those efficiencies would accrue to the ceding insurance companies and not necessarily shareholders.
In conclusion, I believe this offer is good for Aspen and somewhat bad for Endurance. My current position in AHL is solely in the form of naked puts (for an effective long equity exposure) and even the ones that I had sold in the money are taken out of the money now. For naked option writing that's as good as it gets and there is no further upside for my position. I have written about this strategy in a precious article. That's a situation I am quite happy with. It leaves me with the favorable problem of having to determine where to redeploy the capital. At the current price to book of AHL, it won't be in either AHL or in the merged company if the deal comes to pass. I probably will not reallocate within the insurance sector. Mergers tend to market near-term tops in a sector and not a bottom, as evidenced by Aspen's run up from $30 to $45 over the past year and a half. It's hard to call that a bottom! It's been a good ride but I think this buyout signals the ride is nearly over.